RAOUL PAL: So today, I'm going to talk to you as Raoul Pal from Global Macro Investor, not Real Vision, because Real Vision doesn't have a view about markets and a view about economies. But I do have a view. And I've got a strong view that's been developing for a while now. As most of you know, I'm a student of the business cycle. I look at the ups and downs of the undulations of GDP. And you realize that things aren't linear. And most economists don't put some cycle into their forecasts. Once I realized how cyclical things were, I realized there is an element of predictability.
Now, obviously, sometimes with the cycle, things don't work out exactly as you imagine the time it doesn't work. For example, I didn't think we were going to get a full recession in 2015. Didn't quite happen that way. We came very close with it, a manufacturing recession around the world. We had a few emerging market crises, but it didn't quite get to full recession. But it came incredibly close. But now, we've got to a point where I've been monitoring how the cycle is developing. And I've come on to Real Vision a couple of times to talk about the bond trade because I said, look, the cycle's turning, the best thing to do is be long bonds. And that's been a spectacular trade.
So, particularly in the short end of the euro/dollar market, and even in the long end, whether it's TLT, or bond futures, there's been a huge amount of money to be made in that. But now, we're getting to the point where the Fed look like they're about to start to ease. And we need to decide, okay, how far they're going to go? And are we going to go into recession? This is probably the only call that matters.
And I've talked before this, the only asset class that matters right now is the dollar which is range-bound. So, it's currently not the predominant factor. Outside of that, it's trying to decide is the world going into recession and is the US going to go in recession? My hypothesis is, it looks like that is the case.
Now, one of the things anybody who knows me knows that I don't talk uncertainties. So, I'm not saying, look, it's definitely a recession, we're all screwed, whatever it is. I don't even know how severe it can be. But what I'm interested in is the probabilities. And the probability that we're going into recession or even in recession now, are very high.
So, having realized this, I thought I'm not the only person who thinks this. But there was a whole group of people who think the opposite.
And it's one of those turning points where I felt insecure to know, am I right or not? I think I'm right. And I think that people I advise, they think I'm right. But there's a whole group that doesn't. And I thought it would be really interesting to explore this thing fully on Real Vision for me to essentially take over the platform for two weeks to really dig in an interview all of the best people I can find in the world, people I really respect, people who don't have the same view as me, who may happen to have the same view, or just different perspectives, to find out really what's going on. And it's going to help me and all of you go on a voyage of discovery to really figure out are we going to recession or not? And then we'll try and figure out over the course of these two weeks as well, the opportunities and the trades that we can make to protect ourselves, or to make money, whichever way this goes.
The Fed's mistake.
So, let's start at the beginning. The Fed started raising rates a while ago, back in 2016. And it was really incremental. And that incremental rate rise really didn't mean a lot to most people. We brushed it off, because rates were going from a very low level to another low level, but they kept going up. There were rate rise after rate rise after rate rises, but all very incremental and small. Then the Fed started QT, quantitative tightening. They started shrinking some of their balance sheets as well.
And again, it didn't look a lot compared to how much the balance sheet has grown over the previous decade. But that it continued for a while and nobody was that concerned about it. I started getting a different perspective from about August of last year. And it really came to the fore in September, October, November and December, where I suddenly thought the Fed have overtightened.
And that nuance shift happens incredibly quickly. Because everybody at the time saying the Fed aren't tightening enough. And oh, my God, the economy is heating up. And if you remember, everyone's talking about labor inflation, wage inflation, the Fed are behind the curve. And from everything I looked at, the Fed had gone too far already. And they pretty much baked the recession into the cake.
So, what was I looking at? The first thing I looked at is it's the rate of change of interest rates that counts. And I think I showed this on my last presentation on Real Vision back in- I think it was October last year. The rates of change of Libor. So, that's just interest rates. They had gone up enough over two years rate of change basis that it was the largest percentage increase in rates in all history.
And again, many of us said, yeah, but the rates are so low, why does it matter? But the point being is, in fact, almost everybody refinanced at the lows. So, everybody with a house, everybody with a business, every corporate balance sheet, every bank, everybody took out more debt at low rates. And that exploded. So, even my mortgage had gone up 40%. And I was a little bit shy, I didn't realize, and it was only one, I suddenly got this statement thrown out. Wow. 40%.
And then I wrote about it at Global Macro Investor. And there was a large family office. And the principal of the family office called me up and said, we finance all of our debts for the family office, all the leverage that they use, and all the other bits and pieces in their businesses and all of that stuff. He said, I refinanced in 2015. He said, it's gone up 80%. I'm like, wow. And how much leverage have you got? He said, well, reasonable because money has been free, so we took reasonable amount of leverage, but it's got up and it's meaningful. So, I started to think they really have overtightened.
So, if you look at this chart of the 2-Year on 2-Year of Libor and I put it against the business cycle, so I used ECRI, you can see it suggests that the business cycle should fall significantly from here. Now, that's one thing. The other thing is the Fed is still tightening by the balance sheet, that's not stopped yet. We don't know whether it's in the July meeting, the September meeting. When are they going to stop doing that? But really, there's a mass tightening going on. And if you can see, that keeps going on month after month.
There is another nuance about to hit us and that is the debt ceiling. At some point, they're going to have to agree a new debt ceiling, it's most likely be this summer. And that will also mean that the Treasury, who've been funding the government in the meantime, are going to start withdrawing the funding by issuing bonds. So, there could be a huge tightening to come in the August, September, October time period of this year. So, there's some further tightening to come even if the Fed end up cutting interest rates.
The other thing that most people don't realize, is even with these ultra-low rates, people have been really penalized. Now, if you talk about what upsets people about the 1% and the 99%, one of the simple things where this shows up is credit cards. If you look at interest rates on credit cards, they're in fact at all-time highs, higher than they were when interest rates were much higher in the '90s, the early '90s, 2000s. It's extraordinary how much people are being penalized to borrow money while- and that's at a household level, while at the corporate level, there's many corporates around the world- not yet in the US, who are borrowing at negative rates. And I'll come on to a whole lot about the corporates in a bit later in this whole thesis.
So, you can see, we've got the setup, where it feels like rates may have gone too far. And I'll come a lot more on to the rates market later in the yield curve and some of the signals there. But you see what turns a slowdown- and we started to see the slowdown happening in December, we saw the volatility rising again in the equity markets. And we started to see the bond market rallying like crazy, the yield curve inverting super-fast all across the curve is what then happened is what you normally need to turn, what looks like something like 2015 into a much higher probability of being a recession is the extraneous event. And that was trade wars.
So, trade wars are not what everybody thinks. There was a lot of noise about them. And at first, people weren't sure what Trump was going to do. But he first went after the Chinese, then he went after the Europeans, and then he's been going around after Canadians and the Mexicans. And then he's done a deal with the Mexicans. And he's done a deal with the Canadians. But trade wars are happening. And China, the Chinese situation is very, very complicated. And with Europe too, they haven't got anywhere in the Europe negotiations yet.
You see, the problem is this, his aggressive negotiating tactics have created a knock-on effect that most people don't understand. If you're a corporate, and you have this game of cat and mouse with China and the US about not only normal trade, but also about technology and the banning of technology to stop technology spreading. There is a definite move within the US administration to really isolate China in numerous ways, but particularly economically.
But don't forget, we've just come from the most globalized world we've probably ever had. So, if we back up maybe six years, we're the epicenter of globalization, and everybody has decided that China is the future, all the big corporations around the world, whether it's BMW or General Electric, have all moved to China. They're building factories, they're outsourcing, and they have supply chains.
Suddenly, they're being told, well, you don't know whether those supply chains are going to stay. You don't know whether you can actually stay in China, or maybe even the Chinese end up booting you out. You don't know whether you can produce cars in Mexico or not. It's really confusing because is Trump going to go back against what he's just done with the Mexicans? What happens with the Canadians? How does that work? Is there any labor arbitrage anymore in a world where he's even going after Vietnam or countries so small to be irrelevant to stop the Chinese circumventing trade tariffs?
He's also manipulating OPEC, and you don't really know where this world is. And no doubt, there'll be a time when he start picking on India as well. So, he's picking on all of the countries in the world. And that's all well and good. And I've talked about this on Real Vision before is a shift away from globalization is not the end of the world, it is the shift itself, that rate of change that matters. That rate of change is incredibly unsettling for corporate America, particularly, and the global corporations, the multinationals.
Almost across every boardroom around the world right now, the conversation is, can we outlast Trump? And that's a bet. If we don't, we've got hell to pay with our shareholders. If something happens, and we don't have an answer, we're in trouble. Well, okay, we'll build some inventory. So, everybody's built inventory, just to give them some buffer. And now, they need to make the decision. Do we pull the plug now? Or do we wait? Wait and see where Trump goes, wait and see whether there's any option.
So, those two outcomes are really interesting to me. Because if you pull the plug now, you break the global supply chains. That's happening everywhere. We've seen the announcement from Apple this week alone, that they're doing it. The others decide, well, we'll wait and see. So, what does that really mean? That means corporate expenditure stops. They tend to then spend fortune on somebody like McKinsey or KPMG, or somebody else, who's going to give them that advice on building new global supply chains, bringing their business back to the US. It's a two, three or four-year project before they make the choice of where they're going to spend and rebuild their supply, their factories and all of this stuff.
So, that generally means is a big crimp on spending that comes from corporations, particularly in FDI. So, that's going to hurt several countries around the world, particularly China. But there's a lot of countries and a lot of companies who are going to see the spending freeze and have to wait and sit it out. So, that is going to have the effects of lowering growth. And I think that is what tipped this situation from a merely a slowdown that was looking nasty into, for me, an almost certain recession.
So, the question is, is where are we now? Many of you remember, I used to use the ISM as my main way of looking at the business cycle. I don't use it much more anymore, because it got a bit broken. And the reason it got a bit broken was not because of Fed manipulation or anything else, it's because the oil sector became so large that the oil price became the largest influence of the ISM itself, particularly the refinery cycle every year. So, I shifted away to the ECRI. And that's the Economic Cycles Research Institute measure, and it's a weekly indicator, and I use the year on year return of the weekly indicator to give me the business cycle. It works very much like the ISM. And it correlates with everything like GDP.
So, you see the chart here of ECRI with quarterly GDP. And you can see how well correlated it is. It's indicating that we've got some weakness to come. Okay, so that's the first interesting point. Then I like to put the ECRI against a number of other indicators that may be forward looking. And this is where it gets interesting. I'm going to show you a whole series of charts now for you to look at.
So, this chart is the Cass Freight Shipments Index. You can see how dramatically freight shipments have fallen, and how much they're suggesting that the ECRI could fall from here and therefore, the GDP as well. Carloadings, a similar way of looking at transportation, it's collapsing. Capital goods orders, these are the big ticket items, the things that a lot of times, you use financing for, or are involved in the global supply chains, you can see how they are rolling over as well and following ECRI lower. If you believe in this supply chain story, and it seems to be bearing itself out in the press almost daily, then you've got to imagine the capital goods orders are going to come lower.
But households are also struggling with the rates. So, you've seen that in how much car sales have fallen. So, car sales have languished, and they're expected to go further. Clothing sales have collapsed in recent months as well, which has been an extraordinary move. And restaurant sales as well have been extremely weak. So, you're starting to see not only is shipping and moving goods around weak, but you're also seeing a weakness in the consumer and a weakness in business expenditure.
Another great global indicator I've looked at is semiconductor sales. Semiconductor sales are extraordinarily weak right now. And they too are suggesting the global business cycle has a lot further to fall. Back in the US, we've also got the housing cycle, it looks like that the Case Shiller House Index is starting to weaken significantly. And it's now at the weakest level since before the previous recession. And we also have weakness in house prices overall and construction. So, I'm concerned that all parts of the economy are showing evidence of weakness.
And I know many people say, well, unemployment is not, unemployment's strong, unemployment, interestingly enough, is the most lagging of all indicators. And just remember that every time the Fed cut rates and unemployment is below 4%, we went to a recession almost immediately afterwards. They're all lagging, so don't get trapped in the unemployment, look at the forward looking indicators. And they're looking problematic.
So, those are just some of the US indicators that I'm finding concerning. There is a general theme of weakness that lies ahead. And if you go back to that first chart I showed you, of the 2-Year on 2-Year rate of change of Libor of interest rates, then you're going to expect to see a creek come down further. And all of these things that are correlated, come down further.
Also, don't forget, the ECRI correlates perfectly to asset prices. If you look at the year on year S&P, it basically is the business cycle. Now, I understand that equity prices is part of the ECRI calculation, but I can use hard data and a bunch of other variations of the business cycle and they all show the same thing, the equity market cyclical right now, just because of the construction of what he was doing last year, it's at all-time highs, it should actually significantly weaken in October, November if the ECRI stays where it is.
The other thing to bear in mind is that looks like there is a marginal pause in the data. And you'll see that in the global data in a second. So, that's one of the things I'm waiting for over the summer, is let's wait and see how this plays out and whether we get some weakness further on again, which is my expectation, but it's really I want to pick people's minds about.
The global picture.
When I look at the world PMI, you can see the world PMI is just heading into recession territory. So, it's weak, it's telling us that there is a definite susceptibility to anything else going wrong. And I'll come to some of the banana skins later. But anything going wrong is going to turn this from a slowdown into something much uglier. I think the Trump trade situation is that very thing. We're starting to see many central banks around the world expressing concern and thinking about cutting rates in response to this very weak economy that's starting to