GARY SHILLING: Yeah, I think we're probably already in a recession. But I think it'd probably be a run of the mill affair, which means real GDP would decline 1.5% to 2%, not to 3.5% to 4% you had in the very serious recessions.
Actually, I started in with the zero coupon bonds from my own account in 1981. And by the mid-80s, the Shilling family, on that one investment, had achieved financial independence.
Well, I'm on record as saying that the 10 Year Yield will probably go to 1%. Now, it's just about 2% right now. I think you could very well see real GDP grow 2.5%, 3% in a very low inflation environment. So, I think it could be a pretty bright future there.
ED HARRISON: Hi, I'm Ed Harrison and we're about to talk to Gary Shilling here on Real Vision. The real question with Gary is not just his long and varied career on Wall Street in terms of being an economist, but also his call with long rates going from 10 years down from 14% in 1982, down to what he thinks is eventually going to be 1%. My question for him is going to be how does he see that call progressing? And what's going to happen to the economy over the near term? Looking forward to his responses on that.
Gary Shilling, and it's great to talk to you. And I'm really excited about this, because you had a long and varied career, and you also are making some non- consensus calls right now that we want to get into. And as I told you before, we started talking off- camera that I wanted to go through the long arc of your career, but then get to that non-consensus call that you're making right now, because I think that we're at a critical juncture in the economy. Let's go back all the way to Standard Oil. My understanding having read your bio, is that you didn't start out on Wall Street. But you actually started out as an economist at an oil company. My biggest question is, is why was an oil company looking for a macroeconomist?
GARY SHILLING: It's interesting, Ed. Standard Oil New Jersey, which was the largest of the US oil companies, they had what they call the General Economics Department. And it really, I think, was because the Board Of Directors- and the Board of Directors, they were all inside employees, they were guys who worked up through the ranks. They weren't outside people. I think they thought that economists were something that was good because everybody had one. There were two things that they all felt they had to have. And they didn't know what to do with them. One was computers, and the other was economists.
So, it was not a terribly useful vehicle. I went from their standard general economics department to what was called coordination and planning, which was getting closer to the action there. But then I left in four years and became Merrill Lynch's first chief economist and I've been basically in Wall Street ever since.
ED HARRISON: Right. Well, tell me about that transition to Merrill and then White Weld and what your thoughts are on how that was as compared to Standard Oil and give me a sense of what the environment was on Wall Street back at that time?
GARY SHILLING: Well, I was always interested in markets. And of course, Merrill Lynch was a lot closer to the markets at least in my position than Standard Oil New Jersey was or Jersey as it was called inside. And it was interesting. One of the things is you had to learn the jargon. When I went there, and they talked about defensive stocks, I thought they meant defense stocks. And defensive meaning things that are less volatile, like utilities and consumer staples, as opposed to things making airplanes and ships and so on and so forth. And it was a different atmosphere. It was sales-driven. And I did a lot of work with particularly the institutional salesman and covering pension funds, various fund managers, mutual funds, et cetera, et cetera. But it was a lot faster paced environment and one that I enjoyed much more.
ED HARRISON: Yeah. And Merrill versus White Weld, what's the difference there, and also the Merrill of then versus the Merrill that we know before it blew up in 2008? What can you tell us about that?
GARY SHILLING: Well, my history at Merrill Lynch was checkered. I went there in 1967 and I forecast correctly the 1969-'70 recession. But that wasn't being bullish on America in the Merrill Lynch parlays. So, the guy running the shop, Donald T. Regan, he was later Secretary of the Treasury and Chief of Staff of the White House, we had a disagreement, obviously, he won. I took my entire staff, went to White Weld with no idea that in 1978, Merrill Lynch would buy White Weld. So, the story in Wall Street was just really true, Shillings, the only guy fired twice by Donald Regan. So, I decided to limit the odds of that third time and set up my own shop.
But White Weld had been a white shoe, a very conservative firm that had really grown by financing pipelines when they're building pipelines from Texas up to the east and they rested on their laurels. And it's interesting, Goldman Sachs at that point was very much a smaller operation. Well, earlier in the nap, but Goldman Sachs was out there soliciting clients and building relationships and White Weld wasn't. And I think that's why eventually White Weld got sold to Merrill Lynch because Donald Regan wanted an investment banking department and White Weld was definitely for sale.
ED HARRISON: And that's how Merrill became the behemoth that it is because before, it was more into the stock broking. Interestingly enough, when you say White Weld, immediately that popped in my mind that Mark Fopp, he actually was at White Weld at that time.
GARY SHILLING: Yeah, he and I met there. He was a- well, he was first an understudy, if you will. And then he was liaison between the research department and the foreign offices. So, he would get questions coming in and he come over and economic question, we talked about it and we'd compose the answers, and that's how we got to know each other, but it was a good firm. I really enjoyed being there. But there's been a transition in Wall Street and Merrill Lynch- interesting thing in Merrill Lynch, when there was May Day in 1975 when they unbundled commission. So, that was the end of fixed commissions. And I had sensed that coming.
Because in 1973, soon after I got there, there was a whole host of big name economists testifying to Congress. This is Milton Friedman and all these guys who basically said there's no justification for fixed rates and Wall Street like open markets. It couldn't exist without competitive markets except in one minor area, where we fix our fees. And so, I went to Don Regan and I said I think that fixed commissions are going to go, and Merrill Lynch would probably set the commissions being the biggest of the retail brokerage houses. And so, he said, well, you may be right but do a study on this. And I did.
And it was probably the first attempt to the cost accounting study of any Wall Street house because Merrill Lynch, at that point, they basically assumed that their basic business was stock brokerage and listed stocks, and it was on the New York and American Stock Exchange, and that bore all the costs. And everything else was saying a subsidiary with no accounting for cost or revenues or anything else. So, we devised a system to treat Merrill Lynch as a bank, in fact, which lent and receive money from his functional subsidiaries. And it really was an odd situation like in commodities, customers put up more money as margin than the broker puts up with the commodities exchange. So, it generates capital, but they were losing money.
Now, how do you compute a return when you're generating capital, but losing money? What's the return? It was a really interesting exercise, but nothing much came of it. But I think it was, at least I learned an awful lot about how Wall Street firms actually work from a financial standpoint.
ED HARRISON: I don't know in terms of sequencing, whether I want to get to what happened in terms of '78 or move to the economy. But let's try talking about you already foreshadowed it in '78, when you left because of Don Regan, and you went out on your own, how was that for you in terms of that transition?
GARY SHILLING: Well, it was rough because my wife and I and our four small kids, we didn't have any meaningful assets, and to suddenly basically be fired, it was a bit of a trauma, but I have some good backing. What was a major trading operation, the biggest trader on the New York Stock Exchange, Spear, Leeds and Kellogg, I knew those people and they provide a contingency loan we set up. We never drew on it, luckily, but at least we had backing. And we did have a lot of the clients that we had, and we build up a business within White Weld, not only serving financial institution, but also industrial corporations, companies like 3M and AO Smith and major industrial corporations, and we were able to bring all that business with us. So, we got off to a start. But it's scary when you're suddenly all on your own. And you've got to start and no big, meaningful capital as a cushion. ED HARRISON: Yeah, I can imagine. For me, I'm thinking though, in some level, that four-year juncture between '78 and '82, could have been fortuitous and not fortuitous. Because you were going out right at the period I think that was the most volatile in terms of the end of that inflationary cycle in the '70s. Take me back to what your thinking was. GARY SHILLING: Well, it was. Actually, by the late '70s, I concluded that inflation was on the way out. Now, the first book I wrote up on that the title was, Is Inflation In? Are You Ready? McGraw Hill published that in the early '80s. But what I saw was a turning of the populace against Washington. He had had previously the conviction that Washington really knew what they were doing. But then you had two things that really destroyed confidence. One was Vietnam, which, of course, was very unpopular, and the other was the Great Society programs that didn't really work. And of course, they generated huge inflation, because you simply had excess demand on a fully employed economy.
Well, something happened in 1978, it was called Proposition 13 in California, which was it basically limited the increases in local property taxes, and it still exists. And that, to me, was an inkling that- because California and all California is a rootless society, most people have moved in there from someplace else, they don't have strong traditions. So, they brought those hula hoops or foreign cars, or in this case, limits on government spending, you can see things start in California and know they're going to spread nationwide. But anyway, I saw that. And then of course, you got to the election of Reagan in 1980. And I said, that this is a change of environment, because I saw the root cause of inflation is being excess demand.
And so, that's why I started forecasting the demise of inflation. And with that, a huge decline in interest rates, Treasury bonds at that point or long term Treasury bonds, 30 Year Bonds are yielding 14.6%. So, that was an extraordinary opportunity for appreciation because of course, as the yields go down, the price goes up.
ED HARRISON: What did you think, by the way, of Volcker's attempt to deal with monetary policy by the money supply, targeting the broad money supply, which was a failure in the end, did you think that was going to work?
GARY SHILLING: Well, of course, it's debatable. I think a lot of people would give Volcker credit, but I think it was really a shift in the attitude of the American people and Volcker couldn't have done what he did if they hadn't had the populace behind him. And in fact, I think inflation was on the way out anyway, before he acted. Nearly jacked up interest rates about 20% short term interest rates and your precipitated two back-to-back recessions. But that was the beginning of the unwinding. But if it had just been monetary policy, why would you have inflation coming down for now, almost 40 years? The peak was in 1980. So, I think was a much more profound change than simply monetary policy.
ED HARRISON: And it is profound. We're going to get to that at the end in terms of whether or not that cycle that you're talking about persists and continues now. But that was the beginning of the great bull market. The interesting bit is before this, yesterday, you sent me a chart on how we think about- when we think about the great bull market, usually we think about equities, and we think about '82 is the beginning and potentially continuing on. But the chart you sent me was about zero coupon bonds. Tell me about that. Because it was shocking, the outperformance differential.
GARY SHILLING: Well, I started investing in 30 Year zero coupon treasuries. Now, zero coupon bonds don't pay any interest, but they are issued at a discount. And the interest in effect is in effect built in the difference between the issue price which is below 100 and they're expiring at 100. It's built-in. Now, the fact that it's built-in, it has big advantages when interest rates come down. You don't have a reinvestment risk. In other words, if you invest it, let's just take an example. Let's say you invest in a 10 Year Yield in security and the rates dropped to 5%. Well, you've got to reinvest at 5%, you no longer can invest at10%, that's gone. But the zero coupons build that in, so you get actually about twice as much appreciation for given declining interest rates with a zero coupon, as with a coupon bond, and the longer the majority, the more bang for buck.
Now, it works both ways. You'll lose more money if rates go up. But actually, I started in with the zero coupon bonds from my own account in 1981. And by the mid-80s, the Shilling family, on that one investment, had achieved financial independence. And it's been a tremendous asset, as a matter of fact, since the early '80s, and we have these documented that these zero coupon bonds have outperformed the S&P 500 by five times- that's including dividends in the S&P, but a lot of people, they think that Treasury bonds are for little old ladies and orphans. Well, I've never, never, never bought Treasury bonds for yield.
I couldn't care less what the yield is as long as it's going down. Because when it goes down, they increase in price, and I bought it for the same reason most people buy stocks. Most people don't buy stocks for dividends, you have some for utilities and real estate investments, but most people are looking for appreciation. And that's what my interest in Treasury bonds.
ED HARRISON: We're going now into asset allocation and stock picking and investments and so forth. I understand that you have been associated, I think it was with Forbes since 1983, one of the longest standing writers at Forbes, and even though you're an economist, they picked you as one of their favorite analysts of the market. How did that come about?
GARY SHILLING: It really came about, there's various people I knew, who had been