05/02/2018 - The Roundtable Insight: David Rosenberg & Yra Harris On Stagflationary Pressures & Volatility In The Economy & Financial Markets

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FRA: Welcome to FRA’s The Roundtable Insight .. today we have David Rosenberg and Yra Harris. David is Gluskin Sheff’s chief economist and strategist with a focused on providing a top-down prospective to the firm’s investment process and asset mix committee. He received both a bachelor and Master of Arts degree in economics from the University of Toronto. Prior to joining Gluskin Sheff he was chief North American economist at Merrill Lynch in New York for seven years during which he was consistently ranked in the institutional investor all-star analyst rankings. Prior to that he was chief economist and strategies for Merrill Lynch Canada based out of Toronto. He is the author of Breakfast With Dave a daily of distillation of his economic and financial market insights and I think now there’s espresso with David also that’s out. Yra is an independent trader, a successful hedge fund manager, a global macro consultant trading in foreign currencies, bonds, commodities and equities for over 40 years. He was also CME director from 1997 to 2003. Welcome gentleman.
DAVID: Thank you very much.
YRA: thank you Richard, this is a great honor for me, thanks.

FRA: yeah, it’s a great honor for having David on our show, first time and I thought we’d begin with some of David’s recent thoughts. You recently wrote about how Canadian equity markets go higher even US markets go lower as a hedge against inflationary pressures. Can you give us some insight on that?
DAVID: Well sure, it’s not even an opinion it’s a fact in a sense that it’s happened so many times in the past and most recently in 2007 and in 2008 as the US market went down 20% in the opening months of the … market. The Canadian market was up 20% and of course, then the wheels fell off when it turned into a global near depression after AIG and Lehman collapsed. But it’s because the Canadian market being so exposed to the commodity cycle and energy and there are so many other sector correlations with the resource sector and the resource sector is classically psycho value. The SME of 100 is because the classic growth index, Canada doesn’t have much in the way of healthcare exposure, doesn’t have much way in a technology exposure. These are there groppy aspects of the US market that’s kept it alive and well for so long. Either you’re buying on the premise that we are entering into the late cycle, I think there’s a lot of evidence and if it late cycle then it’s value over growth and then if you’re talking about stylistic investing value over growth you have to understand if you look at North America Canada is deep value in terms of sector representation. The US is much more growth oriented. I look at it not just from historical experience in terms of late cycle investing but just looking at evaluations. The Canadian stock market right now trades at a forward multiple of a 14.7 times the coming year’s earnings estimates. In the United States that number is over 16. I look at some other benchmarks as well in terms of valuation matrix and wherever there’s been a day that the Canadian stock market has been this inexpensive relative to the United States.
FRA: Yra have you seen that type of behavior in the financial markets in in your trading?
YRA: It’s interesting to see David and having read his work for so many years. Mine doesn’t take that type of analysis. I will read that and put that into my thought process but then I have to ask, David, about yesterday when to governor Palu speak and his concerns about that their Canadian personal debt levels were elevated and she’s like the bank of Canada is worried about them. How would that play into that scenario? That’s the question that would arise from the way that I would analyze this. I’d like to hear David speak to that.
DAVID: Right. I think that as far as I know the only central banker that is talking insistently about debt exposures and sensitivities and fragility is the Bank of Canada. I guess that’s partly because there’s no real bubble this time around in US household balance sheet. I would argue that even letting out the cash, we have some sort of a bubble in the US corporate balance sheets. Debt worldwide looking at governments, we all own this debt. We can say this … debt in US household balance sheets but the government debt, if we look at corporate debt, household debt. We’re in a situation now where globally outstanding debt in all levels of society is 164 trillion that’s with a T trillion dollars. We’ve already taken out the previous credit bubble peak of 2007 and half that debt and it might not be households in United State system, this time around. We’re get to a government debt bubble I’m sure looking at the future fiscal situation in United States half that debt is in Japan, China and the US. Basically this is a global situation, we just happened to have an honest central banker in Ottawa talking openly about it. He’s basically saying that this is actually one of the risks for the Canadian economy. We have NAFTA risks, we have really an incoherent energy policy to ship the oil out of Canada at the present time. Hopefully that’s going to change. We have divergent tax policies. All that is true. The Canadian economy even with the community boom is destined to underperform the Unites States economy. Of course we don’t have fiscal stimulus in the tax side that the US has so that goes without saying. You see that’s from my economics perspective and then when you put in a strategy a heart, what do you see? Well you’re on the correlations and you’ll see that the Canadian stock market, the TSX does not have that much of a correlation with the Canadian economy, believe it or not. That’s because most of the companies in Canada are truly global in nature. Even the Canadian banks, so you’d been thinking wow the Canadian banks, how much would be exposed. These are giant multinational corporations. You have banks like the bank in Nova Scotia that had a branch in Latin America before they ever had a bunch in Toronto. Going back a century or more. You go along the whole eastern seaboard in United States all you see are those green comfy couches from the Toronto dominion bank. You see what I’m saying basically is that the Canadian stock market has a much more torque to the global economy than it does to the Canadian economy. It doesn’t mean that there’s some special situations or some consumer cyclicals or consumer discretionary stocks that are relayed back into Canadian domestic demand. I will way suggest to stay away from those. I think the energy stocks here, McTaps are priced very attractively and I have nothing to do with the level of Canadian debt on the household site. You have a lot of Canadian companies you see if the bank of Canada hadn’t been keeping interest rates below the US and right now there’s a big negative interest rate spread. Look at where oil prices are right now. The Canadian dollar should be at 85 cents in quotes, should be but it’s not, it’s closer to 78 cents. Well there’s a lot of Canadian companies that have very high at us dollar revenue streams that we’re going to benefit immensely from this ongoing shall we say surreptitious policy in Ottawa to keep their Canadian dollar depressed. Something that doesn’t manage to make it to Donald Trump’s tweets is where the Canadian dollar is relative to the US dollar but that benefits a lot of Canadian exporters.
YRA: You think that that’s an active policy out of Ottawa that’s extended to central … heavily involved in that. Believe me I believe that … Certain as I can look to see what the Australian … When the RBA issued its statement the other night they all target currency whether they do it in the open but when you talk about the strength of your currency and your reason to keep interest rates on a hold … I understand the G40, I understand the G7 but if these are active policy then of course it gives leverage to the Ross Navarro Lighthouse Group about what countries are doing. So you think that that’s an act of policy approach from Ottawa?
DAVID: Well look there’s nobody that … Especially the central bank that’s going to come out and tell you where they would like to see the Canadian dollar. They’re not going to say directly. I think your comment before is right. I think of Steven Mnuchin’s comments in Davos which I believe he made on January the 24th which was like two days before the stock market peaked. Talking openly about the wonders over having a cheap us dollar. The trade weighted US dollar index is dominated by the euro and in the euro really peel back over the course of the past couple of weeks. I never really understood why I thought about 125 to begin with. The reality is that for Canadians what the Australian dollar does if you’re trading aussie currency you do business in Australia that’s obviously important but for Canada over three-quarters of our exports go to the US so that’s what really matters for the Canadian economy and for Canadian profits is that particular relationship. Maybe it is off the radar screen. You can’t have it both ways. If you’re going to have a situation where Donald Trump’s spray team and his NAFTA team creates this air of uncertainty. Nothing has happened yet and maybe we don’t get this solved until later this year if at all. What it does in Canada is it creates this cloud of uncertainty and when you’re uncertain because don’t forget if you’re setting up shop in Canada you’re not really just setting up shop as a business to service 35 million Canadians, you’re doing it the service 300 million Americans south of the border, that’s where the big market is. If you’re going to create a situation in Washington where you’re going to put this cloud of uncertainty over your chief trading partner called Canada you don’t get business investments. Business investment stays in the sidelines. Without business investment you don’t get a lot of growth, you don’t get a lot of employment. Nothing is zero in Canada but the economy is being held back by this air of trade uncertainty that is something that Canadians have imported from the United States. We didn’t start this whole thing, we got to renegotiate NAFTA. What that does is as the Fed raises rates the bank of Canada just says we’re on hold basically because we are frozen in time here for a variety of reasons. Stephen Poloz has mentioned several times that NAFTA uncertainty is part of it. What’s the … going to say? You’re deliberately keeping interest rates below where they are here and they’re artificially depressing the Canadian dollar. The Canadian government will say we’d rather not do that but because you’re creating this air of uncertainty because Canada is a much more intense export-oriented country than the united states is so NAFTA matters infinitely more for our economy than those in the states so naturally we are going to keep rates below and keep the Canadian dollar artificially below until something changes. We successfully renegotiate NAFTA, then that could all change. There is a method behind the madness whether or not it would ever be openly admitted. It’s funny because in the last policy review, the Bank of Canada just came out and lament about Canadian competitiveness. How our non-energy exports have lacked far behind what their models would say. That is code for we’re comfortable actually from a policy perspective having the Canadian dollar trade at competitive levels to make interest rates… or it should be for an extended through a period of time.


YRA: the amazing this is, and I am long term bullish on the Canadian dollar. First of all because, if we go back to the great financial crisis, for lack of a better word. The Canadian banks were certainly low capitalized. They did not suffer because of their lending risk. Their lending practices were so much better than the US banks probably by design. Number two there’s never been a quantitative easy program in Canada. There’s no quantitative easy program as Peter Boockvar would say. You have to go to quantitative tightening. I mean overall the underlying fundamentals to the Canadian financial system, yes I know they got a little bit of a bubble because they’re achieving rates over than it should be by regular market signaling. I think Canada is very well positioned. Once they work through the points that you just raised.

DAVID: I agree with what you said but, I think that we really do have to complete the analysis in this sense because, there are some fundamental reasons why the Canadian economy is being held back. There’s a fundamental reason why a lot of capital investment has been deflected away from Canada. There’s a reason why the Canadian dollar is trading about seven cents below any semblance of equilibrium value. Still on the other side of the equation, we have … You could say well the United States is blowing its brains out on physical policy. Well that might be true. But for the here now, for the first time in decades, the net effect of corporate tax rates in the United States is lower those is in Canada. In Canada being the junior partner and younger brother, we have to have compelling reasons for companies to want to set up shop here. We have to have lower tax rates here. We’re not a price maker on tax policy globally. We’re a price taker not a price maker. It was disappointing that there was no reference outside of one sentence to any response to what happened in the United States. Vis-à-vis at least the corporate tax situation, and then you layer on the accelerated depreciation analysis. If you’re a North American company right now, you’re incentivized to the taxes from right now to book your revenues in the United States which means that’s where the employment and investment are going to be directed towards at the expense of Canada. We have diverging fiscal policies point number one. We don’t have a coherent energy policy which is a very big problem. Hopefully that could change, but that will take a lot of political will, especially at the federal level. On top of that, we do have the situation where consumer balanced sheets are over extended. How that plays out. Of course you do have overextended housing markets in Toronto and Vancouver, which is not 100% of the national market, but it’s still 35% of the national market, and that’s not exactly trivial. I would say that there are some constraints. There’s all this sort of things that is on the bank of Canada’s radar screen, they’ve talked about it. There’s still some I would have to say, you could argue that there are unresolved issues in the United States as well. There’s at least as many if not more can at the current time.

FRA: What do you think of the rising US dollar as a recent trend? Is that going to take place for a longer period of time or … Is it related to the nine trillion and overseas US dollar the nominated corporate then?

DAVID: Well I think that it’s … It’s this classic economics 101. It’s the country that is tightening monetary policy, and the country that is using fiscal policy is usually the country that has the stronger exchange rate. That generally comes through in relative industry differentials. To me the big surprise for the past year, up until the trade weighted dollar starts to really turn around, it’s Back to where it was the first week in January. There was a time where if you looked at the yearly trend in the US dollar, just in the opening months of the year was down roughly 10%. That was really what would go against any macroeconomic textbook would tell you where the currency should be going. Then there was the other side of the argument which is that we have this band of trade protectionist in Washington. You have a president who his whole professional life and now carries it inputs his political life has always made [unintelligible] the current account deficit is his modus operandi. There’s another side, another side to the equation that well, if United States is going to ever want a really balance its deficit, well it’s going to have depreciate it’s currency 10% which is exactly what happened. I think that as this comes down to the old market refrain that you typically get the currency that your president wants. It was no secret that president Trump, would have preferred to have a weak currency that boots exports. I think what’s happening now is this realization. The Fed futures contracts are pricing in more fed. You’re seeing in the UK Mark [unintelligible] is peeled back. The ECB has more less gone quiet. The BOJ is not going to be doing anything. The Bank of Canada the view the beginning of the year was that they were going to raise rates several times. The only central bank it seems right now that’s in play in terms of raising rates is the Fed. I think that’s been part of it. You’ve also seen … Although the data flow in the United States has not been very impressive. I can’t do summersaults over 2.3% GDP growth the same quarter that we got. The fiscal stimulus. Be that as it may it’s the old saying about, in the land of blind the one eyed man is king. I suppose the US with 2% growth is the king, because the data in the UK have been very weak. The data in the Euro zone in particular has been extremely soft over the course of the past few months. I think there is this view on a relative basis that these interest rates differentials are going to work in the US dollars favor. Even more than people thought a couple of months ago. I think that’s a starting to finally come through in the currency markets.

FRA: Yra your thoughts.

YRA: Well, being a currency trader for over 40 years, and I’ve written about it for the last year. … The dollar, there’s fiscal stimulus coupled with interest rates differentials, and how the central bank is raised their rates when nobody else is, sure as David directly says. There’s always been the backup to a stronger currency and where was it. I of course … I agree with it because, I go back to that when Trump was having all the manufacturing, CEOs at the White House back in January February 2017, and Mark Fields who was then the CEO of Ford comes out and immediately calls the currency manipulation the mother of all trade barriers. Well that’s evidently what got discussed at the White house, and that Trump [unintelligible] the euro moved from 106 pretty much history line all the way up to 125, 126. Which bothers one mind because … I’m not one who accepts the European growth story willy-nilly. I think that’s a lot of nonsense to me, I say that for many reasons. The missing dollar really has caused a lot angst to the market, a lot of large hedge funds had miserable years trying to make that trade. I stone cold agree with that. I think now that we’re getting a little more maturity and some more negotiating tactics, there’s no question in my mind that guys like Robert … and Ross Mnuchin, I’m not sure what to make of … Certainly the Navarro they will use the currency as leverage. Trump especially accepts that. It’s interesting David say that the president gets the currency that he wants eventually. I think that’s is true and now I think the market is just … It’s just liquidated in some of the short dollar positions and trying to work through their way through this, this understanding with the dollar differential, the interest rate differentials. Certainly favors the United States and now we saw … with a phenomenally devilish press conference last Thursday. I think the ECB would relish nothing more than the weaker euro. That gets a question I … My favorite train would probably be long gold and short all the fiat currencies, not necessarily the dollar expression because interest rates to the US of course are now … We can argue what are, but they’ve at least going to a real yield. I don’t think there’s anywhere else in the world of the main developed nations where you get a real yield, on your short of interest rates. I think at least the dollar will hold here barring any type of any misstep by the US administration.

DAVID: I’ll just add further that. Look at where the two year note is trading right now at two and a half percent. Then take a look and see where a two year German bond is trading at -0.6. You have over a 300 basis point gap. Not even taking out any real duration risk. Like coming to the front end of the US seal curve compared to we’re in Germany. That spread is widened out, you asked me what’s changed. If that spread is widened out in Americas favor to the tune of 40 basis points just in the past three months. I think that’s really what caught the raider screen a lot of FX traders and why the US dollar starting to come back to life there.


YRA: I agree and plus, in saying that because I know a lot of traders who … They would buy, well when you thought the Euro was going higher, they would do these as unhedged decisions because there wasn’t enough in it. Because if you put your hedges on, by the time you do it wasn’t worth doing. Now, there’s enough meat on that bone to do those things and still being able to hedge a position who wanted to generate a much greater return than you could have as David talks about. That 40% rise in the differential I significant to attract people’s attention.

FRA: In terms of volatility David why do you think markets have been more volatile this year versus last year?

DAVID: Well, where do I begin? I think that we are in a … Last year in some sense was easier from a policy perspective. Yellon … continuity from Ben Bernanke. Markets are very comfortable with her. We didn’t really know what to make of what was going to happen with healthcare reform. Obama care form that didn’t go through. Then moved on tax reform, that gave momentum and the administration of congress at the home run by the end of the year, but that increasingly was getting priced in. I guess that when president Trump talk about how governing can be complicated. I think this year is a lot more complicated. A lot of the good stuff that happened in terms of the deregulation, in terms if the tax release, that’s behind us. What’s ahead of us now are the other parts of the election campaign. Which is more problematic or certainly provides a lot more uncertainty for investors. It relates … We weren’t talking this much about trade policy last year. We weren’t talking … We all knew it was part of the election campaign, but we were told take the president seriously not literally. I think that people didn’t really take it too seriously, maybe they should have. Now we have trade, we have tariffs or the threat of tariffs on steel and on aluminum. And on… dairy farmers. Acrimonious talks at least at the outset of NAFTA. What’s happening on the China side, the European side, exemptions here and none exemptions there. We’re in a much more uncertain global trade environment. Who know when that’s going to get resolved or with the other. DC markets will react at the merchant to not just change but the prospects for change. Because everybody that manages money for a living, is ultimately not just a manager of investments but a manager of risk. The risk on global trade has changed. It’s changed in the way towards cost push inflation, when we’re already late into the cycle. We have that aspect to it. We can talk what heightens your political risks, but …heightens your political risk, they always seem to be around. I think the situation on trade, is fairly serious in terms of what it means for the market multiple. Because the market multiple basically, and that’s the story this year. The story this year wasn’t earning, the story is the fact the multiples has compressed. The multiple is the inverse of uncertainty. Actually I think about the heightened volatility. That’s part and parcel of the inverse of volatility. We have a lot more volatility because we have less liquidity, and we have a more generally uncertain environment. Upon the liquidity for the federal reserve in a second because I think that’s big part of it. Because the fed has to respond all of this. We have policy over here, creates cost push inflation, that’s definitely happening. We saw that in … report before that the Philly Fed survey. We are looking at this hard and soft data. You’re seeing cost push pressures and a lot of it is because of the shift and the trade situation. Look at the fiscal situation too. I don’t think anybody is anticipating, we’re going to go for $500 billion deficits which are high enough as it is to over a trillion dollars. I say that today when the treasury comes out with this free funding announcement. I think the market was speaking about corporate tax reform was a good thing, but they were thinking that the government would lower the rate but broaden the base, and that never happened. The base didn’t get broadened, there’s just more bills and whistles then we cut taxes to households, and then we put an extra few hundred billion dollars on spending just on top of that. I don’t think that investors were looking at trillion plus dollar deficits as far as the eye can see. Of course at a time when the fed is striking its balance sheet. Creates a situation where bond yields go up and interest rates are basically a very powerful valuation determinant for other asset classes. We’re going to interest rates backing up for a variety reasons. One of them is the shift in the fiscal landscape. That’s another reason why we got a more volatile environment. Is because and is reflective of the [vecks] being 60% higher this year on average than last year. Is because of the uncertainty on trade, the uncertainty on fiscal, in terms of deficit finance tax cuts. Not tax cuts funded by spending constraint. It’s funded by higher deficits. The bar market maybe having trouble with that, then that will come back into the stock market as we’re seeing with the lag. Then on top of that … responds. I thought it was actually very interesting. The view back in the fall of last year was that … was going to be just a clone of Janet Yellon, different gender, no Brooklyn accent mind you, but they just … this is a new … Not just the Fed chairman but the whole voting membership of the [FMC] is totally different. It is a more a … fed. You saw it right in front of your eyes. The first meeting, what does [Powel] do? Raises rates. Not just raises rates, raises the growth forecast, raises at the merge and the inflation forecast, raises actually at the margin his estimate of where the neutral funds rate it. That’s all in one meeting, and was already after the stock market had officially collected 10%, and we’re going through tremendous fluctuations and volatility. He doesn’t come out and say, by the way this is going to cause us to take down our forecast and move us to the slide like. It’s quite the contrary. We’re going to actually have to do more at the margin, and we actually raised our forecast. It’s for our firm believer, that the physical boost is coming down the pike even though we somehow missed a good part of another first quarter. He already proved his medal that, he’s not going to come to the investor. He’s not going to come hold your hand because the market rate is 10%. … Bernanke certainly would have done that, Yellon probably would have done that. Here we correct 10% first movers, hike interest rates? I think that for an investor, you don’t have a central bank watching your back than you had in the past of five, 10 or even 20 years. I think this is all being reflected in the shrinkage of the market multiple, to reflect the fact that the times are changing.

FRA: Right, your thoughts Yra also.

YRA: I wrote a large piece where I quoted … My daughter actually works at Bloomberg. She used it in a radio spot that she had done for Bloomberg, that the Greenspan put was kaput. Because you could hear it in the language, when … and others started talking about that … that there was a shift and that Powell had definitely had control over this fed and no others. Because usually you would get some dissonance but there’s been no dissonance. It’s like he wait it out to look it. I can’t be at odds with you there’s certain shifts here, and they all could hide behind the unknown of how that physical stimulus will pay out because we just don’t know. With higher interest rates, will that totally eat whatever benefits were coming from the fiscal stimulus? I’m a big believer and I think J. Paul is much more market oriented. We saw that going back to what David said. If we go back to the late January, early February, there was no, no comment from the fed when the market was down 10, 12 13% in those few days, that they were all worried about it. In fact it was basically stay the course which was what a breath of fresh air that is because, I think the central bank is reacting to markets. At every major reaction is a terrible thing. I thought that back in May, June of 2013, I thought Bernanke made a terrible mistake with the temper tantrum and immediately reacting. He should have stayed there of course. I think we would have been in a much different place and much better place. I was not a …policy to begin with. The more I see and the more that he has more respects for markets the more I respect him and … does have control of the spread at this time. I think David’s point is that …voting change we are getting a more hawkish, even guys like Cash … who’ve been just ridiculously devilish with comments at times are known falling into line even though he doesn’t vote. But it’s amazing I would think that he would think more … speak without a vote. His language is much more leaning towards a heated dichotomy … But certainly not us devilish as he previously was so I think that point is well taken.
FRA: Overall David do you see stagflation in the global economy or in maybe in certain regions?
DAVID: Well I mean I’m seeing notably in the US market and I wrote about it today in my daily and if we are going to define it as rising inflationary pressures and soft growth, I think that we have it. If the ISM yesterday for example, you’re taking a look at the dressing index or was it a price level in 7 years. The past couple of months the vendor delivery delay index which used to be a favorite at the fed going back 20-30 years ago that’s been over 60 now for the past couple of months. Extremely elevated backlogs at a 14-year high. We’re getting some real serious bottlenecks in the economy, there’s worker shortages across number of sectors especially in manufacturing and in transportation related areas of the economy and we’re starting to get some such shortages of materials and that’s one of the things I’m saying that’s caused part and parcel by the growing spectra of trade frictions and tariffs and so on top of what you’re seeing on the energy side which of course is a different story. We are getting a culmination of rising wage pressures, nothing that is dramatically accelerating but moving up and moving up faster than it has been in any other time of the cycle. As we saw last Friday with the employment cost index which is actually once again everybody focuses on average early earnings. The employment cost index I remember the day when that was actually the Fed’s preferred measure, nobody wants to talk about it right now but it’s growing at its fastest rate. Since we’re in the last cycle before the recession so we have rising inflationary pressures on the material side on the labor side and I’m not seeing escape velocity in the economy I think all were going to be left with, with this fiscal stimulus, I’m not talking about the corporate tax reform aspect to it, that was necessary and I was in favor of that. But a blowout on the fiscal side really is going to be … domestic fiscal deficits. Which are going to be a dead weight drag on the economy for years to come. I’m really quite astonished at all the supply siders out there that think that this is actually the fiscal stimulus part to this thing was what we needed. Quite to the contrary, they’ll be a big price to pay in terms of losing fiscal flexibility in the future as a result of what’s happened over the course of the past several months. Congress put that aside though. Yes I’m seeing that the economy disappointed. Look we went into the first quarter, the Atlanta fed was calling for 4% growth we got barely above 2. In our strip out inventories and net exports that GDP number in the first quarter what you call real final sales to domestic purchases which is a real key underlying number on what’s happening to the demand guts of the economy excluding the foreign sector, excluding stockpiling and it was 1.6. I remember the days we got a 1.6 unreal final sales will be talking about around is there recession around the corner? People seem to think that’s a good number today I guessed we’ve readjusted our definition of actually what a good economy is. Then in looking at some of the anecdotal data flow like the ISM index and some other numbers of the sector quarter I’m not seeing much of a list so they view that the first quarter was just a weather report I’m not so sure about that. I’m not seeing the economy right now is growing and my opinion and rather temperedly and we haven’t seen the full impact of the fed rate hikes and the balance seat adjustment hit the wheel side of the economy or the market just fully or at least just not yet. Inflationary pressures are rising. Well people come back to me and say well you’re talking about stagflation yes and then people naturally go back and say what about the 1970s? No we’re not going to go back from where bill buttons were not going to go back and listen to the [Gs] all day long. It doesn’t have to be like the 1970s just like when people … If I talked about a bubble, people say well it’s not the banks and it’s not … it’s not always about the banks it’s not about household balance sheets there’s different accesses. People say they … stag inflation because they think it only happened in the 1970s but a stagflation is strictly defined as soft growth and rising inflationary pressures. We do have that in our hands right now I’d say we have a mild case of stagflation by the way again what is one of the great edges or ways to benefit in that environment is to be really long tooth specific sectors. Energy stocks are a great hedge against the inflationary aspect of it and financials.
FRA: Go ahead Yra.
With everything that you discussed does the US cover at this time. I know I have to put into the fed because all the signaling mechanisms that we’ve seen over my life in this business. in 41 years and I’ve looked at the yield curve as such an important indicator for so many years I’m not sure what it means in this but with all these consulates of debt, of course rising. We go back to the IMF and the number you … is 164 trillion but especially in the US with growing and I know I know this kind of funded on the short end which I would argue is probably a bigger mistake. But why should this curve be flattening at this time? Is it because the fed is being too … Or the market deems it to be too aggressive or is it still the impact of the QE from whatever the numbers are out of Japan and of course Europe we know those numbers that they actually exceeded it in April. Does that bother you at all David?
DAVID: I think that is … I’ve never really seen a fed tightening cycle fail to tightening the yield curve. Their two-year note is really sensitive to one thing and one thing only and that is fed expectations. You get out the longer end-of-the-year curve, say 10s of 30s and then there’s are confluence of factors between the term premium and real interest rates and replacing expectations. The longer you go in the curve, really the more complicated it is. Inflation expectations certainly have risen but they’re barely more than 2%, they are not rising other control. I mean they have risen. But then again the 10-year no yield is sitting close to 3% it’s not as to war 2 and a half anymore. The fed has already raised rates worth 150 basis points so far. Normally when they raise interest rates and you get towards this more mature phase of the tightening cycle the carb tends to flatten pretty dramatically. I’ve always talked about the yield curve. I’ve been in this business over 30 years and I’ll tell you that I always talked about the yield curve as a great leading indicator. I was screaming from the mountaintop when I was at Merrell back in ‘06 and talking about … Sorry.
YRA: That was great work…
DAVID: The thing is that the question I got … I would bring up the old cards at meetings and I’d talk about the meaning of the inverted yield curve at meetings and I would explain the yield curve at meetings. Today I go to a meeting and the first question I get is what do you think of the yield curve? All the business TV stations all about the yield curve. All the newspapers talked about the yield curve I’m starting to think because I have a real … that may be for the first time in 50 years the yield curve is not going to matter because it comes down to Bob Ferrell’s rule number 9 when all the experts in the forecast agree something else is going to happen. We may end up getting … The first time we get a recession actually without the yield curve having to invert. Remember other things were happening, the Fed where we have large scale deficits they may well be that and I think you’re right. They can’t fund 1.3 trillion dollars of gross new treasury born this year at the front end of the yield curve. Maybe the fact that they flooded the front end is why the yield curve was flat, maybe it re-steepens. I don’t know, it’s hard to really make book especially looking globally at the extent to which the central banks have added on so much duration to the balance sheet. That does the yield curve have the same meaning that it used to. I’ve changed my focus towards more of the general level of interest rates. Does the yield curve really matter? Let’s look at the United States. 47 trillion dollars of outstanding debt at every level of society. At the peak of the last cycle in 2007 it was 30 trillion. It’s gone from 30 to 33 trillion to 47 trillion. We’ve actually just blown out the peak of the debt level that defined the end of the credit cycle of 2007 by multiples. It actually boggles the mind. I actually never would have ever thought it could happen. I thought we were going to go through a real deleveraging cycle and in residential mortgages you could argue we did. We certainly didn’t do it with student loans or subprime models or autos in general certainly corporate balance sheets are extremely bloated. Look at the government sector commercial real estate. You can point your finger but I think it’s going to be more and especially a lot of high yield debt investment-grade debt, the leveraged loans, a lot of the stuff we’re going to be going through a master refinancing campaign in the next couple of years at higher interest rates. I think what happens if we aren’t going to get a default experience we’re going to get rice delinquencies. This isn’t so much a situation as to what it means in the banking sector at large but really the big bubble and this is true in Canada as well as in the non-bank financials that funded this thing. I don’t think the U-curve matters that much. I think the general level of interest rates and the powerful impact it’s going to have on debt servicing cost and the strains that come from that as this mountain of debt rolls over it’s going to be I think the real critical factor and so we might not even have a yield curve inversion putting the economy in recession this time it will just be that interest rates across a spectrum rose and created a tightening in financial conditions along the way.
YRA: Listen if there’s any buyer strike to us debt going on, we need greater premiums. It could happen and that’s why it’s very hard for me as being a … I love the work going back to ’06. I was a client of Merrill Lynch. I had a lot of … at the time. For me so I paid very close attention when you are rent because I’m a big believer in yield curves. I’ve done studying these for … I have a study that … going back 30 years so I pay attention because I’ve got the scars to prove being wrong. I go back to the UK in late 80s early 90s, I sat through 4 interest rate cuts and lost nothing but money I was low on guilts. The guilts keep going lower and shorter. I’m taking about futures prices. They kept going lower. I said how can this be happening? I learnt and bother to study I said I am missing something here. The guilts should have been rallying of course it went the other way and it really made me very aware of how these yield curves can move in ways that you won’t even think about. I’m paying close attention here, I think you added quite a bit. I remember in 2006, 2007 when they had 210 US curve actually voted 26 basis points which was very telling and then of course … Able to really time this what the lug is before when it comes because of course the SMP is one. … New heights. It was really matter. It does matter as you point out. That’s a great discussion I appreciate that.
FRA: Just finally your thoughts David on what have asset classes makes sense. How can the investors position themselves no specific names of companies or securities but generically your thoughts?
DAVID: Well look I think have to … I was saying that the theme for this year was its time to be the students not the teacher. In other words instead of trying to call the market why don’t we just heed the market message and I think that’s really important because the market is giving us a tremendous amount of information, a lot of it came down from when the early question about volatility. The extent of the volatility and the extent of the back-up and interest rates at the very front end of the yield curve is telling you something very important for the coming year. The 2-year not yield is alone a great leading indicator. When you get the … up 60% in this period of time and it sustained tremendous information that we were heading into we were in a transitional market. Basically what’s very important is for everybody to break out of the comfort zone of what works so well that cycle and understand that those trends are shifting. We’re in a transition right now so we are in a transition basically in my opinion in terms of what the markets are telling us that we are classically entering into a period where active investing is going to be far more superior than what’s worked which has been these blindfolded perceive ETF investing. I think that the markets are telling us that we’re going into a period where value is going to be surpassing growth for an extended period of time and I think that what you want to focus on you want to have more cash on hand than you normally do. Whatever your comfort level is. I think that long short strategies in the fixed income market generally speaking. Credit hedge funds good place to be. I’d be focusing on low data stocks with low GDP sensitivities so a little more defensive for a special situation. You want to protect yourself from rising interest rates especially the front end of the yield curve. The Fed is not done just yet so floating rate notes and as I said before the financials within the North American stock market. We actually have been doing quite well being a life insurance company and I think some inflation protection which is why I like the energy stocks. You might like to buy real return bonds or inflation protected securities, I think wouldn’t be a bad place to be. But I think that really morphing in towards that late cycle mindset and that means that if you don’t have commodity exposure in your portfolio you might want to start adding some. It also means by the way the Canadian dollar right now at 77, 78 cents will go to 85 sets if and when the bank of Canada ever closes the negative industry cap and allows the Canadian dollar to trade more with where the end of the line lower prices right now. Something else to keep at the back of your mind is that a North American investor getting some currency exposure in a currency that lagged well behind the US.
FRA: Go ahead Yra.
YRA: I know we’ve been … Everything that David said I find common ground with it. I look at the Mexican peso outside the politics … Because they are really well positioned on their currency basis valuation … That’s why the trump administration is a big part of the equation. Besides that everything that David said is on my radar screen but the issue that … goes back to it and what I followed it through is of course the market exposure to not just a passive trade but the risk purity trade. Everybody talks about … how much they have or AQR but to me the reach in market is not just the massive positions of those to hedge funds but the amount of what I call tail coding. It always goes on. Because one somebody comes up with a formula there’s a lot of copy cats out there and I think that’s why we see volatilities explode. Because there were a lot of people mimicking Bridgewater and others and putting on the same position. I think that they have position on that they have no idea of how they absolutely will eat themselves and explode upon themselves and I view that as a phenomenal risk factor going forward and I don’t know how they escape from it other than going to the central banks and begging them to take their position.
FRA: That’s great insight gentlemen thank you very much for the discussion and just wondering how can our listeners learn more about your work David.
DAVID: Well I produce to dailies as I think you mentioned I produce Espresso with Dave and Breakfast With Dave. So with me it’s always about food. Feel free to email me if you want to get on our trial distribution list for the dailies that I do. My email address is Rosenberg SNB rosenburg@gluskinsheff. So Rosenberg@gluskinsheff.com or call me up at 401-668-188-919 and I’d be happy to facilitate that.
FRA: Great and Yra?
YRA: Okay as usual I’ve got so many things but I keep pushing out the blog that I write is most from underground … and rationalist who can go long. I keep writing there and I’m actively trading some … Always happy to discuss any types of trades that people may have. The discourse that goes on at the blog is really at a high-level. I’ve got a really high readership that … Whack jobs as I called them and we keep it to a very high level. This has been a great honor for me on another financial impression authority ability. I have great respect for Dave Rosenberg over all these years and we didn’t just go negative. Because what I thought about this I said well when we are going to be here because I know from reading David’s stuff and hearing him paying attention when he’s on these things and we wind up in a very doomsday scenario but that’s not it at all. In fact I tongue and cheek so all this is going to be a rendition of … very high level and I appreciate it.
FRA: Great thank you. We’ll end it there.


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