Motley Fool Money - Generational Tailwind for the U.S. Economy

Episode Date: July 24, 2022

The Federal Reserve could hike short-term interest rates to 4%, and that still might not be enough to cool inflation. Rich Lyons is the first Chief Innovation and Entrepreneurship Officer for the University of California, Berkeley. Before that, he spent a decade as the dean of Berkley’s Haas School of Business. He joined Motley Fool Contributor Rachel Warren to discuss: - How the Federal Reserve could hit a “hard break” with higher interest rates - A venture capital view about the future of crypto - How universities are creating a generational tailwind for the economy Host: Rachel Warren Guest: Rich Lyons Producer: Ricky Mulvey Engineers: Dan Boyd, Brandon Gentry Learn more about your ad choices. Visit megaphone.fm/adchoices

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An important part of where long-term equity returns come from is punctuated updrafts. It's the bang upward. So something moves like quickly in a couple of weeks. It's like, wow, 10% in a couple of weeks of this kind of thing. It's not like, oh, you just need to get in and then there's a steady trend. No, it's these punctuated updrafts. And nobody knows when those are going to happen. I'm Chris Hill, and that's Rich Lyons.

After spending a decade as the dean of the Haas School of Business at UC Berkeley, Lyons has become the school's first chief innovation and entrepreneurship officer. He joined Motley Fool contributor Rachel Warren to talk about the Fed, finding strong companies during a downturn, and a generational tailwind for the American economy. I want to start off by hearing your insights and talking about a topic that I know is on a lot of investors' minds, a lot of minds of those in our audience. And that's the impact of inflation and current market headwinds on investing as we head into the second half of 2022 and beyond.

And I'm curious, you know, from your vantage point, and what ways do you see the rampant rising rate of inflation and the current market dynamics as impacting investing, you know, through the next quarter? Yeah, well, you know, the next quarter. And as we look forward, most economists would say inflation per se, if it's just sort of stable and everybody's living with it, doesn't necessarily have to have any foreboding consequences for investing over a quarter or any particular horizon. The real issue here is that it's spiked up so far, especially relative to expectations a year ago, that the Fed is reacting. And it's that Fed

reaction, right? The short-term interest rates, the so-called Fed funds rate and some of the other things that are going to slow down the economy. They're designed to slow down the economy, not because that's the goal, but because that's the way you ring inflation out of an economy. So people have been watching the Fed, as they always do, but we're especially watching right now. And that short-term interest rate is likely in three weeks to go up another 75 basis points, three-quarters of a percent, and further beyond that, where they will stop, everybody is guessing. So the risk of a recession, sort of negative real growth, two quarters in a row or longer, is getting very high.

Now, markets are rational. So markets do their very best to forecast. And so they're already impounding the fact that the Fed is raising interest rates and is going to continue to it. So in terms of the outlook over the next three months, part of what you're trying to figure out is, is the market still a little too optimistic? Or is the market a little too pessimistic at this point? Everybody has their view on that.

But it is really important. It's not enough just to say interest rates are going up. Inflation risk is high, therefore returns over the next three months are going to be low. That's too simplistic. The question is sort of is the market overreacting or underreacting. My own view is that the Fed has got some more raising to do. I think I'm not very optimistic about near-term asset values. I think the Fed to really get the interest rate and the economy to a place where inflation comes down, that that short-term interest rate has to go up a good deal further, and that's going to be painful. You know, something that I think has come up a lot in the discussion in recent months

has been this idea that we continue to see inflation rise. We see the very aggressive actions the Fed is taking by raising rates to try to curb inflation, and that has kind of been the favored tool for a very long time to reduce inflation. but many of the factors we've been seeing that have fled into the, fed into the current inflationary environment aren't necessarily all under the purview of the Fed. Is there a specific reason that, you know, raising rates is kind of that favored tool? Are there other tools in the Fed's toolkit, or is this essentially what they can do? Oh, well, that's a fun question.

The short-term interest rate and the one that most specifically, the Fed controls that I mentioned before, the so-called Fed funds rate, has been the true. central main instrument of monetary policy. It's sort of how you adjust the pacing of the economy and thereby adjust the pacing of inflation. Quantitative easing, we've just gone through a period where, in fact, we were trying to stimulate the economy, right? And so that's back when I took macroeconomics in college, quantitative easing wasn't even a thing. So this whole idea that the Fed could adjust its balance sheet separately from the interest rate and have an effect on the economy. But that quantitative easing is a sort of very dull instrument.

It's not, the interest rate is really the key. So despite the fact that that, you know, most people would say the Fed didn't cause this inflation, we've had a lot of shocks hit the economy, right? The Russian invasion of Ukraine, the war, the supply chain and general disruption that was going on even before the war due to COVID and other factors. And this has been a worldwide thing. It's not just a U.S. thing, right? It's not just, hey, you can look at what's going on in the U.S. and see what happened.

It's all the Fed's fault because inflation is going up through Europe and many other places. So the Fed's job, though, is given where we are and given these shocks, and the Fed didn't cause Ukraine, and the Fed didn't cause COVID, but they are at the helm and they need to do something. And if I were Jerome Powell, I'll put it that way, it's sort of like your reputation is on the line. And I think he and the other Fed governors are going to react pretty strongly, still pretty strongly. You know, I think another question that sort of comes up in this conversation is we're seeing, you know, a decrease in capital flowing into a variety of sectors right now. And then as we're looking at the current market dynamics, are there any, you know, specific industries or industry specific tailwinds that you see is kind of presenting some of the most interesting and investable opportunities at this point in time? Yeah, you know, the way I think about a question like that is maybe a little bit different than some others.

I think about it a little bit more in terms of asset classes. And you could say, well, that's kind of one level up from the question. But, you know, one of the, so I do a lot, as you mentioned in the intro around innovation and entrepreneurship at the university level, but even more broadly we interact as a research university with lots of founders and venture funders and so forth. So I would point to the whole private assets category. I mean, this is not a new point. But, private assets and venture assets. I'm on a board or two and the investment committees and the idea is, you know, what percentage should be going into alternatives and private assets, even in more in particular. And I think, of course, we've had a great run in a number of private asset categories, but I think there's still a secular movement toward private assets that's going to continue. I don't see it reversing, even if in the near term returns to venture have gone down most recently and so forth. So, I think of it a little bit more that way, that private assets, venture investing,

sort of moving further upstream and the economic value that's getting created in this very dynamic economy. That's where I see it. So, for example, if you thought about science-intensive companies, right, a lot of ventures, there are a lot of entrepreneurship out there. But the kind of entrepreneurship that's attracting a lot of private capital, a lot of it is science-based. It's like CRISPR, right? So Berkeley recently won a Nobel Prize of Jennifer Dowden on CRISPR.

It's like, gene editing, it's like, wow, we have just begun as an economy to write the story of what CRISPR technology is going to do in the economy. And I, you know, CRISPR wasn't just an amazing scientific discovery. There's a lot of economic benefit. Now, CRISPR was sort of the original invention. It's 12 years old. It's like, show me, show me, show me. Well, it's very often in the life sciences that it's that year from 10, to 20 from the original discovery that you start seeing the major, major impact. And that's likely

to show up in the private asset category first. Yeah, I think it's exciting when we look at the age of innovation we live in. It does present a lot of opportunities that extend kind of far beyond the current dynamics that we're seeing. And that brings me to another area that you commentate on frequently, which is the crypto space. And I know this is also a segment that many members of our audience follow closely. We've seen a lot of popular crypto and crypto-centric investments tumble in recent months. This has seemingly kind of disproved the idea that I believe have been out there before that crypto could be a hedge against inflation. I know there's still some mixed consensus about that. So what insights can you share about the future of crypto based on your

experience in the space? Do you think the value of startups and other companies operating in the segment will remain steady in the future? Do you think regulation poses a key headwind here? What are your thoughts? Yeah, well, it's a lovely question. It's a big, big category. So I teach this stuff in my class. I teach international finance mostly, and you just can't teach international finance without talking about crypto and staple coins and things like that. So that's sort of where I come from. And I'm not just a, you know, a massive advocate for the category, but one of the things that I do hear sometimes is the naysayers. It's sort of like, you see, you see, look what's happened, blown off a bunch, blown off a bunch of value, right? And the idea is, I look at the whole

crypto or blockchain founded space as kind of like the way I think many, at least the smart money was thinking about the internet in, in 1998. I mean, sort of like, look, a lot of those companies didn't make it. A lot of those values lost a lot of value. And what do we have today? We have Amazon. I mean, did the world get transformed? Yes. and it's still getting transformed. So I think of it as a very skewed distribution. There are going to be some really big winners. There's going to be some transformation, folks.

There's no question about poo-pooing the whole category is ridiculous and naive, in my view. But the idea that they're all going to work or all not going to work, that's not the right way to think about. There's going to be some very big winners. And the others are, for the most part, going to go by the board. So that's just kind of, it's a different distribution. It's kind of like the distribution in venture, right? The idea is you're making venture capital in metal. It's like, you just need one or two of those to pay off big. You don't expect eight of them to work.

That's just not what a venture portfolio looks like. And I think that's kind of what the crypto world looks like. Another point that I would add here is, look, has crypto blown off some value? Yes. Has it has, but so is the NASDAQ. I mean, just look at other asset categories. It's not like, yeah, they have what's coming to them. It's like, yeah, so is your, your, you're publicly traded tech portfolio or what have you, right? So, um, You know, look, we have to be careful in any kind of new asset domain, and crypto certainly requires that care. But I'm still overall an optimist so long as people keep thinking about this idea that it's going to be a small group, a very big winner is at the, you know,

10 plus year horizon. Yeah, I'm curious, you know, we've seen a lot of kind of mixed reactions to a growing talk about regulation in the crypto space. Do you think this will help or hinder companies that are in this area? Because as you mentioned, there's probably going to be a few really key winners and a lot that get a lot of hype and then kind of fall by the wayside. You know, I mean, ultimately, I think scaling, big time scaling, I mean, you can say, look, Bitcoin has scaled. It's a global marketplace or whatever you point to here.

But I think deep integration into the economy is going to require, it, right? Before coming, you know, when Tesla came out and said, we're going to start taking, you know, our revenues in crypto currencies and so forth. And so things like know your customer anti-money laundering and some of these other things, it's sort of like, I think that's going to enable the crypto world to be central to the world economy. And I mean central, central, right? So there's a scaling opportunity there. I think a lot of people think of regulation, bad, we're trying to unfetter this brand new market. And I get that argument at some level, not all regulation is a good thing. But the idea that we create standards, like there have been

a lot of industries in the past, when you think about video and other things, it's like once a standard gets set, then the whole market can kind of start to innovate against that standard. And so I think if we thought about regulate some of the regulation that's coming, almost surely, as being kind of like standard setting that creates platforms on which we can now collectively innovate and create private value that we can fully capture. So I'm an optimist in that space. I think there's more upside potential than downside potential. Yeah, I think it's a really helpful way to look at it. You know, something else you touched upon earlier that I kind of wanted to lead into a little bit, this concept that great companies are

often kind of born in a downturn. I think it's something that a lot of, of investors are pondering these days. We live in a time of unprecedented innovation. And that's very exciting. It presents a lot of opportunities for investors, but I think it also requires, you know, investors to look carefully before they invest in a company, especially as the market continues to be highly turbulent. So as investors, what can we look for to evaluate and find those truly great businesses, you know, in choppy and increasingly competitive markets? You know, part of what, so when we think about a down market or if you think about recession scenarios and things like that, those are disrupted scenarios.

I think that's part of why asset values blow off so much value. It's sort of like, this isn't just a small shock. You're kind of going to a place where some fundamental stuff is going to get realigned and changed, right? And we say, yeah, it's a dislocation, right? And so that dislocation and it creates opportunities. And so I think that's part of it. It's sort of like when we start, there's this old idea in economics called hysteresis,

right? So if I don't have a, but imagine I had a cup in my hand and this cup is sitting in my hand. And you apply a force to that cup and then you remove the force, the cup bends over a little bit, but then it writes itself. But if you apply too much of a force, it changes state. and it's not coming back up when you take the force off of it. And so I think that's part of when we think about the disruption that's happening in what's currently happening.

The flip side of disruption is opportunity. And so I think that would be one answer to it, is kind of look for where disruption is happening and look for people who are opportunistically going after the other side of that disruption, the opportunity that's getting created. The second thing I would point to, I'll be quicker on this one. But I think the second one is there's talent that's getting. free up. I mean, that's part it's not just people are now unemployed, you know, it's sort of like

even people who continue to be employed have more bandwidth. But some people are actually saying enough of that, I'm going to launch myself. So, you know, I think for a lot of, for a lot of people investing in new opportunities, they're investing in the person as much as other things. And so look for people who's bandwidth and is getting freed up and try and invest in people and teams that are getting freed up in the disruption. You know, and we've seen very, I think, mixed responses from individual and retail investors understandably reacting to the current state of the markets. There's been, you know, anxiety.

We've seen reports about how, you know, the fear index is at an all-time high. You know, there's been worry about the future of investments and companies across a range of sectors. And I wonder if maybe you can talk through a bit about the importance of taking a long-term view on investments versus kind of giving. into that often natural knee-jerk reaction, you know, to rising interest rates and falling stock prices. And then, you know, on top of that, how can investors differentiate between, you know, good businesses in a turbulent market versus businesses that have actually taken a turn for a valid

reason, and that's correlating to the stock price? Yeah, those are two good questions. I'll get to the second one. I think for the first one, and now I'm going to sound kind of like the academic, here comes the textbook. But the idea is. is, look, patient capital. I mean, study after study after study, after study says, you know, people trade too much. They don't beat the market. I mean, look, all of us have this instinct in us. All of us trying time the market. If you were being disciplined and you looked at your own account and you really were honest about whether you're able to beat the market with your timing, you will find that you aren't. Okay. And there might be one Warren Buffett outlier in a million,

but so it's, I'll use the phrase a fool's errand, but it is, it is a very hard thing to do. And here's part of why it's a hard thing to do. It's sort of like, okay, I've heard that before. But here's why. If you look at the data, if you look at the data on equity returns and so forth, an important part of where long-term equity returns come from is punctuated updrafts. It's the bang upward. So something moves like quickly in a couple of,

weeks. It's like, wow, 10% in a couple of weeks of this kind of thing. It's not like, oh, you just need to get in and then there's a steady trend. No, it's these punctuated updrafts. And nobody is, knows when those are going to happen. And if you are out when those happen, you've lost out and those punctuals, if you take out the punctuated updrafts from sort of returns to equities or other asset classes, your returns are a lot, lot lower. So anyways, that's really part of it. It's, it's, it's, um, it's, um, it's, um, it's, um, it's, um, it's, it's, um, it's, it's, look, if you want to trade for consumption reasons, like I'm just having fun and I'm not trading anything that really matters for my family or for my retirement, it's like, have fun.

But if you're trading assets that matter, don't do it. Go along horizon. I think it's a really important thing to remember as well. And then when we're kind of looking at the volatility in the market, you know, are there some kind of key hallmarks to look for the differentiate, you know, good businesses with falling share prices versus businesses that perhaps fundamentally weren't as strong to begin with, and there is actually a valid reason why that stock is fumbling in the current market. Good question, hard one to answer. I think it was a Warren Buffett quote, but somebody smart said, you know, when the tide goes out, we find out who was swimming without a bathing search, right? And it's just, it's a fun quote in part

because there's so much wisdom in it. And, you know, I think, like, for example, in the area that I'm closest to is kind of venture investing because of the role that I play at UC Berkeley. And I think part there is sort of like, look, have you been capital efficient, right? It's sort of like, look, for a lot of startup, you know, founders, the idea is we haven't lost that much money. It's sort of like, if you're the CEO of name your company, public company, if you said yesterday, we haven't lost any money until, you know, it's like, yeah, you have, your stock price is 25% down.

It's 25% down, okay? Deal with it. But for a startup founder, it's sort of like, we're the same company. We haven't lost. It's kind of like, no, asset prices have fallen. You're worth 25% less. You can deny it. But for a lot of, you know, venture founders, it's sort of like they're saying,

we don't need to do financing at that price. It's like, it's too low a price. It's like, you know, probably not, maybe, but sort of like move on. And so I think, I think part of it has to do with, I'm coming back to the capital efficiency the idea is when when markets start to get tight and you start asking like, well, what are the ingredients that are gating factors on this company getting healthy again and regaining its momentum? Access to capital is very often one of those. And so part of the question there is like, how soon is this company going to need capital? You know, can it survive from six months to a year

without new capital. So those are some, maybe I'm a little too much capital focused, but I think the way companies, their vulnerability to capital access is going to be an important factor over the next year. I think that's very key. And as well, one of the things that kind of plays into this discussion

that I think is very relevant to us as investors, but also as consumers, and you touched upon earlier, is this idea of whether or not a recession might be around the corner. We've had economists predicting, yes, it is. And we've had others saying, no, probably not. And I think probably the truth is that no one knows. So I'm curious to hear your take if you want to share it. But beyond that, you know, how can we reconcile the idea that the economy is fundamentally strong with some of the current turbulence that we're seeing in the

economy as well as, you know, the stock market as a backdrop against that? Yeah. So real quickly on, you know, hard to forecast recessions. I don't have a lot more information than anybody else. I just have a little bit of experience thinking about the macro economy. And I think, look, the bet is just how tough is the Fed going to be with that short-term industry? If you're talking about a recession in the U.S. as opposed to Europe or elsewhere, right? But, you know, if we go in the next meeting of the Federal Open Market Committee from 175 basis points to 250, because if they move 75 basis points, and then the next time they move 50,

and they're at three and then they're at 350 and then they're at four. Could the Fed take us to a 4% Fed funds rate? That's quite possible. And I think, you know, under those scenarios, I think those kinds of, because when inflation is running well above four, think about it this way, right? Do we have the brakes on or do we still have the accelerator pushed? You say, wow, we're going to go from 1.75% to 4%? That's like crazy breaking, right?

But if the inflation rate is six and the nominal interest rate is four, right? That's a negative real interest rate. I mean, kind of just economics 101, that's not a hard break on the economy. That's more of a break than what you had before, but that's still a negative real interest rate. It's not until you start getting to positive real interest rates that you really start breaking. And when you frame it that way, it's sort of like, ooh, there's a lot of headroom in Fed increases before the economy's really, really going to slow down. And many people feel the slowdown is going to be needed to get inflation down. So, so I think that's the fundamental way to think about that. Sorry, the second

part of your question. Yeah, just looking at this backdrop right now and what we're seeing in the market, you know, does that reflect a strong economy, some of the turbulence that we're seeing in the market? And I think it's clear that obviously the economy, the stock, are two separate things, but the movements of the market do often occur in response to the economy. So as investors, you know, how do we look at that? Yeah, so there are really a lot of strong points, right? The labor market is incredibly strong. That's part of what's pushing inflation up, right?

I mean, even if you said there's no Russian invasion of Ukraine and there's no COVID, you get an unemployment rate that's down as low as the U.S.'s unemployment rate is. And that puts upward pressure on inflation, right? If you are a supplier of labor, you have more bargaining power. I mean, that just stands to reason. And so, you know, and that's a very positive thing, right? If we had an unemployment rate at 8 or 9%, which, you know, through some of the 80s disinflation, 70s and 80s, you had much higher unemployment rates.

That's even tougher. It's like, wow, the Fed's tightening, and we've got a 7% or 8% unemployment rate. that's really tough. So the fact that the labor market is quite healthy by historical standards is a super positive thing, right? It's a positive thing to the economy and so forth. So, you know, there are a number of, I think if you thought about kind of still kind of the innovation energy of it, well, I'll give you one small example, okay, but this is a little bit close to home, but I'll toss a day. Because one of the, what I'm going to call it a generational tailwind, like pushing us forward,

super positive when you start thinking about private assets and new companies and entrepreneurship and so forth, right? You should see what has happened to your nations, those of you that are Americans, your nation's universities. Because I'm just going to use birthday as an example, but a lot, it's like, wow, if you look at the innovation and entrepreneurship ecosystem at UC Berkeley and we've created a time lapse, look at it in the year 2000, 2005, 2010, 2015, 2020. We've got links on our website. It's like, wow. So, university. universities 20 years ago, even 10 years ago, many of them, it's sort of like innovation and entrepreneurship. Yeah, we do science, we do patenting, we do licensing, but it's sort of like,

yeah, we have some classes in entrepreneurship. But it's sort of like, no, research universities, part of their impact on society is being juiced in a major, major way by this commitment to innovation and entrepreneurship, keeping consistent with their missions. And so I see that as like one of these fundamental, powerful forces. This isn't just one or two or three universities. It's cross. And so that mindset, the way we're teaching our students, the opportunities we're giving our students, if you thought about that as the ultimate engine room, I'm being a little bit obviously affected by my own view here. But I think that's a terrific medium and long-term engine to be cut. As always, people on the program may have interest in the stocks they talk about,

and the Motley Fool may have formal recommendations for or against, so don't buy yourself stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.