LYN ALDEN: So I'm Lyn Alden, and I'm here with Eric Basmajian of EPB Macro Research. And we're going to talk about a couple different things related to his strategy and about the global macro environment at the current time. So, Eric, welcome to Real Vision.
ERIC BASMAJIAN: Thanks. Thanks for having me.
LYN ALDEN: Yeah, so I'm looking forward to this conversation because we've had a lot of interactions in the past about some of the things happening on the economy, and so I figured it's great that we're able to talk about it. So why don't we start by you giving the viewers some idea of your background and what your overall process is as part of your research?
ERIC BASMAJIAN: Sure. So I'll start with a quick background for those that are unfamiliar. I studied economics at NYU. While I was there, basically my last year I worked at Morgan Stanley full time on the wealth-management team.
I then jumped straight to the buy side. I worked for a quant fund in Midtown. It was good experience. Learned some programming, some statistics.
Economics was always my passion. So I was still studying economics the whole time I was there, basically reading everything that was available in terms of academic research on debt and the impacts there. I have a big focus on long-term trends.
That's obviously where I ran into the work of Lacy Hunt, who's been highly influential to my thinking. I also studied quite heavily Geoffrey Moore who used more of a leading-indicator approach to the business cycle. So using some of those statistical techniques that I was working with at the fund, I was creating some of my own composite indicators, taking five or six or seven different data points and combining them into one aggregate indicator.
So basically what I do was I was taking the long-term trends, which you know sometimes don't change for 20, 30, 40 years. And it could be valuable for some people to just ride that trend for a long time, but having experience on the buy side with performance that gets marked to market, it's just not realistic for most people to stay on such a long-term trend like that. So I tried to bridge that gap by staying focused on those long-term trends but also using a leading-indicator approach to pick up the cyclicality within some of those longer-term trends.
And I left the fund, started publishing my own work, and that's kind of how EPB Macro Research got started. This is going to be the fifth year, and that's kind of the 30,000-foot overview of what I do.
My views now are that the long-term trends, the impacts of debt and other structural forces like demographics, are pulling us towards weaker and weaker growth. But at the same time, the leading indicators are pointing higher, which gives us some short-term momentum to the upside. And that can make allocating a little bit trickier than when the trends are aligned. And I'm sure we'll have a chance to discuss those two things, but that's sort of where I shake out on the long term and short term.
LYN ALDEN: Yeah, perfect. I think that kind of sets the stage to go in a couple different directions. I guess to start with, if we focus on some of those leading indicators, can you give the people a sense of what sort of indicators you focus on, and what are they kind of telling you about the next, say, six months or so? Or what is the timeline you're looking at when you say shorter term?
ERIC BASMAJIAN: Sure. So for me, short term is exactly what you said. So 6 to 12 months is sort of the range that I'm talking about with the short term. Anything shorter than that is a little bit too noisy for me.
So most of the leading indicators that I'm focused on are very heavily centered in the manufacturing sector. That's the most volatile sector, much more than the services economy. And I believe a lot of people overlook the manufacturing sector, especially in the United States, because they say it's such a small percentage of the economy. It doesn't really matter.
But the volatility of the manufacturing sector is so much greater than the services sector that it actually still drives the ebbs and flows of GDP. And my big process is following the rate of change or the direction of growth in growth and inflation. So those shorter-term manufacturing sectors pick up different types of production backlogs or new orders to inventory, things like that. And this situation with COVID sort of caused a lot of these indicators to go haywire.
And what I mean by that is when the lockdown happened, we saw consumption stop for a brief period of time. But then what we saw was consumption shift very dramatically towards things that could be consumed at home, lots of durable goods. And that caught basically every supplier totally off guard, and what we saw was inventories get depleted to basically the lowest level we've ever seen as a percentage of GDP.
And then as a result, all of the suppliers had to restock all of that inventory. And we started to see a classic economic sequence come through all the leading indicators where commodity prices, specifically lesser traded ones-- not really like copper or oil but some of the industrial metals really start to pick up. New order to inventory ratios started to explode. And we sort of began this manufacturing restocking rebound that's happening globally, and it's causing a strong upturn in both the rate of growth and inflation, which is a little confusing to people because they look at maybe the labor market that's still really impaired or just the partial shutdowns in some parts, and they say how is the economy improving? But that manufacturing process can be so strong, and that's what we're seeing now.
And it's still ongoing, and for the next couple of months, I think that the bias for both growth and inflation are still going to be higher. And that's counter to my long-term view, which makes the allocation process slightly more difficult, avoiding or underweighting things like long-term Treasuries that may benefit from some of the long-term trends. So those are kind of the indicators that I look at, mostly manufacturing based. And right now, they're still off to the upside.
LYN ALDEN: Yeah, so if you focus on those indicators and then how they pertain to market prices, what sort of correlations or causations have you found? So say you're accurate about all these, the growth and the inflation. How do you translate that into an investment portfolio, and how do you kind of monitor risk or monitor if those trends are working out?
ERIC BASMAJIAN: Sure. So I start with a balanced framework, and this can be applied to any sort of balanced framework. I gravitate to the all-weather framework combination of long-term bonds, intermediate-term bonds, stocks, gold, and commodities, and that's sort of where I approach every situation. I come to the table with a balanced framework.
Then I tilt in a direction that's most aligned with the long-term trend. So I'm always going to have a bias towards the Treasury allocation or the growth-slowing allocation, which tends to favor Treasuries over things like commodities. But then I also am cognizant of the short-term trends. So when the short-term trends are pointing higher, you'd want to be doing the opposite, basically. You'd want to be overweight or starting to overweight commodities, risk assets, things that perform well when growth is increasing, and those are the correlations that I find.
So when growth is increasing, specifically nominal growth, equities perform basically the best out of all those assets, commodities the second best. And within the equity sector, you want to be tilted more towards the cyclical equities, the small caps, the industrials, things that benefit from that manufacturing upturn.
So I come to the table with a balanced framework. I have a long-term bias to my long-term views. Then I take the shorter-term indicators and I sort of tilt or overlay that on top. And right now with the indicators pointing higher, tilted more heavily towards commodities than I normally would be, and my stock allocation has small caps where it's typically more large-cap defensive as a balanced framework.
LYN ALDEN: And how are you seeing banks fitting into that? Because I saw some interesting charts the other day showing that banks and energy have been key underperformers for a while now. So a lot of people focus, for example, on growth versus value, but value can be further separated into defensive value versus cyclical value, and it's really been in that cyclical value where there's been a lot of underperformance. And there's some kind of a recent rebound there. We see them kind of up ticking, especially ever since we got some of the vaccine announcements a few months ago. So how do you see the energy and financial sectors kind of playing out over the next six months or maybe longer term?
ERIC BASMAJIAN: So I'm a little bit more cautious on the banks. I mean, I've had a long-term short position in specifically the regional banks since 2018, which has worked out quite well. But I've pared that back to basically the smallest allocation I could have on the short side because these cyclical trends-- when there's an upturn, the bias for long-term interest rates is higher. So the bias for the yield curve is steeper. That's going to tend to benefit the banks.
But I'm cautious on the banks because they're fighting such a secular trend of rock bottom both short-term interest rates and long-term interest rates that I'm aware that the short-term trends can benefit them. But I think that the banks, specifically the regional banks-- I don't really deal too much with the large banks that have much more diversified revenue streams. Focusing mostly on the smaller banks that are mostly just spread plays. And I'm still cautious there, but I've pared back the short position to as small as I can because of the cyclical upturn.
So once I see the indicators start to roll over again and I would think that long-term interest rates would start to have downward pressure, I would increase that short position again because I think the long-term trends are very powerful against the banks. Looking to things like Japan and Europe, I think that our smaller banks will go the way of Japan and Europe. Larger banks, totally different story.
Energy is interesting as well. I don't like the energy sector. I prefer to just be exposed to the commodities at this point. The energy sector, high debt. The business model of the energy sector, specifically the frackers, is one that makes me cautious. Have to spend a lot of capital to build a well that just depletes, and then you have to spend more capital on another well. And that business model, to me, is tough because it's so reliant on constantly issuing new debt or new equity that during these upturns, I prefer to just be exposed to the actual commodity price versus the energy sector.
So I am still cautious on those too. I haven't added those as long despite the upturn. I've added just mainly small caps in general on a broad basis instead of going down into the sector layer.
LYN ALDEN: Yeah, I agree on the frackers. That's been an area I've been avoiding. For my energy plays, I'm mainly focusing on the ones that have kind of longer-life assets and the few out there that actually have pretty strong balance sheets-- some of the international ones, for example.
I guess speaking of international, so we're both based in the US, and so we have a somewhat US-centric view. I know in my work I also carried out to focus on other sort of countries because those can give us kind of a different secular trends, which could be helpful in a portfolio. So what extent do you incorporate international markets into your framework, and do you have any allocations that are kind of important for those at the moment?
ERIC BASMAJIAN: Sure. So my work internationally is much more broad. You've done some brilliant work on individual countries. I focused mainly on US and then ex-US, or if I was to break it down a little smaller, mainly the developed markets.
So the way that I play international, mainly international equities, is you're right, I'm very US-centric. When the dynamics that I found, going back to the leading indicators, is that when the leading indicators of US growth are pointing higher, that generally means global growth is going to be heading higher, and especially because the manufacturing sector is so correlated globally that when there's a manufacturing upturn, there's a manufacturing upturn basically everywhere.
And during these upturns in growth, as counterintuitive as it may sound, better US growth tends to lead to a weaker US dollar. So when we have an upturn, the dollar tends to get weaker. That gives a big boost to everything international.
So I have increased my international exposure since basically I started to see the upturn in the leading indicators around the summer of 2020. And that's when I started to increase the exposure to international equities on a broad basis. One of the allocations I have is VXUS, so basically everything ex-US. And that's basically the way that I play as far as an allocation. The way I play international is when there's an upturn, I expect the dollar to lose value or the dollar to be softer, so I allocate more heavily than I would on my baseline approach to international equities more broadly.
I don't often get into country specifics as far as the allocation. I have research broadly on the developed markets-- Japan, Europe as a whole, the United Kingdom. Maybe we can talk some long-term stuff about that. But as far as the allocation, I'm mainly US or ex-US. And when there's a growth upturn, I shift more of my equity allocation to ex-US, which I have now.
LYN ALDEN: Yeah, it makes sense. And so I guess to dive into those developed markets, when we focus on Japan versus Europe for the United States, do you see any major differences between the three, or do you see them all kind of on the same sector trends? Like, for example, one thing I often highlight is that one big difference between those ex-US developed markets is that most of those have more structural current-account surpluses. The United States is on the opposite side of that.
Do you see that playing into your analysis at all? Or basically if you were to kind of describe the paths that those three are on, obviously they have a lot of similarities, but do you see them as kind all on virtually identical path or somewhat divergent paths?
ERIC BASMAJIAN: Well, I don't think that they're all on perfectly identical paths, but my main framework is looking at the debt and the impact that it has on growth there and then the demographics. And those two factors, all the countries are headed down basically the same path. Like you pointed out, there's different current-account situations.
But as far as the US-- and we can probably dive into this. The situation with the US can be interesting because in the short term, the larger trade deficit can work to our advantage. And part of my thesis is I do believe that the twin deficit will get worse in the United States.
And that can be to our benefit in the short term because it can help us support higher consumption and higher investment than we otherwise would be able to have without foreign support. It could lead to longer-term problems down the road. We tend to see the twin deficits get really bad with emerging-market countries. It's a unique situation, I think, with the United States. So it doesn't play into my long-term thesis as much as I think it plays into your long-term thesis, and this could be where we slightly diverge on the long-term trends.
The way that I would view the United States with the trade deficit is there's this view that if foreigners immediately stopped funding our deficits that interest rates would rise and the currency would depreciate, and that's possible. But the way that I would see it also is if the trade deficit started to shrink or foreigners started to buy less of our debt, that would have to come out of one leg of our GDP equation as well, and the leg that I believe would fall in that scenario would be private investment.
So I believe that either way, a larger trade deficit or a smaller trade deficit are still going to lead to weaker growth. It's going to lead to weaker real growth-- maybe not nominal growth, but it's going to lead to weaker real growth in either scenario because either we're going to be hollowing out our manufacturing sector if we have a larger trade deficit, or if we have a smaller trade deficit and we're not able to get external funding, we're going to collapse private domestic investment, and both of those have negative long-term consequences for real growth.
And if our real growth continues to be dragged lower, I think the inflation rate ex some currency crisis will tend to follow the direction of real growth as well.
LYN ALDEN: Yeah, so if you focus on overall investment, do you have a way to separate kind of what you think is going to be productive in the long term versus what might be malinvestment or what might be misallocated, or do you kind of put all those together? Because obviously it's hard to determine in advance. But basically I think one argument we can make is that the United States has had-- because as you point out, we're very unique in that sense. As a developed market, we have some of these characteristics that don't quite fit other emerging markets because we are, to a large extent, external funded as the global reserve currency. And so do you see that as kind of playing a role?
I know that from my work, it's really kind of showing up in some of these more extreme politics or more a populist-versus-establishment situation because we have a higher degree of wealth concentration than most other developed countries. To some extent, there's been a shift from a developed-market labor to emerging-market labor, but the United States has kind of accelerated that more than some of the others because we've kind of undermined our manufacturing base a bit more by prioritizing other areas. And so, of course, we've had the benefit of technology and health care and areas like that.
So I guess getting back to the question, do you kind of-- when we focus on foreign investment, do you have a way to kind of separate where that's going or what that might be benefiting?
ERIC BASMAJIAN: The way that I look at investment is I look at the velocity of money. and I look at the money multiplier. And as long as those two factors are continuing to move down, that would argue that the investment's unproductive.
So in my view, we can talk about velocity. I think it's a little bit-- hammering on velocity as a useless indicators I think is getting to be an overused point. I think there is value in the metric.
There's two main ways I think