Soaring US Debt Burden & The Global Market Reset | Gerard Minack
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The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough. Thank you. Let's close this door.

Today, I'm joined by Gerard Minnack of Minnick Advisors. Gerard is a very special macro analyst, and he's been independent for over a decade. But prior to that, he had a very storied career as a strategist on Wall Street. Gerard, been meaning to get you on Monetary Matters for a long time. I'm glad we finally got a chance to do it. Thanks for coming on. Thanks for having me, Jack. Great to catch up.

Gerard, tell us what you're thinking about interest rates. I think you've got some views about bond yields and interest rates.

So tell us what you're seeing there and why it's significant. We've seen a major regime change going back a number of years. I was a card-carrying secular stagnationist. I thought the world was turning Japanese. And right from actually after the 2000 crisis, I thought that we were heading lower for longer. And particularly after the GFC, that reinforced the view.

I resigned from the Secular Stagnation Club in the pandemic. I thought the pandemic was going to catalyse a couple of changes that was going to bring the curtain down on the secular stagnation era. And amongst those changes were larger government deficits and an increased demand for investment, which reflected a number of things, including the whole climate change story,

higher defence spending. And as we saw, globalisation crumble a little, not completely, but certainly we've got to build in some redundancy to supply chains and build up inventories. In other words, the balance, the global balance between saving and investment, which had been operating in a way that had excess saving for decades, was going to tip, that we were going to go the other way, and that was going to force up

real yields. And that's been the whole story really since the pandemic. People were surprised how far the Fed hiked in the tightening cycle and how that did not cause the US to slip into recession. And now we've got this rise of large budget deficits and it's culminating now in the Trump regime's fiscal loosening, which

is going to reinforce the whole hire for longer mantra. So there will always be cycles. This is not to say that we never have rallies in bonds, but the fact is we had four decades where we saw consecutively lower lows, lower highs for yields. Now we're in a world not of always ever escalating yields, but I think the new regime is going to see treasuries settle in a sort of 4% to 6%

which is significantly higher than anything we've seen since the GFC. And as I said, that's being reinforced by this loosening in fiscal policy that looks set to be delivered by the Trump regime.

That loosening ironically is coming at a time when many of Mr. Trump's policies are putting pressure on the saving rate countries that have funded those deficits to actually do less saving themselves. And I would argue that Mr. Trump is going to be the catalyst for some other countries to do what they should have been doing anyway. But amongst other things, it'll be

Europeans running larger deficits. Germany has released its debt break, for example. We'll be spending more on defence infrastructure. There's pressure on China to become a more consumer-driven economy, which they can fund out and reduce consumer saving. So you've got potentially a collision between the US saying, we want more of your saving. We need it to fund our deficit.

At the same time as the rest of us saying, well, we're going to keep our saving at home. Thank you very much. And that collision is going to put up wood pressure on real yields. And there's a fattening tail risk that the whole thing could become disorderly, which would see a sort of a sharp ratchet up in bond yields or potentially a sharp decline in the dollar. That's not my base case, but I'm increasingly alert to that tail risk.

So interest rates are just a reflection of the difference or the relative amount of the savings, so the opportunity to invest and investment demand. Right.

What is it about the 2020 to now period and to the near future that you see that where the savings is lower than the demand for investment? You mentioned one thing of green energy, but I know the governments are running large deficits now, but

Over the past 40 years where bond yields have done nothing but go down, the government also ran quite significant budget deficits. So what is it about this new era where you see the demand for investment being somewhat higher than it has been and the demand for investment relative to savings being particularly higher? If you look at the data over the last 30 years,

Rates are a function of this balance between supply, investment and saving. The really big change was on the investment side. We've seen investment shares of GDP in developed economies decline. There was quite a few reasons for that. One of the most important and basic was demographics. If you go back to first principles, how much investing do you need to do? Well, that's driven in large part by how many workers you've got to give capital to. And as working age population growth was slowing, we saw a decline in investment share of GDP.

What's breaking the link between investment and those basic demographics is the massive task of retooling our energy system for climate change. Defence, we're all, everyone's increasing their defence spending, which is also driving a wedge between the usual fundamentals and demand for investment. And we also see the breakdown in globalisation. So that means that we're seeing supply chains that were really optimised for capital efficiency growth

fraying at the edges and people building in redundancy. Then on top of that, we've got these large deficits. Now, these deficits are larger than what we saw in the aftermath of the GFC. You may recall that after the big deficits within the GFC,

There was a wave of austerity in developed economies as people were worried about being ironically worried about the inflation consequences, which obviously never emerged. But that austerity pushed Japan into a double-dip recession. It pushed Europe and the UK into a double-dip recession.

My own view is it risked a recession in the US. The US got lucky in a sense because the shale oil boom came along almost as an exogenous boost and they avoided that downturn. So I think that the big change is the combination of those private sector demands for CapEx with what are now extraordinary large deficits for an economy or economies running near or at full capacity.

And as I said, the sources of saving are less willing or less able to provide that saving in a globalised capital system. And it's worth focusing, I guess, particularly on the role of Japan. I mean, Japan has been a huge pool of saving that's been attracted to the rest of the world's capital markets because their own interest rates were so low.

The irony now is Japan is going back to being, in a sense, a normal country with normal inflation and able to normalise interest rates. And that means that they're not going to be the anchor that provides a drag on interest rates elsewhere. Right now, we're in an almost unique position in recent financial history, where if you look at the attractiveness of Treasuries versus Japanese government bonds,

From a Japanese perspective, it's now more attractive for them to invest in their own bond market than to buy treasuries and hedge the FX risk. Plus, and this is the special source, it's actually more attractive for a US investor

to buy JGBs hedging for FX risk than to buy US Treasuries. So we're going to see this redirection at the margin of flows potentially because yields draw money and that's going to be to the detriment of the US. And I think that's one of the reasons that we're actually seeing US yields under upward pressure as Japanese yields are also rising. So

We are seeing a changed world on a number of fronts, but I think it's deeply significant that the Japanese interest rate structure is normalizing after 35 years of being well below other developed economy rates.

Your point is that bond yields are basically fungible because you can always hedge the currency risk. So if the Japanese 40-year was literally at zero in 2019 and 2020, and now it's over 3%, so still maybe somewhat low, but that's a huge, huge move up. And therefore, other duration, long duration, sovereign government bond markets around the world have to adjust. You've got a chart from your research showing that

about turning Japanese, not with regards to deflation, but with regards to public debt to GDP. So the U.S. debt to GDP peaked during World War II, 120% or so. Since 1980, it has gone from under 40% of GDP to now about 120% of GDP. Japan is, you tell me exactly, 200 or something.

some percentage of GDP there. Do you think that we are going to get to Japanese levels of debt to GDP? What would be the consequences of that? What are the consequences now of 120% debt to GDP, which is already high? The forecasts I was referencing were...

expectations around the House of Representatives, one big beautiful bill act and their proposals for fiscal. So that's going to get mashed up as they go through the reconciliation process with the Senate version and ultimately to the White House. Now, it may turn out that the Senate's going to add even more debt to the story, but let's just stay with what we know at the moment.

And the forecasts are that if we were sure that the taxes, tax cuts that the House is going to sunset realistically are going to be made in perpetuity, then we're heading towards a 200 percent public sector debt to GDP ratio over the next 30 years in the US. Now, let me be clear. That's the forecast.

I think it's unsustainable. I do not think that the US will get there. Even though Japan is at 200% public sector debt to GDP, there are a number of significant differences. Firstly, Japan actually has quite a lot of financial assets. So if you look at gross debt, net debt, it's close to about 120% of GDP. But then if you look at BOJ holdings of JGBs, then what's left is quite a small debt pile of 20% to 30% of GDP. Effectively, the Japanese...

have monetized a lot of that public sector debt. So the burden that the private sector has to hold is quite small.

But the second big difference is just quantum. We're talking about percent of GDP. Of course, America is a much larger economy. So if you look at actually the dollars that the rest of the world's got to swallow in terms of their debt, the US burden is much more onerous. And then thirdly, Japan is a saving rate country. Japan can self-fund those public sector deficits. It's running a current account surplus. So it's actually exporting savings in net terms

to the rest of the world, America famously runs a large external deficit. So the Japanese have been up to sustain public sector debt at 200% of GDP. I don't think America will get there. So America, in my view, is on a path that is unsustainable. And if something's unsustainable, it will ultimately stop.

I don't know what the magic level is, to be fair. Obviously, the pressure is going to intensify as debt does escalate. If rates go up, the debt service burden is going to reach unprecedented territory. At what stage that forces policymakers to change the trajectory, I don't know. I don't know if it's going to become disorderly, if the market just absolutely protests. The risk of that would increase dramatically.

if ever the market perceived a serious threat to Fed independence. I'm not saying the Fed remaining independent means that any level of debt is sustainable. That's not the story. But the threshold at which markets start to really worry, the bond vigilantes start to protest,

would be lower if the Fed was perceived to be adjusting policy with one eye on making the fiscal situation more sustainable and making monetary policy inappropriate for inflation conditions. And if we ever got to the stage of some sort of financial repression,

i.e. where we force people to swallow bonds, then I think the response would be the currency breaks. And I know some people are referencing what happened back in the post-war period where we had quite aggressive financial repression. But just remember what that involved. That involved controlling assets

at interest rates both borrower rates lender rates uh controlling what the banks needed to own but also capital controls now if we were to go back to that it's a it's a whole world away from where we are today i can't see that we are going to get that extreme and if we only partially try and suppress rates then as i said i think the currency goes

So it's a different, the US cannot replicate, in my view, what the Japanese have done over the last 30 years. We've got these projections that are unsustainable. They will force a course change at some stage. I'm not exactly sure when, but what we're already seeing now with rates rising, real rates rising, is the market starting to realise that, hey, we need to send a signal. We can't swallow this projection of escalating debt.

And if it stayed on that path, we'll see rates go even higher. And when you say that the US debt is unsustainable, you definitely could be right. You probably are right. And people who were saying the same thing 30 years ago, eventually they may be right too. But this is a long-term time horizon. Same way, some prognosticator in the year 200 AD predicting that the Roman Empire would collapse, they ultimately were right, but just not during their lifetime.

I think we can be a bit more precise than that. I mean, the conditions after the GFC, I thought, were fairly clear that the world could tolerate higher debt. We had a whole problem of excess saving. And, you know, as Japan had shown, in that situation, it was right and proper for the government to run larger deficits. And I think the whole problem of the post-GFC cycle is governments were too restrained and

They kept economies too cool. And that came at an enormous cost of missed employment and missed GDP growth. What's changed, particularly as I said, after the pandemic, was this other need to do CapEx. You could see the balance between saving and investment changing. So I'm not quite throwing my hands up and saying sometime in the next century. I think the process of the market changed.

uh feeling the weight of higher budgets is started i mean we are seeing real yields up we are seeing nominal yields at levels that in many cases we haven't seen since the gfc so uh

I don't know exactly. I can't give you a month, but I can certainly say that the process has started. And if the debt levels continue to build, we will get market reactions. So we are seeing the market respond to higher public sector debt in a way that we haven't seen for 15 years.

And so the 10-year yield in the U.S. Treasury is just below 4.5%. That is up massively over where it was after the great financial crisis. And you said you think short term, you see it in the range of 4% to 6%. Tell us just about your confidence level there. And then also, I mean, if you are quite confident that there is a...

a greater demand for investment and less savings relative to that. You know, I mean, do you think yields could go higher than higher than 6%? Well, let's talk about the next two or three quarters where the cycle can dominate. And we need to talk about what the Trump administration is doing. You know, I see Mr. Trump as a massive adverse supply side shock for the U.S.,

an adverse demand side shock for the rest of the world. That's an important distinction. If policymakers are responding to an adverse demand side shock, the response is very clear cut. You loosen policy, either monetary or fiscal.

It's much more complicated when you respond to an adverse supply side shock because if growth is slowing because potential growth is down, then it doesn't justify easier monetary policy. Now, what are the elements of the adverse supply side shock? Well, everybody's focused on tariffs and they are important, but I always start my discussion with people by looking at population. It's very easy to measure.

Potential GDP growth is a function of productivity growth and growth in working-age population. Prior to the pandemic, US population growth was running at about 0.5%.

It fell in the lockdowns, but then rebounded over the last 18 months, which was actually a positive supply-side shock, and population growth peaked last year at about 1%. Now, that was always going to slow. I mean, if Kamala Harris hadn't won the White House, I'd be sitting here saying US population growth is going to slow. But it's probably going to slow further now that we have an administration that's trying to crack down on migration, and I see population growth slowing from its peak.

at 1% last year to probably around a quarter percent. So that's a 75 basis point reduction in potential GDP. So it's a money-back guarantee that US growth is going to slow because of that. And it's not something that the Fed can respond to or needs to respond to with lower rates. Then we have the tariffs. Now, this is absolutely a movable feast, as we know. On the current regime,

which includes tariffs of 30-odd percent on China, 10% on everyone else at least. So that's the range. You're looking at tariff revenue raising about 1.25% of GDP in additional revenue.

So that's a tax increase that's obviously going to novel growth. It's like any tax on goods is highly regressive. And I make that point because the tax cuts are highly positive, skewed to the top income end. So we are going to see a whole lot of low and middle income earners being made worse off by the combination of the Trump fiscal loosing with the spending cuts on some of the social welfare programs, along with the tax increases implied by the tariffs.

So it's going to slow growth, but almost as bad as the tax increase is the uncertainty. And we're seeing capex expectations shaken by the uncertainty around the tariff regime. So we're going to get a slowdown. There is a risk, a larger than usual risk, that all that tips the US in the recession. I'd put that at roughly one in three. So let's look at the two scenarios that we've got for the next two or three quarters. There's the recession scenario. Now, even though tariffs will add to inflation,

If we're heading for a recession, the Fed will cut. The Fed cut even in the 70s where we had hardcore stagflation because the Fed understands that recessions always bring inflation down. It did that even in the 70s. It would do it now, even if we had tariffs. The Fed will focus on the employment side of its dual mandate.

The Fed has always cut by at least 200 basis points in a recession. So we would get more rate cuts than what are priced by short rate futures. And that would put some downward pressure on long rates, although the curve would steepen or always steepens in a Fed easing cycle.

The trickier case is the base case for me, where we get a growth slowdown, but it reflects that declining potential GDP. And we do get some at least transit inflation pressure coming through from tariffs.

Now, I deliberately use the word transitory. That would give anybody on the FOMC a bit of the shakes because like generals fighting the last war, what was the mistake they made last cycle? They initially dismissed inflation as being transitory. That will make them, I think, unusually reluctant to

to see any tariff-related increase in inflation as transitory, particularly now that some measures of inflation expectations have become unanchored. So I think the Fed would be very reluctant to ease

as inflation jumps, even if growth slows, particularly if growth slows in a way that matches the declining potential. So this could be the first growth slowdown that we have in four decades that's not met by a preemptive easing in Fed policy. We may only get one or two Fed rate cuts,

If that's all we get, to go back to the Treasury point, we probably had Treasuries still around 4.5%. I think that there's very little relief at the long end. The Fed only cuts one or two times. And if they cut nothing, then we probably see long rates actually go towards 5%.

So that's my base case, that we get a growth slowdown with very little response from the Fed, but there is a risk of a recession and that would lead to more aggressive policies. But that's all the cycle. I mean, ultimately, if you're thinking structural rate levels and through the cycle averages, then I think that we've got, as I said, something in a 4% to 6% range.

I'm not sure that we would go sustainably above 6%. Nominal GDP growth is much lower now than it was in the 70s. Ultimately, one of the things that underpins my view is the Fed will continue to target inflation and be relatively successful in that. I say relatively successful in the sense that if you look at the post-GFC period, the Fed actually undershot its inflation target on average between the GFC and the pandemic.

um if the Fed roughly hits its inflation Target which you know in PCE terms let's say it's around two percent that means CPI per terms it's it's closer to two and a half um well okay two and a half percent CPI something for real growth such return premium and we're up towards that range I've been talking about but that's a lower range than what we saw in the 70s so I don't think we escalate yeah

I know you're not saying endlessly. I don't think we go back to 70s style rate structures, but we're certainly in a higher rate structure than we've been in for the last 15 years. Hey, Monetary Matters listeners, tariffs are shaking global markets and gold is responding, hitting all-time highs as market uncertainty fuels a surge in demand for physical gold.

The VanEck Mark Gold ETF, ticker OUNZ, is the only ETF that lets investors convert their shares into physical gold delivered directly to you. Now that's a standout feature. Visit vanek.com slash OUNZ Jack to learn more about OUNZ today. Please click the link in the description to view the OUNZ prospectus. Thanks for listening. Let's get back to today's interview.

And we'll set the tariffs aside for a moment, just on that secular view where long-term 10-year yields are from 4% to 6%.

How is that world different than a world in which interest rates are much lower, like 2% to 3%? What is the impact on growth and inflation? And at what point does usually sufficiently high interest rates discourage government borrowing and encourage fiscal retrenchment? Well, look, in an economic sense, it's probably best to see these rates as a function of the economic fundamentals rather than the other way around a bit.

almost by definition, if I'm saying that we're in this range, the economy can cope with those rates. And in a way, we've already had a taste of that because when the Fed did start to tighten after the pandemic, it pushed rates much higher than most people perceived the economy could cope with. And that really underscored the point that

We do have a more resilient private sector than we had around the GFC. That's partly because the household sector in particular has deleveraged since the GFC. The corporate sector is not, but it's turned down its debt. Now, that means that the increase in rates is going to take time to feed into their net interest expense. That will happen and that will be a headwind for margins. We'll come back to that in a moment.

The point I make to people about rates is so long as you believe that the Fed will roughly keep inflation around target,

The response to these, in a sense, tip between investment and saving balances is we need structurally higher real rates to kick inflation around target. It's the mirror image of what we saw really from the 80s through to the GFC, where to keep inflation around target, we needed real rates to be lower on average in every cycle through that sort of 30 to 40 year period. Now we need higher real rates to keep inflation around that target.

The interesting thing is, what does it mean for investors? I mean, one of the hallmarks of that sort of soft secular stagnation period was that we had two decades in the US of unprecedented, sustained inverse equity bond correlation. And if you look historically, more times than not, equity bond correlation is positive. It tends to be inverse historically.

When inflation is below 2.5%-ish, it's not always inverse, but it normally is. Once you get over 2.5% on a trend basis, you're always positive. So I think we're going back to a regime of typically positive equity bond correlation. Now, that has a number of consequences. Firstly, if you're running a risk parity investment strategy, which has as its foundation that we're in a world of inverse equity bond correlation, you have a problem. You have a real problem.

But what it does mean is that bonds will not be the shock absorbers they've been for the small up and downs for equities because they're going to move in the same direction. Even when you have structurally positive equity bond correlation, bonds normally do protect you in a hard landing. So that still applies. But the big difference is how bonds behave in between the hard landings. For two decades, when we had strong inverse correlation,

Bonds were insurance policy that required no premium. Bonds were rallying. They actually gave you a decent reward. In this new regime, insuring your equity risks for downturns will actually cost you opportunity cost by holding treasuries. So that's the difference. For leverage, we had a huge period of increasing leverage from 1980 up to the GFC period.

The misconception is that that borrowing was used to fund spending. That in net terms was not true. Almost all the borrowing that we saw over the period was people borrowing to buy pre-existing assets. We developed a whole lot of financial structures that deployed leverage within them. And that was as simple as, I mean, when I first joined markets, insurance companies used to own office blocks. They had $100 million of premium. They'd buy an office block for $100 million.

Then someone had the smart idea of creating REITs. And so you'd have a structure where you'd put in your $100 million, but then you'd borrow and add some funding and own four office blocks that were $400 million. So you were just using leverage to buy pre-existing financial assets. And of course, households do that all the time when they increase their mortgage size to buy an established home.

That worked wonderfully well for four decades when the trend in rates was down. I mean, there was the odd bump in the road as rates backed up, but overall, because rates kept on making new lower lows, you were incentivized to deploy more and more financial leverage.

Well, that incentive is changing. The optimal amount of leverage to deploy in your financial structure is going to be lower going forward than it has been historically because rates are going to be higher. And I'm not saying they're trending up indefinitely, but they're certainly in a higher range after four decades of trending down.

For equities, the story is actually a little nuanced. It's wrong to say that equities always re-rate when bond yields go down. There was a sweet spot. There is absolutely a sweet spot. But history shows that when bond yields normally went to very low levels,

That typically was detrimental for equities. And the reason was the economic conditions that pushed bond yields to very low levels were normally economic conditions that were not good for corporates. And I mean, Japan's been a poster child of that for three decades. They had extraordinarily low yields relative to other developed economies. And the Japanese market was in relative terms a disaster.

So as yields go up, as we head towards the sweet spot, it's absolutely plausible that that goes hand in hand with equity gains. And I've said for some time, it will be great for Japanese corporates if JGB yields go back to 2% or 3%, because the macro conditions that would push JGB yields there would be terrific for a large part of the corporate base and

The banks are the absolutely best example because higher yields probably means higher borrowing. It also means steeper curves and higher net interest margins. And that's the way it's played out. The big exception to that point that low yields normally go hand in hand with lower equity valuations was actually the US market in the post-GFC period. And that market broke with what happened in other markets. It also broke with

than historical performance in the US. The US also was an example where rates went to very low levels, was normally destructive of equity valuations. What made it different in the post-GFC period was US corporates were able to continue to grow their earnings, notwithstanding the sluggish, low nominal growth environment.

That ability to grow earnings was led by what we came to call the MAG-7. Now, that MAG-7 was a bit of a changing feast. We kept on putting in companies and pulling them out, but there was a core of companies that were able to grow earnings. That ability to grow earnings in the post-GFC period was scarce. The U.S. was the only major economy that was able to generate EPS growth. If you actually look at global equities, X the U.S.,

their earnings today, their EPS in dollar terms, remains below their 07 peak. So we've had no growth in earnings outside the US for 15 years, whereas the US actually had

Stronger than usual earnings, the long run average earnings growth for the S&P 500 is about 1.8% real. Over the last decade, it's been 4%, so more than twice as fast as usual. So that obviously generated this massive US outperformance driven by earnings, but because the US had this earnings growth, it re-rated.

Now that has made the US market almost uniquely vulnerable to the prospect of rising rates because the US market is now expensive in absolute terms relative to its own history. It's expensive relative to other equity markets and it's particularly expensive relative to treasuries. So the prospect of rising real rates, I think is a larger headwind for US equities than for other markets. I mean,

We need to talk about some other factors in relation to other markets and why they may start to outperform. But the rate story is one piece of that. Now, so far, I mean, the US has been able to withstand that rise in rates. I mean, it's had some setbacks this year, but for other reasons. But ultimately, I do think it's a headwind that's unique to the US, that expensiveness relative to treasuries. That's one of the reasons, I think, that we're going to see a period of sustained US equity underperformance here.

because of this increase, this structural increase in rates in the US and the increase in rates elsewhere. But the US is much more vulnerable to what that means for valuations than, for example, Japanese or European equities are. So to the question, how do higher bond yields or rising bond yields impact the stock market? Your answer is somewhat complex. You first make the point that on a short-term correlation basis, if the bond market sells off a

normally that has been associated with the stock market actually doing quite well and vice versa. When the stock market does poorly, the bond market does well, and that is good for trading strategies. And that's the point you made about correlation. There was a negative correlation when inflation is below a certain threshold, but now that inflation is above that threshold, that you think that correlation doesn't hold. And by the way, I actually think

I kind of like to trace ideas. There are a lot of people in America who make that point that I don't even know if they're actually aware that I think you have played a big role in that argument. And because I know various people who read your work, so I just want to give you credit there. But on a long-term basis, forget about the short-term trading correlations. The longer-term basis, are rising yields good for the stock market? You're saying with everything being equal, yeah, it makes sense that

on an evaluation basis, it makes stocks less attractive. But often the conditions that would lead to higher bond yield are the conditions that are good for stock market. So there's a lot of, not contradiction, but a lot of

differing forces there that pull and push in various directions. So broadly speaking, you think that the higher bond yields will be a drag on the US market, but there'll be less of a drag on other stock markets? Do I have that right? And then also just talk about, because I'm like many people watching, a Warren Buffett guy, think about valuation, future cash flows,

And Warren Buffett and a lot of corporate finance professors think in this very valuation perspective. But if you actually look at the data of what happens, just tell us about the impact of higher yields. Because for example, the 10-year yield is a lot higher now than it was in 2021. But NVIDIA is a lot higher now. At certain levels of growth rate, it doesn't matter if the 10-year is at

10 or 15%, right? Just how does all of this shake out for you, Turo? Turo Moriarty: Yeah. So a couple of points there. A very simple way to think about this is you're in a recession. And so recessions are not good for corporates and not good for shares. On average, the S&P has a 31% drawdown in NBR defined recessions.

So equity investors are desperate to see signs of improving growth. So if you get an upside surprise to a macro variable, growth variable, what do you see? Stocks will rally on that, but treasuries will sell off.

So yields will go up. But the equity market doesn't care that yields are going up. It's focused on the prospect of better growth. So that's when you've got this stage of a very strong inverse correlation. A data point that is bad for bonds is terrific for equities. And that can continue through the initial recovery phase until you get to a level, perhaps the expansion is well underway, where now the reaction differs. Yes, macro strength will still make treasuries sell off.

But all of a sudden, if you get too much macro strength, the equity market starts to worry, oh, that means more Fed rate hikes or higher yields, and we respond to that. So the simple point is the relationship between treasuries and equities is not linear.

There's a level below which you've got this quite powerful inverse correlation. And we get to a level higher where perhaps investors focus turns from being concerned about growth to being concerned about inflation and rates, where it becomes positive correlation. So that's the simple way to think about it. In terms of other sort of points people make about bonds,

I strongly push back against the view. I'm not saying you make it. Strongly push back against the sort of simplistic view that, oh, look, when rates fall, long duration stocks outperform because the discount that we are meant to apply to their earnings and their long duration, they disproportionately benefit.

That's not how the market works. It's quite common that as long yields fall, you'll get two types of companies do well. You'll get your tech stocks, long duration stocks doing well, but you'll also get your bond proxies doing well. So these are utilities that offer a lot of yield, they're short duration.

So how do you explain when yields fall that long duration and short duration stocks both simultaneously do well? It can't be a duration story. What's going on? My point's always been that if yields are falling because people are becoming concerned about the growth cycle,

What do they want to buy? They want to buy stocks where they've got greater confidence about the earnings outlook in an environment where growth is slowing. Well, there's two types of companies that fall into that basket. There's your bond proxies, the utilities that have highly reliable earning streams. But then you've got your secular growth stories, which by definition don't depend on the cycle. If you've got, as you referenced, NVIDIA, which is obviously at the moment a secular growth story,

Who cares whether the economic consensus rises up or down their GDP forecast by a percent or two?

NVIDIA is running on a strong acyclical thematic called AI. So the reason I think that we get this sort of barbell effect as yields fall is people are not focused on duration. They're focused on earnings reliability. Conversely, as the cycle improves, and it's almost a case of everybody can generate earnings in the improving macro environment, we go back to a broader range of equities. So I don't like looking at...

the effect of bonds on equities through a duration lens. I think it's what it tells you about the cycle and where in the cycle you are. If you're in a recession, you're desperate for growth, so higher bond yields are sending a signal of better growth, you buy equities. If you're later in the cycle and you're worried about the Fed, when bond yields go up, it's telling you the Fed's probably going to tighten more, and that's not a great development for equity investors or whatever, so you couldn't

So where we are at the moment, and this gets to the differential impact of higher bond yields for different markets, because the US market was the only major market to re-rate in the low-row period.

post-GFC environment, it is uniquely vulnerable to the prospect of rates going up. And it's not just that it re-rated. I mean, the whole 15 years of outperformance, the whole idea of US exceptionalism, I think has got stretched too far. Now, I need to sort of frame this up a little bit.

I am not, and I don't think anybody else is arguing that over the next cycle, Japan or Europe will become more dynamic or innovative than the US. But that's not the way to look at it. By the end of last year, if you looked at US equity valuations relative to the rest of the world,

On the valuation metrics I look at, I look at four or five. Every one of them, the US was at peak, all-time peak valuation premium to the rest of the world. So the question was not whether Japan was going to become better than the US, it's whether that massive valuation gap was going to narrow. And if it started to narrow, you were potentially looking at a period of US equity underperformance. And

The bond story is part of why I think that valuation gap is going to narrow over the next few years. So you think that the valuation gap between the US and the rest of the world, the fact that the European market, the Japanese and the Chinese stock market and other markets that will narrow and that other foreign stock markets will outperform? Yeah.

Yes, correct. And there's a few elements to it and not every market. You mentioned the Chinese market. I'm not a huge fan of that, but I certainly am a fan of Japan and I think also Europe can do well. Now,

To explain why we may see the performance gap narrow, we've got to understand why we got to this stage initially. And I've already alluded to it in part, which is it was simply the earnings gap that drove the outperformance. The US did re-rate relative to the rest of the world, but I think the reason the US re-rated in the post-GFC period was the only major market that was able to generate earnings growth and

If something's scarce, its price will go up. The ability to grow earnings was very rare, so the American market got re-rated. So if we're going to see a period of US underperformance, we really need to see that gap between very strong US earnings and what had been flat earnings in the rest of the world start to narrow.

Why should that happen? Well, the key to that extraordinary US earnings growth was the Magnificent Seven. I think going forward, we need to christen a new group, not the Mag Seven, but the AI group. I mean, some of the Mag Seven are not really AI stocks and some of the AI winners like Broadcom are not in the Mag Seven as we define it at the moment.

So I think the period of exceptional earnings growth in the US will come down. The curtain will come down on that when the AI trade fizzles out, which I think it will. And I'll explain why in a moment. And then on the other side of the ledger, we need to see some earnings growth in the rest of the world. And I think we're already seeing that. And I'll talk about that.

Well, let's go back to the AI trade, which really over the last two or three years has been absolutely central to the superior earnings growth in the US. There's a couple of things to talk about there. And both of these are very reminiscent of what we saw in the late 90s TMT boom. The first is simple accounting and the way we recognize investment expense. If Microsoft spends $100 million on Nvidia chips and

Reportedly, NVIDIA has a 90% margin on their top-end chip. NVIDIA is going to report a $90 million profit, but Microsoft will not report a $100 million expense. It's a depreciation and amortization charge, typically around $15 million. So Microsoft spending $100 million on CapEx is going to boost, in the year that CapEx is done, make seven profits by $75 million profit.

So there's this marvellous self-sustaining dynamic at the moment between the investment boom of the Mag 7 and their own profits. They're almost lifting themselves up by their own bootstraps. Now, that's nothing more sophisticated than just accounting, but it does warn you that if the CapEx boom was to roll over, that dynamic works in reverse. The top line for NVIDIA immediately falls, but the depreciation, amortisation expenses continue to be a drag on the people that were doing the CapEx.

The much more important question, and this gets to the heart of when this dynamic may reverse, is how investors see the potential payoff for all this massive investment. Now, I need to distinguish quite clearly between the issue of what will AI do to the broader economy versus what sort of industry will the provision of AI services be? Now, on the former, what difference will AI make for the world?

I'm agnostic. I'm not sure. It could be utterly transformative. That's not the point. The key investment point is the second issue. How profitable will providing AI services be? Now, a number of these companies have got marvelous legacy businesses. I mean, these are gold mines and they've been making huge return on invested capital for many years.

Those gold mines, those industries tend to have three characteristics. First, large upfront costs. And if you want to compete with Google Maps, go map every city in the world. That'll keep you busy for a while. The second is low marginal cost of servicing an additional client. It doesn't cost meta much if someone extra signs up to become a WhatsApp user.

And thirdly, network advantages. I'm on Instagram because you're on Instagram. And if you've got those three attributes, they tend to be winner-take-all industries. And the return on invested capital for the winner is astronomical. Will providing AI services be like that? And my answer is no, it's not looking like that at all. One of the messages from DeepSeek is that the startup costs are actually going to be quite low.

And one of the messages from the cutting edge large language models is that doing searches are actually very expensive. And we can see that just simply from the massive energy consumption that all these data centers are using. So it's not cheap to service an extra LLM search. And then thirdly, I don't think there's going to be any network advantages. We could get to a world of bespoke AI. I mean,

BlackRock may have its own AI and it's going to be built or taught on in-house proprietorial data that he won't want to share with anybody else.

So you're going to have different AIs, no network advantages. The marginal cost is quite high and the entry cost is quite low. That will make for a very contestable marketplace. And what I think it will mean is quite low returns on invested capital. In other words, these massive amounts of investment that not all the mag seven, but the big AI leaders are doing is actually going to be dilutive of their existing franchises.

So the nearest analog of this is when the market tolerated for a year or two Mark Zuckerberg pouring billions of dollars, 20 to 30 billion, which we thought was enormous at the time. It's chump change versus what they're spending now anyway, on the metaverse. And the market said, yep, you beat Mark, go for it. But then after a year or two, they said, Mark,

Show us the money. Where's the returns? And when he couldn't, we saw a massive derating. So I'm waiting for the show me the money moment on this massive AI investment. And just to remind people, I mean, the Mag7 last calendar year poured $300 billion US dollars into CapEx. The year before, they spent $200 billion. So they've spent half a trillion dollars in two years.

If the returns on that are disappointing, these things will derate. And that's with the analog to the 1990s still holding. I mean, back then, the boom was all about the internet and mobile computing and Microsoft with the personal computer. That was transformative. I mean, the world is different today because we have the internet, because we have these supercomputers called phones. But you know what?

Building this stuff for most companies is not a goldmine. I mean, building laptops, okay, it's an okay business, but it's not a goldmine. It's not a MagSevern's type margin. So you can have technologies that do transform the world but are not hyper-profitable

like some of the existing franchises that the Mag7 have now. And that's my point about the IO thematic. I think it could be transformative, but it's going to be disappointing in an investment sense. And that, because it's been so much led by the US, is going to be half the story to why the US may start to underperform going forward.

The other point I'd make just very quickly on the US versus the rest of the world, if you X out the MAG7, earnings growth for the S&P 493, so to speak, has been normal. It's been in line with long-run average. It's not been particularly special. It's been in line with what the earnings growth in the rest of the world has been over the last decade. In other words, the last 10 years, the S&P 493 global equities X to the US have had the same earnings growth.

And yet the S&P 493 trades at almost a 40% premium to the rest of the world. So even if I sort of scratch my head and if I said, look, the MAG-7 is above my pay grade, that rest of the market trades on what I think is an undeserved premium to rest of world equities.

Just very quickly on the rest of the world, I made the comment before that earnings today are no higher than where they were in '07. Now that sounds terrible and it's not good. You've got to take a step back. The fact is that '07 peak was a massive, massive EPS bubble. People forget that in the prior cycle, so the cycle that peaked

at 07, just before the GFC. The rest of the world massively out-earned the US. Their dollar EPS more than quadrupled in seven years, which pushed earnings way above the US and way above the pre-existing trend for earnings outside the US. What was going on?

Well, the rest of the world in that GFC, pre-GFC cycle, had a much bigger exposure to the three big boom thematics of that cycle. And those three big thematics were the boom in financials. Financials were a much larger part of equity indices outside the U.S. compared to the U.S.,

The boom in commodity prices and emerging markets, obviously EM is part of that, USX, the World Index. And the economic boom in the European periphery, which was all about the entry of peripheral countries to the EU and the convergence of rates and that triggered a massive boom. So, you know, Porsche could sell cars to unemployed Greeks forever.

Now, all three aspects of that boom, as we know, bust, and that created a massive DPS hangover for the rest of the world.

They didn't get back to their pre-bubble trend until about 2018, 2019. But aside from the pandemic, earnings outside the US are now back on a sustainable growth trajectory. So I think we've overcome that big bubble period. So whereas I think US growth is going to slow as the AI driver has a show me the money moment,

and the rest of the world is back on a sustainable growth trajectory, and some of them I think will do particularly well, like Japan, I can see that earnings gap narrowing.

And that massive near record valuation premium of the US versus the rest of the world starting to narrow. And this is a process that will take time. Large pools of capital only move slowly. But one of the great trending variables in global finance is the performance of the US versus the rest of the world. It tends to go on decade long trends, either up or down.

And if we have seen a major peak, then I think we could see a sustained period of rest of world outperformance versus the US.

So you've got this phenomenal chart on the earnings per share of the Magnificent Seven versus the S&P 493, the S&P minus the Magnificent Seven. And then the MSCI, basically all of the world stock markets minus the U.S. And so the Magnificent, if everything earnings per share was at 100 going back to 2015,

The Magnificent Sevens is now earning close to $650. So it's up 6.5 times, whereas the S&P 493 and the rest of the world stock markets are now up to $150. So they're up 50%. So it's

just a huge, huge dispersion in terms of not the valuation, but the actual earnings per share that has gone up. How much of that second thrust higher from 2023 up until now has been driven by the AI trade? Because certainly from 2015 to 2022, that huge, huge thrust upwards in the Magnificent Seven, I would say mostly is not due to at least what is currently viewed as AI. It was viewed...

viewed by very strong pricing power, the network effects, things you earlier referenced earlier. And do you also think that that, you know, is a trend that is going to, to, to reverse as well. And, and I'll also just say that, you know, do you think that let's say Microsoft is going to, uh, you know, be a, deserves a different multiple than let's see, um, you know, uh,

a European company that is much more cyclical and has much less pricing power? Or is it the very language that I'm using right now? Am I just colored by the fact that the past 15 years, Microsoft has been a much better investment and has done better earnings per share? Probably one of my biggest mistakes over the last three years is I just didn't realize how significant the chat GPT announcement was and the subsequent boom in AI. But to go back and unpack what's happened since the GFC with, as I said,

This group of mag seven companies, which we kept on sticking some names in and out, but they were on a tremendous growth trajectory after the GFC. These big platform companies just milked what was fantastic franchises and broadened it out to a global footprint. And so they were on a growth trajectory that was much faster than the S&P 493.

Then along came the pandemic. We all got locked up. We all went online. And guess what? That's where these companies almost live. So they saw their earnings that were already on a very fast trajectory accelerate away from that underlying trend as we got locked up. But then the payback period was as we got unlocked, we spent less time online and their earnings started to fall and it went back to that pre-existing trend. And that's where I thought...

they were going to stay or possibly even go below trend. But then bang, chat GPT and collectively the mag seven earnings have doubled in that two year period since chat GPT or two and a half years since it was announced. Now that I got blindsided by that. I never realized how their earnings would be absolutely turbocharged by AI. But that gets back to what we've already discussed.

Their earnings are up partly because they're spending money on their own products, and the market is giving them a premium valuation because they believe that this investment spending will get a tremendous return for these companies, which I'm dubious about for the reasons I've explained. So I think a lot of this investment will actually be dilutive of their existing franchises. At the cost of valuation, yes,

I don't want to talk about Microsoft specifically. It's a great company. I'm not saying that the US will get to the stage where it's trading at a discount. In fact, I normally look at valuations or the relative valuation of the US compared to the rest of the world, not in absolute terms, but as a Z score. In other words, how far away from the long run average premium is the US? So if we went back to the long run average, the US would still trade at a premium and

It goes back to a prior point. I'm not saying that there'll in any sense be the gap between the rest of the world and the US will close. There'll always be a premium, I think, for the US. The point is the premium, I think, has got too large. And we can see a reversal of that combined with a narrowing in the earnings gap. And that's more than enough to get, I think, several years of US equity underperformance.

I'd also go to that point. One of the valuation measures I use is I looked at valuations on a sector neutralized basis. In other words, just reweight both the US and the rest of the world to give them the same sector weights. So

That means that the valuation premium on the US is not because, for example, it's got a larger IT sector than the rest of the world because tech everywhere trades at a premium and not because it's got a smaller bank sector and banks everywhere trade at a discount. You neutralize all that and you still have the US trading at the end of last year at what was a record valuation level. So it was just this belief system.

in US exceptionalism that has become deeply embedded after 15 years of outperformance. And the US was exceptional over the last 15 years. It did have this tremendous earnings growth. My point is that's absolutely in expectations, it's in valuations, and it's in positioning. And from that starting point, we can get a reversal. And in fact, I mean, that's how the year to date has played out. We've had substantial US underperformance over

which I think is the start of a longer trend. And looking at the valuations of the Magnificent Seven, the S&P 493, and then the non-US companies, the rest of the world's stock markets, the Magnificent Seven is at about 26, S&P 493 about 18 or 19, and the rest of the world's countries markets are at 13 or 14. So the Magnificent

which are more overvalued, the Magnificent 7 or the S&P 493? Because if the Magnificent 7, you know, 26 sounds expensive, but if you can multiply by six your earnings per share over the next decade, that is really good. And if the MSCI World, XUS, and S&P 493 can only increase that by 50%, you know, six divided by 1.5 is four. So shouldn't, you know, if...

past decade is like the next decade, which is a very dangerous thing to say. Shouldn't the PE ratio of the MAG-7 be four times higher than the S&P 493 and the MSCI-XUS world? And if the earnings per share growth of the S&P 493 and the MSCI-XUS world have been the same, isn't the S&P 493 in a bubble or elevated valuations, given that it has much higher valuations than the rest of the world?

Let me take the easy bit first. Absolutely, I think the S&P 493 trades at an unjustifiable premium to the rest of the world.

The other easy thing to say is that, yes, if the next decade for the MAG7 repeats what they've done over the past decade, I will be 100% dead wrong. So my bet is that they won't be able to do that and that the optimism about their earnings outlook is overdone. The reality is the MAG7 is a disparate group. The thematic that's driving markets at the moment is AI. That

That's not all the Mag7. So, I mean, take Tesla as one example. Now, I need to stress, I have no qualifications in marketing. I've never studied marketing in my life. But...

I would argue that if you're selling your product, Tesla cars, to upper-income, white-collar, left-leaning professionals, you shouldn't go around doing Nazi salutes. It's not good for the brand. And more fundamentally, Chinese EVs are starting to eat Tesla's lunch. So I think that's a stock that's got real problems. Apple hasn't really, in my view, done a major innovation since the iPhone. Its top-line growth is...

It's low, it's juicing its EPS by buybacks. I mean, that's the GE way to greatness. And if they stay on that trajectory, it's not going to end well. But then you've got the big platform companies, the hyperscalers. I mean, they're the ones that really are in the frame for the AI thing. And as I said, I'm sceptical that the provision of AI services is going to be profitable enough to justify the premium valuation, right?

And it's going to be difficult for them to sustain the EPS growth that they've achieved over the last two years. That should be an uncontroversial, not a controversial forecast, given that they've doubled their earnings in two years. I don't think anybody realistically could expect them to sustain that sort of growth. So I think we are going to see some disappointment there.

I admit, I can't tell you exactly when. My hunch is it's no more than a year away that we have the show me the money moment. But as I'm saying to my own clients, if we were to catch up at the end of the year and the S&P 500 was to have its third consecutive 20% plus return year,

And that would be much better than I'm now expecting. I'm almost certain that the reason I will have been wrong is not that I've got the macro wrong. It's not that I've got the rates wrong. It's that I've miscalled the AI thematic and it's run on and driven the market for another 12 months. And I don't think that will happen, but I wouldn't be that surprised if it did. That's the biggest risk around my caution on the US equity market at the moment, that I miss time when that AI thematic may fizzle out.

Earlier, you said you're not a huge fan of Chinese equities. Why is that? Fundamentally, Chinese companies in aggregate are poor allocators of capital. That's compounded by

a political system that interferes aggressively with the market. The reality is, if you look at the MSCI indices, there's been no growth in Chinese EPS growth, EPS over the last decade. So notwithstanding huge GDP growth,

And the listed sector in China, in aggregate, has been unable to translate that earnings growth, that GDP growth, sorry, into EPS growth. And part of the story over the long run is the poor dilution of capital has led to a lot of dilution. There's actually been earnings growth, but earnings don't drive equities. What drive equities is earnings per share.

And there's been a wedge between earnings and EPS. Now, the contrast, if China is an example of an economy that's had a lot of GDP growth and almost no EPS growth, the reverse is Japan, that over the last dozen years has had not a lot of GDP growth, but has had tremendous EPS growth. And that's because Japanese corporates, which historically, and by historically, I mean back in the 80s and 90s,

were terrible allocators of capital. They had very low margins. They did a lot of investing. That was the era of market share maximization rather than profit share maximization. Terrible return on assets, high leverage to try and juice up their ROEs.

In aggregate, they've changed over the last two decades. They have cut back their capex. They've increased their return on assets. They've increased their margins. And they've been able to generate EPS growth, even though their domestic economy was languishing. And now...

There are unevenness between the companies. I'm a strategist, so I look at the aggregate. So that's what I'm watching at the moment. I think, I've just come back from Japan. I was there last week, that we are seeing further structural progress. So I think this is a trend that will continue. So you've got that structural trend. The market looks cheap.

The only reason that Japanese equities have underperformed the rest of the world over the last 10 years is that the markets continued to derate relative to the rest of the world. That derating started.

35 years ago, it absolutely deserved to de-rate initially. At the peak, Japan was trading at a 400% PE premium to the rest of the world. So from that starting point, you needed to de-rate. But the last decade, Japan has been trading at a discount, and that de-rating has simply made it cheaper relative to the rest of the world than it has been.

And finally, it's got a huge exposure to the cycle. Japan is the world's most cyclical major market. So if we go through this soft patch, which we're entering, as we come out of that, Japan has got a structural change story. It's got

a cheap valuation and it's got a huge sale that we carried once we get favourable cyclical wins. So I think Japan is going to be terrific in a way that China will not because China's still got the problem with the allocation of capital. And then, I didn't even mention the geropologics, but

Obviously, one thing that every investor is very conscious of, particularly after Mr. Putin invaded Ukraine and anybody that had assets in Russia, basically had to mark them down to zero. If you're doing an assessment of what's my likely return on an investment in China, you have to have to have a view on how likely is it we have some big geopolitical blow up.

that could mean anything you own in China gets written down to zero. You have to take that into account if you're doing your expected return analysis. So that's a structural problem for China that comes on top of the very fundamental problem that in aggregate they cannot allocate capital very well

And in China, I think you're looking at some of the huge indices in China, which are dominated by a lot of state-owned enterprises. I think it's probably those companies that have been the worst allocators of capital, as well as issuing shares, so diluting investors. But would you say that there are some private companies, or at least not only private companies, I'll

Alibaba, Tencent, or some companies like that, that they are doing buybacks, they are cheap, and the risk of a total right down to zero because of geopolitics remained. But would you say that there is opportunity in some pockets of China, or is it a strict no-go zone for you? Oh, no, no, no. There are opportunities. Now, I'm not a stock picker, so I'd always have to hand it over to someone who's got that bottom-up expertise. So, yes. And if you can pick better companies, knock yourself out. My point is, as a strategist looking at

aggregate index earnings, aggregate return on assets. China doesn't look particularly attractive, not nearly as attractive as Japan. But I take your point. I mean, there are some diamonds in the rough. And I do agree that China is absolutely under-owned and in aggregate looks very cheap. Now, I think that cheapness is deserved, followed up the index performance. But if you can find some quality companies that have been sold off indiscriminately, then yeah, no.

by definition, knock yourself out and go load up on them. Being aware of the geopolitical risk, obviously, and one of the things I've detected is those geopolitical factors are

are putting a real roadblock to people investing in China. There's a lot more people that are now managing to an Asia X Japan, X China benchmark or an Asia X China benchmark. They won't be going out. They won't be going back. They're excluded from their benchmark. It doesn't mean that there's not opportunities there, but I do think that means China will probably

be permanently cheap, perhaps not as cheap as it is today, but there are some people that see it beyond the pale and they will not be going back.

So it sounds like you really like Japanese equities. And just going back from 2014 until now, you've got this great chart showing that actually earnings in Japan, earnings per share in Japan are up as much as the rest of the developed markets, ex-Japan. It's just that they've gotten cheaper. So you write underperformers will end when derating does. So I can tell you've got a lot of thoughts on

Japan, just talk to us. Is something strange going on there from a macroeconomic point of view with regards to inflation, with regards to wages, with regards from the 40-year yield going from zero to 3.3% in a few years? Just what is the cause of this potential reversal in Japanese macroeconomic destiny? I'd separate out the view on the equity market versus the view on the economy.

One of the things about particularly the non-financial corporates in Japan is if you look at their sales growth, it really has disconnected from domestic GDP over the last 20 years. I mean, they are increasingly global, global in their sales and global in their production. I'm not saying it wouldn't be helpful if the domestic economy was stronger, but I don't think it's essential that the domestic economy improve to be bullish on the non-financial sector.

It is essential if you're looking at their banks, because if you don't have some domestic growth, you won't have credit growth. And if you don't have domestic growth, you won't have a normal yield curve, and that will be bad for their interest margins. So separate the market view to the economic view.

But the economic view, I think, is relatively straightforward. After 35 years of battling deflation and then lowflation, it looks like policymakers have finally got what they've been aiming for, which is the return to normal nominal growth and normal inflation. And what's driven that is that they've finally got wage growth returning. Initially, in the aftermath of the pandemic,

Japanese inflation did jump, but it jumped for the wrong reason. It jumped because of imported prices. Now, if you've lifted inflation because your import prices are going up, that's not sustainable because higher import prices is immiserating. It makes you poorer. It's into your lending standards.

The way to have sustainable inflation is to not lift the price of what you consume, lift the price of what you produce. What does an economy produce? Well, the largest single thing it produces is labour services. So you've got to get wage growth up. And that's exactly what Japanese policymakers have accomplished over the last 18 months. So I think Japan, in a macro sense, is now back in the realm of

a normal developed economy. I mean, it will not grow as fast as somewhere like the US partly because the demographics are different, but it can now sustainably have inflation with a one or two handle.

That will allow the Bank of Japan to normalise rates. Now, with its big debt load, that can cause some indigestion and you don't want it to happen in a disorderly way. And the recent pace of the increase in long rates is a little disconcerting. But this is why now the Bank of Japan is on a very gentle tightening tilt when most other central banks in the developed economy are on an easing tilt.

because they've finally accomplished something they've been after for two decades, which is normal inflation. So that's good for the macro economy. Hopefully encourages higher investment spending, which I think ultimately it will. And that in turn will generate higher productivity growth and therefore higher sustainable real GDP. Once again,

Japan will not be growing at a US pace, but it'll be growing at a faster pace than what we've become accustomed to over the last three decades. So that's the good news. That's got strong implications for rates, and we're seeing that adjustment underway right now. That will cause a little bit of indigestion for the fiscal story, but I go back to a point I made earlier. If you look at the government's net position, net financial asset position, it's not as bad as the gross position.

Its debt is around about 120% of GDP, but a lot of that is held by the BOJ. So effectively, they've done a massive monetization or debt swap.

They've swapped JGBs for zero-coupon non-redeemable notes, something we otherwise know as cash. And so they don't cost anything to service, and they're never going to get redeemed. So I don't think the fiscal situation is as dire as the headline figures suggest, but there will need to be some budget repair. But that will be made easier in Japan as nominal growth picks up, because that will just simply generate more revenue for the Japanese government.

If you look at the equity market in that context, the prospect of strong nominal growth is critical for the outlook for financials. I mean, they live in a nominal world. Credit growth is a function of income growth. If there's no nominal income growth, there was not going to be any credit growth. So Japanese banks can start growing. They've got a global footprint with higher rates. They can make better net interest margins. This is all very good for them. And you've seen that response already in the share price.

In terms of the rest of the market, yes, the big headwind has been for a decade just derating. If you just look at Japan, MSCI index in dollars versus rest of the world index in dollars, Japanese companies have grown their earnings at the same rate as the rest of the world for the last 10 years. The dividend yield has been the same.

The only reason it's underperformed is its P.E. has been falling when the rest of the world P.E. has been rising. So my simple takeaway from that is the day Japanese equities stop deriding is the day they stop underperforming.

I think it's absolutely defensible to think that they can actually re-rate somewhat because they are trading at what I think is too large a discount to the rest of the world. And if we do get a better cycle, history says that they will grow their earnings faster than the rest of the world because Japan is a very cyclical market. That's the one small caveat. We are...

seeing some softness in the world. As we've already discussed, I see a reasonable chance of a US recession, perhaps a one in three chance. But if you look at oil prices, you look at copper prices, they are telling you that the world is a soft place and that doesn't play to Japan's strength. So

So at some stage this year, I want to load up on Japanese stocks. You don't need to rush because we have got the cyclical soft patch, but I think it's going to do very well in the next cycle, Japanese equities.

One thing you believe I've read in your research is that the neutral interest rate, that is the level of interest rates that is neither stimulative nor will cause a recession and cause a contraction, is higher. When you talk about Japan, I can't help but think about demographics. The population in Japan peaked, what, 10, 15 years ago. The population in Europe, the growth rate is very, very small. In China, it is very, very small and going down. South Korea, the birth rate is all-time low.

The United States relatively has been better, but in some part due to immigration. And as you mentioned earlier, that trend is reversing quite dramatically. But can you square your view that...

the neutral rate of interest is going up when the growth rates in the population is going down. And the percentage of working age population relative to the entire economy is going down as well, which I associate maybe you disagree with lower neutral rate of interest, right? Yes. Look, we need to understand how demographics can affect rates. And part of the story is this

this balance between saving and investment. And you go back to first principles, how much investment does an economy need to do? Well, the first thing that drives it is how many extra workers are going to join the workforce that I need to provide investment for? And that's why if you look over the last, well, really since the post-war period, the rise and fall of rates, real rates in developed economies,

coincides with the rise and fall of working age population growth. Courtesy of the baby boomers, that peaked in the 70s or 80s. As a result, investment shares of GDP were at all-time highs. That high investment relative to saving pushed up real rates. And investment spending shares of GDP have been falling ever since, in line with the deceleration of working age population growth.

Now, if that was all I had for the story, you'd be right. Demographics are not going to change. One little footnote, the biggest single success of Abenomics in Japan was that we did see, have seen, the last decade, a clear break in

between working age population and underlying demographics. The participation rate has risen dramatically in Japan over the last 10 years, and that really is Abenomics lifting female working age participation. So there has been in Japan over the last decade, demographics have not quite been destiny in the way many people expected because we've seen a big increase in female workforce participation. There, that's as an aside.

But here's the thing. That longstanding link between investment spending, share of GDP and demographics is starting to break. And it's starting to break because we've got these extraneous new reasons to do investment. And that's what we've been talking about before.

Higher spending on defence, nothing to do with demographics. Higher spending on climate change, nothing to do with demographics. The fraying of globalisation, therefore the need for redundancies to be built into supply chains, higher inventory levels, once again, nothing to do with demographics. So my big picture story is that longstanding link between demographics and investment and therefore investment

interest rates is breaking down because we have these new sources of investment spending that are unconnected to the demographic big picture. And that's going to drive up real rates globally. We've got global capital markets. There's always differentials between economies, but basically they move directionally in similar areas.

And I contrast what I expect in Japan to a place like Australia, my hometown, where we've had very fast population growth, the fastest population growth of any major developed economy for two decades. And yet...

I don't think that has meant that our neutral rate has increased. In fact, I think our neutral rate is still where it was pre-pandemic, which was around zero real. And the problem here has been that although we've had fast demographics, we've had lousy investment spending for various reasons. That means we've had no growth in the capital stock per worker over the last almost decade. And we've had no productivity growth for the last decade. So we've had this very anemic trend

near zero per person growth story and that has kept the neutral rate near zero even though we've had population growth that I mean leaves America in the dust let alone a place like Japan so

Demographics are crucial, but there are examples where the link between the neutral rate and demographics have broken down. In Japan, I think the neutral rate is going to be higher than the demographics would suggest. And in Australia, for most of the decade, we've had the neutral rate lower than our demographics would have suggested. So there is nuance in the story.

I've heard it said that Australia is a country that has had very, very few recessions and recessions are almost unheard of in Australia. Why is that the case? Because I think that Australia's raw materials...

as a sector of GDP is higher than a lot of nations. And why didn't you have a recession in 2014 when oil prices and copper prices and everything went down by a lot? What is the secret of the Australian economy not having recession? The first thing is that population growth, that we have had such strong population growth. That just means that there's natural impetus to grow.

If we defined recession in terms of a decline in per capita GDP, we've had setbacks. But most people don't do that. They just look at headline GDP. So that's the first thing. The second thing is the Reserve Bank of Australia has got

in my view, the world's most powerful monetary policy lever. And what makes it powerful is two things. Firstly, Australian households are massively levered, much more levered than, for example, the US. We've got household debt to income of almost 200%, which is twice the US rate. But the second element that makes it such a powerful policy lever is that almost all our interest rates are floating rate, including our mortgages.

So people talk about long and variable lags for monetary policy. In Australia, it's about five days. If the RBA changes the cash rate on a Tuesday, the commercial banks will normally adjust my mortgage rate the following Monday. So that means that the RBA can give huge relief if there's a shock. If it cuts interest rates by, let's say, 4%, which it did more than that in the GFC, the

4%, when the debt is almost 200% of income, that gives cash flow relief of 8% of income almost overnight to the household sector. That's a huge adrenaline shot into the system. Conversely, of course, when they tighten, it has a swift restraining effect. So that's an advantage that most other countries don't have. And then the specifics of, say, the GFC, the policy makers are

at the time, did what policymakers elsewhere did in the pandemic. They delivered timely, targeted, temporary cash relief to people. They just literally sent checks. So when Lehman's failed in September '08, the people that were running the country at the time to give them their due realised almost overnight the significance of that.

and the Australians received their first cheques from the government before Christmas '08, and they kept on sending cheques. And every time there was a cheque, you saw a spike in spending. So the combination of that fiscal largesse and the reduction in interest rates from the RBA meant that in 2009, which globally was the worst period for growth,

Australian disposable income went up 10%. I mean, 10%. So everybody else has got a GFC.

We've got 10% income growth. So we avoided a recession. Now, that was a lesson that everybody else repeated in the pandemic. I mean, the pandemic, on the one hand, we're locking you up. On the other hand, here's a wad of cash. And I mean, the NBR said there was a recession in the US. I don't think that they should have. I mean, recessions on their own definition is downturns that last more than

several months. Basically, we had a two-month recession, which I don't think it was a recession. And, you know,

The rest of the world learnt the lessons that Australia deployed in the GFC and we've been doing it ever since. So very fast monetary policy response, sending checks when required, all against the backdrop of very fast population growth. And we really haven't had a recession since 1990. So 35 years without a downturn. It is a remarkable record, but it is flattered a little bit by the fact that we're looking at agri-GDP, not per person GDP.

And that point about what percentage of debt in the economy is fixed to floating rate is so important. Australia has a ton of floating rate debt. So when the central bank lowers interest rates, it actually causes a real effect for everyone who has that floating rate debt. Whereas if people had fixed rate debt, they would have to refinance in order to get that advantage. In the US, we have a lot of fixed rate debt. So maybe that's why when the Federal Reserve raised interest rates in 2022, it didn't slow down the economy by as much as people thought. I actually heard on a panel, current Secretary

Treasury Secretary Scott Besson talked about how when he was working for George Soros and they broke the Bank of England, that that was a key part of his analysis, was that the UK had a lot of floating rate debt and that the Bank of England

couldn't keep on defending the pound by raising interest rates because it was caused such such havoc to the economy um gerard is my understanding that the australian stock market is somewhat expensive and it's expensive given that it has a lot of banks and financial companies and commodity producers somewhat cyclical businesses uh uh you know which normally have a somewhat smaller multiple what is your view of the australian equity market as a client said to me yesterday um

The Australian equity market has a US valuation with a European growth outlook, which is not a bad way to summarize it. So we do have anemic growth if you look at current consensus forecasts. We're only expecting 2% EPS growth over the next year, and yet we're trading at a valuation that is not quite American, but it's absolutely not cheap.

What explains that? I think it's a little bit of a pressure cooker effect because we have, I think now, the world's third largest pool of pension savings. We have been contributing on a compulsory basis to our pension funds for four decades. I think now that we've got a pool of money that's

three or four trillion Aussie dollars. And that domestic buying pressure has put our market on a premium valuation relative to our growth rate and relative to our own history. I often just extract the mining sector from our index because the miners are obviously globally facing. If you look at the valuation of the Aussie market, X the miners,

At the start of the year, we were at a valuation level that we'd only seen twice before in history. In the late 90s, in the tech boom, and immediately before the pandemic reopening, where the market was quite correctly anticipating a rebound in earnings. So it's a very expensive market for what is low growth. And some of our big pension funds are now acknowledging that.

that they've almost reached the limit of how many Australian equities they can buy. Our largest single pension fund, Australian Subar, has been on the public record saying that they're very close to saying we can't own any more equities and they're redirecting their investment flows to overseas. So I think the Aussie market looks relatively unattractive with one small domestic wrinkle. So this applies to me, it doesn't apply to you. So this, for domestic residents,

If a company pays the appropriate tax rate on their profits, they can effectively distribute their dividends tax-free. So that means if I buy an Australian bank that's got a dividend yield of, let's say, 6%,

And that's almost tax-free to me. That's like another investment that offers a 10%, 9% taxable yield. So there's a lot of people that are willing to buy Australian stocks for that dividend yield and almost not look at the share price. The banks have been big beneficiaries of that. They've historically had very high dividend yields.

And you can see when they brought this change in, the so-called franking system, prior to that, Australian companies had payout ratios absolutely in line with the rest of the world. Ever since then, we've had a huge jump up, and I think we've averaged 75% to 80% payout ratios ever since because Aussie investors love their dividend yields.

But that wrinkle aside, there's not much reason, I think, for foreigners to come to the Aussie market. It looks very expensive flow growth. It may be that if you bought it unhedged and the Aussie dollar goes up, there'll be a return. But you know what? That's a currency bet, not an equity bet.

So I'm telling people, my clients, that they should be looking overseas. When they look overseas now, I'm saying look at places other than the US. So I'm not particularly keen on our market. On rates here, I don't think rate markets are pricing enough RBA rate cuts to come. I think the RBA is still overestimating where the so-called neutral rate of interest is.

We had for six or seven years before the pandemic, the cash rate near zero in real terms. There was not any evidence that that was on the stimulatory side. The RBA continually undershot its inflation target, continually overestimated how fast wage growth will be. And I don't see why anything's changed. So I still think the neutral rate of interest here is near zero in real terms.

If the RBA hits its inflation target, which is around 2.5%, that implies that the cash rate should be around 2.5%, and that's not being priced by futures here. So there's a trade there that may take a little bit of time to play out, but I absolutely think the market's underestimating how far the RBA can ultimately cut rates

Gerard, it's been such a pleasure having you on Monetary Matters. For a lot of people, when I ask them, I say, okay, where can people find you? But for you, it's a little more complicated. You're not on LinkedIn. You're not on Twitter. Your website isn't really there. So how can people get in touch with you and learn more? I'm on Bloomberg. So just search me there, message me. Or if you want to send me an email, I do respond to those emails.

So it's Gerard, G-E-R-A-R-D, my first name, at minacadvisors.com. And that's advisors, A-D-V-I-S-O-R-S.com. So send me an email or Bloomberg me. I'm happy to respond. And my service is selling my research. And I'm happy to give people a trial if they are interested.

Thank you again, Gerard. Appreciate everyone for listening. Remember to check out today's sponsor. Click the link to show them some love. And remember to also subscribe to the Monetary Matters YouTube channel, as well as leave a rating and review for Monetary Matters on Apple Podcasts, Spotify, and other platforms. It really helps the show. Thanks again. Until next time. Thanks, Jack. Thank you. Just close this door.