I had the opportunity to speak with a 30-year veteran, now the Pennsylvania State Senator, Doug Mastriano. Who’s been fighting, probably the loudest in the state of Pennsylvania to reopen the state & get PA back to work.
mean just it was a long haul it was a
great time served with so many beautiful
people it’s been simply amazing let’s
talk about your experiences over there
I’m sure you had scary times I don’t
care who you are I’m sure you’ve seen so
much what experiences did you take from
there they’re helping you do your job
now as an elected official I’m not going
to call you a politician today there’s a
negative connotation especially in this
environment for any a politician but but
your elected official what experiences
are you taking
the key thing that I saw this you know I
did not deploy to the Balkans I don’t
want people who deploy but I supported
the mission I went there many many times
spent a lot of days there supporting the
mission and that that one in particular
struck me because that was a civil war
and then I look around at the atrocities
ever committed and you know people that
want to say maybe we need something like
a civil war in America like you you’re
nuts we don’t want that in here and the
other thing is is just how precious rare
and valuable our freedoms are we take it
for granted every day we wake up you
know you and I can talk and I worry
about the police monitoring our speech
at this moment anyway and we could
liberalize normally and do we want to do
except now and so when I come back I
retire from the Army I’m reflecting on
my career I’m about to go on an
interview with another guy a couple
years ago when I was just leaving the
army and I was before we were recording
I’m complaining about how I’m handing
over the country and state in pretty bad
shape to my son and this young man
looked over and he said well Colonel do
something about it and I’m like oh man
because normally Colonels and generals
are offered you know a nice package by
the federal government to continue to
serve and as a civilian because they say
best so much in US and I thought about
that I had all these excuses like hey I
don’t like politics I don’t have the
money I don’t have the connections I was
prohibited for thirty years while I was
then officer which is a good thing from
being involved politically but he was
right it’s like we need to do something
about it so you know I ended up running
and winning and so I bring with me or
all the thoughts of the sacrifice and
deaths and deployments of all those I
served with here the heroism of so many
the fear that came with it the
uncertainty in life and that’s why I’m
the leading voice of opposition to
governor cuz he has no idea what he’s
doing and those willing accomplices in
the population there’s those busy bodies
that want to go in and oppress you wear
your masks social distance they have no
idea that they’re nothing but useful
idiots for this bad agenda here to
destroy our country and everything is at
stake and we’re about to lose our
freedoms if we don’t stand up and resist
can you tell us some other some other
pieces of legislation that you’re
working on right now in Harrisburg yes
so there’s a couple things here that are
interesting I I together with Senator
Argyll and Schuylkill County we have
legislation and to require the General
Assembly the house has Senate every ten
days to renew emergency order Senator
Kim hill at a Westmoreland County she
has legislation for constitutional
amendment to limit its every 30 days
those are important to sew up right now
and so we need to get those moves so we
can’t have a governor willy-nilly
declaring a 90 day emergency and then
renewing it on this side of control
right now in the middle of a second
emergency order going through September
on this can you imagine this if he gets
away with it
I mean we’re gonna see what happens for
sure well senator thank you for being on
the let then I appreciate it I
appreciate your time you heard it from
the senator every vote matters
I’ve listened this year to a lot of
things I’ll be voting I suggest everyone
to vote whichever way you feel you think
this country should go senator thank you
so much for your time I wish you the
best luck in your upcoming election and
thank you for everything you’re doing
for reopening say the Pennsylvania thank
you for giving the people a voice here
and our lives do matter and what we do
echoes across the generations end to
eternity so this everything’s at stake
for our children and children’s children
we gotta win this fight and together we
will we must thank you senator have a
good day I appreciate everything thank
you bye-bye to be encouraged and be bold
and courageous here a lot of us say call
my vote doesn’t matter my voice doesn’t
matter and and I prove that together you
know with my online chats hear that we
created a movement of thousands of
people last month I reached about three
and a half million people many of those
people have been engaged their Senators
reps and pushing them to do the right
thing a lot of times these these
politicians have been doing this all
their lives here they lost our moral
compass but when the people rise up and
start pushing them I had one of the
senior guys tell me okay you call your
people off be now we compelled him to
force a vote on us here we can make a
difference together and so if I happen
to be the voice right now the people
here to fight for our freedoms here let
we gotta stick together as he as I
Benjamin Franklin said there in the
revolution if we don’t hang together
we’ll hang separately so we gotta hang
together and win this fight
While the “when” and “how” are impossible to predict, market history tells us that the post-Financial Crisis bull market had to eventually come to an end.
What prudent investors could have been preparing for all along was this eventuality – something we’re now seeing violently upend global markets and asset prices.
Eric Basmajian (EPB Macro Research) joins the podcast and explains how he takes his deep understanding of macroeconomic conditions and builds an “all-weather” portfolio, capable of withstanding any market storm.
This article includes a full transcript of the podcast that was posted last week.
Editors’ Note: This is the transcript of the podcast we posted last week. Please note that due to time and audio constraints, transcription may not be perfect. We encourage you to listen to the podcast, embedded below, if you need any clarification. We hope you enjoy.
Jonathan Liss [JL]: For reference purposes this podcast is being recorded on the morning of February 19, 2020. I’m joined today by macro specialist Eric Basmajian. Eric is Head of Macro Research at Pervalle Global, a discretionary hedge fund specializing in global macro-driven trades across all major asset classes.
Eric first began contributing to Seeking Alpha in 2017, building up a following of more than 12,000 investors and becoming Seeking Alpha’s top contributor in the economy vertical through his unparalleled analysis of key macroeconomic trends, and his ability to turn this analysis into actionable top down portfolio advice.
In 2017, Eric launched his Seeking Alpha Marketplace Service EPB Macro Research and he hasn’t looked back since. In addition to the steady stream of macro analysis subscribers to EPB Macro Research get, they also gain access to EPB’s model tactical asset allocation and long only asset allocation portfolios and active chat room and direct access to Eric, and of course, relevant to listeners of Let’s Talk ETFs. Those portfolios are all ETF portfolios.
You can subscribe to EPB Macro Research by going to seekingalpha.com and typing Eric Basmajian that’s E-R-I-C B-A-S-M-A-J-I-A-N into the search bar at the top of the site or by going to seekingalpha.com/marketplace and looking for EPB Macro Research there. All right, let’s get into it. Welcome to the show Eric.
Eric Basmajian [EB]: Thank you for having me on, and thank you for that introduction.
JL: Yes, absolutely. I think you are doing something in terms of your macro analysis that not that many people are doing not only at Seeking Alpha, but just in the broad world at large. So, I wanted to start out by discussing and understanding how you got into that kind of an approach to markets. You started out at a place called Panorama Partners, where you were scanning for mispriced equity derivatives. How do you go from there to a fully top down macro-driven approach?
EB: Yes. So, my educational background was in Economics from New York University. And after that, I had some experience in wealth management, but I had a desire to go to the buy-side of the financial sector. And at the time, it was a little bit unconventional to go directly to the buy-side, the traditional path was usually to the sell-side and some sort of equity research and then moving over to the buy-side. And then opportunity opened up at a fund. It was a quantitative fund, which was a little bit out of sync with my background, but I wanted to go to the buy-side.
So I took that job, which turned out to be an incredible learning experience, because I was able to sit next to some really smart people, some [quant’s] learning how to program and things like that. But while I was there, I still had the interest in economic cycle research. That’s really where my passion lies. So I continued to study economic cycles and people like Geoffrey Moore who’s dubbed as the father of leading indicators.
And I really started to have an appreciation for economic analysts that were not model-based, they were more indicator and sequence-based. So, what I mean by that is a lot of people get turned off from economics, because they’re so used to the classic model-based forecasts, where you have a bunch of inputs, some sort of model, and then it spits out some number like we have unemployment and then it spits out what inflation is supposed to be.
EB: The opposite approach is more of an indicator or sequence-based approach, where you see trends in the economy and then various indicators move in a predictable sequence. So Geoffrey Moore was really the pioneer of that process. And there was a mathematical bend to his analysis, because you have to combine things like hours worked, things like dollars consumed, you have to combine different indicators that have different units and figure out what the optimal weightings are for these baskets and things like that.
So, I was able to sort of marry the mathematical and quantitative overlay with some economic indicator approaches and then started to build my own indicators on top of that. And then sort of started to look out and see if there was anyone else who was doing this. And there were some people who were publishing leading indicators and similar economic cycle work, but what was missing was the translation to the portfolio. How do you take – okay, so leading indicators of the economy are pointing down, what does that mean?
How do you translate that into into an investment outlook? So that’s what I did is I paired the two together and I looked and saw known was publishing information like this, I started to publish on Seeking Alpha, and it caught a lot of traction really quickly. And then, as you said, I haven’t looked back since then. So, now we’re publishing the economic cycle research and how that translates to a portfolio?
JL: Yes, sure. And you’re also doing this at a hedge fund at the same time, correct? Are you basically taking a similar approach and distilling it for subscribers on your Seeking Alpha Service?
EB: So – yes, that’s exactly right. So, with the – with Seeking Alpha, I have an economic cycle research and then I publish a portfolio that goes along with it. And it’s the portfolio supposed to be used as a guide, because there’s so many investors investing in different accounts and IRAs and brokerage accounts and leverage and non-leverage and hedge funds.
So, everyone is able to take that information and customize it to their personal situation. With the hedge fund, I’m consulting on economic cycle research and then working to develop a portfolio more specific to what they want to do over there. So it’s a little bit more customized. There’s futures and things that we don’t get into in the service, which is mostly ETF-based.
JL: Yes, sure. So the research is the same, obviously. The conclusions are the same, but then how it gets executed, it’s going to be different on the end….
EB: Exactly. That’s exactly right.
JL: …well for, whether it’s high-end retail investors or kind of lower-end financial professionals, people like RIAs and FAs that are not going to go out and start…
EB: Exactly. And on the institutional side, there’s a little bit more optionality that they have. For example, if you’re really bullish on short-term bonds, let’s say, and you only have access to ETFs, sometimes they don’t move very much and investors may get tired of them. I mean, they could be a good investment. But if something moves 2%, 3%, some investors may not be happy with that as a slice of their portfolio or institutional investors can wander into futures or euro-dollars or things that are more levered instruments?
JL: Yes, sure. No doubt about that. Okay, cool. So, let’s get into the current macro picture here. We’re going to hear the Fed later today, it’s February 19, just to remind people, produce its minutes and weigh in on the state of the global economy right now, particularly in light of some of the disruptions to supply chains we’ve seen from coronavirus, but basically, over the last few months, we’ve heard everyone from Jerome Powell on down assert that the U.S. economy is strong with no significant macro headwinds. Do you share this assessment?
EB: Well, I don’t, and it’s a little bit contradictory, because while a lot of these Fed officials or politicians or whatever claim that the economy’s so good, the last quarter year-over-year was about 2.3%, which is right in line with the average of the last 10 years, but in order to achieve that 2.3%, we’ve had trillion-dollar deficits, accommodations in the repo market and some variation of QE, not QE, whatever you want to call it, so.
JL: They play word games with it, but sure.
EB: Yes. If the economy is just fine, we shouldn’t have so much accommodation to achieve just what’s the trend level of growth. So, ultimately, what the economy is suffering from is just an all-developed economies.
- It’s just massive over indebtedness, which is constraining the rate of growth,
- it’s constraining the rate of inflation, and
- it’s causing interest rates to go lower, which hurts savers.
And the Fed and Central Banks are trying to fight a battle of too much debt with policy tools that are inappropriate. Lowering interest rates is sort of paradoxical, because the problem is too much debt. Lowering interest rates facilitates taking on more debt, which can extend the game for a period of time, but the net result is weaker and weaker rates of growth over time.
So, the Fed is sitting there. The economy is strong, yet they cut rates three times, started some form of QE and helping the repo market a little bit. So, the economy is not that fine from a structural standpoint. There are a lot of issues there. Demographics continue to worsen over time, which will continue to be a headwind. And cyclically, the economy was also declining for most of 2019. We had GDP growth year-over-year in 2018, reach a peak of about 3.2%, that declined to 2.3%.
So, on a secular basis, the economy is slowing. Cyclically, the economy is still slowing. If you look at the growth rate, 2.3%, if your opinion is that that’s fine, then that’s solid. But the reality is that the economy is slowing in terms of the growth rate.
JL: Yes, sure. So I’d love to get into what the Fed is doing and maybe what they should be doing right now a bit more. You made an amazing call back on December 17, 2017 in a PC release to your EPB subscribers called the The Math Behind Quantitative Tightening – Why It Will End Early.
So your basic thesis was that by embarking on a policy of monetary tightening through ending QE, raising wait rates and unwinding its balance sheet, the Fed would cause the monetary supply to shrink too quickly, cutting into GDP growth, pushing long-term interest rates lower and likely sending equities lower [indiscernible]. Your prediction was that the Fed would have to reverse, of course, before the end of 2018 something we subsequently saw play out exactly as you predicted. Fast forward to today, is the Fed funds rate in the right place right now?
EB: So it depends what the goal of the Fed funds rate? If the goal, some people want the Fed funds rate to be higher, because they think we should “pop” the bubble that we have. But if we’re talking about maximizing unemployment and price stability, then the Fed funds rate is too high for the level of debt in the economy. And we’re likely to see that Fed funds rate continue to get chopped all the way back down to zero, even at 1.5%.
If the Fed kept the Fed funds rate here, it’s too constrictive on the economy. And we can see that the market is trying to tell the Fed that there’s some negative shocks from the coronavirus outbreak that’s causing a bid for long-term bonds. But here we are three rate cuts later, 75 basis points lower and the 10-year versus three months is inverted again.
So the Fed continues to cut rates, but the curve stays inverted. That’s telling the Fed that that their policy is too restrictive. So we were able to make that call on quantitative tightening, because when you’re in a highly levered economy, or too much debt, you can always tighten conditions, raise rates a little bit, contract the money supply, and there’s so much leverage in the system that the economy responds pretty quickly. The more debt that there isn’t the system, the less tightening you need to go a long way.
Conversely, when there’s a lot of debt in the system and monetary policy has been pushed to its extremes, the concept is called pushing on a string, where you can no longer ease policy and get a result in the economy. And that’s sort of where Central banks are headed around the world. Japan may be there already, the ECB is finding out pretty quickly that that they’re there. When they brought rates to zero, there was a cyclical recovery. They never were able to get off zero. And now some economies around the world like Japan are teetering on another recession.
So, in short, the Fed funds rate is just too high for the structural headwinds in the economy. And over time, whether it be this year or next year, they’re probably going to start walking that rate back down close to zero.
JL: Sure that says signs of an actual recession seem imminent, I would imagine?
EB: Well, it’s possible that there’s no recession either. We – it feels like ancient history, but the Fed funds rate was at zero for quite sometime and equities didn’t go to infinity. And Japan has been at zero and Europe has been at zero. So, just because we go to zero, it doesn’t mean equities go to infinity and we don’t have to have a recession. But we’re going to continue to see that the trend rate of growth is just so weak in across all developed economies, especially with what’s going on in China. That’s going to cause just growth to continue to miss expectations.
And we go back to 2018 and we were waiting on a second-half recovery and then that got pushed out. And then every growth narrative that we’re supposed to have seemingly gets pushed out two quarters, pushed out two quarters, until we realize that we’re kind of sinking into yet another lower low of trend growth. So the recession can’t be taken off the table, because the employment we can get into it, the employment market showing declining rates of growth, especially in the cyclical areas. So that’s, that’s a cause for concern.
EB: Recession is not imminent as far as what our leading indicators look like, but you can’t take it off the table, either. Because as long as growth is declining and growth is heading closer to zero, recession risk is rising, it’s not falling. So we can’t take a recession off the table as long as growth is declining. And even with – without a recession, the Feds probably going to have to walk the rate down to zero. There’s – the rates in the U.S. are significantly higher than everywhere else in the world. And by that, I mean the overnight rates, the strong dollar gives the federal problem. So for a variety of reasons, economic and non-economic, the Feds probably going to have to bring that closer to zero.
JL: Sure. And I guess, the obsession that market pundits have with an actual recession, which is just a technical, two consecutive quarters of negative GDP growth. It’s probably mood, if you hit very low growth even if it doesn’t dip below zero for two quarters in a row, the underlying economic weakness is still being felt by people in the Street.
EB: That’s exactly right. That’s exactly right. And all the same things typically happen. We’ve no recession since 2009. But every time we go into one of these growth scares or recession scares, equity sell off, long-term interest rates fall, the Fed becomes more accommodative. It’s all the same stuff that would happen in a recession, it’s just less severe.
And the tipping point between the growth scares and the growth slowdowns that we’ve had in a full-blown recession, the only major difference is job losses. We haven’t had sustained job losses in any of the sectors of the economy, even manufacturing for a prolonged period of time since 2009. So that’s the main difference is the recession versus no recession scenario typically comes down to job losses. And that’s why we have to continue to monitor what’s going on, because in the manufacturing sector, we are starting to see job losses.
We saw a few months of job losses during the 2016 downturn. It wasn’t enough to cause recessionary conditions. But here we are, again, where last month, I think, it was 12,000 manufacturing payrolls lost and that’s not the first month. So, that’s something to keep an eye on.
JL: Sure. And I think that’s probably a good place to pivot over to the U.S. consumer, because manufacturing has been in a recession, certainly in key economies like Germany for sometime now, arguable in the U.S. also, but it’s certainly been kind of the weak link. But, of course, manufacturing is a much smaller part of the economy of a services-driven economy like the U.S., then consumer, which I believe is around 70% of the U.S. economy. Where do you see the consumer? I mean, there’s definitely some hardening trends, for example, household debt is much lower this time around than it’s been during past cycles.
On the other hand, you seem to have kind of just totally stagnated wage growth, particularly the middle and top of the employment structure. So where do you see the consumer? And what will it take for the consumer to kind of be rolled back? Because I think, the consumer has really been what’s kept the U.S. economy propped up and continuing to grow at reasonable rates, particularly relative to the rest of the developed world?
EB: Yes, I think that’s a great point. And what we saw in 2019, as you said, was a sharp decline in industrial growth around the world and consumer spending, growth was fairly stable. What’s interesting is that the narrative was that the consumer was really strong. And when you look at the data, it’s not exactly the case. Consumption growth never really increased. It was just remarkably stable at about 2.5%, 2.6%.
So consumers weren’t spending 4%, 5%, 6% year-over-year, it was just remarkably stable. So even though the manufacturing sector was weakening, the whole economy wasn’t dragged lower. Now, as we move throughout the year in 2020, we’re actually starting to see our leading indicators of industrial activity improve. Some of that is just due to the base effect of year-over-year comparisons. Some of it is a small cyclical upturn in global industrial growth.
Now, that’s been derailed temporarily by the coronavirus outbreak, which we can get into. But before the virus, you had a small cyclical upturn in some industrial sectors. While the industrial sector was improving, you had a handoff to the consumers, which started to weaken. As a result of the 2019 slowdown in industrial growth, cyclical employment decelerated sharply.
So we track a cyclical employment basket, which includes manufacturing, construction and trade and transportation services, and it’s about 25% of total jobs. The growth rate of that cyclical jobs basket has slowed to the lowest level of this cycle as of the last report down to just 0.6% year-over-year.
So in the cyclical areas of the economy, you think of autos and various categories of manufacturing and construction. The growth rate of employment is moving to zero, which is problematic for consumption, because that cyclical employment tends to be a high paying jobs, a lot of value add. So as the industrial sector is starting to improve slightly, it’s not improving enough to pick up employment.
And as a result, we’ve slipped into this lower low employment growth, which is dragging consumption down now. And we saw that in the last retail sales report, where the control group for retail sales, which excludes a lot of volatile categories, almost declined 200 basis points year-over-year on a sequential basis slowing, I think it was about 3.5% year-over-year and you take out some inflation, the retail sales was under 2% for January.
So we have this subtle shift going on where industrial activity is improving a little bit, the consumer is starting to weaken and the result is that you still have a decline in the growth rate of the overall economy. We can’t seem to sustain growth above 2.5% for any extended period of time, which goes back to the secular conditions that we talked about.
JL: Yes, sure. And what do you make of the fact that we had three consecutive quarters of earnings recession – corporate earnings recession last year, which didn’t seem to bite into overall GDP growth in anyway. Is that going to be kind of a positive effect going forward the fact that we don’t seem to be in a corporate earnings recession anymore? Can that kind of balance things out here?
EB: Well, with corporate earnings, we have to be a little bit careful. The earnings that get reported from S&P 500 companies are adjusted, double adjusted and triple adjusted. And they have share buybacks and shrinking the share count.
JL: Right. Yes, they definitely have some magician re-going on?
EB: Yes. And they always seem to beat by $0.01 every time.
JL: Right. That’s why there’s people obviously that look at things like free cash flow, because you can’t make that up in the way that you can’t fake that in the way you can GPS, where you just change the numerator and then…
EB: Exactly. And even better is, we can actually – in the GDP report, it comes out with a lag. So for Q4, GDP, we just got the first number. So corporate profits were not included for Q4 yet. But on the – it’s on the second or third revision, we’ll get the the corporate profit numbers and these are compiled by the BEA and the IRS. So this is actually profits that people are sending, not profits that you have to pay tax on.
So you can’t report profits that are too high to the IRS, going to pay too much tax, you can’t report profits that are too low, because you have to stay in the bounds of what’s legal. So you could actually look at the GDP report, it’s quite lagged, and you can get a sense of what corporate profits are across the whole country. And corporate profits have really gone nowhere since 2014. Believe it or not, and especially if you adjust for inflation, I think, real corporate profits are actually down since 2014.
So the actual true non-financial engineered earnings growth in the economy has tracked the economic cycle quite well in terms of a structural weakening of the ability for corporations to generate profits. That’s been masked by a lot of financial engineering, which for better or for worse makes it seem like there are these robust periods of 20%, 30% earnings growth and then you have to compare against 30% earnings growth and earnings go negative, and then you compare against negative, so they go positive.
Whatever the case may be, we have real earnings that aren’t showing material improvement. But for the time being, the equity markets not overly concerned with the lack of profit growth.
JL: Right. Although I guess, if you look at the actual internal dynamics of this bull market, and particularly over the last five years or so, you’ve quoted a period of 2014. There’s a small number of stocks, maybe a dozen or so, that have really been incredibly overweighted in terms of powering everything we’re seeing here, your apples and Microsoft’s and Amazon’s and Google’s. And so I would assume that if you take those company’s earnings growth, which are real and legit earnings growth out of the mix, then you have something for most American companies like an actual long-term earnings recession here, correct?
EB: That’s exactly correct. Exactly correct. So for majority – and if you look at the corporate world outside of public companies, it’s the exact same thing, and especially those companies that don’t have access to financing as cheap as these large corporations do and that’s exactly spot on. Just to hammer home that point, we recently wrote an article published on the free side of Seeking Alpha, which looked at since GDP growth peaked in the middle of 2018, the equity markets gone up, which is a little bit out of the ordinary typically, when the growth rate in the economy is declining, equities are a little bit softer.
But since 2008, the best sectors ranked in order have been utilities, technology, real estate and consumer staples. So outside of technology, you have utilities, real estate and staples. You couldn’t get a more defensive basket than that. And as you said, there’s basically four technology stacks – stocks that are driving all the technology sector higher.
But it goes to show you that while the equity market nominally has gone up, the ratios and the relative performance in the equity sectors is very consistent with slowing growth. The bottom of that list would be financials, industrials, materials and energy, all of your cyclical stocks that everyone keeps waiting for the cyclical rebound, we’re shifting more cyclical, because we’re going to have a second-half recovery.
And while the market goes higher, bailing out a lot of those calls for a cyclical rebound, it’s being led by utilities, real estate, staples and some parts of tech. So there are parts of the equity market that are very consistent with what’s going on in the economy. You just have to look past the headline indices, which get carried by the largest market caps.
JL: Sure. Yes, definitely. So I mean, it just – I’ve listened to things like Bloomberg surveillance that help it a fair bit and other similar types of programs. And you kind of hear a steady drone of people coming on. I mean, you hear obviously, all kinds of different opinions. But you – I’ve heard, particularly of late, a steady drone of people coming on saying, they think tech is getting a little toppy in those big names. And if you look historically, small caps value financials are all actually undervalued. But it sounds like to me that kind of just tries to look at data mined to some extent and look at, “Well, this is how value has performed traditionally.”
But if you look at the fact that the companies that these people are advocating buying or actually in some kind of a secular earnings decline or recession, I’m not so sure that now would necessarily be the time to load up the wagon with some of these names?
EB: Yes. And one of the thesis out there on tech stocks is, when growth is slowing, interest rates typically fall. So if interest rates go down, it makes sense as to why utilities and real estate would perform well.
JL: You’re saying, because people are desperate for any kind of real yield and…
EB: They’re desperate for yield and whatever yield you do have gets valued higher if the discount rate goes down. So it makes sense. The theory on tech is that in a world where there is no growth, going through all the things we talked about a secular decline, I mean, industrials are not really growing anywhere, materials and energy, the certain categories of regional banks. I mean, banks around the world have pretty much all gone to zero except in the United States.
So there’s pockets are really a majority of these sectors that have no growth and they have a lot of structural headwinds. Technology, if you can find a company that is truly growing revenues at 20%, 30%, 40% per year and the risk-free rate is 0%, people say, well, that growth, the growth that I can find should get priced at a premium, because there’s no growth anywhere else. So if you have a lower discount rate and you do have some legitimate growth, I guess, that’s how people back into a justification for tech stocks.
JL: Well, so I mean, certainly, if you have, let’s say, a two handle on a 30-year Treasury and then you look at companies like Apple, Microsoft, Facebook, et cetera, that are growing earnings steadily at 20% a year well, even if they’re not paying a dividend, it just seems like if you’re looking out 10 and 20 years and looking which asset is likely to be worth more based on what you put into it, it does seem like the steady growth story is likely to outperform something that’s predicted to just appreciate it by 2% a year?
EB: Exactly. And just to emphasize that one point, I mean, here’s another thing that is interesting. When you have an inverted yield curve, you have higher yields on the short-term and lower yields on the – in the – on the long end. So a lot of these tech stocks have no profits today. All their profits are expected to come down the road. When you think about the opposite for an industrial company, if the world is going to look like no growth in 20 years, all their profits are today, not tomorrow.
So with these companies that have no profits, they’re pitching an idea that right now we have losses, discounted at a high short-term rate, all our profits are going to come 5, 10, 15 years down the road, you should discount that at the 10, 15, 20-year rate, which is zero or one. So they’re discounting future profits at a lower rate and discounting their losses at a higher rate. So in a weird way, an inverted yield curve helps a company that has no profits today and profits tomorrow.
JL: Yes. So load up the truck on Netflix then.
EB: One way to justify it if that’s, I suppose, where you want to be.
JL: Yes, I mean, yes, I don’t actually want to get into that. But I think they might be facing some other headwinds there.
EB: And that’s the ticket. I mean, that concept works wonderfully even if growth is slowing as long as there’s no recession. As soon as recession fears creep in and corporate rates start to go up or spreads widen and people fear that that company that has no profit today won’t be able to get that next round of funding. The whole thing kind of collapses on itself.
So it’s a game that that works really well while it’s going up and it makes a lot of sense. But as soon as a recession fear creeps into the market, people fear that company won’t be able to roll their debt or issue new equity. And once the capital market is closed, a lot of these no profit companies have a big problem.
JL: Yes, certainly, no question, which, again, is what makes some of these really big tech names so appealing, because they’re not really growth stocks in the model of growth stocks, let’s say, going back 20 years during the tech bubble…
JL: …2000 tech bubble. If you look at companies like Apple, like Microsoft and those two in particular, which are the two largest holdings in market cap weighted index. And they make it into both value and growth indexes for a reason, because they really are not pure growth stocks by any stretch. They have many aspects of value stocks. They pay dividends. They actually increase their dividend payouts every single year, which, again, is something that value investors generally look for. They have incredibly pristine balance sheets, so for not talking about companies that are over leveraged and waiting to become profitable.
EB: Yes, absolutely. I mean, an interesting thought exercise is, what’s the value of the last share of apple? So if Apple’s mission was we’re going to lever up at 2% or 3%, or whatever they can take out debt and we’re going to buy back every single share we can. What’s the value of the last share?
And people feel like they have a – they’re going to buy back 6% to 8% of the float every single year. It won’t take very long before they’ve shrunk the float X amount and the price should be here, trying to front run that continual stream of share reductions, I get the concept. But like you said, it’s the sort of the only game in town for in a weird way to think about it.
JL: Yes, absolutely, which I guess could bring us nicely into the coronavirus. Apple was just kind of, I guess, the first large company to come out with a statement just a few days ago, coming out of the the President Day holiday weekend, that they were going to be materially affected in terms of their production lines, that they’re going to be rolling out their low-cost iPhone later on as a result of it. And it seems like they’re probably just the first of many companies that can’t quite quantify it yet. But certainly, putting companies, let’s say, like utilities and Reed’s companies that really should not be affected by what’s happening in China. But.
JL: …if you look at most companies, it’s not only tech companies, everyone from Apple all the way down to Walmart, I would think would be heavily affected by this.
EB: No question.
JL: So what is your point of view? I guess, I’m more interested not necessarily in the coronavirus, specifically, but just in general, how you deal with these kinds of large black swan style market events in portfolio construction. And without, let’s get into the coronavirus, specifically. But then I’m also curious to just hear your broad approach to how you handle these kind of known, unknowns, some events going to creep in at some point, you don’t know exactly what it’s going to be and how you construct a portfolio to handle those kinds of shocks.
EB: Yes, that’s a great question. So this sort of comes into shock investing or how investors deal with shocks in general. So typically, we have to understand what the trends for growth and inflation are before the shock happened. So if we go back before anybody had any idea about what was going on, what was the trend in growth and inflation around the world?
Well, growth was still slowing, let’s talk about the United States. Growth is still slowing in the United States, but you actually had a small cyclical upturn in industrial commodity inflation. So you had a small upturn in inflation, and you still have growth slowing. So that was the trend heading into the virus, then a shock happens, which temporarily throws the market into a growth down inflation, down deflationary type environment.
But the underlying trend was still growth down, inflation slightly higher, typically with a shock. If the shock does not last long enough to cause a recession, and that would have to be many, many months. Job losses would have to occur as a result of it. Let’s say this lasts two months, or three months and there’s no job losses as a result. You’re going to get a snapback effect to whatever the underlying trend was.
So if this is solved in six weeks, you’re likely to get a major snapback in commodity price inflation that may have been oversold based on fears. So what we do is, we continue to allocate our portfolio towards the underlying trend. So we continue to use this opportunity to sell some of our deflationary exposures or disinflationary exposures. So we took this opportunity to sell utility stocks that have rallied so much, and we’ve been increasing commodity exposure, because whenever it is solved, there’s going to be a snapback towards the underlying trend.
Now, what happens if this does last six months or eight months, and many job losses occur and the economy does devolve into recessionary condition? Well, that’s when the overall portfolio construction is tasked with handling an event like that. So with our portfolio construction, our baseline is always a portfolio that’s balanced based on risk.
So if we had no idea what was going to happen tomorrow, we want to have an equal balance of risk to growth improving, growth declining, inflation improving or inflation declining. Those four scenarios can pretty much cover any economic outcome that you can think of. Some people like to define it as prosperity, recession, inflation or deflation, any economic event has to fall into into those buckets.
So we start with a portfolio that’s balanced, not knowing which of those four outcomes is going to happen. Then we use our economic indicators to tilt the portfolio to which of those buckets we think is the most probable, and then the overall portfolio still has balanced, which will cover you from from a shock.
So just to summarize, we allocate towards whatever the underlying trend is, which is growth down, inflation slightly up, but since the portfolio is constructed from a place of balance to begin with, if this does devolve into recession, we have an overweight allocation of treasuries and gold and things like that, that would balance out the situation getting materially worse.
JL: Yes, sure. No, that’s – it’s well put. And do you have any hot takes on the coronavirus here and whether this thing looks like it’s going to run its course? I mean, it seems right now that while it’s highly contagious, it doesn’t seem to be particularly more virulent than the seasonal flu. And the seasonal flu is not something anybody takes into account when building their portfolio or looking at long-term outlook. So what – do you have any takes on it there?
EB: Yes, that’s right. I have a few personal takes. I mean, the only thing I would – the actions that they’re taking are a little bit different than what they’re saying. What they’re doing seems pretty extreme. With that being said, I have no opinion as it pertains to my market outlook or my portfolio. I don’t let any of those things really sway anything of the portfolio decisions or economic outlook that I have. I sort of stick to the underlying trends and then use portfolio construction to hedge the rest.
But what I would say is that their actions seem a little bit more extreme than their words, which I guess makes sense. I mean, nobody wants to have a panic. But they’re – it seemed like they’re cleaning the cash and doing a lot of stuff over there that you don’t normally do with the standard flu.
JL: Sure, yes. Although it’s hard to know how much of that is just kind of the system they have in place there, the total lack of transparency, they can get away with it.
Okay, so turning back to the U.S. economy and then I think we should probably pivot over to some more practical portfolio stuff here.
JL: So just in terms of your – given your prognosis here, in terms of what you think it would take to actually solve some of these underlying issues in terms of over indebtedness and, of course, the more indebted countries like the U.S. and the developed world get, the less productive debt there is, they’re basically just servicing debt, it’s not leading to actual growth anymore. How do we break this cycle? What is it take kind of a good recessionary cleaning to break the cycle with all the terrible outcomes that individual suffer there? Is there a way that this can be unwound without total shocks to the system?
EB: Right. That’s the million-dollar question. And when we think about debt, we have to think what is debt in its truest form? I mean, debt is future consumption pulled into the present. So when we just look at the U.S., if we look at public sector and private sector debt, we have about $70 trillion worth of debt. And that doesn’t include off-balance sheet liabilities, like unfunded liabilities and things like that.
So we just have $70 trillion of public and private balance sheet debt. That’s debt that we consume today that we said we were going to pay tomorrow. And governments and Central banks for the past really 20 years have tried to solve a problem of too much debt with more debt. Everyone says the solution is fiscal spending. Well, how are we going to finance that fiscal spending? Is that going to be more debt? And debt is not always bad. I want to make that clear.
If you use debt for an investment that generates a stream of income to pay principal and interest, that would be a good use of debt that can actually increase the velocity of money and increase productivity over the long run. Unproductive debt is when you take on debt and consume something that does not pay a stream of income. So if you bought a T-shirt on your credit card, you’re going to have to divert future income to repay that debt.
In the economy, we just have too much unproductive debt that we have to divert today’s income to pay and we can’t solve the problem by taking on more debt. All you do is, you buy yourself two or three quarters of transitory growth. And then the problem becomes worse down the road. We saw this in the – with the 2018 tax cut. We pulled forward a lot of a growth. We got to 3% year-over-year and then, for a variety of reasons, we fell right back to trend at 2%.
EB: So in short, austerity is the only long-term solution, you sort of have to let the debt burn out. You have to get fiscal spending in order, you have to probably balance the deficit. I mean, we’re not even close to that. And there’s no prospect of that happening anytime soon. But the reason none of that’s ever going to happen is, because that causes pain in the here and now.
If we contracted government spending to the point where we were running a budget neutral, that would be a major hit to growth, considering that a significant portion of our recent economic growth has been all government spending. So in short, you do need some period of austerity throughout history. That’s the only thing that’s been proven to reset an economy. You can have things like currency devaluations, but that’s only been proven to work in smaller economies, because if you’re a major economy and you go down the road of currency devaluation, well, you lend yourself to a lot of competitive devaluation.
So euro might try and devalue their currency. Japan may try and devalue their currency. But if it’s a small country, like maybe Vietnam or Malaysia, the world may let them slide with a currency devaluation and no one’s going to devalue their currency, because Malaysia devalued theirs.
EB: But if the euro – if they tried to devalue their currency 20%, everyone else would try and try and respond. So, the short answer is, you need some period of austerity, but unfortunately, that comes with economic hardship in the present, which is why it’s unlikely to be solved.
So with that being said, you can extrapolate, well, what have we done in the past? We’ve taken on debt to solve a debt problem. What are we doing now? We’re taking on more debt to solve the debt problem. The result in the past was lower growth and lower interest rates. The path forward is probably lower growth and lower interest rates.
JL: Sure. And I guess, the political system that we’re in not only in the U.S., but really everywhere in the democratic world is, I think, particularly not helpful, because you’re dealing with, maybe if people were elected in 10-year terms, it would be a different story. But you’re talking about an election cycle, that’s four years in the case of President, just two years in the case of the House of Representatives, people are always running for office. And that means you can never say, well, we’re going to have to suck it up for a few years to get back to some kind of equilibrium. Because in the meantime, people feel the pain and they’ll throw you out of office and vote somebody else in. So the policymakers are not incentivized to make these kinds of long-term strategic decisions unfortunately?
EB: You’re spot on. That’s exactly right. And one thing I do want to make clear is that, there is a tremendous amount of economic hardship. That’s been a result of these policies. It’s just – it just happens in a way that’s almost a little bit more insidious in the fact that you can’t see it in everyday life. So one way to think about it is, I had a – I did an analysis, whereas if you take consumption and investment or what I would call core GDP, so it excludes government spending and exports.
From 1947 to 2007, consumption plus investment annualized 3.7%. growth. Over the last five years, it’s been 2.65%. So we’ve lost almost 100 basis points of trend growth. And if you extrapolate that curve forward had we continued to grow at the 3.7% trend, household income, median income would be almost $20,000 higher than where it is today.
So there has been a significant hollowing out of the lower-end of the income scale, where household income is 15%, 20%, 30% lower than it otherwise would have been, and that takes a tremendous toll on the real economy. It’s just not recognized in financial markets until it starts to creep up the ladder and impact corporations or wealthier individuals that may have a more outsized impact on consumption.
But we should make no mistake that people say, there’s no ramifications to running big deficits. We haven’t seen any problems yet. We have seen tremendous problems and those problems manifest themselves in zero interest rates, no savings, and a lack of ability for a majority of the country to see rising income growth. So there are negative consequences. But like you said, there’s no incentive to change the current paradigm.
JL: Sure. Just to not to harp on this point, but I mean, at least from what I’ve been seeing and reading it, while there really has been stagnant wage growth, other than maybe at the very bottom of the scale, household savings have been relatively good over this expansion period?
EB: So it has increased. There was a change year or two ago in the BEA calculation. I mean, it was – they were reporting it down at about 3%. They claim that they missed, I think, it was $500 billion of small business, cash or something along those lines. So they had a huge benchmark revision that took the rate from about 3%, like 7% or 8%.
JL: So is this just sort of like a technical – it might not represent real world conditions?
EB: Yes, a little bit. Yes. And just to give you some context, when I talk about the austerity of trying to pay down some of the debt in the 40s, I believe, the savings rate went to like 28% for like four or five years. So the inverse of savings is consumption. So if you have the savings rate rise to 25%, then consumption is going to fall. So in the context of, it’s better than 3%, but a healthy society has a lot of savings. Savings equals investment.
JL: Sure. Although yes, I guess, rates in the 40s were – yield in the 40s was a hell of a lot higher than it is right now. So…
EB: Well, after the depression, we actually had rates on the long bond that went pretty close to where we are.
JL: Where we are, yes.
EB: …and then after the 40s, it went up. Yes, that’s right.
JL: Yes. All right. Well, fascinating stuff. So I guess, we could probably keep on talking macro for like another five hours here.
EB: Yes, definitely.
JL: I’d love to get a little bit actionable here, if possible, to give listeners something to say sink their teeth into think about in terms of their own portfolio. What is your portfolio construction process look like? Practically speaking, how do you transform your assessment of key macro indicators and trends into specific asset class allocations? And I guess, it start with what your baseline allocation is? And, of course, I just want to remind listeners that nothing here is a recommendation for any specific person. Everybody has their own financial conditions, their own tolerance for risk and their own ability to tip bear pain. So, this is obviously a theoretical conversation here?
EB: Yes, and thank you for that. So, as I mentioned before, I’ll try and do it a little bit more succinctly. There’s two parts of the process. There’s the economic cycle research and then there’s the portfolio construction. So if I start with the portfolio construction, there’s only – we can break down economic events into four scenarios: prosperity, recession, inflation or deflation and different assets perform differently based on the environment.
So in a period of prosperity, stocks will probably do better than bonds. But in a period of inflation, perhaps gold and commodities will do better than bonds or a period of deflation. If we have a negative inflation rate, then a 2% yield is actually 3% in real terms, if it’s a negative 1% inflation rate.
So it all depends on what economic environment you’re going into, which will determine which asset class is going to perform the best. Ray Dalio and Bridgewater made the concept of a risk parity or an all-weather portfolio popular. And that meant was, if I had money, and I wanted to invest it over 10 years, and I wasn’t allowed to touch it ever, what would be the best allocation? Well, it wouldn’t be 100% stocks, because there are plenty of 10-year periods throughout history that stocks have had a negative return. Maybe it’s gold, maybe it’s commodities…
JL: Not only negative, but actually, I think I just saw somewhere that if you look back over the last 100 years, bonds have outperformed…
EB: Hey, it’s – that’s exactly right.
JL: ….stocks like 40, 45 of the 100.
EB: That’s exactly right. It’s exactly right. So, the basis is, if I have no idea what’s going to happen, I want to have an equal balance of risk to all scenarios. And given that stocks are a lot more volatile than bonds, that doesn’t mean allocate 25% to all four scenarios. It could be something like 60% bonds versus 30% stocks, that may be an allocation that that’s more balanced based on risk. It depends on what type of duration you have for your bond investments and what type of stocks you pick if they’re high beta stocks or defensive stocks.
But the point being is, your four basic scenarios, and if I had no idea what was going to happen, I want to have a balance of risks to all four scenarios. That’s the baseline portfolio and I use the all-weather portfolio as my baseline. A lot of members EPB Macro Research use something different is their baseline. But the important point is, you need a baseline of where to start if you had no idea what was going to happen. Then you look at the economy…
JL: And, of course, it also depends on somebody’s ability to, in other words, when do you need the money to be available theoretically?
EB: Totally, exactly…
JL: 30 years changes the calculus?
EB: Exactly, exactly. So then you look at the economy and we have a view on secular trends that we’ve talked about a lot. So what are the forces causing interest rates to go from 20% to 2%. Are those forces are going to continue? We look at how close is the economy to a recession and then we look at the direction of growth. So three different timeframes. The direction of growth being is growth going – GDP going from 4% to 2%, or 2% to 4%. Neither of those are recession, but the direction of growth is important.
So we have an outlook on growth across three different time durations. We also have an outlook on inflation. We have leading indicators of inflation. And then we say, “Okay, based on these four possible economic scenarios and based on our economic outlook, we do have an idea of what is probably going to happen, which economic bucket is most likely going to happen.”
We never know anything for sure and there’s always the possibility for Black Swan events like the coronavirus, so we don’t shift all our eggs into one basket based on the economic cycle view. But what we do is, we tilt the portfolio in the direction of the most probable scenario. So to give you an example, in 2019 or late 2018, we had leading indicators of growth turning down and we had leading indicators of inflation turning down. We also knew that we had secular conditions that were pointing down.
So we had a perfect scenario of growth and inflation, where with a high degree of conviction going to decline. So what did we do? We took what was a balanced allocation and we extended the duration by moving into some – an ETF like (EDV) as opposed to (TLT). TLT had a duration of roughly 17, where EDV is closer to like 23 or 24 [years].
JL: Is that just because it has more 30-year [treasuries], or does it even have…
EB: It was – it STRIPs. Yes, it was like STRIPs.
EB: In the EDV. So we would extend the duration and we took our commodity exposure or actually all the way to zero. And what that did is, it allowed the portfolio to make outsized gains by properly forecasting the right environment that the economy was going into. Had we been wrong? Of course, the portfolio would have underperformed the baseline, but we never would be in a situation where we get totally cleaned out, because the portfolio always has some balance and that keeps volatility low and it also keeps your ability to adjust your positioning, because the portfolio is not very volatile.
Everyone has an investment strategy of, I’m just going to stay long risk assets, because my time horizon is 50 years and stocks will go up over 50 years. That strategy works well when the market is going up and your dollar cost averaging. But there’s a lot of people who down 50% or 60%, may stop that strategy. And that’s the biggest mistake and that’s the biggest impact to long-term returns.
So we don’t want to be in a scenario where we’re down 40% or 50%. If we’re wrong on the direction that the economy is going into and we shift assets into the wrong bucket, the portfolio may take a couple of percent hit just based on what the baseline was. It still may rise in value, it’ll just underperform slightly.
So we have the four buckets. We have our economic view. We tilt them to the direction of what we think is going to happen. That could be more bonds, more commodities, more stocks, and then we just ride the cycle and we don’t – once we once we get the forecast correct, we don’t shift very often. There’s no incentive to buy and sell and move out of things every single month. We’ll keep the portfolio static for a few months. If in late 2018, we had the call on growth slowing correct, growth still slowing, and interest rates are still falling.
So there has been no reason to move in and out of these assets. And you could even get long-term capital gains on some of the investments if you hold it for a long period of time. So whenever we see another major inflection in growth and inflation is when we’ll make another major portfolio shift.
JL: Yes, sure. And so like – I’d love to get into some of the…
JL: …specifics here and drill down a little more. So starting with the equities side of things, are you generally shifting allocations within the equity side of the portfolio, either, let’s say, to a sector rotate between consumer cyclical and discretionary things, defensive and less defensive assets. And similarly, are you doing this on a global scale? So are you saying, trend growth in the U.S. is X, whereas trend growth in Europe as Y, and then in the emerging markets it’s Z and changing your allocations accordingly? Or is it really – what is really what you’re focusing on the balance between the major asset classes, stocks, bonds, commodities?
EB: So yes to both. It’s U.S.-centric. But, for example, before the coronavirus outbreak, we saw that leading indicators of global industrial growth returning higher, much more pronounced than U.S. indicators. So as a result, we shifted some of our equity exposure into (VXUS), which is an international ETF.
JL: Sure, it’s Vanguard.
EB: Yes, exactly. So the portfolio is always going to have SPY or some allocation to the S&P 500. And it’s always going to have probably TLT or some long duration Treasury. And that’s, as you mentioned, for the balance between asset classes. So what we’ll do is, we’ll have our allocation to SPY. And one of the things that we did throughout 2018 and 2019 was, we kept our allocation to SPY. But we also added an allocation of (XLU), which is Utilities, because the idea was, if growth is going to slow and inflation is going to slow, Utilities performed the best in that environment.
I don’t want to put 100% of my equity exposure in Utilities, but I want to have my allocation to the S&P and I want to just overweight that blend with Utilities make the basket a little bit more defensive. Utilities ended up knocking the cover off the ball, they’re up almost – we held them from the middle of 2018 until last month. They’re up almost 50%. And we just sold the Utilities…
JL: Yes, makes that 29% gain on the S&P 500 and 2019 look like the joke, right?
EB: Yes, yes. And it’s incremental, though.
EB: It’s not that we had 50% of our portfolio in XLU and we made 40% returns, it’s incrementally shifting the balance of the equity blend.
JL: It’s how you deliver alpha versus just…
EB: Exactly, exactly.
EB: So, the S&P  is a pretty defensive mix relative to other countries. A lot of countries are super overweight industrials and financials. The S&P has a lot of tech and staples and things like that. So…
JL: Right, although almost no Utilities?
EB: Yes, almost no Utilities.
JL: So highest on a percentage basis?
EB: Exactly 2% or 3% in Utilities. So you add another 2%, 3%, 4% or 5% of your portfolio into Utilities, and you create an environment where now you may have 6% or 8% of your total portfolio exposed to Utilities, then Utilities go up 40% or 50%. Incrementally, for the level of risk you took, that was a tremendous gain, considering that the portfolio was still hedged to all of the downside risks by having a massive allocation to Treasury bonds.
So you still get the upside in equities and you get more upside if you’re able to capture the sectors correctly. But you’re still totally hedged from the downside with allocations to gold and Treasury bonds.
JL: Sure. Yes.
EB: So yes. So we do both. We mainly focus on the construction between assets and it’s U.S. centric in that sense. But if we see indicators globally pick up more than the U.S. and that means that the dollar may go down, for example, then we would shift our equity exposure more international. But that whole equity basket, whether it’s Utilities or S&P or international, from a portfolio construction standpoint, that all falls under the category of equities and pairing equities off with other assets to mitigate the risk of all economic scenarios.
There’s a lot of deviation between sectors like XLU and (SPY) or VXUS during a bull market. But as they say, in a recession, a lot of these correlations just converge to one. So maybe they’ll be down less, but I would expect VXUS, even though it’s International and SPY to generally move in the same direction. It’d be unlikely to see VXUS down 50%, but the S&P up. So those all get grouped under the equity basket. And then we think about the portfolio from the standpoint of asset class balance.
JL: Yes, sure. And so just another question or two on the equity side. So you – when you want to move more defensive, so you can, of course, add something like the spider sector, Utilities, XLU, or something of that sort. What would you do in a case like, for example, and this is maybe not that theoretical right now.
But you’re looking at a totally flat yield curve or even inverted in some key places, and you’re saying, what, this is a long-term secular risk to financials. I would love to underweight financials and tamp down that SPY exposure to that sector. Is there a way that you’re able to do that? Do you short it or I don’t know, put an options overlay on a fund like (XLF)? How would you deal with that sort of scenario?
EB: Yes, that’s such a good question. And there’s a few ways that we do that. And that’s why we publish a long/short portfolio and the long-only portfolio…
JL: Right. That’s going to say, yes, you do have two portfolios…
EB: For that reason, exactly. So you’re spot on that financials, specifically regional banks, as opposed to large banks like JPMorgan (JPM). So something like (KRE), is something that we’ve been short since the middle of 2018 and they’ve performed terribly regional banks, and it’s been great for the – good for the portfolio. But KRE, as an investment, has been, I think, it’s at the same level it was in like December of 2016 or something like.
EB: And that’s just, because the secular trend of lower interest rates just crushes anybody that borrow short and lends long.
JL: Yes, it’s their whole business. They’re not like the big banks where they have like eight other lines of business to them.
EB: Yes, or 800 other lines of business…
EB: …exactly right. So in the long/short portfolio, what we would do is, we would have our allocation to SPY and say, “Okay, we have an allocation to SPY, instead of buying 10 of the 11 sectors and leaving out financials, we’ll buy our exposure to SPY and we’ll short KRE, and that way we’ll net out some of the exposure to financials. In a long-only portfolio…
JL: I guess, you’ve done – I guess, sorry, just not to interrupt…
EB: Yes, no.
JL: …but you’ve done a calculation there that, if it’s, let’s say, I don’t know, 12 basis points per each of the sectors that cost to borrow short would be better than, I guess, you don’t want to have to be rebalancing the sector funds right now, so?
EB: Right. And you can calculate it. So you literally just net out the exposure that you have or you can try and be outright short that sector if you think that it has a lot of headwinds and just be long, you could still be net – your portfolio can be net long, long the market, but have an outright short exposure to something like financials. As long as it’s in the context of a portfolio that’s generally balanced, that can be a huge alpha generation show.
JL: Sure. Yes.
EB: So it’s always in the context of generating the alpha. But yes, you’re spot on. So in our long-only portfolio, you can’t short any – anything and we try and we do everything with no leverage and no options leave all of that customization to everyone for their personal situation. But what we would do is just try and mitigate the risks of something like financials pulling down the S&P by overweighting some portion of fixed income or some part of the Treasury curve that would benefit equally.
So, if interest rates went up, financials would probably do well. So, you can have a similar exposure to short financials as long some part of the Treasury curve. It’s not exactly the same, but you try and replicate similar economic scenarios, thinking about prosperity, recession, inflation, deflation, how do each assets perform well? Well, if I think we’re going into a disinflation or deflation, I could short financials or buy Treasury bonds sort of can work the same?
JL: Yes. No, makes a lot of sense.
JL: Okay, cool. So moving over to the fixed income side of the ledger. So just curious here, are you essentially advocating holding only treasuries and then adjusting the durations based on, where the interest rate environment is at and where you see things headed, or any exposure to corporate debt or municipal debt or other sovereigns?
EB: So right now, we have only exposure to Treasury bonds. And most often, our fixed income exposure will only be Treasury bonds, because if we wanted to shift into corporates, we probably would express that in equities. It’s possible we have some corporates if there’s some good opportunities.
But going back to the overarching theme of prosperity, recession, inflation, deflation, if I want it to be in corporates, why do I want to be in corporates? Is it, because I think that we’re tilting more towards prosperity? And if that’s the case, would I want to be long equities or the same corporate? And if – and then that’s the case, I’d probably be long the equity, but it is possible that if I was – if the indicators were pointing towards a scenario where growth was going to improve or an area or risk assets were generally going to do better, you could add high-yield exposure or something along those lines.
But I wouldn’t – I would think of my corporate bonds a little bit more similar to my equities than I would my treasuries, because at the end of the day, they’re both fixed income. But what the treasuries are there to do is hedge against the recession-deflation scenario. So if I started to swap my treasuries for my corporates, I would lose a significant portion of that deflation or recession scenario. I would no longer be protected against something like that.
Typically, what I would do is, I’d keep the allocation to treasuries and move it more into equities. But when investors customize what they do based on the model portfolio, they can see a shift into equities and prefer to go into something like corporates as well. But on the fixed income side, it’s mostly treasuries, specifically for the purpose of hedging the deflation, growth slowing recession scenario.
JL: Sure. Yes. And I guess, it really does come down to what you’re looking for out of your portfolio. So like…
JL: …me personally, I really only view fixed income at this stage and not quite 40, I’ve got a while to go here before I’ll actually need any of this. It really is just to tamp down overall portfolio risk and be a truly non-correlated asset. And if you look at what corporate debt did in 2008 and 2009, it really performed terribly. I mean, it wasn’t down 60%….
JL: ….like an equities were, but there were places where it was down 30% and 40% and 50%. And that’s when it wasn’t going to 0% with all the companies that actually got wiped out during that period.
EB: Right, right.
JL: So, you’re – I think it makes sense to maybe broaden beyond treasuries. If you really are looking to have a core principle, that produces income for you on a regular basis. But if you’re not looking to produce income in the here in the now, it probably is, for most investors are necessary to go beyond treasuries in terms of just that non-correlated asset that behaves.
EB: I totally agree. And again, like you said, I’m so glad you brought that up. It really depends what you’re trying to get out of it. So everyone looks at treasuries and says, like, “You’re crazy. Who would buy a Treasury at 1.5%?” But not to mention the fact that the long bonds gone up like 20%, last year, something like that. So you can make gains in these things that are pretty significant.
But you’re not bought – at least for the context of the portfolio strategy that I run, you’re not buying the Treasury for the yield. No one’s buying the Treasury and say, I’m going to live off the 1.5%. You look at in Germany, like who’s buying these negative yielding bonds? What people have to remember is that, these sovereign bonds are the risk-free rate, and they’re the safest asset or what the system deems as the safest asset.
And treasuries, as long as the U.S. dollar is the world reserve currency, U.S. dollars in treasuries are like the lifeblood of the entire global financial system. So there’s a huge demand for treasuries as collateral. There’s a huge demand for treasuries as an asset that will perform well, if a recession happens or if deflation happens.
So someone who’s buying a German bond at negative 50 basis points, one, they could be buying it, because they have to, they need some sort of collateral that the system deems as safe against other loans or against a portfolio of derivatives they need, by regulation, some form of safe collateral. And in the world right now, based on the amount of derivative exposure and debt, there’s just a lack of safe assets, which is one reason why Treasury bonds are always so bid.
The number two is, if there’s a scenario where the economy tips into a recession, no one’s going to care about the 1.5% if that yield – it’s driven down to zero, because people are just going to need the safety of the asset. So it’s really the duration and the protection against deflation that you’re buying treasuries, not for – so much for the income associated with it. And I think that’s the point that you were alluding to.
EB: It’s tamping down volatility. It’s to protect your portfolio against a 50%, 60%, 70% decline scenario, which isn’t helpful to anyone, regardless of your investment time horizon. A lot of people use these compound interest calculators and say, “If I make 8% a year for the next 50 years, I’ll have X, but how many people’s return streams are 8% a year every year?” They usually come in, up 40, down 20, up 10, down…
JL: They’re lumpy, and if you were planning on retiring in January 2009, without logic, it may not have worked out.
EB: Exactly. And there’s a lot of experts on retirement planning out there that say, I think it was the article that I read that says, when you’re about 10 years before retirement, which is a lot earlier than most people start to think about this, the return on your portfolio becomes the most important factor. When you’re in your 20s, maybe the amount that you contribute is more important than the return.
But like you said, if you’re within 10 years of retirement, let’s say, in the equity market has a 50% decline, like in 2008, eventually you made it back. But you have to think you’re starting to now draw out money from the account at a point when it’s already down 50%. You could find yourself in a scenario down 60%, 70%, 80% capital, once you start including the withdraws, and it could take 10, 12, 15 years to get back to the break-even. So that’s a scenario you obviously have to protect against.
JL: Totally. Yes, and you’re starting with a much lower base at that point.
JL: Yes, absolutely. What would it take for you to have to move over that TIPS staying on the fixed income side of things?
EB: I have gotten a lot of questions from members on TIPS and I think TIPS are – can be a great part of the portfolio. Again, I typically stick with nominal treasuries and then the inverse of TIPS would be gold. So gold typically responds to changes in real interest rates or changes in TIP rates.
So if real rates were going to go lower, you could benefit it had you had bought TIPS. But the flipside is you could also benefit from buying gold, because if TIPS – if the rates fall, real rates fall, gold will go higher. So I see a lot of invest investors in EPB Macro Research have used TIPS to hedge against an inflation scenario.
Personally, I prefer a scenario of nominal treasuries in gold plus commodities for that inflation scenario, although TIPS can be used in place of gold perfectly well. But from my – I try and keep the portfolio construction process pretty simple. And I think that the combination of nominal treasuries gold and commodities works pretty well. But yes, TIPS totally weren’t.
JL: Sure. Yes, I guess, it depends again on what you actually need in real time. So because gold obviously doesn’t pay any yield. So if you’re just looking to protect your portfolio in down times…
EB: Unfortunately, I don’t think TIPS pay any yield anymore.
JL: Yes, they definitely don’t pay a real yield, but at least…
JL: …when you’re in TIPS, you’re getting something every month.
EB: Right. Yep, yep, totally.
JL: So that I guess could be one difference there?
EB: Yes, exactly. And I think you’re spot on with the point of, a lot of investors are income investors, meaning that they have this desire for their fixed expenses or their – or they only want to withdraw the dividend yield. But theoretically, what they really want is total return. I mean, nobody needs income they need total return, because if you bought an energy stock yielding 9%, but the principal went down 80%, like, yes, that’s no good for anybody. So, income is not really what people need, they need total return. And you could just liquidate 4% of your portfolio every year, if that’s the yield that you want, if you’re gaining in total return.
So when I think of the portfolio construction that I have, it’s a lot less geared around the nominal yield more around trying to protect against as many different economic scenarios as possible, while generating the highest total return, the lowest volatility, and then you can create an income stream off that.
But a lot of times, especially when the risk-free rate is so low, investors are so fixated on income, income income. They don’t realize that they’re getting pushed into vehicles that are incredibly risky. Just conceptually, if the risk-free rate on a 10-year is 1.5%, and a stock that’s yielding 8% or 9%, and if junk bonds not even yielding 9%, what does that tell you about the safety of that yield or the risks associated with that yield? There’s no free lunch. So a 9% yield in a 1.5%. environment. If there’s a downturn, we’ll see if that 9% yield is still a 9% yield.
JL: Sure. Yes. I mean, I think Buffett referred to this as return-free risk.
JL: So yes, but I mean, I think behaviorally and psychologically, it does. It makes sense that, people that have spent their entire lives saying, “Okay, I make X every single month, right? Because I get a paycheck. And then I spend why and I make sure that I’m bringing in more than that I’m spending.” You kind of want to keep that mindset in retirement also and say, Okay, I have $2 million in the portfolio. I’ve got a yield of 5%. That gives me $100,000 a year that I know I’m getting. Now, of course, you don’t know you’re getting it, because companies cut dividends and they default on debt…
JL: …and all kinds of other things happen. But I think it explains to a large part psychologically why that fixation happens, because of the swings in the underlying valuations of everything, stocks, bonds, commodities, people, like the idea of having an income stream and kind of mirrors with their paycheck that they collected every month.
So they could calculate out, okay, I could afford to take this many vacations and get a new car every five years, et cetera, because I know how much is coming in. But….
EB: Exactly. Yes, that’s – and the reason that the portfolio construction that we use is so powerful is, because that’s a great point that you bring up. And someone says, “Okay, I want 5% yield.” Well, there’s no way on earth in today’s environment, you’re going to get a blended 5% yield unless you’re massively tilted towards risk. So stocks or junk bonds, let’s say.
So you can do a Monte Carlo simulation, or you can test what’s the probability that my portfolio is going to succeed over the next 20 years with the current setup and a variety of different things are going to happen. And you can test and say, “Well, okay, well, nine out of 10 times, the portfolio is okay. But in the 10% chance that there’s a major market decline, I have a real problem here. And when you’re planning retirement, a one in 10 shot is kind of a lot. Most people don’t want to gamble with that kind of a risk.
But then you could say, if I have a balanced portfolio of bonds, stocks, gold and commodities, and I want to withdraw 5% per year, what’s the chance that the portfolio is going to last 10 years? And you can find a portfolio that has a 99% or a 99.5% chance of survival based on the portfolio construction and how much risk you want to take and how long you have until retirement? Because the portfolio balance is hedging you from all of those scenarios and you can just withdraw the money rather than putting it into risk, trying to live off that dividend income and putting yourself in a scenario where there you don’t have 100% chance of that portfolio making it 10 years.
JL: Yes, sure. Definitely. Okay, cool. So let’s move over to commodities here briefly, I guess, at least.
JL: So you seem to use gold as the main commodity exposure you have, correct, or are you mixing other things and also?
EB: So I use gold as a hedge against declining real interest rates? And gold is…
JL: Oh, right. Okay, sorry, you’re separating gold out of it.
EB: Separate gold.
EB: I don’t know if it’s like a permanent portfolio concept and instead of cash, you have commodities and there is the fourth…
EB: Yep. So sometimes, we have cash as well to…
JL: And that would just something like a short-term, like a fund like Bill or something like that short-term…
JL: Yes, yes, yes. Okay.
EB: Yes exactly. And when the Fed funds rate was 2.5% and leading indicators were saying that growth in inflation were declining. That could be a great investment for a period of time, especially like a year like 2018, where stocks were down, people say cash is trash well wasn’t yes, it was worked pretty well in some years. So there are a lot of benefits to cash. But yes, we typically have gold, Treasury, stocks and commodities.
And the gold is separated from the commodities, the gold is uncorrelated to basically everything hedges against the client and real interest rates. A lot of people think gold is an inflation hedge. Not exactly, because if inflation goes up 3%, but interest rates go up 4%, real rates are going up and gold probably won’t do that well?
So it’s really the interplay between inflation and interest rates that impacts gold. The commodities are more in there for a true inflationary scenario with less of an impact on what happens with interest rates. So yes, separating these two…
JL: Yes, there’s demand and consumption dynamics that don’t really apply to gold that due to actual commodities?
EB: Yes, gold is almost always in the portfolio. It’s in there for a variety of reasons. But one of them is certainly a alternative currency or a hedge against the dollar. I mean, a portfolio hedge against something dramatic happening. Those things are all hedged by some allocation of gold, as well as some more short-term decline in real interest rates.
So the Fed cutting rates to zero may benefit gold, but gold may also benefit if there’s some major fear about the U.S. dollar or something like that. So, there are a lot of different things that gold does that maybe commodities don’t, which is why I typically separate them into two baskets.
JL: Yes, sure. Absolutely. And then in terms of commodities exposure, what’s your general approach there?
EB: So given what I’m trying to do with commodities, which is hedge inflation, like, is if I have treasuries in the portfolio and I’m always going to have treasuries in the portfolio, but leading indicators of inflation are starting to pick up. That’s a scenario where Treasury bonds might not do so well, because rising inflation would probably cause yields to rise.
So I try and think of what am I trying to get exposure to that’ll hedge treasuries the most? Well, industrial, commodities like oil or copper or things like that are probably going to do best if there’s inflation upturn and that’s going to hedge my Treasury position the best.
So I try and find ETFs that are heavy in oil and things like that, that are very inflation sensitive. A lot of these commodity ETFs have precious metals as well with gold and silver and stuff. So you get a little bit extra there, two ETFs that I have in the portfolio are (GSG) and (DBC). An alternative to DBC, I think, is (PDBC), Paul D-B-C, which I think has no K-1, DBC has a K-1.
JL: Okay. I was going to say when they add an extra letter, it’s either something like no K-1 or else they’re managing the contango and some…
EB: Yes, and the commodity ETFs are tough, because they’re all kind of based on futures, which is I think something we’re talking about maybe earlier was, on the institutional side, you can get exposure to commodities futures and things like that. But when we’re trying to use a portfolio of ETFs, a lot of the commodity ETFs are our futures base, they deal with some of the roll and stuff like that. But the main point is…
JL: Although that can theoretically be beneficial if they’re in backwardation, but yes?
EB: Exactly. The main point is, what am I trying to hedge against with commodities? I’m not speculating on oil going to 80 or copper going to whatever. It’s more of, what are the indicators saying are the indicator suggesting that we’re going to have an upturn in inflation and it’s more of that, okay. An alternative inflation likely means that my Treasury Holdings are not going to do so well.
So what can I add that would boost the return of the portfolio in a scenario like that to offset some of the declines in the Treasury Holdings? Keeping in mind that any cyclical upturn in growth or inflation can’t get too far without running into the secular headwinds that are pushing the economy towards lower growth and lower inflation. So that’s the main concept behind commodities in the portfolio.
JL: Yes, sure. Okay. And then I guess, final question here, moving beyond these three major non-correlated asset classes. Any attempt to include other sorts of asset classes, what are generally referred to and institutional land as alternatives, different kinds of liquid alternatives or, I don’t know maybe private equity exposure. And anything of that sort? I guess, not in the publicly available. When – are you – you guys doing that kind of stuff on the hedge fund side?
EB: Yes. So we’re, like you said, when – with ETFs, we’re constrained to what we can with ETFs. But what’s great about this approach is that, when you have a really firm understanding of the portfolio construction process and what you’re trying to do, which is balance your risk to all four possible economic scenarios, you can start to look at your personal assets more holistically and figure out, Okay, where does maybe rental real estate fit into these four economic buckets? Is my rental real estate going to do well during prosperity?” Okay, great. Is my rental real estate going to have a mortgage? Well, having debt can sometimes be good if there’s inflation.
So maybe you can put rental real estate into a bucket of prosperity and inflation, maybe it covers those two buckets, then you figure, “Okay, how do I hedge against that scenario?” And you could start of look at everything you do in your personal assets through the prism of what four economic scenarios is this asset going to do well in and then look at all of my assets and figure out where’s my exposure? Where am I overweight?
A lot of people just have like a 60-40 portfolio without realizing that almost 80% or 90% of your risk is in that scenario is tied to the stock market. So have an idea of, of the volatility of the asset, which will give you an idea of how much of your portfolio you should put into it. What four economic scenarios it’s going to perform the best in and then what’s the balance of all of my assets?
At the hedge fund, we stick mainly to public markets. Things like Bitcoin, sometimes leak into the portfolio, depending on the environment, but it’s mainly public market…
JL: [Indiscernible] that actually.
EB: Yes. There’s public markets and futures, again, just trying to forecast the direction of growth and inflation and then what asset is going to perform the best in that scenario. But the extrapolations to your personal life outside of just public markets are endless.
There’s all kinds of different investments. There’s art. What does art perform well and well, maybe art is good in inflation, maybe art is terrible in deflation. You can just start to get an idea of where your balance of risk is. And I think a lot of people may be surprised with just how much risk is concentrated to the prosperity scenario, and how they’re underexposed to the deflation or recession scenario.
And not trying to articulate a view that those things are always going to happen. There could be a scenario, where leading indicators are turning higher, but there’s always the possibility that those things happen, they happen. In the past, every six to 10 years on average, it’s not a formula to suggest when the next one is going to happen. But it’s a way that you can be comfortable with the risk that you are taking.
There’s a lot of investors that got burned in 2008. And now they say, I don’t want any exposure to risk assets. But meanwhile, if they have some exposure to risk assets and you can articulate a way that they are hedged against a downturn scenario, even adding 10%, 15%, 20% of a portfolio in risk assets can be tremendously helpful.
JL: Yes, absolutely. Plus, I mean, I think if that whole period taught us anything, it’s that things that people perceived as there’s not being risk assets actually were as risky and prone to bubble type behavior as the riskiest stocks out there, so…
EB: Right. They’re – even…
JL: So on a working assumption, real estate just always went up, never went down. That was totally [indiscernible]
JL: …both corporate bond portfolios got eviscerated during that period.
EB: Yes. And you could look at the ton of assets out there today that people like we were even talking about earlier, will justify all day that that technology stock of our secular growers or – well, of course it’s going to be secular if we haven’t – if a company hasn’t faced a business cycle yet, then I guess, it’s secular. But that doesn’t mean tech stocks are bad and just having exposure to SPY means, I have a big exposure to technology.
So it doesn’t mean it’s bad. It’s just how much risk am I putting into one factor of exposure, which is equity market risk. And I think a lot of investors if they deconstructed their portfolio would realize, I got 80%, 90%, 95% of my portfolio in stock market risk, which is fine, if that’s your intention. But I think a lot of people may have that level of risk without realizing how out of balance they may be.
JL: Yes, no question about it. Anyway, Eric, this has been really awesome. I think it’s been a great conversation.
EB: No, this is great. And I just want to mention that for anyone that is interested in trying the service, we did fit the welcome process out with a welcome video and a process overview video, which I could – which takes you through the process of the economic indicators and the portfolio construction in a slide deck presentation. So there are more visuals and there’s obviously a two-week free trial.
So if you want you can join, look at the welcome video, look at the process overview video, decide for yourself if it’s something that may be valuable for you, and then come on board or cancel. But it is worth just going in there and checking out the videos, because with graphics, it makes it a little bit easier to understand.
JL: Yes, definitely, definitely. Anyway, Eric, I want to thank you for being so generous with your time today. Keep up the great work and best of luck with EPB Macro Research and your other jobs and investing in everything.
EB: Thanks so much. I can’t wait to do it, again.
JL: Yes, absolutely. You will definitely be back on the show sooner rather than later.
JL: All right. Great, thank you.
The Interview · Featuring Michael Gayed and Michael Venuto
With coronavirus wreaking havoc worldwide, it’s a perilous time to be in the market. Businesses around the world are shutting down. Equities are plummeting as investors flee to safety, and central banks, desperate to contain the financial contagion, are reaching into their arsenal to do whatever it takes. Today, Michael Gayed, portfolio manager at the ATAC Rotation Fund, sits down with Michael Venuto, chief investment officer of Toroso Investments, and explores the question that’s on everyone’s mind: Is this a fleeting moment of panic, or are we seeing the conditions for a true doomsday scenario? The pair place the massive sell-off in context, explore whether ETFs are making the violent price swings worse, and take a deep dive into the plumbing of the markets. Filmed on March 10, 2020, in New York.
Sir James Michael “Jimmy” Goldsmith (26 February 1933 18 July 1997) was an Anglo-French financier. Towards the end of his life, he became a magazine publisher and a politician. In 1994, he was elected to represent France as a Member of the European Parliament and he subsequently founded the short-lived eurosceptic Referendum Party in Britain.
In this interview, Sir Goldsmith discusses the ramifications of free-trade agreements that were about to take place in 1994 (GATT), as you can retrospectively see, he correctly predicted many of the things that happened after that.
This is an episode of Off The Chain with host Anthony “Pomp” Pompliano and guest, Raoul Pal, the CEO of Real Vision Group.