Viktor Shvets on How the Fed Has Become a Prisoner of Its Own Making

This episode delves into the challenges the Federal Reserve faces in managing monetary policy in a complex economic landscape.

1. The Federal Reserve's heavy reliance on data has made it reactive rather than proactive.
2. The 'dots' system from the Bernanke era contributes to market volatility without providing clear guidance.
3. High U.S. interest rates impact global economics, affecting both emerging and developed markets.
4. Despite high volatility, central banks can rapidly counteract policy errors due to abundant global capital.
5. Political and economic pressures could drive significant policy shifts and global economic restructuring.

1. Introduction

Tracy Alloway and Joe Wiesenthal introduce the episode's focus on the Federal Reserve's challenges. They highlight how the Fed's approach to policy has become overly data-dependent, leading to potential volatility. Tracy Alloway: "The Fed's approach has led to a situation where each CPI report can swing policy expectations dramatically."

2. Discussion with Viktor Shvets

Viktor Shvets discusses the limitations of the Federal Reserve's current monetary policy framework and its implications for global economics. Viktor Shvets: "The Fed has become a prisoner of the very policies it implemented, focusing too heavily on short-term data."

3. Global Economic Impact

The episode examines how U.S. monetary policy affects the global economy, highlighting the interaction between high U.S. interest rates and international market dynamics. Viktor Shvets: "U.S. policies not only shape domestic economic outcomes but also have significant ramifications worldwide."

4. Policy Flexibility and Risks

Discussion on the Fed's ability to respond to economic shifts and the potential risks of policy errors in a volatile global environment. Viktor Shvets: "Even if the Fed commits a policy error, the abundance of capital allows for quick corrections, mitigating long-term harm."

1. Monitor economic indicators closely but maintain a long-term strategic focus to avoid reactive decision-making.
2. Diversify investments to mitigate risks associated with volatile interest rates and policy shifts.
3. Stay informed on global economic trends, as U.S. monetary policy can have far-reaching effects.
4. Consider the potential impacts of policy changes on both domestic and international markets when making business or investment decisions.
5. Engage with financial experts to better understand the implications of Federal Reserve policies and market reactions.

This week, we'll get fresh inflation data in the US, which will inevitably feed into the Federal Reserve's future decisions to raise, hold or lower benchmark interest rates. Meanwhile, the Biden administration is preparing to announce new tariffs aimed at curbing Chinese imports in key industries, including electric vehicles, batteries and solar cells. On this episode, we speak to Odd Lots favorite Viktor Shvets. The Macquarie strategist has a way of threading the needle between major global events and reaching back into history to provide context for our current macroeconomic moment. He describes the US central bank as a prisoner of its own policies, namely data dependency and the "dot plot." Meanwhile, China faces "massive" overcapacity problems as more and more countries put up barriers to its exports. We also talk about generational shifts and what they mean for investment.

People

Viktor Shvets, Tracy Alloway, Joe Wiesenthal

Companies

Bloomberg, Macquarie

Books

None

Guest Name(s):

Viktor Shvets

Content Warnings:

None

Joe Wiesenthal
As a real estate manager, principal asset management harnesses the power of a 360 degree perspective, delivering local insights and global expertise across public and private equity and debt. Their teams apply local insights and global perspectives to help identify the most compelling investing opportunities. Principal asset management actively invested learn more@principalam.com dot investing involves risk, including possible loss of principal. Principal Asset Management SM is a trade name of Principal Global Investors, LLC. Take your business further with the smart and flexible American Express business gold card.

Tracy Alloway
It's packed with benefits to help unlock more value from your business purchases. That's the powerful backing of American Express. Learn more@americanexpress.com BusinessGoldcard Bloomberg Audio Studios podcasts Radio news hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alaway. And I'm Joe Wiesenthal.

Joe, did you watch the FOMC presser recently? No, I did not. We were recording an episode of the Odd Lots podcast, what had happened? So I know that you didn't watch it either, unless you watched it on video afterwards, in which case you are a better journalist than I am. I didn't.

Just to clear that up, what I did was I read a bunch of analysis of the Fed meeting and a bunch of news summaries of what happened. And I have to say there was one term that I really liked, one description, I think it was in the Ft, and they sort of described the Fed as a monument to stasis. I mean, that could be a good thing. First of all, by the way, plug, there's a really, the other thing you can do if you miss a presser on the Bloomberg terminal, and I forget the code right now, but they produce transcripts very fast and the transcripts aren't published of the press conferences. Like, they don't appear anywhere.

Joe Wiesenthal
So plug for our terminal here. But yes, look, it's been a weird year for the Fed, right? Because, I mean, inflation continue at least through Q one of the year, inflation hotter than expected. All these expectations of cuts keep getting priced out. Everyone's higher for longer.

It's unclear whether the sort of simple models that we use, like, I mean, I think everyone sort of knows this. Nobody really knows how inflation works, but everything seems to be okay, right? I think one of the issues that the Fed might be facing is they put so much emphasis on data dependency that it kind of means that like every monthly reading of CPI can generate a completely different response. So when CPI comes in stronger than expected, everyone starts panicking about a lack of rate cuts. And maybe even you get a rate hike at some point when it comes in weaker than expected, you know, as it was doing up until.

Tracy Alloway
Until fairly recently, everyone gets very excited and we get that kind of Goldilocks moment in equities. There does seem to be this weird tension between, I know they don't use formal forward guidance anymore, but in a way, the dots sort of serve that purpose and sort of imply the Fed's so called reaction function. And so we're supposed to sort of take all of these data points, plug them into this black box reaction function, and then sort of implicitly see what that means for policy. But it does seem like things move a lot from data point to data point, so it becomes very present oriented, maybe? Yes, that's a great way of putting it.

And then the other thing I would say is, in addition to all the complexity around what's going on with the US economy, and it's kind of phenomenal in many ways that we're still having intellectual arguments about what the impact of higher interest rates actually is and whether or not it actually does anything to bring down inflation. But beyond that, the other thing that's starting to happen is we are seeing international consequences, and we've been talking about them on the show of the higher for longer stance. So the dollar has been rising. I think the spot dollar index is up almost 4% so far this year. And then against specific currencies like the japanese yen, it surged even more.

And so we are seeing those tensions between strength in the US economy, you know, ongoing inflationary pressures, higher rates for longer, potentially kind of meet emerging markets, and also developed economies in the wider world. Totally. We had that interview recently with Hugh Hendry. Extremely colorful character, to say the least. But one of the points that I found very interesting was we're not really used to an environment in which it's the US that's lapping everyone else, growing much faster than g seven or g ten or g whatever peers sort of powering ahead all this domestic investment, and so we get this upward pressure, higher rates, higher dollar stress elsewhere.

Joe Wiesenthal
It's an interesting environment. G whatever is a good term. They should have a g whatever conference. Can I coin that? Yeah, because I know Ian Bremmer has the g zero, but, like, I don't.

Tracy Alloway
I like g whatever, the g whatever summit, that should be a thing. Any country can come, okay? But when we want to connect the dots between what's happening with central banks around the world, between the US economy and the Fed and the global macro situation, there's one person that we like to call in particular. So today we are bringing back Victor Schwetz. He is of course a strategist over at Macquarie and we love talking to him.

So, Victor, thank you so much for coming back on all thoughts. Thank you for having me. Remind us, before we begin, it's not just us, right? The data dependency of the Fed. They have emphasized that a number of times and to some extent it seems like it is coming back to haunt them whenever there is a stronger than expected it inflation print.

And then we had payrolls since CPI and payrolls came in, you know, lower than expected for the first time in ages. And everyone got really excited about that. You're absolutely right, Tracy, that what essentially we have is the Federal Reserve is a prisoner of policies they start putting in a couple of years ago, which is essentially being extremely data dependent rather than forward looking. There is another problem, and that's the dots, one of the most destructive instruments from Bernanke era. So it's not anything to do with Jay Powell.

Viktor Shvets
I think if he could, he would have got rid of dots today. The problem he has is that the volatility getting rid of dots probably will be greater than the volatility dots themselves are creating. So he's trying to denigrate it by arguing that dots degenerate almost immediately as soon as they're published. So he's trying to take our attention away from dots, but as long as they're published, they are the material. So you've got a data dependency on the one side, which is basically dependency on a backward looking or at best contemporaneous numbers that you have.

You also have a lot of faulty numbers, whether it is how you determine shelter expenses or owner equivalent rent. How do you relate secondhand car prices? How do you measure insurance policy or financial markets? But there's also major problems with bureau level statistics. I mean, I'm glad that they've increased or revised our work last week, which basically showed the productivity miracle wasn't really there.

So you have quite a faulty numbers, both from Bureau of Labor Statistics. On the labor market you have mostly backward looking or contemporaneous numbers in terms of inflation. And if you become data dependent, you starting to create exceptional volatility because you're basically like a deer in a lime scene in a light, you're stuck. You cannot move to the left, you cannot move to the right. Now, what I think Jerome Powell is doing quite well is trying to introduce some degree of forward guidance.

So essentially what he's saying and what he said last week is that if I think of the shelter expenses. They're not quite as bad as a numbers look. And he's absolutely right. If he talks about other service oriented numbers again, whether it's insurance or anything else, he kept emphasizing they're not as bad as what they appear, both in CPI and PCE. And he's been quite vocal that the labor market actually a lot looser than what Bureau of Labor Statistics highlights.

But the problem is, Tracy, if you are a prisoner of data dependency and dots, the chances of committing a policy error increases. And so one of the questions I struggle with, whether in fact it matters if Federal Reserve does commit a policy error. I feel like we could have a whole episode just on the dots. And the problem with this is a communication strategy. Maybe we will.

Joe Wiesenthal
But anyway, it's interesting you said this, just, I guess it was either today, earlier today, or yesterday. Minneapolis fed Neel Kashkari ended his speech. The final section of his speech. Shout out to our old colleague Luke Kawa for flagging this. This is also a communication challenge for policymakers.

In my own summary of economic projections, except the formal name for the dots submission, I have only modestly increased my longer run nominal neutral funds rate, blah, blah, blah. The SEP does not provide a simple way to communicate the policy that the neutral rate might be at least temporarily elevated. Decode that. What is the issue, as you see it with the dots? Well, the.

Viktor Shvets
Well, there are a couple of issues. One of them, dots work very well. If everything is placid, not a problem. Whenever you have a high degree of volatility, either externally or internally driven, dots really don't tell you anything because it's really a personal opinion of several governors. Some are voting, some are not voting right now, and it's not linked to either federal policy.

It's not vetted, it's not researched. There is nothing in it. So long as the line of sight is relatively stable, dots are absolutely fine. As soon as you get the volatility. They are not.

And I think Philip Lowe, who retired as a governor of Reserve bank of Australia late last year, put it the best way. He said central banks will never see again inflation contained in a narrow range. Now, what it basically means that this idea that you have relatively flattish outlook and you try to manage it on a margin is becoming irrelevant. So, for example, the Federal Reserve, at the end of last year, on a number of variables, they went past their mandate. In fact, they overachieved their mandate.

And if you look over subsequent three or four months, suddenly they were way ahead of their mandate. And that's what Philip law was highlighting, that from now on, you're going to have a great deal of volatility of those numbers. And I think the dots by themselves magnify that volatility, rather than creating a greater sort of clarity for market participants. So why do you say that a Fed policy error might not matter? And I should caveat this with, you know, Joe and I spend a lot of time online and going by some of the, you know, social media discourse.

Tracy Alloway
The world basically revolves around whether or not the Fed's going to make a policy currency error. And the bias is always, the Fed is doing something wrong in one way or another. But why do you think it might not matter? Well, I usually say to people, look, we had terrific tightening, we had some withdrawal of liquidity. Could you explain to me how high yield spreads are only about 3%, which is the lowest ever?

Viktor Shvets
How could you explain to me that double b debt is trading at only 2% spreads? How can you explain to me that despite a very significant rise in US dollar, which both of you have just highlighted, that basis swaps are only five bps? They should be more like 50 bps or above. To me, the advantage of our era is that, first of all, we have too much capital. In other words, the idea of scarcity of capital that underlines things like DCF calculation or underlines most of the investment decision do not apply.

When you have too much capital now, it is not evenly or fairly distributed by any means, but there is plenty of capital. And the way you can measure it is essentially what is the value of all your financial instruments globally against real underlying economies. And what you find, depending how you do all balance sheet commitments, how you do derivatives, you could be looking five to ten times larger than the underlying economies. So we have plenty of capital. What it basically means, no matter what Federal Reserve does, it's very hard to tighten because that capital just keeps circulating, looking for diminishing returns.

The second thing we have, and Bloomberg plays a great role in it, is that we have instantaneous repricing. So anybody, any word in the market, it instantaneously gets repriced. And the third thing we have is that central banks are rolling out policies at an incredible speed. They're not even debating what is the outcome of those policies or what are the implications of what we're doing. Usually something happens on Thursday and Friday, and by Monday it's all fixed.

Are we going to have new policies for private capital, private debt, equivalent to what we have for Silicon Valley bank? Are we going to have special policies for parity trade basis trade from some of the niches in the high yield market. Of course we are. So if you have too much capital, if you're repricing instantaneously, and if central banks are willing and prepared to plug the holes almost instantaneously, this is a world of no risk. In other words, the way I put it, if the risk is everywhere, the risk is nowhere.

And if the risk is nowhere, then you can explain speculation, you can explain the gold price of bitcoin, you can explain why high yields will be trading at only 3% spreads. Because there is no risk. And the reason central banks are doing it, not because they're greedy for power or anything else, there is no shadow deep state or anything like that. The reason they're doing it is because of the dangers of not doing it. If you think of.com comma, that was only one asset price going wrong.

If you think of GFC, that's really a big asset, but only one. Today, landmines are everywhere. And those landmines, each one of them could be bigger than the original GFC. And so the result is central banks really don't have a choice. So even if Federal Reserve does commit a policy error, which is possible, they can unwind it in split seconds.

The way I describe it in my notes is to say, let's assume you get up, get in the morning, say, oh my God, it's going to be a terrible day. By lunchtime, I know it's okay, and by evening, let's have a dinner, and the whole thing just evaporated. Now, the key question, however, to ask what price do we pay for it? And the price we pay for it, is this volatility of inflation rates, is this volatility. It is volatility of the neutral rates.

In other words, the way I describe it, risk does not disappear, it just migrates. So if you keep the market placid, which is what we're doing, risk simply migrates somewhere else. It migrates into politics, it migrates into social sphere. It migrates into geopolitics. And so we do pay a price.

We do pay a price for this. But to argue that central bank is committing an error, furniture must be broken, is wrong. Even if they commit the error, which is possible, they can unwind it in 30 seconds.

D
As a leading real estate manager, principal asset management harnesses the power of a 360 degree perspective, delivering local insights and global expertise across public and private equity and debt. Our experienced teams are uniquely positioned to uncover compelling opportunities in today's market, giving our clients an exclusive advantage. Principal asset management actively invested. Learn more@principalam.com Dot investing involves risk, including possible loss of principal. Principal Asset Management SM is a trade name of Principal Global Investors, LLC.

E
Hi, I'm Ron Krzyzewski, chairman and CEO of Stifel Financial Advisors. If you're not growing your practice, you're losing market share. Stifel is a growing entrepreneurial, advisor centric firm built for successful advisors like you imagine having the resources of the largest wire houses and the support of the boutique shops, but none of the bureaucracy to get in the way of you serving your clients. At Stifel, it's your business, your book, your clients. I always tell the advisors we're recruiting, I want you to come to Stifel and double or triple your business.

Most of them laugh and shake their heads, but I'm serious, don't take it from me, take it from Stifel's number one finish in JD Powers 2023 us financial advisor satisfaction study. So there's a reason why 148 financial advisors joined Stifel last year. Come join us and find out why. Stifel is the firm where success meets success. Visit www.choosestifl.com Stifel Nicholas and Company Incorporated.

Joe Wiesenthal
Member SIPC and NYSE. I want to get into maybe migrate the conversations, geopolitics and this migration of risks, because you write a lot very well on that, but just sort of real quickly before we do that, but in your view, you described this world of like so much capital relative to GDP, you know, and people, you know, they blame QE for stuff like this or whatever. Is there like an original policy sin? And I don't even know if it's a sin. Paul Walker okay, explain.

So what is this sort of original sin that created this world of abundant capital? Well, if you singapore Paul Walker, he mostly known of course for squashing inflation. But if you go back in time, I think his much bigger legacy is creating that system of global recycling of capital and addiction to debt and addiction to asset prices. Prior to, well, essentially what happened. We've deregulated the financial sphere.

Viktor Shvets
We've deregulated capital flow. The idea was that United States will take the money from other people and stimulate consumption. Those other people will be buying treasury bonds, for example, in order to get returns to lower the cost for us consumers, but also to reduce their currency and make themselves more competitive. Now, Paul Walker was expecting that currency eventually will recalibrate this process, but they never did because nobody ever wanted to have an appreciating currency. And so we're stuck in a world of accumulating, I guess, disparities between savings and spending.

In other words, US and the UK, consistently net spender. Germany, Netherlands, China, Korea, Japan consistently net saver. And we've never really rebalanced it properly. So one of the side effects of that was that it became easier and easier to borrow, easy and easier to bring future consumption to the present to maintain your lifestyle. It became easy and easier to multiply credit.

Instead of having one instrument per asset, we can now have five instruments per assets. Ten. And each one of those instruments can be leveraged yet again. And yet again. And so all of that created massive amount of capital.

I mean, if you think of the financial stability board, they try to calculate the overall level of financialization. They're usually behind time. They only have 2022 numbers, but essentially what they were showing, about $500 trillion. And that's based on the net derivatives and not including any of balance sheet commitments or major ones. That effectively was five times global GDP.

So that's what started. So if you were to ask one person or one time when that happened, it's really Paul Walker who created our debt and asset based culture. Now, Greenspan, in late eighties, all he did, he took Walker's idea and brought it to logical conclusion. And that was a Greenspan put, which Bernanke and Yellen subsequently maintained. Yeah, it is interesting.

Tracy Alloway
I think I might have written a little bit about this in the A lots newsletter, or kind of thought out loud about it. It feels like we're internalizing the idea that the supply of credit can expand even as the cost of money goes up via benchmark rates, which might not necessarily be a new dynamic, as you just described, but like one that was probably underappreciated. Unintuitive. Yeah, unintuitive and underappreciated until this very moment in time. I want to ask one more thing on the US economy and the Fed before we maybe broaden out the conversation to geopolitics and pressures in other parts of the world.

But I remember one of the things I really liked about your framing of the post pandemic period was, unlike a lot of other pundits, you did not go back to the 1970s as your preferred historical analogy. You went back to the 1918 spanish flu, which resulted in a big run up in inflation, but then a pretty rapid deflationary bustle. And I'm curious, you know, here we are in 2024. Inflation is still relatively strong. We haven't seen interest rate cuts at all.

And as expected, maybe back in late 2022. Going into 2023, there were a lot of people who predicted we'd see cuts and recessions, and I think you might have been one of them. But have you been surprised by, I guess, the stubbornness of inflation and the higher for longer scenario in the US? And how is that stacking up against that 1918 parallel? Well, the way I look at it, my argument was there will be no recessions in the US.

Viktor Shvets
There will be no recession globally because we don't have recession. There is nothing to recover from, so don't expect any significant recovery. That's why my global growth rates always pitched at around two 2.5%, which is at least 75 basis points less than what we used to have with the previous decade, and about 100 basis points less than what we used to have in the past. My view, as you correctly said, that as you have sort of misallocation of demand and supply curves, as we have destabilization of demand, of supply curves gradually winds down, inflation should come out. No need for recession, no need for unemployment.

But there is a price we pay and the price we pay, there will be no recovery and there will be more or less a circular stagnation argument globally, some countries will grow a little bit faster than others, and that will be primarily driven by primary deficits, because overall deficits don't matter, primary deficits do. And the US happen to have the highest deficits. US is now running about three, three and a half percent of GDP. Primary deficits. Europe is less than one, Japan is less than two.

So if you have a higher primary deficit, you push up your neutral rates higher compared to, for example, european monetary union or Japan. Now, this inflationary trend in the global is still continuing. Now, if you think of g five CPI, for example, when we were here last time in sort of late 22, early 23, the number was 5%. In March it was 2.4. Now 2.4.

It's only 2030 bps higher than it was over the previous 25 years. But the leadership changed. If you think of the second half of 23, disinflation in the US was extremely strong, but inflation in Europe, UK and Japan actually was climbing, not down. What you saw over the last four months is that inflation start breaking in the UK, start breaking at eurozone, start breaking in Japan. Disinflation got stronger in China as we progress, but in the US, it stuck and actually gone up a bit.

Now, the question is whether that's something unique to United States or whether in fact, in the second half of 2014, we're going to relieve what we had in the second half of 23, and the United States will join the rest of the world in a disinflationary trend. That's my base case. Now, what underpins it is neutral rates and productivity. Now, my view is that neutral rate has not changed. Neutral rate is a long term process.

That's why almost all models are still showing that neutral rates in the US are 50 to 100 basis points real, which means policy rate should be closer to three, not 5.5 on that basis. But in the short term, you can have a spike in those neutral rates. Now, I do think neutral rates spike despite the fact that models don't show it. I think it did spike. Now, the question is whether it's already coming off or whether somehow we can keep neutral rate at a much higher level.

One of the key elements there is productivity. Now, I'm not a buyer that there will be any productivity improvements. In other words, labor productivity or multifactor productivity is not going to recover for at least ten years, possibly even 20 years. Now, if you take a view that productivity is not going to drive it, then either you have to have much higher primary deficits continuing or you have to have some other form of shocks in the system in order to drive it up. So if I'm correct that neutral rates have not changed and it's still 50 to 100 basis points real, then it must be coming off.

As it comes off, deflator comes off, nominal GDP drops from. In the US, it's already down from 12% to 5.4 as it starts dropping towards 4%. You can't keep policy rates at 5.5 unless you want to have a recession. That's the only reason to have it. So I'm still in the same camp, except it's desynchronized or going back to Reserve bank of Australia.

It's violent how it moves. Also, one more point in the US, inflation is really in pockets in 22 or 2021, even in early 23, it was all over the place. Right now is just in pockets. So all you need to do is to bring those pockets down to a low level. I mean, we could also just talk for an hour about why it'll take 20 years before we see a productivity boom.

Joe Wiesenthal
But let's talk a little geopolitics. So this idea, risk has been taken out of the financial system and it migrates elsewhere. Maybe to politics, maybe to geopolitics. We're obviously in a moment and you're going to see it by all the trips people in the administration take. To trips to China where there is significant amount of anxiety about China geopolitically.

Military to military communication, cooling the temperature, coupled with industrial anxiety. Are they going to own the EV market for the entire world, etcetera? Draw that line for us, maybe start there, draw that line for us between the sort of taking out of financial risk and that migration and how that fits into the China thesis. Sure. Well, one of the things I disagreed with almost everyone over the last two or three years, remember the view was that China is running out of people and so China will be exporting inflation.

Viktor Shvets
Now my argument all along was China cannot export inflation, their major export of disinflation. And the reason for that is very simple. China, just like Japan's seventies eighties, has a very high national saving rates. They're running at about 45%. Just like Japan in seventies eighties could have put policies in place to consume it, but they didn't.

Neither have China. And so the result is they must invest at least 42 43% of GDP. Think of the numbers. That's an equivalent of nine to $10 trillion invested every year. It's double of GDP of Japan invested every single year.

Now if you're investing that sort of money, it doesn't really matter what you invest in, you create massive overcapacities. And if you go into niches, things like what Xi Jinping calls productive forces, things like electric vehicles, robotics, automation, solar industry, if you go into smaller niches, you almost automatically create three times global demand, if not more. Now at that point they have very limited choices. Either they change their pivot, pivot their policies dramatically send checks to people. Instead of building another factory, build a social safety net, raise universal basic income.

They already have universal basic income in China. Just raise it and equalize it across the country. So you either do that, but if you're not willing to do that, which they're not, then the only way you can do it is accept that you lost the capital and closed the factories. And we will discover China potentially is much smaller country than what we thought it was. Or the other alternative, dump that access capacity onto other countries.

But given the amounts of money involved, there is not much you can dump on Kazakhstan. So there is only UK, European monetary Union or EU, United States, Japan. There's very few places that can take that sort of capacity. And so what's happening? Those countries are putting up barriers.

Now the reason they're putting up barriers is that China also wants to change the world. They want to redesign everything, whether it's human rights information, whether it's the role of state versus individual, whether it's role of state subsidies, trade rules, they want to change everything. So if China did not try to change the world world, I think the extent to which the barriers would have come up would not have been as aggressive. But now China has a catch 22. Barriers will come up, which means it's harder to sell that excess capacity.

You don't want to recognize the loss of the capital and what you're trying to do is to go on a charm offensive. That's why chinese president is in Europe right now. From a us perspective, what us is trying to do is gradually grind China out of the western system, but without dislocating refrigerator prices or without dislocating things that housewives are using. And the way you do it is starting from the top, starting from the high tag and just keep moving and slowly grinding them out, slowly retarding their growth rates, at least relative to what you can do, but without triggering a real conflict. So to me that's a cold war.

You're walking a tri trope between degrading as much as you can your opponent without triggering something really nasty. And I think so far, to be fair, whether it's Janet Yellen, whether it's blinken, whether it's Sullivan, I think they've done a pretty good job of actually achieving that balance. Whether that can be maintained, however, depends extent to which chinese economy and society perform to some extent. I mean, it also depends what happens in the US, of course. But, but if you just look at China, it depends on that because remember, nominal GDP in China already fallen from 10% to four.

Now, in other words, as you create more disinflation, as you saw in Japan, it is really nominal GDP. That tells you the extent of the pressure. Now, if economy and society are geared towards a double digit nominal GDP, if you can't raise it, inevitably pressure starts rising. And so the question is extent to which that pressure rises. What is China's response both in terms of geopolitics, in terms of politics, but also in terms of economic policies and how you're going to change them?

Tracy Alloway
Well, this is kind of what I don't get, and this came up in the episode we did with Hugh Hendry recently as well, where he was talking about the old traditional chinese export model for reasons that you just laid out as well, just isn't going to work anymore because Europe is not going to accept a flood of cheap electric vehicles coming in from China. And so I guess I'm a little bit confused exactly what China is planning here because the resistance from the rest of the world seems so glaringly obvious. When China first started talking about building up, you know, technological independence in things like semiconductors or strategically important technologies, I was under the impression that, like some of the idea there was to sell it into the domestic population so that you don't have to worry about the US suddenly cutting you off from important chips. You would have your own supply and then you could do with it what you will. But as you laid out, like boosting domestic consumption doesn't actually seem to be a priority right now.

They still seem to be very focused on exports. So I guess I just don't get it, because to me, the problem with that strategy seems so obvious. One of the ways I describe it is the way I look at Xi Jinping and the way I look at chinese leadership right now. It's sort of a mixture, very stern, paternalistic attitude. Being soft is bad, suffering is good.

Viktor Shvets
That's one side of it. The other side of it is very classical economics and marxist economics. They're effectively harping back to the day of Quincy, David Ricardo, Adam Smith, Karl Marx. And those people were not thinking of prices, they were thinking of value. Now, since late 19th century economist, abundant value.

So we only look at the prices. So if you're a billionaire, you must have added value because price is telling you have classical economies, says, no, this guy just captured somebody else's value. He didn't create value. And so if you take that mindset, who is creating value? Who is destroying value?

If you ask David Ricardo, does he think financial markets or capital markets value creative, the answer would have been no. The best thing you can argue, they relocate it, but they don't create it. Who is creating value? And so for Ricardo or Adam Smith or even quincy before that, the argument people who produce stuff, whether it was agriculture early on, whether it's manufacturing, whether it's technology, and so the emphasis seemed to be much more on supply. The emphasis seemed to be much more production.

The emphasis is to start to strengthen, as Xi Jinping calls it, productive forces, which is a classic marxist argument, productive versus unproductive. Strengthen that, put obstacle in front of people who you don't regard as productive. And they're incredibly suspicious of capital, markets and finance. Right? So the disorderly expansion.

And so that's right. What Karl Marx used to call fictitious capital, capital that multiplies for its own sake without doing anything good to anybody else. And so if you take that mindset, and that is not the mindset of western economies, but if you take that mindset this sort of stern paternalistic attitude and the emphasis of what he described, productive forces, you understand why they're reluctant to actually do anything about it. Now, eventually, as I said, early on, the pressures has to rise and they will have to pivot. And we saw with COVID in late October, early November 2022, that he can pivot very, very quickly.

That's why there was a disorderly opening after COVID. There is a possibility that there will be that moment when you actually will have the change. But the longer he waits, the worse it gets. And the reason is very simple. China is not Japan.

Japan had an open capital account and fluctuating currency and convertible currency. So when Japan run into the wall, they just collapse overnight. China has close capital account, currency is not convertible. Central bank is not independent. Actually lost all the power, pretty much.

Commercial banks are not commercial, and private sector is not really private. So when you're operating behind the walled garden, you can't have Minsky moments, you can't just hit the wall and collapse. But what you can do, you can basically have increasing headwinds as you keep going. So if Japan operated chinese system in 1990, they didn't have to go down. They could have survived until 96 or 97.

But the longer you go with that, the worse it gets. And so they need to recalibrate. So recalibration, which is needed, change your policy settings quite dramatically. Number two, change your geopolitical stance quite dramatically. In a sense, stop trying to rebuild the world and change the world and change domestic politics.

In other words, give a little bit of freedom for people, both businesses and consumers and households. If there is this pivot change, you still have to pay a price. Because one of the things I highlight is capital stock. IMF calculates it. And if you think of 2004, China had capital stock of, I forgot, like $4 trillion India had won.

In 2028, they will have $105 trillion. US, for example, will have 70, 75, India will only have six. So China absorbed over $100 trillion of depreciated capital in couple of decades. When you absorb so much capital, which is entire world gdp, when you absorb so much capital so quickly, inevitably you have an indigestion period. So that indigestion period will be with you even if you make a policy pivot today.

But what will happen if they do? That risk premium will improve, because China is the only market in the world and the only asset in the world where risk premium over the last several years have gone up almost everywhere. Risk Premier actually falls.

D
As a leading real estate manager, principal asset management harnesses the power of a 360 degree perspective, delivering local insights and global expertise across public and private equity and debt. Our experienced teams are uniquely positioned to uncover compelling opportunities in today's market, giving our clients an exclusive advantage. Principal asset management actively invested learn more@principalam.com dot investing involves risk, including possible loss of principal. Principal Asset Management SM is a trade name of Principal Global Investors, LLC. Hi, I'm Ron Krzyzewski, chairman and CEO of Stifel Financial Advisors.

E
If you're not growing your practice, you're losing market share. Stifel is a growing entrepreneurial, advisor centric firm built for successful advisors like you imagine having the resources of the largest wire houses and the support of the boutique shops, but none of the bureaucracy to get in the way of you serving your clients. At Stifel, it's your business, your book, your clients. I always tell the advisors, we're recruiting, I want you to come to Stifel and double or triple your business. Most of them laugh and shake their heads, but I'm serious.

Don't take it from me. Take it from Stifel's number one finish in JD Power's 2023 us financial advisor satisfaction study. So there's a reason why 148 financial advisors joined Stifel last year. Come join us and find out why Stifel is the firm where success meets success. Visit www.

Dot choosestrew. Stifel Nicholas and company incorporated member SIPC and NYSE I want to push on two specific things you said. So one is you talked about chinese dumping, and I sort of understand conceptually the idea of dumping in a commodity like steel, whether you produce a bunch and you can't use it all at home, or maybe even like solar or something like that. But a lot of the chinese export success seems to be in making high quality non commodities that are just very competitive for cost reasons and in some, arguably quality reasons. One example would be people saying that the Xiaomi phone now has a better camera, say, than the iPhone.

Joe Wiesenthal
So that's one thing. And then the other thing is you say you credit Yellen and blinken for maintaining something reasonably well, this attempt to degrade China, but not necessarily provoke something stronger. What have they actually done substantively? Because I see the trips and I see the talk and the anxiety and the, you know, the FT columns about dumping and all that stuff, but I don't really understand or can't quite internalize what substantively they have accomplished. Well, what you need to avoid is very dramatic moves.

Viktor Shvets
Okay, so in other words, the last thing you want is to stop slapping tariffs on very primitive products. But remember, China mostly actually does low grade stuff. People are focused on cameras, etcetera. But a lot of China is basic chemicals. It's toys, it's that sort of stuff.

So try to avoid displacing that trade as much as possible. Try to focus on the areas that are important for you strategically. And that's what Trump started to do, but very chaotically. And what Biden administration have done very systematically over the last four years now, except the China trade will get rerouted. Now, the fact that suddenly Mexico and Vietnam became major partners of the United States have very little to do with capacity of those countries to actually produce it.

It's a lot of chinese trade gets rerouted through those places and accept that, because you're getting some of the benefit of that, including sometimes better quality, lower prices that consumers and businesses in the United States can benefit from. At the same time, what you're trying to do is reestablish as much contact as you possibly can, because as defence secretary was saying back in Singapore, when Chinese refused to talk to him 18 months ago, he said, with the Soviets, we never agreed on anything, but we talked. And the same is here. You need to maintain the lines of conversation so that you know how far you can go, where you cannot go, how far you can push, how far you can bring it back. So what you try to avoid is a chaos.

What you try to avoid just slapping stuff all over the place, trying to avoid pushing China too far, and at the same time, gradually, as I said, degrading it. Now, there is a possibility, and it is a small possibility right now, but there is a possibility that something horrible is going to happen either in Russia, Ukraine, or something horrible might happen across Taiwan Straits, and the whole thing will start escalating beyond what you're trying to do. And at that point, we could potentially see zeroing out even of chinese and Hong Kong assets. You can even see Us Department of Treasury arguing that they don't recognize, for example, the currency of Hong Kong dollar. So in extreme, you can have a very extreme outcomes, which I think are not likely so long as there is no, as I said, disasters occurring along the way.

Tracy Alloway
So we just have a few minutes left, and I want to go back to what you said earlier, where you were talking about the idea of financial risks migrating into, I guess, the real world, into the political sphere in one way or another. And you are actually the only sell side analyst I know of who has mentioned the Columbia protests specifically, where here in New York, Columbia is not that far from us. Talk to us a little bit about how that kind of political discontent plays out in your world, in the world of investment and macro and things like that. Why is that on your radar? Well, usually when you have generational replacement and everything is fine, like, economies are fine, finance is fine, technology is fine, there is no displacement politically or geopolitically, then one generation just slips into another, almost unnoticed.

Viktor Shvets
That's what happened to baby boomers and x generation. But whenever you have as an x generation, we never. We slipped out before we were even in. We never get any attention. No.

Tracy Alloway
Are you millennial? No, no, I'm 80. I'm x. Anyway, go on. But whenever you have.

Viktor Shvets
Whenever you have a major technological financial disruption, what happens is that you have, or whenever circumstances change massively, for the better, for the worst, one generation cannot slip into another generation. That's what happened to baby boomers compared to silent and gi generation. The baby boomers could not relate to their parents or to their grandparents. They had radically different views what they wanted to do. And so the younger generation, anybody born sort of after sort of early eighties onwards, have a very different view of the world.

And the reason they have very different view of the world, because they did not experience a world where jobs were plentiful, where you've gone to college, you automatically had a good job. They found that your jobs degrade, they found that professional lives degrade. They found that technology gives you many tools, but it also degrades both your pricing power and marginal pricing power. They found that politics become disoriented as that occurs. They found that democratic policies cannot solve the problem, extreme polarization.

So they, in the mixture of technological, financial and political revolution. And when you have that change, that generation thinks very differently, and eventually they become a very large cohort. And when they become a large cohort, they demand a change. Now, what baby boomers were asking for is not what this generation is asking for, but they're asking for change. In my view, the change, all the surveys that come out, the change they're asking is very much community based, is very much community of equals, is very much government supported.

In other words, harping to their grand grandparents who lived in 1940s and 1950s, rather than to their parents and grandparents. And so usually it starts with those types of demonstrations. Doesn't really matter what the excuse is, whether it's a civil rights, whether it's a court cold war, whether it's Vietnam war, whether it's inequalities, whatever that is, something triggers it. But then as they get bigger and bigger part of the population, they really drive the policy. So today, late millennials in Z already almost 50% of the population, but they're only about 39% of the adults.

They only 25% of the voters in the US, mathematically, by 28, 29, there will be majority of adults. And by earlier to mid 2030s, there will be absolute majority of both voting and the adults. And so the question is, what type of policies, economic policies, political, social policies, would they demand? Baby boomers wanted freedom, free enterprise, personal responsibility. You give me the rope and I can hang myself with it or I can succeed.

These guys asking for something else. And so how would all of those policies change? And I think they're going to bring us back to 1950s. That probably will be more likely outcome rather than sort of 1990s. Two thousands.

Tracy Alloway
I like how conceptually we've sort of come full circle because we're back to, I guess, demographic changes driving potentially higher deficits over the long term, fueling us exceptionalism in some ways. Maybe. Yeah, let's take it. Victor Schwetz, thank you so thank you so much for coming back on odd lots. Thank you.

Viktor Shvets
I appreciate it. That was great, as always. That was really fun.

Tracy Alloway
Jo. I feel like any mention of generations always leads to debate over the cutoff points. Well, I may have said. I don't know if I've ever said on air, so I'll just say that I have a very simple test for the dividing line between x and millennial. Cause some people say 79 or 81 or.

Yeah, I've heard 1980 and above. Yeah, I've heard that too. But I think there's a very simple test to do it, which is, did you have Facebook in college? Because that gets you in that ballpark automatically. But also that's generationally transformative.

Joe Wiesenthal
Social media is, like, clearly a dividing line. I did not have Facebook when I was in college. I got my first account, I don't know, like, 20. It was after I graduated. By a couple of years, you apparently did.

So, IMAX, you're a millennial. That makes a lot of sense. Thank you. I think it, like, I think is a test. And apparently, I guess it probably rolled out to people on Harvard earlier.

The implication is that people at Harvard became millennial before the rest of everyone else. Well, yeah, I was at LSE, and I think we were one of the first international universities to get it. I have to say part of me kind of misses the college era of Facebook, where, like, we just spent an inordinate amount of time, like, poking each other. I don't know if you're that. Anyway, back to Macro.

Tracy Alloway
There's so much to pull out of that conversation. It's always great talking to Victor. I guess one of the things that strikes me is, you know, he highlighted the, I guess, unexpectedly loose financial conditions. And to me, it does feel like that is a key part of what's happening in markets right now. And it kind of goes back to that point I was making earlier where I don't think anyone expected the cost of money to go up so much, viz, benchmark rates and the Fed's rate hikes while the supply of credit continues to expand.

And that to me is sort of like the key to a lot of what's going on in asset prices. Why we haven't seen that huge default cycle that people were predicting, why we haven't necessarily seen as many layoffs as a lot of people were predicting and things like that. Yeah, totally. Like, we can easily point to a few different categories, like aspects of real estate in which. But no, it's totally true that it's sort of a puzzle.

Joe Wiesenthal
And I don't think anyone has a great answer for why, uh, you know, people talk about refinancing and everyone has a third year fixed. Maybe that has something to do with it. Still, it's not entirely intuitive why that hasn't had a larger compressing effect on asset prices. You know, there's so much to pull out of that conversation. And every conversation with Victor, like I said, we could have talked for like an hour on the problem with the dots.

And maybe we should do that because it does seem like that's getting more attention to sort of being handcuffed by the dots, perhaps, you know, obviously, and we'll do more China episodes. But is it really possible? And I guess I have my doubts, but what do I know? Like to degrade China's cutting edge capacity in such a way that doesn't provoke actual geopolitical conflict. Something more mild.

Big questions there. Dots seem so innocuous to me. It's so, it's, it's funny that we're talking about them as like, wait, can. I give a confession? And I always do my confessions at the end.

Tracy Alloway
Cause I hope that no one's listening. No one's listening. I always turn off odd lots. You turn off odd lots right here. I always forget whether the dots are what the individual FOMC member thinks should be the optimal path of monetary policy going forward versus what that FOMC member thinks the policy will be going forward.

Joe Wiesenthal
And I like I know there's a right answer in one, but I always forget which is which. Oh, I hate stuff like this because it makes me. It's one of those things like you just talk about kind of naturally without thinking about what you're actually looking at. But I think it might be what they think appropriate monetary policy should be. No, you're right.

I just, as I was saying it, I also pulled up the Bloomberg dots. Explainer anyway, which, I mean, also, you would expect it to be that, right? Yeah. Right. Well, I mean, yeah, bring back the Boe fan charts.

Tracy Alloway
That's what I say. Let go of the dots and let's just do a range of probabilities for interest rates. And we can have either fan charts or those hair charts, the Harry charts, the Medusa charts, which I love, or. Just go back to the old days where they don't even tell you what rate that they sent and the market has to figure it out because the overnight rate, that would probably be fine, too. I don't think we need all this communication.

Joe Wiesenthal
I appreciate it. I like the speeches. They're interesting. But we don't even. We went for years without that.

Tracy Alloway
It would be very interesting to Victor's point about sort of real time repricing to see what a system like that would, would mean for financial markets right now. Maybe it would be better. Let's all slow down. I think it's possible. All right.

Shall we leave it there? Let's leave it there. This has been another episode of the Odd Thoughts podcast. I'm Tracy Alloway. You can follow me at tracyalloway.

Joe Wiesenthal
And I'm Joe Wiesenthal. You can follow me at the stalwart. Follow our producers Kerman Rodriguez, Herman Ehrman, Dash L. Bennett at Dashbot, and kill Brooks at Kill Brooks. Thank you to our producer, Moses Ondom.

For more odd lots content, go to Bloomberg, where we have transcripts, a blog and a newsletter comes out every Friday, and you can chat with fellow listeners in our Discord Chatroom 24/7 talk about all these topics, discord, gg, oddlots, and. If you enjoy audlots, if you like it when we try to figure out what the dot plot actually is, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad free. All you need to do is connect your Bloomberg account with Apple Podcasts. Thanks for listening.

Tracy Alloway
Collaborate for a greener future at the Bloomberg Green Festival, a groundbreaking celebration of the thinkers, doers, and innovators leading the way from design and culture to technology, science and entertainment. Hear from inspirational speakers and immerse yourself in climate solutions. July 10 through 13th in Seattle. Title sponsor Amazon Official Airline Alaska Airlines get 20% off using promo code Radio 20 at bloomberglive.com green festival.