Cracking the Code to This Economic Cycle with Gerard Minack

29:16One of the successes of Abenomics was to lift female participation. And so you have actually seen now a rising labor supply in Japan as what had been dreadfully low female participation comes back to normal. And then had no immigration either. They were essentially a closed labour economy. That's right. That's right. So even that's changing at the margin, not to be decisive, the really big change is that female labour participation. But they are even starting to consider in some of the low-skill, typically coping with the ageing problem, whether to bring more people in. classic story of get someone to do the the dirty work now it wants to do okay so we've set us up super fascinating um let's talk through where we are in the cycle now because this is confusing the hell out of a lot of people and i'll be honest ral right now i'm saying you are right to be confused um and you've called me just as my views are also starting to shift a little.

30:15If we had talked even a month ago, I would have said with fairly high conviction, the US is heading to a recession. I wasn't surprised that it's taken so long. I was not in the first half recession camp. I thought it would be a late 23 story. But now I'm starting to wonder if they could pull off what I considered to be highly unlikely, which is a soft landing. and the single most important data point that has changed my view is that wage growth is now decelerating without a rise in unemployment. So once again, to think in terms of how an economist would see it, the well-known Phillips curve, the relationship between unemployment and wages, which had sort of jumped out in the pandemic, is now coming back in.

31:10if you look at the employment cost index which i think is the best measure of wages and just look at the quarterly numbers on an annual basis in the middle of last year they were going up five and a half percent now the fed had told us that it could tolerate up to three and a half so you were two percent above what the fed could tolerate and if you thought to get wage growth back down to that three and a half you needed an increase in unemployment, then I was arguing you virtually need to make a recession your base case. You probably know the factoid, there's never been an increase in US unemployment, more than half a percent, without a recession.

31:52So it's just really difficult. I mean, history shows it's really difficult to manage forward-looking monetary policy by watching backward-looking labour market indicators. It's a classic story of driving the car by looking in the rearview mirror it virtually always ends up off the road in a ditch well guess what's happened since we've had sequentially slower wage growth and the June quarter 23 data point which we just got showed that on an annualized basis wage growth is now running under four percent so we're at five and a half we're aiming to get to three and a half we've made three quarters of that journey without any rise in unemployment and that really comes back to something you just had mentioned the the odd supply side shocks that really were almost unique to this pandemic and it wasn't just in the good sector and this is the lesson I think we need to appreciate the disruptions in the good sector were obvious from running out of semiconductors to running out of dunny paper.

33:02But the labour market disruptions were arguably as important. And it's fairly easy to point out why we had such labour market disruptions. When we got locked up and they sent us checks, we went online and bought stuff. Now, what did that mean in a labour market sense? We didn't need people to service meals at restaurants. we didn't need people to clean hotel rooms we didn't mean need people to fly us around what we needed was people to make the toilet paper and deliver it to us so all of a sudden there was this huge switch in the demand for labor then we have reopening and all of a sudden we don't need so many delivery men we need people to go back to being baggage handlers at airports checking clerks at hotels.

33:49So look, almost overnight, you saw this massive toing and froing in labor demand, not just quantity, but the areas where we needed the workers to be. And that created a dislocation, particularly in the US labor market. And what we saw was an unusually high number of vacancies for the given unemployment rate. So that tells you there's something wrong with the labour market that you simultaneously had unemployed with a high vacancy rate. Now, I always used to say, how long will this take to heal itself? I'd love to have data on how the last 10 pandemics have affected labour market behaviour. I didn't have the data, and my presumption was always that this would take so long that it wouldn't be a factor in how the Fed operates money policy.

34:45I think I'm wrong. What we're now seeing is we're seeing vacancy rates fall with unemployment low. So we're starting to get a better labour supply demand balance. In other words, the workers are going to where they need it. And that's being associated with this decline in wage growth with the unemployment rate fairly steady. so the healing is happening fast enough that it gives the fed a much better chance of pulling off a soft landing now i don't want to say immediately that let's all just assume a soft landing there are still reasons to think that a hard landing is a serious risk and i'll be honest i'll give you my odds of a recession i think it's a coin toss and if you say jared that sounds like you don't know then that's not a bad surmise.

35:37I mean, here we are. I can see it heading both ways because I can still see the reasons that I was expecting a recession, which is that much of the policy restraint hasn't yet made its way through to the real economy, remain intact. But I now think the Fed's got more flexibility to respond than I thought it would have had if we had been talking even a month ago. Because I think the Fed can quite rightly say now that it can pause and pause indefinitely. And even if growth starts to slow below trend, it opens up the prospect of it easing next year. I think for sure growth will slow, but there is a much better chance now of us avoiding a hard landing than, as I said, I thought even a month ago.

36:27So a couple of things on that. Firstly, all of the forward-looking indicators we all use, right, all signified a recession. Pretty much every single thing we've had in our box of tricks for the last 30 years said recession. And it's been weird that GDP's not got there. We've seen this sort of thing a couple of times before where it's maybe it's got delayed by some reason. So that was one thing to me that was like, okay, this is weird. Why? I don't really understand the why bit yet. On the other side, after the greatest rates rise in history, rate of change, it's like, that doesn't make sense. And the other thing is, I guess what you're suggesting is, maybe the wage stuff is just a bit delayed, you know, because there is a lag to this stuff, and maybe we're just getting itchy in the middle of it, saying, well, why hasn't it happened and it's still yet to come up?

37:15Our work suggests that GMI, if it's going to happen, it's going to happen in the fourth quarter in terms of unemployment going up. Yeah, okay. Well, let's take your first point. this is where a lot of the long-standing leading indicators gave frankly a bum signal and I think I know why and it goes back to this amazing toing and froing between goods and services I mean the good sectors let's be frank had a terrific pandemic demand just went through the roof because we got locked up and we could only buy goods. And that included the resi sector, residential construction, having a terrific pandemic also.

38:01Since really 18 months, two years ago, consumers have been redirecting their spending away from goods and towards services. Now, that means if you look at real consumer spending on goods, it's at zero growth for almost two years now. Now, historically, most of the leading indicators we look at have got a heavy skew to the good sectors. It's your PMIs, it's your new orders, it's your housing starts. Because normally, in most cycles, good sectors are the canaries down the coal mine. Their weakness signals a broader macro downturn. Well, that simply wasn't the case this cycle. The weakness in the goods sectors this cycle was payback for the extraordinary strength they'd enjoyed through the pandemic.

38:49Meanwhile, the service sector was seeing a revival and was growing in an above-trend pace. Now, just think two of the consequences of that. The first is almost every goods-based leading indicator, as you said, flagged recession. The one I pick on for no real reason is the conference board leading indicator. It hasn't given a bad signal in six decades. They do statistically retrofit it, so it's a bit like it's good at forecasting the past. But anyway, that's my forte as well. No bad signals in six decades. It was signaling a recession the first half of the year. Wrong. And why? Well, the leading index is actually designed to pick up swings in the industrial production cycle, not as a broad economic indicator, but that's how it's become used.

39:39And it's got a heavy skew to the goods sector. So that's the first consequence of this flatlining in goods while services were very strong. But the second consequence is probably even more important. If you spend a dollar less on goods and a dollar more on services, that's GDP neutral. But it's absolutely not labour market neutral because service sectors are much more labour intensive. So what we saw through the last 18 months is GDP growth has slowed in most economies, but the labour markets stayed tight as a drum. And you can see that everywhere in the developed world, but the best example at the moment, I think, is Europe.

40:27I mean, if you believe the data, Europe has seen two consecutive GDP declines, very small ones. But nonetheless, back-to-back negative numbers. Anybody who's going to Europe at the moment would know Europe is so far from recession. It's a joke. I mean, the place is absolutely pumping, and the labour market's strong, and unemployment's at multi-decade lows. Why? Well, they're not buying as many BMWs as they used to, but everybody I know is going to get a leave for a holiday. So you've had this real disconnect between labour market strength and what has been a deceleration in most GDP indicators.

41:09I mean, I've seen this. We've seen it here in the Cayman Islands as well, right? It's like the busiest tourist season in history when consumer discretionary spending got slaughtered. And I think this is part of this pandemic thing is, like, we all work from home more now, right? We don't go to the office. We don't socialize. We don't travel as much. We don't do the business trips that you and I used to see each other somewhere in the world. We don't do as much of that. But what we do do is spend discretionary spend on those times that we do get together. like holidays or restaurant meals. Now, the question is whether that sustains a structural change in how we operate now or it's just still another pandemic wash-through.

41:52Well, I'd argue it's a pandemic wash-through, and this goes back to why, even though I sort of gave the bullish spin before that we're seeing wage growth go back to an acceptable level without an increase in unemployment, I mean, policy is restrictive, and there's been a number of factors that have delayed the impact of policy on the real economy. And let me run you through some of the delay factors. The first is exactly this point. Labor markets have been unusually strong in the face of weak GDP because of the mixed shift in consumer spending. But that's a delay factor. I mean, labor markets are actually slowing.

42:33Employment growth is decelerating. and once consumer spending gets back to the usual pre-pandemic trends, this should be a wash through the system. I don't think we're in a world of structurally higher service sector spending relative to goods. This is just a payback for the fact that service sector spending collapsed in the pandemic while good sector spending went a mile above trend. So it's a transient wedge between the two. the second delay factor is even more obvious and discussed it's the fact that when we did get locked up most governments sent us checks that we weren't able to spend all of so we came into this with almost in every developed economy a pile of excess saving now on my numbers that pile of excess saving has been run down by over one and a half trillion dollars since the start of 2022 So in other words, consumer spending has been$1.5 trillion stronger than it would otherwise have been, courtesy of this piggy bank.

43:38The third factor that I think has delayed the impact of restrictive policy on the real economy was the unusual behaviour of long-end rates in this cycle. Now, this is crucial, particularly to the US, because the US is a long-rate economy. Who borrows at the Fed fund rate? Commercial banks in the overnight market. most private sector borrowers are further out the curve. So long rates is what matters to most people. Now, if you look at most cycles, the 10-year yield goes up right through a Fed tightening cycle until very late in the Fed tightening cycle. And the ultimate peak in the 10-year yield is normally at or above the ultimate peak in the Fed fund target.

44:21Well, not this cycle. the 10-year yield peaked seven months ago, it peaked around the point that the Fed lifted the ceiling on the Fed fund rate to 4%. We're now at 5.5. There's been 150 basis points of Fed tightening with no significant flow through, not just to Treasury yields, but even to private sector yields. The 30-year benchmark mortgage rate is now roughly where it was when the Fed hyped to 4%. Now, I'm not saying that monetary policy is easy. I think it's restrictive. But what I am saying is the last 150 basis points of Fed tightening did not make the stance of policy significantly more restrictive.

45:04So that's a delay factor. the irony here is as the market starts to think about the possibility of a soft landing it's going to have to readjust where it thinks the neutral rate of interest is and that means you're going to see upward pressure on long end rates moreover if there's a soft landing we're seeing falling inflation expectations so what we're now I'm going to see potentially is a new leg of policy restrictiveness as long-end rates drift up, inflation expectations drift down, so real rates are going to continue to rise, and that will, as it normally does, have an impact on the real economy.

45:47The fourth and final sort of delay factor is that we've seen the return of fiscal policy stimulus. Now, on a crude estimate, and this is the headline number I need to qualify. If you just look at the four-quarter change in the federal budget balance and when it widens, when it becomes a larger deficit, that stimulus. Well, here's a factoid for you. Right now, we've seen the greatest easing in fiscal policy in 2023 since the end of World War II, aside from the pandemic and the GFC. I mean, it's amazing how the budget balance has blown out this year. Now, that's the headline number. It's a crude estimate.

46:33Some of the reasons for that deterioration, I wouldn't hand on hard really count as genuine fiscal stimulus. To give you one example, we all know asset markets were terrific in 2021 and 2022. 2020 and 2021. So in 2022, there was an enormous amount of capital gains tax paid. We all know that markets absolutely sucked in 2022, but there's no capital gains tax being paid. So part of the reason for the blowout in the deficit is the collapse in capital gains tax payments, something I wouldn't really count as a stimulus. But you can't deny the on-the-ground impact of things such as the Inflation Reduction Act.

47:23And you can see it in the CapEx numbers. So there has been this very unusual, very late cycle, second wave of fiscal stimulus that has also, in a sense, delayed the impact of monetary policy. But many of these things are transient. And what I particularly highlight is real rates, I think, will be heading up. The labour market will start to slow as the surge in service sector spending fades. And most importantly, that piggy bank of stimmy checks is being run down. I don't think it's going to provide much support to growth as we end into next year. So I still think there's a real chance of a recession.

48:05It's a lower chance than I was arguing a month or two ago, but I certainly don't think we can be complacent. And when I look at markets, you know what, I mean, you talk to a lot of people also, Raoul. My sense is not that people at the start of the year were believing in a hard landing and now will believe in a soft landing. My sense is at the start of the year, people thought they knew what was going on. Now they think they've got NFI and they've really lost their sure-footedness. and it's a bit of a corny thing, but I really do think this is a two-way market. If the data actually confirmed that we are heading to a soft landing, then I don't think that's in the price.

48:52I think we get more equity strength. I actually think the curve needs to swivel. There'll be further upward pressure on long-end rates. On the other hand, if there's a hard landing, that's a mile away from being priced and we'd see a major adjustment if we do get macro data that disappoint. But the timing there is crucial. And one thing I continually emphasize to people, you have to remember equity investors are happy people. They are glass half full people. They aren't very far-sighted when it comes to bad news. And my factoid here is, if you ignore the two oil shock downturns, which I justify by saying, well, the reason equity sold off was just the lift in energy prices.

49:41The S &P 500, on average, is within 2 % of its cycle peak two months before the start of an NBER-defined recession. In other words, the recession has to be that close to appearing for the equity market to price it in. So if you think, for example, the recession starts March quarter 2024, it would be completely in line with history for the equity market to rally right through most of this year. so why was so what i look at the forward looking indicators let's say the age old the trusty s &p year on year versus the ism right it did exactly what it should do on the tin and it kind of forward priced it last year so how can i how can it go down again for something in price in the previous year uh i i think last year's sell-off um was connected to two things and not as directly connected to the ISM as I know the correlation worked.

50:47I have that chart in my mind. Yeah, we all lived that, lived and breathed that. Correct. I mean, firstly, we saw a big inflation and rate shock. And the telltale signs that that was what was driving the market is if you looked at the relative sector performance through 2022, what was the big underperformance? was all your highly rated stuff. What did well was a hell of a lot of your cyclicals. Now, that's not a market that's pricing in a cyclical downturn. That's a market that's derating on the back of higher interest and higher inflation. Specific to tech, what we also saw last year was a decline in long-run expected DPS growth.

51:38Now, this is crucial. I mean, a lot of people believe that the key to equity bubbles is low rates. That's complete bonkers. If low rates were the key to high valuations, then Japan would have the world's most expensive equity market. Boiler alert, it doesn't. What is absolutely essential to any equity bubble is bullish earnings expectation. So if you look at the biggest ever US equity bubble, which was in 2000, the TMT bubble, long run tech sector EPS forecasts were running at 18 % compound. I mean, you know how compounding works. If earnings are really going to grow on a long run basis at 18%, tech was going to eat the world.

52:25And that got us valuations that were absolutely nosebleed. against the backdrop, people forget this, in 2000, both the 10-year and the 30-year index length bonds in the US were over 4%. I mean, it was the highest real rates in years. And that coincided with the really expensive equity market. And then what happened? Earnings expectations fell, real yields fell, and the equity market derated. so what happened in 2022 is we saw once again referencing the the the long-run earnings expectations for the tech sector they actually fell to the lowest level ever we have data on that since 1985 so it was a combination of a inflation shock and a derating driven by lower long-run earnings expectations, I think, were the key to what happened in 2022.

53:25Now, let me tell you something about this year, but I immediately have to say, this is where I've been good at forecasting in the past. Alas, I did not say this at the start of the year. So this is, once again, Harry Hindsight is a gun performer. and this I've got to give credit to a mate who's a client, one of the smartest guys I've ever met and I caught up with him in London at the middle of the year and we were talking about this sort of amazing re-rating through the first half of the year and he just sort of looked at me and said well you know what, we had six months where growth was better than expected i.e.

54:03higher and inflation was better than expected i.e. lower. Now growth slowed but we didn't have a recession, inflation was above target but it's the price to the downside and you know what you look at history if ever you get simultaneously growth surprising to the upside inflation surprising to the downside you tend to see equities re-rating because that's a true goldilocks mix so um i think you know we got wrong footed by uh many people got wrong footed by you know assuming the recession was going to come too soon and probably not putting enough weight on the fact that inflation was declining.

54:46Yes, it was still above target, but it was declining in a pleasantly surprising way. Now, the forward-looking point is, will those things continue to generate those positive surprises? And that's where the whole hard landing, soft landing sort of issue comes in. Obviously, if it's a hard landing, then you won't sustain those surprises and you'll get a second league to the equity market sell-off and that second league will not be driven by derating due to inflation shock it'll be driven by cyclical concerns and this gets back to one of the things I said you know when we started to talk ask me about anything and I'm going to have completely contradictory answers whether you're asking me about a three-year view or a three-quarter view if there's a recession you do not want to buy uh you know cyclical stocks like energy or materials or industrials because they're all highly sick but if i'm right on my structural view my one line tag on how the world will look next cycle is blessed are the goods makers because it's going to be a cycle that plays to their strengths and that includes the companies that provide the inputs to goods makers, your energy companies, and your industrial commodity companies.

56:11So I'm quite bullish those companies on a three-year view, but I wouldn't be buying them today if you are still in the hard landing camp. And that's the conflict between the cyclical versus structural outlook for those companies. It's always amazing how we've got to be schizophrenics in this business, right? You have to be able to have two competing ideas in your head at the same time and be comfortable with the schizophrenia happening. Because the people who don't do that are the people who consistently screw up because they get married to it. It's just an assessing probabilities. And it's just always good you come on here and say, look, I don't know, but here's how I see it.

56:48And it's kind of adjusting as we go. Yes. And I mean, as I said, you've called me real, just midpoint adjustment. and so yeah I'll be as influenced by the data I'm very conscious that part of the reason I've become less bearish is I've done what I always tell people not to do I've probably put a lot of weight on one data point and you should never put too much weight on one monthly or quarterly data point so we need to get this story of immaculate disinflation confirmed by further data points but I have to recognize that the new news was a lot better than I had been expecting and that's that's how I adjusted my views so final question we won't go through in detail because I could talk to you for hours because you know everything in such amazing detail you're like a human computer for this stuff uh you sent out a note this morning on China what is your top-down page on China because obviously people need to people are looking at that thinking have they screwed this all up?

57:50What's going to happen? What's your kind of quick overview of that? Let's first of all put geopolitics to one side. I have views on geopolitics, but everybody does. I think even without talking about geopolitics, China looks kind of screwed. And the problem is, the root cause of their problem is the household sector saves too much. Now, let me explain why that's the root cause of the problem. China looked terrific for three decades and although China's rise was extraordinary the template it was following we've seen other emerging developing economies use the same template and it's a fairly simple process you suppress consumer spending so the household sector has a whole lot of savings that you then use to generate a CapEx boom and you direct that CapEx typically to export-orientated manufacturing.

58:50And then you say to all your farmers, stop working on the farm, come work in a factory. And if you look at the data in China, factory workers typically had a five times greater GDP per person output than farmers. So this process of taking people from farms and sticking them in factories generated a huge surge in productivity and obviously aggregate GDP growth. Now, China was the largest example of that, but at the end of the day, template that Korea followed, that Taiwan followed and Japan followed. Now, when you get to middle income, what you then have to do is dial it all around and say to consumers, okay, you start spending and we'll dial down the capex.

59:41well that's where the Chinese policymakers have run into problems and that is why they've been forced to keep capex at extraordinarily high levels because as you know in a closed economy and I know China is not completely closed but it's not exactly open if you've got this torrent of household saving Chinese policymakers have had this fire hose of capex that they've had to point around And really the entire story of the last 15 decades has been where do they spray this high level of capex that's necessitated by the high level of savings. And they've sprayed it, as we know, at infrastructure, building out the world's largest high speed train network at a huge amount of airports.

1:00:30We've seen it sprayed at commercial property. We've seen it sprayed at gleaming office blocks. We've seen it sprayed overseas because the Belt and Road Initiative is part of this story. I mean, it's not just that they were funding port facilities in Sri Lanka. It was Chinese people and Chinese firms and Chinese resources doing the CapEx. But most famously, they pointed the fire hose at the residential property. And that became a huge bubble. Now, what we've seen increasingly over the last 15 years is that humongous flow of CapEx leading to diminishing economic and financial returns. In terms of the economics, the GDP that each dollar of CapEx generates used to be about 50 cents.

1:01:24Is that because of the debt, you think? I think it's just diminishing returns. I mean, the first high-speed rail that you might build between Beijing and Shanghai is going to create tremendous benefits because you've got two major population centers. By the time you're doing them between second and third rate cities, just simply the payoff becomes a lot less. And so that's a fundamental economic problem. And you can also see it in terms of financial returns. If you look at the return on assets in the listed sector, that's collapsed over the last two and three decades. So it's become a real financial problem.

1:02:01And this gets to the heart of why Chinese equities have given you appalling returns over the last 25 years, even though China on one level has been a huge GDP success story. Because this poor allocation of capital has meant that ROAs have been deteriorating and EPS growth has been virtually non-existent. So it's created problems for the real economy. It's created problems for investors. Now, the issue now where we stand today is policymakers can, if they want, generate symptomatic relief. They could provide fiscal stimulus, and that, I guess, would produce a short-term bounce in markets. But ultimately, the fundamental problem they face of excess saving is if they don't resolve that, then they're going to continue to have to deploy wasteful, inefficient, counterproductive CapEx.

1:03:01And the worst thing that that CapEx is now doing by creating more and more capacity in an economy that stopped growing sufficiently fast is you're robbing producers of pricing power. And what we're now seeing is CPI below year-ago levels, and I think most importantly, GDP prices, so economy-wide prices below year-ago levels. Now, that may not have been a problem three decades ago when China was a relatively lightly levered economy. China is now a heavily levered economy, particularly relative to its per-person GDP. and the lion's share of that leverage sits in the corporate sector. Now, as you know, debt and deflation is a suboptimal macro combination.

1:03:51So if they continue to do CapEx that ROBS produces, highly levered producers of their pricing power, you're heading into a major crisis. So they've got a real problem with the structural economy and I haven't even mentioned the geopolitics. So, I think that I can't rule out short-lived rallies. We saw in Japan as it sort of sunk into the morass. There were several tradable rallies in Japanese equities that were triggered by large fiscal stimulus programs. but as I used to say this is like putting 20 ,000 volts through a corpse. Once you turn down the voltage, it's still a corpse and so you could see policy makers deliver some voltage to the Chinese economy but if the household sector continues to over save and under spend it's going to become increasingly comatose Fascinating We'll see how it plays out and what that does for world growth Gerry, look, as ever, amazing conversation just it's really interesting times right you know whether we're in the structural secular shift i'm the other side of that equation this whole economy right now is complex it's just it's fascinating so it keeps us on our toes we thought we'd seen it all right you're on the other side and you've been very polite and tolerant by not taking a few swings at me um but that's not the point i get you here to hear your view i don't get you here to to force my view no no no over a beer sometime yeah no no correct and so well i am starting to travel again so we should uh compare diary dates i'll be in the u.s in october i'll be in hong kong i think i will as well i think i'll be i'll be in the u.s in october let me know ping me an email yeah will do always great to catch you okay fantastic i was right jerry super interesting lots of complexity of thought i think for a lot of people listening to this you have to see how all of us who've been around for a long time in financial markets have to always have in our heads all the opposing arguments that's why i got gerard on because it's an opposing argument from somebody i really respect to mine and gerard's doing it himself with his own views about where we are in the cycle he's like it could be this it could be this i think if that i'm shifting my probabilities that's the magic here is anybody who's dogmatic who says they know for sure is not right what you always have to do is assess everything and ask can i be rolled where would i be rolled how would i be rolled anyway fantastic macro master class um i hope you enjoyed it what's up revolutionaries thanks for tuning in for more content like this head over to realvision.com and get unfiltered access to the very best, brightest, and biggest names in finance.