Moving From an Income-Driven to a Credit-Driven Cycle | Bob Elliott

Summary

Hidden Forces Podcast Summary Episode: Moving From an Income-Driven to a Credit-Driven Cycle | Bob Elliott
Host: Demetri Kofinas
Guest: Bob Elliott, Co-founder and CEO of Unlimited
Release Date: October 7, 2024

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Introduction In this enlightening episode of Hidden Forces, host Demetri Kofinas engages with Bob Elliott, the co-founder and CEO of Unlimited, a forward-thinking financial services firm leveraging machine learning to mirror index returns of alternative investments. The discussion delves deep into the Federal Reserve's strategic shift from combating inflation to nurturing the labor market through significant interest rate cuts. Additionally, the conversation explores the broader macroeconomic landscape, including the implications of labor strikes, the evolving dynamics of household balance sheets, and the intricate state of China's economy.

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1. The Dock Workers Strike and Labor Market Dynamics Timestamp: [02:43] - [05:10]

The episode kicks off with a timely discussion on the newly initiated dock workers strike amidst the recording date of October 1st. Demetri probes into the strike's potential economic ramifications, particularly its impact on inflation and the labor market.

Bob Elliott observes, “There is still a relatively tight labor market because the only way that people are striking is if they have sufficient confidence that they're going to be able to extract meaningful concessions” ([03:22]). He underscores that such labor actions are indicative of continued elevated wage inflation, which poses challenges to the Federal Reserve's disinflationary efforts.

Elliott further notes the resilience in global supply chains compared to previous years, suggesting that while the strike has immediate effects, the economy possesses enough cushion to absorb these disruptions without derailing the broader disinflation narrative ([05:10]).

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2. The Federal Reserve’s Policy Shift: From Inflation to Labor Support Timestamp: [06:07] - [08:02]

Demetri shifts the focus to what he identifies as the primary macroeconomic narrative—the Federal Reserve’s reversal in policy stance. Elliott elaborates on this pivotal change, highlighting its uniqueness in the current economic climate.

Bob Elliott states, “This easing cycle comes at a time when you're not seeing a meaningful deterioration in economic conditions” ([06:44]). He contrasts the current environment with past scenarios where central banks typically eased policies in response to economic downturns. Instead, the Fed is proactively lowering interest rates in a robust economy, a move Elliot finds atypical and potentially precarious.

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3. Income-Driven vs. Credit-Driven Business Cycles Timestamp: [08:41] - [12:40]

The conversation transitions into Elliott's framework distinguishing between income-driven and credit-driven economic cycles. He emphasizes that the recent economic expansion is primarily fueled by income growth rather than borrowing.

Elliott explains, “Income growth has been a meaningful driver... people are getting higher nominal wages... driving higher wage growth and income growth” ([10:38]). This dynamic sustains nominal GDP growth independently of credit expansion, challenging traditional credit-centric economic models.

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4. Household Balance Sheets and Economic Health Timestamp: [12:53] - [16:39]

Delving deeper, Elliott assesses the current state of household finances. He presents a nuanced view, highlighting a "K-shaped" recovery where median households are thriving while younger cohorts face financial strain.

Bob Elliott notes, “The median household in the United States is doing pretty well” ([15:52]). However, he cautions that this success is uneven across different demographics, with younger and asset-less households experiencing greater economic challenges.

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5. The Fed's Aggressive Interest Rate Cuts: Analysis and Consequences Timestamp: [17:05] - [22:02]

A critical analysis of the Fed’s substantial 50 basis point interest rate cut follows. Elliott reflects on his initial expectations versus the actual policy shift.

Elliott admits, “...the Fed rewrote their reaction function. After years of a reaction function where they were very sensitive and slow moving, they basically said we're going to be proactive and accommodative” ([18:54]). He raises concerns that such proactive easing in a strong economy might reignite inflationary pressures, a scenario he believes the Fed underestimates.

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6. Political Influences and the Potential Impact of a Trump Administration Timestamp: [35:15] - [40:56]

Demetri introduces a speculative discussion on how a potential Trump 2.0 administration could influence economic policies, particularly tariffs and immigration.

Bob Elliott emphasizes caution, stating, “From an investor's perspective, you want to be careful to, let's say, extrapolate campaign rhetoric into policy establishment” ([35:15]). However, he explores scenarios where aggressive tariffs and immigration crackdowns could significantly impact inflation and labor supply, potentially squeezing economic growth and elevating prices in key sectors like housing and agriculture.

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7. The State of China's Economy and Global Implications Timestamp: [40:56] - [50:02]

A substantial portion of the discussion focuses on China's economic struggles related to debt deleveraging and real estate sector challenges. Elliott characterizes China’s current economic predicament as akin to a depression driven by systemic debt issues.

Elliott asserts, “China's experiencing a debt deleveraging... depression” ([40:56]). He critiques China's asset-focused stimulus measures as insufficient and misaligned with the fundamental need for economic and fiscal support to genuinely revitalize household demand and restructure bad debts.

He warns that without comprehensive policy shifts towards economic easing and debt restructuring, China’s efforts may lead to disappointing outcomes with limited global repercussions beyond commodity and oil prices.

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8. Asset Allocation Strategies in the Current Environment Timestamp: [50:02] - [53:19]

Concluding the episode, Elliott offers strategic insights into asset allocation amidst the prevailing economic conditions. He advocates for a balanced approach that leverages hard assets while mitigating downside risks.

Bob Elliott recommends, “Gold outperforms bonds in about 50% of equity drawdowns” ([52:12]). He suggests that investors consider increasing allocations to gold alongside traditional bonds to enhance portfolio resilience. While acknowledging the allure of gold miners, Elliott prefers direct investment in gold for its predictable performance and historical reliability as an inflation hedge and alternative store of value.

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Conclusion This episode of Hidden Forces provides a comprehensive analysis of the Federal Reserve's unprecedented policy shift, its implications for the broader economy, and strategic investment considerations in a transitioning economic landscape. Bob Elliott's insights shed light on the intricate balance between income growth and credit dynamics, the precariousness of current monetary policies, and the critical state of China's economic health. For investors seeking to navigate these complexities, Elliott's recommendations on asset allocation offer valuable guidance for enhancing portfolio robustness in uncertain times.

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Notable Quotes

1. Bob Elliott on Tight Labor Markets:
   “There is still a relatively tight labor market because the only way that people are striking is if they have sufficient confidence that they're going to be able to extract meaningful concessions” ([03:22]).

2. On the Fed’s Proactive Easing:
   “This easing cycle comes at a time when you're not seeing a meaningful deterioration in economic conditions” ([06:44]).

3. Explaining Income-Driven Growth:
   “Income growth has been a meaningful driver... people are getting higher nominal wages... driving higher wage growth and income growth” ([10:38]).

4. Assessing the Median Household:
   “The median household in the United States is doing pretty well” ([15:52]).

5. On the Fed Rewriting Its Reaction Function:
   “After years of a reaction function where they were very sensitive and slow moving, they basically said we're going to be proactive and accommodative” ([18:54]).

6. China’s Economic Deleveraging:
   “China's experiencing a debt deleveraging... depression” ([40:56]).

7. Asset Allocation Advice:
   “Gold outperforms bonds in about 50% of equity drawdowns” ([52:12]).

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Further Resources For more insights from Bob Elliott and other financial thought leaders, visit Unlimited or follow Bob on Twitter @obbyunlimited. To explore additional episodes of Hidden Forces, subscribe at HiddenForcesIO Podcasts.

Transcript

[Demetri Kofinas]

What's up everybody? My name is Demetri Kofinas and you're listening to Hidden Forces, a podcast that inspires investors, entrepreneurs and everyday citizens to challenge consensus narratives and learn how to think critically about the systems of power shaping our world. My guest in this episode of Hidden Forces is Bob Elliott, the co founder and CEO of Unlimited, a financial services firm that uses machine learning to create products that replicate the index returns of alternative investment. I asked Bob back on the podcast today to discuss the big macroeconomic story that everyone's been talking about, which is the Fed's pivot from fighting inflation to supporting the labor market by cutting interest rates into an apparently strong economy. Bob and I discuss what sorts of consequences this new policy stance may have, especially if consumers and businesses seek to take on more debt, moving us from what has largely been an income driven business cycle to a credit driven one, potentially adding rocket fuel to an otherwise already strong economy. We also discussed the economic conditions in China, the importance of the recently announced stimulus, and how China's economy matters not only to investors in China, but to those with no direct exposure to the country's economy or stock market. There is no premium portion to this week's episode, which gives you the perfect excuse to go back through our library of content and catch up on anything you've missed or re listen to some of our great conversations on on this and related topics. The easiest way to do that is at HiddenForces IO Podcasts where you can select from a number of content categories. If you want to learn more about our genius community and how to participate in our live Q&As with people like Bob. Or join one of our many dinners that are hosted in the private dining rooms of some of the finest restaurants in the world, attended by some of the world's most successful investors, policymakers and thought leaders in a variety of disciplines and fields, you can do that at hiddenforces IO. Subscribe. Lastly, because this conversation deals with investing, I want to make absolutely clear that nothing I say on this podcast can or should be viewed as financial advice. All opinions expressed by me and my guests are solely our own opinions and should not be relied upon as the basis of for financial decisions. And with that, please enjoy this excellent and informative conversation with my guest, Bob Elliot. Bob Elliot, welcome back to Hidden Forces.

[Bob Elliott]

Thanks so much for having me.

[Demetri Kofinas]

It's great having you on, Bob. I don't remember when you were on last time. I feel like it was more than a year ago, might have been a couple years ago and you were making the same case that you've been making now, and you were very early on the bullish economy call. And we're going to get into that. But before we do, the news that we're dealing with today is the dock workers strike that commenced. We're actually recording this on Tuesday, October 1st. Just given the fact that this is obviously so important for the economy and obviously has huge ramifications for inflation, I'd love to know your thoughts on it. Again, it's just happening now, we don't know where the negotiations are, et cetera. But what are your thoughts about the significance of this strike?

[Bob Elliott]

I'd say that you could look at it through two lenses. The first is as an indication of what's going on with labor markets. And anytime you see these strike dynamics that emerge, each one feels like it has something to do specific with that set of circumstances, the dock worker strike or the Boeing strike or other ones. But what that highlights in general is that there is still a relatively tight labor market because the only way that people are striking is if they have, you know, sufficient confidence that they're going to be able to extract meaningful concessions out of, you know, the corporations that they're striking against. And so I think that's an important component to not see this strike as an individual thing, but as part of a larger dynamic around, you know, continued elevated wage inflation in the US Economy. And then when it comes to the specifics related to shipping, you know, supply chain disruptions were a primary driver of the inflationary dynamics that we saw. Not the only driver, but an important driver. And a big part of the disinflation that has occurred that the Fed and other central banks have been able to ease in response to has been as a function of global goods and traded goods prices coming down a lot. And the various disruptions that might intercede that could cause that disinflation or deflation to change course, at least stabilize or even go higher, could create a challenge for the Fed and other central banks around the disinflation narrative that has been so important to them in the last six or 12 months.

[Demetri Kofinas]

So my thinking on this has been because it's an election year and because the President has the ability to intercede and create a cooling off period of 90 days, that this is not going to be an immediate problem. Do you agree with that? And how important is it to have a view on this acute issue at the ports?

[Bob Elliott]

I think the main thing I'd say is that for most international traded or shipped goods, there is more resiliency in the supply chain today than there was 6, 12, 24 months ago. And as a result of that, whether there's a cooling off period or just the negotiations that occur over the course of the next several weeks that finally get this resolved, there's probably enough cushion. Similarly, there's enough cushion that elevated shipping costs and time to delivery related to what's going on in the Red Sea is manageable at this point. But I think the overarching dynamic here is it doesn't take so many of these things to eventually build up and start to create strain on the system, particularly if they're persistent. And that's the real risk, is less any individual moment and more a persistence of these supply chain challenges.

[Demetri Kofinas]

All right, so let's get to the reason that I brought you on here today. The big macroeconomic story is obviously not this, at least not yet. And it isn't the ongoing difficulties facing the Chinese economy as policymakers there work to deleverage and reduce the relative size of the real estate sector. The big macroeconomic story is the Fed and its regime reversal from fighting inflation by raising the cost of capital to supporting the labor market, beginning with an aggressive 50 basis point cut in the middle of last month. How important is this policy change in your view?

[Bob Elliott]

Well, I think the Fed is an important leader in a global dynamic that we're seeing, which is a shift pretty much of all central banks in one form or another towards an easing dynamic. So taking advantage of the disinflationary conditions that have existed over the course of the last year or two and now transitioning to an easing cycle. The thing that's very different about this easing cycle relative to many easing cycles in the past is that it comes at a time when you're not seeing a meaningful deterioration in economic conditions. Typically, central banks are responsive to deteriorating economic conditions, not engaging in easing policy, essentially leading or before economic conditions deteriorate. If you scan across what's going on in the overall economy, world GDP growth is at 3 to 3.5%. It's been that way for a few years. Global stocks are at all time highs, credit spreads are at essentially all time lows. And so you have a situation where economies are doing pretty well and central banks are easing into economies doing very well. And that sort of over easy policy is unusual relative to what we typically see.

[Demetri Kofinas]

I do want to ask you about that because this has been, with the exception of the bank of Japan, I think most major central banks, certainly the ECB and now also the People's bank of China and the government there are doing more to try and stimulate their economy. So we'll have a chance to talk about that. But as I mentioned at the top, you were really early in putting forward a framework for understanding the structural drivers of the post Covid recovery cycle. And this led you to be bullish where many other investors and commentators were bearish on the US Economy and the stock market. What is it that you feel other analysts and commentators got and continue to get wrong when making forecasts about U.S. economic growth?

[Bob Elliott]

Well, I think most of us who have been doing this for the last few decades have, have experienced primarily credit driven cycles and sort of the classic textbook business cycle dynamic is a credit driven one. And so if that's your lens, you would see rise in interest rates, a relatively meaningful rise in interest rates, and say that rise in interest rates would likely curtail credit sufficiently to create a negative economic environment. And the reality is that what we've seen over the course of the last couple of years in the post Covid period is not a credit driven cycle. In fact, borrowing, whether it's in the US or Europe or other developed economies, borrowing by households and businesses, has basically remained at recession like levels. And nonetheless, despite that fact, these economies have continued to power forward. And the reason why they power forward is because income growth has been a meaningful driver. Now, income growth is very confusing to people because you say where does income growth come from? And the answer is spending growth. And then people say where does the spending growth come from? And the answer is income growth. And that confuses people because there isn't an obvious source of that dynamic occurring. But the reality of what's happening is simply that people are getting higher nominal wages, in part as a function of the elevated inflation that we saw and tight labor markets than driving higher wage growth and income growth. And that spending, one person's spending is another person's income and that continues to drive forward overall nominal gdp despite the fact that interest rates are elevated, despite the fact that money growth has actually been negative over the course of a couple of years. All of that can operate and continue without the need for borrowing, low interest rates or money creation to occur.

[Demetri Kofinas]

So I've heard you say that the velocity of money is financing this expansion. What do you mean by that?

[Bob Elliott]

Well, if you think about a traditional sort of monetarist perspective, they'd say nominal GDP is driven in part by the velocity of money, the total quantity of money, and then the velocity of that money. Now that's a little confusing because in many ways velocity is just an outcome Right. You can observe nominal gdp, you can observe the quantity of money, and then velocity just essentially is the factor that fills it in. And it's hard to understand what exactly is velocity or predict velocity. And so I don't think it's a good concept to think about independently. What all it's doing though, all that figure is doing is it's trying to capture a basic concept which is how much are people taking an income and then taking that and spending it? Right. That's all velocity is. And how often are they continuing to spend it until the point it becomes dead money, which is the put on deposit in a bank and then put as a reserve asset, that's when it's dead money. And if you look at something like, let's say less credit developed economies, a traditional emerging market economy, let's say, is almost always a velocity driven economy because the amount of money outstanding is relatively constant. And then what you see there is that money moves around the economy at different paces, dependent upon exactly what the sort of animal spirits are, depending on what income is and what spending is. And so you don't even necessarily need to have changes in money to create changes in nominal gdp. Or even a better example is if you look at the US economy back in the 1800s, where essentially we had to fix money supply because we were on the gold standard and relatively underdeveloped credit systems, you had big swings, huge swings, in fact, in terms of economic activity, despite the fact that money was basically a constant figure. And all of that goes to how much are people making that choice between earning income and spending it. And to the extent that they choose to spend that income that they're earning, that creates increases in velocity.

[Demetri Kofinas]

So I'd like to dig in a bit deeper on how structurally sound this economy is. Obviously, household balance sheets and the state of households is very important. What is the condition of households right now and how do we evaluate that?

[Bob Elliott]

Well, I think you want to look at households both from a cash flow perspective and then from a balance sheet perspective. From a cash flow perspective, nominal wage growth is running at 5, 6, 7% in terms of total nominal wage compensation. Recent figures that were released revised that figure up, highlighting the fact that wage growth is even stronger than many expected. When you have nominal wage growth at 5, 6, 7%, that's pretty strong. That's stronger than basically we've seen in many decades. And that's fueling the ability to continue to spend on a nominal basis at 5 or 6% a year, which is pretty strong in comparison to what the overall productive capacity of the economy is, which is closer to maybe 2%, maybe a little bit over 2%, depending on how you think about it. And so from that perspective, households are, from a cash flow perspective, are actually quite strong because they're earning income, they're spending that income, and that's turning around and is becoming other households income, which is supporting a continuation of spending. It's not a spiral, it's just a dynamic, right, that that can continue to happen. And unlike previous expansions, for instance, during the 2006-8 credit boom, there isn't a creation of debt that is used to finance that spending. And so there isn't the buildup of liabilities that are unsustainable. And that's where we go to the balance sheet perspective. Household balance sheets in aggregate have never been better. The amount of wealth that households have relative to the liabilities, their net worths are at all time highs and have expanded, you know, about 4x over the course of the last couple of decades. That's a great outcome from a nominal perspective. And they've also expanded in real terms. So it's not just on a nominal basis. I think the challenge is that that's super bifurcated in the economy where there are asset owners, particularly boomers who own houses or Gen X, or millennials, older millennials who own houses and have taken out low interest rate liabilities, or have 60% of people who own their house, don't have essentially any meaningful liability. So that segment of the population is doing great. 401s at all time highs, houses at all time highs, low debts, they're doing great. The problem is that particularly younger cohorts who don't own assets and are more on the early stage borrowing side of things, things are a lot tougher for them. And so that from that perspective, you know, you have to think about the overall economy is doing pretty well. Overall households are doing pretty well. But there is that sort of K shaped situation that's going on.

[Demetri Kofinas]

That's actually a good point. So when we're talking about household wealth, are we talking about the average or the median household? And how important is it that a significant percentage of households don't own assets and have actually seen their financial situations worsen as asset prices have risen and as the cost of capital has gone up in recent years?

[Bob Elliott]

Right. Well, I think it's important to recognize the median household in the United States is in pretty good shape. The median household owns their home, has a 401k, is invested in the stock market, has A job. The median household probably has two people working a job and is experiencing a nominal income growth that's around 5 or 6%. So the median household in the United States is doing pretty well. But that doesn't mean there isn't pain for those households that are particularly younger households or younger individuals that, that don't have houses 401ks and are increasingly feeling some pain related to the unemployment, which has been the rise in unemployment, which has been more concentrated in younger cohorts rather than older cohorts so far, yeah.

[Demetri Kofinas]

I mean, to your point, the very conditions that create strong household balance sheets, which are rising asset prices, are also negative for those that I don't actually own them. So it becomes a compounding problem in the other direction, especially since interest rates have gone up. So speaking of interest rates, is it fair to say that you were expecting the Fed not to cut as aggressively as it did a few weeks ago? And if so, why? What do you think that you got wrong there?

[Bob Elliott]

Well, I think in general, if you were to plot me or you in any economy that for the last couple of years was growing at or above potential growth, with low unemployment relative to history, stocks at all time highs, spreads at all time lows, and inflation still modestly above target, and interest rates that have basically been the same for the last couple of years, what would you say, given that set of circumstances, would be the next policy move by a central bank? You'd say maybe nothing, maybe even a little tighter. And that's essentially the dynamic that we were in and the dynamic that the Fed was facing when they made their policy decision. So in the world of macro betting, to be clear, you always are betting the odds. The odds are not certainty by any stretch. And so looking at that suite of dynamics, the odds favored the Fed being less easy than the few hundred basis point of cuts that were priced in. Now, that was wrong in the sense of the Fed came in and basically said we're going to cut. And not only are we going to cut, I think the most important thing is the cuts were not because they thought that the economy was meaningfully deteriorating. That would have been, let's say, that would have been a disagreement about the macroeconomic projections, the future. Instead, the Fed rewrote their reaction function. So after years of a reaction function where they were very sensitive and slow moving, they basically said we're going to be proactive and accommodative. That's a change in the reaction function. It wouldn't necessarily align with what the macroeconomic conditions are. But that's the decision they made. And when you're trading markets, you trade the markets and the policies that exist, not the ones that you think are the best policies to implement.

[Demetri Kofinas]

That's a great point. Actually. This was something that James Aiken and I spoke about in our most recent episode in trying to understand why the Fed didn't just begin cutting, but also cut so aggressively. And one of the theories obviously, is that they're actually looking to get ahead of those long and variable lags. Another theory is that there's a political motivation to it. And another theory is that Jay Powell, paradoxically or ironically, maybe that's a better way to describe it because he was late in raising, he wanted to be early in cutting. How do you explain this decision, and does it even matter? Do we need to try to understand it?

[Bob Elliott]

Yeah, I mean, I think my first reaction, part of what is important as a macroeconomic investor is pushing away whatever feelings of good and bad policy that you think should be done. And for whatever reason, when a credible, I should say, when a credible central banker says, here's the policy we're going to pursue, or here's the reaction function that we're going to pursue, you take that as a given kind of regardless of what the reasoning is. Now, it can be important to understand the reasoning to some extent because to the extent that the inputs of that that are going into that reasoning are shifting, you want to be ahead of that or at least understand it. I think many people will attribute these policy shift or change in the reaction function is probably the best way to describe it. They'll attribute it to things like politics or the desire to not have a, you know, a certain candidate in office or not. You know, having done this for many years and having engaged with folks at the Fed for many years, I do not believe that there is a political aspect driving this decision making. Fundamentally, I would take Chairman Paladin's word. He believes inflation is beat. And if he believes that inflation is beat, he believes he can be proactively accommodative in order to support the economy and labor markets without the consequences of elevated inflation. And if that's the case, then a proactive easing reaction function makes a lot of sense. But I think that's the basic sticking point, which is that he sees inflation as beat. And I think those folks like myself look at what's going on and say probably not. And if anything, being accommodative makes it less likely that inflation is beat ahead rather than more likely.

[Demetri Kofinas]

So what is the risk that by having cut as early as they have that they end up having to chase down inflation again.

[Bob Elliott]

Yeah. I think the answer is if you cut interest rates into a relatively strong economy in a late cycle environment, if you look back through history, it's pretty clear what typically occurs, which is that you reignite inflationary pressures. Now, I don't think we're going to quickly go the ways of the late 1970s.

[Demetri Kofinas]

Is that the precedent for what is happening today? If we had to reach for a historical example, would that be it? Would it be the Burns Fed?

[Bob Elliott]

Yeah, I mean, I think that in a less extreme context. Right. We are probably not going to have oil prices rise by several multiples as a consequence of a conflict in the Middle East.

[Demetri Kofinas]

We have a conflict and we've had a conflict. Well, today it's funny, you and I are talking and I've gotten so desensitized to these threats by Iran or Hezbollah or whatever, but Iran apparently again, Iran probably put out a communication to the US Government saying hey, we're going to shoot a ballistic missile over, so please shoot it down. Of course that's not how it comes out in the press, but we are in the midst of a year long conflict in the Middle east and it's actually shocking. There are so many things that have been shocking in the last few years about the reaction of financial markets to what would seem to be very scary risky situations that we find ourselves in.

[Bob Elliott]

Yeah, that's for sure. And I think from the Fed's perspective, when you look at what's going on and you say what is sort of the risk scenario is easing too quickly into an economy that's already relatively strong in a global environment where inflationary pressures are emergent, structural inflationary pressures are emergent, and where global conflict, which global conflict, is inflationary, full stop. For a variety of reasons, both because it hurts, deglobalization, and also just conflict in general is about creating things and destroying them. And so that all is inflationary. That's the risky path that could easily play out and would lead to inflation re accelerating or being on the upside to the Fed's scenario. Chairman Powell doesn't believe. I don't know if he believes or not. I can't look into his mind, but certainly his rhetoric indicates that they're not meaningfully concerned about that scenario relative to the inflationary pressures that they're seeing and relative to the beneficial aspects of easing to support and stimulate the economy at this stage. So that's the trade off that they're making.

[Demetri Kofinas]

Yeah, he probably Forgot how much he hated seeing those memes of himself all over the Internet in front of a podium holding it as money's flying out, saying money printer go brr. I was told, I think by Nick Timiraos that Powell really hated that I might be wrong. I don't want to actually say that. I feel like someone told me that. I don't know if that person was in a position to know or not. But you've actually made the point also that if businesses and consumers start taking out debt again, that this could be like adding rocket fuel to this economy. In terms of a timeline, in terms of lags, what should people be thinking about in terms of what that looks like over time? If businesses and consumers do get pretty aggressive because they haven't been again, a The shock of 2008 and the experience that came with has made people I think more risk averse in taking out debt. But suppose that this changes. What could that mean?

[Bob Elliott]

Well, my guess is that we're just at the start of re acceleration of borrowing and part of typically in a late cycle environment, people have already borrowed a lot. If you look at businesses in the late 90s, if you look at households in 2006 and 7 and 8 were already borrowing at secularly high pace and today the exact opposite is true. They're basically borrowing both households and businesses are borrowing in line with recessionary type levels. And so what you have is a pretty good economy. You have interest rates that are coming down and you have low borrowing that's occurred and you have reasons to borrow and invest. On the corporate side, the capex related to, let's say technological innovation and onshoring, there's clearly a significant amount of capex that is projected to occur related to those activities. So far most of that capex has been financed through cash flow and that can only go so far. And it may be attractive to take advantage of the overall strength in the economic conditions to step on the gas in terms of that capex and invest even more to try and get ahead. And so there I think there's really incentives for businesses to borrow, particularly as rates are coming down. And on the household side, to be frank, housing demand is the primary way in which households borrow. It has been extraordinarily depressed for years as a function of higher interest rates and higher prices. And the reality is that families at some point need to buy houses, people need to buy houses. The current run rate of home sales is well below what sort of the natural rate of home sales is. You know, people have kids, people you Know, get married, people get divorced. You know, those are all the sort of standard activities and there's only so long those things can exist before people need to start buying homes. And so odds are what will happen is the affordability problem can get solved through innovation in the structuring of the mortgages. You know, my guess is the five one arm that no one that has been left for dead for 15 years is going to be the hot mortgage product in the spring as interest rates are coming down.

[Demetri Kofinas]

Yeah, that's for people that didn't catch that. Bob's talking about adjustable rate mortgages which were of course the source of enormous risk heading into the 2008 financial crisis as those rates adjusted upwards and people were unable to pay their mortgages and lost their homes.

[Bob Elliott]

I was even pitched recently at interest only mortgage which I thought, wow, I thought had gone the way of the dinosaurs. And talking to a financial advisor, he said no. He's got all his clients in these great interest only mortgages. He's refinancing everyone into floater interest only mortgages in his book because they're saving a bundle. And that is such a good example. If the demand is there, the financial innovation will come. And with wage growth rising at 5 or 6% and the interest on mortgages being tax deductible, very important to remember from a US context then actually even mortgage rates at 5 or 6 aren't that bad. Right. Because the post tax effective cost is meaningfully lower than what that 5 or 6% rack rate is. And if you can on top of it make it interest only, you start to get to something that looks affordable or the flip side is you start to get a lot of demand that's going to raise prices at.

[Demetri Kofinas]

So is that basically the benefit of getting an interest only mortgage as opposed to renting, which is it's a tax arbitrage because on its face it doesn't really make any sense. You're basically renting the house.

[Bob Elliott]

That's right. I mean you get the tax advantage and then of course you get the asset appreciation to the extent that you believe that there's asset appreciation. And of course I think for a lot of folks the, let's say the quality of the living experience is different in an apartment versus in a standalone home. And so that's the combination of things that drives people to buy homes. At least in the United States context it may be different, it is different elsewhere, but that's the real advantage.

[Demetri Kofinas]

Let me ask something else, Bob. Let's talk a little bit about the Stock market and its reaction, or lack thereof, to the tightening cycle. What explains that? Should the Fed have done more on the balance sheet side if we wanted to see a reduction in stock prices and risk assets overall, and would that have even been desirable, do you think?

[Bob Elliott]

From the Fed's perspective, the financial conditions are not particularly tight. I understand that the Fed and various people will say financial conditions are tight, but when you have stocks rapidly appreciating and you have spreads at all time lows, financial conditions are not tight. And so the outcome that they got was a function of the fact that they didn't do much or they weren't particularly aggressive in selling financial assets, which would have had knock on effects through the financial markets and in particular the stock market, and left those assets to continue to appreciate while claiming that they were worried about inflation and raising interest rates. And so those two levers, the interest rate lever, because of the fact that the income growth is the primary driver of economic expansion, the interest rate lever wasn't all that effective. And the asset selling lever, which would have been much more effective or at least much more direct in terms of helping create a drag on economic activity, they just didn't do enough. Relative to all the other pressures, which is frankly strong nominal gdp, strong financial conditions, low spreads, et cetera, all reflective of the fact that the economy was pretty strong, just overwhelmed what the Fed was doing, which was a relatively modest contraction in money supply relative to the other pressures that were in place.

[Demetri Kofinas]

Do you think this is a lost opportunity to try and further normalize the balance sheet? Is this also evidence that they don't really care to normalize it?

[Bob Elliott]

The balance sheet is probably best thought about as a combination of a tool of monetary policy and a macroprudential liquidity mechanism. And on the macroprudential liquidity mechanism, we went from a period of time back pre financial crisis where there probably wasn't enough liquidity available for the banking system to today. Banking reserves and liquidity for banks is in pretty good shape.

[Demetri Kofinas]

I mean, they had to change from a corridor to a floor system in part because of the size of the balance sheet and the ampleness of reserves.

[Bob Elliott]

That's exactly right. And part of the story is if all the reserves are captured by one particular bank or a small number of banks, you can have unequal distribution. And so part of the dynamic there is you essentially have to have a lot more liquidity so that you can have the vast majority of banks have a strong liquid position. And so it might look like the balance sheet is essentially too big relative to the liquidity needs, the sort of net liquidity needs of the system. But only now, sort of at this level, can the Fed, I think, basically say that the vast majority of banks have the liquidity that they need. And so that kind of puts a floor on what's going on with the balance sheet, that the balance sheet's going to be big relative to where it was pre financial crisis. That's all there is to it. And then within that, they can use the balance sheet on the margin to manage monetary policy, which I think their goal here or their belief is that interest rates are a much more effective tool at managing monetary policy than then our balance sheet shifts. I don't think that that's true. Obviously the quantities and sizes matter in terms of exactly what you're talking about. But in a highly financialized economy, financial asset prices are a meaningful driver of economic activity and essentially the choice for households and businesses between saving and spending. And so it seems to me that the balance sheet would have been a much more effective tool than interest rates. But they don't see the balance sheet as a meaningful effective tool of monetary policy and so simply have discarded that lever, particularly from a tightening side.

[Demetri Kofinas]

It sounds like maybe I need to also. And we need to stop using the term normalization because it implies that somehow the current conditions are not normal and what they really are is they're just not what they were 20 years ago. And maybe we all need to get over it.

[Bob Elliott]

Well, certainly if you think about interest rates, a lot of folks think about normalization. Folks who started their careers in 2010 think normal is zero and think normalization is moving close to zero. And I think normalization is in the framing of the beholders. Talk to someone who was trading in the 70s and they think 5% interest rates are extraordinarily low. And so I think that part of the story there is just getting away from normal, as you say, and getting towards a concept of what is appropriate given economic conditions. And that is much more an empirical assessment than it is a theoretical assessment.

[Demetri Kofinas]

Yeah, it was quite a treat to get earned income or interest income on the money I held in deposit in the last few years. I'm going to miss it as it goes away. Let's switch now to politics. I mentioned that in my conversation with James Aiken. We talked about some of the possible theories behind Powell's and the FOMC's decision to cut by 50 basis points, and that one of them was possibly political. I should have specified that even though when I asked him that question. I did also imply that maybe Powell wasn't particularly excited to have Trump back in office because we know he had a contentious relationship with him. But actually, Aitken's response was interesting and one I hadn't thought of, which was that the 50 basis point cut could have been political in the sense that Powell knows that the next cut comes around the time of the election, that he may not be in a position to be able to do it. So maybe he front loaded some of those cuts. But furthermore, he made another interesting point. And this is what I want to ask you because you've also, I think, suggested something similar in your tweets, which is that under a Trump administration, Jay Powell may be cutting a lot less, not because he has a problem with Donald Trump, but because Donald Trump's policies, as they have been enunciated, are inflationary. So I'm curious to know what your thoughts are about a Trump 2.0 administration. If Donald Trump were to come into office, how do you handicap that as an investor and what type of economy and what impact would that have on financial markets, do you think? Based on what we know he has said he wants to do, I think.

[Bob Elliott]

From an investor's perspective, you want to be careful to, let's say, extrapolate campaign rhetoric into policy establishment. And so I'm always hesitant to do too much in terms of projection of what's going on. And in general, if you look back through time, even something as sort of concrete as the Trump tax cuts, like you could have waited until it was pretty obvious that it was going to happen before taking bets on who would be the winners and the losers as a function of that and generated alpha.

[Demetri Kofinas]

Let's also tell people what I mean off the top of my head, I wish I'd actually written it down, but I think I'm pretty sure 10% across the board tariffs is something that he has said that he wants to do. And am I right in thinking that he wants to do 50% on China.

[Bob Elliott]

Or is that 60% on China? Yeah, 60%.

[Demetri Kofinas]

And so that seems highly implausible. So I'm with you. But anyway, I wanted to just tell our listeners what some of the numbers are that I have in my head.

[Bob Elliott]

Yeah, and that's right. And that level of tariffs would put us at a level of tariffs that we haven't seen in a hundred years. Yeah, I would say the post World War II economies. But to be clear, it's not an unheard of level of tariffs in the sense of there are definitely plenty of Economies that hold tariffs at that level or goods in the US Context that are tariffed at that level. So it's not an impossibility. And in fact, President Biden implemented a series of tariffs at that level as well, de minimis in terms of size, but implemented various tariffs at that level as well. And so I think we're in a story. The idea of moving 10% tariffs on all goods, all imported goods, and 60% on China would likely have several points of CPI inflation as a consequence, and that would be relatively substantial impact. And the reason why that is is that prices on those goods would likely immediately rise to reflect the tariff cost, since in most cases imported goods do not have domestic production capabilities. Particularly if you think about lower value added imported goods, I don't know, like laundry baskets and, you know, plastic toys and stuff like that. Big base, right. Big pants, all that stuff. None of that stuff's produced or very little of it's produced in America. And there's very little supply chains that are created. So you'd almost directly see a pass through effect of it. As you start to get to more sophisticated goods, let's say automobiles and things like that, there's more ability to generate supply, although because companies generally have productive capacity in line with their demand, it's challenging to spin up additional supply. So a reasonable assumption is a pretty much direct pass through effect of the tariffs on prices. The other thing that I think is probably could be even more impactful than tariffs with a prospective Trump administration is a crackdown on unauthorized workers in the United States. Whether there's obviously a lot of challenges with the idea of deporting tens of millions of people, but even bringing a share of those people out of the workforce for fear of being caught as an unauthorized worker could create a significant constraint on labor supply. Remember, labor supply, and in particular immigration driven labor supply has been the critical thing bringing down wage growth and bringing down inflationary pressures in the US economy over the course of the last 18 months. That's already slowed considerably with the Biden administration. I don't say closing of the border, but more meaningfully limiting border crossings. And if we were to not only limit border crossings or immigration, but start to reverse the supply effect from particularly unauthorized workers in lower income cohorts, that could create quite a squeeze on that segment of the labor market.

[Demetri Kofinas]

I mean, besides general service industry, it would have a huge impact on home construction, the cost of home construction, and I believe also food prices as well. Right. I mean, immigrants are very, very important in the agricultural supply chain. Are they not.

[Bob Elliott]

Yeah, that's right. You know, there's a wide variety of services related activities that immigrants have come in and worked in those industries. And if you look at sort of where the easing has been, the greatest easing in the labor markets, it's been at, for instance, non high school educated workers, which, you know, not all immigrants are in that cohort, but a substantial portion of unauthorized workers are in that cohort. And so by reversing that, you're essentially reversing out the supply pressure, the disinflationary supply pressure that's been so critical in that segment of the market that had seen some of the highest wage growth up until we saw a significant increase in immigration in the last couple years.

[Demetri Kofinas]

So Bob, before I ask you my last question, which is about asset allocation, I have one more question or series of questions on China's economy. So as I mentioned at the top, and it's not a shock to people, the Chinese economy has been struggling largely because of a deliberate set of policy choices by policymakers in China to bring down leverage in the real estate sector and reduce its importance to gdp. We've now seen some efforts at stimulus that have been announced. Where do things stand economically in China in your view? And how does the performance of the Chinese economy matter to non Chinese investors or to those without investments in China?

[Bob Elliott]

For most investors, I would emphasize the thing that matters for China from a global investors perspective is mostly their economic activity in the second and third order, consequences on major developed economies of that economic activity and on things like oil prices and commodity prices, Chinese markets, some people invest in them offshore, but they're not a huge portion of many investors asset allocation or book. And so when you're thinking about China from a global investor's perspective, really focusing on the economy and if you look at what's going on there, China's experiencing a debt deleveraging. A more provocative way of describing it is a depression. And the important thing to recognize there, depression is not a term that is meant to denote a particular rate of GDP growth. It's meant to denote a type of macroeconomic dynamic which is where debt deleveraging occurs and where an easing of monetary policy is insufficient to create a cyclical bottom and re acceleration of the economy. And in those circumstances, so the U.S. for instance, in 2008, it's a perfect example where interest rates went to zero and in October of 2008 was like interest rates are low, time to borrow and re accelerate this economy. Because you had that deleveraging dynamic that was overwhelming and that Particularly occurs in an environment where asset prices are falling rapidly, which creates disincentive to borrow and buy assets or house, you know, invest in houses or balance sheet impairment. Right, exactly, balance sheet impairment. And so that's basically what's going on in China. And you know, for many years Chinese authorities did nothing related to this or by and large nothing that was meaningful in response to it. And really since the start of the year, I'd say they're going through what I'd say is a very typical policymaker experience related to a deleveraging, which is the first thing they did early in the year was very, very sentiment oriented, which is they said, stocks are down, we're going to get the national team to buy stocks. And stocks went up. And then they quickly realized that that actually doesn't do anything. And the reason why that doesn't do anything is Chinese households don't really own stocks. And who cares if stocks are up or down. The problem is debts are super high and people want to delever. And so that created pain. And then what we've seen here is round two is what I describe as an asset focused stimulus, not an economic focused stimulus, which is again more support to the equity market to get a pop, and then also trying to support housing market in a variety of ways. But almost all of it is supply oriented. And the problem in China is not supply. Anyone who wants a loan can get a loan in China. The problem is nobody wants to borrow and nobody wants to buy assets because assets are going down rapidly and the level of prices is still, I mean, Shanghai, Beijing, the level of house prices relative to incomes are still the highest in the world by a mile. So if you look at that, you'd say it's not good value and it's falling. Why would I ever lever up and take advantage of that credit supply that's going on? And that essentially will likely create disappointment. This round will likely be disappointing because it's still too sentiment oriented and too asset oriented and probably not big enough is the reality. There's a 10. The valuation of empty apartments in China is $10 trillion. And so China says we're going to give our banks $150 billion. And you're like, yes, but the problem is orders of magnitude bigger than that. Chinese housing is the world's biggest asset class. It's easy to forget that in the west or not even realize that in the west it is the world's biggest asset class, the world's biggest asset, some of the world's biggest stimulus and credit restructuring. To deal with that problem when the prices are falling. And so odds are this will be another source of disappointment. And it's only until we get to economic easing, meaningful economic easing, particularly fiscal easing to support households to support their demand, and a restructuring of the bad assets and the bad debts to basically reprice the assets at a fair market value. Those two steps need to happen in order to actually get this resolved. But we're not there yet.

[Demetri Kofinas]

So Chinese real estate is what, 25% of China's economy?

[Bob Elliott]

Yeah. And interestingly, it's a huge portion of economic activity. And interestingly, because the policymakers are so focused on the prices, what they said was that they're actually going to limit construction. Now, what a silly way to deal with this problem, which is you have an economic problem and they're so focused on the prices, they're going to actually limit the actual activity. They're going to limit the GDP associated with this activity. Right. And the incomes and all of that. And while that might help the asset prices, it's actually a drag on economic activity, which is a little counterintuitive to what their goals are.

[Demetri Kofinas]

I mean, their goal seems to be a controlled deleveraging of the real estate market so that they can also shrink it as a relative size of the economy. Do you have some sense, is anyone out there doing this work, trying to understand what a reasonable timeframe is in which they can achieve something like this?

[Bob Elliott]

Well, they can achieve it, I'd say, relatively quickly, is the reality.

[Demetri Kofinas]

Well, without significantly impairing their economy. Right. I mean, that's the balancing act, isn't it?

[Bob Elliott]

I think it's less of a balancing act than folks may realize. And the reason why that is is that the vast majority of the debt and the assets, it's all domestically oriented. It's all domestically denominated. The borrowing is in domestic currency, and so you could restructure the debts relatively quickly. A simple example is if what you did is you issued special bonds financed by the central bank printing money, and used that capital to buy all the bad properties that are out there and you just put it into an asset management corporation and took it off the balance sheet of everyone, it would support prices, deal with the bad debts, and frankly, take some supply off the market.

[Demetri Kofinas]

And improve the financial conditions of, you know, the bank, Chinese citizen, and the Chinese citizen.

[Bob Elliott]

And your only risk there, your primary risk there, is that it could be incrementally inflationary. But if what you're doing is engaging in an inflationary activity against a big deflationary force, Right, Done. Well, you know, those two things balance out and you don't get a big acceleration of inflation. And the wild thing about China is that they have done this before. And the root of the big state owned banks today are asset management corporations coming out of the Asian financial crisis. And there they had policymakers that actually managed that pretty well, creating those asset management corporations, moving the bad assets off, restructuring it, recapitalizing the banks, and frankly teeing up the Chinese economy for what was 20 years of some of the most unbridled success, some of the best success that has ever existed in modern economic history. And so they have the skill sets to do it, they have the techniques to do it. They're not constrained macroeconomically. So the fact that they're not doing it, it's a policy decision, not a consequence of circumstance.

[Demetri Kofinas]

Right. And we have seen them pivot. We saw Xi Jinping pivot, most famously during COVID from the COVID lockdown. So it's conceivable that they could change policy like that and that would have enormous impact on the global economy, wouldn't it?

[Bob Elliott]

I think that's certainly possible. And I want to emphasize the fact that they're shifting. They've gone from a period where they did essentially nothing and let the deleveraging run to a period where they're starting to stimulate. Here is better than nothing. And I think as part of that broader arc globally, it's a bit of a different flavor, but part of the broader arc globally that we're transitioning from relatively tight money and monetary conditions relative to economic conditions to a period of easier monetary conditions relative to economic conditions. And China is certainly part of it. It's just that there's a fair amount more to go. I think the main question is, and this is the challenge in trading any Chinese assets is this is a political decision. And I think that's part of it. One of the things that has been a big shift in the Chinese economic management has been basically all the Western trained economic technocrats that sat in all the various areas like the PBOC and other government agencies, all of them have been silent. They're all gone. The only people making economic decisions are political figures and political figures without meaningful Western economic experience. And so it's going to take a political decision to change, basically implement what is the necessary economic policy. And we know where the political decisions are made with only one person.

[Demetri Kofinas]

Bob, as I said, my last question for you is about asset allocation. What type of asset allocation is favorable in this environment that both gives investors exposure to upside, but also gives them some downside protection as well.

[Bob Elliott]

Well, I think if you look back through time and you look at sort of over easy type macroeconomic environments, it typically favors hard assets. Gold, commodities, stocks you can think about in many ways as a hard asset since you know, it's tied to real economic cash flows and nominal gdp and it disfavors things like bonds in particular as essentially what's happening here is that by simulating and supporting nominal GDP growth, you're eroding the value of money relative to stuff on a forward looking basis. And so that's the basic story. So when you look at most investors portfolios, most investors are overweight stocks and in general probably will do okay given that circumstance, although they might be overweight very, very highly valued stocks, at least in the US Whereas an over easy policy generally favors more of the unloved sectors of the market that catch up with the high performers as liquidity kind of goes everywhere rather than is concentrated in a very small number of performers. But they're probably overweight bonds in terms of assets that might protect them from whatever downside circumstance could plausibly occur. And so that's where I think for most investors, gold becomes a more compelling option. And people snicker at gold and they say it's not yielding and things like that. But if you just look at the empirics, gold first of all is the best performing asset, major asset class in the last couple of years and this year included. And second of all, gold outperforms bonds in about 50% of equity drawdown. So just if you put aside the snickering that it's a barbarous relic and start to think about just what its economic properties are, its return properties are, you should be holding as much gold and risk terms as you hold bonds in a standard portfolio.

[Demetri Kofinas]

Well, for those investors who are concerned about the fact that it doesn't yield anything, what about gold miners, which are I believe relatively cheap right now? Do you have a view on that at all?

[Bob Elliott]

Gold miners? I don't trade gold miners and it's because I don't have any particular expertise in the companies. When you start to buy the miners, you're basically meaningfully exposed to the cost side of the equation. And those costs can move for reasons that have nothing to do with what's happening with the top line. And so in general, I like holding the asset directly. Its return properties are relatively well known. Its use as a alternative money has existed for thousands of years. And so it's a pretty well known asset in terms of how it's likely to perform in various circumstances. And I particularly emphasize that to the extent that you believe that there is a rising risk of conflict, gold very directly outperforms bonds in those environments, both because of the inflation hedge properties as well as the fact that it serves as an alternative money for investors that would otherwise be overweight dollars that might be antagonistic to U.S. interests.

[Demetri Kofinas]

Bob, it was great having you back on, man. For people who want to follow you and learn more about you and your work, how can they do that?

[Bob Elliott]

Yeah, yeah. So for people interested in various macroeconomic takes on an ongoing basis, check me out on Twitter Obby Unlimited. I also have a YouTube channel where I'm clipping my various media appearances and do a monthly macro outlook that gets posted there as well. So which people seem to like or at least they're watching. And so definitely check me out there. It's obiunlimited. My day job is actually having been in the hedge fund industry for for many years, I've sort of taken a different angle at it, which is to build technology that allows me to look over the shoulder of the biggest hedge fund managers in the world and then take that understanding and package it into financial products that are available for everyone. So hedge fund returns available for everyone at lower cost and people can learn more about [e-mail] Fantastic.

[Demetri Kofinas]

And for everyone listening, there is no premium portion of today's episode we which gives you the perfect excuse to go back through our library and catch up on anything you've missed where we listen to some of our great conversations on this and related topics. The easiest way to do that is at HiddenForces IO Podcasts, where you can select from a number of content categories or on the Related tab to this week's Episode page. Thank you so much for coming back on Bob. This was great.

[Bob Elliott]

Thanks so much for having me.

[Demetri Kofinas]

If you want to listen in on the rest of today's conversation, head over to HiddenForces IO, subscribe and join our Premium feed. If you want to join in on the conversation and become a member of the Hidden Forces Genius community, you can also do that through our subscriber page. Today's episode was produced by me and edited by Stylianos Nicolaou. For more episodes, you can check out our website at HiddenForces, you can follow me on Twitter at kofinas and you can email me at info@hiddenforcesio. As always, thanks for listening. We'll see you next time.