It was a pleasure to welcome Kris Kumar, CIO of Goose Hollow Capital, to the Alpha Exchange. Our conversation starts with Fed policy and the manner in which the 500bps of policy tightening is impacting the economy. To this, Kris argues that the propitious starting position for households and corporates in this cycle has been quite different than in previous ones, thus blunting the impact of rate hikes. He points as well to loose fiscal policy with the unemployment rate so low. For Kris, what happens next depends more on fiscal than monetary side.
We next consider the backdrop for valuations, starting with fixed income. Kris sees safety that comes from a coupon on 2’s that approaches 5%, noting that there are positive real yields generally in most of the world. From an earnings yield perspective, however, US equities have zero premium to bond yields and Kris points to the concentration of earnings growth coming from the top of the SPX, which, in turn, is a bet on generative AI. Should this growth not materialize, the lofty multiples currently awarded these stocks could be re-rated.
Within equities, Kris makes the argument that we’ve invested a lot in bits but not in atoms and, going forward, investment dollars may move away from tech into areas associated with energy demand. How else to satisfy all of the incremental power to run all of the data centers built?
We finish the discussion with an assessment of the price of vol. Kris points to the epically low implied correlation on the SPX, a result of the bifurcated market in which a small but valuable subset of the index is a bet on AI. He sees scope for the still elevated level of rate vol to come down but upside in vol on commodities like copper as a function of all the spending on infrastructure that will ultimately come as a function of the AI boom.
I hope you enjoy this episode of the Alpha Exchange, my conversation with Kris Kumar.
[00:00:00] Hello, this is Dean Curnutt and welcome to the Alpha Exchange, where we explore topics
[00:00:07] in financial markets associated with managing risk, generating return, and the deployment
[00:00:12] of capital in the alternative investment industry.
[00:00:20] It was a pleasure to welcome Chris Kumar, CIO of Goose Hollow Capital, to the Alpha
[00:00:24] Exchange.
[00:00:25] Our conversation starts with Fed policy and the matter in which the 500 basis points
[00:00:30] of policy tightening is impacting the economy.
[00:00:32] To this, Chris argues that the propitious starting position for both households and corporates
[00:00:37] in this cycle has been quite different than in previous ones, thus blunting the impact
[00:00:42] of rate hikes.
[00:00:43] He points as well to loose fiscal policy with the unemployment rate so low.
[00:00:47] For Chris, what happens next depends more on fiscal than monetary.
[00:00:51] We next consider the backdrop for valuation starting with fixed income.
[00:00:56] Chris sees safety that comes from a coupon on twos that approaches 5%, noting that
[00:01:01] there are positive real yields generally in most of the world.
[00:01:05] From an earnings yield perspective, however, U.S. equities have zero premium to bond yields
[00:01:09] and Chris points to the concentration of earnings growth coming from the top of
[00:01:13] the S&P, which in turn is a bet on generative AI.
[00:01:17] Should this growth not materialize, the lofty multiples currently awarded these stocks
[00:01:21] could be re-rated lower.
[00:01:23] Within equities, Chris makes the argument that we've invested a lot in bits but
[00:01:26] not in atoms and going forward, investment dollars may move away from tech into areas
[00:01:31] associated with energy demand.
[00:01:34] How else to satisfy all of the incremental power to run all of the data centers built?
[00:01:39] We finish the discussion with an assessment of the price of vol.
[00:01:42] Chris points to the epically low level of implied correlation on the S&P, a result
[00:01:47] of the bifurcated market in which a small but valuable subset of the index is a
[00:01:51] bet on AI.
[00:01:53] He sees scope for the still elevated level of rate vol to come down, but upside in vol
[00:01:58] on commodities like copper as a function of all the spending on infrastructure that
[00:02:02] will ultimately come as a function of the AI boom.
[00:02:06] I hope you enjoyed this episode of the Alpha Exchange, my conversation with Chris
[00:02:10] Kumar.
[00:02:12] My guest today on the Alpha Exchange is Krishna Kumar.
[00:02:16] He is the CIO of Goose Hollow Capital and investment manager with a macro lens
[00:02:22] and creator of some ETFs catering to institutions and high net worth individuals.
[00:02:27] Krishna, it is great to welcome you to the podcast today.
[00:02:30] Thanks, Dean.
[00:02:31] A pleasure to join your podcast.
[00:02:33] I'm a big fan.
[00:02:34] I'm excited to be here.
[00:02:35] Listen, you and I have known each other for a bit but I've recently reconnected
[00:02:40] and I'm very excited about that.
[00:02:42] You've got a lot of ideas and an interesting framework that I think balances some of
[00:02:48] the need for evaluating the here and now, but also really incorporate some longer
[00:02:52] term themes and thought process around where things are going over many years.
[00:02:58] So I'm very interested to explore some of your thought process around that.
[00:03:03] Let's get our conversation underway with just a little bit of your own background,
[00:03:08] some chronology in terms of your experience in the markets, how you got to be
[00:03:12] the CIO of Goose Hollow.
[00:03:14] So just take us through quickly your background and then we'll pivot to just the broad
[00:03:19] elements of your macro framework.
[00:03:21] So I started off on the foreign exchange derivatives side.
[00:03:25] So I worked at Citibank and then later at Barclays, mostly foreign exchange derivatives
[00:03:32] and towards the end of my stint at Barclays as part of a proprietary training team there.
[00:03:37] And then I spent about 10 years on the sell side, mostly focused on FX and front end
[00:03:43] related things. And then in 2011, I decided that I wanted to do my own thing.
[00:03:50] Started a small systematic firm that was doing systematic strategies.
[00:03:55] We got up after a great start.
[00:03:58] But do you remember that was the time when the Fed and other central banks were
[00:04:03] doing a fair bit of easing, which meant that the interest rate volatility and FX
[00:04:10] volatility kind of collapsed to the foreign exchange rates where not moving much.
[00:04:14] It wasn't the best of times for a strategy like that.
[00:04:17] But I was lucky to get introduced to some folks later with Omega.
[00:04:22] Omega, as you know, was a large equity hedge fund, the government,
[00:04:27] the legendary equity investor.
[00:04:29] I was very lucky and fortunate to work with them for about three years.
[00:04:33] So I spent three years on the Omega macro team, managed substantial amount of
[00:04:38] assets, a colleague of mine.
[00:04:40] After that, we left to go work at a firm called NKD.
[00:04:45] They're also a large credit macro hedge fund, very successful fund,
[00:04:51] been around for a long time.
[00:04:52] I spent about two years there.
[00:04:54] In late 2018, I decided that I had seen how some of the larger firms
[00:05:00] operated and I wanted to be on my own.
[00:05:03] I started with Holo 2.0.
[00:05:05] In this format, we initially started with a few large institutional clients.
[00:05:10] And then about two years ago, we decided that we also wanted to be in the
[00:05:15] public ETF space.
[00:05:17] We launched one ETF in late 2021 and then we subsequently launched
[00:05:22] a couple of other ETFs recently.
[00:05:24] Fantastic.
[00:05:25] Well, I want to probe a little bit on the FX derivative side of things.
[00:05:30] I'll preview it by saying I was a young hungry kid coming out of the
[00:05:34] University of Chicago in 1996 and I hit the Lehman Brothers
[00:05:38] equity derivatives desk.
[00:05:39] And so this was well before the dawn of electronic option trading
[00:05:44] and certainly zero DTE.
[00:05:46] They didn't even have weeklies back then.
[00:05:48] But during my time in business school, I got myself enmeshed in
[00:05:53] Risk magazine just looking at a lot of the option pricing pieces that
[00:05:57] were coming out, you know, variations of Black Scholes that were meant to
[00:06:00] solve for some bell and whistle associated with some option structure.
[00:06:05] And so I started suggesting these option trades on the derivatives desk,
[00:06:10] the equity derivatives desk, and they were like, there's not even
[00:06:13] close to the kind of liquidity you would need to trade these.
[00:06:16] But of course in FX derivatives, things like double no touches and so
[00:06:20] forth really have been around and are kind of a legitimate part
[00:06:24] of the trading process.
[00:06:26] I'd love for you just to tell us just a little bit about FX derivatives
[00:06:31] and maybe some of the esoterica that it's made its way into the
[00:06:34] trading process for buy side institutions.
[00:06:38] There's a few things to think about.
[00:06:40] The first one is FX is one of the few markets where it's a complete
[00:06:46] market, meaning you have add or degrue securities.
[00:06:50] So essentially what I mean by that is you have every possible strike
[00:06:54] at every possible point in time, you could actually get an option price for.
[00:07:00] Right? So in equities, let's say you want to trade S&T.
[00:07:03] Now it's different.
[00:07:04] We almost have an expiry every day.
[00:07:06] But historically, like you had the monthly and the quarterly expiries
[00:07:11] and the month ends, that was really where the most liquid point.
[00:07:15] But in FX, if you wanted to take a view on something three days from now,
[00:07:21] there is a market for it and somebody will make your price in the major currencies.
[00:07:26] So in that sense, it's a very complete market.
[00:07:29] And it's a nice place to start because you imagine things that you want to do
[00:07:34] and go and price it and trade it.
[00:07:37] So that's the nice thing.
[00:07:38] But the flip side of FX is that if you think about foreign exchange,
[00:07:43] foreign exchange is the result of some other transaction.
[00:07:47] Foreign exchange by itself, people think about it.
[00:07:50] And from time to time, it becomes super important.
[00:07:53] I think now is a good time to think about FX.
[00:07:56] But historically, you would have very long periods where nothing happened in foreign exchange.
[00:08:01] And the reason is if the central banks are not diverging much,
[00:08:06] if they're all doing the same thing, then there is nothing to do in FX
[00:08:10] because central bank exchange rate is just the price that the central bank set.
[00:08:15] And so if they all decide to concur on things and don't do much,
[00:08:19] then nothing really happens.
[00:08:21] You have some carry that drives slow, but really there's no big moves in FX.
[00:08:28] So what that means is for every five years, you get like some big move,
[00:08:33] some big trade, and everybody tries to make money when that happens.
[00:08:38] The rest of the time, you have to deal with the carry
[00:08:41] and you have to deal with very small movements.
[00:08:44] So if you think about this yen move that's happened,
[00:08:48] the yen has gone from 120 to 160.
[00:08:52] If you go back in time in 2011 or 2010, the yen was at 80.
[00:08:58] So it's gone from 80 to 160.
[00:09:00] So you say, wow, big move.
[00:09:02] But it's taken 13 years for that to happen.
[00:09:05] We know many stocks that have doubled this year.
[00:09:09] I mean, they're doubled in last month.
[00:09:11] And if you take something like Meta, Meta went from $90 to $500
[00:09:18] in a very short period of time.
[00:09:19] So what that means is in foreign exchange,
[00:09:22] in order to actually generate returns,
[00:09:25] some people just look at it as the residual, an equity trade
[00:09:29] or a bond trade they're doing.
[00:09:30] And it's just like, oh, do I want that risk or not?
[00:09:33] For other people, the FX becomes important
[00:09:37] because if you are in the FX market trying to make returns,
[00:09:40] you have to somehow leverage these small moves.
[00:09:44] And hence, I think you have fairly complex options traded
[00:09:49] in foreign exchange.
[00:09:50] I mean, I'm going further back in time.
[00:09:52] I think the glory days of FX was from 2001 to 2007,
[00:09:59] 2008, I would say, because we traded all kinds
[00:10:03] of crazy instruments that now people would say,
[00:10:06] how did you even risk manage this thing?
[00:10:08] How did you even take into account all the things
[00:10:11] that could happen?
[00:10:12] So there was a period where there
[00:10:14] was a lot of excitement on complexity.
[00:10:18] But now I think the FX market has changed a little bit.
[00:10:21] There's still a lot of barriers and all these things
[00:10:24] that trade, but to the large extent,
[00:10:27] it's just first-generation exotic.
[00:10:29] Well, what we mean by first-generation exotic
[00:10:31] is digital, which are essentially
[00:10:35] called threads and put threads,
[00:10:36] barriers, which are really a vanilla option with a one-touch
[00:10:40] attached to it, like an American-style digital
[00:10:42] attached to it.
[00:10:43] And that's pretty much the majority of the FX market
[00:10:47] at this point.
[00:10:48] Of course, people trade double no touches and worst-off
[00:10:52] knockouts.
[00:10:53] And we've traded every possible thing you can imagine.
[00:10:56] In fact, my craziest FX trade actually goes back to 2007.
[00:11:01] We had a client that wanted to trade an FX option
[00:11:05] on a credit event.
[00:11:07] So this was the time when people were doing CDOs
[00:11:10] and CDO squares.
[00:11:12] I don't think they printed a CDO cube.
[00:11:13] I was actually going to patent the exponential CDO.
[00:11:17] As you know, if you do a Taylor expansion
[00:11:19] of exponential CDO, you have all the terms.
[00:11:22] So I said, okay, maybe I should patent this thing.
[00:11:24] That was the time.
[00:11:25] And so we actually traded this thing
[00:11:27] where it was actually a room.
[00:11:28] It was a Canadian paper company, Habit TV.
[00:11:32] If that company defaulted, there
[00:11:35] would be an FX option that came into life.
[00:11:38] And if it didn't default, then the FX option didn't exist.
[00:11:41] We actually somehow managed to trade this thing.
[00:11:44] There was a time when all of that was going on.
[00:11:47] And now I think you still have a lot of complexity
[00:11:50] relative to other markets.
[00:11:53] Some of that is the need for leverage in foreign exchange.
[00:11:56] So if you want to make any returns in FX,
[00:11:59] let's take an example.
[00:12:00] Let's say we think that the yen is going to strengthen
[00:12:03] from the end.
[00:12:04] The yen trading at 155, it's going to go to 130
[00:12:08] in a year's time.
[00:12:09] You're going to have to figure out a way
[00:12:11] to use some sort of option structure
[00:12:15] to ensure you're making any meaningful amount
[00:12:17] of money on this move.
[00:12:19] The actual move is like a 10% move or 15% move.
[00:12:23] It's not really meaningful.
[00:12:25] You have equities that move 5% in a day.
[00:12:28] So if you're going to be having this position
[00:12:30] for two years, you have to hope that you're going
[00:12:33] to make more than 15% on a move like that
[00:12:36] on the risk you're taking.
[00:12:38] So I think there is definitely a need for derivatives
[00:12:42] in the FX space, particularly for investors.
[00:12:46] I mean, also, like the other aspect of FX
[00:12:48] is that you have certain participants
[00:12:52] who are kind of banishing constraint.
[00:12:55] Think about a typical corporate.
[00:12:57] They need to hedge their foreign exchange,
[00:13:00] but they need somebody to give them a balance sheet
[00:13:02] so they can actually use the hedge.
[00:13:05] And they can probably not spend much in premium.
[00:13:09] They won't get the accounting treatment for doing that.
[00:13:12] So there is like a fair bit of complexity
[00:13:15] that they can do, and that creates liquidity
[00:13:19] for the other side.
[00:13:20] Because if all the hedge funds want to bet on the yen,
[00:13:23] you need somebody else that's willing
[00:13:25] to take the other side.
[00:13:26] And oftentimes, that's the hedgers.
[00:13:29] And in this case, it's the corporates,
[00:13:32] it's the real money investors that want to hedge.
[00:13:35] That's a quick overview on FX Mark.
[00:13:39] Yeah, no, it's so interesting.
[00:13:40] And I think what we'll do is we'll circle back
[00:13:42] to a little bit of a survey of the price of risk.
[00:13:46] Maybe it's FX vol, we'll spin around the asset classes
[00:13:49] and get your take on where there's value,
[00:13:52] what you think these prices tell us
[00:13:54] about the state of the world.
[00:13:55] You did allude to this idea that FX is in some ways
[00:14:00] driven by monetary policy divergence.
[00:14:04] And so I wanted to maybe start with the US side
[00:14:07] and talk about monetary policy,
[00:14:09] the state of where you think the Fed is going.
[00:14:12] And then also, I think increasingly a part
[00:14:14] of the US risk conversation is this big bad asset class
[00:14:19] called the risk-free one in treasuries.
[00:14:21] And there's definitely at least a lot
[00:14:24] of my conversations increasingly start with the debt
[00:14:28] and the size of these auctions and so forth.
[00:14:31] And it's not to be a alarmist,
[00:14:33] it's just to say that this has become much more
[00:14:36] of a topic of conversation than it was pre-pandemic,
[00:14:39] let's say.
[00:14:39] But why don't we start with just the US setup
[00:14:43] on growth and inflation, how you incorporate that
[00:14:46] into your process of evaluating
[00:14:48] where you see opportunity.
[00:14:50] If you think about it, the Fed funds and SOFR now
[00:14:55] is really the pricing function for all assets.
[00:14:58] If you tell me where three months SOFR is gonna be
[00:15:00] in two years time, I can probably make a good guess
[00:15:04] on where these assets are gonna be based on that.
[00:15:08] I think first on the macro picture
[00:15:11] on growth and inflation,
[00:15:12] think about on the growth side,
[00:15:15] the thing that surprised a lot of people
[00:15:17] is that we've been very resilient,
[00:15:20] for lack of a better word.
[00:15:21] We've been very surprised at this rank
[00:15:24] and it's got to do with three unusual conditions
[00:15:27] in my mind.
[00:15:28] The first one is the household sector
[00:15:31] and the corporate sector is in a great place.
[00:15:34] They basically, if you take the average US corporate,
[00:15:37] I'm talking about the high quality companies,
[00:15:39] the IG companies, they've all turned out
[00:15:42] a lot of their debt
[00:15:43] and their cash balances are for some of them, they're high.
[00:15:49] And so they're earning a lot of interest income.
[00:15:52] And so historically when you had this sort of tightening,
[00:15:57] the corporate sort of felt it immediately
[00:16:00] because the borrowing cost has gone up
[00:16:02] and that hasn't happened.
[00:16:03] And the same thing with the household sector.
[00:16:05] We have a very beautiful instrument
[00:16:07] in hedging instrument in our economy,
[00:16:10] which is the 30 year fixed mortgage.
[00:16:12] And most people have 30 and fixed mortgages.
[00:16:16] So which means that the interest rates going up
[00:16:18] at the margin makes a difference.
[00:16:21] But for many households,
[00:16:23] if they've kind of got a 30 and fixed mortgage,
[00:16:25] they're getting more income on the deposit they have
[00:16:30] and then on the liability side, they've turned it up.
[00:16:32] So we've taken all of this duration risk
[00:16:35] from the corporate sector and the household sector
[00:16:38] and you put it on the government balance,
[00:16:40] which is what we did after COVID.
[00:16:43] That is a massive difference compared to previous cycles.
[00:16:46] The starting position for households
[00:16:49] and the corporate sector is very different.
[00:16:51] So that's why we haven't seen much of an effect
[00:16:55] from this tightening.
[00:16:56] Now I'll get to this in a minute,
[00:16:58] the tightening it's not like gravity,
[00:17:01] tightening eventually catches up.
[00:17:02] So eventually when the corporate staff
[00:17:04] will roll over the debt,
[00:17:06] which is my estimate 7 trillion of debt
[00:17:08] that needs to get rolled over in the next five years,
[00:17:11] we're gonna have some impact from that
[00:17:13] because the average interest burden
[00:17:16] is gonna increase by about a couple hundred basis points.
[00:17:18] And that's gonna come out of profits.
[00:17:21] Imagine you're gonna have to pay 200 basis points more
[00:17:23] on 7 trillion, okay now your profits
[00:17:26] are gonna go down by that much.
[00:17:27] So clearly there's gonna be an impact
[00:17:30] when this debt gets rolled over,
[00:17:31] it just there's a lag effect in that.
[00:17:34] Let me just jump in on that Chris
[00:17:36] and I think that's really fascinating
[00:17:38] to sort of think about the positioning
[00:17:41] of the household and corporate sector going into this
[00:17:45] and the impact of rising rates.
[00:17:48] And as you said, some people effectively have
[00:17:51] the government upside down,
[00:17:52] a rare case where you're lending to JPMorgan
[00:17:55] at a higher rate than you borrowed from it,
[00:17:57] really rare.
[00:17:58] Are you in the camp that higher rates
[00:18:01] are actually stimulative or are you more in the camp
[00:18:05] that they're just not the beta of the economy
[00:18:09] in terms of absorbing higher rates
[00:18:11] is just much less than it otherwise would be?
[00:18:14] How do you think through it?
[00:18:15] That's a great question.
[00:18:16] There's no straightforward, simple answer to it.
[00:18:19] And I wish I could just tell you yes or no to that.
[00:18:22] So I would say on the second point you made,
[00:18:25] the beta is more to the longer duration assets.
[00:18:28] If you think about the US,
[00:18:29] we are the ultimate long duration account.
[00:18:32] Look at S&P 500, look at the company,
[00:18:35] 40% of the index is tech companies,
[00:18:37] which are all long duration.
[00:18:39] You think about tech, tech's a long duration asset.
[00:18:42] So the whole entire economy is a long duration account.
[00:18:46] We have 30 year mortgages,
[00:18:47] our corporates can borrow money long-term,
[00:18:50] we have corporates issuing 20 year bonds.
[00:18:53] It doesn't happen elsewhere.
[00:18:55] Most of the emerging markets and other smaller economies,
[00:18:58] you go to Canada, you get an arm
[00:19:01] and rate gets changed quickly.
[00:19:03] I have a friend of mine, she bought a house in 2020
[00:19:06] and her mortgage reset.
[00:19:08] Now her interest payments are double
[00:19:10] what she was paying before.
[00:19:11] And thankfully she can still afford it,
[00:19:13] but it's a real tightening.
[00:19:14] Whereas here it's different because the sensitivity
[00:19:18] is more to the longer duration.
[00:19:20] So it's more to what happens
[00:19:22] to the 30 year part of the curve
[00:19:23] and the 20 year part of the curve
[00:19:25] and 10 plus year part of the curve
[00:19:28] and less to what the Fed does.
[00:19:30] So the Fed hikes out of the 50 basis point.
[00:19:32] Obviously people will be upset and all that,
[00:19:35] but is it gonna really tighten as much?
[00:19:37] I don't think so.
[00:19:38] And the same thing is the Fed cut 100 basis point.
[00:19:41] Yeah, at the margin it will have some impact
[00:19:44] because a lot of lending, credit card lending,
[00:19:46] stuff like that are linked to prime rate
[00:19:48] and that'll have a follow through,
[00:19:50] but it's not at the margin gonna make a big difference.
[00:19:52] But let's say the 30 year bond goes to 7%.
[00:19:56] I can tell you that most assets people own
[00:19:58] are gonna be substantially lower
[00:20:00] because you go to discount all your cash flows
[00:20:03] at a much higher rate and all these long duration assets,
[00:20:06] which is a venture, real estate, tech,
[00:20:10] all of this stuff is fairly long duration assets.
[00:20:14] You would have to basically reconcile that.
[00:20:17] So the other thing I was gonna mention Dean on this
[00:20:19] was so the first one is the starting point
[00:20:22] on the household sector.
[00:20:23] So they're starting at a very favorable place.
[00:20:26] The second thing is that if you look at fiscal policy,
[00:20:31] we've never had such loose fiscal policy
[00:20:34] with the unemployment rate at cycle lows.
[00:20:37] So historically if you look at it,
[00:20:38] we spend money in recession,
[00:20:40] our fiscal assets go up in recession.
[00:20:43] But this time around,
[00:20:45] we have very low unemployment rate
[00:20:48] and fiscal policy is extremely low.
[00:20:51] The last one is that if you think about
[00:20:53] even the inflation side,
[00:20:54] we had inflation averaging 5% a year ago.
[00:20:58] Inflation is definitely coming down dramatically
[00:21:02] without having any real impact on the economy.
[00:21:05] So if you think about jobs or any of this sort of stuff,
[00:21:09] we haven't really had much weakness
[00:21:11] in the labor market just yet.
[00:21:13] We haven't had any big issues come up
[00:21:17] besides the banking stress we had last year.
[00:21:19] So I think overall the Fed's done a pretty good job
[00:21:23] in landing this thing.
[00:21:25] Now obviously they can always make mistakes.
[00:21:28] They could overestimate how strong the economy is now,
[00:21:32] underestimate how much easing they have to do.
[00:21:35] I don't think they have any good forecasting tools
[00:21:38] and all this stuff
[00:21:39] and they're gonna have to meet the rules up
[00:21:41] as they go along.
[00:21:43] But I do think that up to this point,
[00:21:45] if you look at what the Fed's done,
[00:21:47] they've hiked 500 basis points
[00:21:50] and nothing's really broken
[00:21:52] besides the banking system,
[00:21:53] which obviously separate topic.
[00:21:56] I think they've done a good job overall.
[00:21:59] Well, let me ask you this.
[00:22:00] If you think about the stance of Fed policy
[00:22:03] versus fiscal policy today,
[00:22:06] it seems in some ways inverted versus let's say 2011,
[00:22:10] especially post the John Boehner,
[00:22:13] Barack Obama showdown with the first debt ceiling.
[00:22:16] There was at least from the US's standpoint
[00:22:19] relative belt tightening in that period afterwards.
[00:22:22] But of course the monetary policy promises
[00:22:25] were almost ad infinitum.
[00:22:27] You kind of forget about these things,
[00:22:29] but I remember looking at some prices in 2013 and 14.
[00:22:33] As I reviewed them,
[00:22:34] I could not believe how much that forward guidance
[00:22:37] was implanted into the yield curve.
[00:22:41] Bernanke was telling us that we were staying at zero
[00:22:44] and of course if it's the Fed saying that,
[00:22:46] the market's gonna generally believe it.
[00:22:49] My question is,
[00:22:50] is the Fed just much more operative on the price of risk,
[00:22:55] whether it's vol or the shape of the yield curve,
[00:22:58] maybe the valuation backdrop
[00:23:01] versus its impact on the real economy?
[00:23:04] How do you separate the ways in which the Fed's deeds
[00:23:08] and actions and words ultimately have impact?
[00:23:12] If I were to reframe your question,
[00:23:14] I think one could argue that it's gone way beyond
[00:23:19] what the central bank would historically have done.
[00:23:22] The central bank was just focused on inflation,
[00:23:25] now the Fed's taking on other mandates,
[00:23:27] so obviously that happened over time.
[00:23:29] But it's also a much more complex economy.
[00:23:33] We don't have a simple economy
[00:23:35] where you have one policy lever that you pull
[00:23:39] and then the entire economy responds to that,
[00:23:41] so you almost need other tools.
[00:23:44] But I wanna say two things on this.
[00:23:45] One is that if you think about the stuff
[00:23:48] that the Fed did in a way
[00:23:50] and the stuff they did in 2020,
[00:23:53] I mean, 2020 was amazing.
[00:23:56] They went and bought ABS
[00:23:57] and they bought either backstop or corporate bonds
[00:24:00] and they did all this amazing stuff
[00:24:02] to make sure the world didn't come to net.
[00:24:04] But you could argue,
[00:24:07] should the Fed actually be involved in these markets
[00:24:10] and should that be the role of the Fed?
[00:24:12] I don't know.
[00:24:13] I think that in my mind,
[00:24:16] what we need is a lender of last resort,
[00:24:19] somebody that can show up when there is panic.
[00:24:22] So when Silicon Valley Bank happened,
[00:24:25] what the Fed did was amazing.
[00:24:27] They showed up and in a weekend everything was done.
[00:24:30] I think that's probably more of the role of the Fed.
[00:24:34] The second thing I wanna say is that
[00:24:36] you alluded to this,
[00:24:37] which is the nature of coordination
[00:24:41] in monetary and fiscal exchange.
[00:24:43] So if you go back in time,
[00:24:45] the central bank independence thing
[00:24:47] is a new thing for most countries.
[00:24:49] Except the ECB, which is created by a treaty.
[00:24:53] Most other central banks
[00:24:54] used to be part of the government.
[00:24:57] In the last 20 years,
[00:24:58] we started to say,
[00:24:59] oh, central bank's independent,
[00:25:00] they're gonna do what they wanna do type thing.
[00:25:03] But now that illusion is gone.
[00:25:05] So you take Japan,
[00:25:07] the BOJ has to coordinate with the MOF in some fashion.
[00:25:10] They can't do opposite things.
[00:25:13] You take the US to a smaller extent,
[00:25:16] like the quarterly refunding announcement
[00:25:18] have to be done in the context of
[00:25:21] how much QT the Fed is doing.
[00:25:23] You can't just have Yellen doing one thing
[00:25:26] and Powell doing something different.
[00:25:29] So there has to be much more coordination.
[00:25:31] Now, the issue is if you look at the UK,
[00:25:34] the Bank of England used to be part of the government.
[00:25:37] So the Bank of England governor
[00:25:40] used to be part of the government.
[00:25:41] The Bank of England as an independent institution
[00:25:43] is a new thing.
[00:25:45] And the Fed, it is an independent institution
[00:25:47] and that's a lot of credibility
[00:25:49] because you just look at the shape of the EU curve.
[00:25:52] The EU curve is inverted because the market is saying
[00:25:55] that the Fed's done a great job
[00:25:56] and inflation in the future is gonna be a lot lower.
[00:25:59] That's how I read the EU curve today.
[00:26:02] If you think about what this coordination means,
[00:26:05] it means that historically you have this incoherence
[00:26:09] where in Europe, the ECB was cutting interest rates
[00:26:14] into the Greek financial crisis.
[00:26:16] And then you had Soybal and all these people in Europe
[00:26:19] saying, oh my God, we have to have austerity.
[00:26:22] You don't have budgets, you don't have my expense.
[00:26:24] And so there was this sort of constant conflict
[00:26:27] between the central bank and the fiscal authorities
[00:26:30] where one of them was trying to go left
[00:26:33] and the other was trying to go right
[00:26:35] and net-net, the outcome was bad.
[00:26:37] So we ended up in secular stagnation
[00:26:40] as Lydie Summers calls it.
[00:26:41] We ended up in this sort of very low inflation
[00:26:43] environment with very low growth
[00:26:46] because of this lack of coordination.
[00:26:48] What we've seen since March of 2020
[00:26:51] is a lot more coordination
[00:26:53] where central banks and fiscal authorities work together.
[00:26:57] And what they've shown is when they work together
[00:27:00] we can generate whatever inflation we want.
[00:27:03] We want to generate 10% inflation.
[00:27:05] We can generate 10% inflation, that's not that hard.
[00:27:08] And if they now achieve this beautiful landing
[00:27:12] where they bring inflation down
[00:27:14] and growth kind of moderates,
[00:27:16] then you would sort of say,
[00:27:18] this is actually working, they managed to do that.
[00:27:20] Now I do think that we're at the stage
[00:27:23] where some of the timing will start
[00:27:25] to be seen in the economy.
[00:27:27] Just some of the data we track,
[00:27:29] credit card balance rates,
[00:27:31] even if you just think about some of the debt
[00:27:33] that needs to be rolled over in the next year or so,
[00:27:36] now you have another market.
[00:27:38] You kind of see like a lot of tightening coming through.
[00:27:41] So there is this idea of this Vixellian rate, right?
[00:27:44] Vixellian rate is this rate at which people are lending
[00:27:47] and borrowing money in the real economy,
[00:27:50] not what the Fed funds rate is
[00:27:52] or what you can get at the Fed discount window.
[00:27:55] And that Vixellian rate is high
[00:27:57] and might go a lot higher.
[00:27:58] So there is this tightening that's coming through.
[00:28:01] But to come back to what you were saying,
[00:28:03] I think the whole coordination part is what has changed.
[00:28:07] So there is a lot more discussion
[00:28:10] when the BOJ decides to do something,
[00:28:13] it needs to discuss with the mom
[00:28:15] what it means to JGBOs.
[00:28:17] BOJ cannot decide on its own,
[00:28:19] oh, we're just going to get rid of our QE program,
[00:28:22] which is not possible.
[00:28:24] That's actually not a bad thing, coordination,
[00:28:27] but it also means that there is a potential
[00:28:31] for inflationary episodes like we have.
[00:28:35] Fiscal authorities, governments like to spend money.
[00:28:38] So you might get whatever the next administration is,
[00:28:40] whether President Biden gets reelected
[00:28:43] or Trump or if it's R.F.K. Jr.,
[00:28:45] we don't know who's going to be next president,
[00:28:47] but whoever comes in,
[00:28:48] there is this tendency to want to spend more money.
[00:28:52] So that becomes a problem
[00:28:54] when you have the monetary authorities
[00:28:56] working with the fiscal authorities
[00:28:57] because there is then this sort of potential
[00:29:00] for higher realized inflation.
[00:29:03] I also think from an inflation perspective,
[00:29:05] what happens next depends more on fiscal
[00:29:09] than on the monetary side.
[00:29:11] That's where I wanted to take it,
[00:29:12] which is maybe goes back 10 or so years,
[00:29:16] but one of the themes in markets
[00:29:18] we would hear a lot of was a shortage
[00:29:21] of high quality risk-free assets.
[00:29:23] And I think it's a little harder to make that argument
[00:29:25] there's a shortage of these things.
[00:29:28] There's more than you could ever imagine coming.
[00:29:30] These refunding announcements are big and getting bigger.
[00:29:34] As you mentioned,
[00:29:34] there's this disconnect between full employment
[00:29:38] and 7% budget deficit.
[00:29:41] Those are substantial.
[00:29:42] And so where I wanted to go, Chris,
[00:29:44] was just around your broad view
[00:29:46] on how you'd characterize valuations.
[00:29:50] Let's maybe start with U.S.
[00:29:51] and you can expand it to global assets.
[00:29:54] Fixed income is in some ways
[00:29:55] the starting point.
[00:29:56] That's the risk-free starting point.
[00:29:58] Equities move around for a lot of reasons.
[00:30:01] They're certainly not completely tied in any way
[00:30:03] to the rate backdrop.
[00:30:04] We have these valuation bubbles and so forth
[00:30:07] that occasionally pop up,
[00:30:08] but a 5% rate today is much different
[00:30:12] than we've experienced before the pandemic.
[00:30:14] And so it in some ways makes its way
[00:30:17] into the conversation around equity valuations.
[00:30:21] Give us the setup.
[00:30:22] When you step back
[00:30:23] and you look at the broad environment for valuation
[00:30:26] across the major asset classes,
[00:30:29] and you've talked a lot about fixed income,
[00:30:31] but maybe bringing equities and commodities as well.
[00:30:34] Let's start with fixed income
[00:30:35] because we always like to think about that
[00:30:37] and then from there get to other assets as well.
[00:30:41] In fixed income,
[00:30:42] we're in a much better place now globally
[00:30:44] than we were four years ago.
[00:30:46] So if you think about two-year notes,
[00:30:49] if you buy two-year notes
[00:30:51] for you to lose money over the next two years,
[00:30:53] interest rates would have to go up
[00:30:55] 400 basis points or more.
[00:30:58] So you have over a two-year horizon,
[00:31:01] very good chance you get a positive return today
[00:31:05] compared to say 2021
[00:31:08] when I think three notes got 10 basis points.
[00:31:11] So you got like this nice yield buffer.
[00:31:15] So we'd like to think about everything in scenarios.
[00:31:18] So in the case scenario,
[00:31:20] let's say inflation does come down,
[00:31:22] but it doesn't come down as much as it has in the past
[00:31:26] because I think there's kind of a floor on inflation
[00:31:29] given the deficits and I'll come to why in a minute,
[00:31:32] but there is sort of like instead of a ceiling of 2%,
[00:31:35] it's almost like a floor of 2%.
[00:31:37] Inflation comes down,
[00:31:38] but not as much as people would like.
[00:31:41] In that scenario,
[00:31:42] maybe 10-year yields should be closer to 3.5%,
[00:31:47] because maybe the sulfur is gonna be at 3%,
[00:31:51] 2.5, 3% end of the year cycle.
[00:31:54] And so we should have 10-year yields maybe at 3.5.
[00:31:57] That's kind of a way to think about it.
[00:31:59] But the real interesting thing is
[00:32:02] you're getting a real return in fixed income,
[00:32:04] not just here but elsewhere too.
[00:32:06] So here we went from negative 2% real rates
[00:32:09] to positive 2%.
[00:32:11] In Europe, we went from negative 1.5, 2
[00:32:15] to positive 1.5% and in the UK,
[00:32:18] we went from negative 2 to positive 1.
[00:32:21] And in places like Brazil and Mexico,
[00:32:25] you have positive 5% or higher.
[00:32:27] So you have real positive return on top of inflation
[00:32:32] in most of the world in terms of fixed income.
[00:32:34] That's a very attractive starting point.
[00:32:37] So now if you then move to equities,
[00:32:39] some of the things that we like to look at
[00:32:41] in terms of understanding valuations,
[00:32:43] as you as you know,
[00:32:44] being like valuations work in the very long term.
[00:32:47] In the short term,
[00:32:48] you can't use valuations to decide on trading or something.
[00:32:52] If you think about valuation,
[00:32:54] from an earnings yield perspective,
[00:32:56] US equities at the moment have zero earnings yield
[00:33:01] on top of what you're getting in fixed income.
[00:33:04] So if you look at equity earnings yield
[00:33:06] minus bond yield, it's close to zero.
[00:33:09] And if you go into other markets, it's similar.
[00:33:13] You have some positive earnings yield in Japan.
[00:33:16] You have a very high earnings yield in places like China.
[00:33:21] China's got a 6% equity risk premium,
[00:33:24] even if you look at the earnings yield
[00:33:26] minus where Chinese government bonds are.
[00:33:29] So there are parts of the world
[00:33:31] where you're getting paid.
[00:33:32] With the US, the equity market is trading more like bonds
[00:33:36] because it's not giving you anything on top of bonds.
[00:33:39] And you have to ask the question why.
[00:33:42] And I think it's got to do with two reasons.
[00:33:44] One is that the composition of the index
[00:33:46] obviously is a lot of technology companies.
[00:33:48] In S&P 500, 30% is tech plus Amazon and Apple
[00:33:53] and some of these other companies, you add them up.
[00:33:56] You have a lot of the index made of tech
[00:33:59] and tech related companies.
[00:34:01] For some reason, the market thinks that
[00:34:03] tech cash flows are very obvious and clear
[00:34:07] when there's not much earnings volatility
[00:34:10] on these large cap tech companies.
[00:34:12] So it kind of puts this higher multiple on it.
[00:34:15] So the S&P is trading currently around 20 and a half times,
[00:34:19] depending on what you think all earnings are
[00:34:21] in 21 and a half and 22 times,
[00:34:23] which is on the expensive side.
[00:34:25] So average S&P multiple going back in time
[00:34:27] is probably 15, 14 and a half, 15.
[00:34:30] So it's definitely on the higher end of it.
[00:34:33] And then if you look at from a earnings perspective,
[00:34:37] the S&P companies made about $216 last year.
[00:34:41] Next year earnings is supposed to grow like 10 plus percent.
[00:34:44] So call it 235 to 40 is what Spencer then,
[00:34:48] I mean, I think Bloomberg had 238
[00:34:50] in terms of expectations.
[00:34:52] But imagine all of that earnings
[00:34:55] is coming from like four companies.
[00:34:58] So if you take those four companies out of the index,
[00:35:01] two on earnings that are actually down in the S&P 500.
[00:35:05] So you basically have an index,
[00:35:07] which is basically a bet on those two companies.
[00:35:11] And those companies essentially are a bet on generative AI
[00:35:15] and this whole productivity boom
[00:35:17] we're likely to get from that.
[00:35:19] That's what the market is doing.
[00:35:21] Now the problem with that is,
[00:35:23] imagine these companies don't actually grow earnings 10%
[00:35:27] or 14%, whatever it's for pencil in or S&P 500.
[00:35:32] And let's say the earnings are flat,
[00:35:35] then the market's gonna be very quick to de-rate
[00:35:39] because what happens is with the market is
[00:35:42] when the earnings are growing,
[00:35:43] it kind of re-rates the market and multiples go up
[00:35:46] and multiples expand.
[00:35:48] And then on the way down,
[00:35:50] if de-rates you could easily see S&P multiples
[00:35:53] at 18 and a half, 19 times or 18 times even.
[00:35:57] And then you've got like a flat earnings growth
[00:35:59] and now suddenly you're at 4,000 on the S&P 500.
[00:36:02] So there is a lot of downside in the index
[00:36:06] at the index level that I'm not saying
[00:36:08] there are some great companies within the index
[00:36:10] those things can go up by fold.
[00:36:12] So that's what we're talking about
[00:36:13] because the index level looks very expensive at the moment
[00:36:17] and we could end up with meaningful repricing
[00:36:22] in these markets.
[00:36:24] I was just gonna say what's super interesting is
[00:36:27] the S&P is a benchmark and there's trillions and trillions
[00:36:31] I'm gonna say maybe seven or so,
[00:36:34] it's probably more like nine that's very explicitly
[00:36:37] literally passively tied to the S&P.
[00:36:39] And then of course the untold tens of trillions
[00:36:43] that are just a nudge away from passive.
[00:36:46] If you ran the correlation to the portfolio
[00:36:48] to the S&P it's 80 to 90%.
[00:36:50] And it's a beast of a benchmark.
[00:36:53] It's an incredible realized Sharpe ratio.
[00:36:55] It's as liquid as could be, it's in broad daylight.
[00:36:58] I kind of contrast that to some of the IG fixed income
[00:37:03] benchmarks again, I go back a couple of years not now
[00:37:05] but go back to that post crisis pre-COVID period
[00:37:10] or even in 2021 when rates were super low
[00:37:14] and credit spreads were super tight.
[00:37:16] Not that hard to beat that benchmark.
[00:37:19] I think part of the challenge I think for investors Chris
[00:37:22] is that the S&P its performance is so unbelievably strong
[00:37:26] and consistent.
[00:37:28] And I don't know if that itself becomes a risk.
[00:37:30] It's so hard not to belong that Magnificent 7, right?
[00:37:34] The career risk of underperformance becomes an issue.
[00:37:37] Yes and no.
[00:37:38] So I agree with you there is definitely this effect
[00:37:41] which is you had a warm up at portfolio
[00:37:45] for the last 30 years, you did well
[00:37:48] which is 90% of the portfolio was in US equity S&P 500
[00:37:53] and you had a little bit of cash just for the rainy day.
[00:37:57] You did pretty well doing that.
[00:37:58] But we have to remember why this happened.
[00:38:01] This happened because we had these amazing companies
[00:38:04] which were able to not just draw a top line
[00:38:08] but also their margins expanded dramatically.
[00:38:11] If you take the Fang stocks and media Nvidia
[00:38:14] and their margin expansion out of the S&P,
[00:38:18] the S&P looks like a pedestrian index.
[00:38:20] It looks like the Euro stocks 50.
[00:38:23] It doesn't look that different.
[00:38:25] So all of this amazing performance
[00:38:28] and sharp ratio that you allude to has come
[00:38:31] because we've had these companies
[00:38:34] that were able to generate this sort of return
[00:38:38] and also to expand margins dramatically.
[00:38:41] Now if you think about margins,
[00:38:43] margins are kind of mean reverting over time
[00:38:46] but they may not mean reverse in the short term
[00:38:48] and a lot of people have gotten it wrong
[00:38:51] betting on very sort of a shorter time scale
[00:38:54] version in this.
[00:38:55] But over time when margins expand,
[00:38:59] there is obviously somebody else that's not getting paid.
[00:39:03] Take the US economy
[00:39:05] and look at the macro profits as a whole.
[00:39:08] So you have the household sector which is getting wages.
[00:39:11] You have the corporate sector
[00:39:13] and you have the credit people
[00:39:16] who are charging a spread on top.
[00:39:18] And then you have the government
[00:39:20] which is taxing the corporate sector.
[00:39:21] So the corporate sector profits
[00:39:24] is a function of how much they're paying in wages,
[00:39:27] how much are they paying in taxes
[00:39:29] and how much credit spreads they're paying
[00:39:32] which is actually just spread on top
[00:39:34] of overall base level of yield.
[00:39:36] So if you take the corporate sector
[00:39:39] and you play this forward two, three years out,
[00:39:42] clearly the base level of interest rates
[00:39:45] that they will pay on average is gonna be up
[00:39:47] if rates are gonna be around here
[00:39:49] because it's at least 250 basis points spread
[00:39:53] to where they borrow money
[00:39:55] to where interest rates are right now.
[00:39:58] So that's just the base level of rates.
[00:40:00] Now you look at spreads,
[00:40:02] whether it's high yield or IG,
[00:40:04] whichever favorite part of the credit market
[00:40:06] you look at spreads are quite tight.
[00:40:09] So if you think about a scenario
[00:40:11] where the government's spending lots of money
[00:40:14] and all of that debt has to be somehow
[00:40:17] somebody has to buy it
[00:40:19] and you've got this issue with the corporate sector
[00:40:22] also showing up with 7 trillion refinancing
[00:40:25] next five, six years.
[00:40:27] So if inflation doesn't come down
[00:40:29] then the amount of interest they will pay
[00:40:32] will be substantially higher
[00:40:33] and maybe credit spreads also will widen out.
[00:40:36] So that could be negative.
[00:40:37] So the base level of rates could be higher
[00:40:40] and also the spread.
[00:40:41] So that will detract on profits.
[00:40:43] The taxes one could argue is already quite low
[00:40:48] and anything maybe we will try to get more
[00:40:51] of those profits and so taxes could go up potentially.
[00:40:55] And then on the major side,
[00:40:57] clearly what we've seen
[00:40:59] is that real incomes haven't gone up as much.
[00:41:03] We've had a big inflation
[00:41:04] but that's gone to the lowest income earners.
[00:41:07] So if you think about the overall economy
[00:41:09] they have a higher propensity to consume and spend money
[00:41:12] and that's why we have this sort of wages
[00:41:15] causing a bit of inflation.
[00:41:16] But the overall, if you look at real incomes over time
[00:41:20] it hasn't really accelerated.
[00:41:22] And so if you have a tight labor market
[00:41:25] and this thing continues for a while
[00:41:27] they would have to pay more of that profit as well
[00:41:29] to retain employees.
[00:41:31] So you could kind of see where this big margin they have
[00:41:35] could get taken away.
[00:41:36] And that's where the scenario that you outlined
[00:41:38] being happened with the US actually under palms.
[00:41:42] The other scenario I can see is that
[00:41:45] if you think about what we did over the last 20 years
[00:41:47] we basically invested a lot of money in bits.
[00:41:51] So we wanted to take AI, take cloud computing
[00:41:54] take any sort of software related thing.
[00:41:57] We are really good at that.
[00:41:59] So most of our largest companies in our S&P 500
[00:42:03] are tech companies.
[00:42:04] So we invested a lot in bits
[00:42:06] but we haven't invested as much in atoms.
[00:42:09] What that means is if now we have to pivot away
[00:42:13] from bits towards atoms
[00:42:15] we need to invest in companies
[00:42:17] that are involved in that.
[00:42:19] So we need to be buying energy companies
[00:42:23] we need to be buying industrial companies.
[00:42:25] The tech companies are already at a very high multiple.
[00:42:30] And if anything, investment flows have to go away
[00:42:32] from them towards some of these other places.
[00:42:35] Just to give you an example
[00:42:36] let's take the outline where you imagine all of them
[00:42:40] if you take all of them at face value
[00:42:42] in terms of how much energy demand they're gonna have.
[00:42:45] So they're expecting about 1000 terawatt hour
[00:42:49] of incremental energy demand
[00:42:52] over the next three to four years.
[00:42:53] And our grid capacity, I mean our total generation capacity
[00:42:57] I think about 4000 terawatt hour at this point.
[00:43:00] So it's about a 25% increase in energy demand
[00:43:04] just from AI and data centers in the next three, four years.
[00:43:09] How are we ever gonna be able to meet that demand?
[00:43:12] How are we gonna ever do that?
[00:43:14] We would have to do every possible forms of energy.
[00:43:17] We would have to invest in nuclear, solar
[00:43:20] every possible renewable source of energy.
[00:43:22] And even then we may not be able to meet that demand.
[00:43:25] If you think from a bigger picture
[00:43:28] just stand back and look at the index
[00:43:31] you're basically betting on tech
[00:43:32] when you're long the S&P 500
[00:43:34] because that's what the index is.
[00:43:36] All the profits are coming from tech.
[00:43:38] 40% of the index is actually tech companies.
[00:43:41] So if you're buying an index and you're saying
[00:43:43] oh, look I have 500 stocks, I have news for you.
[00:43:47] No, you don't.
[00:43:48] You have seven or eight stocks at best.
[00:43:51] If you look at the performance of the S&P last year
[00:43:54] it was 26%.
[00:43:57] There's the RSP which is just the equally weighted version
[00:44:00] of the S&P.
[00:44:01] It was up half that.
[00:44:03] And I think what you're suggesting is at least
[00:44:06] potentially over a forward looking timeframe
[00:44:09] there's scope for a reversal of that
[00:44:12] where some of the more industrial energy-centric companies
[00:44:17] take up some of the slack
[00:44:18] and maybe it's just because the price is already
[00:44:22] reflecting so much optimism for tech
[00:44:24] even though they're great companies
[00:44:26] and doing amazing things that the price got there first.
[00:44:29] And so the forward return outlook
[00:44:31] is just not as favorable.
[00:44:33] Is that kind of where you're going?
[00:44:36] I would also add on what you just said
[00:44:38] if you take something like Microsoft.
[00:44:40] Microsoft's a great company.
[00:44:41] Their market cap is say roughly three trillion.
[00:44:45] The entire energy sector
[00:44:47] you take all the companies in the energy sector
[00:44:49] the market cap is probably half of that.
[00:44:52] It's probably one and a half trillion.
[00:44:53] And then you take the pre-cash flow
[00:44:56] that Microsoft generates
[00:44:57] in order to do the buybacks and dividends
[00:44:59] and all the other stuff,
[00:45:01] all the investments they're making
[00:45:02] open the eye on other companies.
[00:45:04] It's 60, 70 billion the whole of Microsoft.
[00:45:08] Now energy sector as a whole generates double that.
[00:45:12] So energy sector I think generates
[00:45:13] about 140 billion pre-cash flow.
[00:45:15] So at some point, if interest rates say high
[00:45:18] people are gonna say, where is the cash flow?
[00:45:21] I wanna see the cash flow.
[00:45:22] And if you notice some of these tech companies
[00:45:25] starting to pay dividends
[00:45:26] because it's partly this question from investors.
[00:45:30] Hey, you're generating all this cash flow that's great
[00:45:32] but we don't want you to invest it
[00:45:34] in some hindsight projects
[00:45:37] that are not necessarily going to credit
[00:45:39] any value to the company.
[00:45:40] Take AI, roughly speaking, right?
[00:45:43] That seven or eight companies
[00:45:45] are investing about 400 billion in AI related things.
[00:45:48] So that's data centers, GPUs, you name it.
[00:45:52] They're investing all of that stuff.
[00:45:54] Now what if all of that investment
[00:45:56] doesn't bear fruit in the next year or two?
[00:45:59] You take most of the studies from McKinsey
[00:46:01] and Goldman Sachs and all these smart people
[00:46:04] they've come out with estimates
[00:46:06] of how much all the AI is gonna add.
[00:46:09] And it's roughly about 2% productivity growth
[00:46:11] over the next three years.
[00:46:12] So it's not now, it's in three years time.
[00:46:15] Maybe you get some productivity growth.
[00:46:18] But what if it's not three years?
[00:46:19] What if it's five years from now?
[00:46:21] And what if at some point
[00:46:23] in the next three, four or five years
[00:46:25] people turn around and say,
[00:46:27] this all sounds good but where is the cash?
[00:46:30] I need to see some cash flow
[00:46:32] because you can't keep up 400 billion of spending
[00:46:36] for a long time.
[00:46:37] You could do that this year
[00:46:38] maybe even do it next year.
[00:46:40] But if rates stay up here
[00:46:42] there's gonna be a big question mark around
[00:46:44] what is it that is result of all this?
[00:46:47] Now we use AI in our work a lot
[00:46:50] like we do every research we receive
[00:46:53] and we do it all kinds of reasoning problems with it.
[00:46:56] And it's great, it's amazing technology.
[00:46:59] But at the same time
[00:47:00] I'm not sure that the AI monetization
[00:47:05] is gonna be similar to how other technologies
[00:47:08] are being monetized.
[00:47:09] So for instance, I use OpenAI, the API
[00:47:13] to do all my inferences.
[00:47:16] But what if I get a GPU
[00:47:18] and I can run Llama 3
[00:47:20] which is a free open source model from META
[00:47:24] in my office closet
[00:47:26] and suddenly now I don't need OpenAI.
[00:47:28] Not only that,
[00:47:29] this is not gonna cost me a whole lot of money
[00:47:31] over time.
[00:47:32] If I can do that I'm a small firm in New Jersey.
[00:47:35] Imagine the large firms
[00:47:38] and they can all do their own inferences
[00:47:40] and they can even build their own models in-house.
[00:47:44] So you don't really need the large companies
[00:47:47] to provide services.
[00:47:48] So I think there's an issue of whether this becomes
[00:47:51] like an operating system.
[00:47:53] You remember when the Unix operating system was on
[00:47:56] there was all these companies selling units.
[00:47:58] There was Sun Microsystems
[00:48:00] and all these other companies.
[00:48:01] But then later on Linux came about
[00:48:04] and then all those companies kind of disappeared
[00:48:06] because everybody said,
[00:48:07] oh open source free I'm gonna use Linux.
[00:48:11] And that could have happened here
[00:48:13] where the best models over time
[00:48:16] are actually the open source models.
[00:48:18] So these companies don't actually end up
[00:48:20] being the big winners.
[00:48:22] And then the other issue I have
[00:48:24] is the whole thing with GPUs
[00:48:25] which is that GPUs seem to be a very inefficient way
[00:48:29] of doing the computation
[00:48:31] because they are extremely energy intensive
[00:48:35] and you need all these cooling systems
[00:48:37] and fairly complex things to pull this thing down.
[00:48:41] And maybe there is simpler things
[00:48:43] that are gonna come about.
[00:48:44] So there's stuff around silicon photonics,
[00:48:47] there is potentially some ASIC or some other solution,
[00:48:50] some other chip formulation is gonna show up.
[00:48:53] And then people are gonna say
[00:48:55] we're not gonna use CPUs
[00:48:57] because it's too expensive energy wise.
[00:49:00] And if that happens,
[00:49:01] all this capex will have to depreciate quite dramatically.
[00:49:06] There are a lot of risks to the market
[00:49:08] because the way the SMP 500 is constructed,
[00:49:13] historically it benefited from large cap companies
[00:49:18] being the dominant players in the market
[00:49:20] and those companies having these massive margin expansion.
[00:49:24] Now on the reverse,
[00:49:25] imagine scenario where the earnings growth isn't great
[00:49:28] and we all decide together
[00:49:30] that what we need really is energy, not so much AI
[00:49:34] because without energy, we can't have AI.
[00:49:37] And so we all pivot that way.
[00:49:39] Then I think we could have a substantial repricing
[00:49:42] in the equity market.
[00:49:43] So obviously other parts of the index will go up
[00:49:47] but as an index as a whole may not do as well.
[00:49:50] Last week when we touched base,
[00:49:51] we talked about the theme of decarbonization
[00:49:54] which is something you've been thinking a lot about.
[00:49:57] You've made the comment to me
[00:49:59] that there's pretty significant implications for inflation.
[00:50:03] You've talked a lot about India
[00:50:05] in terms of the introduction of air conditioning
[00:50:09] and of course climate change and the impact there.
[00:50:12] Take us through your thought process
[00:50:14] if this sort of longer term thematic thinking
[00:50:18] on a perhaps slow moving but a powerful trend and theme
[00:50:23] that you think is ultimately gonna have
[00:50:25] a lot of implications for how assets are priced
[00:50:28] and maybe how commodities are priced as well.
[00:50:31] Yeah, I think decarbonization is a big topic
[00:50:35] and we could do a part two on that.
[00:50:38] I'd like to highlight three things
[00:50:40] that I think important on this.
[00:50:42] The first one is that obviously you think
[00:50:45] about this whole idea of not using fossil fuels
[00:50:48] and using renewable energy
[00:50:50] and be doing everything from our grid
[00:50:53] to the cars we drive, to our cooking stoves
[00:50:56] and all that sort of stuff.
[00:50:57] I mean, it takes a lot of investments to do that.
[00:51:01] So you need like a lot of capital.
[00:51:03] If you're gonna be redoing all this stuff,
[00:51:06] you're gonna suck a lot of capital from elsewhere.
[00:51:09] So if you imagine like we decide,
[00:51:11] okay, we need to have all these solar farms
[00:51:13] and we're gonna have all this nuclear energy.
[00:51:15] So we're gonna build like small modular reactors
[00:51:18] or large reactors, whatever the reactors might be.
[00:51:21] All of that stuff is gonna need a lot of capital.
[00:51:24] So the real interest rate has to go up
[00:51:26] if we're gonna do this.
[00:51:28] And part of this is,
[00:51:29] I think there's two reasons why we're doing this.
[00:51:32] One is obviously from a client perspective,
[00:51:34] it could be argued that changing our energy mix
[00:51:37] might be good, but we could also argue
[00:51:39] that it makes us more self-sufficient.
[00:51:42] You are already the largest producer of crude oil
[00:51:46] and imagine if we were able to do all these renewables
[00:51:49] we would be a very energy rich country
[00:51:52] and we can attract all kinds of manufacturing back to us.
[00:51:55] So that's, I think part of the second thing.
[00:51:58] And then the third reason of course is
[00:51:59] geopolitical reason, which is,
[00:52:01] do you really want to depend on other people
[00:52:05] being nice to you in order for you
[00:52:06] to go about your life?
[00:52:08] So I think we've kind of realized in the last few years
[00:52:12] that maybe having this sort of global supply chain
[00:52:16] and stuff not such a good idea
[00:52:18] maybe we should keep things closer to home.
[00:52:20] And so you see Mexico has had a big manufacturing
[00:52:24] Renaissance and Mexican Peso has done well
[00:52:27] and Equities there have done well as well.
[00:52:29] On the decarbonization side,
[00:52:31] I think the first thing in my mind is that
[00:52:34] it means the higher real interest rate
[00:52:36] because you're gonna suck a bunch of capital into that
[00:52:40] and that is gonna mean interest rates
[00:52:42] would have to go up a little bit.
[00:52:43] The second thing is that we wanna be very competitive
[00:52:47] in terms of energy.
[00:52:49] If our energy costs are $50 a megawatt hour
[00:52:54] and China's cost is $15 a megawatt hour,
[00:52:58] it's a big deal.
[00:52:59] Because if somebody can generate power
[00:53:02] at a much lower cost,
[00:53:05] then they're gonna be able to out compete us
[00:53:07] in all sorts of industries.
[00:53:09] So part of the problem we're having now
[00:53:11] is China's done massive amounts of investment
[00:53:16] in all these things.
[00:53:17] Just in energy, just to give you an example,
[00:53:20] they've actually installed more solar last year
[00:53:25] than the entire installation in India.
[00:53:27] So you take all of India's solar installation,
[00:53:30] I mean, they've done more than that.
[00:53:31] The same thing with all the other things.
[00:53:33] They have more nuclear power plants
[00:53:36] that's gonna come live.
[00:53:37] They basically made themselves very resilient
[00:53:41] from any external shock by investing in all this stuff.
[00:53:45] And of course, you could argue
[00:53:47] that that creates a lot of excess capacity.
[00:53:50] Now they can turn around and dump that capacity
[00:53:52] on the rest of the world.
[00:53:54] So everybody's worried.
[00:53:55] So Yellen has been there
[00:53:56] and other countries are complaining to them as well.
[00:54:00] Obviously if you've driven one of their EV cars,
[00:54:03] I had drove a VYD in Mexico.
[00:54:05] It's a nice car.
[00:54:06] Wasn't inferior in any way.
[00:54:08] You could see how something like that
[00:54:11] could be a huge winner in emerging markets.
[00:54:14] Could be a very inexpensive electric car,
[00:54:17] very cheap to maintain.
[00:54:18] So that creates a problem for the rest of the world.
[00:54:21] So we have a lot of EV companies here,
[00:54:24] amazing companies,
[00:54:25] but then cost-wise,
[00:54:27] if you're not able to compete with them,
[00:54:29] that's gonna be a problem.
[00:54:30] And I think it comes down
[00:54:32] to having a very low cost of energy production
[00:54:36] and having the grid to do it.
[00:54:38] So that's why I think the second point
[00:54:40] on the decarbonization thing
[00:54:42] is it's a natural security issue,
[00:54:44] but also a competitiveness issue for us.
[00:54:47] We need to be able to compete with the rest of the world,
[00:54:49] bring all this manufacturing here,
[00:54:51] and we need very cheap source of energy.
[00:54:54] Of course we have gas
[00:54:55] and we have all the oil we would want,
[00:54:58] but it's nice to have solar
[00:55:01] and some of these other forms of energy
[00:55:03] because that makes us more resilient.
[00:55:06] So I don't think we wanna bet on one form of energy
[00:55:09] or the other because we just don't know.
[00:55:11] I'll give you an example on solar.
[00:55:14] There was a story where in India they had a solar farm.
[00:55:17] It was an offshore solar farm,
[00:55:20] and then they had a storm
[00:55:21] and the whole solar farm got destroyed.
[00:55:24] So imagine we went
[00:55:25] and did all our solar installations in the Midwest
[00:55:27] and we had some tornadoes come through
[00:55:28] and take all the panels out.
[00:55:31] It'd be a big problem for us.
[00:55:32] So we need to have that,
[00:55:33] but we also need to have
[00:55:34] some other sources of energy.
[00:55:36] So that's the second aspect
[00:55:38] of this whole decarbonization thing.
[00:55:41] So interesting and we've become accustomed.
[00:55:44] Maybe it's more of a societal thing,
[00:55:46] but we're so instantaneously focused.
[00:55:49] This is perhaps reflected in our industry
[00:55:52] in the zero DTE option craze
[00:55:55] of which by the way I've learned
[00:55:57] that the option volume in India
[00:55:59] far surpasses that in the US
[00:56:02] and in any other country in the world at this point.
[00:56:05] I had not known that.
[00:56:07] There's a very short attention span for folks these days
[00:56:12] to think about these longer term themes.
[00:56:14] I think a couple of things.
[00:56:15] One is you really got to have,
[00:56:18] and I'll borrow from Seth Klarman here,
[00:56:20] the patient investor.
[00:56:21] There's so much focus on the day-to-day P&L,
[00:56:25] which of course is a reality you have to tend to,
[00:56:27] but sometimes I think it pulls people away
[00:56:30] from being able to really think
[00:56:32] through longer term themes that'll play out,
[00:56:35] but it'll take some time.
[00:56:36] Here's where I wanted to close.
[00:56:38] We started with FX derivatives
[00:56:39] and you've got a background in macro
[00:56:42] and also just a keen understanding of structure
[00:56:45] and things like convexity and the price of vol.
[00:56:49] As you sort of look at the prices across the asset classes
[00:56:53] and across vol surfaces as they say,
[00:56:57] anything stand out to you
[00:56:58] as especially interesting, actionable,
[00:57:02] head scratcher type of prices
[00:57:05] where you're trying to understand
[00:57:07] why a price is clearing at the level it is,
[00:57:11] either on the high side or the low side.
[00:57:13] What looks real interesting to you right now?
[00:57:15] I think there's a couple of things on the vol front.
[00:57:18] If you look across the weighted asset classes,
[00:57:22] index equity indices,
[00:57:24] interest rates, commodities, currencies,
[00:57:27] pretty much across the board,
[00:57:29] volatility is lower or towards the lower end
[00:57:32] of the spectrum, except in interest rates.
[00:57:35] In interest rates, you have pockets
[00:57:38] where rate wall is actually on the higher end,
[00:57:40] but the rest of them like in equities
[00:57:43] and even in currencies,
[00:57:45] currencies in particular walls come down a lot
[00:57:48] because the central banks are not active.
[00:57:50] The debt stocking, the ECB stocking,
[00:57:53] BOSJ did something,
[00:57:54] but they're still just getting off from their chair
[00:57:57] so there's a long way for them to go.
[00:57:59] So when those central banks start to do things,
[00:58:03] that's when currency wall gets going.
[00:58:05] In equities, volatility is pretty low,
[00:58:08] but as you know, it's because
[00:58:10] where implied correlations are.
[00:58:12] So we have this weird market
[00:58:14] and goes back to what we were talking about before.
[00:58:16] We had four or five stocks driving the market
[00:58:21] in terms of earnings growth
[00:58:23] and then the small caps haven't done so well.
[00:58:25] So if you take the S&P 500,
[00:58:27] it's a tale of two markets.
[00:58:29] The small caps that struggle a little bit
[00:58:32] and then the tech related,
[00:58:33] I wouldn't call them tech
[00:58:35] because there's some hardware companies
[00:58:36] and some industrial companies that have also done well.
[00:58:39] So that stuff's done really well.
[00:58:41] So there's a lot of dispersion.
[00:58:43] So because of the dispersion,
[00:58:45] we have very low implied correlation
[00:58:48] and that's driven index fall down.
[00:58:50] So now if you get an unwind of that
[00:58:54] and how does it happen?
[00:58:55] It could happen because people agree with me
[00:58:58] and say, oh, this AI stuff
[00:58:59] is gonna take longer to happen.
[00:59:01] AI might be much bigger than we think,
[00:59:03] but it could take a lot longer.
[00:59:05] And in the short term,
[00:59:06] nothing really much comes out of it.
[00:59:08] So that could be a scenario
[00:59:10] where implied correlations would go up
[00:59:13] and dispersion comes down
[00:59:15] and you get the whole fall move potentially in equities.
[00:59:19] In rates, I think it's got to do with the Fed
[00:59:22] because clearly it's hard for the Fed to lay out
[00:59:27] where they're gonna be a year from now
[00:59:29] or even six months from now
[00:59:31] because there is still a bit of inflation
[00:59:34] that they wanna get over.
[00:59:36] So I think the moment we get
[00:59:38] a couple of softer inflation prints,
[00:59:41] maybe starting this month,
[00:59:43] maybe then interest rate volatility comes down a little bit.
[00:59:46] So that would be the catalyst
[00:59:48] for that volatility set lower.
[00:59:51] And then of course in credit,
[00:59:52] as you know, default rates are low.
[00:59:54] They're starting to go up
[00:59:56] depending on where you're looking in credit.
[00:59:58] Of course, the credit card,
[00:59:59] the interest rates are going up,
[01:00:00] but at the index credit CDX level,
[01:00:03] as you go through the cycle and it's more tightening,
[01:00:07] you could clearly see more defaults next year.
[01:00:10] And as you go into that,
[01:00:11] credit spreads will widen
[01:00:13] and then obviously wall kind of is correlated
[01:00:16] to spread moves.
[01:00:18] You could see that credit wall will pick up
[01:00:20] later this year.
[01:00:22] Commodity wall, though, the overall is lower
[01:00:25] and that's only because we've been anchored
[01:00:27] by this period of extreme price action
[01:00:30] due to what happened in Russia,
[01:00:32] what happened in the Middle East.
[01:00:34] That's caused us to be open to the idea
[01:00:37] of crude oil going to $150
[01:00:40] and other commodities going up.
[01:00:42] But overall, you look at it,
[01:00:43] commodity volatility looks cheap to us
[01:00:46] because a lot of things can happen.
[01:00:48] Particularly if you're gonna do all this AI spend,
[01:00:52] you're gonna need a lot of commodities,
[01:00:54] not just energy, you're gonna need copper,
[01:00:56] you're gonna need other things,
[01:00:58] graphite and lots of other things.
[01:01:00] So we're gonna need more commodities.
[01:01:03] And I think like there's more appreciation now
[01:01:05] that the supply driven inflation is not so great.
[01:01:10] If you go back in time
[01:01:11] and look at the last three, four years,
[01:01:13] some of the inflation we got was really supply driven.
[01:01:16] Some of it was demand driven,
[01:01:18] but a lot of it might've been supply driven.
[01:01:20] And if we had a better handle on commodities overall
[01:01:24] using other ER type things,
[01:01:27] but for other commodities,
[01:01:28] maybe we won't get that sort of chance.
[01:01:31] So I think like commodity volatility
[01:01:33] could again, rain up this year.
[01:01:35] So that's something we're more inclined thing
[01:01:37] there is potential for volatility there.
[01:01:40] It's an interesting setup.
[01:01:43] I think none of these option prices
[01:01:44] are really outside the boundaries
[01:01:46] of what they're realized vols justify.
[01:01:49] S&P is realizing, depending on your day,
[01:01:51] from 2012 to 14,
[01:01:53] you referenced copper on the lowish end of implied,
[01:01:56] but also not really justified to be much higher
[01:02:00] based on realized.
[01:02:01] And I'd say the same with crude.
[01:02:03] So it's a very interesting setup
[01:02:05] and probably doesn't really incorporate
[01:02:07] any of the forward looking longer term horizon actions
[01:02:13] that you're highlighting here.
[01:02:14] So it's quite interesting to look at.
[01:02:16] Well, Chris, this has been a great conversation.
[01:02:18] I have truly enjoyed learning from you
[01:02:20] and getting a chance to listen to what's on your mind
[01:02:24] and your framework.
[01:02:24] And I'm really glad we have an opportunity to do this.
[01:02:27] So thank you very much.
[01:02:28] Thanks Dean, thanks for having us.
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