James Aitken – Opportunities and Risks from Monetary Policy (EP.326)

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2:31Hello, I'm Ted Seides, and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can join our mailing list and access premium content at capitalallocators.com. All opinions expressed by TED and podcast guests are solely their own opinions and do not reflect the opinion of capital allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions.

3:11Clients of capital allocators or podcast guests may maintain positions and securities discussed on this podcast. My guest on today's show is James Aitken, the founder of Aitken Advisors, a one-man macroeconomic consultancy based in Wimbledon, England, that works with 100 of the most influential pools of capital in the world. James has been a repeat guest on the show. Our very first conversation five years ago, including his background and process, and the most recent one last year, are replayed in the feed. If you search on the podcast page at capitalallocators.com, you can find the rest of his appearances.

3:49Our conversation this time around covers the precarious setup from fiscal and monetary policy. We turn to attractive opportunities arising from it in the U.S. industrial complex, Japan, and the U.K., and risks on the horizon from volatility targeting, unprofitable businesses, illiquid exposures, and the absence of governments willing to embrace pain. We close with James's thoughts on his home country of Australia, and for the first time, how he's making his research more broadly available. Before we get going, we wanted to help you come down from what might have been an intoxicating July 4th celebration here in the US, a part of a six-week summer break in Europe, a food coma induced siesta in Latin America, or a drunken bash just for the sake of it anywhere in the world.

4:37The somewhat crappy, non-summer-like recent weather in the Northeast aside, there may be no better way to sober up than listening to this week's macroeconomic picture from one of our go-to strategists on the show, James Aitken. His soothing Australian accent can set you at ease, even if the warnings of what could come next may not. So sober up, have a listen, and search for the opportunities that let you keep the party rolling. And when you're out there partying, don't forget to tell your mates to tune into Capital Alligators to hunt for the good and warn about the bad in capital markets worldwide.

5:13Thanks so much for spreading the word. Please enjoy my conversation with James Aitken. James, so great to see you. Very nice to see you, Ted. Well, it's confusing times. And so I would love to start by asking you what is most on your client's mind? It's like every family car journey. Are we there yet? That's the number one question. Are we there yet? Is monetary policy sufficiently restrictive? How should I think about credit, gross stocks? How should I think about opportunities? Are we there yet? Is there a rising probability that central bankers can finally signal mission accomplished? So yeah, are we there yet?

6:00It's the number one challenge for all of us. Is it safe to take on more risks? Should we be more defensive? Have we outlawed recessions? All these kind of questions. And it's been a very remarkable three years and a very remarkable 18 months, because I don't think any of us would have imagined that in the context of the most rapid rate hikes any of us have experienced, that the fallout of that could be so limited. Let's break it down and start with those hikes. How are you thinking about the monetary policy action and the fiscal policy action happening at the same time? Perhaps we should go back a little bit in time just to set the scene because it's difficult and it's certainly different.

6:47And this is just a very rough, high-level survey. For 20 plus years, monetary policy was the only game in town because fiscal policy could not be turned on. Fiscal policy was reluctant to be deployed or couldn't be deployed. And that unfortunately meant that central banks, to avoid disinflation and liquidation of risk assets, were compelled to do things that central banks were never designed to do out of necessity. And the irony today, Ted, is that monetary policy is still the only game in town, but ironically, because fiscal policy can now not be turned off. And if you and I and anybody listening were looking for a guaranteed way to bring inflation down to where people are more comfortable with it, well, the most abrupt way of doing it is not by saying, oh, maybe we need to hike, maybe we need to do this with policy rates.

7:48it's to turn the fiscal spigots off. There's not much of that on display right now, least of all in the United States, where frankly fiscal policy is all in as far as the eye can see. So I'd say that's one of the primary differences here, or as I said earlier, ironies that for 20 years monetary policy was the only game in town because fiscal policy could not be turned on and monetary policy is now the only game in town because fiscal policy can't be turned off. And And quite frankly, Ted, because the fiscal response to the COVID situation was so huge and we did things that we never thought we could do, which is direct fiscal transfers to households and businesses, I'm afraid what that has probably done is reset expectations of what fiscal policy can do and how it can be deployed in future downturns.

8:43So now it's out of the box. Fiscal policy is probably going to be more proactive and generally stimulative. And that makes it incrementally more difficult for all our central bank friends. So that's just to set the scene. The other thing that's been on my mind is we talk about nominal policy rates and this, that and the other. And yet financial history guides us that you're unlikely to arrest an inflation problem with peak negative real policy rates. And it's only as we turned into the late first quarter and second quarter of 2023 that, for example, the real Fed funds rate turned positive. And the reason I've been thinking about real policy rates a lot is as you look at the seven big disinflations in the United States since 1951, the end of the Treasury Fed Accord, Those big disinflations only occurred, unsurprisingly, when the real Fed funds rate or predecessor equivalents were notably positive, which makes a lot of sense.

9:51It would be unlikely for the Fed to have arrested this inflation problem with peak negative real policy rates, or frankly, a real Fed funds rate anywhere below what we've seen over the last, say, 20 years, just as it would be unlikely for the ECB, the Bank of England, the RBA to arrest this inflation problem with what are currently negative real policy rates of anywhere between minus 200 and minus 400. In other words, we're still groping for sufficiently restrictive monetary policy. But the sting in the tail is that as 2023 goes on, central banks will continue to hike at a somewhat slower place.

10:33They know that. They're not shying away from it. Inflation will continue to drift lower somewhat, although it's still arguably far too sticky. And as 2023 goes on, therefore, real policy rates will continue to increase, most notably in the United States. And by the end of 2023, we could end up with a real Fed funds rate that is as high as anything we've seen, at least since 2006. And you'd imagine that eventually that's probably going to subdue the animal spirits that are manifest everywhere today. I mean, look, I'm coming every morning since the start of this year, turned on my Bloomberg, and somewhat to my surprise, it's a sea of green every day.

11:16James, I want to ask, going back to macroeconomics 101, the relationship of monetary policy and the economy, is this thought that you raise rates, money comes out, you have the reverse multiplier effect. You lower rates, creates the stimulus, you have a multiplier effect, and the economy banks lend money. How does the multiplier effect work when there is this persistent fiscal stimulus and you're trying to temper the economy? Well, isn't that a good question? Let's think that through. If we were to sketch how tighter monetary policy feeds through to the real economy, in the US and frankly most levered economies, it's the cost of borrowing goes up.

12:08It's more expensive to refinance your mortgages. In general, financial conditions tighten, meaning stocks drift and sometimes head a lot lower. You've got a rising risk premium in credit. And basically, when the consumer looks at their monthly statement, they say, gee whiz, our household net worth has peaked. It's coming down. I probably should restrain consumption. And then that tends to feed on itself. and ideally brings you in for a nice, gentle, soft landing, except that there's not much history of that. But really, the key thing is it tends to work through household balance sheets, the consumer and consumption in general.

12:51And sometimes it works in a spectacular way, as we saw in 2007 and 2008. So first and foremost, that's the transmission mechanism, the cost of lending to households in the real economy in general. Well, what's interesting, at least over the past 12 months, is that we saw the immediate response from interest rate sensitive sectors of all sorts of Western economies as wage went up. You know, the usual things went bump in the night. There was a bit mortgage costs went up. Household balance sheets felt a little bit more constricted. Consumption slowed a little bit and so on and so forth. But that channel isn't quite working in the same way, because guess what?

13:35US households in particular are not stupid. They can see around them that inflation is going up. They can see that boring rates are probably going to go up. And guess what? A vast number of them termed out their funding, which was very smart indeed. This is a very tentative observation. But unlike most spectacularly 2006 to 2008, perhaps the elasticity of US household balance sheets and US household consumption to rising Fed rates is much lower simply because US households appear to have termed out their funding. And then when we compare historical episodes of US households being overextended, not just with mortgages, but with credit cards and everything else, they're in very good shape compared to any time, certainly in the past 20 years, in terms of credit card borrowings and this, that and the other.

14:32Now, of course, we're already seeing plenty of evidence of people who completely misjudged the cycle, such as Silicon Valley Bank and others. They're paying the price. and there will be people who get into strife, whether it be commercial mortgage-backed mortgages. We can go down the usual checklist. But in aggregate, quite remarkably, this is a US economy that is still on fire. The pass-through effect this time, if the Fed's going to succeed in bringing inflation down back to target levels, it's going to have to be more persistent and more hawkish, I would argue, than any of us have experienced.

15:08And if on the one hand, the Fed taketh away, and on the other, President Biden giveth, then effectively, it's like running a heater and an air conditioner at the same time. And there is no overstating the profound impact of this Inflation Reduction Act. It is just starting to be felt. It seems every marginal dollar of Western CapEx coming into the United States because the tax subsidies are so generous, not to mention all the skilled workers and everyone else required. But the multiplier effect of that is just beginning to be felt and will be felt for many, many years to come, no matter what happens in November 24.

15:48So look, how to break down your question, it would seem at this stage that this isn't a rerun of 06, 07, 08, or any previous housing channel slowdown. It's part of the reason is fiscal policy is all in as far as the eye can see. I mean, I'll just say in brackets that to see the US budget deficit at 8 % of GDP now before any recession is deeply unsettling. Deeply unsettling when the US still largely relies on the kindness of strangers who may not be as excited about Treasury bonds as they were 10 years ago. But look, fiscal policy all in at the most basic level means that monetary policy has to do more of the heavy lifting.

16:37We remain fast and sufficiently restrictive. And I'll just say my intuition would be that the Fed hoped that they would have stopped hiking by now, not just paused or skipped or any of this other jargon. I'm pretty confident the Fed hoped that they would be able to stop hiking by the end of the first quarter of 2023, pause, look around, wait for the lagged impacts of monetary policy to bite. So we're getting the softening that we expected. We're getting a slight loosening in the labor market. We're getting a slight increase in continuing jobless claims, continuing claims in the US, we're seeing slight tightness in terms of lending to the real economy.

17:21But by and large, this juggernaut keeps powering on, and it's absolutely remarkable to watch. The counter to the idea that the consumer's elasticity to the Fed rate hikes is much less than it had been, is that the banks, by definition, are upside down. To the extent that consumers termed out their mortgage, the bank is now underwater on a market-to-market basis. We saw that in SVB and the others. So the bank is usually the core of the multiplier effect. How is that going to play out when the Fed, as you mentioned, needs to keep rates hiking to cool the economy, but the higher the rates, the more many of these bank balance sheets are upside down?

18:05Let's see if we can answer that with a little bit of financial history, which is the savings and loan crisis. And it's similar but different. That's the lesson of financial history. It never tells us anything. It merely suggests a frame of reference if we're trying to untangle complicated things. So this savings and loan crisis suggests that what you tend to see is the initial wobble where a couple of the most poorly risk-managed institutions get into difficulty. So the savings and loan crisis blew up in 1982. No surprise, similar reasons, you had a cap on deposits. Mr. Volcker put rates up a lot.

18:47And unsurprisingly, the deposits left certain savings and loans institutions for higher yields. Oh, guess what? We're upside down. Whoops. So it broke out in 1982, and then nothing happened, although it was helped a bit by Mr. Bolker being a bit more dovish. There was another mini eruption in 1984 where Congress tried to fudge it and bizarrely said the SNL should take more risk. But the SNL crisis wasn't eventually resolved until 1989. And there are some similarities here, but for different reasons. I mean, I'm certainly one of those people who think post-Silicon Valley Bank, the delta on the willingness of every US bank, but particularly the smaller ones, to lend to the real economy, it has to be negative.

19:38It just has to be in terms of capacity and obviously in terms of the cost. So we know the delta. But it's extraordinary when you look over the Fed's weekly data on small bank lending, loans and leases, and this, that, and the other. And it's started to tick up again. Smaller banks are seeing deposit inflow. So it may not be great for bank earnings, but there's a hint that we can muddle through here for longer than people may expect. And just to add to that, I think people overlooked just how generous the Fed's bank term funding program was. Imagine you and I were somewhat slow-witted bank treasurers.

20:25Uh-oh, we've got all these treasuries on our balance sheet that are not worth par, they're worth 75. Oh, Jay Powell said, here's a new facility. Bring all your treasuries to us at face value for a 5 % fee. Well, that's a no-brainer. We'll just take our entire balance sheet of treasuries to our friendly local regional Fed and say, here you go, son. So it's no surprise that that generous facility acted as a giant firebreak. And then in the second instance, something that's still little commented on today is that the Fed provided a bridge loan to the tune of$212 billion to the FDIC's bad bank. Now, Ted, that is not surprising, but it's still breathtaking in its scale.

21:09And I think the most interesting part of that, compared to years gone by, is that there was not one peep from Congress on either side of the aisle about the generosity of the Fed's response to ring fencing, sandbagging, Silicon Valley Bank. So the point here is that so successful has the Fed's backstop of regional banks and so forth been that it has not only prevented the accelerating tightening of credit we all expected after Silicon Valley Bank, it's actually incentivized banks to be calm, be measured, and to keep lending where appropriate to their clients. It's a remarkable thing indeed. And the perversity of it for the Fed is frankly, that's so successful has this bailout been so generous that they're probably going to end up taking the Fed funds rate to a level that none of them actually imagined when they started 2023.

22:09This gets us into, you know, from the what in your vernacular to the so what. And let me start that with something I always scratch my head in trying to understand, which is what you've just described is the Fed assuming, let's just call it at best, mark-to-market losses at banks. Someone has to take these losses. We do have this 8 % deficit. Where does this go? How long can you keep socializing these losses without what seems like a political will to either raise taxes or rein in budgets such that eventually you can pay off these losses? One of my clients reminded me yesterday of the difference between emerging markets and developed markets.

22:58And he said, in a crisis, emerging markets see their yields go up. And in a crisis, developed markets see their yields go down. The reason being that developed markets, by and large, are permitted by reason of standing to print their way out of trouble. And that's generally true of developed markets. When there's a crisis, because there's perceived policy credibility, yields tend to fall. And unsurprisingly, in the world's reserve currency, the United States has benefited from exactly that. But it feels a bit different this time, because, again, that budget deficit situation, the US relying on the kindness of strangers.

23:49Some of the biggest recyclers of dollars do not appear to be terribly in love with US treasuries anymore. And then you've got these growing socialized losses. You have high inflation. In the background, I hear every day all these voices saying, oh, yes, don't worry. the Fed will be compelled to do yield curve control to peg the Treasury curve. That's how we get out of Dodge. And I'm like, well, okay, if we dare to believe that the Fed is going to be the money printer of first resort, and basically buy the entire Treasury curve, where does that put the dollar? That's all to be resolved in the future.

24:31But of course, you're asking the right question. Socialization of losses is one thing, but I wonder if it all boils down to one simple thing. The ability to deploy fiscal policy may not be down to whether you're the world's reserve currency or not. The ability to deploy fiscal policy in scale or just fund or socialize losses depends on your ability to roll over all your sovereign debt at a fairly predictable, fairly low rate. Otherwise, it just doesn't work. And we've all grown up in this environment of declining inflation, declining interest rates, during which, with the exception, infamously, of certain emerging markets, the ability of developed markets to refinance themselves has never been called into question.

25:25But we've never had a starting position such as we have today. So to answer your question about how long is it possible for the US to socialize losses or effectively, what's the capacity of the Fed to underwrite every wobble in the financial system whilst they continue to fight the inflation fight? The argument from the central bankers would be, well, there's no problem. We're doing our job. This is how it works, deploying our balance sheet, wearing our financial stability hat. In brackets, don't ask us how we miss Silicon Valley Bank, we'll get back to you. That's all could be a bit challenged in years to come.

26:01But then let's not get too tinfoil out about it. Let's just focus on something important, which is incentives. Let's take a topical example. Here in the UK right now, despite everything people read about inflation problem, the haplessness of the Bank of England, all of which is true, UK private banks and high net worth individuals are falling over themselves to buy gilts. Yeah, quite shocking, right? Very simple reason. Gilts are the munis of sovereign debt. We all know about the tax attractiveness of muni bonds in the US, but gilts, there's no capital gains tax on gilts for UK taxpayers. And there are a whole bunch of short-dated gilts out there trading at very hefty discounts with very low coupons that the private banks and high net worth individuals in this country are piling into because it's a very tax efficient deposit account.

27:00And that's logical. The reason I bring that up is because incentives matter. And for the first time in, let's say, roughly 25 years, Ted, you and I and everyone listening, we're paid not to have a view because money is not free anymore. If interest rates are zero, then we have to have a view all the time because any decision to step out of risk assets, no matter what the risk asset is, is a career decision if you're not paid to wait. Well, that's completely flipped on its head. If you and I can get the best part of five and a half, 6 % on a UST bill, we don't need to have a view on all these things.

27:40We're like, you know what? We are paid to wait. And that gets me to your question. Who's going to buy all these bonds that the United States is selling in 2023, 2024, 2025 with a rising budget deficit before the recession comes? And my answer is everybody. Everybody. You give people the right incentive, the right coupon, they will buy it. That gets us into another difficult subject, which is if savings, whether they do domestic or global savings, are going to crowd in because the yield is so tempting to sovereign paper. They're going to crowd out, if you will, of other things. And that's why the years to come are so complicated, because if we're going to be choking the world with sovereign bonds, and some countries are deficit countries and others are surplus countries, boy, oh boy, someone's going to have to take down a lot of debt.

28:42And I think at the right price, it could frankly be you and I. Well, let's take that and walk through getting into the markets, what you see as some opportunities and risks from this environment. And why don't we start with the opportunities so it's not all gloom and doom? That's actually a really good point. It's never all doom and gloom, is it? It never is. And as you told me when we had that lovely lunch a month ago, the hardest day to invest is today. It's always, oh, it's so hard to invest. No, it isn't. Somehow people have coped with investing for centuries, Ted. How on earth did they do it?

29:22And as we all know, there's been a whole lot worse things happening in the world than are happening today. It's not to negate some of the challenges we face, but boy, oh boy, there's been some much more difficult investing environments than June 2023. So the hardest day to invest is today. And the hardest thing to do when everyone is jumping up and down and screaming like they are today is to keep an open mind. And I think I said to you in one of our earliest discussions that as much as everyone thinks macro is what's going wrong, it's so important to keep a view of the right tail of the distribution in macro, which is what's going right or what could be going right.

29:59And it's harder and harder to do when everyone's on recession, Ross, but that's okay. First one through a few practical things. If government is going to borrow a lot of money and spend a lot of money, how do I line myself with government, goes back to the earlier point. I think the multipliers and impact of the Inflation Reduction Act, people are barely beginning to understand how powerful that is. I mean, I was looking at the chart the other day to see the hockey stick in US construction manufacturing spending. It's real. And all these very good industrial companies in the United States and some here in the UK who have US businesses, they're going to have a full order book as far as the eye can see as the ripple effects of the Inflation Reduction Act and the accelerated onshoring of all sorts of manufacturing take hold.