Dean Curnutt: My guest today on the Alpha Exchange is Ian Harnett. He is the co founder and chief investment strategist at Absolute Strategy Research, a firm analyzing global macro on behalf of an institutional client base. Ian, it’s great to have you on the podcast today.

Ian Harnett: Thanks very much indeed Dean. It’s great to be with you and a great pleasure to take part in one of your very well known podcasts. Indeed sir.

Dean Curnutt: It’s going to be a great convers at an interesting time in markets, in the global economy, in policy and these are all areas that your firm has spent coming up on 20 years diving into. So in advance, congrats on your forthcoming anniversary. It’s great to be with it for such a long period of time. Tell us a little bit about your career history. So you got your start in I think in some policy making roles and you moved to UBS. Tell us a little bit about the early days.

Ian Harnett: I came out of academia and working universities into the Bank of England where I was on the economic forecasting team for a while before shifting into the dark side of investment banking where I started off as a UK specialist but gradually broadened that to be much more looking at Europe where at UBS my team got the number one ranked status for as an equity strategy team, not just economics team. And since Absolute Strategy research started in 2006 very much we’ve broadened that again to being global multi-asset commentators and researchers.

Dean Curnutt: You launched your firm amidst the Vix of 10, I launched my own amidst the Vix of 80. So it’s an interesting starting point. What was it like getting your start during what was in some ways in real time easy to see a massive leverage bubble building up, but not necessarily easy to action it in terms of investing. We have guys like John Paulson who obviously made a truckload, timed it quite well, but it was kind of easy to see but not that easy to profit from.

Ian Harnett: No. And I think we, my co founder David Bowers and myself. David had been chief global strategist at Merrell’s and I’d been at ubs and what we could see was that there were these pressures building. Fortunately we started with quite a dark view of how the world was going to develop. As you say, low volume is actually one of the risk signs. We look and the pressures were building and we could see them building in the housing market. We started also by looking at the financial stability reports and degassing those and sending them off to clients. But we also recognized it was a global phenomenon, not just a US phenomenon. Dean and so we helped people recognize some of the pressures that were emerging in emerging Europe. And we basically got a forerunner of what was going to come in America. But yes, fortunately, and there are a few articles in the FT that you can still read where we. We flagged some of the risks to come going into the gfc. But the good news was that more importantly, we helped people turn around in March 2009 where we could see that big change with the G20 initiatives that took place.

So, yeah, we played it initially through Europe, emerging Europe, the Swiss Franc, and then via the American housing market.

Dean Curnutt: You mentioned the Global Financial Stability Reports, and I’m certainly a reader of what the IMF puts out. And I wanted to just maybe get the conversation going in terms of the independence of ASR, which I think is a great benefit. If we go back to 2006 and you read some of those reports, a lot of the narrative was around the central banks having conquered the business cycle, that credit derivatives and financial innovation had created a dispersion throughout the system of credit risk that was stabilizing and not destabilizing. And I’m curious, just as you think back at that time and then maybe in subsequent cycles, this risk of groupthink, sometimes that becomes a thing in markets, and then how your firm just operating independently perhaps avoids that.

Ian Harnett: It’s very clear, and we saw at the time, and the bank of England talked about the fact that it was an endogenous process and it was all fine. Their risk team had a slightly different narrative to what we were hearing from the governor at the time. But yes, the risk of groupthink, both at an institutional level, policy level, but also within research teams, is something that we try to push against. As you say, we’re fully independent, so we don’t have any ax to grind with anybody. And that’s one of the things that we take into clients and one of the reasons why I think we’ve been ranked Europe’s leading independent for the last decade or more. We are unashamedly prepared to say what we think at the time. And I think the good news is that after a decade, the Financial Stability Reports went through a period of being very anodyne. After the gfc, they were afraid of actually flagging too much. Now they’re starting to get much more informative once again, and we’re finding them. There are some interesting little footnotes that you occasionally find in these reports.

Dean Curnutt: Well, markets, if they’re anything, they are certainly teachers of lessons. And if we’re intellectually honest, they are.

Ian Harnett: Humbling, I was going to say they’re teachers of humility. That’s the thing that we say to young analysts coming into absolute strategy research. The one thing markets teach you is humility. You don’t get any choice on that.

Dean Curnutt: One of the things that comes out of Too Big to Fail the book and the Big Short, the movie is a gentleman by the name of Howie Hubler at Morgan Stanley, who had a gigantic position, effectively, you know, the same position as guys like Michael Burry, a basic betting against the housing market. So he was long protection, subprime CDS protection, and the carry was kind of eating him up a little bit. And so he, you know, converted his trade into some version of benefiting from some risk off, but then being exposed to the wheels truly falling off the bus, which is of course what happened. And he completely blew up, lost $8 billion. Right. So again, just, just to this humility, what if you were just to sort of think through again 20 years for ASR, some of the lessons that you take from these periods of stability, of instability of the interaction between policy and markets. There’s so many things. What are some of the things that have been formative for you on your framework?

Ian Harnett: The framework that we’ve tended to use is a multi factor framework, just having a single methodology. As we’ve seen recently, valuation hasn’t really mattered in the short term. So we look at economics, earnings, valuation, liquidity and momentum when we’re thinking about markets. But I think a couple of things that I point to besides that lesson about humility is to recognize that actually these periods of low volume do tend to be periods where risk is building, it’s building somewhere in the system because they are always driven by excess liquidity. So I think that’s one of the things that we need to be watching out for and one of the things that we talk to our clients a lot about. The second thing, which is something that we’ve been talking to clients and policymakers about for the last decade, is that the lesson we took away from the GFC is systemic risk is multiplicative, it’s not additive. And by that I mean that in the aftermath of the gfc, we went and regulated all the big banks, all the big insurers, they were called SIFIs. But actually, if you think about what caused the GFC or what triggered the GFC, it was actually the small stuff blowing up.

It was that BNP Money Markets Fund, it was Bear Stearns before Lehman’s, and Lehman’s was considered as small enough to be allowed to fail. And that was the mistake that in a multiplicative system, if a node goes to zero, everything goes to zero. And that’s I think again the danger today is we’re all looking for the big stuff to blow up. But actually it’s probably going to be a relatively small item that could unhinge markets when we eventually get some kind of more aggressive setback.

Dean Curnutt: Well, first I love talking to folks from the UK and Europe because the plural gets used Lehman’s. I always like that. So you know, when we look back on the precursor to the GFC we see Lehman’s and Merrell’s and so forth with 30 to 35x leverage it. In hindsight it’s just unbelievable that these, you know, very mark to market, you know, repo funded entities were running with such leverage. Again, easy to look back on, perhaps easy to identify as well, but not obviously easy to truly capitalize on. The system always reacts, right, so you sort of fight the last war. The policy response neuters the banks. But as you say, there’s sort of always a leverage buildup somewhere. There’s always sort of excess liquidity somewhere. And maybe where we can start, because this was a topic of our conversation when we chatted was around some of what you observe in the insurance space. I’d love to just get you, you know, to, to frame that out for us a little bit, you know, big picture and then we could kind of zoom in. But you know, for me I’m always trying to think, okay, what could go wrong?

What are the structural components of the markets that could lead to something that, where there’s spillover and I think that’s where you’re going here is potentially one.

Ian Harnett: Of the things that we’ve been trying to emphasize to clients, Dean, is that which the global financial system has changed and is changing and we’re in a world now dominated by non banks rather than banks. And in the United States that’s been one of the big successes of America is that it’s made this transition from a bank driven economy pre GFC into this non bank driven economy. And one of the stats that we like to share with clients is that America has 73% of all its private sector financial assets controlled by non banks. So that’s the pension funds, the insurance funds, hedge funds. So we have this quaint idea from our Economics 101 about this being a bank driven economy where rates can change, reserve ratios. That’s not the way the economy works anymore. So what happens in these areas of non banks is Critically important how they’re funding the interaction that they have in actually funding the banks as well. So the nexus between the non banks and the banks has been really critical or has become critical. But also it’s been very funded by global portable capital. These institutions have been adept at accessing the cheapest possible global capital.

But in a world where you get weaponized trade, you typically then end up with weaponized capital as well. So going forward, will American non banks and global non banks have that same access to global capital? Europe and China very much more banking driven system still, but America much more non banks. But then what we’ve seen recently, and this is something that the financial stability reports are beginning to catch onto is the rise of the private equity backed insurance companies. The scale of that increase has been quite dramatic and the range of the large private equity companies taking up assets or buying assets assets in the insurance sector. But what you see from BIS and other reports is that those banks, those insurers that are actually controlled by private equity are taking bigger positions in private credit. They tend to be riskier positions and they have lower capital coverage as well. So you can see here that these PE influenced insurance companies are getting some quite big numbers now. It’s all of the big players shares, but this data from the BIS just highlighting that they’ve got riskier assets on average and in some cases very much so and lower capital ratios as well.

So this is at the heart of where the problems are. And there’s been some great work by the New York Fed. The staff report number 1057 if you want to read it, about insurance companies as being the amplifiers of risk. If you, if we do get some kind of fire sale event coming through.

Dean Curnutt: You’ve been in markets as long as I have, so you’ll remember some of the earlier doozies. And I always go back to long term capital. For me it was a formative example of when a very large position taken by a counterparty with also a lot of copycat capital as well. Everybody wanted to do the same swap spread narrowing trades and short equity volume. But you have an entity taking on this risk that is an extremely mark to market sensitive counterparty. And that’s where you can get the flames, where there’s a mark to market sensitivity. So I’d love to learn a little bit more about the insurers because if they’re taking private credit risks, but I don’t think about them as mark to market sensitive in the same way as I would think about a hedge fund with a bilateral no And I think.

Ian Harnett: How this plays out is something that we still don’t know. But I think that that’s one of the things that we never quite know what the catalyst is going to be. But you can see where the concentration of risk is starting to occur. And that is the type of thing that then we find out, oh, there was this instrument, that instrument that they were using, the arbitrage of using Bermuda and reinsurance. It’s those kind of things that where there’s complication, where there’s new assets, but also where there’s a big rise in physical numbers of institutions crowding into a space. These are all classic signs to me of excess risk taking and a sign of potential volatility going forward. As I say, how that breaks down, hard to say. But what we do know is that the private credit that is being purchased, you can actually model those private credit returns using BDC returns. And recently we’ve seen some of those BDCs, those business development courts coming under pressure. People ought to be recognizing that the assets that they have really do need to be assessed accurately. As long as you can hold them for the long term, that’s great.

But as you say, if you get withdrawals and you get people surrendering policies, then that potentially is where you start to see some stress.

Dean Curnutt: And because we’re doing both video and we have an audio podcast version of this, take a moment to describe a little bit of the chart that speaks to the private equity industry. The private equity influence, insurers being in riskier assets and having lower capital.

Ian Harnett: We’ve seen the kind of holdings in the last decade of private equity influence, life insurance ownership go from around about 20, sorry, 200 billion up to around about 1.2, 1.3 billion. And that being about 18% of the total assets that the insurers have got. And the key point here being that the type of risk you’re asset assets, we’ve got a chart that shows the most exposed of those P backed insurers and the lowest exposed, the highest one’s got risk assets of the level three assets up to about 60% of their assets. Whereas the median for a regular insurance company would be something like 20%. And their capital ratios are significantly lower. And that’s really where we are on that.

Dean Curnutt: It’s not a fair fight when you compare anything to the gfc, the setup there in terms of the tidal wave of risk that was underappreciated, underpriced, we had just this gross mispricing of mortgage credit risk that was just endemic to the system. When you look at the risk taking side, the underwriting side of private credit, do you see anything there that has you concerned?

Ian Harnett: Well, I think the thing that worries us is that we do a lot of work on long term capital market assumptions. And the clue is in the name. They’re assumptions, they’re not forecasts. And what we found looking at this survey of capital market assumptions over the last few years is that they are invariant. Really the premium is invariant to the starting point of the valuation. There’s always a 2% premium. Now our view view is that actually you can capture the same long run returns from private credit through other instruments, through listed instruments, where you have that liquidity and yet people are paying up for something that’s illiquid. And the whole strength of asset allocation is that you get to rebalance. But if you’re clearly tied into a lot of illiquid instruments, then you don’t have that flexibility. And as long as you can match that with your liabilities, then that’s, that’s potentially fine. But as I say, they need to be fully matched. And the danger is, as we’ve seen in other risk taking environments, people always just cut corners. They think, well, I don’t need to be fully exposed. And this is one of the things we say about dry powder in the private equity space as well, which is people think about dry powder as being good news.

We actually think of it as being bad news because let’s assume that we have a cash flow event and one of the things we’re talking to clients about at the moment is cash flow, cash flow, cash flow. You get a cash flow event, it’s going to impact private as well as public listed companies. But in a private listed company, what’s going to happen is that they’re going to go to the asset owner and say deliver on your dry powder. Now let’s assume you’re a prudent asset owner. You have that money deposited in a mutual fund or money market funds. That’s what’s being used to fund the banks. So let’s say you have to take that out overnight. And the ECB estimate something like 9% of all European bank funding is, is non banks funding in short dated paper. And that’s if you’re a prudent asset owner. But let’s say you’re slightly imprudent. You say, well I’m never going to get called on this. So I can have 90% of it in money market funds, but the other 10% is going to be in a Liquid equity fund. So you phone up one of the big institutions, I need 300 million tomorrow.

What do they do? They sell what they can. And that’s the most liquid stuff, the stuff that’s made most money. So this is potentially how risk can amplify through the system in the way that we view private equity, private credit. And that is the kind of thing that can then trigger some of these bigger risks. Short term, we don’t see those risks coming through, but longer term, those are the kind of areas that we’re concerned about. Team.

Dean Curnutt: Okay, so you’ve identified some kind of structural vulnerabilities just in the way in which markets are kind of funding themselves. And definitely something to pay attention to. Maybe not actionable tomorrow, but worth watching. And you use the term cash flow. Why don’t we talk about cash flow in the context of what everyone’s focused on the long side of things, which is the AI trade. So big picture, describe how you guys are thinking about the AI trade. Obviously, it’s this incredible challenge for investors because being too long is risky and not being long enough is probably riskier. Right?

Ian Harnett: Career risk versus investment risk.

Dean Curnutt: Yeah. You wind up with something that almost inevitably has got to get crowded. The optionality of this is, is so high that there’s almost no price that’s too high to pay for a stock. And there’s no capex high enough if you are in that hyperscaler competitive universe. But I’ll just turn it to you one, just big picture what you see there, and then we’ll drill down to some of it.

Ian Harnett: So big picture, we think it is a bubble unambiguously. And the conversation we have with clients is that to say that to have it outperformed in this market, you almost have to have been fiduciary, irresponsible, given the concentration that there is. And so we’ve got a chart for clients that just shows previous bubbles and I’ll describe it for the podcast people. And what we’ve done is deflated all previous major equity bubbles. Oops. Right, that’s. That’s my bad. The previous equity bubbles, to give them a normalization, how many times has a particular bubble outperformed the global equities market during that time? So in the TMT bubble between 1995 and 2000, basically TMT stocks outperformed five times over relative to global equities. That the commodity super cycle, the basic resources, also outperformed around about five times more. It took them a longer time to build that. Since the NYSE created the Fangs plus Index, which I think has done quite a good job of capturing all of these Trends. Back in 2016, this bubble or this group of stocks have outperformed global equities six times over. So the way that we think about bubbles, Dean, is to say, right, well what have they got?

They’ve got scale. Well, I think beating the equity market six times over in nine years is a pretty good starting point. Secondly, you’ve gone exponential on a log scale on some of these assets. That’s always a signal with bubbles. But then particularly in equity bubbles, what you do is that those companies use their assets, that elevated equity price to buy other things. M and A starts to go up in the sector that bids up prices. You get this self referential process. They also buy each other’s goods and then the piece de resistance, they lend you money to buy their goods and you lend them money to buy your goods. So that vendor financing circle plays in. But what all this does is the sector or the theme in question becomes like Giffen good as economists call it. The more the price goes up, the more it attracts capital and that drives down capital. And if I can just squeeze on a slide, the last bit of every bubble is a capex bubble because you get this accelerated build out. And that’s I think, where you get to the risk for markets today, which is either the hyperscalers themselves run out of money, or the lesson that both my co founder David Bowers and myself learned of MEROS and UBS respectively in 2000 was that the clients ran out of money.

So you can have this lovely structural story called AI or the digital world that we’re living in today, instantaneous communication across the world. This is everything we dreamt of in 2000. But if your clients are cyclical, then that’s the problem for you. And at the moment, where are these AI companies selling to? They’re selling to financial services. Are financial services cyclicals or are they structural growth stories? They’re cyclicals. Retailers, they’re cyclicals. This is the problem and it’s why the bubble blew up in 99, 2000. As interest rates go up, you start to squeeze the rest of the cash flow of the rest of the market. So what we were looking at is the cash flow of the hyperscalers is interestingly when their cash flow broke down in the past, they’ve cut buybacks rather than Capex. There will be problems in the debt market. We’re already seeing some of that with Oracle. But actually it’s going to be the cash flow of the people buying these services, buying these products, that’s going to be the key thing for us. So we’re in that end game, but we’re probably not at the end yet.

Dean Curnutt: There’s so many interesting aspects to what you’ve just laid out. No, it’s fantastic. I love the term self referential because the stories around whether it’s OpenAI to Nvidia or the customer supplier relationships are, you know, very, very significant. What’s, what’s so interesting to me is, is someone that focuses a lot on looking at options and, and things like correlation. I’ll just throw a stat at you. So we’ve got four stocks each of which is circling around 4 trillion in market cap. Apple, Nvidia. What am I? Microsoft? And what’s my, what’s my fourth? Google. Right, so those are your four. That’s 16 trillion in market cap. It’s 28% of the S&P 500 in four stocks and they’re largely being rewarded for the same thing. Maybe Apple’s a little bit different, but the correlation of these stocks is remarkably low. It’s 25% over the last six months. That’s a crazy low number. If I look at the banks as an example, JP Morgan to Citi to, to Morgan Stanley to Bank of America, Wells Fargo, that’s more like a 65% correlation and that’s not even during a crisis. That’s just a natural level of correlation. They’re in the same business and I feel like that’s something that markets are missing from a risk standpoint.

Now I’m sure you get a lot of pushback on this Ian, right, because folks are long and right this story, you know, I’d love to hear some of the pushback maybe go back to the TMT, you know, the dark fiber analogies to you know, to 99 and 2000.

Ian Harnett: The biggest pushback is, you know, because one of the points we make to people is actually you need the bust to deliver the long term gains and that actually it was only after you’d had that bust in that 2000-1999 period where TMT capex dropped from 20% compound over five years down to zero, that it was only in the aftermath of that that you then started to see the build out. When those assets had been purchased at a low price, the fiber could be repurposed and the pushback is ah, but this time Ian, it’s going to be different because your GPUs are only, they’ve only got a depreciation life of three years or whatever. So you’re not talking about railway lines, you’re not talking about fiber that have got 25 year life. Our observation would be to say, well actually you have got data centers. These are big physical buildings. They’ve got a lot of stuff coming in, a lot of stuff going out. You will be able to buy those at a dime a dozen and after you get some kind of pullback, similarly, those GPUs, they’re priced up here today, but if we get a period where that demand slows, there’ll be price right the way down there.

You can afford to rip out the whole of that data center, replace it because it will be so much cheaper. But for us, that’s where the key pushback would be. Many people say, oh well, it’s just the long run, growth will carry on forever. As I say, I strongly believe AI will be part of our lives in 10 years time. But digital is what it is today. But those large stocks that are the winners today, as you say, Microsoft, Apple, Oracle, Google, Amazon, they were the winners in 2000, but it didn’t stop them losing between 65% and 95%. So I think the thing we tried to differentiate on Dean is this idea of an investment bucket bubble versus an economic bubble. So let’s distinguish the two. And valuations are the things that differentiate that.

Dean Curnutt: Yeah, and I think, and maybe this is another slide you can display, but I’ve seen this on Twitter, it presents itself as a scatter plot of CAPE ratios versus 10 year returns. People have different views on it, but I think one of the things you’re saying there, the point you’re making is entry price matters. You know, you know, if you look at again back to the GFC and Paulson, he made so much money because he bought these, you know, these puts basically for a song, the market was giving him away. And it’s not as if the market’s giving away Nvidia and all the stocks that are kind of next to it in terms of valuation. So this is a scatter plot of Shiller CAPE versus subsequent 10 year nominal returns. You’re a believer in the sort of big picture of this and maybe just describe what you try.

Ian Harnett: I think what we believe is that valuation starting points matter. And so we wrote the notes about how investors potentially face a lost decade. Because if there’s a very nice sloping line down 50 years of data and you can actually do the chart over 100 years as well, and you get the same kind of picture that if you start from a valuation of around about 40 on the Shiller PE. Historically, your returns have been somewhere in the next 10 years compounded between minus 3 and plus 3%. You’re going to be at something like that. So very, very modest returns. But of course, if you buy when your Shiller PE is down at 10 times, then it’s likely that your compound returns are going to be something like 15%. So for us, the concern we have is to differentiate again between investing and trading. Trading is about, as you say, short term momentum options volatility. Now today it’s also about algorithmic trading, it’s about passive investing, it’s about momentum investing. So everything’s fine until it stops. And as we’ve seen with Oracle recently, you can get a 15% drop in a day just on a single piece of news that is momentum investing or momentum trading.

But investing is about thinking about what am I trying to achieve over the next five years, over the next 10 years in that environment? Historically, valuations, your starting valuations always mattered. The higher the valuation, the lower the probable return going forward.

Dean Curnutt: And so you talked a little bit about cash flows. I’d love to just go back to that a little bit more because I.

Ian Harnett: Think.

Dean Curnutt: Again, not to be long this for the typical fund manager who is up against what I like to just say is the best benchmark the world’s ever seen, the s and P500. Man, it’s tough.

Ian Harnett: It’s a nice phrase.

Dean Curnutt: Yeah, it is a. I mean you got a benchmark running at a two sharp for a couple years in a row is, it’s pretty challenging, it’s tough to beat. So you want to try to, you don’t want to try to time it, but you want to try to put that mosaic together that’s going to give you some further conviction that, okay, the market’s starting to come around. Perhaps it’s impatience. The market’s obviously giving these stocks a ton of rope right now to keep doing it. But maybe relate this back to your comments on it comes back to cash flows and how you think about trying to find that turning point where the market becomes a little more skeptical as to where we’re going here.

Ian Harnett: The two things that I’d bear in mind are first of all, we’re not calling that at the moment. We’re still risk on partly for two reasons. One, because we’re in an environment where you have got, we think you’re going to get above 4% nominal GDP growth. And one of the other lessons that we learned the hard way in 2023 is that as macro people, we were looking at real variables, but actually for an investment perspective, it was nominal things that matter. As long as nominal US growth is above 4%, then probably things are okay. But the thing that worries us today is that we have this very unique situation. And I’ve got a chart that shows compares the S and P forward earnings the year on year changes in forward looking earnings expectations currently running at around about 12.5%. Historically, those changes in forward earnings expectations have gone hand in hand with changes in Fed funds rates. Rates until the pandemic. And since the pandemic we’ve had this asynchronous response for earnings and for rates. Now what we worry about is that as we get further from the pandemic, you’re more likely to see rates and earnings converge again.

And how that converges I think is really critically important for investors. Historically. If you’ve seen an economy where the earnings growth slowed down, yeah, you can get those rate cuts, but normally it doesn’t stop you losing money in equities. But if we were to say at the moment people are expecting those rate cuts to come through, but let’s say they don’t, they say, okay, we’re going to see the President and the administration run this economy hot. Okay, we might get a mid single digit to double digit earnings growth growth, but you end up with interest rates flat or maybe even going up towards the end of next year. You can tend to deal with that much better. But when rates really start to ramp up again, that’s where you get the cash flow pressure starting to potentially arise, but only if nominal growth gets below 4% and we’re not there yet.

Dean Curnutt: So one of the narratives in the market is this K shaped economy. We’ve seen charts of the S and P versus the Jolts index and people like to tie it to the launch of ChatGPT. You’ve also described the K shaped economy in the context of corporates and there really is a lot of valuation dispersion. I think you’ve pointed to some of that. How does Fed policy interact with this economy when so much of the growth is is AI Capex centric? How unique of a time are we in Fed policy as being supportive or not supportive of the economy?

Ian Harnett: Well, I think one of the things that I didn’t mention about bubbles is that bubbles are always inflated by liquidity and that’s key to it. And we’ve just seen the recent FOMC meeting cutting rates and adding liquidity via the purchases of bills running at 40 billion that’s going to help keep this growth bubble inflated short term. But we worry that the K shape economy so the reason why we’re talking about the K shape economy is not for the consumer, which I think a lot of people are looking at, but it’s actually these margin charts that we’ve got on screen at the moment. For the people on the podcast, what you have is that margins for the large cap stocks are running at around about 14, 15%, mid cap S&P 400 stocks, X financials running at 8. But the smaller cap stocks, the 600 are running at around about 5%. So very sharp decline over the last couple of years for those smaller cap stocks, very sharp rise for the larger stocks in the US universe, if we are going to see stress, it’s going to come from those small cap stocks first. And at the moment, interestingly, whilst the margins are weak, we aren’t seeing the labor market shock coming through.

And indeed for clients, we’ve been showing them a chart of the nfib, the National Federation of Independent Businesses. They have a lovely surveyor. Anybody that wants to know about small caps, use that NFIB survey. They’re actually starting to see that their worries about the quality of labor going up. Historically that’s tended to be an environment where unemployment comes down. They’re finding it hard to get the right workforce in place. So if we were going to see a big sell off, if we’re going to see liquidity really squeezing corporates and forcing unemployment up. And remember, it’s companies that make you redundant. So all the time that people are forecasting double digit earnings growth, I find it really hard to get worried about unemployment. We ought to see that in small companies being worried about having to lay off their workforce. And at the moment we can’t see that. Dean so this is another reason why we’re very happy being risk on. We’re very happy being overweight equities and we’re very happy being overweight US equities still, which I think surprises some people, notwithstanding all those valuation worries, notwithstanding that bubble worry as well.

Dean Curnutt: I’m wondering if you could take this up a little bit. I’ve been doing a lot of thinking on this and there’s been a couple of pieces written that sort of pointed me in this direction, which is kind of an inversion of cause and effect between the markets and the economy. In the GFC period, it was really the market that took the economy down. In traditional cycles the economy weakens, corporate profits weaken, maybe layoffs go up, up and the Market goes down, it responds to a profits outlook that worsens. And I’m wondering right now if the wealth effect of AI is so significant. Jita Gopinath, who was the chief economist of the imf, of course, she wrote a piece in the Economist about a month ago. I thought it was just thought provoking. It was, was essentially some version of boy, everyone’s long and benefiting from the, you know, tremendous, tremendous returns. You showed it in that bubble chart of how much wealth has been generated not just by people that are lucky enough to work at Nvidia, but you know, there’s a, a 401k millionaire now, right. That just didn’t exist a couple years ago.

And it’s, you can look through a lot of things when you’re feeling that wealth. But if your vulnerability of these high flyers ultimately materializes, I’m wondering is there more of an impact back into the economy via the wealth effect than we might normally see? Is that something you guys have thought about?

Ian Harnett: There’s certainly a possibility of that. I think the one thing to bear in mind, and this is the reason why both and I was at the bank of England at the time in 1987, and also in LTCM, in retrospect, rates were cut too much after LTCM. When it’s an equity sell off and an equity driven wealth effect, consumers typically can absorb that. When it’s a debt wealth effect, as it was in the gfc, it’s a much greater stress. But you’re absolutely right, there’s lots and lots of, there’s a strong wealth effect. At the current time, we’re flagging one source, not only equities, but actually also the housing market. There’s $36 trillion of housing wealth in the US housing market that could be untapped. That’s positive equity. And we think going into the midterms, this is something that President Trump and Secretary Benson will be desperate to do. So freeing up the housing market partly because MAGA voters are house owners, not renters. So getting those new house prices up, getting more flexibility and ability of people to move by perhaps going to assumable mortgages, that’s the kind of thing that we think you’ll see happen.

But there’s a downside to that wealth as well, though, Dean, which is one of the things we’ve talked to clients about a lot over the last couple of years, is that wealth effects actually lead inflation. And central bankers, if you remember, told us that this is one reason why they wanted to do QE in 2009. Because they said, right, we’ll bid up those prices of assets and that will help to create a wealth effect that will mean that we won’t go into a deflationary world. But now, whenever anybody asks Chair Powell about whether he believes that they need to be worried about asset prices and record highs on the S and P, et cetera, no, we’re not interested in asset prices at all. And yet historically, changes in the average of equity returns and bond returns have actually tended to lead the acceleration and deceleration in inflation. So if anything, at the moment I’m a bit more worried about what those wealth effects might mean for inflation rather than worrying about what they might mean for the scale of any recession afterwards. Because it’s likely to be that wealth effect that ends up driving the Fed to raising rates.

Perhaps as we get through later, after the midterms, I don’t think they’ll want to raise them beforehand.

Dean Curnutt: As you mentioned your time at the bank of England, it just got me thinking about just the back end of these various developed sovereign bond markets. The UK being obviously an area where you have great specialty and had a short lived but really fascinating and substantial risk event in 2022. And so as the US let’s say say, embarks on or continues an easing cycle and it’ll be, maybe there’s two more turns left, maybe there’s 50 basis points left, we’ll see. But it’s just unclear what’s going to happen to the back end. And I’m curious as the policy rate comes down, but the back end is just irresponsive to it. Are we easing or not? Are we like what, what’s happening there in terms of, so it’s working its way through the economy.

Ian Harnett: So I think that will be an easing process. But that lack of back end move is potentially going to limit the scale of the overall impact. I think that the reason why the back end is not moving is twofold. First of all, and remember this is a global phenomenon, it’s not just a US phenomenon, it’s not just a UK. Every country likes to think that their 30 year is unique in some way and yet that’s not the case. But the key thing to recognize is that the majority of central banks have missed their inflation targets for four or five years now. And we’re seeing in the stock bond correlation has now turned positive. You haven’t seen that since really on a structural basis since before the introduction of 2% inflation targeting and independent central banking. And so this means that at the heart of what we’re seeing and why those bond yields are being bid up is that actually people no longer believe that they are the natural hedge for their portfolio of equities. And I think so that’s the starting point for us in the uk. I think we have a pretty unique situation.

I think we’re a very inflexible economy now and we have a high level of indebtedness. The problem is that one of the things we’ve emphasized that I think actually the administration in America is doing absolutely right is they recognize that the only way you can get the deficit back under control is to try and re lever the household sector relever the corporate sector. Because the counterpart to the budget deficit is actually the private sector surpluses. So to get those lose the deficit improving, you have to grow your way out of it. And clearly the winningest president in history is not going to want to do debt deleveraging. Debt deflation in a midterms year. So America, we are going to run the economy hot in the uk. One of the most worrying charts I found recently shows that over the last decade all three sectors, the government sector, the household sector and the corporate sector have all delevered relative to GDP at the same time. Now that is a disaster. That is genuine debt deleveraging. The last time you saw that in a developed economy it was the Eurozone crisis. Prior to that it was Japan, prior to that it was the 1930s.

This is a recipe for social unrest, political change. The last time we saw it in the UK was the mid-1970s and it led to the Thatcher revolution. But not without a lot of pain first. So I’m very worried about what that does to European to UK bonds. Because if growth slows, you know the one thing that happens is your deficit gets worse because you have to spend more on non discretionary spending and your tax receipts clash. So debt crises are always delivered by growth disappointing, not the level of debt per se or the level of interest rates. That’s my trick question for economists. What’s the equilibrium level of debt to GDP for any economy? And they can’t tell you because it changes. But if you’ve got weaker growth, then you have a big problem. Problem for Europe, the problem is that France has got debt ratios which are higher than in the US and it’s not just government debt, but actually it’s private sector debt. So if economic growth was to slow in Europe, then actually the risk of a French debt crisis could be a problem. But the good news is that that might actually trigger European capital Markets union, you need something of that kind of scale to deliver.

But for me, this rise in the bond yields at the back end, the one place that I slightly worry about is that there’s one very robust economy that historically has had very low bond yields called Germany. It’s got a very low debt to GDP ratio, so everybody’s very relaxed about it. But we know that they’re about to do a lot of spending on defense, on infrastructure. There’s going to be a lot of issuance coming through. There’s political uncertainty around Chancellor Merz as well. And if inflation was to start rising in Germany, some of our equilibrium models based on 10 year nominal growth profiles have equilibrium bond yields almost 100 basis points higher than they are today. So if anything, I’m slightly more concerned about the surprise for markets could actually come through those yields being bid up, rather than something like the French oat.

Dean Curnutt: You mentioned getting that turn right back in 2009 and sometimes buying again. It’s buying when there’s blood in the streets and things look terrible, but also appreciating the force of the policy response behind you. And so some version of what we’re all trying to do is in some ways trade that policy response. So as the US has got its midterms next year, and I can tell you that this is a win at any cost for both sides. And of course the White House has got a lot of sway in its ability to hand out sweeteners, try to put the voter in a, in a good mood. And so I’m wondering if you have thought through the, the sort of second derivatives of there’s likely some policy response that’s a part of trying to win the votes next year. Perhaps there’s inflation implications, maybe there’s a, a bid to gold, renewed bid to gold. I’m wondering how you’re thinking about the playbook in light of what could be a generous White House next year.

Ian Harnett: One of the things that we’ve emphasized is that as I say, to get debt down, what you want to do historically is you’ve got to pass that government debt to someone else. You’ve got to force re leveraging into the rest of the economy. So the area of America that has delevered most since the GFC is actually the household sector. So it’s actually households that you could get to take on more debt. But that means that, so what’s the collateral that you can reflate and that you can lever? It’s got to be housing. So this is why I think some innovation around Housing finance is the most likely thing. Maybe the privatization of Fannie and Freddie as well. I can see this is why they’re wanting to go down that route. Wrote similarly privatization more generally was one way that Margaret Thatcher in the UK won the support of a whole generation of working class people because she gave them an opportunity to own assets that they didn’t have previously. The other thing to recognize is that a lot of the funding for President Trump came from crypto. Crypto is also an asset that you can potentially, potentially lend against.

And we’ve already seen some deregulation here, so we expect to see more of that kind of deregulation. Dean around digital assets we’ll see the use of stablecoins to help drive those interest rates down at the front end trying to lock the back end rise. Everything that we can see, bill purchases, stablecoins, everything is designed to try and hold that front end down and stop the back end going up too much. So will that support gold? Potentially yes, because we know that anytime that rates are low then that potentially is good. But as you say it comes with a risk of higher inflation. But I think let’s remember that people don’t actually worry about inflation and we joke with clients that the only people that worry about core inflation are central banks. The rest of us us worry about price levels. It’s about price levels. And so we’ve got a nice chart that shows how price levels since the GFC for things like gas, food, beverages are up 30, 32% and this is the squeeze on real wages that has taken place. And our guess is that to try and control for that President Trump, Secretary Besant will use any kind of administered prices they can get their hands on to try drive those prices down.

We also believe that there’s a strong deal that has been done probably with the OPEC countries to drive oil prices lower. This is a pretty stunning chart. We’ve been using this for well over a decade that the EIA and to describe it for people on the podcast that the EIA this is the EIA inventory forecast for for liquid fuels inverted and it maps almost perfectly onto oil prices, Brent crude prices. And what this shows is that going forward looking at the current projections from the EIA oil prices by 2027 gas prices sorry would be down at $30 per barrel. So I’m sure it’s not a coincidence that Saudi has got access to the F35 technology. I’m there’s a counterpart to that which is a willingness to continue to pump oil at attractive prices. Everything that can be done to keep inflation under control. I believe will be done to keep inflation and keep price levels under control going into that midterm. And earlier this week we saw a 12 billion dollar program for farmers to try and keep food prices down. Similarly and Secretary Besant at the Milken Institute talked about not just drilled, baby drill, but also build, baby build to try and make sure that the housing supply was plentiful and to keep those house prices down.

Dean Curnutt: So where I wanted to finish was just again on the, the back end of the, let’s say the US yield curve. Not just tens but thirties. It’s a long way out and there’s a lot of interesting cross currents that set prices there. You’ve got reserve managers, you’ve got asset liability matching strategies, you’ve got the basis trade hedge funds doing cash versus futures basis trade. So there’s a lot of different motivations for engaging in that. But at the end of the day there are are fiscal dynamics, there is some version of trust that’s embedded. And you said something that really just got me thinking. When we think about the term bond market vigilante, we think about a violent move. This group that’s overseeing the market and ready to act quickly. But as you described this 3% inflation, we’re above target for years now. Maybe the vigilantes never say anything and they just say, you know what, the risk premium is just higher than it was. We’re not going to make it a violent action. But it just gets embedded and it’s hard to regain that credibility if you’re above for a long enough time. I just love for you to riff on that a little bit as we.

Ian Harnett: Close now we have a very simple model. A lot of our models are very simple. We’ve got about 30,000 macro to market charts, so a lot of them are very straightforward. But historically the 10 year trend growth in nominal GDP has given you a pretty good estimate of where equilibrium bond yields should be for that 10 year and 30 year. Because the 30 year doesn’t tend to get out of line too far relative to those 10 year returns that is currently running. When you project looking at the bis, the oecd, imf, World bank type of numbers, those are still running at around about 5 to 5.5%. So that tells you I think where eventually we will see these, probably the cap on the 30 years because remember that in an upswing of yields, the 30 year gives you a pretty good idea of where the Fed funds rate will tend to peak out, go away and have a Look at that chart if you want to check that out. It’s actually quite a nice little thing. The 30 year gives you a sense of where the next cycle might see the Fed funds peak out.

So we can have this short term drive down in inflation from oil prices and gas prices helping to subdue those bond yields. And I think that will moderate some of these pressures. But eventually, if you’re growing, if your economy’s growing at 5, 5.5%, then probably you are likely to see your bond yields converge to that kind of level. And all the manipulation of qe, et cetera, can slow that process. If you unwind that process too quickly, then you’ll get there very quickly. But that’s why we’re structurally bearish on bonds. And we worry that you’re losing that hedge. And that’s going to be the big problem for investors going forward, which is their bond portfolio is going to be less of a hedge. And that means you’re going to need more real assets, you’re going to need more commodities. And you can see why people are going into things like gold.

Dean Curnutt: Well, Ian, we can leave it there. We covered a lot of ground. I want to congratulate you for your upcoming 20th year. Fantastic achievement. Where can folks find the work of Absolute Strategy Research if they were interested in taking a look?

Ian Harnett: On our website, www.absolute-strategy.com. click on the link there that says client trial. And we’d be delighted. For one of the issues is we’re a regulated entity, so it is for professional invest. But we’re delighted to have people look at our research. We love charts, we love context, we love history. And it’d be a delight for people to have a look at our work and to trial with us.

Dean Curnutt: Thank you for being a guest.

Ian Harnett: Thank you, Dean, for the invitation.