Podcast Write-Up #5: Mauldin Economics - The Gates of Hell w/ Louis Gave
A chat about energy, deglobalization, the dollar and how to position your portfolio going forward
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Release date: 26.08.2022
Host(s): Ed DAgostino (link, @EdDAgostino)
Guest(s): Louis Gave (link, @Gavekal)
All charts have been added by me.
Q: Quantitative tightening isn't reported on in the media as much as the discussions around interest rates. What are your thoughts on QT, what kind of impact will it have on the Fed's goals and on the economy?
Louis believes that we haven't been hearing about QT because in reality, it's not happening at the moment. Inflation started to break out in March 2021, and the Fed continued to expand its balance sheet until May 2022 despite sky-high inflation prints. Since May 2022 there has been a marginal shrinkage of the balance sheet, but so far we haven't seen any quantitative tightening despite inflation at 8.5%. He thinks it's because central banks need to help governments to roll over their vast amounts of debt: in the 1970s debt/GDP was around 30-60%, while today it's rarely below 100%. Central banks are stuck: if they stop rolling over government debt they could create a debt crisis.
The Bank of Japan has been a trailblazer:
they were the first one to go to zero interest rates,
the first one to do QE,
the first one to do yield curve control (YCC).
And for each of these steps, people were sceptical. Now they've embraced full yield curve control and buy a limitless amount of JGBs if yields go above 25 bps. Louis wonders how long it will take until the Fed is going to implement YCC. The ECB is already trying to do spread curve control.
Once the Fed starts doing QT it will have a broadly negative impact on global asset prices. But for now, the Fed isn't withdrawing liquidity.
Ed references a paper by the Atlanta Fed where they estimate that letting $2.5 trillion roll off the balance sheet will be equivalent to about a 75 bps rate hike. He thinks that's a huge underestimation. Louis agrees, because that's roughly 10% of US GDP, so it seems not really appropriate.
Q: How do you see inflation in Japan relative to the US and Europe?
Japan has to import all of its energy, so you would assume inflation would be higher. But it depends on what you think inflation is caused by. Louis believes the reasons for today's inflation rate are:
the energy crisis, and
“crazy fiscal and monetary policies adopted during the Covid period".
Japan isn't committed to deglobalisation like the West: it's not picking fights with China and Russia. Japanese energy imports from Russia have gone up massively. Fiscal and monetary policy in Japan during Covid was also very different.
If you think inflation is the consequence of supply chain issues: why aren't Japan and China suffering as well? Louis believes inflation is the price we pay for the policy choices made during the Covid period and for us actively embracing deglobalization. That's a political choice and it comes with a cost.
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Q: Is deglobalization happening at the corporate level at a relevant scale right now?
Louis believes that there is, and it started in 2018 when Donald Trump decided to weaponize the semiconductor industry and cut off Huawei from chip supply. From China's standpoint, Huawei was their first tech champion with a global brand and market share, and they saw it as the US crushing their success. That spurned them towards independence on the semiconductor front, on the energy front and with their currency.
China pushing hundreds of billions of dollars into semiconductors has led to established manufacturers holding back their CAPEX because of the massive competition they expected from China. For example, 2019 was the first year that TSMC's CAPEX fell since the Asian crisis. That caused the semiconductor shortage of 2020/2021. (Note: in the following chart, TSMC CAPEX fell in 2018 but increased in 2019.)
Political intervention from China and the US created a lot of uncertainty in the semiconductor industry, which caused investments to be held back. Anybody who can move away from China is trying to do it, but they find it challenging. Production is shifted now not because it makes sense economically but because of political reasons. And that comes with a cost: supply chain dislocations and higher costs of production.
Q: Do you think the deglobalization between China and the West is going to continue and will that lead to a higher baseline level of inflation?
It's extremely likely. The US and China are drifting further apart, he mentions Nancy Pelosi's visit to Taiwan. Inflation today is not a bug, it's a feature: 12-18 months ago central banks told us they wanted inflation. Now we're at a phase where inflation has become inflationary because it changes people's expectations. Louis mentions a study by Vincent Deluard (@VincentDeulard) where he looked at inflation across different countries after 1945. Once inflation got above 5% it only goes back to below 2% about 1.6% of the time 12 months later, while 20% of the time it's either above 10% or between 5-10%.
He thinks energy and food prices won't be lower in a year because of underinvestment, problems with fertilizers and other issues.
Historically the Fed had to bring interest rates above the rate of inflation to make it roll over, which isn't going to happen. If they wanted to do it they would have done so when inflation was at 4%.
Q: What's going to happen with Europe during the winter when Russia is going to have a lot of leverage because of Europe's dependency on their energy?
The only good news is that everybody already knows all the bad news. Europe is heading into massive energy and political crises. Louis mentions a quote by Benjamin Franklin: if you give up liberty for security you end up having neither. In Europe, people have been pushed into the bargain of giving up freedom on monetary, fiscal and energy policy in exchange for more prosperity down the road. In reality, they have “ended up at the gates of hell”: we've lost control of monetary policy, the inflation rate is as high as it hasn't been in generations, fiscal policy is increasingly constrained and energy policies have been "so stupidly dumb”. Now there's a risk of significant political crises.
The energy crisis in Europe is going to lead to supply chain disruptions and will be inflationary for the rest of the world, too. Just as an example: a lot of auto parts are still produced in Europe. It's also going to be a hit to global growth.
Q: Can the ECB do something to mitigate the inflation situation?
The silver lining for Europe is that oil is still not too expensive. Natural gas in Europe costs about $600 of oil equivalents, electricity about $1,000. Europe can buy oil for energy, which is a bad way to produce electricity, but that's the best they can do. That's very bullish oil and very bearish Euro, because Europe has to pay in dollars.
As for what the ECB can do, Louis doesn't really know either.
Q: What are your recommendations to an investor in a world with higher baseline inflation, higher interest rates, energy constraints, etc.?
(Note: Louis is using some weird American football analogies. I have no idea how football works, so if I got something completely wrong here, please let me know in the comments.)
Building a good portfolio is like building an American football team: you need different players for different things. The big challenge is now: the defensive part of the portfolio used to be government bonds, and we've seen in the past year that this no longer works. The S&P 500 is down 20% and TLT also went down 20%. Treasuries didn't provide any protection, so bonds don't do the defensive job anymore that we want them to do. Which assets behave with a negative correlation to everything else?
The first one is energy: this makes sense in an inflationary environment, because if oil goes to $150 then the rest of your portfolio is destroyed. There are a lot of ways to play it: high-beta would be coal mines, conservative would be MLPs, oil refiners or uranium. It should be 25% of a portfolio because it behaves like no other asset.
The second one is emerging market bonds. Emerging markets usually blow up during a Fed tightening cycle, but this time is totally different: Brazilian bonds are up, Chinese bond yields have gone from 3% to 2.75%, Indonesian bonds are up. EM bonds are behaving completely counterintuitively, and that's a strong signal for Louis. He thinks big parts of the world are secretly de-dollarizing. A few weeks ago, China did a deal with BHP to price iron ore in renminbi. That's a big deal because they can now go to Rio Tinto or Valet and make them do business in renminbi too or cut them out. China has been trying to do this with Russia for years but now with western sanctions, it's going to work out: the biggest commodity exporter (Russia) and the biggest commodity importer (China) are moving their trade away from the dollar, so there's less need for US dollars. That might explain why emerging markets aren't doing badly during the current US dollar liquidity squeeze.
Q: What are the ramifications for the dollar near-term?
The dollar index is really a proxy for EUR. The only positive case for the Euro is that everyone is bearish already: it looks terrible from a technical and fundamental standpoint. So, between the USD and the EUR it's clearly the USD, but it's different versus the Yen. The JPY is undervalued, they've started to do business with Russia again, they're dealing with the energy crisis by restarting nuclear power, so Louis is bullish JPY. He's also bullish all relevant emerging market currencies like INR, ZAR, and CAD versus the dollar.