RAOUL PAL: Are we going to have a recession? Is inflation going to infinity? Stagflation. There's so many voices out there saying so many things. But how do you figure out the good takes from the bad? What if everybody's wrong?
Here's my take. I think that economic growth is going to fall sharply at the second half of the year, sharper than people expect. And maybe that changes the equation for the Fed. I think inflation is going to ease off quite sharply too. But I've been in markets long enough to know that we all get it completely wrong sometimes, and I could be dead wrong.
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There's a lot going on. So, I just wanted to pick your brains, see how you're seeing the world. So, give us your big picture view. And then we'll start digging into some stuff as we start chatting.
LYN ALDEN: So, I think like how COVID-19 accelerated a lot of trends that were probably already going to be in place anyway, I think the recent military conflicts we're seeing are accelerating some of the problems that were already mounting. And so, for example, we already saw Europe have some energy issues even before any of this conflict broke out. And some of that was now accelerated.
I think, same thing for food insecurity and things like that. And essentially, I think what we're seeing is a slow unwind of the global monetary order that's been around for the past 50 years or so. And moving towards a more bifurcated world, where we have maybe a little bit more decentralized payment channels, maybe more decentralized choices of storing value, as well as supply chains themselves becoming more bifurcated, because we're seeing food protectionism, commodity protectionism, different trade happening around these more like alliances rather than a global market.
RAOUL PAL: Do you think that-- I completely share your view on that. What I'm trying to figure out is whether this is creating a step change in inflation, i.e., the trend of the last 30, 40 years has gone, or whether demographics and technology still trump out in the end. And this is a temporary structural shift we're seeing which is generating this.
LYN ALDEN: Most inflation is transitory, but transitory can last for years in inflation's case. In the 1970s, we're transitory, but it was long enough that it wasn't really transitory in terms of a trading perspective and investment perspective, and lifestyle perspective.
My base case for a while has been that the 2020s would be more inflationary than the 2010s, that the exact height they were going to reach depends on these variables that are hard to predict ahead of time, like whether or not there'll be war, whether or not there'll be factors like that. I think now, we're at risk of hitting some of the higher levels of that range, that probability range that I think was going to play out anyway. And now, we're on the higher side.
I would characterize as like the 19770s and the 1940s, in the sense that we are going to probably have a pretty persistent amount of inflation. But even that, it won't be a straight line. If you look at the 1940s, you had price controls at some point. 1970s, you had price controls, you had wage controls. Basically, there are periods where even in an inflationary decade, you can have disinflationary periods, so you get these waves of inflation.
And I think the 2020s would be no different, where you could get, for example, a de-escalation of some of the big trends we've seen now. Things can be overdone, traders can pile in, things get to consensus, and then there's some unwind of that. And then you can have another spike up. We've already seen this happen in European natural gas, for example. There are periods where it got overdone, came back down, and then got even more overdone.
And I think you could have the same thing on a longer trend line. So, I do think that if you look over the past 25 years or so, historically, money supply and CPI, if you use a five-year rolling period rather than the noisy year-over-year period, that generally has pretty strong correlation. But there are periods where you can have a pretty significant disconnect. And that's usually due to some rapid technological change, we've unlocked some new abundance that allows for less inflation than you'd expect from the money supply growth.
That happened, for example, in the late 1800s. You had the invention of the internal combustion engine, you had electrification, you had the discovery of oil, the United States had nearly unlimited land. That was abundance. And you had a similar thing of the past 25 years where we unlocked so much global labor. And corporations are able to do a lot of geographic arbitrage that you've had a disconnect between say money supply growth and wages domestically in many countries.
I think that that particular force is probably coming to an end, at least for a period of time, because we've squeezed a lot of juice out of the globalization orange. And that now, we might have hit peak globalization, meaning that we don't unwind globalization necessarily, but we could stop accelerating globalization. And all else being equal, that should be more inflationary.
RAOUL PAL: One of the things I'm thinking of is I've been looking at thinking that the 1940s is probably the most similar period, less so the 1970s. It was the post war, it's the same structure we've got now, GDP was volatile, inflation at first took off and then eased over time once we start to see manufacturing pick up and all of that. We saw yield curve control, we saw a lot of fiscal stimulus. What period do you think we're most similar to?
LYN ALDEN: I do think the 1940s are the single most close period to what we have now. And this whole debate over the past few years that people had about inflation versus disinflation, what is money creation? Where does inflation come from? What made the 1940s different than the 1970s is the 1970s was a very bank lending driven inflation. You had the demographics boom, the Boomers were entering the home buying years and that was around the world.
You had a big expansion of, of money supply led by commercial bank lending. And then on top of that, you add fuel to the fire with deficits around guns and butter program, Vietnam War, things like that. But it's really a bank lending driven type of inflation. Whereas the 1940s were totally the opposite, where banks weren't doing a lot of lending, it was the monetization of very large fiscal deficits, the wartime finance, a command-and-control economy.
And also, the 1970s, you have super low debt levels, at least public debt, and pretty low private debt levels, so they could raise rates dramatically to try to cause a mild recession to contain inflation without causing widespread insolvency. Whereas in the 1940s, when you had sovereign debt levels very high due to the war, you couldn't realistically raise rates to double digits. Instead, they held rates low, they did yield curve control.
And so, that decade, the 1940s, if you go from, say the early 1940s to the early 1950s, when you had that final inflation spike, you had about 6% average annual inflation, but it was very bumpy. You had really at one point, definitely 90% year-over-year CPI, but then the next year, you'd have like zero or even like mildly deflationary, then you'd have another spike, and so I characterize this period similar to the 1940s.
The one thing that might be similar to the 1970s is the energy situation. What made the 1970s also unique, besides the demographics boom you had, is that US domestic oil production peaked in 1970. We had this nearly a century-long continual expansion more or less of US energy production that peaked in 1970.
The US became more reliant on the Middle East at the same time as we're going through that very big demographics boom, and that's what fueled inflation because you had that supply.
RAOUL PAL: Yeah, you had a supply and demand shock at the same time.
LYN ALDEN: Exactly. Whereas now, we have less of a demand shock, obviously, but we do have a supply shock. I think we have 1940 style monetary and fiscal policy combined with not unlimited commodities. That's where we get this more inflationary environment from.
So, I think the 1940s are similar environment, especially you can say right now, the United States looks like the 1940s UK, because back then, the United States was running structural trade surplus, we looked more like China in some ways. We were the rising power, we were the export place. Whereas the UK was more of the established power, the structural trade deficit, and going through the same wartime financing.
RAOUL PAL: James Aitken, he's got 30 years of financial experience, and is widely followed by policymakers, investors, hedge funds around the world. He takes the secular inflation view. As is Gerard Minack. Gerard runs Minack Advisors, and he also advises the world's most preeminent hedge funds, family offices and institution. What's interesting about Gerard is he was a secular stagnationist for decades until now, he's changed his view.
GERARD MINACK: I've been a card-carrying secular stagnationist for a long time. Before even Larry Summers popularized the term, I was telling people that the world was turning Japanese. Well, I've resigned from the club. I think the era of secular stagnation is over. I do think the pandemic has been the catalyst for change. I say catalyst in the right way to use the word. It's accelerated changes that I could see were going to happen anyway.
With fiscal, a change in central banks, higher CapEx. I think after four decades, the forces of secular stagnation are becoming more powerful. We finally see a change in the secular trends. Let me just make it very practical for the people who watch this who are more interested in market outcomes than they are in economics. The key financial consequence of secular stagnation was the trend decline in interest rates.
We have seen for four decades, the cycle in interest rates in the US, every cycle low has been lower than the prior low. Every cycle high has been lower than the prior high. And you weren't doing this, I wasn't doing this. We weren't trading markets in the 1970s, and I was watching markets in the 1970s, none of us has seen a cycle where the peak in the 10Y Treasury yield was higher than the prior peak.
I think that's coming. I think in this cycle, we get the peak surpassing the prior peak. And that's the most concrete outcome of the secular changes. Now obviously, what's happening in Ukraine complicates that, and there are tail risks there that I appreciate.
If we can put that to one side, which is in a real world seems it was impossible. Prior to Ukraine, I was absolutely telling people that we would see interest rates in the US go higher than we have seen for several years. It would be the first time that we've seen a cycle peak exceed the price cycle peak. It's still my base case, but with a little less conviction because of what's happening in Ukraine.
As we came out of the GFC, the market was saying, you know what, the long run real Fed Fund rate can be 2% to 2.5% positive. And that was what they were also pricing prior to the GFC. So, no change. Despite that the depth of the downturn, we were going to go back to a world where ultimately, the neutral rate of interest was over 2% real, and we would have positive real rates on average through the cycle.
It was only when you had the Euro crisis and austerity in the US that the near-term rate expectations collapsed, and people moved to assuming lower for longer. But even then, they're expecting that we'd go back to real positive rates in the long run. Last two years, that real long run Fed expectation has turned negative.
We have markets now that are no longer pricing lower for longer, they're pricing lower forever. We'll never get out of this. We'll always have negative real rates. Once again, it's the resilience of the view that nothing has changed. I just think that's a mistake. I think the world has changed. And that's not to say that we're going to get necessarily higher inflation.
It's [?] the interest rate required to have a normal inflation rate is now higher than it was post-GFC. And the peak in rates this cycle is going to be higher than what the market expects, and the world has changed. But the market so far, I've got to say, doesn't agree with me.
The resilience of the economy in the face of rising rates is what I debate with everybody at the moment. What's absolutely central to my view is that the US, and this is particularly true on the US, it's not necessarily true elsewhere, but I think the US will be more resilient than markets recognize. I think the household sector is in as good a shape as it's been for three decades. It's de-levered, del-levered by defaulting but hey, let's de-leveraging after the GFC.
Debt to income is down. It's at around about 100% of income. The debt service burden is at the lowest level since the mid-60s, and most household debt in the US is mortgage debt, and most mortgage debt is fixed rate. So, it takes a long time for Fed rate changes to feed into debt service burdens. There's a lot of saving that's been built up through the pandemic because of unspent stimulus.
But most importantly, it comes back to the change in the Fed behavior and a point I mentioned earlier, which is that wage growth is so strong. Now, for the average American, they don't get dividend checks. They don't get interest checks. No one gets interest checks at the moment, but yeah. In normal times, the average American doesn't get interest checks. Their bread and butter is wages, is labor costs.
Now in the December quarter last year, that was up 3% real. That means the average American getting 3% more. That's with inflation at four-decade highs. The nominal increase in aggregate labor income was almost 9%. Now, what I expect is that inflation will fall over the next 12 months. I think that labor income growth will also slow a little, but I think inflation will slow faster.
We're going to end up at the end of this year, I think, with aggregate real labor income running at 3% or 4% real. If that translates into real consumer spending, given that consumer spending is 70% of GDP, that's going to add more to GDP growth than any sensible estimate of what trend GDP is, and interest rates are not going to make a difference.
I don't want to come across as a bear at the moment. In my worldview, this is going to be a tough period for low yield, no yield assets. Now, that runs the risk gamut from on the one hand, ostensibly safe assets. Who knew bund yields could go positive? There's going to be people that have been in the market a couple of years ago going, this is like a Y2k problem. I didn't know that you're going to have a plus sign in front of the bund yield.
And here, I'm going to turn your toes, Raoul, but [?] which is crypto, so no yield speculative assets. I think the two edges of the risk spectrum are going to be under pressure, but the stuff in the middle can do okay. History shows that broad based equity markets, they do okay when the Fed's tightening. What's the killer for equity markets? It is recession. It's not until markets sniff out recession that they suffer.
Putin and the pandemic changed everything. And I don't think the markets yet work that out. The market is still in a pre-pandemic mindset where, as I said, when I look at my Bloomberg, there is no debate. The market is saying we remain in a low rate, low growth, low inflation structural situation, and I just think the market is wrong. It would take time for the market to come around to my view. But I think that means that, particularly for rates,
RAOUL PAL: Do it. Do it, my friend.
GERARD MINACK: Because it really tells me the reason we've got expensive equity markets is low rates. Give me a break. That's bullshit. Low rates historically have gone hand in hand with equity markets that do rate. Low rates do not leave equity valuations. If you look at the long run relationship between interest rates and equity valuations, when rates are falling from higher levels, absolutely good for equities. When rates go to very low levels, normally bad for equities. Of course, this is correlation, not causation.
The macro conditions that lead to low rates are almost always macro conditions that make it difficult for companies to grow earnings, which is why if you really believe low rates go hand in hand with equity valuations rising, why isn't Japan the most expensive equity market in the world? That's right. So, the US is the one market that re-rated in the post-GFC cycle.
Why? Well, it wasn't Fed QE. It wasn't low rates. It was that that was the one market that could grow its earnings. It was the exceptional market, because you had companies that were able to grow earnings in a low growth, low inflation cycle.
Now, that ability was actually quite limited. And it was the six, you had the FAANGS-- it's no longer FAANGS because Facebook is now a Meta. But the six big companies grew their earnings throughout the last cycle. If you pull them out of the S&P 500 and create an S&P 494, which is what I do, that has not really done a lot better than the rest of the world.
And just to underscore what a horrible cycle it's been, if you look at the either trailing or forecast earnings, doesn't matter, for the MSCI All Country index, excluding the US, i.e., the world outside the US. Earnings in the forecast or trailing today are lower than they were at the peak in 2008. We've had global equities outside of the US 14 years, zero earnings growth. Now, when the market is derated notwithstanding low rates, the US was absolutely the exception and it rerated.
Now, the forward-looking point is, if you live by the sword, you'll die by the sword. If you rerated because rates went down, you'll derate when rates go up. But if you are a market like Japan, I can't think of anything more positive for Japanese equities than JGB yields go into 1%. If JGB yields go to 1%, Japanese equities are going to be on huge bull market, because the macro conditions that would push JGB yields to 1% is going to be absolutely