Episodes

Dan Ferris: Hello and welcome to the Stansberry Investor Hour. I'm Dan Ferris. I'm the editor of Extreme Value and The Ferris Report, both published by Stansberry Research.

Corey McLaughlin: And I'm Corey McLaughlin, editor of the Stansberry Digest. Today, we talk with Alfonso Peccatiello, editor of The Macro Compass.

Dan Ferris: Today, Corey and I will talk about Nvidia and fed-funds futures.

Corey McLaughlin: Remember, if you want to get in touch with us, send a note to Corey McLaughlin and tell us what's on your mind.

Dan Ferris: That and more right now on the Stansberry Investor Hour.

Let's talk about – we have to talk about Nvidia. First of all, we decided that I don't know how to pronounce it, or one of us – somebody said "Na-vidia," somebody said "In-vidia." I said "In-vidia."

Corey McLaughlin: And I said the "N" is silent and let's call it "Vidia."

Dan Ferris: Vidia, there you are. Nvidia went up a bunch on Wednesday. They had a good earnings report and they projected a huge increase in second-quarter sales. First-quarter sales were up. What was it, like 16% or something? And second-quarter sales they said would be $11 billion, which year over year for the quarter is like 60% or something. It's huge. It's a huge amount.

So the stock was up like 24% the next day, and there are all kinds of good little bits in the news about how much that is. I think it's more than Adobe. They added more than the market cap of Adobe. $184 billion in market cap was added. Actually, I'm sorry – it was added on Thursday.

Corey McLaughlin: Yeah. It's one of the biggest moves in U.S. stock market history by market cap. They're now the fifth largest American company by market cap just after one day, a couple minutes, in a couple minutes.

Dan Ferris: Yeah, bigger than the market caps of Texas Instruments, Intel, Qualcomm, and Applied Materials, bigger than each of those, just added on in one day.

Corey McLaughlin: Right. So I guess the question is: what does this mean? I'm sure you have some thoughts on that.

Dan Ferris: Yeah. I couldn't help noticing the term "AI" 15 times in the press release. The founder and CEO, Jensen Huang, said that basically every company in the world is using AI, and the chips that Nvidia makes somehow enable that. So that's why they're seeing this big bump in sales, and it's going to be even bigger in the second quarter. So that means that the company is worth 145 times net income, trailing net income, for some reason. I don't know. Maybe you know.

Corey McLaughlin: No. I can't really tell you, other than to me this was kind of the opposite of what we saw last year in the markets, when after certain tech companies reported earnings they went down 20% or double digits. I'm thinking of Netflix and Meta. It was the opposite. It was everybody was frightened and things were going down.

Now, this to me is like, all right, now we're talking about AI and chips and a stock going up 25% in one day. It tells you there's still juice left in this market, as you've been saying, like this bubble. There's still flickers there and this is a pretty big flicker. This is like a flame going pretty high.

Dan Ferris: Quite the flicker, yeah.

Corey McLaughlin: Yeah. I have no doubt there's going to be increased demand for these chips, for AI, and some of them are power like ChatGPT, which has become a mainstream popular kind of word for AI, basically. So yeah, when you're throwing these things around like we're going to increase supply to meet the demand of AI, OK, this is going to get some attention.

Dan Ferris: Yeah.

Corey McLaughlin: But you mentioned the valuation is a bit much. I think anybody would agree on that, even the people that are benefiting from this.

Dan Ferris: I was curious about Nvidia. I never looked at it very hard. So I thought, well, let me go look and see how rapidly everything is growing, but stuff is shrinking. The operating margin peaked in like 2018. It's down from like 30 – I should have these numbers in front of me. I just call everything off the top of my head – 30-something, 35% or so, and now it's like I think at 16%.

[Crosstalk]

Corey McLaughlin: We get the point.

Dan Ferris: Yeah. And trailing 12-month revenue, the second-straight quarter of trailing 12-month revenue decline. Net income is from something like $10 billion to now it's like $4 billion. I don't get why it's worth 145 times earnings.

I'm not long in the stock. I haven't made a ton of money on it. So you can say, "Well, you're complaining and you missed one of the biggest run-ups in history," and you'd be right. I've made other good calls, but I certainly missed things like Nvidia because I just don't get why it's worth so much, and it reminds me too much of Cisco.

I'm a victim of my memory, I guess. It reminds me of Cisco trading for like 200 times earnings, 200 times net income in 2000, at its peak. Of course, that thing is still 25% from its all-time peak. It hasn't gotten there. It hasn't broken even with that. Even if you add in the dividends, it's still 25% from getting back to that peak. So I feel like this is the same thing.

I don't doubt that AI is huge. AI is a huge development. It could be on par with the Internet itself. But as an investment proposition, we have seen these no-brainer, this is the next big thing picks valued at astronomical valuations go wrong for decades before. So I don't know.

Corey McLaughlin: I would say if you own some shares, now would be a great time to take some profits on it. How many more days are you going to get 25% gap-ups overnight? So if anything, enjoy it if you own it. Enjoy it if you own it. I like that.

Dan Ferris: Yeah. Enjoy them if you own them.

Corey McLaughlin: Actually, this reminds me that our friend, Dave Lashmet, was one of the early ones that picked Nvidia. He doesn't have it in the portfolio anymore because he sold out at a higher – I think somewhere around this price, maybe a year-plus ago, and he made – what was it? I'm looking at it right now – almost a 1,500% gain in one of the legs of the positions that he recommended in his model portfolio in Stansberry Venture Technology.

He saw it, what you're talking about when it had the potential to grow. This was years ago, not at this point now that you're talking about. Maybe things are actually slowing down for them a little bit.

Dan Ferris: You're right. Dave did the thing that I failed to do. You're right.

Corey McLaughlin: Yeah, OK. But I mean that's – your point is but now we're at this point like, OK, 100 and – what did you say, 145 times earnings?

Dan Ferris: Thereabouts. That was like a day or so ago, but yeah, 145 times net income. It's like saying if you bought the whole thing yourself today, you'll get your money back out of it in 145 years. It doesn't seem like a good bet.

Corey McLaughlin: Yeah. I will say that the buzz around AI right now reminds me of all kinds of other buzzes that we've seen in the past. So yeah, if anything, maybe it's more of a sign of that. To me, it's more of a sign of – like if you want to take this out and make it into a macroeconomic discussion, it's a sign that there's still just – or that there's growing risk appetite now for growth stocks again, which, again, I think may play into the whole – maybe we're going to talk about this next – the Fed story and the interest rate story, and whether they're seeing enough out of the market right now that they're happy with it.

Jerome Powell is never going to come out and say "We don't want the stock market going higher," but when inflation is at 40-year highs still, and you have been raising rates like you haven't since the '70s still, and you've got a stock going up 25% and becoming a top five market cap, what does that tell you if you work at the Fed?

Dan Ferris: Yeah. Well, it tells the futures market something, doesn't it, because they have these fed-futures contracts that are basically – they expire on the date of the Fed meeting when they make the announcements. So the next one expires June 14.

I'm telling you, I've looked at this contract for a little while and it was like 80% probability that rates would stay unchanged at that meeting, and then a high probability that they would stay unchanged for another meeting or so, and then be cut in July or September, the next two meetings.

Now, as we speak, I'm looking at the screen, and the Fed watch tool that looks at this says there's a 58.5% chance of another 25-basis point hike at the June 14th meeting. It has never been said that the higher probability was a hike until now.

Then you go to the next contract, which is essentially the next meeting in June, and it says basically the highest probability is that same range. So it's saying a hike in June, stick in July, stick in September, and then the probability of a cutback of 25 basis points is highest in November. So it's all getting pushed out.

Before, it was a probability of a cut in September. Now, it's a probability of a cut in November. What's it going to be a month from now? December, January '24, March '24? You know what I'm saying? It just keeps getting pushed out, much like inflation and interest rate expectations themselves.

We started out with transitory. We started out with supply shock, transitory, pandemic. Then we're like, oh, higher for longer. And now we're like, "Whoa." Core PCE is just really, really sticky and here we go. Here we go with inflations and rates higher for longer.

Corey McLaughlin: Yeah. I'm having déjà vu to last year. I saw the same behavior in the bond market, the fed futures. It was the same thing. It was literally the same thing. Nobody was expecting the Fed to go as high as they did. Then a week or two before these meetings, you saw these bets change.

This isn't like out of thin air, just speculation. These are $5 million contracts, you know, fed-funds futures. So this is like big money. That's why I pay attention to these because you're not – I mean you're taking on some decent risk here, the people who are trading these.

So yeah, it's worth paying attention to. I kind of noticed that too yesterday. Last week Thursday was the first time that this market started pricing in another rate hike, and the bond market is typically ahead of the stock market on these things. So you just wonder what's next ahead for stocks.

It's setting off my Spidey-Sense a little bit because I'm just remembering last year whenever we saw these types of moves in terms of expectations for interest rates changing. The stock market didn't really react to it until it happened from the Fed. There were big moves when it actually happened. So if they do raise rates in June, there's going to be a lot of volatility around – people are obsessed with the debt ceiling at this point, but I think this is a bit more of an important practical story to think about.

Dan Ferris: Yeah. They're obsessed with the debt ceiling and that could be over in a minute. I mean could be over in a heartbeat. We don't expect that to go on long at all.

Corey McLaughlin: Right. I am of the belief that if they wanted to end that right now, they could. That's why Congress can enjoy the Memorial Day weekend as much as, hopefully, you and I will. They could have signed this thing last week and had it done, but we'll see.

Dan Ferris: We will see. I think actually your point is right. The narratives are debt ceiling. That's sort of taken over everybody's mind right now, and all the headlines and everything. You can't not read about it. If you want to read the Wall Street Journal or Bloomberg or Financial Times, whatever it is, you absolutely must read the words "debt ceiling" to get to whatever it is you're trying to – whatever else it is that's unrelated to that they're trying to read.

So you can't escape it, but it truly is a transitory phenomenon. Even if they go too far and drag it on and drag it on, and stop making payments and cut discretionary spending and all those things, we know they won't cut debt payments. So they'll do something before it gets to that point. But no matter how bad it gets, you're so right to point out that the real issue is this, interest rates, persistence of inflation, and impact on markets.

Corey McLaughlin: Yeah. If you look at the bond yields the last couple weeks, it's gone up a pretty significant amount across all the different durations, and the yield curve has gotten actually inverted a bit more. The 10-year, two-year comparison has got inverted more. It's back to what it was in March, right at the onset of the banking crisis.

Since then, things have gotten a little better because people were expecting, oh, the Fed won't want to do more harm, but it seems that sentiment is passing and we're getting into maybe they'll hike more thought process because I think – this is important, too. I've been reading the Fedspeak lately, and these guys, the different Fed officials have gone on TV saying they're changing the language from a pause, a possible pause to a skip.

So instead of pausing, which implies – apparently the Fed decided they don't like the word pause anymore and have moved to skip, because pause implies that you won't raise rates anymore, but skip implies that you could raise again. So I think that's playing into this story, too, with what we're seeing in the bond market and fed futures.

Dan Ferris: All right, Mr. Fedspeak interpreter, let me ask you.

Corey McLaughlin: There you go. I didn't even use the Dan Ferris publication that we came up with a couple weeks ago.

Dan Ferris: Right, rating each sentence hawkish or not. But let me ask you then. Are they trying to condition us for higher-for-longer rates, or are they conditioning us for something else? It sounded to me like they were trying to get us used to the idea that rates aren't going down anytime soon. When they switched from pause to skip, that tells me something, that they're like, "Let's just change the wording here a little bit. Let's just get them used to the idea of, "No, not cutting."

Corey McLaughlin: Yeah. I think they're trying to get that message across that they're thinking that "We're not going to cut this year at all," which is what has been – I don't know. I guess enough people in the market still think that. I don't think either one of us thought that, unless a recession really requires it, a sort of deep recession requires it. But even then, then you're sacrificing inflation.

So yeah, I think they are trying to get the message out now, I believe, that, "Our base case is not cutting rates anytime soon, if anything, raising them. Even if we don't raise them in this June meeting, we might raise them at the next one."

Dan Ferris: Yeah. It could just be a skip. That's right.

Corey McLaughlin: Hop, skip, jump. They've got all the – it's wild, yeah.

Dan Ferris: Right. So basically, the era of zero interest rates is finally over, and all the implications of that are unwinding, and I'm sitting here looking at a Financial Times that is called, "U.S. Credit Squeeze Triggers Rise in Corporate Bankruptcies," and then it says, "Chapter 11 filings by indebted companies jump in May, including five during a 24-hour span."

Just a little quote from the article, "Eight companies with more than $500 million in liabilities have filed for Chapter 11 bankruptcy this month, including five in a single 24-hour stretch last week. In 2022, the monthly average was just over three filings. Twenty-seven large debtors have filed for bankruptcy so far in 2023 compared to 40 for all of 2022."

This is the bleeding edge of the – you know, we're wiping out the zombies. We've armed the population with high interest rates and they're wiping out the zombies.

Corey McLaughlin: Yeah. As you're speaking, I'm thinking this whole timeline is just getting pushed out a bit more of like when the Fed may stop this, quote, inflation-fighting and rate-hike cycle and all of that. I think this whole thing has just gone on longer than people have thought.

If I've learned anything since paying attention to the markets, it's that trends can go on longer than you would think. So until we see signs of that changing, I mean inflation, like you mentioned, is still high. The latest PCE number is still high, which is the one the Fed pays attention to.

Yeah. At the same time, you're seeing spending, American consumer spending still up there, but more of it being put on credit cards, which tells you that people are feeling pinched with higher prices. I don't know. We're headed to that point, what you're saying, but we're not there yet.

I don't know how high the Fed wants to go at this point. Maybe this stuff turns around, back again soon, to what the expectations were two weeks ago, but it kind of shows you how close we are to higher rates rather than lower rates.

Dan Ferris: Yeah. Well, we have a lot of questions about this. I think we should probably ask them to someone who thinks a lot about them and has written and spoken a lot about them recently.

His name is Alfonso Peccatiello. We all know him as Alf. I follow him on Twitter. You could probably just type Alf into your little Twitter search window and find his feed there.

We spoke with him recently. He had a lot to say. Let's listen to that. Let's do it right now.

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Dan Ferris: Alf, welcome to the show. Thanks for being here.

Alfonso Peccatiello: Hey, Dan, it's a pleasure. Thanks for having me.

Dan Ferris: Alf, I admit I am a reader of yours, a subscriber of yours and I enjoy your content, and a follower on Twitter as well. Rather than all the usual background stuff that we do, I think we have to jump in here. We have to jump into the deep end because there's a topic that I know is on everyone's mind. If want to read about something else in the financial press, you can't do it. It's just – you know.

That of course is the debt ceiling, and you had a few things to say about this recently. I was most interested in your view of this as a low-probability, high-severity event. I think that little matrix is really important. I hope our listeners will write that down and make a note of it. Do you use that all the time?

Alfonso Peccatiello: Yes, I do. So then let's start to explain what that is. Before running The Macro Compass like I do today, I ran a $20 billion portfolio for a large European bank. That taught me a few things. One of them is risks in markets should be measured as a probability they will happen, and how bad is the outcome if they happen.

The debt ceiling fits into this part of the quadrant, of this model where you say: is the U.S. going to default? It's a low-probability event. I mean in the end, they're going to probably find a deal. But what is the magnitude, the severity, the impact on economic growth if they actually do default? It's very, very large.

So I think right now, people under that assumption should understand two things. One is the incentive scheme for Republicans here is to drag negotiations for as long as they can.

Biden was very late in taking them seriously. So they started negotiations very late, and Republicans now are probably going to try and drag this for as long as they can, to try and get the best out of a deal. That's what you do. When you have time in your favor, you drag the negotiations longer.

The problem with that is markets also have another uncertainty ahead of them. Will the government actually have enough money by June to meet its obligations as the negotiations go on? The answer is very uncertain. If I run estimates, the government might make it, maybe they don't. It's very uncertain. So it's two uncertainties ahead of them. Will they strike a deal? Will the government have enough money to actually make payments in June?

Now if you have both of these uncertainties, I think the probability that something goes wrong is a bit higher than what the market is estimating as we speak. So if you look back at 2011, you have a similar situation. In July/August, we are running into these debt ceiling deadlines, and at some point all of a sudden people realized, oh god, maybe we are not going to make it.

Then you look at asset class performance and gold rallied 25% in five weeks. And the S&P 500 went down 15%, 20% in five or six weeks. So you start looking at this and you're like maybe measures are underestimating the probability that something goes wrong. They know about the magnitude, but I think they have been too relaxed about the probability so far.

Dan Ferris: OK. To me, this is a very interesting viewpoint, because I've been of the mind that politically it serves absolutely no one to allow the government to default or miss payments or however they're going to structure that when they have a real problem and don't have enough dollars to make that first payment.

It serves no one politically. They all look like idiots to me and you'd think that if the Republicans are playing brinkmanship with this and bringing it right up to the brink, that they know they're going to make a deal and they know they have to make a deal.

So I find it very interesting that you're saying we've underestimated the probability of this. What do you think that first week or those first few days look like? Is it like we're shutting down public parks and things like that? You're not really talking about missing a debt payment, are you?

Alfonso Peccatiello: No, I'm not talking about that.

Dan Ferris: OK, just so we're clear.

Alfonso Peccatiello: It is a very valid question because the other thing we need to make clear is I think they're going to find a deal in the end. What does the end mean? Well, it might be the middle of June, the 20th of June. It might be a couple of weeks where it's very unclear what the government is going to do.

So markets which are extremely calm going into the event, I think had the chance to reprise the probability, the uncertainty higher. They are doing that as we speak. I mean the S&P has lost already a couple of percentage points and so on and so forth.

What happens if actually there is no signed deal and, at the same time, the government runs out of Treasury general account money at the beginning of June? The government doesn't default. The government prioritizes payments at that point.

So on June 12th, new money comes in from a new round of tax receipts from the government. So the government does have money. The problem is that the government cannot do deficit spending. So it needs to prioritize where it spends money because it can't issue bonds to fund deficits in the meantime. So the government has some money, and generally speaking, I would expect the government prioritizes debt payments.

So then I agree with you. The government will not default. The political costs and in general the financial markets would be completely rattled if they let that happen.

But think with me. If the government has to prioritize payments and it does prioritize debt payments and debt services, then all other discretionary spending is going to receive a cut. My estimate is that government discretionary federal spending is going to move down by about 30%. So a third of discretionary spending needs to be cut to prioritize payments. Even if you do that for a few weeks, it's not great for growth, is it?

So the market is then going to be forced again to favor the defensive assets, bonds, and gold, rather than equities and more offensive assets. That I think is, again, not a negligible probability.

That's how I see the debt ceiling. Ultimately they will find a deal. I think the Republicans at that point will have applied enough pressure, maybe destabilized the economy a little bit heading into 2024. Then you're right. They don't want to be seen as the guys leading to a disaster. Nobody wants to be pictured as one, but they can create and they can destabilize and shuffle around quite a lot before we get there.

Dan Ferris: I want to say that I realize there is kind of a counternarrative, too, which is that you can say, "Well, we tried. We tried to have discipline, but the Democrats wouldn't let us," or something like that. So I'm aware that it's a more complicated issue than that. But in the end, I don't think a lot of people would see it that way.

So let's talk about that 30%. I have been probably slower than most. I'm always late to the party, but I've been slower than most kind of giving up on the idea that a recession is imminent, but a 30% cut to discretionary spending with the U.S. government, with all the money they spend, that would change my viewpoint, I think. It would have to. I mean we'd be there pretty quick, wouldn't we, in a recession?

Alfonso Peccatiello: Yeah. If you cut discretionary spending by 30% before six weeks, the estimate is that both Q2 and Q3 GDP will be negative as a result. The impact is large. I mean government spending accounts for a lot of GDP creation in the U.S.

Government deficits are very large. The government injects a lot of money into the economy every year in the U.S., a bit more of it last – during the pandemic, we went ballistic, but it is an important driver of GDP growth. So if you reduce that by a lot, even for four to six weeks, that might actually send us into a recession.

I think it accelerates already the negative gross inputs for revenue in the U.S. You talked about giving up on a recession. It's been very frustrating as a macroeconomist or as an investor to navigate this period, because we were at some point, in October last year, where it seemed increasingly clear that the recession was just about to hit, at the beginning of 2023.

Slowly but surely, you've realized the direction of travel is right. Yes, the economy is weakened, but U.S. GDP growth trends are roughly in the 1% real growth area as we speak. So earnings are negative on a year-on-year basis, so company earnings are coming down. That's generally not good for growth and it bodes for a recession. But on the other hand, consumer spending, the services sector, and the labor market are holding on relatively well. I mean they are not recessionary as we speak.

So the confluence of all factors makes for a below-trend U.S. growth, but not a recession yet. That's been frustrating to many that expected a recession to hit already. If you get these discretionary cuts to federal spending, then I think you get quite a boost to the recessionary costs because the economy is fragile. The growth trends are weak. Then in that case, you would basically add another layer of complexity and probably, in the end, send the economy into a recession.

Dan Ferris: That would not be any fun for anybody. Let's see. Where are you now on this? As an investor, it's kind of a difficult moment. People want to flee to safety, and they want to flee to safety in Treasury bonds. If you're pricing in this admittedly extremely unlikely event, you might avoid doing that.

Without giving away any of your secret sauce – I know you have subscribers who pay for your secrets, what does one do at a time like this?

Alfonso Peccatiello: As an experienced macro investor who has made a lot of mistakes in his career as well, I understand that it's easy to scream on a podcast, "Buy this, buy that," but in reality, investors always have to have attackers and defenders in their portfolio, because on exam day you never know exactly how it's going to play out. So this is how I'm looking at the world right now.

If you're looking at having some exposure toward good growth, you normally buy equities. That is the asset class, stocks that perform the best if the economy is doing fine.

I don't like U.S. stocks that much, as we speak, because the Federal Reserve has been raising rates for a while. It will keep policy tight for a very long period of time. Valuations are still relatively expanded. The S&P Ford valuations are about 19, 20 times earnings. I mean it's not cheap from a risk premium, from a valuation perspective, and there are lots of macro clouds ahead.

But if you look outside the U.S., you can still have some attackers in your portfolio. Look at Japan, for instance. Japan has been a place that was massively underinvested for years because nobody was interested in a story that there is no growth. There was no growth in Japan.

Fast-forward to today though, there is growth and there is inflation. So nominal growth is picking up. Wages are rising by over 4%. And the new governor at the Bank of Japan doesn't seem to be in a hurry to raise interest rates.

So what's happening is that this ends up stimulating this growth even further, and these Japanese equities are at very reasonable levels. The price-to-earnings ratio is 8 to 9, not 20. So you can actually get some good exposure there.

If you look at some emerging markets, another underinvested place over the last 20 years. There's Latin America, there's Brazil, and there's Mexico, but Eastern Europe is doing well. Poland is a great place to invest. So you don't necessarily have to have U.S. equities. You can look a little bit around, especially in this cycle, and have some equity exposure.

Then you need defenders. The defenders at this part of the cycle are two mostly, I would say. The first is gold, that both in debt ceiling uncertainty, like in 2011, did very well. But also, generally speaking, when the Fed is done hiking rates and there are macro clouds ahead, generally having an allocation to gold helps preserve the wealth in your portfolio.

The other obviously is bonds. Now bonds here, of course they are a bit more effective, especially short-rated bonds. You see that the T-bill deals are going to 6% because people are uncertain. Will I get paid? Maybe I need to wait a month more to get my money. So with rising uncertainty, I demand a lower price to buy these T-bills.

But long-end bonds, third-year bonds, 10-year bonds, those actually are reflective of economic conditions, growth, and inflation over 10, 20, and 30 years. So if you think that the Federal Reserve cannot keep interest rates at 5% forever, if you think that by keeping policy tight until something breaks, if you actually manage to break something at some point, then the Fed will be forced to cut rates. Then buying long-end bonds will protect your portfolio against the drawdowns.

So these are the defenders I like, long-end bonds and gold, most importantly. You cannot have a portfolio only skewed to that. You always need to have a balance.

So for the attackers, instead of looking at the U.S., I think people have to look broader at the world, in a broader sense, because it's not only the U.S. guys. There are a lot more out there that still are at reasonable valuations with a good growth story, like Japan, and other emerging markets.

Dan Ferris: Yeah. I like Japan too. Long bonds, huh? I think some people call that a gutsy call right now.

Alfonso Peccatiello: Well, I always wondered about something. The U.S. economy, looking at government debt and private sector debt together, so not only the government but also U.S. households, U.S. corporates, let's look at the debt of the entire U.S. system.

We are running at about 270, 280% of GDP in the U.S. So you can say the U.S. economy, between the government and the private –

Dan Ferris: Oh, totally, OK.

Alfonso Peccatiello: Total debt is leveraged about three times, so between the private sector and the public sector. Has something really changed then that makes the ability to produce cashflows, earnings, salaries, has that really changed from before the pandemic till today?

I mean demographics is what it is. Productivity trends are what they are. We become an older economy as we go. If that hasn't really changed, the ability that the economy has to generate strong growth to pay this debt has not really changed that much.

So what we did in the past is we made sure that interest rates were lower. That's how we engineered, that's how we kept the system afloat. That's how the system can be levered 300% of GDA in aggregate, between the private and public sectors, and still function. Because every time we wanted to indebt ourselves more, we just allowed ourselves to do it at the lower interest rates. Mortgage rates in 2000 were at eight, nine, 10%, and they were all the way down to 3% in 2021.

It's easier to lever up if your mortgage rate is very low. It is much more difficult to sustain high debt levels if corporate borrowing rates are higher, if mortgage borrowing rates are higher, even for the government. If the government needs to pay four or 5% interest rates to get debt on, it's more expensive to do so.

Unless you have stronger cashflows, stronger growth, stronger structural growth drivers, the system doesn't hold well with interest rates being that high. You can see that already in the mortgage market.

I mean commercial property prices, housing prices are declining already. Why? Mortgage rates are 7%, guys. It's not easy to afford the median house price at today's mortgage rate. It's too expensive. So the system is not in equilibrium anymore then.

This is why I think to balance it back you need again lower interest rates. The Fed can't lower rates as we speak, because inflation is too high, so they will force interest rates to remain high, but the longer they remain high, the higher the risk that the system breaks. This equilibrium is very fragile and it needs to break, and when it does break, then it does a lot of damage to the economy and then ultimately the Federal Reserve needs to cut rates.

In every recession, the Fed cuts rates by 2,400 basis points. I really don't see why this time would be different, especially if something serious really breaks.

Dan Ferris: Right. I noticed – well, you can see it in other places, too, but in fed-funds futures they were discounting no change in June and July, and then in September an actual 25 BPS cut. And now I think that cut is pushed to – when is the next one, October, November, whenever it is. Even just no change is pretty hawkish, it sounds like you're saying as well. No change at all, that's tightening, right? If you don't cut, you're effectively tightening at this point.

Alfonso Peccatiello: You are totally right, Dan. This is an important concept for our listeners to understand. There are two sources of tightening policy. The first is when you move rates from zero to five, whoa, that's tough because conditions change really rapidly. So all these overvalued tech stocks and unprofitable tech companies, yeah, they need to get repriced because, ladies and gentlemen, the era of 0% interest rates is not there anymore. So all your valuations need to be repriced.

Now we had seen that happening in 2022. That's the most intuitive source of tightened. Everybody understands moving from zero to five is very, very hard.

A lot of people underestimate the power of keeping rates at five for a long period of time because that means that the people, the companies, the households that were immune or that handled well the first iteration, so the rate of change, the tightening impulse, the ones that handled that well are now faced with tighter for longer policy.

Let's take an example. Let's say you are a highly indebted corporate in the U.S., one of these junk, zombie companies out there. You survived and you did OK between 2014 and 2021 because your borrowing rates were very low – qualitative easing, 0% interest rates. Credit spreads were five. So these companies could borrow at like four or 5%, OK, despite being junk, zombie companies.

All right. Now you get a jump in borrowing rates. Today, junk corporates in the U.S. have to borrow at nine to 10%. Let's say they were smart. Let's say in 2021 they borrowed a lot because interest rates were really low. So they frontloaded some of their borrowing needs in 2021.

OK, so here comes 2022. There's a sharp repricing. Yeah, but they don't need really to borrow. They can wait. They got their funds, they were smart in 2021. They got their funds.

So in 2022, they suffer, but they come relatively unscathed out of it. First off with 2023, OK, we don't borrow. Rates are not coming down. We'll just wait a little bit longer.

Then the economy weakens. Then sales start coming down. Then you're looking at the second half of 2023 and you're like, "I need to access the capital market at some point. I need some bank loans at some point to refinance my business." So the longer these tight conditions last, the more likely it is then that some of these dominoes will fall.

You don't need rates to go to seven, 8%, and continue going up for a tightening policy. If you keep rates at a high level for a long period of time, you're achieving the same mechanism. It's just more boring. It gets less headlines in the newspaper, but it is happening under the hood.

The fact that mortgage rates are sticky at 7% for a long period of time means that the housing market will be frozen for a longer period of time, which increases the chance that something goes wrong. You see already KKR, Blackstone, all these large real estate investors, they are freezing redemptions from their real estate funds.

If you want to get your money out from a Blackstone real estate fund, I have news for you... you can't. There are monthly gates to redemption. So you have to wait and you can only get out a small amount. Why? Because they know if there are large redemptions, they need to sell a lot of properties into the market. Where are the buyers with mortgage rates this high?

So it's a very precarious equilibrium, and the longer you keep these conditions tight, I believe the higher the chance that something goes sour in some places. I can't predict where... regional banks, the real estate market. It can be some other credit market. We don't know exactly where, but there are cracks appearing, and the longer you keep it tight the higher the chance something goes wrong.

Dan Ferris: Alf, I'm glad that you mentioned the effect of 0% rates for so long because the pandemic did this to me too. The effect is so huge and so – it's ubiquitous. It's everywhere you look, so you get used to it and you don't see it anymore.

I'm beginning to realize the degree to which the pandemic has affected things. Then I look and I think I'm seeing one effect, but then I think about the pandemic and I think, "Well, no, maybe it's different."

I think 0% rates are like that. I feel like 0% interest rates, it's like the most dramatic, completely transformative thing that ever happened to the global economy. The more I sort of step back and I step back and I step back, I feel like, wow.

You mentioned Blackstone, but I was thinking about BlackRock recently. I wonder. Would they have, whatever it is, I think $8 or $9 trillion or something, whatever is under management, seven or eight or nine. I don't know what it is. It's trillions and trillions of dollars under management.

Would they have gotten here without zero? They're selling ETFs and index funds and things. Would they have gotten there without 0% rates? And what happens on the other side of 0%, when we get higher for longer? Is there effective run on their AUM?

I wonder about the effects of that. I feel like I'm only just beginning to have an awareness of it. Do you think there's super-long-term consequences for 0% rates for all that time?

Alfonso Peccatiello: Yes. I think we have maybe incentive schemes wrong for the private sector. We have encouraged unproductive behaviors.

Look, let's make a simple example. In Europe, just to change a bit the paradigm from the U.S. to Europe, in places where the access to credit was very readily available – take Northern Europe. Countries like the Netherlands, they are much more easy with giving credit to people. A lot of people got extremely cheap mortgages. In Germany, 30-year mortgage rates were below in 2%. Imagine that, a 1.5% 30-year mortgage.

This lasted for years and years and years on end then. So a lot of people actually did become millionaires by simply buying a house. So what does that do to the productivity of these people? What does that do to their willingness to participate in the labor force? It doesn't do much, because by simply accessing leverage and cheap credit, and by riding the asset price boom, they are done.

So this is one of the many wrong incentive schemes, I think, that we gave away. And this lasted for years. Now it seems like a distant past, but you have to go back not that far away. You have to go to 2019. I mean European banks were faced with negative interest rates. So that meant they had to give credit to anything out there then because otherwise, they were losing money. A bank is not in the business of losing money. They want to make some money.

So what happened? They loosen their lending standards. They did so-called covenant-lite loans, which is a lot of jargon for, "I'm not going to check you out. I'm not going to check how indebted you are. I'm not going to check your fundamentals. Please take my money because I need to make some loans. Otherwise, I'm going to keep losing money on my negative risk rewrites."

We gave really, really wrong incentive schemes, and now I think you're right in the sense of we are reversing that. So we had a big cleansing in 2022, I think. I mean look at some of these IPOs and SPACs and all these highly frothy kinds of markets. They were down 90% at some point. So we had a proper cleansing of that.

But still, I think we are still facing a pretty large tail of businesses and behaviors that flourished during this zero interest rate phenomenon, and that were kind of unscathed or they managed to handle 2022. If I look at the persistence of this high-interest-rate policy now, I have to worry, honestly, that all this unproductive behavior, zombie companies, I think they are bound to suffer at some point.

I don't think it's a linear process. I think it's rather a one-off event. It's a Minsky moment, where we realize, oh, we still have a lot of dust under the carpet. We didn't see it coming. We thought it was OK. We thought something was different, that the economy could handle. In the U.S., 5%. In Europe, we are talking about 4% interest rates... 4% risk for interest rates in Europe, a place that had negative interest rates for years on end. I have to honestly be worried about the persistently high interest rates, and what that does to unproductive companies and weaker balance sheets out there.

Dan Ferris: We know what it's done to some banks, don't we?

Alfonso Peccatiello: Yeah.

Dan Ferris: We know it wiped a few of them out, because they had the confluence of being a financial, plus being really exposed to those zombie – well, not zombies necessarily, but cash-burning tech companies let's just call them. It just created a horrible situation.

But lately, when I just glance at regional banks and things, they seem to be kind of coming back, and it seems to be – are we beyond this? Maybe it's over.

Alfonso Peccatiello: For the banks, I pride myself on having sent an article on March 10th, I think, which was called "Order Please." The article was, "Guys, let's try to see what's happening here."

The analysis was there are some very weak links in the U.S., poorly regulated banks, loosely regulated banks that acted like cowboys because they didn't have tight regulations to stick to. So they're poorly run, terrible risk management, and they're going to blow up.

The rest of the banking industry though, is not going to get affected by this that much. This turned out to be the correct take, but we are now in the second stage of the problem then. We have moved, I think, from the liquidity stress, higher interest rates. What is this going to do to these Treasury positions of banks?

I mean the Federal Reserve has created basically a backstop facility, you can say, from the emergency problem of, oh my god, my bonds are worth seventy cents on the dollar, and I'm going to be forced to sell them because deposits are going away and I need to service this deposit. So I need to sell my assets. I'm going to blow a hole in my balance sheet and my capital is going to be wiped out.

Now you don't need to do that anymore. You can just leave the bonds at the Federal Reserve through one of these facilities, and they will give you the funding. They will give you the replacement for these deposits going away, in other words. It's an emergency backstop facility. It has worked, I think, to reduce that risk.

But we have another problem. Deposits keep going away because of a reason. People can get a 5% risk-free rate today. They don't want to get money parked at 0%, because slowly but surely deposits go away. If you're a bank and you need to consistently replace deposits, you need to go to the market or to the Fed or somewhere else, and the cost for replacing these deposits, you need to pay market rates. Market rates are not zero. They are five or 6% if you are a bank. Now that means that the net interest margin, that means the profits these banks can do, obviously shrink pretty aggressively.

Now this process takes time. It doesn't happen overnight. It doesn't cause insolvencies overnight. But this process of compressing margins for banks, together with deteriorating asset quality, because that's what we are moving to now, we are moving the focus from liquidity to, "OK, you guys made a lot of loans to unproductive businesses in 2017, 2018, 2019. You're full of commercial real estate exposure. You're full of, well, not great credit quality exposure. What about the asset quality for our bank loans?"

We are shifting the attention to that. Generally, again, that is a slow-moving train wreck, a bit like the compression in margins. That's why, again, this is another story. It's not going to be something for big headlines tomorrow, but under the surface then you need to understand that the banking system is deteriorating, both because of the compression of margins and because of the credit quality of their assets, which is deteriorating.

When is the bad news going to hit? I don't know. I don't have a crystal ball. But I know there is a process underlying which is weakening the bank's balance sheet. This is one of the reasons why, again, I think adding defensive assets in the portfolio is the right thing to do right now. You don't know exactly when something is going to break, but the probability that something breaks increases over time the longer the Fed keeps policy this tight.

Dan Ferris: And something breaking, meaning worse than three banks going under?

Alfonso Peccatiello: Definitely. Again, if you look at other episodes where something broke, even when inflation was 2% and the Fed could pivot very easily, I mean in 2018, you've got the equity market going down 15, 20% in a few quarters, actually in a few months. That was pretty sharp. In 2019, you've got the repo market crisis. I mean we're talking systemic stuff here.

In 2000, you've got the dot-com bubble breaking. That was a very, very large bubble that actually broke. Then in 2001, we got a recession. In 2008, we got a global financial crisis due to the housing market breaking down.

So in principle, yes, we could get one of these very convex, very vicious re-leveraging cycles. The reason why I think that is possible, and I don't know exactly in which corner it's going to pop up, is exactly what we discussed before. Zero-interest-rate policy led to excessive risk-taking, led to these unproductive behaviors.

As we were looking to generate returns, it was interest rates were negative, regulation was loosened and banks took more risk, and shadow banks entered the stage. Actually, the availability of credit was provided not by banks, but by shadow banks, by other operators in this financial market.

There are layers and layers and layers of leverage then. Generally, leverage is OK, as long as growth is fine and interest rates are very low. Today, growth is deteriorating and interest rates are not that low anymore, and the combination honestly makes me a bit worried at this stage.

Dan Ferris: Yeah. I've started to wonder about shadow banks, too. It's a typical term that scares people, but it takes in a lot of different types of institutions. I mean I mentioned BlackRock effectively – you know, you could say they're the biggest one of all. But there are a lot of other folks who are completely – it's completely private. They're not regulated like a bank at all, and yet they're making exactly those kinds of loans and other bank-like services.

How does an investor get a handle on that, get an idea of what is going on there? Do you have to live in New York and know everybody in town? I don't know.

Alfonso Peccatiello: It's very hard. Because of the lack of regulation of the shadow banking industry, that also means that getting data on the shadow banking industry is very hard because they don't need to report much on their credit activity. Also, they don't do standard lending. It's not like they produce bank loans.

The way they provide credit is by adding collateral, so mostly Treasurys. These companies have Treasurys on their balance sheet, and then they use the Treasurys as collateral to give credit away to the markets, for example, to other market participants. So it's not easy, honestly, to keep track of that.

At The Macro Compass, I actually have some instruments that try to proxy what's going on at the overall credit perspective of the economy. So that takes banks, that takes capital markets, it takes shadow banks, but it is a very complicated market. It makes use of the so-called euro-dollar market a lot as well, but basically you use safe collateral like Treasurys to be able to get or provide credit to other institutions.

Honestly, it's what I always say. The Fed worries about the credit markets they can track very closely, but there is a gigantic market outside of the Fed's control out there, which also expanded beyond the borders of the United States. I mean the euro-dollar market allows entities that are not in the U.S. to use dollar collateral to produce loans denominated in dollars.

That's very scary because these companies, these banks, these shadow banks, the moment they cannot get their hands on the dollars anymore, the moment the economy is slowing down, they have exposure to dollar loans. They have issued dollar credit. So how do they plan to service that? How do they plan to keep this system functioning without being able to do to the Fed and say, "Hey, I need dollar liquidity."?

So this system is gigantic. It's very hard to track, and I do my best at The Macro Compass, together with tracking a lot of macro indicators.

Dan Ferris: Yeah. Bank for International Settlements says there's $12.8 trillion of this outstanding, outside the U.S., dollar denominated outside the U.S.

Alfonso Peccatiello: Yeah. It's something I've had to look at myself as well. It's over $12 trillion. It's dollar-denominated debt issued by entities not sitting in the United States. $12 trillion.

So the first question you ask yourself is: what happens if these companies, if these countries cannot get their hands on enough dollars? What happens if global rates go down? What happens if commodity prices move down? What happens if asset prices move down? Basically, the economy goes down.

If I am a Brazilian corporate and I borrow a billion dollars, I cannot go to the Fed and say, "Hey, I need some dollar liquidity please." I need these dollar, hard-dollar cash flows. So you have entire gigantic system out there of dollar debt that the Fed cannot control or influence actually, if not with swap lines, with other central banks as an emergency measure. I mean the shadow banking system, the euro-dollar system is something really important to track.

Dan Ferris: Something really important to track that you can't track. Yay! [Laughs]. Right? It's really important and we know nothing about it. Yay!

Alfonso Peccatiello: Well, what you can do is obviously you can gather data and proxies like I do at The Macro Compass, but also there is one interesting thing: markets. I mean all of this is linked to capital markets. So if you know where to look in financial markets, you can get early warning indicators for potential stress in the euro-dollar market. That you can do. That is what I do as well, given the experience.

I worked for a European bank. Mind you, European banks have big dollar credit exposure. I mean they generate dollar credit, but they do not always have access to the Fed, and I was in one of these banks. So by being in the trenches, you can understand how a European bank gets the dollar funding. Therefore, you can also track these markets to understand if there's stress building up. Is there a big demand for dollars because something is going wrong, so banks need this dollar funding.

That's what I do at The Macro Compass, try to track these market indicators. That is to say then that it's a very opaque market. The best you can do is try to get a hold of what is happening out there, but it is not transparent. It's not easy to track.

Dan Ferris: Right. I think that's a good place to end. Before we get to my final question, I did say at the outset that I'm a subscriber of yours. Where can our listeners find you?

Alfonso Peccatiello: They can find me at TheMacroCompass.com. That's the website where you can subscribe to my services. What I do there is I basically try to break down developments in macro and markets in plain English, so that people can understand what is going on in all the corners of the markets, try to put all of them together, and also make it actionable with ETF portfolios, trade ideas.

The idea is to put the money where the mouth is, to apply all the macro models, but to come up with something that helps people to manage risks through the cycles. All of that is on TheMacroCompass.com.

Dan Ferris: All right. My final question is the same for every guest, no matter what the topic. Sometimes we even have nonfinancial guests and I ask them this exact same question. It's always the same. It's very simple. If you could leave our listeners with a single thought today, what would it be?

Alfonso Peccatiello: You don't know the future in advance. Nobody does. We always have to think in probability terms. Be humble and open-minded to markets. The next five to 10 years are more likely to have more macro uncertainty than the five to 10 years before us. That we can try and say.

There are so many geopolitical currents out there. Central banks are moving across the plays. The pandemic has generated some changes in the economy. So it is more likely that the next five to 10 years are going to be more uncertain.

The only thing you can do, because you can't predict exactly what's going to happen then, is to study macro, to become a better macro investor. The best investment you can make is always in your own knowledge and learning and understanding macro and paying attention to it, and to risk management.

So I think that that's very important to say because the last 10 years have been pretty easy for investors. If you just bought some stocks and some bonds and sat on it, you made 10% a year with minimum volatility.

Guys, that is not the normality. That was a regime that was there and was prevailing for some reason. These reasons might not repeat over the next five to 10 years. The best investment you can make is in your own macro learning journey and education.

Dan Ferris: All right, good answer. Thank you. Listen, Alf, thanks for being here. I enjoyed talking with you.

Alfonso Peccatiello: Thanks, Dan. I'll be happy to be back.

Dan Ferris: Yeah. We'll have to have you back in six or twelve months and see where the world is by then.

Alfonso Peccatiello: All right.

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I think Alf is right that it's a little more important to be macro-aware. There's more macro uncertainty probably likely starting now and for the next several years. You know some of my ideas about how I think the market is going to go sideways and things are going to be difficult, et cetera, but it was good to hear – I don't know. Maybe I'm too guilty of wanting to talk to people who I know agree with me on certain things.

So I don't mean to be that guy who is always looking for confirmation, but it does work out that way sometimes, and Alf agreed that 0% interest rates for so long was such a weird thing, but he had a very good way of putting it though, didn't he? He said it basically incentivizes people the wrong way. They become less productive. They allocate capital poorly. It's just bad for the world to make money really cheap and easy and to make investing look really easy, the way it has been the last several years.

What happens after that, when there is a reckoning, is not good. So as I expected him to say, you need to play defense in your portfolio.

But he also emphasized that you can have what he called your attackers. You can look outside the U.S. and your defenders are gold and he likes long bonds, but your attackers, one of his was Japan, which I sort of agreed with.

So what Alf brings to the table is a really nice balanced viewpoint, I think, and a reasonable, rational one. The way he talked about the debt ceiling in terms of the probability being very low, extremely low that we'd default or get into any big trouble. But if the Republicans play brinkmanship long enough, you know, we could be in a recession.

So I hope you were taking notes. That was a lot to take in, but for me, it was really fun. I really enjoyed it quite a bit. So that's another interview and that's another episode of the Stansberry Investor Hour. I hope you enjoyed it as much as I did.

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