Guest: Whitney Baker is the founder of Totem Macro, leveraging extensive prior buyside experience to create unique research insights for an exclusive client-base of some of the world’s preeminent investors. Previously, Whitney worked for Bridgewater Associates as Head of Emerging Markets and for Soros Fund Management, co-managing an internal allocation with a dual Global Macro (cross-asset) and Global Long/Short Financial Equity mandate.
Recorded: 2/15/2024Â |Â Run-Time: 1:23:22Â 
Summary: In today’s episode, Whitney explains what led to $500 billion in money expansion last year and why that’s driven recent performance in asset prices. She discusses the challenge the Federal Reserve faces as they try to balance inflation concerns with the need to support asset prices.
Finally, Whitney talks about the huge opportunity she sees in emerging markets today and which countries have attractive valuations and troughing conditions.
 Listen to Whitney’s appearances in episodes 387 and 453.
Comments or suggestions? Interested in sponsoring an episode? Email us [email protected]
Links from the Episode:Â
- (1:37) – Welcome to our guest, Whitney Baker
- (1:55) – Whitney’s view of the macro landscape
- (4:48) – What led to the money expansion the past few months
- (14:57) – The challenge the Fed faces
- (30:58) – Opportunity in emerging markets
- (40:46) – Interesting markets to keep an eye on
- (48:03) – What leads to Whitney seeing an investment opportunity
- (58:57) – Update from Whitney on launching a new fund
- (1:04:11) – Whitney’s view on gold
- (1:07:17) – Larry Summers Tweet
- (1:10:53) – Whitney’s most controversial viewpoint
- (1:14:44) – Using useful resources from history
- Learn more about Whitney: Twitter; LinkedIn
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Transcript:
Meb:
Whitney, welcome back to the show.
Whitney:
Hey, Meb. Thanks for having me back.
Meb:
You are one of the most often requested podcast alums, so it’s good to have you. I think it’s been, what, about a year since you were last on?
Whitney:
I think so, yeah. That’s nice to hear. Thanks.
Meb:
What’s going on in the world? Give us an update. Walk us forward.
Whitney:
Well, since the last time we talked, it feels to me like so much has happened, but also nothing is really different. There’s been a lot of volatility, but we’re still in the same place we were towards the end of 2021, maybe not quite as extreme, but exact same anatomy of what’s going on with the markets. The macro picture is reasonably similar. How things are going to unfold is reasonably similar in terms of what’s different from priced. So it’s interesting, because it’s like, in my mind, this repeat of; all right, we’ve talked about how we’ve had this big secular upswing. We’ve had a cyclical bubble on top of that and now we’re hovering around the most concentrated asset exposures to the most expensive markets in at least modern history. And the bubble is huge relative to the economy. So we’ve got all of these challenges and the Fed is here trying to navigate this without really any framework that applies in a way that enables them to simultaneously choke off inflation and this high self-reinforcing growth cycle without nuking the bubble that they created through the money printing over the last 15 years.
And obviously the fiscal side is doing exactly what it did in 2021. The Fed is monetizing it and so it’s shocking to me that we just ran through the same exercise. It’s like, okay, when there’s a fiscal blowout, when there is Fed monetization of that, the fiscal blowout’s not funded with duration, because either, in the 2021 case, the Fed was buying the duration. In the 2023 case, there was no duration issued, because the market couldn’t handle it, and so the government issued the deficit entirely in bills. So you’ve got this big increase in essentially transfer income to the private sector that’s been monetized, funded with bills and therefore frees up a lot of money flows to go into assets that have done well on a trailing basis. And so here we are and people are surprised that with this huge fiscal blowout and the monetization of that, the economy’s not really going down. If anything, it’s accelerating and the inflation problem persists. So, it’s a lot of the same mispricing’s after a roundabout way of getting here that we’ve talked about the last couple of times I’ve been on your show.
Meb:
Yeah. You have a quote that nails this home where you were like, “in this cycle, assets outperformed the economy by the widest margin in the history of mankind, which is a long time. Now the reverse inevitably must happen.” One of your word clouds you like to use a lot, you talk about flows and flows can mean a lot of different things, but one in particular that I think has been a focus at the end of the year, and this is Whitney’s macro strategy letter, is talking about bank reserves and how they have driven these cycles up, down, up, down, up, down, up, sounds like a Nintendo cheat code. Talk to us about that. What does that mean and why is that important to follow?
Whitney:
I don’t want to go too much into framework, because I tend to do this a little bit and we’ve done it before, but just the most important point at the high level is when we’re talking about flows, I don’t mean to suggest we’re talking about tactical, speculative flows or indicators of positioning and things like that. Those things, when they swing around, they can drive tactical moves in markets, week to week vol and so on, but they don’t really drive the overall directionality, nor do they drive the macro conditions that are going on. And so what we mean by flows is thinking about broad money creation and credit creation. And credit creation is really just essentially lending by commercial banks typically to the private sector, to other parts of the economy that actually spend that money in the economy. And so this is not like a hard and fast rule, but by and large when credit is expanding, that source of financing is going into things that are goods and services and so it either creates more volume of goods and services or higher prices, if the supply of those goods and services is constrained. So, you can think about credit creation as disproportionately driving macro conditions.
Then you’ve got money creation, which is the point you’re raising about bank reserves. Money creation, in the narrowest sense, is when the Fed is printing or when central banks are creating base money, which historically was very tied to interest rates. Historically, they would just create base money as a way to, if they’re creating it, they’re essentially reducing base rates by increasing the supply of money. If they’re trying to tighten rates, they affect that in the market by reducing the supply of money. And so those things went hand in hand. Rates followed supply of money for logical reasons. Interest rates are just the price of money. Going back to really the GFC, what happened was big de-leveraging globally, we had a massive synchronized global boom in the 2000s, created a bunch of unsustainable spending, a lot of debt that hit a wall in the GFC. And so there’s this global disinflationary de-leveraging pressure for a long time as private sector participants work through their balance sheets.
Okay, but the Fed doesn’t want deflation, and so what they do to keep total financing overall flat, thinking about money and credit together, is they increase base money, overall credit is essentially de-leveraging relative to incomes, but the injection of money puts a floor under asset prices and then ultimately works its way through financial channels, through to greater wealth, higher asset prices and it helps ease the de-leveraging pressure that the credit crunch creates in the economy. So the problem is when they take that to an extreme, knowing that money goes necessarily through these financial channels, whereas credit typically goes directly to real economic channels, what you end up getting with a lot of money printing is financial inflation and not asset price inflation, want to think about it that way, and market caps rising relative to GDP, which is financed by credit, which is relatively weaker.
And so that’s the background for why, today, we have not just an extreme bubble in terms of asset valuations. We’ve had this extremity in property bubbles in Japan and China, and obviously we had very large tech related bubbles in the U.S. in the 1920s, the 1960s, the 1990s, this last decade. The thing that’s different about this time is that we’ve had 40 years of relatively unconstrained money printing, because of the de-peg from gold. This got taken to this illogical extreme, let’s say, in the last several years of COVID, and then the government took that printed ammo and mailed it to people and delivered it to the private sector, so now the private sector is spending that money. So it breaks that link between spending being dependent on credit to now spending being dependent on money, both directly through fiscal transfers, but also indirectly, because that money is propping up the asset bubble which drives people’s willingness to spend and their balance sheet ability to spend, which is why savings rates are plummeting.
So that’s the issue. That disconnect means that market cap to GDP globally, but particularly in the U.S., is massive. It’s this hyper financialization of the economy has happened for 40 years and then in this blow off top in the last several years. And so because of that, two things have happened. One is the supply of money is now completely disconnected from the price of money. Interest rates were zero for a long time. They increased the supply regardless. The supply of money expanded, provided balance sheet for these financial assets which are now very high relative to GDP. And so people are looking at correlations that aren’t really causal. This was a common narrative in the market. The bubble in growth stocks is a function of interest rates. Okay, no, it’s not really.
Really what happened was there’s a lot of money printing, the Fed’s buying bonds, so it’s supporting bond prices. It’s displacing investors who previously owned bonds who are now going into other assets and propping those asset prices up. So it looks like bubble stocks are very much a function of yields, but actually both things, yields, i.e. bond prices, and stock prices are a function of this huge amount of money that’s being injected. The Fed now has to choose. They can’t nuke this bubble, because it’s so big relative to GDP that if they did, it would just be catastrophic in terms of the balance sheet fallout. And so on the one hand trying to choke off this high nominal income growth, nominal spending growth, inflationary cycle we are in, but then when they do that by contracting liquidity, they impact asset prices. Like last year, you saw the worst bond drawdown since the 1860s, and so people who hold bonds are not equipped for that. They weren’t expecting it, they’re not capitalized, they’re levered players and so on. And so then the Fed freaks out about, “Oh my god, systemic risk and we got to pivot back.”
And so in 2023, there was really two Fed pivots. One was the over response to what they perceived to be a systemic banking crisis. Bear in mind these are people who see no cost to printing. They’ve been able to print and spend for 40 years. It hasn’t created a lot of inflation, because of offsetting globalization and the dynamics there, which provided supply that met the demand by all of the increase in money and credit over that 40 year period. And so they have this Pavlovian response to any market weakness, particularly in the sovereign bond market. And it’s not just the Fed that did that. The BOE did it too when pensions were selling gilts, because of the drawdown in gilt prices.
And so they pivot back, from late March of 2023 through to May, injected almost like a QE1 sized amount of money. So you saw base reserves in the banking system going from contracting in 2022, because of quantitative tightening, to expanding again in 2023. And then even though there was no banking crisis, if had it happened provided an offsetting credit crunch, it didn’t happen. And so you end up in this world where you got a lot of money printing, you got a lot of fiscal stimulus, fiscal deficit blew out from 5 to 8% of GDP last year. You have really no impact from rate hikes, because there wasn’t really a lot of credit going on in this cycle. If you have an entirely fixed rate stock of debt, it’s very hard for that rate hiking cycle to actually flow through to that debt and squeeze people’s incomes, which would then generate some sort of reduction in real spending. And any reduction there was in credit was more than offset by the fiscal expansion.
So that’s the issue that the Fed is facing and that happened in the first half of the year. And then when you look at the market action, when did the new narrative in the tech bubble, the AI stuff, Mag 7 all this stuff, when did that really disconnect from broad stocks? During that exact same period, during late March to early May, that whole rally extended and those concentrated stocks did very well, because they received a lot of the retail inflow that was down the chain from the Fed having printed a whole bunch and it just continued through the end of the year. Although, that wasn’t really the Fed’s choice, that was more the government realizes they’re issuing a percent of GDP, there’s no demand for the bonds that they’re trying to place. And so around September, they decide; we’re going to issue bills. This is Brazil style stuff. We’re going to finance at the very short end, because no one wants our term debt and instead of actually fiscally contracting and being somewhat responsible, we’re just going to finance in a way that doesn’t actually crowd out any other assets from balance sheets, doesn’t require people wanting to actually buy our bonds.
And so, this was a wonky mechanical thing, but when they issued a lot of bills, what happened was money market mutual funds, which have a lot of cash as a byproduct of QE, had parked that cash in the Fed’s reverse repo facility, they were earning 5.3 in that facility, those guys pretty much want to buy bills. They want to buy all the bills that exist. They want to term match their CDs or their inflows with the assets that they put that money into. And so when the government started to shrink the bill stock, a lot of that money went into the reverse repo. When the government decided to throw out bills like confetti, because the bond market couldn’t really handle the supply, all of that money came out of the Fed’s reverse repo and then expanded bank reserves in a second pivot. It wasn’t really the Fed’s choice, it was more just a natural wonkiness in terms of how the monetary pipes were working, but that’s why we got $500 billion of base money expansion last year, even though quantitative tightening was ostensibly going on the entire time.
Meb:
Well, damn Whitney. All right. There’s five different ways to go here. That was great. There’s a couple comments you made. One, thinking about the Fed and thinking about asset price levels, that’s not something they, at least to my knowledge, they explicitly target, but is that something you think is front of mind for them? It seems like the narrative is inflation’s conquered, it’s back down to mellow levels. Maybe talk a little bit about inflation, about the Fed and what their mandate is, what they’re thinking about.
Whitney:
So there’s a few things. So, ostensibly the Fed’s mandate is employment and inflation. The reality is they’re human beings. They’re no different from any other market participant in that they’re using frameworks and heuristics that have been based on recent history and have worked in recent history, and they’re talking about very academic things like the concept of a neutral interest rate. To me that makes absolutely no sense, because the interest rate that is neutral at any point in time is going to be a function of how much debt there is, how much of that debt is floating rate, how much recent debt was taken on. It’s a constantly dynamic concept. So the point is I think they’re trying to steer policy using things that are grounded in somewhat academic frameworks, when what we’re dealing with is a situation which emerging markets have seen very many times, which is this issue of; how do you actually know when your own policy is restrictive enough or not restrictive enough, netting it with what the government is doing as a way to control your end targets?
The problem the Fed has now is that their inflation target, which is essentially the binding constraint at the moment, it eased up last year for reasons we can talk about which had nothing to do with supply or falling demand in the U.S., which is interesting, because people are confused about why there has been this transitory slowdown in inflation, but it’s very logical. They’re using these backward looking frameworks and they’re saying, “Look, we don’t really know what’s going on, but it looks like inflation’s come down and maybe there’s space to ease.” And because they’re fighting the last battle, they’re somewhat like PTSD from the GFC and saying, “Look, we don’t want a bank in crisis. Everyone’s over focused on the issues at the banks, even though the banks are incredibly healthy.” That’s why they were so quick to react to what was going on with really what were three really badly managed banks that had particular levered exposures to the VC cycle and to the bubble that we’ve just come out of, rather than being indicative of broad systemic banking issues.
And so the Fed showed their bias in that moment. They showed that they’re basically playing this whack-a-mole game where, okay, when inflation looks problematic, they go over here and they tighten and they try to suck out liquidity and deal with the inflation problem, but then by doing so, they suck out some of the liquidity that they then injected previously which held up asset prices. So naturally asset prices, that disconnect they created starts to close. That’s a natural consequence. They go back over to that and say, “Oh my god, this is going to create a problem given how levered balance sheets are and so on.” And so the problem is that the amount of liquidity that should be in the system, that is consistent with getting the inflation situation actually durably under control is too small relative to the amount of liquidity that’s needed to keep the asset bubble either elevated or deflating in a really manageable glide path.
And so that’s why you’re getting essentially sideways asset moves. So if you think about; okay, big rally in bubble stocks through early Feb 2021, then the broader stock market, November 2021, big draw down. Okay, then the Fed reacts and pivots back, injects money, big rally, it’s where we are now. In that rally, injecting more liquidity then adds more stimulus, particularly with the fiscal kicker, to the growth and spending cycle we’re in and the inflation constraints we have, then they got to pivot back over there and deal with that. And so they’re just flailing around, like one of those balloon guys outside of a car dealership. They don’t know what’s going to happen. They have no framework to even explain what’s going on now, and so they’re just very reactive in the same way a lot of market participants are reactive.
The problem with that is they don’t really have a good way to calibrate what they’re doing. Why is it that the market is currently priced for, even after the inflation print we just saw, which there’s a lot of reasons why and we can go into them, why inflation is a problem, still is a problem, will be particularly a problem in the U.S., relative to everywhere else, but the recent prints are showing that. They’ve been showing it really since July of last year. The market is still pricing like 80 bips of cuts this year. Why is that the case? Employment is very tight. The economy’s running very hot, super above potential, particularly when global economies are running with a lot of slack. They’ve just come out of recessions. They’re the opposite. They haven’t been the economies that have done well in the last cycle. The U.S. has, so it came into this running hot and is now running even hotter as a consequence of not having the recession that all those other countries just went through and that’s basically the problem.
So we’re here in this situation where the markets are saying; in the past 20 years there’s been big nominal rate hike cycles, that’s created recessions. Then there’s easings. We’re going to price that easing, we’re going to misprice that recession, which never happened, and for some reason the markets seem to expect rate cuts now, which from my perspective, it doesn’t make any sense, because the assets are high, the economy’s doing well, inflation is accelerating, the economy’s reaccelerating, there’s nothing to respond to in terms of the need to ease policy and yet that is still what’s priced.
Meb:
You mentioned the rest of the world, a lot of places going through recessions. Is that now something they’re coming out of? Looking beyond the border of the U.S., what’s going on in the rest of the world right now?
Whitney:
Even just take the core inflation, why did that slow down? Entirely due to goods prices, entirely. Services has reaccelerated, shelters remained hot and so on, so it’s entirely this narrow category that is goods. Okay, well why did that happen? Was it the supply chains from COVID? No, supply has not increased. U.S. import volumes have not increased, U.S. production, industrial production or manufacturing production has not increased and U.S. demand of goods has not gone down and it remains, in real terms, at about 115 versus 100 base of COVID. So, 15 point real expansion in goods demand in the U.S. has, if anything, started to reaccelerate lately.
The reason that inflation went down in a transitory way in the U.S. and never went down to anything remotely like the target or a sustainable directionality towards the target, but the reason it slowed, big part of the reason, was that goods are obviously globally priced. They’re essentially tradable items within the CPI basket. They’re globally priced and the rest of the world just went through recessions. Why did that happen? Two reasons. The rest of the developed world has really floating rate debt stocks, so the five points of rate hikes that didn’t really do much in the states, they were also replicated in places like the UK and the Nordics and broader Europe. And those guys, because they don’t have this 30 year guaranteed mortgage, because they don’t have very big bond markets where corporates finance at duration and things like that, the majority of their debt is floating rate, so the rate hikes actually flow through reasonably quickly. They also didn’t have any fiscal offset. The fiscal side has been contracting in these places and so the fiscal drag was adding to the private sector drag from their rate hikes.
Then the other point was they had an energy shock. We go back to the war, when that broke out, depending on the country, like Japan right through to the UK and parts of Europe outside of Spain and some of the more peripheral countries, had something like a 3 to a 5% of GDP net shock from the energy price inflation in 2022. And so the U.S. is net neutral. It’s an exporter of energy, but it’s also an importer of certain types of energy and so on net, it’s basically neutral. It wasn’t exposed to the gas blowout in Europe and to the extent broader energy prices went up, all that does in the U.S. is redistribute income from consumers to producers, but it stays within the borders of the economy. Whereas in these other places, it’s a net shock to those economies. It basically means they’ve got to pay foreign suppliers of energy a whole bunch of income domestically which squeezes the income available to spend on other things domestically.
So for those three reasons, there was very large economic adjustments in a lot of the developed world, but also parts of the emerging world that also responded very aggressively with rate hikes and fiscal tightening. So that’s why goods prices generally fell globally and why, as they come out of these recessions, we’re already seeing goods sectors start to expand again, demand is expanding again, goods pricing is expanding again. It hasn’t quite made its way to the U.S., so even if you look at the print from yesterday, goods prices are still negative and all of that heat is from the services side of things which reflects the domestic overheating, the high wage growth, the high nominal income and spending cycle that we’re in. And so the U.S. remains uniquely late cycle, in the world’s economies, uniquely over capacity with this very entrenched tight labor market, high wage growth, high job growth.
And what that means is that households who are receiving something like 6% annualized wage growth and 2% job growth, they’re getting something like 8 or 9% annual nominal earnings growth, even before considering the fiscal piece. And so it is not surprising that their spending is roughly approximating that, but because we are so late cycle and operating so much above capacity, there’s not a lot of widgets left to go, or whether widgets are tables at restaurants or whatever the items are that they’re spending on, there’s just not a lot of incremental capacity to feed this acceleration in nominal spending. And so if 9% spending growth happens and there’s not a lot of volume growth to meet that, the marginal demand is met through price increases and that’s why inflation is reaccelerating again.
And so from my perspective, yes, the rest of the world is coming out of these recessions and they’ve had meaningful adjustments. Their economies are pretty low in terms of the levels they’re operating at. They have sufficiently choked off their inflation through that combo of three drags, the rate hikes flowing through, the fiscal drag and the energy shock which aid into domestic incomes. And so now they’re recovering coming out of this and it puts us in a situation where, number one, that removes the disinflationary goods drag from the U.S. inflation picture at a time when core services is annualizing at about 10%. Okay, so that’s not good. And those guys don’t have these inflation pressures. If you look at core inflation in Europe or the UK, even in Japan, it’s decelerating and it’s very low. It’s, in most cases globally, below target in a pretty sustainable way. So this sets you up for a situation where the growth differentials are going in the favor of the rest of the world. The inflation differentials are going in the direction of the rest of the world, therefore the monetary policy differentials, in terms of interest rates, are also going to be easing in the rest of the world and remaining tighter than priced in the U.S., which is obviously another tailwind for assets in the rest of the world relative to the U.S.
And then you get a situation where, what we did see in 2023 that was different from 2021, the main difference was that the dollar was weak. Normally in this bubble, the dollar has rallied alongside U.S. asset prices and that’s because everyone in the world was putting every net dollar of risk capital into the U.S. during the bubble. It was like the only game in town. So all the money’s coming into the U.S., it’s reinforcing the bubble in U.S. assets, but it was also propping up the dollar. The dollar obviously has an ongoing need for financing.
The issue now is that in 2023, a lot of these other stock markets in the world, including the riskiest parts of the EM, complex including cyclically geared economies in Europe and so on, Japanese stocks as well, they all started to do very well, because they’ve got this early cycle trifecta of troughing economic conditions, trough positioning and near trough valuations, the opposite of the U.S. And so that stuff’s doing well and so why does that matter? It matters, because the dollar directionality, the fact that the dollar didn’t rally with the bubble coming back last year, shows you that the flows that drove the bubble coming back last year were domestic in nature, which makes sense, because we know it’s essentially the Fed printing, which it works its way out through domestic financial channels, to retail players, who then put it into the stock market and the foreigners did not buy into that rebound. The foreigners allocated their marginal capital to stock markets elsewhere in the world, to things like Colombian sovereign bonds, which did 70% last year, to all these other assets that competed with U.S. assets for relative return strength. That’s important, because going forward, the dollar’s incredibly expensive and it’s dependent on these ongoing inflows of capital from foreign players who already have more U.S. exposure, as a share of their portfolios, than ever in the last 150 years.
And so they’re oversaturated in the U.S. and that’s been a function of the U.S. being the best performing set of assets and now that the U.S. has these fundamental, negative differentials going forward and the price momentum, at least in a relative sense is turning against the U.S., it stands to reason that the marginal flows could not just be marginally allocated to different assets, but that foreigners could start to sell what they own, of these crowded positions in the U.S., and put that into global assets with better fundamentals and cheaper values, which would be a problem for the dollar, which if that’s allowed to happen, essentially by Fed keeping things overly easy, overly prioritizing the financial side of their mandate versus the actual economic inflation side of their mandate, they keep things too easy, what will ultimately be happening is that the Fed will be printing money that will essentially be going straight to foreigners as they redeem their dollars and sell U.S. assets and take it abroad. And that is how you get into essentially inflationary currency spiral where, I’m not talking about the pace of which necessarily looks Brazilian or something like that, but just at the dynamic level, if there’s a lot of money being created that’s economically inappropriate in the U.S. and foreigners are selling those assets at the same time, that money just facilitates the foreign exodus and creates a currency transaction which then pushes the dollar down.
And as EMs know, inflation is your first test. If you fail to meet the inflation constraint and you’re an externally reliant economy that’s running hot, late in the cycle with a lot of fiscal spending and a lot of printing and overvalued assets in an expensive currency and you overdo that, then the currency becomes your binding constraint. So if the Fed allows it to get to the point where the currency decline is accelerating, it’s down about 10% off the recent peak, but if it accelerates in a rapid way, then that feeds into the inflation problem, which again is like a particularly U.S. phenomenon, going forward, in a way that just reinforces further foreign selling, because foreigners don’t tend to stick around for that kind of financial repression, negative real returns to their assets, but also negative real returns to the currency.
Meb:
It’s an interesting comment on the sentiment and then hopping over to the equity markets now where a lot of my friends in the ETF world, you’re seeing a lot of closures in the single country names. So there’s a lot of ETFs where if you only wanted exposure to certain countries, I’m thinking Pakistan, I’m thinking Portugal, I know one of the Colombian ETFs closed, these are closing down. And I love to see that as a global ex-U.S. value investor, because it’s the magazine cover sentiment, but as you mentioned and you talk about in your letters, the rest of the world is not a homogenous place where everything is going up and rosy, and everything’s going down and dreary. Then I was thinking, as you mentioned the former British colonies, India, particularly their stock market, has been going gangbusters. And then on the flip side, you have something like China, which for many years their stock market seemed to move in unison, but certainly there’s been a massive divergence over the last year or two, particularly with China. Talk to us maybe a little bit about the global picture with various countries, you can focus on any of them in particular.
Whitney:
The initial observation you’re making is, in my view, a very important point, which is emerging markets is not an asset class, it is an average. It’s an average of a whole bunch of different countries and actually the diversity within that group of countries, think about India, to your point, and Taiwan. These two economies and populations and markets could not be more different. So there’s so much diversity within EM, much more so than developed markets, but folks, because of the liquidity, trade developed markets as if they’re standalone things, they look at their own drivers and characteristics and fundamentals, where most money that’s going cross border in and out of emerging markets from the west is going through either mutual funds or ETFs that are benchmark weighted. And so what this means is, if their active funds managers can go overweight one country or underweight another country and so on, but those are small flows relative to the overall flow, which is whether people are actually investing in those vehicles or not.
And when they are, what it means is money is coming into EM like an on-off switch, even though the conditions in different countries are radically different. And so what it means is, from my perspective, and you can make the same case about global economies today, but EM through time is a very good alpha landscape, because if you’re fundamentally trading alpha in the way that we do it is looking for disconnects between asset pricing and the fundamentals that normally drive assets, and usually there’s some particular flow that is either propping up an asset after all of its fundamentals have already inflected or the inverse, there’s a flow that’s keeping assets weak or continuing to put pressure on them and leaving those assets in a backward looking way, even though conditions have started to get materially better. So you get these big disconnects between the flows and therefore the asset pricing and what actually was going on in those places.
In large part in EM, because of this on-off switch, like capital allocation from foreigners treating it as one homogenous asset class, and so to your point about individual country ETFs and things like that, they’ve never been a dominant flow going into any of these markets and particularly right now, the point about shutting them down relates to the backward looking nature of how people behave. Okay, EMs had a terrible 10, 12 years as a block, but also the particularly volatile countries within that block have been dealing for 10 years with money leaving those assets, bearing in mind 2010 BRICS then is FANG today, it was the late cycle, oversaturated, over owned stuff and so as conditions turned out to be worse in BRICS and other more high volatile EMS than were priced at that time, money left those assets, went into the U.S. bubble and that’s why you had this inversion in prices.
And so people look backwards and say, “Oh, the bubble is going to sustain. We’re over allocated to the U.S. Structurally, it’s going to take over the world.” These narratives that validate the over positioning there and the overpricing there, and the same narratives apply to the stuff that’s incredibly cheap, that’s priced for distress, that a lot of capital has already left, that nobody owns, and yet where the economies and the fundamentals have adjusted to that withdrawal of capital and already started to inflect higher. And so leaving these individual asset classes or these individual countries or closing down these ETFs and so on, if anything, just makes that preponderance of flow dislocations even more replete in the universe.
If I think about the overall landscape, very difficult for global beta, particularly because total global investment portfolios have never been more weighted to the U.S., even in 1929, and within that weighting to the U.S., they have almost never been more weighted to the top 10 stocks. And so there’s a huge amount of concentration in assets that do well in disinflationary, high liquidity, structural growth environments when the global cycle is weak.
Now we’re coming out of that and yet the asset repricing hasn’t happened. But what that’s meant is that okay, bad for beta, you got to grow into this bubble by inflating the economy into asset prices which are high, so you don’t create this nuclear balance sheet shock, that’s negative real returns to assets. And on the other hand, a lot of assets in the world have never been cheaper or are roundabout their cheapest valuations, have nobody positioned in them. The reason they’re cheap is because those flows have left those assets, the economies are troughing, the earnings are troughing, the currencies are troughing, you name it. There’s this alignment of supporting factors that means that you can generate alpha in this universe today, because these divergences are so wide and because the suppression of macro volatility is constrained, it’s over now, the returns to trading alpha and normalizing these dislocations are very, very good. It’s a zero-sum game. You got to be on the right side of the equation. It takes skill rather than just parking your money in assets and waiting for them to go up and so on, but the point is, it’s a very rich landscape for alpha and a very bad landscape for beta.
So that’s the broader overview. And then the point you made about India, China is an interesting corroboration of that, which is China has a similar problem that the U.S. has, but it’s different in structure from the balance sheet perspective in the sense that if you go back to the early part of this upswing, globally, coming out of the GFC through about 2015, there was two engines that were propping everything up. One was the U.S., a lot of its money printing and the tech sector and all this stuff kicking off. They did enough balance sheet cleanup of the banking system to generate monetary liftoff, so it was the one country in the developed world where rates were positive and so on. So they had all these things going for them from the results really of money printing to offset the credit crunch. China was doing the same thing. It was reflating the global economy, but with debt creation. The bubble it created as a result of that debt was not in tech stocks, but was in property assets. And then they tried to get a handle on that. They also obviously had a lot of tech gearing in the beginning as well until all the Jack Ma stuff and the crackdown on essentially profitability and billionaires over there.
The issue with China is it also has this bubble that it has to work through and this is a classic debt bubble. And so it’s the same thing where you just have to keep assets stable or maybe declining gently, but mostly you want to grow incomes into those assets. So things like the multiple of house prices to income go down from 15 times, where it is now, to something like 5 where the average person can afford to buy a house without all this debt. And that’s the point of trying to deflate this bubble sideways. The U.S. is doing the same thing with tech stocks and growing overall aggregate economic cash flows into stock market caps, as China is doing in terms of trying to manage the debt burden sideways. Because these two bubbles are so huge, it’s going to take a long time to work into them.
These are the sorts of conditions that create lost decades and I think people are realizing that with respect to China. Now, I mentioned before that the active flows by managers in EM mutual funds and things aren’t normally the dominant driver, but when you take a whole lot of flow out of China and you put it into the other major liquid market in emerging markets, which is India, you can get meaningful re-rating of one at the expense of the other. And that’s what we’ve basically seen over the last three, four months is a huge amount of flow out of China and into India within the context of overall stable asset bases in EM. So it really is just a trading off of one versus the other. You have to think about that in terms of this flow that’s currently going into Indian assets and creating very expensive pricing in Indian assets, is that going to sustain or not? Or will there be… Maybe if it doesn’t, is there another flow that will come in and re-risk into Indian equities and take the baton and keep prices high?
The immediate flow of taking a given amount of balance sheet out of China and putting it into India, that’s a one-off flow. Once it’s done, there’s no more overweight to China to then pivot into India, and so that source of foreign flow is unlikely to repeat. And so from my perspective, India has this issue where structurally it’s got a lot of good prospects, it’s got very high potential growth, reasonably low private sector debt, it’s got demographic growth, it’s got productivity gains. There’s a whole bunch of benefits on the productivity and opening upside from the Modi reform agenda and pulling foreign manufacturers in, and there’s all sorts of stuff going on there, but it also has a lot of gearing to tech. Indian exports are predominantly services and the nature of the services is essentially either business process outsourcing or servicing the tech back offices of multinationals. If you look at the increase in that economic driver, it looks just like the U.S. tech bubble.
There’s also a VC style situation in Bangalore. There’s a lot of private equity in India relative to other emerging markets, there’s a lot of tech innovation. And so it’s naturally attracted a lot of both economic income and multiples on that income, because of tech related flow in both cases. And at the margin, it’s also attracted this rebalancing flow out of China and into India, which has benefited the broader stock market. So from my perspective, it doesn’t meet the criteria of the sorts of alpha trades we really like, which on the long side are that alignment of a whole bunch of troughing conditions, where asset prices are overly discounting continued weakness, and yet everything is already moving up. We look for those disconnects. India doesn’t have that. It was more expensive in 2007 than it is now, but otherwise it’s never been more expensive.
Meb:
Are there any areas in particular that look really interesting to you? You mentioned there’s pretty wide dispersion, so there are a handful of countries that are single digit PE ratios or any that are on the upswing, that look particularly more interesting to you than others, or any places you think you really want to avoid?
Whitney:
No, absolutely. The thing that makes the environment very good for alpha is there’s a lot of markets with this combination of all peaking conditions, peak valuations, peak positioning, lots of flows having gone in, lots of fundamentals that are peaking out, have benefited from the last 10, 15 years. And so everything’s going south together from high levels. There’s also this whole other panoply of places with the opposite. That’s why you can express longs and shorts in a completely beta neutral way and generate a lot of alpha out of the divergences that exist.
So, at the high level, the answer to your question is it was provided in 2022, which was; okay, going into 2022, like late 2021, I think when we first came on here and talked to you about this stuff, it was like; all right, U.S. bubble has a problem, because inflation binds the Fed. The Fed is creating the kindling, which is going into the stocks and supporting this price blow off. And so this combination of things is problematic, and yet we’re sitting there saying, “We like Columbia, we like Chile, we like certain assets in Brazil, Mexico, and Eastern Europe.” So people are, at that point, saying to us, “Look, how could you possibly like these places when you expect there to be much more aggressive Fed hiking cycle than priced, a lot of quantitative tightening, a risk off situation in broad risk assets, potentially a global slowdown? Why?” And the thing that was interesting about 2022, which bears out the broader point, is that, again, people look back to the last time there was QT and they say, “Oh man, it came out of EM. EM did so badly. These economies in Latin America did terribly because of that.”
Well, yeah, that’s because the QE was going into those assets and into those economies at the time. They were turning people away at the door. So then the QT happens and it sucks the liquidity out of wherever it was just going. That’s the main rule with respect to changes in monetary flows and financial flows, it’s not that QT, or Fed hikes, or whatever are always bad for emerging markets. It’s that in that cycle it was, because that’s where the money was going. In this cycle, the money was going to tech. And so when QT happened, tech and secular growth, disinflationary, not just the U.S., but North Asian assets did the worst. And the only things that actually went up in 2022, including… This was a year of, as I say, Fed hikes, QT, risk off, global growth slowdown, a rallying dollar, and with things like rial going up relative to the dollar in that year, our best trade in the year was Turkish bank stocks in that environment.
And it’s some combination of the fact that, number one, the money leaves these assets, they sell what they own, and those things do badly as a result. Number two, if there’s an inflationary environment, which is the reason why money printing is constrained in the U.S. and why the bubble assets went down, okay, well, there are certain companies and banks and countries in the world that have a little bit of experience dealing with that. You better believe if somebody is going to be able to make money out of inflation, it’s a Turkish bank. The Turkish ALM managers, they know how to deal with it. They hold a bunch of linkers, the Brazilians are the same. The companies in these countries know how to essentially structure their cashflow, so that they’re resilient to inflation volatility. And so that’s what happened. Earnings tripled in the Turkish stock market, because of that, and they tripled off a price to earnings multiple of 1.5 times going in. That was how distressed a lot of these high vol EMs got to, because the flows had left them so aggressively and gone into secular growth, disinflationary stuff.
And just for context on how extreme that whole thing got, in 2001… I don’t mean to continue when Turkey’s a relatively niche market, but it was not untypical or unrepresented of what was going on broadly in high yield EMs. In 2001, it had its biggest recession and crisis in modern history, sovereign defaulting on bank obligations, banks essentially in crisis and recapping, currency crisis, balance of payments crisis, all this at the same time, the stocks troughed at about three times earnings. So going into 2022, we’re half that level. And okay, people don’t really understand the Turkish balance sheet that well. It’s very arcane and complex, but the point is it’s much more resilient. The conditions are not anywhere near the same as they were in 2001, and yet the multiple was essentially already a very depressed level.
So it’s those sorts of weird mispricings that then, the thing that’s creating the dislocations and flows, once that goes away, which in the last 15 years has been central bank money printing and volatility suppression and the momentum chasing flows that followed those central bank flows, once that whole thing stopped, these disconnects close. And so that’s why those assets did well in that year. And actually the point remains that even after having outperformed in that year and having done reasonably well last year, even through the U.S. bubble rebound, because the conditions were so extreme going in, those gaps, and this is mirrored in value growth spreads and things like that, those gaps have only just started to close off very extreme levels. So, people say, “Columbia has done so well last year.” Yeah, that’s true, but off an incredibly, incredibly low base.
So a lot of the best long opportunities are still in those sorts of places. The things that did the best in the 200s, in the volatile parts of EM, so Eastern Europe, Mexico, Brazil, Columbia, Chile, and within EM, if you want to think about the other side of that trade, it’s places in North Asia that benefited from both the gearing to China in this cycle, in the early part of this cycle, also the gearing to tech, so places like Korea, Taiwan, Hong Kong and Singapore that have inherited U.S. QE as a byproduct of their currency regime, and so created their own domestic bubbles and asset price bubbles and so on as a result of that, those are all the sorts of places, and I don’t mean it clearly splits out between Asia and everywhere else in EM, but it’s just those are the places you would look for those extremes and where those aligned extremes exist on both the long and short side.
Meb:
I know this is hard, and I hate this question and I don’t really have an answer to it, but I’m going to allude to; what do you think is going to be the catalyst? People love asking this question. Let me give you an example. I went on TV yesterday and I was talking about how everyone’s obsessed with NVIDIA. It’s up a bunch this year. It’s been a multibagger in the last 12 months. It’s in the multitrillion club now, becoming quickly one of the biggest companies in the world. Everyone’s obsessed with it. It’s like the topic du jour. It’s up there with Tesla with probably the amount of tweets people are focused on it. I said, “We have an emerging market strategy,” and I didn’t even mention the name of the stock. “You can buy semiconductor companies in emerging markets, Taiwan, South Korea, for example, has had better performance than NVIDIA since the beginning of last year.” And then I said, “Just for fun, I searched on Twitter to see how many people were talking about this on X, and there was one tweet and it was a macro guy just shouting into the void.” The point being is that the euphoric interest or not even euphoric, just no interest whatsoever, what do you think changes that from your experience? Is it just the price? Because it seems like some of these countries are actually doing great.
Whitney:
This is a key difference in terms of how we think about markets and trading that I think a lot of market participants do. In my view, 80% of what you hear people talk about is narrative based and noisy and backward looking. It’s like, I think this thing matters, therefore I trade X, but not then taking the step of figuring out systematically, okay, why does that thing matter? Which flow does it connect to? Is it a large flow? Where’s that flow going? Which asset is it supporting? And what would make that flow stop? So, from our perspective, we have this framework which is this money and credit flows, it’s very useful, because it gives us a way to know and test out systematically what’s driving a given flow and also to size things. So you’re covering 35 countries and 6 asset classes in the world, you got to have a pretty efficient process for taking in news flow and discarding it and figuring out what’s actually important or not.
And the vast majority of what you hear, in terms of global market chatter every day, is just irrelevant. It either doesn’t actually drive the things people think it drives or it’s such a small thing that… And maybe it drives things tactically, like people talk about spec positioning and peaks and troughs and spec positioning. And again, these are very tactical drivers, because the flows behind that are so small relative to broader sources of flow, like pension fund allocations and cross-border allocations and these things that have real actual size to them, that drive the trend. So people are sitting there focusing on these week-to-week narratives and broadly speaking, these things don’t matter.
So what we try to do is we say, “Okay, if you think about just at the highest level,” as I said before, “the money creation side of things, money’s going into assets. It typically works through financial channels, credit goes through economic channels. Okay, which players are taking their asset investments and putting them into which assets, at any point, and what is actually driving those players?” In the U.S., to point to your NVIDIA example, well, it’s quite obvious that the stock is rerated. This whole thing is rerating. There’s not a lot of earnings tailwind here. And I think that’s triangulated pretty simply by just talking to TSMC. Okay, semi volumes are down, because the AI piece is only an incremental 6%. It’s just not that big. And so what you end up with is this big rerating. Fundamentally rerating is driven by investor flows, like supply and demand for a given asset at a prevailing price, and so what those investor flows are, going into NVIDIA, are retail in nature, which is very typical of the end of a bubble, and particularly this one where we’re so extreme in the sequencing of this bubble that an incremental dollar printed by the Fed pretty much creates a mechanical impact in the high risk, high duration, high volatility end of the bubble stocks.
And so, as is also classic at the end of a bubble, you just get this narrowing in breadth. It happened in the late ’20s, it happened in 2021, it’s happening again now where this incremental retail flow is chasing narratives, creating rerating, which ultimately elevates these asset prices substantially versus their cash flows, so that at this point the cash flows need to surge just to validate those asset prices. And they might, but at the same time, the flows that created those asset prices are going to stop. You need to figure out what will stop those flows. In this case, it’s when the Fed expansion of the balance sheet then reverses, which is likely to happen in the second quarter, based on what’s been going on now.
And so that to me is a very clear example of understanding the behavior that’s supporting the asset and then figuring out what the core driver of that behavior is from a macro flow perspective. And we would do the same thing with the rest of the market. So, as an example, the broader EM universe, a lot of what drives it in terms of these big upswings that last for a while is the marginal flow coming in from foreigners. That flow is by and large a momentum seeking flow, if we’re talking about stocks. Obviously in the bond market, it’s a carry flow, which is its own form of momentum. But in stock markets, what happens is cross border flow essentially chases where assets have done well. And so what you tend to see in the early parts of upswings for EM assets, coming out of recessions, which are in volatile EMs, typically due to balance of payments challenges, what you see is; okay, you’ve got this asset, which is essentially running hot, economies running hot, the assets are expensive, the currencies are expensive, there’s a lot of reliance on ongoing foreign capital, there’s current account deficits, there’s fiscal deficits and so on. Foreigners decide, “All right, we don’t want any more of this stuff,” or there’s a global tightening or whatever, so this is EM in 2011.
Then that flow coming in slows and that sets in motion this whole sequence of events, which is predictable, and understandable, and timeable, which is this balance of payments crisis. So that flow stops happening, the currency falls, the rates go up, the fiscal tightens, the private credit creation contracts, the economy weakens, import spending goes down, then the current account closes. So in that case, the dominant thing that’s going to create a rebound in those assets is this gap, the foreign exodus of capital both stopping, but stopping because the economies have gone through this adjustment process to reduce the need for that capital.
So you had a supply imbalance of there’s a lot of need for investment into peso or whatever to finance this gap, and now all of a sudden the current account doesn’t exist, so foreign flows leaving doesn’t create as big of a problem. And just that delta inflow from abject selling to stability creates a huge rally. What ultimately happens is the currency stabilizes, that means inflation comes down, the rates can ease, the fiscal can ease, credit rebounds, growth rebounds. And so all those things ease liquidity domestically and that goes into those stocks. So that’s always the beginning of the equity rally coming out of recessions in these volatile emerging markets. And then once that happens, foreigners are over here, they see it going on, and eventually they start to respond to what are very powerful returns at the early parts of cycles, and they chase those returns.
So in terms of understanding where we are in that EM story today, we have not had the return of foreign investors to more volatile EM markets. Like, yes, Columbia’s done well, Brazil has done well, these places have outperformed places in Asia and so on, as you’d expect. But largely that’s because they did their adjustments and in the course of doing those adjustments, the U.S. bubble ending in 2021 stopped this withdrawal of capital out of those markets. At the same time, they then responded with asset cheapening. They hiked a lot, their currencies fell a lot. Their stocks were very low coming out of COVID. They did the adjustments that were needed to that withdrawal of capital. And we’re at that point where it’s just the impulse from foreign selling stopping, which has allowed these rebounds.
The next step is that foreigners chase that and you start to see flows pivot out of the U.S. or even just at the margin being allocated from Europe and the U.S., maybe not even with selling of their U.S. exposures, but just allocation of marginal investments into these EM assets. And at that point, when they start coming in, that then creates a surplus of flow coming into the assets relative to where it’s currently priced and you get a very sustainable rally and that’s what drives the mid-cycle of all of these equity rallies. And we’re not quite there yet, but I think we’re getting there, because we’re now getting to the point where foreigners are starting to notice, “Okay, the U.S. assets rebounded, because of the money printing. I think going forward that ends.” And so you get the next down wave again and this sideways, lost decade type dynamic. And so you’re setting up for asset performance differentials where the U.S. is relatively weak and all of these cyclical, distressed or high value markets elsewhere continue to do well. And that divergence creates this inflection and where people are thinking about allocating their marginal capital.
So that hasn’t happened yet, but that flow will be very powerful in terms of driving those markets. Also, because of the point you raised before, which is those markets are small, everybody left those markets and they shrunk a lot, and those assets cheapened a lot and the market caps are down and people are shutting Colombian ETFs and so on. So when they start to come back in, that’s a large flow in now what is a small market, so it makes the return of foreign capital pretty combustible on top of this acceleration in domestic liquidity and credit conditions.
Meb:
You mentioned a phrase on prior podcasts, which I forgot the other day, and I literally had to go back and listen to find it, this concept of Giffen goods and thinking of items that people become more interested as the price goes up. And I was thinking particularly on the foreign developed and emerging market indices that are market cap weighted, and I’m just thinking in my head about how much of the interest is driven by the U.S. being at all-time highs. And while some individual countries are, many of these foreign countries haven’t gone anywhere for a decade plus.
Whitney:
It’s just the demand for that sort of asset increasing with the price. You could think of gold sometimes as a Giffen good, but usually there’s some other causal driver that’s driving demand and the price up at the same time, usually currency debasement or inflation hedge flows or something like that. But as it relates stocks, it depends on the particular flow that’s driving the asset. But what is reliably true is that retail flows and cross-border flows are both almost through the cycle driven by trailing returns. And so that’s true in both of those cases. In the U.S., it’s retail setting the marginal price of the bubble, they’re reacting to the fact that we’ve had 10 years of stocks going up. It’s like a FOMO thing, and so they react to that trailing outperformance by allocating even more of their marginal savings to it.
And in the cross-border world, it’s like I just said, flows come out of the west and into EM after EM has done well. And by the time they come in, yes, this is mid-cycle usually, and there’s a lot of legs left to go until it gets overextended. And then it’s like Argentina 2019, where you’re at the opposite end of that, so much flow has come in that it’s created weird asset overpricings and over-reliance on that flow and expensive currencies and that kind of thing, and so that sets up the reversal. But the point is that those two flows are very reliably, through the cycle, a function of trailing returns. So that’s where the Giffen good behavior exists is in both retail flows and in cross border capital flows.
Meb:
I figured we’ll bounce around and ask a few questions here in a minute, but first we haven’t even touched on the big news today. You are joining us on the dark side, so from a long time being on the buy side and then publishing research, you’ll soon be launching a fund this spring. First of all, congratulations.
Whitney:
Thank you.
Meb:
And also, my condolences, depending on all the headaches and agony and ecstasy that go with being in charge of other people’s money. Tell us a little bit about what’s going on.
Whitney:
So you’re right. My whole career has been buy-side, running different hedge strategies, different places, including Soros and Bridgewater. I don’t particularly view it as agony. That’s where I’m very comfortable. We’ve got a process that we’ve built throughout my career, but which is somewhat systematic in nature and boring and we had five years in the advisory building, the infrastructure for the launch and the strategy and our tech stack and our IP and so on. When I left Bridgewater and we started working with CIOs in that capacity, we were constrained in terms of being able to run money, but it gave us a good incubation period to build all of that infrastructure. And from my perspective, I’m very excited just to get back to the core business of being behind the screens and understanding what’s going on and making sense of the world. And that’s the kind of stuff I really love to do.
Meb:
And so what’s on the menu? Is it long, short? Is it all assets? Are you looking at stocks, bonds, futures, swaps? What are you going to be getting into?
Whitney:
Yeah, so at the high level, global macro strategy with an emerging market bias, which from my perspective means top 35 countries in the world or so, the liquid markets, all of their macro assets. So six asset classes including financial subsector equities, but also currencies, sovereign bonds, short rates, sovereign credit, and quasi sovereign credit and equity indices and financial stocks. So what we do is, the thing that I’ve been alluding to before, which is we look for these disconnections around inflection points. So essentially, we’re trying to systematically understand what drives a given asset, a currency or a stock market, or something, through understanding the flows that drive the economy and the asset itself. We then look for these extremes and when the assets are disconnected from inflections in those drivers, so we’re trying to fade these extremes in asset pricing versus fundamentals that occur around unanticipated inflection points, both tops and bottoms.
And we do that in a way that leans into this high win rate of those trades and the asymmetry of those trades, but in a way that hedges out all beta, so it’s beta neutral, and then it essentially constructs a portfolio systematically in a way that weights diversification of those trades. So we’re trying to essentially engineer portfolio returns that are stable and do particularly well in market dislocations and downside, but which are comprised of a whole bunch of very uncorrelated individual alpha trades that are assembled in a way that makes the most of their diversification benefit relative to each other.
Meb:
Everyone loves to think in buckets. Where do they fit you in? Is it a discretionary macro bucket, or are you like the alpha juice over on the side next to there? I love how you say beta, because I say beta. It was like when we had Grantham on the podcast, how did he say REITs? R-E-I-Ts? He said it’s something that was really funny and endearing. Listeners, I’m the world’s worst at mispronouncing words, so I can’t even begin to give people a hard time, but okay, so where do they bucket you?
Whitney:
We’ve got a whole range of different types of LPs, whether it’s single family offices or CIO types that have been clients for a while or institutions and broad institutional allocators, and some of them are just very opportunity centric, so they just view things on a case by case basis. The institutional guys tend to put us into either, if they have a dedicated hedge fund bucket, or if they have an alts bucket. What I’ve noticed is that there is much more, at least within the hedge fund bucket, so leaving aside the PE or the VCs type stuff that they’re exposed to, at least within hedge fund buckets, there is a recognition that a lot of strategies are embedding a lot of beta and that ultimately if you want beta that belongs in one part of your portfolio and if you want alpha and diversification that belongs in your hedge fund bucket, and so I think there’s a little bit of that refinement in their process, which is helpful to us, but is also consistent with the kind of points that you were making before about in the past there was a lot of discretionary macro funds that were running really high vol with a lot of embedded beta and there wasn’t so much discernment of that when all assets were rising and there were these tailwinds to various different strategies and so on.
But discretionary macro that has embedded beta has been challenging for the same period that EM has been challenging as a beta asset over the last 10, 12 years, because if you think about what happened, macro vol was suppressed and price distortions happened, because of central bank printing. Things like short rate trading, you couldn’t really do, because rates were zero. So there’s a bunch of different factors behind that, but the allocation to macro in general has been falling and pretty low, and what macro people have, they seem to be taking a more discerning eye to making sure that it is alpha within their hedge fund buckets rather than having beta in both their beta buckets and their hedge fund buckets.
Meb:
That’s exciting. Best of luck to you. We’ll definitely touch base again post launch. Let’s jump around real quick. We’ll touch on a few different topics, spend a little time, long time on each. You mentioned gold briefly. It was a ways into the podcast. Gold’s been hanging out at these 2000 levels. It goes up, it goes down, but what your thoughts? You got any thoughts on the shiny metal?
Whitney:
It’s one of those things, because there’s a contingent of people that are always bullish gold and certainly from a portfolio, if you just wanted to think about a broad portfolio allocation for the long run, there is a role for gold within that. But thinking about it as an alpha trade, when it is actually most useful, it’s part of this broad bucket of inflation hedges, but inflation hedges come in different flavors. So you’ve got things like hedges to cyclical overheating, which is stuff like TIPS, which literally gives you protection against CPI. Okay, so that’s a good example of an inflation hedge that works under particular conditions, when it’s the economy that’s driving this overheating and that overheating showing up in consumer prices. Commodities are an inflation hedge in different ways at different points in the cycle, depending on what’s driving that economic overheating. And gold is most traditionally an inflation hedge specifically when inflation is driven by currency debasement.
What I think is interesting about gold, it is obviously related to real rates or at least perceptions of real rates in the same way that most inflation hedges are, i.e., when real rates rise or people perceive them to be rising or forward real rates are rising, even if ex post ones aren’t. Then people tactically trade inflation hedges around that, because the idea is obviously people extrapolate a rise in real yields through to choking off the inflation that these assets are supposed to protect. It’s interesting to me how resilient it’s been, because I think, number one, we’ve got inflation accelerating, but number two, there’s a mispricing of yields and short end rates in the U.S. that’s coming out of the market. In reaction to that, you’ve got this issue around real rates where I think priced in inflation will go up, but priced in yields will also go up. And so what happens to real rates is a function of the speed of those two things.
But in my view, you probably have some sideways movement in gold as that whole thing nets out. But ultimately, as the dollar weakness continues, my view is they will overdo it on the easing. They will over prioritize keeping assets high relative to choking off the economy, particularly because it’s a political year. And so in the process of doing that, when all of these diffs are set up to favor global assets over the U.S. assets, that people are already overexposed to, that that creates a lot of problems or potential problem for the dollar. Now, I don’t know how quickly that goes, but in general as that goes, that’s quite bullish for gold in particular as a form of inflation hedge. So, tactically don’t really have a strong view, because this real rate dynamic is ongoing and how that gets repriced and where to. But ultimately I think gold, it’s interesting how resilient it’s been at the highs here when I think it’s baking in or it’s reacting to that interesting observation, which is that the dollar has not been rallying with U.S. assets, which is a sea change from the entire first 12, 13 years of the bubble. And I think gold is starting to reflect that a little bit.
Meb:
I’d be curious to see what happens when it really starts to break out. If it breaks out, excuse me. Gold miners, man, they’ve been stuck in the doldrums for quite a while. Why are you picking fights with Larry Summers on Twitter? What was the origin of the topic there? What’s Larry been saying that sets you off?
Whitney:
So I think Larry has been by and large in the camp that looks at the flows and the strength of the income growth in the economy and looks at the nature of what actually drove the inflation and why it’s become entrenched. So there was this other camp that went, “Oh, it’s transitory, it’s going to go away, it’s supply chain disruptions and so on.” To me, that camp, which is not the Larry camp, represents the worst mistake of this narrative-based approach to thinking about the economy, which is you could easily check if that’s true. If the price increases are driven by supply constriction, then volumes would be going down, there would be less supply and prices would be going up, and that’s just how a supply shock works. But these folks who are thinking about COVID having supply disruptions and that being the driver of the inflation didn’t do that check, because had they done that, they would see that actually demand for everything was surging by, as I mentioned earlier, in goods 15 points versus pre-COVID levels, obviously services following on after reopening.
So this was a demand surge which was fiscally funded and supply valiantly tried to keep up with that, but just couldn’t. At that pace of expansion, it couldn’t. And so you got these price reactions to the limited availability of widgets, but not because supply was shrinking, because supply was trying to keep up with demand, which was being massively juiced by this combo of monetary and fiscal easing to excess in 2020.
And then ultimately what happened, so Larry’s saying this whole thing, which is the same thing we were saying and all of that made a lot of sense, and then he gave up last year. He was like, “Oh yeah, the inflation’s come down. The transitory people, they weren’t right, but maybe they were,” and he didn’t really follow through to try and understand why inflation has come down, whether it’s sustainable. Oh, interesting. Demand is still high even in goods, interesting. Supply hasn’t gone anywhere and yet the prices have come down, oh, maybe it’s because of foreign demand. There’s a set of mutually exhaustive hypotheses that you could put forward and then go and test to figure out why it is that marginal goods pricing came down. And he didn’t attempt to do that. So, I feel like recently he just threw his hands up and said, “Well, I still think it might be sticky or something, but I’m not sure why.” And from my perspective, that’s because he didn’t really persist with the line of questioning as to why.
Anyway, that was it. I don’t mean to pick fights on Twitter. Sometimes I think that maybe I have a bad habit of doing that. I don’t know. I’m more in agreement with him than not.
Meb:
Picking a fight, I’m being dramatic. It’s more of an academic debate we’re having. That’s the whole fun on this. It’s boring if you just come on and agree with everyone all the time. Which reminds me, if you sit down and Whitney’s at a table in Switzerland, or where do all the macro people hang out? Here in Los Angeles, New York City?
Whitney:
Yeah, Texas. There’s some in Texas, there’s some in New York now, Connecticut.
Meb:
And you’re hanging out with a bunch of macro folks, so your peers, professionals, what’s a view you hold, it could be a position, but really it trends more towards framework, but you can answer it any way you want, that you say this statement, say it on Twitter, and most, two thirds, 75%, let’s go 75% of your peers would not agree with you on? So, where you say this and the rest of the table just shakes their head, is there anything that comes to mind?
Whitney:
Probably the majority of things that we think are important other people don’t necessarily value at the same level of importance. So it’s a broad question, but I think one good example is the importance of listening to policymakers. That, generally in markets, whether it’s asset class specialists or equities or bond folks, whether it’s macro folks, there tends to be this desire to listen to what policymakers are saying. And I think that’s really a waste of time, because in my experience, whether it’s emerging markets, whether it’s the Fed today, whether it’s the pivot in the early part of last year, whether it was being late to tightening or whatever, two things are true. One is systematically short rates are never priced accurately, almost never. If you go back to post GFC, I’m sure you’ve seen that chart where everybody’s forecast for yields just kept going like this, but the actual yields just kept not moving, because we were in a de-leveraging and they’re extrapolating the previous cycle and so on. And now the opposite is true, where everyone keeps pricing in cuts in 2021, 2022, and 2023, these cuts get priced in and the reality is very different from that. And so it is generally the case that short rates are mispriced.
And then, it’s also generally the case that the Fed, just picking on them, because they’ve been I think the most egregious in terms of generating imbalances and so on, they are worse than the market. So, they generally forecast rates that are less accurate than the market. We know the market is very mispriced typically relative to what ultimately happens. And so if you listen to the Fed and what they think they’re going to do and their frameworks, and did Jay Powell have coffee before he spoke? All of this witchcraft, from my perspective, what you’re then leaning into is, let’s say the median market participants getting the trade wrong on rates and then they, for some reason, take information from the Fed, which systematically gets the trade even more wrong.
So if you listen to them, you’re leaning in the direction of more wrong than the median view already is rather than trying to anticipate; okay, what constraints are these people and players operating under? What balance sheet constraints do they have? What are their goals? What are their levers? And given their track record of behavior, what are they going to do in terms of when they actually hit this inflation constraint or when this systemic banking crisis happens, how are they going to react to that? It’s useful to understand their bias through time, but it is not useful to understand what any one particular policymaker is saying about what their near term actions are going to look like, because they don’t even know.
Meb:
So the old Greenspan briefcase. What was it, the Greenspan… What color was he wearing? What did people look for in the ’90s? I don’t even remember. But they used to really follow Greenspan on some of these signals, divining what could possibly be going on.
Whitney:
A lot of the cases, people have different trading strategies than us. People are typically trading assets through the cycle. People typically shy away from trading inflections, even though that’s a lot of where the alpha naturally lives, because they shy away from it. And so people are trying to do different things than us. And so part of it is this tactical trading strategy where maybe what Jay Powell says one week impacts prices that week or something like that, but generally speaking turns out that he has no greater ability to forecast and actually has a worse ability to forecast rate trajectories than the market at large. So I think part of it’s that, but also that’s just a difference in how different people try to make alpha through time.
Meb:
You consume, like I do, a lot of financial history. What are some either good resources, either current, or books, or podcasts, or things you’ve been reading lately that you think, or just in general, that are particularly wonderful?
Whitney:
I find that to be a tough question, because I do definitely consume a lot of history, but I try to do that empirically. So what I’ll do is try to figure out; what is a particular dynamic going on today? All right, maybe it’s an inflationary recession, maybe it’s an erosion of wealth or a sideways bubble deflation, whatever it might be. The chances are that we’ve seen it before somewhere at some point in time and probably many times before. The example I always give of this is the balance of payment cycle and the crisis and the adjustment process and all that, we’ve seen it like 50, 60 times even in the last 20 years in liquid markets. And so what I’ll try to do is go back to really contemporaneous accounts of what’s going on at the time. So I’ll go back into news archives and into historical magazines that were published in the ’20s or ’30s or whatever it might be, and try to figure out what was driving people’s behavior and sentiment and therefore their flows at the time, so that I can create patterns that drive different, let’s say, inflection dynamics or phenomena that go on that are a function of flows.
So there’s a lot of that, and you can get a lot of that by reading things like Lord of Finance and these sorts of books that really hone in on a particular decade or a particular challenging time. But I just find that going back and trying to study the extremes in economic conditions and market conditions contemporaneously tells you what participants were getting wrong at that time.
Meb:
Well, you were talking about the big bond drawdown of, what was it, 1880?
Whitney:
The late 1860s, yeah.
Meb:
1860s, which it’s odd to me, I think if we were watching CNBC and stocks were down by half, which is roughly where the long bond is, particularly after inflation, people would be losing their mind. But it’s odd that the bond investors, and I don’t know if this is more of a retail phenomenon or what, but it’s not that they don’t seem to mind, maybe they don’t even know. The responses I get on Twitter are always curious. They’re like, “Well, I’ll get my money back in 20 years or 30 years.” I say, “Well, that’s not really how this works.”
Whitney:
No, there’s a different nature of the balance sheets that tend to hold bonds, which is that they tend to be held as locked in, long duration cashflow streams that hedge a particular liability. The idea is if you’re a life insurance company, or a pension, or whatever, if you just buy and hold a bond, the return on that bond is the yield that you buy it at. As long as you don’t have a liability mismatch, you don’t really have to think about the mark to market of it. That’s the behavior of a lot of bond investors.
There are other folks, like the Japanese banks, who’ve bought a ton of U.S. duration, because of QE and very low spreads and rates in their own country, and they’ve wanted to play this both the carry and the basis of the currency risk. And so they’ve got these huge duration positions which are hedged on a currency basis at the short end. And so now they’ve got an inverted curve. They can’t hedge, it’s negative carry. The bonds are down 20%. They started out three times more levered than Silicon Valley Bank, and they’ve got problems. And their regulator is coming and saying, “Trim that position.”
So, it’s not always the case that bond folks have that bias, but a lot of them do. And the other point is, bear in mind, this is not the case today, but historically there was some central bank buying U.S. bonds in pretty much every year for the last 40 years, whether it was a foreign reserve target or whether it was the Fed itself, there is a disproportionate amount of price and sensitive flow that’s going into bonds and has been going into bonds, and that’s part of why the drawdown was so steep was that flow stopped. So that’s been a big source of it as well.
But for private players like pensions and nominal return targeters, long-term horizon investors, they have this issue where, since the early ’90s, bonds have been negatively correlated to stocks and so they’ve held a lot of bonds to cushion their downside, but that was a flukish environment, which doesn’t exist anymore. Now, money up, money down is driving bonds up and stocks up and bonds down and stocks down together, so that correlation’s over. That’s a fundamental problem in terms of the structure of a lot of balance sheets today, particularly because those liabilities are coming due with the demographic profile.
So, this is why I think we structurally have an issue around bond demand, regardless of the nature of the holders in the past, just based on who has capacity to buy incremental bonds now, when we’re, okay, we’re issuing bills, but at some point we’ve got to switch to issuing actual duration bonds if we’re going to keep running this huge fiscal deficit. So, I think the market’s already shown you when they tried to do that in the first half of 2023, okay, it’s a banking crisis, the short end is pricing this huge shock, and yet the yields didn’t go down. We put out a note at the time; have you noticed that the yields aren’t going down? There is no demand for any marginal duration supply, which is why they were forced to switch to bills. So there’s a bunch of structural and tactical problems around bond demand supply.
Meb:
When you think of the term, even credit, some of these traditional spread products normalize, we still have this somewhat odd yield curve. Is that something that you think resolves sooner than later, or are we going to be in this weird fixed income environment for a while?
Whitney:
This is a good example of the type of framework or heuristic that has now gone stale. People thought, “Okay, there’s an inverted curve and for the last 30 years that’s meant there will be a recession, so therefore there’s going to be a U.S. hard landing.” And that’s by and large the mistake that a lot of people made in 2023. What that actually was, this negative yield curve, it was frankly what emerging market investors have seen many times, which was the central bank distorting the price of the long end while trying to hike the short end to deal with inflation. That dynamic happens at the tail end of balance of payments crises usually.
So there’s just things like that that are rules that people have lived by, these bond stock correlations, the yield curve dynamics, that could mean many other things depending on macro environments, and yet, which people are not quite used to navigating what the changing interpretations of these things are. So from my perspective, you’d expect the long end to essentially blow out a little bit, particularly when they start issuing more duration. However, you also know, as soon as that happens, there’s going to be some backup and then the yield will be capped by the fact that the central bank will come back in and take up or provide incremental balance sheet, like they did with the BTFP, for that supply.
So it’s a weird trade and there’s a limited movement in yields that will be tolerated. But the problem is when they get to the point where they’re trying to suppress that move, and when they do that it creates currency weakness, that is going to be a problem, because that’s the ultimate constraint to their ability to do that. But in the near term, I think that as we start to see yields blow out again, and the yield curve steepen coming out of this, which is normal in an inflationary late cycle, externally dependent in the macro environment, that ultimately that has consequences for the currency. If you keep the yields below what the market wants to pay for them, then the foreigners will leave first, and that will impact the currency. It will constrain your ability to sustain that mispricing.
Meb:
Awesome. Whitney, if people want to get in touch, check out your research, what is the best place to find you?
Whitney:
I’m on Twitter, I’m on LinkedIn, but you can shoot us an email at [email protected].
Meb:
Awesome. Whitney, thanks so much for joining us again.
Whitney:
Of course. Thanks for having me, Meb. Anytime.
