Episode #438: Rob Arnott & Campbell Harvey on Why They Believe Inflation Hasn’t Peaked
Guest: Rob Arnott is the founder and chairman of the board of Research Affiliates, a global asset manager dedicated to profoundly impacting the global investment community through its insights and products.
Campbell R. Harvey is the Head of Research at Research Affiliates and Professor of Finance at the Fuqua School of Business at Duke University.
Date Recorded: 8/10/2022 | Run-Time: 1:10:33
Summary: In today’s episode, Rob and Cam touch on the state of the economy, Cam’s research recessions and yield curve inversions, and why the Fed is not positioned to handle the inflation crisis we have today. They share why they both have a non-consensus view that inflation hasn’t peaked yet. Then they touch on what areas of the market look attractive today.
Be sure to stick around until the end when we chat with Cam on his interest in DeFi and what he’s most excited about in the space.
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Meb: Welcome, my friends. We have a truly exceptional show for you today. Our returning guests really need no introduction. They are Rob Arnott, Founder and Chairman of the Board of Research Affiliates, and Cam Harvey, Head of Research and Research Affiliates and Professor of Finance at The Fuqua School of Business at Duke University.
In today’s episode, Rob and Cam, touch on the state of the economy, their research on recessions and yield curve inversions, and why the Fed is not positioned to handle this inflation crisis we have today. They share why they both have a non-consensus view that inflation has not peaked yet. Do we see a return to double-digit prints in 2022? Then they touch on what areas of the investment markets look attractive today. Be sure to stick around until the end when we chat with Cam on his interest in DEFI and what he’s most excited about in the space. Please enjoy this episode with Rob Arnott and Cam Harvey.
Meb: Rob and Cam, welcome back to the show.
Rob: Happy to be here.
Cam: Great to be back.
Meb: Where do we find you guys today? Florida Durham. Is that right?
Rob: I’m actually in Newport Beach. I avoid Florida during the summer.
Cam: And I’m in Durham, North Carolina.
Meb: Rob, good to have you back in SoCal, I was actually down in Huntington Beach yesterday, should have dropped down and said hello. Just got out of the ocean, listeners. I’m still a little wet from the surf today. Beautiful day in SoCal. Summertime is almost over. But let’s get into it. We’re blessed to have these two heavyweights with us today. I want to start with Cam because we last had you on in 2019. And guess what we were talking about, your favorite topic, the yield curve inversion. But the question I want to start with was, how did you know and how did the yield curve know a pandemic was coming? Because it got another one right. What is it like 9 for 9 now and 10 for 10?
Cam: So, obviously, the inverted yield curve in 2019 did not forecast COVID. And we will never know the counterfactual if there’s no COVID. But, generally, at the time in 2019, there was a lot of sentiment that the economy was slowing. Our Duke CFO survey had 70% of the respondents believing that a recession would start in 2020 or early 2021. So, again, we’ll never know, maybe it’s a lucky observation. Maybe not.
Meb: Yeah, for the listeners, just real quick background, we’ll post the link to the show notes, listeners, to listen that old episode. It’s awesome in its entirety. Give us the real quick background on the yield curve, because we’re darn close now, if not there, right? Pretty close?
Cam: Yeah, so the background briefly is that the link between the slope of the yield curve, so the difference between long-term interest rate and the short-term interest rate is the topic of my dissertation at the University of Chicago in 1986. And I noticed that when the yield curve was negatively sloped, so this weird situation where the short rates were higher than long rates, that that preceded recessions. And as you know, a macroeconomic data is not a lot of data, not a lot of recessions. And I had like four. And the indicator was four out of four. And my committee was skeptical but given that the idea had a good solid economic foundation, they signed off on the dissertation. And then afterwards, we got a sample.
Usually what happens with an idea that’s published is that if you’re lucky, the effect gets weaker. And if you’re not lucky, the effect goes away. In my case, we’ve had four yield curve inversions since the publication of my dissertation. And each one preceded the recession. So far, no false signal balls, and I look at, like, a 10-year yield minus three-month Treasury bill.
Rob: The media seems to fixate on tenure versus two-year. And I think that’s an important distinction. If you look at… Right now, I’m looking at tenure at 278, and three-month at 257. The 10 versus two has been inverted for a while. But the 10 versus three months, probably inverts the moment the Fed makes its next decision.
Cam: Yeah, I totally agree with Rob, you know, certain groups within the Fed, like the 10-year minus two-year. And my response to that is, well, maybe there’s so many different ways to measure the yield curve. So, 10 minus two, it could be five minus two, it could be four and a half minus one and three quarters. There’s many different ways to do that. And I make the simple argument that well published since 1986, it’s four out of four since 1986, is not broken. So why would you go to another metric that actually has false signals in it?
So I don’t understand but this is really, really important. It’s not just about inversion. So my dissertation links the slope to economic growth. So whether you’re inverted, or whether the yield curve is relatively flat, that implies that future economic growth is going to be low. Obviously, a negative slope implies negative growth. That’s very bad, and that’s usually recession. But just a flat yield curve is not good news. And what we’re seeing in the bond market is, I think, reasonably reflecting what’s happening in the economy.
Meb: So let’s talk about that now. You guys had a good piece out lately that you started writing about possibilities of recession and what the rest of 2022 may look like. Rob, kind of let you take the mic here. What’s kind of the thesis behind that? Are we going to skirt this sucker or is it a kind of look out below?
Rob: Well, Cam, I’m interested in your perspective on this. You’ve heard me say many times that I don’t think yield curve inversion predicts a recession, I think it causes a recession. And the rationale there is very, very simple. The long end of the curve is a market rate. It’s set by supply and demand. It tells us what the market believes is a comfortable yield for a market clearing price. The short end, not the two-year, the short end is set by the Central Bank, and is a managed rate.
So, when the yield curve inverts, the Central Bank is deliberately choosing to stifle growth, to crush growth, inflation that is caused by factors that are totally out of the control of the Fed, war in Ukraine, supply chain disruptions, pandemic. People paid well enough to stay home and choosing to do so are afraid of going to work and choosing to stay home reducing the supply of goods and services, free money put into their accounts, increasing the demand for goods and services. All of these things are out of the control of the Fed.
And the Fed, the guy with a hammer, who sees everything as a nail sees inflation risk as something that they must control, even though the inflation was caused by factors outside of their control. And so the only tool they have… They have a lot of tools, but they’re all elements of the same tool, which is to crush demand. And so Rudi Dornbusch back in 1997, famously MIT economist famously said that, “No economic expansion ever died of old age. They were all murdered by the Fed.” And I thought that was a wonderful quote. But be that as it may, my view would be the yield curve inversion is the Fed deliberately crushing demand and causing a recession rather than predicting one. What’s your take on that?
Cam: Yeah. So, it’s really an interesting point, Rob. I guess, what I would say is that what you’re saying is not inconsistent with the prediction. So, you can actually be causing a recession, but just looking at the yield curve is valuable, because it is predicting what will actually happen. So, I agree with you that the long rate is much more market-oriented. And we can see it’s kind of obvious what’s happening. So the Fed is increasing the rate. And that rate is the short-term rate that’s flattening the curve or inverting parts of the curve. And then this is basically to combat supposedly inflation. And we can look historically at inflation episodes with the Fed doing, you know, similar things, and they drive the economy into recession.
And I agree with you, and it’s actually very disappointing to me that the Fed isn’t more creative, that they have one tool. And it’s a really blunt instrument. And that is to increase the Fed funds rate and the media is focused on it. Even today, you’re looking at the numbers after the inflation release, and people are talking down a 75 basis point increase in the Fed funds rate. So it’s like they just focus on this one thing on the demand side, they want to crush demand to reduce the price pressure but I think it’d be much more creative in looking at all of the other aspects that are driving inflation on the supply side.
And even though they don’t have necessarily direct control over some of those supply factors, they can work with their colleagues in the treasury, just like what happened in the global financial crisis, and come up with a strategy that goes beyond this debate of, oh, 50 basis points, or 75 basis points, or less than just push us into recession. And that’s going to decrease the demand and decrease the price level, all this stuff.
And I think that people also on the policy side don’t properly appreciate the cost of a recession. So we look at, well, stock prices go down or we measure the decrease in GDP growth, but they ignore all of these other costs, people being displaced. Nobody wants to be laid off. Nobody wants to go on unemployment insurance.
Rob: Suicides and divorces soar. So there’s a very real human cost. The other thing that I think is interesting is you recall our CEO Chris Brighton’s jokes that he had McDougal is lost in the Scottish countryside and asking a local, “How do I get from here to Dundee?” And the local replies, “Well, I wouldn’t start from here.” You don’t start from a negative real rate. You don’t start from zero interest rates. Zero and lower is a completely artificial rate, perhaps useful when the economy is in absolute disintegration, but more likely useful never. Australia was called the lucky country, 30 years with no recession all the way from 1990 until the pandemic, how did they do that?
Well, until the mid-2010s, they studiously avoided negative real rates. Interest rates are a speed bump in the economy which prevents reckless spending. If there’s a speed bump, you’re not going to drive recklessly. And if the speed bump is too high, you’re not going to get anywhere. So no speed bump is bad news. Reckless spending, malinvestment, misallocation of resources to higher real rates stalls the economy, there’s a sweet spot in the middle somewhere in the neighborhood of 1% real rates, where the economy doesn’t need to have a recession because the money isn’t spent recklessly, and the Fed claims to be data dependent.
But the data that they don’t look at is what is the long end of the yield curve tell me is a safe maximum for short rates. So I was of the view, and I think you’d agree, Cam, that coming off of the zero base raising rates was long, long, long overdue. And they could raise it as briskly as they wanted, as long as they stayed half a percent below the long rate. And now, we’re 15 basis points below the long rate. It doesn’t matter if 50 basis point hike or 75 basis point hike. Sure. Inflation coming in below expectations for a change reduces the likelihood that they’ll go 75 but are they going to go less than 50? I don’t think so. And 50 pushes you into inversion.
Cam: So, there are so many things, Rob, that you said that I agree with. And let me just emphasize one of them. So, when the COVID hit, and there was a panic, there’s a liquidity crisis, many high-quality firms looked like they would go out of business. I was very supportive of the injection of liquidity because this was a natural disaster. And the problem is that even after it was clear that the economy was recovering, that the recession was historically unprecedented for being so short, employment is growing, and the stock market going to all-time highs, yet we continue this distortive policy of having essentially a zero short-term interest rate and then continuing all of the quantitative easing. I have no idea what they were thinking.
Rob: Yeah, same thing after the global financial crisis. We’ve had a dozen years of negative real rates and of nominal rates, near or at the zero bound. And Japan and Europe said, “We’ll see you and we’ll double down and go to negative rates.” Pardon me, paying for the privilege to lend money? The whole purpose of interest rates is to attach a price for time. There’s a book coming out, I think this month, called “The Price of Time,” which focuses on the horrible impact of negative real rates, and really lays a lot of current society’s ills at the feet of a deliberate choice to pay people to borrow. And if you pay people to borrow, those who can have the luxury of having access to those negative real rates, top-rated companies and governments will wind up apportioning money to whatever stupid project they have in mind.
Cam: So you’ll wonder why the U.S., and Europe, and Japan is stuck in this really low growth mode. So we’re lucky to get 2%, Europe maybe 1% real GDP growth. It’s, in my opinion, can be partially or maybe largely attributed to the distortive interest rate policies, where you have companies that are not productive, that should actually go away, that are propped up as zombies because the cost of borrowing or servicing their debt is so small, and it’d be way better to reallocate the capital and the labor to more productive opportunities, yet, that has not happened. And it’s been a long time. And we’re paying the price of that distortion. And let me also make an important point. This isn’t a new position for Rob or we’ve been saying this for years. So it’s not like we just showed up today with this revelation. We’ve been warning about this distortion. We’ve been warning about the dangerous Fed policy for how many years, Rob?
Rob: Well, over a dozen years, actually going back to the housing bubble of the mid-2000s.
Meb: By the way, the Ed Chancellor book and referring to, Rob, we actually just recorded a podcast with him. And so it’s not out yet. But by the time this drops, listeners, it will have been published in one of my favorite stats from the book as he was talking about quantitative easing, all the way back to the time of Tiberius. So, listeners, will have to go listen to it to see what that means. But I wanted to make a comment and a slight joke but also it’s kind of serious is I think some of the best jokes comedians are. I said, “Why wouldn’t the Fed just show up to the meetings, get a 12-pack of beer, watch “Seinfeld” reruns, and just peg Fed funds to the two-year.”
Because it looks like, you know, the overtime, it’s pretty darn close. But over the last decade, it’s been a period where, you know, there has been this big spread. And now, you have this crazy scenario… I feel like if you went back a couple of years, and you said, “Meb, Rob, Cam, we’re going to give you a glimpse into the future. Inflation is going to be 9%, and the Fed funds rate is going to be sub-3. What do you think is happening? Like, what is going on in the world?” You say, “No idea. Like, the world’s gone crazy.”
Cam: Yeah. So let me try on that one. So if you looked at the Fed funds rate, and then subtract the year-over-year inflation, you’ll see that we’re in a spot today that we’ve never been historically. And a lot of people look back 40 years ago because we’re talking about inflation today, that is in the range that we were at 40 years ago. And what they don’t realize is that it’s worse than you think. So, the inflation, the way it was calculated 40 years ago, was based upon housing prices. And housing is about a third of CPI. Today, we’ve got a smooth version of owner-equivalent rent. And if you did the apples-to-apples comparison, where you calculated inflation like you did in 1981, the rate would be 12% or 13%. And we’re looking at the 8.5%. Now, the reason I’m mentioning this is your particular example. So, what was the Fed funds rate in 1981?
Rob: Three and a half.
Cam: Meb, any guess?
Meb: Rob’s gave away the answer plus I was only five, so I go to the…
Meb: See, all you had to do back then and just buy some zero coupon bonds and go away for 40 years. That was the right trade at that point.
Cam: So, can I throw in another dynamic that is kind of below the radar screen? And that is that I believe that the Fed is constrained today, way more than the early 1980s. Because in the early 1980s, the debt to GDP was about 34%. And today, it’s over 100%. So as the Fed increases the rates, it increases the debt service cost in a way that is magnified by a factor of four compared to the early 1980s. And given we’re already in a deficit situation, a serious deficit situation, how do you pay for that extra interest? You actually monetize it. And the Feds got to be thinking that if we push the rate too high, we actually could feed further inflation. And that wasn’t true in the early 1980s.
Rob: Here’s a fun thought experiment, a suppose Powell channels his inner Volker and says Volcker took the rate to an all-time peak of 20.5 ever so briefly. Inflation correctly measured is about the same as it was back then, I’m going to do that. Okay. If you have 20% interest rates, if that migrates its way into the overall cost of capital for government, because keep in mind, raising the short rate doesn’t boost the cost of servicing government debt, except over time as the debt rolls but if the debt were to roll into a 20% yield, just bear with me. If your debt is 100% of GDP, that debt service costs you 20% of GDP, 20% of GDP is 100% of the tax revenues the Feds work with, 100%. So the entirety of tax revenues would have to go to servicing debt zero to any of the things that the government does that ostensibly make our lives better.
Meb: So, we’re in this awkward position, and I like Cam’s analogy of the double barrel Nerf gun because I got a five-year-old. So we’re thinking that right now. We could probably all agree mistakes have been made, where they’ve led us to is sort of this like, really tough spot. Let’s say Biden calls you two guys tonight said, “Big listener of the “Meb Faber Show” helps me go to sleep at night. But Rob and Cam had some really good points. I want you guys to come in and give me some advice of what we could do now.” What do you say? Like, is it the path of least pain somewhere?
Rob: My short answer would be the ultimate tax rate is the rate of spending, because that comes out of either tax revenue or borrowing, both of which divert resources from the private sector, macro economy. So, Joe, my recommendation is to slash government spending, slash waste, there’s a lot of waste, slash unnecessary programs that work incentives for the macroeconomy. And let interest rates be driven by the long end of the curve, the notion of a 12 pack of beer, and just peg the right to match the two-year or peg the rate at the 10-year minus 50 basis points or something like that would be wonderful way to manage our way to a miracle economy that doesn’t have recessions, except when there’s an exogenous shock, like a pandemic, a natural disaster. How do you think Joe would react to that advice?
Meb: But that’s, you know, the command. They just put out this Inflation Reduction Act. So I think…
Rob: This is the most ironic name for spending bill ever.
Cam: So let me give a try and let me specifically address the inflation crisis. And I really believe this is a crisis. And it will cause a lot of harm to our economy, not just the increased rate of inflation, but potentially some of these very naive policy mopes. So, what I would do is, essentially give the Federal Reserve a different job. So, they’re doing just one thing with this blunt instrument. And they’ve got 400 Ph.D. economists.
And I would assign them to look at the components of inflation and to make recommendations as to how we can be creative on the supply side to reduce some of the price pressures. Now, obviously, as I mentioned earlier, this goes beyond the Fed’s mandate, but surely they can work with Treasury to design a more creative policy. That’s number one.
Number two, I would recommend that the messaging should change. We can’t just rely upon the Fed and its blunt tool to deal with this. That indeed, I think that there should be a grassroots effort to deal with this crisis. And Rob and I discussed this example that I like to use about the city of Long Beach, California. And let me just go through this example. So as you know, Long Beach not too far away from you is host to the largest container port in the U.S. We’ve got a supply chain crisis that is actually causing prices to go up and inflation to go up.
And it turns out that there is an ordinance in Long Beach, that you cannot stack more than two containers. So that’s the local law. And it’s a reasonable law because it blocks the view of the ocean. So, the people of Long Beach took the perspective of, “Well, we’ve got a national crisis, what can we do to help out? What can we sacrifice in the short term to help out this crisis?” So they went ahead and changed that ordinance, so you could stack four or five containers to make it much more efficient at Long Beach.
That is an example of a grassroots effort where you’re not relying upon the Fed to tell you what to do, you just do it on your own. I think we’re relying way too much on our policymakers. There’s many things that can do. That Long Beach example is just one of potentially hundreds, if not thousands of examples of things that we can do to reduce some of the price pressure.
Meb: Good, Cam, let’s get a bunch of your former Ph.D. students and unleash them on the world. We’ll have a bunch of doohickeys solving the world’s problems. I like it, optimistic, certainly but I love the idea. You guys alluded to this. And we’re actually on a CPI print day earlier. But we’d love to hear you expand a little bit on this topic of inflation because I feel like y’all have a slightly non-consensus view. I think most of the media and most of my contemporaries, I think the consensus is, yes, inflation is high. It’s coming down, it’s not going to last. You know, by the end of the year, we’ll be back down at 3%, and all is copacetic. and wonderful. But that’s not what you guys were talking about. And the comment about housing and rents, I thought is really interesting. I would love to hear you guys expand a little bit and kind of tell us what your thoughts are there a
Rob: A couple of quick things. Firstly, one thing that is not widely understood, and Cam alluded to this, is that the calculation of CPI changes over time. Back in 1980, inflation peaked at 14.7%, largely because home prices were a key constituent part of CPI inflation. The BLS was called at the inflation rate coming in so high and sought to identify some way to smooth and moderate the most volatile component home prices. And so, what they came up with is, if you own a home, and your house price goes up 20%, the last 12 months according to Case Shiller, it’s up 20%, your home was worth 20% More than a year ago, my goodness, that’s huge.
If your home is up 20% of your cost of running the home up 20%, no. So let’s change it to owners’ equivalent rent. Now, to be sure if you’re buying a home, you feel that inflation, if you’re selling a home, you enjoy that inflation. But if you’re in the home, it’s a non-event temporarily, temporarily. And so, what they came up with is owners’ equivalent rent, since my home is not listed in the newspaper as its rental value changing month to month, how do they calculate it? They do a survey of thousands of people.
They ask you, “What do you think your home would rent for?” And if you’re like me, you don’t have a clue? You would be in the right ballpark, but only barely. And so, what do you do? You pick a number out of the year that you think might be sort of right and you anchor on the past. What did I say last year? 4,000 a month? Okay, let’s call it 4,100. Now, as home prices soar, that starts to accelerate OER but with a lag, the first year of soaring prices doesn’t even register.
It’s the year ago and year before numbers that start to register. And so, over the last two years, OER has risen 7%, 2% then 5%. 5%? You got to be kidding. Two and 5%, 7%, over the last two years, home prices according to Case Shiller are up 37%. What happens to that 30% gap? The 30% gap goes up over the next decade, about half of it over the next three years.
And the result is that you get a catch-up. That inflation already happened. It already happened. It just shows up in the statistics late. Similar thing is done with renters inflation. You ask the tenant, what are you paying compared to a year ago? If you haven’t renewed your lease, the answer is zero inflation. If you are about to renew your lease, brace yourself for a shock, rents are up 15% year over year. In Miami, my hometown, 41% year over a year. Unbelievable jump in rental costs. So that’s one thing. That’s going to be playing catch-up for the next two or three years.
The other thing is, every month, you have the same inflation as last month, plus one new month minus a year ago month. You have no clue what the new month is going to be. At the time of this recording, CPI just came out at zero for the month. The expectation was 0.3, the year ago number was 0.5. So you’re replacing 0.5 with 0. That means that the year-over-year inflation dropped to half a percent to 8.5.
Now, the beauty of looking at the year-ago months is that you know what they are. And the market pays very little attention to this. The next two months, not seasonally adjusted are 0.2 and 0.3. The likelihood of those two months coming in below that are very slim. So our expectation is we finished the quarter in the ballpark of nine again, and finish the year higher than that. So, we don’t think we’ve seen the peak yet the market overwhelmingly thinks last month was the peak.
We think that’s probably wrong. I wouldn’t bet the ranch against it but I would bet the ranch against the 3% that you alluded to, very simple reason. We had 6.3% inflation in the first half of the year. And that’s not annualized it annualized just over 13. We had 6.3. So you’d have to have deflation, the next five months in order for inflation to come in below six, let alone three. So, transitory, not if you measure it in a few months. If you measure it, could we have nice low inflation into 2024? Sure. Is it likely to happen next year? Not with the catch-up that’s going to happen on houses.
Cam: Yeah. So Rob makes a really important point that we emphasize on our paper, that there’s inflation that’s already happened that isn’t reflected in the actual reported inflation. And this will cause persistently high inflation. Let me add just a few more numbers to what Rob said. So, suppose that the next couple of months, we have pretty favorable sort of prints, where we get a quarter of a percent, which is, let’s say, 3% annualized rate, which you would think the Fed would be very pleased with.
So we get a 3% annualized at 3% annualized on a monthly basis, then the release that is just before the midterm election, the inflation reported would be 8.5%. And then let’s look at another scenario where the next two releases, they’re not like 25 basis points, they’re zero, just like what we had recently, zero. Then the last report before the election, we’ll have 8.0% year-over-year inflation. We still have the eight handle with zero. So, again, this is not transitory. This is something that will be persistent, and we will have to pay the price. And frankly, in my opinion, the mess that we’re in is self-inflicted.
Meb: To put another data point to your comment, I did a Twitter poll, as I love to do just to gauge sentiment, and most of my audience leans I think professional investors, and I said, was this 9.1 I think was that the high? I said was, this the high inflation print of this cycle is? Well, over two-thirds said yes. Right? So, like, I think what you’re right on, the consensus is it’s coming down. You know, if you, again, rewind to 5, 10, 20 years ago, at any point and said, “Meb, Rob, Cam, we’re going to give you a crystal ball, and in the year 2022, you’re going to have 9% inflation, what do you think the long-term PE ratio on the stock market will be?”
And, Rob, you did some work on this a long time ago, the PE Mountain top I think it was the right name of it, and we’ve talked a lot about it since, king of the mountain. And, you know, my least popular Tweet of the year is probably on this topic. There was no opinion in the tweet, and I simply said something along the lines of, “Historically speaking, when inflation is above 4%, above 8% or 7%, here’s where the PE ratios tended to have been.” And, oh, my God… I think it was in January, so the market hadn’t really, you know, started to move down yet. And oh my goodness, the responses. Give us a little review about how inflation and stock market valuations go hand in hand.
Rob: Well, this was a paper that I did with one of our previous colleagues, C. Chow, who work that I had done in the past showed that there’s a sweet spot for inflation in the 1% to 3% range, where valuations can be sustained pretty high. There’s no such thing as stable, high inflation. There’s no such thing as stable deflation. There is such a thing as stable, low inflation. And the instability of deflation, the instability of high inflation wreaks havoc on business planning, on pricing policy, on staffing questions, on payroll expectations, you name it. And the result is valuation multiples tend to be lower when inflation is outside that sweet spot.
The other sweet spot is on real rates, again, 1% to 3%. If real rates are 1% to 3%, you’re in a world in which the speed bump is there suppressing the temptation for idiotic spending policies, either at the corporate or the individual or the government level. And the speed bump isn’t so high that it stalls everything. And so, that 1% to 3% range is very comfortable for valuation multiples, see came up with the innovation of creating a fitted curve, a bell-shaped curve to these data. And the bell-shaped curve fits gorgeously. We then tested it all over the world. I think it was eight different countries. We found the same curve applies globally.
And so, what we find is that the natural Shiller P/E ratio price relative to tenure, smooth earnings is in the mid-20s. If you’re in the sweet spot, let’s say at 2% inflation, 2% real rates, the further you might move away from that mountain, the lower the valuations go, and when you get 4% or 5% away from that peak on either dimension or both dimensions. You’re in a regime where half that, 10 or 12 times seems to be the natural Shiller P/E ratio. Now, you don’t get there overnight, of course. But when you’re running at a 9% inflation rate, now, in fairness, we used rolling three-year inflation. So there you’re looking at a number more like four. But if we stay above four, and that drifts up to five or six, and if you have 6% and then 3% is the 10-year Treasury rate, that’s a minus three real rate.
That’s way outside of the sweet spot plus six inflation, way outside of the sweet spot. Now, you’re down to where the historical norm for Shiller P/E ratio is ballpark of 10. Now, the path by which you get there is choppy and uncertain, but directionally, it would be a strong bearish signal for relative valuations over the coming three, four years.
Meb: Cam, you talk a little bit about inflationary times too. You wrote a paper, it’d be hard pressed to find a topic that I couldn’t say you guys have written a paper, you know.
Rob: Cam, especially. He’s amazing.
Meb: So, like, I think a lot of investors, you know, this year, institutions alike, by the way, you know, they’re looking at their portfolio, they’re saying, well, stocks are down, bonds are down. What the hell? You know, they’re not diversifying. But, you know, in times of inflation, what works? What should people be thinking about?
Cam: Yeah, that’s exactly what my research looks like and looking at different inflation surges. So it’s kind of obvious, like, Rob gave a list of why an inflation surge is bad for equities. It’s also the case that different categories of equities are differentially impacted. So if you look historically, the category that gets walloped is consumer durables, whereas it’s maybe intuitive that some other categories like utilities or anything medical is less vulnerable to inflation. So, even within the equity category, there could be some sector rotation to dull the blow of inflation. As for fixed income, obviously, it’s almost mechanical that fixed income gets hammered when inflation surges. So where do you go? And you’ve got a couple of opportunities, one, is to increase allocation into real assets. So, commodities, indeed, sometimes they’re causing inflation.
So, a diversified portfolio commodities real estate, things like that in the real category but there’s other options, including active strategies, like factor strategies where they’re resilient, let’s put it that way, to inflation. So there are many things you can do in the portfolio to mitigate the blow of this basically self-inflicted situation that we’re in.
Rob: Another thing you can do is look outside of our own borders and the emerging economies of the world, the majority of them correlate positively with U.S. inflation. They tend to benefit more than suffer from U.S. inflation. In the long run, not in the short run, in the long run, that’s good for both their stocks and their bonds. Emerging markets debt currently yields more than U.S. high yield. You can find in emerging markets broadly diversified emerging markets, bond strategies in the 7% or 8% range, local currency, the currencies have been hammered, they’re cheap. So you can get an added kicker from currency rebound, and emerging markets, stock markets are cheap. In the aftermath of the invasion of Ukraine, there was broad damage across the emerging markets.
Now, what exactly does Ukraine have to do with Chile or Indonesia now much. And so the opportunities are there, but it’s for the patient investor, who doesn’t mind shrugging aside interim volatility, but looking outside of mainstream value is also cheap all over the world. U.S. value stocks broadly defined to mean whether you’re using Russell value or Fama-French value is priced cheaper than long-term historic norms, while the growth side is priced at extravagant valuations. So, in the U.S., to the extent that you want U.S. investments, value can shrug off inflation. Inflation is good for value. Why is it good for the companies? Not really.
But if you have the added uncertainty of unstable high inflation, companies with a solid foundation of earnings, dividends, buybacks, net worth sales per $100 that you invest, where you’ve got a lot of the underlying fundamentals per $100, are likely to shrug off that uncertainty better than those that are basically speculations on impressive continued growth. Interesting case in point, Cisco was the most valuable company on the planet briefly in March of 2000. It’s had 13% annualized growth in the last 22 years, whether you’re using earnings or sales, 13% annualized growth, that’s tremendous. That works out to four doublings, 16-fold growth in 22 years, gets price cheaper than it was in the year 2000.
So, when you have growth that’s priced at extravagant multiple, somebody coined the expression in the 2000 bubble that I just loved. These prices are discounting not only the future but the hereafter. We have companies that are discounting not only the future but the hereafter. So stick with value in this kind of environment for sure all over the world and look a field to see if there are some markets that are attractively priced, non-U.S. developed economy bonds, heavens, no, the yields are zero, emerging markets, bonds, sure, to the extent you want fixed income, why not have fixed income that pays seven? And emerging market stocks, especially on the value side, where you’re taking out the 10 cents in the Alibabas the world very cheap. In even … Europe, and Japan value stocks are pretty damn cheap.
Cam: Let me just push a little bit on that, Rob. We’ve had this discussion before. In general, I definitely agree in terms of the value versus growth. And let me add just another kind of obvious reason. And that is that value stocks have lower duration than growth. And if we are in a situation with this persistently high inflation with rates are heading up, and you can just see this casually looking at what happens to NASDAQ versus Dow Jones in terms of rate expectations that those growth stocks are much more sensitive to interest rate increases.
So, that’s just like another layer there. I would be a little more cautious in terms of emerging markets. So, I don’t want listeners or viewers to think that cheap means necessarily a bargain or underpriced. Sometimes they are a bargain but sometimes they’re just riskier. So you need to take that into account. So there’s got to be a balance. So, there are definitely opportunities in emerging markets, but you need to look case by case and determine whether that valuation makes sense because it’s just super risky, or maybe it’s a deal. So I believe there’s opportunities out there and just really case by case.
Meb: We had a ranking, where we were ranking a bunch of global stock markets across a bunch of different variables. And sometimes the countries will bounce in and out of the developed category and emerging into frontier, frontier back into emerging. But I think the number one, if not the cheapest was Egypt, which was… I was like, I don’t know, if you characterize… Like, if anyone professional would consider Egypt investable, like, the ability to go home to your clients and say, “Okay, just listen to “Meb Faber Show,” we got to put all our money into Egypt.” I think no one should take that advice. However, I think the Goldman had a hole. Last time I saw and said the average allocation on emerging markets despite being ballpark, low teens of global market cap, the average allocation in a portfolio is like 3% for a U.S. investor.
So, traditionally very under-allocated. All right, so we only have a few minutes, Rob’s going to hop. Cam, I would love to keep you for five more minutes after probably it’s talked about your book, if you want to stick around. But we’re going to do something different. I’ve never done this before. So we’ll see how it goes. In reality, we probably should have done this for the entire podcast, where I just let you to talk to each other. Rob and Cam, you get to ask each other questions. So you guys have known each other for a while. Is there anything you guys are working on? Anything you wanted to ask each other? Get the input or needle them? Maybe? I don’t know. Give them a hard time. Rob was laughing first. So we’re going to let Rob ask Cam a question, and then vice versa with our… And you guys got to keep it kind of short. Rob’s on a clock here.
Rob: Cam, apart from yield curve inversion, what is the insight that you’ve had during your career that you think is the most important exciting insight other than that Ph.D. dissertation insight?
Cam: That’s a tough question, Rob.
Rob: There are a lot of topics.
Cam: Yeah. And it’s a real struggle between two things. And actually, I’m going to choose one of them, and then I’m going to use the other for my question to you. So, probably the other thing that I really am still excited about in terms of my research was a paper that I did in the year 2000 in the “Journal of Finance,” that essentially made the case that we need to take a downside risk into account in the portfolio design stage. So we usually think about a Sharpe ratio, where it’s expected return divided by volatility, but risk is deeper than volatility. And people don’t like the downside risk and they really like the upside. But volatility treats those as symmetric.
Meb: Or even asymmetric on the downside.
Cam: Yeah, so I did a redraw of the famous efficient frontier, where you’ve got expected return against volatility, to make it three-dimensional, to include as higher moment which I refer to a skew. And you design a portfolio so that you might have various different combinations in your portfolio that have the same expected return, the same volatility, but different levels of skew, you would choose the one with the highest positive skew. And you don’t like the portfolio with the negative skew. And, unfortunately, all of the textbooks just give the usual Markowitz 1952 expected return and volatility. Markowitz was smart enough in 1952 to figure out that his model only worked if there was no preference for skewness.
And we know there is preference. So I think that that is a contribution indeed, in my 2000 paper, I had this model but the skew-beta. So you have like a beta against the market, plus this extra term. I had to compete against the famous Fama-French three-factor model, and it did okay. And my model falls rate other theory, these other models don’t explicitly take the downside risk into account. And I hope that someday, this will get more attention because it’s intuitive, it’s the way people act. And also asset returns are prone to these tail events. So that’s probably the thing that I put as number two.
Meb: I like it. Cam, now you get to flip the script, take the mic, ask Rob anything you’ve always wanted to ask him.
Cam: Yes. So I’ve never asked Rob this question, but it is something that I’ve kind of noticed at Research Affiliates, and it’s a kind of a pleasant surprise. And Rob has thought deeply about this idea of overfitting, where you try all of these things to get the best model, go to market with it, and then it fails on a sample. And there’s all these incentives to come up with the highest Sharpe ratio strategy and present it to potential clients and things like that.
Rob: Now is Bernie Madoff’s secret to success?
Cam: Exactly. So, I’ve noticed that the culture at Research Affiliates is not like that. And I’m wondering if you could explain to me how, given that you’ve been, you know, the founder of the firm, how you engineered that because it’s unusual. So the people are thinking about this problem all the time.
Rob: Well, I think in terms of engineering, a lot of it has to do with just asking the question again, and again, and again, and again, and again. When presented with a research finding that looks too good to be true, pose the question, how do I know that this is true, and isn’t a product of data mining? Now, I was a quant before the term quant was invented, not by much but it started my career in ’77, and the term quant was kind of embedded in the early ’80s.
And I approached the world of finance from the vantage point of scientific method, not data mine. Scientific method is different. Scientific method starts with a hypothesis. The hypothesis is useless if it’s untestable. And so, falsifiability is the most damning expression in the hard sciences, come up with a theory that can’t be tested, can’t be disproven. You’ve come up with something that’s pretty much useless, interesting thought Candy that’s about it. And then turn to the data to ask, does the data support the hypothesis? Do not, do not go to the data, ask what can we find in the data. Now let’s come up with an explanation after the fact. Beautiful example, quality factor.
If you asked a student of the markets, “Should you get an incremental reward for higher quality companies?” Well, maybe at the same valuation multiples, you should. But just on the basis of quality alone, come on, you should have a lower risk premium for a lower risk company. So the quality factor on a standalone basis not adjusted for evaluations should be a negative return factor. But instead, the factor community finds positive returns associated with quality, then comes up with a story for why. And then when it if it doesn’t work, they tweak the quality definition to get it to work again.
So one form of data mining is drill into the data, find something that seems to work historically, assume that what is past is prologue, and go with it and say, “Here’s our idea.” Then come up with an explanation, a theoretically sensible sounding explanation for why. The second order of data mining that’s even more dangerous is when your model doesn’t work. We have competitors who come up with multifactor models. And when they don’t work for three or four years, say, “Never mind that, we have a new model that’s never failed in the last 20 years.” No, if you use history to improve your backtest, if you use a backtest to improve the backtest, you’re engaged in the worst form of data mining.
So, this is something that I’ve been very sensitive to throughout my career. And I think it affects and informs the culture at our company because I keep asking the same questions. And you have to because it goes against human nature. Human nature is, oh, this word beautifully. T status three, cool, this is going to work. Not necessarily, past is not prolonged.
Meb: As you get older. And being you know, involved in markets, there’s a certain element of humility too, where you’ve kind of been slapped so many times that even something that does work. I mean, value stocks are a great example, where there are plenty of times it doesn’t work. And at some point, you see times where the spreads can even get crazier, things that we’ve never seen before. I mean, even the last few years, I mean, was the fastest ever from all-time high to bear market and vice versa. First time ever, there was like a calendar year where every month was up in the stock market. You’ll see new things too, I think going into the future thinking that you know, yes, it’s a guide but, hey, this is perfectly going to predict is like the wrong lesson to history because it can be a lot of pain. And we’ve seen a lot of people not make it through the other side. Rob, if you need to hop off, but I was going to ask, Cam, since we last had you on, you wrote a new book. Tell us what it is.
Rob: I will hop off. But first, I will say, it’s a great book. It’s a terrific book. Those who haven’t read it and are curious about the whole evolution of decentralized finance and crypto and NFTs, if you want to learn more, Cam is the go-to expert on the topic and his book is marvelous.
Meb: Well, that’s quite the endorsement. Rob, thanks so much for joining us. Cam, tell us about this book, “DeFi” for the YouTube crew, you can see a tiny view of it on the video, but for the podcast listeners, tell us about this new book.
Cam: Yeah, so I’ve been in this space a long time. So, indeed, I had a decentralized finance idea in the year 2000, where I pitched a simple idea with a partner of mine, in terms of forex trading, where it might be that you’re a client of a bank, and you need, let’s say, 100 million euros at the end of September, you go to the bank, the bank quote you a price for it but there can be a customer at the same bank that needs to sell 100 million euros at the end of September. They go to the same bank, they ask for a price, they get a price. The bank quotes a different price that spread. And the simple idea was, why not put those two customers together and avoid the spread, pay the bank a fixed fee for doing the credit, and then had a network effect because customers actually dealt with more than one bank? So you could match across banks.
And basically, you can imagine this pitch, you go to a bank saying, “Pay us some money to implement this for you, and it will guarantee that your profits go down.” Very difficult. But this was kind of a prelude to the future of decentralized finance. And I’d start my book with the observation that we actually started market exchange with decentralized finance. And that was the barter method, which was horribly inefficient. And then money was introduced to make exchange much more efficient. And now, we’re in a situation where there are alternatives to money. So this book is based upon eight years of teaching.
So Duke University has been rare to have blockchain-oriented courses for many years for my students, and this idea that we’ve got new competition. So this is competition for the Central Bank. This is competition for the commercial banks, the exchanges, the insurance companies. And indeed, in my vision of the future that I sketched in the book, right, in the future, everything is tokenized. And indeed, already central banks have real competition. See go to pay for something at your grocery store, right now we pay in Fiat currency, U.S. dollar. But your wallet, which is your smartphone will have U.S. dollar tokens, maybe Euro, Yen, gold-backed tokens, maybe bond, stock mortgages, land, all of these tokens are available to you, and you choose what to pay with.
And it’s seamless. It’s so easy to do. The only difference is it’s your choice as to what to pay with. And this provides a competition to the central banks. Indeed, some central banks are already being disintermediated with this new technology, especially central banks that are reckless, like Venezuela. And Venezuela is a great example here. You’ve got hyperinflation. So, if you’re rich in Venezuela, it’s likely you have a bank account in Miami in U.S. dollars. So, the hyperinflation is, you know, annoying, but it’s not a disaster. And it used to be the average person in Venezuela is hammered. This inflation is attacks. They can’t afford to have an offshore bank account. But now, they have got a smartphone in under smartphone is a token USDC that’s pegged to the dollar that you can actually see the assets that they’ve got, so it’s safe.
And they are disintermediating the Central Bank. So I’ve made this provocative statement, and we’ll see if it comes true. Maybe if I’m around, you can invite me back in 15 or 20 years. And basically, my statement is given this new competition, that 20 years from now, we’ll look back at Fiat inflation as a historical curiosity, okay, where we have this situation because the government has the monopoly over the form of money, that will be broken in the future. And the future that I sketched in this book is the future of inclusion, which means anybody can have a bag, which is their wallet. It’s a technology of financial democracy, where there’s no client or banker, retail investor, institutional investor, everybody disappear.
And the other thing that’s really important in my book, I’m a finance person, and there are always two sides of the coin, there’s expected return, and there’s risk. And what I detail in the book are all of the dimensions of risks. And some of these risks are new risks. And this technology is young, very young, maybe 1% into this technological innovation. And there will be bumps in the road, major bumps, up and down. And that’s exactly what you would expect. And so I think that much of the attention today is focused on, you know, Bitcoin, or Dogecoin, or things like that. It is a really deep space. I categorize WANTE different subcomponents of this space, including things like NFTs, that I think are really very interesting, and will define where we go in the next few years. Indeed, I think the biggest deal in this space is Web3.
And Web3 does not exist without decentralized finance. So in Web3, you’re able to be paid or pay in a very simple way using the centralized finance rather than traditional credit card or our bank account. And that is a very substantial growth industry. So it is exciting this book, you know, that I’m not much of a book writer, historically, I’m mainly published in academic journals but this is particularly interesting for me, because it gives me a chance to talk about the future.
Meb: My approach to learning about this space, because, for me, it’s fascinating, but for the most part, I’ve been a kind of sideline observer, cheerleader. I have a tweet from 2013, where I’ve challenged anyone to a sushi dinner, that if they thought that the Bitcoin ETF would get approved by year-end, and I’ve tried to re-up it every year. I think we got to be close, though. I think 2023 is probably the year. But my approach is, A, to read books like yours, which are great overview of what’s going on, but two, is to try to keep abreast with what’s going on startup world. So a place like Angel List, listeners, you can sign up and review deals. You don’t have to invest but you can review… I think I’ve reviewed over the past 10 years, like, something like 7,000 companies.
But you notice some trends. And one of the big trends the last couple of years is every year notches up the percentage of companies that are involved in this Web3 DeFi crypto space. And the vast majority of them, it’s been above my pay grade. But much like the old school portfolio method where portfolio managers back in the day, they would buy one share of a company just to get the annual report on some of these, like, I’ll put in a little money, just to follow along and get the updates so that it like forces me to stay current. So I invested in my first NFT and it was a decentralized really fun project that it was a group that went and bought a soccer team in UK, and is like as Wagmi United, and they brought a Crawley Town team. And part of the NFT is you get a bunch of swag and jerseys and stuff. So, basically, but I wanted to follow along because like what a cool story. I don’t know how this ends. I expect I will not make any money but it forces you to kind of see what’s going on.
Cam: Yeah, your example is a good example. And I teach multiple lectures on NFTs. Originally, the NFT was called a deed. So, think of it like a deed on like a house or some land. So it’s a unique representation of some value. But we’ve kind of gone beyond that. So, the NFT, it could be, for example, a ticket to a concert. And the NFT might have some art associated with the concert. The NFT might get you discounts on some of the gear at the concert, a t-shirt or something like that. The NFT basically could be collectable in the future as kind of evidence that you’re at this concert. The NFT also allows you to create a community of those that were, let’s say following the artists at the concert.
The NFT potentially allows the artists to directly interact with the community. And that’s really valuable because today, they can’t because you got Ticketmaster or whoever in the middle, and there’s no relationship between the actual fan and the artist. A middle person is blocking that. So this opens up all these possibilities that I think are really exciting. NFTs mainly get play for digital art and gaming and things like that. Those are only the low-hanging fruit. This is way deeper.
My two favorite applications in NFTs right now, one, is fashion. And we talk about fashion in my course. And all of the major fashion houses are heavily into NFTs because people want to wear something unique. And the NFT gives them a digital version of something unique. And the two applications are an augmented reality situation where you go into some sort of gathering, and everybody is wearing their NFT fashion. And it can be really bizarre because it’s digital, but you can actually socialize.
And perhaps a more important application is that in the metaverse, people need to wear something. And right now, it’s kind of cartoonish, but, you know, in the future, it’s going to be super realistic. And that’s a big growth area. The other obvious application in NFTs is identity. So NFT is a unique token. And an NFT that identifies you opens up all these possibilities where this NFT could be linked to all of your financial information, your driver’s license, your passport. All of this stuff that we usually have to carry around, we will no longer have to carry around. And, yeah, so there’s many possibilities here. We’re just at the beginning. And it’s, in a way, a little unfortunate that kind of the regular media don’t really go a little deeper, they focus on the scandals and whatever ransomware stuff. You know, those are risks. And if you want something completely risk-free, invest in treasury bills.
Meb: Yeah. That’s the kind of the beauty of the startup model, you know, 1,000 experiments, 10,000, 100,000 experiments. It’s a unique kind of Silicon Valley cultural phenomenon that’s, I think, you know, spreading all over the world now. We see some of the best ideas and startups we see are now in Pakistan, or Africa, or Latin America, it’s really exciting to see in a world coming full circle of inflation being a relic would be a welcome world to live in. Cam, this is amazing, as always. People want to follow along your writing, listeners, go buy the new book “DeFi and the Future of Finance.” But with everything else you’re up to, where do they go?
Cam: The best thing to do is to follow me on LinkedIn and Twitter. So, those are the two areas. And if you want to see my research writings, go to my website, or ssrn.com that lists all of my recent papers.
Meb: Awesome. Cam, thanks so much for joining us today.
Cam: Thank you for inviting me.
Meb: Podcast listeners will post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback at firstname.lastname@example.org. We’d love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.