#20 - Matt Smith: Ruffer, Market History, Outlook

35:14And he's a mean reversion guy. uh and i think he's totally right that's generally an excellent principle uh on which to base your investment thinking but a study of history can help you understand why mean reversion can be suspended because because it can be right um uh we're in a period where it is currently being suspended. And as he said, that will change, but it hasn't helped him over the last decade or so. The study of institutions in particular can help you, I think, get a better understanding of why mean reversion can be interrupted or why it can be excessive. Anti-competitive forces, the power of the government, in the economy is a very important one.

36:13It can bring you to a greater understanding of the great waves of inflation and of populism, of capital versus labor. I think it's instructive to think about differences between the Gilded Age in America and the 1970s in America. In one, you had a lot of very significant technological development, and pretty, in fact, almost non-existent anti-competitive forces in very small state, very high returns to capital, a lot of wealth concentrated in very few individuals. And in the 1970s, where almost the reverse was true on every front, returns to labor were much higher than returns to capital. certainly that you know the pendulum was swinging hard that way union power was very significant returns to capital if you invested in the bond market were were terrible truly terrible and and uh not much better in the equity market populism was very much in force you know what are the things that drive that because governments and populations have the power to suspend mean reversion.

37:33And which of those sounds closer to today, we can come back to, but I think I know where we're headed. So that's the first lesson is mean reversion is the guiding principle, but it's very important. History can help you understand why that principle can be suspended. Secondly, it's very important for understanding money. And at Ruffer, we commissioned a book written by Edward Chancellor called The Price of Time. And it is a superb and very interesting history of interest rates. I know that sounds like a paradoxical concept, but it shows you that there's nothing new under the sun when it comes to finance qe and zero rates are technically an innovation and certainly that's how everyone thinks but through uh huge parts of the uh medieval era the charging of interest rates were was was banned by the church in in europe it was a full zero interest rate era and and the uh the thinking was that if you had interest rates other than zero, it would cause all of the highly indebted landowners to go bankrupt.

38:54And the highly indebted landowners who were kind of in power didn't want that. And to me, that's absolutely no different to the post-global financial crisis era, when it was kind of acknowledged that raising rates would bring down some of the highly levered edifices, not least the government. So why would you not have zero rates if you can? The people in power and the people with the economic models always like zero rates because A, it tends to benefit them and B, in economic theory, the lower the rate, the better the economy will hum along um so zero rates are not new the ability of governments to debase the currency that they spend in in order to fund more spending than they bring in through tax is as as old as the concept of money itself as soon as you understand that really it's it's kind it becomes extremely clear that governments will always default towards inflation.

40:11They will always default towards currency debasement if they can get away with it. There has to be a defining ethos in a country where the population is truly fed up with inflation and effecting regime change, as in at the top, to deal with that. That tends to be the only time that you end up with hard money policies in the full franchise era, I would say. There were obviously times, I mean, there were long periods, especially through the 19th century, where very hard money policies were run. But there wasn't a full franchise democracy in the same way as today. And that, I think, leads you to the third lesson, which is that hard money is typically denied to people by the government, if at all possible.

41:08in the 15th century, the governments of Europe, on the whole, made the only coins that they made available to the wider population were made out of copper and sometimes silver. Those are not metals that have a very restricted supply, especially if the price goes up a bit. And so really no one had a way of preserving their wealth through time except the elites who had gold. Typically, when gold or hard money becomes a difficult issue for governments, they start to do something about it. I certainly don't need to tell you that living in the United States where private possession of gold was made illegal from 1933 to certainly 1971 with the end of the gold window.

42:02But I think it persisted longer than that. which is why silver has such an important, you know, silver is a much more important metal in the United States than it is in the UK because it was seen as an alternative. So yeah, those I think would be my three lessons. You know, you must understand the institutional framework in which markets are operating to understand how quickly one should expect mean reversion. Secondly, the governments will always try and spend more money than they tax unless they're explicitly mandated to do the offset by the voting base. And thirdly, and it's related, it's extremely inconvenient for governments if there's a readily available hard currency alternative for the population.

42:54And I think that does lead you to discussions about things like gold and Bitcoin as investments. One of my observations of history is countries tend to go through this typical life cycle. They start poor and they know they're poor. And then they start to become rich, but they still feel that they're poor and they spend like they're poor. And then they realize they're rich and they are rich. And then eventually they're poor, but they still feel like they're rich. and it seems like as that happens and you hit that last phase where you feel like you're still rich and you want to stay rich but you're actually poor, that's when you start getting some of those, the printing of money, the basement of currency, trying to extend your debts.

43:38It's really fascinating how those cycles just repeat through time. I couldn't agree more. And most successful empires throughout all of human history have been based around a gold-denominated coin. And I'll get my history wrong here, but the Romans had a solid gold coin. The Byzantine Empire had a solid gold coin. The British had the sovereign, and the US had a dollar on the gold standard. That attracts capital, keeps capital allocation honest and efficient. But eventually, as you say, you get overspending or inefficiency and that solid currency begins to be chipped away. There's a quote from the philosopher John Locke from 1691.

44:33And he says, roughly, if ill husbandry has caused a nation to waste its wealth, then the cutting of interest rates simply increases the amount of money. It does not bring back that wealth. And he knew that 350 years ago. If you've done bad capital allocation, you can't just cut rates and hope that that will fix it. If anything, as you say, that makes things worse by causing people to feel richer, but delays and prevents that important recognition moment when people go, okay, that capital was badly allocated. We need to kind of write it off and start again. When you look at history, what period would you say most closely parallels what we're going through today and perhaps where we're headed?

45:41That's a very easy one for me. And that's the late 1960s, which probably tells you a lot about where I think we're headed. you had a period coming out of the Second World War. The Second World War was a time of locked down travel restrictions and destruction of supply chains. In the post-war period, you had transitory high inflation. and you know it was correct to to to say you know don't don't mess around too much with policy settings inflation's gone up but it'll come back down again as supply chains heal and it did that uh you know it went from kind of 10 to zero and back again a few times and through the 50s and 60s you had very high real economic growth high levels of fiscal stimulus and a view that you could control the business cycle with correct application of fiscal and monetary policy But slowly the system was becoming more inflationary.

46:47Spare capacity was reducing, slack was reducing, economic growth was picking up, and unemployment was falling. and uh i'm going to quote here uh liberally from a speech uh by arthur burns in 1978 i i post the experience of the 70s um and he was a chairman of the federal reserve at the time yes exactly right so you know he's got an incentive to be pretty uh to blame other factors than himself but i think the clearest thing you can learn by studying central bankers through time is that none of them, and I mean none of them, are independent. They're all products of their time. So, you know, to attribute any kind of power, really, to any of them individually, is, I think, a waste of time.

47:46They do what the popular and political atmosphere around them permits them to do. And that was exactly Burns' point. He said people over time came to see the government as the solution to all of their problems. And he specifically says, what an inversion that is of the American mentality through all of the 19th and early 20th centuries, where it was very much, you're on your own and pull yourself up. You had excessive fiscal and monetary stimulus, thanks to the Vietnam War and the Great Society program. You had crop failures in 1973 and the OPEC price shock in 1974. So we were familiar with all of that, zero rates, a lot of QE, some fiscal through the IRA, the CHIPS Act, the CARES Act.

48:41And then with Russia, Ukraine, you had rising food and energy prices. And he says two things were critical. The goal of the Federal Reserve and the federal government was to promote maximum employment, not price targeting. And I think implicitly, that's where we are today. And secondly, budget deficits, as a result, were incurred, I quote, when business conditions were poor and also when business was booming. I think the fact that in a presidential election year, when the budget deficit is at 5%, 6%, 7%, no one is talking about that. That is almost the single most important piece of evidence pointing towards an inflationary future.

49:35Neither candidate is saying, I'm the fiscal rectitude candidate. And that's exactly what was going on in the 70s, right? The solution to rising inflation was more spending. And we have that again today. When energy prices went up in 2022, the response of the uk government and the european government was to spend money to prevent prices rising uh and and if you understand anything about how the price mechanism works that's a bad idea and you know the same was true in california i think uh you guys had gasoline subsidies uh to prevent the price rising too much i'm actually not saying that that was a bad idea uh and i i think they would say, look, we've been vindicated.

50:28It helped smooth a temporary price spike. My point is that that tells you so much about where we are today psychologically. And that's really what matters, is what is the attitude of government and the voting public towards inflation. It's a very simple question you have to answer. do people hate the pain of dealing with inflation or do they hate the pain of inflation itself? You know, which do they hate more? And I think there was a period in 2022 when people said, well, yeah, this inflation thing really is a problem. Let's deal with it. But as it came down and you had a banking crisis as a result of the tightening, quite quickly, everyone went, I think we don't want the pain of dealing with inflation, thanks.

51:23And it seems to be resolving itself in the background. So let's take our foot off the brake. And I think where we are today, people hate the pain of dealing with inflation a lot more than they hate the pain of inflation. And you will get inflation structurally until that is no longer true. The Gerald Ford campaign included in October 1974 something called WIN with inflation now and these were kind of badges that were handed out it was a sort of a signature policy and it involved things like carpooling, turning down the heating in your house, I mean really sort of pathetic kind of macro-pru, I guess, ways to deal with inflation.

52:22Anything to avoid actually hiking rates. And that was at a point where inflation had averaged 6 % over the previous five years. Today, it's averaged 4 % over the previous five years. So we're not far off. But that was in 1974. They just didn't do anything about it. And over the next five years, inflation averaged 8%. That was the point at which people decided we've had enough. We're electing a president focused on deregulation and supply side reform in the form of Ronald Reagan and a central banker who is willing and mandated to hike rates until the monetary aggregates start contracting, until inflation is under control.

53:11and they imposed tight money policies through two hard recessions. I always like the quote that Volcker had coffins left outside the Federal Reserve building made out of two by four planks that were put there by bankrupt home builders. And he had car keys posted through his mailbox from car dealers who'd gone bankrupt. You know, that's what tight monetary policy really looks like. Even if you think we're in 1974 today, it took another five years of very high inflation before people were willing to elect someone who would deal with it. And I think we're miles from that today. You know, if I had to summarize where I think we are today with regards to inflation, which is possibly the most important macroeconomic variable, I would say that we have moved from a ceiling of 2 % on CPI to a floor of 2 % on CPI.

54:19And that is a true regime shift. It doesn't sound like very much, but the asset allocation implications are very significant. And I think we've seen one cycle of inflation. We're going to find out quite how far down inflation comes again. How sticky does it prove to be? How much do the Federal Reserve really care about getting it right back down to two? Are they willing to impose the true tight monetary policies that are needed to do that? And I think we will learn a lot once that tightening cycle comes into contact with the enemy. There are three enemies. The first one is interest costs. Your own Congressional Budget Office says that interest costs are nearly 20 % of government revenues today.

55:17And actually in the fiscal year to date, the US government has spent almost exactly the same amount on interest as it has on the armed forces. Basically, on the whole defense budget and basically through thousands of years of economic history, when that happens, when interest costs rise a long way up the national budget line items, the government does something about it. you know, either cuts rates or it starts to enact policies to force down the rate of interest on bonds. And we're very familiar with what those are. And then we will, you know, I think that the true kind of inflation fighting credibility of the Fed will be revealed at that point.

56:04And that actually, you know, incidentally tells you what our structural allocation in the portfolio today is, which is inflation-linked bonds and precious metals. Inflation-linked bonds currently price a 30-year inflation rate of 2%. That is completely unchanged from the pre-COVID era. And that is essentially a vote of confidence in central banks, saying that they are independent, they'll do what it takes to get inflation back down to two, They'll hold it there. And for all the reasons I described above, I think this is the late 1960s. And I really want to take the other side of that 2 % view.

56:50The interesting part about the 60s and 70s period compared to today is we can look back and see the lessons learned from that. And I'm curious what your thoughts are about the Fed today not wanting to repeat the mistakes made in the 70s and letting inflation run too hot for too long before hiking rates and short-circuiting that process by hiking rates relatively quickly after inflation spiked. Does that end that cycle or does it just delay that inevitable inflationary impact? I certainly have to acknowledge, if you would ask me at the beginning of 2022, what would happen if the Federal Reserve held, tightened to 5 % interest rates?

57:36and held them there for 15 months as of today, I would have said bad things will happen. You know, this is not an economy, more accurately, or more importantly, this is not a financial market that can cope with a risk-free rate of 5%. Yet here we are today. It clearly has done. and that is, I think that's pretty extraordinary to my mind. Now there are some mitigating factors. There's been very powerful fiscal stimulus. The rate of change in terms of interest rate hikes has slowed a lot. So rates volatility has come down and markets are forward-looking. They can see that inflation has gone near enough to target.

58:24They can start to price interest rate cuts. But still, I think It's important to acknowledge that only the government is a borrower at 5 % interest rates. So right now, through 2023, there was almost no equity issuance. There was very little debt issuance in the corporate sector, but there was a heck of an increase in government debt. This year, credit issuance has gone up for sure, reflecting quite tight spreads, and equity issuance has risen as well. But still, it's really dominated by government borrowing requirements. And as we know, cash levels in money market funds, for example, have gone up enormously, reflecting the fact that a 5 % risk-free rate is pretty damn attractive.

59:20So if no one can really make the economics work on borrowing at 5%, eventually you'll do some damage. It's taken a lot longer than I expected. The question is, if you start to see some economic weakness, and I think that is probably the right axis to be thinking about things right now. That's the place where the market could be most surprised. I'm not an economist, but the constellation of data points that are coming out do seem to be pointing towards incrementally weaker economic growth. at a time when that's kind of the one thing that people have assumed to be constant. You know, everyone's been very focused on inflation and is it coming down or not?

1:00:07And growth is just assumed to be pretty solid. That would be a surprise to a market that has taken it for granted. And we mustn't forget the importance of reflexivity in a modern hyper-financialized economy like the US. If your stock price is going up, you can pay your employees more cheaply through stock-based compensation. You can buy companies more cheaply through all stock purchases.

1:00:38And CEOs are more confident. They take the share prices and input into their CapEx decisions, into their hiring decisions. So there's a huge reflexivity to asset prices, especially in the United States.

1:01:01And that potentially makes the economy very vulnerable to a slowdown in markets. If you got that at a time where the economic fundamentals themselves were also weakening, then you could have quite a sharp sell-off. And that's not something we're worried about imminently, but it is something that, because we don't like to put too much emphasis on timing, it is something that we're positioning for in our portfolios. today. If we zoom in a little bit on financial markets history, one of the big phenomenons today is this AI boom. And there's been a lot of parallels drawn to the internet boom of, call it 25 years ago.

1:01:43How do you think about those two relating to one another? And is your sense that that AI boom is going to end in a similar way as the internet boom did? What I found so interesting about AI is it's very difficult to find anyone with a balanced opinion on it. The people who understand it, who truly understand it and a part of its creation are kind of limitlessly optimistic about what it might do. Elon Musk talks a lot about AGI. So does Sam Altman. If they're right, you don't want to be shorting that. The thing is, the internet was absolutely the right idea. It's involved in almost every second of our lives.

1:02:27But if you bought internet companies at the wrong time, you lost 80 % of your money if they survived. You know, that was for the good ones like Microsoft and Amazon, you know, to say nothing of the ones that vaporized. And, you know, it goes back to that incredible feature of financial markets that it can take a great idea and make it into a bad investment. I mean, I, as I say, I'm not a mathematician. From my very limited understanding, AI is extremely high grade regression. regression. And if that's correct, then it is going to be better than anything else on earth at understanding the past, but unable to extrapolate that in anything other than a linear or rational way.

1:03:24And you've seen a lot of waves of technology through time. people worry about the same things every time. Jobs destruction, excessive returns to capital, deflation. We probably do get those. the question is, you know, how soon? There are a series of great articles from the 1920s, a lot of hand-wringing by the kind of moral authorities of the day about how the younger generation were rotting their brains and wasting their time listening to the radio, and how that was kind of impeding their ability to think and was just a waste of time. Possibly they were saying the same thing after the invention of the printing press.

1:04:20So instinctively, I would treat it the same way as other technologies in the past in terms of their impact. The railway, a massively transformational technology, capex heavy in the same way that artificial intelligence is through data centers, power intensive, but resulted in a series of boom and busts on the stock market. So I think you have to split the economic impact, which is, I think, much easier to gauge from the investment quality, which, because markets are mass human psychology and they get very excited about things and they get very pessimistic about things can make good ideas, bad, bad investments.

1:05:11It will undeniably become an essential part of our daily lives. It doesn't need to be an essential part of your daily portfolio. Probably not today would be my view. The last point on financial markets history and relating it to today that I wanted to cover is we live in a world of elevated geopolitical risks. When you look at history, those types of concerns have typically not had a long-term impact on financial markets. How do you think about that today, studying history? I find geopolitics so difficult because the signal-to-noise ratio is awful. there are so many things that you're told to worry about that turn out to be totally irrelevant but the the impact you know the magnitude of things that it is correct to worry about is very very high the thing is governments governments are people and people are unpredictable so that makes it very difficult to have a good grasp i try and educate myself about the institutions involved, the incentives involved, and the geography involved.

1:06:32Those are typically, I find, the most important lenses. I think a surprising amount can be explained by geography. And I think what you can say is that in 1990, You had an unusual moment, Francis Fukuyama's end of history, where you had a very large and very long-lasting peace dividend as the major Western economies demilitarized. You had a very significant tailwind of cheap commodities and energy out of the Soviet Union as that collapsed and all its products became available on world markets in a way that they weren't before. And you had very low sanctions and regulation on who could trade with whom.

1:07:31It became a pretty globalized world. and that itself results in cheaper prices for everyone. If you look at the profits made by the trading houses like VTOL, Trafigura, Glencore, Gunvor, those all kind of sprung into existence in the 70s when there were a lot of sanctions and restrictions on who could trade with whom. And they make billions and billions of dollars today after a slightly fallow period. because those trading barriers are starting to go back up. But in the 90s, they collapsed. China joined the WTO, the formation of GATT. Geopolitics became a non-event. And you had these huge disinflationary tailwinds take place for a very long time.

1:08:20I think all of those factors are reversing today. So I can't give you an opinion really on Israel v. Hamas. But I can tell you that the peace dividend is unwinding. Every major Western economy is remilitarizing, and that has a cost. It's money that has to come from somewhere else, or it's inflationary. the access to cheap commodities and energy out of the Soviet Union hit a pretty hard stop in February 2022 and the free movement of capital in and out of China is starting to be pretty restricted as well the trading houses are once again making a lot of money which tells you that goods travel is not that smooth around the world.

1:09:16So I think geopolitical risks are already present. The guys at the doomsday clock are always at kind of five seconds to midnight, right? It sort of goes from four seconds to midnight. They never get relaxed about it. Markets are typically relaxed about geopolitical risks because they've been paid to be so. But it's very hard to say in the short term, but if you zoom out and look at the the atmospheric conditions, things are getting more stormy. I think the right way to play that is through trades that enjoy, investments that enjoy rising inflation and rising volatility rather than specific geopolitical plays like oil.

1:10:05But it's definitely taking place. I'd like to ask you about the U.S. stock market. It's enjoyed a tremendous run since the lows of the global financial crisis 15 years ago. It seems that these are great companies. All you have to do is just buy the S &P and forget the rest. It would be helpful if you could provide some perspective on long-term market cycles or super cycles and if you see any early signs of a potential inflection point. The money question. I'll start off with an observation about where we are today and then talk about how we might have got there. The first thing to say is that the real equity risk premium today is about 0.75%.

1:10:56So what does that mean? The excess of the earnings yield of the S &P over the 10-year tips bond is 75 basis points. So the 10-year is about 2.2 % real yield and the S &P earnings yield about 3%. Now, what that tells you, if we look back through time, historically, the equity risk premium at any given moment has been a reasonably good guide for what real annualized excess returns you should expect from investing in equities instead of investing in tips. So if that's correct, and on our website, there's an article written by our head of investment strategy, Tern Drisma, with the kind of statistical backing of this.

1:12:03If that's correct, then the excess return you should expect every year for the reward you should expect for going from the bottom of the risk spectrum, US government debt, 10-year tips, to what is the top of the capital structure, S &P 500 equity, is 0.75 % per year, which is to say very poor compensation for the extra risk. Now, for context, that's an extremely low level. It was lower in the peak, the very peak of the dot-com bubble, when you had cheap bonds and very expensive equities. And it was about the same in the late 60s, early 70s. Again, a period I think that's relevant for today. And in both cases, the outcome was actually worse than 0.75%.

1:13:02Equities actually underperformed bonds for the next 10 years. And so, you know, the ERP is not a good guide on a one-year view. It is a very good guide on a 10-year view. So from a sort of starting structural asset allocation perspective, U.S. equities are expensive relative to U.S. bonds. That's one point that's important to bear in mind. The second is to think about what the market dynamics have been. the QE era, the zero interest rate era, that was ultimately a bubble in bonds. So an underrated dynamic of the last 15 years has been that returns to size have been phenomenal and also sustainable because only big companies have bonds, you know, can access the bond market.

1:13:59And so they've had a lower cost of debt than the rest of the market. Now, if you add into that David Einhorn's observation on the shift to passive investing and the fact that that puts the most dollars into the biggest companies, then they've also had a lower cost of equity. So the last 15 years have seen big companies with a major competitive advantage. the ability to issue debt cheaper than anyone else a lower cost of equity than anyone else and they've used that to buy competitors they've used that to lever up and buy back their own stock as i said if you can pay your employees in highly valued stock there's possibly even a reflexivity to a higher share price and they have phenomenal pricing power these companies you know that's the main attraction is that as inflation goes up, they can put prices up too.

1:15:01Now, through all of history, companies with too much pricing power get taken apart by the government. The most famous example is Standard Oil, but it takes a political mood shift, takes a popular mood shift to elect the people to do it, and we simply haven't had that. I think that's the big reason why Jeremy's mean reversion simply hasn't taken place yet. And to understand why and what might happen in the future, I think you have to look at demographics. We've been through, I think, a pretty much unique period where the largest asset-owning class has also been the largest voting bloc. normally what happens is that assets are owned by the elite and the elite are not certainly in a full franchise democracy they're not the largest uh block at the ballot box but by definition um but in eras when you had high wealth uh inequality and not full franchise you typically had revolutions if the rich got too rich.

1:16:20Since the 90s, the boomer generation has had a lot of the household wealth, real estate and stocks, and they've also been the largest voting force. So you've had a very unusual period where the explicit policy of government has been to encourage returns to capital and to prevent anti-competitive forces,

1:16:50to prevent anti-monopoly forces. That has allowed these companies to stay big and keep their returns very, very high, but it has led to greater inequality. If you do own shares in these companies, you've done very well. In real terms, you've got a lot richer relative to the people who didn't own them. And there will come a time when enough people are voting, a majority of people who are voting, don't have shares in these companies or don't have a stake in the wealth of the country. That's a very dangerous time. The middle of 2020 was when the millennials overtook the boomers as the largest population block in the United States.

1:17:38the average household wealth of the 18 to 34 age range in the United States is about $250 ,000. For a 65 to 74-year-old age range, it's nearly$2 million, a very large imbalance that will have to be slowly addressed through time. That is unlikely to be a dynamic that favors the current composition of the US stock market. Either anti-competitive forces will grow as they have been in the European Union, where these companies aren't located, right? So the lobbying voices are more evenly balanced, or the owners of these assets, the older generation, who need to sell them in order to fund their healthcare, their cost of living as they retire, they'll have to sell them to someone.

1:18:34And the younger generation can't afford to buy the houses of the old. They can't afford to buy their shares. So either their wages need to go up a lot or their asset prices need to come down. And broadly, that's kind of how we've constructed portfolios at the moment. Protected against enduring inflation, which is almost certainly what happens if everyone's wages are going up. and mindful of asset price declines, which we think are probable not possible, given the extent of overvaluation in particular U.S. equity and credit markets. What you just said relates to something you brought up earlier and you alluded to, is this longstanding battle between capital and labor.

1:19:23And we know labor won in the 70s. That's when you had the rising wages and rising inflation, and capital has won more recently. And we know that the pendulum can swing to extremes. Where are we in that? You talked about it a little bit, but does it look like that's turning? And is your sense that it might go to the other extreme? I think it's turning from an extreme point. It's the most important question. and it basically tells you in your portfolio, do you want financial assets like stocks and bonds or do you want real assets like commodities and timber, farmland, that kind of thing. The head of the IMF, Olivier Blanchard, had a great quote and he said, inflation is fundamentally the outcome of the distributional battle between companies, workers, and taxpayers.

1:20:24And it stops only when everyone is forced to accept the outcome. And I think what's going on at the moment is a distributional battle. A huge percentage of the profit share over the last 30, 40 years has gone to capital, to the owners of companies, to companies themselves, the managers of companies, and both governments and workers are now saying, okay, I think enough is enough. You are starting to see the first signs of inhibition on the free movement of capital and the free movement of technology. Those are both vital components to successful globalization. And if you look at China, there are soft curbs on American capital going into China, your board of trustees will be asking you some pretty stern questions if you have a large allocation to China.

1:21:22And as we know, the US is attempting to deny Chinese access to vital modern technologies like semiconductors. So on the capital side, it's looking less positive, notwithstanding the fact that the new technologies like ai tend to be moments of high returns to capital rather than labor so we have to bear that in mind but on the labor side um you know we've had a period in the uk where people were arguing for higher wages getting those higher wages then going on strike for even higher wages and getting those wage rises too and i think most importantly through all of that, enjoying public popular support for what they were doing.

1:22:13There's a great saying from one of my favorite market strategists and commentators, a guy called Ben Hunt of Epsilon Theory. He says, shortages are the first sign of inflation in the wild. And I think that's a very simple rubric, very effective. If something is in shortage, it tells you it's underpriced. uh there was no toilet paper in covid because it was underpriced you know if it were 50 bucks a roll that would have been uh you would have been able to buy it whenever you wanted labor is increasingly in short supply people are hoarding labor uh you know there's a kind of a great retirement going on uh people are either retiring because of age or they're retiring uh because they They don't see the point in participating in a capital market skewed against them.

1:23:10And so the returns to labor or the bargaining power of labor is going up. And there have been countless successful union wage negotiations in the United States over the last 24 months. When was the last time you could say that?

1:23:27So the pendulum is swinging, I think. I recommend to you and to anyone listening an incredible interview from 1994 between Charlie Rose and Sir James Goldsmith. And neither of those are particularly kind of clean characters. But the point he makes is to ask, what is the point of the economy? Do we work for it or does it work for us? and i think since the 90s that we have worked for the economy you know capital has been the dominant force i think covid catalyzed but was not the driver of or it was a pre-existing force uh a shift towards you know well actually maybe the economy should work for us um and maybe higher wages higher standards of living lower inequality those are things that public is keen on now um and in a democracy what the public wants it gets eventually and the more that the system tries to prevent that from taking place the higher the probability of a uh a rupture of some kind um so you know personally i would see inflation as a good thing.

1:24:55I think that it's a very friendly way of having this capital to labor adjustment take place. So let's dig into that a little bit more. One of the structural issues that we have is massive debt that's growing by the day as you have these unbelievably high deficits. So how do we, as an economy, get out of that cycle without stoking inflation and trying to do that while keeping rates low because we have so much debt? How does this game end? The short answer is that it's very difficult. And you have to look at everyone's incentives. The historic way for dealing with very high debt burdens was to run quite high levels of inflation and keep interest rates quite low.

1:25:48So the economy kept functioning because interest rates were low, but real growth was typically negative because the inflation rate was so high. That does deliver the economy quite quickly. However, there is a crucial caveat, which is that you have to artificially restrict the flow of capital and the supply of credit. And that is a bit that people forget, I think. um we had interest rates run below the level of inflation i.e negative real yields for all of the 2010s and as a result we had a debt kind of super cycle because you know if the real cost of borrowing money is negative you'd be insane not to do it right and hence corporate leverage went up a long, long way.

1:26:47So to delever through inflation effectively, you have to have credit controls. I think that's a perfect example of the kind of unimaginable that was nonetheless a very recent feature in markets. um in the the 60s you had very stringent credit controls you know what i mean through through a lot of the early part of the second half of the 20th century you had credit controls it was the government that directed credit in the economy you know this part can have credit and can grow this part needs to shrink and my dad has told me many times how if you went on holiday into europe uh from the uk in the 60s and 70s you could take 50 pounds with you that was kind of it uh you know you weren't allowed to take capital out of the country and so people had all kinds of complicated mechanisms for getting money out uh but it was very difficult um the so that's one one answer to your question one that's been tried before uh The other one, which has also been tried before, is a kind of, it's what a guy called, a strategist called Russell Napier calls phase two financial repression.

1:28:10So phase one is interest rates below the rate of inflation. Phase two is where you mandate the holders of assets to buy government bonds with their assets. so you kind of artificially bring down the cost of capital for normally the government um now that sounds pretty far-fetched uh surely the government can't do that and the thing is it can and it has been doing it for a very long time you know things like the basel series of bank regulations, the solvency to requirements for insurers. Broadly, they just compel savings institutions to increase the percentage of their assets that are held as government bonds.

1:29:02And it's a form of kind of implicit yield curve control. And I don't see any reason why that couldn't go further. In the UK, we've just had the launch of something called a British ISA. this is a kind of tax protected wrapper where you can put money into it and any gains are free of capital gains tax but you have to invest them in british assets it would be a very simple piece of legislation in the u.s for them to say you know if you want to keep the tax advantages of your 401k or your roth ira you have to invest them only in u.s government bonds that's a very effective way of pushing down the interest rate on US government debt.

1:29:45It sounds ridiculous, but it has already happened just to a more invisible extent. And it's certainly happened in the past with war bonds, war loans, that kind of thing. So the third way is that we discover a series of new and incredible technologies, like maybe AI, and maybe nuclear fusion. And that just enables such remarkable economic growth that we're able to, through increased productivity, pay down the debt load. But that's very rare for that to happen in history. And typically it's accompanied by very significant population growth at the same time, which might be possible. But, you know, as Jeremy said on your podcast, resource depletion is a thing.

1:30:47You know, we're confronting that as a species for the first time. Yeah, it seems like the path of least resistance when you have too much debt is keep rates low to help you maintain your debt payments and your interest costs and inflate your way out of your debt problem. because that's in some ways the least painful way to effectively default on those debts rather than outright default. It seems like if you just look at history, that's often the way things transpire. And if the government and all of the relevant players have the tools in order to engineer that, it seems that that's ultimately the outcome that should play out, at least the highest probability of that outcome.

1:31:34That's certainly what we think. If governments engineer a fall in nominal government bond yields and markets start to price structurally high levels of inflation, then that is a perfect scenario for inflation-linked bonds, which price off nominal bond yields plus break-evens or minus break-evens. So they are a core allocation in our portfolio, the TIPS and the British equivalent. In both cases, the very long dated versions, the 30 and 50 year bonds, because that's where you get the real convexity. Let's talk about inflation a little bit more. That's obviously the big topic over the last several years.

1:32:25And if we kind of zoom out and look at history, you've essentially had either falling or low and stable inflation for 30, 40 years. And you've discussed some perspectives on why that regime may be completely changing. Would you talk about your long-term views on inflation and maybe get a little bit more specific compared to what we talked about earlier? It can be simply summarized as the period from, let's call it, 1995 to 2021 had a 2 % ceiling on CPI. And the period from 2022 onwards will have a 2 % floor on CPI. And if you break down the composition of that, for most of the 2000s and the 2010s, you had 3 % to 4 % per year services CPI.

1:33:29So that was the rise in the cost of supply-constrained goods like healthcare, education, that kind of thing. And you had minus one to minus two percent per year deflation in the cost of goods, in good CPI. And that was things where the supply capacity for those was increasing significantly, like TVs, fridges, washing machines. You know, those are things that have devalued very significantly in real terms. It doesn't always feel that way because of the technological improvement that is contained within the price. But$1 ,000 in 1995 did not buy you as capable a smartphone as you can buy today for$1 ,000, that's for sure.

1:34:26So, you know, plus three to four met minus one to minus two for a long time. and that gave you 1-2 % CPI.

1:34:41Post-COVID, the picture's been different. And it's important to state that it was changing pre-COVID. Beginning in about 2016,

1:34:54the major disinflationary forces of the 2000s and 2010s were waning. So that was things like the vastly cheaper cost of labor in Asia relative to the developed world, the cheap commodities out of the Soviet Union, as I mentioned, the demographic dividend from huge numbers of younger people entering the workforce, and a big increase in female participation in the workforce. Plus, obviously, all of the incredible technological developments since the mid-90s, really. And most of those are now waning, if not actively reversing. And that means that you've got what is still 3 % to 4 % services CPI, but good CPI is where it used to be pre-1990s, which is around 2%.

1:35:53That means that to get overall inflation below 2%, you're going to have to work really hard. That means tightening into and holding tight through a recession. A lot of demand needs to be destroyed to keep inflation below 2 % on a sustained basis. and you know as i said earlier i just don't think that there is the appetite at the institutional level i.e the fed at the political level i.e the treasury uh or at the popular level i.e the voting base people feel like inflation has kind of been vanquished and they've they've been they've been right so far you know i think unarguably the inflation has been transitory.

1:36:45The thing is, if you study inflation through human history, it's always in the shape of sine waves. It's never a straight line. It's never, bang, you go from low to high inflation. It's always higher highs and higher lows in inflation. you think it's gone away you get a kind of george bush style mission accomplished uh aircraft carrier moment um and that was kind of december for the federal reserve they said look it's gone we can start cutting and then either you do start cutting and you realize that actually you hadn't finished dealing with it okay like a weed in the garden you just kind of cut the top off um or it comes back before you can even get there, which is what the market was grappling with for the first four months of this year.

1:37:38I don't know which it will be, but I have high conviction that it's one of those two. And most importantly, the market believes the opposite. So you're given a great asymmetric investment opportunity to take that view. My experience is markets tend to be very slow to price in regime changes because it's very easy to assume that the future is going to resemble the recent past and markets will revert back to wherever they were as their normal resting place. Unlike what often happens when you get these regime changes is it takes a while for the market to recognize that. And in some ways you can see that now with, you mentioned earlier, They're markets discounting roughly 2 % inflation for 30 years and not fully recognizing the forces that allow the inflation to be a 2 % ceiling for multiple decades.

1:38:35And a lot of those have clearly changed. Exactly. And markets give the money to the people who have done best in the previous cycle, right? The people who have the most money at the moment to manage, the people who have been most successful are the ones who said, yeah, inflation is coming back down to two and staying there. And so regime changes always catch markets on the hop because the people who were most successful in the previous regime were those who most rigidly denied the possibility of a future regime shift. And that's why it's always, you know, they tend to be such high vol moments, because the market, having been pretty certain about one outcome, suddenly incrementally starts to price a very different outcome and volatility is just the result of uncertainty, basically.

1:39:28And that's, I think, the most high conviction thing you can say about inflation is that it will be more volatile than previously. And the thing is that volatility and expectation of future volatility has almost exactly the same price and asset allocation impact as actual future higher prices. Risk premia have to rise. You have to demand a cheaper price for the thing you're buying to reflect that future uncertainty. And that would basically be my one line summary of the market today. almost all risk premia are very, very low, as the market is extremely certain about future outcomes for inflation, for the economy, for geopolitics, for everything.

1:40:15To me, that doesn't seem right. I think the market should price more uncertainty right now. And very importantly, because it's obviously a critical input into risk premia, the risk-free rate, the interest rate that you're paid to not take a view is, especially in real terms, extremely, extremely high. And so, you know, we have a portfolio, because we're unbenchmarked, unconstrained, that is currently highly allocated to cash to US floating rate treasury notes, because it gives you the optionality that cash always gives you. But at the moment, it gives you a very high return as well, especially risk adjusted.

1:40:59You are literally paid to wait in a way that you haven't been in more than a decade. The other assumption I feel investors are making is, based on recent history, is the so-called Fed put, meaning you get a downturn and the Fed will cut rates and that's become its reaction function over the last 30 years. That could be very different if inflation stays elevated. uh it hamstrings them from automatically cutting and providing stimulus when there's a cost to doing that uh which didn't exist for the last 30 plus years but today could be a real issue correct and actually i i don't think it will stop them from doing something uh you know if you look at the reaction to svb pretty small bank uh immediately bailed out, as in depositors guaranteed immediately, at a point when inflation was nearly in double digits.

1:41:59I think that tells you that the Federal Reserve has a total priority for financial market stability over price stability at the moment. That will change in the future. I think there are two tricky bits in thinking through what you've said. The first is, if it's correct that the US economy is highly reflexive, i.e. economic outcomes are sensitive to asset price inputs, then even a modest decline in financial markets could start to kick off quite a self-reinforcing decline in the economy, which would then lead to further asset market declines and so on. And secondly, markets do have to be careful what they wish for when it comes to Fed stimulus.

1:42:56If they obviously overdo it, which is the playbook, as you say, and the government does the same thing, that is when risk premia could actually counterintuitively start to rise. the market might say well this policy setting you know zero rates is just inappropriate for you know sure it's a recession but we're at three three and a half percent inflation the deficit goes to ten percent that is when questions start to get asked about the ability of the government to fund itself um we saw those briefly last year we have to be careful about asserting that the the game hasn't changed and that the standard rescue the market playbook will work.

1:43:45That takes me to currencies. How do you think about currencies, including gold and crypto, in today's environment and which ones look most attractive to you? Our founder, Jonathan Ruffer, often says, if you have a strong view about a currency, then you should go lie down in a dark room for 30 minutes and when you get back up see if you still hold it um i i they're difficult to predict uh i would split them between hard currencies such as gold and and personally i would put bitcoin in that camp i i don't i don't really see any difference whatsoever between gold and bitcoin other than sort of length of track record you know i don't i don't hold either myself but to me they're both just supply constrained assets with zero intrinsic value that humanity has elected to place a value on there's nothing to differentiate between the two of them but you know or paintings they're kind of all the same thing And those are good hedges against currency debasement.

1:45:07You know, it is always very interesting to look at prices in gold terms. If you take oil, for example, in the 1950s, an ounce of gold bought you 20 barrels of oil. And today, it does the same thing. now you might think the gold price has gone up a lot in the meantime oil price has gone up a lot in the meantime that's actually just the dollar messing you about now in periods when the oil price went up a lot like the 70s an ounce of gold bought you 10 barrels of oil and then in the 80s an ounce of gold bought you 30 barrels of oil but it's a pretty narrow range and so a lot of prices can just be messed about by what fiat is doing If you look at the Dow Jones, which is the index with the longest history, the index price in gold terms was around five in 1920.

1:46:07And it is just over 100 today, total return. So 20-fold increase, about 3 % a year, roughly. um that i think that's the right way to think about what a non-debased currency should deliver putting your money you know into capital markets it's not the much higher numbers that people quote like seven eight for the long-term return on equity a big part of that is uh It's what the currency is doing. So that kind of informs the second part of my answer, which are the best fiat currencies. There aren't many good ones. I've referred to it in the past as an ugly contest, the least ugly wins. I think the country that can most cope with high interest rates is likely to be the best place to put your money if you must hold fiat.

1:47:12that's probably the United States. It's got great domestic resource availability. It's got a capital-friendly political system and legal structure. It's got a lot of immigration. It's got very high innovation. And debt levels are not ridiculous in the real economy. You know, households are pretty de-geared. The corporate sector is geared, but less so on a net basis. And the government is indebted, but not ridiculously. I think financial markets are the main risk in the United States. But somewhere like France, China, Brazil, these are places where debt levels are very, very high. And so the ability of the economy to cope with high rates is very low.

1:48:05So the probability that they run excessively low real yields to help with that is high. They're places that I would not want to have capital in the currency. The big question is what to do with the biggest short vol trade in human history, which is the Japanese yen. They're still at zero rates. It's kind of unbelievable. and their currency tells you that that is a slightly inappropriate policy setting, but also that it's not easy for them to get out of that. I think what you want in a currency is something that is asset-backed. Does it have good economy behind it? Does it have good savings behind it?

1:48:54Does it have what looks like an accelerating nominal cycle taking place? Japan ticks all of those boxes. There are kind of tailwind dynamics. like the fact that a large number of Japanese corporates have stopped repatriating their dollar profits because they see the yen keeps declining. And Japanese savers have a huge amount of their savings abroad. On top of the fact that it's probably appropriate for Japan to enter a hiking cycle for the first time ever, they have a lot of money that they could repatriate to Japan if those returns on capital start to rise. So although it's got a big government debt problem, we have a large allocation to the yen in portfolios in reflection of the fact that it looks to be a highly asymmetric currency investment.

1:49:51Matt, you've been extremely generous with your time. Do you have any final thoughts to share or any advice or general advice for investors? Thanks so much for all of your great questions. I only have one real piece of advice, which is to read widely. I think people can get wrapped up in very narrow financial market books, books on investing. If it's correct to say that markets are just human psychology writ large, I think it is, then there's almost no book that isn't of relevance, right? including all nonfiction, which helps you to understand human psychology from a different angle. I'm about to start reading a book about mushrooms.

1:50:45I know that I will be surprised at the potential investment insights in that. I wouldn't say it's, well, I hope it's not fiction. So, yeah, read widely. it widens your horizons and helps you to understand the wide links that you need to make for successful macro investing. That's great, Matt. I appreciate your time. Thank you for joining us. Thanks, Alex. And speak soon. Thanks for listening. We hope you enjoyed this episode. Please visit our website at insightfulinvestor.org to access past shows and learn more about our podcast. If you have questions, feel free to email us at info at insightful investor.org.

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