Best of Real Vision: Raoul's Business Cycle Thesis (2016)

0:03It's a brilliant, brilliant event and you'll come away with lots of new ideas and a better understanding of this incredible exponential world.

0:16You get to speak to the smartest people, people like you trying to figure this out, but also the people on stage. They're the experts.

0:28So we get all of that all in one place in Singapore. What more can you ask?

0:39see you at token 2049

0:542016 the importance of the business cycle or why I learned to reject theoretical economics This was something that I really had in my mind when I started Real Vision. I wanted to get across. And I walked RV members through my framework of building a business cycle framework for investing. And it really did change many people's lives. Most people weren't using the business cycle then. Now, obviously, a lot of it's going to be out of date now. But you can understand how I worked. Now, even I've evolved somewhat. but I think you'll find that there's something in this for you and you can learn. Whether you're a plus member, a pro member or an RVIP, you've got access to these macro tools that have now become the macro investing tool.

1:40That's all based on this framework. So I think you'll really, really enjoy it.

2:02Thank you.

2:27I've been in the global macro business for 26 years now. And over my time of analysing markets and trading markets, I've realised that the study of economics really lets people down. And we use global macro, meaning global macroeconomics, and we're supposed to be basing our strategies around that. But once you start looking at economics, you realise there's a big flaw in how economics are presented to us, what's taught at universities, and how we understand global economies. In my world of trading markets and looking for opportunities and risks, I'm not interested so much in the theoretical economics, because theoretical economics don't work.

3:02You tend to see words like, Keteris Paribus, which means all things remaining equal. And that tends to give away something meaning that this doesn't work in the real world. And that's the problem we've got to in this world, where we've had extreme uses of Keynesianism, economic policy, and monetarism. And the two lots have been blended now, where we're trying anything in which to get ourselves out of a bigger picture issue. I spent a lot of time, I guess, since really the late 90s, trying to understand other ways of looking at economics that may be more applicable and maybe more real life. And I think real life economics is what's important.

3:34I think the studies of behavioural economics are very crucial in this. And so for me, the thing that I stumbled across, that I seem to be one of the few real proponents of these days, and it's weird, is the business cycle or cycles in general. Global economies ebb and flow over time. And you can see that when you look at any chart of GDP growth anywhere in the world, it goes up and down. It's that up and down that I'm interested in, because what happens is economies trend. And if they trend, it makes them forecastable. And if they're forecastable, we know that they also can affect asset prices, and therefore asset prices become forecastable.

4:11So it's this age-old trend. I mean, it goes back to the crop cycles in Egyptian times. There's always been a business cycle. There's always been big secular cycles driven by a number of factors. So what I want to do is go through the various types of cycles. The secular cycle, which is sometimes called kondratiev waves. Then there's the business cycle and the shorter term business cycle. And many of these break down to other cycles too. It's going to sound very complicated at first. And in the end, I'm going to show you how to put the whole lot together and make forecasting economies and asset prices much easier than you ever imagined.

4:43It's not some sort of voodoo process. It's all really about probability analysis and understanding trend and cycles. So the first cycle I think we should look at is the secular cycle or the Kondratiev wave, as some of the Austrian economists used in the past. Now, again, let's just not confuse Austrian economics with what I do in the business cycle. Mine's much more practical related. Again, theirs is a bit more theoretical, but it's based in that element of understanding there is a boom-bust cycle and you can't avoid it. If you avoid it for certain periods of time, you end up with a bigger boom or a bigger bust.

5:14So anyway, so the longer-term cycle, how do we look at that? How do we understand really what the long-term picture is? This is where I start with everything. This is where I form my global macro framework. And the one I look at first is demographics. What's happening to the demographics of that country or that region? So for example, we know in many of the Western countries the demographics have aging populations. Aging populations tend to mean the consumer spending over time declines. At first an aging population means people invest in stock markets for the retirement. But in the end, they divest money from their savings to spend into retirement.

5:50So that drives a lot of economic behaviour. And it's very important to understand demographics. We have demographics, as I mentioned, in the West, where things are looking increasingly less robust. Therefore, we're seeing slower economic growth over time. It's more deflationary. For example, my father retired several years ago, he's 78 now. But when he retired, His spending patterns collapsed. He didn't buy a car every two years. He bought one every five or six years. And that's a very deflationary situation. And that's one of the reasons why we've got a secular decline in inflation rates and edging into deflation.

6:24Also, there tends to be excess savings in that cycle because these people need money to retire. That also drives down interest rates over time. And also, stock markets, as I said, were driven up by these, tend to get driven down over time by this process. I'm also very interested in places where the demographics aren't the same as the West. Because you like to have a world where you've got longs and shorts. I may be somewhat more bearish on the Western world in terms of asset price performance, but I'm very bullish on other places. And I've talked a lot on Real Vision Television before about monsoon.

6:58And monsoon is a region which is basically around the Indian Ocean. And it's the countries with the best demographics in the world and the highest saving rates in the world and the lowest debt per capita in the world and the lowest government debt in the world. Those are kind of like the US economy was in the 50s and 60s when the US had the baby boomers just starting and people went out into the workforce and bought their first car, their first house, their first suit. That huge incremental spend is A, inflationary, but B, tends to drive massive economic growth. I'm going to appear a lot less on camera in this particular presentation because there's some charts I need you to look at and spend some time dwelling.

7:35So I'll kind of talk behind the charts if that's all right. The first chart I want to look at is the chart of the long-term equity market cycle. That's another chart we add on to the demographic cycle to get an understanding of where the global economy is going or the particular market we're assessing. How I look at this is use the 10-year moving average of the year-on-year rate of change of equities. I know that sounds a bit complicated but basically it gives you the equity cycle. You can see from the chart equities are very cyclical when we look at it in those terms. We know that once they've peaked we're going to get declining returns of equities going forwards for the best part of a decade or longer.

8:13We saw the very sharp fall that we had from the 2000 high going down into the low back in 2009. However it's bounced back up again and I'm not entirely convinced that this market cycle is over because the time is very short versus previous cycles. So that tells me that this is probably a shadow bounce in terms of returns, and likely going forward is a process of more low returns coming out of stock markets. And I think that will mean negative returns to come. And I think the final bottom of the cycle will play out maybe in the next five years, which will be basically in line with the other cycles.

8:51And that's some of the important things to know. What we're looking at again is probability. The probability is that we think it will hook back down again, much like it did in the mid-30s, you can see on the chart. So if that's the case, then it's going to come back down to the low levels that we saw before. Any cross below about 5 % on this chart means we get some really nasty surprises and a terrible economy. Knowing the global imbalances that we've got, the chances are still high that that's the case because those imbalances haven't been cleared. all of the other market troughs. We saw very low market valuations and low debt levels.

9:26We haven't got to that clearing point yet. So I think that's to come. And again, this probability allows us to understand when this is likely to happen, because we understand that there's a certain length to the cycle. So if we think the cycle now is rather short, we know that there is a period of time for which we should be expecting the bottom. It gives us a probability that the bottom is still yet to come, and that's how we need to think about things. So now we can understand demographics and how they drive things. We can also understand the equity market cycle. So the next thing we need to, and that's probably driven by demographics partly, to be fair, the next part we need to look at is the commodity cycle.

10:05Commodity cycle is one of the oldest cycles of all. So the chart you're looking at now is the overall commodities GMI composite super cycle. It's a long name, but basically it's a mix of a whole load of commodities. and then we look at the 10-year on 10-year moving average. And again, you can see it's very cyclical. Now, what it tells us is the cycle has not bottomed yet, that this is the global commodity super cycle bust that I've talked about on Real Vision and many of the other guests have. We know that that bust takes a certain period of time to get to and we know that commodity returns stay around zero on a 10-year on 10-year basis for an extended period of time.

10:42Those bottoms last maybe a decade. So we've got a long period ahead of both falling returns from commodities and then a whole period of stagnant or low returns from commodities. Many of you remember the final part of that in the late 90s before gold and oil and all those other commodities took off. That was the final part of the commodity super cycle bust. That all lies ahead. So I really can't be bullish about commodities in a meaningful long term way for a long period of time. That doesn't mean that precious metals cannot outperform, because I know many of you are interested in precious metals.

11:17It does mean, however, that generally the commodity complex, and I'm meaning mainly the industrials and potentially also the agriculturals, don't tend to do well. The next part of the long-term cycle framework that I use is the debt super cycle. I think many of you are familiar with that. It's the big boom and bust and build up in debts that happens over generations. And it's that big unwind, the secular unwind, the debt deflation, that is an interesting part to us, or the big boom. So again, we can talk about countries like India or countries in the Middle East or countries around the Indian Ocean that have very low debts and a good demographic.

11:54We would therefore imagine that over time, that young population will borrow money with which to buy houses and cars, and the debt super cycle begins. And that will run for several decades until a point where the debt becomes unsustainable. Countries will ebb and flow within that. And some will have a debt super cycle that runs too quickly. Egypt, for example, had it recently. They had too much housing build. We've seen that in the Middle East somewhat in various places. But other countries don't have too much debt issues. But over time, they will. But again, when we flip back to the West, we can see or we understand that there's huge debt problems.

12:28The US alone, if we look at total debt to GDP, to world GDP, is the most indebted country as a percentage of world GDP of any country in history. Also, the world is currently about 350 % debt to GDP, which is the highest ever recorded in the world. So we have a massive debt super cycle underway. We know the rate of change of debt buildup is now falling. That rate of change is the peaking out of the cycle. And then we've got the overall bust to come. The overall bust has to be when debts get written off, inflated against or devalued against. But that debt has to go. And it can take a long period of time.

13:05The chart I've decided to use to illustrate this point is the US total debt as a percentage of GDP, which I referred to earlier, but the 10-year on 10-year percentage movement. Now, what you can see, again, is it's cyclical. We had a huge buildup in debt in the early 80s. And that debt has, over time, been slowing. And we can see the big rate of change, which I was talking about, the importance of the rate of change happening now. We've got an enormous falling off in the rate of change of debt buildup. And that generally indicates to you that the debt super cycle bust is underway. And that process will take decades, if not longer, to sort themselves out.

13:43We don't know how it's going to finish, whether it happens in a big shock. And I've talked about the reset before. I've also talked about a debt jubilee, which is debt forgiveness. These are maybe the ways we do it. We don't know. Maybe there's a hyperinflation or inflation out of debt. But over time, debt burdens are unsustainable. And I know many people, particularly in the Keynesian camp, will say, you know what, we can run debt burdens forever. We'll just finance them by printing of money. Well, in the end, that doesn't work because something... Have you ever wanted to trade Bitcoin but haven't dared try?

14:14With Plus500 Futures, you can trade crypto without the hassle of opening a wallet. With just a few clicks, you can register and start practicing with their free and unlimited demo. See a trading opportunity? You'll be able to trade it in just two clicks. Feel ready? You can move to real money with as little as$100 once your account is approved. And the great thing is that in addition to crypto, Plus500 gives you access to a wide range of instruments. S &P 500, NASDAQ, gas, and much more. Explore equity indices, energy, metals, Forex, and beyond. With a simple and intuitive platform, you could trade anytime, anywhere.

14:48Experience the fast, accessible futures trading you've been waiting for with Plus500. With over 20 years of experience, Plus500 is your gateway to the markets. Visit us.plus500.com to learn more. Trading in futures involves the risk of loss and is not suitable for everyone. Not all applicants will qualify. Plus500, it's trading with a plus. Let's that debt unwind because what happens is the massive amounts of debt causes a fall in the velocity of money. And therefore, any increase in debt or quantitative easing or any form like that has limited impacts. So eventually, the debt burden just becomes too big, or deflation comes, and your debt burden in real terms keeps going up.

15:30And that's why everyone fears deflation is the rising debt burden when you've got such enormous debt burdens already. So when we put all of these together, we can see that the equity cycle, the commodity cycle, the demographic cycle, the debt cycle are all going lower. So if that's the case, then we can't imagine a world where there should be protracted growth. It should be low growth with a bias towards periodic busts. And this is why I have a bearish bias right now. People think, you know, I'm the great bear. I'm not. I'm bullish on other places that don't have this setup. This setup just generally tends to create problems.

16:07And it means that the risk reward gets skewed towards more risk and less reward. And I know that looks a bit funny after we look at the equity markets over the last five years or so. But when you look back, equity markets have produced virtually no returns over the past decade, if not longer now. And I think that's the thing. I'm looking at longer term cycles here. I'm not talking about the shorter term cycle. The shorter term cycle is really the crux of what we need to use for investment. One is the framework, our secular framework. Next is how we implement that framework and where we are within it.

16:40And that's why I use the business cycle. So the chart you can next see is an idealized business cycle. It kind of goes up and down. That's the boom-bust cycle we're so familiar with. And it would be perfectly measurable if it was like this, because then we know exactly when the trough comes, exactly when the boom arrives. However, it's not like that. It's variable, but it is still predictable because there's a range of outcomes that we know. We know there's a certain length to each business cycle on average. We know what the longest one is, the shortest one is. So once we know that, we also know that, as I mentioned before, business cycles can trend.

17:15And you can see that once it's peaked out, it goes to a trough. That's boom to bust, recession. We know there's a certain period of time. We know there's a certain depth to that cycle. So that helps us forecast things. But let's have a look at the real world a bit. This chart is the business cycle versus recession indicators. The recession is grayed out on the chart. Now, as you can see, it doesn't quite look like that idealised cycle, but you can see it is a boom-bust cycle. It is cyclical. It goes up and down. There is no disputing that. This is the simple failure of most economists to understand.

17:50This is why almost all economists never forecast recessions, because they look at linear models. They take a snapshot of the world today and assume that's where it's going to be tomorrow. It's utterly clear that once you've had a peak in the business cycle, you know that the next major thing in the business cycle is going to be a trough, which would be a recession. Therefore, you can forecast a recession and when it's about to come and how long it will take and what it's going to look like. So what is this voodoo magic? Where does this cycle come from I've just produced? Well, it's really simple.

18:18And you've heard me refer this many, many times before, both in my written research and also in Real Vision. It's the ISM. The ISM is our best guide to the global business cycle. It's a bit weird because it's the global cycle and it's the ISM, but I'll come onto all of that later. The ISM is the Institute of Supply managers survey in America. And they survey purchasing managers and ask them about business conditions, inventories, sales, and that kind of thing. And they create a composite index. And that composite index has been going since 1948. And prior to that, there was something called the Treasury Survey that started, I think, in about 1896.

18:51I have all of that data and use it all the time. This is where I think my competitive edge, if I have one at all, is in understanding this. I'm a bit of a nerd when it comes to the business cycle. And what I love is very few other people understand it. Yet it's so intuitively understandable, once I explain it to you, that within 10 minutes you'll be able to make your own forecast about economies and about asset prices as well. I've been around various universities talking about why what they teach at university in economics is rubbish. And I base it on this to say, I can get you as a student to forecast the economy better than most Wall Street economists over the next three to five years.

19:26And I think that's the genius of what the business cycle does for us. So this chart is the chart of the ISM, as I mentioned before. Basically, what you need to know is when it crosses 46, there's 100 % chance of recession. When it crosses 50, there's about a 65 % chance of recession. When it crosses about 47, the odds rise over 80%. How do we get those odds? Well, we basically look back of all other past examples and calculate the odds. How many times did it do this at this certain time or this certain level? So that's how we get odds from this. So I know recently that the ISM has been bouncing.

20:04I think it's likely to be a short-term bounce because of the secular cycle that we know and that we have not had a recession yet. We may be starting one that I've been calling for for some time now, suggesting that 2016 is a recession year. It's a bit early to tell, but I still think it will play out that way. But the point being is the likelihood is that the ISM still has further to go to the downside. There are times when it didn't. And we can see the failures in the mid-90s where it chopped up and down, but we didn't get a recession. That was the Greenspan years with excessive use of monetary policy that got us to a lot of the problems we are today.

20:39It's a concept that I've talked about before, which is suppressed volatility leads to hyper volatility. Greenspan thought he could manage the business cycle and eradicate it entirely. And again, economists and media grouped together and said the business cycle is now dead. That was just rubbish. They suppressed it. And what happened after that was two recessions. We had a bust of the tech bust. Then we had another boom and then an even bigger bust. And I think that process still has not played out because the debt bubble has not played out. So the hangover from both the Reagan years and then into the Greenspan years with the big debt buildups, those haven't gone yet.

21:14And they're still yet to be worked out. So anyway, my bias is for the ISM to continue to fall over time. Again, I can be wrong. It's based on probabilities. But I still think the probability lies in my favor. So why do we care so much about the ISM? Well, this chart shows you why you need to care. It's the ISM versus US GDP. They're basically the same thing. So the business cycle is the economy, which is the point that so few people understand, but make it very simple. So therefore, we know where the economy is going if we know where the ISM is going. So when the ISM hits something like 46, we know the US economy is going to be in recession.