Global Macro Podcast #006 | feat. Michael Green

[Music] if i'm running a discretionary program and that's going into some form of a structured product and this doesn't happen for precisely this reason if i choose to do something that is different than i would have done historically then the results of that product could be very different than what i have advertised them for and i become liable right and so i'm forced into a quantitative system this is actually part of the reason why i partnered with wayne as i realized that until the rules change there is actually no substitute to a documented quantitative process for me the best part of my podcasting journey has been a chance to refine my own investment framework through a series of conversations with extraordinary investors in every corner of the world in this series i along with my co-host robert carver and maurice siebert want to continue our education by digging deeper into the minds of some of the thought leaders when it comes to how the world economy and global markets really work to try and learn how they think we want to understand the experiences that have shaped them the processes they follow and the historical events that have influenced them we also want to ask questions outside our normal rules-based playground we're not looking for trade ideas or random guesses about an unknown future but rather knowledge accumulated over the course of decades in the markets to try and make us better informed investors and we want to share those conversations with you our guest today is one of you real independent thinkers and a student of markets and market structure and perhaps the leading mind when it comes to how the growth of passive investing is changing markets in a way that few people realize so i'm absolutely convinced that you will have your eyes opened from our conversation today with michael green of logica capital advisors mike thanks so much for joining us today for a conversation as part of our mini series into the world of global macro where we relax our usual systematic or rules-based framework to provide you with a broader context as to where we are in a global and historical framework and perhaps discover some of the trends that may occur in the global markets in the next few months or even years and ultimately how this will impact all of us as investors and how we should best prepare our portfolios so we're super excited to dive into many different topics in the next hour or so not least because you have done a lot of work on some of the structural changes in the markets due to high levels of passive investing that i'm sure we'll be spending some of the time on but let me just kick it off with kind of a 30 000 feet question mike and that is where do you think we are in kind of a big global macro picture because as i've said before on on this series you know it feels to me that it's kind of a blend of things we've seen before in the past a lot of people compare this to the 30s and 40s japanese bubble in the late 80s of course the tech bubble great financial crisis and then of course we've added something brand new namely a global pandemic which makes it pretty unique how do you see it right now so i think those comparisons are often drawn in terms of of where we are in relative to to history i think one of the things that's hardest is we all know the phrase history doesn't repeat but it rhymes and so we're constantly looking for those patterns right i have had the view for a while that it's very lazy to compare the time period that we've gone through to the 1930s right this idea that we were in this great global depression following the global financial crisis the primary pushback i'd have against that is the continuing growth of wealth disparity right inequality has continued to expand and the 1930s were very much an inequality equalization time period particularly after the 1929 to 1932 time period if anything i think we're actually still in the 1920s and potentially haven't seen our global financial crisis yet i'm sure you follow a lot of the people we follow as well but it kind of ties in a little bit to the fourth turning from neil howe where yeah yeah exactly where he says you know the first crisis that you think is the big one may actually not turn out to be the big one that comes usually at the end of the fourth turn which of course we know that he predicts to be this decade so that's pretty interesting of course your friend that at real vision uh royal pal he talks about kind of the three phases that that he's seeing kind of the unraveling and now we're in the hope phase of the current market and then comes kind of the insolvency phase do you think in the same terms or so i do think there's a lot of similarities in the in the line of thought right so the biggest concern that i have and i did an interview with rowell i think it was april 8th so fairly soon after the the quote-unquote bottom and my objection continues to be that it feels like we are projecting history onto the future right so we're saying this has to happen and the challenge in comparing the 1920s and today is just that in the 1920s we had a convertible currency right it could be convertible and it was convertible into gold and so the level of defaults the level of uncertainty in terms of people's ability to source dollars to service the debt was much more constrained in an environment of the gold clause right we don't have that today and so to expect the same outcomes to expect policymakers to sit by and say our hands are tied as they watch the potential unraveling of the system i think is is hard and so i think we'll continue to get lots of signals from the market that effectively say the equivalent of hey pay attention to us you have to respond we have to do something or that will happen again i think we'll continue to encounter those types of crises but to expect the same outcomes when you have a radically different currency structure than you did in the 1920s to the 1930s i think feels strained sure i really like the point you made about inequality in crises because normally you're right asset prices get smashed in crises dividends get smashed and you know the the wealthy of people who own those assets tend to see their income reducing so that that's really interesting it does suggest that either we're not there yet it's all this this crisis may be truly different i want to kind of lead that into a subject that i know you've talked about a lot before which is passive investing um well it'll be my tombstone yeah so um i think one thing about crises like these is that they they may cause kind of these big secular trends that we see in things to sort of reverse partly or completely and obviously there has been a big rise in past passive investing over the last well 20 years i guess possibly going back further does this feel like there might be a change here so there's there's kind of a little bit of anecdotal stuff going on there's this kind of investment as entertainment thesis you know it does seem like there are more individual investors piling into robin hood and buying individual stocks and then if you you know if you're investing for entertainment you're not going to go and buy a kind of boring kind of market cap way to dcf you're going to want to buy individual stocks story stocks name stocks and have some excitement so that's one thing that's going on but i do wonder whether this crisis generally could cause that that trend potentially to to stop or even reverse and maybe there are other explanations of to be going on there so so the one thing that i always highlight for people with passive is just that it's the growth of passive is now basically built into the system right from regulatory framework all the new money that comes into the us savings and investment accounts primarily in the form of 401ks and iras are coming in in passive vehicles right and so this is actually by law or not quite law but certainly by regulatory fiat into the 401k space where corporations because of the dol's fiduciary rule that didn't fully go into effect but went into effect enough that it caused the changes that have have reinforced this you know if you are a corporation you offer a 401k plan to your employees and you offer them a plan that does not have the cheapest and lowest cost index funds in it then you actually become liable right you become liable not just for the excess fees but you actually become liable for the underperformance that could potentially accrue and nobody signs up for that that's not what corporations do right that's actually why they wanted to get away from defined benefit plans they didn't want to be responsible for the outcomes they want to be responsible for the contributions and so the entire system has aggressively shifted to converting those inflows to coming in through passive vehicles primarily through things like target date funds at this point we're looking at well over 100 of the net flows that come into particularly the equity space and increasingly in the fixed income space are coming in in the form of passive vehicles and until that changes until we actually change the regulatory structure i have a hard time seeing it reverse so in essence this means that the hr representative is the new cio that's exactly what it means those guys make the calls right they say we're doing this we're buying the s p 500 or we're doing whatever whatever the case may be and here and you know i live in germany and it's the same thing long gone are the days where you know retirement money was allocated to a mutual fund manager that was kind of like you know discretionarily trading stocks buying value whatever the case may be right now all of those products are linked to an index be it the tax index or the euro 650 index and they may have a guarantee right so there's a long put option or some sort of a guarantee uh for retirement attached to that as well but it is an index product and all the flows happen at about the same point in time which is the end of the month or the beginning of the next month that that's kind of like the sweet spot where all the money flows and i think what one can see and it amazes me is that well first off i mean this has been long reported the average correlation and the average co-movement between stocks increases but what you also see is that you know the breadth of the market changes you know all of a sudden all of the stocks in the tax for instance which has 30 stocks are above the 50-day moving average it happens more regularly whereas previously 10 years back it was kind of like a 50 50 type of thing now it's no no that's not a 50 50 type of thing that's a 95 odds that if one stock is above the 50-day moving average all the other 29 are above the 50-day moving average too well and that's one of the big legacies coming out of the global financial crisis right so the reason why all those products in one form or another refer to index products is because you don't want again you don't want to attach any form of liability if i'm running a discretionary program and that's going into some form of a structured product and this doesn't happen for precisely this reason if i choose to do something that is different than i would have done historically then the results of that product could be very different than what i have advertised them for and i become liable right and so i'm forced into a quantitative system this is actually part of the reason why i partnered with wayne as i realized that until the rules change there is actually no substitute to a documented quantitative process you just can't run on a discretionary basis you can show a back test if you have a quantitative process and an institutional investor can disregard that but those back tests can be used for things like selling a variable annuity those back tests can be used for fixed income annuities those back tests can be used for structured products in terms of the marketing of those products and the only requirement is that you have to stick by them we've so stacked the deck against discretionary active managers that i'm not really even sure it's a game worth playing unless you choose to actually change your process to take advantage of the features of the market and very very few people are doing that it's just hard you have to bend your mind and change everything that you've been taught for the past 25 years i mean i'm curious i mean i'm sure we're going to talk more about the effects of passive growing in terms of the equity space but just our curiosity are we seeing exactly the same trends on fixed income i mean is is passive also dominating to the same extent or always in fact maybe because yields are so low people say wow but i need to find an active manager because i can't live with with zero the fixed income space is about 10 years behind the equity space in terms of the growth of passive in terms of individual discrete allocations there's been a tremendous amount of growth in the etfs and the fixed income space and in particular they've been widely adopted by fixed income managers that use them to access some forms of liquidity but again if i look at the investment public in the united states by far the largest source of growth in the fixed income spaces is through the target date funds themselves and so the vanguard and blackrock and and capital group vehicles that dominate that space between the three of them they hold well over 50 percent of the target date fund universe those are really the primary sources of growth and those have their own index construction problems that in my opinion actually exacerbate many of the problems that we're seeing so fixed income i would actually say is analogous to the indexing of of the u.s equity markets prior to the com changes right there's just a structural mistake in the way the indices are constructed and then in addition to that i would say we have in the u.s the fixed index annuities and the va type of products right essentially all of which are index linked or if they're not index linked to indices such as the s p 500 they're linked to custom indices you know produced by qis type of bank strategies which themselves probably make reference to an index again so it's you know self-referencing inside the product back to an index and those products by the way also strongly strongly growing in asia uh singapore hong kong taiwan to a certain extent still japan so this train seems to have left the station and gained speed that more and more of the money is going passive and one wonders what's the end game with that how long will that go on price insensitive buying and selling at settlement or close linked to an index without any consideration of let's just call it value or whatever fair price right when does it stop when will it break well that's of course the 64 trillion dollar question right yeah so please tell me trillion dollars don't tell anybody else just me yeah yeah no this is part of the way i always try to solve these problems is i take them to the reducto ad absurdum conclusion right and so one of the key differences between a discretionary manager and a an index manager is how they hold cash or how they treat cash and so if you think about the mathematics of what happens a discretionary manager and we've got our own proprietary research that we've done on this we'll typically hold about five percent cash right now in order to keep up with an index they may take that down and we do things like track the cash balance as percentage of market cap to give us an indication of this sort of stuff and um michael hartnett has a a good piece he calls the flow show that tracks the level of cash allocations and it has a consistent negative correlation with the return profile one of the things that i point out to michael all the time is just that the only people that respond to his surveys are active discretionary managers right nobody vanguard is responding and so when he says that the market is five percent cash or four point seven percent cash what he's talking about is the discretionary managers the vanguards of the world run with no cash all right my personal favorite example again i go back to things like target date funds you know they carry no cash the vehicles they invest in carry no cash the only way that they accommodate rebalancing is because they have a constant flow of new capital coming in and so you have these sorts of crazy dynamics and if you just walk through the implications of a market that has five percent cash to a market that has zero percent cash the only way that can be accomplished is by inflating the assets themselves because what you're really doing is you're saying i need to reduce the cash to zero well the cash is neither created or destroyed destroyed at any point in this process i buy you sell cash is unchanged so the only way to accommodate lower levels of cash just by driving the asset prices themselves up and so how does this conclude i think it concludes with the world's most ridiculous melt up when we do the math and walk through the implications of going from a five percent cash world to effectively a 10 basis point cash world which is roughly the average across the index space the market has to go up 50 x 50 x not 50 percent not five percent until i was like 50 times we're talking shiller pes in the 500 600 sort of range now do i think we'll get there no because before we get there the volatility has exploded to such an extreme that a catastrophic event that just wipes everybody out and they say well we're not going to do that again right or we're going to freeze the market we have to stop the market in some way shape or form like i'm convinced that that's how this ends so you're the school that ets make the market more unstable i guess then well they do both right and so that's the irony when you when you introduce an alternative approach to managing money that has a at least initially it has a diversifying effect if i have managers who will only buy when stocks are below 10 times earnings well then if stocks go to 20 times earnings because of some external force the next buyer is 10x right so the market has to full 50 that's what the dot-com cycle was by the way if i take a scenario in which the marginal buyer is always somebody who says i can't hold this cash if you give me cash i'm going to use it to buy prices are going to inflate right if you combine those two you get a diverse ecosystem and so stocks can go up and down in relatively small ranges it's actually evolved dampening up to about a point on our math it suggests around 30 passive penetration was the trough in terms of what you would expect in terms of realized volatility because you had people who wanted to sell and people who would buy without thinking about it it was a diverse ecosystem now as we're pushing out of that we're moving into a higher volatility regime and of course it's really tough to diagnose this right i mean i have a hypothesis i have got models that show that this is what happens and so far they've been largely accurate but man it's awfully hard to argue that a global pandemic is actually you know linked to passive investing per se i feel it's very much linked to the responses that we've seen the reactions in the market but like most social sciences it's a one-off experiment i don't i can't repeat it and be like okay everybody let's go back to february and you know we'll do this whole thing without the past with without passive or without the pandemic right you just can't recreate the experiments and so you have to have a hypothesis and until you're proven wrong you keep operating on it so it's not like 87 where you could argue that feature of market structure which was portfolio insurance a lot of people probably think that was the cause of the crash so if we go back to say 1929 maybe it's a bit silly comparing 1929 to now because it's such a long time ago but i think i've seen the figures that stock ownership was was lower in the sense that only about 10 percent of u.s household households owned stocks and now it's 50 the difference being of course back then i think most people probably owned them as individual names and were kind of actively trading the money themselves rather than it being passively invested although there were a few things called investment trusts that were a bit strange so do you think that would the market be more or less stable if we were somewhere between those two extremes or it's hard for me to get my head around the fact that individual investors retail investors who generally speaking can be pretty wild in their behavior make this system less stable than than the sort of you know this mental image i have of a river of money kind of flowing consistently through through the system well so i i think we have to be very careful right because one i do think that that you referred to the unit investment trust i actually think that they are very similar to much of the financial innovation that we're talking about with passive right they largely were designed to deploy capital there was far less consideration to what actually sat inside them in many cases they were blind in terms of they didn't disclose either the amount of leverage that they used etc and i think that's another component that people gener generally under appreciate is that while we all complain about leverage and we complain about the high levels of debt the flavor du jour of how we solve this is something like risk parity which says okay let's lever our portfolio 10x and the fixed income space all right let's add what you're actually doing is adding debt right you're adding recourse debt to your portfolio and saying that's the solution to how we trade a world that has too much debt let's radically increase the quantity of debt right well by definition if you choose a levered approach you're talking about increasing the demand for financial assets in aggregate so i think there's a lot of similarities again this is one of the reasons why i draw the analog to the 1920s because i think we have financial innovation without very thoughtful application of what we're actually doing and then in just in terms of would the market be more or less volatile i just think it's really hard to say right i mean the bid-ask spreads in the 1920s in a world that was dominated by high commissions by restricted access it's just really hard to actually draw a direct analysis yeah right yeah hard if not impossible probably i mean all those you know time periods are so different there's it's nerve god exists i mean there was a yeah there was a period during the sumerian no i'm joking but it's it you know it's that was a joke i'm referring um yeah we have no idea we really don't and so the only thing we can do is build a model and if that model broadly fits the data then you know you continue to follow it yeah i mean we're seeing i i was i was really surprised i i saw it on twitter i think last week uh u.s pension funds considering to lever up uh so you know i mean to the extent they're doing 60 40 or risk parity or whatever it is that they do with their long-term asset allocation but they're going to go i don't want to say all in but they're they're they're they're shifting up one gear right because they need to deliver i don't know what it is seven percent they cannot deliver seven percent in the current straight environment so what do you do you lever up this to me sounds like a recipe for disaster i have to agree with you i think part of the irony is that most leverage to this point has been held within limited liability format and so calpers for example who is who the headlines were for last week like they can absolutely buy as a limited partner into a fund that is levered 20 to one right that's that's a way of of tapping leverage but it's non-recourse what they're talking about doing is actually borrowing money that is fully recourse to the pensions and then deploying that like from a risk control standpoint somebody needs to be slapped upside the head that's just stupid it really is and it only happens in an environment in which people are just so arrogant that they honestly can't think about the liability that they're creating for the taxpayer there's so many things really to unpack with you mike and now since we are talking about pensions i mean i'm curious about a couple of things one is of course a lot of people talk about the looming pension crisis i think actually on real vision you ran a whole series on it so i'm kind of interested in in your view on that but i'm also interested a little bit in demographics i mean how does that all play in because i imagine that the younger generations obviously are most likely passive type investors robo investors or whatever i imagine that the older generation my age plus maybe not so much and then there's the whole you know demographic shift the boomers retiring and needing money back i mean where where does this all fit in yeah i know i think you're hitting on obviously the critical issues right i mean again we don't have a model we can run things forward but we have to do so with uncertainty about the asset return framework right and so one of the brilliant things about at least the way this seems to be structured is if i think the market is going to go up 50x or more accurately you know 20x from these levels well then we've solved the problem right it's all it's all fixed let's just go levered long and everything's going to be fantastic the problem is though that what that's doing is that's pumping up the claims that the boomers have on the system and it that in turn then needs to be sold and so you have this perverse impact where the money that is coming out is a function of the level of the asset price but the money that is going in is a function of the level of incomes right and so when i start talking about incomes i'm obviously talking about earnings and those can be both on you know the on both on the corporate side and on the personal side they're linear in their construction right they basically have to be one-to-one against an income stream there's only so many pieces of the pie that can be split up if we decide we're gonna pay a lot more for that and we build out on the backs of young people who are deciding you know with through no fault of their own right it's simply this the system that we've set up that six and a half percent of their paycheck every two weeks goes in to try to buy stocks at higher and higher valuations well they're getting less and less ownership for each dollar that comes in and the money that is coming out is ultimately going to swamp that and so i to me that's the real pension crisis is that at the end of the day the cash flows don't match and so the only the only solution to that is somebody else has to step in and either suspend the prices on the assets so that they can't be driven downwards which is what i would argue we've done for the past 20 years i think this is largely the phenomenon that we see with the fed's reaction function or we could decide that we're going to replace the actual cash income that's lost at some level the problem is politically where do you pin that do you pin that at s p 15 times earnings you pin it at 30 times earnings do you pin it at 100 times earnings the problem is is that we keep setting that level higher and higher the fed's reaction function is getting quicker and quicker and quicker because this problem is just growing people it was entertaining when i'm talking to people who are quite a bit older myself about pensions and i saw so you know pensions don't really exist they're just essentially a contract between you and the younger generations as to how you're going to transfer money to each other and ultimately that that has to happen in through some mechanism right so in this country i guess we have a bigger state state pension government-funded pension and any shortfall in in sort of private pension income will most likely come through higher state pensions but of course where's that coming from well it's going to come from general taxation who's paying the tax it's the younger generations the distribution of how the distribution of how that kind of reallocation of wealth from old to young happens may be different depending on the the mechanism but ultimately if the boomers have got these huge claims then they're either going to have to be as you say reduced somehow or repudiated i guess effectively or um there's going to have to be another another mechanism of getting the money out of the younger generation to ultimately pay it well i think there's a couple of different ways it can happen right i mean one is as you said we could explicitly reduce it that's difficult to do in a democratic system it's fascinating to watch and this is obviously one of the implications of something like neil howe's generational view right is that ultimately there's a war between the younger and older generations and do we choose to actually stick by that well the older generations control the infrastructure they control the political systems at least for now they certainly control the access to the power in the form of police and everything else and i think we're starting to see these systems bang against each other historically we have not had problems to this level with the exception of there's just a very few empires where you have anything remotely close to this right the roman empire had achieved a level of relative affluence that it had to deal with stuff like this and so the the transition over the first century bc from the roman republic to the roman empire is one that i continually emphasize for people right that we are looking at a system where what everybody is crying out is we need a single strong individual who can take control of the system and force people to make the changes that they're refusing to make as a democratic politic right as as the voice of the people we're refusing to do that so we need to have a strong well that's a dictator i mean that's that's what a dictator literally is and so i i'm very concerned that we're meaningfully stressing the democratic institutions and i would highlight in the united states i think this is also very true in europe you're seeing the discussion right now with germany and the rest of europe ultimately deciding how we're going to choose to allocate those resources is really hard right california is broke totally broke if i look at it from a you know standpoint i had a twitter response the other day you know in this version of the european debt crisis the role of greece will be played by california and italy will be new york right and we need somebody to bail out california we need to bail out illinois or we need to decide we're not going to do that and if we choose not to do that then there's going to be huge implications and there's going to be huge implications that we choose to bail them out like we're not we don't have good choices in front of us and we don't have good systems for dealing with it that's essentially the picture that we're looking at here in europe right where we don't have a fiscal union we have a common currency and a common central bank but no fiscal union no you know centralized taxes none of that stuff so the system is under permanent tension of breaking because of the imbalances that it creates yes [Music] i want to come back to is what you always read is kind of like you know during these uncertain times if you need any guidance you know look at me blah blah blah but in markets it's always uncertain even the easy peasy bull market right trading is never easy there's always uncertainty but what i want to say is it you know we're getting to to more and more levels of extremes that is at least my feeling when i look back over the past say 25 years we've had many crises and you know all of that it's always there's always been uncertainty but what's happening now i mean every crisis that we're getting into seems to be a little bit worse than the one that we had before in terms of money printing in terms of central bank reaction functions whatever the case may be so it feels like at some point we will get to this end game and something will break democracy will break whatever the case may be there there will be something weird going on and my question is really how would you best from a you know asset allocation trading investing trading point of view how would you best prepare for that well so that's actually why i joined up with wayne and we chose to launch the logic absolute return product right we've actually tried to design it to be a product that takes advantage of the features that we think are likely right so rising volatility a market that is increasingly extreme in both directions those those are outcomes that lend themselves to strategies that use derivatives and so that's what we've tried to do right we've actually tried to build a product that is capable of exploiting this phenomenon it's challenging though because as volatility rises the price of that non-recourse leverage which is what we think of as options providing the price of those begins to rise and other people begin to pursue these strategies and so you know we just we have to be thoughtful about how we adapt at every step in the process we've gone in the period of of you know give or take five months so that our theological absolute return product has been live we've been through almost every possible node in terms of our our allocation schema and as a result we're actively involved in developing more technologies more approaches to what could happen next how would we be prepared if x happened how would we be prepared if volatility rose from an already elevated level there's a different answer to that than volatility rising from a very depressed level and so we just have to be very thoughtful about how that's done i don't think that there is any one system that you can set and forget and say you know here's a permanent portfolio a lot of people have spent a lot of time trying to do that and they've used the past hundred years of data but we've been talking for 20 minutes and i've already introduced the roman empire right so now we need 2 000 years of data right i mentioned sumeria let's get 5 000 years of data and then let's consider the fact that we happen to be the only inhabited planet that we know of right somewhere out there there's probably a 10 000 or 10 million year history of of an investable society maybe there is passive investing passive investing who knows right it's intergalactic who cares right but that's part of the point you use the phrase non-ergotic it is a non-ergotic system our participation in the system changes it and all of the models that we've adopted over the past 70 years especially passive investing assume components of an ergotic system we use the phrase monte carlo simulations by definition monte carlo simulations assume ergodicity they assume that the distributions are stable and unchanging and that's just wrong it's just wrong and so we built this giant edifice that now manages roughly half the assets on the planet under the assumption of the earth being flat it's not flat that's gonna cause accidents the more resources we allocate to a system built on the idea that the earth is flat the more people we're gonna have to put at the stake to prevent the truth from getting out so this is just we've built an edifice that i think is absurd i agree i mean you have people like naseem to lap talking about the the massive impact off the tails right and he has a big following but this is only one part of it we know there are tails we know tails are better uh on both sides of the distribution actually but what you're talking about is that the distribution that we're looking at may actually be completely wrong correct i think that is absolutely correct i think the irony is the process of building the perception that the system is understandable under some form of log normality or some form of brownian motion right which is it sits at the heart of all sorts of well-roused and equip equilibrium models the process of assuming that and putting capital to work under that framework this is what i was referring to earlier perversely actually imposes that framework if i have capital and every time something moves two standard deviations down and i buy it well then guess what at two standard deviations the tails are going to increasingly be less fat it's gonna look more normal actually it's gonna it's gonna experience increased kurtosis right the center is going to be higher because there's more people engaged in the process of mean reversion now all of a sudden what causes it to break is when forces that we couldn't have foreseen overwhelm those mean reversionary characteristics and then the market is forced to unwind in an extraordinary fashion so that's you know this is very much the minsky type framework right stability begets fragility or instability and so we've built up this giant edifice that is just predicated on assumptions that were made because it was easy the math is really easy with log normality the math is really easy if we have mean reversionary behavior there's lots of assumptions and things that we can point to and the fact the markets largely behave that way because individuals discounted historically so if individuals discount if the market participants discount then the market will exhibit mean reversionary behavior but if the systems are built to reinforce the momentum characteristics that the system is built to say hey let's reinforce these dynamics because we assume everybody else has already done this work and we put all the capital there then we destroy the mean reversionary characteristics of markets that's exactly what we're seeing you mentioned history and i guess we all study history we'll use historical data to build our models and we try and draw as you say we try and draw some analogues back in time but one of the things that and i'm curious to see whether i can make this fit into the discussion and that is when we go back in time one thing that we observe is that countries were much more individual because they did we didn't have the technology so a lot of the time when we had a crisis these crises were isolated it's okay so japan had a crisis but the rest of the world was doing okay and then europe had a crisis but other parts of the world did okay right now it seems like correlations between economies have increased dramatically for the first time i mean it's not happening just now but it's it's been around for only a few years in a in a bigger picture so the economies are coordinated and for the first time i think right now we have g10 currencies we have the interest rates pretty much at the same level so what risk does that introduce that the whole world seems correlated in lack of a better word well i think i think you know the answer to that right i mean if there's increased correlation then there's increase there's decreased ability to diversify your risks right the system becomes more prone to extreme behaviors wayne has a really good illustration that he uses says look if you think correlations are low at 25 percent or zero percent correlation well that means things move in the same direction 50 of the time if they're 25 percent correlated that means they move in the same direction 62 and a half percent of the time if they're 50 correlated then they're going to move in the same direction 75 percent of the time and so the more correlated they get the more extreme the peaks and valleys there's very little modulation that becomes possible and again this just goes back to the underlying building of the in the fragility of the system if the system is predicated on the assumption that the authorities will do everything they can to keep the system in place to maintain the current functioning of the system there's a huge moral hazard associated with that this exact same one we were just describing in terms of the mean reversionary characteristics of markets when that breaks and when some external force causes that to be challenged then all hell breaks loose and i would say that this pandemic has been interesting like we've seen some very real world stresses where optimized systems don't work really well i mean the u.s experienced toilet paper shortages like that's absurd we experienced you know shortages of very basic things like personal protection equipment for doctors we were told masks don't help not because it was true but because we needed to preserve the masks for use by medical profi professionals right we didn't want to see hoarding activity we didn't want to freak people out and so i think there's no question that there's an extraordinary amount of fragility that we've established and breaking down those that element of cooperation whether it's between the u.s and china or whether it's between european states or u.s states all of that effectively exposes the gaps in the system if california decides to hoard ppe and not share it with new york then both have to supply more ppe on a short-term basis and it becomes more difficult for an already stress system to meet that that's a reduction of the surplus that i would actually character like people talk about and i've spoken openly about this before people use the phrase you know we we live in the age of uncertainty that is such a pile of you know dog doo doo i guess that's the uh the technical term right we live in the in the in the environment of absolute certainty how are you going to get to work every day well you get on this giant concrete structure that's been built by the resources of society and you transport yourself in your 4 000 pound piece of equipment to a parking garage where you're going to take an elevator that had to be constructed to take you up to your office right you only build those systems in environments of intense certainty i tell the story i use the analog in places like africa where they still wash their clothes in the river the river has crocodiles well what happens if you wash your clothes in the same spot every day the crocodiles are going to be there they'll be waiting for you there's a rule that says not a rule but it's a rule of thumb that says you can swim across the river at a point of entry once if you do it twice the crocodiles are gonna start paying attention but the third time they're waiting for you imagine if every three days you had to change your route to the office because there were crocodiles waiting for you and that's uncertainty it's only when we have extreme surplus that we create the certainty that we can then turn around in first world problems like gosh i'm so uncertain what am i going to have for dinner tonight not am i going to eat for dinner or is something going to eat me for dinner right it's you know do i want vietnamese or chinese or thai that's not uncertainty still a very difficult decision always going to be time but yes go ahead i guess one effect of certainty i'm not sure about going back to roman times but the bank of england did do a paper relatively recently with interest rate data back about 700 years and that showed a kind of slow secular decline in real interest rates globally from about 15 to where we are now which is you know pretty close to zero i guess you know lower real interest rates are are a byproduct of certainty because you don't need as much of a premium for for lending money we've talked a little bit about the kind of hunt for yield and um the comfort losing leverage to do that and that's you know an obvious byproduct of having this low interest rate environment but what else is out there what are the other kind of carry trades that you see potentially people going into or that are already in and will become become overblown as a result of on the back end of 700 years of falling interest rates that don't look as if they're going up anytime soon so i think that's an interesting paper for a couple of reasons and i'm actually doing some work collaborating with the gut with a brown professor's name's mark blythe on a paper that talks about some of these components one again remember anytime you look at a long history of data it's anything that that is predicated on uncertainty like interest rates if you're looking at a long history of it it almost is by definition going to fall because if it has risen you're in the dark ages and you don't actually have the ability to access long reams of history so you just have to be somewhat careful about the point in time there's a reason we don't have a 5 000 year history of interest rates the second component that i would say is this a big chunk of what drives real interest rates and there was a really good paper out of uc davis talking about the dynamics of pandemics back through the ages and comparing it to wars right so real interest rates are actually driven in large part by the availability of competing uses of capital so if i don't have a road between two major cities or i don't have a train between two major cities there's a high roi associated with that anything else i want to use the money for rather than expanding the trade between those two places is going to have to compete with that underlying dynamic so i think part of what you're actually seeing with the low level of real interest rates is a combination of low to negative population growth rates particularly adjusted for demographics in the developed world right like what's the return to widening the highway you know between new york city and boston it's pretty low and there's not a lot of value there and if anything the disruption associated with that construction is far more than the value that could be created we see this with the dynamics of high-speed rail and so those factors i think largely are are responsible for the low level of interest rates the low level of real interest rates that we're experiencing the hunt for yield the search for yield is the second dynamic which is that we've by and large chosen through policy to lower interest rates and raise the value of existing capital and lower the opportunities to invest new capital and yet people are living longer and facing a need to draw down assets in a way that forces them to seek out forms of yield that allow them to live off of their assets and unfortunately the way that most people are choosing to do this whether it's because they don't understand the implications of what they're doing or whether it's because they understand it and consider the risk offset by the socialization of losses they're choosing to monetize greater sources of volatility so yield enhancement strategies that involve things like selling puts or selling calls is overriding that's just another way of creating an interest rate so an investment grade bond has a functionally identical payoff to that of a deep out of the money put on the s p 500 you capture a little bit of premium that you amortize over time and you know you get a fixed income component to it and your prospect of loss is quite low so what we're doing when we decide that we're going to lever up investment grade bonds is all we're doing is we're saying okay let's sell lots and lots of puts or if we move to high yield all we're doing is we're shifting that strike closer to the money if we decide that we're going to lever up equities then theoretically we're actually moving to selling at the money options and so all of the you hear people talk about it all the time i'm going to sell one put and buy 10 calls well guess what you just you know you just sold a put right you basically sold it near the money put that potentially creates nearly unlimited liability for you and so most of these structures in one form or another are undoing a feature of the 19th century the dramatically increased risk actual real risk-taking activity which is the introduction of the limited liability corporation the introduction of what we classically think of as equity we're now in the process of trying to convert all that back to lloyds of london right if i write puts on a stock i have a very different profile in terms of potential losses than if i actually own the underlying and one the most i can lose is my investment and the other i could theoretically lose many many times the margin that i've posted against it so i think we're in a process of returning risk and putting more and more risk onto the household onto the individual investor with the presumption that the state is going to be there to bail them out i agree i want to you know coming back to the foot selling i completely agree the volumes of what i hear from speaking to some of the dealers on systematic selling of vol and systematic selling of out of the money posts in particular they're not back to the levels that we saw in january february but they're substantially up from where they were say two or three months ago so the memories of those that have been hurt seems to be super super short and even though they've been hit on the chin it seems they just don't care the the addiction of to getting a yield and generating a little bit of x-ray income be that two or three percent is kind of like blinding them to the risks again i think i would almost flip that and say that the that is actually a byproduct of the memory is getting quote-unquote longer and longer right so if i've got a 50-year history of all events and after every single one of those fall events it was super profitable to sell volatility which is somewhat by definition because if it wasn't then guess what the world ended right so like the somewhat terminal event anyway right well if you have that quote-unquote certainty associated now with a 50-year history that says this is what happens and you don't have any deep understanding of why this happened or the fact that you're observing this that this happened means by definition your data set is skewed then you become more confident and this is what we've been taught i mean there's an entire field of behavioral finance and behavioral economics that tells us that all the cautious behavior that we engage in right is foolish all right we've programmed the machines to intentionally ignore this and so by definition it's going to look like our our memories are getting shorter but in reality we're more reliant on a longer data series of history good point you touched briefly on on interest rates we talked about interest rates coming down and historically has gone down i couldn't help notice that jeremy sequel came out this week on barry ritz hall's uh podcast saying that he wanted to go on record or he had just gone on record saying that he thinks interest rates have bottomed for a generation at least maybe even forever which is quite a bold uh claim of course he could be right i'm curious to know where you think or how you think a potential regime shift in interest rates i mean obviously interest rates historically has gone in cycles this cycle is a little bit longer than usual nevertheless we don't really know if the cycles have have broken so there is certainly an argument for for higher interest rates maybe not in the short end where central banks are in control and of course i know they want to try and have some kind of yield curve manipulation going going on but they may not succeed in that what how do you see the whole interest rate spectrum so first of all i think it's impossible to make that type of call or forecast i think it's tempting to to make that sort of observation when you have an environment of negative interest rates to be clear i think negative interest rates are absurd and that they're a view that i articulated back in 2015 is now i think increasingly accepted that they're ultimately harmful to the banking system right that they create a tax on the banking system i would just phrase it differently i mean what would you call anything in which you give a registered agent to the government 100 bucks and they give you back 99. right we call that a tax and so negative interest rates are just a form of taxation we've recognized that for a variety of reasons primarily because of the collateral basis of a credit system right that we can charge people negative interest rates for holding that collateral we can charge them a tax on that collateral now that's caustic to the banking system and it ultimately inhibits risk taking but we are able to do that right we could also make it very explicit and say hey if you want to maintain a bank charter you're going to have to pay a million dollars a year 10 million dollars a year or some scaled to your assets framework that would be the exact same thing as saying we have negative interest rates and so as you would expect in that type of framework we see the banking systems getting hollowed out we see them consolidating we see fewer local and small banks that are ultimately predicated on the idea that they can earn a return on the capital that they're investing because governments are choosing to tax them out of existence right and so their systems are consolidating and by definition becoming more fragile and so is there a limit to that yeah i mean ultimately we will enter into a regime of capital scarcity do i think it's possible to pick that it happened now versus it's going to happen five years from now versus it's going to happen 10 years from now i just think that's there's a huge element of hubris associated with that and by and large you know i think jeremy siegel's long-run type forecasting it should be clear you know i'm very skeptical that it works yeah not really a question as i guess we're almost out of time but an observation that you know when you're actually running money or trading you worrying about trends that are going to happen three four five years in the future is a little bit pointless i think there's that but i also think so look the one thing that i will say and i do think that this is actually really important is when you think about dynamics of things like risk parity i think the market is already pricing in elements of that post 1998 it became the response function of the central bank the only one that really matters which is the fed but anytime something goes wrong they're going to cut the price they cut the price of money they're going to reduce the yield right so what does that actually do that means that bonds which go up in price risk-free bonds which go up in price when the interest rate is cut now having negative correlation with risk but a positive expected return as long as they maintain a positive yield moderate portfolio theory tells you that the optimal portfolio in which there is something that has negative correlation with risk yet offers positive return shifts from a backpack problem a 60 40 allocation to a levered portfolio now what happens and and i would argue that this is actually the core of the reason why we see negative term premium in the united states right because people are increasingly paying for that put it's an explicit acknowledgement that there is value to that 10-year bond because of the duration and the response that it has in your portfolio if we move those interest rates negative then guess what all you have is puts it has a negative expected return and a negative correlation to risk all of a sudden we have to switch back to the 60 40 portfolio away from the levered portfolio that creates a net decrease in the demand for financial assets so i think the end game is relatively close to this nonsense of hey we're going to cut interest rates every time something goes wrong but i think the irony of course is that almost nobody thinks about it in those terms we tend to think about it as well how much yield is left how much yield can we get that's not the value of that asset the value of that asset is that you've got a positive expected put and we're close to the end i hope so yeah maybe in the us interest rates are going to stay above zero or about there and then and then the other the other measures may be yield curve control or some form of mmt we'll see what that brings i i know we're almost out of time and but you just brought something i think is really important i do think it's important to distinguish mmt between a description of the financial system and the monetary system which is what it really is and prescriptions around what we can do with that and so i hear people use the phrase mmt all the time to talk about well this is where we're going no that's where we are we are in an mmt system there is no convertibility there is the only way that dollars are created is because the government decides to spend them and put them into existence and taxes are then a means of mopping them up right interest rates in that environment are just another form of fiscal policy but if we choose to actually believe mmt peter thiel what i was working for had a great line on this which is i think this might accurately describe it but if anybody actually tried to run a government this way it would be the end of the system and i think that's really critical that we have maintained these convenient fictions to prevent governments from spending money in the way that they want in any way that they want right we've created restrictions initially we had the gold standard to limit the ability to increase the quantity of money so the governments had restrained we then decided debt provided that tool well none of those were actually true it really is just a question of what's the productive capacity and so the mmt is right but it offers almost no prescriptions for how that money should be spent and so by handing it over to the politicians we're at least in a situation where you could see outcomes of how that money gets spent that we've never predicted yeah it seems those restrictions that you're referring to they become weaker and weaker and less and less there's more leeway in the way the money gets spent in the u.s you've received your i'm not sure what the name of those checks were signed by donald trump you know it's a form of the helicopter yeah paycheck protection right uh form of helicopter drop of money essentially right i mean so we're we're you know the same seems to be happening here in europe we're going down that route where things that you thought previously impossible all of a sudden start to become possible because those restrictions that we imposed on the system that everybody believed in all of a sudden there's a reason to do away with them and people acknowledge it and just get get on with it yeah i i think it's more pernicious than that right you you start your children off believing in santa claus not because you actually want to lie to them but because it's a convenient reason for why they should be nice rather than naughty right now santa's keeping a list right well by the time they realize that santa claus may or may not exist in the real world i'm not going to spoil this for any five-year-olds who are watching that's how talk it over yeah that works fine right but by the time we get to that point they've actually already established norms of behavior so it's it is a convenient fiction to say well government spending is limited by the quantity of debt that we can issue if it's done in fiat terms right that's a convenient fiction but there is actually value to the restraint associated with that belief right and so my my fear is exactly as you're saying the more we recognize well there is no limit based on the quantity of debt right or the need to service debt that's written in uncle sam's script the bigger the risks are that we actually have uncontrolled government incursion in our lives well it seems like the big reset comes the day when when we lose confidence in that notion that you can just keep adding and adding debt you know but we're not there yet it would seem i would flip it and say that moment comes when we realize that there's no reason for us to actually pay our taxes and if there's no reason for us to pay our taxes either because a foreign power has invaded or because the government is illegitimate in terms of its claim on force then that problem is here i the concern that i have honestly is that if anything we're showing the exact opposite right i mean we've become in the united states in a way that i don't think anyone could have forecast i think in europe you know you you were further along this path in a lot of ways my kids said to me going into the the coronavirus dynamic like how do we protest if we're not allowed to go outside if we're not allowed to say we object to this if we're not allowed to say that we can't gather together and say hey we shouldn't have schools shut down if you if there's no mechanism for that how do you avoid paying your taxes well it's very convenient i mean i know this is a completely new discussion we could spend another hour or two with you mike but uh i mean it is another discussion right that that what the pandemic also did was it kind of took away some of our ways of um as you say of protesting and saying no we we don't agree right right and that's an interesting concept which a lot of conspiracy theories have their own thoughts on but let's leave it with that i mean this this was really great mike thank you so much for spending some time with us we really do appreciate it and i'm sure all our listeners do as well and by the way make sure to follow mike's work on twitter real vision and his new venture at logica funds from rob moritz and me thanks so much for listening and we look forward to being back with you as we continue our global macro mini-series in the meantime be well thanks for listening to top traders unplugged if you feel you learned something of value from today's episode the best way to stay updated is to go on over to itunes and subscribe to the show so that you'll be sure to get all the new episodes as they're released we have some amazing guests lined up for you and to ensure our show continues to grow please leave us an honest rating and review in itunes it only takes a minute and it's the best way to show us you love the podcast we'll see you next time on top traders unplugged [Music] you

Channel: Top Traders Unplugged

Views: 1,227

Rating: 5 out of 5

Keywords: niels kaastrup larsen, moritz seibert, rob carver, global macro, macro investing, macro trading, michael green, logica, funds, Passive investing, etfs, interest rates, inequality, Mean reversion, yield curve, MMT

Id: ROkNc9HeHK0

Length: 61min 27sec (3687 seconds)

Published: Wed Sep 09 2020