Top Traders

12/10/2024 by Betsy McDowell

Commodities, often viewed as volatile and unpredictable, are poised for a resurgence, presenting a compelling opportunity for savvy investors.
Adam Rozencwajg, reveals why commodities are radically undervalued and poised for a potential upswing.
What are the intricacies of commodity cycles, the factors driving current undervaluation, and the potential catalysts for a resurgence in this asset class today?

When constructing a diversified investment portfolio, most investors gravitate towards familiar territory: stocks, bonds, and real estate. We might consider sprinkling in some gold or perhaps a broad commodity index. But rarely do we delve into commodities like oil, natural gas, copper, and uranium — assets often perceived as volatile and unpredictable.

“Commodities, as we all know deep down, move in these big, long cycles,” says Adam Rozencwajg, Managing Partner at Goehring & Rozencwajg, a firm specializing in natural resource investments.

Adam, with his partner Leigh R. Goehring, has spent decades charting the intricacies of commodity markets, identifying value where others see only risk. Their approach, honed through years of research and analysis, centers on understanding the ebb and flow of these long-term cycles.

Adam's perspective challenges conventional wisdom, suggesting that we may be on the cusp of a significant shift in commodity markets. He points to historical precedents, where major changes in monetary systems triggered commodity bull markets. “We firmly think, looking at history, that this time is going to be no different,” Adam asserts. “I think we're in the right zip code, as they would say in the US, the right neighborhood, for change in the monetary systems, just like we had in those other times. And I suspect that that will be the ultimate catalyst here.”

Cem Karsan and I invited Adam back to a Global Macro edition of Top Traders Unplugged for another fascinating discussion exploring the complex world of commodities. We delve into Adam's big-picture framework, discussing the historical context of commodity cycles, the factors driving current undervaluation, and the potential catalysts for a resurgence. Join us as we unpack the nuances of this intriguing asset class, uncovering valuable insights for investors seeking to diversify their portfolios and capitalize on contrarian opportunities.

Understanding commodity cycles

Adam, a staunch believer in cyclical patterns, emphasizes that commodities are not merely speculative assets subject to the whims of short-term traders. Instead, they are deeply entwined with the fundamental forces of supply and demand, capital expenditure, and investor sentiment. These forces, he explains, create a cycle of booms and busts.

He elaborates on how these cycles play out: “There are periods of time where commodities are in a slight deficit, and prices can rise quite dramatically. Companies, at the time, earn supernormal profits. It’s not uncommon to see them have yearly cash flow returns of 30% or more in the good years. Money, at some point, flows in to chase those returns. Stock performance is very high. And there’s a virtuous cycle there, pushing stock prices higher, attracting more capital. And then it becomes a classic reinforcing cycle.”

This “virtuous cycle,” however, eventually sows the seeds of its undoing. Adam explains, “What eventually happens, though, is too much money comes in and eventually too much supply comes online, and the market slips from deficit into a surplus. Prices collapse and investor returns plummet.”

To grasp the current scenario, it's essential to understand these historical cycles. Adam points to several periods where commodities became radically undervalued relative to financial assets, each triggered by a seismic shift in global monetary systems:

1929: The end of the classical gold standard, marked by the reversal of Benjamin Strong's experimental quantitative easing policies, led to a decade of strong outperformance for natural resource equities.
1968: President Johnson's decision to remove the legislative mandate for the US Dollar to be backed by gold coincided with the bottoming of the commodities-to-equity ratio, paving the way for the commodity boom of the 1970s.
1999: A complete reordering of Southeast Asian and Chinese central bank policies, shifting from a dollar peg to a below-market rate to spur exports, resulted in a subsequent surge in commodity prices.

Adam argues that these historical precedents reveal a crucial insight: major shifts in monetary systems often act as the catalyst for new commodity bull markets.

Uncovering value in commodity markets

The million-dollar question, of course, is: are we on the verge of another such shift? Adam believes we are, and the evidence, he argues, is hidden in plain sight. Despite strong fundamental factors pointing to a commodity upswing, investor positioning remains stubbornly low.

“There’s almost no exposure from these people in the market,” Adam observes. “An easy way to look at it, maybe not the most precise but fairly easy, is that you look at what’s the energy weighting of the S&P 500? The long-term average is 10%, 12%. The bull markets top out at 25% and 30%, and they bottom historically at 5% or 6%. So, in the last four years, the high in the energy weighting in the S&P is more typical of past cycle lows.”

This lack of interest in commodities extends beyond just energy. Adam points to consistent outflows from commodity-focused ETFs, indicating a broad aversion to the asset class. This, he believes, creates a compelling contrarian opportunity. The current underinvestment in commodities, driven by factors like the rise of passive investing and the allure of technology stocks, has led to a disconnect between valuations and underlying fundamentals.

“If all I had to work off of was the underlying data, and the supply and demand figures for the different commodity markets, I would be as excited and as enthusiastic as I’ve ever been,” Adam states. “But instead, when you look at the price action, it certainly has been frustrating. And there, of course, lies the value. The disconnect between the two is that the fundamentals have only gotten better.”

Years of underinvestment in exploration and production have resulted in tight supply conditions across various commodity sectors. This is particularly evident in energy markets, where US shale production has peaked and is now in decline. Simultaneously, emerging markets like India and Indonesia are experiencing rapid economic growth, driving increased demand for commodities like copper and energy.

The ongoing green transition, despite its challenges, is also expected to fuel long-term demand for certain metals and minerals. Adam also points to another critical factor: the precarious state of the current global monetary system. Burdened by excessive debt and sustained by experimental monetary policies, the system is exhibiting signs of instability.

Adam sees this as a potential trigger for a major shift that could propel commodities to the forefront of investor attention. These factors, when viewed collectively, present a compelling narrative of undervaluation and opportunity within commodity markets. However, volatility is an inherent characteristic of this asset class, and understanding its nuances is crucial.

Navigating volatility and risk

A discussion about commodity investing is incomplete without examining the volatility of this asset class. Prices can swing dramatically in response to geopolitical events, weather patterns, economic data and even investor sentiment.

As Cem points out, it’s important to understand not just the direction but also the potential for sharp, unpredictable movements.

“The catalyst that often pushes these things back into line is volatility,” he observes. “It is dislocations. The reason is that people are aware that this cycle is going on, and they are buying. That said, these things can become undervalued and stay undervalued for some time.”

He likens investing in commodity producers to “net selling puts,” a strategy that profits when prices remain above a certain level but carries the risk of significant losses if prices fall sharply. This is a crucial point for investors to grasp, as commodity producers, while offering leverage to rising prices, are also exposed to the downside risks inherent in the underlying commodity.

Adam, while acknowledging the volatile nature of commodities, argues that this very volatility presents opportunities for savvy investors. “I do anticipate that the moves higher will be volatile, they’ll be unfortunately probably chaotic,” he concedes. “You’ll have periods of time where they will undoubtedly have pullbacks, the likes of which we’re in now.”

He advises investors to focus on the long-term fundamentals and resist the temptation to react impulsively to short-term price swings. This requires discipline, patience, and a deep understanding of the underlying forces driving commodity markets.

“The stock market for commodity stocks used to be more of a discounting mechanism than it is today,” Adam reflects. “It used to be more of a future-looking forecasting instrument than it is today.”

Adam argues that this shift highlights the importance of taking a contrarian stance and looking beyond the market's short-term noise. By embracing a disciplined approach and maintaining a long-term perspective, investors can navigate the inherent volatility of commodities and position themselves to capitalize on the potential rewards this asset class offers.

Embracing contrarian opportunities

The world of finance often rewards those who dare to be different, who can see value where others see only risk. Commodity investing, with its inherent complexity and volatility, is a prime example of this principle. Several factors point to a potential resurgence in this asset class, yet the masses remain hesitant, clinging to familiar investments. This presents a compelling opportunity for contrarian investors willing to embrace the challenge.

Adam offers a key piece of advice: “Everyone is a trend follower and a herd investor because, probably, from an evolutionary perspective, it always made much more sense to be in the herd and in the pack and not off on your own saying, ‘oh, actually we should look this way.’ The lion would come and take you out pretty quickly. Leigh and I sometimes joke that we’re very happy that we live when we do and not back in the caveman days, because we would have been picked off a long time ago because we’re really not very comfortable in that herd. We’re much more comfortable, I think, being contrarian and looking at things where other people aren't, because that’s where value is.”

He argues that this contrarian mindset is essential for identifying and capitalizing on opportunities that the herd overlooks. By understanding the long-term cyclical nature of commodities, recognizing the current undervaluation, and embracing the inherent volatility, investors can position themselves for potential outsized returns.

Of course, venturing into any new investment territory requires careful research and due diligence. Understanding the specific dynamics of each commodity sector, the risks involved, and the appropriate investment strategies is crucial.

The key is to remember that fortune favors the bold, especially when the herd is looking the other way.

This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.

05/10/2024 by Betsy McDowell

The “good macro” era of steady growth and low inflation is over. A new set of economic realities is taking shape.
Economist Philipp Carlsson-Szlezak, Chief Global Economist at BCG, challenges businesses to rethink their assumptions about “good macro.”
How to navigate tight labor markets, evolving debt dynamics, and persistent inflation.

If it feels like the news is constantly warning of impending doom, you're not alone. Recession fears, inflation anxieties, geopolitical tensions — it's enough to make any investor feel like they're navigating a minefield.

As Philipp Carlsson-Szlezak puts it, “The airwaves are dominated by doomsayers who predict the end of times regularly.”

As the Chief Global Economist at BCG and the co-author of Shocks, Crises, and False Alarms, he's spent years analyzing economic trends and advising businesses on how to navigate choppy waters.

While Philipp acknowledges the challenges of the current climate, he doesn't buy into the doomsday narrative. He points out that for a while, businesses got comfortable with “good macro” — steady growth, low inflation, and easy access to capital. But that era is shifting.

“Global macro demands more vigilance, demands a lot more engagement by executives and investors,” Philipp says. “But there's lots of good things that are still working well for those operating in the global economy.”

Kevin Coldiron and I invited Philipp to another Ideas Lab edition of Top Traders Unplugged to dig into those “good things” and explore how companies can adjust their strategies to win in an uncertain economy. Here are just a few highlights.

The labor (un)comfort zone

One of the most significant shifts in the “good macro” landscape is the rise of what Philipp calls the “era of tightness.” “The era of tightness refers predominantly to the labor markets,” he explains. “It's when the unemployment rate drops below a so-called neutral rate of unemployment. Essentially, labor is quite scarce.”

This scarcity of labor is creating challenges for many businesses accustomed to easy access to a readily available workforce. But Philipp argues that this “tightness,” while uncomfortable, can actually be a powerful catalyst for innovation and productivity growth. “When firms can't hire the labor they want, they're first nudged and later forced to embrace technology, and that moves their production functions to the frontier.”

He points to the auto industry as a prime example of the dangers of failing to adapt. During the COVID-19 pandemic, many automakers anticipated a prolonged economic downturn and canceled their semiconductor orders. “They went to the back of the line,” Philipp notes, “when instead of a really long recovery time, they got this very aggressive recovery with spiking demand for automobiles.” The result? Crippling semiconductor shortages and production bottlenecks.

A shift towards a more technology-driven approach has the potential to unlock significant productivity gains over the long term. As Philipp points out, there are other benefits to this new era: “[An era of tightness] comes with a lot of good things, including wage growth, particularly at the bottom of the distribution.”

The debt dilemma

Government debt often evokes fear and anxiety, conjuring up images of economic collapse and financial ruin. But is the situation truly as dire as many headlines suggest? Philipp Carlsson urges a more nuanced perspective, drawing on historical context to debunk the prevailing debt anxieties.

“The entire framing of debts in terms of levels is dangerous and tricky,” he cautions. Fixating solely on the size of the debt, without considering other crucial factors, can lead to misguided conclusions. He points out that the trend of stimulating economies through debt has been growing for decades, going as far back as the Reagan era, despite the Republican party's claims of fiscal responsibility. This “culture of stimulus,” as he calls it, has added both fiscal and monetary tools to the mix, with the “Fed put” becoming a classic reaction to even minor economic weakness.

A new fiscal reality

But the economic environment is changing. Philipp draws a crucial distinction between existential stimulus — the necessary measures taken to prevent systemic collapse in times of crisis — and tactical stimulus, which he characterizes as more frivolous attempts to “juice the cycle.”

“Existential stimulus is the ability of policymakers to backstop the system in moments of true peril,” like the 2008 financial crisis or the 2020 pandemic, he explains. And this ability, he argues, isn't going away. Financial markets and political will are likely to support such interventions when truly needed.

However, tactical stimulus, the kind used to address minor economic dips, faces more constraints when inflation is a growing concern. Philipp notes that market forces, sometimes referred to as “bond vigilantes,” may step in to push back against excessive spending and debt accumulation.

He cites the example of Liz Truss's short-lived government in the UK, where plans to boost the economy through borrowing were quickly met with resistance from bond markets. While he believes the U.S. has a higher tolerance for debt due to its reserve currency status, the risk of a market backlash is still greater in an environment of rising inflation.

The R v. G equation

To understand why debt levels alone don't tell the whole story, Philipp introduces a critical concept: the relationship between nominal interest rates (R) and nominal growth rates (G). “The question is: Is it easy or hard to carry that kind of debt level?” he asks. And that comes down to two variables: the nominal rate of interest compared to the nominal rate of growth.”

When the nominal growth rate (G) is higher than the nominal interest rate (R), a country can manage its debt burden more effectively, even at higher levels. “If my nominal rate of growth is higher than my nominal rate of interest, I can carry a very high level of debt,” Philipp explains. “In fact, if the spread is favorable, my debt to GDP ratio will fall.”

To illustrate this point, Philipp points to Japan: “I think about Japan. And you've had economies at much lower levels of debt — like below 70% and 60% — with a sovereign debt default.” Despite having one of the highest debt-to-GDP ratios in the world, Japan has not experienced a debt crisis, thanks in part to a favorable R v. G scenario.

The lesson for investors? Don't get caught up in the debt fearmongering. Instead, focus on understanding the bigger economic picture, including the dynamics of growth and interest rates.

The inflation puzzle

Inflation is a specter haunting boardrooms and household budgets alike. But before we spiral into a panic about runaway prices, it's crucial to understand the nuances of this complex economic phenomenon.

Philipp Carlsson cautions against lumping all inflation together. “We need to differentiate between cyclical and structural inflation,” he emphasizes. “[Much of the commentary] has gone off the rails over the last few years because we weren't willing to differentiate between the two.”

Cyclical v. structural: understanding the difference

Cyclical inflation refers to short-term fluctuations in prices, often driven by temporary shocks to the economy. Think supply chain disruptions during a global pandemic, a sudden surge in energy prices due to geopolitical events, or even a shift in consumer spending patterns as we saw during the COVID-19 lockdowns. Central banks, like the U.S. Federal Reserve, typically address this type of inflation through adjustments to interest rates, aiming to cool down an overheating economy.

Structural inflation, on the other hand, is a more persistent force rooted in the underlying dynamics of the economy. It's influenced by factors like demographics, technological change, and the long-term credibility of monetary policy. Philipp points out that structural inflation is “determined by inflation expectations.” In other words, if businesses and consumers believe that prices will continue to rise in the long term, they're more likely to accept higher prices in the present, creating a self-fulfilling prophecy.

Decoding inflation for business decisions

While cyclical inflation has grabbed headlines in recent years, Philipp argues that structural inflation remains largely under control. “If you look carefully over the last few years, inflation expectations stayed firmly anchored,” he notes. This means that despite the recent price volatility, there's no evidence of a broad-based shift towards a 1970s-style inflationary spiral.

This distinction between cyclical and structural inflation is critical for investors making portfolio decisions. For example, if you believe the current spike in commodity prices is primarily cyclical, you might be hesitant to increase your exposure to commodities, anticipating a potential price correction as supply chain issues ease. However, if you believe we're experiencing a more persistent, structural shift towards higher inflation, increasing your allocation to inflation-hedging assets like commodities or real estate could make sense for a long-term portfolio strategy.

The key takeaway: Don't just react to the headlines. Take the time to understand the forces driving inflation. As Philipp suggests, “In the 2020s, it's quite plausible that more often you're going to be somewhat above [the inflation target], and you're going to have to sort of bring it down.” This means we should expect a more volatile inflation environment, where agility and informed decision-making will be critical to navigating the inflation puzzle.

The new playbook for “good macro”

The economic landscape is changing. The “good macro” environment that many businesses have come to rely on is evolving, presenting both challenges and opportunities.

Labor markets are tight, pushing companies to innovate and embrace new technologies. Debt levels are high, but understanding the dynamics of growth and interest rates is essential to assessing true risk. And while inflation remains a concern, the ability to differentiate between cyclical and structural forces is crucial for making informed strategic decisions.

The future belongs to those who can read the signals, adapt their playbooks, and embrace the new rules of the game.

28/09/2024 by Betsy McDowell

Global liquidity is a hidden force that can make or break a tech company's growth trajectory.
Understanding the interplay of debt, central bank actions, and capital flows is crucial for navigating today's economic currents.
A weaker dollar cycle could be on the horizon, presenting both challenges and opportunities for tech leaders.

When strategizing for growth, most technology leaders focus on product development, marketing, and sales. They rarely consider a less obvious factor influencing their success — global liquidity. Yet, the ebb and flow of funds through global markets can significantly impact a technology company's ability to secure funding, navigate economic fluctuations, and achieve its growth objectives.

“Debt needs to be refinanced,” explains Michael Howell, Managing Director of CrossBorder Capital, a leading advisory and research firm focused on global liquidity flows. “And in order to refinance, you need balance sheet capacity. And that's what we think of as liquidity.”

Many investors, particularly those focused on equities, may not fully grasp this concept. As Michael points out, “If you have come from a fixed income perspective, you understand that debt is a finite instrument, and it needs to be refinanced.”

Michael's career began at Salomon Brothers in the 1980s, and he's since become a recognized authority on global liquidity. He brings a unique perspective to understanding market cycles, emphasizing the often-overlooked impact of central bank actions, capital flows, and the dynamics of debt refinancing.

We invited Michael to join in another Global Macro edition of Top Traders Unplugged for a deep dive into these critical topics. We discussed inflation, interest rates, the U.S. Dollar, China, and more. Here are just a few highlights.

Liquidity: The unsung hero (and villain) of market cycles

Michael's central thesis revolves around the power of liquidity — the lifeblood of financial markets. He argues that liquidity, or the flow of funds through markets, exerts a more powerful influence on asset prices and economic cycles than many traditional economic indicators. “Broadly speaking,” Michael explains, “credit is extended into markets by the financial sector in a very broad sense. It's not just banks; it's also shadow banks that are important.”

This flow of money, both in the form of central bank actions and cross-border capital flows, creates a ripple effect that determines which assets rise, which fall, and the overall tempo of economic activity.

Michael highlights the interconnectedness of the global financial system, stating that “this has become a global phenomenon and it's facilitated leverage. And there's sort of the whole range of instruments that are available. So it's become a lot more sophisticated, but at the heart, it's really a flow of money or liquidity into markets.”

Understanding this flow is crucial for investors. Michael emphasizes that it's the momentum of liquidity, rather than the stock, that truly drives markets: “I've always come from the school that it's flows that are more important because markets are priced at the margin,” he says. “And so, what you need to look at is the flow of new money coming in or exiting a market. And that is what makes a big difference.”

To illustrate this point, Michael points to recent market volatility, particularly the sharp fluctuations in the Japanese Yen. While many attributed this to the unwinding of the Yen carry trade, Michael suggests a more nuanced explanation.

He believes that the Yen's rapid decline in early 2022 was likely an engineered move, possibly orchestrated to pressure the Chinese financial system. The subsequent rally, he speculates, could signal a “tacit deal done on currencies,” leading to a shift in the dollar's trajectory and a potential easing of monetary policy by the Fed.

The debt dilemma: A looming threat or manageable risk?

While liquidity fuels market cycles, Michael also expresses concern about the increasing mountain of global debt. He warns that this accumulation of debt, driven by factors like aging populations, rising healthcare costs, and increased defense spending, poses a significant risk to long-term economic stability. “The [global financial crisis] increased debt,” Michael observes, “COVID amplified that dramatically, and the aging demographics are rising. Government debt is going to increase significantly.”

The challenge lies in refinancing this massive debt load. As Michael explains, “You've got 350 trillion of debt in the world economy with an average maturity of five years. Which tells us you need to refinance 70 trillion dollars of debt every year — just to stand still.”

This refinancing burden necessitates a continuous injection of liquidity, leading to monetary inflation. He argues that if debt continues to grow at a faster pace than the real economy, as projected by data from the U.S. Congressional Budget Office, global liquidity will need to expand at a similar rate, effectively creating a perpetual cycle of monetary expansion.

He questions the prevailing belief that central banks can smoothly withdraw stimulus without causing market disruptions. Citing China's experience with quantitative tightening (QT) as a cautionary tale, Michael argues that the true impact of QT in the West might be masked by the U.S. Treasury's shift to shorter-term debt issuance.

“There's been no QT in the U.S. for 18 months,” Michael contends. “They've been pushing liquidity into markets.” This, he suggests, could create hidden vulnerabilities as large amounts of debt come due for refinancing in the coming years. He points to record low levels of term premium in the bond markets and the unusually wide spread between U.S. agency mortgages and 10-year bonds as evidence of this potential manipulation.

Furthermore, Michael highlights the potential social consequences of relying on monetary inflation to manage debt. He warns that this approach can exacerbate wealth inequality, as “you're increasing wealth for asset holders and wage earnings are losing out on the wealth.” This dynamic, he suggests, could lead to social unrest and political instability.

The dollar's reign: How long can it last?

The U.S. dollar, long the world's reserve currency, has enjoyed a period of remarkable strength. But Michael believes a weaker dollar cycle could be on the horizon. He sees the potential for a shift in the dollar's trajectory, driven by a combination of factors, including a potential easing of monetary policy by the Federal Reserve and a rebalancing of global economic power.

Michael points to historical parallels, such as the Plaza Accord of 1985, where a coordinated effort among major economies led to a deliberate weakening of the dollar to address trade imbalances. He speculates that a similar dynamic could be at play today, pointing to the recent rally in the Japanese Yen as a possible sign of a tacit deal among global policymakers.

“It could equally be,” Michael suggests, “that there was a deal struck that said enough is enough. We've achieved what we want. The Chinese have basically agreed to something. We don't know what, but it basically means that the dollar now should begin to weaken.” His skepticism about the Yen's rapid moves stems from his extensive experience: “In my experience, I've never seen a move as dramatic as that in a G7 currency.”

He also emphasizes China's crucial role in the global dollar system, highlighting the complex and often counterintuitive relationship between Chinese trade surpluses and the dollar's value. “The more that the Chinese use non-US banks to recycle their funds,” Michael explains, “the less efficient it will be and the lower the elasticity of dollar supply, which underpins, in the medium term, a rising dollar.”

However, he also acknowledges China's efforts to reduce its reliance on the dollar, noting that they've made progress on it. But the question of who wants to hold the Chinese currency remains. He believes that the Yuan's path hinges on whether it starts to appreciate, possibly due to Fed easing, or if China engages in significant money printing.

While Michael believes a weaker dollar is likely, he doesn't anticipate a sudden collapse. He states, “I don't think it's going to be a big inflection because I think there's a lot of factors underpinning the dollar in the medium term.” This suggests a gradual shift rather than a dramatic devaluation.

Riding the liquidity wave

As Michael's insights demonstrate, global liquidity dynamics play a pivotal role in shaping market trends, influencing investment decisions, and driving economic cycles. For technology leaders, understanding these dynamics is no longer optional; it's essential for navigating the complexities of today's interconnected world. By adopting a liquidity lens, tech leaders can anticipate market shifts, identify emerging opportunities, and make strategic decisions that position their companies for sustainable growth.

It comes down to this: adapt to the liquidity current or be swept away by it.

22/09/2024 by Betsy McDowell

The stock market is significantly overvalued, setting the stage for a potential recession that may be closer than many think.
Peter Berezin, Chief Global Strategist at BCA Research, offers a sobering yet insightful perspective on the economic headwinds facing the tech sector.
Why the AI hype might not translate into real profits for tech companies.

When we talk about the economy, it's easy to get swept up in the day-to-day fluctuations of the market. We obsess over the latest Fed announcements, parse through earnings reports, and scrutinize every new data point that crosses our screens. But what if we stepped back for a moment and looked at the bigger picture? What if, instead of focusing on the trees, we considered the entire forest?

“The stock market is more than 50 percent overvalued right now, the highest level of valuation since August 2000,” warns Peter Berezin, Chief Global Strategist at BCA Research. It's a stark statement, painting a far more precarious picture than the “soft landing” narrative many cling to.

Peter, drawing on his decades of experience analyzing global economic trends, offers a sobering prediction: a recession is coming, and it's closer than many think.

He doesn't mince words when outlining the forces at play: “The excess pandemic savings are gone. More people are faced with higher rate mortgages, and critically, job openings now have sort of normalized to very low levels.” His team at BCA Research, backed by their quantitative model incorporating these leading indicators, recently downgraded stocks. It's a clear signal that the economy is shifting, and tech investors need to be prepared.

Alan and I invited Peter for a candid conversation on the Global Macro edition of Top Traders Unplugged, exploring these critical economic indicators and what they mean for the tech sector. We delved into the AI hype cycle, examining whether the current optimism is justified. We also discussed potential investment opportunities in undervalued markets and strategies for building more resilient businesses in a downturn. Here are a few highlights from our discussion.

Decoding the economic warning signs

Peter doesn't sugarcoat his assessment of the current economic climate. “In my view,” he states, “most scenarios point to recession.” This view, however, runs contrary to the hopes of many. Peter argues that several key indicators point towards a recession.

He points to the housing market as a prime example. “Homebuilder confidence has plunged again,” Peter observes, adding that “the housing market is weakening.” He notes that people simply can't afford to buy new homes at current prices, and existing home sales are at historic lows. This lack of demand is squeezing homebuilders and further weakening the housing market. This weakening in a traditionally strong sector is a cause for concern.

He also points out that while people might feel wealthier due to increased home values, it's difficult to tap into that wealth. The demand for home equity lines of credit (HELOCs) is weak, and banks are tightening lending standards, making it harder for consumers to monetize their home equity.

Moreover, Peter highlights the precarious state of consumer spending. “The savings rate right now is like 3.5%. This is unsustainably low.” This, coupled with the fact that excess pandemic savings are gone, suggests a potential pullback in consumer demand, the engine of the US economy. “People are going to have to save more,” he warns, “and the problem is that if they try to save more in aggregate, what that's going to do is reduce demand across the economy.”

The labor market, while seemingly robust on the surface, also reveals cracks upon closer examination. Peter notes that “job openings now have sort of normalized to very low levels.” This, along with rising credit card delinquency rates, points to a potential rise in unemployment, further impacting consumer spending and overall economic activity. “If labor demand continues to decline,” Peter cautions, “we will have this rising spiral of higher unemployment.”

He emphasizes that the labor force participation rate is already back to pre-pandemic levels, and employment gains are starting to slow. This, combined with slowing wage growth, suggests that income growth will continue to decelerate, further pressuring consumer spending.

Further complicating matters is the government's limited ability to provide fiscal stimulus. “The budget deficit is very, very large,” Peter explains, making it politically and economically challenging to implement counter-cyclical measures to soften the blow of a recession. “It's going to be difficult to do significant counter cyclical fiscal policy next year given the starting point of the deficit and the very unfavorable debt dynamics,” he adds.

Peter's team at BCA Research has incorporated these worrying trends into their quantitative models. Their recent downgrading of stocks reflects this pessimistic outlook, sending a clear signal to investors that the economic tide is turning.

Will AI deliver on its economic promise?

The tech world is abuzz with excitement about artificial intelligence (AI), and understandably so. The rapid advancements in AI, particularly in large language models (LLMs), have opened up a world of possibilities. However, amidst the hype, Peter injects a dose of realism. “It's not so obvious where all the big profits from AI are going to come from,” he cautions.

While acknowledging AI's transformative potential, Peter questions whether the current valuations of AI-related companies are justified. “You're kind of betting on the most favorable outcome,” he observes, pointing out that investors are assuming rapid and substantial returns on AI investments. He draws a parallel to the dot-com bubble, where investors poured money into internet companies with unproven business models, only to see many of them crash and burn.

Peter argues that the competitive landscape for AI is still evolving, and it's unclear which companies will emerge as dominant players. He uses a striking analogy to illustrate his point: “Perhaps these large language models will be more like airlines — very useful but they never make any money.”

Just because a technology is powerful and widely adopted doesn't guarantee profitability. He points out that many AI models are converging in terms of their capabilities, making it difficult for any one company to establish a clear competitive advantage.

He further highlights the limitations of current AI models, particularly in their ability to generate genuine innovation. “If you use ChatGPT or Gemini, the answer often comes back more or less the same. Where's the competitive moat?” he asks.

If AI models are primarily synthesizing existing information rather than creating truly novel solutions, their long-term value proposition might be less robust than many assume. “The architecture of these models or the neural nets and the transformers — it's very similar,” Peter notes. “The training sets are basically the same. So are you surprised that the answers are the same?”

Peter also points to the disconnect between revenue and profit when it comes to AI hardware. He uses Nvidia as an example: “Nvidia sells a chip, it books a profit, but when Google buys that chip, that's CapEx.” This distinction is crucial, as significant upfront investments in AI infrastructure might not translate into immediate or sustained profits for companies deploying these technologies.

Peter warns that this capital expenditure on AI hardware could lead to disappointing returns and even losses for tech companies down the line, especially if the promised productivity gains from AI fail to materialize.

This raises a critical question: could the current AI hype, fueled by speculative investments and inflated expectations, exacerbate the impact of a looming recession on the tech sector? It's a question worth pondering as we navigate today's economy.

Turning economic headwinds into tailwinds

While a recession presents undeniable challenges, it also creates opportunities for discerning tech investors and businesses. Peter, amidst his warnings of an economic downturn, offers valuable guidance for navigating this turbulent terrain.

He emphasizes a cautious approach to AI investments. Instead of chasing the hype, focus on companies with clear paths to profitability and robust competitive moats. Look beyond flashy demos and promises of disruption, and carefully assess the underlying business models and potential for sustainable revenue generation.

“It's going to take a long time to make money off these products,” Peter cautions, suggesting that investors with shorter time horizons might be disappointed. He also warns that competition will arise to challenge companies like Nvidia, which currently enjoys high profit margins in the AI chip market.

Peter also suggests exploring opportunities in undervalued markets. He points to Japan, where the yen is significantly undervalued, as a potential area of interest. As other central banks around the world cut interest rates in response to a recession, the Bank of Japan's more stable monetary policy could make the yen an attractive investment.

“The yen remains a very, very cheap currency,” Peter observes. “It's close to 40% undervalued relative to PPP.” He predicts, “Those interest rate differentials are going to move in favor of the yen, and the yen will strengthen.”

Moreover, Peter recommends diversifying portfolios to include defensive assets. Gold, a traditional safe haven during times of economic uncertainty, might provide a hedge against volatility. Bonds, particularly longer-term bonds, could also offer value as yields decline in anticipation of central bank rate cuts. “Our target for the 10-year treasury yield is 3%,” Peter states, suggesting a significant decline from current levels.

For tech businesses, Peter advises prioritizing efficiency and cost-cutting measures. A recession demands a leaner, more agile approach to operations, focusing on core competencies and maximizing resource utilization. He points out that even if the Fed cuts rates, it might not have the desired stimulative effect on the economy, as longer-term bond yields have already priced in a significant amount of easing.

He also suggests exploring alternative funding options, such as private credit, as traditional lending might tighten during a downturn. This proactive approach to securing capital can help businesses weather the economic storm and position themselves for growth when the recovery begins. Peter notes that there was a story in the FT about how a lot of startups are going bust because they're unable to access the credit they need.

Finally, Peter emphasizes the importance of building resilience and adaptability into business models. A recession often accelerates existing trends and exposes vulnerabilities. Tech companies that can anticipate these shifts, adapt their offerings, and embrace a culture of innovation will be better positioned to emerge stronger from the downturn. He cautions that “the average interest rate is going to rise, even if the Fed cuts rates,” due to the high interest rates on existing loans.

Prepare for the storm, position for the future

Peter's economic outlook is a stark reminder that the tech sector, like the broader economy, is cyclical. Periods of rapid growth and innovation are often followed by periods of correction and consolidation. While a recession presents undeniable challenges, it also offers opportunities for those who are prepared. By heeding Peter's insights — approaching AI investments with caution, exploring undervalued markets, prioritizing efficiency, and building resilience — tech investors and businesses can weather the coming storm and position themselves for success in the long term.

As Peter says, “A recession is coming, and preparation is key.”

14/09/2024 by Betsy McDowell

Humans are innate tinkerers and technologists, says Mark Mills, who heads up a national energy think tank. Technology makes civilization — including laws, government and politics — possible.
Even if the convergence of different technology-driven forces isn’t unique, the current convergence of information technology, materials and machines is.
Will America sovietize its economy? Probably not, and — despite somewhat constrained growth — economists are surprised that the U.S. is surviving the predations of policymakers.

If you’re wondering where productivity boosts are going to come from in the economy, you’re not going to have to wait much longer.

You’re looking at an imminent and brand new Roaring Twenties, says Mark Mills, Executive Director of the National Center for Energy Analytics. Mark is the author of The Cloud Revolution: How the Convergence of New Technologies Will Unleash the Next Economic Boom and A Roaring 2020s. He believes that there are unique opportunities to grasp — so long as America doesn’t hamper itself.

Mark rejoins Kevin Coldiron for a stimulating discussion about the beginning of a roaring period of productivity and economic growth, driven by technological convergence that hasn’t been seen in society for a long time.

In fact, while the concept of technological convergence itself isn’t unique, the current convergence the world is experiencing is. Those who embrace what technology can do for civilization — as well as for markets — are set to gain big time.

These are some of the key takeaways from Mark and Kevin's discussion about where the economy may be headed and the evolution of economic trends in light of his expectations.

To make our future is human

“We’re all forecasters and we’re always forecasting,” Mark says. “It's how we plan and live our lives.” Basically, it’s human nature to think about the future — be it business, government policy or life more generally.

While technology is a special sub-category, it impacts everything. Ten thousand years ago the world couldn’t have looked more different, technologically-speaking, than it does now. And yet, “the same energy forces, materials and nature exist,” Mark explains. “What's different is our knowledge about information and the technology we've developed from that knowledge to manipulate nature — literally manipulate.” To build, we manipulate atoms and molecules. Meanwhile, technological change and progress are different things: The former doesn’t necessarily result in the latter.

To be human is to make: “We’re innate tinkerers and technologists,” Mark says. “Technology is not exogenous to humans: It’s human nature.” Politics, governance and law all matter in making predictions about the future, but it’s “technology that informs and enables everything that makes civilization possible.”

The unique convergence of three forces

Because of the inertia of systems, broad decades-long predictions about the future are “necessarily dictated by what we know how to build today,” Mark says. But what people don’t often realize is that many revolutionary technological changes have histories stemming back decades into the past: Think automobiles, airplanes and computer chips.

“Every entrepreneur will tell you that the overnight success of 20 years of incremental engineering and proven development leads to that inflection point where that new product, technology or service emerges suddenly on the market and in the public conscience,” Mark explains. The apparent leaps and bounds in AI that the world has recently seen are a case in point.

The three forces that lead to a convergence resulting in economic growth are:

Information technology including microprocessors
Materials such as those from mining
Machines that we use to move and make things

The world hasn’t seen such an era-defining convergence in a long time. In the past, when world-changing inventions like the printing press and television converged with radical developments in machinery, there was a bigger revolution than if one of those things had happened individually.

“It happened in the 1920s with air travel, the car, the telephone, and the telegraph, and of course the advent of pharmaceuticals and steel — three revolutions that typify the change and happen simultaneously in different domains,” Mark says. “We have the same thing happening now: The cloud itself as an information tool is the biggest infrastructure ever built by humans,” Mark says, “and combines with AI, which is now maturing to a point of high utility.” Advances in both biological and physical material sciences — along with the development of autonomous robots and machines used to make microprocessors and semiconductors — also converge with these trends.

No surprise that tech results in rising energy consumption

On the subject of developing trends since his first discussion, Mark says there have been “no surprises” — due to the nature of inertia and the velocity of building things, which are well-established laws in physics and engineering. “You get discontinuities over long periods of time, but in a decade they’re very, very rare,” he explains.

When something like AI enters society's consciousness, stock markets react. Witness the Mag 7 stock explosions and the media taking notice of computing power demands. As early as the 19th century, the economist William Stanley Jevons knew that efficiency and production cost reduction increased consumption: Just look at steam, electricity, and compute. “The market response to consume more valuable goods is almost always greater than efficiency gains,” Mark explains.

But AI is painted as a bit of an environmental boogieman. It’s the data centers — essentially warehouse-sized computers, Mark says — that are hoovering up electricity. “Building steel mill-class facilities at 10 times the rate that you build steel mills” will do that, Mark says. AI isn’t blameless though. It accelerates the process in two ways:

AI chips use much more electricity than conventional chips, in the same way starting and permanently running something like a power plant rather than episodically like a car will use more energy
AI increases the value of conventional data because collecting more data fuels AI

“The global cloud uses twice as much electricity as the country of Japan does for all purposes,” Mark highlights, “and more energy than global aviation — while cloud AI is accelerating faster than global aviation.”

That’s not to say AI chip-makers like Nvidia, AMD, and Intel haven’t already begun improving energy efficiency. But this will lead to more energy consumption — not less.

Nonetheless, constraining AI — via public policy, in a bid to reduce consumption — means constraining the whole economy. Having enough electricity is only a constraint if markets are constrained in supplying electricity. “This is not a size forecast — it's a behavioral forecast,” he explains. It can easily be rectified by building what we know how to build “to fuel the economic revolution that AI offers”

Framing the materials and mines that fuel cloud growth

For materials, Mark takes a realistic perspective. “Numerical framing is important,” he says. “My forecasts are not based on what I'd like to have.”

Mining is at the front and center of his theory: “There is nothing in society — no product or service that exists — that didn't start with a mine somewhere.” The exception is in primitive societies, wherein animal-based materials like bone, sinew, and leather prevailed. And even with some recycling, mining virgin material is impossible to avoid. “Everything costs energy; everything involves waste,” he says.

Starting with mining, the questions become about quantities required and cost of material. “Making the complex things that we build and operate takes energy,” he says. When they become waste, they're worn out, broken and fall apart — the energy went into their complexity, not just the materials.” It’s Physics 101, Mark says.

Physical automation is also set to improve mining through “robotics, better knowledge of how we can manage materials and more efficient extraction” via enhanced chemical processes. AI-driven supercomputers will improve these processes further. “All that will happen, but it takes time — these are industrial systems,” he says. “They get better measured in decades, not years.”

Finally, framing mining has to start with understanding reality, not wishful thinking. “Mining is not an easy industry,” he says. “The average time to open a new mine is 10 to 20 years,” Mark says. In the U.S. it’s longer due to opposition, so few if any mines have opened for decades, despite there still being mineral resources to mine. “We've chased mining out of the United States,” he says. “It didn't leave voluntarily.”

But there'll have to be more mines for economic growth “Acknowledge that growth is good and requires more materials,” he says. “You want to extract them in the most benign way possible.” Better here than in other countries with more lax labor and environmental laws and protections.

“Once you’ve framed it right, you might arrive at policies that are sensible,” Mark says.

Manufacturing as a service

What brings together the advancement of the three different dimensions is the notion of manufacturing as a service (MaaS). Mark offers two different examples to explain:

Nvidia has no manufacturing plants for its AI chips — the MaaS is provided by Taiwan Semiconductor Manufacturing Corporation (TSMC)
The prevalence of specialization and internal integration varies between industries, and while its evolution is unavoidable, AI, automation, and cloud technologies accelerate the process

Mark predicts an increasing number of non-semiconductor companies adopting an Nvidia model “where they design, vet, and market things that they don’t actually manufacture.”

Most people have never heard of publicly traded Canadian Magna International, but it manufactures world-class parts for BMW. Likewise, “most vintners don’t grow grapes,” Mark says — they buy them. It’s now easier — and more important — to specialize in manufacturing due to automation and AI.

The economy is resilient

With interest rates up from zero to 5% in 18 months and no economic crash in sight, Mark believes that “we're in a period similar to the 1990s: We can see computers everywhere except in the productivity statistics.” While hard to measure their ultimate effect, it bore out soon enough.Likewise, next-generation technology computing is currently hard to tease out but is already making waves.

“There are data supporting the contention that a lot of the resilience in the economy is in fact coming from AI and cloud technology,” Mark says. This is the beginning.

“The extent to which we can really roar and get big productivity boosts,” he highlights, “is now going to be significantly impacted by policy.” Constrain or unleash: This is the choice facing policymakers. But Mark believes it will happen anyway because markets are unstoppable in the long run.

“I'm hoping and don't believe America will sovietize its economy,” he says. “We have somewhat constrained the growth, but not as much as the partisans on both sides would say or complain. Hence, the economists’ sort of surprise that we're surviving the predations of policymakers.”

Here’s to hoping we continue to survive them.

01/09/2024 by Betsy McDowell

The investing world is flatter now than in the lazy days of value investing, says Aswath Damodaran, professor of corporate finance and valuation at the NYU Stern School of Business.
AI may be significant, but not for the reasons most people think: We don’t ask the right questions. There are too many viewpoints and not enough time to think for ourselves as investors.
Investing styles that lack dynamism and focus on what worked in the old time value investing world won’t work in this ones.

In a world beset by AI hype, here’s a hot take: “The net effect of AI is going to be close to zero.”

That’s what Aswath Damodaran, professor of corporate finance and valuation at the NYU Stern School of Business, says in conversation with Alan Dunne during a recent episode of Top Traders Unplugged. Aswath is the go-to expert in all things valuations, with multiple books and papers published on valuation, corporate finance, investing and portfolio management.

But he’s not just markets through and through: “My first passion is teaching,” he says. Corporate finance and valuation just happens to lie “at the intersection of numbers and stories, people and businesses. It's the combination of psychology, statistics, data and economics that makes it fascinating.”

And the most fascinating thing of all? We’re not even asking the right questions about AI, which means we could be getting all the investment stories wrong. “Unless we ask the right questions, we could be right about the big story of AI being a revolutionary change, but wrong about every investment story we create,” he explains.

When not teaching, he shares his musings on markets and lectures on YouTube. At the same time, he strongly recommends giving yourself idle time and space to think. “We're surrounded by so many opportunities to go look things up and read what other people think that we're drowning in other people's opinions,” he warns.

Aswath’s incisive opinions span Nvidia, AI, valuations and why value investing isn’t going to work like it used to.

What follows are some of the biggest takeaways.

Bullish on big tech? Not likely

If you want real performance, look at the Magnificent Seven (mag seven) stocks — Apple, Microsoft, Google parent Alphabet, Amazon, Nvidia, Meta Platforms and Tesla — but don’t expect a repeat in the near future.

While Aswath bought Nvidia six years ago, he doesn’t consider himself bullish by any measure. “This notion of bullish and bearish is a fancy way of saying I can't make a decision,” he says.

Instead, buy what you want to own when it’s cheap based on your valuation. “If I'm really bullish on something, I should own it. If I don't own it and claim to be bullish on it, you should be skeptical about what I'm bullish on,” Aswath says.

And what’s all the fuss about with Nvidia anyway?

“I don't think AI or any other buzzword adds a half a percent or 1% to GDP on a net basis,” he says. “It might do on a growth basis, but it does so by destroying other businesses that contribute to GDP.” He has the rise of PCs, the internet, smartphones and social media in his sights as what everyone presumed would make the economy grow faster, but at what cost?

GDP growth was lower during the 1980-2010 period before winning businesses grew as much as the buzzwords that boosted their growth. They came at the expense of other businesses that shrunk and went away. For that reason, “the net effect of AI is going to be close to zero,” Aswath explains. That doesn’t mean no winners and losers from AI: just that, economically, it won’t make much difference.

“We talk about disruption a great deal — we don't talk about the disrupted along the way,” he says. “This notion that AI is somehow going to carry the entire economy and the market upwards is a delusion.”

AI is here to stay and may well herald a revolutionary change — for both business and society. All four technology innovations — PCs, the internet, smartphones and social media — bore winners now worth trillions, but “the net effect on markets was surprisingly neutral, because for those winners, there were dozens, even hundreds of losers,” Aswath says.

AI winners may not be the companies you think. Bringing it full circle, “Nvidia reminds me of Cisco,” he says. Cisco didn’t gain as much as some — like many of the mag seven — from the growth of the internet. Nvidia is an AI architecture business that’s monetizing revolutionary changes, but even if the AI industry overall is worth trillions of dollars, the architecture charging that isn’t more than half of that.

Where does that leave Nvidia?

Asking the right questions to break the delusion

“AI is a buzzword,” Aswath says. “Using AI as a rationale for pushing up the prices of companies without getting specific” is an unsustainable tactic.

Nvidia’s $3 trillion market cap — with a built-in expectation of an exploding AI chip market — highlights what Aswath calls “the big market delusion, which is when you have a big market and people keep using the macro story to justify why they’re paying more for the company.”

But he also points out that “eventually the delusion breaks because the numbers start to roll in,” and optimism can no longer carry momentum. “AI is B2B: It's not what you and I will be spending on AI — it's what companies will be spending on AI.”

Identify the winners and losers from this latest change, and you’re closer to asking better questions. Rather than pushing up prices on the back of expected AI use, ask for specifics. Continuing the delusion is like being on the losing end of the dot com boom.

“Unless we ask the right questions, we could be right about the big story of AI being a revolutionary change, but wrong about every investment story we create based on it,” Aswath explains.

AI is a combination of “two big forces that have been in markets for the last two decades: more powerful (and miniature) computers and data.” The winners — big tech companies like Facebook, Apple and Google — exploit AI by using rather than creating the architecture that enables AI. “They have the data, cloud systems on which we store the data, and they have powerful computers.”

The question is: How do young startups match the data and computing power of these giants? That remains to be seen.

Here’s what investors need to remember

“This is the strangest business on the face of the earth: In any business, professionals do better than amateurs,” Aswath says. “But professional money managers have been losing this war for four decades.”

Active investors who didn’t own FANGAM stocks in the last decade are at a huge disadvantage. “If your investment strategy is focused and concentrated — like old time value investing — that’s a huge red flag,” he says. Maybe you lucked out and got onto a winner, but many investment philosophies — like buying stocks with low PE ratios or small cap investors — are structured away from them.

“Any style that's not dynamic and doesn’t allow you to stretch across the market is a style I would avoid,” he says. “If you’re an active investor, you can’t be rigid.” So, what’s changed?

“The market and economy have changed,” he says. “More businesses have become winner-takes-all businesses.” Compare hospitality in the 2000s — splintered, with no hotel company owning more than 6% market share — with Airbnb today. As recently as 2008, the car service industry was similarly splintered — with the largest cab companies owning a maximum of 1% market share — but ride-sharing today allows for a monopoly. Networking effects snowball success: as businesses get bigger, it gets easier to get bigger.

If you’re in a winner-takes-all economy, it shouldn’t be surprising to see the biggest winners being the biggest companies. In four decades, the investment world has flattened. Old time value investors could be lazy and still make money. No longer is that the case.

“What I heard from value investors was we’re the grown ups. These traders and tech investors are shallow,” Aswath says. “The problem with being righteous is you think you deserve to be rewarded for doing the right things.” If you don’t get rewarded, you suffer, and double down — then go bankrupt short selling.

Every single company was a momentum stock at some point in time. “Every one of the mag seven stocks in the last 15 years has been cheap at least three times,” Aswath says. “The word you should avoid in investing is never. When you say I will never buy that stock, you've drawn a line in the sand. At the right price, you should be willing to buy any stock. I want investment philosophies that start with and then build on that premise.”

Establish the equity risk premium

Start with the premise that sensible, rational investors should demand more than the risk-free rate when investing in risky assets. Then, take an average of what a group — such as finance students, some of whom are more risk-averse than others — demand as a premium over a risk-free rate. That’s a market’s equity risk premium and how you establish valuation.

But you need a forward-looking number, not a historical, backward-looking premium. Valuation textbooks are no good for the 21st century. “What I'm trying to estimate is what I tried to do in my room for the entire market,” Aswath says. Instead of asking them, he looks at what they pay. “I can then reverse engineer what you can expect to make,” he says. “It's very grounded in reality and is completely model-agnostic.”

The equity risk premium becomes a number to debate the correct prices of stocks. Expecting to make 16% based on the last decade isn’t the right approach. The equity risk premium replaces the blunt instrument that is the PE ratio, which fails to factor in rate levels, growth and cash flows.

What investors should really do about AI

If Aswath had one piece of advice for investors, it would be to “read less and think more.”

In a world of too many opportunities to drown in others’ opinions, “part of the investing journey is developing your own original way of thinking that reflects who you are as a person, what makes your investment philosophy. For that, you’ve got to allow your mind some idle time. We don't really have that idle time anymore.”

AI can work with data, charts and a replicated Warren Buffett mindset, crushing any advantage that we, as humans, have against AI — if we don’t give ourselves time and space.

“There’s a bot out there with your name on it that's coming for you, and your job is to find things to do that your bot can't do. Think of that as your 10-year mission. You have about a decade to play this out, because if all you do is mechanical stuff, a bot will do it much better than you can very soon.”

25/08/2024 by Betsy McDowell

The electric vehicle revolution is driving a surge in demand for lithium, but traditional mining methods raise serious environmental concerns.
Innovative approaches are emerging to diversify lithium sources and minimize environmental impact.
Ernest Scheyder shares insights about lithium mining and the potential benefits and challenges of alternatives to lithium mining.

When we think about powering the future with clean energy, images of sleek electric vehicles and sprawling solar farms often come to mind. But behind these symbols of a sustainable future lies a critical, and often overlooked, element: lithium. This lightweight metal is the key ingredient in rechargeable batteries that power everything from smartphones to electric grids, making it indispensable for the global transition to renewable energy.

But as the demand for lithium skyrockets, so do concerns about the environmental footprint of its extraction. Traditional lithium mining, with its massive open pits, vast water consumption, and potential for habitat destruction, has many wondering: is swapping gasoline for batteries truly a win for the planet?

“As we think about where we want to go green and how we're going to go green,” says award-winning journalist Ernest Scheyder, “I think these [supply chain and environmental concerns] have to be part of the collective discussions.”

Ernest has spent years immersed in this complex world and is currently a senior correspondent at Reuters. His book, “The War Below,” chronicles the global battle for critical minerals like lithium, pulling back the curtain on the often contentious struggle between economic needs and environmental concerns.

However, Ernest's work also reveals a glimmer of hope in the form of alternative lithium extraction methods — technologies that promise to minimize environmental damage without compromising production. “There's no free lunch,” says Ernest, succinctly capturing the inherent trade-offs involved in any large-scale resource extraction. But the quest for cleaner lithium is gaining momentum.

Kevin Coldiron and I invited Ernest to Top Traders Unplugged for a thought-provoking conversation about the challenges and opportunities of lithium extraction in the age of clean energy. We talked about new technologies, environmental concerns, the role of indigenous communities, and the future of a sustainable lithium supply chain.

Here are a few highlights from our conversation on the alternatives to lithium mining and their potential benefits and challenges.

Alternatives to conventional lithium mining

Direct lithium extraction

Imagine a giant, high-tech water filter selectively extracting lithium ions from underground brine reservoirs — that's essentially what Direct Lithium Extraction (DLE) aims to achieve. This innovative method bypasses the need for large, open-pit mines and sprawling evaporation ponds, offering a potentially more sustainable approach to lithium extraction.

Instead of relying on solar evaporation, DLE uses specialized absorbent materials or membranes to capture lithium from brines pumped to the surface. This process has several key advantages:

DLE significantly reduces water usage compared to traditional evaporation ponds, a critical consideration in arid regions where lithium-rich brines are often found.
DLE requires a much smaller surface footprint than conventional mining, minimizing habitat destruction and visual impact.
By eliminating the lengthy evaporation process, DLE has the potential to shorten production times, allowing for a quicker response to growing lithium demand.

However, Ernest cautions against viewing DLE as a silver bullet. “As of today,” he says, “no direct lithium extraction technology has worked yet at commercial scale without the use of those evaporation ponds.”

The challenges, as Ernest highlights, are multifaceted. Firstly, the brines, often found at temperatures exceeding 400 degrees Fahrenheit, are incredibly corrosive. “Just that super hot brine,” Ernest recounts, “one scientist I talked to for the book called it ‘a nasty mix of a soup.'” Such extreme conditions demand specialized materials and engineering designs to ensure equipment durability.

Secondly, the complex chemical composition of brines poses a hurdle. Selectively extracting lithium without capturing other unwanted elements requires sophisticated filtration techniques. This is still an active area of research and development.

Despite these hurdles, several companies are pursuing DLE technology. Ernest notes that giants like Berkshire Hathaway, ExxonMobil, and Albemarle are all investing in this area, driven by the promise of tapping into new lithium resources and contributing to a more sustainable future.

“If it [DLE] could be made to work,” he says, “it could unlock vast supplies of lithium across the world.” However, Ernest emphasizes the importance of a realistic outlook. The potential is undoubtedly there, but the path to widespread commercialization is still paved with technical challenges.

Enhanced brine extraction with reduced environmental impact

While DLE offers a potentially revolutionary approach, researchers and companies are also exploring ways to improve the efficiency and sustainability of conventional brine extraction methods. These innovations aim to reduce the reliance on large, open-air evaporation ponds, which, as Ernest points out, have come under scrutiny for their high water consumption, especially in already arid regions. “You're basically taking a water source out of the ground in a very arid climate,” Ernest explains, “so that doesn't necessarily endear [the companies] to the local community.”

One promising avenue involves the use of specialized membranes and absorbent materials to selectively extract lithium from brines. These technologies allow for a more targeted and efficient extraction process, potentially minimizing the need for vast evaporation ponds. Ernest, in our conversation, highlighted the ongoing research in this field, noting the potential for these advancements to significantly reduce water usage and waste generation. He also emphasized the industry's awareness of the need for more sustainable practices: “Increasingly you start to see some mining companies, when they build processing facilities, they are building in recycling plans for 10, 20, 30 percent of the production.”

Another area of innovation focuses on optimizing the evaporation process itself. Researchers are exploring techniques to enhance evaporation rates while minimizing water loss and land disturbance. This could involve using covered evaporation ponds to reduce water loss through evaporation, or exploring new materials that enhance lithium concentration in the brine, shortening the overall processing time.

Some companies are even experimenting with closed-loop systems for brine extraction. These systems aim to recycle the water used in the extraction process, minimizing overall water consumption and reducing the discharge of potentially contaminated wastewater. Ernest points out that this aligns with the broader push for a circular economy in the industry, where “old electronics can be completely recycled and then used to make new ones, so we don't have to have mining anymore.”

While these enhanced brine extraction methods may not be as radical as DLE, they offer a more incremental path towards a more sustainable lithium supply chain. By improving the efficiency and reducing the environmental footprint of existing techniques, these innovations can play a significant role in meeting the growing demand for lithium while mitigating its impact on water resources and fragile ecosystems.

Lithium extraction from clay deposits

While brine extraction methods dominate the current lithium landscape, a relatively new source is gaining attention: clay deposits. These vast clay deposits, particularly in the United States, are now being eyed as a potentially more sustainable source of lithium.

“Another region in the United States that's got a lot of lithium is the Smackover Formation,” Ernest explained during our conversation, “which is an underground reservoir that goes from parts of Texas, through Louisiana, through Arkansas into parts of Mississippi and Southern Florida.” These clay deposits, formed over millions of years, contain lithium trapped within their mineral structure.

Extracting lithium from clay offers several potential environmental advantages compared to traditional hard-rock mining or brine extraction. Firstly, it can be less invasive. Unlike conventional methods that require digging massive open pits, clay-based extraction can involve smaller surface footprints, minimizing habitat disruption and visual impact.

Secondly, while the exact water requirements depend on the specific extraction technology used, clay deposits generally require less water than brine extraction methods, especially those relying on large evaporation ponds.

Finally, clay-based extraction could potentially tap into previously uneconomical lithium resources. As Ernest noted, “It had been a huge oil-producing region for a long time. It's got a lot of brine there still in these underground reservoirs … but they also contain a lot of lithium.”

This opens up the possibility of co-extracting lithium alongside oil and gas production, making use of existing infrastructure and potentially reducing the overall environmental impact.

However, extracting lithium from clay is not without its challenges. Developing efficient and cost-effective technologies to liberate the lithium from the clay matrix is a key area of research and development. Additionally, the processing of clay-based lithium resources may require different approaches compared to traditional sources, requiring further innovation and investment.

Despite these challenges, the potential of clay deposits as a more sustainable lithium source has attracted considerable interest. Several companies and research institutions are actively exploring and developing clay-based extraction technologies, driven by the need to diversify lithium sources and reduce the environmental impact of this critical mineral.

Charting a sustainable course for lithium

While conventional lithium mining has raised valid concerns about its environmental impact, the exploration of alternative extraction methods offers a glimmer of hope. DLE, with its promise of reduced water consumption and land disturbance, represents a potential paradigm shift.

Meanwhile, advancements in brine processing techniques offer a more incremental yet impactful approach to minimizing the footprint of existing operations. And the emergence of clay deposits as a viable lithium source opens up exciting possibilities for diversifying supply and reducing reliance on more environmentally intensive methods. The path forward requires a collective effort, embracing innovation, responsible practices, and informed decision-making.

10/08/2024 by Betsy McDowell

Despite their different underlying economic conditions, central banks around the world have largely kept similar monetary policies anchored on inflation targeting.
According to economist Adam Posen, the public often carries negative misconceptions about inflation data, leading to investor overreactions on central bank communications. The Federal Reserve especially must work to set and manage realistic expectations.
Regardless of who wins the 2024 election, the American political climate is poised to keep inflation above the target rate for at least the next five to ten years.

Since the COVID-19 pandemic, nearly every major global economy has followed a similar monetary policy. First, interest rates plummeted to stimulate the shell-shocked economy, then central banks reversed course to address the subsequent inflation.

While 2024 has been a year of speculation on Federal Reserve rate cuts — and a growing chorus to expect “higher-for-longer” interest rates as the U.S. economy has remained stubbornly resilient to the pressures of inflation, there’s a larger macroeconomic mystery that isn’t getting much attention.

With the notable exception of Japan, central banks around the world have kept interest rates elevated since early 2022. Intriguingly, however, these major economic areas — the U.S., the European Union, the U.K. and Brazil among others — have significant differences in energy supply, labor markets, proximity to conflict zones and other factors that one might predict would create differences in monetary policy. What’s driving this almost singular narrative of central bank decisions?

This is the question Adam Posen recently asked in an opinion piece for the Financial Times. Adam is President of the Peterson Institute for International Economics, a nonpartisan global think tank, and his long career includes numerous consulting positions for the Federal Reserve, Bank of England and other government agencies.

In 1998, Adam co-authored “Inflation Targeting: Lessons from the International Experience.” This book was an early case study on the efficacy of inflation targeting — that is, a central bank’s transparent commitment to bring inflation to a specified rate. Somewhat to Adam’s surprise, this theory mapped out almost three decades ago is an accurate descriptor for current central bank behavior.

“If you have a credible long-term anchor for expectations with an independent central bank acting transparently, you can ease [inflation] in the short term,” Adam says.

Host Alan Dunne recently spoke with Adam on a Global Macro edition of Top Traders Unplugged to ask more about the underlying factors informing expectations around central bank decisions and the political conditions that could influence monetary policy decisions in the next few years. Read on for the key findings — and advice on how investors should move in response to central bank communication.

The mystery of central bank conformity

In many ways, Adam argues, the near-uniformity of central bank positioning on inflation should come as a surprise to economists.

“There’s a huge difference in energy consumption and energy market structure in the U.S. versus Europe versus the U.K.,” Adam says. Parts of Europe have much larger exposure to imported food and imported energy when compared to the U.S., while the labor market in Central and Eastern Europe has considerably lower costs when compared to Western Europe, the U.S. and Canada. Of course, there are also differences in demographics, political systems and proximity to the ongoing conflict in Ukraine.

And yet, dozens of nations all hiked interest rates in 2022, and, in the first half of 2024, the European Central Bank (ECB) and Canada were among the many financial institutions to announce rate cuts, almost as if there were a global playbook that everyone’s following.

“The fact that such different economic structures didn’t have differing effects [on interest rates] needs an explanation,” Adam says. “Otherwise, there’s nothing that’s similar across countries.”

The only common thread is a policy response to inflation.

So what exactly is that policy? More than just a numerical response to consumer prices and employment data, Adam sees a concerted effort for central banks to set and uphold public expectations. This is the idea of a target inflation rate, which for the ECB, U.S., U.K., Brazil and many other nations stands between 2% and 3%. If inflation remains above the target, central banks will tighten, while if inflation nears the target, interest rates will drop. Critically, for this system to work, central banks have to be transparent.

Managing expectations

Speaking about high-income economies in particular, Adam describes the public view of inflation as asymmetric. “[Most people] hate overshooting inflation more than they hate undershooting,” he explains.

For instance, it’s well documented that, over the last year especially, most Americans have negative misconceptions about the economy, such as believing the economy is shrinking while actually GDP is growing. Above-target inflation, then, likely sounds worse to the general public than it does to economists or investors.

Unfortunately for central banks, most forecasters see inflationary headwinds in the next decade. “For climate reasons and geopolitical reasons, we should expect there’s going to be more energy and food price shocks, more wars, sadly, and more migration,” Adam says. So central banks are between a rock and a hard place — the public hates high inflation, but a 2% target seems unattainable for the foreseeable future.

Even if some members of the Fed might think 3% or even 4% is a more realistic inflation target, moving the goalposts now risks a major hit to their credibility. “Announcing inflation targets is kind of like announcing an exchange rate peg. Once you announce it, it’s very hard to change,” Adam explains.

The result is what has become these highly dramatized news conferences where Jerome Powell, Chair of the Federal Reserve, tries to offer guidance while preventing an overreaction in the markets. He strikes a balance between reminding that the U.S. hasn’t reached the 2% inflation target while maintaining enough positivity to avoid a backlash. “Whenever [Powell] makes a statement, he’s correcting to the dovish, or the hawkish side from what his last statement was,” Adam notes.

But is it misleading to put so much emphasis on the nominal interest rate? Some critics of inflation targeting say that is.

More than just numbers

Economists look not just at the established Fed funds rate but also the real interest rate — one adjusted for inflation. For example, if the interest rate on a deposit is 4% but inflation is 3%, the actual return on investment is only a 1% gain in purchasing power.

Alan asks, “Which of these is more important — nominal [interest] rates, real rates, financial conditions or changes in the rates?”

For Adam, financial conditions are an easy winner. As discussed, the Fed’s changes to the nominal rate aren’t necessarily tied to the impact of inflation, and “the real rate of interest is not a sufficient statistic for credit conditions,” he explains. Bond credit spreads, international capital flows and even consumer savings behavior all impact the lending process.

As an example, Adam points to the 2023 collapse of Silicon Valley Bank (SVB) as the result of poor regulation and supervision, not as something tied to inflation or interest rates. In other words, the financial conditions driving tech startups to make heavy withdrawals — combined with SVB’s failure to properly manage its deposits and hedge against interest rates risk — were to blame, not the central bank’s monetary policy.

The takeaway? Adam advises investors to be wary of market overreactions to any interest-rate announcements from the Fed.

“If there is a large move due to a [Federal Reserve] statement, I would take the other side of that bet,” Adam says.

Observations of the US economy

After more than a year of holding interest rates steady, the Federal Reserve has signaled that it won’t wait until reaching the target of 2% inflation before cutting rates. How should investors understand the current state of the U.S. economy? Adam offers four observations.

1. Prepare for a soft landing

Powell’s comments show that the central bank may be responding to public pressure. Instead of holding the line until inflation comes down closer to the target rate, the Fed may look to keep pace with other nations that have already started to lower the cost of borrowing.

“The Fed is not as tight as they think they are,” Adam says. “I don’t expect any sharp downturn.” In other words, one way to look at the sustained inflation in recent months is to say the Federal Reserve isn’t putting enough pressure on the economy to dampen the market. The so-called soft landing that avoids a recession is increasingly possible, especially if a small downtick of the Fed funds rate reignites business spending.

2. Expect congressional spending

No matter the outcome of the 2024 presidential election, Adam predicts Congress will continue to stimulate the U.S. economy in 2025 — at least more so than where most baseline expectations sit right now.

“There’s going to be defense spending, infrastructure spending, industrial policy spending, irrespective of what happens [in the election],” Adam says. Government spending could be another factor helping the U.S. avoid recession, and potentially a factor keeping inflation above the target rate.

3. Watch for a productivity jump

In 1996, before the internet had taken hold of everyday life, then-Fed Chairman Alan Greenspan predicted the information technology boom would drastically increase economic productivity. Now, in the age of artificial intelligence and machine learning, we could be looking at another productivity jump in the next several years.

Adam sees labor hoarding and heavy investment into AI technologies as two indicators that a positive productivity shift is coming, “probably in less than five years.” A corresponding surge in economic output is another reason the U.S. is likely to sidestep a recession.

4. Get ready for stagflation politics

Finally, no matter who takes the White House in 2024, Adam expects policy-making to slow economic growth and raise prices for Americans.

Anti-trade policies — as both Democratic leaders and Donald Trump have campaigned to be tough on China — will likely have an inflationary effect as tariffs pass higher costs onto consumers. Meanwhile, “anti-migration policies, including deportations, are going to be contractionary,” Adam adds. The combination of higher prices and slow economic growth is known as stagflation.

Monitoring political impacts

Speaking of politics, Adam views far-reaching nationalist policies as the biggest threat to central bank independence. “If there is a fiscal crisis in the next few years,” he says, “it is likely going to be completely due to political breakdown in the U.S., not due to market forces.”

But thinking optimistically that Congress can continue to function — growing peacetime, non-pandemic deficits will keep high interest rates on U.S. bonds. If China, historically one of the largest holders of U.S. Treasuries, slows its bond purchases, there could be even more upward pressure on rates.

“We potentially end up with a world that further increases U.S. interest rates because there’s just simply a smaller supply of savings to fund a larger supply of Treasuries,” Adam explains.

Think contrarian

So we’re left with a familiar paradox. The public has no patience for inflation, and it behooves the Federal Reserve to speak in terms of meeting a target, even if all other economic factors indicate that goal is entirely unrealistic in the next few years. The Fed is clearly feeling some pressure to announce rate cuts in the coming months, but Adam sees sustained high rates as the more likely macro-narrative. If other investors are prone to overreact at the next Fed press conference, perhaps it’s wise to look the opposite way.

03/08/2024 by Betsy McDowell

Is the U.S. economy about to enter a recession? That’s up for debate, but there are leading indicators we can use to make an educated guess — like the Sahm Rule.
Economist Claudia Sahm developed the rule that bears her name based on the rate of percentage change of the unemployment rate.
What does the Sahm Rule reveal about the economy’s current condition, and why is this metric so revealing.

“When I went to college, I didn’t even know what an economist was, let alone that I wanted to be one,” says Claudia Sahm, Chief Economist at New Century Advisors, author of the Stay-At-Home Macro Substack and creator of the Sahm Rule.

“Within pretty short order, I was convinced that economists can do good in the world. We have tools to go at problems that are really important.”

Claudia’s perspective on economics highlights the importance of interdisciplinary thinking. She argues that understanding economics isn’t just about studying current theories and data but also involves considering broader contexts. Her emphasis on interdisciplinary thinking — integrating political economy, historical perspectives and practical policy design — provides a more comprehensive, adaptable understanding of economic issues, which is essential for progress.

Claudia joined host Alan Dunne on an Global Macro installment of Top Traders Unplugged to discuss the current macroeconomic outlook, the state of the US labor market, the recent decline in inflation and much more.

Sahm signals

“The origin of the Sahm Rule ties very much into why I’m an economist,” says Claudia, who developed a proposal in 2019 with several other economists on how to prepare better for the next recession. “This was before we even knew that a recession was coming, and the idea was to take policies that we often do (in my case, the stimulus checks) and put them on autopilot; tie them to economic conditions, have them ready to go, and as soon as the economy takes a turn for the worse, get the help out.”

Identifying the economic conditions that could “very predictably” signal a recession is invaluable “because things, once they start going south, can head south fast,” she adds.

The Sahm Rule focuses on changes in the unemployment rate as a leading recession indicator.

“There’s no magic level,” Claudia points out. “The United States has gone into recessions with an unemployment rate of 4% and with the unemployment rate at 8%. It’s really about how things deteriorate. Are they getting worse?”

Data from the past several decades, however, tells us that “it doesn’t take much of an increase in the unemployment rate to tell us we’re in a recession,” she notes.

Forecasting the future

While rooted in economic data, the Sahm Rule’s development was influenced by Claudia’s broader perspective on policy — such as automatic stabilizers that adjust based on economic conditions. Her foresight was particularly valuable during the COVID-19 pandemic, when rapid economic intervention was crucial.

Despite its innovative design, the Sahm Rule has not yet been used to trigger preset economic measures. However, its existence underscores the importance of preparing for economic downturns in advance. By automating policy responses, the rule aims to reduce the lag between economic shocks and government intervention.

One might argue that the Sahm Rule is a model for proactive economic management. By automating certain policies, governments can ensure timely support in response to economic shocks, reducing the impact of recessions.

Are we heading towards a recession?

The relevance of the Sahm Rule is readily apparent in the current economic climate. While we haven’t reached the 5% increase threshold, the unemployment rate is at 4%, indicating that the economy is on shaky ground.

The periodic recession anxiety we’ve seen in recent years has previously been accompanied by a strong labor market. Now, Claudia says we’re “much, much, much closer” to a recession than we’ve been at any point in the post-pandemic recovery.

“The labor market, for the U.S. really, is the linchpin because most Americans spend what they make — either because they have to or they like to,” she argues. “And most Americans, what they have to spend comes from their paychecks. So we’ve seen a very positive virtuous circle between the labor market and the American consumers. If you lose that, then you’re done.”

Alan asks, “What led to this point?”

“Unlike some of our peer countries, we had a very rapid recovery,” Claudia explains. “And not just the inflation came back. The United States last year had above-trend growth. Things were just moving really fast. And we want to get onto a glide path. We want to come out of this in a sustainably good place. When things are running too fast, it’s often not sustainable and you end up crashing.”

The U.S. economy experienced rapid growth, followed by a period of moderation. This transition makes the economy more vulnerable to policy mistakes. Sahm emphasizes the importance of monitoring a wide range of economic indicators, not just relying on a single measure like the Sahm Rule. The labor market, in particular, is a crucial indicator. Strong employment supports consumer spending, which drives economic growth.

Our next cycle, by the numbers

The most recent labor data was “seemingly strong,” says Alan. “But at the same time, the prior numbers were weak. And then you’ve had a recent pickup in jobless claims. At the same time, the jobs have been easing. … Putting it all together, how would you characterize it?”

Claudia points out that the payroll employment number in May was a far bigger increase month over month than expected (although she notes that the payroll employment data was weaker in April).

Although May’s impressive numbers led to a widespread belief that the labor market was strong and defied expectations, the unemployment rate hit 4% for the first time in over two years.

“We’ve had a notable increase in our unemployment rate since the middle of last year,” Claudia says, adding that that 4% figure has “some very clear ties to the jobs number in the [same] survey,” which was “horrible” — down by about 400,000.

Will the Sahm Rule hold true in the coming months?

Time will tell. But Claudia’s approach to economics demonstrates the value of looking beyond traditional boundaries toward a more nuanced understanding of economic issues. As the unpredictable becomes utterly predictable, her insights remind us of the importance of maintaining a broad perspective. By staying open to new ideas and learning from the past, we navigate the complexities of today’s economic landscape with more resilience than ever before.

21/07/2024 by Betsy McDowell

Recent advances in neural imaging give a psychological basis for why people often misunderstand each other in conversations, according to bestselling author Charles Duhigg. Conversations have emotional and social components beyond the practical sharing of information.
“Supercommunicators” are skilled at asking meaningful questions and mirroring the emotional energy of others. With practice, anyone can learn to have more effective communication.
Conversational best practices foster trust, strengthen insights and create more efficient decision-making, even in traditionally quantitative fields such as finance and investing.

It’s a familiar story. A person comes home complaining about a long, frustrating day at work only to bristle when their spouse offers some advice. “I’m trying to help,” the spouse says, but their words have only made the situation worse.

This was the case for Charles Duhigg, an award-winning writer for The New Yorker and bestselling author of “The Power of Habit.” Despite a successful career in journalism, Charles often encountered communication challenges at work. Things weren’t any different at home, either.

“I would come home after a long day of work, and I would complain about my day and my co-workers. [My wife] Liz very practically and reasonably would offer me some advice, [but] instead of being able to hear what she was saying, I would get even more upset,” Charles recalls.

This pattern prompted an investigation. Why, despite our best intentions, are humans so bad at basic communication? Charles’s extensive research resulted in his newest book, “Supercommunicators: How to Unlock the Secret Language of Connection.”

Charles joined host Kevin Coldiron on an Ideas Lab episode of Top Traders Unplugged to discuss his findings and the workplace implications of proven effective communication styles. Read on to discover the psychology behind meaningful conversations that build trust in relationships.

Communication brain science

To start, it’s not that conversational dynamics are a new topic. Humankind has thousands of years of spoken language experience. But only in the past few decades has neuroimaging allowed researchers to map brain activity while two people are talking.

“One of the things that we’ve discovered is that every discussion is made up of multiple kinds of conversations,” Charles explains. For instance, you might think a colleague is simply asking for your help interpreting a technical analysis, but there are hidden neurological dynamics at play. These simultaneous psychological conversations fall into three categories:

Practical — exchanging information, solving problems or making plans
Emotional — verbal expressions of feeling in search of an empathetic response
Social — relating to each other based on social identities and societal norms

Imagine that the colleague asks for help, which seems practical, but the emotional reason they’re asking is that they feel frustrated and inadequate for not solving the issue on their own. Socially, the tone of your response will likely change depending on whether you consider yourself a mentor or a peer, and other person’s reaction will likewise depend on how they view you. If you answer the question but misjudge the emotional or social dynamic, your colleague may not feel heard.

“This has given rise to what’s known as the matching principle in psychology,” Charles says. “Being able to communicate [effectively] relies on having the same kind of conversation at the same moment.”

To address this, successful communication requires a sort of negotiation. The first goal of a conversation should be ascertaining what the other person wants. Charles compares this to a schoolteacher asking a student, “Do you want to be helped, do you want to be hugged or do you want to be heard?”

Highly effective communicators understand which type of conversation their listener most wants to have and adjust their posture accordingly.

Traits of a ‘Supercommunicator’

Fortunately, all of us have the innate tools to navigate these conversational dynamics. Humans have highly evolved communicative abilities. “All of us, at some level, know how to connect with other people,” Charles says. “It’s just that sometimes we forget it.”

A “supercommunicator,” then, is not someone born with a special talent for socializing. Rather, it’s someone who has recognized that communication involves a set of skills that they can cultivate. They enter conversations with the intention of hearing the other person well.

But it’s more than just paying attention and making good eye contact. Conversations are cognitively intense, and most people are more focused on what they’re going to say next than on watching their audience’s behavior. This means supercommunicators must emphasize that they understand the nuances of the conversation.

“There is an instinct in all of our brains to suspect that the other person is not actually listening to us,” Charles says. To calm this fear in another person, supercommunicators can follow three simple steps.

Ask a question
After the other person responds, summarize their answer in your own words
Ask if you understood correctly

When we get it right, the effect is transformative. “That feeling that you have after a great conversation is actually a dopamine reaction inside your brain that’s been trained by evolution to push us to connect with other people,” Charles says.

So if supercommunicating is really this easy, why do conversations go wrong?

How to ask deeper questions

Ironically, it’s often the most important conversations that we’re least prepared to have. Someone might come into a discussion already full of anxiety or heightened emotion, perhaps already with the belief that they’ll have to fight to get their viewpoint across.

In a conflict, Charles recommends first pausing to determine the type of conversation the other person wants to have. “Reset and say, let’s get on the same page here. Are we talking about solving this problem? Are we just sharing the problem and how we feel about it?”

Charles points out that our most trusted confidants are often the people who know what to ask. They have a skill set to identify the primary type of conversation, and they can effectively draw out our thoughts and feelings through deep, vulnerable questions.

Inquire about values

“[A deep question] doesn’t have to elicit emotions,” Charles clarifies, “but it does have to elicit values, beliefs or experiences.”

A social question would be asking a doctor where she practices medicine. This is taking a polite interest in her career, but it doesn’t build a personal connection. A deeper question would be asking her what she loves about her job — something that unlocks her values and passions. Depending on how she answers this deeper question, you’ll have a better sense of whether the conversation is moving in a practical or an emotional direction.

“It's really important to train ourselves not to ask about the facts of someone’s life, but how they feel about their life. That’s where a deep question resides,” Charles adds.

In most cases, a deep question invites a dialogue. As the other person talks about their values and beliefs, it’s natural for you to respond with something meaningful about yourself, strengthening the interpersonal connection. Maybe you’re not a doctor, but you can sincerely relate to helping those in need.

Match emotional energy

Another best practice in meaningful communication is to mirror the other person’s emotional energy. This doesn’t mean mimicry or that the reaction has to be insincere. “Matching is just acknowledging that you feel a certain way,” Charles says.

Imagine that a coworker shared that their aunt had recently passed away. Most people would politely offer condolences, but a quick “I’m sorry” likely doesn’t correspond to the emotional heaviness that the coworker is feeling. A better response, Charles says, is to ask questions.

Rarely, though, should the question be “How can I help?” Often someone experiencing a loss wants an emotional conversation more than a practical one. Instead, a good question would be, “Tell me about your aunt. What was she like?” Showing empathy and a real interest in the other person’s thoughts is a mark of emotional intelligence.

“At their core, that’s what supercommunicators do. They show us that they want to connect with us,” Charles says.

Consider multiple identities

The previous examples are most applicable when meeting someone new or when someone is experiencing a difficulty. In everyday workplace interactions among colleagues, effective questions consider the complexity of a person’s identity.

“When we talk about identities, sometimes people just default to race or politics, but there are a thousand different things about you,” Charles says. “Rather than always force identities into a conversation, just try and figure out if identities are important.”

For example, a conversation about school systems will likely trigger certain identities. Parents of school-aged children may feel personally connected to the issue, but that’s not to assume that someone without kids won’t have an opinion.

Instead of saying to that person, “You don’t have kids, so you probably don’t know much about this,” a supercommunicator will acknowledge other identity touchpoints. They may say, “You live in this community. What do you think?” This invites a response rather than creates a divide.

Communication in technical fields

But what about in technical fields where emotionally charged topics are less common in the workplace? Kevin wonders how these supercommunciation skills apply to the quantitative world of investment. “Are these deep questions appropriate in any context?” he asks.

“Absolutely,” Charles says. “If you’re in those minutes before a meeting starts, or when you're trying to get to know someone, ask, Why did you decide to become an investor? What’s your favorite part of [the] job?”

Not every interaction, of course, needs to be a deep conversation. Practicing these skills can not only build relational bridges; it can also hone another communication skill — listening.

Especially at a large investment firm, analysts need to feel comfortable sharing ideas and be able to trust each other’s insights. In some cases, practiced supercommunicators can even have a competitive edge in market predictions.

“Sometimes you’re watching someone respond to questions in an earnings call … if you know how to listen really well, you can pick up on what goes unsaid,” Charles adds. Honing communication skills in workplace interactions makes it easier to pick up on nonverbal emotional cues.

With the right intention and focus on these communication skills, anyone can be a more effective leader, a more productive teammate and perhaps even a happier spouse. Meaningful conversations are the foundations of our most important relationships.

29/06/2024 by Betsy McDowell

The future remains unpredictable, but one thing is clear: The global economy is in turmoil. Investors, businesses, and governments need to reconsider their strategies in response to rampant inflation, the persistent climate crisis and an aging population. Additionally, they face unprecedented peacetime debt, disruptive innovations and the impacts of multi-globalization.
With so much occurring at once, distinguishing significant trends from minor fads is challenging. In their book “The New World Economy in 5 Trends: Investing in Times of Superinflation, Hyperinnovation and Climate Transition,” Koen De Leus and Philippe Gijsels analyze trends that will shape the markets (and our everyday lives) in the coming decades.
How will artificial intelligence (AI) change the economic landscape? Will robots take our jobs? Which companies will emerge from the AI revolution with a stronger (human) workforce? Koen and Philippe talk about their book and provide insights into these questions and many more.

Koen De Leus and Philippe Gijsels, the authors of “The New World Economy in 5 Trends: Investing in Times of Superinflation, Hyperinnovation and Climate Transition,” field lots of questions about the future, but there are two they hear more than any others.

The first one is, “Is AI for real?”

That’s a “very fair question,” says Koen, Chief Economist at BNP Paribas Fortis, the largest bank in Belgium. “Because we’ve had five waves of AI already over the last 50 to 60 years, and each and every time it was a hype that died out reasonably quickly.”

As you might imagine, it’s no longer just hype and the answer is a resounding yes. But what’s different about today?

Koen points out that centuries ago, Leonardo DaVinci drew detailed sketches of parachutes, helicopters and submarines, just to name a few innovations.

“But these products never came into being until 300 years later, because he did not have the parts,” he says. “If you want a helicopter, or an airplane, or a car, you need a motor. When you want a computer, you need a microchip.”

The “parts” we need for artificial intelligence are quantum computing power and big data — the ability to process, store and analyze it.

“These two parts are … on the table [today]. So therefore, I believe that AI is for real,” Koen says.

The next question inevitably is, How do we benefit from AI?

In “The New World Economy,” Koen and Philippe, the Chief Strategist at BNP, explore this concept as one of the five “global megatrends” to expect between now and 2050 (along with inflation, climate change, demographic shifts and massive debt).

Koen and Philippe joined host Kevin Coldiron on an Ideas Lab installment of Top Traders Unplugged to discuss their book and their forecasts for the decades to come, including commodity trends, supercycles, energy transitions and more.

Read on for their insights on how AI will shape the labor market — and our everyday lives.

Hi, robot

Artificial intelligence is fascinating and full of promise. But it’s also the subject of widespread fear: What if we’re replaced by machines and lose our jobs?

According to Koen, McKinsey has estimated that between 2030 and 2060, about half of the work activities performed by humans today could become automated.

“That's scary,” he admits.

However, he notes that in 2020, the World Economic Forum estimated that 85 million jobs will disappear by 2025 — but 97 million jobs will be created in the age of AI.

“The big question is, who loses their jobs?” Koen asks. As he sees it, the “losers” will be the companies that do not invest in AI technologies now and shape the innovation landscape in their favor.

The companies that harness AI and — critically — train their people to use it, will make their own opportunities, increase their market share and attract top talent.

“You don’t have to be afraid of artificial intelligence,” he says. “You really have to be afraid [if] you don’t use artificial intelligence yourself.”

‘Factories of the Future’

“The New World Economy” profiles a program called “Factories of the Future,” administered by Belgian technology consortium Agoria. Only the most “forward-looking manufacturing companies using the most advanced digital technologies” can earn this distinction, says Koen. Today, the label has been bestowed on about 60 Belgian firms, and the program is being rolled out all over Europe.

“The factories of the future are coming,” Koen argues. He explains that he and Philippe surveyed a range of companies in their native Belgium. Unsurprisingly, those with a “Factory of the Future” designation have a very different take on the impact of automation on jobs than those that do not. Forward-thinking companies tend to be optimistic that AI’s net disruption on the labor market will be minimal in both the short and long terms. But more traditional companies were “very afraid” that their industries would “lose quite a lot of jobs.”

Notably, “Factory of the Future” companies increased employment by an average of 30% between 2015 and 2020, while traditional enterprises were stagnant or experienced negative growth. Productivity at future-forward factories rose by 10% on average, but only by 5% at the conventional plants.

The ‘Magnificent Seven’ incumbents

Kevin points out that when we examine how the market reacts to AI innovations today, it appears that there’s an assumption that the current “tech incumbents” like Apple and Meta will be the long-term winners as AI evolves.

“Do you agree with the market, that these incumbents are going to be the winners?” he asks Philippe. “And if not, how do investors navigate or try to take advantage of these trends when the potential winners aren’t necessarily obvious right now?”

Philippe points out that the “Magnificent Seven” (Meta, Apple, Microsoft, Alphabet, Nvidia, Amazon and Tesla) “really dominated the market last year and the first couple of months of this year.”

He argues that “innovation also means incumbent players coming in and replacing the old companies,” noting that the last big breakthrough before AI was … well, the internet.

We saw the creation of something like 600 companies capitalizing on the Web 1.0-fueled tech boom of the ’90s, but most of them went belly up when the dot-com bubble burst. Just a few big ones, like Amazon and Google, survived and became today’s “incumbents.” However, history tells us that they’ll eventually become the old guard.

This time, it’s different … or is it?

That was the case during the early days of railroads, Philippe explains. There were hundreds of rail companies in the U.S. alone, and they “all went bankrupt four or five times,” he quips.

Now, just a relatively small handful of rail companies remain even though railways are still critical infrastructure.

Likewise, the auto industry included thousands of companies in the early 20th century.

“There was even one in Belgium — which also, by the way, went belly up,” says Philippe.

Today, there are only a few dozen automakers and far fewer big players in the automotive manufacturing world.

When it comes to AI, “we could expect …. that new incumbents come in and replace the old players,” he adds. “Now, I’m very careful when I say this, because it’s always very dangerous to say that this time, it’s different. But never before [have] we had companies with market caps of $300 billion, with so much cash, so much profit … so much knowledge, the possibility to buy whatever they want. So at this time, they [the “incumbent” companies] could take a chunk of this market. That’s always possible.”

The Domino’s effect

So what’s an investor to do? Strike out and take risks with leading-edge startups or throw in our lot with the Magnificent Seven?

“That’s the question,” Philippe says, adding that many of us are “chicken” and try to split the difference.

“We do not want to lag behind the market or competitors, so we make sure we’ve invested enough — not too much — in the big guys. But we also look for other opportunities. … We are looking for the Domino’s Pizza of AI.”

He explains that analogy by pointing out that Domino’s is a fairly big company, but it’s a pizza company — “hardly what you would call a technology company,” he says.

“But if you look at the stock [listings] and take away the name Domino’s Pizza, and ask anyone to watch it, they would say it’s like Bitcoin, or it’s a technology company because it has gone up 40-fold or something like that. And what did it do very well? Well, when 4G came into being, they used that new model to take orders … that was one of the ways to grow.”

So whether you’re aiming for a slice of the startup pie or a hefty helping from the tech giants, just remember: Sometimes, the next big thing is delivered right to your doorstep. After all, who knew a 63-year-old chain could innovate its way to grabbing the biggest slice of the pizza market pie? Similarly, in the realm of AI, the most groundbreaking advancements might not come from the obvious players. Keep your eyes peeled for those unexpected contenders—today’s humble pizza delivery could be tomorrow’s AI revolution.

16/06/2024 by Betsy McDowell

As central banks around the world consider easing their monetary policies, inflation remains a significant risk factor in portfolio allocation.
U.S. private growth is far outpacing Europe, but American politics arguably create more uncertainty than the EU’s moves in the next few months. The 2024 U.S. election will have reverberating global macro impacts.
While predictable interest rate changes favor a 60/40 portfolio allocation, diversification into structured products and trend following may provide even more upside in periods of high volatility.

Inflation is like politics — we’re hearing a lot about it in 2024, and most people wish the topic would go away.

But as we look ahead to pivotal elections in the second half of the year against the backdrop of a tense, populist-driven geopolitical climate — where are markets moving, and what allocation strategies are best suited to manage volatility?

To answer these questions, co-host Cem Karsan and I met with Christian Mueller-Glissmann, Head of Asset Allocation Research and Managing Director at Goldman Sachs. It’s been six months since I last spoke with Christian about his investment framework, and we’ve since seen an optimistic equities market in the U.S. and hints of a reversal in the Federal Reserve’s monetary stance. Meanwhile, European markets are also preparing for a rate-cutting cycle, and the manufacturing and energy sectors are in focus as world leaders lean into protectionist policies.

On the latest Global Macro episode of Top Traders Unplugged, Christian discusses the complexities of capital allocation in an uncertain geopolitical climate, and we assess the benefits and drawbacks of using a traditional 60/40 allocation benchmark. From wide-angle views on European and U.S. markets to specific insights on investment strategies, here’s what to watch for in the coming months.

The state of market sentiment

In 2022, we lived under a cloud of recession fears, and then in 2023 sentiment swung the other way with bullish expectations of the so-called Goldilocks scenario where growth would continue and inflation would come down.

“Since the beginning of [2024],” Christian says, “the sentiment has shifted from Goldilocks to a bit more pricing reflation.” Referring to an increase in money supply and a stimulation of the economy, reflation policies typically follow periods of economic contraction.

In our present context, central banks may look at signals that inflation is declining, lending has decreased and key markets are losing liquidity, and decide that it’s time to slash interest rates. The risk, of course, is moving too quickly to loosen monetary policy before inflation comes down to target levels, a concern reiterated at the most recent meeting of the U.S. Federal Reserve.

“I think the problem right now is this ‘reflation flirtation’ turning into desperation because you obviously have inflation potentially being more sticky than you'd like,” Christian notes.

While Christian doesn’t see markets in “desperation” mode quite yet, he highlights the concern around high equities and low volatility. If markets are elevated in expectation of central bank policy changes, but inflation stays high, a renewed uncertainty will bring more volatility to the stock market.

“The market is potentially getting very sensitive to growth in the next few weeks,” Christian says. “We’re coming back to this idea that inflation is actually uncertain, more volatile and potentially becoming more of a risk factor in the portfolio on a more sustained basis.”

Drivers of inflation

Structurally, what’s propping up inflation despite the decrease in money supply? Christian looks at a series of global macro factors, many of which will be prime topics of debate in key elections later this year.

“There’s decarbonization, deglobalization and demographics on the negative side [of inflation], and then more fiscal dominance and fiscal policy expansion on the demand side,” he says.

To the first point, investing in clean energy and onshoring manufacturing puts pressure on key commodities and elevates prices. Deglobalization efforts also disrupt current supply chains and create economic inefficiencies, and an aging population can also impact employment markets and consumer prices.

On the other hand, a record-high global debt and a loosening of monetary policies are contributing factors to inflation in international markets. As elections for the European Parliament take place in June and the U.S. presidential election occurs in November, how are world leaders responding to these inflationary pressures, and what’s the potential impact on investment allocation?

The U.S. vs. Europe

While the U.S. and Europe have many parallels in their political discourse around foreign policy and economic expansion, structural inflation risk takes different shapes on either side of the Atlantic.

“In the last few months, the European inflation picture has continued resetting whereas the U.S. has stabilized because the growth backdrop is better there,” Christian argues. Several considerations support this claim.

Private sector differences

The European private sector as a whole has lagged behind its American counterpart. The U.S. continues to outperform other nations in economic growth.

In the U.S., says Christian, “Households are doing really well. The unemployment rate is low, and the [S&P 500] is up, which means the households in aggregate actually have a very healthy financial backdrop.” Meanwhile, Europe’s heavy exposure to the global manufacturing recession is a lead weight tied to the region’s economic turnaround.

High debt exposure

The European Union and the United States both have substantial debts on their balance sheets. When nations are heavily indebted, they eventually have to get rid of their bonds, and — with few foreign buyers in the market — this is commonly achieved by offloading the debt to banks. Currently, the U.S. debt represents a higher percentage of GDP , which, in theory, creates a greater structural risk in the U.S. Yet European households are more exposed to the bond market, which means inflation could be more of a risk there.

Japan is a notable example of offloading debt to banks, and, as Christian notes, “A lot of people say that Japan is the template that Europe might follow.” European households generally have a high allocation to bonds and savings accounts — in part because the return on European equities is so poor. This creates a situation where households are exposed to inflation on both sides of the coin. High inflation means savings are less valuable, but as inflation cools, bond yields fall.

Political backdrop

Yet if inflation is a bigger risk in Europe, politics are a bigger risk in the U.S. “Populism has been a thing in Europe for a long time,” Cem observes, “but the pushback is more significant.” Heavy investment into liquefied natural gas is driving energy costs down while the fiscal policy has a high number of checks and balances.

The U.S., on the other hand, sits on substantial uncertainty regarding its foreign policy, trade relations with China, corporate regulation and other issues depending on who wins the White House later this year. No matter what happens, it will probably be more in favor of U.S. equities than bonds, Christian predicts, but the uncertainty will ramp up volatility.

“Europe, to some extent, looks a bit less scary on the fiscal side [compared to the U.S.], partially because of that political backdrop,” Christian concludes.

Assessing the 60/40

With all these factors considered, what’s the impact on portfolio allocation? Christian suggests taking the 60/40 portfolio as a starting point, then considering how the volatility of inflation will shake up markets.

“The best way to characterize this debate is to ask how many growth shocks are you generating relative to how many rate shocks are you generating?” he says. A “shock” in this sense is a surprise, good or bad, that suddenly swings the pendulum in investor activity.

When most of the surprises are coming from the equities market — a “growth shock” — stocks and bonds tend to have a negative correlation, which benefits the 60/40 allocation. As inflation calms down and central bank moves become predictable, it becomes less likely that investors will be surprised by rate changes, which means fewer “rate shocks.”

But Cem pushes back. If we’re potentially looking at long-term structural inflation, he wonders, “Why should 60/40 always be our starting point?”

Christian answers, “Generally, when you have high inflation periods, the optimal portfolio tends to shift towards 100% equity, but you need to own the right equity.” Of course, unless you can predict the future, a smart portfolio is a diversified one. The optimal asset mix may include commodities, real estate and other alternatives to de-risk in periods of global economic uncertainty. An allocation closer to 60/40 is perhaps a safer play when volatility could swing.

Volatility in a holding year

Cem describes the holding pattern in U.S. markets, and effectively the global markets, as investors await the result of the presidential election. “There are all kinds of things that won’t happen or are less likely to happen,” he says, from corporate actions to geopolitical events.

In other words, it’s the calm before the storm.

This creates an opportunity for structured products that offer downside protection against high volatility while still holding growth potential. Christian sees some benefits in capital-guaranteed products, “if you’re in a low-vol regime with high rates.” Macro conditions favor bullish sentiments on equities, and bonds still have a decent coupon before central banks cut rates.

Cem adds that perhaps with so much expectation for volatility and risks to increase, implied volatility could compress, creating a long-term trend that requires more active portfolio management to find the most profitable opportunities. “It might be very bearish for implied volatility in the next decade,” he predicts.

Keys to strategic allocation

Between the tried-and-true 60/40 and a step into trend following and structured products, portfolios could go many different ways as we await central bank policy changes and the upcoming election results. In closing, Christian offers a few allocation principles.

Stay balanced

While higher-for-longer inflation naturally offers more opportunities in equity markets, bonds can provide some stability. “I think the bond market at four-and-a-half-percent yield provides you a buffer for growth shocks,” Christian says. If there is some sort of economic disaster, the surest position is a balanced one.

Look beyond the dollar

If inflation remains high in the U.S. while other places — such as Europe — see inflation come down, the real yield on U.S. equities will start to look less attractive. “The further out you look, the more you worry about the stickiness of inflation and surely you need to diversify that risk,” Christian says. “That’s where commodities come in.” He sees gold in particular as a hedge against economic stagnation.

Remember the cycle

Finally, we can remember that economic fluctuations are cyclical. While there’s quite a bit of geopolitical weight impacting the next few months of 2024, that pressure will abate, and then in a few years, the pattern will repeat. “We’ll have to diversify and manage inflation risk in the portfolio much more [now and going forward] than in the last 20 years,” Christian predicts. While markets can sometimes feel unpredictable, there are always patterns and trends to see that will aid in portfolio allocation.