Inflation is elevated these days, and markets around the world are pricing in rate hikes. However, risk assets like stocks are doing just fine. There seems to be some presumption that any Fed rate-hiking cycle will be mild and that ultimately inflation will settle down without too much further pain. Matt King, the Global Markets Strategist at Citigroup, isn't convinced. On this episode, he explains why what we're seeing now is the impact of a big "whack" to the global economy, one which has no natural mechanism to rediscover equilibrium or balance. He believes that, for the Fed to actually tame this inflation, it may need to go further than just modest hikes, and move aggressively to tamp down demand, possibly creating a recession. Transcripts have been lightly edited.
Tracy Alloway:
Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe Weisenthal:
And I'm Joe Weisenthal.
Tracy:
Joe, doesn't it feel like supply chains are everywhere at the moment?
Joe:
You know what, yeah. So we're recording this November 1st. I saw like three or four, maybe five, supply chain-related Halloween costumes on Instagram this weekend. No, I don't think like kids themselves are excited about dressing up as something supply chain-related, but it definitely seems like for a certain group of adults that was like a very humorous spooky thing this year.
Tracy:
Yeah. I saw a pumpkin that had supply chains carved into it, which I thought was phenomenally spooky, but I mean, it is true that this is the issue that everyone is trying to wrap their heads around at the moment. And to be honest, I feel like it's not something that most economists have necessarily, or most macro analysts, have necessarily had to think about in detail before. Obviously everyone talks about inflation. People think about what's driving that (although I still maintain that we actually don't have a really good idea of how inflation works), but I don't think anyone, you know, in preparing to be a macro investor or a macro trader or a macro analyst, I don't think anyone ever sat down and thought, wow, I really need to, you know, start understanding how like drayage works at the ports.
Joe:
No, definitely. Definitely not. And I mean, I think that's spot on and I think there's like two things that I've been thinking about. One is like in normal times, whatever that means, the supply chain is invisible to people, right? Like maybe you see trucks, but besides that, it's like the product is on the shelf. So it's kind of a bad sign that people are like talking and thinking about this because normally it's like, you know, you just expect it to just work and the stuff shows up and most of it is still showing up. But the other thing is, I think like, you know, by and large, from an economist perspective, it's like, this is such incredibly like complex systems that it almost feels like, you know, you had that great piece on the blog about saw dust and the price of milk. And there's all, you know, a little part here goes missing and that causes some other industry to miss a thing, etc. It does not feel like economics, as we talk about it typically is particularly equipped to really like wrap your head around this, at least like know, by and large, this is not part of most economists’ toolkit.
Tracy:
Totally. And of course the discussion about supply chains and how that feeds into prices and whether or not all of that is transitory, is happening against this broader backdrop of just mass uncertainty about where we are in the economic cycle, what central banks are going to do. And of course you mentioned, we're recording this on November 1st and it is an absolutely massive week coming up for central banks. We have a meeting for the Bank of England and the Federal Reserve, and they're going to have to figure out how they're dealing with these inflation pressures, whether or not they're going to push back against markets pricing in more hawkish moves. We just had some massive, massive moves in the bond market just last week with everyone sort of pricing in rate hikes much, much faster than I think most central banks would want them to. So it just feels like this really complicated time from a macro perspective.
Joe:
Incredibly complicated. One thing that's really striking right now is that the job market feels very disconnected from perceptions of the economy. The job market is booming in the sense that if there's tons of job openings, wages are growing really fast. In the post-great financial crisis period, the job market was the economy. That was really the only thing that mattered was the pace of job creation. Now, you know, we have all these surveys of consumers and they're like, yeah, the job market is great. We still think the economy stinks. That is a very new thing. The other thing, and you know, this is what we'll get into is from a central bank perspective, right? The economist’s sort of mantra is, okay, still it's transitory. And that doesn't mean it's going to go away right away. But by and large, this is related to reopening kinks and people shifting consumption from services to goods and all that stuff. And all that's fine. But that doesn't, I think even in mainstream eco, that is not a get out of jail free card for central bankers because they ascribe so much weight to expectations. And so, because they're like, well, okay, maybe the inflation is just related to supply chains and that will smooth out, but because they worry about changing inflation expectations as a driver of inflation itself, I think that explains why they're still getting like, clearly very anxious all around the world.
Tracy:
Well, totally. And I also think if you say that inflation pressures are transitory than the converse has to be true as well. You know, maybe at some point they disappear and we suddenly flip into deflation very, very quickly. Okay. Without further ado, I am very, very pleased to — because we've been talking a while — I am very pleased to introduce our guest for this episode. He's one of my all-time favorite analysts and also someone who has been doing the sort of granular detailed supply shortage work as a macro analyst. We're going to be speaking with Matt King. He is strategist of Citigroup Global Markets. Matt, thanks so much for coming on the show. Again!
Matt King:
My pleasure. You're much too kind as usual in your introduction.
Tracy:
So maybe just you know, let's start with what Joe and I were just discussing. How strange is it as a macro guy? You know, you've been covering the markets, global economies for a long time, but I don't think until this year you've ever really had to dive into, you know, shipping rates and things like that. How much of a learning process has it been?
Matt:
So there's any number of things which are completely different. Likewise, we hadn't really had to worry about inflation except in a negative sense until now. And I've been deep in the disinflationary camp and then suddenly you're recognizing this potential for a paradigm shift. So, yes, absolutely, I had never had to plot inventory curves for European gas storage, for example, never mind worry about effects cascading across from one segment to another. But what strikes me in all of this, you're too complimentary about the bottom up work I'm doing. And in a sense, I'm terribly interested in that. And yes, I'm having conversations with my shipping analysts and they're saying, oh, even as you strike deals now beneath the current spot price, it's nevertheless, you know, double or triple the rate that people have been paying over the last few years. But what strikes me generally is everyone has all these micro explanations for the distortions that we're seeing — the blockages in Long Beach and the gas prices in Europe and the wind didn't blow enough and what have you.
And for me, the striking thing is just the sort of systemic features that nobody's talking about, the way that economies have become steadily more specialized in ways that are highly efficient to make firms profitable when everything works, but are also vulnerable to exactly these sorts of breakages. And again, in this assumption that everything is transitory and sorts itself out, and everything goes back to normal, I'm just terribly conscious — again, you were sort of hinting at it in, in this discussion of how systems behave — you know, economics is full of examples of systems that are nice and well-behaved, and you nudge them a bit and then prices go up and demand goes down and then they come back into equilibrium. And yet I can't help but feel exactly, as you were saying, the economy is a complex system, supply and demand are deeply interlinked.
We've made the systems more inelastic through this specialization process, and we've just given everything the most almighty whack. And there are plenty of systems in physics that don't behave sensibly once you give them an almighty whack, they go into a completely different form of behavior. And once they do so, they don't necessarily neatly settle down again. And so I'm just a bit conscious that everything we've got used to in this whole great moderation and just in time supply chains and everything, there is some risk that we've now given everything such a big whack, that it doesn't simply settle down in the way in which the textbooks suggest.
Joe:
I mean, what you said about the wind. And I was just thinking about this this morning, because it was actually, you know, obviously there with those — I think it was about a month ago or a month and a half ago — in the UK, there were like three or four days where the wind didn't blow very much. And you know, that shouldn't be a big deal, but I think we were talking with Jeff Currie over at Goldman Sachs and he made the point it's like, normally the wind not blowing for three or four days is just not a very big deal. It happens. Only when things are so stretched, does the wind not blowing for three or four days cause this like insane swing in the price of natural gas or electricity. And then just this weekend in the U.S., it was really windy in Dallas and that's caused this huge cascade of cancellations of flights from American Airlines, which is headquartered in Dallas. And it feels like the thing that sort of is going on is, as you said, there's all these idiosyncratic events. So there's a drought in Brazil. There's no wind in the UK, et cetera, but that when the system is stretched these little things could create rippling chaos.
Matt:
And I think one of the things that's interesting about that is you might almost speculate. I mean, some of it, yes, is smaller, more open economies like the UK that have cut themselves off from Europe being vulnerable. But some of it is, is it a coincidence that actually some of these supply shortages are almost most intense in the most highly capitalist economies like the U.S. where actually you've had an incentive over decades to make everything efficient, to whittle down your inventories, to make a nice lean product, which, again, when it works, it gives you the super high profit margins, but the sorts of redundancy or overcapacity, which you might have built in as a cushion, that's exactly what we've taken out, whether it's from supply chains, or even whether it's from health services and things, and suddenly you're seeing the potential vulnerabilities that result.
Tracy:
So what do the supply chain issues actually mean for the economy from a very, very broad perspective, because I mean, this is something Joe and I have been talking about for a while. And I think even last year, I mean, this was very, very early on, but I remember writing something in like March, 2020, because I'm in Hong Kong and I was seeing what was happening in China and talking about whether or not supply chain bottlenecks would end up being like short-term good or bad for the economy in the sense that, you know, you get this bullwhip effect, people start over ordering inventory, start building up, and then they realize, oh, well actually we've ordered too much. And then they cut sales. So I don't know. It seems like you can argue it both ways, but how are you broadly thinking about this in terms of your economic models?
Matt:
I think it makes me mistrust the models that we built up over the last few years, even more than I mistrusted them anyway. I think it makes me worry about the return at least temporarily to some form of boom-bust cycle. And if I had to guess, I would say my suspicion or fear, but maybe I'm just being overly negative, is that the price increases are a bit stickier and more lasting than we would have liked and than the central banks would like, and conversely maybe the growth is a bit less robust than everyone likes to think at the moment. And as you say, it's this capacity to suddenly go back to destocking/restocking cycles that we'd forgotten about. I almost see it in my own behavior when I go to the supermarket. When everything is fully available, you buy only what you need, but the moment it starts getting a little bit low, you think, oh, maybe I happen to buy an extra one.
And it's that potential to suddenly change the system's behavior, this inelastic linkage of supply and demand, or this shift back to what our German economists are calling a stop-start manufacturing cycle. Again, it's interesting as you start having these conversations around stagflation and everyone protests, well, that's absolute rubbish. We can see the inflation side of it, but demand is really robust. And as we see these potential shifts again, I think that the possibility that they end up rippling or cascading through the economy and are more lasting, even though the existing, the original problems get fixed. That potential again, I think is underappreciated in the nice linear models that everyone has got used to.
Joe:
You said something really interesting that had been on my mind as well, which is that like we see the supply chain shortages, and it seems like the inflation data worse in some of the more hyper like lean, efficient capitalist economies, like the U.S. Inflation in the U.S. is higher than it is in say, the European Union. And I'm curious, like, there is this debate. It's like a) is this just because the European Union is behind the U.S. when it comes to reopening, they were a few months slower with vaccinations b) is it because the U.S. sent out that extra round of checks? Is it a pure demand impulse or c) is it, as you say, the drumhead in the U.S. is tuned tighter, and maybe they're, you know, the EU economies — there’s more vacation time as everybody knows, people have more time off, etc. — aren't as hyper-optimized to be like working efficient 24/7. I mean, nothing's even open 24 hours in most European cities.
Matt:
So I guess the example that I was really thinking of is simply Japan, where inflation expectations have moved up much less than in other markets. Europe versus the U.S., I'd say that this thing with running just in time economies or running everything lean, maybe that increases the vulnerabilities to suddenly supply chains failing. I don't know that that necessarily increases the price pressures or at a minimum that feels indirect to me. The obvious explanation there I have to say is simply the Larry Summers explanation, as you said. It’s just, you know, you suddenly put in 15% of GDP of fiscal stimulus to an economy, which is already recovering really strongly, and you combine it with zero rates and massive amounts of QE. It's almost unsurprising. There's all this uncertainty as to what the output gap really is, but it's just unsurprising when at that point, it starts to show up in high prices. And it's really that fiscal stimulus, which has just been disproportionate in the U S relative to the rest of the world.
Tracy:
How come stocks don't seem to care about any of this?
Joe:
Yeah. I wonder this too.
Tracy:
Like, a really basic question.
Matt:
The basic questions are always the best and the hardest. So we have likewise been scratching our heads around this, and the obvious thing you can point to is the strength of earnings, but even — and earnings have indeed been completely phenomenal — even then, though, it's sort of interesting that you look at say changes in earnings expectations, and they're still going up, but barely. And the rate at which they're going up has rightly been plummeting. And so while the guidance has not been quite as negative as it might have been if all of these problems were filtering through with one or two single name exceptions, there still looks like there's a big mismatch between again, those underlying fundamentals and these potential problems. And as you say the price action, and to some extent likewise, you can point to a narrowing of the stock market performance.
But I think the big picture explanation, which increasingly I'm minded towards is even as a number of people start saying, well, we've priced in too many rate hikes. When you break down the rates market, move into inflation expectations on the one hand, and then real rates on the other, you come to this rather remarkable conclusion that actually all — or even more than all in some cases — of the move up in nominal rates, if the pricing and in rate hikes, has been inflation expectations. And what that means is that real yields are basically still at the lows — they’ve just began moving up a little bit in Germany, in the UK, just the last day or two — but again, there's as one comment, but it, to me that means that we're not actually pricing any tightening at all. It's almost just that we priced a stealth easing.
And I think that goes a long way towards explaining why it is, especially in recent years where investors have sort of been trained almost, oh don't look at the underlying fundamentals, they haven't got anything to do with the market price. It's only about the stimulus is only about the real yield. And they're seeing real yields back at the lows and they're saying, well, therefore there's nothing to worry about. And even as you get this aggressive yield curve flattening in particular, again, it really feels to me as though there's just a mismatch between yield curves increasingly saying, hang on a minute, we've got a policy error here. And then as you say the equity markets say no don't care. The long-dated real yield has just gone down, let me increase my estimate of the fair value of everything ‘cause I'm discounting my dividends at a low rate. It is remarkable and I think is increasingly a source of vulnerability. And yet as of today, it's mostly carrying on.
Tracy:
So you mentioned real yields, and this is something that we've been asking a number of our guests about. And it is true if you look at real yields, so yields adjusted for inflation, right now, they look incredibly low, particularly when you look at previous sort of periods right before, or right as the Fed was actually tightening monetary policy. So for instance, if you compare them to what was going on in 2013, when we had the taper tantrum, there's just this huge, huge difference. And I guess my question is why is that? It seems like such an oddity in the market that as we expect central banks to start tightening, we have real yields that seem to have barely budged.
Matt:
For me, there is a long-term story here and where we're going to probably get to is what level of real yields really counts for investors. But the long-term story, the slightly scary story is, the last few cycles have not really gone according to plan. At no point, at least until now, have the central banks had to raise rates to shake off an inflationary and overheating economy. And what's triggered recessions has instead been accidental bursting of asset price bubbles. And the scary bit is that each time it's been a lower level of real yields, which has triggered that bursting of an asset price bubble. And it's almost as though it's taking a lower and lower level of real yields or a larger and larger degree of stimulus to keep investors holding on to fundamentally expensive assets. And my usual bad joke is it's been years since I visited any investor in any asset class who was buying things because the analyst told the portfolio manager, it was cheap.
It's always the PM telling the analyst, well, we've just had another inflow and we've got to put the money somewhere. And the latest example here for me is 2018, which is still my favorite comparison with where we are now, where again, growth had been strong and there was fiscal stimulus in the system. The equity market was making new highs. The Fed thought it had an appropriate level of bank reserves and appropriate level of monetary policy, an appropriate level of real yields. And then all of a sudden, you got this correction in markets out of the blue and that threatened to seep into the economy and persisted until the Fed basically turned around 180 degrees. And on the one hand, that level of real yields was 200 basis points above where we are today. And it seems odd to think that we could again have outflows when real yields are so negative. And yet for me, the long-term pattern suggests that actually — and the wobbliness that was starting to get in some market behavior. And to some extent in fund flows at the moment — suggests we could be much closer to that point then people imagined.
Joe:
So I want to go back to something that you said, because I think it's worth diving into deeper. And, you know, you're pointing out that, okay, we've had this big repricing of the short end of the yield curve globally. And that means, okay, the expectation is that, you know, central banks around the world, major central banks are going to be hiking sooner than people had expected two or three months ago, or even maybe even one month ago. But as you're saying that doesn't necessarily imply that they're actually getting more hawkish because if inflation is expected to outpace those gains over the next one to five years, then you can have rate increases and yet actually the real yield…
Matt:
They may need to tighten rates in order to prevent there being an effective easing.
Joe:
Right, and so the one, so I guess the risk then for the markets or the scenario that it feels like people aren't talking about, and I don't know, you know, is this sort of the disorderly rate hike cycle where it's something a little bit more like the early 1980s where a bunch of central bankers say, oh, this is a serious problem. Rate hike, rate hike, rate hike, rate hike, inter-meeting rate hike, anything to stop inflation. That would be like the sort of true hawkish risk that could take down risk assets? Orr where do you weight that scenario?
Matt:
I think it's not very likely, but I think it's not very likely because I see risk assets crumbling first and hence we come back to this paradox that if they hadn’t crumbled, then you may go down that route. So again, Larry Summers made an interesting comment at Citi’s Australian conference recently that he thinks the U.S. economy could withstand policy rates going to five, sorry to three, three and a half percent before there was a correction in the economy. And if it were just about the economy, then I think I might sympathize with that view. But my suspicion is that actually we would go back to there being outflows from mutual funds and ETFs and people going back into cash long before that point, just as was the case in 2018. And I think maybe the underlying reason why it takes a lower and lower level of real yields to prop everything up is because there's more and more debt in the system.
And now of course, there's more debt still. And so again, my suspicion is that that we would reach that point earlier. And if markets were wobbling, then actually — which again, Larry perfectly acknowledges — but then I think the risk of it filtering through into the economy more than might've been the case historically, that's actually quite elevated. And I think that's this thing that investors everywhere are struggling with it. The bond market is, you know, the bond market flattening is telling you, if you go down that route, it will be a mistake. It won't last very long. The underlying disinflationary pressures from the overhang of debt are still there and we're going to be stuck back in secular stagnation even more strongly than previously. And ultimately I think that's right, but the thing that's likely to make it right, is a correction in equities and credit and housing. And so far, there's no sign of that whatsoever.
Tracy:
So I have a slightly strange question based on that, but what would happen if central banks just did nothing, you know, if, if they actually stuck to the transitory inflation argument and said, they're just going to look through what the bond market is doing at the moment. Would that be like a big crisis of central banks’ credibility, or maybe it wouldn't matter so much given that people are basically pricing in a policy error if they do start to tighten.
Matt:
I like to think in terms of what I call a credibility gap between inflation expectations on the one hand and real yields on the other. And when I look at that, basically we've already got the biggest gap between real yields and inflation that you've had since the 1970s. And while I don't fully know, as I look at some of this aggressive behavior in bond markets in Australia and Canada and places that did almost seem dormant previously, and as I look at the still terribly low levels of term premium which exists across the board, I think you're quite close to the point where the central banks are damned if they do and damned if they don't. If they don't respond at all, then I think quite rapidly, you could see the bond market being destabilized at a minimum, let's say in the five-year portion the longer-end may yet flatten more still.
And I think that's just, that's just tough for the central banks to escape from, frankly. Now maybe I'm wrong and that point is further away, but it's almost as though they back themselves into a corner because to begin with, they said, well, we don't need to worry about inflation, unless it turns into rises in inflation expectations. And lo and behold, you've got longer-dated inflation expectations in the U.S. north of 4% on the New York Fed survey. And likewise, they said, well, we won't need to worry about it unless it turns into a, you know, unless it moves away from just a few commodity prices. And it turns into rises in wages and lo and behold, you've got average hourly earnings north of 5%. And so, again, they've almost backed themselves into a corner. I'm not actually convinced that inflation expectations are quite as pivotal as the central banks think they are, but the markets are now liable to respond to that. And I think that's what's creating this environment that we're just starting to see where the market says, look, either you do the tightening and you have the abrupt turn around as the Bank of England is doing, or else I'm almost going to force you into it, maybe not over the next two years, but definitely over the next five years.
Joe:
So, you know, I'm thinking about this in the context of how we started the discussion, which is the economy as this incredibly complex system that we've given a huge whack to. And I think people could debate what the whack was. There was obviously the pandemic itself and then the fiscal policy response and the public health policy response, which involved lockdowns in many places. Numerous jolts out of equilibrium. Do rate hikes, like work? I mean, in this sort of environment? In other words, like, okay, maybe there's some sort of traditional economic conception of overheating where demand is picking up a little bit, and then they hike rates and then close off loan growth and that closes demand and everything gets back to normal, but do rate hikes do anything or accomplish anything in an environment in which we're not seeing normal, in which we're seeing as pendulum swing around like crazy?
Matt:
Even after the event, people will argue about it.
Joe:
Yeah, of course.
Matt:
And I think that for me, the paradox is it is a bit like bringing up children or something. You almost need to be stricter today in order to create longer-term stability. And conversely, if you are lax today, then the bad behavior will carry on. And maybe that was, I used in my presentation, this example of the double pendulum, where once it starts going a bit bananas, it doesn't settle down by itself. As the oscillations get smaller, it remains very erratic until you really crimped down demand, until you really almost stopped the system through a recession or through rate rises and only then can you, does the thing start behaving? So on the one hand, yes, there is exactly a perfectly valid criticism that look, if I raise interest rates, it's not going to, you know, improve the availability of truck drivers necessarily.
And so it seems a terrible shame to crimp down demand as a means of bringing the two back into line with one another, but equally Mervyn King put it nicely on another Citi call, he said the role of a central bank is to keep supply and demand in line with one another. When the virus first hit, it became clear we're going to have a massive shock to demand. And so you needed all the support in 2020, but then equally it became rapidly clear that there's also been a shock to supply. Now, if anything, you just don't have that need for super easy monetary policy. And if you carry on with it, it's quite likely that you do get overheating and the erratic behavior continues. And so for me, maybe, I mean, at a minimum, even if they were right and some of the immediate inflationary pressures have slowed down.
But for me, there's a funny parallel almost with climate change here. What's the paradigm we've been in for an extended period? It's one where even if there hasn't been CPI inflation, there's been asset price inflation, and there's been these boom-bust cycles in asset prices. And central banks have looked back and said, but we fell short on the CPI target. We should have had easier monetary policy. And now they're trying the easy monetary policy. I and many people in the market look back, at the boom-bust cycles, at the asset price bubbles, at more and more debt in the system. And say with hindsight, you should have had tighter policy at a minimum when the bubbles were forming. And I think the trick — and likewise, you were right to ease in2020, but you should have tapered way earlier — and the trick to doing it is to make it conditional, to take the holistic view.
That includes asset prices a little bit more, or looks at broader credit dynamics and says, yeah, I will tighten rates today, but if it starts going horribly wrong because there's a big bust in that in the housing market or an equity markets, then I will be easier in future. And on the one hand, a number of central banks are moving in that direction. The ECB, whether it's we're going to maintain favorable financing conditions, or the BOJ with yield curve control or the RBNZ with having to include house prices alongside their CPI target. But on the other hand for the big one, for the Fed, that still is almost anathema and they're inclined to function differently and say, no, we need to pre-commit to a certain course of action. And for me that's the paradox. You may need to almost commit to being more volatile with your policies in order to get market stability and conversely, by committing to easy money for longer, you've pushed the system into an unstable state.
Tracy:
You touched on this earlier, but I would just love to drill down a little bit more, but, you know, when it comes to the inflationary pressures that we're seeing now, what's your sense of the breakdown between demand versus supply issues? So, you know, we've all been talking about the supply chain shortages, transportation gridlock, but on the other hand, we have had massive fiscal stimulus that's injected trillions of dollars into the economy, put money into people's pockets. And I was just looking at a chart today, I think it was from Barclays, but it basically showed that incomes in the U.S. even if you strip out government transfers -- so, you know, unemployment, stimulus payments and things like that — even if you strip those out, they've still been going up quite a lot. So people are wealthier than they were before. So I don't know, it just feels like it's sort of, it's difficult to get a good handle on what is demand versus supply at the moment.
Matt:
That may be true for the U.S. in particular. The U.S. is the only place where people's incomes really went up massively. And yes, of course we have the inflation pressures showing up elsewhere as well. And so I think in the immediate analysis, you have to say, well, it's about supply shortages about bottlenecks. It's about, you know, the lack of wind in Europe and gas prices. And yet the conclusion that people therefore draw is it would make no sense to tighten policy in order to deal with it. And again, it's sort of this presumption, it will settle down by itself, and I'm no expert on the 1970s. But again, it seems to me ironic that there too, you start from what was largely about supply constraint, supply shortages in segments like oil. But again, you saw that actually that became much more entrenched.
The inflation that resulted became much more entrenched than you would have thought. And almost the only way ultimately to bring the system back into line was through the aggressive rate rises to make everything settle down. And so I think that that for me, again, is the paradox. Even if the problem is the supply side, it may be that you need to tighten policy and reduce demand in order to get the good behavior. The just-in-time behavior, the smooth behavior that we got used to. To revert to it. And that's the puzzle. Everyone is busy scratching their head, looking at these micro supply chain shocks saying, I don’t understand. Why can't it just go back to how it was previously. And I think the system is a bit more complex than that.
Joe:
So just to be clear though, you think it might take inducing a recession or some sort of like meaningful slamming the brakes of demand to get back to some sort of what we might call equilibrium or balance or normal behavior?
Matt:
Yes. And either that happens by itself because the market valuations are overly elevated, it happens earlier than you would have thought, or if it's not happening. And the equity market is making new highs and the housing market is becoming even more ridiculously expensive than it is at the moment. Again, I suspect you may need to move in that direction.
Tracy:
So I'm conscious that we're having this big global macro discussion and we haven't actually talked about China just yet. And, you know, I'm based over in Hong Kong and we were watching the Chinese PMI numbers come in over the weekend, which showed, you know, a pretty stark slowdown. And again, you start to think back to parallels of I guess early 2018 when we sort of had a weakness in China spread to global markets. How are you thinking about that at the moment? Is there a likelihood that the slowdown in China? China's refusal to actually stimulate or ease the economy at this point in time, that starts feeding into global markets and the economy?
Matt:
The funny thing is that the China slowdown, while I think it's hugely significant and EM investors seem to think it's hugely significant. Again, DM investors have most shrugged it off. And even the numbers over the weekend are a perfect illustration of this, the market just hasn't seemed to care today. And so either the slowdown needs to become much more entrenched. And yes, when I speak to investors, a number of them do seem to think that there's going to be a more aggressive easing earlier than we do. And we look instead at China's willingness to tolerate slow down and draw bearish conclusions, but again, it's puzzling how the market hasn't responded. And maybe this comes into a whole sort of broader set of questions around how markets have really been behaving and what the underlying drivers have been. So a conventional analysis would be, oh, the China slowdown might be significant for some commodities or might be significant for, you know, Germany exporting, and Switzerland exporting to China, but it's not a big deal for the U.S. with its more insular economy.
And maybe we can have the same conversation around, you know, rate hikes and tightening of policy. A conventional approach would be to say, but oh, normally markets do well during the first few rate hikes in the cycle. Surely there's nothing to worry about. And for me instead, there's a whole broader story which has become ever more intense over the last decade almost, where all my favorite fundamental relationships are broken down as companies have levered up and spreads have tightened in, and there's been lots of uncertainty, but there's been no volatility. On where the underlying drivers of everything, as far as I can see in market terms, have revolved around the wall of money, the reach for yield, the global liquidity patterns. There are a number of terms for it, but it really boils down to, for me, this quite literal process of money creation.
And it's in this context where China has historically over the last decade or so been terribly important, not only in the immediate commodity markets and some real estate markets where you might've imagined, but even more broadly than that in 2015, 2016, I remember people were struggling with the same thing and they said, how come the China slowdown and the depreciation of the renminbi is suddenly causing a sell off in the S&P when the U.S. doesn't export that much to China. And one of the responses I gave at the time is China maybe only 20% of the stock of global debt, but it's 60% of the flow of private borrowing. And often it's been 80% of the impulse of the change in the flow. And I think this, this for me, a lot of what's happening to markets more broadly, we all tend to assume that markets have this nice balance and it's between the buyers and the sellers, and everyone has their own independent estimate of fair value.
And if a few buyers and sellers drop out, it doesn't really matter. But for me, markets in recent years have been driven much more by the massive off-market price-insensitive buying that has come as a result of money creation, most obviously from QE through central banks, but also through China on a great many occasions. And I think what we're just beginning to realize at the moment is that that QE is not going to be there. The Goldilocks environment is [not] going to be there. The central banks can't provide support. And similarly that flow of credit from China rippling out and setting prices in global commodities, if they're really committed to financial stability as they now seem to and rebalancing the economy away from the real estate market, that's not going to be there. And what we've seen on previous occasions like 2018, where we did this on a smaller scale, is that you don't get an instant correction down in market prices, but there's a sort of void beneath the market price. As you discover that the inflows aren't there anymore. And once you suddenly have somebody who really needs to sell, that's when you're prone to this sudden sort of gapping. And so that is my interpretation here, but hey, maybe I'm completely wrong. And there's just another more traditional view that says, no, China doesn't matter anymore. There's too much stimulus elsewhere. And so we don't need them.
Joe:
So this is like a perfect, and you mentioned, you know, the big risk asset reaction to the RMB. And, you know, this gets to the puzzle that we've sort of been, that we started with, which is why with all of these sorts of things staring at us in the face, the supply chain issues that don't seem to be smoothing out the hawkish pivot from central banks and the market expectations thereof, which we see reflected in short-term rates, elevated inflation, why, you know, why it hasn't hit risk assets. And your view seems to be that it's coming. That at some point, you know, maybe central banks will have to induce a recession. Maybe the market's going to do it for it and so forth. So setting aside what happens over the next like week or the next month in markets, what is an investor to do? If the Goldilocks era of like the post-GFC or the great moderation, which was arguably longer, is officially coming to an end. Then in theory, I would imagine portfolio strategy should change too. So what does that translate to in terms of like rethinking portfolios?
Matt:
So if you really think that Goldilocks is over that the inflation is permanent and that the central banks will allow it to run, but then obviously you start digging out your very long-term historical returns and you look back to the 1970s and so on, and you look at what would be an inflation hedge, and people sometimes say equities on the numbers I look at, that's not very persuasive. You really come back to commodities, especially obviously, and to some extent, real estate as being your inflation hedges. If you think that you're in this almost temporary environment where the inflation pressures are there, but actually markets everywhere have been made fundamentally expensive by all of the stimulus in a way that means that you could be close to some form of tipping point, especially if real yield start going up, then in a sense it's more complicated.
Maybe it's more temporary, but it's more complicated. And that's the framework that I've tended to use. I like to talk in terms of the real yield cycle, where when central banks come to the rescue and real yields go down, you’re supposed to pile in even though the fundamentals look bad, and then there's a second phase where growth begins to return and investor and inflation break evens move up. And the market rally shifts away from investment grade to high yield and away from growth equities and towards more cyclical equities. But if you, if we're now getting back to this point where fundamentals are supposed to be taking over, but real yields start moving up, multiple times we've seen in that environment, maybe temporarily bank equities do a bit better, but basically it's really difficult. And, you know, even things like gold might ultimately be a defense, but they tend to do poorly if real yields are going up in the near term.
And almost what you end up doing is going back into cash in a great many cases and awaiting a re-entry point either to government bonds and investment grade credit, because inflation is under control when the yield curve flattening is carrying on, or conversely, if when the central banks are going back to easing, then you compile into risk assets all over again. At a client event recently, we did an interesting survey where we asked if there is a correction in markets, will you be buying the whole way through, because you've been preparing for this, will you be buying only when we get back towards fair value, call it 5% or 10%, maybe 10% percent down in the equity market, or will you only go back to buying once the central banks are back to easing again, and the rather dismaying response from a majority was a little bit like 2018, 2019
We're going to wait until the central banks go back to easing. And if that's the case, the trouble is again with the inflation pressures in the system, we're miles away from that point where the Fed kicks back in again. And so just temporarily, basically I end up holding much more cash than you would do otherwise. And maybe you can combine it with put spreads or barbells with some commodities or some risk assets, or even some of my strategists are saying things like Asian high yield, where at least you escape the systemic pressure where everything has become correlated with real yields, everything has become correlated with central bank policy. At least I get something idiosyncratic in my portfolio. Again, that's the ideal. But basically we've created this environment where everything depends on monetary policy, more than it depends on fundamentals, those periods where monetary policy at least temporarily is withdrawn, they get really, really difficult.
Tracy:
So this is one of the things that stands out in this conversation and also from your work, it's the sort of like being trapped in a endless cycle idea where we have this feedback loop of easy monetary policy that inflates risk assets that then leads to some sort of destabilization in the market. And then the central banks come back in and ease further. And we start the cycle all over again. Is there any, and I'm conscious that you've been writing about this for a long time, but is there any off-ramp that you see? Are we ever going to get away from this cycle of financialization?
Matt:
I certainly hope so. And in a sense, we touched on it already. For me, what this boils down to is basically a series of cycles in which you buy the bubble and you sell the bath. And so when the central banks come to the rescue and we pump the system full of debt, it may look terrible from a long-term sustainability perspective, but you close your eyes and buy it. And conversely, whenever they try and do the right thing, again, it's almost like dealing with climate change that would make things more stable in the long-term. Actually in the near term, you get nervous about a correction in markets. And so for me, these long-term questions boil down to can we achieve some form of long smooth deleveraging and clearly the hope is, oh, now with fiscal stimulus, productivity will go up and everything will be fine. Personally. I don't believe that at all.
For me, actually, the right thing to do is to almost aim for some form of long smooth deleveraging . I've said for years, the best I can imagine is a benign Japanification, but coupled with deleveraging. And people say, oh, that's just austerity. That that never works. I think actually the eurozone periphery has done way better than people give it credit for. They haven't needed more and more and more austerity. You just adopt a less credit-intensive growth model, which is very difficult at the beginning. And it gives you a negative impulse at the beginning, but then you can achieve a steady deleveraging. And I hope that we may yet get to this. For me, the policies that were created are the ones where the central banks act as a backstop when things are going wrong, but then are much more circumspect than they have been about, about inflating bubbles.
And that for me is the sort of key judgment here. It’s if there is another correction in markets, how do they respond? Is it providing much more temporary sort of support or conversely, do they say no, we just need more stimulus, still backed by even larger amounts of QE. Even as we see this spilling over into things like inflation. And so that's been the trade off for a long time. Unfortunately selling to the general public, the idea of the long smooth deleveraging, it's sort of like vote for me, I'll give you 10 years of stagnation, but it’ll be better for your children. And that's a difficult sell. And yet the easiest solutions are steadily increasing the likelihood of runaway inflation, increasing the likelihood of kind of monetary debasement in a sense, we've had that displacement already, not with respect to goods prices up till now, but relative to asset prices and people's ability to afford a pension or afford a house. And the more debt you put in, the more polarized systems become, the more unequal everything becomes the greater is the likelihood of those really negative tail scenarios.
Joe:
You must hear this debate a lot. And we have a lot of guests in part because of my own personal predilections and interests that come at this from the MMT perspective that says government debt is fundamentally different than private sector debt. And that if you look at say right now in the U.S. for example, household balance sheets are extremely good shape. And part of that is due to asset prices. Part of it is due to generally speaking, households not having taken on a lot of debt in the post-GFC period, and that we did have this big private sector de-leveraging. And while it's true that government debt, Treasury issuance, has shot through the moon, but that's fundamentally different. Governments don't have credit risk in the same way that households and firms do. And that therefore the U.S. is already currently in a implicitly or explicitly much less leveraged position. The economy does not bear the same level of private sector debt risk than it may have, you know, prior to the great financial crisis or several years ago,
Matt:
I don't buy any of it. Or rather, I buy very, very little of it. It is certainly true that governments are able to pull more levers and cope with debt in ways that corporates or households cannot. However, debt is this almost magical thing, which on the one hand is just money that the system owes to itself. And the process of adding more of these obligations to the system is almost always positive for growth or positive for asset prices provided that it remains credible, provided that people believe that they're going to get paid back. It's sort of like, you know, having a pension, when you think that the government is going to pay you a pension in future, you go out and you spend more money today. The moment that you get to the point where you start to call into question whether or not the government is actually going to be able to afford the healthcare that it's promised you, then you're spending today gets called into question.
And while the limits around this for governments are greater than they are for private sector actors, when you do the long-term historical analysis, Ray Dalio has done some wonderful work on this, and you look back across centuries. Unfortunately, all the signs that the system could be close to a tipping point. Maybe it's a bit better now because interest rates are lower, but basically we've passed them already in terms of aggregate debt levels across the public and private sector together, in terms of political polarization, in terms of inequality. And frankly, all of that is extremely alarming. So to me, yes, it's all just an accounting construct, but actually it's such a powerful accounting construct that governments and central banks are not actually as fundamentally different as we imagine, the clue is in the title, you know, debt or credit, it's about credibility.
It's about whether those promises will get repaid. And as you make more and more promises, so at some point those get called into question. And maybe on this what's further alarming is even though in general, we don't seem particularly close to that point. And even emerging markets that are stretching things in many cases today, we've had currency weakness, we haven't had runs on currencies today. I also think, unfortunately, it's a bit like bank runs in the 1930s or in the 19th century. The thing that causes a run on my bank or my government or my currency isn't necessarily anything I've done today. It's the fact that there was a run on the currency down the road, a run on the bank down the road, and suddenly investors get nervous. And so if we start to see this in emerging markets or in some of the smaller economies, then actually it could quite rapidly spread through to the stronger economies. And that as I look at the price action in some of the front-end of rates markets today could be a very, very early precursor, but you begin to see that potential contagion effect coming through.
Tracy:
All right. Well, Matt, it was lovely having you on as always really appreciate you coming on the show.
Matt:
My pleasure.
Joe:
That was fantastic, Matt
Tracy:
So, Joe, I always love talking to Matt and I do think he's a really good foil for some of the other guests that we've had on the show recently. And I have to say, and unfortunately our listeners couldn't see this, but as we were talking with Matt — we were doing this over Zoom — and Matt was bringing up, he basically had a presentation for every single one of his points and would pull up stuff from like three years ago and flip through it as he was speaking. And at times like this, I kind of wish we were doing this as a like a digital video show or TV or something like that. But that was really good.
Joe:
That was great. And he had like a chart for every question we, and he immediately knew where it was. It was like, why is it, blah, blah, blah. And he’d immediately be like, Bing, here's a chart that I put in a report. No, I agree it was good. And, you know, I do think that there are many issues that he identified from my perspective that are clearly of concern. And I would say one is just this sort of general assumption that we will come out of this sort of like Goldilocks. Okay, we're going to to hike. We're going to have a couple of hikes in 2022. Maybe we get a hike in 2023. Then we get the rate cut cycle and then risk assets go up. So let's just fast forward to the end of the video tape. And we know it's going to be fine because we've seen this a million times, therefore, you know, it's all fine. It does kind of feel like investors are in the mode — oh, we saw this movie before we saw the taper tantrum. It ended up not being a big deal. So why sell stock? And I do think we don't really know. I mean, like maybe it won't be that smooth this time.
Tracy:
Right. I was also thinking about that. That is the key difference this time around is we've had, you know, over a decade now of deflation or very low inflation. And so investors got used to that cycle because the Fed could just continuously drop interest rates and nothing really happened to prices. But the big difference in 2020 and 2021 seems to be that we do actually have a risk of inflation. And so the idea that they're just going to immediately revert back into easing after a big market blow up, I don't think that's necessarily a given. And I don't think investors are really thinking about that at the moment.
Joe:
No, and I definitely don't think investors are thinking about like, look, it's pretty stark as he laid it out. And it's kind of Volcker-ish that maybe there's so much sort of chaos, pendulums swinging in unpredictable ways, that the only way to slow that down, or that central banks decide, okay, we have to induce a recession because right now things are too unstable. I don't think that’s on many people's radars. The expectation is we're going to get rate hikes next year. But as he pointed out, it's not even clear that the market believes rate hikes will be a monetary tightening because if inflation is expected to outpace the rate hikes still, then you can have real yields go up and you're not actually, you're just sort of like keeping things neutral.
Tracy:
Yeah. It's always a bit scary when people start talking about, you know, basically resetting the financial system or the economy.
Joe:
Just to push back, one thought I had though is like after crises, there is that temptation that like, everything is different this time now. And we certainly had that in 2010, but that one was kind of different. It's like, oh, we need to retrain everyone because there just aren't the jobs that there used to be, and everyone needs to become a coder in order to get back to full employment. It turns out we just needed to have more robust growth and nothing had fundamentally changed from the pre-great financial crisis to the post-great financial crisis economy. So I also think that people should just remember that every time there's a big event, there is that temptation to say something big has changed and it's not always the case.
Tracy:
It's different this time?
Joe:
It might be the same this time. But that’s just my pushback.
Tracy:
All right. Shall we leave it there?
Joe:
Let's leave it there.