TIP700: How to Invest during Fiscal Dominance w/ Lyn Alden
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You're listening to TIP. For episode 700 of The Investor's Podcast, I'm joined by none other than Lynn Alden to discuss fiscal dominance. When it comes to macro analysts, there's no one I follow more closely than Lynn. While many value investors claim that following the macro environment isn't all that important, Lynn makes a compelling case that fiscal dominance has a considerable impact on financial markets overall…

and her conclusions have helped shape how I think about managing my own portfolio. During this episode, we discuss what fiscal dominance is and why it matters, why the S&P 500 is at all-time highs with the backdrop of higher interest rates, whether Lynn expects US big tech to continue to outperform, where we're at in the liquidity cycle, how to invest during a period of fiscal dominance, Lynn's three major trends to never fade in much more. With that, I really hope you enjoy today's episode with Lynn Alden.

Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, Playthink.

Welcome to the Investors Podcast. I'm your host, Clay Fink. And today, I'm thrilled to welcome Lynn Alden to the podcast. Lynn, welcome back to the show. Happy to be back. Always happy to talk.

So this is actually my first time interviewing you on the podcast, but I've been following your work for quite some time. And I must say, I'm a huge fan. I had to go back and see what was the first time you were on We Study Billionaires. It was June of 2020. And you've been a guest on the show many times since then. So it's crazy to think it's been coming up on five years. You've been in this space doing all the great work that you do.

I enjoy doing it. It's certainly been a wild ride. And in many ways, I've been doing it longer than that, but only in kind of the audio format have I been doing it since 2020. So before that, it was mostly just writing.

So I wanted to start with your recent article from January. It was on fiscal dominance, which is a drum you've been beating for quite some time. And we have many listeners, of course, on the show that are from the value investing community who don't particularly follow macro trends. And we don't talk a ton about macro on the show, but I think there's really no better person to bring on than yourself to discuss this. So I think a good place for us to start is just by touching on what fiscal dominance is and what brought us to this point.

Yeah, it's a good question. And for relevance, my background initially was writing about stocks. So I came from an engineering background, but in terms of publishing around investment themes, I started focusing on individual stocks. And then I realized that this was going to be a macro-heavy decade. And that if I want to get my investing right, including in individual companies...

it really pays to understand kind of the big flowing backdrops of that. And the fiscal dominance was kind of the, probably the single biggest macro theme that I wanted to be on the right side of, but there are some others as well. So fiscal dominance is basically an inversion of

of how things have mostly operated in the US economy for the past 40 years, call it pre-pandemic, roughly, really since probably, you know, it kind of ended in 2018, 2019. But in that kind of monetary dominance environment, most new money creation is

comes from fractional reserve bank lending. And monetized physical deficits contribute to that, but most of it is through bank lending. And that's where most central bank tools are designed to either curtail or increase inflation.

which is to say most of their tools are designed around how much bank lending is going to happen. So they can kind of put the brakes on bank lending indirectly, or they can kind of put the accelerator and encouragement toward bank lending indirectly. Fiscal dominance, however, is when more money creation is happening from monetized fiscal deficits in various ways. Those

There's a couple of different ways to define fiscal dominance. You can keep it simple and say, basically, if over a full business cycle, if annual government fiscal deficits are larger than the sum of new bank loan creation, or even larger than the sum of bank loan creation plus corporate bond issuance, then you're essentially in fiscal dominance. Another way to put it is to say that the deficits and the stock of existing public debt are so large

that central bank tools to control the rate of money supply growth and price inflation become less effective. And there's a spectrum there. So they become less and less effective the further into fiscal dominance that an economy is. And the reason for that is if you go back to the Volcker time, so that was monetary dominance. And if you look at where the money supply growth is coming from, it was largely coming from bank lending because the baby boomers were entering their home buying years, kind of peak credit formation.

A lot of reasons why there's inflation is obviously also oil price. But in terms of money supply, most of that was coming from banks. And public deficits were moderate to low. They had some years where they were higher, but most of it was from bank lending. And they jacked up interest rates. And back then, public debt was only 30% debt to GDP. And so when they raised interest rates, they slowed down bank lending by a lot more than they blew out the fiscal deficits. But it

But if you look at the current time, where public deficits are over 100%, over 120%, depending on what metric you're looking at, and most of the money creation is not coming from excessive levels of bank lending, when they raise interest rates to try to curtail that, they do slow down bank lending, but then they blow out the physical deficit by an even bigger number. And that kind of makes their whole approach a little bit murkier in terms of having the right tools to even address it. So basically, fiscal dominance is when

central bank typical tools become a little bit less effective. They lose some of their independence and fiscal deficits and fiscal policy become a bigger than normal component that investors have to consider and that impacts an economy.

If I were to almost summarize these monetary dominance and fiscal dominance, for multiple decades, much of the money creation was just in the private economy through the bank lending. So people going out and buying new houses and cars or taking out loans for their business, and the money creation was growing that way. But now a lot of it is stemmed from what's happening at the federal level, where there's trillion dollar deficits, and it's less impacted by that private side.

And if I were to try and explain what's kind of driving the fiscal side, I think demographics plays a key part of it. And then obviously you touched on the debt levels. So when interest rates go up, interest expenses going up as well. Is there anything else that sort of drives this being a structural trend of the fiscal side being so important?

Well, the structural side is that this is partially accumulated. So, you know, we had 40 years of rising debt to GDP from 30% to over 100%, and that was accompanied by structurally falling interest rates. But a structural component is when you hit zero and you bounce off zero and just start going sideways, let alone if we start going up, then the interest expense stops being offset by that falling interest rate.

And so we start to enter more of a structural spiral. So the demographics aspect is fairly structural, not just the one cycle thing. It's a multi-decade thing. And then two, just the fact that that existing stock of debt grew so much, and then we kind of tapped into 40 years of falling interest rates. That's behind us now. Those are what make it structural rather than just a one cycle phenomenon.

Yeah, it seems that when interest rates are so low, the government can just sort of get used to spending a certain amount. They're like, oh, interest rates aren't going to be that low forever. So is it fair to equate large fiscal deficits with persistent levels of inflation? And where would you expect that inflation to percolate in the economy?

I wouldn't equate, but I would say that fiscal deficits are one key source of inflation. The other one would be excessive levels of frackerners or bank lending. Basically, anything that grows the effective money supply, and there are a couple of different ways to measure what the money supply even is because there's kind of different levels of moneyness involved.

for different types of financial assets. But anything that kind of structurally grows the money supply over a multi-year period with some lag is going to impact prices of various things. And that's going to really kind of show up in whatever is scarce. Robert Leonard

And one of my kind of big macro focuses of this whole kind of call it past five years was everyone was saying bank lending is sluggish, we're not going to have much inflation. And I was saying, no, no, these large monetized fiscal deficits are going to be inflationary, partially for consumer prices and in general for asset prices broadly, including the asset prices we like to invest in. And so that, you know, been a pretty structural part of this whole period.

Yeah. I mean, I think the fiscal dominance piece has been a contributor to just today's environment just being a confusing time for investors. So for example, historically when inflation has gone up, it's been a negative for stocks because it typically means say higher interest rates, which means higher discount rates, which means lower stock prices and potentially a more uncertain and unstable just economic environment, which broadly investors don't like.

How would you explain why the S&P 500 is at an all-time high despite this backdrop of higher interest rates and recent years' higher inflation?

I would say because we're mirroring the 40s, 1940s, more than we're mirroring the 1970s. So when people think of inflation, they often think of the 70s, especially if we're talking developed markets. But again, back then, that was monetary dominance. That was not due to fiscal dominance. And public debt was very low. So when they encountered high levels of inflation, their response was to put the brakes on as hard as possible, which is it raised the discount rate for everything. It's bad for stocks. We had

We had persistent energy shortages. So anything that is impacting the margins of equities is going to be a problem. Whereas what we saw in the 1940s and again in the 2020s is not excessive bank lending. It's large monetized fiscal deficits and a very large stock of existing public debt.

which effectively constrains them at being able to raise interest rates enough to combat it. So in the 1940s, they did outright yield curve control. So at one point, they had 19% year-over-year inflation, but they were locking the 10-year yield at 2.5% to basically inflate away the debt. In the 2020s, it's been less explicit, but the fact that we had up to 9% year-over-year official inflation, higher than that when you include kind of the delayed housing aspects, I

And yet, federal funds never got much above 5%. They were kind of slow and less decisive at doing kind of the Volcker moment. And so when you're running kind of double-digit money supply growth, but interest rates are only 5%, equities are still a pretty attractive place to be in that environment. And then a lot of it comes down to whether or not there are shortages of key inputs. So basically, if you have oil shortages or similar types of structural shortages, you

then that is likely to impact equities negatively. We saw that in 2022. So we saw the oil price spike. We saw kind of the peak inflationary levels. That was not a good year for equities after a strong 2020 and 2021. But as that abated, we still have this kind of structural fiscal backdrop. But we don't have, at least in the US, we don't have shortages of fuel. We don't have shortages of labor, shortages of ease to some extent, at least at the moment. So it's not negatively impacting margins too much.

And the industry levels are not super high to contest the valuations too much. I do think valuations are kind of rich, but effectively, nothing really rattled equities in what you'd expect from a 70s environment. And it was anything more like a 1940s environment.

I think back to when I was first getting started with investing around 10 years ago, and many of the big tech companies were dominating the market. They had, call it, 200, 300, $400 billion market caps. And everyone's thinking, how much bigger can these companies get? And here, 10 years later, many of these companies are 10 times the size, maybe some of them even bigger. And I can't help but wonder if fiscal dominance has somehow contributed to the growth of big tech and allowing them to just get

so much bigger than most people would have ever, ever expected. So I'm curious to get your thoughts on that.

I do think fiscal dominance plays a role. It's not the only role. But basically, when you have structural growth of the number of dollars and things close to dollars, like T-bills, in the system, and you don't have major bottlenecks of energy, then that finds itself in asset prices. So we have pretty high home prices still, record high gold prices. And then, yes, the leading kind of dominant companies, people are... One is their earnings have been very strong because they've captured a lot of that kind of monetary growth.

And then also in some of their cases, we placed high valuations on them. And then the extra component that we go through these kind of like dollar cycles or capital flow cycles. So at the current moment, a lot of global capital is stuffed into US equity markets, which also allows us companies to grow even faster because it lowers their cost of capital and then it jacks their valuations up relative to their earnings.

So I think it's on one hand, it was a genuine technological trend that was bigger and more impactful than most investors thought. But then on top of that, we have these kind of inflation of financial assets, because that's where a lot of the money supply ends up when there's no other shortages or limited other shortages. And the fact that the difference in valuation between a US tech stock and a similar Chinese tech stock is very wide for a bunch of reasons. Robert Leonard

I guess to piggyback on that, you just mentioned that a lot of capital is being stuffed into US equity markets and the valuation differences are quite stark between the US and everyone else. There's the US big tech and then there's just everybody else in the world. Is that something that's structural as well that you just expect to persist?

That one's got cycles that it historically goes through. Those cycles could change. This one's already kind of lasted longer than I would have guessed. And kind of one of the main things about that is that the way the global reserve currency works is that the whole world kind of needs dollars. They price a lot of international contracts in dollars.

They often borrow, if they're borrowing from an external source, it's often in dollars, even if it's a non-American lender. Like a French firm might lend to a Brazilian firm in dollars just because it's the largest, most saleable liquid currency, kind of the de facto. And that basically means that the whole world needs a steady supply of dollars to service their existing dollar debts that they owe often to each other, not to the U.S.,

And areas that accumulate a lot of extra dollars have to reinvest that somewhere. They don't just hold pallets of dollars.

And historically, it was the treasury market. As that became less attractive over time, they stuffed into US stocks primarily. And so basically, whenever money is weak, people monetize other things. In many economies, that's the real estate market. In the US, we don't monetize our real estate market as much as say Canada or much of Europe or Australia or China. Instead, us and the rest of the world monetizes our equity market. So we take our trade deficits that we're constantly running with the rest of the world

And then they're reinvesting that into our financial assets. Now, that can eventually get to a point where everybody's on one side of the boat. There's kind of marginal ability to keep that up. And then you go through kind of a gradual balance of payments crisis and money flows elsewhere. And you get one of those emerging market boom cycles for a period of time. Haven't had one of those since the early 2000s. I've been a little early on this in the past. I do think that we'll have another cycle of capital distribution in the years ahead.

I hesitate to give a date because, again, I've been early in the past. I would say that the fact that they're cutting interest rates, and then probably by the end of 2025, there's a good chance that Fed will go back to quantitative easing to maintain ample reserves in the banking system in their current framework. I do think that that could contribute to the next cycle of

Dollar weakening, capital kind of broadening out into some of these cheaper markets, a kind of a virtuous cycle there. Tariffs could complicate that analysis. But overall, that's kind of my base expectation is to probably see another one of those cycles.

Robert Leonard

When a country enters a period of fiscal dominance, it starts to have emerging market characteristics. I was curious if you could share what you mean by this.

So an emerging market, when they have a recession or a crisis, it often doesn't look like a deflationary one. Instead, it often looks like a more stagflationary one because their liabilities are denominated in a currency they can't print. Their own currency often blows out in supply and therefore goes through a devaluation. So when you look at an emerging market in a recession, often in local currency terms,

their financial assets are often doing pretty well. Their equity market could be doing all-time high in their local currency and their housing market might be all-time high in the local currency. But when you price that in dollars or gold, it's generally not doing very well at all. And I think that's a thing we have to kind of apply to some of these developed markets, especially the US, which is to say, okay, so a lot of these assets are hitting highs in dollar terms.

A lot of them have rolled over in denominating gold terms, right? So we pick a harder currency that kind of ignores the fact that the denominator itself is being diluted. Then the S&P 500 as a whole has actually had kind of been treading water with gold for a number of years now. And it's because it's a denominator. So basically, when a country's in fiscal dominance, it's more likely to run hot than to run cold.

And then therefore, even when it encounters kind of economic softness, the fact that the fiscal situation is still so kind of loose keeps things kind of higher than you'd think. So in cycles that are primarily like bank lending, when bank lending dries up, that can drive a pretty big economic contraction. But if bank lending is smaller than the amount of fiscal deficit just pouring into the economy quarter after quarter, then even soft patches can still be kind of hot.

And then hot patches can be very hot. So they can come with a side of inflation as well. To many people in the economy, they won't feel as hot as they are because some of that is the denominator itself. And so, I mean, I just got back from Egypt, for example, and in Egypt, they have double digit inflation.

Unemployment is not really the issue, but instead the issue is that everybody feels a little bit poorer in a recession there, not because they lost their job, but because with their existing job, they can buy fewer things, especially anything that has an import component. So cars, computers, certain types of food, fuel, things like that.

It takes more hours of labor to buy the same amount of stuff because that kind of the weakness gets diffused through the economy rather than isolated to just the people that lost their jobs. Let's take a quick break and hear from today's sponsors.

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there's so many interesting implications of fiscal dominance. And one of which I wanted to highlight here is just how the US treasury market has developed. So with the increasing public debt, higher interest rates, and we've seen a declining interest from foreign entities in owning US treasuries. So the US, I think as part of a reaction to this is they've started to issue more

short-term debt instead of locking in longer-term like they have historically. And I think this gives them a little bit more flexibility if interest rates were to decline in the near future, then they could potentially roll it over at longer durations. And it gives them a slightly better interest rate for the time being, just looking at short-term versus long-term duration. What are some of the implications of the US's debt rolling over more at that short-term duration relative to longer-term?

Well, that's another emerging market characteristic, although it's only directionally so. So in the extreme sense, sometimes when you have a fiscal crisis in an emerging market, they'll roll all their government debt over in short-term paper. And that's obviously a more extreme environment. A T-bill is effectively closer to a piece of currency than a bond. And therefore, when your whole government stock of debt rotates into short-duration T-bills,

It's kind of closer to money printing in a way. Now, the US is only doing that around the margins and kind of has just a longer runway to kind of mess around with this kind of thing. But effectively, what that means is, yes, if interest rates come down, then they have more flexibility in refinancing at those lower rates. But another side of the coin, if interest rates stay high or go higher, that existing stock of debt has to refinance at those higher rates.

The more impactful issue there is how it affected liquidity. And this is where it gets kind of wonkish. But when the Fed did QE during the pandemic, they did excess QE. They did more QE than they needed to. And they actually ran into banks had a certain point where the big banks couldn't take more deposits. It would start to affect their supplemental leverage ratio

and other things like that. And so it's actually like spillovers where money had to go elsewhere. It piled into a reverse repo facility. And the Fed opened that facility so that they wouldn't drive T-bill yields below their target rate so that they would be able to be as hawkish as they want to. And so then when the Fed transitioned to doing quantitative tightening, because they did excessive QE before, there was this kind of remaining $2 trillion in the reverse repo facility. And all...

And all of that, investors in the reverse repos, mostly things like money market funds, would happily also invest in T-bills, but not longer duration treasuries. And so when the treasury was running into liquidity problems in 2022, 2023, one of the things they did was say, "Okay, well, let's issue more of our public debt as T-bills because we can suck it out of this reverse repo facility."

And effectively, what's happened is that the Treasury has offset some of the Fed quantitative tightening. So in 2022, we had pretty much true quantitative tightening. We also saw asset prices do very poorly for the most part. But in 2023 and 2024, although the Fed was still doing quantitative tightening, the Treasury was at a similar rate, sucking money out of reverse repos and putting it back into the banking system due to issuing that extra T-bills. It's kind of the only way to get money out of that void.

And that's almost drained now, but that's kind of been a policy mix over the past, call it two years, of still being able to finance the debt without hurting market liquidity, kind of trying to have their cake and eating it too, which works as long as they still have money in their reverse repo facility, which they largely don't anymore.

Robert Leonard : Earlier, you mentioned that in 2022, inflation was running around 9% and interest rates were much lower than that, which in theory would make the debt more manageable if your debt to GDP is coming down. And it makes me wonder if yield curve control or some form of yield curve control is something we can expect in the future where eventually just interest expense becomes too much, the deficits are too much, there's not enough demand for treasuries.

So there's some yield curve control and more monetization of the debt. I'm curious to get your thoughts on that. I think you can get indirect yield curve control. Certainly, they could turn to yield curve control if there was an explicit need for it. So the Fed discussed doing it during the pandemic, like in their meeting minutes. That's subsided now for a while. You can get indirect yield curve control, which is to say that they just don't raise industry rates as much as you'd expect.

compared to inflation levels or compared to other rules of thumb. And you can get wider spread between treasuries and the rest of the market. So right now, mortgage spreads over treasuries are somewhat elevated. And if you look at the Fed's kind of long-term plan, they expect to eventually go back to buying treasuries, but continuing to divest over time through letting them mature off their balance sheet, mortgage-backed securities.

which effectively means that they're supporting the treasury market and no longer supporting the housing market, which makes sense under a fiscal dominance framework. And so if they do policies like that, if they continue to provide liquidity whenever there's a serious sovereign bond market issue, so this happened in 2022 around the UK gilt crisis, the US treasury market had similar kind of wobbly characteristics of the UK. It didn't break quite as thoroughly, but it was

It's kind of on thin ice. And that's when they kind of shifted to some of these more pro-liquidity policies. I basically think that they'll continue to have a shadow mandate where they don't let serious issues happen to their sovereign bond market. And while yield curve control is kind of like the ultimate market override, that they'd be kind of slow to break the glass and do that approach, I think that there's a difference between the more readily turned to effective yield curve control, which is to say bond yields are probably going to persist lower than money supply growths.

over multi-year periods. You've often said that nothing stops this train when referring to the period of fiscal dominance. So is that how this sort of resolves itself over time and debt levels become more manageable? Or is there other scenarios that you foresee potentially playing out?

Well, when any entity gets too leveraged, unless they can have some major productivity miracle, they're generally going to have some type of default. Now, if you're a household or a corporation that doesn't print your own currency, that default can be nominal. If you're a government that prints your own currency, instead, that default tends to be through purchasing power or redefining what the unit is. So every time we change the dollar peg to gold or drop the gold peg altogether, that was effectively the fault. We're changing what the contractual unit is, making it less scarce.

Or you can have a period where if you run interest rates below the inflation rate or below the money supply growth rate for quite a while, then if you're holding sovereign bonds, you're underperforming pretty much every other financial asset. So over the past, call it five years, if you held bonds, you lost out compared to equities, you lost out compared to housing, you lost out compared to gold, any sort of scarcer thing outperformed. And even in nominal terms, it was one of the worst periods in bond market history.

And so while I don't think we'll repeat that scale of underperformance, when you go from zero rates to five rates, that kind of crazy inflection point kicks in. But I think ultimately, we're stuck in an environment where treasury bonds kind of are a lackluster asset to hold.

Because kind of like background money supply growth, inflation eats away at any sort of potential yield you get. Everything else kind of keeps running hot to varying degrees. And the reason I refer to nothing stops is trading is because I think the deficits are

more intractable than most of the optimists think, which is to say there's very narrow roads to actually meaningfully narrow those deficits. And the other hand, I don't think it's going to blow up next year or the year after or the year after that. I think the runway that they have with little moments of drama here and there is pretty long. And so I think the effective outcome is things run hot for a period of time.

which has various investment implications for assets across the board. I don't recall to what extent you touched on the effectiveness of raising taxes in order to help curtail large deficits. What are your thoughts on the US government's ability to raise taxes and what that might, you know, the knock-on effects of that?

Well, so the first step along the way is the fact that there's high levels of political polarization that makes raising most types of taxes hard. Maybe tariffs are a different category, but it'd be very hard in the current political environment to raise taxes on Americans directly, like higher income taxes or higher corporate taxes. If anything, they might go in the other direction.

And two, even if you were to manage that, because the U.S. is more financialized than most other countries, our tax receipts are heavily correlated to asset prices with a lag. So if you pick another economy like Canada or Germany and places like that, their tax receipts are more heavily tied to the state of their economy than what their stock market is doing. But because the U.S. stock market is so big and so monetized,

and the way that our tax structure works, and because of the amount of wealth concentration we have, and how much of our consumer spending is driven by that upper third of spenders that generally have exposure to the stock market, we have this kind of feedback loop where if you try austerity to a certain kind of meaningful extent, it's likely to negatively impact asset prices, and then that's likely to manifest in lower tax receipts, and therefore, narrower deficit reduction than estimated to be.

And so that Gordian knot is pretty hard to untie without more structural reforms, not just saying, hey, this tax rate is going to go from this to this. It's basically kind of overhauling much of the whole tax and spending system to begin with. So while there are potential paths that could narrow it and therefore make the economy run less hot in debasement terms, I generally consider most of those below probability unless I see those begin to manifest.

I think back to, it was in 1933, President Franklin Roosevelt, he issued Executive Order 6102, which led to the confiscation of gold held by private citizens. The US bought privately held gold at $20 an ounce, and then the gold was revalued at $35 an ounce, essentially revaluing the dollar and repricing public debt. So with that historical precedent, is there anything we should potentially consider as investors to prepare for some sort of

debt restructuring that will impact the dollar and make that debt more manageable. Well, so back then, because the dollar was tied to gold, actions like that were more relevant. Also, that was the peak centralization in the US, which is to say that one party controlled like 70% of Congress, like a supermajority. And so you had kind of a ton of power invested in the executive branch with a legislative branch

fully aligned with them, the least political polarized we've ever been in the country. And so some of these more draconian actions were possible than they are in a more polarized environment. So I think that's one start. So I think it's less likely to see something literally along those same lines. But we do tend to see in these environments more command and control economies. And tariffs are one such thing or banning this app from being in our country and outright capital flow limitations.

you do start to see, as you see bigger fiscal deficits and bigger public debt, you also tend to see more central government declarations of how things are going to go or what we're going to invest in or what's a favored industry versus not a favored industry. So I think that's a relevant thing to be aware of is that you generally want to be on the right side of where those deficits are going or what a given administration is trying to optimize for versus suppress elsewhere.

There are also some wonky things that they can do with gold, even in the current monetary system. And so there's a section in the Fed operating handbook where the Treasury can effectively revalue their existing gold. So the Treasury holds gold, the Fed has gold certificates, and basically the Treasury holds gold at an older price. They haven't really repriced. So it's like $42 an ounce, something like that.

something compared to 2700 or whatever we're at now, they can reprice gold. You could say they could reprice it to the current market rate, or they can effectively even reprice it higher. And when they do that, they fill their treasury cash account up without issuing debt. It's one of the only mechanisms they have to create new base money without associated debt issuance. And that would be inflationary. And it's basically a devaluation of dollar relative to gold,

without a peg. So they still have recapitalization tools like that. The more likely case you see it spread out over a longer period of time, kind of like what we've seen, is that we've seen sovereign debt underperform everything else and things run hot. I think if we get into an environment where we have another inflation spike, and if you get one of those capital flows where capital leaves the US, like we've seen in prior cycles, we could see more draconian actions. We've seen the president threaten

either sanctions or tariffs on countries that try to use other currencies. So some of this could get more explicit, which is normally what you see in periods of high public debt or kind of large rotations like this. So I think we have to be geared towards surprises.

So Stanley Drunkenmiller, he once stated that earnings don't move the overall market, but liquidity does. So focus on the central banks and the movement of liquidity. And this ties into some of your earlier points that central banks aren't the only player with regards to liquidity. We also have the fiscal side. And you wrote this great article with Sam Callahan on global liquidity and its correlation with asset prices. So Bitcoin had the highest correlation with global liquidity at 83%. The S&P 500 had

had correlation of 81%. Then we have gold at 68% and long-term bonds at 45%. So with equity markets at all-time highs, I think many people are concerned that we're at or near a market top, but the Dixie, the dollar index has been showing relative strength and there's potential for new liquidity to enter the market in the coming year. So I'm curious to get your take on where we sit in the liquidity cycle today. Robert Leonard

So pre-election, the liquidity situation is pretty good. And that's because, as I mentioned before, we had the Treasury offsetting the liquidity drain from the Fed. And so you had kind of a neutral to positive liquidity situation. Now, post-election, there's been a strong surge in the dollar index, and that generally impairs global liquidity because the dollar is the unit of account for the majority of cross-country debt.

And anything that hardens your liability denominator compared to your cash flows is generally a liquidity draining thing. And so it's been a little bit more torn in these past few months. But that does mean that they have an arsenal to potentially drain the dollar value, make deals kind of like back in the 1980s, you had the Plaza Accord. We could see a Mar-a-Lago Accord or any sort of other kind of like negotiation to ease the dollar a bit.

It could occur when the Fed goes back to quantitative easing, which they might do later this year, just to maintain kind of liquidity in the banking system. So I do think that we have higher kind of liquidity ahead, maybe a bumpy ride to get there. The biggest wildcard, where I'd say I don't know, is tariffs. Because if you jack up tariffs a lot and pull some of that global liquidity back in, then that's a liquidity offset. That kind of sucks liquidity out.

So depending on how big tariffs get or how much uncertainty there is around them, that even if they don't get big, they kind of change corporate decisions for trade. That's probably the biggest overlay or the biggest question mark on top of what could otherwise be a decent liquidity situation. But that is also where earnings and valuations start to matter. So in a given quarter or even a given year, things like earnings and valuation don't tend to matter too much. But of course, over a five-year stretch, earnings matter. A company growing earnings at 15% a year

is generally going to do better than a company with flat to negative earnings growth over that period, depending on starting valuations. So I think that the biggest risk is in companies that have a lot of foreign exposure, because we have a lot of then unknown exposure to tariffs, geopolitical issues that are

that are trading at high valuations, don't have a ton of growth. And on the other hand, there are plenty of companies, I think, in the US and globally that are trading at pretty reasonable valuations. And they can probably take some punches along the way with liquidity. The other factor that is worth looking at is that, so in fiscal dominance, the deficits are more important than bank lending. But it's not to say that bank lending is not important at all.

And if you look at senior loan officer surveys of banks, historically, whenever more than 40% of them are tightening lending standards, we're in a recession, going back four or five recessions. And in 2022, 2023, we hit that threshold without a Enber-defined recession. And the misery index, which is unemployment plus inflation, that reached levels normally seen with recessions. Consumer sentiment reached levels normally associated with the recession.

But I would argue that it was overridden by fiscal dominance. So if you just looked at what was happening in the private sector, it looked like a recession. Now, we've come out of that to some extent. It's still not... We don't have booming bank loans growth. We don't have a booming lending environment. But we are off the lows that we were at a couple of years ago. And so if we do see a general mild uptick in bank lending, a little bit of an unclear situation...

at the fiscal level, because tariffs and strong dollar and kind of trade policies, that's kind of the big unknown. You could have an environment that's just kind of flat up for liquidity.

while running these big background deficits, and therefore assets that are not too overvalued to begin with just keep grinding higher in price. Whereas I would be worried about, I mean, like Costco is trading at like 50 times earnings, Walmart's trading at like 40 times earnings. There are interesting companies that are very high quality, but that are trading at valuations that are historically abnormal for them. I would have some concerns around those in a middling liquidity environment. Robert Leonard

Yeah, I think there's a good argument to be said that the years ahead could be a good environment for stock pickers that avoid the insanely priced companies. When I think back just post-GFC, I just think about how recessions can just look different than they have historically just due to the impact of the fiscal side. And it kind of brings to the question of how does this backdrop of fiscal dominance change how you or someone should invest relative to, say, a more normal? It

economic environment. So one of the ways I've kind of, the joke way I've described it is it's like I'm so bearish, I'm bullish. So in 2022, I was concerned around slowing economic growth. So purchasing managed indices were rolling over. Bank lending was, like I said before, getting quite tight. A lot of these normal recession indicators. And I was thinking, okay, recession's probably on the horizon. But

But in a fiscal dominant recession, I still prefer equities over bonds at those levels. And then by early 2023, when we started to see the treasury kind of add liquidity back into the market, and we saw like fiscal deficits even uptick further, I kind of said, okay, we're back on the accelerator here. We're kind of in outright fiscal dominance here. So even though the PMIs are sluggish, bank lending is sluggish, fiscal

things that would normally say recession, it's, well, it's overridden by the fiscal deficits. So the investing implication was be more bullish than you otherwise would be given these recession indicators. Doesn't mean ignore valuations or have no risk management, but basically, I always, my default is lean toward things running hotter than you'd expect because

Because most of what people's expectations were built in this four-decade period of monetary dominance. That's kind of the most people's careers. And whereas we're at fiscal dominance now, so things work a little bit differently. And so I would invest, for example, more in travel-related companies because that's on the right side of fiscal deficits. So seniors are getting large social security checks. A lot of the wealth is in the upper third category.

And they take a lot of trips and there's a lot of pent-up demand after a few years where travel was more friction-filled. So being in sectors that are either directly or indirectly on the right side of the deficits, and in general, being less kind of deflation or deflationary bust-oriented and being more, you know, any problems, there are problems out there, but they are offset partially by the size of these deficits. And so things just run hot, which includes equities.

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So I have probably a fairly difficult question for you here. So as a host of this show, some people will come to me for investing or finance-related advice. And these are everyday people that just want a place to park their savings and save for retirement. And I'm sure many people in our audience find themselves in a similar situation because they might be the person in a friend group that knows a thing or two about investing and

I love helping people with these types of things, but I just can find it extremely difficult to give guidance that sort of makes sense to them and they can resonate with. And I should make it clear, I'm not a financial advisor or in a position to give professional advice, but let me pose a scenario to you. So let's say someone who isn't financially inclined wants to start saving for retirement, but they aren't interested in learning more than they feel like they need to, because learning about these types of topics almost feels like it's studying microbiology or some other

intense subject. So when you say the terms fiscal deficit or reverse repo, you just kind of lose them. So part of me is thinking the simpler you can make it, the better. So just buy something like a total market index or the S&P 500. But the other part of me wonders if you're almost doing more harm than good because of where valuations are at for many companies and how concentrated the index is in the US at least. So

Let me pose the question to you. How would you go about pointing someone in this situation in the right direction? Well, I have, for example, like an ETF-only portfolio that tries to simplify some of these themes. And while obviously that has certain limitations in terms of being able to express your view on a market, it's simpler to manage and fewer moving parts.

And so in general, I recommended the three pillar portfolio. So instead of a 60-40 stock bond portfolio, the problem with that kind of portfolio, which is fully geared toward disinflation, and specifically disinflationary growth. So during periods of kind of everything's going well, high productivity, disinflationary growth, you want to be in equities. And then during disinflationary recessions, you want to be in bonds. And so for having that mix is good. The problem is that when you run into either monetary inflation decades, like the 70s,

Or fiscal inflation decades, like the 40s and the 2020s, the bond side doesn't do very well. The stock side, more mixed, depending on where that inflation is showing up. And having an inflation component, a third kind of pillar in that portfolio, is helpful. And so that's why I put some energy producers, gold...

Bitcoin, these harder assets. And where you take that out of in the portfolio can depend on your risk tolerance. So I might say, okay, well, my bond portfolio, I'm going to shorten the average duration of it because I don't want to own super long duration debt unless the yields get very attractive. And I'm going to put some of that in gold, which is a somewhat similar volatility profile

but generally holds up better in those types of debasement heavy environments. And then I'll take some of my equity component and put it into Bitcoin because I've looked into that a lot. I'm bullish on the asset. High volatility, obviously. So I want to, you know, the benchmark is other high volatility assets. And that's how I've generally recommended investing, which to say everybody's different. Everybody has their own situation.

situation, but consider a broader portfolio. There's also little things people can do, like if they want to invest in the S&P 500, but they're worried about valuations or concentration, they can buy an equally weighted S&P 500, which gives them exposure to the same companies, but you'll have a more mid-cap tilt because every company in there is weighted equally rather than Apple and Nvidia and stuff dominating it. Now,

In these years where over like a multi-decade period, and it might not be in the future, but over a multi-decade period, the equal weight has outperformed market weight. But there are multi-year stretches where it underperforms. So it underperformed in the dot-com bubble, it underperformed in this current run-up of tech concentration. And so you might have years where it's not working super well, but generally speaking, if you're worried about getting someone to invest at the top of a bubble, the equal weight shows...

fewer bubblish characteristics. Again, your mileage may vary, but those are some of the things I generally recommend is broadening the portfolio, focusing on scarce assets, and just being a little bit aware of concentration. Probably the other framework that I always have people think about is dilution. So any given asset you're holding, you have to ask, at what rate am I being diluted? Or do I expect to be diluted? So if I'm holding...

a T-bill or a T-bond, and I'm getting, say, a 4% yield, and average historical US money supply growth is 7% a year, I'm getting diluted at like a 3% rate per year. My share of how many dollar assets exist is shrinking by roughly that rate. And if I hold gold, the gold mining rate is estimated to be around 1.5% per year. So

The existing stock of gold increases by about 1.5% per year. So I'm getting gradually diluted as my share of the gold network just by holding gold. Now, when you look at, say, a big tech stock like IBM, they're buying back their own shares. So you're not getting diluted. If anything, you're getting concentrated. But then you have to ask, how am I faring in the industry that's relevant for it?

And so in the whole kind of tech cloud area, something like IBM is getting diluted because it's losing market share to the other big newer tech companies. And therefore, you're getting diluted not in terms of debasement, but you're getting diluted in terms of

you own a smaller share of the whole tech cloud hyperscaler enterprise software environment than you did five years ago because you're owning the losing horse in that sense, at least in the past. And so whether it's stock picking, whether it's asset selection, always at least be aware roughly that

What are the sources of dilution? And what is the estimated dilution rate? That applies to real estate as well. And I think that's a kind of a good rule of thumb framework to think about, even if for some of those, the exact number might be hard to find. It's still generally findable. And either way, it's a good way to think about it.

I think the dilution rate you mentioned is something that's just missed on so many people. I think most people are thinking my dollar's being diluted at 2% or 3% per year. But the point you're making is that the money supply is long-term average grows at 6%, 7%, 8%, something like that, depending on the time period you're looking at. Yeah, I mean, that's something I think just so many people are just totally overlooking and not even considering. Robert Leonard

Yeah, I think the way to think about CPI inflation is, structurally speaking, we should expect deflation, which is technology gets better over time, our supply chains get better over time, we're more efficient at making a TV than we were 10, 20 years ago, and therefore the price should collapse, which for TVs it has. But central banks have a positive inflation target, so they want everything to get gradually more expensive over time, generally because they want the money supply to keep growing up. And so if you look at a typical developed market,

You might have a long run average of, say, 7% money supply growth, but then say 3% or 4% productivity growth per year, which is essentially negative inflation. And therefore, you're left with 3% or 4% average price inflation per year because

Because you have that debasement rate offset by the productivity rate. And if you just measure against the productivity rate or the kind of remaining, if you just look at CPI, it's still not necessarily asking the right question because you could be underperforming other financial assets, holding a bond that years ago would be maybe yielding you 2%.

And you say, well, I'm kind of keeping up with inflation. It's like, sure, but you're not keeping up with the money supply growth, your share of the network is shrinking, and those that are holding scarcer assets and shorting the thing that you're holding with fixed rate debt attached to real estate or attached to corporate assets, they're the real winners. So you always want to be on the right side of dilution in its various forms.

So I believe a bit earlier, you mentioned three pillars of a portfolio, and I believe those would be equities with a component of energy producers, some bonds and some hard assets. How important do you feel that international diversification should play a part of that? And how important do you feel that is?

I view it as moderately important. There are times where the whole world's kind of stuffed into US assets, and therefore you can get some benefit from being international. Out of the investment calls I've made over the past, call it five years, that's been one of the harder ones for me is getting an international component right, because I've been on the right side of fiscal dominance, the right side of gold and Bitcoin and leaning into stocks over bonds. And they said that I'm in bonds, I want shorter duration bonds. That's all been good.

But where I've been a little bit weak is expecting better performance from international than we've got. So the cycles lasted longer for pro-US assets than I would have guessed. And it's still hard to say when it might end. But I generally do think that kind of like how having an equal weight SPF 100 can spread you out a bit, I do think having some international diversification can reduce the tail risk of your portfolio. And along with those other assets, make it so that it's more likely to just go up into the right over time.

with fewer big bumps along the way, because there's fewer tail risks that could bring down your portfolio. So the other day you sent out your newsletter titled The Three Trends in Society to Never Fade. Many of the great investors are able to identify a long-term structural trend and just hop along for the ride and be willing to hold for the long run. So besides fiscal dominance, what are the three trends in society to never fade? Robert Leonard

So I covered in that one, one is energy density. So never want to be on the wrong side of energy density, basically harnessing dense sources of energy either as a producer and therefore selling them. Or if you're a consumer, you want to have access to more dense sources of energy than your competition. And so while the world's kind of gone through this greenification, and while there's certainly merits to that, I think the issue is...

it kind of turned into losing sight on what is really important, which is energy density and overestimating some of these technologies that are less energy dense and underestimating the persistence of energy dense sources. So my view is continue not to fade that for the next several years, 10 years plus.

The next one is computation. Basically, you want to be on the right side of the fact that computation is likely to increase dramatically, just as it has been, but it could accelerate now because we have new uses for it and we've reached certain thresholds where we can do more with it. And so you want to be on the right side of structural computation growth. And then the third would be network effects, which is to say that any investment, it could be a stock or it could be other types of assets where the winner gets benefits from being the winner. So Facebook is better...

than an upstart because a lot of people are on Facebook, right? And it's funny, in the US, a lot of us have left Facebook if we're not in the older audiences. But for example, like in Egypt, young people use Facebook for everything and WhatsApp for everything, which is owned by the same company. So network effects are very powerful. So that applies when I'm looking at a network effect like the dollar system, a network effect of a company. So basically, it's keep betting on winners, right?

unless you see very clear signs that they're likely to be disrupted. It's very hard, but not impossible to disrupt a network effect. So generally speaking, I want to be on the right side of ongoing structural network effects, rather than always assuming this is the year where that network effect is going to completely reverse, because the probability of that is low in the grand scheme of how long and how big network effects matter.

One of the interesting aspects of the first two components is energy density. One thing you outlined in that article was just how important it is for societies to grow and flourish and continue to develop. And then the computation side is interesting because it can really drive these technological advancements in energy. So even though your money supply is, say, growing 6%, 7% a year, energy prices can be pretty stable. So do you expect that technology

to potentially be an issue over the next 10 years where maybe the computational advances just aren't enough to keep energy prices from kind of getting out of hand and CPI getting out of control? Or how do you see that developing? So I tend to think that AI and computation is going to impact white-collar work a lot quicker than it's going to impact the physical world.

And so I think that whether or not we have ample energy is going to be more about policy and geopolitics than about that rate of computation growth, which is to say the more countries embrace energy density, the fewer wars they have between countries, the more they want energy being able to flow around pretty freely and encourage more infrastructure and productivity, like production build out of that. That's the biggest variable.

And so if you have ongoing money supply growth, ongoing productivity growth, and you do keep energy prices under control, then a lot of that value accrual is going to be in whatever is scarcer, right? So it could be waterfront property. It could be the best stocks that are having a lot of the earnings growth. That's where a lot of that value accrual is going to grow. On the other hand, if you do have energy shortages, then it impairs the margins of companies. It can slow down the real growth rate of these other places. And

and generally you want to be in those energy assets. That's part of why I view energy producers as a pretty good portfolio hedge in this environment, because if they keep flowing, if prices are not too high, then they might not do great, but they're pretty cheaply valued. They'll keep spitting off dividends and buybacks and things like that. And the other side, the portfolio will probably do better. On the other hand, if you do have energy shortages...

then some of those other portfolio parts might not do very well, at least for a given period of time, whereas the energy component could do quite well. That's what happened in 2022, for example. And so I think those work well together to minimize those risks.

Well, Lynn, I want to be mindful of your time here. Really enjoyed this chat. So many great answers from you, and I'm sure the audience is really going to love this discussion. So before we close it out here, please give a handoff to how the audience can learn more about your work if they'd like, if they haven't already, and how they can get in touch. So I'm at lynnaldin.com, on Twitter at lynnaldincontact, and people can check out my book, Broken Money, on Amazon or elsewhere. Thank you.

Yes. If you haven't read Broken Money yet, highly recommend it. It's a wonderful book. And Lynn did an excellent job outlining much of what she's done over the years. So Lynn, thanks again. I really appreciate it. Thank you. Thank you for listening to TIP. Make sure to follow We Study Billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com.

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