ED HARRISON: Ed Harrison for Real Vision. And what do you know, we have someone special in studio in New York.
RAOUL PAL: Hi, Ed. How are you?
ED HARRISON: Good, it's Raoul Pal who is the founder of Real Vision who's going to talk to us a little bit. Actually, you know, Raoul, what I want to do, we talked about this a little bit ahead of time, is you just released sort of a 2020 comprehensive review, 147 pages if I'm right, right?
RAOUL PAL: Yeah, that's right. So for Global Macro Investor, which is my kind of institutional research service that I write for the world's biggest hedge funds, family offices, sovereign wealth funds, banks, that kind of stuff, I do this great January think piece where I'm freed of just looking at the day-to-day of markets and think about all of the interesting things that's in my brain going forwards, whether it's for this year or the next 10 years. So that was 147 pages.
Hopefully we'll talk about some of this stuff today, mainly on the focused on the markets and looking forwards in the economy. But I'm going to give it to everybody, all Real Vision subscribers, so they get access to the research. Now obviously, it has to be delayed a bit because the GMI guys paid a lot of money for it. So at the end of the month, they'll be able to have that 147 page report so everybody can have a look at that and understand what it is that I do. It's all part of this Real Vision access product.
ED HARRISON: Excellent. Yeah, so what I want to do is take a look at that and use this sort of as a basis of conversation. So we can sort of do a preview. Maybe we'll show a few of the charts as we go through it. But the thing that I'm most interested in is the part where you talk about your thoughts on the market. And you've always told me you have a 6 to 24 month time horizon, so this is a good sort of 2020 type of preview. How does that sound?
RAOUL PAL: Yeah, perfect.
ED HARRISON: Excellent. Let's go right into it. I want to talk and in fact, you talk about this in your piece as first on your thoughts on the market is the Fed. Because the narrative that I'm hearing in the market that is coming up a lot now is that OK, we got a 30% plus pull up in equities in 2019, and that's going to continue the positive momentum into 2020 because it's been a massive injection of liquidity into the markets. The Fed, with their whole repo injection, is goosing the markets in a way that's going to make 2020 a very positive year. That's the reflation trade. What do you think about that?
RAOUL PAL: So I think partly it's right. So partly I think that the extra liquidity that the Fed pumped in, it wasn't so much extra liquidity. It was just putting liquidity back because there was a period where there was no liquidity and the Fed were forced into some pretty extreme measures to force liquidity back in over year end and the tax season and all of this kind of stuff.
So that did goose the markets. That increase in the Fed balance sheet was about 11%, which was the second largest increase in balance sheet outside of the financial crisis first one. So basically, it looked very similar to the Y2K increase in balance sheet for different reasons and a different variation. But the point being, it was an explosive increase in the balance sheet that seems to have fed its way through.
Additionally, that reflation trade was kind of built on the fact that people were looking at the year-on-year comparisons. So everyone forgets that November, December were horrific in 2018. Many economic indicators tanked over that period of time and equities tanked. So what you get is this kind of year-on-year comparison effect where people are showing us against let's say ISM where it looks like equities that say ISM is going to go back to the highs again. It's all misleading because of the year-on-year comparisons, and that filters through into a number of different economic indicators.
So I'm not a big reflationary believer. The other thing I think that is going to happen is the Fed are going to start tapering some of this repo injections. Now we got through year-end. We've still got the end of the financial year, so I think there's more to come. But after that, there's almost no treasury bills for them to buy. So there's not enough issuance, in which case they're probably going to move out to two years. But I have a feeling the balance sheet will actually start shrinking as some of the bills roll off. So the rate of change of balance sheet, which is the important thing, is not going to be as fast as it was.
ED HARRISON: Well, you know, there are two things in that that I think are interesting. One is where that balance sheet is going to, that is the massive increase in balance sheet. How is that being transmitted to the economy? And we can talk about that. But the second thing is this whole concept that the Fed wants to have an all clear, meaning that they feel that OK, now we can actually taper some of this injection because we passed through the year-end. That is it actually a dangerous proposition. And you've talked about this in the context of Y2K and what happened subsequent to that. Can you talk to those two issues?
RAOUL PAL: Yeah, so look, the transmission mechanism, I'm actually not really sure of how this works. But essentially, it freed up balance sheets to do stuff. Now, what was interesting is the Fed specifically mentioned relative value hedge funds, essentially, to give them direct injections of liquidity because they basically are the policeman arbitraging the treasury markets and the bond markets and the money markets. So my guess is once you free up liquidity for those guys by the prime brokerage operations of the banks, it freed up access to more leverage for equity. So I guess that is the mechanism overall, and the rest is the crowd herding behavior.
The Y2K issue, I think what's interesting is it's the rate of change that matters the most. So if the rate of change of the balance sheet is not growing as fast as it was, generally, that's less positive for risk assets. If they really do allow some stuff to roll off and really reduce the balance sheet somewhat, well, if you remember in Y2K, we had a 13% increase in the balance sheet going into that period and then it slowly unwound over the next three months.
By March, the equity market topped and then the economy tanked with it. The economy started weakening already, much like it is now, while the equity market was at all-time highs. It's a very similar set up, and I have a suspicion that we're going to be in the same boat again and the Fed are going to be cutting rates this year as opposed to standing pat, which most people were expecting.
ED HARRISON: Right. And you have a few charts, actually, in this GMI report-- from what I can recall. I'm actually going through it right now and taking a look-- which show the uncanny resemblance between the data that we see today and the data that we saw in 2001. And for me, it begs the question about the underlying economy rolling over and potential similarities today because at the crux of this, we're talking about the potential for either A, mid-cycle slowdown or B, an actual out and out fall into recession at some point in 2020, 2021.
RAOUL PAL: Yeah, look, and nobody's got the truth because nobody knows what it's going to be until it plays out. But my suspicions on my analysis and the balance of probabilities are that I think people are going to be wrong-footed this year. If I look at every single economic forecast on Bloomberg, every single one is positive GDP growth. The average growth they're looking for is 1.8%.
But then when I look at the bond market, it's telling me something different, and I listen to the bond market. Most equity guys scream, oh, the bond market's wrong. It's equities that are right. Usually it's the bond market that's right because the bond market is a much more precise voting tool on the economy and the future economic direction.
So when I look at the euro dollar futures chart, so that's the interest rate futures for December 2021, liable futures for that period, it is the closest mirror I've ever seen on any chart pattern versus the 2001 period where rates got cut, we'd had this long period where the Fed were pat for a while, everybody thought that was going to be OK, and then before we knew it, the economy continued to weaken and euro dollars exploded and yields fell.
What's interesting is the 10-year bond yield chart versus the same period also looks identical. I've never seen this before. And you know, I know it's a bit voodoo, it's not science, but it's contextualization of what the bond market is telling us that I'm interested in. Can the chart pattern fail? Of course it can. But the contextualization reinforces my view that the economic data going forwards is most likely to be weaker and the consensus is wrong.
ED HARRISON: Right, and you have a number of charts actually in that GMI report that look at ISM. The only pushback that I could give before we go into this, I'll preview is that a lot of the data are based on ISM manufacturing, whereas non-manufacturing tells a slightly more bullish picture. But let's look at ECRI, ISM because all of that data seem to be saying that actually this bottom that people think that we've put in, which we have in Japan and Europe, is not in the United States. The data show continued falls in the ISM in equities.
RAOUL PAL: Yeah, so there's two things going on here. One is the year-on-year comparisons are making things like Asian exports look good. They're not. So what you basically got is just the base effect. So the base effect is stopping and looking so negative, but it's actually very fragile. When I look at global trade, whether it's world shipping, whether it's air freight, whether it's car loadings in the US, whether it's container shipments, I mean everything are all still falling. Not one of those is hooked up. So it's telling us there's a structural problem with World Trade going on. And those numbers out of Asia and Europe I think are suspect.
What is also interesting is many people are looking at the OECD leading economic indicator in the US, leading economic indicator, and the ECRI. Both of those have an equity component. Because of this weird year-on-year effect that we talked about, it makes the equity market year-on-year look ridiculously strong, and it's filtering through to those and hooking them all up.
So I've looked at the OECD leading economic indicator minus equities. It's actually at new lows. When you look at the ISM, which doesn't have equity component, new lows. When you look at all of these other data, the trade data, they're all at new lows. When we look at stuff like car sales and retail sales and restaurant sales and furniture sales, they're all still extremely weak. When you're looking at production, it's extremely weak. So I have a feeling that people have been wrong-footed by equity translation effects and base effects. So that's my suspicion in that whole equation.
ED HARRISON: Right, and where I was coming in terms of manufacturing versus non-manufacturing, I was just looking at the December 2019 numbers. Interesting, and tell me how you would parse this data, is the dichotomy between what I would call forward-looking sub-indices and the actual production indices.
So in the November series, we saw 51.6, which is very weak for business activity, but it jumped up to 57.2, pulling up the non-manufacturing ISM. but When you look at new orders and employment, they were both down, suggesting that there's going to be weakness, even in the non-manufacturing sector going forward. What's your view into that?
RAOUL PAL: Yeah, there's something going on with inventories, which seems to be clear. Also I think a key thing that I stress, and basically the last 20 years of my career has been analyzing the ISM. And one of the things that I do know is the ISM, non-manufacturing lags. So if you think of lags of data, the ISM is pretty good. The equity actually I prefer because it's weekly data, but it's got this equity component right now that makes it a little bit complex. Then it's the ISM, then it's the ISM non-manufacturing, and then at the end of the whole lot is employment.
What was interesting is the employment numbers this month was starting to look like they're turning. So that would play into this lagged effect, and the market, particularly the equity market, tends to focus on the lagged ones. So I acknowledge the ISM non-manufacturing, but I think it is lagged, and I think the cyclical component of the manufacturing economy is what drives the non-manufacturing economy because that's where all the cash flow gets derived from from the export production and those goods that plays salaries, that drives the non-manufacturing economy.
So I think even though people say, and people have had this argument with me since 2000, that non-manufacturing matters more because it's a larger part of the economy, it's never played out that way. Every time the manufacturing goes into a deeper recession, 2016 had been the only outlier in this, it's tended to lead to the rest of the economy going with it.
ED HARRISON: Right. And I would say that if we see a 43, 44 on the manufacturing ISM, the goose is cooked for the non-manufacturing.
RAOUL PAL: Yes. I use 45 as basically the recession line in the sand. 47, where it is now, is 0% GDP growth. Interesting enough, we've got the Atlanta Fed now cast at 2.4, the New York Fed at 1.1, and HedgeEye's version at zero. I think the HedgeEye version looks more correct if I look at the ISM data, but we can't tell because we've got other issues with this non-manufacturing that's still a little bit higher, et cetera. So we'll have to wait and see, but that would be a cat amongst the pigeons if the GDP number comes out for Q4 much closer to zero than everybody's expecting because then everyone's going to go, the Fed's on hold to the Fed is going to have to cut rates with any weak data.
ED HARRISON: Right, because that would make us at stall speed versus potentially not within stall speed.
RAOUL PAL: Yes, exactly right.
ED HARRISON: One last thing here on the macro economy. I want to talk about Europe because I've heard a lot of stuff. Ursula Bundeline who is now the new EC head has been talking about Green New Deal and stuff like that. I've been listening to the German ARD, their nightly broadcast, and over and over again, they're talking about this whole concept that--
RAOUL PAL: You're just showing off that you speak German.
ED HARRISON: Yes. But they're talking all the time about the fact that they're going to start spending money on the environment, that this is a big issue, that this is how they're going to goose their economy. So when we look at the data coming out of Europe, are you at all bullish on the policy mix that we're going to see going forward in Europe?
RAOUL PAL: I tend to be more cynical on it. I think that policy mix will happen. I have a feeling that there is an alignment that needs to happen between the central bank and the governments, and so there's going to have to be some funding of this, through the mechanism of the ECB buying bonds to allow the governments to print money. So printing money, that will lead us onto the currency markets, which we should talk about later.
I have seen Japan do this for 30 years. And fiscal stimulus tends to ebb and flow. So it comes into the economy, and then two quarters later, it's out. The US did it with Trump's fiscal stimulus. It was a big stimulus, right?
ED HARRISON: Right, yeah.
RAOUL PAL: It was bloody two quarters, and it was gone. So it tells you that the underlying state, Europe can't stand on its own two feet. We need a global recovery. And for a global recovery to happen, we need China, the US, and Europe to basically be doing things. And as we know, usually that happens in a recession, where everybody coincides policy to a more extreme measure. And it usually has an 18-month lag before it really works its way through.
So I think you're dead right, it's coming. But Europe alone I don't think will move the dial. We saw the German's car sales numbers were truly shocking. So we have a structural problem with manufacturing and global trade, which has been brought about a lot by the Trump kind of reorganization of global trade and supply chains that's still yet to work its way through. And I think we have to get through the US election before any corporate boards have some clarity on what supply chains should look like.
ED HARRISON: Right, meaning that there's not going to be a pickup in investment as a result of this phase one deal between China and the United States.
RAOUL PAL: Correct, and anybody I speak to, they're like, well, firstly we're going to take two bets here. One is sit it out and hope after the election. So that means there's really no business investment going on globally. So that is slow, and global trade is slow, too.
Secondly, if it looks like that those supply chain breakages are lasting, which it looks like they probably are, in which case they're going to have to employ McKinsey and KPMG and Bain and all these guys to figure out the new supply chain strategy. That thing takes 18 months to figure out. So I just see that this is a window, if I'm looking at this particular thing, where there is a potential for that recession to fall just because of the paralysis of what the organizations, who are slow to change, have to change.
ED HARRISON: Right. And Raoul, you mentioned, when we were talking about Europe, this leads into the dollar. So I want to go back to currencies, as you were saying. I want to go to the dollar because in your GMI piece, you were talking about a consensus