GM84: What Everyone Saw, but No One Priced ft. Bob Elliott

We are more likely than not moving into a world where, you know, foreign stocks, particularly from a foreign equity investor's perspective, are going to look a lot better. Meaning, their own domestic markets are going to look a lot better from their own currency perspective than US assets, for an extended period of time. And so that's an underlying trend that I think is an important one tactically and strategically to be thinking about. Imagine spending an hour with the world's greatest traders.

Imagine learning from their experiences, their successes, and their failures. Imagine no more. Welcome to 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 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. Bob, welcome back to the show.

It's been about a year since Cem and I spoke with you, and I think it's fair to say that a few things have happened since then. So,we're excited to have you back. How have you been? Thanks so much for having me. It's been a lively year. I feel like we've been through kind of every regime you could imagine. Right? You know, it’s been highly stimulative and then, you know, the DOGE and extended regime, and then run it hot and tariffs, I mean, man, we just, every day it's something new.

Maybe global war is coming. You never know. You never know. BeforeI dive in. Hi to you, Cem. How are you doing? Doing well. Summer in Chicago, so, this is always a good time to be alive. Super. NowBob, when we had you on last year, you articulated what I think was an important macro framework of the post Covid era, that we were in an income driven expansion, not a credit boom.

And that simple idea reframed everything - why higher rates weren't breaking the system, why spending stayed resilient, why the Fed frankly looked a little bit lost. But here's

the thing, we're one year on and while consumers are still spending, they're leaning harder on credit.

Profits,you could argue, are wobbling, inflation refuses to behave, and we starting to see a quiet or perhaps not so quiet emergence of real fragility. And this is even before we take into account international relations. So, maybe to start off, I wanted to revisit the idea of the income loop and just

ask the simple question, is it still running or has that loop already cracked? Yeah, I think the income driven expansion, in many ways, sits underneath kind of everything that's going on. And a lot of what we sort of look at on the day to day basis is sort of the pressures and the wiggles on that income driven expansion. Butlook, at a big picture level, even relative to where we were last year, you know, labor markets, like, the unemployment rate's basically flat.

Income growth continues to run at about 5% to 6% nominal. Spending growth is running at about 5% to 6% nominal.

Andwhile there are sort of corners of the labor market that have clearly softened, particularly for, you know, younger workers or those who previously had lost their jobs, you know, having a little bit harder time finding a job, the big picture story is the economy, absent any of these essentially these policy moves, we would continue to be in sort of a traditional late cycle environment where, unlike previous cycles, credit is still not a big part of the story and where income growth is a big

part of the story. Ithinkthe challenge here is, we've entered, with this new administration, they're, essentially, exogenous efforts that are making slower growth policy more of the norm ahead. And so, that is the challenge. You sort of have a fine economy, particularly if you look backward looking, particularly sort of, let's say, the fundamentals - the underlying fundamentals are pretty good. And at the same time, you've got this policy, almost by choice, that could be creating disruption.

Yeah, actually I'm going to jump in here, Niels. I think the other complicating factor is, you know, when you do a 90 day pause on some really big thing like tariffs, it actually has the opposite effect of pulling forward demand. So, not only can you not see the effects, you kind of might be seeing the opposite effects, and you would expect that. So, I think it's very muddy right now. I think it's really, really hard to tease through the current data and see through it in any particular way.

Isthere anything that you're looking at, Bob, on the data front that's telling you, like, kind of three months forward how things might be looking as opposed to kind of where it is now? Yeah, it's a good point. And we sort of had a pre-tariff set of demand, like in things like autos, that sort of pulled forward demand and then now we're having sort of a run of activity ahead of the possibility that the pause rolls off.

From a timely perspective, given the income growth dynamic, the labor market continues to be one of the core cornerstones of overall economic conditions. Andof course we see, you know, weekly data with continuing and initial claims, which, particularly initial claims, are short-term leading but then become… In most cycles you want to think about interest rates and credit, and that's kind of the flow through, and that leads employment.

But in this income more income driven expansion those employment measures are actually very critical because they serve as the foundation of what's likely to transpire in the course of the next, you know, three to six months. And so, we haven't really seen, you know, much disruption. I'dsay what we've seen is a very, very gradual deterioration, that would be commensurate with a gradual slowing of the economy, that would be consistent with a late cycle type environment.

But nothing there is pointing to a problem. Ithinkthe challenge is that when you look on a backward looking basis, things are mostly fine because of the dynamics that I described. But then you have essentially the tariff shock which is, you know, let's say at current rates 15%, between 15% and 20% on effective 2024 imports, that's like a 2% of GDP tax hike. Nowif we were talking about an immediate 2% of GDP tax hike, everyone would be looking around and saying, yeah, growth is going to slow.

Demand's going to slow, growth's going to slow, profits are going to slow. Like, you know, that would be kind of obvious to people.

Butinstead I think some combination of the TACO belief, and a little bit of misunderstanding about how these things work, means that everyone's sort of looking backwards and saying, everything's going okay, if anything a little bit better, and just kind of like missing the fact that there's a wall ahead of us that will eventually affect the economy if these tariffs stay in place. Yeah, you can't help but feel like there's this uneasiness, right. That you're kind of in this eye of some storm.

I think I'd add to that with you have this new budget that, in theory, will get passed, that has also yet to hit markets. Andmy bigger issue, I know everybody's kind of focusing on employment, and I agree, you and I have agreed for quite some time secularly, this demand side economy relative to the supply side economy that we’ve been running for the last 40 years, this income driven economy really has changed the whole picture.

But it primarily does it, in my opinion, through the inflation picture - the long-term interest rate picture. And so, I'd be curious to hear your thoughts on where you see kind of the other side of the storm as we get through here on inflation. Obviously, backwards looking, inflation looks like it's cooling, everything seems hunky dory. Growth is strong, inflation seems to be cooling. Idon'tknow. I’d love to hear your thoughts on that.

If you're, again, any data that you're looking at, and particularly given kind of the supply demand imbalance on the back end of the curve. What you're seeing back there vis a vis not just inflation, but also what you think is likely to happen in the long run.

Yeah, I think the challenge right now in terms of inflation is, in many ways, the same, which is like if nothing was going on, we'd basically be seeing a gradual cooling of inflation that is still a little too high for the Fed's mandate, but kind of okay, stomachable by the Fed such that they can at least continue to cut rates very gradually in response. And now we get, essentially, a tariff shock.

And,you know, we've seen dynamics like this happen lots of times in the past, which is with VAT shocks, with VAT hikes, and what the second and third order effects of that are. And, you know, consumers see those things. They see even though it's a tax, and if it was a sales tax, you would think about it like a little bit differently. They see it in the price of the goods.

And so, then what ends up happening, you know, they'll see the tariffs in the price of the goods and so, then they see higher inflation in terms of the things that they're buying. The challenge is, if it doesn't get paired with higher nominal incomes, there's only one solution which is that you have to reduce real spending. There is no other solution to that problem.

Iguessyou could borrow more, but households aren't really likely to extract a lot of value out of their houses and things like that. That's kind of like the old days. That's like 20 years ago you'd lever up your house in this sort of scenario. It doesn't seem like households want to do that. So, basically it will lead to lower real spending. And I think the question is, kind of, how does that imbalance work? How much does it get taken out of profits? How much does it flow through to prices?

How much do those prices then slow demand? That's kind of the question. Andyou know, there's been lots of individual case studies like the case study of the washing machines and how they flowed through to prices (washing machine tariffs), but we've never been like, you know what we should do, like have an instantaneous 20% tariff in the single largest economy in the world and let it ride and see what happens.

There's a lot of unknowns in terms of how exactly this is going to flow through to inflation. Ithinkthe real risk, the more strategic risk, is that you get another bout of inflation. The Fed's a little handcuffed. They're not really going to tighten in response to incremental inflation here. They might not ease, but they're not really going to tighten in response.

Andso, you've got sort of a tricky moment where you could sort of re-embed some elevated inflation expectations that are pretty undesirable and that could then go over and influence long-term bond market expectations or maybe the currency more than long-term bond expectations, currency and gold more than bonds. I think everybody's focused on the recessionary effects of

tariffs, this idea that tariffs may be inflationary as a first order, but as a second order, are they deflationary? But in my opinion, I think there are very few people thinking about the potential wage growth that may come from it.

That'skind of the whole point of the tariffs, right? The whole point of

the tariffs is to bring jobs back and we're cutting immigration. But I hear very few people talking about wage growth. That once again… By the way, this has happened for five years, that deflation might not be, and recession might not be the actual result. That the actual result might actually be a demand/push economy, which is what we're doing. That's what populism, protectionism does.

So,I think the one thing, again, that people aren't thinking about is

this could be inflationary. Not just from a secular kind of, hey, we're taxing goods and prices of things go up. But even on a secondary perspective, if we are cutting labor, that causes a problem of cutting goods and we need to create more goods here. That's a problem as well in terms of potentially creating demand, more demand. Can I ask both of you a question here? So, we seem to be driven much more by narratives than by data compared to at least when I started out my career.

I kind of agree with what Cem says that, you know, we should think about, you know, the labor force and what happens with immigration. Butfrom a completely outsider here across the pond, when I think about the new administration in the US, and you think about what they said they were going to do going into government, and they started out doing some of that, DOGE is kind of a good example.

But it just seems to me that a lot of that policy is just going straight back to what all governments do and that is borrow more money, lift the deficit, et cetera, et cetera. So,I'm kind of thinking, and obviously I have no idea whether that's going to happen, but maybe we're all just still believing the narrative they gave us with immigration, but in reality, it's just not really going to happen.

We're going to see flashes of it on the news, but in reality, the labor force isn't really going to shrink in the US. Oh, I don't know about that. I mean, the labor force in the US, labor force growth has gone from increasing at something like 2 million annualized pace to zero. That's

a pretty huge adjustment that we're seeing. The challenge with it is that it takes time. There's no incremental labor. Let's say, construction labor, it's like it's a little hard to find someone, a little harder to find someone, and a little harder to find someone.

Butif you combine the fact that we went from 3 million inbound immigration, of which about 2/3 were in the workforce, give or take, of that incremental focus, there's also children and people who are not in the workforce,

but about 2/3 float into the workforce. Combined with the fact of the rescinding of various work visas. So, most recently, I mean, just in the past week, the Supreme Court upholding the rescission of 500,000 work visas for immigrants that are from certain Latin American countries, you're talking about a pretty big sucking out of the labor market dynamic.

Thething that has not really happened is they haven't really deported anyone. Like, I actually, I had a chart recently

where I just… They had a big Splash. We deported 70,000 people in our first hundred days. And you're like, that's a pace of like, basically the same as the previous administration.

So,you know, okay, like, good headline. Lots of, you know, patting ourselves on the back that actually didn't matter. But the combination of things, in

terms of restricting essentially the inbound flow with some of this work visa recision is, you know, meaningful in terms of this labor market and we'll keep it tighter for longer for sure and support wages, as Cem's saying. Yeah, Bob, I couldn't agree more. Look, you know, we've pulled off 2.4 million in supply of labor and we're in an incredibly inelastic tight labor market. That's fascinating, actually. People are all focused on the tariffs. Will they, will they not?

But in the meantime, the immigration thing, which was one of the biggest things of the election, and one of the things we most worried about is tick, tick ticking along. And that is, that's a big deal to that inflationary push that we've been talking about. So just another thing before we move on, and I don't know where you want to go with your questions, Cem, but debt seems to be creeping back.

I think people, from what I can tell, are spending more on their credit cards, hitting sort of record highs. I think there's rising delinquencies as well. Are we going towards some kind of maybe hybrid regime? A little bit of both and not one or the other? Well, I think probably what you're seeing there, to some extent, is a reflection of the K shape dynamic where there are the bottom quartile of, I'd say, financially stressed folks.

It isn't necessarily consolidated solely amongst lower income cohorts. It's just, you know, if anything, actually the most financially stressed are in the middle income areas of the market. Andso, I think what we're seeing is stress emerging as, essentially, they are reaching their limits around what are the different levers that they can pull in order to continue to keep up their consumption.

And you know, things like the student loan repayment or restart is an example of the sorts of compiling stresses on those folks. Now,if you go back and look through time, often that would take the form of starting to create significant credit stress in financial institutions and then create a credit cutback. And that slowing of credit from boom to slowing would create a slowing of the economy. The thing that's going on right now is we haven't had so much of the debt boom part of things.

And so, it means that as those credit stresses emerge, their sort of second order effects are less significant than you'd typically see in a traditional cyclical environment. So,both things can be true, which is we have a mostly fine income driven expansion and there is a cohort of people who are financially stressed and you know, every week that goes by, they become incrementally more stressed. Probably not enough to bring down the overall economy though.

Yeah, Bob, I think one thing you highlight there, which I think is so critical and has been the case really for the last five years and is a secular trend, but I think is accelerating is, you know, the top 10% of the distribution here in the United States now constitutes 40% of retail demand. And we are now beginning to institute policies that are paired with AI. You know, the number one cohort that's going to be hurt there by AI's growth is that cohort.

Andwe're instituting policies now that are actually continuing, through protectionism and populism, to help the bottom and move that money from kind of that top 10%. Maybe money still flowing to the top .1, but I think that is an incredibly important dynamic - this kind of K shape that you're talking about.

Everybodyis really thinking about this still two dimensionally, like the last 40 years, that if the economy slows down then the long end of the curve, the yields, will come down and inflation will go to zero, etc. But I really think this dynamic of continuing to send money to the bottom, send jobs to the bottom, and hollow out that top 10% is going to be a very, very big change from what we've seen. I think the challenge is, in terms of the hollowing out, who actually gets the hollowed out?

And it's probably, from my perspective, as you look at the pressures, it's more the middle that's kind of getting hollowed out and sort of distribution going to the top and the bottom. Which is kind of interesting in the sense of it aligns with the coalition, let's say, of the current administration, which is a bit of top and bottom coalition building from an income perspective. Andso, I guess in that sense it shouldn't be all that surprising. But it's going to create a real stress point.

It creates a stress point amongst a cohort, a traditionally sort of stable cohort in the sort of longer-term American prosperity sort of perspective that probably is creating stress or challenges from a long-term growth perspective, but in favor of sort of the very top and the bottom amongst US income cohorts. Yeah. To add a little bit of color to that, there is no middle anymore, compared to where it used to be.

And when you say middle, what I'm actually seeing is, again, that top call it 1% down to 10%. Like it is top middle for me. It is top, realistically that it’s coming from. It's just not the tip-top - not where the majority is. It's from this kind of upper middle class. And it seems like we're sending enough money to the bottom. And we've seen this kind of growth there, where demand and growth there is pushing into a new lower middle class a bit more of that.

So,we're definitely changing the demographic picture dramatically. But it is very nuanced and details are making a big difference in outcomes and inflation and I think that's really what's driving the stagflationary. Yeah, I mean part of the question, you know, strategically is the US dynamism question. A big cohort of the US dynamism, through time (like if you look back over the post war period) has been basically picking the best of the middle and giving them opportunity to go to the top.

Plus, frankly bringing in skilled immigrants who come to our various educational institutions, and benefits, and sticks around for a variety of reasons.

Andso, part of the question here, from a long-term growth perspective standpoint is, are you actually meaningfully reducing the potential GDP growth of the economy, the sort of structural foundations of what creates innovation and long-term productivity gains of the US economy both through hollowing out the middle class, reducing immigration, and, let's say, challenging our knowledge institutions? And as a function of that, that'll have essentially negative dividends.

We'll have drags on US economic conditions for a while in favor of, essentially, income transfer to the bottom. And in some ways AI is a productivity enhancing activity but it's less compounded productivity gains and more isolated productivity gains. This may be beneficial in a shorter-term time frame, but if you look out over a longer-term time frame could create challenges in terms of overall productivity growth.

Which kind of aligned, Cem, with, your sort of strategic slower growth, higher inflationary dynamic. Yeah, it's really these two… I mean, if you really like simplify, simplify. There are two major forces, right? I mean there's a bunch of others, but one is this protectionism, like, really China/US. If we're really going to continue to put a, a real lever between the two or kind of divide the two, that will drive, by definition, growth on the bottom.

We will repatriotize the bottom, the cheapest goods of all, the cheapest production, the lowest end. And it's not just China, but that's the biggest part. Whileat the same time, in theory, you would think, well, the growth of AI, it's so fast and dramatic, it can replace, but it's replacing a completely different sector as a completely different section.

So, we are getting massive deflation in one part and massive inflation in another part if you really think about it, if, assuming, I think we know where AI is going, although there are tons of policy changes and things can slow it down, etc. But the one big question, I guess this is where I would lead into for a question for you, Bob, is where are we going with China? Because that is the biggest question of all.

And I think that uncertainty, this TACO trade, the uncertainty tied to what is happening, where are we actually going to end up is really the part that's hardest to put your finger on. Yeah. I mean, where we go with China is so emblematic of all the different pressures that we're talking about from a strategic

perspective. And I think the challenge here is there's a lot of uncertainty.

Ithinkit sort of goes back, a little bit, to taking the new administration kind of at its word in terms of what its priorities are. The joke is, like, if you want to understand what the administration was going to do, I basically just take the campaign rhetoric that's largely what they've pursued. It doesn't mean it's exclusively what they've pursued. But,

you know, amongst immigration, tariffs, you know, cutting the deficit was never really a big story. If you actually listen to the campaign rhetoric, it was never kind of like the big thing that was focused on.

Itwas much more around, you know, reshoring and restricting immigration. And so, when you go and you look at the engage… I should

say, and also military toughness was a big campaign rhetoric story as well.

Andwhen you go and look at the relationship with China through that lens, essentially, let's call it a strategic decoupling with China. It hits on all those dimensions in terms of helping support the base, in terms of

onshoring, helping restrict immigration. Chinese immigration hasn't really been a big story, but, you know, the US Is doing what it can.

Thereare still hundreds of thousands of students, Chinese students from China, every year, that we've basically now decided to kick out in one form or another. So, that's a strategic decoupling. And then, from a military perspective, you know, basically figuring out ways to ensure that our military is disconnected

from anything to do with China, whether it's about rare earths and things like that, or manufacturing. And so that kind of decoupling, that is kind of where we're going.

Andfrom a strategic perspective, what that means is you're basically duplicating a lot. We went through 30 years, basically, where we created a global economy that was really focused on creating the most efficient implementation of

all manufacturing production everywhere. And so, whoever could do it the best, most efficiently, most effectively, just in time, all of that.

Andnow imagine you've basically smashed that whole system to one which is a parallelization of supply chains, production, isolation, etc. And that inevitably can create a higher nominal growth support. You know, it certainly supports nominal growth, but a lot of that is likely

more through raising prices relative to raising sort of real economic activity, which is kind of, you know, it's not really supported by this sort of activity. Yeah, I actually agree, I agree that's where we're heading now. There were some real questions in January, though. Because I think the bringing in of Elon Musk and kind of the more wealthy, more traditional Republican, small government, kind of part of the coalition, this time around, like Trump 1.0 very much was populism, protectionism.

He was a vehicle of this. And to be clear, since 1982, he's been talking about this topic. So,this is core to who Trump is, protectionism, bringing back jobs to the US, not sending everything abroad. But this Trump 2.0 seemed like it would be potentially very different. And if you think about what they came in with, it was, DOGE. It was a lot of supply side, the big tax cuts, lowering kind of spending writ large. There was SNAP payments and Medicaid cuts.

Meanwhile, there was a general thought process, and Bessent was out there vocally talking about it in January, like, we need to get the private industry going again. Right. And I didn't think it would happen as quickly, but there was a real question, which way are we going to go here? Are we going to try and go back? Are we going to maybe have a deal with China? And by the way, Elon also was kind of pushing for a resolution of some of the tariff stuff.

They were kind of like willing to deal with it. Butwhat we saw was, in the first hundred days, a dramatically big bad poll number for Trump, like the worst since the 1940s. And that resulted in a complete kind of… And by the way, there were, like, pitchforks and fire, Molotov cocktails at Tesla dealerships. And you put the wealthiest man in the world out in front, and you try and do a supply side policy in a populist protectionist time period. And guess what?

That was in complete contradiction to who Trump's base is. Andthey just cut the cord, pushed the lifeboat off to sea and sent Elon kind of off on his own. And not surprisingly, now Elon is kind of pushing back publicly against a lot of the policy. I mean, they're trying to play nice. But clearly this is going in a much more Trump 1.0 direction, to your point. And I think that is important.

Ithinkthat's actually critical because there was some hope in a lot of things kind of going on in January, February. And I think we are right back to where we were, if not worse. Then again, my only big question is what is going to happen with China? If there's some big deal with China that can change everything. Can I throw in a comment/question? So, you bring

up China. I don't know if any of you have come across the new book that just came out like a week or two ago called Apple in China. Have you heard about that? I have not, no. Okay, definitely worth for you to check out. So, the author is a journalist, Patrick is a journalist. He spent a number of years also, I think, in Asia. And essentially, he writes this book where he basically completely sort of describes how Apple built their supply chain and why it ended up in China.

Justto give you a couple of stats and, and then kind of maybe hear your response or your thoughts about it. So based on Apple's own data now, in order to do this, in order to basically make their products as great as they are, they had to send thousands of the best engineers from Apple to China. So according to Apple data, from what I can tell in the news, Apple trained 28 million Chinese people. Thereare 3 million people working in China for Apple, only 160,000 outside of China.

And according to him, the author Patrick McGee, Apple simply cannot produce, even if they wanted to, they cannot produce outside China. Nobody has the skill to do that. And you could almost go as far as (and I think he's kind of alluding to) that you could say, well, actually, Tim Cook is kind of pretty important in why China is more advanced than many of the Western countries today in the technology space, because Apple trained them to be.

So,my question is just, I mean, again, we hear all this rhetoric about, oh yeah, we're going to bring jobs back to the US and all of that stuff. The question is really, has anyone from the new administration maybe thought about can it really be done? I mean, it's one thing to say. The narrative is great, but can it really be done? I'm not so sure. Well, I think that the challenge is when you get down to the details, it is a real challenge.

And I think it's easy to talk about $5 trillion of investment coming into the US from various folks, and it's a lot harder to actually build the factories and get the supply chains over. And I think one of the challenges, the biggest challenge on that is that it's not like we've created (for a lot of these areas), it's not like we've created smaller scale, but nonetheless nascent capabilities.

So,like if you look at something like steel and aluminum, you know, we do have some steel manufacturing in the United States. And it doesn't mean that we can meet all of our demand or whatever, but it does mean that there are skilled people who have worked in steel plants and, theoretically, we could build it, but it's going to take 25 years to build up the full manufacturing capacity.

Youknow, or autos, there's plenty of auto capability in terms of people sitting in southeast Michigan who have been doing this for a long time, southeast Michigan and Ontario, I should say. And so that's certainly possible. But a lot of the other stuff is not… A lot of the other manufacturing has not been in the US for 25 years.

The electronics, the furniture, the toys, a lot of the stuff that can seem trivial but really is part of our sort of day-to-day consumption and part of the inputs to all of the other things that happen - lots of made America things. Iliketo joke about my, my kids’ shampoo, you know, where, sure, the shampoo is made in America, but the bottle is made in China. And it's not like you could take delivery of the shampoo without the bottle.

I think someone posted a picture of a Maga hat and it actually, it said inside, made in China. Right, exactly, exactly. So, that's one of the challenges is just given that we're coming off of this 30 years of like just-in-time creation, most efficient supply chains possible, there's a lot of elements, a lot of disruption that if we go down the path of, let's call it, the strategic embargo. Which I found it interesting that even Bessent started saying embargo with China.

The impact of that is not just on the imports. The impact of that is much broader than that. And you know, we're not that far away from that. We'reright on the cusp of strategic embargo at 30% tariffs. If we're much higher than that, it's going to be really challenging and create magnified effects. Now, I think the, the only saving grace of this, from a macroeconomic perspective, is, like we saw in April, if this starts to get meaningfully priced in, it may start to create a response.

Is that TACO? Well, TACO, when equities are at all-time highs, is a very different story than TACO in response to 25% declines in equities. Andso, you're probably going to need more pain to roll back the behaviors, to limit the impact on the economy, then at least, certainly, where we are in terms of asset pricing right now. Yeah, I mean, I think you have to. The reality is if we choose to prioritize median outcomes, it's painful. I mean this is not going to happen.

You're not going to fix 40 years of what we've done in a year or two. Ithinkthe key is separating… You know, we're actually doing something with a long-term view, believe it or not, you know, for the first time in 40, 50 years. And that takes short-term pain. At the end of the day the question is, will they be able to deal with the short-term pain? Because politically they have to get reelected every two to four years. And I think that's the big question.

And that's what these lags of, you know, these delays, extensions, that's why TACO exists. If you think about it, it's this short-term having to deal with markets, having to deal with the politics, which are very immediate and short lived, while you're trying to make big structural changes. And I'm guessing that's like an on-again, off-again kind of trying to manage what otherwise is a very difficult situation.

The basic path here is you either have to accept a significant amount of pain, which, in general, western democracies are not particularly good at doing that outside sort of proactively, in wartime maybe, but proactively, that is not a particularly well-traveled path.

Orwhat you have to do is create enough stimulative effect that offsets the pain part of the equation through either running large deficits, transfer payments, cushioning the challenges, running easier monetary policy than would be appropriate given inflationary conditions or economic conditions – basically, do a bunch of offsets. Andyou know, and this isn’t black and white. It's not like terrible pain or dumping money into the streets to offset what's going on.

But I think probably what we're seeing is a path that has a bit of elements of both of those things. Which is that there is some element of pain that's going to occur as we engage in, to some extent, some strategic decoupling that exists relative to the rest of the world, and then at the same time some amount of, you know, easy money policies that will offset that.

Andthat combination of things, it's interesting, it's like not particularly good for stocks, it's not particularly good for bonds, but it is pretty good for gold and bad for the dollar. And actually, it's really good for the economy broadly. Like, demand and the rebuilding the middle class. The economy by the way, does not have to be weak. This idea that the stock market is somehow tied to the strength of the economy.

I think that part is going to break people's minds, that they don't necessarily have to be. I think we could get really strong, above trend economic growth like the ‘60s and ‘70s, but with really, really poor equity market returns. The sort of link between those two points which you're making there is that there's no reason why profit margins necessarily have to be pushing to all-time highs.

You can have a circumstance where, you know, if we have some moderation of profit margins, said definitely, part of the tax (and I describe it as a tax on the economy, not a tax necessarily on individuals, but a tax on the economy), part of the way that that can flow through is you can just have reduced profit margins. And reduced profit margins are obviously not good for stocks and not good for companies.

But that reduced profit margin can flow through and be beneficial to individuals, and wages, and their spending. Andso, that's a way in which this can play out, which is not great real returns for stocks, not great profit margins pushing higher essentially transfer payments, whatever, transferring the capital to the lower income cohorts who have higher wage growth and the outcomes that you're saying. And so that that's a combination that can exist.

Thechallenge, I think for most investors, is that is a pretty (just in the same way it was in the late ‘60s and early ‘70s), that is an awful outcome for most financial market investors because basically no one's prepared for that at all.

This is a perfect segue to, actually, I think another big, important conversation that you and I actually had a lot in common on and think a lot about. I know with your unlimited funds you do think about this a lot. But most people think (I'm just going to reiterate this idea) that if we have strong economic growth… If you ask your average person what drives the outcome for equities? It’s, well, if the economy is strong, stocks will do well.

But the reality is, in real terms, from ‘68 to ’82 (the last time we saw interest rates go bottom left to top right), we saw, in real terms, 2.5% GDP growth - in real terms, above inflation, with a lot of inflation. So, nominally it was very high. That is significantly higher than we've seen in the last 40 years. Thatis 0.75%, you know, almost a percent higher than the 1.7% or so we've seen in real terms for the last 40 years.

But in the last 40 years we've seen about 10% real, annual growth in the equity market. And in ‘68 to ‘82, we saw negative 4%, actually, in real terms - over negative 4% per year. So, dramatically different outcomes. Andthe reason, as you highlighted, is because labor was getting a larger share of the earnings. Profit margins, which sat at a record for the time, in 1968, collapsed into 1982. That's one. Two, the divisor, the discount rate forced multiples, at 23 pe in 1968, to 4.5. Why?

Because in 1982, with a 20% 10-year bond, you needed a 21%, 22% earnings yield of the S&P to invest in the S&P. It's that simple. Andso, this idea that the divisor was a much more mathematically powerful effect on equity values than the 0.75% or 1% economic growth per year is mathematically, it's clear, it's, it's obvious, not to mention the profit margin compression.

So,I think we could, like we were talking about, if you see a strong economic growth scenario where it is a demand/push economy, where you are pushing money to the bottom and rebuilding kind of your own economy, at the end of the day, that is going to have to make demand, first of all, for stocks go down dramatically. And that discount rate is going to ultimately weigh. And it does with a lag. As we know with the CAPE.

InShiller's CAPE, you know, interest rates work with a long and variable lag. Why does that lag exist? Because 1968 - a similar thing. Here's a similar thing. Everybody goes in and gets debt in 2020, 2021. And that lasts. That debt, that cash lasts for five years, seven years - that's the average time period. But eventually people have to come back and get that liquidity from the market at a much higher rate. Andthat's when the rebalance happens between stocks and bonds.

So, I see this whole thing playing out that we've been talking about for five years. But I really think the economy will continue to be much stronger than people expect. I think this is because we are sending money to demand, to the velocity of one people. The people who take all the money they get and spend it. And we're taking it away from the velocity zero people. The people at the top. 0.1% or, or 1% or 2%, who spend maybe 10% of the money.

I think that is a huge, huge deal and a very different outcome. Butthe reason this is important, now to kind of get off my soapbox and go back to you, Bob, is if that is the case (and we've seen periods like this, not just the ‘60s and ‘70s), investing 60/40 is a disaster. The Sharpe ratio of 60/40, for the last 40 years, has been about 1. Butif you take that period out of it, you know what the Sharpe ratio is of 60/40 in the last 125 years? 0.3.

Yeah, which is what you'd expect strategically for two assets with a 0.25 Sharpe ratio and a modest positive correlation. That's what the portfolio should look like. Right. The problem is it's very disjointed. During periods like the last 30, 40 years the negative correlation of the bond and stock part of your portfolio, which has been relatively consistent, completely doesn't just break down and go to zero. It goes positive. They become positively correlated.

And that's because they're both subject to that discount rate. And so we go through decades, and this happens again and again throughout history where stocks and bonds don't work. Everybodyassumes passive investing is this new technology, this new innovation - that's the way to invest. Well, no, it's not. The reason it became popular in the late ‘80s was because interest rates went from the top left to the bottom right and they continued for 40 years. Passive investing is not a new idea.

We've had indexing for almost 150 years. It's the same thing. Whydidn't anybody index invest consistently passively, even though we knew that was a thing until about 40 years ago? I mean, think about it, right? It's pretty obvious it didn't work. Andso, what happens when it stops working? Yet, now everybody just does that. That's a lot of pain. And that's where you and I come into this, right? That's why alternatives and non-correlated assets are so critical.

Youknow, we're calling alternatives, like private equity and private credit, which are just leveraged versions with no mark to market of the assets - stocks and bonds themselves. What we need is truly non-correlated assets. AndI'll get off the soap box, but I'd love for you to talk a little bit about what you're trying to do there, how you're trying to make that more accessible and get into some of the ways you do this.

Because the real challenge is that some of these strategies are, A, not scalable, and, B, that's the problem with 60/40, like that's scalable. These alternatives cannot be. So, how do you make them scalable and how do you make them more accessible to people?

Yeah, yeah. Well, I think it, it all started… I totally agree with you in terms of the need to build better portfolios and, in particular, build better portfolios that can withstand a wider range of different macroeconomic outcomes than basically peak disinflationary growth that we've seen over the course of the last 40 years.

Andso, I think one of the interesting things is, if you take a step back and you just look at what are the strategies, what are the return streams that are the most diversifying to a 60/40 portfolio? What you basically see is private equity, private credit, and venture capital, which have been all the focus of the alternatives world, are basically useless. Youknow, it's like if you want venture capital type returns, like, go lever up stocks. Like, it's fine.

You can get that return stream for one basis point. Or private equity, certainly, you can get that effective return stream for a basis point. The things that are truly diversifying are… There are basically three things that are diversifying to a 60/40 portfolio, meaningfully diversifying. Oneis gold, which nobody owns and is about as cheap and easy a diversifier as you can get. So, if you take nothing away from this, you should go out and allocate some money to gold.

Twois diversified commodities, which there's now lots of ways in which you can gain access to diversified commodities, I mean, like, industrial oil, copper, etc., those are actually strategically beneficial and then tactically very interesting if you just think about how the world is pricing in nominal economic conditions right now. Basically, extractive commodities are weak at a time when stocks are very, very high.

So even if you believe the economy will be great, why wouldn't you be buying extractive commodities since they're so cheap relative to, essentially, equities, on a global basis? Andthen the third is alpha strategies, diversified alpha strategies and particular macro diversified alpha strategies. And I think that's very important because the ability to bring to bear long and short (and short being an important component), long and short positions and flexibility is really important.

The key issue is you have to be able to do that at a much lower fee point. Because if you pay people 2 and 20, you basically eat away… all the alpha's gone. The manager takes away all the alpha. Andso, having sat in the seat, taking the alpha, it's a pretty good business if you could take all the alpha for yourself in the fees. But if you can get access.

And this is really what we're focused on is how do we create access to these alpha strategies without all the fees, without all the negative tax implications and things like that? Becauseif you get access to those, those are essentially the most compelling diversifiers that you can have in your portfolio.

So, if you just took your 60/40 and you and you shifted, and you put in gold, diversified commodities, and diversified alpha, at a low cost (particularly macro strategies), you can meaningfully improve the quality of the performance of your portfolio from a reliability standpoint. Relative to 60/40, even in pretty good 60/40 times, which is important to recognize. Yeah, I mean at Kai Wealth where instead of a 60/40, we really are

focused on kind of 30% non-correlated. When we talk about alternatives, you know, similar to you, it truly is alpha strategies, non-correlated strategies.

Youknow, the current portfolio, for most endowments and foundations, is not just 60/40, it's worse. Because a

lot of them have 60% to 70% exposure in privates, which is leveraged equity, leveraged credit, with no liquidity, with, you know, 5, 10-year lockups and 2 and 20 fees.

They'rebasically paying for leverage and they're kind of saying, well, that volatility number that defines a Sharpe ratio doesn't exist because we don't see it. And

that's been the case, by the way, for 40 years. That works great in an environment where you don't have a drawdown in equity performance that lasts longer than four years. Because if you have a 10-year lockup, then you never see that volatility.

Whathappens when that drawdown is 10, 15, 20 years and your levered equity is at 2 and 20? I think there's a lot of pain that could happen in private

equity and private credit. I think it's something that, again, will happen. It'll be a slow motion train wreck and then eventually accelerate because it'll be a function of a drawdown in a mark to market that will actually be experienced by investors because it'll last longer than a decade.

Andso, I think that's the big story, is what is an alternative and, and how do we get access to that at scale? And you know, there's a lot of alpha strategies. There's global macro,

as you mentioned, but I can name merger arbitrage, convertible arbitrage, managed futures, trend following, distress debt event driven, commodity focused, long/short equity, long/short credit. I mean we could go on, there's like a hundred. And I think most of these are foreign words to your average investor and I don't think they will be in three, four, five years.

Ithinkalso, importantly (this is my hobby horse), but derivatives, you know, options are a huge, huge game changer here because not only do they allow you to take access to non-correlated bets, not just up/down, they allow you to get capital efficiency. And as

interest rates go higher, capital efficiency becomes paramount. This idea of stacking yield, getting that T-bill rate, and then being able to, on top of that, stack a non-correlated yield. You don't need much alpha to start making a really good looking kind of non-correlated strategy. You can get it at scale too, if you can stack. And I think that's an important concept that I think very, very few people know and understand now.

ButI think, you know, that's 1% of the market or 0.5% of the market, which has doubled and

tripled the last several years. That's going to double, double, double again. And I was just at an equity derivatives conference, and there were twice as many people there than last year.

And structured products, by the way, have gone from 500 billion issuance a year to 1.5 trillion in three years.

I think that is a world that is just ripe for explosion in terms of just demand, and it's becoming more and more efficient. I think we're really hitting a tipping point there. Yeah, I think the challenge for a lot of folks, when they're looking at this though, is how do you pick your manager? That's the big pickle. If you talk to the advisor on the street, the guy in Dubuque who's trying to build his portfolios.

And so, from our perspective, a big part of what we've been trying to do is remove the single manager idiosyncrasy. Nothingagainst what you're doing, Cem. I agree with that, but. No, no, to be clear, I completely agree. But this idea, diversification is the chief. Exactly, exactly, and, in particular, what you see when it comes to alpha strategies is, if you just take, as you say, that universe, there's a bunch of different ways you can generate alpha.

And if you look at all those different managers, they basically all generate alpha. And particularly if you bring the fees down, they definitely generate consistent alpha over time. Absolutely. As a group, as a cohort, and it makes sense. Look, you've got the smartest minds in finance all trying to figure out how to beat markets. Like, yes, they should generate alpha over time. The challenge is that any one manager, it's like, huh, what's going to happen with that one manager?

They might be down 30, they might be up 30. It looks random when you pick one manager. But from our perspective, what you can do is you can index alpha. Now that alpha indexation totally changes the game because you get that manager diversification which allows you to get a more consistent benefit, more consistent drawing on that wisdom of the crowd.

Andif you could do that at low cost and higher target return, that is a combination that can be very, very compelling for a lot of portfolios and, frankly, hasn't really existed until you could put it into an ETF wrapper. Yeah, this is a critical point. If anybody's listening, this is so critical. People think that these big Millennium, Citadel. 0.72, Valley ASNI returns, for the last 25 years are because these guys are geniuses. It's actually way simpler.

And the fear about hedge funds is overstated. Whatis happening at a multi strategy hedge fund is this idea of diversification that is at the core of the success of this true diversification. Not like diversifying stocks but not diversifying... truly non-correlated distribution of returns.

Ifyou take 50 different strategies that are truly non-correlated from each other and don't own an asset so they're not exposed to the same thing, at the end of the day you can have a bunch of 10% yielding strategies, or 9% yielding strategies that may not be that exciting. That have maybe a 1% Sharpe which sound pretty good but, like we aren't hitting a home run. They could have a 15% to 20% drawdown each.

Andif you looked at each manager on their own you'd be like, that's good but meh, I've been getting 12.5% in the S&P. Why bother? But this amazing thing happens when you put 50 together. You still make 10% but your Sharpe goes to 2% or 2.5%. Nothing changed except you just put them together. That is diversification. That is true diversification. Not just taking 500 stocks in the S&P. That is diversification of total income stream, total risk. That’s the alchemy of risk.

That is what's happening at the hedge fund level. And I think that's the critical point. And to your point, the hedge funds are capturing too much of a large share. This is due for democratization. Butthe key points here that make it challenging for an ETF, and these are the things that we need to find solutions for, or are trying to, is getting the leverage and getting the capital efficiency that these hedge funds do. Because it's all done internal. All the strategies are done internal.

It'svery different to have a fund of funds relative to a multi strategy hedge fund because the multi strategy hedge fund, at the end of the day, only probably deploys 60% of the capital because they're all in house, and gets embedded leverage. So that 10% yielding strategy all of a sudden yields 15%, 20% still at that 2, 2.5 Sharpe. And that drawdown which went down to five, rnaybe you take it to 7.5, 8, which is fine.

It's the leverage that's critical because a lot of these strategies aren't scalable. And if you can get capital efficiency and leverage (and that's the key to deploying this), providing that leverage internally, at scale, for these strategies is important because you can get a lot of great Sharpe ratios. But getting the returns, the actual total returns is hard, and getting them scalable.

And I think that's a critical point here, and I think that's the real thing, I think a lot of us are trying to solve for. So, I have a question for you, Bob,

and free to jump in here Cem, as well, because I've been quietly listening, but very intently, to this conversation because you've kind of moved into my territory, and what I've been spending the last 35 years working on, and that is exactly uncorrelated or non-correlated strategies.

Andas Bob rightly pointed out, or you Cem,

trend following is certainly one, perhaps ‘the one’ when you look at that. So, one of the things we do at the shop that I work with is we have a chart where we look at the pre-crisis, so 2002 to 2007 period. We look at the actual crisis, ‘07 to ’09, and we look from ‘09 to now.

Andwhen I look at the correlation, for example take global Macro

from the official databases, it actually has positive correlation throughout any of the three periods between somewhere 25% to 60% plus correlated to the S&P from ‘09 to 2024. Okay, so my question is just sort of more an understanding of it because of course I agree with what you say, that that's the magic. How do we do that? And of course, I have my strong opinions about replication in general, but that's fine.

Butmy question is, within the replication world that you operate

in, Bob, how do you get the non-correlation, say for example from Global Macro when the underlying strategies appear to be pretty correlated or somewhat correlated, let's call it that, to the S&P 500 if we are, as you both seem to agree on, heading into a period where say equity returns will be much weaker than perhaps we've gotten used to. How do we bridge that gap?

Well, I'd say the first thing is, if you look at macro over the course of the last 15 years, in the post GFC period, I'm not quite sure what data you're looking at. I'm using the BarklayHedge database. Yeah, which, if you look at a holistic look at macro in particular, and there are some reasons why the BarclayHedge index is a little more tilted, a little better for your equity long/short managers than it is for your macro coverage.

You see correlations that are in the 0.3 type range which is pretty good because anything moving up into the right is going to have modest positive correlation during the stock market boom, which we've seen in the past 15 years.

Ithinkyou could also see, through that time frame, some of the defensive benefits of something like macro where you've got, you know, very, very strong performance, in 2022, offsetting the performance of both stocks and bonds during that period because of the flexibility to be able to go long and particularly short during those environments and where those managers have done particularly well.

Andso, I think, you know, if you look at it over a variety of different time frames, those macro strategies are quite beneficial to a portfolio both from a correlation standpoint but also from a risk standpoint. One of the things I like to talk about a lot, when it comes to things like macro strategies, is the asset managers. What they're particularly good at is helping contain downside risk which, when you think about a return consistency perspective, that's really beneficial.

And so, you have modest correlation, good protection on the downside, and defensive properties. Andthat's, you know, I like to describe it a little bit like an all-weather alpha which is like… You know, one of the challenges with trend following is it's defensive.

And it's good that it exhibits defensive properties but it also has long periods of poor performance, or mediocre performance maybe is the better way to describe it, which makes it challenging for a lot of investors to hold in their portfolio. Whereas,if you have something like macro, you have the flexibility to move beyond just trends and look at other elements driving the returns.

And so, you can get some of those defensive properties with the sort of good returns, also during good times, that make it a strategy that's a little more reliable in terms of being able to stick with it in investor portfolios. And when you do your replication, do you replicate an index per se?

Yeah, I mean what we do functionally is look at all the different indices because each one… I mean we could spend a lot of time down in the weeds about the nuances of all the indices and probably you and I would enjoy that conversation. But probably the listeners are not that interested in the weeds of hedge fund index construction.

Butfunctionally what we do is we look at all the different sources of different hedge fund performance information and we basically use all of them as inputs, in part, because each index has its own idiosyncrasies. And you don't want to get too reliant either from a performance information perspective or, frankly, from a business perspective on any one particular index because it can be, you know, any one index can be a little wonky or incomplete in terms of its coverage.

So, we look at all of them and average them together in various ways. And Niels, I would add to your correlation comment, you know, beta is not systemic to these hedge fund alpha strategies. I think the reason that you see the positive alpha is quite simply because everybody's been kind of cheating, right?

Likein the sense, hedge funds have to compete with stocks and bonds and when stocks and bonds, for 40 years, have been in a 12.5% annualized rate, they're providing non-correlation at their core and they don't need to have beta, but they prefer to have some beta in order to at least compete. Andso, my view is, whether it's macro, global macro, or equities, all the models, everything's subject to recency bias and so everything is kind of pushed to be a bit more correlated.

And I think that if you start to see that's not as important, I think those betas can easily be brought down, and will. Notto mention, I think the alpha and edge becomes more non-correlated in a world where you have more disjointed… particularly with global macro, where you had more kind of things happening across, globally. Things become less correlated cross country which means there's more non-correlated alpha. And I think that's an important point.

I agree with that, and of course you're right. I mean, all of us have had to compete with some very strong equity markets, and so on, and so forth, and there should be hopefully more of a difference, so to speak, in a world that becomes more challenging, for

sure.

Sincewe're coming up to the hour point, or so, I want to give you, of course, Bob, a chance to take us in a direction that we didn't take you or Cem, if there's anything else you want to bring up. I mean, there's so many. My list of questions is much longer than what we've touched on, from Japan to

debt.

Andby the way, we're recording today, on the 2nd of June. Over here in Europe, especially for those of us who were in the markets when we had the financial crisis and the bond crisis some years ago, every time politicians were out saying something like, oh, we're never going to devalue, we're never going to break the old European monetary system that existed and broke in 1992. Every time they said that, you kind of felt they're saying that because it's probably not going to

hold.

So,I couldn't help notice that Bessent, today, came out saying, oh, the US Is never going to default. Thought it was kind of an interesting comment all-of-a-sudden. Anythingyou want to leave us with, Bob?

Well, I think the only thing, sort of going back to the macro, the more sort of strategic macro perspective, that we didn't really touch on too much is we've talked a lot about economic decoupling, but the thing that we haven't really talked about is financial decoupling. And I think that's a really important sort of underlying theme that is really, you know, this is just getting started.

Forthe last 20 years, basically, the US has absorbed the vast majority of capital, global financial investment. And part of the reason why that was, was because the US, 25 years ago, was really driven by reserve accumulation. Although that hasn't really been a story in the post GFC period. It really has been about how, you know, essentially the US was the most attractive place for capital.

Andas we create barriers, as we do strategic decoupling globally, I think there's a lot of portfolio managers that are looking at the situation and saying, why am I so radically overweight US assets? European, big institutional allocators have funded something like 30% of the incremental demand of US stocks over the course of the last 10 or 15 years. That is a lot. That is a huge flow coming from those allocators.

Andprices are reflecting that, meaning weak prices elsewhere in the world and very high prices in the United States, or weak currencies in the rest of the world and a dollar which has sold off, like in any strategic sense, that is not that far off from secular highs. Andso, I think this is the sort of thing we've all talked about becoming enamored with 60/40, you've also become enamored with US stocks outperforming everything else in the rest of the world.

And, you know, these sorts of things take a long time to change. Ifyou've sat in a European pension fund investment committee, you know that it is slow moving, let's say. But once the ball gets rolling, it can go on for a long period of time. And so, you know, we could easily have a circumstance where that unwinding is detrimental to the dollar and beneficial for foreign stocks for the first time in 15 or 20 years.

And really, a totally different secular dynamic than what we've seen in the post GFC period. Andit's something that I think, you know, people kind of were like, oh, look at those German defense stocks going up a lot. And then we're like, ah, that was a flash in the pan. Forget that. And underlying it, you know, who knows, tactically might wiggle up or wiggle down.

But we are more likely than not moving into a world where foreign stocks, particularly from a foreign equity investor's perspective, are going to look a lot better. Meaning, their own domestic markets are going to look a lot better from their own currency perspective than US assets, for an extended period of time. And so that's an underlying trend that I think is an important one tactically and strategically to be thinking about as well.

Yeah, And I think particularly, I mean, one thing that people aren't talking about too just is that the new budget has a significant amount of remittance taxes on foreign investment. I mean, if you're trying to encourage foreign investment, that's probably not the way to do that. AndI think there are also, you know, things in there where we can pull levers in the US to punish certain entities.

And so, if you're going to start manipulating and changing kind of the rules of engagement with international investment, and close your borders in some ways, that can cause some major shifts in psychology among international investors. I just got a warning saying that Bob's microphone has been disconnected. So, he simply cannot give us any more of the wisdom. But I think it's a good time to wrap up.

Andactually, both of your points right here, I think are very good in terms of why, as you both agree. Things like global macro, or diversifying trend following, whatever it may be, but things that have a big playing field, a big sandbox, could be really, really important in the future for sure. So,as Bob, you cannot say anything. I want to thank you from both of us for another tremendous conversation. We got around a lot of subjects. We could have continued on many more.

We stayed away from those we had agreed on initially not to go to. So, I think we did pretty well. Andyeah, I look forward to having you back in the future because of course it's a very global macro driven world we're in. So, from Cem and me, thanks ever so much for listening. We look forward to being back with you next week as we continue our global macro series. And in the meantime, take care of yourself and take care of each other. Thanks for listening to Top Traders Unplugged.

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