#994 - Does Inflation Matter to the Fed? | with Cem Karsan

0:09Does inflation matter to the Fed? Hi, everyone. Welcome to the Real Vision Daily Briefing. with me today is Jem Carson, founder of Chi Volatility. Hey, Jem, it's great to see you. Good to be back. So we had a stronger than expected reading on PPI, and there was a time this would have rocked markets, but bond yields are up, stocks were down. They were up initially, but then they fell. But we have monthly options expirations happening tomorrow. We have the Fed next week. So there's a lot going on. What are you watching in the short term here? Well, I mean, look, PPI, this is actually, you know, number go down on bad PPI actually is about a random number indicator.

0:49I mean, we got CPI and the market was up 60 points, right? Right. The reality is the last five out of five of the last six numbers have been not just hot, but very hot for inflation, whether it's unemployment, CPI, PPI, pick your number. I've been saying for two months, you know, the transitory 3.0, right? Like, let's let's talk about how inflation has gone again for like the third year in a row. And then let's let's all step back and actually start thinking about why. and it's that populism that you're referring to. And it's structural inflation. It's not about cyclical. It's not two dimensions.

1:27We talk about this at the time. It's structural inflation. Cyclically, we're slowing down. What does that mean? Stagflation. I've been saying it for a year and a half, two years. Stagflation. Here we go. Fed is in a box, right? That's what matters here. The Fed is in a box. But what matters in the context of a box is if you have two choices and you don't know what to do, it's what you decide to do that matters and what has the fed decided to do since december ignore the inflation say i can be volcker or i can be burns and they're being burns it's very clear they said they want to be volcker though he said that so many times the narrative is one way though but this just proves that that volcker thing was just narrative you can't say i'm going to be volcker and try and talk the market into it right which is what they're trying to do and then go go say we're going to cut three to four to five times, right?

2:20And so since December, it's been very clear in the face of five out of six numbers being incredibly hot, what's the response been? We're maybe going to do cut less, right? Like, okay. All right. So what does that mean for markets? That means, you know, green light, like here comes, you know, inflation. We're okay with inflation, here comes the liquidity. That means we're inflating everything. And that won't be pretty in the long run. That means the steepening in the yield curve, which we have talked about again for several months now, you and I. That means the short end of the curve is going to start coming down because they're going to cut, right?

3:01But that does not mean the long end of the curve is coming down. That means it's steepening. And we have not seen a cutting cycle like this with a steepener in decades, call it 40 years. That is really confusing. And what that tells me is that as we've been expecting that eventually the Fed is going to lose control on the long end of the curve. That is the big problem that eventually happens. We're not there yet. We're not months away. We're not quarters away, but we are within years of that happening. When that starts to happen, that is an accelerant to inflation. When inflation expectations creep up along the curve.

3:35We know this from history. That's the worst thing that can possibly happen for inflation itself. It's a circular reaction function. So that's what we're thinking about. Why is the liquidity, there's all this talk about issuance, right? We've been talking about this for some time and how that's going to pull down the market. Why has that not? If you go look at liquidity, we're only issuing 1.5 % of GDP when the deficit is 6 % per year. So how are we doing that? That's at the long end of the curve. We're issuing at the short end of the curve, and we're playing all kinds of games at the short end of the curve to absorb liquidity, whether it's pulling from reverse repo, changing Basel requirements, It's, you know, all the things that the Fed does to create facilities to keep the liquidity flowing in the context of a need for more issuance.

4:29It'll eventually be a problem. But in the short term, it doesn't matter. So there's all kinds of reasons why liquidity is not being removed from the system. And the Fed is willing to step in and stimulate at this point. Now, the real question is why? Why is the Fed doing that? And it's because it's an election. It's because it's election. We can dive more into that. But right now, the green light is on. And this is, in our opinion, the beginning of the end. So this is the blow off top and the liquidity coming and the squeeze. And so the beginning of the end. So what kind of time frame? Because that's super important, right?

5:12And I think you're really giving voice to so many people we've had on. and I was trying to figure out a way to articulate this. There's a sense of concern, especially when we're talking about tech stocks, for example. There's a sense of concern, but everybody, especially if they have any shorter term trader type perspective, will be like, listen, you can't argue with this momentum. Like it's very hard to argue with the momentum we're seeing, even though we feel so uneasy about it. So if we're in that phase where you are getting this, you know, risk on liquidity because of what the Fed's doing, how long does that last it's a blow off top that seems short but i don't know what's what kind of time frame should we be thinking about with that so everybody wants to know when when we go down when we go up right the answer the answer you don't have to play that game it is a it is a foolish game to play the game is to play the distribution is to play what is what are the higher likelihood events in this type of a scenario and the higher probability as we've been saying is the tails get fatter and particularly the right tail upside vol is too cheap and vol starts increasing well below well before we get a a eventual big decline it happens every time and we're talking about a big structural decline not a one day one week one month decline that's not what we're talking about when we're talking about the year over year declines the bigger ones you see it before it's coming and the market reacts before it's coming blow off tops happen for a reason they happen because at the end of the day, people are short for a reason.

6:47People start saying, I'm not going to be long this marketing where I'm going to take some off the table. I'm going to write calls over my positions because I don't think it can go any higher. I'm going to do X, Y, and Z. And when the market starts going higher, that creates more people that have to buy back their shorts or buy back in because they're not following the indexes to the extent they should. And that forces convexity to the upside. Of course, it's forced buying. and forced buying and getting those people back in and saying, I give up. Enough is enough is ultimately what leads to the end, right?

7:19That's how the machine works. You cannot get a decline when everybody expects it. It needs to be hard. And it becomes increasingly hard to take a short bet when vol goes higher as well, because the higher vol goes, the more difficult it is to hedge. And the harder it is to hedge, the more markets move and the more volatility there is. It's reflexive. So market up, vol up is the most likely scenario. And that also impends more and more vol as we increase. We've been talking about it for three months. We've seen a secular increase to it. This is just the beginning. Usually it's a year at least of this.

7:50We will continue to see more of this. That is the way to play it. Long dated calls, short stock, net long belt is play the convexity. So we have a question from Doug. Is this why gold remains stubbornly high? Yes. If you look at 68 to 82, 14-year period, markets went nowhere. We've covered this quite a bit. The best performing asset by far is gold. Why gold? It's not just because it's an inflation hedge. It's also a currency hedge, right? It is a hedge against the risk of not knowing where is safe. And why are these things connected? Why are these two things connected? Well, not just because of the debasement of currency and those thoughts, which is what most people think.

8:31It's because populist periods, periods of inflation are periods of deglobalization, they're periods of global strife, of war, for lack of a better term, economic war, hot wars, cold wars, you name it, right? Commodity wars, right? All of these things are entities saying, okay, my people, my populace matters, not corporations and profits, my populace matters. And when you start doing that, it's a competition. It's not a collaboration. It's a competition game. We are amidst a massive competition game that's just getting started. What happened in the last competition? The Vietnam War, the increase of the Cold War, OPEC crises, we can go on and on, right?

9:10That's the type of world we're in. It rhymes with what we're seeing now, and it will only continue. periods of protectionism, periods of entities flexing their muscles in any way they can. And at the end of the day, what does that mean? That means people doubt the dollar, they doubt, but they have no other choice. And currency, hard currencies are in vogue during that time. So this is why Bitcoin has also, in my opinion, done well. It's a safe harbor for people particularly outside of the developed world to kind of move assets and protect them in a deglobalized world. Now, does that mean, I know kind of general opinions here, but does that mean that's a long-term buy?

9:53If decade's a long-term, then yes. If it's a 20, 30-year buy, there's other questions to ask yourself. Yeah, we have seen that. So it's interesting you're thinking about, because I think the question was about traditional gold, But you're seeing this move in both of those because some people would say maybe call them digital gold, a version of digital gold. You see this move as being driven by this uncertainty, this concern that people have, this populism. Yeah, Bitcoin is millennial gold, right? And what I mean by that is gold has no intrinsic value, really. It's not useful. It's just because people deem it to be a currency and a hold of value.

10:40It has value. It goes up because people feel like it's a hold of value. It is a narrative story at its core, right? You have to have people's belief in something. Without that belief, Bitcoin is actually worthless, right? It has belief because people believe it is worth a hold of. And millennials are the ones, are the primary beneficiaries. They're growing into political governments. They're the primary beneficiary of a lot of the political populism. The things are the driver and the beneficiary and will continue to also inherit the wave of money. And so they are, you know, if you're looking for money flows into something, that's a pretty good place to be.

11:22Right. Ask yourself, what are millennials, what do they want and what are they going to get in the next 10, 15 years as a function of this populism? and buy that. There's lots of things. Cheaper housing, you know, it can go on and on about what they want. Yeah. And we know what they're worried about, which is debt. So, Jim, you just sort of gave an overview of the series we're doing right now, which is How to Un-Fuck Your Future, because there is a lot of discontent happening. People do feel like they're screwed. They're very worried about the levels of debt and the sort of vacuum of anyone doing anything about it.

11:58And then there are all these people coming up with opportunities or solutions or how do you best prepare yourself for these really uncertain times. I want to play a clip from a conversation that Ash had with Charles Hoskinson, the co-founder of Cardano, at the very beginning. It's part of the series. It was last week, but we're counting it as part of the series. And he's talking about this sort of feeling around inflation and some of what you were just referencing. Let's have a listen and we'll talk on the other side. Have you ever wanted to trade Bitcoin but haven't dared try? With Plus500 Futures, you can trade crypto without the hassle of opening a wallet.

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15:17You know, I always go back to The Simpsons. It's the most prescient show of all time. The real mindfuck of The Simpsons is that was a show that started, I think it was 1988. Homer Simpson is an uneducated blue-collar worker, and he owns a home with four bedrooms, two cars, his wife stays at home, and he can afford three kids. Think about that. That's the real mind of that show. And that was commonplace in 1988. We all just, nobody looked at that like, what the heck is going on? And then you look at today, can you have that kind of lifestyle on a blue collar salary? No, that's inflation. As for the real rate of inflation, they rigged the numbers.

15:55They say it's 5%, but let's cut oil out of that. Let's cut meat and poultry out of that. Let's just, let's take all the things you actually need in life. My brother lives in Gillette, Wyoming. He does a lot of real estate transactions. We would see trailers and modular homes go for$50 ,000,$75 ,000. Those same properties in Gillette are selling for$180 ,000 five years later from 50 ,000. And they tell me the inflation rate's only 5%. It's not a real number. Everybody is seeing it. They're feeling it real time and wages are not going up. So they feel it. They say, I'm done. I need something else.

16:31Where do I go? And that's what creates a revolution. And that revolution is a monetary revolution. And people are going to flee into cryptocurrency and they're not going to go for half measures. They're not going to go into cryptocurrencies. The only thing that they offer is digital gold because they can't vote with it. They can't bank with it. They can't have financial services with it. They're going to go for a full stack thing where they actually feel like they have a stay. And that's why I think the third generation is so important. And all cryptocurrencies, whether it be Tezos or Algrand or Cardano that are pursuing that, they're going to fare very well when that transition occurs.

17:04I love the reference of the Simpsons. I know some of you in crypto world will have your thoughts about what he's saying about Bitcoin, ETH versus Cardano. We'll put that aside for one second. But Jim, I think he sort of tapped into the same exact thing you're talking about, Dee and Jacob Shapiro talked about in the beginning of the week with us, and it's kind of been threading throughout. How are you thinking about this populism as we head into not just an election year in the U.S., year here in the U.S., but there are like 50 elections around the world. It's an incredibly important year, 2024, in terms of voters just heading to the booth.

17:43We have a very different perspective than others. I've seen a lot of stats come across recently. People are like, election years, it's overdone, blah, blah, blah. People are missing the point. They are missing the point. If you take elections 1928 all the way through 2020, right, all the data, 24 years of elections, the average returns are 11.5%, okay? So yeah, 3%, 3.5 % more better than average sounds pretty desirable, 83 % positive. But what people don't realize is it's very concentrated, not just randomly concentrated. 1964, 1968, 1972, 1976, 1980, what do those years have in common? Those are five of those 24 years.

18:34What do those years have in common? The last period of inflation and populism, right? If you take those five elections, the average performance, and they're back-to-back elections, the average nominal performance was 21%. Every single year was positive double digits, 11 % or higher for five years in a row. and we've talked about this 1968 to 82 the market went nowhere for 14 years in nominal terms so if you look at the five that are in that window the the sorry the four that are in that window and you remove them all the other 10 years of that 14 year cycle were negative 9 on average 10 out of the 14 years and nominal terms and real terms down 20 on average per year during that cycle Yet all the election years were positive double digits.

19:27That's not a coincidence. That's what happens on populist years. And guess what? The first populist election we had in 2020, what was the performance in 2020? 21%. These things are not a coincidence. Every single populist election is double digits, massively positive. And why is that? I didn't just look at these data and make up this thesis. I actually went to go look at the data because I was like, wow, it's a populist election. those must be much more positive than regular elections let's go look at the data sure enough when there's populism there's spending and liquidity is coming to to the head what happens markets go up number go up it's not a surprise right it makes sense and it's a hundred percent positive i know that's not a lot of data but it's double digits it's speaking loud and clear by the way if you take those six populist elections out of the 24 years how do the other 18 years live?

20:20How do all other elections outside of populist elections live? Positive 5%, well below the average performance. So it's not about elections writ large. This whole election year stuff misses the point. Not all elections are the same. It's populist elections. It doesn't matter if you're left or right. We're spending. Here we go. We want spending. We're going to stimulate. That matters. And on top of that, guess what? Populist years aren't just more spending. There are contested elections, 64, 68, 72, 76, 1980, 2020. Every single one was a contested election. And we're used to incumbents winning.

20:58Guess what? Only one of those incumbent won. And guess what? That was Nixon. And he got kicked out of office because it's a populist period and people aren't happy. People want change. And so that's what happens during populism. Contested elections, serious confrontation, deglobalization, more spending to try and get votes, competitive on both sides. And that means markets go up. But in the context of those periods, just to be clear, those are eras that are very bad for markets. It's just very positive in the context of a very negative thing. We're spending. We're getting ourselves into a bigger hole.

21:32We have bigger problems. It's okay for the market. Here comes the blow off top. But be prepared on the other side of it. I think that's very important. People are missing that picture. I think that's so interesting. That's so important because it's not just about knowing that now. it's that preparation on the other side that I frankly would worry about. So we have some questions coming in. So which one to ask first? They're all so good. Okay. So Mark is asking, you reference distribution as a strategy, considering gold and Bitcoin narratives. What's your all-weather portfolio? We're going to take another quick break to hear a word from our partners.

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24:03Well, an all-weather portfolio is diversified. So it says, I'm never going to tell you all in Bitcoin, all in gold or gold in Bitcoin. That's just irresponsible. And you're not benefiting from the benefits of diversification. The key here, and we actually do wealth advisory for bigger clients. So we have an all-weather portfolio that we follow. What does that generally look like? We, instead of just buying bonds, because we believe duration is a problem during periods like this. We do T-bills, but we do what's called yield stacking. We benefit from this idea that derivatives, which we didn't have the benefit of in the 1960s and 70s, are capital efficient.

24:45They were created for efficiency of capital first and foremost. And so you can use derivatives, take the T-bill rate, which is 5.5%, and then stack the yield on that collateral, very low leverage, very low risk, ways of getting from 5.5 % to 8%. Non-correlated, not tied to markets. Why bother? Take a bond alternative that's much more stable that doesn't have problems with duration. We think about a third of your portfolio should be in those types of products. After that, we think that you should be focused on thematic equities. What do I mean by thematic equities? What wins during these periods?

25:18These inflationary populist periods, the market does poorly, but the economy actually, we've talked about this, grows above trend. GDP growth will be quite strong because we're in a demand push economy. So the economy does okay, but the problem is profit margins get compressed. So you have to be in the things that don't get compressed on the profit margin side and benefit from where the flows are coming. What are those things? Yes, commodities. Commodities businesses do quite well. What else does well? Places where government spending it takes hold. Global defense, healthcare, infrastructure, right?

25:53Sit at the mouth of the fountain. Where's the liquidity coming from government? Where do you want to be? Buy government where the liquidity is coming from, right? If you want hot water and you're at the spa, go to the mouth of the hot water in the water. Don't go sit there trying to bet on beta. Beta is not the story. Beta will not perform, but bet on the economy. Guess what? The Warren Buffett value, you know, DCF model way of investing, it's going to work again. It's almost like people have sworn it off. We've been talking about this for years. Guess what? Berkshire is at an all-time high again.

26:23It's not a surprise. That's the stuff that will matter. It's real cash flow. Money's expensive during these periods. And you want to be in a place of strength where you're not worried about reinvestment. So thematic equities can do very well. This is a time of rebalancing and shifting, right? We know energy, for example, is about 3%, 3.5 % of the S &P 500. It was over 30 % in 1982 at the end of that cycle. So relative appreciation is very important during these periods. So we think about 40 % of your portfolio should be in thematic equities, and the other should be in alternatives. There's all kinds of alternative strategies.

26:56Ours would be one, like hedge fund strategies, that have nothing to do with the market and actually benefit from times of less liquidity because people can compete less and the power of derivatives allows for more efficiency. Lots of big hedge funds were born during this environment. People lost interest in hedge funds because they could get 10 % on average per year, close their eyes, and just make money on beta. Why create value? Why pay the fees? Why do anything? Well, that 5 % alpha, which was non-correlated, all of a sudden matters again. And that's really important. So non-correlated investment sounds hard, almost impossible.