When Consensus Gets the Cycle Wrong ft. Dario Perkins

[00:00:07] Dario

They’re basically trying to recreate what the US has had over the last 50 years, which is that if you can get a vibrant defense industry, you know, these are high quality manufacturing jobs, science, engineering, technology. A lot of those sort of big technological breakthroughs, of the last 50 years in the US, have come from the defense sector.

I think Europe can see this as a catalyst for growth. And the countries that benefit most, at the moment, are places like France and the UK which don’t have a particularly good growth story or good sort of growth consensus. So, I think this is a really positive development.

[00:00:45] Intro

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

[00:01:40] 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 a 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.

[00:02:25] Alan

Thanks for the introduction, Niels. Today I’m delighted to be joined by Dario Perkins. Dario is MD of Global Macro at TS Lombard. He was previously a senior European economist at ABN AMRO. Previously in his career he was a senior Economic Advisor at the UK Treasury where he was advising Gordon Brown.

Dario, great to have you back. You’ve been on with us before but great to have you back. How are you doing?

[00:02:50] Dario

Yeah, it’s good to be back. There’s certainly plenty to talk about. Started the year with a sort of storm.

[00:02:57] Alan

Absolutely. I guess we’ll get into it. But uncertainty is back as a topic and geopolitics, and tariffs, obviously. But I guess, coming into the year, where everybody published their outlook and growth, I mean, I had a quick look at yours yesterday and you seem to be on the more upbeat side in terms of the growth outlook before, I guess, the most recent news came out.

[00:03:25] Dario

Yeah, I mean I’m still quite bullish about how the global economy is going to evolve this year. As you said, I wrote this note at the end of December, looking at the sell-side consensus for this year. And it was just incredibly boring.

Basically, everybody was expecting an exact rerun of what happened last year: similar levels of growth pretty much everywhere, inflation coming down a little bit further but not quite getting to central bank’s targets, interest rates going to neutral (these magical neutral estimates that central banks have sort of imagined, and yet the bond market’s completely bought into because it sees interest rates staying at those levels forever).

And then, when you read those outlooks, they will say the same thing. They’re these pockets of vulnerability. But it’s all about the K shaped economy. I mean if there’s one sort of big consensus idea in the world, right now, it’s this K shaped economy. The idea that some bits of the US economy are quite hot and doing well – the top of the K, so sort of high-income consumers, you know, Mega-Tech. Some bits of the K are doing quite badly. But those two things balance out, and they give you this sort of beautiful Goldilocks environment where all you need to do is think about AI and buy big tech companies.

And I just don’t really buy it. I think either things are going to deteriorate more, and that bottom of the K will get worse, and we’ll sort of slide into a recession. Or, much more likely in my view, with all the policy stimulus that’s coming in the world, we’ll actually see the bottom of the K start to recover. And I think global growth will bounce quite strongly this year.

A lot of this is about policy stimulus that’s coming in the US but also there’s a lot of policy stimulus in Europe and in China. And I think that people are underestimating that stimulus.

My worry, which is really for later in the year, is that with all this policy stimulus these governments are also doing things that are damaging the supply potential of their economies. The immigration controls in the US are the obvious example of this. But there are other countries pursuing similar policies because of the lurch towards populism.

And so, you sort of have a rerun of what happened after the pandemic, which is that we’re putting all this stimulus into the economy, but we’re also doing things that are damaging the supply side of the economy.

So, where do you end up? You end up with an inflation problem. And 12 months ago, I think if people had asked me for a sort of historical parallel, I would have said it looks sort of like the mid ‘90s. The economy is sort of landing, the inflation problem is going away, labor markets are rebalancing. It looks a bit like Alan Greenspan’s economy in the mid-‘90s.

That was before we had this sort of lurch again into populism and all of these supply side problems. And now I think this is looking a bit more like the late ‘60s. So, I have this period in mind, 1967 to 1969 in the US, which was in 1966 you had this sort of recession scare in the US. The Fed cut interest rates, but it looked like they delivered this perfect soft landing in the economy.

But under sort of enormous political pressure to get into interest rates down, and because they overestimated how much supply potential they had in the labor market, the Fed cut interest rates quite aggressively. The economy started to re-accelerate.

For a while, for about 12 months this was a really good narrative – reflation, bullishness, stock markets loved it, yields went down because the Fed was cutting interest rates. But within 12 months, the inflation problem starts to come back. Then the Fed has to deal with it. And then the environment turns quite toxic.

So, coming into this year, I do feel quite bullish about the economy. I don’t think we’re going to have an immediate inflation problem, but towards the end of this year and certainly into next year, I think you can see probably what’s going to bring an end to this cycle, and it will be policy tightening. And if we get that policy tightening, then I think things like worries about AI bubbles and all of that stuff then start to matter much more.

[00:07:36] Alan

Yeah, it’s interesting, as you say, that parallel between the ‘90s or the late ‘60s, and there are other parallels as well, I guess. You know, Nixon had price controls and now Trump is tinkering with interest rates and all manner of things.

I mean, you talk about stimulus and you draw a parallel with the pandemic. Now, clearly the amount of stimulus coming isn’t of that magnitude. But do you see, is the stimulus in The Big Beautiful Bill, is that what you’re talking about? And how big do you see that stimulus as being?

[00:08:12] Dario

Yeah, so there’s a few parts to it. So, in terms of fiscal policy, what the Trump administration has done is it introduced these tariffs. The tariffs (and we know from the revenue that’s been raised) were a fiscal tightening of about 1% of GDP. And they passed this budget bill in August, which was a 1% easing of GDP.

And so, a lot of people looked at that and said, well, they’re taking away with one hand and giving with the other, and those two things balance out and there’s no net effect. But what they forgot is that the fiscal tightening happened immediately, and we’ve already gone through that. There’s been that squeeze on the corporate sector in the US that came from these tariffs because they didn’t pass the one to consumers. And the boost from the tax cuts is actually starting now, at the beginning of this year.

So, what we’re doing is we’re going from a 1% of GDP tightening, to a 1% of GDP easing. And remember, if you tighten policy and then leave it alone, that alone, the effect on growth starts to fade. So, even if they hadn’t had the tax cuts, you’d have this sort of… the fiscal impulse would already be turning more positive. But now you have these tax cuts on top of that.

And in addition to that, there’s this talk about actually giving these tariff rebates. And these tariff rebates, which they were talking about $2,000 per taxpayer, they’re not even tied to what happens with the Supreme Court anymore. This is just a sort of promise to help the bottom of the K and it’s part of this sort of affordability agenda in the US.

So, if we get that, that’s another one and a half percentage points of GDP. So, suddenly going from minus 1% of GDP last year, and still recording 2% GDP growth to, potentially, one to two and a half percentage points easing this year. That’s big.

And on top of that, we’ve had the Fed cutting interest rates. It’s cut interest rates 150 basis points so far. They’ll probably cut interest rates a little bit more this year. There’s going to be enormous pressure on the new Fed chair, whoever that is, to keep cutting interest rates.

And if that wasn’t enough, you have an administration, as you said, that is sort of moved into the MMT book of, well, let’s think about things that we can do to sort of bypass monetary policy and get credit going again. So, you’ve got regulatory changes trying to get the banks to lend. You’ve got this promise to cap the charge on credit cards at 10%. You’ve got the whole sort of energy agenda that’s trying to stimulate the economy while getting energy (I’m not so convinced that bit’s going to work, but it’s part of this). And then you’ve got various attempts at sort of stealth QE with sort of issuing debt only at the very short-term, buying mortgages.

Everything about this policy is all about, let’s try and run the economy hot, let’s try and get things going. And if you listen to the Treasury Secretary, Scott Bessent, who gave this 25 minute interview on Friday, he was talking about, what do we want in our new Fed chair? We want somebody that’s going to do exactly what Greenspan did in the ‘90s and cut interest rates in order to allow this big productivity boom. And we want somebody that can get the rest of the committee to go along with that. They have to have gravitas and be convincing.

So clearly this is all pushing in one direction. This is about running the economy as hot as they possibly can and not worrying about the potential inflation consequences of that because they believe in this sort of AI productivity fairy that is going to rescue them from any of the inflation consequences.

So, you’re right, in terms of magnitude, this isn’t as big as what happened after Covid. But then I’m not talking about inflation going to 10%. I’m talking about inflation going the opposite direction to which the universal consensus of the sell-side and the buy-side think inflation is going to be lower.

You know, if you look at the sort of distribution of CPI forecast for the end of this year, there is nobody that can’t see inflation not falling. There is nobody that doesn’t think central Banks will be cutting interest rates. So, you know, we’re very sort of skewed in one direction, all of this stuff.

[00:12:26] Alan

Lots of interesting points to pick up on there.

The Supreme Court, productivity, the Fed, the inflation outlook. Maybe just to close off on the Supreme Court, just because that’s kind of front and center at the moment. I mean, what’s the market reaction likely to be? How would that play out if they do vote down the tariffs, I mean, obviously there are potential other routes for Trump to go down, but how do you see it playing out and what’s the likely market reaction?

[00:12:56] Dario

I don’t think there’ll be a huge reaction. I suspect that if they did vote it down, there’d be a positive reaction, in equities anyway. I’m not sure that bonds would like it because there has been this fiscal tightening that’s come from the tariffs. I think they will try to go past it.

You know, if you listen to what various members of the administration have said. They already have a plan B. You know, they’ve already thought through what’s going to happen, so, they’d probably move to that quite quickly, I guess.

You know, my one concern about all of this, and it sort of plays into the sort of storm that we’re having at the moment in the US (which is with these threats of tariffs on Europe) Is that we do need, at some point, this uncertainty to begin to fade a little bit because, as I said, I think this reacceleration in the economy is coming. But what we don’t want is a sort of another round of sort of stinging tariffs that make businesses reluctant to invest and hire again.

[00:13:55] Alan

Yeah, and on Greenland, on that, I mean, it could end up dominating for the next six months or it could go away in a week. It’s that kind of thing, I guess. I mean, what do you think? What’s likely to come out of Davos or how’s it likely to play out, do you think, in the next while?

[00:14:11] Dario

I think that we’ll get the TACO trade once again, the Trump chickens out again. I think that will probably come quite quickly. They’ll look for the sort of flimsiest of excuses to walk some of this stuff back. They’ll talk about having negotiations, and because Europe is going into these negotiations, they’ll take the tariffs off for a while, that sort of thing. So, I don’t think this is going to be a serious problem. I guess one element that does concern me is the sort of global investor response, which is, I think, after Liberation Day, global investors looked at the US and they said, what the hell is happening? There were these big question marks about the sort of basic competency of US policymakers.

And even though Trump chickened out again, and again, and that TACO trade was this sort of very bullish cry in the US, and retail investors loved it in the US. Global investors were still quite nervous about what was happening. These policies were still happening even after the various chickening outs.

And you’ve seen that in the dollar. There’s been a nervousness to have dollar exposure. I think we’re seeing that again over the last 48 hours. And it’s not that all these global investors are just suddenly dumping their dollar assets, but they’ve got these exposures and they’re starting to hedge them and that’s quite dollar negative. And this constant succession of examples of incompetence in the US, I just don’t think that’s helpful if you’re a global investor.

And you do have alternatives, now. If we’d gone back 12 months ago, I was quite bullish on European stocks, global stocks. I thought the US exceptionalism theme was massively overdone. People got very upset about that. They were shouting at me. They couldn’t see past constant US outperformance. And actually, the US underperformed last year.

So, in a context where your domestic markets are actually doing quite well, I don’t think you really need all that dollar exposure. So, I think that plays to this narrative as well.

[00:16:21] Alan

Now, you touched on Bessent’s remarks about the Fed, and we also had Trump saying he was leaning towards keeping Kevin Hassett in his current position because he’s such a good defender of the administration. And he does that most days on CNBC, it seems.

I mean, the prediction markets have been all over the place. Hassett was favorite. Warsh was favorite. Waller was favorite at one point, but I guess Warsh is now the favorite, is he?

Waller is kind of maybe what the markets might hope for in terms of a credible selection. I mean, how do you see it? Are there any others or people like Rick Rieder, even Jamie Dimon was mentioned at one point? Are there others out there that are possible?

[00:17:07] Dario

I mean, right now it looks very much like Kevin Warsh. I think if you sort of… I did some sort of game theory on this a few weeks ago, thinking, well, what happens if Hassett comes in? He’s going to do what the President. wants him to do and push for lower interest rates. But the FOMC as a committee, I think there’d be serious question marks about his credibility.

I’m not sure that the other members of the FOMC would go along with that. So, I thought if we got Hassett, we’d just end up with what was calling the sort of BOE-ification of the Fed, which is that we’d have these constant disputes, we’d have huge amounts of disagreement and dissent, and probably a Fed that just couldn’t move. It would just be stuck there.

And that wouldn’t be great because markets don’t like that sort of volatility and noise, and they don’t like a sense that the Central Bank is powerless to respond to whatever is happening. I think Bessent is quite smart. I think he’s thought about that and he said, well, Hassett is not a great fit for the Fed now because he’s not going to be able to carry the rest of the committee and deliver those interest rate cuts.

Whereas, personally, I have massive doubts about the credibility of Kevin Warsh as well. But I think he has these credentials. He’s been at the Fed, he was once a monetary hawk. He’s very skeptical about QE. He talks about shrinking the Fed’s balance sheet, crowding in the private sector.

A lot of conservative economists love these sorts of ideas. And I think he’s probably got a better chance of actually getting the rest of the committee to do what the President wants them to do and cut interest rates. So, I should think that’s the reason that they’re now moving towards him.

In terms of other candidates, I don’t think it will be Waller. I think investors would love the idea of Waller doing it because, you know, he wants to cut interest rates, but he wants to do it for the right reasons. You know, he hasn’t been talking about productivity fairies and all this other stuff that those other Fed want-to-bes are talking about. And he’s quite credible, but I just don’t think he’s going to…

I think, you know, the big thing for Trump is that he appointed Powell. And if you go back, you know, he regretted it within weeks. You know, within weeks he was saying, maybe I’ve appointed the wrong person. And obviously that’s just got worse and worse over time. And now we’ve got to the point where, you know, he’s calling him a moron, and a numbskull, and all these other words he’s used to describe Powell.

So, I don’t think he’s going to want to take any chance of doing that again. And I think he worries that maybe Waller would, you know, if the economy did rebound, Waller would probably change his views on interest rates. Whereas from Warsh and Hasset, you got this narrative of there’s this massive productivity boom coming. I’m going to be just like Alan Greenspan. It’s a great argument if you want to be on the Fed because it allows you to say, well, I need to cut interest rates, but I’m doing it because the economy is so strong.

Waller wants to cut interest rates because he thinks the economy is really weak. That doesn’t play to the narrative that everything Trump is doing is fantastic. So, it’s difficult to see him coming in.

Rick Rieder, I don’t know him particularly well. I’ve spent some time sort of researching his ideas. He seems quite consensus in terms of, you know, quite vanilla. He expects pretty much what I said the consensus expected this year, you know, growth to be 2%, inflation to come down towards 2%. He’s sort of optimistic on AI, but, you know, I’m not sure that he’s going to capture the President’s imagination in the way that Warsh has managed to do.

And the big thing about Warsh is that Trump thinks he looks good on TV. He’s in love with his boyish good looks. And so that seems to be playing into the arithmetic as well.

[00:20:59] Alan

Yeah, yeah. I mean, you do talk about credibility. And obviously Warsh was a Fed governor before, so it’s not like he’s without credibility. But at the same time, he’s not a hardcore economist, like Kevin Hassett, who has the economic academic credentials. And I mean, Warsh, he was at, I think, was the M & A and Morgan Stanley (or something like that) before the Fed. I think he is well connected in Republican circles, I think.

[00:21:28] Dario

I think he’s well connected to the Trump family as well, as far as I know, in terms of his wife and background. But I think that the issue of Hasset is that Hasset has done various things. You know, there was once a time that Hasset was sort of a vanilla conservative economist like other guys. I think that’s gone in recent years because, you know, number one, he apparently came up with a plan to fire Powell, which is not something you do if you value the independence of your Central Bank. And he’s constantly talked about how the statistics are being made up and, you know, they’re political. And I don’t think you do that if you valued the independence of the Fed either.

What makes me worried about Warsh is, you know, and I’m a bit skeptical about this productivity story. I think that’s a little bit too convenient. And, you know, when you hear him talk on TV, it’s very much, you know, sort of Team Trump. It’s as if he’s talking for the administration. And I just don’t think that’s something that you would do if you were truly independent. But I get it, you know, I think he can convince the rest of his colleagues to cut interest rates, which is what the job is going to be.

[00:22:34] Alan

Yes.

[00:22:34] Dario

I’m not sure that’s coming from an entirely honest place.

[00:22:38] Alan

If you take what Warsh says, at face value, you know, it could be problematic for the administration down the line. As you say, balance sheet reduction, how does that play out? We’re talking about an administration that needs to see its deficit financed.

And Warsh has these views, which it’s not clear exactly how it would be enacted. I mean, in this excess reserve world, is balance sheet reduction even feasible or plausible? I mean, is it just hot air, or is there a potential to see change here at the Fed in terms of how they operate?

[00:23:16] Dario

No. I mean, it’s sort of playing to the narrative of that the Fed has become too woke, it’s too involved, we need to trim it back. I think Bessent and Trump love that idea.

The issue is that if you look at what Warsh is actually saying, it doesn’t make a lot of sense. The idea is that the balance sheet has got so big that it’s crowding out private investment. And if you could cut the balance sheet, you could reduce interest rates.

Now, that sort of runs against the narrative that most people have believed over the last few years that if the balance sheet gets big, it suppresses interest rates and causes investment to get too strong. I think the only way you can sort of reconcile what Warsh is saying, is if there’s an implicit demand for fiscal tightening. Because then the argument is, you tighten up the government’s fiscal position, that allows the Fed to reduce its balance sheet at the same time, interest rates will go down, you then crowd in the private sector.

And that’s been a popular story with Scott Bessent as well, who keeps sort of channeling Rubinomics of the ‘90s, because that’s exactly what happened in the ‘90s. It wasn’t about the balance sheet, but it was about years of fiscal tightening during the ‘90s under Clinton and Robert Rubin, and Greenspan basically accommodating that by cutting interest rates.

So, you de-leveraged the public sector and re-leveraged the private sector. And at every opportunity, Bessent talks about this. So, there’s this sort of narrative out there, which is you get Kevin Warsh at the Fed, you get Scott Bessent at the Treasury, you get this supply side, Clinton-like economics.

The difficulty is that the revealed preference in all of this is the opposite. There is no sense in which this administration is tightening fiscal policy. Everything is going in the opposite direction. And so, if Warsh isn’t going to get the fiscal tightening, that this seems to be based on, there’s no chance

that he’s going to be able to rein in the Fed’s balance sheet. So, it’s all a sort of fantasy. I can’t see any of this happening.

I think this is just a fantasy and I think that all we’re going to do is we’re just going to end up having lower interest rates, running the economy hot, and eventually having some consequences from that.

[00:25:33] Alan

Yeah. He has, as you say, suggested a belief in the productivity boom similar to the ‘90s, the Greenspan era. Obviously, at a high level, you could draw the parallel, but things are quite different.

In the 1990s, you had the kind of Capex on the Internet spend, but it was the prior kind of, I suppose, investment in PCs and the greater adoption of PCs that was driving the productivity boom. And obviously the boom was very apparent. Growth was over 4%, I think, towards the end of the ‘90s. We’re not quite there yet.

But I mean, AI and productivity, the last couple of quarters, the productivity numbers have picked up a bit, so has raised hopes that maybe it’s starting to kick in. To date, it’s been more anecdotal, I think it’s fair to say. You know, what do you think is driving the most recent pickup in productivity? And is it reasonable to expect AI to have a meaningful effect at this stage?

[00:26:35] Dario

So, I’m a massive AI skeptic, but we can get into that. In terms of the recent productivity data. I think this is just an entirely cyclical story. I think what’s happened is that we had the pandemic. For a while, we had these massive labor shortages. And then companies went on this huge hiring spree where they were just desperate to get workers in, and they didn’t care about the efficiency of those workers. It was just about getting people in the door.

And then you come into this year, those labor shortages have gone. You get all of these tariffs. You get all of this uncertainty. You get this margin squeeze that comes from the tariffs and the fact that companies are reluctant to pass these on because they’re worried about the shape of the economy. And so, what happens is that they just stop hiring and they start to force efficiency gains on their workers. And they can do that because of the fat in the system that’s grown up.

Now, I think there has been an acceleration in productivity that started before the pandemic. Which is about this sort of tighter labor market and a hotter economy. So, I do think you are getting some productivity from that. But I think that is mainly a cyclical story about where the labor market is.

And I would be very cautious about expecting the productivity numbers of the last two quarters to just continue indefinitely. I think, if activity does accelerate in the way that I’m expecting, I think companies are going to have to start to hire again, rather than just keep trying to squeeze these efficiency gains out of their staff.

In terms of the AI story, firstly, I think there’s massive question marks about how much AI is going to boost whole economy productivity. You did get this sort of productivity boom in the late ‘90s. I think it’s going to be quite hard to replicate that. I think that people that work in this industry, or in the tech sector, have a slightly distorted view about what the rest of the economy does.

Most people do not work in industries where AI can just replace what they’re doing. They work in the NHS or in the supermarket. So, I think there are question marks about this sort of massive labor shedding that people talk about.

But my big problem with this whole AI productivity story, let’s do another Greenspan story, which you’re getting from all of these want-to-be Fed chairs right now, is that it’s just not an honest description of what actually happened under Alan Greenspan. Because what happened under Alan Greenspan is that you got to sort of 1995. 1996, and Greenspan starts to think that productivity is improved, but this isn’t being recorded in the official statistics. So, he says to the rest of the staff, let’s hold off raising interest rates, let’s see how this is playing out, I think there’s this productivity boom happening and I don’t think we should be raising interest rates.

And a big part of that story was that you had this traumatized worker. This idea that workers were getting replaced so they weren’t demanding big increases in wages. So, all of this productivity was going to profit margins and lower prices.

I think that basic story turned out to be wrong, because even though it was true that productivity was accelerating. What really happened is that wages actually followed. So, from 1995 to 1996, you get this acceleration in productivity in the US, but you also get this acceleration in wages, and profit margins actually go down.

So, the idea that you had a traumatized worker that couldn’t demand wage increases turned out to be wrong. And even the way that Alan Greenspan reacted to this story changed.

So, in 1995, 1996, this was a reason to be dovish. We don’t need to raise interest rates. Maybe we can cut interest rates. By 1999, 2000, he started to think that all of this investment was actually pushing up the neutral Interest rate, the sort of R squared number that central banks are again enamored with. And he argued that this was a reason for actually raising interest rates, that you had too much investment, the economy is starting to overheat. He believed in all of these wealth effects as well. And so, he pivoted quite hard and became a hawk on all of this stuff.

And these Fed officials today, or want-to-be Fed officials, for their own sort of convenience, are saying, well, let’s do what Alan Greenspan did in 1995. But they’re forgetting the 1999 version of Alan Greenspan, which was very different.

And I think what this shows you is there are big question marks about how this all plays out, because in the first instance, there’s a question about how much productivity will actually improve as a result of AI? There’s then a question of will this go into wages or will this go into profit margins?

And if it goes into profit margins, is that going to allow companies to cut their prices, or are they going to keep raising their prices and allow their profit margins to go up, in which case there’s no deflationary effects? And then you have this question of, if all this investment is happening, and all these AI data centers are massively energy intensive, shouldn’t that cause equilibrium interest rates to go up?

This is a really complicated story. It’s something that we’re going to have. To monitor over time. But this very simple narrative of, oh, look, the AI fairy is here, let’s just cut interest rates. It’s just not true.

[00:31:56] Alan

But you’re right, I mean, the theory is high productivity is a higher trend growth and a higher neutral rate, as you say. But there is a timing dimension to it.

But, yeah, I mean, sorry, one of the things that struck me is I went back to the last minutes, just because I hadn’t been following them so closely, to see what is the Fed saying about this? Nothing. I mean, productivity, I think the word productivity appeared twice in the last minutes. So, clearly it is something that’s preoccupying the minds of the markets and these Fed candidates, but not hugely the Fed.

I think, at the last press conference, Powell said, he referenced it, he says, yeah, I can see how it might have an impact. I use ChatGPT a bit myself, or something like that. But it doesn’t appear like the Fed is really grappling with this as a kind of an ideological issue at the moment, is that fair to say?

[00:32:50] Dario

I think so. And I think that part of the reason for that is that the Fed doesn’t really engage in the sort of meme-anomics that we seem to be subject to these days, which is that there are these narratives out there which are just not true, which appear all over Twitter and on social media. And one of the big narratives of last year was that the only reason the US economy was growing, or avoiding recession, was because of all this AI investment. And AI was the only thing that was propping up the economy. And that story just wasn’t true.

It wasn’t true at all. And if you look at the contribution of AI Capex to GDP, there was one quarter where it was sort of outsized contribution, mainly because everything else was so weak, because it was just around Liberation Day where the economy just froze for three months. But as a story, as a whole, the impact of AI was trivial, you know, really not a big economic driver. And so, the idea that this was driving productivity is just not true.

But also, the idea that we’re seeing massive job losses, which is another story that’s all over social media that AI is already generating job losses. Look at what’s happening with new entrants. The unemployment rate for 17 to 24 year olds is rising rapidly and the narrative is that’s all because of AI. And again, it has nothing to do with AI.

What’s really happening is you have an economy where companies are reluctant to hire, but they’re not firing anybody either. And for most age groups, those two things balance out. You don’t get fired, but you don’t get hired either. So, you’re just sort of stable.

But if you’re coming out of school or university, and going into the jobs market, and there’s no hiring, naturally the unemployment rate of those groups will go up. But it’s not because of AI. It’s just maths. That is just mathematics. It’s nothing to do with AI.

And so, I think that there is this massively overinflated story about what macroeconomic impact AI is actually having on the economy. And if you’re a policymaker, this sort of AI question is sort of interesting for the next sort of five years. How is this going to play out? How should we respond? But it isn’t the thing that’s driving your interest rate decisions right now.

Unless you want to join the Fed and come up with a good reason for cutting interest rates that isn’t, I’m really worried about the economy because Trump’s tariffs are causing all this destruction.

[00:35:24] Alan

You presented your more upbeat case, and we did touch on Chris Waller. I mean, Waller has been at the forefront in calling for lower rates on, kind of, the weak labor market, at least going back over the last six months. Not as much as Steve Miran, but he’s kind of been in that direction.

I mean, where would you disagree in terms of the economic outlook to, say, Chris Waller, who seems to have got it pretty right in the last one to two years?

[00:35:51] Dario

I think it’s on the labor market. So, I think that Chris Waller is quite concerned about the state of the labor market. I think we haven’t seen any job growth in the US for six months. That is incredibly rare outside of recessions. And by incredibly rare, I mean it has, literally, never happened before. Typically, once the US economy stops adding jobs, it sort of breaks below this stall speed and then chips over into a recession.

And that’s the sort of whole basis of the idea that there is this stall speed in the economy. Once you get growth below a certain level, things just sort of deteriorate nonlinearly. And there’s definitely historically been this reflexivity. You know, when companies start to lose jobs, that hits confidence, hits spending, feeds back into profits, leads to more rounds of redundancies. I mean that I think is the definition of a recession, that exact dynamic in the labor market.

And so, I think, you know, some Fed officials have looked at the state of the labor market and said, you know, we are really dangerously close to stall speed here. If this was a normal economic cycle, we’d probably be headed for a recession. This is something that we need to guard against and cut interest rates. And I think they look at their mandate and say, well, which part of the mandate is likely to spiral against us? Is it inflation or is it jobs? And I think their view is it’s all about jobs.

But I think they’re just misreading what’s happening in the labor market. I think the weakness in the labor market is all about this policy uncertainty. I think companies have been reluctant to hire. I don’t think they needed to hire because of this fat in the system that’s allowed them to push these efficiency gains.

And so, I think as the sort of demand comes back and confidence comes back, I think companies will start hiring again. I think we’ll bounce away from this stall speed. And I also think a big part of this weakness is the labor force because, if you’ve got these very stringent immigration policies, and your net immigration is probably negative, including sort of illegal immigration, I think the labor force isn’t growing. And so, you know, I think it makes it that much harder to sort of trigger stall speed.

The other reason I don’t worry about the labor market too much is I don’t think there’s anything fundamentally wrong with the economy. You know, typically that stall dynamic happens because there is something quite profoundly wrong. You know, you’ve got some big misallocation of resources, or you’ve got some big credit bubble in the system, and then the labor market stalls because that bubble is bursting. And then as it bursts, you get this sort of big deterioration.

I don’t see that right now. There’s no over investment. Maybe big tech is spending too much on AI but, as I said, that’s not a massive macro story. I think if you look at the corporate financial position is basically balanced. Typically, that’s in deficit and the deficit Is getting bigger ahead of a recession. There’s no obvious credit bubble. Credit hasn’t really cycled. For the last 15 years, since the global financial crisis, we’ve deleveraged a long way.

So, I just don’t see anything fundamentally wrong. I think we’ve had a sort of reckless administration that’s been doing all of this stuff that is producing a degree of chaos and uncertainty and that’s been the thing that has prevented hiring. But I don’t think it’s enough to tip the economy over.

[00:39:23] Alan

Good stuff. I mean, curious to get your thoughts on bond markets. I mean, US markets have been very stable. I guess you’ve had different forces. On the one hand, deficits have been high and rising. At the same time, the Fed’s been easing and the curve steepened.

Outside the US we have seen this trend of higher yields continuing, very notably in Japan, even in Germany at the long end. What’s your read on the US markets, and, I guess, if your scenario plays out this year of a resumption of growth, presumably risks to the upside for yields?

[00:39:56] Dario

Yes, so, my view on bonds for a while has been that Covid would mark this sort of secular turning point in yield. So, we’ve been on this secular bull market with yields coming down. It was 20 years of lower lows, and lower highs in yields. And I felt that Covid would mark that turning point and we’d now be in a world of higher highs, and higher lows, over time.

And I think that’s basically playing out. I think part of it is a resilient story. So, the fact that all of these central banks raised interest rates, they did it much more than people expected. Nothing really went wrong, nothing broke, the economy has proven to be quite resilient.

I think we’ve had a bull market that for, sort of, three, four years has played with this idea that maybe there’s going to be a recession. So, you’ve had these drops in yields, but then the recession hasn’t materialized and yields have rebounded. I think that’s very much where we are.

I think about yields in sort of three components. So, you think about real yields, inflation expectations, and the term premium. And I think real yields are about right. I don’t worry too much about that. Inflation expectations, the market expects an era where inflation is slightly above target as opposed to being slightly below target. Again, that’s something I agree with. That’s something I’ve been saying for a number of years now. That sort of basic tendency of inflation has changed, but not in a particularly alarming way.

It’s all about the term premium. And I think if you look at the term premium now, we have the same term premium that we had at the end of the 1990s. Now, the 1990s, we did get the Rubinomics. We were running budget surpluses by the end of the 1990s. We had a decade of supply improvement. We had rapid globalization, tariff barriers coming down everywhere, collapse of the Soviet Union.

All of those were the sorts of environments that would push the term premium down. So, it’s slightly concerning to me that we have that same term premium now, even though all of that is going in the opposite direction.

The fiscal deficits are staying bigger, governments are playing a much more activist role in the economy. We’ve got a series of negative supply shocks, whether that’s immigration, or trade barriers, or whatever. You’ve got the potential for continued disruption to supply chains from geopolitics and all of that stuff.

To me, that’s all upside for the term premium. I struggle to see how the term premium could come down. I think it’s much more likely to rise over time. And I think that’s the thing that’s going to drive yields higher over time. And to me, the term premium is all about the sort of basic insurance properties of bonds.

For a long time, we’re in this really nice dynamic where inflation and growth just move together. They went up together; they went down together. It gave you this beautiful negative correlation between bonds and equities. And that meant that bonds had this really strong insurance property, particularly if you could trust into the Fed, and the independence, and all of that stuff.

I think if you’re in a world where you start to think more about supply shocks, and you’ve got these doubts about the credibility of the Fed, for all of the reasons that we’ve explained, I think that sort of bottomed out equity correlation starts to change. And it’s not that it’s going to be positive all the time, like it was in the 1970s, but it’s just not going to be as negative as it was on average. And there’s going to be periods, like the last couple of years, where that correlation will be positive.

And if that’s the case, bonds aren’t such a good equity hedge anymore and the term premium has to widen. Because the term premium is like the insurance fee on holding bonds.

[00:43:46] Alan

So, I mean, practically, what could that mean? I mean, obviously 10-year yields have been stuck around 4.1%, 4.25%. I think we’ve touched above, maybe touch at 5%. Could you see them going above there at some point?

[00:44:01] Dario

I mean, I can definitely see another 100 basis points on the term premium, which would push up the whole curve. I think that’s the risk here. I just think everything is pushing in that direction. At the moment we’ve talked a lot about Fed independence. Whoever gets the job, I don’t really trust them at this point.

The fact that they’ve sort of threatened J. Powell with jail time doesn’t scream that the next Fed chair is going to be completely independent because that surely will be on their mind. If I didn’t do what Trump wants me to do, am I going to end up in jail? Do I want to go to jail or do I want to cut rates? So, there are these questions.

I don’t think that’s really playing into market dynamics right now. I think that, for most people, this is a theoretical discussion. They don’t know who the next Fed chair is going to be. They don’t know what the economic outlook will be.

If we’ve got a recession, it will be easy for the Fed to cut interest rates and wouldn’t have anything to do with independence. I think, if I’m right, the economy starts to re-accelerate and that’s when this stuff starts to matter again. Because then you get into questions, well, is the labor market tightening up? And if the labor market is tightening up, shouldn’t the Fed be raising interest rates? And if the Fed is still talking about cutting interest rates, why? Why are they doing that? That’s when these independence questions start to matter a lot more.

[00:45:22] Alan

And we’ve obviously seen this kind of strong bond market reactions in Japan of late. Just looking at it here, Japan 10-year yields were up to just under 2.4%. And obviously, for a long time Japanese yields were zero or negative and then started to move up ‘20, ‘23 or so.

I mean, for a long time people thought, okay, big sell off in the JGB market, rising yields, that would unwind the yen carry trade, we’d get a big surge in the yen. That hasn’t happened. It seems to be more Japanese bond market weakness being associated with a weak end. Is that the new dynamic or are we waiting for something to break with respect to Japan or how do you read it?

[00:46:03] Dario

Yeah, I’ve never really bought into the argument that sort of Japanese buying is distorting the term premium in the US, or keeping yields artificially low. So, I think that link between US yields and Japanese yields was always a bit overstated. You know, I never really bought into that story. I think you can explain the term premium, as I have done, with sort of macro fundamentals rather than, you know, flows or (What do they call it?) sort of savings gluts, and those sorts of arguments.

I regard what’s happening in Japan as sort of bullish in the sense that, for the last 30 years, Japan has struggled with this deflationary trap, and they finally seem to be out of it. They’ve got this mild wage price dynamic. Which is not anything alarming. This is a sort of normalization. That deflationary psychology is gone.

One of the big takeaways, I think, that you do have from this is that demographics are not deflationary. That was the consensus before the pandemic, that aging populations would give you ever lower bond yields. I always thought that story was wrong. And I think this demographic inflection point in Japan is actually pushing yields higher. And at the moment I regard this as sort of normalization.

The Japanese economy is gradually normalizing. The bank of Japan is pushing up interest rates. I think they will be quite cautious in doing that because they don’t want to get a sudden appreciation of the end, which is the thing that’s always killed them in the past when they’ve tried to raise interest rates. But I think this is a welcome dynamic.

And the same story for Europe. You asked about Europe as well. I think for a long time Europe was obsessed with this idea that it was turning into Japan. You were going to get this deflationary dynamic. We had years of ECB QE. We had years of negative interest rates. If negative interest rates aren’t a sign that something has gone profoundly wrong, I don’t know what is. And we’ve emerged from the pandemic with a much more healthy labor market. It’s a higher pressure labor market that is generating wage growth that’s allowing all of these central banks to move interest rates higher. I think that’s a pretty good dynamic. And I don’t get the sense that it’s going too far.

And I think even the sort of fiscal concerns about those countries are a bit overdone. You take Germany. Germany is going to do what, 2% of GDP in fiscal easing this year. But it’s happening against a backdrop where only 12 months ago everyone was obsessed with the prospect of de-industrialization and some sort of German depression. So, you know, there’s plenty of spare capacity in Germany.

I don’t think that fiscal stimulus is going to go into inflation. I think it will go into growth. And that’s probably good news from the perspective of the ECB, given what it thought it was facing a decade ago.

[00:49:07] Alan

Certainly, Germany has obviously taken dramatic steps in terms of the debt break and their announcements around infrastructure spending and defense spending. You mentioned kind of the stimulus, at the start of the conversation, in Europe as well. So presumably that’s what you’re talking about.

I mean, from a European perspective, do you think that’s going to see like a notable change in the growth outlook this year? Listening to the ECB, at the back end of last year it seemed to be, I saw Isabel Schnabel speaking. She was saying risks were now tilting more to the upside for inflation and rates. Is that your read as well?

[00:49:46] Dario

Yeah, I think so. I think that people are much too bearish still, in Europe. I think there’s a sort of… I talked about meme-anomics. There’s definitely a meme-anomics about Europe, which is, it’s that sort of image of rockets landing in the. US versus the bottle top in Europe being attached to the bottle. You know, this is European technology; this is US technology.

I think that, you know, Europe has emerged from COVID in a pretty good position. I think, you know, they’ve got a much better labor market, a higher pressure labor market that is creating wage growth. I think it will create productivity. I think there’s plenty of pent-up demand. You look at savings rates, they’ve been quite high in recent years.

I think that people looked at the European economy, post Covid, and they were just too bearish because they were forgetting that Europe faced a series of really nasty shocks. We had that period where inflation was running at 15%, and wage growth was running at 2%. So, this enormous squeeze on real incomes, which was never nearly as bad in the US.

You had a global manufacturing recession for three years because coming out of the pandemic everyone was buying goods. They then rotated into services. So, you’ve got a manufacturing recession on the back of that. If you were a company in Germany or France or even Asia, this was effectively a global recession that you were facing, and you had this massive monetary squeeze.

The ECB and the Bank of England, they chased the Fed in raising interest rates. They tried to sort of ‘out hawk’ the Fed, but the issue was that most of US debt is tied to long-term, and Europe has huge amounts of variable rate debt, particularly on the corporate sector.

So, if you looked at the squeeze that was engineered by interest rates going up, it was much greater in Europe than it was in the US or some of these other countries. And all of these factors have now unwound. You know, wages are outpacing prices. So, the cost of living crisis is gone.

The ECB has cut interest rates much more quickly than the Fed and has gotten back to what they think is neutral. It’s probably fair, I mean I don’t put a lot of weight on neutral rate estimates, but it seems like credit is flowing again. It seems like the construction sector is starting to turn. And, you know, that sort of manufacturing recession, the inventory overhang is gone. The uncertainty from the tariffs is clearly weighing, but eventually that dissipates too.

So, I think that you could see. A pretty good boost coming to Europe, with or without the fiscal spending. And now you’ve got the fiscal spending on top. Now that fiscal spending is pretty significant. The fact that it’s coming in Germany is also significant because it means that Germany can’t lecture the rest of Europe about the need for austerity, which is how it spent most of the 2010s. And one of the things people missed is…

I looked at consensus forecast for Europe for this year and they were basically assuming that you’d get this acceleration In German GDP which was just a sort of fiscal story. But they were missing the fact that everybody in Europe, their biggest export partner is Germany. So, if Germany does re-accelerate, that is really positive news for France, Italy, you know, all of these European countries, the UK.

And so, I think they’re missing potential spillovers from this to the rest of Europe. So, you know, I think, particularly compared to the consensus 12 months ago which was all about de-industrialization and this really sort of quite bleak outlook for Europe, I think there’s a really positive story here.

And I even think, if you look at this longer term, you know, one of the pushbacks I get from investors is, well, what’s the point of defense spending? You’re just buying bombs and recruiting soldiers.

And even here I think they’re sort of missing the point because, if you’re as sad as me and you read these sort of European policy documents on what they’re trying to do here, they’re basically trying to recreate what the US has had over the last 50 years, which is that if you can get a vibrant defense industry (and the emphasis is on industry rather than just the army) these are high quality manufacturing jobs, science, engineering, technology.

A lot of the big technological breakthroughs of the last 50 years in the US have come from the defense sector. I think Europe can see this as a catalyst for growth. And the countries that benefit most, at the moment, are places like France and the UK which don’t have a particularly good growth story or good sort of growth consensus. So, I think this is a really positive development.

[00:54:30] Alan

So, I mean, will that be enough to address the budgetary issues in the likes of France? Obviously, you know, they’ve been struggling to pass a budget for a while. Obviously, deficit levels are high. The kind of the old master criteria have been brushed aside because they’ve been too hard to adhere to. Was that a story for last year, unlikely to be a story for this year, do you think, or how do you read that?

[00:54:55] Dario

I don’t even think it was a story for last year. I think it was a story in sort of punditry for last year. I don’t think it was a big story in terms of markets. I think it’s quite hard to get excited about European fiscal anymore because firstly, I think stronger growth helps, but it’s more about the sort of dynamic.

I know there’s this sort of PTSD from the euro crisis, but it’s just really hard to get that dynamic again. Because at the heart of the euro crisis there was this question about a backstop for the system. And I remember 2011, 2012, 2013, every conversation with global investors was, where’s the backstop? Is it going to be Germany? Is it going to be the ECB? The Germans didn’t want to do it. The ECB didn’t want to do it. Trichet was reluctantly buying bonds.

And at that time, it was basically a one way bet against these countries because if you dumped Italian bonds, the spreads would rise, it would demand more austerity or the Germans would demand more austerity as a solution to that, it was completely unsustainable. So, the odds of one of these countries quitting the euro intensified.

So, it became this sort of self-fulfilling one-way bet. And there are a lot of hedge funds from the US and the UK that were playing that way one way bet. And then when Draghi came in and said he’d do whatever it takes to stop this, it stopped.

The one-way bet became symmetrical. If you were shorting these bonds, there was a good chance the ECB would come in and blow you up with their unlimited balance sheet. So, nobody was interested anymore.

And personally, I think since then I’ve just not found European politics interesting at all because I don’t think it’s a market story. And so, I can’t see those sorts of dynamics coming back because I think the ECB has understood that part of its role, as a sort of modern central bank, is to be this backstop; that it has to protect monetary transmission.

So, I just don’t think this is going to be a big story again, this sort of Euro crisis dynamics. The only way in which this becomes relevant to markets again is if you end up with some anti-EU government that actively wants to pursue the end of the euro or leaving the euro, and then you’ve got a serious political crisis. And at that point it doesn’t matter what the ECB does because they can’t backstop a government that wants to leave the currency. But right now, that doesn’t seem likely.

[00:57:28] Alan

Fair enough. Just conscious of time, I mean, we haven’t talked about China at all. And obviously, I mean, China’s been recovering gradually from its own adjustment, kind of the property downturn and we’ve had various stimulus measures. But I suppose the big debate around China has been its orientation of trying to export its trade surplus, its excess capacity to the rest of the world. And that being a pushback, obviously, in some places like the US and also with some tariffs in Europe.

I mean, how do you see that getting resolved over time? Is that a sustainable… I’m assuming it’s not a sustainable model for China, but is that going to be a pressure point in the system?

[00:58:14] Dario

I think they realize now, quite seriously, that they have to rebalance their economy away from exports. I think they’ve realized that there can’t be a sort of China shock 2.0. Because the rest of the world doesn’t want to absorb that spare capacity in the way that they did after the original China shock.

I think, if you go back to the early 2000s, economists were quite naive about this stuff. They thought that trade was unambiguously good and, you know, cheap stuff was good. And, and I think that consensus has changed.

And I think certainly, you know, as soon as we started to see these EVs and stuff coming out of China, I think you’ve seen this sort of reaction from the rest of the world. The tolerance for that isn’t there.

I mean, I was bearish on China for a long time. You know, back in the sort of the mid 2010s you could see that this was basically the biggest credit bubble in history. And although there was this sort of stop/go policy, and they were just adding huge amounts of leverage to the system, you could see that, in the end, that was going to affect growth in a really big way.

I never thought that China would have a sort of Lehman moment, but I thought that you couldn’t completely cheat the rules of economics, and eventually you get this sustained slowdown. That’s definitely what we’ve seen over the last few years.

I just think now the pressure is growing for China to re-stimulate the economy. Again, I think the consensus has given up on this idea. So, the consensus forecast is just that this year will be weaker than last year for China. If you look at credit or infrastructure spending or any of that stuff, nobody’s expecting anything. They’ve completely given up on the idea of Chinese stimulus. So, compared to expectations, I think there’s reasonable chances of a positive surprise here. And, you know, I do think they’re going to be willing to spend more.

You know, we’re not going to get the enormous fiscal splurges that we had in the 2010s, because they’ve seen that that can be quite dangerous. But they’ve also realized that they’ve got to get the economy growing again. So, we’re sort of, you know, we’re re-accelerating, not just 10% growth rates, but, you know, compared to consensus expectations, plenty of room for positive developments.

[01:00:29] Alan

Good stuff. So, it sounds like overall some reasons for optimism growth, maybe not as boring as the consensus is suggesting. And I mean, that’s all assuming, I guess, that this Greenland stuff blows over reasonably soon. Is that a fair summation?

[01:00:48] Dario

I think so. If we’re going to get some massive escalation in the trade war, then that changes things. But so far, everything we know about Trump is that TACO usually kicks in quite quickly, and the tolerance for pain isn’t there. And ahead of the midterms, in particular, this is all about getting the economy growing again.

And it goes back to this K shaped economy. There’s this sort of naive investor belief that the K shaped economy is just going to persist indefinitely, but politically it doesn’t work. You can’t have it, particularly when you come in with a populist agenda. And so, you know, they need to get the bottom of the K to recover.

And my concern is that once you’ve got a recovery in the bottom of the K, the top and the bottom. no longer cancel each other out and you’ve no longer got this Goldilocks environment.

So, you know, I think this is a bullish environment. I’m quite optimistic on stock markets, global stock markets. I think that’s going to be the dominant story for the next six months. All I’m saying is that I think you can also see, for the first time, how this cycle is actually going to end.

Maybe that’s a story towards the end of this year. Maybe that’s a story for next year. But I think this overheating dynamic probably cuts the cycle short. So, bullish, but not bullish in the sense that this is just like 1995 where this can continue for the next five years, thanks to the productivity fairies.

[01:02:12] Alan

Yeah, good stuff. Well, appreciate you coming on and people can follow you and your comments on X. I think you’re fairly active there still and competitive, I think, at times as well with some participants, but always great to get your thoughts.

[01:02:28] Dario

The thing is, I don’t really get into arguments with people on X. I tend to be quite critical of policymakers and it’s not about politics. I’m critical of all policymakers. I’ve been just as, as critical of the Europeans as I have about the Trump administration. I just think these are the sort of masters of the universe and we should be free to criticize them when we think they’re going in the wrong direction.

[01:02:53] Alan

Absolutely. But always appreciate your frankness on that side. So, thanks for coming on. From all of us here on Top Traders Unplugged, stay tuned. We’ll be back soon with more content.

[01:03:06] Ending

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