MAGGIE LAKE: Hello, welcome to the Real Vision Daily Briefing. It's December 6th, 2021. I'm Maggie Lake, and here with me today is Alfonso Peccatiello, former head of a $20 billion investment portfolio and author of The Macro Compass newsletter on Substack. Alfonso, welcome back.
ALFONSO PECCATIELLO: Is it old now to say that Alfonso is back?
MAGGIE LAKE: It's not. That's the banner of the day. Alfonso and I actually spoke earlier on Real Vision. Some of you may have had a chance to catch up on that. We took a big picture look at the macro environment and how to position your portfolio as we head into 2022. We had so much to cover, he was kind enough to come back and join us for the Daily Briefing today, where we're going to pull the timeframe in, I think just a little bit now and talk about maybe navigating these markets right now.
Once again, feel free to drop your questions in the chat and we will get to as many as we can. It's a great day to be talking. Today, we saw a big bounce back in US equities, the S&P 500, NASDAQ, Russell all up between one and a little over 2% easing a little bit off those highs as we get to the close. The VIX easing back, the 10 Year Treasury yield edging up, it's still at 1.43%. Still pretty flat yield curve, and Bitcoin up well of those recent highs.
Let's start with the picture for US equities. We've been really seeing the swings ever since Powell came out and gave that testimony indicating they were going to speed up the taper. Does the rally today seem sustainable? What's your view as you're looking at stocks?
ALFONSO PECCATIELLO: Well, today's one of these days where it's all cheerful and it's risk-on. Maybe it feeds into the narrative that this time is different, but it's not. Let's talk about the equity market first and get into the business. If you're an equity investor, most of you guys will have stocks in your portfolio.
Your total return prospects for the next few years are actually dictated by three things, the dividend yield you bought at the beginning and the earning per share that will be realized or you expect from this stream of cash flows by owning the stock in a company, and how much do you pay for the stream of earnings, so that's the price to earnings. Those are the three most important component and as dividend yields today is pretty low, they explained not much of the return of stocks basically.
We can focus on earnings per share and price earnings. This chart that I pulled up from today's edition of The Macro Compass, which is my free newsletter on Substack is basically showing how the funk 12 months forward PE, so the valuations basically 12 months forward. They are inverted in this chart, and they're depicted in orange and how they correlate very well with real yields in the US. The story there is as real yields drop, then valuations of the tech side the most, let's say valuation intensive part of the stock market actually go up.
If you invert valuations, you will see a pretty good correlation between valuations and real yields. Now, as the relationship has held for long, one has to question the direction of real yields first to get an understanding of where valuations are going. Valuations are obviously something that is relative. If you're an investor, you have the equity market, but also you have the bond market, you have commodities, your real estate, you have cash as an alternative.
You will always be looking for places to effectively invest where it's most convenient on a relative basis. If your risk-free real interest rate actually goes up from here, then it becomes less punitive for you to allocate some of your money into short term cash. It happens to be that my view on real interest rates from here is that they're going to gently go up as the Federal Reserve has pivoted, and it's effectively trying to steam down inflationary pressures, move up nominal yields, get out of the zero lower bound.
As they reduce inflationary pressure, and the labor market heels, they allow real purchasing power of Americans to go up which fits very well into Biden's agenda of getting effectively, the House and the Senate again in the midterm November 2022 elections.
MAGGIE LAKE: If you have that scenario, what does it mean for the economy?
ALFONSO PECCATIELLO: Yeah, the economic forces are, I always think you need to split them between structural forces and cyclical forces. From a structural perspective, basically, things haven't changed much. At the end of the day, the structural drivers of the economy are the labor supply growth, how productive is this labor supply growth and how productive is this capital that flows into the economy?
Those are the two main drivers and the labor supply growth isn't getting anywhere as basically birth rates are dropping, and the demographics is something you can't fight about as I explained in my newsletter today. The productivity of the labor force is also not going anywhere. You might argue that the economy's got an overhang of debt, private and public debt that also weighs on long term nominal growth as also the technological advances weigh on that perspective.
On the cyclical side, though, there are some times upswings like the ones we have seen, the animal spirits that we have seen throughout 2021 with vaccination, fiscal stimulus, the credit rush from 2020 feeding into 2021 economic upside. If I look at the animal spirits, they're definitely fading away, as well indicated me by my proprietary metric, the credit impulse that tends to explain and predict very well both asset performances, and soft and hard economic indicators.
Because, guys, at the end of the day, credit creation is what matters for the cyclical upswing recovery together with the labor market. Credit creation has decelerated from the last quarter of 2020 all the way into 2021. That normally doesn't bode well for real economic growth heading into the end of 2021 and the beginning of 2022, as the private sector does not have a fresh injection of newly created money, either from banks, they are not lending, or from the government, which is not injecting on a net basis, new stimulus into the private sector.
The labor market, on the other hand, is healing slowly but surely, which should provide a little bit of a tailwind to the story that only know the cyclical upswing and the narrative that this is going to be a crack up nominal growth boom is actually fading away and so are asset classes that are trading according to the secular trends over the last few months and not to the crack up boom narrative that was prevailing.
MAGGIE LAKE: This is so important. Let's break down a little bit this asset classes that do well in the quadrant, but this is an important point that we talked about earlier. When you say you watch credit as new money coming into the economy, and you say the banks aren't lending, the government right now is not or is at least pulling back at the extraordinary measures that they took earlier, the support that came earlier in the year.
A lot of people get confused and look at the Federal Reserve and say they're super accommodative. Yes, they're tapering, but they're still buying. You say that is not money going into the economy. That's a misunderstood concept.
ALFONSO PECCATIELLO: Absolutely, yes. The creator of money in our monetary system and credit system are commercial banks and the government. The Federal Reserve can expand their balance sheet to accommodate the process, the Federal Reserve as any other central bank can. We can talk about that accommodation later on but let's focus back again to the fact that the creator of money in our system are commercial banks and the government.
Every time a commercial bank makes a loan, it creates money out of thin air, does not use reserves, it does not use deposits, that's false. It's empirically proven to be false. Every time a bank makes a loan, the asset side of the bank goes up and new deposit as well as created as a result of the loan, which is created, this deposit will end up somewhere else in the banking system or in an aggregated system, it will end up at the same bank.
The main concept is credit creation happens when a new loan is made or happens when the government decides to inject new resources into the private sector via net deficits or just print fiscal stimulus and does not intend to tax those back to basically deprive the private sector from those resources later on. Those resources tend to basically be stuck in the private sector. Those are the two ways to create money.
In 2020, we have created a lot of money, not the Fed, not the ECB, not the BOJ, but the governments have done so and the banks have done so because the governments were guaranteeing the credit risk of loans, then basically, banks were lending out almost without credit risk. In 2020, we have seen an explosion in credit impulse, my metric went through the roof, I've never seen something like that in such a short time.
Guess what? A few months later, if you allow a little bit of lag, all the assets that are on the right side of this compass, so in quadrant two and quadrant three, went through the roof. Basically, you add all the emerging market FX overperforming the dollar. You have the dollar tanking cyclical stocks to the roof, copper, all the industrial commodities you can think of, overperforming growth stocks, so the NASDAQ sorts of things were actually doing pretty okay, but not as much as the high beta real economy things that actually get the boost out of credit creation that feeds into earnings, feeds into nominal activity, gets into this animal spirit and also, it's reflected in asset allocation.
Fast forward to today, this credit creation has decelerated pretty aggressively. Banks are not lending that much on net basis, the government hasn't released another huge pressure on the fiscal stimulus into the economy. What matters here is the impulse, so not the direction but the acceleration or deceleration of this credit creation. The system is created anyway to always increase credit. We increase leverage, we increase the amount of debt in the system, that's how the system is built.
How quick or how slow we do that leads to a stronger or a lower impulse, and at the moment, we are in the left side of the quadrant where the impulse is actually pretty low. It has been lower since the end of last year and that's why since May 2021, we find ourselves in the left side of the quadrant and in the upper left side of the quadrant
MAGGIE LAKE: Yes, but you are here, red dot, right?
ALFONSO PECCATIELLO: Yes, May 2021 to now. Interestingly, May 21, everyone's still screaming that Treasury yields will close the year at 2.5% or 3%. Jamie Dimon said it was 4% or whatever he wanted it to be but ultimately, my credit creation model was already telling me that was not to be the case.
Also, the relative monetary policy stance is the other metric we use. So yes, guys, central banks matter. They accommodate this process. They basically are able to switch the asset side of the private sector from an amount of assets to a lesser amount of assets and more amount of bank reserves and bank deposits. That's exactly QE.
They take the amount of bonds away from the balance sheet of a bank or a pension fund or an asset manager, and now this private sector entity finds themselves with less bonds, and more reserves if it's a bank, or bank deposits if it's an asset manager and a pension fund. Those bank deposits from a pension fund can't get into the real economy. The only thing they can be allowed to be transformed into is regulatory allowed assets, both for banks and for pension funds.
Most of the times that's bonds again, so as you can see, they get stuck into a financial system and as banks don't lend reserves, these reserves have zero correlation with bank net lending. Japan is the perfect experience. The BOJ balance sheet went through the roof in the 1990s and the amount of bank reserves in the system was increasing 20%, 30% of a span of like 5 to 10 years. The amount of bank loans was decreasing by the same amount.
MAGGIE LAKE: We've seen this play out, and that is the fear of folks like us who have been watching this, that we are in this trend where the US and Europe and the developed world is following that playbook or they can't get out of it anyway.
We have a question from Bo, which you've already answered but I'm going to just tack on something to that aren't, the 6% to 8% swings in the 10 Year Treasury, a red flag for this market. I guess is the long end reacting to that macro picture that you just pointed out while we see the short-term reacting to the change, that unexpected change coming from the Fed?
ALFONSO PECCATIELLO: Yeah. Guys, the master macro trade since summer this year has been a flatter yield curve in the US, in America, but in the US, it's been very, very strong. I pointed this out in The Macro Compass newsletter right in the summer. When you get this low in credit impulse, that anticipates basically a slower economic impulse as well with a bit of a lag but at the same time, you got the Federal Reserve and other central banks that are keen on getting away from this top accommodation levels.
Then you will have the front end of the bond market that actually rises up. It has to reprice a hiking cycle and the risk premium that this hiking cycle will be faster or sooner than what they expected before. From then, yields actually tend to go up but the long end of the bond market works in a completely different way. The long end of the bond market is much more influenced by long term nominal growth perspective.
That's basically real growth and inflation expectation and there is a term premium attached to that as well, but if you as a central bank is tightening during a slowdown of credit creation and economic growth anyway, you are going to only accelerate the return back to the secular trends that drive the long end of the bond market and the yields reflected there and you're going to reduce the uncertainty around what is the future outcome for this very long end bond yields and long-term nominal growth.
You're going to reduce this outcome and you're going to reduce this uncertainty and bring the outcome to one basically central outcome which is long term nominal growth is going to remain to be poor over the next 20 to 30 years, therefore owners of long-term bonds can actually demand a less premium to own these bonds and yields can be allowed to drop. The yield curve flattens at that point pretty aggressively, which is completely counterintuitive to the narrative that the Fed is behind the curve, inflation is going to run away, bond yields have to be at 10%, the bond market is peaking pretty loud, guys, since the last six months.
MAGGIE LAKE: With a flat yield curve or flattening yield curve, what does that mean for stocks? We still have people forecasting gains in stocks eat through the yearend and then also into next year, can the stock market rally when the long end of the bond market's telling you that there's suboptimal growth?
ALFONSO PECCATIELLO: There are different sectors in the stock market, so it's hard to make one full assessment but if I had to try, then as I was saying before, the valuation side of it, that's the real interest rates at the short end, tend to reprice a little bit up. Nominal yields go up, inflation expectations probably are tamed by the tightening intervention of central banks, and the base effect's kicking in any way, you have these real yields going up.
Valuations, it's hard to foresee that they can go to the moon from where we are. Then you have the earnings per share. You have the earnings growth. Then there, the consensus forecast for 2022 in the S&P earnings growth is something about 8% year-on-year. In 2023, it's something about 10% year-on-year. If you think about these numbers, they are still relatively optimistic.
They basically foresee a slightly above trend nominal growth for the US economy in 2022 and 2023. From what I see happening on the credit impulse perspective, I'm not so sure that ultimately, we'll have such a rosy above trend nominal growth next year. Maybe earnings per share can disappoint a tiny bit, but if you come back to the interaction with the bond market, then in a situation where nominal growth is occasionally nothing ridiculously good and for sure over the long term, you don't have this crack up boom nominal growth narrative playing true, then you rather have to go back to the secular trends where you prefer growth stocks over value stocks, you prefer developed market stocks over emerging market stocks.
This is a trend we have seen over the last 20 years. It's there for a reason and I don't think anything structural has changed to move the needle there.
MAGGIE LAKE: It sounds like you're saying we are remaining quadrant one. Christopher, and you can correct me if I'm wrong, Christopher is asking on the site, the difference in quadrant one-- that's hard for me to say today. The difference between EM stocks and EM equities if there is-- yeah, I think he's looking at emerging markets. In long, I think it says EM stocks, and then short, it says EM equities. I don't know. Is it certain ones are high beta. It looks like it's in both.
ALFONSO PECCATIELLO: I'm not sure if I'm missing something in the question. Sorry, I can't follow up.
MAGGIE LAKE: That's okay. Christopher, we'll pick that up with you afterwards. In the meantime, I want to switch to-- we're getting a question as well to talk about Bitcoin. We've seen that really, pullback, we're up to here but we're well off the highs.
There's been a lot of frustration, Jim Bianco and I were talking yesterday, saying he was frustrated that it's moving in correlation with risk assets when the idea was that it was going to be a hedge to risk assets. What do you see happening in the Bitcoin market, and why do you suppose that is?
ALFONSO PECCATIELLO: Okay. The reason why I laughed, Maggie, is that Bitcoin is an extremely complicated topic. It attracts a huge polarization in discussion. It isn't worth zero, it's useless. It has to go to zero or it's the ultimate hedge to any risk assets. It's the superior pristine collateral, we're going to the Bitcoin Standard.
This maximalism, I think it doesn't help the discussion over digital assets, which will be pretty important, I think, are here to stay over the next decade as they fit into a digital revolution effectively, we are witnessing and they are probably here to stay but I don't understand why there's this polarization. The way I tend to look at things is much more practical, let me