Kopi Time E114 - US markets with Dr. Komal Sri-Kumar

position was Chief Global strategist and chairman of asset allocation Committee. SHS. Views on asset allocation investment risk management are widely followed in the financial industry as well as by numerous institutional investors. Shri. A warm welcome back to C

the path for interest rates, the path for equities. And if you made a decision on what was going to happen, you found analysts changing their views in 2 to 4 weeks, they completely had to reverse themselves. That is, I think the big surprise and to me, the big change happened even within that, within what happened on the rate front and think about October 22nd, 23rd, the 10 year treasury yield peaking at 5.02% and a couple of minutes ago,

it just closed at 4.2%. So you've had an 80 basis point move which has taken place in just over a month and what explains the 80 basis point move absolutely nothing animal spirits. And that is what is surprising to me that markets will go up and go down, especially on the fixed income side with very little to explain for it. But I have my own reason. For it and I'm happy to talk about it.

The expectation is that the Euro European Central Bank is probably going to do something very urgently with respect to cutting interest rates perhaps much faster than the fed. And that's, and as far as the relationship with the Asian currencies is concerned, there are two things I think at work. One from the US side, the expectation that the fed may indeed cut rates very quickly. Despite Jerome Powell's protestations that he's

not going to do so. And the second one is again that Mr Ueda at the Bank of Japan may be getting ready to get rid of the 1% peak that they that they informally fall over the 10 year J GB yield. And if that's the case and it's allowed to go up, clearly, it marks a further appreciation of the yen with respect to the dollar.

different two months ago. And it's, it's evolved around the European outlook and to your point about the E CBS policy direction, which I mean, I have a feeling might again change in the early part of 2024 if data flows were to change. All right, going back to rates, I am interested in a couple of things. So one is the whole us fiscal picture and it impact on rates. Second is the whole supply demand of bonds.

I mean, in 2024 or 2023 to your point, this entire rally of the last couple of months or even less than that has happened still against the back of a really poor fiscal outlook. So how do we reconcile the market structure by that interest as well as the rather alarming supply side of the bonds?

placed and without any difficulty so far. And that's what brought the 10 year yield down to 420 this Tuesday afternoon in the United States that this is, I would give an analogy to explain what is happening. You're looking to buy a home and there is only one home available in that neighborhood.

It's not in great shape, it's actually deteriorating, but you want a home and that is a good place to put your money and to try to improve it in the future or you can go without a home, what are you going to do about it? So if you are a global investor, if you do not like the US Treasury's policies and I don't, but where are you going to go? Are you going to go into Chinese Renminbi? You're not going to go into the Euros and the German market is too small

to take it. There is no other alternative. Five years ago, the thought was China would be a competitor to the United States in terms of where the US dollar is going. And the Chinese Renminbi Yuan would surpass the US Dollar in terms of supremacy. It just hasn't happened and I don't think it is going to happen in the foreseeable future. So from if you were Janet Yellen and you were looking at the situation, you don't have much to worry about

the global demand is going to exist. And that's the reason why the US fiscal mismanagement, the big important topic though it is it is essentially in the background. It's not very relevant to explain bond yields.

most parts of Asia. So the uh the gap if you will is being picked up by the private sector, both us private sector and non us private sector have bid very, very enthusiastically for us treasuries through the course of this year. Um So it goes back to your point that you don't really like the Chinese home and the European home, you may not like the US home that much, but it's still AAA. So you used to buy the US home.

So when all of that is the case, it's a very easy bet that us dollar is where you're going to be. There's one competition though, look at the price of gold and I have to speak to a client early next week. And I'm pointing out that first for the first time in quite a while gold is getting a life. And the reason that is the case is because you're going to have a situation when rates are going to come down in the United States, we'll reserve to later as to why rates may come down.

But when rates are going to come down, holding us dollars, whether in the form of treasuries or in the form of other assets becomes less attractive and the opportunity cost of holding gold goes down, which is I think what is going to happen? I think the gold price is going to go up, but it's not as if you can use gold as a currency to physically move from one to the other. So as long as that's not the case, it's very little competition still for the, for the dollar supremacy in global markets.

actually in a rather high. Despite the fact that S and P 500 pe is extremely high. The yield gap vis A vis the US Treasury is still substantial and still people buy a lot of stocks,

But I point out in a recent write up that between March of 2020 March of 2021 one year, the balance sheet of the fed increased by 77% to about $7.6 trillion in March of 2021. And right now, it is standing at $7.7 trillion. If you compare today with March of 2021 there has been no quantitative tightening. It's all a matter of your perspective. It's a matter of where we are standing when you're viewing it.

The other point is that the interest rates were reduced to zero and maintained when the economy was recovering and that was highly irresponsible and you cannot make up for eating an unlimited amount of food and drinking a lot by saying that you're going to go hungry and you're going to stop eating for the next week. It doesn't, you do not get back to good health as a result of what you did before. So that's close to what the Fed is doing.

They made a huge mistake. They've never admitted it. By the way, Jerome Powell called the increase in the inflation rate as quote unexpected. It has nothing to do with monetary policy. It has nothing to do with zero interest rates or increase in the balance sheet. So I think there is so one reason why the equities have continued to do well is because there is a lot of liquidity. Thanks to the Federal Reserve. Second, you refer to the fiscal deficit. You are, it is not your time to pay the piper.

You do not have to pay any penalty for the fiscal deficit, but you can enjoy the benefit of the deficit and that stimulus is also helping the equity market. So that is the second reason why I think it's persisting When does it come to an end? And that's where I differ from the consensus. The consensus believes that there will be some form of a recession, maybe a mild recession, a soft landing, but that still requires the fed to cut interest rates because inflation will come

down to very low levels. I disagree. Janet Yellen said earlier today that she believes that she disagrees that the last one mile of inflation fight is the toughest it is. I have followed markets for 50 years and every time starting from the Richard Nixon author Burns Years, they have been very difficult once you bring it down to very low levels, it unless you show determination to keep it there.

So that is again a reason why there is a concern in the market about equities, something may break in the system, you may have a credit even which will bring the equities down. And then of course, you have a period of equities and the pressure and before they pick up again, so think about December 2008 to early March of 2009, December 2008. We were still suffering from the aftermath of Lehman Brothers. The Federal Reserve had cut interest rates to zero.

They talked about quantitative easing in a, they basically increased it in a massive manner after September of 2008. But it took until March 9th of 2009 for the S and P 500 to reach its bottom. So you may have a situation like that where equities go down, but that's going to be the time you go and when this blood on the street you buy again. So my outlook for equities is from the current level go down perhaps in the next six months. It then languishes for 3 to 4 months at that stage.

Then the fed once again introduces quantitative easing brings down the uh brings down the interest rate. It doesn't matter what the inflation rate is. As for the, for the central bank, inflation is a consideration only when there is no crisis. When there is a crisis, you set aside your inflation concerns and just inflate. And that's I think what's going to happen that will help equities and that is also going to be very beneficial overall to risk assets.

was growth was going to slow substantially. It didn't at all. I think US will probably end up with 2.5% growth for 2023. So higher than 2022. Uh and it will take that momentum to some extent into 24. So before we talk about 24 just the performance of the first three quarters including the spectacular third quarter that we saw.

So that is one reason why, why I think uh you have the the vibrant US economy. The second you mentioned is clearly the A I the revolution, there is a productivity growth and that is showing up in recent productivity numbers. Uh being healthy productivity again, is a very volatile concept. You have it going up for quite a few quarters and then it does you cannot sustain it. So that's the second reason why I think

it is sustained. Uh But the question is when you look at the overall us economy market and when you look, by the way, when you compare it with what happened to the what the treasury market is telling you the eel curve, the 2 to 10 eel curve inverted in early July of 2022. So that's about 17 months ago and invariably every time it has resulted in a recession.

And now you see that in terms of slower labor market growth, wages are coming down to some extent, the jolts report as we call it, the job openings are not as strong as they used to be. The quit rate has gone down from earlier levels. So all of those are suggesting that it is slowly starting to take shape. So the answer to your issue, which is I think very relevant is you have not banished recession, you have not gone into a state of Nirvana where you have perennial rapid economic growth.

What you have is a situation where rapid growth was promoted by technological changes as well as by the stimulus, but eventually it is going to revert and you're going to reach a situation where the recession is going to come. It is delayed but not denied, denied,

there's bound to be some financial accidents. So what's your sense? I mean, are there risks lurking here and there?

Why does that happen recently? An estimate by a study by the Federal Reserve Bank of Kansas suggested that $550 billion worth of assets of us banks are under water and that is the equivalent of 30% of regulatory capital.

Now that is for the entire banking system. But clearly there are some banks which are in much better shape than that or they have other assets to offset the losses they have taken in buying long dated treasuries or long dated mortgage backed securities and see the yields go up after that. But then if you say that there are some smaller banks which are accounting for $550 billion or most of it, you're talking about them using up much more than 30%

of the regulatory capital. That is a national average. That is one sign of trouble that I can see. Second one is the fact that you have the commercial real estate problem, which is essentially like a tsunami. I mean tsunami doesn't happen one instant. It gathers force for a while. And then by the time you see it, it is too powerful as of now hand where there are buildings in New York and San Francisco, which are changing hands at much,

much lower prices than they did in 2019. Sometimes at 60 to 70% discount from the price that was paid four years ago. And that's one. And secondly, the interest rate high interest rates mean that very many of the landlords are now able to go to the banks and say I'm not going to pay you the higher interest rate you want us to pay. You have two options. You can either reduce the interest rate for us and I can pay you a lower interest rate or second here are the keys keys to the property, you can

take it. Goodbye. I'm leaving. In either case, the banks are clearly at a disadvantage. This has not come out in full and has not been discussed in public when you look at the banking regulators, when they go before Congress or when Janet Yellen repeatedly says the banking system in the United States is very sound. That word is hers, not mine. And she has repeated it quite a few times. My responses show me how it is sound but there is

no explanation. There's nothing that happens. So that's the second one that I worry about. Third regulations on the banking system are tightening and the regulators are telling the banks not to make so many quote unquote risky loans. These were the same regulators who thought that buying long

dated us treasuries is risk free. Uh I learned from my work at Drexel Burnham, working with Michael Milken, that us treasuries can be among the most risky assets because they carry an enormous amount of interest rate risk, not the credit risk. So when that happens and they have lost a lot of money though they are that they are going to be pushed to lend less money as the recession approaches.

So if there is a credit crunch that takes place, that can add to the overall tsunami of a credit event that is taking place, that's why I'm just sitting by and watching and so I expect so I expect the Federal Reserve to change its policy to have a pivot in terms of interest rate policy, but not because inflation comes down to 2% or goes below it. But more because of the fact that there is a credit event which forces them to cut rates.

are risk lurking there or not. What's your sense

But if it is thought to have systemic implications because of a failure, they will be bailed out. That is the history of us monetary policy. Take a case of the long term capital management. In 1998 we all thought it was a small firm in Greenwich, Connecticut. We thought it was doing risk free arbitrage, but we didn't realize until it was too late that they were levered 27 to 1.

So when the hit came to credit and the credit crunch followed after the Russian debt default of 1998 the Asian debt crisis of 1997 LTCM couldn't take it and they had to be bailed out and the policy changed. So while I agree with you that there is a problem with private equity firms as to whether the firm is systemic or not, will determine whether it will lead to a change in policy or not change or not. Refer to a change in policy.

we see the opposite. But the strange thing is sitting here in Singapore, there are a lot of real state investment trusts which are structured around you us properties uh and they've all done very poorly this year. Uh In many meetings that I have with my colleagues, I always say that, you know, we look at the US economy doing so well, inflation is coming down. But our clients who hold us reeds, they've had the really, really,

you know, terrible year minus 2030 40%. Uh why don't we see it, you know, transmit to the financial system. And the typical answer is that it's sort of, you know, under wraps uh that, you know, some evergreening here, some restructuring there, but sooner or later, somebody will have to pay the bill right now. A lot of private clients are paying the bill.

to recover and crucial to my belief. Here also is November 2024 is the presidential election month and it is, the government is going to try as much as it can to avoid the c A recession as they go into the elections. But as we found out from 2008 that is, they don't always succeed. Uh George W Bush was the president. We were going into the 2008 elections. You had Barack Obama trying to become president for the first time. We

had John mccain who was his competitor. And John mccain subsequently said as late as September 1st of 2008, he thought he had a decent chance of winning in November, then came September 15th and the failure of Lehman brothers and the picture changed completely. So what this government is going to do is they are probably going to uh watch, listen, read history and try to stimulate in the second half of the year.

So that's one reason why I think there will be faster, faster growth in the second half compared with the first half of 2024. On the inflation side. Again, we are looking at core inflation which came out today, Core inflation is still 4% and the Fed's target is 2%. It is double the target and the headline is under is coming down. But then a huge chunk of the headline inflation rate moderation is because of a 9.5% fall month on month decline in gasoline prices, not annual month on month decline.

So that's not going to be continued, it's not going to persist. So I think you're stuck at somewhere between 3.5 and 4% on the core inflation rate, which is, which is not a killer. It is not like what Richard Nixon had or uh the next president J uh J Ford had with the with the um chairmanship of Arthur Burns or G William Miller. But what you do have today is just inflation still above the fed's target and whether it will tolerate that or not. So if that is they can, they don't have the option.

I think of declaring victory and walking away because they made one mistake about inflation being transitory and that was wrong this time, they have to get it right. Which is also another reason why I think a credit even becomes more likely

CP I anyway, uh and manufactured goods by and large, you know, are, are not a big source of inflation as they were during the bad years of the pandemic. But then when we come down to rental accommodation as well as services, I'm not quite as Sanguine. Uh I just came back from the US, from your home state of California. Uh I, I don't see uh you know, major easing of pressure on those two fronts. Uh What's, what's your view?

natural gas prices coming down, gasoline prices coming down. But it doesn't mean all of the other products are going to stay down. Second one as the Biden administration likes to point out that the wage increase is now staying ahead of inflation, real wages are increasing for workers. But when you look at the workers and how they have experience going back to 20 in 2019, that you have essentially a situation when the real wages over the last 3 to 4 years has actually fallen.

And that is again, something that they will have to correct going forward. And that is, I think another risk as far as the US economy is concerned.

next year, if not earlier. And then you do your view, I think I heard you earlier talk a little bit about QT. So you elaborate on that as well, both the rates and the QT pipeline for 2024.

with the United States. And you're right, they cannot finally calibrate when they are going to cut rates. That's why I say you, one of two things has to happen. Either the inflation rate goes down to 2%. The target is reached, Fred declares victory and then they can cut rates massively from where they are today. Second, you have a credit, even in which case, you do not have to worry about inflation, you have to save the system and they, they do it. Uh look at the Ben Bernanke approach in 2008.

He thought the subprime crisis was a 50 to $100 billion problem. That's what he said to us. Congress in July of 2007, it turned out to be a massive crisis the following year. So then he said, ok, he was going to start quantitative easing, which he described as being a temporary process, which is still in existence all these years later. Uh But again, he was called the Savior of the system, not the person who did not anticipate the crisis. He even has a Nobel Prize to show for it after

all of these years. So the question is the risk and reward that you have on the central backing side are not consistent with what is required for good economic policy, good monetary policy. So what is the fed going to do? They are going to wait to see if the inflation comes down and it doesn't come down to 2% stays at 3.5. They will continue to pass. They'll pass tomorrow for the third time in a row. They can pause for six or seven months and at the same time, say that we are not going to

increase interest rates. We are not going to decrease interest rates. So, but actual cut would be such a big move that I think they have to be careful when they do that. And I think that will happen only with the credit event. What about the quantitative tightening? They have a problem because they have increased it so much from pre pandemic days. They essentially doubled it from

the beginning of 2020 to March of 2022. When the quantitative tightening began, the balance sheet increased from about $4 trillion to almost $9 trillion before it's come down now to 7.7. So they have to cut a bit more. And I think at that stage, they say we are not going to do QT anymore, but we'll be closely watching it and whenever that is possible, we are going to reduce the fed's balance sheet.

In other words, we don't have a timetable because between really because they are concerned about having a timetable and how it would strangle the economy, but we are ready to tighten again if necessary. So that's I think what's going to happen that may happen by March or April and you go on further uh with the, with the interest rate remaining where they are and the cut takes place when the credit even takes place.

let's talk about the fiscal part for a second. Uh We have a rather dysfunctional congress, we have these, you know, uh rather potentially severe events like a debt ceiling issue and then some last moment engineering pushes the can down the road by a few months. And then again, there is another crisis but surely in a situation like that, the Democrats really are not in a position to add more fiscal stimulus.

and the 100 billion spending for that purpose. Right now, it's a huge sum of money to be spending when you're trying to improve your fiscal situation that it happened in the last couple of months. Yes and so I wouldn't put it beyond them to find other ways to provide stimulus. If not, then monetary policy will have to step in. And if you remember once again, going back to history because I study history to learn what we what may happen again.

Ben Bernanke made the statement that he was easing on policy after 2008 because the Congress did not allow for increased spending in the Obama administration. And so as a result of that, they had to use monetary policy as a substitute for fiscal policy. And my response and I wrote it once saying it is like saying I have tried different medications for my headache. My headache will not go away. So I've decided to take a gun and shoot myself in the head.

But guaranteed 100% there will not be any headache after that. But is that the kind of cure you want to have? But that, that is, again, it is clearly something that will be open. I don't believe that the fed is an independent institution and if necessary, the fed will step in to substitute for fiscal policy if, as you say, they are not able to increase spending in the new setup.

presidential election. It should be, you should have independence but you have independence for only a year and four months after that, your own nomination is in trouble and then you have to figure out whether you're going to be nominated or not. And think about it when the Powell renomination came up, I said publicly he should not be renominated and, but he was renominated. If I remember my number is correctly, the Senate approved him 80 to 19 with one abstention.

So when the senators complain about its policy, my response often is you guys confirmed him as chairman. Who are you, who do you have to blame yourself? And so I think what will happen is that there is no independence in that sense because the fed chairman doesn't have to be renominated by the new president and he or she has still to be confirmed by the Senate which may or may not happen. And that those are the two holds that politics has on the fed chairman.

What I have suggested in my weekly writings that you receive. Kor is to say that the fed chairman should have a single six year term and he or she will not be eligible for renomination that will give it some independence, not the present way where we say he is independent. Oh, no, no, no, he really is independent. I compared it to Jerome with Janet Yellen saying the banking system is very sound and she repeats it very often hoping that that means everybody will believe it.

So you need to have a structure and if you have a six year term for a chairman. That's a long enough term. It's six years are a long term. It's, it's two years longer than the president and you can have it ending like today, but then it will go on for six years so that you, you do not have to act in a way that you're looking, um, of studying favor for a re-election.

So can conflicts de develop between the Fed and the Treasury? Absolutely, they can, uh for example, uh Yellen has said in her speech today, I think she was speaking to the Wall Street Journal at the conference and she mentioned that she thinks a soft landing is possible in contrast to Powell who has looked for pain as the as the inflation rate is

being brought down. So she is giving a very Biden, please reelect a Biden kind of a speech compared with Powell who is at least staying objective even though I disagree with his policies. So yes, there can be more conflicts developing as the election date comes closer,

initially and then they stopped worrying about it. And despite Trump's various uh mercurial action had a pretty decent time during his tenure. Uh and then uh under Biden, I remember you actually pointing it out in the last podcast that we had that the moment the Georgia election happened, the market roared because the expectation was there will be huge fiscal support for the economy going forward. So walk us through the two scenarios. None of them

seem extremely appealing. But the two scenarios that we have one is a Trump victory. The other is a Biden re-election and how the markets will behave around that in 2024.

And Nikki Haley is considered the most likely competitor who can, who's closest to Trump in terms of winning over, but she's still very far behind, that doesn't seem to be in prospect today. So I'm going to assume to answer your question, Timor that it is going to be Biden versus Trump. And if that happens also saying that the whatever you may think in a, in a foreign country and think about the United States, the people who vote are those of us who are

us citizens and who are voting for the candidate? We care more about our wallet and what is there in it than the prestige of the United States on the world scene? What does that mean to us? Biden's economic rating in polls is low and going headed lower no matter how much the administration tries to point out the pace of economic growth. Consumers are spending well, unemployment is remaining low. The population is focusing on inflation and how much they have lost.

Also, they go back and say during the Trump years, we did fine whether he was responsible or not. Uh Clearly, the market is saying they were better off in the Trump years than they are in the Biden years. So what does that mean? It means to me that if it came to a head on clash between the two and if the elections were held today, it is likely to be a Trump, a Trump victory over Biden. Something needs to change dramatically between now and next November for that to be changed.

And as to, well, there are all kinds of other political issues. Trump has said that he will be a dictator for one day if elected. And what does that mean? How do you become a dictator and then you're no longer a dictator. Nobody is given a power in that manner. So there are other issues which I think the electorate is not focusing on yet,

But between the other thing is that, I mean, these are, you know, since we are talking about prognostication after all, neither of them are exactly, you know, very fit candidates going into, you know, 2024 you know, closing in on, in their eighties, the uh health issue, uh if it were to surface. So you think that, you know, Nikki Haley would be one plausible candidate on the Republican side. Do you see anybody on the Democratic side other than Kamala Harris?

Her popularity continues to remain low rightly or wrongly. She's not given a lot of credit for what has happened in the, in the administration. And if so if uh so you are talking about essentially the Republicans arguing that a vote for Biden is actually a vote for Kamala Harris. So you are actually trying to get her elected and she will be there before the end of the next

four years. That's, that's the pitch in terms of saying that you should give the vote for the Republicans, but it's, as you said, it is so convoluted with so many indictments and whether they go to the court for a decision before next November or not, or if they are, if he's convicted and elected as president, what do you do after that? These are constitutional questions which even lawyers are probably unable to answer at this stage.

things at least under wraps is substantial. And therefore, we don't have to worry about too much risk premium, having to be priced into the dollar or the treasuries around these uncertainties.

to continue there. Do any of the people in these countries say we don't like the person because we don't have free democratic elections. No, the thought is whether you're doing well in terms of your income, your living standards and that also is going to affect how the dollar trades with respect to the other currencies and how the foreign countries deal with the United States in terms of trade. Yes, you can have side effects.

You can have Trump imposing tariffs more so than Biden would have done. But look at what Biden has been able to do. He has not been able to remove the tariffs on China that were, that were imposed by Trump, he had to continue with it. So the short answer for you, I gave you a good long winded explanation. The short answer is politics probably don't matter for the economy, markets or the dollar.

Have a great day.