JOHN BURBANK: Price is really just the balancing of liquidity. It is not the proper discounting of the future. If globalization was good for growth, the fracturing of globalization, the limiting of globalization has to be bad for growth, right? It has to be. Now you have to change and bet against the Fed to win.
RAOUL PAL: One of the reasons I personally love Real Vision is the circle of people that I can call upon is truly amazing. And this piece is literally two of the smartest people I've ever met. And two of the nicest people I've ever met. Is John Burbank and Alex Gurevich. John and Alex are really interesting for this conversation because they are both deeply involved in fixed income. There is a particular trade that John has put on very, very successfully that Alex is involved in and has a deep understanding of that I'd like John to explain to you. This is John's idea of how to trade the cycle and particularly the rate cycle. I've been talking about over this week that rates may go to zero and how we can make an extraordinary amount of money out of it. So I'll leave you to really enjoy the conversation of John Burbank and Alex Gourevitch.
ALEX GUREVICH: I'm Alex Gurevich, the founder and CIO of Quantum Investments, and I am delighted to have as our guest today, John Burbank, the founder of Passport Capital. He founded the Passport Capital I believe, in the year 2000. And it's been very successful and very well-known in the '00s during the times leading up to the financial crisis. Very successful fund.
But I'm particularly excited to have John here, because not only are we in a closed space in this building, but also in a close intellectual space, I believe. We occupy similar intellectual space, though we trade different products. For me, it is important that like myself, he is engaged in a long horizon thinking and trying to understand what things really are, and seeing forest behind the trees, and trying to understand that regardless of current market noise, the current perception, where certain price or asset is likely to be two years from now, not by this afternoon at the close.
And that's why I think we can speak the same language, even when we talk about different products. When you end up being a contrarian, you're against 90% of the market, And yet you sit there 95% sure that you're right while 90% of smart people are wrong. In 2004, I said, one should buy every deferred [? variable ?] contract of any maturity if it trades below 100. So basically in 2004, I made a statement that European interest rates will be zero or negative in perpetuity, which was probably 10 years before its time.
I don't think that was as much a brilliant-- it was some kind of mixture of a brilliant insight and some luck. I was just frustrated with the efficiency of European Union. That's really what I was speaking in. I didn't have that strong perception how Europe will really play out. But I said it and it carried some weight back then.
Now what I would like to kind of open up with asking John is what are the instances-- maybe bring up some historical examples from your career when you could really nail it. And how would you attribute some of it to luck and some of to what it is that today allows you to nail it?
JOHN BURBANK: Sure. So probably the best thing to start with is that I started in January '96 at a small hedge fund here in San Francisco doing emerging markets. And emerging markets were a rapidly new asset class. And so there's a lot of excitement about it. But I'm sitting in San Francisco doing emerging markets, and our fund went up every month into from January '96 to October '97. And then EM collapsed, and people did not predict that. And the US kept doing well. It bottomed in '98 about a year later, and then the US went up to a bubble, and nobody pretty knew that.
So I guess early in my career in the '97, '98, '99 and 2000 period, what I saw was two things. A 90% crash in EM in a year in dollars and a huge bubble and things that didn't make any financial sense. What I saw was it's possible for liquidity to take prices very quickly to places nobody ever predicted. And I came up with this view that maybe financial markets aren't nearly as smart on a longer term basis as you think. And that the very improbable or impossible happens on a regular basis.
And so what I'd like to think-- my hypothesis was maybe you can actually identify places that would create that asymmetrical or high leverage situations, but they had to be things that had never happened before. Because essentially, people look backwards and extrapolate forward. They look at a chart backwards and they think, oh, if it's down, it's going to go up, if it's up, it's going to go down. They regress to the mean, basically.
But the world moves forward, the world progresses. And essentially, the other principle is that, I like to say price is a liar, meaning if the massive liquidity has moved so much to one direction, it's pricing in something, but it's not actually true or it's not going to be true in a month a year, two years, the liquidity is going to change directions. And therefore, you're going to have a chance to either make or lose a lot of money.
So what I've tried to do is to understand many different asset classes, many different markets to put together an understanding of where prices are, where liquidity is. And then match it to the fundamental changes in industries, and companies, and perspectives. So if you go back to 2000, August of 2000 is when I started, just before the US market rolled over. We've had-- the world has changed immensely. China wasn't even understood to be a demand driver for commodities until 2003. Tech was this bubble it was forecasting incredible promise, but that promise didn't really become I think, just kind of in markets until 2013, when growth stocks really started outperforming.
Price is really just the balancing of liquidity. It is not the proper discounting of the future. So the question is, where is liquidity now relative to where liquidity is going to be in the future for fundamental structural reasons?
And so one way I use it is go back five years. Five years is a long time in the financial markets. So go back five years, in this case, 2014, middle 2014. And think about what the world thought was going to happen and compare it to where it is now. Go back five years before that, 2009, and think about what you thought about the world then versus where it was in 2014. I mean, five years is a long, long time. Because liquidity has a chance to move dramatically to one place or another.
And I'd say markets are more efficient now. I think the most powerful dominant companies in the world are generally us and some Chinese internet companies, and I don't see a lot of vulnerability there. And I think the liquidity of the S&P, the governance of the S&P, which is incredibly different than it was 10 years ago is reassuring to people. But now we have a difference, a big difference in the perspective of US Fed governors in long term structural trends that I think creates an unusual once in a 10 year bet that anyone can make, which is really got my focus.
ALEX GUREVICH: So I think the origin of the idea for this interview was started possibly with the conversation that we had about six months ago. It actually it was exactly six months ago. It had to be first week of January. I remember I was on vacation in Hawaii, and you reached out to me to discuss calls on your eurodollar futures.
JOHN BURBANK: Yes, exactly.
ALEX GUREVICH: And the interesting situation was then levels on the market just went through this liquidity risk squeeze and a risk growth scenario fourth quarter 2018. Fixed income market got out of pricing imminent tightening cycle. But once we rebounded from the absolute lows of the stock market, stock market strongly bounced last few days of 2018. It continued to rally into early 2019, we went into this environment that is basically on hold for the rest of the year. And as far as I remember, implied volatility in the futures.
By the way, for listeners who are not familiar with them, those are contracts on forward interest rates. And basically, those are the easiest to trade contracts which reflect future Federal Reserve policy. The volatility was extremely low, close to record lows or at least lows for quite a while, implying a very low likelihood of any kind of action. And we started talking about this and I think we were both of the strong opinion that rates were actually going to be cut this year and there was an opportunity there.
And so this is a good segue into discussing why you were so convinced. And also why you think that you are so convinced while a lot of people were still either calling for Fed on hold or even expecting of the dust settles, for hikes later in 2019. I mean, a lot of people were still calling four hikes in the second half of 2019, which of course, in hindsight, looks preposterous. But the interesting thing, that it looks like preposterous for you and me back then. So what is that that allowed you to outmaneuver people, and what was the trade? And what was it that allowed you to outmaneuver people so much?
JOHN BURBANK: Sure. Starting in January 1996, I've seen a few different cycles for all different reasons. The procyclical Capex bubble of the internet build out in the late '90s. And then Greenspan created credit bubble, and the Wall Street leveraging of the investment banks. And all the banks with a crappy product of subprime and that blew apart.
And we have a different situation because the world moves forward so much in 10 years. And so we have a different situation, which was also not believed which, is more like we're talking about the Euribor bet, which is rates in the developed world outside the US are zero to negative. And the demographics are supporting that idea.
And finally, we also have, I think, the biggest thing, although not it's certainly not the only thing, is we have this trade war, which is essentially the crystallization of a long term structural bet by the world on globalization. 2016, we had Brexit in June and then Trump election in November. So in my opinion, those you should put together, because finally, a group of people who I think have been hurt by globalization were identified-- in Britain's case, they didn't realize that was going to be the result. But in Trump's case, I think he identified that and they barely elected Trump. And he has supported that platform.
So in my opinion, that is the crystallization of a multi decade process. And if you want to see a really good forecast of this, you should see on the Charlie Rose show, Jimmy Goldsmith in 1994, campaigning against the Gatt treaty, saying that all it was going to do was put out of work a huge number of people and developed markets. And despite being a libertarian billionaire, although he was an NP of Europe, he accurately forecasted what was going to happen in 1984. And the world went forward enfranchise you know EM labor, was very cheap, it did incredible things for EM. And it ultimately though, misled a large group of I guess you'd say the middle class in the real world.
And so 22 years later in 2016, you had Brexit and the Trump election. And in my opinion, that was the crystallization and the backlash globalization. The trade war with China is the next step of that. So I look at this as a-- this has never happened before. We've never lived through a fracturing of the world, I guess, since World War II, I suppose. Cold War was basically the outcome of a separation and fracture.
But this is-- we don't know how serious this is. And the market I'd say has consistently underpriced the result of that trade war. They keep thinking there's going to be a truce, just like the Trump-- I don't know what Trump exactly thought he was accomplishing at the G20. But this is as big a thing as there exists. This is a war. This is a tipping point of recognition now. Trump brought this from his base, but now there's bipartisan agreement essentially, that the US has to partition China essentially, to limit China's power and ambitions. How many bigger things are there to suddenly occur?
So I'd say these things that haven't happened before are difficult for a group of people or individuals to properly discount into the future, yet it's consistent with this demographic, this slowing trend. This disinflationary trend that you can see if you look at the 10 year treasury over the last 20, 30 years, this demographic trend of low birth rates in the developed world. And essentially, if globalization was good for growth, the fracturing of globalization, the limiting of globalization has to be bad for growth, right? It has to be, unless it's met with a massive fiscal stimulus, I guess, which is temporary and inefficient in nature.
ALEX GUREVICH: Do you think that that breakdown of globalization is also deflationary? Or is it possible to be inflationary in terms of its effect on interest rates?
JOHN BURBANK: So right now, I think it's deflationary because there's a pulling back by companies and corporates, because they see their confidence level has dropped tremendously. So their plans to spend I think have been reduced until there's more clarity. So I think at this point, companies are pulling back more and more. We're seeing it in copper, we're seeing it oil, we're seeing it in how rates are trading. We're seeing in the PMIs of China peaked first, then Europe peaked, then the US peaked.
So the question is when will this be transferred to the consumer, which I think it is. But the point is I don't know what's going to happen all I'm saying is this isn't a temporary event. This is a structural event born out of last 20, 30 years. And finally, there was an identification of a group of people who have been disadvantaged, it's now spread around the world, right? So just three years from that tipping point, I just don't see it's going to get put back together. This is a partitioning.
So right now, it's deflationary. I think on a nominal basis, it could be inflationary because of the less efficient means of production and costs, et cetera. But I think if that's the case, it's bad for real growth without some massive fiscal stimulus. So in essence, I end up with this deflationary, and there's going to have to be some know much greater policy actions to support this.
In the last 10 years, we've gotten used to it Congress doing very little and almost nothing after the first two years of Obama's administration was done, and the Fed doing everything. So rates were zero for seven years. Another thing to think about is the first two years of the Trump administration is different than the second two years. Obama had the benefit of the Democrats having both the House and Senate. He passed a health care deal and nothing else really got passed, nor did he really try to do a lot for business.
Trump's first two years promised to do a lot of things. And I think the animal spirits lift in the US was there. He also accomplished that tax cut, which was pretty stimulative. So I think the first years of Trump with the Republicans having House and Senate, he got something significantly done for Americans and incorporates. And there was a stimulus, and there was this burst of enthusiasm.
But now the second two years, the Republicans don't control the House. And there's a huge backlash, there's a huge separation as we see that I think is going to last for 10, 15 years between liberals and conservatives. But really, it was globalist and the backlash of Trump supporters. But even that has become-- I think there's a basic agreement that we have to limit China.
So what I'm left with is for these two years, these last two years of Trump, He Doesn't have the power to make things happen the way they did the first two years. And we're going to suffer from the year over year comparisons from those first two years. Plus, we have the outcome of the trade war. Plus, all the liquidity that was put into the market in 2016 after a very bad 2015 by Europe, and Japan, everything, everything rose up and now it's been falling, as by the PMIs. And China was the first one to peak. Then Europe a quarter later. And then the US.
So I feel like it's kind of looking at a patient if you're a doctor. If you only want to see the good parts, you could say this person's really healthy. But if you actually looked at the full patient, you could see a lot of problems and want to prescribe things. Somehow, the Fed only changed their mind when the S&P fell 20%. And if you look at the S&P, you're being misled as to the health of this patient. In a way, I could say it's just capital accumulating to the best companies, strongest companies in the world, the most liquid situation.
But many of the things in the world are showing poor health. And the gap of rates in the Fed to the rest of the world is really, really large. And so the getting down to the trading question, other than that fourth quarter where equities fell and then have rebounded, how do you hedge yourself from this trade war being far worse by the disinflationary impulse around