Viktor Shvets on How the Fed Has Become a Prisoner of Its Own Making

26:56Draw that line for us. Maybe we'll start there. Draw that line for us between the sort of taking out of financial risk and that migration and how that fits into the China thesis? Sure. Well, one of the things I disagreed with almost everyone over the last two or three years, remember the view was that China is running out of people, and so China will be exporting inflation. Now, my argument all along was China cannot export inflation, their major export of disinflation. And the reason for that is very simple. China, just like Japan's 70s, 80s, has a very high national saving rate. They're running at about 45%.

27:33Just like Japan in 70s, 80s could have put policies in place to consume it, but they didn't. Neither have China. And so the result is they must invest at least 42, 43 % of GDP. Think of the numbers. That's an equivalent of$9 to$10 trillion invested every year. It's double of GDP of Japan invested every single year. Now, if you're investing that sort of money, It doesn't really matter what you invest in. You create massive overcapacities. And if you go into niches, things like what Xi Jinping calls productive forces, things like electric vehicles, robotics, automation, solar industry, if you go into smaller niches, you almost automatically create three times global demand, if not more.

28:19Now, at that point, they have very limited choices. Either they change their pivot, pivot their policies dramatically, send checks to people instead of building another factory, you know, raise - Build a social safety net. Yeah, raise universal basic income. They already have universal basic income in China. Just raise it and equalize it across the country. So you either do that, but if you're not willing to do that, which they're not, then the only way you can do it is accept that you lost the capital and close the factories, and we will discover China potentially is a much smaller country than what we thought it was, or the other alternative, dump that access capacity onto other countries.

29:00But given the amounts of money involved, there is not much you can dump on Kazakhstan. So there is only UK, European Monetary Union, or EU, United States, Japan. There's very few places that can take that sort of capacity. And so what's happening, those countries are putting up barriers. Now, the reason they're putting up barriers is is that China also wants to change the world. They want to redesign everything, whether it's human rights, information, whether it's the role of state versus individual, whether it's role of state subsidies, trade rules. They want to change everything. So if China did not try to change the world, I think the extent to which the barriers would have come up would not have been as aggressive.

29:41But now China has a catch-22. Barriers will come up, which means it's harder to sell that excess capacity. You don't want to recognize the loss of the capital. And what you're trying to do is to go on a charm offensive. That's why a Chinese president is in Europe right now. From a U.S. perspective, what U.S. is trying to do is gradually grind China out of the Western system, but without dislocating refrigerator prices or without dislocating things that housewives are using. And the way you do it is starting from the top, starting from the high tag, and just keep moving and slowly grinding them out, slowly retarding their gross rates, at least relative to what you can do, but without triggering a real conflict.

30:26So to me, that's a cold war. You're walking a tritrop between degrading as much as you can your opponent without triggering something really nasty. And I think so far, to be fair, whether it's Janet Yellen, whether it's Blinken, whether it's Sullivan, I think they've done a pretty good job of actually achieving that balance. Whether that can be maintained, however, depends extent to which Chinese economy and society perform to some extent. I mean, it also depends what happens in the US, of course, but if you just look at China, it depends on that. Because remember, nominal GDP in China already fallen from 10 % to 4%.

31:04Now, in other words, as you create more disinflation, as you saw in Japan, it is really nominal GDP that tells you the extent of the pressure. Now, if economy and society are geared towards a double-digit nominal GDP, if you can't raise it, inevitably pressure starts rising. And so the question is, extent to which that pressure rises, what is China's response, both in terms of geopolitics, in terms of politics, but also in terms of economic policies and how you're going to change them? Well, this is kind of what I don't get. And this came up in the episode we did with Hugh Hendry recently as well, where he was talking about the old traditional Chinese export model for reasons that you just laid out as well just isn't going to work anymore because, you know, Europe is not going to accept a flood of cheap electric vehicles coming in from China.

31:54And so I guess I'm a little bit confused exactly what China is planning here, because the resistance from the rest of the world seems so glaringly obvious. When China first started talking about building up technological independence in things like semiconductors or strategically important technologies, I was under the impression that some of the idea there was to sell it into the domestic population so that you don't have to worry about the U.S. suddenly cutting you off from important chips. You would have your own supply, and then you could do with it what you will. But as you laid out, boosting domestic consumption doesn't actually seem to be a priority right now.

32:38They still seem to be very focused on exports. So I guess I just don't get it, because to me, the problem with that strategy seems so obvious. One of the ways I describe it is the way I look at Xi Jinping and the way I look at Chinese leadership right now, It's sort of a mixture of very stern paternalistic attitudes, you know, being soft is bad, suffering is good. That's one side of it. The other side of it is very classical economics and Marxist economics. They're effectively harping back to the day of Quincy, David Ricardo, Adam Smith, Karl Marx. And those people were not thinking of prices.

33:16They were thinking of value. Now, since late 19th century, economists abundant value. So we only look at the prices. So if you're a billionaire, you must have added value because price is telling you you have. Classical economy says, no, this guy just captured somebody else's value. He didn't create value. And so if you take that mindset, who is creating value? Who is destroying value? If you ask David Ricardo, does he think financial markets or capital markets value creative? The answer would have been no. The best thing you can argue, they're relocated, but they don't create it. Who is creating value?

33:49And so for Ricardo or Adam Smith or even Quincy before that, the argument people who produce stuff, whether it was agriculture early on, whether it's manufacturing, whether it's technology. And so the emphasis seemed to be much more on supply. The emphasis seemed to be much more on production. The emphasis is to start to strengthen, as Xi Jinping calls it, productive forces, which is a classic Marxist argument, productive versus unproductive. strengthen them, put obstacle in front of people who you don't regard as productive, and they're incredibly suspicious of capital markets and finance. Right.

34:25So curb the disorderly expansion of capital. That's right. What Karl Marx used to call fictitious capital, capital that multiplies for its own sake without doing anything good to anybody else. And so if you take that mindset, and that is not the mindset of Western economists, but if you take that mindset, this sort of stern paternalistic attitude and the emphasis of what he described productive forces, you understand why they're reluctant to actually do anything about it. Now, eventually, as I said early on, the pressures has to rise and they will have to pivot. And we saw with COVID in late October, early November 2022, that he can pivot very, very quickly.

35:04That's why there was a disorderly opening after COVID. And so there is a possibility that there will be that moment when you actually will have the change. But the longer he waits, the worse it gets. And the reason is very simple. China is not Japan. Japan had an open capital account and fluctuating currency and convertible currency. So when Japan ran into the wall, they just collapsed overnight. China has closed capital account. Currency is not convertible. Central bank is not independent, actually lost all the power pretty much. Commercial banks are not commercial and private sector is not really private.

35:37So when you're operating behind the wall garden, You can't have Minsky moments. You can't just hit the wall and collapse. But what you can do, you can basically have increasing headwinds as you keep going. So if Japan operated Chinese system in 1990, they didn't have to go down. They could have survived until 96 or 97. But the longer you go with that, the worse it gets. And so they need to recalibrate. So recalibration, which is needed, change your policy settings quite dramatically. Number two, change your geopolitical stance quite dramatically. In a sense, stop trying to rebuild the world and change the world.

36:15And change domestic politics. In other words, give a little bit of freedom for people, both businesses and consumers and households. If there is this pivot change, you still have to pay a price. Because one of the things I highlight is capital stock. IMF calculates it. And if you think of 2004, China had capital stock of, I forgot, like$4 trillion. India had one. In 2028, they will have$105 trillion. US, for example, will have 70, 75. India will only have six. So China absorbed over$100 trillion of depreciated capital in a couple of decades. When you absorb so much capital, which is entire world GDP, when you absorb so much capital so quickly, inevitably you have an indigestion period.

37:03So that indigestion period will be with you even if you make a policy pivot today. But what will happen if they do that, risk premium will improve because China is the only market in the world and the only asset in the world where risk premium over the last several years have gone up. Almost everywhere, risk premium actually falls.

37:29Thank you.

38:27We'll be right back. account are offered by Public Investing, Inc., member FINRA and SIPC. Crypto trading provided by XeroHash. Complete disclosures available at public.com slash disclosures. The Chase Inc. Business Premier card is made for business owners who make things happen. Designed for high spend and limitless cash back, Inc. Business Premier is a painful card with built-in flexibility. Get the buying power you need to make large purchases, cover unexpected expenses, and help your business grow. Earn a total of 2.5 % cash back on every purchase of$5 ,000 or more. Plus, earn unlimited 2 % cash back on every other purchase, giving you unlimited earned potential to invest cash back into your business, from innovation and technology to everyday expenses.

39:11Inc. Business Premier is the only business credit card with 2.5 % cash back on every purchase of$5 ,000 or more. And it's part of a suite of credit cards from Chase for Business, designed to meet your needs every step along the way. Learn more at chase.com forward slash business card. Chase for business. Make more of what's yours. Accounts subject to credit approval. Restrictions and limitations apply. Cards are issued by JPMorgan Chase Bank and a member FDIC. I want to push on two specific things you said. So one is you talked about Chinese dumping, and I sort of understand conceptually the idea of dumping in a commodity like steel, or they're, you know, you produce a bunch and you can't use it all at home, or maybe even like solar or something like that.

39:55But a lot of the Chinese export success seems to be in making high quality non-commodities that are just very competitive for cost reasons. And in some arguably quality reasons, one example would be people saying that the Xiaomi phone now has a better camera safe than the iPhone. So that's one thing. And then the other thing is you say you credit Yellen and Blinken for maintaining something reasonably well, this attempt to degrade China, but not necessarily provoke something stronger. What have they actually done substantively? Because I see the trips and I see the talk and the anxiety and the FT columns about dumping and all that stuff, but I don't really understand or can't quite internalize what substantively they have accomplished.

40:39Well, what you need to avoid is very dramatic moves. So in other words, the last thing you want is to stop slapping tariffs on very primitive products. But remember, China mostly actually does low-grade stuff. People focus on cameras, et cetera. But a lot of China is basic chemicals. It's toys. It's that sort of stuff. So try to avoid displacing that trade as much as possible. Try to focus on the areas that are important for you strategically. And that's what Trump started to do, but very chaotically, and what Biden administration have done very systematically. over the last four years. Now, except the China trade will get rerouted.

41:21Now, the fact that suddenly Mexico and Vietnam became major partners of the United States have very little to do with capacity of those countries to actually produce it. It's a lot of Chinese trade gets rerouted through those places. And except that, because you're getting some of the benefit of that, including sometimes better quality, lower prices that consumers and businesses in the United States can benefit from. At the same time, what you're trying to do is reestablish as much contact as you possibly can. Because as Defense Secretary was saying back in Singapore when Chinese refused to talk to him 18 months ago, he said, with the Soviets, we never agreed on anything, but we talked.

41:59And the same is here. You need to maintain the lines of conversation so that you know how far you can go, where you cannot go, how far you can push, how far you can bring it back. So what you try to avoid is a chaos. What you try to avoid, just slapping stuff all over the place, trying to avoid pushing China too far, and at the same time, gradually, as I said, degrading it. Now, there is a possibility, and it is a small possibility right now, but there is a possibility that something horrible is going to happen either in Russia, Ukraine, or something horrible might happen across Taiwan Straits, and the whole thing will start escalating beyond what you're trying to do.

42:38And at that point, we could potentially see zeroing out even of Chinese and Hong Kong assets. You can even see US Department of Treasury arguing that they don't recognize, for example, the currency, Hong Kong dollar. So in extreme, you can have very extreme outcomes, which I think are not likely, so long as there is no, as I said, disasters occurring along the way. So we just have a few minutes left. And I want to go back to what you said earlier, where you were talking about the idea of financial risks migrating into, I guess, the real world, into the political sphere in one way or another. And you are actually the only sell side analyst I know of who has mentioned the Columbia protests specifically.

43:22We're here in New York. Columbia is not that far from us. Talk to us a little bit about how that kind of political discontent plays out in your world, in the world of investment and macro and things like that. Why is that on your radar? Well, usually when you have generational replacement and everything is fine, like economies are fine, finance is fine, technology is fine, there is no displacement politically or geopolitically, then one generation just slips into another almost unnoticed. That's what happened to baby boomers and X generation. As an X generation, we slipped out before we were even in.

44:04You're not X. Are you older or millennial? No, no, I'm 80. I'm X. Anyway, go on. But whenever you have a major technological financial disruption, what happens is that you have, or whenever circumstances change massively, for the better, for the worst, one generation cannot sleep into another generation. That's what happened to baby boomers compared to silent and GI generation. The baby boomers could not relate to their parents or to their grandparents. They had radically different views what they wanted to do. And so the younger generation, anybody born sort of after sort of early 80s onwards, have a very different view of the world.

44:47And the reason they have very different view of the world, because they did not experience a world where jobs were plentiful, where you've gone to college, you automatically had a good job. They found that your jobs degrade. They found that professional lives degrade. They found that technology gives you many tools, but it also degrades both your pricing power and marginal pricing power. They found that politics become disoriented as that occurs. They found that democratic policies cannot solve the problem, extreme polarization. So they're in the mixture of technological, financial, and political revolution.

45:23And when you have that change, that generation thinks very differently. And eventually, they become a very large cohort. And when they become a large cohort, they demand a change. Now, what baby boomers were asking for is not what this generation is asking for, but they're asking for change. In my view, the change, all the surveys that come out, the change they're asking is very much community-based, is very much community of equals, is very much government-supported. In other words, harping to their grand-grandparents who lived in 1940s and 1950s, rather than to their parents and grandparents.

46:03And so usually it starts with those types of demonstration. It doesn't really matter what the excuse is, whether it's a civil rights, whether it's a Cold War, whether it's Vietnam War, whether it's inequalities, whatever that is, something triggers it. But then as they get big and bigger part of the population, they really drive the policy. So today, late millennials in Z are already almost 50 % of the population, but they're only about 39 % of the adults. They're only 25 % of the voters in the U.S. Mathematically, by 28, 29, there will be majority of adults. And by earlier to mid 2030s, there will be absolute majority of both voting and the adults.

46:43And so the question is, what type of policies, economic policies, political, social policies, would they demand? Baby boomers wanted freedom, free enterprise, personal responsibility. You give me the rope and I can hang myself with it or I can succeed. This guy's asking for something else. And so how would all of those policies change? And I think they're going to bring us back to 1950s. That probably will be more likely outcome rather than sort of 1990s, 2000s. I like how conceptually we've sort of come full circle because we're back to, I guess, demographic changes driving potentially higher deficits over the long term fueling US exceptionalism in some ways.

47:26Yeah, let's take it. Victor Schwetz, thank you so much for coming back on All Thoughts. Thank you. I appreciate it. That was great. Yeah, that was really fun.

47:47Joe, I feel like any mention of generations always leads to debate over the cutoff points. Well, I may have said, I don't know if I've ever said it on air. So I'll just say that I have a very simple test for the dividing line between X and millennial, because some people say 79 or 81. Yeah, I've heard 1980 and above. Yeah, I've heard that too. But I think there's a very simple test to do it, which is, did you have Facebook in college? Because that gets you in that ballpark automatically. Yeah. But also that's generationally transformative. Social media is like clearly a dividing line. I did not have Facebook when I was in college.

48:23I got my first account, I don't know, like 2012. It was after I graduated by a couple of years. You apparently did. So I'm X, you're millennial. That makes a lot of sense. Thank you. I think it's a test. And apparently, I guess it's probably rolled out to people in Harvard earlier. The implication is that people at Harvard became millennial before the rest of everyone else. Well, yeah, I was at LSE and I think we were one of the first international universities to get it. I have to say, part of me kind of misses the college era of Facebook where we just spent an inordinate amount of time poking each other.

48:56I don't know if you remember that. Anyway, back to macro. There's so much to pull out of that conversation. It's always great talking to Victor. I guess one of the things that strikes me is, you know, he highlighted the, I guess, unexpectedly loose financial conditions. And to me, it does feel like that is a key part of what's happening in markets right now. And it kind of goes back to that point I was making earlier where I don't think anyone expected the cost of money to go up so much, viz benchmark rates and the Fed's rate hikes, while the supply of credit continues to expand. And that, to me, is sort of like the key to a lot of what's going on in asset prices, why we haven't seen that huge default cycle that people were predicting, why we haven't necessarily seen as many layoffs as a lot of people were predicting and things like that.

49:44Yeah, totally. We can easily point to a few different categories, like aspects of real estate in which, but no, it's totally true that it's sort of a puzzle. And I don't think anyone has a great answer for why people talk about refinancing and everyone has a third year fixed. Maybe that has something to do with it. Still, it's not entirely intuitive why that hasn't had a larger compressing effect on asset prices. There's so much to pull out of that conversation and every conversation with Victor. Like I said, we could have talked for like an hour on the problem with the dots. And maybe we should do that because it does seem like that's getting more attention to sort of being handcuffed by the dots, perhaps.

50:23You know, obviously, and we'll do more China episodes, but isn't it really possible? And I guess I have my doubts, but what do I know? Like to degrade China's cutting edge capacity in such a way that doesn't provoke actual geopolitical conflict, something more mild. Big questions there. Dots seem so innocuous to me. It's so it's it's funny that we're talking about them as like. Can I give a confession? And I always do my confessions at the end because I hope that no one's listening. No one's listening. I always turn off all thoughts. Turn off all thoughts right here. I always forget whether the dots are what the individual FOMC member thinks should be the optimal path of monetary policy going forward versus what that FOMC member thinks the policy will be going forward.

51:10and I like, I know there's a right answer in one, but I always forget which is which. Oh, I hate stuff like this because it makes me, it's one of those things like you just talk about kind of naturally without thinking about what you're actually looking at. But I think it might be what they think appropriate monetary policy should be. No, you're right. I just, as I was saying it, I also pulled up the Bloomberg Dots explainer. Anyway, there you go. Which, I mean, also you would expect it to be that, right? Yeah, right. Well, I mean, yeah. Bring back the BOE fan charts. That's what I say. Let go of the dots and let's just do a range of probabilities for interest rates.

51:45And we can have either fan charts or those hair charts, the hairy charts, the Medusa charts, which I love. Or just go back to the old days where they don't even tell you what rate that they sent and the market has to figure it out because the overnight rate. That would probably be fine, too. I don't think we need all this communication. I appreciate it. I like the speeches. They're interesting. But we don't even we went for years without that. It would be very interesting to Victor's point about sort of real time repricing to see what a system like that would would mean for financial markets right now.

52:15Maybe it would be better. Let's all slow down. I think it's possible. All right. Shall we leave it there? Let's leave it there. This has been another episode of the All Thoughts podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway. And I'm Joe Weisenthal. You can follow me at The Stalwart. Follow our producers, Carmen Rodriguez at Carmen Herman, Dashiell Bennett at Dashbot and Kale Brooks at Kale Brooks. Thank you to our producer, Moses Andam. For more Odd Lots content, go to Bloomberg.com slash Odd Lots, where we have transcripts, a blog, and a newsletter. It comes out every Friday.

52:44And you can chat with fellow listeners in our Discord chatroom 24-7. Talk about all these topics, discord.gg slash Odd Lots. And if you enjoy Odd Lots, if you like it when we try to figure out what the dot plot actually is, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad-free. All you need to do is connect your Bloomberg account with Apple Podcasts. Thanks for listening.

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