JULIAN MCCORMACK | Platinum Asset Management

· Podcast Episodes
Valuey not growthy investing as we drop the numbers into the 2023 spreadsheet - Julian McCormack from Platinum Asset Management

Inflation, recession, high interest rates, mortgage stress, cost of living pressures, and I'll add war to that list as well. Just some of the cheery headlines that we can look forward to in 2023. And this is the first recording of the new year. And who better to welcome back to the microphone than old friend of the podcast Julian McCormack, investment Analyst from Platinum Asset Management.

We began the conversation by exploring the world of fixed income. These are divided into government and corporate bonds.

You can either own it or loan it

When it comes to investing, there are two basic options: owning it or loaning it. When you own an asset, you have a direct claim on its value. This could be something like buying a share of a company, which gives you part ownership and a claim on its profits.

On the other hand, when you loan money, you are essentially lending your money to an entity with the expectation of getting paid back with interest. This could be something like buying a bond, which is a loan to a company or government.

This type of investment can be important for retirees who like certainty in their income streams. Other investors may use fixed income to hopefully add stability to their overall portfolio.

There are two main risks associated with fixed income: interest rate risk and credit risk. Interest rate risk is the risk that changes in interest rates will impact the value of your investment. When interest rates go up, the value of your bond goes down, and vice versa.

Why? Because when interest rates rise, new bonds are issued at higher rates. Existing bonds with lower rates become less attractive to investors. As a result, the value of the bond you own may decrease. Even though you will still get the same return if you hold it till maturity.

To measure interest rate risk, investors use a metric called duration. The longer the duration, the greater the bond's sensitivity to changes in interest rates. Credit risk is the risk that the borrower will not pay back the loan.

Some larger companies have a lower risk than companies that may be smaller and more speculative. Government bonds, on the other hand, by and large don't default.

If this all sounds complicated don't worry. There are many actively managed ETFs and managed funds that will help to manage these type of investments.

"When you remember or hear about someone talking about their 17 or 18% mortgage in the late eighties, inflation is higher now than it was then. Right? So that is just giving you a little sense of how incredibly distorted the world has become for a whole bunch of reasons. And I would summarize that distortion as saying no one really wanted to take the pain of an adjustment after the financial crisis and indeed going all the way really back to the early 2000s under Greenspan and that that induced this sort of mollycoddling effect by central banks."

And what does Julian see for 2023?

"It's not the end of the world. It's just much more like the early eighties, mid seventies and sort of the nineties recession as well. We just haven't had one for a long time. They're not that much fun. Just be cautious and don't pay too much for stuff because you do want to be cautious in this environment. And right now I think people will feel pretty chipper cuz markets are up a fair bit. I mean the Dax is up like nearly 30% of its lows that, you know, most European markets are within 10% at all time highs. So now people will feel comfortable. We will go through cycles of them feeling very uncomfortable again. Exactly as through the course of 2022, possibly for another couple of years. That's all. And so just understand the process you're in and that we are likely going into a recession."


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Phil (0s):
So the reporting season, well, actually, actually, the other thing that was really interesting as well as watching Alibaba at the moment, and, you know, which was in such a down trend, but I think the overriding thing for me with that was Charlie Munger took big positions, didn't he? And Yeah. Alibaba, and then Yeah. And got burnt by it.

Julian (21s):
Yeah. I don't, I dunno, his entry levels, but

Phil (24s):
I think around a hundred, something like

Julian (26s):
That. Yeah. I mean, I think people, I mean, one of our sort of peers in the industry got a bit carried away with China just as we were getting a bit cautious on it. So, and now we're in this interesting position where I think, I think there is quite a simple trade around a Chinese reopening. I think it'll be pretty gradual. Yeah. If there's one thing that Chinese are very, very sensitive to, its inflation. So

Phil (51s):
Why is that?

Julian (52s):
Well, it's a very long history of Chinese empires, you know, dynasty, imperial dynasty's collapsing under high food prices. So they're, they're extremely sensitive to, you know, unemployment. You

Phil (1m 7s):
Take such, you take such a historical perspective on things, don't

Julian (1m 11s):
You? Well, yeah, I mean, we tell these ourselves, these stories that we live in a new world, but there's nothing new. I mean, you know, my sort of latest sort of obsession at the moment is we tell ourselves we're in these, you know, nice little discreet nation states or whatever, but we're, we're really not. I mean, the US is an empire, you know, just the continental US is an empire, right? I mean, they fought a pretty good war with the French and a pretty good war with the, well, the French and the Indians and the,

Phil (1m 37s):
And the British.

Julian (1m 38s):
And the British, and a pretty good war with the Spanish right. To get control of that territory, right? Yeah. And it's all pretty disparate and all pretty different. And China's an empire, you know, just Han China took over its whole territory. Indonesia's clearly an empire. It's an empire of Java. So, you know, we can tell ourselves that the, the goals are all different or whatever, but I don't, I don't know that they are hugely different. And I, you know, and we're seeing that right now in Europe, sadly, you know, so I think it's, you know, anyway, but, but yeah, no, the Chinese are, and, and in, in, in very recent history, Tiananmen Square corresponded to, you know, really very serious economic disruption in China in the late eighties and early nineties with incredibly high inflation, you know, 25% inflation.

Julian (2m 31s):
Yeah. So they're, they're very sensitive to it. But, but as well, you should be, you know, there's, there's, there's never a good outcome once you get very serious monetary inflation. Mm.

Phil (2m 43s):
Which is what we're gonna be talking about today. So let's do an introduction.

Julian (2m 46s):
Let's do it.

2 (2m 48s):
Shares for beginners.

Phil (2m 50s):
G'day. And welcome back to Shares for Beginners. I'm Phil Muscatello, inflation recession, high interest rates, mortgage stress, cost of living pressures, and, and I'll add war to that list as well. Just some of the cheery headlines that we can look forward to in 2023. And this is the first recording of the new year. And who better to welcome back to the microphone than old friend of the podcast, Julian McCormack, investment Analyst from Platinum Asset Management. G'day, Julian.

Julian (3m 18s):
Can I feel great to see you?

Phil (3m 19s):
Yeah, good to see you on. Happy New

Julian (3m 21s):
Year. Happy New Year to you.

Phil (3m 22s):
So Platinum Asset Management focuses on one asset class, international shares. So today we're zooming out to consider the big picture. So we were just talking then, I'm, I'm gonna add that in, you know, there's the prequel to the podcast episode, and inflation seems to be the big thing. And the first question that I had for you is what went wrong for markets in 2022? And I'm also feeling that that's almost the wrong question because question, there's no Right, but, but there's no right or wrong. Is there

Julian (3m 51s):
Not real? Oh,

Phil (3m 53s):
It's just situation, the way the situation is, you know? Yeah, yeah. Cuz people get it in their heads that, you know, markets are against them or markets, you know, they can run with the markets, but the markets just are, aren't they?

Julian (4m 5s):
Pretty much, yeah. And the answer I was gonna give you was they went down a bit cuz they went up a lot.

Phil (4m 14s):

Julian (4m 14s):
That sounds simple, but, but it's about right. And we are very sensitive to the notion of things of companies overearnning. And that gets a bit confusing for people cuz they think, well, more money's better, but up to a point, Lord Copper. So when, you know, think about it in, in terms of your own personal capacity to earn money, you can go through, you know, sprint periods in your life where you work two or three jobs or you, you know, you really squeeze out at one job and do very well or whatever. But if it's unsustainable, you know, it can't last forever. I can't remember who said that, but it's, it's a funny old quote.

Julian (4m 55s):
It's one of those sort of, you know, Sam Goldwin quotes and that's what we saw. So a combination of the end of a period of structurally declining inflation and interest rates, which was probably already ending. Like this is the thing that catches people out. What has entered people's minds is, is is where everything was fine before Covid and then Covid came, and then everything got pretty screwy after that. And so wages were growing properly measured in the states at about 4% year on year, late 2019 into early 2020, you began to get incipient inflation in the system.

Julian (5m 37s):
We'd already had a couple of goes at tightening rates, you know, remember and, and shrinking the balance sheet. So

Phil (5m 43s):
Because that was about 2018 wasn't That's right. That the Powell was trying to get the interest rates up somewhere in the Trump preside.

Julian (5m 48s):
They've been talking about it since 2015. Yeah,

Phil (5m 49s):
Yeah, yeah.

Julian (5m 50s):
So that's, you know, we've had a, a fair old guard for a fair range of, you know, period of time. And then you get this incredible stimulus, which was fiscal, not monetary. So it was government spending, not, not not interest rate manipulation. And the combination of those factors saw this incredible share price performance. You know, as in the states, the market I know sort of reasonably well we go from about 3000 points to, to, you know, just under 5,000 in about 18 months.

Phil (6m 30s):
So that's pretty unusual. S&P500.

Julian (6m 32s):
S&P500, thank

Phil (6m 33s):

Julian (6m 33s):
Yeah, yeah. Specifying, yeah. And then NASDAQ does much better than that. So the NASDAQ goes from, you know, just under 8,000 to, to 15,000 in that period. So,

Phil (6m 44s):
And, and when you say the, the stimulus and it's monetary stimulus, sorry, I always get confused between the two.

Julian (6m 51s):
Well, you, you shouldn't feel funny for getting confused cuz they're, there's, there's two sides of the same coin

Phil (6m 58s):
Because one's interest rates and one's Yeah.

Julian (7m 0s):
Government's, one's interest and one one's wasn't government spending. So in various different guises in the, in the systems in which we operate in inverted comas in the west, but I include sort of Japan and South Korea and stuff, there are appropriations powers that reside with the, the, you know, whatever the legislature is. And then there are these other bodies that sit off to the side of it, which have sort of delegated powers, which, which we call central banks. And they have basically set their mandates around the use of interest rates. They can use monetary aggregates, they can use a whole bunch of things if they want, but they don't do that anymore.

Julian (7m 42s):
And then they've done this funny thing added onto that, which is bond buying, but it really amounts to the same thing. It is, it is the setting of interest rates in order to induce activity. So long way of, of sort of introducing a point, which is to remind people that we had about a decade of zero interest rates and not much going on. Right? Yeah. It was all a bit, it was, it was fine, but it was all a bit lousy, you know, it was a long slow expansion, nothing amazing. And then we got the fiscal in combination with it and the world went mad. So it's those combination, it's that combination of things that, that saw equities go ballistic.

Julian (8m 22s):
So stocks go up a lot. And that was really, I, I'd summarize that as you held a pretty high multiple of earnings and the earnings went wild. I mean wild. So, you know, US corporate earnings went up by over 50% in a couple of years.

Phil (8m 41s):
And, and that's over the last, oh say 2019 to from

Julian (8m 46s):
20, from, from 2020 early, from the beginning of 2020 Yeah. Really to about the end of 2021.

Phil (8m 53s):
Yeah, yeah,

Julian (8m 54s):
Yeah. Right. And then they sort of held that level. No, well, they've done all right since then, you know, earnings wise, but, but that 18 months was just dramatic. And so that's really pretty simple, right? Because the, the, the terminology gets confusing because cuz deficit sounds bad, but if a, so let's just close the economy off and, and, and say there's only three sectors within it, there's a household sector, so you, me and our families and whatever, there's a corporate sector, so the people who employ us, and there's a government sector, which is pretty self-explanatory. So if we just, if we just rather falsely define the economy as those three sectors, if the government sector is printing or producing a deficit, it's automatically injecting a surplus into those other two sectors.

Julian (9m 46s):
And, and that's what we saw in the presence of this very accommodater. And that's the fiscal bit, that's the government spending. And then the monetary stuff was important because mainstream economists get themselves a bit tangled up, in my view, around this printing of deficits because they say to themselves, well, oh no, don't worry about that mate, because if the government prints a deficit produces a deficit, it's gotta fund it. Aha. So that's a trick because if we go back to that three sector model of the economy, or if the government's printing a deficit, how are they gonna do it?

Julian (10m 26s):
Or they need to either tax us or sell bonds to us. So therefore it's all a bit of a, a zero sum game or a constant sum game. But that ignores what we'd now call sort of an unconventional monetary policy. Right. So the setting of interest rates by virtue of the buying of bonds at the central bank, that that allowed this enormous fiscal stimulus with no, well, in the very short term no sort of cost Yeah. To the other teams, no consequences. That's right. That's right. That's what it feels like in the immediate term. And now

Phil (11m 6s):
The sugar hit

Julian (11m 8s):
An enormous sugar hit's a good way of characterizing it. And now you, and now you get to the hangover of that sugar hit, you know, that, you know, the, the, the, the, the kids ate a whole lot of kid catt and, and, and red cordial at 12 o'clock and now it's three 30 in the afternoon, things aren't gonna go that well. Right. So that's what happened in 2022. Yeah.

Phil (11m 27s):
Well that's great because that kind of segues into what I wanted to talk about in the bond market. Yep. Because I don't think many investors really understand the it's fixed income. Is that what it generally is called? The fixed income market. Yep. And there's corporate bonds and there's government bonds. Yep. That's basically it. Yep. But it's huge, isn't it? Massive. Yeah. Much, much bigger than

Julian (11m 48s):
Multiples of

Phil (11m 48s):
The bo stock market markets around the world. Yeah. Yeah. So can you just give a bit of an overview, your

Julian (11m 55s):

Phil (11m 56s):
Can potted summary of it.

Julian (11m 57s):
Sure can. And there's two different bits. Well, as you, as you specified. So there's a corporate bond market and you are taking a credit risk with the issuer in a, in, in, in addition to the interest rate risk of, of what that instrument will pay you.

Phil (12m 11s):
Can I just interrupt you just for a second because Yeah. Another guest said to me, and it was a great summary, you can either own it or loan it, it, it's, so two ways of investing. That's it. That's great. Just do break

Julian (12m 22s):
It down. That's a hundred percent right. I was actually thinking that as you were, as you were as you were talking. Not in that lovely episode.

Phil (12m 28s):
Poetic. Poetic,

Julian (12m 29s):
Exactly. Not in that poetic way, but that's right. You can, you can either provide equity or you can provide debt and, and anything else like a hybrid, an option, a derivative or whatever, it's a form of one of those two things. Or even sometimes a bit of a combination of both, you know, in the form of a hybrid, so, or a convertible or whatever. Right? They're, they're combinations of debt or equity. So you can own it all, loan it. So if we are in fixed interest world or bond market world, we're only dealing with loaning. So we don't own anything. They're by and large nominal assets. So they're priced in dollars that can lose value in the presence of inflation.

Julian (13m 12s):
And most bonds will be fixed coupon. Right? So I bought a whatever, 8% yielding corporate bond.

Phil (13m 20s):
We, we, well we hear about the 10 year bonds say just as simply 10 year Australian bond. And in 10 years time, if you hold it for that length, length of time, you'll get that return.

Julian (13m 29s):
That's It.

Phil (13m 29s):
But in the meantime, it goes up and down in value

Julian (13m 31s):
Wobbles, up and down. And those wobbling up and downs, they, they influence the value of that instrument day by day by day. So, so the price is set with regard to the interest rate and simply put, it's worth Remi remembering, if you buy a bond that yields five and then interest rates go up for the dollar you spent buying that bond at pager five, the next day, if it goes to 10%, you can buy a 10% yielding thing. So the thing that you own that's yielding year five is worthless. Hmm. It's not worthless. It's worth less. Right. So, and then the credit risk part of that is, well I, and I hope they pay me back.

Julian (14m 19s):
So, so there's the interest rate risk, which is what I mean by the change in rates determining what, what I should pay for the bond today. And we measure that via a thing called duration. And then on top of that, there's this other thing, credit risk. Now that's all corporate bonds, that's all companies borrowing money from you. Right? So if it's BHP , they're probably gonna pay you back if it's, I shouldn't use any names of companies, but if it's, you know, spy.com or something Yeah, yeah. It might not. And, and so that's, there's an overlay of credit risk on, on, on top of that interest rate risk. And then we get to government, they by and large don't default in their own currency.

Julian (15m 0s):
If they do, they're trying pretty hard to do it. But then you might be taking some currency risk as well, which is, you know, a bit of an overlay. But if you are, if you are buying a US treasury or you're buying an Australian government bond, you're taking absolutely minuscule credit risk, you know, to the extent that we call it a, a risk-free rate. Yep. You know, somewhere out the curve depends on how you think about the world, but you know, it's either gonna be a 10 year or the five year or something, which is the, the price that sets all other prices. Right. Because if it's risk free and I can get that return. So if it's a, if it's a US 10 year and I'm getting, you know, wherever we are today, three 50 or whatever it was, you know, last night, 3.5%, why would I pay someone much more for anything that that yields less than that?

Julian (15m 54s):
Cause I don't have to take any risk. I, you know, those blokes gonna pay me in dollars. So I sort of know that's there. Yeah. So that, that sits at the heart of how we price all assets. And so when rates go up, then you get this repricing effect of all other assets. And, and some of that's just very simple. You know, am I gonna pay as much for a house now that my interest rate to borrow against that house has gone up? No, I can't, my alternative use of capital has changed. You know, in that example of having a 5% yielding bond versus a 10% yielding bond the next time that,

Phil (16m 28s):
That's interesting you say though, alternative use of capital Yeah. Because your capital can go into anywhere an equity market Yeah. You know, REITs all sorts of instrument instruments Yeah. But your decision is affected by that risk free rate. Yeah.

Julian (16m 43s):
It's all that relative pricing. Yeah. Yeah. And, and so where in this, I think we think quite protracted period of really the repricing of risk because we had a decade of those zero interest rate and indeed negative interest rate policies or outcomes. And that was massively distortionary and is now coming back outta the system. And, and so what I, what I would ask people to remember if they're about my age or up is when you remember or hear about someone talking about their sort of 17 or 18% mortgage in the late eighties, inflation is higher now than it was then.

Julian (17m 28s):
Right? So that is just giving you a little sense of how incredibly distorted the world has become for a whole bunch of reasons. And maybe I shouldn't get too distracted, but I'll just, I would summarize that distortion as saying no one really wanted to take the pain of an adjustment after the financial crisis and indeed going all the way really back to the early two thousands under Greenspan and that that induced this sort of molly coddling effect by central banks, the and the, and the

Phil (18m 5s):
Molly co coddling markets. Well

Julian (18m 7s):
Gen wanting to Yeah. You know, avoid any sort of adverse outcomes. So, so bankruptcies and reconstructions and, you know, things get hard. This is, these are cyclical systems

Phil (18m 17s):
And interest rates cause those sort of

Julian (18m 19s):
Interest rates cause problems. Yeah. And the effect of that in this last period of, you know, not unconventional monetary policy was to set rates at zero and to flatten yield curves. And that's very problematic because money is created in the commercial banking system that that's where, I don't know, 99.99% of all money should be created

Phil (18m 49s):
Because that's when, when you get a mortgage from the, the bank That's right. They're just suddenly making up the money and giving it to

Julian (18m 54s):
You. You've summarized that perfectly because most people, if they've, you know, if they remember their silly old economics professor, professors will think, no, no, no, no, that's not right because it's a fractional reserve system. And so the bank has a reserve and so they take some of the, you know, they take their deposits and they lend again, that's all bunkum. It's not true. It's not true Legally what happens is, you know, as a sort of step by step process, when my loan is approved, a deposit is created. Hmm. That is legally what happens. That is functionally what happens. Yeah. And, and then I go and spend it.

Julian (19m 36s):
Right. And, and then I'm on the hook for it. It's not free, but then I'm on on the hook for it. So money creation happens in the, in the, and there is a, there is a, a view to deposits or, or reserves, which is we, you know, there, there's periodic testing and, and I, I don't understand the Australian banking system as well as I understand the US one, but you know, there, there is a, a weekly observation of, of reserving in the banking system. And reserves only matter when they're in short supply cuz that forces rates up. So when, when we're talking about the interest rate that the federal reserves, the central bank of the states sets, that's the inter, that's the fed funds rate and it's in a 25, I was gonna say 0.25% band.

Julian (20m 23s):
And the central bank maintains that band and within that band banks exchange reserves. So just think about, I'm Citigroup and your Wells Fargo, someone, all my mortgages come in and they, they pay back a mortgage, their mortgage, now I've got too much money. But you are in the re reverse situation that week. Everyone's rushed into your, your branches and they've taken out mortgages, you don't have enough capital. But we can just resolve that by me lending you some. And I do that within the fed funds market, at the fed funds rate. That is what the interest rate that's being set by the central bank is it, is that rate,

Phil (21m 4s):
So they're the gear wheels that are intertwined with each other. That's right. And turning and affecting Each other.

Julian (21m 9s):
That's right. That's right. And that gets really important because if there's plenty of reserves in the system that rate just ticks along and we all know what will lend to each other out and blah blah blah. And that's, that, that's an overnight rate in inverted commas, it's not really an overnight rate, it's a second by second rate. You know, we are, we're constantly doing this intertwining of our balance sheets in the banking system and then all other rates are sort of set off the back of that. Right. So if I go out further in time, I want more rate usually. And, and, and if I am taking more risk, then I want more rate as well. So, so everything else should slope upwards from that sort of t equal zero rate, the, the fed funds rate or what we'd call a cash rate.

Julian (21m 53s):
So when you adjust rates up, it, it, it has the effect of in effect taking liquidity out of the system. Those terms are sort of banded around liquidity, blah, blah, blah. But

Phil (22m 9s):
So that whole money sloshing around the system is reduced

Julian (22m 13s):
In effect.

Phil (22m 14s):
Yeah. Yeah. In effect. And the tide goes out

Julian (22m 16s):
And the tide goes out. But it is more nuanced than that. Yeah. Because people must remember, you know, what the world was like in 2005 or six with much higher interest rates. Yeah. Liquidity was everywhere. Yeah.

Phil (22m 27s):
Yeah, that's right. You know, I had, and they was 6%

Julian (22m 28s):
I I got sick of people jamming letters from the bank through my letter box offering me another credit card offering me, you know Right. With a much higher rate. So it's not just the rate, it is actually the animal spirits with which we're all operating. So, so it it is, it is, it's never one thing. But the, but the rate is pretty important

Phil (22m 49s):
In the expression in your face, which listeners can't see at the moment. But you referred to the, and I'm thinking you are starting to talk about the yield curve here. Exactly. And the, the direction of the yield curve. We've heard about the inversion of the yield curve. Yep. And this is a really hard question for people to understand. Can you try and explain it simply what's going on, what it means to equity markets?

Julian (23m 10s):
And I think it is really simple. I think it is really simple. If I lend you money today, I'm pretty happy if you just pay it back. But if I lend you money in a year's time, and especially if it's a lot of money, I want to, I wanna rate that compensates me for that. And that's, that is, that's the yield curve

Phil (23m 30s):
You take. So the longer, the longer you go for you, the

Julian (23m 32s):
Longer you go, the more you should ask for, right? Yeah. Yeah. Like, like it's an opportunity cost for you. And there's a bit of risk in there around credit as well. So at t equals zero at, at today, the rate should be lower than in a year's time and five years' time and 10 years' time. And that should be, you know, relatively monotonically sloping. So one directional Yeah. At, at a pretty constant slope in a sort of in inverted commas a normal environment. Yeah. So what happens when the yield curve invert for some reason, we can go and get a rate as a bond buyer that's lower five years or 10 years out than for example, at the two year.

Julian (24m 20s):
So they're very, so

Phil (24m 21s):
That's an inverted yield curve. It's going in the direction. It's an unusual direction,

Julian (24m 25s):
An unusual direction. So, so what's happening there is the, in investors are demanding a higher rate at the two year mark than at the 10 year mark. And all the 10 year is, is the average of 10 years Right. Or or however many periods you wanna divide that up into. Yeah. And so what it's saying to you is that interest rates will be higher for the front part of that period of time than at the back part of that period of time. And that i i is used as both a predictor of recession, but I think more importantly it helps to force recession to occur.

Julian (25m 8s):
And so this is where I think there's a bit of confusion about this, the academic papers around this stuff, I think the best relationship is between the three month and the 10 year. But people look at two year and 10 year tenors and, and, and use that as predictor of recession, but it's doing something mechanical as well because remember money creation occurs in the banking system

Phil (25m 32s):
And these are these wheels moving

Julian (25m 33s):
Around. Yeah. These wheels moving around

Phil (25m 35s):
Or cogs moving around effective

Julian (25m 36s):
I That's right. And if I'm a banker, I am looking to borrow short and lend long, but if I'm borrowing short at a high rate and lending low at a longer rate at a longer tenor, I'm not no huge hurry.

Phil (25m 52s):
Am I? There's no reason to, there's no reason to, to lend money is there?

Julian (25m 55s):
No. Yeah. So that helps force recession onto the system. So it's, it's the combination of both of those things and it's sort of used as some sort of magical augury or something, right? Like Oh wow. You know, it's predicting something, it's actually forcing it to happen. Mm. Okay. So it's not, it's not just predictive. Yeah. It's helping force it to happen. And that is observable right now. So you, you have had very rapid credit growth. Well it for modern times, very rapid credit growth in the states, which looks like it will slow, is how I'd premise that largely because we get survey data from the Federal Reserve. So we get a senior loan officer survey and the, and so senior loan officers are saying they are tightening lending standards right now or actually in the last quarter, but also the money supply is shrinking.

Julian (26m 45s):
So, so if there's less and the money supply's a pretty problematic thing because there's not really a quantity of money. So when I say that, think about us at a dinner table and if we all sit down with a hundred bucks in our pocket and there's 10 of us, there's a thousand bucks. Right? Well, but is it because what happens if we all lend each other 50 bucks? Is there more money or less money? And then we keep doing that in circles. Is there more money or less money? Well, it's bloody confusing because it's the same amount of money, but now there's all this credit on top of the same amount of money. So it's the circulation of money as well as the quantity of it, which makes the, which makes it very difficult to measure. But, so we do have measures of it, of the quantity of money and, and the one that everyone tends to look at is M two, which is cash and cash, like, you know, cash and near cash instruments.

Julian (27m 35s):
And that is shrinking in the United States today, year on year for about the only time in history. It's un incredibly unusual for the money supply to be shrinking. Very, very unusual. And the three month rolling and four month rolling and six month rolling, year on year change is, is, sorry, period on period change is off the charts unusual. Why? Because we got so much of it, right? Like we got 20% of GDP injected into the economy over two years by the government funded by the central bank as we discussed before.

Julian (28m 16s):
And all that's happening is that's coming back out. So,

Phil (28m 20s):
So it's just a natural reaction to the excesses of the past and the the consequences,

Julian (28m 25s):
It's a reaction to it, but I dunno if it's natural, it, it just is a reaction to it. And central banks have been absolutely shocked by the boom in inflation because we all told ourselves stories about inflation that it wouldn't Oh no, it can't happen.

Phil (28m 40s):
But isn't that just a basic thing when you put more money into a totally an economy, it's gonna overheat it a hundred percent. It's just happened so many times in history.

Julian (28m 47s):
A hundred percent. There

Phil (28m 53s):
Was some, we're talking about the Federal Reserve, who I supposed or you know, or the RBA here. Yep.

Julian (28m 59s):
There was,

Phil (28m 59s):
There was, it's supposed to be, have expertise in this area.

Julian (29m 1s):
Yeah. I look, I have a bit of sympathy for them. I have a bit of sympathy for them and I, and I was, we are, we were kind of inflationist, but even we were saying, you know, like careful, we don't know because the institutional framework in which this stuff is all happening has a massive bearing on it. And what do I mean, wealth inkequality, it's probably pretty important for understanding inflation and inflationary dynamics.

Phil (29m 24s):
It's a huge, I mean I didn't wanna bring it up, but it just seems to be that when asset prices exactly rise, the people who are rich already are just gonna get richer.

Julian (29m 32s):
Exactly. And it has no real world consumer price inflation rate impact at all. No. So that's 0.1. Point two, you've had this very unusual fall in the labor market participation rate in the United States. And if you go back about 18 months, that's what the Federal Reserve guys were saying,

Phil (29m 52s):
People who just don't wanna work.

Julian (29m 53s):
Well it's a whole bunch of things living in the basement. Do you know what the difference is between them and us? Mm. And it's not just them, it's, it's the United States on one side with a participation rate of about 61 and then us, New Zealand, Canada, Germany, a whole bunch of other sort of low population growth places with very, very high levels of income and wealth. So, so not that different. We have 65 to 68 70 in Germany. So what the hell is the difference? Why is five or 6% of the population in one place not working? And it is in the other place? And I hate to tell you, I think the difference is incarceration rate and opioid abuse.

Julian (30m 37s):
That's the difference.

Phil (30m 38s):
Wow. Yeah, because they are huge problems in the states.

Julian (30m 41s):
It's huge problems and it's difficult to, for people to get their head around it. We don't know what the mortality rate is controlled, you know, double blind studies of mortality among opioid users are incredibly low. But that would be an clinical environment and sort of population level studies of drug users like heroin or whatever it, it's

Phil (31m 5s):
Oh even and but fentanyl now, which is incredibly toxic.

Julian (31m 8s):
Incredibly, incredibly dangerous stuff.

Phil (31m 10s):
Yeah. People are taking it in unsupervised dosages.

Julian (31m 13s):
Yeah. Yeah. So, so we don't know what the mortality rate is. My guess is it would be very low single digit percentage otherwise, well, it's not observable in the data to see a higher

Phil (31m 28s):
Percent, but there will be a number of some

Julian (31m 30s):
Sort. So, so if it's, if it's 1%, it's 10 million people off their scone on opioids, right? So if it's 1% dying with a hundred thousand people dying per year, there's 10 million. We also know that there's a roundabout 250 million prescriptions for, for opioids written every year in the states. So that's roughly one prescription for every adult in the country. That's a pretty good rate. So there's a lot of people and obviously that's gonna be very unevenly distributed. So, so What's the point about that in terms of monetary policy? I have some sympathy for the Federal Reserve folks who were saying 18 months ago.

Julian (32m 12s):
Well, I mean, we are not seeing inflation, we're not seeing wage growth and we, we, the inflation that we might be seeing might just be a blip and it might go away and it might draw more people back into the labor market, point1. Point 2, Well there's no unions anymore mate, so no one's got any labor bargaining power, so therefore wages won't go up. Well everyone just quit. That's what happened. So the, the, you know, the job levers to unemployed, so the ratio of people who are quitting jobs, ratio of people unemployed, the ratio of people who are ratio of jobs open to the ratio of, to, to the number of people unemployed are just off the charts high.

Julian (32m 57s):
And so finally, finally, once labor markets got tight enough, you entered like a different sort of regime that said we're only just now starting to compare to the high rates of labor of wage inflation of last year. Mm. So the rate of change is probably likely to go down at the margin would be my guess because, and so, so if we wanna check this stuff, I can go and check the Atlanta Fed wage tracker. That's really, that's really useful. It's a proper measure of what's going on in the labor market as opposed to average hour earnings, which is really bumpy. And that's, that's pretty simple because I mean, if someone retires and they're a neurosurgeon and they earn a million bucks a year and someone enters the labor market and they're a barista and they earn 50 grand or did wages go down?

Julian (33m 50s):
I mean, sort of but not really like the wages per sort of unit of work done. Yeah, like type, yeah, yeah. Like you need to sort of think pretty hard about how to measure those things. And that's what that Atlanta Fed wage tracker does. So that, that is, looks pretty stubbornly set at about 6.3, 6.4% year on year, which is the highest in the series by miles going back to 1983. So it's in wages now. The rate of change of the wages might come down because, because if wages were 103 years ago, then they went to 110 over the last couple years, maybe they won't go to 120, maybe, maybe they'll slow down a bit cuz the rate of change was so fast.

Julian (34m 34s):
But I th it, my gut feel is that wages will be very, very stubbornly high. And that is what is being observed.

Phil (34m 44s):
And in our previous discussions, you've mentioned that these high wages always precede a recession, correct? Yeah. And high employment precedes a recession, correct?

Julian (34m 53s):
Yeah. That's the cycle.

Phil (34m 54s):
That is, that is, there's no getting around it is there? Nope.

Julian (34m 57s):
Yeah. Nope. Well, there hasn't been here. The two, so average ALI earnings have never gone from over five to under three without a 10% unemployment rate. So it's a, there's only a couple of observations of that in 60 years or 70 years. So it's, you know, it's not a scientific example and what Jerome Powell, who's, you know, the head honcho at the Federal Reserve is saying is, well, I don't know, maybe we just need to lower the amount of jobs being offered, but I don't know how the hell you do that. That's, that's really threading a needle

Phil (35m 30s):
And especially if you've got that under participation rate as well. Yeah, exactly. Keeping a, a lid on things as well.

Julian (35m 35s):
Yeah, precisely. There's, there's a few funny things going on around that. There's probably a bit of labor hoarding. So if you are running a factory and you're finding it difficult to employ people and you've found it really hard over like five years and it's got harder and harder and harder to employ people and now you've got your team fully set, you don't wanna fire anyone, you look after them, don't, you're afraid of losing, losing them. Yeah. Right. So there is a bit of labor hoarding going on and, and, and that is probably skewing the unemployment rate lower. So, and, and migration has been really lousy as well. And so the flexibility of labor systems all over the world has been impaired by just covid.

Julian (36m 16s):
Right? Yeah, yeah. You know, you know, we can't get fruit pickers, you know, my, my cousins run a farm over in WA and one of my cousins does fly and fly out cans to basically Geraldton wa so that's a pretty long trip, mate. But they can't get anyone else. So that's going on all over the world. Yeah. So less flexibility, blah, blah. And those things are always self-correcting, but the mechanism of correction is usually pretty painful. And so that then gets back to corporate earnings because what we're talking about is a, you know, and the Fed is saying this, we have a role in moderating demand. That's what they're saying. That's direct quote.

Julian (36m 56s):
And that means somehow inducing people to do less stuff. And about the only way they can do that is via the wealth effect. So driving up interest rates, which then resets the prices of everything, which you talked about before. Yeah, yeah. And that's why they're doing quantitative tightening, which is, you know, rather than buying bonds, so swapping a bond for cash, they're taking the cash and putting the bond back out. So it's taking cash back outta the system in very rough terms. So there's a wealth effect thing. And so we've seen that through 2022. But there's also, so

Phil (37m 35s):
It's a little bit like the pump in your blowup mattress, you know, hundred percent put, put some in then take some out. A

Julian (37m 39s):
Hundred percent. A hundred percent. Like it's mechanically like that. So remember we tried that for 10 years. Mm. Didn't really do anything in the real economy, you know, we had pretty stubbornly low rates of economic growth. In fact, it was the longest slowest economic expansion of the post-war period and I think actually in the history of the Republic of the United States. And then you got this big whooshing effect at the end. And then, so there's two effects, wealth effect, which I talked about all the way on the way up doing quantitative easing. They talked about the wealth effect and now this moderating demand thing, it is parking people on the sideline of the labor market.

Julian (38m 19s):
It's, it, it's inducing less hiring and or people getting fired, sadly. That's just the way that

Phil (38m 28s):
Works. So the inequality happened when asset prices were being, were ballooning through the, the that period and then the people, people that are gonna have to pay for it, are they less equal?

Julian (38m 38s):
It's nuanced, Phil, because contrary to the mythology of the seventies, the seventies was a really dynamic period for everyday people. It

Phil (38m 49s):
Wasn't. So people, people don't, who might remember or not old enough to remember the seventies was a period of stubbornly high inflation, wasn't

Julian (38m 56s):
Stubbornly high inflation. And it gets

Phil (38m 57s):
And an oil crisis

Julian (38m 58s):
And an oil crisis. And it was a very difficult period and a very dislocated period in some ways very similar to some of the institutional framework type stuff that's happening right now. Yeah. So there was a monetary system and it ended Yep. There was an energy supply system and it ended. Right. So, so the monetary system was, we went off, you know, Nixon shot the Bretton Woods system, which fixed the exchange rates of currencies globally

Phil (39m 31s):
In which we didn't do until the eighties here in Australia.

Julian (39m 34s):
That's right. It took us into 86. Right. But, but we did, because we kept on ratcheting. Oh, okay. Right. Exchange rates different. So, so we went from, I mean, we were a buck 10 or something right. In the Britain woods period. And we went to, you know, sort of whatever it was, seventies or eighties. And then, and then we, and then we, you know, liberalized, I'm getting those numbers wrong, but yeah, people can check them. But, but yeah, so what we'd all sit around and have these currency boards or whatever, and then finally everyone just gave up and said, oh, stuff it, we'll just let 'em all trade with each other. And that happened through the seventies. So it was very disruptive. We had an energy supply system with the United States being the supplier of oil to the rest of the world and or controlling oil supply in the parts that it needed to.

Julian (40m 16s):
That's why there is a Saudi Arabia, right. Because this the, you know, the,

Phil (40m 21s):
That's much oil

Julian (40m 22s):
Or the, the Saud family, right. Like, you know, that country's named after a family, right? That's right. Yeah. And that family with the blokes who said, you know, we'll do a little deal here. Right? And, and you know, part of that was I oil well that all broke down because, you know, the, you know, what was it, six day war, Yom Kippur war, you know, there's a whole bunch of pretty uncomfortable stuff that happened in the Middle East. And the Arab well got jack of it and said, well, we're gonna, and literally said we're gonna use the oil sword. So, so that system of energy provision ended. Mm. The United States went from being an energy exporter to an energy importer and the places it was importing from became much less amenable, at least on face value to, to doing that cheaply and easily.

Julian (41m 12s):
So all those things happen and that's sort of all happening now. I would suggest we want to transition away from fossil fuels is very difficult. Yep. So we, we are,

Phil (41m 21s):
The price of energy is

Julian (41m 23s):
Good. Yeah. We are in effect getting our own energy system provision of, of energy now. And there is in enormous strains around this post Breton woods dollar based systemic exchange rates as well. And and that's problematic. Crypto is a part of that. You know, there are these sort of manifestations of this stuff cropping up all over the place. So difficult environment, but do you know what, these economies created heaps of jobs and they grew very fast through the seventies, but in a very, very volatile fashion. Right. So the average rate of growth real in the states was just under three and a half percent through the seventies.

Julian (42m 7s):
But you basically grew at five real or zero and it just lurched around all over the place. And it was in the presence of, of, of this inflation. So what I want to impress upon people is we have had a sort of one way street in terms of asset prices for a long time, which

Phil (42m 30s):
Is stock market prices as a big part of it.

Julian (42m 32s):
Yeah. And property.

Phil (42m 33s):
And property, right?

Julian (42m 34s):
Yeah. So all that's happened I think is we've had a a, a resetting lower of, of interest rates and a resetting higher correspondingly of borrowing capacity. And we've made it pretty expensive and difficult to build houses as well, which doesn't help. Which is, you know, is a guy at Bennelong, I'm forgetting his name is excellent. Chris Benfield, you should look at, everyone should look at his stuff is excellent. He makes the point. We do make it very difficult and expensive to build houses as well. So it's a combination of all those things, but yeah, whatever we can borrow a lot more that goes into the price of houses, at least Parley. And look back to that earlier point, interest rates incredibly low for the observed inflation in the system that and

Phil (43m 21s):
Historically as well. Absolutely. Historically. And we're talking about, you know, what is it, 3% or something?

Julian (43m 26s):
Yeah, totally. Totally. Right. So one just needs to be pretty cautious about wanting to take on a whole lot of risk around that because going back all the way back down to the point around yield curves, the cost of money's too ha has been historically too low. It is adjusting higher. That process is difficult and volatile right now. Markets have become pretty fascinated with well inflation and interest rates. And so right now, today, early January, I mean markets have responded very, very well to the start of the new year and have been pretty, they've been very chirpy actually really for most of the,

Phil (44m 13s):
On any sniff of the ideas. That's right. Interest rates are not gonna go up as fast as That's right.

Julian (44m 18s):
That's awesome. That's awesome. So I I'm very cautious about that. We are very cautious about that whilst acknowledging that that markets are big and smart. So maybe the market's right and all we have to worry about is inflation, but we would suggest that the next leg of this process is corporate margins will adjust much, much lower,

Phil (44m 38s):
Which means that the return on listed investments is gonna be down lower.

Julian (44m 43s):
Yeah, yeah. That's right. And so multiples have come down a bit

Phil (44m 47s):
Like the PE ratios,

Julian (44m 48s):
The PE ratios have come down a bit. Yeah. But have they, we're not sure they have, because the earnings probably need to get reset much, much lower. And, and, and let me just put it in sort of concrete terms. I mean businesses that we look at every day in trucking, or we're looking at one at the moment that sells pool equipment, right? These businesses, they're, the earnings doubled in two years and now people are pricing them on the earnings that doubled in two years

Phil (45m 16s):
Because they're looking backwards at the earnings

Julian (45m 18s):
And they're thinking, well that looks pretty cheap. Yeah. I mean that's pretty cheap. And, and, and people's estimates for next year are up in every major market in the world. I think that's farcical because the, the bit that we haven't touched on much and I, I'm, I'm testing yours and your enlisters patients, so I'll do this quite quickly,

Phil (45m 37s):
But No, it's okay. We've been going for 15 minutes, but it's the first one of the year, so let's just keep track.

Julian (45m 41s):
Yeah. Well I don't want to crap on too long. But the other part of this is going back to that point around we had zero interest rates for 10 years, didn't do stuff all and then what happened? We got fiscal, so government spent money, that won't happen again to the same extent. And, and in the United States it will not happen again. Yeah. So people must not think that this parliamentary wrangling stuff that's going on in Congress is random. It's not. That's an agenda being expressed. It's exactly the same thing that's happened in 2010. So that was the tea party revolution. This does, this one doesn't have a name, but it's the same thing.

Julian (46m 22s):
Yeah. So

Phil (46m 24s):
An enforced kind of fiscal rectitude.

Julian (46m 27s):
That's right. Yeah. That's right. And, and so from 2010 through to the Trump tax cuts that were announced in 2016, implemented in 17, as I recall could be wrong. The US deficit shrank by seven percentage gdp. And that's, that's roughly what that economy grew by. Less than as a result.

Phil (46m 45s):
It's fascinating to me that you're sitting around with your colleagues at Platinum and these are the kind of discussions that you are having and

Julian (46m 52s):
Yeah, I mean these

Phil (46m 53s):
Are the kind, because you, you really want to have a look at what's going, you, you're trying to work out what's going to happen to markets in the future. Yeah. And they're gonna affect the investments that you're making. Yeah. Which companies you're going to buy and which ones you're going to avoid.

Julian (47m 7s):
Yeah. By and large, we have a bit of a look, we have a morning meeting every day and then there's couple of other meetings a week. But really all you're doing is sitting around reading and, and then dropping numbers into spreadsheets and just

Phil (47m 21s):
Having and seeing what comes out. Just

Julian (47m 22s):
Having room play around with it. Yeah, yeah, yeah, yeah.

Phil (47m 25s):
But like platinum, a lot of people's money via their super would be invested in Platinum and other Yeah. Fund managers like yourself.

Julian (47m 35s):
Yeah. And we're beginning to justify the faith. Cause we, we've stretched the friendship for a while there. So the exercise that we are really engaged in is a balancing of risks. So it's, it everyone can see what something earned last year. Yeah. And you just have to work out what you wanna pay for it. And we, we can get a bit sanctimonious about not wanting to pay too much and that's cost us returns in the last, you know, in the last part of this last cycle, which is what I meant by my comment, now there's a bit of a reckoning happening there. And so folks like us who are just a bit more, you know, valuey rather than growthy, we tend to do a little bit better in that environment so we don't lose as much and we might even, you know, post some positive numbers while, you know, markets in general or other folks go the other way.

Julian (48m 25s):
And that's sort of what's happening at the moment. I just add one other thing to that as well, which is a pretty big sort of thing is, the other other thing that's happening is China's beginning to go, okay, we would just suggest that there's probably a long slow, but a definite reopening trade there probably been pretty well expressed pretty quickly. So, you know, I'm not suggesting people get too carried away with it, but it will be very gradual. And the Chinese are obsessed with, with avoiding inflation. So, so they observed what happened in the west, they don't want any of that, but they are getting to a post covid or I don't know if it is post covid, but we all just get used to it, whatever it's that they're in.

Julian (49m 15s):
Yeah. And that was always gonna happen. Yep. That was always gonna happen. And that puts a bit of a beard underneath. I mean a hop, I mean, you know, basically all of Europe, I mean has sort of, you've had this, so China's sort of reopening, they're a huge trade partner of, you know, a whole bunch of the Europeans, which has helped. It's been, it's, I think it's observable in the Aussie dollar, which has been pretty chirpy since about, you know, October iron, all prices or coal prices, copper prices, blah blah blah. Right. So that, and that's sort of bubbling away as well. I wouldn't suggest it'll be anything like a boom, it'll just, it'll just be boring.

Julian (49m 55s):
Right. And PE people just need not

Phil (49m 58s):
Too hot, not too cold. Well

Julian (49m 59s):
Goldlock it might be too cold, it might be a bit boring for everybody. It might be a bit bit lazy and slovenly, but that's, that's fine. You know, that's fine. And so I would suggest to people that China looks a little bit like Japan in the early two thousands. It's about the same length of time since that equity market made a peak. So Japan made its peak in 89. Yeah. China made its peak in 07. You know, we're a full 15 years on getting on for 16 years on that equity market's about half where it was back then in an economy that's 15 times the size. Yep. It's a pretty interesting start.

Julian (50m 40s):
And the nature of that economy has changed a lot. And we're just gonna have to get our heads around recognizing that this is a functional place. People looking for a, some crisis or collapse or whatever. People have been looking at that for 30 years. Right. Japan had a ripping great collapse, but 15 years later you could buy Don't tell me could you? We did. We we've, you know, we've made six times our money in Japan in 20 years and the place has got cheaper every year. Well how does that happen, Phil? Because the companies make money. Yep, yep.

Julian (51m 20s):
They make money and

Phil (51m 21s):
They're very conservative alone run conservatively runners. Totally. I believe. Yeah,

Julian (51m 24s):
Totally. So is there, they

Phil (51m 27s):
Don't take on debt in,

Julian (51m 28s):
In Japan, do they? Not anymore because that was what that 80sk boom was, was a debt bubble and then they'd learn that lesson, they won't do it anymore. And so, you know, that that's, that just broadens the return profile of markets globally. And we, because of the length and strength of the last cycle we are in, people feel like, you know, e every one of the top 10 companies in the world should be in the US and you know, everyone should own 'em and blah blah blah. That's just a cycle. That's just a cycle. You know, seven of the top 10 companies in the world in 89 we're in Japan. It's not natural that one place has more.

Julian (52m 9s):
Yep. They'll have a few. It's a, I'm not by any stretch denigrating the states, we have 25% of our money there. Right. So Right. It's just that of all places, people in Australia might wanna understand the world as being a lot bigger than 2% of world's economy here and 20% of the world's economy in the states. There's all this other stuff which we actually know a lot about. Yeah. Because we sell our stuff to China and then India's some function of that thereafter. And there's another billion and a half people, you know, in broader Asia after that. Yeah. You know, in big countries that grow pretty quick. So that's all good, that's all good stuff.

Julian (52m 50s):
You know, all your, your energy complex and iron ore and your, you know, your specialty metals and your clean energy and all that, it's gonna be, that's gonna be the next cycle, right? Yeah. And we've just got a tricky little period of adjustment around getting somebody cost of capital back into the economy and probably parking a few people on the sidelines in the, in the meantime to get to that point. So it's, none of this is the end of the world. It's just much more like the late, I was gonna say late eighties probably, you know, early eighties, mid seventies and sort of the nineties recession as well. We just haven't had one for a long time. Time. They're not that, they're not that much fun. Yeah. But they're just, it's not the end of the world. It's, you just got to don't be levered.

Julian (53m 33s):
Right. Just be cautious and don't pay too much for stuff because you do want to be cautious in this environment, but don't, you know, I don't lose don't lose your mind and don't expect the end and Right. And right now I think people will feel pretty chipper cuz markets are up a fair bit. I mean the Dax is up like nearly 30% of its lows that, you know, most European markets are within 10% at all time highs. Yeah. So, you know, now people will feel comfortable. We will go through cycles of them feeling very uncomfortable again. Exactly as I have through the course of 2022, possibly for another couple of years. That's all. And so just, you know, whatever, stay the course or trade it or do whatever you want, but understand the process you're in and and understand that we are likely going into a recession.

Julian (54m 23s):
It's likely pretty long and grinding. It's likely not great for asset prices, but again, it's not the end of the world.

Phil (54m 29s):
Julian, that's a great point to end on. Thanks very much for coming in and joining me

Julian (54m 33s):
Today. Ah, it was a pleasure to talk to you, Phil.

Phil (54m 34s):
Thank you. Happy 2023.

Julian (54m 36s):
Yeah, have a good one.

Phil (54m 37s):
If you found this podcast helpful, please tell a friend, especially if it's someone who needs to start thinking about investing for their future, you'll be helping them and helping me to keep this show on the road

4 (54m 47s):
Shares for beginners is for information and educational purposes only. It isn't financial advice and you shouldn't buy or sell any investments based on what you've heard here. Any opinion or commentary is the view of the speaker only not shares for beginners. This podcast doesn't replace professional advice regarding your personal financial needs, circumstances, or current situation.

Phil (55m 6s):
And thank you for listening to my podcast.

Shares for Beginners is for information and educational purposes only. It isn’t financial advice, and you shouldn’t buy or sell any investments based on what you’ve heard here. Any opinion or commentary is the view of the speaker only not Shares for Beginners. This podcast doesn’t replace professional advice regarding your personal financial needs, circumstances or current situation