From Inflation to AI: Diego Parrilla’s Framework for Market Survival

0:00Hi, everyone. I'm Raoul Pal, the CEO and co-founder of Real Vision. Here at Real Vision, we're committed to give you the best knowledge, tools, and network to help you succeed in your financial future. If you're enjoying this podcast, please take a moment to give it a five-star rating. It truly helps us continue to bring top-tier content. Thank you so much.

0:28Welcome back to Real Vision. I'm Ash Bennington. Today, I have the pleasure of speaking to Diego Paria, author of The Anti-Bubbles and The Energy World is Flat. But before we get started, don't forget, tickets for our upcoming in-person crypto gathering in Miami are now up for sale. Head over to realvision.com forward slash CG2025. That's realvision.com CG2025 to get yours. Diego, welcome to Real Vision. Always a pleasure to have you with us. Thank you for having me, Ash. Theo, you're always one of our fan favorites. You have such a big, comprehensive view of the world. It's always a pleasure to have you with us to map it out.

1:0750 ,000-foot view. Where do you think we are right now? Well, let's take that view for a second on that. Maybe some of the viewers might have, since I've been in Real Vision for almost 10 years now. But let me work through this from the anti-bubble perspective. And generally, the idea is that there's no magic formulas. You can't just, when there's a problem, you can't just pretend that you can print and borrow your way out. And as a result, I think the monetary and fiscal abuse that we're seeing is not really solving the problems. What it's doing is doing four things. And we can go in more detail.

1:55I think what's happening really applies to all of those dimensions. But the first thing that happens when you are literally just trying to print and borrow your way out is you are not solving the problem. You're delaying or kicking the can down the road. So you're basically spending and borrowing your way out. Then it becomes a bit of an intergenerational issue as you're pushing things out. Hey, I hope you enjoyed the episode. If you want to dive deeper and really dig into what's going on and how to understand it, then grab my everything code PDF for free. Just hit the link in the description below.

2:31You're going to love it. I'm sure it's going to really help you. The second thing that we're doing is we are transferring the problem. So things like monetary policies without limits or in some ways, you know, they're going to create currency wars, create, you know, other types of dynamics that effectively look to print and devalue and transfer. And we're seeing effectively this dynamic, which has been driving global market for a long time, leading now to trade wars with things like effectively trying to have more protectionism, try to increase barriers, try to effectively bring things inwards.

3:23Again, this currency or trade wars are not really solving the problems. They're just transferring them around. The third thing that's happening is we're transforming the problem. And you don't have to be a genius to realize that if you're printing literally trillions and trillions of dollars and euros and yen and yuan, effectively, there's a natural increase in inflation. which is 100 % driven by these monetary drivers, and that is needed to be able to finance the gain. And so I think in that transformation, we're seeing big changes. We're seeing fixed income becoming a less reliable source of protection.

4:13We're seeing inflation eroding, the value of many things. and inflation has pretty nasty second and third order effects. It's leading also to the transformation of the problem into things like inequality, social unrest or populism and obviously geopolitics and wars, which I think are here to stay. And lastly, the fourth point is, you know, it's not really a zero sum game. We have, in my view, we're enlarging the problems. And I think this dynamic is creating addiction and situations where effectively the world is going to need more printing, not less. It's going to need more debt, not less. And so all these bluffs that we're seeing across central banks in the world that we can normalize things are effectively like great philosopher Mike Tyson would say, everybody has a plan until the market punches you in the face, I guess.

5:23And that's really the crude reality that places like Japan or the UK or Europe or China or other places are facing. And so I think from a big picture perspective, the thesis has been reinforced, has not only survived, it's actually become even stronger and more relevant with time. And so I think these dynamics are very much in play today, a combination of kicking the can down the road, transferring, transforming and enlarging. And that in some ways is leading to wider divergence, which I think is one of the big themes that the market's looking at. into the future. And some of those who've abused the system will pay for that.

6:07But that's in some ways the backdrop of the big picture of where we are. Diego, that's so well said. Let me ask you this. As you map out these structural challenges that lurk beneath the surface, these tectonic plates shifting, and as you framed it there at the 50 ,000 foot level, everything that's going on that could present a challenge, a headwind to the West more broadly and the U.S. obviously more specifically. But let me ask you this. As we sit here at S &P 6 ,000, 6 ,075 on my screen, by the way, I should say we're recording on Monday, December 16. I know this is going to air a little bit later, but the broader trend is still very much in place.

6:47As we sit here looking at 28 % returns year-to-date in TTM on the S &P 500, how do you think about those two things at the same time, reconcile what's happening beneath the surface with the performance that we're seeing in U.S. equity markets? Well, I think what is very obvious, linking to my first point, is that it's hard to be short. It's hard to be underweight. It's hard not to be invested. And if you think about it and take a step back and take a 5, 10, 15, 20-year view, it's really hard not to be invested. It's not just the equity market. It's real estate. It's anything, really. And I think that's kind of what we've seen is mommy and daddy, as I call them, central banks and governments, they face this dynamic, you know, where every time there's a problem and we faced quite a few in the last few years, from that regional US banking crisis that everybody forgot about all the way through wars and pandemics?

7:55And the answer is always the same. And so I think in that sense, the first point I would make is that it's hard not to be invested. In some ways you could argue, and I think this was one of my tweets a little while ago, I'm so bearish that I'm bullish in the sense that, yeah, you know what's coming. You know that every time a problem comes, they're going to be effectively doing more of the same. And so those pro-inflation, pro-growth, pro-fiscal are dynamics that are difficult to fight. That doesn't mean that there's no risk or should be just complacently buying into the central bank. I think it's almost the opposite.

8:37And that brings us to the dynamic or the concept of the anti-bubble. I mean, it's ironic that as valuations are ever increasing, in some ways, the other side of the coin is insurance. Portfolio insurance protection becomes extremely cheap as the market plays this bubble anti-bubble dynamic. And so my approach is really to embrace the volatility of the market, to embrace, if I may say, the stupidity or the complacency of the market in a very unemotional way. I think you have to be long. And there's no question about that. You need ways in which you're just long inflation, right? Long the market.

9:24But you also need to complement it with ways in which you add that defense. You have your football team or your hockey team or basketball or Formula One, whichever sport you like. You need to play offense and defense. But I think there's a key element there, which is the rebalance and is how you combine these pieces and you take advantage of this to basically create additional sources of return as you monetize. So I think looking into next year, I don't have a crystal ball, unfortunately. I think that are strong forces and imbalances in both directions. We're going through clearly a super cyclical event with a major game changer in the form of AI, which we're all trying to get our heads around and see what it truly means.

10:13And we all know it's huge. There's a world before and after, and there's going to be dramatic opportunities and transformations. At the same time, there are going to be excesses and overvaluations. And I think it's going to be quite an eventful year. Lots of people have written off inflation or geopolitics or credit issues or bubbles or others. So I think in that sense, you know, this is about building teams or furios that can perform well in either condition.

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11:46Not all applicants will qualify. Plus 500. It's trading with a plus. With the view that in the medium long term, I think you need to have this long bias. Who's in some ways to take the other side of the question? Where should you not be? and who is paying for this party. And again, if you take a view that is more medium, longer term, I think it's cash and fixed income to a lesser extent, but also credit. So assets that are effectively short inflation. And what I mean by this is if you own bonds that in 30 years are going to give you 100 euros or dollars or yuan back, I don't think those$100 are going to buy you a piece of tuna in 30 years, right?

12:38So in some ways, this fixed income or cash or the markets, whilst they might look rational and conservative, they may not be if this real dynamic of inflation continues to play out. And I think that touches on another critical point back to the thesis, which is what's inflation versus official inflation, real inflation, or loss of purchase power and loss of purchase power after taxes. And so you actually think about this game that central banks play, pretending that inflation is under control and creating some somewhat arbitrary numbers with extreme precision of how things are moving to the basis point where all of us know on our day to day, the real inflation we feel in our pockets is completely different.

13:34So using the analogy that I've used in the past, we're all frogs in this monetary broth where inflation is increasing at a significantly faster rate than official inflation. And those frogs that stay in the water, i.e. cash-fixed income, are going to get boiled to death. In fact, in that dynamic, I think it's sort of how this ties it a little bit with respect to global markets. There's a lot of risk, but there are big forces that I think are, over the very long term, will continue to create this inflation pro-growth and dilution of the debt and the cash and fixed income investors. And again, what does that mean to equity markets?

14:25It depends. There's a positive initial bias, but ultimately inflation is bad for everything and everyone. So we are, again, the thesis, for those who have dedicated my book, you'll know that I tend to do it by saying, I hope you like it. I hope I'm wrong. Because I do feel in some ways like a doctor that is diagnosed in this terrible disease. and you know so on the surface everything's great we get this wealth effect compounded by crypto and many other things that are making everyone feel quite wealthy the I think the situation is significantly more fragile underneath and precisely for that fragility we will get even greater responses down the line which sort of feeds back into this this crazy you know dynamic that we live through You said that so beautifully, and I think you really hit on something that strikes a chord with people emotionally when you talk about the wealth effects.

15:28Wealth effects are all well and good if you own assets. If you own assets and you see the cost of living offset against the gains that you've seen in those assets. It's the holiday season. Everyone's going to experience this probably at least once where you're going to be at a party and there's going to be a Wall Street guy there or a finance guy there explaining, listen, you know, CPI in November, it's ticked up 0.3 percent. You know, this isn't that bad. And yet the lived experience that people have of watching the cost of living spiral out of control for many people in this economy here and around the world, I should say, it's a very painful and difficult experience, which brings me to something you said earlier.

16:07this idea of you're so bearish that you're bullish. I think this is probably the secular version of bad news is good news and good news is bad news. Talk a little bit about what that implies for portfolio allocation. We can keep going a little bit deeper into the philosophy of it, but I want to get your view of what that implies. You sort of started to tee this up where you talked about how the 100 euros or the$100 aren't going to buy a pack of gum in your view in the future. What does that actually imply for structuring a portfolio? Yeah, let me, thank you for that. Let me add on wealth effect, which I think it's incredibly important here.

16:47So what is wealth effect? And the way I define wealth effect is the illusion of wealth, right? It's, you think you're wealthy because the mark to market of something you own is gone up. And as a result of, it's basically an artificial setup, But we can think of a few areas where we might see assets that are, you know, value that levels that might not be realistic. Okay, take your choice. I'm not going to pick on any at this point, but there's quite a few candidates. Now, the problem with wealth effect is that it's a double-edged sword. So on the way up, wealth effect, it's brilliant. end, it's a virtuous cycle and you feel richer and you spend more and the proceeds that you make trading X or Y, Tesla or crypto or whatever it goes and gets reinvested, you feel really good, you spend more and you feel really, really wealthy.

17:47The danger of wealth effect is that if this thing is artificial, when things actually implode, they create vicious cycles. and those vicious cycles effectively can be extremely destructive because effectively you know i've heard this many times it's like oh my god this this asset just lost uh whatever 100 billion in valuation in minutes where did it go and and my answer is you know where it went it went where it came from thin air it never existed so wealth effect never existed and and And I think that's something people need to be very, very careful. The fact that something in your account says there's a lot of zeros, it doesn't mean that you can actually monetize that or if everyone tried to do it.

18:38So I think wealth effect is tricky. Now, wealth effect at a small scale is, there's a bit of a zero-sum game, you know, things never really existed. But when this wealth effect becomes bigger, This starts to imply gross misallocations of capital. And I'm talking about wealth effect and bubbles together. That's when things start to get really systemic. And we've seen it several times. And I think that's the tying into your point is I think we're experiencing a lot of that in certain areas. And to the extent that some of those write-offs would be non-events or to the extent that they really truly start to impact employment and consumption and financial conditions, I think the central banks will come in with more of the same and governments.

19:36And that more of the same is more fiscal, more spending, more debt. And from levels where we're already at, you know, super high levels. I mean, look at the US and going from Trump 1.0 to 2.0 where we are, but then also monetarily, you know, through the effectively interest rate dynamic. And so I think in that sense, if you look at some of the economies or countries that are already way past the point of no return with respect to their level of debt, and that includes Japan, for sure, China and others, when you factor in the entire true liabilities, both committed and emitted. this is a situation that is tricky and why you could be very bearish about the economy and what's coming but then if you actually measure the reaction of the market or the equity market yes, we are in some situation where bad news is good news but that's not natural and that's not necessarily very healthy and ultimately creates this addiction of the fact that if you were to step out of certain markets, there would be the immediate abyss.

21:03Think about what would happen to JGBs without DOJ buying them or what happened to the UK with Liz Truss when she tried to do a few things. So I think you kind of face that underlying situation of artificial settings that in some cases are way past the point of no return and that they will require more of the same in scale. And that brings us to this idea that, you know, you're going to need more, more printing and more debt, not less. That's probably the base case. And, you know, again, I must say, on the other hand, it's pretty remarkable how things have held. And they've held in some ways for this combination of, you know, truly game-changing technologies as well as wealth effect, and some of these things that set the path of where we go.

21:57So it's going to be uncertain. It's going to be volatile, but certainly it's not a done deal. And I think it's a more fragile situation in all respects than what you might look at just by looking at the price action. Yeah, or as Raoul might say, more cowbell, more of the above, more of the same. Diego, walk us through a little bit, and I know you've done this here on Real Vision before, but walk us through a little bit of the genesis of the anti-bubble framework and talk about how it might apply. We're in this period here, obviously, between the election of President Donald Trump and the inauguration of President Donald Trump.

22:37How might some of the ideas in the anti-bubble framework apply to what your expectations are for 2025? Okay, so just to define the concept first, for those who are not familiar with it, I always like to borrow George Soros' definition of bubble. And he talks, he defines bubbles as assets that are artificially expensive based on a misconception. So some belief that is widely held, but it's false. So a situation where the emperor had no clothes. So eventually, it's a matter of when, not if, that bubbles collapse. The idea of the anti-bubble is, when I put my engineering hat on, is you generalize the concept.

23:26And I said, well, misconceptions can distort reality. But not only through artificially high valuations, which we call bubbles, you could also have artificially low valuations. And the concept of anti-bubble has these three dimensions. The first one is this idea of assets that are grossly artificially cheap. So it's a matter of when, not if, that they will basically implode higher. The second idea is that bubbles and antibubbles are like distorted mirror images of each other. They're based on the same misconception. But in terms of catalyst and timing, it's the exact same moment that the antibubble implodes or explodes and the antibubble implodes higher.

24:10And so I called it anti-bubble, like an antivirus or an anti-missile. It depends mechanism against the bubbles. And the third dimension is this idea of reflexivity, how bubbles and anti-bubbles feed each other. So think about the S &P and the DICs, for example, how artificially low volatility can contribute to artificially high equity prices, both qualitative and quantitatively. So qualitatively, it's this perception, this complacency, this idea that there's no risk. Quantitatively, it's strategies like CTA, trend following, bold target, risk parity, effectively levering up as the market goes up and the trend's strong and volatility is lower.

24:58All of which reverse very quickly when volatility explodes and sort of tricks that bubble. So in this framework, I guess with the bubble-empty bubble is, you know, what's the misconception? Tell me the misconception, I'll tell you the bubble and empty about in some ways. And so we are in a situation where there are many of those. We talked earlier about the misconception that monetary and fiscal policy solve problems. The answer is no, they don't solve problems. They delay, transfer, transform, and enlarge them. But when you think about other dynamics such as AI, it's much less obvious where you are in the sense that as a game changer technology, we know that there's a before and after.

25:44But the misconception might be, you know, the linear kind of thinking about growth and consumption. And generally what we've seen in many, many bubbles is the fact that most companies invest as if they were the only guy doing it, right? Not realizing that everybody else is their own chat GPT and whatever. So I think eventually this game, like the dot-com bubble in 01 will result in a flatter world. It will result in... At that time, it was the internet, the broadband that connected the world. And if you were an accountant in Bangalore, you could work for someone in California. That changed the world.

26:27I think today we're going through a dynamic where we're going to see a lot of solopreneurs, many one-man billion-dollar companies. I mean, this is where we're going. And what that means for other sectors, other companies, opportunities, there's going to be tremendous opportunities, but not necessarily where we're looking for them now. Some of them will appear and will continue to flourish. So I think back to portfolio construction, I think you've heard me many times talk about the sporting analogies. When we think about portfolio construction, And I think it's healthy to think about what you own as a team, you know, and I'm Spanish, right?

27:12And to use football or soccer more. But again, you could use any sport you like because they're all similar. But there's an offensive part of the game that looks to make money, both in capital and income gains, that are parts of the portfolio that look to protect both nominal and real and inflation adjusted. And so I call those guys upside alpha and downside alpha, those strikers and defenders. And every game, including investing, is a game of offense and defense, right? And what you don't want is to fall in the risk of false diversification. So to end up with a team of 11 strikers or 11 goalkeepers.

27:57And the problem with this is that a lot of people get fooled by looking at correlation, which is what really drives the behavior in terms of average correlations. That's kind of meaningless. What really matters is how do you behave under extreme circumstances? So we're looking at conditional correlation. How did you do in March 2020? And if your portfolio, every single asset in the portfolio fell in March 2020, then you're not diversified. You might think you're diversified. It's normal conditions. Some things go up and down. But you actually had 11 strikers. So it's very important to understand that these relationships, these correlations change.

28:45And they're very dynamic. And they can be driven and impacted by many things. but certainly positioning, it's critical in other things. So when you think about portfolio construction, it's critical to create this team that will do well, can score goals, can defend, can pass the ball. And one of the areas that I've been doing a lot of work is precisely on that element of teamwork, portfolio teamwork. So we have one, you could share some of the performance numbers And I think that graph will show very clearly the composition of the team when you combine the upside alpha in the form of some sort of equity investment, downside alpha with the protection when it matters.

29:30And this year we had a big event in August, which was short of live, but it left a few dead bodies in the river flowing down. And how you basically use those to take advantage of each other. How do you use, how you accumulate and monetize in a way that your team is always very balanced. So, again, I keep going back to this idea of building solid teams with people and portions that do their job. They do it as a team and you do it in a very unemotional discipline basis. But it takes quite a bit of art and science to figure out not only the what, but also how much and when. And so that's kind of part of the work that we do in the strategies that we manage.

30:21We combine these assets into mandates such as protected rebalanced equity, which you might show on the screen. So I think it's sort of the natural, how do you link this macro picture with the opportunity set in a framework that is all about behavior? It's not about labels. So when you hear about asset class construction or diversification, the risk of equity down, fixed income down, which is the Achilles heels of the 60-40 balance portfolio and frankly, the global financial system, because I think that's when things really go wrong. You know, if equities go down, but fixed income is there to protect you, like bonds go up, then in some ways you're okay.

31:14But the scenarios where inflation is really high, central banks need to respond with higher rates, that exposes some of the complacency in the market and what's been priced in and equities suffer. You start to see that false diversification resulting in big drawdowns and things start to implode and compound on themselves. So it's absolutely critical to find much more reliable, reactive sources of protection, which is what we tend to do on a day-to-day basis. That's really the spirit of our business and what we try to do as the goalkeepers of the team. Yeah, and when those inverse correlations move toward positive correlations, you see exactly what you just described, this idea of false diversification.

32:01and obviously is a challenge. Let me ask you this. As you talk about offense and defense bubbles and anti-bubbles, which directions and which areas might we see in terms of sectors where we could see mispricing as a consequence of the AI revolution beginning to roll onto the table? Well, fantastic question. And let's think through this. So in terms of big to small, top down,