We’re in a moment of extraordinary uncertainty for the world economy. Inflation is hot. The pandemic is still with us. And of course, Russia’s invasion of Ukraine has created a host of new uncertainties, not to mention further inflationary pressure. Against this backdrop, major central banks are set to embark on an aggressive schedule of rate hikes in the hope of cooling inflation and engineering a so-called “soft landing.” On this episode, we speak with Macquarie strategist Viktor Shvets, who warns that central bankers may be making a policy error, and may be forced to reverse course as soon as next year. Transcripts have been lightly edited for clarity.
Points of interest in the pod:
On historic parallels — 03:25
More on the Spanish flu analogy — 9:35
On yield curve inversion — 16:11
How asset price volatility can spark recession — 21:56
Why he was bullish on Chinese stocks — 29:02
On a break between China and the U.S. — 37:23
On what investors should do — 41:41
On a policy error in the making — 48:20
Tracy Alloway: (00:05)
Hello, and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe Weisenthal: (00:10)
And I'm Joe Weisenthal.
Tracy (00:11)
Joe, it feels like there's a lot of uncertainty at the moment.
Joe: (00:15)
You think?
Tracy: (00:19)
So obviously you have what's going on with geopolitics and Russia's invasion of Ukraine, and that's obviously a big thing for markets, but even without that, you were sort of at this inflection point where central banks were just beginning to respond to inflation risks, and there's this question of how much of an impact that's actually going to have on risk assets.
Joe: (00:43)
Yeah, that's exactly right. And I think it's kind of been a confusing couple of weeks in terms of understanding both the plan from central banks. And of course, primarily we're talking about the Fed and the market response to them because we did have the start of a rate hiking cycle, 25 basis points — many more hikes expected and the immediate market reaction was this rally. And the question is does the market not believe the Fed is going to go that hard? Does it think the Fed isn't gonna need to go that hard? Or is the market gonna be surprised that the Fed really is gonna do what it says? And maybe we're gonna get multiple 50 basis point hikes, lots of confusion. The start of the rate hike cycle has not really created any certainty about what's next.
Tracy: (01:31)
No, and we actually had to have Jerome Powell, the Fed Chair come back on and just emphasize that they were actually going to hike at a potentially significant rate. And then we saw the market reaction, but I mean, even beyond the U.S., there's been a lot of uncertainty. And just looking at China at the moment, we've had, you know, a big sell-off in China tech stocks yet again, at the same time that there was this expectation that they were going to be easing even more. And then we saw them crack down further on the tech space and then they seem to walk part of it back. So this is another open question mark, over what exactly China's central bank is doing here. They seem to be, you know, taking two steps forward and then one step back and trying to calibrate everything. I feel like it's just confusing the market at the moment.
Joe: (02:21)
Everything. The real estate in China of course is a huge, huge deal. Energy. So much.
Tracy: (02:28)
Yeah. Okay. Well, on that note, on the note of uncertainty, we are going to be bringing one of our favorite guests. We're gonna be speaking with Viktor Shvets about, well, everything, really. What central banks are doing, the situation in Russia, what's going on in China. He's gonna try to tie it all together. Viktor is of course, the head of global and Asia Pacific strategy at Macquarie Capital. So Viktor, thank you so much for coming back on the show!
Viktor Shvets: (02:53)
Thank you for having me.
Tracy: (02:55)
I feel like one of the things that happens when we are in times of uncertainty is everyone starts reaching for a historic parallel and then they try to sort of fit that on what's happening now. And there's never a perfect one, but it does feel like the one that's emerged as consensus most recently is the idea of going back to the 1970s era of high inflation, sort of commodities shock that then feeds into the broader economy. Is that the right way of framing things?
Viktor: (03:25)
As you correctly said, no historical parallel is perfect. If you think of the 1970s we today live in a very different world. Labor market and the structure of the labor market is massively different than what it used to be. Our financial leverage addiction to asset prices is radically different to what it used to be. If you think of technological innovation we really live in a world where technology is everything. But people say tech, I basically say, “what do you mean by tech?” Everything is tech. The 70s and 60s were much more about inventiveness rather than innovation. We have very different demographics. We have very different income and wealth inequalities which are closer to 1910s/1920s Gilded age than they are are to the 1970s. So there is no perfect parallel. The way I prefer to look at it is to say there were three big shocks to the system.
One was in early 1920s. The other one was 1945-1948. And the third one was clearly the 1970s and what we're going through is just another one of those cycles, each one of those episodes have something to teach us. And so to me, just looking at 1970s sort of ignoring the lessons of some of the prior periods, for example, clearly there was a massive spike of inflation around 1919, 1920, 1921.
That was the end of the Spanish Flu as well as the end of the Great War, WWI. What you have then is a significant tightening of monitoring fiscal policy occurred. And one that occurred in 1921, 1922, there was a massive deflationary bust. CPI was negative more than 20% before it finally stabilized in 1923.
If you think of 1940s, again, that was the back end of WWII. We had a significant inflationary spike early on with monetary policy remaining incredibly loose. They didn't really tighten at all. And what was happening through the back end of 1940s, inflation just worked its way out of the system. And the only time it picked up again was in 1951 in a lead up to the Korean War. But then it stabilized for almost two decades after that point.
So the question is when you look at all of those periods, what they're telling us is that, you know, premature tightening is not necessarily a good thing, waiting too long is not necessarily a good thing. Just using fiscal policy might or might not be the right thing. Every one of those episodes is different. And I said, what you need to look at today and say and ask, why are central banks tightening?
Well, because there is inflation, okay, why do we have inflation? Why did we not have inflation in December, 2019 before Covid? Why we were not running out of people in December, 2019 and why we're running out of people today? Well, the answer is it's not demand, demand globally is only slightly higher than it was prior to the onset of Covid. I mean, there are some exceptions, the U.S. is further advanced, other countries less, but globally, it's not that much higher, so it's not so much demand, but clearly what happened is a demand shifted massively to goods against services, right? What we had is a massive disruption of supply chains. What we had is massive shocks to the system, but theoretically, all of that prior to Russia's invasion of Ukraine started to normalize. If you think of more supply indicators and the value chain indicators, the stress maximum stress was about September, October, 2021 after that it was all easing back.
And so if you think of why tighten today, why do we have a problem today? Well, because we disrupted. We disrupted labor market. We disrupted supply chains. We disrupted products. We disrupted everything. And so the result is there is massive shortages suddenly emerging that, do you just leave it to work it so its way through the system, because what we are seeing today already is that fiscal pulse is massively negative global. We are taking out amongst the G5 economies about $3 trillion. Monetary policy is becoming negative too. We're taking out more and we will take it even more as we go forward. The result is that leading indicators are already weakening and cyclicality are weakening. The system is already adjusted and as it continues to adjust, why do you want to necessarily court 1921, 22-type deflationary bust by tightening in the face of already declining pressures? Now you could argue, of course you could argue, of course, that look, Russia/Ukraine upended all of this, and we suddenly have another shock. Absolutely. But monetary policy is not the best tool to use when you have a supply chain problems.
Joe: (08:47)
So I mean, God, I have like a million questions after that fantastic overview, but I just wanna home in on something very specific. I'm surprised that for all of the talk about inflation with an ongoing pandemic that I hadn't heard more about the inflation in the wake of the Spanish flu. Cause you think while, if we're looking for historical analogies, a pandemic and subsequent inflation would be a pretty good place to start, and yet you don't really hear many people go there. Can you just talk us to us a little bit more about that inflationary boom, then bust, what was the catalyst for that inflation and how long did it last? And then of course you mentioned the tightening and the turn into a bust, but give a little bit more color on what happened on
Viktor : (09:35)
Yeah, sure. Essentially the thing to remember in 1913, 1914 the world was incredibly globalized, right. In fact, globalization of 1913, 1914 was not again replicated until 1990s. And so there was a lot of books written back in 1909, 1910 basically saying there is a lot of geopolitical pressures, but the war is inconceivable because we're so interconnected on a global basis. Plus our weapon race are so dangerous and so deadly that it just can't have a war. And of course you did. And so one of the things that happened in a wake of the global war or WWI is that all the supply and value chains were disrupted all, all the things we are seeing today through the war, there was a lot of disruption of physical capacity occurring. And so there were shortages, and the inability to supply goods was very pronounced toward the back end of World War I the other thing you had, you had a disruption of the labor market. Not as extensive.
Spanish Flu was much more deadly primarily because our medicine and science just progressed so much over the last you know, 70, 80 years, it was much more deadly, but in some ways it was a little bit less disruptive to the labor force because people just moved on with it. Nevertheless there was a disruption of Spanish Flu occurring at the same time. And so there was a very significant spike in inflation rate because of a global disruption because of destruction of capacity on a global basis because of the Spanish flu. And so what happened is that Federal Reserve Bank of New York massively raised the discount rates and as they raise discount rates and fiscal policy were brought back into under control, in other words, deficits were reduced. You ended up with a significant past.
Now this episode was described by Milton Friedman, and many others. And the view was that if perhaps Federal Reserve of New York acted earlier rather than waiting for inflation to persist, maybe they wouldn't have had to tighten as much. So there was, there is a debate clearly going on what you should have done, but then net outcome was more than 20% deflation in 1921, 1922, but 1923, it, it stabilized. And in fact, the climate was slightly inflationary and, or slightly disinflationary all the way to the, the crash of 1929, 1930. And so, so that's an example. This is the example of the government, or the public, instrumentalities, either waiting too long to act and, or acting too much and causing significant economic and asset price disruption. Now in 1940s, on the other hand, remember the interest rates were fixed back.
And so there was no change in interest rates, no change in the discount rate. Fiscal deficits have come down, but only gradually the government was prepared to spend money, either for construction or restructuring of the industries from wartime to peace time. And so the result was a very strong inflation spike in 1946, 48, was basically out of the system by the time you get to about 1949 and it only spiked again at the onset of Korean War. But then after 1951, it basically stabilized. So that's a result of basically telling you that we've made a decision back then that we are going to have inflationary spike, and we're going to work. It its way out of the system rather than fight it. Whereas in 1920s a decision was made that fiscal policy needs to be brought under control and monetary policy was significantly tightened.
Now, if you think of today's experience what we actually have decided in 2020 is that we would like to have inflationary spike rather than deflationary bust. Remember when the onset of Covid started banks were making huge provisions and the reason that we're making huge provisions that we expecting a deflationary bust but it did not happen. And the reason of course, we know it didn't happen is because fiscal authorities all stepped up and propped up demand. That's a cause for all the problems we are experiencing today. So in other words, we propped up the demand demand shifted to goods. Again, services, suddenly we have shortages, suddenly we have inflationary spikes. And so the question now is, um, it's all working its way out of the systems. Logistics is getting better. Certainly prior to Russia was getting better supply times were getting better.
Should we just let it through because we already have economic activity slowing down. Most leading indicators are slowing down. Global money supply is now only growing at 3, 4%. Global credit is improving somewhat, but on a momentum. It was negative for at least the last eight or nine months. And global credit is only growing at about 3%. We're already taking out a lot of fiscal stimuli out of the system as well. Should we just let it run off, and do very little to sort of to aggravate that situation. Now Russia/Ukraine of course made a massive difference now. And so, but as I said earlier on things like geopolitics or care crisis, they're fat tails. They can never be estimated they can never be predicted, and, and a monetary policy, as I said, is not necessarily the best, not necessarily it's not the best or it's not, it should be the tool that actually addresses either of those things.
Tracy: (15:35)
When you look at the yield curve right now, it's clearly pricing in recession, but there is this big debate going on about how much informational value is actually embedded in the yield curve given, you know, how much of the Treasury market is locked up by the Fed or in bank balance sheets and things like that nowadays. But clearly just looking at the yield curve, you would think that the market sees some sort of policy error on the horizon, you know, rates rise too much and eventually we end up hitting economic growth in order to bring down inflation.
Viktor: (16:11)
Yes, that's exactly what the yields are telling you. And when people say let's look at the short end or the long end that's incorrect. You should always look at the long end because that's where businesses, the banks are expressing their view as to the trajectory of growth as to trajectory of inflation rates, what the equity rates they should have, you order to finance their balance sheets in order to carry on with their business.
And whether you look at 2/10 whatever you look at there is this incredible flattening occurring. In most cases you only have 20 bips left in some parts of the curve. You already inverted. And so the Federal Reserve and northern central banks can’t leave yield curve inverted for any lengths of time, because basically as you correctly said the message it conveys to the marketplace is that credit conditions are going to be too tight.
And therefore interest rates ultimately have to be at a much lower level and that impedes economic activity as you go forward. So they can't just leave it unattended, so to speak. And so the market is basically saying a policy error is in the making. It will bring down massively economic growth rates. We might end up with recession. We might end up with a sequence of heart attacks potentially, but ultimately, the inflation will get out of the system through U.S. substantially reducing the demand and that's what the market is saying.
But on the other hand, as you correctly said, informational value of yield curve has significantly eroded. The way basically compared is to say, you know, private sector are the musician in the orchestra pit. And the central banks are conductors. In the past, they were happy just to conduct, but now they quite often jump in the pit and start playing instruments as well as conducting. And so they do both and, and so whenever you have central banks starting to lend to the main street or buying collateral, that they should never be buying, or a breaching rule, state financing or having emergency credit lines, just because repo market is not functioning properly, we'll just have a massive line out there to make it work properly the way we think it should be working. And so whenever you have that, now, the question is how much informational value do you have when the market is so distorted? Ad that's part of the reason why I think term premium just disappeared. Even today it's negative, you know, 30, 40, 50 bips, which normally it should be more like 150, 160 bips
So as a result of term premium being so low, it's easy to invert, but it conveys information to the marketplace as to what the real economy rather than financial economy is doing. And the other thing I think it's important to highlight whenever you read I don't know, all the important people, you know, Blanchard or El-Erian, they're all focusing on a real economy. It's all about labor markets. It's all about capacity constraints. Very little is discussed about financial economy. It is regarded as somewhat of redistribution mechanism. It is not really a creative anything, but we know that is not true. And a financial economy is at least six times larger than the real economy. And it has, it can really crush real economy if it comes to it. So one thing with that is missing in that discussion is asset prices. And the impact of volatility of asset prices will have on underlying economic activities. Where said, we all talk about wages. We all talk about wages per hour. We all talk about capacity constraints, ships stranded in Los Angeles Harbor, but we're not talking about asset prices. And if we cause significant volatility of asset prices, what does it do to inflation and the answer, it actually crushes both of them.
Joe : (20:29)
So I wanna drill into this further, and I should note for listeners, we're recording this March 23rd. So who knows what will happen in the next few days before people hear this, but I doubt that this volatility will have gone down so much. The counter argument to what you are saying is that there's so much real demand that's been put in the pocket of households. I'm thinking back to say a conversation that we had with Jeff Currie about what drives commodity inflation, and the idea of purchasing power being put into lower income households is incredibly powerful. It results in more goods purchases or results in more commodity intensive demand and so forth. And so the argument that everyone should focus on the real economy is in part driven by the sort of fact that lots of people have lots of real buying power and they're buying stuff, and that's, what's causing the jam at the ports so forth. And the counter argument is that, well, yes rich people control a lot of the world's financial wealth, but not, you know real activity from a demand perspective. Talk us through a little bit more why you see in this environment a financial asset volatility, which we've particularly seen in the bond market lately, how that feeds through to potential bust, potential recession, potential disinflation?
Viktor: (21:56)
Well you're specifically thinking of the United States because other other markets don't have quite the same dynamics, but if you think of the United States the top 10% of households control roughly 70,80% of that assets, bottom 50% of households control, absolute and own absolutely nothing right? On the net basis. And so the whole idea is that the asset side of the balance sheet is that those top 10% of the households they control assets, the liability side of the balance sheet is a bottom 50,60%, right? And those bottom 50, 60% must be encouraged to consume and to borrow because if they don't then the value of the top 10% of the households will come down. In other words, asset values will come down. But what we have seen through the Covid and what we have seen through every one of the episodes over the last 20, 30 years that the wealth creation of the top 10 just keeps on accelerating and keeps on accelerating.
And that means the top 10% getting more and more wealthy. That's your inequality argument. And in fact, it's not just top 10%. You have to remember top 1% controls about 30, 40% of that wealth. So it's even more than just top 10. It's more like top one. And so the result is that they're accumulating more and more and more assets. They're accumulating assets at a faster pace than they can consume, at a faster pace than they will get provided for their retirement, for example and as they continue to create this extra excess that needs to be deployed somewhere and where doesn't get deployed well, either gets deployed in the Ferrari cars, you know, Hampton mansions, you know, Picasso paintings and the rest of — maybe super yachts and things like that. But mostly it gets distributed back to the bottom 60% to continue to encourage them to consume now because you're generating more and more. Well interest rates have to be lower and lower, right?
Because you're generating more wealth than you need. And you need to transfer that to the bottom. And the bottom is already barely keeping up with commitments, which means the cost of money has to continue to fall if you were to encourage those bottom 50, 60% to continue to consume. And so the problem becomes if the bottom 50, 60% cannot consume, and or if you slow down the wealth's accumulation at the top of the pyramid, then a cost of money will go up, right? Because you don't have as much excess capital to relocate to the bottom 50, 60%. And as it goes up consumption at the bottom, 50, 60% goes down even more. And so the way I look at it, the role and function of federal reserve is to be an intermediary between the top 1% and the bottom 60%, I'll call it top 10%.
And the bottom 60%, they are the conductor of the orchestra, which may have to make sure that the two sides of the balance, all of the assets belong to the top one, top 10%, all of the liabilities belong to the, to bottom 50 or 60% that those two are in unison. That those two are in relative harmony. And that's not an easy task. Now one way of getting rid of the system is to say, let's just get rid of monetary system. As we know it. In other words, we live in a world which is highly financialized, highly leveraged. We are all dependent on asset prices as a cue for our decisions, whether to spend or to save whether to invest or to share buybacks, or what sort of CEO compensation you're going to do, let's break that system and let's create a different system.
Well, it's fair enough, but how do you break it without causing massive volatility and massive collapses of asset prices in the meantime, because what people will find if you create too much volatility, you know, fork are not going to be worse, what you think they are, pensions are not going to be worse. What they think you are real estate prices won't be the same as what they're today. So when people are discussing that we should junk this monetary system that we have built since 1980s and replace it with another system. I basically say good luck. I agree we we should have done it 20 years ago, 30 years ago. Okay. Good luck. How are you gonna do it? How are you gonna go from point A to point B? Clearly the answer is fiscal policy. That's how you go from point A to point B, but fiscal policy is much more inflationary than a monetary policy.
Monetary policy is basically disinflationary, but fiscal policy is inflationary because it takes the money from the cloud of finance and puts it down to the ground where real people live. And so as you create more inflation, you destabilize your monetary system before you actually build in a new system. So how do you make this transition? And so nobody in my view knows how to do it. We all sort of understand that it has to change over time, but most of the thinking, most of the advice is still very, very conventional, still treating financial markets as an afterthought, still treating asset prices as an afterthought. It's all redistribution. If one got, well, say the other one got poorer you have a transfer of wealth, it's not treated as part of the system itself, and a critical part of the system, given that it is five times larger than the underlying economies are. So that's the answer in the short term. You're absolutely right. You put more into poorer people's hands, they consume it. That's why you have increase in demand. That's absolutely correct. But they forget the other side of the balance sheet, where do those assets belong? Those assets in the top one, 10% of the households.
Tracy: (28:06)
I wonder if we could shift focus slightly and maybe talk about what's been going on in China? Because there have been a lot of headlines coming out of that specific market, but they've also been overshadowed a little bit by events in Europe. So we've seen a big rout in China, equities — tech stocks and real estate stocks. And then it seemed like the authorities came out and seemed to suggest, okay, maybe we went a little bit too far. Maybe we're gonna start rolling back some of these various crackdowns that have really hit those two industries. I believe you were fairly bullish on Chinese equities, certainly for 2021 and maybe going into 2022, but just talk to us about how you're thinking about that market at the moment and whether or not the central bank seems to be correcting its path?
Viktor: (29:02)
Yeah, you're absolutely right. Going into 2022, I was bullish on Chinese equities for a couple of reasons. First of all, remember China is the only major economy on the other side of everybody's tightening. China is the only one which is completely contra-cyclical. China already was counter cyclical over the last 18 months.
And for the next 12, 18 months, it looks like China again will be counter-cyclical. And being on the other side of tightening trade has a great deal of value for investors. Not only it gives you more inflation growth in China, but it also assumes at least that probably on balance ought to be weaker as China stimulates and the rest of the world tightens. The other argument that I had was all to do with political geopolitical and regulatory pressure, whether it's Olympic games, whether it's Party events all the way through November, 2022, that China will try to downplay some of those challenges, whether it's political or regulatory.
In other words, it's not going to be of primary importance. Now don't get me wrong. China will not change its political system, its political views or its regulatory views one iota. There will be no change. It's an irreversible trend, but at least for a period of six to 12 months that the degree of pressure that China will be under will diminish. And the third reason of course with China was a performer, through 2021 and earlier part of ‘22. And I was assuming that at least some of that can be can be reclaimed. So if you think of it right now, it's been a wrong call because China under performed so far, Asia, Japan, as well as as well as emerging market universe by another eight or 9%. And that's heading under performed by 20% last year.
So clearly it was a wrong call. And there are a couple of reasons for that. Reason number one is what you've alluded to. The Chinese policy makers are really calibrating this idea that they aren’t going to do the same thing as what they've done the last three times. They don't want to add another 10 of 15 trillion of debt, although they don't mind a little bit more leveraging. They don't want infrastructure investment to be galloping 25, 30% again. They don't want another massive bubble in real estate. And so they are trying to calibrate, trying to give you enough stimulus in order to achieve gross expectations without complicating the longer term picture. And so the result is you actually have less differentiation, I guess, between tightening and easing countries. And so this argument that you on the other side of the trade, so hasn't been as strong as I thought it might be.
The second area of course, is politics, geopolitics and the regulatory drive. To me, China has no choice but to support Russia and the reason for that is very simple. It's nothing to do with economic. It's nothing to do with markets and it's everything to do with the fact that Russia, China, some other places like Iran, Central Asia, they look at the world in a similar way. In other words, their view is the state is dominant. Their view is it's interest of society and community and trumps [that of] individuals. They have their own view what international rules should be, whether it's rules for the trade, including how you treat state-owned enterprises, absolute sort of harking back to 18th century and all part of the 19th century, where there was absolute sovereignty … Nation is entitled to do whatever they want within their own borders.
Whether it's internet and localization of internet. Whether it's role of the state, whether it's a role of state versus the private sector, both Russia, and China believe that the private sector is subordinate to the state and should be largely doing what the states think they should be doing. Now, China clearly is not Russia. It gives a lot more freedom to private sector. It's much more innovative, so it's not the same, but the basic concepts are the same. And so what we are seeing is this massive illiberal Eurasian bloc forming led by China, what I call the Sinosphere, but within that will be nestled a smaller, you know, Russian empire, Iranian empire many other parts. And to me, the objective of redefining global rules re global behavior to be much more in line with the way countries like China, think about the world is far more important than any particular given trade relationship or a slight ... of our GDP numbers.
So the Russian invasion of Ukraine did not come at the good time for China. And I'm sure China would rather not have that, but at the end of the day, at the end of the day China… they can't be completely neutral in this because as I said, they do look at world very similar way. The way places like Russia, Iran look at the world and the same applies to regulatory issues because it goes down to the concept of a separation of state enterprises and state itself versus private enterprises. What we have seen since 2012 is increasing fusion between the two. Prior to 2012, you actually have separation. And in many ways, state enterprises were encouraged to behave more like private enterprises since 2012, there was a very strong link towards fusion of the two.
So the space separating state and non-state private and public has been diminishing for more than a decade. And so when people say, Hey, we are finishing with a regulatory aspect. No, we are not. You can ease back a little bit tactically, but the basic strategic thrust of lack of separation between the two is something that is going to stay with us. And I was surprised a little bit that actually continued as aggressively as it did over the last six months. So to me when I look at China, people want and investors want to have a bit of ray of sunshine and any idea or any concept that somehow Russia/Ukraine might be winding down in some form, any view that perhaps regulatory pressures will get a little bit less, perhaps you're gonna get a little bit more stimulatory action as we progress through the balance of the year still should be enough for Chinese equities to outperform emerging markets. But as I said, in an earlier part of the year, that call was wrong because basic ingredients that I was hoping are gonna play through that didn't quite get there.
Joe : (36:31)
I wanna expand further on this idea as you put it, the sort of Eurasian illiberal coalition or block. And one of the thing that's been striking of course, with Russia is beyond just the formal sanctions, the degree to which U.S. companies or European companies as well, have just sort of abandoned Russia, abandoned operations in many cases, severed ties with the local unit of the business. And I'm curious that, you know, what is, if these blocks harden and these relationships harden, what does that mean for the U.S.-China economic relationship? And could there be a slower version of that same process in play by which, you know, if there is this separation, if there is two internets, if there is this sort of dramatically different regulatory environment there, will we see this sort of some sort of break with the companies that have trade and links in both countries?
Viktor : (37:23)
Yes, you will. I prefer to call it a slow-moving train wreck. So Russia was an immediate implosion, a very, very fast implosion. China is not Russia. China is critical to every supply and value chain. China is more than 10% of the global economy. It's not less than 2% of global economy. So the things that could be done to Russia could never be done to China because the blowback to the Western economies and the Western societies will be just enormous. But what you're going to get, I believe, as we continue forward, as the blocs harden, sort of the Anglo sphere, the EU 27, the Sinosphere, the illiberal Eurasian block, you will find more and more separation. It usually starts with the software areas and more high tech areas. So for example, transfer of knowledge, transfer of technology educational institution, ability to acquire skills it progresses on some more humanitarian pockets.
And then it progresses on to sanctions against certain individuals. It progresses to inability to access capital. And so that's an inevitable progression. Access to capital will be a privilege not a free market opportunity, the way it has been over the last three to four decades. But then gradually we’re creeping up into other relationships as well as we progress forward. Again, I want to highlight that China is not Russia, and, and this disconnect or ability to quarantine the country of the size and important of China is just not all nobody will ever contemplate it. But gradually bit by bit over a long period of time, that's going to be the answer. And so the question that becomes from an asset perspective, or investor perspective is "is China investable? Is its portfolio manageable?" Because if we continue on this path, which looks likely, then for international investors, opportunity to invest in China or Chinese equities will become more constrained.
Now that doesn't preclude private equity participating in various ventures. It doesn't preclude companies investing into some plans, for example, whether you're private equity, whether you are a company or whether you are portfolio manager, you'll be second-guessing yourself. You'll be saying, should I do this? Will I wake up on Monday morning and find in Financial Times I had done something I shouldn't have done? And whenever people start to second guess themselves, so to speak, they are slower. They will be a little bit less committed. And I think that's what you're gonna see. You're gonna see a little bit less commitment, slower responses, more desire to look again and double check yourself, whether you in fact are doing the right thing. And if it does, it wouldn't just apply to portfolio managers. It will apply to their trustees. It will apply to management teams that are running those funds.
So I think you're absolutely right. That's what the final trajectory would look like. Does it mean China will be starved of capital? That's not the case. China has no shortage of capital, right? China needs expertise and knowledge rather than capital. So it doesn't mean necessarily disaster for China or the Eurasian block or a Sinosphere block or whatever you call it. It doesn't mean that at all. Just it will be functioning by different rules. It will have different systems, it'll have different role of the state and private sectors. It'll just be different. But it doesn't mean necessarily a disaster.
Tracy: (41:10)
So given all this uncertainty that you've laid out, what are you actually recommending people buy at the moment, because I feel like we often have these macro conversations and, you know, it's like, here's a risk. Here's another risk. Bonds clearly aren't a good bet if rates are gonna go up significantly. But on the other hand, you probably don't want to own stocks if you think that rates are gonna go up and then lead to some sort of recession. It feels very, very hard to advise people on what exactly to buy in the current environment.
Viktor: (41:41)
It is. And that's one of the problems with not having a normal distribution of events. People are functioning and corporate finance and investment theory functioning on the normal distribution. In other words, you can anticipate, you can predict certain outcomes. You can estimate what the impact of those outcomes will be. As soon as it is no longer normal distribution, those events cannot be predicted. Those events cannot be estimated, and enhance as a portfolio manager, you are lost, whatever bet. It's just a bet, it's a gamble. It's not really an investible proposition. Now you might take a view that commodities is a way to go forward. Absolutely fine, but more likely than not that actually over the longer term might turn out to be wrong, unless you are in the right commodities. People will say, should I go into high asset, lower return and capital type company?
Well, yes, maybe, but it depends. What's gonna happen. Depends. What is the role of the state going to be? What is the role of fiscal policies are going to be? The same applies to the bond market. The same way as we're worried about inflation, the same inflation could collapse very quickly as we go into 2023. Remember inflation is a delta. In other words, all the prices have to be higher in March, April 2023, compared to March, April 2022, to give you a positive read on inflation. And it is quite possible that the markets are right that by ‘23, 24, you're gonna have at least three or four interest rate cuts occurring rather than a tightening of monetary policy. It is also possible that fiscal policy will go back into becoming a player after contracting for 18 months.
So all of this could change very quickly and therefore 10-year bonds could end up back at one, one and a half percent easily, rather than just marching on to two and a half three. So to me in all this sea of confusion, and we haven't even talked about whether it's a healthcare emergency whether it's pandemics or whether it's your political events, we haven't even talked about that. So in that sort of sea of confusion, to me just identifying what are the right circular drivers, what is changing, isn't changing well, financialization is not changing. Remember the only reason U.S. has an opportunity to raise money. Risk cost of capital is because the policy rates today in the us are below neutral rates. Neutral rates in us are roughly around zero in real terms. That means about 2% in normal.
But if you think of eurozone in Japan their policy rates are in line, if not even higher than they neutral rates. So they can't really tighten. And so U.S. has an opportunity to tighten, but as they tighten it, get closer to our star or a neutral rate, what's gonna happen. Volatility of asset prices increase. So financialization is unstoppable because as soon as volatility of asset prices goes up, central banks have to back up. And this idea that we need to generate more money and more liquidity than underlying economies require cannot very reversed. So that's a given. The other thing is given is technology will continue progressing right now. We have shortages here and there, but at the end of the day, technology will continue reducing marginal pricing power of both capital, marginal pricing, power products, corporates as well as, as well as labor that should be that should be. And the third thing that should be given is that geopolitical, social and political pressures will continue boiling over and might get much tougher actually, as we go over the next over the next five to 10 years.
So none of that stuff is actually changing. So if it is not changing, what do you want to buy? Well, you want to buy that are actually replacing today's world and building the new world. That's your copper, your nickel, your aluminum, your lithium, your rare earth, your semiconductors, What else do you want to do? Well, capital goods companies that actually will be rebuilding. What else was destroyed plus building the new, the new era. What else do you want to do? Well, the new startups that will be operating new world, whether it's alternative transportation platforms, energy platforms, whether it's a fusion of Infotech and biotech all of that stuff. Plus in addition to that, some software and select digital companies, you want to have not all of them, but you want to have some of them. You want to look at any company in any sector that has not just pricing power, but ability to do things differently, whether they're products, they're marketing, the way they use technology and therefore their productivity growth rates are faster.
To me in a sea of confusion, the only thing is certain you is that go with a circular of strengths and go with the productivity drivers. In other words, those guys who consistently deliver access our productivity circle of strengths, productivity drivers, to me, that's an easiest way to to sort of conceptualize it. In the short term, however, yeah, you you're absolutely right. Energy. If you take out energy, global markets would not have performed. And if you were in energy, you are up 25, 30% against any index. If you have a mix of energy and financials, you would've been up at least 10, 15%. If you are somebody like Cathie Wood of ARKK, which is completely on the opposite side, you would've been down 25, 30% against the indexes. So somewhere in between those extreme outcomes to me is the sort of the essence of resilient portfolio. Do you really want to plunk more on energy at the current prices? Or do you really want to completely double down and triple up on extreme startups or on profitable tech companies? The answer to me, both of those answers are wrong because both of them will lead to very high crystallized volatility. And somewhere between those outcomes, I think, lies to resilient performance.
Joe : (47:50)
I just want to go back real quickly just to this idea of prior to the invasion of Ukraine, there are already indicators of normalization, and it's really not clear how much aggressive easing is needed, especially in light of the massive amount of fiscal that's being taken out of this system. What is the worry? And, you know, we talked about the, the deflationary bust after the inflation of the Spanish Flu. How do you see a potential policy mistake playing out right now?
Viktor: (48:20)
Well, the the only number sort of to look at is really financial conditions different countries call a different, the names, call it stress conditions, some call it some other names, but essentially all of them are the same. All of them take into account variety of spreads are like high yield spreads, right? And variety of volatilities in various markets in order to define how how easy or tight financial conditions are, what you have seen so far in the last sort of six weeks, seven weeks is a fairly dramatic tightening occurring in Eurozone, as well as in in other markets. But in the U.S. so far the tightening has been less pronounced. And the reason for that is that as I said, the r-star in the U.S. is above the policy rates. So you still stimulate. You still have the capacity to come to come up.
The question is, how far can you come? How close can you come to a r-star? Can you go above r-star. To me the answer is you can't go above that, but as you go closer and closer, volatility of asset prices increases. Now, remember, theoretically, our style is zero real, which is say 2% nominal. So there is a room for 50 bits, maybe another 25, maybe a little bit more, but as you go up and get closer and closer to our star volatility of asset prices will six potentially significantly increase. When that happens, it flows straight through into financial conditions, indexes, and that's a queue for central banks to pull back. They have no choice, but to pull back very quickly. And, and so I, I, as you know, I, I tended to believe that 22 will be the year of removal of fiscal and monetary supports 23, 24 will be the years of putting it back on.
Hmm. And, and so I still maintain that that probably will be the right answer and the queue will be financial condition indexes. If you want to look at specific areas, of course, you can look at high yield spreads. You can look at the plumbing of the banking system. There are specific indicators, you can look at it, but all of that is kind of conceptualized into financial condition index. Now, you can also argue that we talked about the yield curve, the more Federal Reserve we need to consider Operation Twist or in other words, some degree of yield curve control. That's something that might be part of the discussion and debate as we go towards the end of ‘22.
Tracy: (51:01)
All right. Well, Viktor, we're gonna have to leave it there, but thank you so much for coming back on the show.
Viktor: (51:06)
Thank you. I really appreciate it.
Tracy: (51:09)
Joe, it's always great hearing from Viktor and he has this uncanny knack of bringing everything together under one sort of giant macro umbrella. But I thought what he was saying about the parallel to the post Spanish Flu era was really interesting. And also to get back to this idea of, you know, we can have an inflationary spike, but that can easily tip over into deflation. This idea of it's not necessarily that prices are just going up and up and up. Right now, it's actually that they're really volatile and it's hard to measure. And so what that means is that it’s really difficult to get a handle on real demand versus sort of fake stockpiling demand.
Joe: (51:54)
Yes, absolutely. And you know, something that he touched on and I've been writing a little bit about this and, you know, even Powell talked about it in his two recent appearances. Whatever you say about the ‘T word’ for transitory, some of the current inflation is still likely the result of it, even though no one uses that word and there's been major disruptions. And there's the shift in consumption from services to goods and all these sort of unusual things and the trillions of dollars that spent, which is now not going to be spent in 2022, there is fiscal tightening. And so I do, you know, no one talks about uses the word transitory, but that is still an element. And if it's significant, and if we were going to see some sort of normalization naturally, plus you add in an aggressive hiking cycle, then you get to the scenario Viktor laid out whereby 2023 they're talking about easing again.
Tracy: (52:46)
Totally. I mean, this is the other thing that emerged from we didn't really get a proper recession after the pandemic because we had all the stimulus. And then we sort of got shunted into a recovery that was really super charged again, thanks to that fiscal stimulus. And now it feels like we're sort of getting the response. I know some people say it was too slow coming, but it actually feels like could come very quickly with Powell talking about 50 basis point increases. And so it feels like we could get a whole other cycle happening very, very fast.
Joe: (53:19)
Yeah. You know, it's interesting. I had this thought about like this sort of, I guess it's like the funhouse mirror version of the downturn and how fast this upturn itself. And you know, what day I felt like that specifically is that day, remember like the price of nickel went completely had to shut down the nickel trading. And the day it reminded me of weirdly was the day that oil went negative. Even though it was the exact opposite move one is this huge spike. But both of these days that sort of like broke the market except in opposite directions. And so to some extent it did we’re just getting this like really extremely torqued version of what we experienced throughout 2020, hopefully things, you know, hence the dream of a soft landing or just have normal.
Tracy: (54:08)
Yeah. Torque is a good word isn't it. All right. Shall we leave it there?
Joe: (54:13)
Let's leave it there.