The Macro "Endgame": Growth, Gold, Deflation, and the Dollar (w/Lyn Alden and Eric Basmajian)
LYN ALDEN: So I'm Lyn Alden, and I'm here with Eric Basmajian of EPB Macro Research. And we're going to talk about a couple different things related to his strategy and about the global macro environment at the current time. So, Eric, welcome to Real Vision. ERIC BASMAJIAN: Thanks. Thanks for having me. LYN ALDEN: Yeah, so I'm looking forward to this conversation because we've had a lot of interactions in the past about some of the things happening on the economy, and so I figured it's great that we're able to talk about it. So why don't we start by you giving the viewers some idea of your background and what your overall process is as part of your research? ERIC BASMAJIAN: Sure. So I'll start with a
quick background for those that are unfamiliar. I studied economics at NYU. While I was there, basically my last year I worked at Morgan Stanley full time on the wealth-management team. I then jumped straight to the buy side. I worked for a quant fund in Midtown. It was good experience. Learned some programming, some statistics.
Economics was always my passion. So I was still studying economics the whole time I was there, basically reading everything that was available in terms of academic research on debt and the impacts there. I have a big focus on long-term trends. That's obviously where I ran into the work of Lacy Hunt, who's been highly influential to my thinking. I also studied quite heavily Geoffrey Moore who used more of a leading-indicator approach to the business cycle. So using some of those statistical techniques that I was working with at the fund, I was creating some of my own composite indicators, taking five or six or seven different data points and combining them into one aggregate indicator. So basically what I do was I was taking
the long-term trends, which you know sometimes don't change for 20, 30, 40 years. And it could be valuable for some people to just ride that trend for a long time, but having experience on the buy side with performance that gets marked to market, it's just not realistic for most people to stay on such a long-term trend like that. So I tried to bridge that gap by staying focused on those long-term trends but also using a leading-indicator approach to pick up the cyclicality within some of those longer-term trends. And I left the fund, started publishing my own work, and that's kind of how EPB Macro Research got started. This is going to be the fifth year, and that's kind of the 30,000-foot overview of what I do. My views now are that the long-term trends, the impacts of debt and other structural forces like demographics, are pulling us towards weaker and weaker growth. But at the same time, the leading indicators are pointing higher,
which gives us some short-term momentum to the upside. And that can make allocating a little bit trickier than when the trends are aligned. And I'm sure we'll have a chance to discuss those two things, but that's sort of where I shake out on the long term and short term. LYN ALDEN: Yeah, perfect. I think that kind of sets the stage to go in a couple different
directions. I guess to start with, if we focus on some of those leading indicators, can you give the people a sense of what sort of indicators you focus on, and what are they kind of telling you about the next, say, six months or so? Or what is the timeline you're looking at when you say shorter term? ERIC BASMAJIAN: Sure. So for me, short term is exactly what you said. So 6 to 12 months is sort of the range that I'm talking about with the short term. Anything shorter than that is a little bit too noisy for me. So most of the leading indicators that I'm focused on are very heavily centered in the manufacturing sector. That's the most volatile sector, much more than the services economy. And I believe a lot of people overlook the manufacturing sector, especially in the United States, because they say it's such a small percentage of the economy. It doesn't really matter.
But the volatility of the manufacturing sector is so much -- RAOUL PAL: Hi, I’m Raoul Pal. Sorry to interrupt your video - I know it’s a pain in the ass, but look, I want to tell you something important because I can tell that you really want to learn about what’s going in financial markets and understand the global economy in these complicated times. That’s what we do at Real Vision. So this YouTube channel is a small fraction of what we actually do. You should really come over to realvision.com and see the 20 or so videos a week that we produce
of this kind of quality of content, the deep analysis and understanding of the world around us. So, if you click on the link below or go to realvision.com, it costs you $1. I don’t think you can afford to be without it. ERIC BASMAJIAN: overlook the manufacturing sector, especially in the United States, because they say it's such a small percentage of the economy. It doesn't really matter. than the services sector that it actually still drives the ebbs and flows of GDP. And my big process is following the rate of change or the direction of growth in growth and inflation. So those shorter-term manufacturing sectors pick up different types of production
backlogs or new orders to inventory, things like that. And this situation with COVID sort of caused a lot of these indicators to go haywire. And what I mean by that is when the lockdown happened, we saw consumption stop for a brief period of time. But then what we saw
was consumption shift very dramatically towards things that could be consumed at home, lots of durable goods. And that caught basically every supplier totally off guard, and what we saw was inventories get depleted to basically the lowest level we've ever seen as a percentage of GDP. And then as a result, all of the suppliers had to restock all of that inventory. And we started to see a classic economic sequence come through all the leading indicators where commodity prices, specifically lesser traded ones-- not really like copper or oil but some of the industrial metals really start to pick up. New order to inventory ratios started to explode. And we sort of began this manufacturing restocking rebound that's happening globally, and it's causing a strong upturn in both the rate of growth and inflation, which is a little confusing to people because they look at maybe the labor market that's still really impaired or just the partial shutdowns in some parts, and they say how is the economy improving? But that manufacturing process can be so strong, and that's what we're seeing now.
And it's still ongoing, and for the next couple of months, I think that the bias for both growth and inflation are still going to be higher. And that's counter to my long-term view, which makes the allocation process slightly more difficult, avoiding or underweighting things like long-term Treasuries that may benefit from some of the long-term trends. So those are kind of the indicators that I look at, mostly manufacturing based. And right now, they're still off to the upside. LYN ALDEN: Yeah, so if you focus on those indicators and then how they pertain to market prices, what sort of correlations or causations have you found? So say you're accurate about all these, the growth and the inflation.
How do you translate that into an investment portfolio, and how do you kind of monitor risk or monitor if those trends are working out? ERIC BASMAJIAN: Sure. So I start with a balanced framework, and this can be applied to any sort of balanced framework. I gravitate to the all-weather framework combination of long-term bonds, intermediate-term bonds, stocks, gold, and commodities, and that's sort of where I approach every situation. I come to the table with a balanced framework. Then I tilt in a direction that's most aligned
with the long-term trend. So I'm always going to have a bias towards the Treasury allocation or the growth-slowing allocation, which tends to favor Treasuries over things like commodities. But then I also am cognizant of the short-term trends. So when the short-term trends are pointing
higher, you'd want to be doing the opposite, basically. You'd want to be overweight or starting to overweight commodities, risk assets, things that perform well when growth is increasing, and those are the correlations that I find. So when growth is increasing, specifically nominal growth, equities perform basically the best out of all those assets, commodities the second best.
And within the equity sector, you want to be tilted more towards the cyclical equities, the small caps, the industrials, things that benefit from that manufacturing upturn. So I come to the table with a balanced framework. I have a long-term bias to my long-term views. Then I take the shorter-term indicators and I sort of tilt or overlay that on top. And
right now with the indicators pointing higher, tilted more heavily towards commodities than I normally would be, and my stock allocation has small caps where it's typically more large-cap defensive as a balanced framework. LYN ALDEN: And how are you seeing banks fitting into that? Because I saw some interesting charts the other day showing that banks and energy have been key underperformers for a while now. So a lot of people focus, for example, on growth versus value, but value can be further separated into defensive value versus cyclical value, and it's really been in that cyclical value where there's been a lot of underperformance. And there's some kind of a recent rebound there. We see them kind of up ticking,
especially ever since we got some of the vaccine announcements a few months ago. So how do you see the energy and financial sectors kind of playing out over the next six months or maybe longer term? ERIC BASMAJIAN: So I'm a little bit more cautious on the banks. I mean, I've had a long-term short position in specifically the regional banks since 2018, which has worked out quite well. But I've pared that back to basically the smallest allocation I could have on the short side because these cyclical trends-- when there's an upturn, the bias for long-term interest rates is higher. So the bias for the yield curve is steeper. That's going to tend to benefit the banks.
But I'm cautious on the banks because they're fighting such a secular trend of rock bottom both short-term interest rates and long-term interest rates that I'm aware that the short-term trends can benefit them. But I think that the banks, specifically the regional banks-- I don't really deal too much with the large banks that have much more diversified revenue streams. Focusing mostly on the smaller banks that are mostly just spread plays. And I'm still cautious there, but I've pared back the short position to as small as I can because of the cyclical upturn. So once I see the indicators start to roll over again and I would think that long-term interest rates would start to have downward pressure, I would increase that short position again because I think the long-term trends are very powerful against the banks. Looking to things like Japan and Europe, I think that our smaller banks will go the way of Japan and Europe. Larger banks, totally different story. Energy is interesting as well. I don't like the energy sector.
I prefer to just be exposed to the commodities at this point. The energy sector, high debt. The business model of the energy sector, specifically the frackers, is one that makes me cautious. Have to spend a lot of capital to build a
well that just depletes, and then you have to spend more capital on another well. And that business model, to me, is tough because it's so reliant on constantly issuing new debt or new equity that during these upturns, I prefer to just be exposed to the actual commodity price versus the energy sector. So I am still cautious on those too. I haven't added those as long despite the upturn. I've added just mainly small caps in general on a broad basis instead of going down into the sector layer. LYN ALDEN: Yeah, I agree on the frackers. That's
been an area I've been avoiding. For my energy plays, I'm mainly focusing on the ones that have kind of longer-life assets and the few out there that actually have pretty strong balance sheets-- some of the international ones, for example. I guess speaking of international, so we're both based in the US, and so we have a somewhat US- centric view. I know in my work I also carried out to focus on other sort of countries because those can give us kind of a different secular trends, which could be helpful in a portfolio. So what extent do
you incorporate international markets into your framework, and do you have any allocations that are kind of important for those at the moment? ERIC BASMAJIAN: Sure. So my work internationally is much more broad. You've done some brilliant work on individual countries. I focused mainly on US and then ex-US, or if I was to break it down a little smaller, mainly the developed markets.
So the way that I play international, mainly international equities, is you're right, I'm very US- centric. When the dynamics that I found, going back to the leading indicators, is that when the leading indicators of US growth are pointing higher, that generally means global growth is going to be heading higher, and especially because the manufacturing sector is so correlated globally that when there's a manufacturing upturn, there's a manufacturing upturn basically everywhere. And during these upturns in growth, as counterintuitive as it may sound, better US growth tends to lead to a weaker US dollar.
So when we have an upturn, the dollar tends to get weaker. That gives a big boost to everything international. So I have increased my international exposure since basically I started to see the upturn in the leading indicators around the summer of 2020.
And that's when I started to increase the exposure to international equities on a broad basis. One of the allocations I have is VXUS, so basically everything ex-US. And that's basically the way that I play as far as an allocation. The way I play international is when there's an upturn, I expect the dollar to lose value or the dollar to be softer, so I allocate more heavily than I would on my baseline approach to international equities more broadly.
I don't often get into country specifics as far as the allocation. I have research broadly on the developed markets-- Japan, Europe as a whole, the United Kingdom. Maybe we can talk some long-term stuff about that. But as far as the allocation, I'm mainly US or ex-US. And when there's a growth upturn, I shift more of my equity allocation to ex-US, which I have now. LYN ALDEN: Yeah, it makes sense. And so I guess to dive into those developed markets, when we focus
on Japan versus Europe for the United States, do you see any major differences between the three, or do you see them all kind of on the same sector trends? Like, for example, one thing I often highlight is that one big difference between those ex-US developed markets is that most of those have more structural current-account surpluses. The United States is on the opposite side of that. Do you see that playing into your analysis at all? Or basically if you were to kind of describe the paths that those three are on, obviously they have a lot of similarities, but do you see them as kind all on virtually identical path or somewhat divergent paths? ERIC BASMAJIAN: Well, I don't think that they're all on perfectly identical paths, but my main framework is looking at the debt and the impact that it has on growth there and then the demographics. And those two factors, all the countries are headed down basically the same path. Like you pointed out, there's different current-account situations. But as far as the US-- and we can probably dive into this. The situation with the US can be interesting because in the short term, the larger trade deficit can work to our advantage. And part of my thesis is I do believe that the twin deficit will get worse in the United States.
And that can be to our benefit in the short term because it can help us support higher consumption and higher investment than we otherwise would be able to have without foreign support. It could lead to longer-term problems down the road. We tend to see the twin deficits get really bad with emerging-market countries. It's a unique situation, I think, with the United States. So it doesn't play into my long-term thesis as much as I think it plays into your long-term thesis, and this could be where we slightly diverge on the long-term trends. The way that I would view the United States with the trade deficit is there's this view that if foreigners immediately stopped funding our deficits that interest rates would rise and the currency would depreciate, and that's possible. But the way that I would see it also is if the
trade deficit started to shrink or foreigners started to buy less of our debt, that would have to come out of one leg of our GDP equation as well, and the leg that I believe would fall in that scenario would be private investment. So I believe that either way, a larger trade deficit or a smaller trade deficit are still going to lead to weaker growth. It's going to lead to weaker real growth-- maybe not nominal growth, but it's going to lead to weaker real growth in either scenario because either we're going to be hollowing out our manufacturing sector if we have a larger trade deficit, or if we have a smaller trade deficit and we're not able to get external funding, we're going to collapse private domestic investment, and both of those have negative long-term consequences for real growth.
And if our real growth continues to be dragged lower, I think the inflation rate ex some currency crisis will tend to follow the direction of real growth as well. LYN ALDEN: Yeah, so if you focus on overall investment, do you have a way to separate kind of what you think is going to be productive in the long term versus what might be malinvestment or what might be misallocated, or do you kind of put all those together? Because obviously it's hard to determine in advance. But basically I think one argument we can make is that the United States has had-- because as you point out, we're very unique in that sense. As a developed market, we have some of these characteristics that don't quite fit other emerging markets because we are, to a large extent, external funded as the global reserve currency. And so do you see that as kind of playing a role? I know that from my work, it's really kind of showing up in some of these more extreme politics or more a populist-versus-establishment situation because we have a higher degree of wealth concentration than most other developed countries. To some extent, there's been a shift from a developed-market labor to emerging-market labor, but the United States has kind of accelerated that more than some of the others because we've kind of undermined our manufacturing base a bit more by prioritizing other areas. And so, of course,
we've had the benefit of technology and health care and areas like that. So I guess getting back to the question, do you kind of-- when we focus on foreign investment, do you have a way to kind of separate where that's going or what that might be benefiting? ERIC BASMAJIAN: The way that I look at investment is I look at the velocity of money. and I look at the money multiplier. And as long as those two factors are continuing to move down, that would argue that the investment's unproductive. So in my view, we can talk about velocity. I think it's a little bit-- hammering on velocity as a useless indicators I think is getting to be an overused point. I think there is value in the metric. There's two main ways I think that velocity increases. I think velocity will increase if there
is an abundance of productive loans. People borrow money, and it generates an income stream above the interest that they're paying on the loan. Over the long term, that'll raise the velocity of money. The second thing that'll raise the velocity of money is a complete loss of confidence in the currency. That can cause the velocity to spike very quickly. So it would be more coincident, but
excluding loss of confidence in the US dollar, which I don't think we're on the verge of in the next year or two years or something like that, unless we see the velocity of money start to steadily increase, we can at least assume that the debt is being used unproductively. If the money multiplier is declining, that means that the monetary base and the money supply are going up at the same rate, which means that most of the money supply is coming from quantitative easing, which tends to get recycled back into financial markets, which I would view as unproductive because we're borrowing money and putting it into-- we're not putting it into the real economy. So it's not going to boost GDP is what I would say. So I would say following those two factors, money multiplier and the velocity of money are the two best gauges we have to deem whether the amount of new investment is productive or not.
And given that those two metrics are still in a pretty serious downturn, we can assume that the debt that we've taken on, partly because of the COVID situation and just malinvestment in general, is still working against us. LYN ALDEN: So I guess if we focus on the debt picture-- because that's something that we both incorporate a lot into our work. I know Lacy Hunt incorporates that a lot into his work as well. And so if you focus on the long-term debt picture, how does that tie into deflation and inflation? Because we both know that high levels of debt can be very deflationary, and it's kind of things around the margin that I think is where a lot of people debate. So if you were to take a step back and explain why debt is deflationary
and maybe how different types of debts could interface differently with the economy. ERIC BASMAJIAN: Sure. So I guess I'll give you my summary of all of the research on debt that I find useful. There's remarkable consistencies across some of the research on debt,
and I note four or five consistencies. First is that a little bit of debt is good. A little bit of debt can boost growth and can be pro inflationary because it can raise output above potential for a period of time. So that's the first thing. The second thing is that a lot of debt is bad for growth. The third thing that's remarkably consistent is the thresholds that are outlined in these various academic papers at which debt starts to really have a negative impact on growth.
And this is not just Reinhart and Rogoff. There's dozens and dozens of studies that have been replicated across different statistical techniques that all seem to settle on the range of about 80% to 90% of GDP, and that's not just at the government level. That's 80% to 90% of GDP across the household sector, the business sector, the government sector, the financial sector. Any one of those sectors tends to cross 80% to 90% of GDP, we tend to see a negative impact on growth. The other thing that's consistent, the last thing, is that once you surpass those thresholds, the decline in growth gets nonlinear. So it starts to look like a U. A little bit of
growth helps. Then it starts to level off, and then it becomes like an upside-down U. So those are the four consistencies. And if we map the US long-term growth-- I published some of these charts on Twitter. Look at like a 20-year annualized growth rate of real GDP. Our growth rate's taking on that upside-down U shape, very consistent with the research.
So then you say, why is the debt causing that downdraft in growth and the inflation rate's following? Mainly it's because private investment is what tends to suffer as debt levels get too high. And when private investment suffers, the infrastructure of the society tends to collapse. You tend to have overcapacity in certain issues or unutilised resources, things like too much excess labor.
And when you have too much capacity in some areas, then that tends to bring the inflation rate down. So the lack of investment tends to suppress the real growth rate, and then the real growth rate tends to drag the inflation rate down because as growth gets lower, you end up having an abundance of resources that you're not using for that growth, and that tends to drag the inflation rate lower. So that's kind of how I square the debt picture with the growth and inflation picture is that too much debt ends up reducing private investment, which ends up reducing real growth, which ends up causing an excess of capacity in certain areas of the economy. LYN ALDEN: And if we focus on correlation and causation, is there a way to separate, in your view, which variable is more causal than the other? Because if you focus on, say, a failing business, if their growth is going down, one of the things they tend to do is take on more debt to try to make ends meet until they run into a problem. And so given that multiple economies do have a demographics issue where they're becoming more top heavy in terms of age, the ratio of people, say, receiving benefits versus paying into benefits makes things very challenging. And, of course, that, over time, translates into slower and slower GDP growth.
There's also a certain amount of saturation. If you go from emerging market to developed market and you start to meet a lot of the needs of the people, growth ends up kind of being somewhat asymptotic in that sense. So do you view that the debt is surely causal of that slower growth, or is that slowing growth then lead policymakers or businesses to begin kind of taking out more and more debt? ERIC BASMAJIAN: That's a good point. I think that
if the debt is productive in the sense that it generates an income stream above the interest, then I believe that it doesn't necessarily have to slow growth, and I think that we would be able to see that in the velocity of money. The second thing is we can stack up how [AUDIO OUT] we're generating per dollar of debt and see that every dollar of debt now is generating less and less growth. So I think that that's a valid point that you make. I think that there's no-- I don't think that we can say that all debt's bad and that every use of debt is going to slow growth. I think that it's the use of debt in the various ways.
I think there's a lot of available research that suggests that-- I'm not making a political point-- that transfer payments tend to be a very low-productive use of debt, and one of the things that we've generated the most amount of debt through is through transfer payments. So I think that transfer payments are causal in terms of the slowing of growth because it tends to reduce private investment. And the point that I would always circle back is that if we measure real GDP per capita, that's effectively the standard of living. It standardizes for population, standardizes for inflation. It's basically the productive capacity of the economy. So the litmus test I would say is, if the debt is being used to raise the productive capacity of the economy, then all is fine. But, if the debt's not being used specifically to raise the productive capacity of the economy, then all is not fine.
And when we use a lot of transfer payments and when we just look at the GDP equation itself, higher levels of government spending will result in lower investment just on an accounting basis. So I think that as long as the debt is being used productively-- I know World War II is an example that you've done a lot of work on. That may be different than today because of how different the debt was used. So I think it can be both causal and-- in certain senses, depending on the way that it's used. LYN ALDEN: Yeah, one thing is if you focus on
the 1940s World War II period, the industrial base roughly tripled. It went up something like 2 and 1/2 times over the course of that decade. And then even after the war it had somewhat of a pullback, but it didn't pull back anywhere near to where it was because of course they were able to repurpose that for a lot of domestic uses. And so a lot of people focus on the war took us out of the depression or whatever, but it was really-- I mean, all the things we did overseas was mostly destructive. It was more about kind of rebuilding the industrial base and things like that. And so how would you describe that as kind
of conflicting with kind of the MMT approach? Which is basically the argument that if you, say, increase money supply a lot, if you increase deficits a lot but it comes along with increased productivity, that should keep inflation low, and that therefore they can get away with more of that kind of deficit spending or monetary increase. Whereas you're saying somewhat of the opposite, that if the industrial base stays low, that actually has a deflationary impact. So how would you kind of clash those two views, do you think, as it relates to whether or not higher productivity can tame inflation or if it can lead to deflation? ERIC BASMAJIAN: Sure. So I would say that
with the MMT, where it goes wrong is that there's no mandate to increase the productive capacity of the economy. Most of the MMT is that we can do job guarantees. And if we say, OK, the government's going to run a huge deficit and it's going to pay people to dig a hole and fill it back up, sure. They can run a big deficit and do that and they can pay those people, but if it's not increasing the productive capacity of the economy, it's not increasing standard of living at all. Then the economy can't really advance. So I don't see how that would be inflationary. The second thing is that when the government spends money, it steals resources from the private sector-- not in a balance-sheet sense. We could always lever up and invest more money, but it steals resources from the private sector. It steals that labor. It steals those raw materials from the private sector that may be able to use those resources more productively.
So if we keep sending people money and sending people money with larger deficits, all we're going to do is divert resources towards consumption and government spending. And then again in the GDP equation, GDP is equal to consumption plus investment plus government spending. If G goes up and C goes up, then I has to come down. And if I comes down and we have less jobs available here and productive jobs here, then we have an abundance of labor. And if we have an abundance of labor, that drags down wages. And to me, that's the deflationary impact that MMT doesn't call for. And the money supply would certainly go up quite rapidly. But in that scenario, the velocity of
money wouldn't increase because it doesn't fulfill the criteria of an income-generating use. So that, to me, is a deflationary impact. LYN ALDEN: So one thing I like to do is kind of use extreme examples to sometimes find kind of the boundary of where a point can go, and then we can kind of bring it back to a moderate example. So if you look at, say, one of the states that's had, say, a major inflation like, say, Venezuela for example-- a combination of bad governance, bad productivity, massive increase in the money supply. And so we had a situation
where the money supply goes up dramatically, but their overall productive capacity has either flat lined or gone down, and basically the whole incentive structure is messed up. Then you get a pretty high inflation rate. So, hypothetically, if you were to say everybody has double as much money as they have now-- let's bring it back to United States. Everyone has twice as much money as they have, but we still have the same amount of homes out there. The same amount of cars are made. The same amount of copper and energy exist, the same
amount of all these kind of different goods and services. How would that translate into prices of those various goods and services and assets? ERIC BASMAJIAN: Sure. So I would just like to create some parameters here. Let's assume that the government sent everybody a check of a million dollars. I guess that's sort of what you're
saying here. There's no doubt that that would raise nominal GDP growth. Absolutely. In the short term, everyone gets a check. It would raise nominal GDP growth. The question is what happens in year two? Does everyone get another $100,000 check? If they do, they're going to need more than that to keep nominal GDP growth on an upward trajectory because they're going to need the same amount of money plus they're going to need additional if they want to have growth. So if we're talking about these one-time payments, it can cause a short- term increase in nominal GDP. That's partly what we're seeing now. But as soon as those payments stop,
GDP goes on a downward trajectory again. So if we're talking about one-time payments, then you're going to have a short-term boost in growth and a short-term boost in inflation until people have a-- because the rate of change in their income would go down. They have, let's say, 20% income growth, and then there would be 20% income decline. So once the prices rose in year two, they would have less income against higher prices, and that would drag the prices back down. If you sustained it and you did $100,000 this year, $105,000 next year, $120,000 in year three, that can keep the upward trajectory on prices. But again, it's only as good as the last payment. As soon as the payments stopped, income growth would go right back down, and then you'd have less income against higher prices. And I believe that that would, in turn, bring the growth rate
and the inflation rate back down. LYN ALDEN: Unless, of course, we got to the part where there would be crisis of currency or something like that. ERIC BASMAJIAN: Exactly. Of course. LYN ALDEN: And so one thing I know we've seen this past year is that some people, when they receive the stimulus checks, they pay down some degree of debt. So we saw some credit-card debt go down. I think it was something like $100 billion last
I checked, which sounds like a lot of money but it's actually a reasonably small percentage of the amount of debt out there. So if you were to have those massive payments. Let's say we have very large, say, fiscal deficits over the next several years, and people end up deleveraging some of their private debt. Does that have a somewhat inflationary bent, or would that remains deflationary in your model? ERIC BASMAJIAN: Well, I think it depends because if we go back to World War II, let's say, one of the differences then was that wages as a percentage of income reached almost 70%. So most of people's income was through wages, and we saw the savings rate rise pretty dramatically during that time. So people were saving out of income. Now we see the savings rate rise. There was a brief spike, but it's savings out of government
dissavings. It's not savings out of income. We see wages as a percentage of total income is actually less than half now. It's fallen to 49%. So all we're doing is we're not really deleveraging the total debt pie. We're just shifting debt. We're basically passing the
baton from the household sector to the government sector. So it would cause the household sector to fall a little bit, and then it would cause the government sector to go up. What that would do, in my way of doing things, is it would make additional debt from the government sector even less productive because you'd have more of a nonlinear benefit at the government level. And then it would make the household debt, new household debt, more productive, but then we'd be delevering just to relever. So I don't see a way that that boosts the long-run rate of growth or the long-run rate of inflation so long as we're just shifting debt from one sector of the economy to the other because if we're increasing debt on the government level, we're still going to be increasing government outlays as a percentage of GDP, which means some other part of GDP has to be going down as a percentage of the pie. And typically government debt is geared towards
facilitating consumption. Well, what we're continuing to see is rising G and rising C, and that's going to put downward pressure on I. Or, to your thesis, if we want to sustain investment, we're just going to have to explode the trade deficit. So either way, I think if we just shift the debt to the government, the result would be lower I or higher trade deficit to produce everything that we're trying to consume. LYN ALDEN: And maybe here we could focus on, say, the mechanics of kind of allocation decisions. So say you are a private capital allocator. You're a venture fund or any sort of pool of money that's looking to
invest in businesses. Maybe it could be a bank making loans, or maybe it could be more of a fund. So to what extent does the government, say, doing transfer payments or issuing their own debt, how would that influence the decision of those allocators on which projects that they want to allocate capital to? So how does that end up reducing their allocations? ERIC BASMAJIAN: If you were a venture fund trying to-- well, I don't know if it would impact their decision all that much because what the research shows, the research that I've read, is that income decisions are mainly based on long-run trajectory of income, not necessarily one-time payments. So I think that perhaps you'd allocate more towards goods consumption or goods producers, but we don't really produce a lot of goods here, so there's not really a whole lot of investment decisions to make. And this sort of plays into the whole malinvestment thesis is where do they invest? There's nothing to invest in over here. If you want to invest in people that produce the things that we're going to consume, it brings investment to overseas. So I don't know if that changes the
equation all that much for me in terms of where I would invest if the government is going to be doing a lot of transfer payments. What we see is when the government is doing a lot of transfer payments, it's having a downward impact on labor. People are working less, and what we're seeing is more consumption of technology at home and goods at home. So I guess if you were to allocate, it would be towards technology producers and goods producers. But the goods producers are offshore, so I think that the allocation would, I guess, be bent towards consumer-based technologies and fintech. And I guess things like that would be the primary allocator. But
I think that the one-time payments are different than a sustained income trajectory because I don't think people are going to make investments based on a one-time spike in consumption. Otherwise we'll be stuck with overcapacity once that consumption dies down. It would have to be based on a long-run trajectory of income growth. LYN ALDEN: Makes sense. And so for a lot of this,
we focus more on the manufacturing side. So I guess if we-- do you do a lot of work on the real-estate sector at all? Because I know that's another significant contributor to the economy. It can impact commodities. It obviously impacts people's household spending habits to some extent. So what are you finding in the real-estate markets? And do you have any kind of shorter-term or longer-term view on where those might be headed? ERIC BASMAJIAN: Sure. So one thing I find interesting with the real-estate market now is we've seen a pretty steady rise in long-term interest rates, yet partly because the Fed is buying so many mortgage-backed securities, mortgage rates actually continue to make new lows despite higher long-term interest rates. So that's putting
a lot of upward pressure on housing prices. And I think what we're seeing now in the real-estate market is a huge demographic shift, obviously, out of cities and to suburbs. That's having, as you mentioned, a huge reflationary benefit that's playing into this manufacturing upturn because everyone has to refurnish a new home, and there's a high-velocity impact to that for a brief period of time. My view is that that's going to continue. I think that there's still legs behind that. I think the indicators of the housing market are still pointing higher. There's a lot of new residential construction still going on. But since we're basically just stealing real estate from the cities to the suburbs, I think that there will be a hangover effect once that whole demographic shift is complete.
So I think that once everyone buys a house and that pent-up demand kind of is exhausted, we're going to have a hangover of all of those refurnished goods that are obviously all backordered now. You can't get a dishwasher, as your friend Luke Gromen was trying to get. So I think that we're going to have a hangover effect there. But as long as the Fed keeps stepping on the mortgage-backed securities and keeps interest rates so low, it is going to facilitate more of a shift from renters to buyers. But that's going to be a problem if those mortgage rates ever start to go up because there's going to be several million new home buyers that find themselves immediately underwater because the price is so sensitive to changes in mortgage rates.
So I think that right now it's powering this-- or it's an added layer to this manufacturing upturn, and that's still going to continue. But once that demand is sort of saturated, then we're going to have a hangover effect because the increase in the real-estate market wasn't from newfound income or newfound jobs. It was mainly just a demographic shift. LYN ALDEN: Yeah, and at those lower interest rates. ERIC BASMAJIAN: And the lower interest rates. LYN ALDEN: That's one of the things I've been watching too because when you're kind of determining the valuation for a company, whether it's a value stock or a growth stock, obviously a big impact is what discount rate you're going to use and what target rate of return you're seeking. And back, for example, in the dot com bubble, Treasuries were yielding over 6% for a big chunk of that. And I like to refer to these
cyclically adjusted earnings yields, which is the inverse CAPE ratio, because that kind of-- ERIC BASMAJIAN: That's my favorite as well. LYN ALDEN: --yeah, smooths out. And so that was the lowest that stocks ever were compared to, say, the 10-year Treasury, and so that was a clear bubble. I think what makes things challenging here is that the interest rates are so extraordinarily low that of course people have a tough time determining what you pay for, say, a software company that might be growing at 10%, 15%, 20% a year. You're not sure how long that's going to go, but you're willing to pay a pretty high multiple for it because interest rates are so low. So I guess in your model, you see kind of a
secular stagnation yield. So you think that after whatever kind of bump we're having now, we're going to return to lower and lower yields. So your view would probably infer that some of those really high growth stock valuations probably remain elevated for the foreseeable future, or would you see it differently than that? ERIC BASMAJIAN: No, I do see it that way. And I think that the-- I do view equity valuations in a very similar way. I use the CAPE ratio,
and you square it up against interest rates. I tend to caution when I square it up against interest rates because interest rates have an embedded growth assumption in them as well. So if interest rates are zero, that can raise the discount rate, but that also is implying that there's really bad economic prospects out there as well. So what we see is that it raises the valuation for certain companies. It doesn't raise the valuation for other companies. So like in Europe, let's say, anything that's a financial has a multiple of 6 or 7 even though interest rates are negative. So if the company has no growth and it's a melting ice cube, then the lower interest rate does not warrant a higher multiple. But to your point,
if you have a company that's growing 20% or 30% legitimately and you discount that at 0% or 1%, then the valuation can get kind of crazy. Now, where this gets into kind of a wonky regime is Amazon is one thing. They have legitimate revenue growth that's double digits. Fine. The question here is now people are selling a story that we're going to have growth in the future, and there's nothing really there. It's just the prospect of growth, and investors are still bidding up those companies. And that's where we sort of I think get into
some dangerous territory where you can make the argument that if the company delivers on said growth, then the valuation should be XYZ. But we have to see the companies deliver on said growth, which may be different than Facebook, Amazon, Google. These are established companies, huge cash flows, legitimate cash flows, double-digit growth. Hard to say that they don't warrant the higher valuation with the lower discount rate.
If you're in a sector like financials that your growth is just structurally impaired, we're not seeing those companies get reflected in higher multiples at all. And then the question is a company that's just selling a story of growth, what do you do with that? I tend to just avoid those companies altogether because I don't know exactly what the rational way to value those companies are and the way to discount how likely they are to deliver on those growth assumptions. Tesla would be the prime example of that. I think they actually have declining revenue growth last time I checked, but the multiple doesn't matter because it's a story stock, and it's the growth of we're going to have a million taxis. The growth is going to be so explosive in the future that we warrant this huge valuation today based on the current rates. And that's a
little bit out of my game because I don't know what the chances of them delivering on that are. LYN ALDEN: Yeah, that's the bellwether I'm watching too because if you look at, say, the amount of cars they delivered over, say, the 12 months, it's something like a 35% increase over the previous 12 months, which is reasonably impressive given the pandemic. But then their stock price went up something like 900%. ERIC BASMAJIAN: That's right.
LYN ALDEN: So it's like it clearly warranted some sort of increase, most likely. But then it's to what degree of increase did it warrant? ERIC BASMAJIAN: Exactly. LYN ALDEN: Especially because they're not, say, a software as a service company. They're a hardware-focused company. They actually have expenditures. And so they're borderline break even depending on exactly how you want to measure profitability. I guess one way we could take this discussion is to kind of focus on the end game here. So I think that's people that have the more inflationary outlook or people have more of a deflationary outlook, that kind of converges towards what is the end-game scenario for this? Because the deflationary outlook is one of those things where it keeps going in a certain direction until something breaks. Either the currency breaks or civil unrest rises because
people have-- their lifestyle decreases. So I guess you could take whatever direction you prefer, but I guess focusing on the economic aspect or some of the tail-risk outcomes that could change some of this, how do you see this kind of long-term grind towards deflation unfolding after it hits kind of maybe certain breaking point? Especially because I think you point out that the deflation is actually accelerating. It's not just a linear decline. It's kind of an exponential. So how would you kind of see that
resolving long term? ERIC BASMAJIAN: Sure. So I think that's the critical point. I think that the-- and it's really the real GDP per capita which is the critical measure, and that's going to continue to decline. And we're seeing a lot of the, quote, unquote, end game play out as we see with all of the civil unrest. That's all totally related. And one of the points that I would make is that we've seen real GDP per capita from, let's say, like the '50s to the '80s was growing in the high 2s to low 3s on a really sustained basis. We've seen that drop to about 1.2%, 1.3% on a long-term basis, but that's just an
average of real GDP growth. As you mentioned, our wealth concentration is pretty extreme. So even though real GDP per capita is 1% on average, there could be-- and I don't have the exact numbers, but there could be 40%, 50%, 60% of the population that's already experiencing a decline in their standard of living. So that civil unrest is manifesting itself in a lot of different ways, including a higher demand for transfer payments, which in my model is going to exacerbate the situation in terms of real GDP. I think it's going to make that worse. Where the end game gets kind of interesting for me is that a lot of the inflation camp-- and perhaps you can comment on this because I'm curious-- is that we can solve some of this through inflation. Where I tend to get a little tripped up with that is if the target that we're looking at is increasing people's standard of living to quell some of the social unrest, we need to do something to raise real GDP per capita. Debasing the currency or inflation doesn't seem
like it's going to achieve that goal, which may not result in any less unrest than we're seeing. The second thing is I don't think we have as precise of a way to devalue the currency as we did when we were pegged to gold, and I think that we lend ourselves to competitive devaluations from other developed countries. And the third thing is that devaluation may help our current debt load as it stands today at the government level, but the largest component of our future liabilities are the entitlement programs. I think today we have something like $3 or $4 trillion of current entitlement programs. That's obviously going to balloon over the next 5 to 10 years. All of those entitlement programs-- I believe there is a study that showed maybe 19 or 20 of the programs have either explicit or implicit inflation links within them.
So they're all linked to inflation. So if we have 5%, 6%, 7% inflation, it may reduce our current debt load, but it's not going to do a heck of a lot for our future debt load because it's all basically linked to inflation. So one of the things that we're going to have to grapple with are these entitlement issues. And whether we remove the link to inflation-- to me, that's some form of austerity because you're giving people less than what they were promised.
So I think that there's going to have to be some form of austerity that comes down the road. And I know people freak out when they hear the word austerity because it's never possible, but when we think about inflation as a solution, inflation is not going to solve the entitlement burden all that much. So I think that we continue to grind towards weaker and weaker growth, and the social unrest gets worse and worse until we either grapple with the debt situation or we have a big problem with the currency, which I think people can be surprised by how long countries can hold it together with really high levels of debt. It mainly comes down to how much they can keep the population under control. But I think there's a scenario where the US could be in a situation of 160%, 170%, 200% debt to GDP, and the situation can still be, quote, unquote, under control in terms of society continues to operate with just with weaker and weaker growth. So I think we continue to go down this path, and I don't think there's a threshold to how low real GDP per capita can go. I think that
that upside-side U relationship continues until we either have some form of forced austerity or some sort of currency crisis, which I wrote a recent note about that. When you think about wealth preservation, there's gold ETFs which are great for getting exposure, but there's no substitute for physical gold. And I wrote a note that having a percentage of your net worth in physical gold is-- I would think for me it's a prudent strategy to guard against that type of scenario because I think that the situation is lower growth, lower inflation until it's not. And the until it's not scenario is basically impossible to time, also known as a Minsky moment. So I think that that's how the end game plays out or the end game as far as my eye can see it right now. LYN ALDEN: Yeah, there's been a similar argument
for farmland because in some ways it has certain characteristics similar to gold in that sense. And I posted a chart a few weeks ago showing that if you look at broad money supply per capita and you look at the price per acre of farmland, they've been highly correlated over something like a 50-year period. And I guess so if we were to kind of maybe wrap this up by kind of separating different types of inflation, I notice people from different schools of thought debate about what is inflation? whether or not it's accurately measured. And they tend to be talking about different types of inflation. And so, yeah, there are some schools of thought that they basically view an increase in the money supply as a form of inflation. They generally would put some caveats on that, different types-- how exactly measure the money supply. But basically if the
amount of currency units in a broad system is increasing, then it's inflationary. Then, of course, we have a basket of goods that we can measure for inflation. And then, of course, there's going to be debates about whether that basket of goods is appropriate, if the adjusters are appropriate, and people will debate about that. And a third type is potentially asset-price inflation where, going back to the Tesla example, say a company produces the same amount of cars or 30% more cars but then its share prices are 5x or 10x higher. Basically you're paying more money for the same
kind of allocation of resources, essentially. And one thing I've found in my research is that when you have that first type of inflation-- so just say you have a massive increase in the broad money supply. That ends up somewhere. And, of course, the big question is where does it end up? And the short answer is that it kind of ends up in whatever it happens to be scarce and in demand. And so if you have, say, overcapacity of manufacturing or you have no problems, no limitations there, it's not going to show up in, say, commodities or products because there's no scarcity, whereas it will show up in things like prime real estate or gold or growth stocks or things like that. So one of the things I'm looking out at the long run is if we see money supply continue to increase at a pretty substantial rate-- which you can get if you're running pretty big deficits and then a lot of that's being purchased in the secondary market by the Federal Reserve. If you were to get that continued currency inflation-- let's call it money-supply inflation. Holding bonds in that environment
seems somewhat challenging because even if you don't get that inflation showing up in the CPI, your purchasing power as it relates to, say, prime real estate or gold or, say, really high-quality equities could continue to diminish. So do you have any sort of separation there? How would you incorporate kind of that into your analysis? ERIC BASMAJIAN: Sure. So I think that's a great point. I think that the inflation as it relates to money supply can be tricky because if I, let's say, print a trillion dollars of currency and then I light it on fire, that's not really inflationary. So as far as the basket of goods and services,
why that's important is because that's what plays into TIPS calculations and that's what plays into the cost-of-living adjustments with a lot of the entitlements. So as much as people hate those metrics, we have to use those metrics because that's what is a huge factor in our future deficits and as well as in the fixed-income market. So I think we have to look at where the money-supply growth is coming from.
And if we look at it over the last year, let's say, and we continue doing what we're doing, a lot of it is coming from quantitative easing and the secondary market, which is causing a huge rise in deposits at the banks. And if you take a nonbank that had a Treasury and then you take the Treasury away from them and give them cash in the form of a deposit, they're not going to invest that going to the store and buying a sandwich. They're going to recycle that back into financial assets. So I think that the financial-asset inflation can continue, and it can continue
as long as this is the way that we're deciding to increase the money supply. I don't think that adversely affects Treasury investors who are targeting more of nominal GDP growth because nominal GDP growth won't increase really in that scenario. The second thing I would note is that that game can continue. And it's not that the market will
rise in perpetuity as long as QE is going on because one of the things we have to realize is that, at the end of the day, these are equities that need to be-- their debt needs to be serviced with cash flow. So a company that may be in good standing with their debt can see their equity valuations rise quite dramatically, but if the underlying economy gets so weak because all the money supply is going back into financial assets, then at some point some company somewhere is literally not going to be able to make payment on their bond. Commercial real estate, for example, will literally not be able to make payment, and then that asset is literally in default. There's currently no mechanism for the Fed to buy defaulting assets at the moment.
So it could be akin to a scenario where you increase money supply and light it on fire in the sense that it could cause this really sharp rise in the equity market. But if the underlying economy gets so weak that a lot of these companies don't have the cash flow to support their bonds, they end up in bankruptcy. So we could see a large rise in the money supply. It goes into the equity market, and that paper wealth kind of vanishes. That could also be a deflationary outcome. So I think that holding bonds in this scenario only gets quite dangerous if nominal GDP is rising on a sustained basis. And for that, I would use some of my shorter-term leading indicators to give me a heads up as to when that's happening, which it is now. So I'm not overweight long-term bonds
at all, actually. I'm actually underweight long-term bonds in this scenario because the expectation that nominal GDP growth is going to increase. But the wild-mania speculation and QE field asset-price inflation to me doesn't work against the bond allocation all that much. Specifically if you have a balanced portfolio that does have a fair amount of equities within it as well as gold as well as, aside from your securities portfolio, a physical allocation to gold, in that scenario I think that bonds still do play a critical role in an overall portfolio. LYN ALDEN: Yeah, going back to that point about
company cash flows and the ability to pay debts, that's actually one of the concerns I have is that we've seen such a speculative bubble, especially the past several months where just if you look at, say, what retail investors are doing with call options and what we're seeing in the valuations in some of these stocks, I think that when the dust kind of settles on some of this, we see kind of a rate-of-change reduction in the amount of, say, money-supply increases or fiscal stimulus. I think it's one of those things where the tide goes out, and some of these things are kind of-- basically I think that their prices have been bid up to a reasonable degree like, let's say, gold. Whereas I think some of these other things that actually have cash flows and then they're
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