[REPLAY] Louis-Vincent Gave – Macro Consequences of Government Sanctions (Capital Allocators, EP.247)

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2:32Hello, 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. My guest on today's show is Louis Vincent Gov, the founding partner and CEO of GovCall, one of the world's leading independent providers of macro research, and GovCall Capital, a manager of $2 .7 billion in assets. Louis launched Govkal alongside his father in 2000 and has become a go -to source for creative research on global economics and asset allocation, particularly in China.

3:25He recently penned CYA as a guiding principle, dissecting the consequences of Western government responses to Russia's invasion of Ukraine. He joined me to discuss the key takeaways. Our conversation starts with Louis' background and founding of Govkal and turns to the potential second -order impacts of freezing reserves, seizing oligarch assets, end of Swiss neutrality, energy prices, and military spending. We close discussing how the situation may affect China. Please enjoy my conversation with Louis Vincent Goff. Louis, great to see you. Great to see you. Thanks for having me. How have you been?

4:07I've been well, thanks. This is the first time I've had you on the show, so I thought maybe you would be helpful to give a little context before we dive in on the Ukraine situation. And why don't you just start with your background and what it is you do, how you got there? Well, first of all, yeah, thanks for having me. It's a pleasure to be here. I'm one of the founding partners of a company called Gafkow. We're based in Hong Kong and Beijing. I've spent really the better part of my past 25 years looking at China and China's sort a major impact on economies and on global financial markets. And GAFCAL is when people know us, they know us because we publish a lot of research.

4:50And sometimes they also know us because we actually do manage money. We manage institutional money, mostly in the Asian markets and specifically in the Chinese Sphinx income markets, which is where the bulk of our assets are deployed. So we're a somewhat unusual firm in that we do provide a lot of independent research, and that's where about two -thirds of our staff works. And then we have another third of our staff completely separate that manage these institutional accounts. And how about a little bit of an overview of you and how you got to that point of being one of the co -founders, I don't know, 20 -something years ago now?

5:25I'm French originally. I grew up in France. I went to college in the US, went back to France. I was an officer in the French army for a little bit in mountain infantry. Then I joined Paribas. And throughout this period, my father had created a big money management firm called Cursator Eden. He was the CIO there. The firm was sold to Alliance Capital in the mid -90s. My father stayed there and he retired in the late 90s. And he kept writing things here and there, mostly for his friends. He left at Alliance Capital. And I saw what he was doing, what he was writing. And I thought, oh, you know, this is pretty interesting stuff.

6:04Maybe we can make a business out of it. Now, granted, this was the late 90s. And in the late 90s, you can make a business out of anything. But that plus the combination of my mother telling me, you've got to get your father out of the house. He's driving me nuts. Having a retired husband is the worst of both worlds. It's more husband and less money. So put him back to work. And so he and I started a small research firm. And we're joined pretty quickly by Anatole Kalecki, who is a friend of ours and a famous financial journalist in the UK. And pretty quickly, everything. So this was all done out of London, but everything we're looking at was telling us that China was going to be a massive shift into the global financial and economic infrastructure.

6:46So I moved to Hong Kong. My father, Charles, moved to Hong Kong. We opened an office there. We teamed up with a fellow called Arthur Kroeber based in Beijing. and he joined us as a partner. Yeah. And that's basically how things took off. So I spent roughly 20 years in Hong Kong. All my children were born there. It's a huge part of my life. A couple of years ago, just before COVID, mostly for school reasons, we decided, my wife and I, to move to British Columbia. And my idea was that I would sort of spend two weeks in British Columbia, two weeks in Hong Kong and go back and forth. But obviously COVID intervened.

7:23And so I've spent the better part of the past two years and is what I think one of the most beautiful spots in the world. So I have to ask before we dive in, what was the dinner table conversation like with your father running an asset manager when you were a kid? My father was an odd money manager and I think he fell into it a little bit by accident. It was, to be honest, neither his temperament, nor definitely his family background. He came from a military family and pretty much aside from my dad, every male on his side of the family was in the military. So the dinner conversation actually didn't really focus on markets.

7:57It was always surrounding current events for sure, but it was very much heavy on history and fairly heavy on religion as well. Well, you just wrote this recent piece that relates to what's been happening in your perspectives, starting with the famous letters CYA. And I would love to just have you walk through some of your takes on the current situation and the parallels that you're drawing from it. Just in case people don't know, CYA stands for cover your ass. And I fear that this is increasingly how policy gets done in the Western world. At least that's the thesis of the piece that you mentioned.

8:34And I wrote a first CYA piece surrounding COVID. And at the time of COVID, what became pretty clear to me was that you obviously had a tough event unfold, you know, the start of this pandemic. And a clamor all of a sudden rises on social media, you know, something needs to be done. And so you get, I don't know if you've ever followed the British TV show. It's one of my favorites called Yes, Prime Minister, where time and time again, the politician is in a situation where something must be done. This is something. So let's just do that, regardless of whether it works or not. That's almost irrelevant.

9:07And I think we saw that in spades with COVID. It was a case of every week, something had to be done before the previous thing that had been decided had even been implemented, we were already moving on to new measures. So, you know, mask mandates and shutting down schools and full lockdowns and so on and so forth, regardless of whether it worked or not. And so with this framework, I think we're seeing exactly, of course, the same thing with the Ukraine situation. You have a horrible event that occurs, you know, the invasion of Ukraine by Russia. And the clamor is, of course, for something to be done.

9:39And before we even have a chance to think, okay, what is the something that we should do to deal with this, we just implement a bunch of measures, one after the other. The first measure is the freezing of Russia's central bank reserves. The second measure is the seizing of the oligarchs' assets. The third measure is the seizing of Russians' bank accounts in Switzerland. The fourth is massive increases in military spending. And before we've even had a chance to stop and think, hold on, if we do this, what are the consequences of that? Already, we're moving on to the next measure. And so this is the world we now live in, where policy doesn't get discussed in parliaments or in Congress.

10:23Politicians don't run on campaign issues, etc. It's something bad happens, quick, let's have a policy and we'll figure out later what the consequences are. Now, when it comes to these measures that have just been taken, the confiscation of the oligarchs assets, the freezing of their bank accounts in Switzerland, the freezing of Russian central bank reserves. I think these are potentially enormous consequences to these actions, and people haven't really thought through them. Well, let's walk through them one by one, and maybe we'll just go in order. So freezing of Russian reserves, we've seen as really a new measure here in trying to control what's happening in the world through economics.

11:02I'd love to get your take on the effectiveness and then the potential consequences, maybe the unintended consequences. Absolutely. Look, I think it's a massive shift. It's enormous. And here, let me start off by just acknowledging that we're, of course, all the fruits of our own experiences. And for me, one of the key events in my career, partly because I had just started working in financial markets, was the Asian crisis. The speed at which Asian markets unraveled in front of my very eyes in 97, 98, just as I'd started covering those markets. And it's called the Asian crisis, but it was really a broader emerging market crisis because Turkey also hit the wall.

11:40Obviously, Russia hit the wall. Brazil and Argentina ended up hitting the wall. And I think when you come out of the Asian crisis, most emerging market policymakers adopt an attitude of never must this happen again. Never must my entire middle class be wiped out in the space of a few weeks. And to make sure that this never happens again, I must basically maintain an undervalued currency, maintain strong trade surpluses that I recycle into U .S. treasuries or German boons and basically build myself a nice big safety cushion in foreign bonds. Now, as emerging markets do this for really 25 years, I think what happens on the other side in the Western world is in the Western world, we just get used to massive budget deficits being funded year in, year out without any question.

12:29And so you end up to where we've been in the recent years, where you have money supply growth growing at double digits and budget deficits that are 4%, 5%, 6%, 8%, 9 % of GDP and no financial consequences for government. There's always somebody to fund these massive deficits, even as, frankly, the attractiveness of Western bonds keeps on deteriorating. Today, you look at Germany, you look at France, you look at Britain, you look at Canada, you look at the US. All of these bonds now offer real yields of anywhere between minus three and minus five. But the reason, of course, emerging markets keep on buying these bonds is not for any return on capital, but it's because of the perceived safety of capital.

13:16It's again, the view that if there's a crisis, I need to have US treasuries. Of course, Russia is now in a massive crisis. And what we've told Russia is that money that you thought was yours is no longer yours because that money is yours only if you behave in an appropriate way. If you start acting like a jerk, then we're going to confiscate your money. So we've just shifted the rules of the game. We've just shifted the rules of the game from this money is yours regardless to not only are the returns on capital on this money absolutely horrendous. And you're basically destroying capital over time with minus three to minus five percent real rates.

13:58But also, if you don't do what you're told, then we're going to take your money away. And so, and I've had this discussion since the Ukraine invasion and this measure was announced with a lot of clients and the pushback is always, well, if you follow international law, then you don't have anything to worry about. But this is all well and good, of course, if you're France and if you're Germany and if you're Britain, you're going to trust the US to not, excuse my French, but to not screw you over. But what if you're China? What if you're Saudi Arabia? What if you're the Sultan of Brunei? You're going to worry about getting canceled from one day to the next.

14:33What if tomorrow China does invade Taiwan? Does that mean that it's $1 .5 trillion of U .S. treasuries go poof? What if tomorrow, if you're Saudi Arabia, what if tomorrow 20 Saudi citizens decide to once again hijack a U .S. airliner and drive it into the Sears Tower or into the Empire State Building? Does that mean that Saudi's reserves get canceled? So all of a sudden, I think it's pretty clear that with this Russian invasion, a new sort of iron curtain has fallen on Europe. On the one side, you have Russia and Belarusia. On the other, you have pretty much every Western democracy. And the Western democracies are telling the emerging markets, like Brazil, like Saudi Arabia, like India, like China, telling them, come and join us on our side of the Berlin Wall, and we'll guarantee you that your assets will be safe.

15:25But those countries all of a sudden are saying, I'm not so sure. And maybe it doesn't make much sense for me to keep accumulating these assets. And so if that's the case, then you enter into a new world where it's, hold on, why do, if you're China, for example, and you're no longer sure, well, you're sure that you're getting a terrible return on assets and you're no longer sure about the safety of assets, then you might think, well, why do I need to keep a cheap Renminbi? Why do I need to keep running big trade surpluses with the US to accumulate treasuries that could be confiscated from me? What's the point of this?

16:01Maybe I shouldn't even be trading with the US. Maybe I should be locking down Shanghai and Guangdong and letting the US get on with it and freeze the US out. And so I think we're moving potentially into a very, very different world. This reserve decision could be one of, I think it's the most important financial decision since the unpegging of the US dollar to gold in 1971. How would you track the potential for these countries significantly changing their reserve policies, say, based on that thesis? All right. On April 11th, I think is a historical day where Chinese bond yields have fallen below US bond yields.

16:41If you look at the 10 -year notes, for the first time in modern history since China has start to open up its capital accounts to foreigners since it's become possible for foreigners to buy Chinese bonds. This is the first time that Chinese bond yields are now below US bond yields. Let's think of that for a second. If I told you three or four years ago that Chinese bond yields would be below US bond yields, you'd have said, no way, this isn't going to happen. Too many structural uncertainties around China, too many uncertainties surrounding the rule of law, etc. So this is one potential answer to your question.

17:15How are you going to track this? Well, it's happening in front of our eyes. It's unleashing right now. Since we've decided to freeze Russian central bank reserves, U .S. Treasuries, German bonds have been in an absolute freefall. Two -year yields have just risen by 100 basis points. This is never in the space of less than a month. This has never happened before. The bond markets are – like the US Treasury in the first quarter of this year, US Treasuries was the worst performing asset. Actually, German boons were worse. But these were the two worst performing assets. It's happening. It's just striking us straight in the face.

17:51Yeah. I mean, how do you determine cause and effect, right? Some of that just could be the soaring inflation that we're seeing in part because of what's happened in Russia. You have spiking oil prices and therefore increased inflation and you'd expect these bond yields to go up. So whereas in China, they're still transacting with Russian oil. So there are other cases for why that could happen, right? No doubt. But was inflation absent a month ago? A month ago, US bone yields were basically, what, 50, at the long end, 50, 60 basis points below where they are today. And you had plenty of inflation.

18:27Inflation was pretty bad a month ago. It was horrendous. Inflation has been horrible and accelerating for six months. You're right that the Russia war makes everything worse. It makes the energy crisis worse. It makes the supply chain dislocations worse. And it does make the inflation problem worse, no doubt about it. And you're also absolutely right that it probably makes it worse for the Western world than it does for China. And so it is hard to know what is cause and effect, et cetera. But to be honest, I don't really care what the cause and the effect is. I'm just looking at the trends. What I have is falling Chinese bond yields, rising U .S.

19:01bond yields. We can debate all day which policy is implementing how, but the trend is there. The trend is your friend. And until you see a change in policies, why would you expect those trends to reverse? To me, that's what matters more because that's what you got to invest on. So when you speak of seizing assets, the oligarchs is a different, very different scenario than freezing reserves. And why don't you talk about your take on what the implications of that and why it's happening? I think the seizing of the oligarchs assets is much, much worse. It's much, much worse because, you know, my starting point when I look at the world today is that the biggest comparative advantage the Western world has is the rule of law.

19:40It's the fact that you can be brown, black, white, Chinese, Indian, it doesn't matter. You can be Hindu, Muslim, Jewish, Christian. You can go in front of a court of law in New York, in London, in Paris, and you're going to get the same fair shake. Hence the pictures of, you know, justice with her eyes covered, etc. This is the greatest strength by far of the Western world. This is why rich people in emerging markets keep on investing in developed markets. And this is why you buy, if you're a rich Chinese, this is why you buy Vancouver real estate. This is why if you're a rich Indian, you buy London real estate.

20:18this idea that you have an independent justice system and that my safety of capital is protected by this independent rule of law. It's a very powerful notion. And it's what, frankly, capitalism is based on. And everybody gets to benefit from due process, et cetera. And what's just happened in the past six weeks, if we said, absolutely, we believe in this fervently, except if you're Russian. And as soon as you make an exception, except if you're Russian, If I'm Chinese, if I'm Saudi, if I'm Bahraini, if I'm Qatari, I'm going to think, what do you mean except if you're Russian? Does that mean except if you're Chinese next?

20:59If I'm a rich Chinese guy and I own a bunch of real estate in Vancouver and London and wherever else, do I now worry that if tomorrow Xi Jinping decides to invade Taiwan, a decision on which I have no visibility, no control and no influence whatsoever, does that mean that I lose all my stuff? Because that's what's just happened to the Russian oligarchs, right? Granted, nobody likes the Russian oligarchs. They made their money most of them by pillaging their country. At the first opportunity they got, they hid that money abroad. So they're not good patriots to Russia. They're not liked in Russia.

21:32And they're not liked in the Western world because they flaunt that money around. But does the fact that they're not liked, does that give us the right to just take their stuff? The fact that Roman Abramenevich all of a sudden can't run his football club. The fact that Michael Friedman all of a sudden has all of his assets seized for the crime of creating Russia's biggest private bank, even though he really has no relationship to Putin. This is a terrible precedent. And it's a terrible precedent to set. And the message it sends to every rich person in emerging markets is your money is safe here as long as your leaders don't do things that we disapprove of.

22:11But the reality is, if you're rich Chinese, the reason you put your money in Vancouver is that you don't even trust your leaders in the first place, right? That's why you're taking the money away. And so now you're being told your money is not safe here. So to me, it's a potential massive shift because the past 25 years has been very odd. We've lived in this world where, in essence, people in poor countries were subsidizing consumption in rich countries. You look at today, the world's big current account surpluses are in emerging markets. You know, it's in countries like China. And the big current account deficits are in places like France, like Britain, like the US.

22:52And those work, the way this balances out is because people in poor countries, whether the governments themselves or the rich people in those countries, were wanting to buy assets in the rich countries. But we have now just changed the equation on making these assets in rich countries attractive, which means that from now on, I think emerging markets, people will keep their money in emerging markets, which should make for much stronger currencies, domestic boom markets. But it also raises a very important question, which is that for the past 25 years, the U .S. has been running massive current account deficits year in year out.

23:28There's now trillions of dollars floating outside the U .S. that grease the wheel of global trade, that are people's working capital. And yes, that make up everybody's safety cushion. If you're a rich Indonesian and a rich guy from Nigeria or et cetera, you're going to have your safety cushion in U .S. dollars. And if now all of a sudden you think, you know what, that safety cushion isn't as safe as I thought it was, and it's dependent on too many factors that I can't control, then I need to shift that cushion to something else, which means that you conceptually could have trillions of dollars that are currently floating outside of the US coming back into the US at the worst possible time, right?

24:08Because you already have 8 % inflation in the US. And if all this money that's now floating abroad comes back, your inflation rate is going to jump even further. US dollar goes down, everything you import from emerging markets go up, etc. And so just as the Western world, as basically in essence told, we'll change the rules on you without any debate, discussion, no parliamentary measures, nothing. It's just, you know what? We don't like you. You're Russian. You're rich. Therefore, you're punished. And by the way, you're punished whether you're in England. You're punished whether you're in France.

24:41You're punished whether you're in Switzerland. I mean, Switzerland for crying out loud. This is the place that banked for the Nazis all throughout World War II and even thereafter. The Nazis that managed to make it to Argentina, to Brazil, they kept their Swiss bank accounts. And here, you know, if I was Michael Friedman, I'd be feeling a little pissed. I'd be like, wait, you're taking my money and not Mengele's? Not Adolf Heichmann's? He gets to keep his account and I don't. And so all this to say that this is a dramatic shift with many consequences. The most obvious one for me is you're going to have to have the birth of new financial centers, which might be Hong Kong, might be Singapore, might be Dubai, but money will be starting to move away from Western world.

25:22Yeah, well, that's the key question, right? If you feel your assets are less safe in dollars, you have to do something else. What do you think that something else is today? Well, so look, I think today if you're a rich Russian tycoon, a rich Russian oligarch, you probably wish you had, I don't know, 30, 40, 50 million bucks in gold bars, and that you probably had 30, 40, 50 million bucks in Bitcoins on a USB key somewhere. Because what we now know is how quickly the rules can change and how quickly things can unravel and how everything can get seized in a heartbeat. And so if you're, I think, a super rich guy, you probably think, I need to have some assets that are off the grid, for lack of a better word.