Then I think people are like, okay, I got to get in on this. You know, this thing is only going one way. I've got undervalued stocks with positive momentum and policy support. If I were Chinese, why would I not want to participate? And so, you see what we've seen in recent weeks, the past couple weeks, where it just gaps up every single day. Whereshorts, and a lot of people were short, can't even cover because you just go limit up on individual names day in, day out.
Which is, you know, as a short (I'm not short), but as a short, not being able to cover shorts is the worst. You know, it ties up your stomach into knots. Imagine spending an hour with the world's greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcometo Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world.
So, you can take your manager due diligence or investment career to the next level. Beforewe begin today’s conversation, remember to keep two things in mind. All the discussion we’ll have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance.
Also understand that there’s a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Here's your host, veteran hedge fund manager Niels Kaastrup-Larsen. Welcome and welcome back to another conversation in our series of episodes that focuses on markets and investing from a global macro perspective.
This is a series that I not only find incredibly interesting as well as intellectually challenging, but also very important given where we are in the global economy and the geopolitical cycle. Wewant to dig deep into the minds of some of the most prominent experts to help us better understand what this new global, macro driven world may look like. We want to explore their perspectives on a host of game changing issues and hopefully dig out nuances in their work through meaningful conversations.
Pleaseenjoy today's episode hosted by Alan Dunne. Thanks for the introduction, Niels. Today I'm delighted to be joined by Louis Gave. We're welcoming Louis back for a second time. Heis the founding partner and chief executive officer at Gavekal Research. He's well known in the market as a commentator and economist, and he's been the author of several books. Louis, great to see you again. How are you? I'm very well, thank you. Thanks so much for having me.
Ithinkbefore we came on, I was thanking you for having me again, and you very kindly said, we'll keep having you on until you get it right. So here I am. I'm back. Well, I listened back to our conversation last night, and certainly, you know, it wasn't all wrong. No, I mean, you were spot on quite a few things. So, I think we'll pick up on that a few times. Andas you know, we normally get our guests to go through their background, but as you were on last year, we won't do that.
But for anybody who doesn't know your background, Louis was on with us last July or so, so you can go back to listen to that conversation. Butpeople who do know you obviously would know your firm is based in Hong Kong, and you're very much a firm with a deep heritage of analyzing and focusing on the Chinese economy. So, it couldn't possibly be a better time to have you on. We'vehad the, well, it's the big bazooka according to some people, but not according to others.
So, I guess the big question is, is this the turning point for the Chinese economy, do you think? I think it's definitely the turning point for the Chinese markets. For the Chinese economy, let's not kid ourselves that the Chinese economy doesn't have challenges. It does. You've got real estate prices that are still soft. Even with these measures, they'll likely stay soft. You've had excess construction for a while.
Youguys in Ireland know very well that when you go through a real estate bust, it takes a number of years to digest the over construction, et cetera. But markets do anticipate these kinds of things. Oneof my core beliefs, when I invest, is very often where there's the most money to be made is when a situation goes from very, very bad to just mediocre. And just in that move from very bad to mediocre, a lot of assets get repriced.
And again, I think if you look back at Ireland some 10, 12 years ago, I think you're very familiar with this cycle. Today,I think what's fascinating to me is the Chinese government, for the past two, three weeks, every day they come out with something new. Every day they're obviously trying to support the economy, trying to support the market. The general pushback of everyone that I talk to, almost everyone, falls into one of two categories.
Eitherpeople say, oh, that's too little, too late, it's not going to move the needle. So that's option one. And option two is people say, oh, well, things must be really bad if they're throwing the kitchen sink in this way. Now,either one of these comments tells me that people haven't been positioned for this and clearly people haven’t been… Stocks have rallied by a third in just a couple of weeks. Very few people were positioned for this.
Let’snot forget that two minutes ago people were going around saying that China was ABC with ABC standing for ‘anything but China’. Of course, today one could argue that ABC should stand for ‘all in by China’. Thats where we are again because and again here, I think the Ireland example of 10, 12 years ago is super important. Alotof people today look at what China is doing and say yeah, that fixes this problem, but it doesn't fix all the problems.
As if governments somehow have a magic wand that they can come in and fix all the problems at once. That just doesn't happen. But if you fix at least some of the problems, if you move from a situation that's very bad to a situation that's better, a lot can happen. So,the comparison with Ireland, what was it in 2012 or 2013, when Draghi came out and said, look, we'll do whatever it takes and believe me, that will be enough. That made the bottom for the European crisis.
And from that point on, European banks started to rally, European stocks started to rally. Andtoday in China, basically the governor of the central bank has come out and said the same thing. Governor Pan came out and said, look, we're going to recap the banks with 2 trillion renminbi. If that's not enough, there's more where that came from, which is a somewhat frankly similar statement. And what's fascinating to me is they chose to recap the big banks.
Noweverybody is scratching their head saying, well, why are they recapping the big banks? The problem is in the small regional banks. But the answer is very obvious. They’re recapping the big banks for them to absorb all the little banks. And if you absorb all those little banks into the bigger banks, I think you’re going a long way into solving the unfolding balance sheet recession that’s been unleashed. Again,I’m sorry to ramble on, but again, the magic wand doesn’t exist.
But you've moved from policies that were quite restrictive on the fiscal side and not stimulative enough on the monetary policy side, to all of a sudden easier fiscal, easier monetary policy. Here's,perhaps, one difference with Ireland in 2012, 2013, and that is that when Draghi said we'll do whatever it takes and believe me, it'll be enough, the euro started to go down. We started to go down. Basically, we'd started to go down already. We'd gone from 150 down to 130.
But then we promptly went to one of five against the US dollar. When Draghi said I’m going to sacrifice the value of the currency to reflate the European economy, everybody was like, okay, great, I don’t want to be long the euro. What’sfascinating to me, in the past three weeks, and really for me that was the signal that this is for real and that this market is going to move fast, is you had the Fed cut, three weeks ago, and the US dollar falls.
Then a few days later you had the PBOC cut, the Peoples bank of China cut, and the renminbi rose. Since China has announced these various stimulus measures, the renminbi has been stronger. Andthat to me is super, super important because Chinese policymakers care first and foremost about the value of their currency. They need to, they want to de-dollarize their economy. They can only do so if the renminbi is strong.
So as long as when they announce stimulating measures, the renminbi goes up, they're going to keep doing it. I was a bit curious about this rally in the renminbi. Presumably the view is, is it that Chinese capital that is currently overseas will be repatriated? Or is there a view that this is strong enough to encourage foreign investors now to come back into China?
Because, as you say, ABC China for a while, it's only two weeks ago that the theme was can we reconstruct the emerging market, the MSEI, emerging market index, without China because there was such demand for that type of index. So,do you think it’s more just Chinese capital coming back, and is that why its risen today? Presumably it’s too early to see foreign capital flowing back in. I think that’s right. Now, obviously, the two are not mutually exclusive. You could have both at the same time.
But, to your point, I think so far, it's basically the foreigners haven't had time to buy, give or take a couple exceptions of guys who run their own hedge funds who can be quite aggressive, guys like David Tepper who went on CNBC, pounded the table and said, look, I'm pushing away all my risk controls. I'm just all-in on China. Which, in itself, is an important change of narrative because up until two minutes ago the narrative was that China was uninvestable.
It's run by this evil communist party that’s going to destroy shareholder value, et cetera, et cetera. So,frankly, one of the best and most famous US investors to go out on TV and pound the table is in itself a proper change of narrative. But, yes, you’re absolutely right. I think if you think of your pension funds, of your insurance companies, your endowments, up until two minutes ago, they were all trying to cut back on their exposure to China, not expand it. Thesethings are slow moving.
They’re going to take a while before… You need to have the investment committee, or you look at the big money management firms, the behemoths of this world, they were all launching emerging markets, ex China funds or Asia, ex China funds. Once you’ve got the funds set up and you’ve got the marketing team ready to go, etcetera, it takes a while to ship those rails. Sofar, to answer your question, I think it's been mostly Chinese money.
And here, this is perhaps the big difference between China today and Europe in 2012 is today China is running trade surpluses of 80 billion a month. Like 80 billion, would it B? This is just gargantuan amounts of money. The biggest trade surplus Japan and Germany ever ran to was about 40 billion a month at the very peak. So,China’s trade surplus is twice as large as anything else you would expect.
And usually with trade surpluses that large, you would expect the guy who makes the shoes, or the widgets, or the cars, or whatever China is selling abroad, to take that money home and reinvest it domestically. Butbecause confidence has been so shot, because of geopolitical tensions, for a number of reasons, I think the Chinese who could keep their money abroad did so. And so here we are. That $80 billion, I think, has been mostly recycled as much as they could in other assets.
Butnow, if all of a sudden, the confidence changes and it's like, oh, the government wants the markets to go up. The government is encouraging companies to borrow and buy back their shares. When before the government was preventing companies from buying back their shares. It’s easing up on margin loans for individuals. It’s doing everything they can to crank up the market. Then I think people are like, okay, I’ve got to get in on this. This thing is only going one way.
I’vegot undervalued stocks with positive momentum and policy support. If I were Chinese, why would I not want to participate? And so, you see what we’ve seen in recent weeks, the past couple of weeks, where it just gaps up every single day. Where shorts, and a lot of people were short, can't even cover because you just go limit up on individual names day in, day out. Which is, you know, as a short (I'm not short), but as a short, not being able to cover shorts is the worst.
You know, it ties up your stomach into knots. From a market's perspective, things going from really bad to just moderately bad is enough to turn the markets. I mean, there has been some suggestion that we should expect more in terms of fiscal measures. Isthat part of your thinking, and is that key to seeing the economy going on a stronger trajectory? Obviously, you talk about the surplus, but the missing piece, for China, has always been this pickup in domestic consumption.
Do you see anything down the line or any radical changes there from a fiscal perspective to address that? So, I think one fascinating development in China today, when you look at consumer confidence in China and you break it down by people's age groups, so Gen Z, Millennials, Gen X, Baby Boomers, etcetera, and where people live, you find out that today there's really two groups in China that are deeply unhappy, with very low confidence.
Those two groups are older folks who live in rural areas, basically the Gen X and the Baby Boomers who live in the rural areas. Andthat's understandable. They're the guys who've been left behind by prosperity, and they live in the sticks, and so nothing great has happened for them. So that group is deeply unhappy. And the other group that's deeply unhappy is the Millennials living in first and second tier cities. And here the answer is also pretty obvious.
They've been the bag holders on the real estate rollover. They're, unfortunately, the kids who bought real estate at the wrong price and whose real estate is down 20%, 30%. So, their balance sheet has been torn to shreds. Now,if you're a Gen Xer, a Baby Boomer living in first or second tier cities, you bought your real estate a long time ago, you're still way up, so you're fine.
If you live in a third or fourth tier city, you're also actually doing fine, because not only has the infrastructure in your town dramatically improved in the past 10, 15 years, you now have high speed trains that can take you to Shanghai or Beijing or Shenzhen in a couple of hours. You have subway systems. All of a sudden you have a municipal pool, you have subways. Your quality of life has improved dramatically.
Butyou also have better jobs, because the big shift in China over the past ten years has been the rapid industrialization. Who would have bet three years ago that China would be the biggest car exporter in the world? Now you take a company like BYD. 15years ago, the average salary at BYD was eleven renminbi an hour. Today it's 65 renminbi an hour. Eleven years ago, 15 years ago, sorry, BYD had 150,000 workers. Today it's got 900,000 workers.
Now these workers are typically, they're not in Shanghai or in Beijing. They're in third and fourth tier cities that you and I have never heard of. So,if you're in a third or fourth tier cities, you’ve got all these industrial jobs that pay better, you’ve got better infrastructure. So, you're actually pretty happy. Again, the guys who are unhappy are older folks in the countryside and younger folks in first and second tier cities. Whyam I going into this?
Because, to your question on stimulus, if you're the government, you think, okay, these are the two groups that basically we need to help out because they've been screwed over in the past five to ten years. So,what you do is you do handouts to the guys in the countryside, and this has already been announced. We're going to send checks to the poorest 15% of the population, which basically is the older folks in the rural areas. So that's one.
Now,then you get to the question, how do I help the younger folks or the millennials living in the first and second tier cities who got screwed over on the real estate? How do I help those guys, acknowledging that I don't want to crank up real estate once again? Because if I do, then I screw over the Gen Z, who then can't afford real estate, who will be unhappy and they might demonstrate like they did in Hong Kong. So how do I help the guys in the first and second tier cities?
So,I'm not going to send them a check because they're already amongst the richest in China. So, if I send them a check, it's, you know, it's like, yeah, would you send a check to yuppies living in Dublin? No, it'll make, it'll make the people living in Cork and Limerick pretty pissed off. And so, what you do is you crank up the stock market. Youcrank up the stock market and you make it very obvious to these guys, you say, look, you guys actually do have some savings.
Put them in the stock markets, we'll crank that up and you'll make some money. Now what's interesting is at the same time the Chinese government, and that should have been a signal, two months ago, came out and said, look, nobody who works in the financial markets will be allowed to get bonuses over $400,000 US dollars.
Inessence, it should have been a sign that we're going to crank things up, but we don't want the same thing that happened in the United States where we organize a bull market to, you know, save the system. And all the bankers pay themselves $5 million bonuses because they have the good fortune of being at the right seat at the right time and just get to ride the wave of a bull market and somehow confuse their own brain and their own activity with the benefits of a bull market.
So,China two or three months ago says, okay, normal bonus is about $400,000. And now what they're doing is they're cranking up the stocks. That's a way to bail out and to make the people in the first and second tier cities happy. Ok? I mean, going back prior to this stimulus announcement, the Chinese policy seemed to be kind of a grab for global manufacturing share. And I mean, you talk about this comparison with Ireland or Europe.
The Irish policy was effectively to deflate the economy, restore competitiveness, attract foreign investments, which put a, you know, a bottom under asset prices. That's fine for a small economy. Now, for a large economy like China, when they deflate the economy, then try and grab international share. Obviously,you talk about BYD, you hear it on radio here in Ireland all the time, but Europe has responded with tariffs. So, Europe, the US are not happy with this Chinese overcapacity.
So, is that sustainable or are we going to see this being a flashpoint, do you think, going forward? I think it already is a flashpoint. To be honest, I think we're a little bit reaping what the US sowed, what happened in 2018. In 2018, the US government said, we're not going to sell semiconductors to China anymore and nobody's allowed to sell, semiconductor equipment makers aren't allowed to sell into China anymore. Thatreally freaked China's policymakers.
They thought, okay, they can do it on semiconductors today, tomorrow they can do it on chemical products or on auto parts or on industrial robots or whatever else. So, we need to be self-sufficient industrially on everything. Andyou see it very clearly in the data. I can send you a chart if you want. Starting in 2018, the message is given to banks, look, no more lending to real estate. From now on, all the loans have to go to industry.
And so, you see industrial loans shoot up and real estate loans collapse. And again, we planted that seed where China basically needed to have its own industrial supply chain for everything. Fastforward to today, five, six years later, and we wake up with horror to find out that China's entire industrial framework has shifted. Where five years ago, I think the view was China produces goods that are 70% as good for 70% of the price.
So, if you want a crappy bicycle, you can buy one in China and its €100 and that’ll fall apart in two years. And then you’ll buy another one. Andthen all of a sudden, we wake up five years later to the fact that China is actually producing goods that are at least as good, if not better than what we’re producing in the western world, and it’s still 70% of the price. From there, to your point, I think there are two kinds of responses from policymakers.
Thereare the policymakers that say, I need to protect my industry. This is not on. This is a disaster. So, I need to put up tariffs. This is what the US has done, Canada has done, and what Europe is now doing. Iwouldsay that in so doing, we basically refuse China's deflationary impact. Now, to be very clear, China has been deflationary for the world for the past 40 years. There's nothing new in China's deflationary impact. Whatis new is we're now saying, you know what?
We don't want China's deflationary impact anymore. It was fine when it was on shoes. It was fine when it was on textiles. We don't want it on cars. So, we're now going to put up all these tariffs. Andthen there's the countries, whether a South Africa, or an Indonesia, or Chile, or a Colombia, that say, I'd love to have a cheap car, thank you very much. I'd love to have cheap industrial robots. If you want to fund them as well, for me, so much the better.
Wherebasically China, today, when you look at countries like Vietnam, like Indonesia, China is basically allowing other countries to industrialize on the cheap with very cheap machinery and on credits through very cheap loans. And in so doing, bringing millions of workers out of the countrysides, out of the rice paddies of Vietnam or Indonesia and into the industrial economy, which is a second deflationary impact, if you want.
So,you look at this, there are the countries that refuse China’s deflationary impact; mostly western world, mostly developed markets. And I would say that in these countries, you cannot own the bonds because these countries used to absorb Chinas deflationary impact and are now rejecting it. So, they’re going to end up with higher structural inflation. Andthen you have the countries that embrace China’s deflationary impact, call them South Africa, call them Colombia, call them Brazil.
They embrace China's deflation, call them Mexico, embrace China's deflationary impact. And in those countries, you can own the bonds. So,if today you're worried, you're thinking, oh, no, China's got all this excess capacity, it's going to be very deflationary for the world. I therefore need to own bonds to cushion myself against this deflationary impact. You have to be very careful as to where you own those bonds.
I would argue you don't want to own them in the western world, you want to own them in emerging markets. I’dmuch rather own a Brazilian tip offering 6.5% real than a US tip offering 1.7% real, at a time when Brazil is embracing trade with China and the US is doing the opposite. Ok, so the other question in relation to China, obviously it sounds like bullish on the equity market and presumably yields bonds will do okay in China.
But the big question, I suppose, for international markets is commodities. We've seen copper responding somewhat. I mean, it does, I suppose, depend on whether we see a real economy transmission from the measures. So, do you think this is bullish for commodities or not? Imean,there's been a lot of talk about the tight supplies in some of these markets, like commodities, like copper, but it's been kind of very much up and down in a range. Is this a potential catalyst, do you think?
Well, it's definitely not bearish. Yes. Is it the catalyst? It's definitely not bearish. And the reality today is we have China easing fiscal and monetary policy. And I would argue, also, you have the US that has just eased monetary policy, the ECB has just eased monetary policy. And it seems pretty likely to me that regardless of who wins between Trump and Kamala Harris, whoever comes in will be easing fiscal policy because that’s what new presidents do.
They come in, increase spending, cut taxes, and by the way, both of them are trying to out compete each other with promises of more spending and promises of more tax cuts. So,I think however you look at it, if you look at the coming year, you’ve got, okay, easier fiscal and monetary policy in the US, easier fiscal and monetary policy in China, easier monetary policy in Europe. That to me is pretty clear that we’re moving into a reflationary world.
Throw on top of that a stronger yen, which is typically reflationary for the world, a stronger renminbi, which is reflationary for the world. So, all that should be good for commodities. Havingsaid that, having said that, it’s interesting to me that, as China has embraced a much easier policy outlook and as Chinese equities have ripped, you're right, copper, iron ore, et cetera, it's bounced, but it hasn't bounced that much.
It's been if three weeks ago you thought, okay, game on, China's doing this. You know what, I don't want to own Chinese stocks because for this or that reason, politics, geopolitics, et cetera. But I'm going to go back to what I always did in the past, which is when China stimulates, I buy BHP and I buy Vale, I buy Rio Tinto and I buy LvMH. You've done fine the past few weeks. It's been okay, but it hasn't been awesome.
Imean,you're probably looking over your shoulder and thinking, damn, darn, I should be invested in Chinese stocks. And here's the reality, China is stimulating today, but this isn't going to trigger a new construction boom. It's just not. It took a while before construction really started going again in Ireland, right? Yeah. I mean, you bottomed in 2012, but it wasn’t until 2017 that construction really started to pick up again.
Andin China, you still have to digest the oversupply that was put on, just as the amount of infrastructure spending that will be done is also not as high. In the past, when China used to slow down, what it would do is go on a huge infrastructure spending bender; build high speed rails, build subways. But these are already built. 90% of Chinese people now live within an hour drive of a high speed rail station.
Andthat extra 10% is people who live in the Tibetan plateau or who live out in Xinjiang. There's no economic rationale to link those guys up. You'renot going to get a big infrastructure boom. What you're very clearly seeing this time is, again, you've got two parts of the Chinese economy that are hurting. The millennials are living in the big cities. The poor people are living in the countryside. And we're basically seeing a twin targeted approach to how do we help these guys out?
Theguys at the bottom, we mail them, checks. The guys at the top, we repair the balance sheets through an equity market boom. Thats what the stimulus is about. I don’t think it’s about buying a ton more of iron ore and a ton more of copper again. Ithinkyou’ll do fine in copper, and I think you’ll do fine in iron ore. But it’s not where you’re going to get the big torque, the big upside this time around.
Okay, you mentioned a reflationary world, which, if you add all the policy moves we’ve seen in the last month or so, it certainly looks like that. But if we went back two months to the start, we're recording on the 3 October. If you went back to the start of August, the sentiment was about recession. We had that week non-farm payrolls, the collapse in the Nikkei, the move down in the US. We've had this very abrupt change in sentiment.
Ifyou look at the US, the economic data has been very patchy or inconclusive, I guess you'd say. You had suddenly weaker payrolls. Today we've had a strong ISM. It’s hard to get a read. And then last week I think gross domestic income numbers revised higher. So, painting a better picture for the economy. To your credit, last year, when you were on, you were saying no recession. So, you got that right. Wheredo you see things now?
It sounds like you're more upbeat on the US and global economy than maybe the consensus. I'm not downbeat on the US. I think there's more opportunities elsewhere. I think whatever opportunities you have in the US are pretty fully priced into the stock market when other stock markets are priced in for far more stale outcomes. Now I don't think you're going to get a bad outcome in the US, but it's not where I'd have most of my capital deployed today.
Infact, one of the things I ponder is that as China rebounds, as emerging markets rebound, whenever China does better, it always sucks in the other emerging markets as well; your Indonesias, your Vietnams. I think that the source of capital will be the US. Theanomaly in the world that we live in today is that the US is 4% of the global population, its 20% of global GDP, its 32% of global profits and its 70% of the world MSCI.
Can you have 70% of the capital allocated to the US when it’s a third of the profits? There’s a dislocation there. So,the story of the coming years should be money coming out of the US and going into these other markets that are stabilizing and picking up. But this doesn’t mean you’re heading into a US recession by any stretch. It probably doesn’t even mean a US bear market. It’s just that as the US underperforms you just get less bang for your buck over there. Sorry. Sorry.
I was going to say that, from an economic perspective, we're into it. I suppose the reason why you might be bullish in the US market is we're into an easing cycle. Historically, when the Fed eases, the equity market either does very well or very poorly depending on if you're going to recession. So, if you're saying no recession that would suggest a favorable environment for US stocks.
We are in an unusual period where the US economy has been going at 6%, 7% nominally, where you’ve had full employment, and where the government has decided to run budget deficits of 7% of GDP. Which, I think, if you go back a year and a half ago when you and I were chatting that was my main reason why I didn’t believe you were getting a recession.
Whenyou look at the weight of government today, and you think that governments run budget deficit of 7% of GDP, you really need the private sector to badly collapse for that to happen. You never want to say it's different this time because you look like a fool, and when it isn't different people laugh at you. But we have to acknowledge that the condition set is somewhat different. Whatcould easily happen, my core belief, if I look at recent years, US twin deficits have been enormous.
Foreigners, the US keeps exporting large amounts of dollars to the rest of the world. The rest of the world actually has too many dollars. Inrecent years they didn't know what to do with these dollars. They didn't want to buy US Treasuries, which is what they would have done in the past, because you’ve got the debt growing by a trillion every six months.
Instead, I think what a lot of foreigners who earn dollars have done is they’ve put these dollars in us stocks and specifically in a handful of stocks. Forme Microsoft, Apple, Amazon, these guys have been receptacles for the excess dollars in the world. And that made sense in a strong dollar world. If you’re Chinese, you earn dollars, you see the renminbi 4%, 5% a year, you see the Microsoft share counts shrink by 3% a year, you see Microsoft cash flow grow 10% a year.
You're like you know what, I'm just going to buy Microsoft. I don't really care about the valuation. Yeah, sure it's 35 times earnings but whatever they're shrinking the share count. It's a very liquid stock. The dollar is going up and if I change my mind tomorrow, I can sell Microsoft and buy something else. AndI think this is the phase where we're now going to be entering is people say you know what, US dollars no longer going up.
I don't need to keep as much US dollar assets and I can let go of my Microsoft now and maybe I buy ten cents, that's a quarter of the value. In market cap it's a 10th of the value but in terms of PEs or whatever else, you're trading at the single digit price to cash flows. It sounds like in the US you're saying no recession, but not exactly a boom. I mean, with the Feds cutting rates, they say they're on a path to neutral.
I mean, what do you think that means in terms of policy or rates going down to, I guess, where's our star, are rates going to 4% or 3% or..? Yeah, I don't think the Fed knows, but I think they're going to get 50 basis points in November. And then after that, I think it'll depend a lot on the outlook of fiscal policy. .
To behonest,ifPresident Trump comes in and extends the corporate tax cuts (he does the tax cuts for families that he's been talking about with tax cuts for newborns, while also massively increasing spending to reindustrialize the United States), and you move from a budget deficit that was planned at roughly 2 trillion for next year (because the corporate income tax was supposed to sunset and corporate income tax rate was supposed to go up), if all of a sudden you move from a deficit of 2
trillion to 3 trillion to 4 trillion, then you’ve got an economy that's on fire, and then the ability of the Fed to cut isn't there. Now, on top of that, you've got another big question mark, which is, of course, what oil prices are going to do. Today,for the past year, oil prices have been coming down. They've been coming down for a number of reasons, not least of which is the fact that inventories in the US have basically been emptied.
The strategic petroleum reserve has basically been emptied. You look at Cushing, Oklahoma, right now. The amount of oil in Cushing is at record lows. Nowyou would think, why are people cutting their inventories? And by the way, also, you look at the futures market, for the first time ever, you've got a net short position on oil. Why on earth do all this at a time of massive uncertainty in Russia, at a time of massive uncertainty in the Middle east, it does strike me as a dangerous situation.
So,could we come into 2025 with oil prices that have spiked because we didn't position ourselves correctly coming into this Middle eastern problems with bigger budget deficits? And if that's the backdrop, it gets pretty hard for the Fed to cut. Okay. And obviously, there's a lot of easing priced in. And obviously, coupled with that, if we get that scenario that you're talking about, I mean, last year debt refinancing was a big theme. It’s less so this year.
We've had suggestions that maybe the Treasury has been tactically issuing more bills because of that and particularly with the election in mind. Are you worried about, you mentioned you're more bullish on emerging market debt earlier, would you have concerns about a fiscal problem in the US or failed auction type scenarios at some point in the future?
Well, I think in the past couple of years, each time the US government has tried, almost every time the US government has tried to go to the long end to issue 10-years, 20-years, 30-years, the market is kind of stalled now. I think when it comes to debt, it's like tequila shots. You never know when you've had enough until you've had too much. Ilookat debt today, most people, when they look at government debt, they look at debt to GDP ratios.
They'd say, oh, when you're above 100%, you get into a danger zone. Now, the reality is we've seen lots of countries move above 100% with no problems, including Japan, all the way to 200%. Tobe honest, that's not the right ratio. The right ratio when you look at government debt and when you're looking for fiscal crisis, isn't your debt to GDP ratio. The ratio you want to look at is the percentage of your debt that is owned by foreigners.
And historically, once you get past 30%, you basically become dependent on the kindness of strangers. And this is when you can sometimes hit the wall. Thisis what happened to Greece, of course, in 2011, to Spain in 2012, to Argentina in 2000 to Thailand in ‘97. You move past that 30% and what happens is one day there’s a bond issue and nobody shows up because everybody’s like, you know what, I have enough Thai debts.
In fact, what happens is as soon as things start to go a little wrong, investment committees get together and say, why do we own all this Thai debt? Why do we own all this Greek debt? Yeah, just get rid of it. And so, there are two major countries today that are above that 30%. One of them is the United States. Nowyou could easily argue, and I would take the argument that in a world in which all animals are equal, there are some that are more equal than others. And that's clearly the US dollar.
US dollar is the world's reserve currency. Whetheryou're Irish, like you, French, like me, you need to have US dollars to buy oil, you need to have US dollars to buy copper. So maybe the 30% ratio doesn’t apply to the US, but the US is definitely testing that they’re adding 2 trillion a year and probably more. So, at some point you start feeling queasy. Theother country that is above 30% is my own, is France.
And here it does feel like, all of a sudden, investors are starting to feel a little queasy about France. To begin with, you’ve got an uncertain political situation, a government that doesn’t have the support of parliament. You all of a sudden have five-year yields on French debt are now above Greek yields, which has never happened in history. So,if you’re looking for a fiscal crisis, I think there are two main candidates today, it’s France and it’s the US.
And it seems, for a bunch of reasons, probably likely that France will hit the skids before the US does. Okay. How do you see that playing out if that comes to pass? Obviously, the ECB have the tools in their toolkits in theory, but it has been tested. Doyou think it might come to that? It's a big question mark, hence the discomfort. Right. But here's what we know is Fritz already massively breached its budget commitments for 2024.
All the European countries were supposed to, in September, bring their budgets to the European Union. France said, sorry, we couldn’t bring ours because we are forming a government. We haven’t had time to make the budget. So, they got an extra three weeks. So right now they’re working hard on the budget.
TheEU is asking France to cut about €15 to €20 billion from their budget, which is, you know, very hard to do for a government that has no popular mandate and that doesn't have the support of parliament. Cutting spending is always hard to do, even at the best of times, when you have the backing of the population, but today the government does not. So,I think what they're going to try to do is raise taxes.
But let's face it, France is already the most taxed country in the world, so we're already on the wrong side of the Laffer curve. They might say, look, we'll increase taxes, but I'm not sure that increases revenues. It might actually decrease revenue. Not only that, but the government may lose the support of parliament. The National Front has already said, if you increase taxes, we're not backing you anymore. So,the government's between a rock and a hard place. So how does it play out?
Well, what happens, you can get the ECB to help if you've got somebody at the helm asking for the ECB's help. But what if you have no government? Yeah, I mean, one of the things that strikes me, listening to you, like a big theme that applies both in the US, and France, and Europe, is productivity. And we've seen stronger productivity numbers in the US of late. And the debate there as to what's behind that is it seems too early for it to be AI, but maybe, maybe not.
I mean, some suggestion is that it's maybe the labor market normalizing after the disruptions during COVID. Andthen obviously, in Europe, you've had this low productivity. And Draghi has been out with his plan and suggestions. Obviously, it's very long term. What's your perspective on those? Do you think the strength we're seeing in US productivity? Is that for real?
What's the story behind that and is there an optimistic case that we might see better productivity in Europe at some point in the future or is that just pie in the sky thinking? I'm positive on both. But look, I tend to have a sunnier disposition. And I also believe that the only wealth is man. And I do think that in Europe, but also in the United States, you've got terrific workforces, people willing to work harder, et cetera.
Now,when I look at my own country of France, this is actually my biggest frustration. We come up with things like the 35-hour work week, and we prevent people from working more. Ithinkactually you could get France booming again by doing fairly simple things; by saying, look, you work more than 35 hours, we’ll actually de-tax those hours. Which is, by the way, one of the proposals, of course, that Trump has embraced to not tax overpay work.
Now, where's the productivity boom coming from in the US? I think the answer is pretty simple. One of our core beliefs, at Gavekal, is that economic activity is energy transformed. And if you look at the past 10, 15 years, the US has had one massive comparative advantage. It has been the shale boom. It has been the fact that the price of natural gas has gone from $10 down to $2. Thefact that the US has gone from producing 5 million barrels a day to 13.5 million barrels a day.
The US basically added one Saudi Arabia in a decade. It's unheard of. Andso, all this added money filters through into the productivity numbers, which is actually the source, as a Frenchman, the source of my greatest… That's my greatest frustration. If you go back 15 years ago, 20 years ago, France had a huge comparative advantage relative to the rest of the world. We were far ahead of everyone in nuclear energy.
We were super, super productive on nuclear energy, basically to please a small minority of greens. Andwhy greens are against nuclear energy is beyond me. If you're worried about carbon in the air, if you're worried about climate change, it's obvious that nuclear energy is a potential solution. Butanyway, to please a small minority of greens that led the left wing in France, first Francois Hollande, and then Emmanuel Macron sacrificed our nuclear stance and our nuclear comparative advantage.
Now, they weren't quite as stupid as the Germans, which went just complete, full on stupid and completely shut down the nuclear industry and in so doing, completely destroyed their productivity, destroyed their industrial base, basically destroyed the very heart of what it is to be an industrial superpower. Because without energy, you can’t have industry. It’s just that simple. Without energy, you can’t have industry.
Nowin France, were now trying to claw our way back, I think that if there’s one silver lining to the Russian invasion of Ukraine, it was that all of a sudden people woke up to the fact that actually nuclear is actually nice, nicer than being dependent on Russian natural gas. And so, you’ve had a big zeitgeist shift on nuclear. So that’s one potential avenue where Europe can sort of snatch victory from the jaws of defeat.
That the past 20 years of industrial policies, energy policies, geopolitics, immigration policies, you name it, like everything that’s been done in the past 20 years, that has just been one mistake after another, I think this is where we can start turning it around, is on smarter energy policies. That was one of the suggestions that Draghi was making about coordination around defense spending and then cross border investment in energy infrastructure.
Do you think we'll actually get to see those measures coming through in Europe, or will you get the usual policy paralysis? I hope we'll see it. I fear we won't. And I say this as a Frenchman, I fear we won't. Andby the way, when it comes to defense spending, when you look at all the countries who are tech leaders in the world, your Taiwan's, your South Koreas, your US obviously, Israel, they're all countries where you have very heavy defense spending.
There's an obvious link between defense spending and technology. Yeah, the Internet was an offshoot of a military program. So,back when the UK, France had proper armies, then we had proper big tech companies. We had Alcatel, we had Marconi in the UK, and then we spent 25 years cutting out defense spending. Because if you're in government and you think, okay, I mustn't have budget deficits and I must reduce my spending, the easiest one to cut is always the army because they don't complain.
Military men don't go on strike. They can't. They're not allowed. It's a culture where you follow orders. So,you're told, okay, you're going to have fewer planes, you're going to have fewer boats, you're going to have fewer radio equipment or whatever else. And the end result of that is that we have no more tech sector in Europe.
Imean,sure, there’s ASML and there’s Infineon and there’s STMicro, but let’s face it, for as rich an economic zone as the Eurozone is, we really have no tech and were pretty much all dependent on US tech. And that’s because, just as we’re dependent on US tech, we’re actually increasingly dependent on US military. Now,will this change?
Will we say, okay, let's get together, fund some proper military equipment here, to be honest, like we did 40 years ago when, as Europeans, we decided to fund Airbus? And I think the answer is that there's no appetite for it today because the reality is that ship has sailed and now all countries have to worry about funding their welfare states.
Welfare states that are sort of falling apart because demographically they were organized like Ponzi schemes, and now you're getting too many old people, not enough young people, and there you go. So, European challenges to continue. Justwanted to talk about the election before we finished. I mean, you touched on the likelihood of high deficits in both scenarios. The betting markets have itself more or less 50/50. So presumably it's a coin flip.
But I mean, do you see any obvious trades or any obvious differences in the outcomes that investors should be thinking about in the immediate aftermath once the outcome is clear? Yeah. So, you're absolutely right that the bulls are 50/50, the betting market is 50/50. But to me, I think Trump's going to win.
And the reason I'd say that is if you go back to 2016, if you go back to 2020, and you looked at the polls in the important swing states, the Pennsylvania’s, the Michigans, the Wisconsins, the states that the candidates need to win if they're going to win it all. In those swing states, back in 2016 and 2020, Trump was down 7% to 10% every time. Andthen on the day he ended up, in 2016, winning a bunch of them and in 2020 losing them, but by very thin margins.
Then today, those polls in those states are 50/50. So, he’s massively outperforming the polls of four years ago and eight years ago. So, it’s one of two options. Either he’s going to win hands down or the pollsters are now much better than they used to be. Buteven if the pollsters are much better than they used to be, it seems like right now, if you look at those swing states, I think he's winning five out of the seven swing states according to the pollsters.
So, I think the advantage has to be towards Trump. And we have to assume that Trump wins. Okay,so if we assume that Trump wins, I think the general perception of a lot of investors I talk to is that, if Trump wins, he comes in and he's very brash and he's rude to all the countries, especially China, and that this leads to a further deterioration in the China US relationship.
Now,personally, I'm not sure about that at all, for a very simple reason, is when you look at the people around Trump today, they're completely different from the people around Trump last time. Last time around, Trump was surrounded, in terms of his foreign policy advisors, really, by hardcore neo conservatives, guys like Mike Pompeo, John Bolton, Nikki Haley, Mike Pence, for whom China wasn't as much a competitor as an enemy.
An enemy because it has the wrong political… it's not a democracy, it's a communist country, et cetera. Fastforward to today, and Trump is surrounded by Elon Musk, Bobby Kennedy, Tulsi Gabbard, people who are far less abrasive with the rest of the world, far more isolationist, no doubt, and perhaps very mercantilist. But what's been interesting is that, on the campaign trail, Trump has been at pains to point out that China is not an enemy. It's a competitor.
Now,it's a competitor that doesn't play fair because they've got an undervalued currency, et cetera. All this to say that I think if Trump comes in, you could actually see an improvement in the US China relationship. Partly also because Trump has been pretty adamant that he wants to find a solution for the Ukraine war. And the reality is, if he wants a solution to the Ukraine war, I think he needs to bring China on board.
He needs to say, hey, China, put pressure on Russia to agree to a deal that Ukraine can accept. And on the back end, this is what I'll do for you. IthinkTrump likes to see himself as a dealmaker. He wrote all these books, the Art of The Deal and whatever else. He wants to sit down with Russia, he wants to sit down with China and come out holding a piece of paper and telling the American public, peace for our days, here's a deal, and we can move forward.
So, I actually think Trump is going to get elected and I think in terms of foreign policy, it could be quite a good thing. I mean, you're right, because people forget that he did actually negotiate the trade deal when it was 2019, 2020, just before COVID, and then it was kind of quickly forgotten about. But what about Taiwan then, in that scenario? Is Trump more amenable to turning a blind eye to Chinese aggression? Or how does that play out?
Because presumably a full-on invasion couldn't be tolerated. But that's the stated desire of the Chinese is to ultimately move on Taiwan. The stated desire of the Chinese is to have reunification, but that doesn't need to happen through military means. Now, there's no doubt that if you're Trump, I think it's pretty clear you're not going to go to war to defend Taiwan. You have no treaty obligation to do so. And Trump is very adamant. He's a very isolationist guy. He doesn't want to.
Now, does that mean that China then moves on to Taiwan? Absolutely not. First,Taiwan is a natural fortress. It's a chain of mountains formed out of the sea. You have only three beaches that you can land on. China could destroy Taiwan. You can send a bunch of missiles. You can send nuclear bombs. But what's the point of that? You don't have the hatred that you have today between Russia and the Ukrainians. They're not calling each other Nazis.
They're not preventing the Chinese language from being spoken. Ifyou look at the Donbas between 2014 and 2022, you'd had over 10,000 deaths on both sides. There's none of that in Taiwan. So, there's not the black blood, there's no sense of urgency. If you're the Chinese government and you move on Taiwan, the reality is most of Chinese major cities are within reach of Taiwanese missiles. So, if you move on Taiwan, you're going to take a heavy casualty count, both economically and in body terms.
So,it's almost sort of mutually assured destruction. Now, China could definitely obliterate Taiwan and completely destroy it, but it would also take some big casualties. So, there's this equilibrium that isn't going to get disturbed as long as Taiwan doesn't declare independence. And today you need two thirds of the Taiwanese parliament to declare independence. And only one third of the parliament is the Democratic Party that is for independence. The other two thirds are anti-independence.
So that's not going to happen. It's a new parliament, so it still has four and a half years to go. So, that's not happening until the next four and a half years. Thereare two red lines for China; Taiwan is declaring independence and Taiwan saying they're going to have a nuclear weapon. And Taiwan is nowhere near on either, is not doing either of these things. So, there’s no reason to think that the status quo changes over the next four and a half years. And what about the Fed and the dollar?
Trump has been vocal about possible interference with the Fed. And also, he harks on about the dollar/yen and the dollar/yuan rates that it has been misaligned. I know Robert Lighthizer has been an advisor. I haven't heard as much about him of late. I don't know if he's as influential, but he was of that view of normalizing bilateral trade levels on a country by country basis. So, do you see that as part of the picture in a Trump scenario, more currency tensions? Yeah, I do. I do.
AndI think there'll be a lot of pressures put on Japan to revalue, put on China to revalue, perhaps less on Europe, because it sounds like the euro is massively undervalued. So, there’ll be a lot of that on South Korea, on all the Asian currencies that are, frankly, too cheap. Butthat could be a setup for a similar situation as we had in the 1980s with the Plaza Accord. If we have a new Plaza Accord, you go back to the Plaza Accord of the mid-eighties. Commodities ripped, equities ripped.
It was two and a half years of intense partying until the Germans decided to leave the Plaza Accord, triggering the 1987 crash. But you had two and a half years of absolute boom. So,I highlight this because I think that's, no doubt, what the Trump administration, a new Trump administration would want to go towards. I think Trump is very clear that he wants a weaker dollar.
Now, a weaker dollar is very reflationary, very, you know, very reflationary for commodities, very reflationary for emerging markets. Of course, you could question, well, why would China go along with it? Why would Japan go along with it? And the answer is, the US has a lot of things that it can provide China, a lot of incentives to throw China's way. We could say, look, we'll sell you semiconductors once again. We'll stop visiting Taiwan every six months.
We'll stop sending high end weapons to Taiwan. Lots of things the US can do for China. So,the possibility of a big new Plaza Accord in which the US dollar is driven down, I think is a distinct possibility if Trump is elected. If that does happen, then to be honest, I think most people don't have enough risk in their portfolios because all risky assets will absolutely rip higher.
Okay, is that something that can be managed given what we were already talking about, kindness of strangers, and the potential desire to continue to make the US attractive as a destination for capital? I mean, if you go into a weak dollar environment, would that naturally put more pressure on US bonds, and creating a potential issue there, or do you think the two of them can be managed concurrently? No, I think you'd end up with a much steeper US yield curve.
I think long term yields would end up at 5.5%, 6% pretty quickly and you'd end up with a pretty steep yield curve. Good stuff. I know just before we wrap up, last time you were very bullish on EM. It sounds like that case is still there. Is that still stronger than ever?
To be honest, now that China is stimulating, historically the case for EM is that EM, in my whole career, either played on a weaker dollar, which didn't really happen in the past year and a half, up until six weeks ago, and now all of a sudden, the US dollar seems to be weakening, or it's a play on China doing better. For my whole career, that's been it. You buy EM when the dollars a weak and you buy EM when China's reaccelerating.
Andif you have both at the same time, China reaccelerating and the US rolling over, EM do very, very well. Now, in fairness, I think if you look at the past year and a half, a lot of EMs, ex China, have actually done quite well. Indiahas done very well, Indonesia has done very well, Malaysia has done very well. Some of the Latin Americans have struggled a little more, but arguably Brazil is so dirt cheap now, and frankly, so is Chile.
You look across EMs, no, I think the setup for a lot of them is actually quite enticing. Good stuff. Well,great to have you back on and I'm sure we'll have you back again at some point in the future just to sense check how all of those forecasts have gone. But fascinating to get your insights. We very much appreciate it. So,for all of us here at Top Traders Unplugged, stay tuned and we'll be back soon with more content. Thanks for listening to Top Traders Unplugged.
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