Speaker 1The valuation declines are coming now. We've been suffering that, P multiples contracting. What's been unusual is that you've got earnings gains that are more than offset that, or certainly in certain areas of the market, that are more than offset that. And the question is, are those earnings gains sustained? And I would be sceptical. And I think the corollary to saying that is you've got a lot of cash flow in these AI companies that's now going to be devoted to paying interest or paying down some of the debt they're taking on. And the debt burden that these companies and the US economy is now taking on are pretty eye-wateringly large. I mean, you're talking about some estimates of putting next year another $2 trillion of capital rate. That's a big raise for AI. And putting that into perspective, I mean, the US government is a trillion dollars of new debt. So this one industry is getting big, big demand on markets. And you've now got more debt outstanding of AI companies than you have in the whole high-yield area in the US. So this is becoming a sort of a monster.
Speaker 2Hey everyone, my name is Anthony Fatsis, and welcome to another episode of the What The Finance podcast. On this podcast, I have the pleasure of welcoming back very popular guest Michael House. And Michael, thanks so much for coming back on the podcast.
Speaker 1Well, Anthony, always a pleasure.
Speaker 2Yeah, looking forward to the conversation. It's been about three or four months, and it seems like a lot's happened in the world. So I'd be really interested in hearing, you know, what are you currently watching in the markets and the economy at the moment?
Speaker 1Well, I mean, we're watching the same as ever. So we look at the flow of liquidity going through markets. That's our guidepost. What we've been seeing through this year is a continuation, maybe, of the trends that were just about put in place in late 2025, which was a peaking of the global liquidity cycle. Remember, this is the flow of money through world financial markets, and it's crucial to the development and evolution of asset prices and financial market stability. And what you're seeing is a persistent drain of that liquidity through this year. You know, recall again that liquidity is a leading indicator. So this doesn't mean to say you get an immediate shock, but it's saying that things are basically getting tougher and liquidity tends to lead. Well, let's say it leads financial markets by around six to nine months, depending on the type of asset, and it leads real economies by around about sort of 15, 18 months or so. So you've got different windows. But broadly speaking, we're seeing declining liquidity and you can evidence that. I mean, take a look at the chart that I put up. And what that shows is the liquidity cycle going right back to the mid 1960s. It's a regular cycle. It basically tends to move through with a frequency of about five to six years. The peak, as I said, was late 2025. It's been going down through this year. There was a little bit of a sort of flick up in September, which was actually down to what the Federal Reserve was doing, which we can dig into later. But basically, that trend still seems to be downwards. And it's slated to bottom sometime in the second half of 2027. Now, it may well be that the flexibility is in when that does bottom. I mean, it may well be that that bottoms sooner in 2027 than we've been suggesting. But, you know, we've got to try and evaluate where we are and see if that's reasonable. But for the moment, liquidity is still going down. It's still creating a lot of problems in markets.
Speaker 2Yeah, it makes sense. And yeah, what are you seeing the Feds doing? What? What actions are they taking to actually potentially increase liquidity?
Speaker 1Well, I think the thing is, is that, you know, we're ahead of or about a week away from another FOMC meeting. The focus inevitably will be on interest rates or interest rate changes or interest rate no changes or whatever. But that will be, you know, what the media are focusing on and be what the press is all about. But that's pretty a very, very small part of how the Federal Reserve or the general and the US monetary authorities, including the Treasury, already operate. And Fed funds is, you know, basically a tiny part of factors that control monetary conditions. So it gets a lot of undue and unnecessary attention and the whole presser just becomes a sort of pantomime or almost a joke at times about what's going on. So I think you need to dig into what the Fed is really doing behind the scenes. And in our view, you've really got to focus on maybe three levels of policy lever. You've got to focus on what the Federal Reserve is doing, what the Federal Reserve is doing and what the Federal Reserve is doing behind the scenes. And then you've got to focus on what the FOMC is doing behind the scenes. important. The most important are, number one, what the Federal Reserve is doing in money markets. And one of the things that we've seen through pretty much the last 12 months or so is the Fed seems to be targeting bank reserves at around about $3 trillion. And whenever bank reserves sort of move away from that level, the Fed changes Fed liquidity. It's something it's entirely in its gift to do. It can control bank reserves precisely and it changes. And what that change basically does is stabilize what are called the repo markets. Now, the repo markets are key funding markets in the US. They're key funding markets for the US economy and for the world, for that matter. They're crucial markets, probably in size, something like about $14 trillion. So sizable amounts of lending go through them. And the repo market is basically a market that operates with collateral backing. So in other words, what you've got to understand is the repo collateral nexus, which is broadly speaking saying that if you post collateral to a dealer bank, in other words, let's say you post a treasury bond or treasury note or bill to a dealer bank, you can then take a loan out using that security as collateral. And that is basically how the funding system in the US and globally tends to increasingly work. The World Bank have actually told us that something like 77% of all global lending now is collateral backed in some form. So this is a big change in how markets operate compared to where we were pre-GFC 2008, 2009. So collateral repo is really the central thing, and the Federal Reserve has got its finger on the pulse for that. The third element, which is actually connected to that, is actually ensuring that the collateral markets are stable. So there's low volatility in those markets. So effectively, if you think about it this way, what you've got is a flow of liquidity into those markets, If you think about that as primary liquidity and that liquidity can be leveraged up using collateral and what we think of as a collateral multiplier will then apply that collateral multiplier. How many times you can borrow or reuse your collateral to look to borrow is something that depends very closely on bond volatility. And if you have a high volatile or high and volatile bond market, your collateral multiplier is going to be smaller and the pool of liquidity is going to be correspondingly smaller. Now, the reason for me sort of going down these other rabbit holes and spending some time on this is this is really crucial to understanding the overall liquidity background. And it's those latter two elements, the flow of liquidity into markets and the stability of the collateral markets, which are really the key dimensions of monetary policy. and what the Federal Reserve is doing, and what the US Treasury doing, are both trying to manage these two elements of the equation.
Speaker 2Really interesting. It sounds like it's a bit of a short-term fix, that this is going to be sort of a policy correction that will then flood liquidity in the market sort of once. Is that how that would work?
Speaker 1No, I think you've got to think about this as a process. I mean, maybe if you take a look at the chart that I've just put up now, What that's looking at is something called repo spreads. And this is looking at the stability of the repo collateral market from the perspective of how much liquidity is available for dealer banks to use. Now, if you get problems in the collateral markets, you can see that that orange line represents a spread against Fed funds or the equivalent, which is interest and overnight reserve balances, the IORB mnemonic there. That spread, which is showing SOFA rates, so this is system overnight funding rates, that spread is very sensitive to liquidity in the money markets, in other words, to bank reserves. Now, if you see a big spike in those rates, which we saw in late 2025, that's saying there's a shortage of liquidity. And if there's a shortage of liquidity, that will basically filter through the system. will basically crunch bigger aggregates of liquidity through financial markets in the economy. It will cause trade fails. It may well cause ultimately defaults. And then you get a lot of financial market turmoil. So they'll be sort of rushing to liquidate assets and positions and deleveraging and whatever. So it's a crucial thing to watch. And you can see in late 2025, that spiked up. Now, the reason for that was that the Federal Reserve, if you recall back at that time were talking bravely about slashing the size of the Federal Reserve's balance sheet and that was of the things that they were intending to do and actually they began that process and they took about 300 billion dollars uh out of money markets out of bank reserves and the result of that was that you've got this repo spike and they very hurriedly uh reversed that process by uh you know getting their acronym department to work overtime uh think up a new acronym which was um rmp uh which is reserve uh management purchases which is just another another name for a different sort of qe policy and they start to inject more liquidity into markets and then you see these repo markets then come down the spreads come down and we're now sort of you know albeit at the top of the range but we're basically uh you know still within that normal corridor now you can see this process in fact on the uh on the next slide and that next slide uh is basically illustrating that process the uh the black line is the data we just saw but inverted and the black the orange line in this case is excess bank reserves now what you can see uh hopefully on this chart is that the two lines pretty much match so when bank reserves were taken down as you can see uh during that sort of september december period so they actually went from um in line with adequate reserves i mean this is a level minimum level of operating the banks that require to actually at the worst point it was actually down as much as 400 400 billion dollars below you saw these big spikes in repo as dealer banks were scrambling for liquidity elsewhere in markets and bidding up uh so far overnight rates for example then you see the federal reserve injecting money through this rmp and then the system then re-normalizes uh spreads start to come in but you can see what they've been doing pretty much ever since is keeping bank reserves pretty much around um on this chart the zero line which is around which is drawn on about three trillion dollars uh for bank reserves and that's how the process is working the other thing that is going on is the move index uh you can see the move index here this is a measure of volatility uh across uh treasury collateral um that has to be restrained as well the average level is about 70 on this index um and that very broadly sort of crude rule of thumb would represent something like about seven percent annualized volatility uh across different bonds uh and so on and so forth so this is an example of what the treasury is doing and what the treasury is doing to try and manage this process so if it jumps up to that danger zone line which is 140 that's a doubling that's effectively 14 annualized volatility uh and so what you can see here is there is i think a deliberate attempt to try and manage this process and so what the treasury is doing parallel to the fed is number one starting to a lot more issuance at the front end of the curve so in other words they're doing a lot of bill issuance secondly there is a lot more issuance at the front end of the curve so secondly they're engaged in buybacks and that is a deliberate attempt in my view to reduce volatility and you can call it uh yield volatility control rather than yield curve control it may be a subtle difference but it's a very important difference a lot of the media that have been you know looking at the bond markets recently have been misinterpreting this whole process and sort of lambasting uh scott besant u.s treasury secretary being naive by you know even suggesting that he could you know waver a six billion dollar buyback program at a 40 trillion dollar bond market and sort of hope to reduce yields i mean he's not that foolish uh what he's doing is actually doing a pretty good job uh he's uh buying what are called off the run or illiquid bonds uh so things like 29-year bonds or nine-year bonds or these sorts of things things that people don't trade very much they're illiquid bonds uh you can often get those 60 cents in the dollar uh which is a great way of helping the u.s taxpayer so in actual fact he's doing a good job not a bad job despite what a lot of the financial journalists seem to claim so these two tranches in all two dimensions uh treasury uh sorry uh treasury buybacks and control of the move index uh and the other leg which is basically fed operations in money markets are really crucial to understand in terms of monetary policy now to cut to the chase which is a long-winded way of answering your question uh it may well be that the federal reserve decides it has to raise interest rates again uh but the fact is that what they're trying to do here is to let air out of the balloon slowly and they don't want disruptions in financial markets and they certainly don't want disruptions in financial markets uh causing a u.s recession uh next year and as i've sort of long said we are in a capital war uh with uh china and uh that capital war uh requires you know persistent economic growth uh it requires sort of you know helping investors in financial markets and so there's a number of other things that are going to happen in the future that are going to happen as a result of this and i think it's going to be really important to think about this and i think we're going to see a lot of things in the future that are going to happen in the future that are going to affect financial markets and we're going to see a lot of things that are going to affect financial markets and we're going to see a lot of things that are going to affect financial markets and we're going to see a lot of things that are going to affect financial markets and we're going to see a lot of things that are going to affect financial markets and we're going to see a lot of things that are going to affect financial markets and we're going to see a lot of things that are going to affect financial markets and we're going to see a lot of are really integral parts of that treasury QE. But that's how the world is shaping up. So in other words, there is a tightening. Liquidity is going down. The Federal Reserve is trying to manage that as best it can. It's not going to stop liquidity yet, or it's not that able. But broadly speaking, those are the things to watch.
Speaker 2Yes, it's very in-depth. Thanks so much for running us through that. So when you say sort of letting air out of the bubble, the balloon, is that to say the credit system and the credit markets and how much is in there? What are you talking about?
Speaker 1Well, I think the thing to do is to look, if you take a look at maybe some of these tensions, and so I'm just going to go back to here. If you look at risk, I mean, this is looking at risk, a traffic light system of risk in the repo collateral markets. And what I've tried to show there is that this is where the tensions are appearing. So if you look at some of those factors, you've got green lights on the SOFA or repo spread, so the Federal Reserve is providing enough liquidity to keep that down. You've got collateral volatility in the move index is sort of above normal thresholds, but it's not really a danger point. It's sort of around levels that are slightly uncomfortable, but not that disastrous yet. But you've got to watch this, obviously, for sure. Trade fails, which again is probably saying that these are sort of failures, delivered bonds for transactions. And this may well be a sign of tension. It's a sign of liquidity beginning to be crimped. That spiked a couple of weeks ago. Latest data is a little bit calmer, but you're seeing some big spikes going on in trade fails. Term premia in the bond markets are beginning to flatline and go down. And that's a fairly maybe worrying sign. In other words, it's saying that people are starting to move into safe assets, government debt assets, which, by the way, as an aside, is completely the reverse of what many of the financial journalists are arguing. They're wrong, unfortunately, in this case. And if you look at the other amber light, which is credit spreads, you're starting to see those beginning to blow out, certainly for the triple C junk versus high yield, the last red, the red dot there on the right, but also to some extent across average credit market contracts. So, you know, things like single A, double A, triple A spreads are starting to move as well. So, you know, you can look at that array of traffic lights and say, well, you know, it's certainly not, it's certainly not six green lights. You've got one green light and you've got a few ambers. And, you know, this is getting a little bit tricky.
Speaker 2Yeah. So do you think there's anything more that the Fed could do to sort of manage these, you know, these issues?
Speaker 1Well, I mean, what it would have to do is to basically keep pushing liquidity into markets. And I think this is a, you know, a difficult, a difficult task because they're sort of damned if they do and damned if they don't. The risk is that if they put too much liquidity and you sort of continue to fuel a bubble and you've got clearly got an inflation problem beginning to, you know, emerge and if they don't put enough in, you risk going to a financial crisis. So it's, you know, it's, it's sort of, we're walking along a knife edge in many cases, but I think what the, you know, they're, they're doing it as best they can. And, uh, you know, I think at the moment they're doing a, they're doing a decent job. Um, but you know, at the end of the day, we know the bond markets are responding and bond markets are responding largely to economic growth rather than anything else. And I think that's the problem they've got is that the US economy is this way too strong.
Speaker 2Yeah, it definitely seems like that. And it's quite interesting. You showed that that chart we're saying, you know, the could of these come down quite a lot. It's sort of, it seems like three quarters down from the, or close to the bottom of the normal cycle.
Speaker 1Um, if you look at this, there's a chart I've just put up, which is looking at a more sort of theoretical justification for what I've been saying. And this is looking at the liquidity cycle, which is in red and it shows the yellow line, which is the notion of real economy. Now, the point about this chart is that this is what we use for asset allocation of understanding markets. And what it's saying is that the liquidity cycle leads. So you get liquidity expanding. Um, so that fuels a rising, um, uh, financial cycle, if you like, or expanding financial cycle, uh, and then money would then start to migrate towards the real economy and then the real economy picks up. Now, if you look at that yellow line or the yellow cycle, it's around about 18 months afterwards. After the peak in liquidity, you see a peak in the real economy. But the most important thing to say is that if you look at that downswing or periods of downswing in the red line, the liquidity cycle, they always coincide with a rising yellow line, which is saying the real economy is basically beginning to strengthen significantly. And that's what we've got right now. So if I sort of move on a couple of slides, sorry, I'm going, I should be going the other way, I think. Sorry, trying to find out where I put my, hang in there. Here, sorry. If you look at this slide, this is exactly the same idea, but it basically is showing actual data. So the orange line is looking at global liquidity, and the black line is looking at the world business cycle. And the business cycle is, is basically all the headline indexes that you see. So the ISM in the US, the EFO in Germany, the Tenkan in Japan, et cetera, et cetera. And what those are basically indicating is a pickup in economic growth at the same time that you've got a significant drop in liquidity. So the point, the key point to make here is it's not really the central banks that are tightening right now. I mean, they're doing a bit, but they're certainly not stamping hard on the break. This is much more about a real economy. It is vibrant, absorbing lots of liquidity and crowding out the financial markets, because they're taking a lot of liquidity from out of finance. And you just think about that in direct terms, think about what a lot of these AI companies are doing. They're running down their treasury holdings, in other words, their holdings within their treasury departments, the cash they've got there, and they're planning it into CapEx. And so money that was in the financial sector is now traveling in the real economy. And, you know, as I often say, all money that's anywhere must be somewhere. So if it's in the real economy, it's not in financial markets. And if it's in financial markets, it's not in the real economy. And we just see the seesaw, and that's what you've got right now. So that's really the backdrop. So then if you start to look at some of these other warning signals, you're seeing credit spreads here beginning to blow out. So, you know, I noticed earlier on that people see junk spreads really starting to race upwards. But you've also got some, you know, average, average credit, corporate credit yields in black against US treasuries, that's blowing out as well. So you suddenly see these these sort of cracks appearing in the system. Commodity markets, this is showing the CRB index. And this is illustrating commodity prices, you know, shown here in orange against the world business cycle. And that, you know, what you're seeing here is a very, very normal cyclical movement. And I think that's the key thing to say here. And if you look at the bond markets, which is a tad earlier, I think sorry, in this to go back, look at the bond markets, this is the yield curve in the US against US liquidity. Again, you've got to say this looks pretty normal. As the liquidity cycle peaks, what you're getting is liquidity basically coming down and forcing the yield curve to flatten. And if you go back to this, this notional or theoretical chart, what this is based, what this is essentially saying is that if as you move through the cycle, the red line is really driving bond markets, and to some extent, the valuation of equities, the orange line, the orange yellow line is driving the real economy. So that's driving earnings, reported earnings, and it's driving commodity markets at the same time. So you can see how asset allocation shifts from bonds initially, through equities, to commodities. And that's really the phase that we've basically been in. I think where we are now, and I'll just maybe just finish a little bit with looking at the equity markets, which I think are worth looking at. This chart's looking at that same process. And what it's illustrating is the orange line in this chart is the valuation model on world equities, showing the change on a year before. So what you can see here is that markets are being derated, you know, as we speak. So the PE multiples are falling from where they were a year ago. And that's quite normal because bond yields are going up and liquidity is tightening. And basically, the PE multiple is a financial variable. Whereas if you look at the dotted line, that's earnings, which is a real economy variable that tends to come through later. And what I've done is to show that alongside changes in PEs, just to try and make the point that the growth in earnings, the dotted line is coming through later and probably more strongly. Than it's done in past cycles. And that may be telling us that, you know, sorry, that is explaining why equity markets have been running on for rather longer than maybe I would have thought. Because you've got this sort of second wind of earnings, particularly from tech, coming through very late cycle. And the question is, you know, does that continue? I mean, that's clearly a moot point. A lot of people are saying, well, it's different this time and that dotted line is going to be sustained through '27 or maybe '28. You know, I personally would doubt that. But I mean, you know, maybe, I mean, it's only possible I'm wrong on that. And therefore, if you've got falling valuation multiples and an earnings cycle that turns down, that's not going to be great news for equities. So all in all, what this is telling us is it's time maybe to rethink bonds and start to think about the attractions of fixed income. And we can move on to that if you like. But you may have some questions.
Speaker 2Yeah, that's sort of where I was thinking, because it sounds like, you know, everyone's talking about yields increasing in government debts and other debt as well. And it's talking about, oh, you know, people don't trust the governments anymore. They don't trust the dollar. There's all these sort of, I guess, narratives that they're putting on it. But it sounds like from your perspective, you're just saying, well, we're going back to the norm. Historically, there's been large capex investments in the economy. And when that occurs, yields go up. Yeah. Am I correct? And yeah, you're absolutely right.
Speaker 1Yeah. I mean, I mean, you can look at this in two ways. I mean, we can dig into those points. But. You know, if you look at this chart, I mean, this is, you know, slightly tongue in cheek, but nonetheless, it's it's it's it's an important statement there at least. And what this is looking at is very long term interest rates. This is 10 year bond yields in the in the US and the UK gathered by sort of going through the archives of the Bank of England and the US Treasury and making a hybrid data series going back to seventeen hundred. Now, the purpose of doing that is simply to say that if you look at the long term. Average, the long term average yield is just under five percent. OK, now you can put this into perspective. And I just plotted the latest data here. The madness is not now. The madness was the previous five years. And you can see the scale to which yields were sort of hammered down, certainly in the wake of the GFC and then COVID added to that. And you were looking at new cases, obviously negative yields. Even in the case of the UK and the US, your shields down to below one percent, which is unbelievable and unbelievably sort of foolish policy that policymakers engaged in. And now where we are is above five percent, but we're above that threshold, which is saying that actually the madness is over. It's probably the first time in a long time you can actually think about buying bonds again. I'm not going to say, you know, they're going to be a super super bargain here. But nonetheless, they look an awful lot better than they did at any time over the last four years or five years. Now, then if you come back to this argument that we were just talking about, which is what's driving the bond market, this chart is looking at bond yields in orange. But for those that are wonkish, this is the this is risk adjusted 10 year yield. So we take out the term premium only because that adds some. But this is basically saying that the underlying level of policy rates, which is what the orange line is really telling us in a risk adjusted form, really matches underlying US GDP growth, nominal GDP growth. Now, what that chart is telling us is you should be around six percent for US treasuries based on based on sort of future interest rates and given the underlying level of growth in the US economy. And the underlying level of growth is pretty rapid. Right now, I know a lot of people say, well, OK, it doesn't feel like that in the US, but you've got to remember, this is normal growth. So inflation is a major component of this. And inflation we know is high or rising. And it may be that real growth is, you know, it's OK. It's an actual fact. Real growth number right now is not bad. The latest Atlanta Fed Nowcast is saying for this quarter about three and a half percent. So you've still got you know, you've got a lot of momentum in the economy and normal GDP is growing at its fastest rate since the mid 90s. To put it into perspective, and then bond yields were eight percent. Now they're, you know, by the way, actually, as we speak, they're exactly five. So you're really in a world that is changing. Now, if you allow for some cooling of the economy into twenty seven back to about six percent nominal and you assume you've got a negative term premium on US bonds of maybe 50 bps or thereabouts, you can see that about five and a half percent is sort of the threshold. Well, there are thereabouts for the 10 year Treasury yield, and that is clearly very different from a sub two percent. uh treasury yield that we saw uh you know five years ago look at the same for japan even more dramatic this is japanese nominal gdp in black and the orange line is again risk-adjusted jgb 10-year bonds and you can see in this case that the transformation of the japanese economy has been unbelievable i mean if you go back to the decade of the of the early 2000s uh you can see there that japanese normal gdp growth was negative over that decade so you know even if you allow for a little bit of growth it's very clear they were suffering deflation uh now what you get is a an economy that's testing five percent nominal growth so clearly interest rates have got to go up in japan uh to match that and the fact that they've been very slow to do it is exactly why the yen is weak uh but that again may be a deliberate policy they want a week again so you know all of this seems to match the backdrop and what it's telling us is you've got to start thinking seriously about bond markets and my sort of last my last offering on this is to show this chart which is really a taxonomy of yield curves now uh again you know once you start talking about bond markets a lot of people's eyes glaze over and you know it becomes very very dull and very wonkish but uh just bear with me because this has a lot of implications for other markets what this is showing is the sequence the theoretical uh movement of yield curves and what it broadly says is that four regimes are our liquidity regimes but they tend to coincide with or or map onto faces of the real economy so rebound in liquidity is recession in the economy uh calm in liquidity is recovery for the economy speculation which we've been in for much of the last year uh in liquidity is booming the economy and then slowing growth uh in the real economy is equivalent to turbulence in our liquidity measures now we've moved around that clock uh pretty consistently from rebound to calm to speculation i noted earlier the consistency of the yield curve movements that we've been seeing and we've moved from a bear steepening um uh up to about january of this year to now a bear flattening which is the speculation area and if you want to look at that just look at the i'd look at the 10-2 that's a bit noisy but look at the certainly the 10-5 spread in the us it's pretty clear uh you've got this bear flattening uh typically i'm not going to say always but typically the next phase is turbulence where you start to see a bull flattening and that ball flattening is that the long end of the market starts to come down in other words yields drop and that's what i've been looking for now i think that the chances i want to talk about is that you know the 12-month view of yields uh you know either staying where they are or falling a bit is actually getting pretty high so you can make money out of fixed income um you know probably over the next 12 months that that's really the bottom line and so it's worth moving on a phase and if you come back to you know my asset allocation analysis which was way back here which we didn't really touch on but if you look at um the phases of the market um rebound calm speculation turbulence in my view we're on the threshold of turbulence right now maybe maybe in it i mean we'll see what the latest data says but we may be close to that now uh that would say then looking forward uh what you've got to do is to basically take a much more defensive stance and as you can see on those traffic lights on the left if you're in speculation uh you want a lot of commodities um and you don't want credit markets something that as i said selling off you don't want too much equity um in once you go to turbulence cut back your equity further you could go into credits because yields have already moved up uh it's early days yes in that process but you get the idea uh commodities you want to start coming out of and you want to be basically moving uh into longer duration bonds and so the key change really um from speculating the turbulence is a switch from commodity markets into bond duration yeah
Speaker 2that's actually what i was going to ask about because it it seems like we are getting quite low on the liquidity stage but then the markets still are all-time high so is that is that abnormal or is it just i think i saw in one of your graphs where it said that you know when the economy is close to peaking that's when you sort of normally get the uh the drop in the speculatory investments yeah i mean
Speaker 1it's as i said earlier i mean i think if you look at the if you decompose equities into a valuation component and to an earnings growth component uh the valuation declines are coming now you you we've been suffering that p mod was contracting what's been unusual is that you've got earnings gains that are more more than offset that or certainly in certain areas of the market uh more than offset that the question is do those earnings are those earnings gains sustained and i i would be skeptical um and i think the you know the the corollary to saying that is you've got uh you've got a lot of cash flow in these ai companies there's not going to be devoted to paying interest or paying down some of that the debt they're taking on and the debt burden that you know the these companies and the us economy is now taking on a pretty eye-wateringly large i mean you're talking about some estimates of putting uh next year another two trillion of capital raise for ai um and you know putting that into perspective i mean the us government is is a trillion dollars of new debt so you know these are this one industry is is getting big uh big demand on markets and you've now got more more debt outstanding uh of ai companies than you have in the whole um high yield area you know in the us so this is you know becoming a sort of a monster
Speaker 2yeah definitely thanks so much for running us through that and if we go to you know we haven't talked a lot about china in the interview which is uh quite uncommon because obviously it's a massive impact on liquidity i know you should have visited there recently so yeah what are you currently seeing in china and was there anything that you found when you would actually uh travel to to the country i think the
Speaker 1yeah i think the interesting point to make about china i'm just going to come on to that now is maybe to start with this chart because that sort of takes us back to the bond story again and it's one that people often talk about and what you've got here is um u.s 10-year bonds in black and in orange there's the chinese 10-year bond now very broadly or very crudely uh you could say looking at the figures on this chart um you've got chinese bond yields of about one and a half and at the time i drew this up at least u.s bond yields were close to five and a half so you've got a 400 basis point gap between the two and as you look at the chart historically you can see that's kind of unusual very unusual because normally u.s yields trade below chinese yields now the reason for that is that it's all to do with relative economic growth and we saw earlier the market was driven by nominal gdp growth now a lot of the analysis that you hear particularly in the media or particularly among friends of china is to say well if you look at this yield spread the reason that u.s yields are going up and chinese yields are going down is that everyone's got great confidence in china and they're losing confidence in the u.s and this big gap is actually a risk premier that's being attached to u.s assets uh because of a trump factor because of u.s uh you know debt burdens or uh the fact that people are falling out of love with the u.s that the u.s is in decline and you you name it i mean there's all these different arguments thrown around i mean there's nothing could be further from the truth it's ridiculous to say this this is not about relative risk premium or fiscal concerns or whatever it may be this is all about relative economic growth and you evidenced that earlier on that the u.s bond market has been driven by nominal gdp um the japanese bond market likewise the european bond market if i know what i'm saying is that the u.s bonds have been driven by nominal gdp and china has been driven by nominal gdp and china has been driven by nominal gdp and china has been driven by nominal gdp and china has been driven by nominal gdp and china has been driven by nominal gdp and china has been driven by nominal gdp and china has been driven by nominal gdp and china has been driven by nominal gdp and china has been driven by nominal gdp and china has been driven by nominal gdp and china has been driven by nominal gdp and china has been driven by nominal gdp and china has been driven by nominal gdp and china has been driven by nominal gdp and china has been driven by nominal gdp and china has been driven by nominal gdp and china has been driven by nominal gdp and china has been driven by nominal gdp and by nominal gdp and china has been driven by nominal gdp and china has been driven by nominal gdp and by nominal gdp and china has been driven by nominal gdp and china has been driven by nominal gdp and It's way, way more important than debt to GDP, more difficult to measure, which is why economists fall back on debt to GDP. but actually debt liquidity is a far more valuable figure because it's showing the burden of refinancing. And if you look at what happened to Japan, you can see there that Japan's red line basically peaked around 2012. And that was where you've got a very high ratio between debt and liquidity. If debt to liquidity is high, it means that the refinancing burden is huge and you get strains in financial markets, Trains are passed on to a weaker economy and Japan basically suffered, you know, it was the lost two decades, if not the lost three decades because of this whole process. Now, they got out of that bind by engaging Abenomics, where they restructured the economy and restructured debt, and by getting the Bank of Japan to buy Japanese government debt with alacrity. And what that did was to devalue Japan's debt. They printed money. That was the solution. The consequence was the yen collapsed, but they basically are now back to a pretty comfortable debt to liquidity ratio. And that should be great for the Japanese economy. As we saw on that GDP data, you're now looking at normal growth for Japan, Inc., of close to 5%, okay, fastest rate it's seen for decades. If you look at China. China is the orange line, and China is basically Japan 15 years ago or 15 years on. And what China's got to do is the same thing, and we project that they do do that, and it's fair to say that we anticipated them doing more this year than they've done. They seem to have flatlined liquidity through most of this year. That's a surprise. It's not what we expected. It may be to do with the Iran tensions. That's a non-unreasonable suggestion, but it's certainly not helpful if China does this. Now, this is the backdrop of what China had been doing through 2022, 23, 24, and 25, where you can see there the black line is looking at change in the size of the PBOC balance sheet. And the PBOC balance sheet, certainly from the beginning of '22 to late '25, has been virtually doubled in size. And then what I put on the same chart is the gold price in US dollar terms. Now it's my contention that what is driving the gold price is basically Chinese liquidity, because it is the most obvious hedge for Chinese residents against this monetization. And the huge debt burden that China is sitting on, or is on China's shoulders, is basically requiring a massive monetization. And a further monetization. And that is likely to drive the gold price higher in the future. At the moment, they're not doing it. This chart here is looking at changes rather than levels of PBOC liquidity and gold. And you can see there's not a bad correlation between those two data series. Not precise, but it's not bad. And therefore, you've got to watch China. Unfortunately, they're not easing that much at the moment, but I think it's got to come, because the economy is not good. It's not in great shape.
Speaker 2RAOUL PAL: Yeah. OK. Makes sense. And I know they still have 5% economic growth targets. Do you feel like they're realistic? Or do you think they'll just achieve that through more infrastructure spending, which is low return?
Speaker 1JAMES GRIME: Well, the answer is that Chinese economic data is different from the economic data that we have in the West. Basically China has evolved from a planning, a state planning system. And under state planning, the GDP aggregate is much more an input figure. So if they're saying that GDP is growing at 5%, what they really mean is that inputs that are going into the production process are collectively expanding by 5%. It doesn't tell you-- it tells you-- draw the analogy. It's saying there's a 5% growth in the amount of sausage meat that's going into the sausage machine. But it doesn't tell you that there's a 5% increase in sausages coming out, if that makes sense. So they can build their-- they can increase, expand input significantly. But you're not going to get very much economic growth coming out of that, because the economy is struggling. And you can maybe see that in a different light. I tried to show this chart, which is marginal returns on capital. And this is just estimates that I put together going back to the early 1980s. And you can see how much the marginal return on capital of China has collapsed relative to everywhere else. I mean, it still looks OK here, but you get the idea that the return on capital has come right down. And maybe my estimates are not precise enough, but you get the idea of the collapse. And that's the transformation of the Chinese economy. They need to find new areas of growth. And they're running out of those.
Speaker 2Yeah, I think it's going to be a massive struggle. So Michael, thanks so much for your time. We sort of covered so much. My last question is, what is one message you want people to take away from the conversation?
Speaker 1I think the message is that you've got to differentiate the trend. In the market, from the cycle, trends are important, but cycles often come back to bite you. We're in a downswing at the moment after having enjoyed a very good upswing since late 2022. I think the next few months are going to be tough, but then I fully expect the trend to basically be reestablished sometime around the middle or by the middle of next year. And you could be seeing liquidity expanding quite significantly again. In that case, you want traditional monetary inflation hedges. The thing that a lot of people have been sort of banging the table about now, those will start to perform.
Speaker 2Perfect. Great message. So thanks again. If anyone wanted to find out more about your work and what you do, where would the best place for that be?
Speaker 1Best avenues would be Capital Wars on Substack. And if you want institutional data or institutional research, it is glindexes.com.
Speaker 2Perfect. I'll put that in the description below, but thanks
Speaker 1again for your time. Thanks Anthony. Enjoyed it.
Speaker 2Thank you. I really appreciate your support and I hope you found amazing value out of this interview. If you really enjoyed it, would appreciate if you liked and subscribe or share. It really helps with the podcast. We're still trying to expand, get to more people to help make sure that everyone understands and decode what's really happening in the world of finance, investing, macroeconomics, and geopolitics. If you enjoyed this one, then you might enjoy this other interview as well. So really appreciate it and thank you.
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