ASH BENNINGTON: Welcome to Real Vision Daily Briefing. It's Thursday, June 30, 2022. I'm Ash Bennington, joined today by Tavi Costa, partner and portfolio manager at Crescat Capital. Tavi, welcome.

TAVI COSTA: Hi, Ash. Thanks for having me.

ASH BENNINGTON: It's a pleasure to have you here. Let's take a look at the closing numbers on the day. It looks like the NASDAQ is off about 1.33%, bouncing around now around the 11,000 level as we close out for the day. S&P 500 off a little under 1%. Dow Jones Industrial Average off 0.9%. Tavi, obviously, lots to talk about. You can see it right there on the tin on the title of the show talking about stagflation. I was just reading on Bloomberg, we are now off to the worst start of the year, worst H1, first half since 1970. A truly staggering statistic.

TAVI COSTA: Yeah, this is old fashioned bear market looks like to me, it's we're coming off. So, really extreme valuations in equity markets overall. In my opinion, the macro imbalances are severe as far as prices. And finally, we're seeing now this lack of liquidity starting to really rerate those valuations at much lower prices. And so, this is a very different environment than what we saw.

Remember the days when people used to say inflation's positive for equity markets, but it certainly hasn't been the case here with cost of capital rising, it's difficult to justify very large multiples in equity markets. So, I think there's a lot more to go personally, and I think this is an old-fashioned type of bear market. And so, growth to value transition. There's a lot going on in equity markets right now.

ASH BENNINGTON: Yeah, it's also an old-fashioned macro environment, you said it really well there. Lots of moving parts to this, we should say out today, Fed's preferred measure of inflation, core PCE, 4.7% in May. Obviously, this is the dial that they watch most closely. So, you have rising inflation. You've got this recessionary headwind coming in terms of contraction of growth in Q1 2022. And now, we try and game this all out. It certainly looks like there's a rising risk of a stagflationary environment.

TAVI COSTA: Yeah, every article in the last six months or so had been all about inflation. I think we're yet to see the new narrative is probably going to be this demand falling off a cliff. And by cliff, I mean we're at record earnings right now still in the equity markets. And it's hard to believe the consumer is not going to get hit over time here. And so, this is a narrative at play now, it's still getting priced in the markets. And I think there's a lot more to go.

Cost of living is historically elevated, you got mortgage rates moving to levels and doubling just in the last six months, which should also be a hit on consumers. Savings rates now are somewhere close to below 4%. They were close to 30% relative to disposable income not too long ago with the government boost that we saw. And so, it this is a very different environment. even wages now in real terms are collapsing. They've been collapsing for some time, and so now we're seeing this divergence, which we've had in our ladder, maybe you guys can show this chart. It's a divergence between consumer sentiment relative to corporate earnings. And so, the next shoe to drop should be corporate earnings and you have to start thinking about what's the implication of that in overall markets as we get there.

ASH BENNINGTON: Yeah. Obviously, a lot of moving parts here. One of the things that really struck me yesterday was Chair Powell's remarks when he appeared with Madame Lagarde of the ECB to talk about Central Bank policy. Obviously, there's a lot of nuance to the way that Fed chairs discussed this. But to me, the message was that he was delivering was very clear it was, damn the torpedoes, full speed ahead, we're going to tighten, we're going to reduce this balance sheet. The dangers that we face on the inflationary front we've joked about it here on the show before the drinking game, whenever we mentioned the Scylla and Charybdis, take a drink, but this idea that the Fed is really trapped now between these two mutually exclusive problematic scenarios. The Fed is meant to have this leeway with the dual mandate, maximum employment, stable prices to try and optimize for one of those variables at a time. But when they both go off the rails simultaneously, you see this risk that we see in markets today.

Chair Powell, I thought yesterday, at least in my interpretation of his remarks, saying, we don't care, we're going to cause pain if it means we can reduce, we just have to reduce this inflation. We're okay with letting more recessionary headwinds develop. We're okay with, I think it's probably reasonable to say, to see some asset price declines in the process. How do you think about it? Obviously, it's a complex scenario, how do you balance out both sides of the ledger, so to speak?

TAVI COSTA: Well, I think the Fed made a major mistake, obviously, in hindsight in 2021, by not looking at leading indicators for inflation at the time. And now, it's about to make another mistake, which is the Fed can commit to the tightening cycle here as long as unemployment rates and labor markets still deteriorate further. But that's a lagging indicator. We all know unemployment rate is a lagging indicator.

And so, what they should be looking at is on the consumer side, because as we see that falling apart, we know companies are not doing very well. You got the rising cost of capital, you have the wage pressure, you have even the raw material prices is still historically elevated. So, they're getting squeezed on their margins. At some point, that should also lead to higher unemployment rates. But that's, again, that's a lagging indicator. Once that happens, they're going to start moving again, and reacting accordingly. But that's going to be too late one more time.

And so, we know that, and so I think we should start thinking about what's the peak tightening cycle here. And I don't think we're too far from that personally. I think the issues in the economy are so large that it's hard to believe we're not going to see something really break here. And we're already seeing it. Look at small cap companies, the crypto markets, technology companies, Ark ETF, everything that was doing very well in the last 12 months has completely collapsed.

And so, I it's hard to believe we're not going to see a major change in labor markets and technology itself, it's one of the largest parts of the economy today. There's about 10% of technology companies actually above the 200-day moving average right now. And this is pretty much near record lows. And then you may think, well, is this the final part of the bear market here? I don't think so.

This is just the beginning, things are coming off so much in terms of valuations historically. It's still the retesting of what we saw back in the tech bubble of 2000. And so, in my opinion, I'm very focused on labor markets, because I think that's what's going to be starting to cause the Federal Reserve to change the narrative as we get into the later parts of the year.

ASH BENNINGTON: I wanted to double click on something you said there that I thought was very important. By the way, for folks who are relatively new to the macro space, you've got leading indicators that precede a movement, you've got coincident indicators that happen at the same time, and you've got lagging indicators that occur afterward. This is one of the things that we talk about, or that you hear said, when you hear folks say the Fed is behind the curve. They're behind the curve, because you see the inflation rising before they begin to tighten.

You were suggesting that they weren't looking at the leading indicators at the time, as inflation was beginning to build up in the system, as price pressures were starting to increase to the upside. Tavi, where are we right now in terms of leading indicators of inflation? And what do you see that suggests potentially the directionality of price pressure?

TAVI COSTA: So, just to set the record straight, I'm in inflation camp. So, I do think we're entering an inflationary environment. But I think we've seen most of the first wave of inflation. Inflation like the 1970s, we've seen three waves. And so, I can change my view regarding, let's say, geopolitics change, and if things really deteriorate in places like Russia and Ukraine, I think you should readjust your views as well. But as of today, I think certainly we're seeing a lot of deceleration on the inflation front.

Look at commodities, a majority of commodities are down significantly. Base metals are down a very large percentage over, some of them double digits already. Nat gas down somewhere close to 50% today, it's over 40% from its peak. Oil prices down significantly as well. We haven't seen yet things like gas-- gasoline prices are still very high. They came off about 15 cents but still up about a $1.50 cents all the way back to a year to date.

So, there's still a lot of issues when it comes to inflation being historically elevated. But the growth of it certainly decelerating and maybe that's what's causing 10Y yields to have moved the way they have been moving, which has been in a decline more recently in the last few days of this reaction in equity markets. So, again, I do think structurally, the inflation story is here to stay. There are a lot of pillars in the inflation side.

The wages growth is probably at the very beginning early innings. I think we're going to continue to see that pressure from consumers to earn more capital from their employers. We're also going to see the issues with capex not get reversed anytime soon from the natural resource companies. I don't think we're going to see the end of fiscal stimulus. And then the fourth one, which is even more important, I don't think we're at the end of the geopolitical problems, I think we're at the very beginning of one.

And so, those trends should still support the inflationary narrative over the long term. But as you asked the question, short term, I think we're seeing the deceleration of that, and maybe we've seen most of the first wave of it.

ASH BENNINGTON: Yeah, lots of important points there. We should say WTI, the West Texas Intermediate, this is the US price of oil on the day, off about 3.5% closing out at 105.94. This rollover really began in the in the second week of June, down from about 120 plus, 122 I think, near the high there. But as you said, also the gasoline price thing, not purely just a story in terms of the cost of inputs, there's also a whole refining capacity distribution play that happens with gasoline in case you're wondering why you see oil prices and gasoline prices not necessarily moving in the same direction.

TAVI COSTA: Yeah, and I would say the first part of the inflation, you have companies being able to pass that on to the consumer, and then as cost of living starts to rise, you can start seeing the pressure from the consumer to earn more capital. That's when you see the reversal of this wages and salaries growth that we've seen, I would say it started really in the middle part of 2021, started really intensifying. And that's when earnings is starting to decelerate.

So, companies start to get a little squeezed because the raw materials that are not able to pass that on to the consumer as much anymore. And you start seeing cost of capital rising too. So, that starts to be squeezed the margins and then on top of it, now, we're at a phase which I think is the most dangerous one, which is when the consumer demand falls apart, too. So, that's another part for corporate earnings.

And so, again, I'm very focused on the leading side of this. And so, the corporate earnings, in my opinion, is very likely to contract significantly from here and guess what? Wall Street analysts are still predicting or suggesting that earnings are going to grow about 15% this year, 20% plus in a second year, and 35% in three years from now. I think there's no way we're going to see that. So, I actually think we're going to see a significant contraction, similar to what we saw in the late 1960s, beginning of 1970s, in the first wave of inflation too.

ASH BENNINGTON: Yeah, to pick up on another datapoint from some points that you just touched on there, consumer spending slowing, decelerating rate of gain up to May 0.2%. This is from a revised 0.6% increase in April, the lowest gain of the year. So, you can see that cooling process, that deceleration, that compression of the second derivative.

TAVI COSTA: Yeah, I think though, the big story is that analysts and investors are finally starting talking about nominal versus real. And I actually think we're going to see nominal contraction in demand. So, this, obviously, with real terms is going to be even worse. So, there is a big case that I believe in real terms, we're probably in a recession already this quarter. And so, it's hard to believe the Fed will be able to do what they're saying in the following years.

But it's also hard to make a bet on the Treasury market if you see Fed Funds Rate already pricing a 60-basis point decline in Fed Funds Rate by 2023, December. And so, in my opinion, they're better vehicles to perhaps play that catch up from the Federal Reserve as you see labor markets begin to deteriorate.

ASH BENNINGTON: Yeah, excellent points there, Tavi. This is that Scylla and Charybdis, the rock and the hard place the Fed is between right now. Talking of which, I wanted to take a look at a conversation that I had with Hari Krishnan out today on the Real Vision platform on Essential, Plus and Pro that speaks to precisely that point. Let's take a look.

HARI KRISHNAN: It may be that the Fed cannot solve this problem. So, if I lay it out as a proper mathematical formulation, it may be that there is no solution. There was a solution when inflation was low, and growth needed to be pumped. Now, there's no solution, because inflation is high, growth cannot be trashed too badly, and growth gets hit first.

The second point is from a training standpoint, how do you move back and forth between betting on Fed hikes and Fed pauses? I think this is a contrarian environment. Over what horizon can be debated. I think over a multi-month horizons, we're in a contrarian environment where the Fed will try and react in a way that's probably a little bit behind the curve to whatever's going on in relative to the inflation picture, the leading indicator picture which of course includes the shape of the yield curve, and the S&P among other things.

And so, what you're going to see is the drunken sailor outcome at this point, which is the drunken sailor's trying to get back to his hotel. And he either walks too far to the left or too far to the right, try to just walk in a straight line and I think the lags-- what lags really do, and this is the crucial point, is that they induce oscillations. If the lags are pretty pernicious, if they're bad, they induce overreactions in two directions. And I think that's what we're facing in the short to medium term.

ASH BENNINGTON: Some disconcerting points there from my conversation with Hari Krishnan out today on Real Vision Plus, Pro and Essential tier. I should say, in the way of full disclosure, Hari and I are old friends. We wrote a book together called Market Tremors talking about some of the challenges we had in the last cycle that continue into this cycle.

What's interesting to me about that clip, Tavi, is the context that Hari is coming from on this. Hari is a gentleman who has a PhD in Mathematics and Chaos Theory. He's looking at this from the perspective of control theory, a 1970s, 1980s framework for thinking about how complex systems work. And essentially, what he's saying is as a mathematician, as a mathematician, there's no solution for this equation that makes sense for managing both the sides of the dual mandate for inflation, and maximum employment. A pretty grim assessment really, from Hari Krishnan.

TAVI COSTA: Yeah, this environment requires a disinflationary environment for things to not completely break apart. And to me, and by the way, those are very valid points that he was saying, and that I think we're facing a trifecta of macro imbalances. We have the debt problem that we saw back in the 1940s just as extreme in terms of the government debt. We're facing the inflation problem of the 1970s in my view, with wages and growth spiral type of movement.

And the third one, in my opinion, is this valuation of the late 1990s, in the late 2000s. And so, those three really constrained policymakers from doing much. And so, any real deceleration of growth or contraction of growth, which I think we're about to see in the next six months, should cause the Fed to actually reverse its policy. And I think that that's the whole story for inflation, in my opinion, is the fact that that's the only way out, in my view.

And so, I think this is just the way to look at things, how they're going to develop themselves a lot more persistently when it comes to cost of goods and services over time, given the effect of those structural imbalances in those pillars of inflation that I was referring to earlier.

ASH BENNINGTON: Yeah. Tavi, we've got questions coming in red hot now, a whole list of them. What do you say we hit some of those and talk a little bit about what some of the viewers are asking, because there's some really good questions coming in?

TAVI COSTA: Let's do it.

ASH BENNINGTON: So, first one comes to us from [?], a longtime viewer of ours here at Real Vision Daily Briefing through The Exchange, this is Real Vision's internal social media network. And the question is, hi, how do you see upcoming midterm elections affecting the stock market if at all, Tavi?

TAVI COSTA: I think we're about to see a shift in politics leadership in a large way, inflation usually causes those shifts. I come from an emerging market, and I've seen those many times. Every time you see growth in inflation, usually, you tend to see changes in leadership. So, I think we're about to see one of those, but I'm not sure it's going to be as critical to equity markets and markets in general as a lot of people will. If anything, it could actually be a net positive from the market perspective side.

But I do think that the imbalances, again, are too large, as we hit a recession here, as we hit a downturn, it's hard to believe we're not going to see, for instance, deficits increasing. In average, all the way back to the 1970s, deficits relative to GDP increase about six percentage points in every recession that we had. And so, it's hard