Odd Lots - Viktor Shvets on Why We Might Be Heading for a Deflationary Bust

Episode Date: March 28, 2022

In times of uncertainty, people often reach for historical analogies. In recent weeks and months, as inflation has continued to climb and commodity prices spike, there's been a lot of talk of a return to the 1970s. But is that the right parallel? On this episode of Odd Lots, Tracy Alloway and Joe Weisenthal speak to Macquarie Capital Strategist Viktor Shvets about why we should instead be looking at a different historical era. He argues that central banks are at risk of raising rates too quickly and flipping the world into recession.See omnystudio.com/listener for privacy information.

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Hello and welcome to another episode of the All Thoughts podcast. I'm Tracy Allaway. And I'm Joe Wisenthal. Joe, it feels like there's a lot of uncertainty at the moment. You think? Why? Why? What's uncertain? Kind of everything at the moment. 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. 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 site. 25 basis point, many more hikes expected. You know, we've, you know, the immediate market reaction was this rally. And so there's questions about, which was not necessarily expected. And the question is, well, is this the market doesn't think the Fed is going to go that hard? It doesn't think the Fed isn't going to need to go that hard.

Or is the market going to be surprised that the Fed really is going to do what it says. And maybe we're going to get multiple 50 base point hikes. Lots of confusion. The start of the rate height cycle is not really created into us. certainty about what's next. 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 seemed 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. And it's, I feel like it's just confusing the market at the moment. Everything. The real estate in China, of course, a huge, a huge deal, energy, so much. Yeah. Okay. Well, on that note, on the note of uncertainty, we are going to be bringing on one of our favorite guests. We're going to be speaking with Victor Schwarz about, well, everything really, what central banks are doing, the situation in Russia, what's going on in China. He's going to try to bring it all together. Victor is, of course, the head of global and Asia Pacific Strategy at McCory Capital. So Victor, thank you so much for coming back on the show. Thank you for having me.

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 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, some sort of commodities shock that then feeds into the broader economy. Is that the right way of framing things? As you correctly said, no historical parallel is perfect. If you think of 1970s, we today live in a very different world. Labor market and the structure of labor market is massively different than what it used to be.

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 the world. where technology is everything. When people say tack, I basically say, what do you mean by tack? Everything is tech these days. Whereas 1970s and 60s, we are much more about inventiveness

rather than innovation. We have a very different demographics. We have very different income and wealth inequalities where closer to 1910s, 1920s, gilded age than we are to 1970s. So there is no perfect parallels.

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 between 1945, 48, and the third one was clearly 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 19, 19, 2021. That was the end of the Spanish flu or process of Spanish flu, as well as the end of the Great War, which is World War I. What you had then is a significant tightening of monetary and fiscal policy occurred. And when that occurred in 1921, 22, 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 World War II.

We had a significant inflationary spike early on. But monetary policy remained incredibly loose. They didn't really tighten at all. And what was happening through the back end of 1940s, inflation. just worked this way out of the system. And the only time it picked up again was in 1951 in the 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 saying. Waiting too long is not necessarily

a good saying. Just using fiscal policy might or might not be the right saying. But every one of those episodes is different. And I think what you need to look at today and ask, why are central banks tightening? Well, because there is inflation. Okay, why do we have inflation? Why we did 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 global is only slightly higher than it was. prior to the onset of COVID. I mean, there are some exceptions. US is further advanced, other countries at less, but globally, it's not that much higher. So it's not so much demand. What clearly happened is a demand shifted massively to goods against services.

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 most supply indicators and value chain indicators, really the stress, maximum stress, was about September, October, 2021. After that, it was all easing back. And so if you think of why tightened today, why do we have a problem today?

Well, because we've 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 in the merging. Now, do you just leave it to work its way through the system? Because what we're seeing today already is that fiscal pulse is massively negative global. We're taking out amongst G5

economies about $3 trillion. Monetary pulse 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, reflation and cyclicality are weakening. The same. The same thing. The system is already adjusted. And as it continues to adjust, why do you want to necessarily quote 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 problem or, uh,

or a geopolitical problem. So it's interesting. So, I mean, God, I have like a million questions after that. And that was like a sort of fantastic overview. But I just want to home in on something very specific. I'm surprised that for all of the talk about inflation in the wake or really with an ongoing pandemic, that I hadn't heard more about the inflation in the wake of the Spanish flu. Because you think, well, 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 to us a little bit more about that inflationary boom, then bust? What was the catalyst for that inflation? How long did it last? And then, of course, you mentioned the tightening and that turned into a bus. But give a little bit more color on what happened then. Yeah, sure. Essentially, the thing to remember, in 1913, 1914, the world was incredibly globalized.

Right. And in fact, globalization of 191314 was not again replicated until 1990s. And so there was a lot of books written back in 1905, 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 weaponries are so dangerous and so deadly that he just can't have a war. And of course, you did. And so one of the things that happened in the wake of global war of World War I is that all the supply and value chains were disrupted, all the things we're seeing today through the war, there was a lot of disruption of physical capacity occurring.

And so there were shortages in ability 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, I mean, Spanish flu was much more deadly, primarily because 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. But 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 the Federal Reserve

of New York are massively raised at discount rates. And as they raised discount rates and a fiscal policy will brought back under control. In other words, deficits were reduced. You ended up with a significant bust. 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 that outcome was more than 20% deflation in 1921, 22. By 1923, it stabilized. And in fact, the climate was slightly inflationary and or slightly decent inflationary all the way to the crash of 1929, 1930.

And 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 by then. 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 to either construction or restructuring of the industries from wartime to peacetime.

And so the result was a very strong inflationary spike in 1946, 48, was basically out of the system by the time you get to around 1949. and only spiked again at the onset of Korean law, 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're going to have inflationary spike and we're going to work its way out of the system rather than fight it.

Whereas in 1920s, decision was made that fiscal policy needs to be brought under control and monetary policy was significantly tight. 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 were expecting a deflationary bust. But it did not happen. And the reason, of course, we know it didn't happen is because fiscal authorities and monetary resources all stepped up and propped up demand.

That's a cause for all the problems we're experiencing today. So in other words, we propped up the demand, demand shifted to goods against services, suddenly we have shortages, suddenly we have inflationary spikes. And so the question now is it's all working its way out of the systems. Logistics is getting better, certainly prior to Russia, it 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 the momentum, it was negative for at least the last 8 or 9 months. And a 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. But as I said early on, things like geopolitics or healthcare crises, they are fat tails. They can never be estimated.

They can never be predicted. And the monetary policy, as I said, is not necessarily the best. It's not the best. It should be the tool that actually addresses either of those things. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real.

Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top-grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out,

go see the record for yourself at vanguard.com slash audio. That's vanguard.com slash audio, all investing in subject to risk Vanguard Marketing Corporation distributor. There's a healing element in salt, in sweat, in tears, in the ocean. In Halifax, being surrounded by salty water and fog is just enough grit to help polish away the pressure of do lists, to just make time for things that feel good, to let the salt cure whatever ails you. Halifax could be the break that finally leaves you feeling like you took one, as long as you're

willing to rub salt in your wounds. Discoverhellifax.ca.ca. 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. Yes, that's exactly what the yields curves are telling you. And when people say, look, 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 equilibrium rates they should have in order to finance their balance shares in order to carry on with their business. And what clearly, whether you look at 2 by 10, whether you look at 5 by 5, well, whatever you look at, there is this incredible flattening occurring. In most cases, you only have 20 bibs left. In some parts of the curve, you're already inverted. And so Federal Reserve and North Central banks can leave yield curve inverted for any lengths of time.

Because basically, as you correctly said, what it basically, the message you can base to the marketplace is, is that credit conditions are going to be too tight, and therefore interest rates ultimately will 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 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 us substantially reducing the democracy. 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 I basically compare it is to say, you know, private sector are the musician in the orchestra bit 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 so whenever you have central banks starting to land to the main street or buying collateral that they should never be buying or breaching rules on state financing

or having emergency repo lines just because the repo market is not function. 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 information of value do you have when the market is so distorted? And that's part of the reason why I think term premium just disappeared. Even today, it's negative, you know, 30, 40, 50, 50 bibs, which normally it should be more like 150, 160 bibs. So as a result of term premium being so low, it's easy to invert, but it conveys less 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 Mohamed Alarion or, or, or, or, you know, or some are 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 the redistribution mechanism.

It is not really creative anything. But we know that is not true. And a financial economy is at least five, six times larger than the real economy. And it can really crush real economy if it comes to it. So one thing with it is missing in the day. discussion is asset prices and the impact of volatility of asset prices will have on underlying economic activities. We all talk about wages. We all talk about wages per hour. We all talk about capacity constraints, ships trended 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 growth? What does it do inflation? And the answer, it actually crushes both of them. So I want to 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 while people hear this, but before people hear this, but I doubt that this volatility will have gone down so much. The counter argument, I guess, to what you're saying, is that, you know, there's so much real demand that's been put in the pockets of sort of, I'm thinking back to say a conversation that we had with. Jeff Curry 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 and 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, from a demand perspective, it's not as significant. Talk us through a little bit more why you see in this environment, financial asset volatility, which we've particularly seen in the bond market lately, how that feeds through to potential bust, potential recession, potential disinflation. Well, if you think of, and you're specifically thinking of the United States, because 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 net assets. Bottom 50% households control and own absolutely nothing on a net basis. And so the whole idea is that the asset size, of the balance sheet is 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 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 or 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 wealth 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 that they can consume or at a faster pace that they will provide for their retirement, for example. And as they continue to create this extra excess wells, that needs to be deployed somewhere. And where it doesn't get deployed, well, either get deployed in the Ferrari cars, you know, Hampton mentions, you know, Picasso painting and the rest of it, 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 wells, interest rates have to be lower and lower, right? Because you're generating more wells than you need, and you need to transfer that wells 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 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%, or call the 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 should, all of the assets belong to the top 1, top 10%, all of the liabilities belong to the 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 this 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 leverage. We're all dependent on asset prices as a queue for our decisions, whether to spend or to save, whether to invest or do 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, 4-1Ks 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 are 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 should. We should have done it 20 years ago, 30 years ago.

Okay, good luck. How are you going to do it? How are you going to 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 disinflationment. 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're destabilizing 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 wealthy, 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, six times larger than the underlying economies are. So that's the answer. In the short term, you're absolutely right. You put more people into poorer people's hand. They consume it. That's why you have increase in demand. That's absolutely correct. But they forget the other side of the balance. Where do those assets belong? Those assets belong in the top 1, 10% of the households. I wondered. I wondered.

If we could shift focus slightly and maybe talk about what's been going on in China because there happened 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 route 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 going to start rolling back some of 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. Yeah, you're absolutely right. Going into 22, 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 the tight. Everybody's tightening. China is the only one, which is completely countercyclical. China already was contraceptical over the last 18 months when everybody was flushing that was money. China actually was contracted. And for the next 12, 18 months, it looks like China again will be countercyclical. 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 RM&B probably on balance ought to be weaker as China liquefies and the rest of the

world tightens. The other argument that I had was all to do with political, geopolitical, and regulatory pressures, that whether it's Olympic Games, whether it's a party event, all the way through November 22, 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, Juan Ayota. There will be no change. It's irreversible trend. But at least for a period of six to 12 months, I felt that the degree of pressure that China will be under will diminish. And the third reason, of course, was China was a horrible performer through 2021 and earlier

part of 22. And I was assuming that at least some of that can be reclaimed. So if you think of it right now, it's been a wrong call because China underperformed so far Asia and Japan, as well as emerging market universe, by another 8 or 9%. And that's how they underperformed 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 policymakers are really calibrated. This idea that they're going to do the same thing as what they've done the last three times is well and truly debt. They don't want to add another 10 or 15 trillion dollars of debt, although they don't mind a little bit more leveraging. They don't want infrastructure investment to be galloping 25, 30%

And 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 reduced gross expectations without complicating 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 far 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 economics. 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 its interest of society and community. Trump are interests 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 sovereignty, sort of harping back to 18th century and part of the 19th century, where there was absolute sovereignty. A nation is entitled to do whatever they want within their own borders. So whether it's Internet and volcanization of Internet, whether it's a role of the state,

whether it's a role of state versus private sector, both Russia, China, believe that private sector is subordinate to the state and should be largely doing what the state 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're seeing is this massive illiberal Eurasian block forming, led by China, what I call Sinosphere. But within that will be nestled to smaller, you know, Russian Empire, Iranian Empire, Central Asia, and many other parts. And to me, the objective of redefining global rules, redefining 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 diminution of 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 has to be on, 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 or Iran look at the world. And the same applies to regulatory issues, because it goes down to the concept of 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're finishing with a regulatory aspect, no, we're not. You can ease back a little bit tactically, but the basic strategic trust 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. And so to me, when I look at China,

People want our investors, want to have a bit of ray of sunshine. And any idea or any concept that somehow Russia in Ukraine might be winding down in some form, any view that perhaps regulatory pressures will get a little bit less, perhaps you're going to 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 going to play through and didn't quite get there. There's a healing element in salt, in sweat, in tears, in the ocean. In Halifax, being surrounded by salty water and fog is just enough grit to help polish away the pressure of to-do lists.

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I want to expand further on this idea, as you put it, the sort of Eurasian illiberal coalition or bloc. And one of the things that's been striking, of course, with Russia is beyond just the formal sanctions, the degree to which U.S. companies are European companies as well as well have just sort of abandoned Russia, abandoned operations in many cases, severed ties. is with the local unit of the business. And I'm curious that, you know, what is, if these blocks hardened, 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 and things? both countries. 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 can 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 blocks heartened, sort of the Anglosphere, the EU 27, the Sinosphere, a liberal Euration block, as it hardens, you will find more and more separation. It usually starts with softer areas and more high-tech areas. So, for example, transfer of knowledge, transfer of technology. educational institution, ability to acquire skills.

It progresses onto some more humanitarian pockets. And then it progresses on to sanctions against certain individuals. It progresses to inability to access capital. And so to me, 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'll creeping up into other relationships as well as we progress forward. Again, I want to highlight that China is not Russia.

And this disconnect or ability to quarantine the country of the size and the port of China is just not all. Nobody will ever contemplated. 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 China investable? Is it portfolio manageable? Because if we continue on this path, which looks likely we will, then from international investors, opportunity to invest in China and 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. But whether your private equity, whether you are a company or whether you're 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 and 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 going to see. You're going to 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 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. And so I think you're absolutely right. That's what the final trajectory would look like. Does it mean that there is no capital in China or China will be stopped of capital? that's not the case. China has no shortage of capital. China needs expertise and knowledge rather than capital. So it doesn't mean necessarily disaster for China or a Eurasian block or a sinusphere block, whatever you call it. It doesn't mean that at all. It just will be functioning by different rules. It will have different systems. It will have different rule of the state and private sectors. It'll just be different. But it doesn't mean necessarily a disaster. 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 going to go up significantly. But on the other hand, you probably don't want to own stocks. If you think that rates are going to 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 the current environment. It is. It is. And that's one of the problems was not having a normal distribution

of events. People are functioning in corporate finance and investment theory functioning under 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 hence, as a portfolio manager, you're lost. Whatever bet you're making is just a bet. It's a gamble. It's not really an investable 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're in the right commodities. People will say, should I go into high asset, low,

return and invested capital type companies. Well, yes, maybe, but it depends what's going to 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, you know, March April 23 compared to March April 22 to give you a positive read on inflation. And it is quite possible that the markets are right that by 23, 24, you're going to have at least three or four interest rate cuts occurring rather than 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 1, 1, 1 and a half percent easily, rather than just marching on to 2 and a half, 3 percent. So to me, in all the sea of confusion, and we haven't even talked about whether it's a health care emergencies or whether it's pandemic or whether it's geopolitical 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, what isn't changing? Well, financialization is not changing. Remember, the only reason U.S. has an opportunity to raise money or raise cost of capital is because the policy rates today in the U.S. are below neutral rates. Neutral rates in the U.S. are roughly around zero in real terms. That means about 2% in nominal terms. But if you think of Eurozone in Japan, their policy rates are in line, if not even higher, that they're neutral rates. So they can't really tighten. And so US has an opportunity to tighten, but as they tighten and get closer to our star or a neutral rate, what's going to 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 off. And this idea that we need to generate more money and more liquidity than underlying economies require cannot be 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 given. 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 five to ten years. So none of that stuff. 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 commodities that are actually replacing today's world and building the new world. That's your copper, your nickel, your aluminum, your lithium, your re-earth, your semiconductors. What else do you want to do? Well, capital goods companies that actually will be rebuilding what else destroyed, plus building 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 Infotac 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 their products, their marketing, the way they use technology, and therefore their productivity grows. rates are faster. So to me, in a sea of confusion, the only thing is certain is that go with a circular strength and go with the productivity drivers. In other words, those guys who consistently

deliver access our productivity. Circular strength, productivity drivers. To me, that's an easiest way to sort of conceptualize it. In the short term, however, yeah, you're absolutely right. Energy, if you take out energy, global markets would not have performed. And if you were in energy, you're up 25, 30% against any index. If you have a mix of energy and financials, you would have been up at least 10, 15%. If you are somebody like Kessie Wood of Arc, which is completely on the opposite side, you would have 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 want to plonk more on energy at the current prices, or do you really want to completely double down

and triple up, so to speak, 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 sort of resilient portfolio. I just want to go back real quickly just to this idea of, as you put it 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 the system. What is the worry? And, you know, we talked about the deflationary bust after the inflation of the Spanish flu. How do you see a potential policy mistake playing out right now?

out? Well, the only number to look at is really financial conditions. Different countries call it different names. Some 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, like high-yield spreads, a variety of volatility in various markets, in order to define 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 emerging markets. But in the U.S., tightening so far 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're still stimulatory. You still have the capacity to come,

to come up. The question is, how far can you come? How close? can you come to our star? Can you go above our star and actually become contraction? 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 star is zero aerial, which is, say, 2% nominal. So there is a room for 50 bibs, 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 potentially significantly increase. When that happens, it flows straight through into financial conditions indexes. And that's a cue for central banks to pull back. They have no choice but to pull back very quickly. And so, as you know, I attended 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. And so I still maintain that that's 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 the 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 it inverts,

the more Federal Reserve, we'd 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. All right, well, Victor, we're going to have to leave it there. But thank you so much for coming back on the show. Thank you. I really appreciate it. So, Joe, it's always great hearing from Victor, and he has this uncanny knack of bringing everything together under one sort of giant macro umbrella. Yeah. 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 what that means is that it's really difficult to get a handle on real demand versus sort of fake stockpiling demand. 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 transitory, some of the current inflation is still likely the result of it, even though no one uses that word. And there's 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 Victor laid out where by 2023 they're talking about eating again. Totally. I mean, this is the other thing that emerged from the pandemic.

We didn't really get a proper recession after the pandemic because we had all the stimulus. Yeah. And then we sort of got shunted into a recovery that was really supercharged, again, thanks to that fiscal stimulus. And now it feels like we're sort of. of getting the response. I know some people say it was too slow coming, but it actually feels like it 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. Yeah, you know, it's interesting.

I had this thought about like this sort of, I guess it's like the fun house mirror version of the downturn and how fast does upturn turn itself. And you know what day I felt like that specifically is that day? Remember like the price of nickel went completely. the Zarkaband to shut down the nickel trading. And the day it reminded me of, weirdly, was the day that oil went negative, even though it's the exact opposite move. Right. One is this huge spike.

But both are these days that sort of like broke the market except in opposite directions. And so to some extent, it did feel like, I don't know, like, yes, I think what you're saying is, well, put, like, 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 lander just to have normal. Yeah. Torqued is a good word, isn't it? All right.

Shall we leave it there? Let's leave it there. Okay. This has been another episode of the Odd Lots podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Allaway. And I'm Joe Wisenthall. You can follow me on Twitter at the stalwart.

Big thanks to our producers, Magnus Henrickson and Colin Tipton. Follow the Bloomberg head of podcast, Francesca Levy at Francesca Today. check out all of the podcasts at Bloomberg under the handle at podcasts. Thanks for listening. Grasso inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world. Listen for complete analysis of the biggest court cases, the latest actions from Congress and regulators, and the legal moves driving the markets, from corporate law to constitutional law, and from state courts to the Supreme Court.

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