It was looking bad there for awhile for Team Transitory. Anyone who had previously even uttered the word "transitory" in regards to inflation was regretting having used it. But lately the term is creeping back in, particularly as inflation decelerates while the unemployment rate remains low. So was the transitory perspective right all along? And is the fabled "soft landing" actually here? Macquarie Capital strategist Viktor Shvets believes it is. On this episode, the return Odd Lots guest gives his view of the economy and why he never gave up on his transitory stance. He talks about why inflation is falling and how many sources of anxiety — from geopolitical risk to deglobalization — won't materialize in the manner that many people are expecting. This transcript has been lightly edited for clarity.
Key insights from the pod:
Why inflation is going to turn lower — 3:07
How does higher inflation become embedded? — 6:07
What deglobalization and ESG mean for inflation — 9:11
US tech and China deindustrialization — 15:38
Will China’s reopening be inflationary or deflationary? — 21:09
On lower geopolitical risk in the near future — 26:33
Tension between the Fed and markets — 30:31
Do financial conditions matter for inflation? — 34:54
How the Fed could cut rates even without a recession — 38:59
---
Tracy: (00:10)
Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe: (00:14)
And I'm Joe Weisenthal.
Tracy: (00:16)
Joe. Soft landing, seems to have sort of…
Joe: (00:10)
Yeah…in the air.
Tracy: (00:21)
It's in the air. It's almost consensus at this point. I mean, markets are rallying, shrugging off a lot of the survey data, which looks a little bit more pessimistic. Which is all kind of strange because you still have big segments of the market -- like bond yields, for instance -- pointing towards recession.
Joe: (00:39)
Yes. That's the really weird part to me. So risk assets, stock market, really nice start to the year. Much different tenor than it had in 2022. We are recording this January 18th. As of right now, the Nasdaq is up 7%. Of course, it got clobbered last year, but, you know, you look at something like the short end of the curve -- three-month, two-year -- markets are pricing in rate cuts really soon. And to my mind, that’s only going to happen if there's a recession or some hard landing. It's hard for me to reconcile what we're seeing in different parts of the market right now.
Tracy: (01:11)
Absolutely. And it does seem to have happened very quickly this shift to, you know, everyone's focused on China reopening -- that unfolded pretty fast. Lots of the soft landing talk seems to have sort of come out of nowhere. You know, two or three months ago everyone was talking about entrenched inflation, the possibility of a wage price spiral. But given the shift in sentiment, I think we need to speak with someone who has been consistent in their view that the world could avoid a high inflationary regime.
Joe: (01:43)
Absolutely. Because you have a lot of people going back and forth. I even saw something in the Wall Street Journal that's like, maybe it was transitory all along and we hadn't heard that word and no one dared uttered it for like six months. And everyone was ashamed about ever even having used that term ‘transitory.’ And now suddenly it's creeping back, that maybe a lot of the inflation really was due to these massive shocks. We experienced the pandemic and the war and that as these things at least normalize to some extent, that the residual inflation would not be as high as some people were concerned about.
Tracy: (02:18)
Right. So today we are going to be speaking with someone who was always on Team Transitory, who never left and defected like a lot of other people, I'm not going to name any names, but someone who has been, I used that word ‘consistent,’ someone who has been sort of banging the drum of this idea that actually a lot of the pandemic related disruptions might go away and we might return to more of what we saw over the past few years or so. You know, low interest rates, lower growth, that sort of environment. So without further ado, today we are going to be speaking with Viktor Shvets. He is of course global strategist over at Macquarie Capital, a repeat Odd Lots guest, one of our favorites. Viktor, thank you so much for coming on Odd Lots!
Viktor Shvets: (03:00)
Thank you. Thank you for having me.
Tracy: (03:03)
So what was it like being on Team Transitory for the past year or so?
Viktor: (03:07)
I loved it, but for very simple reason. Whenever everybody agrees, you know something is wrong. You know you need to get away from that. With inflation, I never felt I needed to get away. And the primary reason for me was that inflation that we have witnessed really has nothing to do with demand.
If you think of the global economy, we are still below the trajectory, pre-Covid. In other words, global demand is less than what it would've been if there was no Covid. The only country that’s slightly different is the US, but even in the US the aggregate demand is only about 90 bips higher than it would've been if there was no Covid. So it's not so much aggregate demand. Rather it is a disruption, unprecedented disruption of the goods market, services market, labor market that was responsible for that.
So if you think of the goods market, for example, if we go back 18 months ago, goods demand in the US and in Europe, were about 10% to 15% higher than it would've been pre-Covid. So even if there was no disruption in ports, there was no disruption in supply, there was no way suppliers could have expected demand to be 15% higher than what it was. Today, if you think of Europe, goods demand is already below the pre-Covid trajectory. If you think of the United States, it's right back the way it should have been if there was no Covid.
But then, before we normalized goods, we started to destabilize services. So you find if you go back 18 months ago, services would've been in the US about 15%-20% lower than it would've been pre-Covid. Today they are within 2% of Covid. So in other words, services pretty much recovered.
So even before we normalized goods, we started to destabilize services. But theoretically, just like the goods market, it eventually normalizes, [the] services market will eventually normalize. And the only problem -- and that's your transitory part -- the only problem is if inflation become embedded -- in a goods market, in a labor market, in a wages market, as well as in a financial market.
And my argument for the last 12 months was that I don't see any evidence at all of embedding. Now if you don't have the evidence of embedding, then inflation should come off pretty quickly -- very similar to what happened in 1946, 1948. And central banks then will adjust their policies accordingly. So the reason I was not in favor of a global recession is that I never felt that we need to destroy demand in order to lower the inflation.
Joe: (05:49)
It's interesting. So it's almost like the issue is not aggregate demand, it's almost like the issue was disaggregated demand. It was this shift. And we have an infrastructure that was sort of designed for one sort of pattern of consumption, a certain amount of goods, a certain amount of services. And it was this shift.
You know, there still is this fear of embeddedness. And people who are against Team Transitory, it's like, yes, we know all the shocks, we know other things, but it doesn't matter because if inflation is elevated for too long, it can risk becoming embedded. What is that process? What does that mean, in your view or how could inflation become embedded?
Viktor: (06:29)
Well, you are absolutely right. The longer it lasts, the more likely it is to become embedded, but we live in a very different and unusual world in a sense that unlike [the] 1960s and 1970s, where we had pretty much -- certainly from late sixties into early eighties -- pretty much inflationary pressures without any disinflationary offsets, or 1990s/2000s, when we had pretty much disinflationary pressures with no inflationary offsets.
Today we have both, we have very strong disinflationary pressures. That's your secular stagnation. In other words, demographics, inability to add labor inputs, things like extreme wealth inequalities, things like technology, things like financialization and indebtedness. They're incredibly strong and they create a disinflationary backdrop.
Now, against that, you need to look at frequent black swans and fat tails. That's what we keep discussing is that normal distribution of events no longer exist. We're getting a lot of disruptions coming in. Now whenever black swans arrive -- and they could be healthcare driven, they could be geopolitically driven -- we have inflationary spikes that occur. But as soon as those pressures recede either from a healthcare or geopolitical perspective, disinflation comes in very quickly.
And so because of this disinflationary backdrop, it's incredibly hard to embed expectation because you are not on a one-way street. Either as the financial markets or the labor market or the corporates. Think of corporates these days, they regain pricing power for like a quarter or two and then they lose it, and then they gain it again or somebody else gains it. There is no consistency of corporate pricing power. There is no consistency of the labor pricing power, in which case it's very, very hard to embed those sorts of expectations.
Tracy: (08:38)
I was about to ask you, what do you say to critics who maybe argue that it's too early to declare a win for Team Transitory, given that CPI is still at 6.5%, but it sounds like you're making the argument that we can get these recurring spikes of disruption-related inflation, but then the deflation narrative will rapidly reassert itself. So maybe a different way of asking that question, what would change your mind when it comes to endemic inflation? Is there something that you're looking out for, for a sign that the regime really has changed?
Viktor: (09:11)
Yes. Couple of areas. One of them is deglobalization. One of the things that I've been debating whether deglobalization as it progresses over the next 10 years, whether it's inflationary. Because the underlying idea is that the essence of globalization is arbitrage of cost, arbitrage of efficiencies, opportunities. As you deglobalize that arbitrage goes away and therefore it's inflationary.
One of the things I've been arguing is that this time around deglobalization will not be inflationary. And there are a couple of reasons for that. Reason number one is that labor is an increasingly smaller percentage of the arbitrage. So if you go back 20-30 years ago, labor in the, let's say labor-intensive industries like clothing and footwear, would've been 60%- 70% of arbitrage. Today it's only 30%-40%. In some of the newer industries, labor is as little as 5%. So in other words, labor is no longer as critical as it was 20 or 30 years ago.
Secondly, unit labor costs in emerging markets have gone up. In other words, wages have increased faster than productivity. So in other words, the opportunities for arbitrage are getting less. The third area is services. These days, services is one third of merchandise trade. You basically cannot do merchandise trade without services. And services are very different dynamics to merchandise trade. It can be located in various jurisdictions, it's much less inflationary.
The other thing to remember, of course, is technology. Think of the United States. United States, between 1990 and 2007, deindustrialized, basically. You had manufacturing output in the US growing only 1%-1.5% per annum. Global growth was more like three and a half, 4%. In other words, US market share has rapidly declined. If you look over the last decade, the US has been matching global numbers. Manufacturing output’s been growing at 3%-3.5% every year.
Now the reason for that [is that the] US is re-industrializing, but the US is re-industrializing in a very different form. This is not the 1960s, 1970s, [there’s] much less fixed assets, much less labor, more robotics, more automation. And so you don't see it really in a labor force. So as a percentage of labor force, manufacturing is down relative to what it was 10 years ago, down from 9% to 8.4%.
But the US is re-industrializing with a much more flexible cost structure. And so the result is [the] onshoring that people expect probably won't be as inflationary as what people anticipate. So to me there is a debate whether you look at the impact of technology, whether you look at impact of services, whether you look at the impact of labor, I just don't see it's going to be inflationary at all as we gradually deglobalize.
Or to put it the other way, globalization is dying a natural death and it will die over the next 10, 15 years. A new form of globalization will emerge, which will not be dependent on relative costs or relative efficiencies. And so that's one area. If I'm wrong on that, then you find inflation becomes much more embedded.
The other area is ESG, particularly the ‘E’ part of ESG. And so if you look at ESG, again, my view is that worry about ESG more than I worry about de-globalization. But if you think of ‘E,’ number one, we are going to take decades to do what we want to do. Nobody is going to touch the sacred goals of reduction of whatever it is we want to reduce. But we will be meandering towards that goal. We'll be trying to reconcile those objectives with the realities on the ground that we are facing. And so number one, it's going to take a long time. It's going to be a lot of meandering.
Number two, we are going to cut costs, not just put on new costs the way a lot of people are expecting. And the third area is technology is reducing the cost of new technology as you apply it. So even if I look at ‘E,’ my argument basically it might not be as inflationary as what people expect. Now there will be pockets of commodities that will be inflationary. So for example, oil – we’ve got plenty of oil, we just don't deliver it appropriately. But we've got plenty of oil. Coal, we've got plenty of coal. We’re just, again, not using it the way we could have used it. But there are some commodities in a real shortage. Copper, nickel, cobalt, lithium, rare earth. So there will be some increases, substantial increases in the value of that. But overall, as I said, I'm not totally convinced that ESG actually will be inflationary.
And the third area is geopolitics. As you know, my view, and that's why part of my portfolio is what I call ‘bullets and prisons’ for the last 10 years, is that I’ve believed in a geopolitical and social dislocation for a decade now. And I can believe that the next 10 years could be even worse than a 10 years we've experienced so far. But geopolitics is a process, it's not an event. In other words, I usually say it took Hitler 15 years to come to power. So it doesn't happen overnight.
And so the critical area to me, is judging the periods where geopolitical pressures might be less acute. And identifying periods where geopolitical pressures will be more acute, recognizing that over a 10, 15 years period it's going to be worse. But there will be windows of two or three years when those pressures actually will be less prevalent. And I think 2023 and 2024 will be a period of lower pressures, not higher pressures.
Joe: (14:52)
There's so many different threads there. That was such a fascinating answer. I want to talk more about geopolitics, but before that, I want to actually go back to what you were saying about the re-industrialization of the US economy because I think that's really fascinating, particularly thinking about the impact of some of the big legislation that was recently passed in the United States, the CHIPS Act which attempts to onshore or recreate domestic semiconductor capacity. And of course the Inflation Reduction Act, which has incentives for domestic battery manufacturing, other things like that. Can you talk a little bit more about what this new vision of a sort of reindustrialized United States economy looks like and how you see the pretty big substantial sort of industrial policy spending plan moving the dial?
Viktor: (15:38)
I usually like to compare the US to China. And I basically say think of China as equivalent of the United States of 1970s. China today is responsible for about 30% of global manufacturing. China today is very heavy in fixed assets, very heavy in manufacturing, very low on cash flow, relatively low on intellectual inputs. This is exactly what United States look like in the 1970s.
So China is in the very earliest stages of conventional de-industrialization, whereas the US is on the opposite side. And that is why people in Michigan and Ohio are voting the way they do, it's already had the body blow of de-industrialization and all the social consequences. And now they're approaching it from a different direction. How do we re-industrialize in a different form?
And by the way, US reindustrialization started a decade ago. This predates Biden. It predates any of the plans, because there are obvious ways of onshoring now at a very different cost structure and a very different positioning. That's why for a decade now, manufacturing output in the US was broadly matching the global manufacturing output. And US market share can no longer decline.
So the interesting thing to me is that if I think of the US 12, 13 million people or so in manufacturing, they are generating manufacturing output -- half of China's. Now, if you think of China, nobody really knows the numbers in a sense that we only measure urban employment. But there is also a lot of rural employment which actually directly or indirectly feeds into manufacturing. So there are all sorts of estimates, but the numbers are anywhere from 80 to 150 million people involved, directly or indirectly, in manufacturing. So think of it this way, 12 million in the US are generating half the output of what 80 to 150 million China laborers and workers are manufacturing. That tells you how much more productive it is and what sort of lower unit labor cost you're gradually getting in the US.
So the way I look at the CHIPS Act and everything else, is that the US finally recognized that instead of just staying ahead of China, they do need to slow down China, in a sense. They do need to put China at least couple of generations behind. And the problem is, in my view, there is not much China can do about it because at the end of the day, it's not about billions of dollars you want to spend, it's about science.
And the reason the Trump administration first up, and the Biden administration, were so successful at kneecapping the high-tech industries in China, is because China completely depends on the Western intellectual contribution. If you cut it off, then the ability of China to maintain its position and improve its position is very significantly retarded. So the way I look, whether you look at batteries, whether you look at rare earth materials, whether you look at biotech, whether you look at chips, the idea is to try to put the US even further ahead.
And strategically, to me, that is the right approach. Ultimately nobody can hold anybody back for any lengths of time. But given the predominance of the US in the intellectual sphere, given that almost everybody relies in some form on the intellectual contribution of the United States, they can actually widen the gap against China. So that's the way I look at that, not so much there is a plan for re-industrialization as such. That's been happening for a while. But shift the United States even more towards a frontier.
China, on the other hand, is facing a period of conventional de-industrialization over the next decade or two, which they need to challenge how to deal with it. They also face agriculture revolution. China had many revolutions, but agriculture was not one of them. So China has a much lower output in agriculture, even though they deployed 288 million people in this area, US has a fraction of that and a much larger agricultural output. So China is facing conventional de-industrialization. It's facing agricultural revolution or improvements in yields in agriculture that they need to do. And many other aspects compared to the US, which is just focusing on re-industrializing in a different form.
Tracy: (20:13)
Just on the topic of China, you know, we mentioned in the intro that the reopening has become a big theme in markets. The prospect of China really trying to restimulate economic growth. And it does seem like, to some extent, they are opening these spigots of credit once again, they're rolling back some of the previous policy crackdowns on sectors like real estate, some aspects of consumer tech.
Two questions here. One, is the China reopening going to export inflation to the rest of the world because it stimulates higher demand? Or is it going to export deflation because industrial capacity is getting boosted at the same time? And then secondly, is it possible for China to return to the period of high growth, you know, above 5%? And Joe mentioned that we're recording this on January 18th. I think we had China's GDP figures just a day or two ago coming in at sub-3%, something like that?
Viktor: (21:09)
Yeah. Well, answering sort of the second question first, if you think of beyond the recovery from Covid, so in other words, beyond the second half of ‘23 and the first half of ‘24, if we start looking into ‘25, ‘26, ‘27 and beyond, I don't believe China can return back to anything like 5%, 6% GDP growth rates.
And the reason for that is simple. Contribution of labor is now zero. In fact, even if you include quality adjustments. In other words, the labor force becomes more educated over time. Even if you include that, there is virtually no labor contribution. Secondly, capital contribution has been very high. Look at the last year, it was all investment. So the result is efficiency of capital utilization is declining. Incremental capital output ratios are now eight-10 times. So in other words, you need $8-$10 of investment for every dollar of GDP that you generate.
That explains why China is reluctant to stimulate conventionally, it's reluctant to unleash infrastructure and real estate the same way as they did on the previous three occasions over the last 10 years, because they don't want efficiency of capital utilization continue to declining, or the opposite side of it, debt increasing. That's why China is carrying $60 trillion of debt right now.
And that leaves you only with one area of growth and that's multifactor productivity. So if you don't contribute labor, if you constrain capital, you only have multifactor productivity. Now the problem is multifactor productivity in China has been declining consistently for the last 10 years. Even on official numbers. On unofficial numbers, it’s actually even bordering negative numbers. In other words, productivity detracts from GDP growth rates. So how do you restart productivity?
Well, to me there are only two ways. Either you go back to the policies from 1980s until GFC, and that is shrinking of the state, shrinking of the role of state-owned enterprises, opening up private sector. You either do that – [the] chances of reversal of policy that they had since 2008, for the last 15 years. And that's the opposite of it. Growing state-owned enterprises, growing the role of the state – [the] chances of that reversal occurring is near zero.
So what else do you have? Well, the only other way to grow productivity is through technology. This is your robotics, automation fusion of infotech, biotech. This is the alternative energy, transport platforms. But this takes a very long time to come to pass. It's a right approach. It's a totally right approach, but it takes a very, very long time. So the only other way to try to grow productivity is to mix and match all of that as much as you can and embark on domestic services. Agriculture, we just talked about agricultural revolution, improving domestic productivity now.
So to me, when I combine those numbers, I can't really see how they're going to come back to 5%, 6% growth rates. And if they do, they're either committing even more capital, which means efficiency, capital utilization declines, or somehow they find a way of growing productivity at a faster than I expect pace.
So that's the second question. The first question is harder. Because if you think of the first question, the opening up was so chaotic and so rapid that it creates both positives and negatives. First of all, you have a spread of Covid, you have meltdown of some of the production and capacity, but on the other hand, you have a promise of much more rapid recovery because there has been massive accumulation of cash. Just like in the United States, just like in the UK, that cash will be drawn down as we go into the second half of ‘23 and the first half of ‘24. So there will potentially be a massive increase in consumption occurring.
At the same time, China is trying to control capital. In other words, you want to grow infrastructure, but not too much. You try to allow real estate to stabilize, but you don't really want to have a major real estate cycle. So depending on how China balances investment versus consumption, and depending how much it recovers, it could be the case that suddenly China might demand another 1 million or 2 million barrels of oil, for example.
Our in-house forecast right now is 600,000 barrels, which means it more or less offsets weakness elsewhere. At the same time, more capacity, as you correctly said, comes in and therefore more deflation is coming into the system. So my view right now is that the positives and negatives in the short term balance, and therefore China is not going to be an inflationary agent. But longer term, as I said earlier, I really can't see how they consistently can return to 5%, 6%.
Tracy: (25:53)
It is interesting, if you look at the price action in the market, we've seen a big surge in copper, which you would associate with infrastructure investment, and not that big an increase in oil prices, which is what you would associate with greater demand.
Joe: (26:07)
Maybe in the second half. Speaking of China, and I wanted to go back to your point about geopolitics, and these are long-term processes, but you think maybe the next two years might be a little more mild on the headlines. I feel like that's always a risky call. But, well, what makes you think that? How do you even begin to analyze the question ‘Oh, is this going to be a sort of volatile year versus a less one in geopolitics?’
Viktor: (26:33)
Well, a couple of ways to look at it in my view. First of all, nobody pushes the envelope all the time because if you push people for too long, people become tired, they become irritated, whether it is domestic policies, whether it's international policies. And that's why even during wars, you don't have consistent wars. You have flareups and then you have relative quiet. In other words, to put it the other way, we don't kill each other every day.
And so the key from an investment point of view, from my perspective is to say, first of all, Russia/Ukraine, have you seen already the peak of economic, commodity and political disruption out of Russia/Ukraine? The answer to me categorical, yes. We can debate in 2023, inevitably Ukraine will attack, Russians will counter attack, Russians will attack, Ukrainians will counter attack. But it appears to be more likely that neither side will be able to overwhelm the other, which implies that sometimes to ‘23 or into early ‘24, there has to be a process whereby they will draw the dotted line on the map.
Nobody will agree on the conclusion, because what Russia’s offering Ukraine, Ukraine will never accept. What Ukraine is offering to Russia, Russia will never accept. But drawing a dotted line like North-South Vietnam or North-South Korea, Himalayas or Kashmir, that is a very likely proposition.
Then you go into other areas and say, okay, China was over the last four or five years, or almost 10 years, on a civilizational mission. In other words, how do you reshape society? How do you reshape politics? How do you reshape geopolitics, whether it's trading rules, internet rules, information rules. I think over the next year or two, there is no doubt that China shifted much more to prioritizing economic stability and growth rather than anything else -- and overcoming Covid. So I think China will be focusing on different things. Now, it doesn't mean that China will not react to whatever happens in Taiwan Straits. It would. But the degree to which China will go out of the way in order to aggravate the tension will be much more limited.
And if you look at the Middle East, for example, you could argue that one of the underrated things clearly of the Trump administration was the Abraham Accords, because they basically what they've done, they drew the line on who is the enemy and who is a friend. And as soon as you draw the line, it actually usually leads to a stalemate. In other words, nobody reconciled with anybody. Nobody trusts anybody. But on the other hand, you don't have the chaos that usually prevails in the Middle East.
So when I look at it, the key areas are where tectonic plates collide, and where earthquakes are likely to happen, which is Ukraine, Belarus, which is Balkans, Middle East, the Himalayas and the Taiwan Straits. I actually think the next couple of years is not going to be [bad]. Now am I a hundred percent confident? Of course not. Nobody can be, but I think it's a bit unlikely that we're going to have a spike anything equivalent to what we have experienced with Russia/Ukraine.
Tracy: (29:44)
Speaking of tectonic plates and the possibility of antagonistic battles, maybe we should talk about central banks and markets? Because there does seem to be an element of tension here where the Fed is talking about how it wants to go hard on inflation, it cares about financial conditions tightening. And yet we've seen risk assets rallying recently, financial conditions loosening.
Meanwhile we're, again, we're recording this on January 18th, we just had the Bank of Japan decision. The bond market in Japan certainly seems to be pushing up against the central bank there. How long can this tension go on for? Is there going to be a time or an event that maybe pushes markets and central banks into direct opposition?
Viktor: (30:31)
It all comes down to inflation. Coming back to our starting point. What is inflation? How embedded it is? How much disinflation is going to come through? Because central banks have to be hawkish. And the reason they have to be hawkish, as you correctly said, the market is a forward-looking machine and the market is anticipating either a recession or greater disinflation coming through. So if you are easing off on your policy, what you find is that the financial condition index will ease very rapidly and before the time when you as a central bank are comfortable that you are now in a position where you want to be.
Now to me, the markets are absolutely correct. What you're going to get, you're going to get longer-term, less growth. Longer-term less inflation. Secular stagnation, the old Larry Summers words -- well, he basically reenacted the old theory back from 1930s. But secular stagnation is back at the heart of the system that we run. And so central banks need to get around to that point.
Now my view, certainly for the last 12 months, was that sometime in ‘23, or I should say late ’22, central banks will start changing the rhetoric. Well, if you think of November, December ‘22, they already started doing it. They're already talking of dual mandate. We don't just have inflation. We need to balance inflation and growth. If you think of the ECB, they're still talking now more, they're talking more about duality of what they deal with. I think all of that will become more pronounced as we go through the first and the second quarter of 2023. Sometime in ‘23, I think we'll get on the same page.
Now, to some extent it depends on China, as we discussed early on, and how much it boosts the global economy and inflation. But in my books, this Federal Reserve will start cutting rates. QT will end sometimes in ‘23. I always point at the middle of ‘23, but it could be later. But QT will end. As we go into 2024, I think not only the rates will be cut, but some version of QE will also will come back.
And that will push you up in terms of growth, in terms of interest rates down. Now, if you think of equities, what is equities? Equities is earnings per share, risk-free rate, and equity risk premiums. Now earnings per share will be more constrained because as I said, we are in ‘23, we're probably going to have 2% global GDP growth rates. Remember, even the US equities these days have closer EPS relationship to global GDP than they do to US GDP. So you're going to get more restricted EPS even in ‘24.
You're not going to return back to 10%-12% EPS growth rates. But there is no need for massive cuts to negative 10, negative 20% EPS. So from an investor point of view, you basically know, yes, you will be getting close to zero, but you're not going to collapse in EPS.
Now the second part of it, which is risk free rate and equity risk premium, what we've just discussed is an environment where risk-free rates will be lower. And at the same time, equity risk premiums also could be lower because we've avoided the worst outcomes. We've avoided bankruptcies, we've avoided the worst possible outcomes. So to me, it's almost like a Goldilocks that is likely to occur. And that's why in November last year, when I previewed ‘23, I basically argue that ‘23 is likely to have a much better risk reward balance than 2022. Perhaps lower volatility than ‘22. It doesn't mean equities as an asset class will appreciate significantly, but it doesn't mean that you need to cut another 25% or 30% out of the current equity value. It's almost like a mini-Goldilocks emerging in ’23, ‘24.
Tracy: (34:31)
Just on the topic of financial conditions, I have a slightly weird question, but I feel like you're a good person to ask weird questions. If most of the inflation is about, you know, we can call them ‘transitory’ or ‘transient’ or ‘narrow’ disruptions, then do financial conditions actually matter when it comes to bringing down inflation?
Viktor: (34:54)
It's a good question, because if you think about it, the same applies to the yield curves and the extent to which the yield curves convey the right information to you when a lot of people and a lot of businesses, no longer depend on the banks and the bank's lending. You have the bond markets, you have wholesale, you have a shadow banking. There are so many other things in there.
For financial condition index, it’s basically amalgamation of various spreads, which is a high yield market which is triple-C debt, which is volatility of the bond market, volatility of equity markets. So it's got a variety of those elements in one number as any given number. It's not perfect because there's just too many elements together, but directionally they are correct. So you find when you do have an easing of the financial condition index, on balance you would argue that it is easier to transact, it is easier to do stuff than it was before, which means it does support more economic activity.
But this idea that as soon as you go into, you know, inverse yield curves for a period of nine months, you always have recession, I think this is very much an industrial age idea going back to fifties and sixties and seventies, eighties and nineties. So I don't necessarily buy that that is, and by the way, it can be reversed overnight. Because remember, not only we have ample capital -- because we have more capital than we need -- which is very unusual in the human history. We've always had a shortage of capital. But we have more capital than we need.
But at the same time we fully digitized, which means investors can react in a split second, it means central banks can react in a split second. That also means communication policy is the single most important tool that central banks have. And so to me, the inversion of the yield curve could disappear in the afternoon. It really could take just a couple of hours and there is no inversion occurring.
Joe: (36:51)
I want to talk about that further. I mean, you anticipated my next question, and I mentioned in the introduction, you know, the short end of the curve is interesting because it implies right, that cuts are coming soon. If you take it literally the three-month, two-year portion of the US yield curve is negative 58, it's basically the lowest since the great financial crisis. Is the Fed going to be cutting soon? What would it take? Would it take recession? Would it merely take disinflation? What would it take in your view for the Fed to go into rate cut mode?
Viktor: (37:23)
Well, and the other question is does it really matter? The numbers you've just mentioned. And if that number persists for a period of time does it really matter to what you do and what the economy does? Now, my view is that what we are going to see, it's sort of, I described it as a pendulum, if you remember the last time we talked. That what we have is rapid pendulum shifts from one direction to another. And that's why my view was that inflation is going to fall much faster than what Federal Reserve or central banks believe. And in fact, the spectre of disinflation could become much more pronounced as we go towards the end of ‘23 into ‘24.
As I said earlier on, China could make a very significant difference to what will happen. But that still remains my base case. So it comes back to inflation, disinflation and growth -- the extent to which Federal Reserve and other central banks feel comfortable that inflation is not a persistent problem, that it's not embedding itself. That a lot of elements were truly transient rather than necessarily embedding themselves into wages market, labor market or product or goods market. And the extent to which the second part of the mandate, which is to do with maintaining certain level of economic growth rates, becomes much more important.
Joe: (38:41)
So if the pendulum theory or the pendulum framework is correct, and if inflation comes down much more rapidly than they expect, it's plausible that we could get cuts even in the absence of recession just because they want to maintain that low unemployment?
Viktor: (38:59)
Exactly right. And that's where the balancing, so what you find, you have more and more governors… because the way the Federal Reserve communicates, it basically gets those governors to talk publicly. And so more and more of those governors will be coming out and saying, ‘well, I think we've done the heavy lifting.’ They'll be saying things like, you know, ‘monetary policies work with the variable and long lags,’ then we'll start talking about ‘we need to think about maintaining employment and growth at an acceptable level.’
So you get a lot more of that communication coming out. And as soon as Federal Reserve changes, other central banks will follow suit. Now, there are a couple of unusual players. One of them is clearly China, which because of the closed nature of the economy, because it's a state capitalism economy, it doesn't really conform to those cycles that we've just discussed.
And the other one is Japan. And the extent to which Japan is on a different tangent compared to everybody else, but if you think of a Federal Reserve, if you think of ECB, if you think of Bank of Canada, if you think of BOE, all of them I think will be pretty much on the same page. And the only question is, and that's legitimate debate, whether central banks will over tighten and whether in fact central banks will perpetuate policy errors without reversing them. My view is no. Even if they over tighten, they can reverse it in split seconds. That comes back to my argument that we have surplus of capital, not shortage of capital.
The US liquidity system, if you think of US liquidity system, banks currently maintain $2.2 trillion in reverse repos. Now remember, reverse repos is just net balance of the system. So there is a surplus of $2.2 trillion that banks cannot deploy, or at least they don't see a way of deploying that capital other than depositing it with the Federal Reserve on an overnight basis.
So the way I look at it is that we have plenty of capital. We are fully digitized, we are dependent entirely on the communication strategy. We can reverse a bear market into bull market in two hours, maybe minutes. And, and Joe as you correctly said, just remember 2018, remember 2019, remember the Federal Reserve restarted QE and was cutting rates about five months before Covid. Covid wasn't even there. Nobody knew that there was such thing as Covid. So you can see how that will happen.
Now, a lot of clients are saying that Covid is such a dramatic event that we are permanently repricing capital, permanently repricing risk. We are now in a completely different environment. I disagree with that. Covid, in my view, accelerated some of the preexisting trends. For example, these days we rely more on fiscal levers than what we did in a previous 20, 30 years.
It accelerated some preexisting trends like geopolitics, for example, and black swans. But otherwise, I don't think it changed the nature of what we do. Think of sectoral balances. Now in the US, we have already drawn down private sector savings. So you find net savings by the private sector as of September, 2022, was almost zero. Now the government is not cutting savings as much. In other words, the government is actually dis-saving.
And so the result is what's happening is that the rest of the world balance for US is growing. It's back to 4%. So if you think of the US/UK, your traditional supplies of real demand in the economy, they're already back to pre-Covid. They're already generating deficit that they're requiring other countries to finance. That means the opposite is also true because it's accounting, accounting identity. It has to be true that the rest of the world is going back to supplying capital. So whether I look at impact of technology, impact of demographics, whether I look at the impact of financialization, whether I look at sector balances, everything tells me that we are reverting to pre-Covid times and therefore this idea that we’re permanently repricing capital, cheap money is gone forever, to me, that's just nonsense.
Tracy: (43:19)
Viktor, I think that's a great place to leave it. We could easily talk for hours here, but yeah, thank you so much for coming back on Odd Lots. Really appreciate it.
Viktor: (43:29)
Thank you.
Joe: (43:30)
Thank you so much. That was great. That was really good.
Tracy: (43:45)
Joe, It’s always wonderful to talk to Viktor, but there was so much to pull out of that conversation. I'm actually having trouble picking just one or two highlights. I did think the comments about globalization were incredibly interesting and we tend to think of globalization as this monolithic process that can only go in one direction, but this notion that actually you can have different types of globalization with different results.
Joe: (44:09)
Right, and Davos is happening right now and I'm sure there are a lot of people talking about ‘oh, de-globalization.’
Tracy: (44:16)
Is this our Davos episode?
Joe: (44:18)
Yeah. I wonder if we'll ever do like a Davos Davos episode episode. But anyway, you know, people are anxious about that. But this idea that it's like, well, maybe it's something different and that actually this sort of disinflationary impulse that we associated with globalization for 40 years, or 30 years, or 20 years, or however long you want to identify it, maybe that hasn't been the story in a long time anyway. And as such, the idea that Covid was going to mark some huge trend break from that is just the wrong way to think about it in the first place.
Tracy: (44:51)
Absolutely. Also, the idea that maybe the yield curve isn't that well suited to providing information in the sort of post-industrial age. I thought that was interesting as well. And something that I think we've written about at various points of time, the idea that there are so many factors that go into bond yields now, not all of them related to the actual real economy, that maybe it doesn't make sense to be looking at the yield curve for that sort of information about what the market expects.
Joe: (45:20)
You know what headline I'm looking at on the terminal is right now that came from earlier?
Tracy: (45:24)
Oh God, what is it?
Joe: (45:25)
Larry Summers is now more optimistic on the US outlook than three months ago. Everyone’s coming around! You know what else I thought was really interesting was the comments on geopolitics, because geopolitics always seems like one of those things where the idea of forecasting seems very difficult and it feels like the risks are always sort of in one direction. There's some black swan.
But this idea that maybe we're in a position where if you look at the major pressure points, or as Viktor identified the tectonic plates or the intersection points, maybe this is a period of some depressurization. I'm hopeful, I want it to be true. I don't know if it will be, but I thought that was an interesting comment.
Tracy: (46:07)
Yeah, shall we leave it there?
Joe: (46:09)
Let's leave it there.
You can follow Viktor Shvets on Twitter at @ViktorShvets.