WBD455 Audio Transcription
Is the US Equity Bullrun Over? With Lyn Alden
Interview date: Thursday 27th January
Note: the following is a transcription of my interview with Lyn Alden. I have reviewed the transcription but if you find any mistakes, please feel free to email me. You can listen to the original recording here.
In this interview, I talk to macroeconomist and investment strategist Lyn Alden. We discuss the signals pointing to the end of the equities supercycle, the risks of energy prices continuing to drive inflation, the IMF and El Salvador, central banks being at an impasse, and Bitcoin’s next play.
“The challenge that central banks face around the world is death by ice or fire; do you want things to unravel in a deflationary collapse, or do you want to keep stoking the fire of inflation… in history, the vast majority of fiat currency regimes die by fire, not by ice - when push comes to shove, they print.”
— Lyn Alden
Interview Transcription
Peter McCormack: Happy New Year to you, Lyn. I know it's the end of January, but Happy New Year.
Lyn Alden: You too, thanks for having me back.
Peter McCormack: Thank you for having you back? I would have you on every show if I could, it would just be you and me making 13 shows a month if we could prep it! But no, I'd always have you back, and it was nice to do one in person, hang out, get some dinner and to do in person. So, hopefully we'll get to do that again this year. I'm going to see you hopefully in Miami, is that right?
Lyn Alden: Hopefully, yeah. Hopefully we'll meet up a couple of times this year.
Peter McCormack: Yeah, fingers crossed. Right, fairly calm January really?
Lyn Alden: Well, I saw a data point that the S&P 500 had one of its biggest down moves at start of year in history, even though so far it's a pretty small move; but it's been so compressed to the very beginning of the year. And it's something where, to my research subscribers, I was talking about being more defensive as they look out to 2022, but of course I didn't foresee necessarily how front-loaded that would be, basically a lot of that unwind happened early on.
So, we've certainly had a lot of market turbulence, both in Bitcoin and in broader markets, especially US markets. I mean, emerging markets have held up better, but it's been a very kind of US-focused and risk assets, Bitcoin, altcoins, they're going down even more, so it's been this risk-off period.
Peter McCormack: So, let's talk about this article you wrote, The Capital Sponge, and I'm going to say what I say all the time, which you tell me not to, is that people should go to your website and they should read it, and they should also sign up to your newsletter, because it's scandalously cheap to sign up to. But yeah, The Capital Sponge, where you were warning basically that the US equity market is a bit too big and we could be looking at a reversal. What was the background to this?
Lyn Alden: Well, the background for this is it kind of relates to what we discussed before, about the petrodollar system, that's the core of the engine but there are other moving parts as well. Essentially what is the case is that each market focuses on their priorities, and the US is focused on making its equity market attractive at the cost of other things. So, we weakened the power of our labour so that was beneficial to corporate profit margins, really emphasising the offshoring more than other developed countries did; and by having the petrodollar system mean that we run these structural trade deficits with the rest of the world, they get all these dollars in order to buy energy.
What they do with a lot of their surplus dollars, they put them back into US markets, so we run a trade deficit, but a capital count surplus where that capital flows back into our markets. Historically, a lot of it went into treasury markets, but those have become less attractive over time, and fewer entities are out there buying large amounts of treasuries. Instead, we've seen a lot of these foreign sovereign wealth funds, foreign pension funds, foreign central banks actually go ahead and buy US equities. It's a lot of capital just pours into US equity markets and bids them up to very, very high valuations.
That can sound like a good thing. I mean, it can sound like a good thing to have foreign markets like your equity market that want to buy it. But another way to describe that is that we are running these trade deficits, so we are buying depreciating consumer goods from China and elsewhere and in exchange, we're selling out appreciating assets, things like our stocks, our companies, our land to the foreign market, because they're getting all these dollars from that trade deficit. So, it's really been a problem for US labour, and it's been a problem for parts of the United States; but it's been very strong for the equity market.
The concern there is that if you map out the history of global capital flows, right now, there's a lot of capital really stuffed into US markets and we've not really seen this level of concentration since roughly the dotcom bubble; there's just so much global capital. So, Americans are underweight foreign assets compared to their history, so Americans are very focused on US markets. They've the highest ever allocation to US equities as a percentage of their assets than they've ever had. At the same time, foreign markets are very overweight US assets, especially US equities.
So, we have somewhat dangerous conditions, in my view, in terms of valuations, especially as we see the Fed talk about pulling back on stimulus, and as we see fiscal stimulus getting gridlocked and pulling back as well. So, I think there's a lot of risks, at least for -- we've seen US capital markets go straight up over the past 18 months, and I think that is somewhat behind us now.
Peter McCormack: And for me to understand, has this kind of pushed and been good for white-collar workers, but at the cost of blue-collar workers?
Lyn Alden: Exactly, and especially the upper echelon of white-collar workers. So basically, the way I would describe it is, let's say we had a global currency, let's say it's the past and I'm pricing my products and services in grams of gold. So, I make machinery, you're over in another country, you're my competitor, you make a similar machinery and we price it in grams of gold.
So, if something happens, let's say there's a natural resource discovery in my country, it does not in any way impact the fact that I'm selling this machinery in grams of gold, there's no impact on my business. However, if we instead are selling our machinery in our currencies, including to a global market, and let's say there's a gigantic natural resource discovery in my country, so we start exporting a ton of oil, well that's going to basically improve our trade surplus, and it's probably going to strengthen our currency. So, my exports, my machines are now more expensive for most of the world to buy compared to your machines.
The problem is, because my employees are paid in that currency, my liabilities are denominated in that currency, it's harder for me to cut my prices in this currency to compete with you. And so, ironically, having a strong currency, at least not fundamentally, not as a universal account system, but in the specifically fiat currency system, having a stronger currency, especially if it's nothing I did, if this other oil discovery is a thing that's leading to this currency strength, that could really mess up my competitiveness.
The term is known as Dutch disease, the economists coined that term. Basically, that's what happened to The Netherlands decades ago. They had this gigantic natural gas discovery, and it's one of those things where the term is basically used for something where it sounds like a good thing, but it actually damages other industries, because their currencies become stronger and it reduces their competitiveness.
The United States basically did that with the petrodollar system. So, instead of discovering oil and gas around the 1970s, what we did was we "discovered" the treasury. So we basically made this artificial system where everybody in the world needs treasuries. If they want to buy oil from Saudi Arabia, we made a deal with Saudi Arabia and the rest of OPEC and said, "Only sell your oil in dollars, make it so that every country in the world that needs to import oil needs dollars". So, we basically created this artificial demand for dollars.
So, any business that wants to export something that has margins, really wants to make things, is less competitive if they're in America, unless they're just particularly good. I mean, it doesn't make it so you can't compete, but it just makes it harder to compete. And the businesses that do really well are the high margin, low capital-intensive, low labour-intensive businesses, so software, finance, healthcare, businesses that can offshore. Those keep doing well, but blue-collar workers really become uncompetitive.
Then also, the United States has the highest per capita healthcare cost in the world by far, despite the fact that we don't really have better outcomes, and that puts a lot of pressure on employers as well, because they're the ones generally paying for a large chunk of that healthcare, at least for the working-age population. So, for a variety of reasons, we structure policies in such a way that it's very conducive to our capital markets.
We've run these gigantic trade deficits, and all those dollars come back into our equity markets and prop up valuations, which is great for the top 10% of the population that owns 89% of equities, including me, but it's really bad for blue-collar workers that are trying to compete in this global market, let alone getting outcompeted by cheap emerging markets, they're getting outcompeted by other developed peers in Germany and Japan, in Switzerland and these other industrial areas, in a large part because of our currency system.
Peter McCormack: Wow, okay. So, you want a strong currency, but not too strong?
Lyn Alden: Well, that's the thing. Ever since the 1970s, we're in these ongoing currency wars. So, if a currency is too weak, the downside is the consumers have less purchasing power, and the country has trouble getting commodities. So, you don't want to have a spiralling, out of control, weak currency, that's obviously terrible.
On the other hand, if a currency gets too strong, because your liabilities and wages and your expenses are denominated in that currency, you can become less competitive compared to your global peers. So, there are a number of countries that at different times, purposely do currency manipulations to keep their currency down compared to the dollar, by basically printing more currency units, buying foreign reserve assets, which could include treasuries, it could include US stocks, it could include all sorts of things like that, and it suppresses their currency so that they can stay competitive and maintain their current account surpluses or trade surpluses at the US's expense.
Peter McCormack: A careful balancing act then. So, just thinking about the US stock market, Danny, my producer, was working at this, and he was explaining to me the size of the US stock market, which kind of blew me away. I had no idea, no one had ever put that into context for me. But he sent me this thing that said, "The US stock market capitalisation currently represents 61% of global stock market capitalisation". Can you make sense of that for me?
Lyn Alden: Yeah, so basically the United States is something like 23% of global GDP, so we're 4% or 5% of the population, 23% of global GDP and 61% of global equity valuation. So, partially it's because so much capital is stuffed in our equity markets that our stocks are quite expensive relative to foreign peers. And different markets have different assets that are overvalued.
For example, our real estate market is not excessive compared to many other markets in the world, so Canada, Australia, much of Europe, China. Many of those countries have more excessive housing valuations, that's where they put a lot of their domestic capital into their housing markets. Whereas in the United States, we obviously have cities that are expensive, but in aggregate, our housing valuations are not ridiculous compared to our peers, and instead it's our equity markets.
So, Americans have higher equity allocations, and the rest of the world puts a lot of their surplus dollars into our equity market. And so similar to around the year 2000, there's just so much capital shoved in the US. We saw a similar phenomenon back in the late 1980s in Japan. There was actually a brief time where the Japanese equity market capitalisation was larger than the US equity market capitalisation. That was during that massive late-1980s Japanese bubble. So, that was an example of so much capital pouring into something relative to the size of its economy.
We basically have a similar phenomenon today, except in some cases it's bigger, because the United States has a larger part of GDP, and so much capital has been extracted from the rest of the world and shoved into US equity market cap.
Peter McCormack: But surely, the equity should represent something in balance to the size of the businesses, dividends it offers; have all those traditional valuations for equities gone out the window?
Lyn Alden: Well, they go out the window temporarily. So, I guess the way I would describe it is, the valuation tells you almost nothing about what returns are going to be like over the next couple of years, but it generally informs you what returns are probably going to look like over a ten-year period.
So basically right now, US dividend yields are lower than most other foreign markets. The only time we had a similar dividend yield was the dotcom bubble. Also price-to-sales, price-to-book, price-to-earnings, cyclically adjusted price-to-earnings, market capitalisation as a percentage of GDP; all of those are elevated to very high levels, either the record highest they've ever been, or the second highest they've ever been. It's partially because we have higher corporate profit margins because of all these tax cuts that we've done for corporations, but also just because of high valuations.
For example, you take a company like Costco, they're a very big retailer, they've been very successful, they've grown a lot. But they also went from their stock trading at 25 times earnings a decade ago, to over 40 times earnings today. So, the stock price outperformed even the company itself. So it's just basically domestic and global investors are willing to pay very high multiples.
One way I would describe it is that, for lack of good money, we've monetised our large-cap equities. Basically, the whole world is dealing with these negative real rates, so their bonds and their cash are yielding below the prevailing inflation rate. So, a lot of people don't want to use money or use currency as a store of value; and instead, one of the things they use is large-cap US companies with smooth growth, and they just say, "You know what, I'm just going to pile everything into that. I'm going to buy index funds, I'm just going to shove as much money as I can into equities, because I'd rather store value there than in a bank account that yields 0.5% while inflation is 7%".
Peter McCormack: Okay, so that makes sense. But with the US equities that high, there must be some risk, some contagion risk for a significant drop?
Lyn Alden: Absolutely, that's my concern, is basically you could either have a significant drop, or even just go sideways for years. We had periods of time where equity markets just chop sideways, volatile pattern for years, because eventually you pull so much capital in, you have to ask, "Where's the marginal buyer?" If US households already have record high allocation to equities, who's going to be a further buyer of equities. If foreigners are already very overweight US markets, who's going to be that marginal buyer.
Now, it doesn't mean that this is the absolute top. You can always scrape the bottom of the barrel, find another pool of capital somewhere that's a little under-allocated and get even higher. Basically, for example, in 1998, if you're talking about how high valuations were, it's going to run even higher over the next two years until 2000. So, it's very hard to call a top.
But it's more like pointing out that conditions are getting quite risky, and basically for whatever reason the US equity market became less attractive to global investors, it could be just because valuations have become too heavy and they've run out of marginal buyers; it could be because we do crackdowns on our Big Tech companies, who want to, say, go after them for antitrust issues; it could be just all sorts of reasons like that. If capital starts flowing out of the US while we're also running a trade deficit, you could have a pretty sharp down movement in the dollar and a sharp down movement in US equities compared to the rest of the world.
Peter McCormack: Okay. Are we seeing that, because I've not been close to it enough, Lyn, but I did see the S&P got hit pretty hard in the last week? I've also noticed specific companies. I mean, Peloton had a complete and utter shit show, Robinhood's massively down from its launch, Netflix I've seen is down, is this across the board? I mean, I see those because they're stocks which are close to the tech sector which I'm in, but has that been across the board?
Lyn Alden: So mostly, yes, but we've seen rotations. So, for example, starting in February 2021, we saw a lot of the unprofitable hypergrowth stocks. They peaked as a basket and started to roll over for about 11 months now, while the broader indices kept grinding up. So, the mega caps kept doing well, while the hypergrowth stocks started to roll over.
What we saw since the beginning of this year is that some of those really big ones started to roll over as well and show weakness. And it's interesting, because value stocks held up better, so some of the less overvalued dividend-paying stocks, slower-growth companies, they did pretty well, and we actually saw emerging markets hold up a lot better in this down move than US stocks. So basically, we did see somewhat of a pull-out of capital.
So, this was in some cases an unusual market move, and it's somewhat similar to how it looked in the real early 2000s after the dotcom bubble started to unwind. And it's too early to say if that's going to be part of a bigger move, but it is, I think, a lot of macro people catch their attention when you see, for example, Brazilian stocks go up on a day where the S&P 500 has a massive down move. That's an unusual risk pattern that is noteworthy.
Peter McCormack: Did you pull any of yours out? Did you put money in Brazilian stocks?
Lyn Alden: I am long Brazilian equities. Obviously, you have to manage position sizes when you do that.
Peter McCormack: When can you manage my money? Can I just send you all money and you manage it?
Lyn Alden: I focus on research only, because I'm busy as it is. If you start managing client portfolios, it gets complicated!
Peter McCormack: I just want to match your portfolio. Okay, how did we get in this position? Is this all back to what the bitcoiners keep talking about, which is cheap credit?
Lyn Alden: A lot of it is cheap credit, and a lot of it is also design, so it goes back. I mean, the whole petrodollar system was designed. It was a purposeful decision to engineer it the way they did. So, for the US specifically, that was a policy that we started and that we still maintain. But more broadly, if you look at valuations across the board, yes it was cheap credit, and it's basically this modern central banking, where whenever there's a crisis, we lower interest rates, and that incurs more debt accumulation. So, we keep grinding down the neutral level of interest rates.
It's also, I think, partially a matter of just slowing demographics. So, people often point out that as debt increases, growth slows down; but it's also the other way around. As growth slows down, policymakers resort to more and more public debt to try to offset that. And so basically, as the demographics boom has slowed down, and some of our systems were designed decades ago when we had faster population growth, so now a lot of countries have these top-heavy systems. So, when you look at, say, just how much debt is in the system, how low interest rates are, I do think we've had a lot of malinvestment and then going back to what I talked about before, that for lack of good money, we monetise other things.
We monetise especially equities, we monetise housing, so we buy a second home. Instead of treating it like an investment, we'd just rather have it there than in cash.
Peter McCormack: Yeah, that's an interesting position. I'm buying a new house at the moment. There was a long period of consideration. I was like, "Well, shall I keep the second house; is that a good place to store money?" But I was just, "No, I'm just going to buy more Bitcoin because that's where all my money goes, Lyn"!
Lyn Alden: Yeah, in a hard money environment, generally you can store money in that money and your investments would be more selective, so you've done a lot of due diligence. In a weak money environment, where your money does not maintain its purchasing power, there's an incentive to store your wealth in other assets. It could be commodities, it could be companies, it could be real estate, whatever the case may be. And so, because we've been in that environment, and it's specifically an accelerating environment, so lower and lower yields compared to inflation, we've just kind of stuffed everything we can into asset valuations.
Peter McCormack: And, where are we at with interest rates, because am I right in thinking there has been two interest rate rises, or there's been signalled a rise?
Lyn Alden: In the United States, they've talked about raising interest rates, they've not done any interest rates yet. So, in emerging markets, they've been hiking rates all last year, in many cases. So for example, Russia, Brazil, they've been increasing their interest rates dramatically. I mean, Brazil went from 2% to over 9% interest rates last year. The UK did a very minor raise, and the US has not done any increases yet, but they're looking to probably do it in March.
Peter McCormack: Do they talk about it as a necessity to talk about it, or as a test of the reaction?
Lyn Alden: So, it's funny, because the Fed does these forecasts. They have these dot plots, which are generally not very accurate; they talk about forward guidance. And they've also talked about how they want to roll out changes slowly, because they don't want to disrupt capital markets. And so, over time, there's been a narrative shift in the Fed where they've talked about, "Hey, we can maybe move forward rate hikes", and then when inflation's getting 5%, 6%, 7%, they're like, "Hey, actually maybe we could do quantitative tightening, maybe we can pull forward multiple rate hikes".
So, it's been this kind of dial turning up over time as headline inflation is surprising to the upside and they're getting political pressure about their policies.
Peter McCormack: Was it 7% last month, inflation rate?
Lyn Alden: Yeah, the headline CPI was 7.1% year-over-year, which was a 40-year high roughly.
Peter McCormack: And do we think that's going to flatline now, or do we think that's going to go higher; what's the talk on that?
Lyn Alden: My base case is that by the end of the quarter, that has a good probability of topping out in year-over-year terms, and that's because some of the base effects start wearing off. So, we've seen this big surge in house prices and rent prices, and just the CPI version of that --
Peter McCormack: Just starting to come in, yeah.
Lyn Alden: -- is kind of on a lag, and that should eventually catch up. But we're seeing stabilisation there. We also see a pullback of fiscal stimulus. So, I do think that by the end of the quarter, we could be looking at kind of a peak in year-over-year inflation. The caveat to that, so the risk to that outlook, let's say, "What would have to happen for that not to happen?" You'd have to see monthly inflation accelerate, which I think the biggest risk would be if energy markets just go crazy. If energy has a big shortage and it spikes, which is certainly a non-zero chance.
Peter McCormack: Well, a war breaking out between Russia and Ukraine certainly won't be helpful for that.
Lyn Alden: Exactly, yeah, there's a bunch of factors like that. But we also just have low oil inventories around the world, in many cases, so we are at risk of an energy shortage. Europe's been going through that in terms of natural gas, and you could have a similar one for oil globally, and I think it's going to happen eventually. I don't know if it will happen this year, but that's always on my radar for something that can cause inflation to remain high and go higher for longer than people think. But I think absent of an energy price spike, US headline CPI has a good chance of hitting a peak, but that doesn't mean it necessarily goes down quickly to its low levels. I mean, you can peak and then stay elevated, kind of roll over and just remain high.
Peter McCormack: So, I get my gas and energy bills rolled into one here, and this time last year, my spend would fluctuate between £50 and £100, so in the summer months, £56 I think it was, and in the winter months, probably double that. Just because of the house move, they wanted proof of address and you can use your utility bill. So, I went into my energy company to download one, and my energy bill this month was £284.
Now, I've got no idea why, if it's one of these things whereby you tend to get an introductory rate and the best thing is to renew every year, because if you renew every year, you get the new rate, and I don't know if I've gone into some flexible rate. But my energy bills are essentially three times higher than they were a year ago, which is phenomenal. It's a £284 bill, which is about $350, for gas and electric for the month, which is phenomenally high. Whereas, usually you plan for gas and electric for about £1,200 to £1,500 a year, I've essentially over doubled on the pro rata rate; it really shocked me.
Lyn Alden: Yeah, European and UK natural gas prices have been very elevated due to shortages, and that's challenging because natural gas is also a big component for electricity production, as well as fertilisers. So, when you have that shortage, you get the spike in prices. And, natural gas is challenging compared to oil, because it's harder to transport, it's more expensive to transport, you have to liquify natural gas, or pipelines, to transport it.
So for example, oil, there's obviously different prices around the world, so for example, Brent versus WTI crude, but the price differentials are usually not that big, because barrels of oil are rather mobile, and so there's less differentiation around the world, it's closer to global commodity pricing. Whereas, natural gas is extremely location specific. So, you can have a natural gas spike in Europe. There was a brief period of time where European natural gas was 14 times higher than the United States, European gas futures.
Now luckily, that level of price differential didn't stay for long, but it's still several times higher than natural gas in the United States. Partially, the United States is able to alleviate that, because for example, we export liquified natural gas and we historically have exported more towards Asia. But because Europe had a more severe price spike, a lot of our ships started going to Europe instead, so you have that price signal kind of self-correcting itself by bringing in more supply.
But because liquified natural gas is technically complex, it takes a lot of infrastructure, we only have limited capacity to do it. That's why natural gas pricing is more variable around the world compared to oil, because there's only so much capacity to arbitrage those price differences.
Peter McCormack: Well, there's a lot of things happening at the same time in the UK. We've got high inflation; I think 5.4% was the last quoted time. We've also got taxes going up, National Insurance contributions are going up. I think the rise is something like going up from 12.5% to 13.8% or something, but it's over 10% increase in that happening. And obviously, energy prices are significantly higher, and that's putting a lot of political pressure on the Conservative Government.
My expectation is we're almost certainly going to see a transition to a Labour Government, traditionally a lit bit more socialist, in the next election, but these similar pressures are happening all across Europe, and it's going to be really interesting to see how that plays out, because I think the government here are in a very tricky position with all of these factors coming in at the same time.
Lyn Alden: Yeah, a lot of it is all these countries increased their money supply significantly, and that caused a demand surge. And even if a country did not do it, so for example, China did not rapidly increase their money supply, but they still have commodity shortages, because let's say the Americans print a ton of money and buy a ton of commodities, commodities are a global market, so that can cause these global inflationary pressures.
So, you don't just get localised inflation, usually it spreads around the world. And sharply rising food and energy prices are a big risk for social unrest in many countries, and are likely to cause political regime changes. That's something we're facing in the United States, it's something you're facing in the UK, it's something you're obviously facing in many emerging markets. It's a really challenging thing for a lot of them to deal with. In Europe, I think part of the reason was, they've cut off some of their most reliable baseload power, so they've made themselves even more reliant on natural gas, and then you have shortage of --
Peter McCormack: Germany and nuclear.
Lyn Alden: Exactly.
Peter McCormack: The nuclear situation in Germany is ridiculous.
Lyn Alden: Yeah, basically solar and wind is useful as a percentage of the grid, but if you have that as too high of an allocation, you can get these shortages, if you don't plan for it, if you don't have the storage for it, if you don't have these other energy markets in place to arbitrage those differences. You need a reliable baseload power.
Ironically, basically with Germany shutting off nuclear, they made themselves more reliant on coal. They could have instead wound down coal, but instead they wound down nuclear; and basically any market that goes after its baseload power, and becomes more reliant on imported power or on variable power sources, puts themselves at risk for this.
Peter McCormack: Crazy times. I think you said to me, "Inflation's going to be the topic of the next decade". I don't know, it feels like we've got a long road to recovery from the COVID situation. Although, the only thing I would say on COVID, it feels like COVID is coming to an end in most places. I feel like in the UK, it certainly is, everyone's getting back on with their lives. But I think the hangover from COVID is going to be lasting many years.
Lyn Alden: I think so. And as we come out of COVID, that can exacerbate some of these commodity shortages. So, over the past decade, commodities go on these big 10-, 15-year capex cycles, to where we know they're oversupplied and so they're super-cheap, nobody wants to put new capital, develop new mines, new production. Then eventually, demand keeps going up, supply eventually dwindles, we start to get tighter markets, then we get this price spike.
A lot of policies and expectations have recency bias built into them, so they assume that whatever's happening now and over the past five to ten years, is that way forever. So, whenever we have these cheap commodity environments of oversupply, people think we've reached the end of commodity scarcity, we've solved our scarcity, we have limitless abundance, we have no inflationary pressures. But inevitably, when that tighter commodity cycle comes, less capex goes into developing new sources, you get that increase in price.
So, over the past five years, we've been in this commodity oversupply environment. And going forward, commodity markets look a lot tighter. So, you can have years when they go down, it's not like a straight line. You can have these economic decelerations and accelerations, but in general we're in a tighter market for supply of energy and other commodities.
Basically, politicians are going to find themselves in a tough position where, if they want to fight that inflation, they have to pull back on things that stimulate demand, but then you can get slower-growing, or outright recessionary economies, which people don't like; or, they can keep their foot on the gas and keep that demand high, but then they have high inflation. So, you see issues where, for example, people have those energy bills skyrocketing. So some countries, they give people money, like energy stimulus, to help people pay, which makes sense, because people are literally getting their budgets squeezed, so the government comes in and helps them. But that also keeps demand high and is part of this inflationary cycle.
It's kind of like grass is always greener. So, if they don't stimulate, people are going to be like, "The economy's sluggish, the government should do something"; and if they do stimulate, they're going to say, "Where's all this inflation coming from; this inflation's too high?" and a lot of it is partially tied to the money supply, and is also the commodity resource cycle we're going through, as well as political decisions around the quality of energy.
Peter McCormack: I want to touch on recycled trade deficits, but just before we get into that, because it will be useful for people listening to understand; I know some people will understand what trade deficits are, but can you explain it again, what a trade deficit is and the impact of having a positive or negative trade deficit?
Lyn Alden: Sure. So basically, if a country imports more than it exports, then it's running a trade deficit. And so, you can use an example of, say, two neighbours. So, if there's two neighbours and one of them is, say, elderly and the other one does a bunch of services for them, so they mow their lawn, they clean their pool, they help them out, so they're basically having a services surplus. So that your trade is both goods, physical goods, and services. It could be software, it could be finance, different services.
So, in that case of those two neighbours, the younger neighbour is helping out the older neighbour in exchange for some sort of payment. So, they can say, "Take those dollars", and let's say they buy part of their land, so the younger neighbour expands his land into that other person's property, because they're basically getting a surplus. Then they go ahead and they buy their shed, they buy their pool and it's like over time, that second home is encroaching on the other home, because the first home is selling away part of its assets in order to pay for that consumption.
That's generally what happens when you run a trade deficit. So, if a country runs a consistent trade deficit, let's say the United States runs a trade deficit, which is what we're doing ever since we introduced the petrodollar system, so foreigners are, in aggregate, collecting dollar surpluses. So, China, Germany, Japan, Singapore, Switzerland, Taiwan, these countries are running the structural trade services, they're getting all these excess dollars, and then they take those dollars and they buy US assets with them.
So, they could buy US treasuries, like paper liabilities for them that are assets; or, they can go and buy hard assets. They can buy our land, they can buy our real estate, they can buy our shares of corporations so they own a bigger percentage of Apple, they own a bigger percentage of our land, they own a bigger percentage of our single-family homes.
For example, decades ago, foreigners owned maybe 3% or 4% of our US equity market, but now they own 20% or 25%, depending on how you measure it, of our US equity market. So basically, we are running a deficit in terms of, we're buying more depreciating consumer assets from the rest of the world and in exchange, they're taking those dollars and they're buying our permanent appreciating assets.
Peter McCormack: So, is that how China has managed to buy up, you know, we've got a massive amount of, say, property which is being bought in London by Chinese buyers. Is that why that happens?
Lyn Alden: Yes. Basically, they're taking all these surplus dollars, also the UK usually runs a trade deficit as well, so they're taking their pounds, and then they cycle those back into those countries. And so, they end up owning a larger percentage of those desirable financial assets, but due to the fact that they're running these manufacturing surpluses and that they're selling more to the UK and more to the United States than we are selling to them.
Peter McCormack: Right, and this is why interest rates are so important?
Lyn Alden: Yes, interest rates are important as well as capital flows. And then it's more complicated, because countries then have liabilities denominated in other currencies as well. So, you can get these weird -- let's say Brazil, for example. So, Brazil has a lot of dollar-denominated debt, so they owe dollars. And what's unintuitive is the fact that they don't necessarily even owe those dollars to Americans, they can owe those dollars to European lenders, they can owe those dollars to Chinese lenders, Japanese lenders. In fact, most of it is not owed to the US. So, they owe dollars to someone in the world.
If the dollar strengthens, imagine that you take out a mortgage in Swiss francs, and the Swiss franc goes up.
Peter McCormack: Well, it's basically leverage?
Lyn Alden: It's leverage in a currency they don't control. So for example, if you mortgage your house in Swiss francs, so your cash flows are in dollars or pounds and your liabilities are in the franc, and if the franc goes up relative to dollars or pounds, your debts just increase relative to your asset values and your incomes, that's the problem.
So, Brazil, if they have all these dollar-based debts and the dollar strengthens relative to other currencies, especially the Brazilian real, they basically get quantitative tightening; they're basically being squeezed. Their liabilities are increasing in value compared to their income compared to their asset values. So, that can be very problematic for them. That's why emerging markets go through these huge boom and bust cycles because so many of them have these dollar-denominated debts. So, they get squeezed by what happens to the dollar, which they have nothing to do with. So, it's really funny.
For example, the Chinese, they have all these dollar surpluses. If they decide to put all that capital in the US, that's going to prop up the value of the dollar, and that's going to squeeze Brazil. So, you have these weird dynamics that happen around the world. If all this capital shoves into the dollar, if everybody wants to buy the Nasdaq, that actually hurts Brazil. But then, if say people pull out of the Nasdaq and the dollar weakens, Brazil gets a reprieve, their liabilities decrease in value and they ease up a little bit, and that allows Brazil to have some breathing room in terms of expansion.
So, part of the downside of having one country's currency as this asset that we use for both central bank reserve assets as a treasury, and as the big liability around the world that all these countries have, is that as that currency tracks or loses capital, it causes these booms and busts in these emerging markets, and it's just a really improperly designed system.
Peter McCormack: Well, which is why it makes sense really what Bukele's doing with El Salvador, giving himself some protection against what may happen with the US dollar.
Lyn Alden: Yeah, well it's problematic for -- dollarised countries that are not the United States have challenges, because for them it's a hard currency, because they can't print it, so for them it's just a hard currency. And, if the US stimulates, so if the US hands out stimulus cheques to all its citizens, the dollar gets devalued, but El Salvadoreans don't benefit from that, other than the fact that they might get some increased remittances from their American relatives. But other than that, they have no mechanism to benefit from that stimulus, so they get devalued. Yet, at the same time, they have less ability to manage their own currency supply.
So basically, adopting Bitcoin as legal tender can increase their money supply, because it brings in another type of currency they can work with; and it also gives El Salvadoreans a chance to save in a currency that over the long run, is probably expected to hold its value better than the dollar. So, they don't keep getting their savings devalued by Americans choosing to stimulate themselves.
Whether an emerging market is dollarised, or whether they're running their own currency but they have dollar-based debts, they all get impacted by what happens both in terms of US policy and in terms of foreign capital flows into and out of the US. So basically, is this was an engineering system, it would be considered a rather sloppy and harmful system for a lot of participants.
Peter McCormack: What did you make of the IMF telling El Salvador to remove Bitcoin as legal tender; did you see that?
Lyn Alden: Yeah, they keep saying that, they don't go into detailed reasons why. The IMF is one of the establishment forces that maintained this big system we just talked about, this kind of whacky capital flow US dollar-centric system. So, they have an incentive to maintain it. The risk for El Salvador, the biggest risk that I see, is that around the time they announced the Bitcoin legal tender law, also a little bit before then, due to some of the authoritarian tendencies they were developing, but mainly it was centred around the Bitcoin law, foreign markets started selling off El Salvador's sovereign bonds, so the yields went up dramatically.
The problem is, if they want to, over time, refinance as those debts come due, if they want to roll those debts into new debts, they would have to agree to much higher yields. And once you get into double-digit yields, you get into a fiscal spiral, that's not really economic to do. So, you can have a real default risk if the rest of the world does not want to buy your sovereign bonds. You can consider it unfair but basically, for whatever reason, the world has sold off their bonds compared to their peers, so they do have a refinancing risk. That could be why they're turning to volcano bonds.
Really, in the long run, the only way they can address that is by showing that the policy's working. So, if they start getting GDP surprises to the upside, due to either increased tourism, or due to high domestic investment, basically businesses and people want to spend capital there, if they start to do well economically, the bond market should realise, "Oh wait, this selloff was irrational. We actually don't mind owning El Salvador bonds, compared to some of their peers".
Or, if the policies don't work out for one reason or another, you can get that pretty bad fiscal spiral. So, the IMF can go and say, "Look at this Bitcoin legal tender law, it's hurting you, you should abandon it, but it's not directly the Bitcoin legal tender law that's doing it, it's the fact that the global market has decided not to buy their bonds, so that's the big challenge for them at the moment.
Peter McCormack: So, I'm just tracking it here, it looks like El Salvador's GDP from 1965, under $1 billion, but it's been a pretty straight-up line. From year 2000, it was $11.78 billion up until 2019, nearly $27 billion. But it dropped last year to $24 billion. Now, my first thing would be to go and look at everyone's and see if that's a COVID anomaly that's hit them last year, do we know that?
Lyn Alden: Most countries denominated in dollars did have their GDP drop in 2020, yes.
Peter McCormack: Right, okay, so that would be for that. There's no way of objectively knowing -- is there any other way you can measure GDP apart for this and account for that anomaly?
Lyn Alden: That's the main one. You can compare it to peers. So for example, if we look at Guatemala, their GDP has been holding up better than El Salvador through this environment, as an example, as one data point. So, you can go and look at a bunch of other peer countries and see how they're doing. Obviously, El Salvador was stressed before the Bitcoin legal tender law, but their bonds were not; their bonds are trading at par, but the country had its own problems.
So I think basically, the bond market is going to watch El Salvador and see what happens with their economy and their judgement of their ability to have persistent tax revenue, support the bonds, and it becomes a self-feedback loop. So, the better the bonds consider El Salvador's prospects of paying back the bonds, the lower the yields will be, and that further increases their ability to pay back the bonds; whereas, if they judge El Salvador as being weak and they sell off the bonds, it makes it even likely that they'll be able to pay back the bonds.
So, it's really going to depend on that, on GDP growth, and on whether or not El Salvador's successful with these other types of bonds they're looking to issue.
Peter McCormack: Yeah, it will be interesting to see what happens with this first volcano bond. I don't know how close it is to being available to buy; it maybe already is, I've no idea, I've not looked. Have you looked much at it now?
Lyn Alden: I did look it up before and I also talked to Adam Back about it. We were both on Swan Signal, so we discussed it. We also discussed it privately a little bit ahead of that just to see if we're on the same page. I think the plan makes sense, and if anything this Bitcoin selloff --
Peter McCormack: It's great for them.
Lyn Alden: They would prefer to buy low. I think Samson Mow pointed that out. So hopefully, they get in on this low point and hopefully Bitcoin does have a good 5-plus-year return prospect, which could help El Salvador over time. The challenge is that, generally you want to see this oversubscribed, because you want to see that they could raise it again in the future, because some of their debt comes due prior to five years from now, and so it's not just the ultra-long term that matters to them, it's about the near time.
Bitcoiners can support them by travelling there, by investing there, but of course there are ethical issues around how the regime is handling some of their governance, so I think there are legitimate questions about that they have to watch. I think people have to be careful about drinking the Kool-Aid, so to speak, so always be sober minded when analysing these regimes and these kinds of policies. Don't necessarily support things just because they're bitcoiners, and don't oppose things just because they're not bitcoiners; always assess things objectively as possible, I would say.
Peter McCormack: I discussed the same thing with Matt Odell in our end-of-year review. It was like, have we perhaps maybe given Bukele a pass as a bitcoiner? He's great at memes, he's put his McDonald's hat on, he's very much acting like a bitcoiner, but does that mean we've essentially given him a pass? Should we be asking tougher questions? I know Alex Gladstein has, and it's one of those difficult things. Even myself, difficult, as someone who's interviewed him twice and wants a third interview, I want to continue having that relationship to talk to him. But what is the cost of that? Should we be asking much tougher questions? It's definitely something that's been on my mind and I'm glad you raised it.
Lyn Alden: I agree. I mean, he's clearly intelligent, he has his finger on the pulse with the Bitcoin community, he has his meme game strong, and I do think that aspects of the Bitcoin legal tender law are useful for El Salvador. He took risks in doing this.
Peter McCormack: Massively.
Lyn Alden: He disturbed the applecart, the IMF and the global perception of their bonds, and so he's gone all-in on this. So, for the people of El Salvador, I want it to be successful. For the perception of the Bitcoin Network, I'd like it to be successful; but I do think also it's important to monitor for areas of risk. I think the biggest one is the sovereign bond yield issue. And two, to not necessarily support regimes or actions, maybe individual actions, that are unethical, so I think the community should hold him to account.
Peter McCormack: Definitely. I do also think, at the same time, it's been very interesting where they'd moved their COVID strategy. In some ways, it's very much reflecting what maybe some of the Bitcoin people have been saying, which is it's more about health, and should we be promoting public health policy, should we be promoting better exercise, diet and body-conditioning to protect yourself from the risks of something like COVID, which I think is a very interesting shift from when previously during COVID, I travelled over there and they had just as tight restrictions as other countries? They seemed to have shifted their policy partly on that, which I found kind of interesting, but all to be seen how that plays out.
Okay, look back to the equity markets. Have we got any risks here, Lyn? Have we got any risks that we have a Great Depression 2?
Lyn Alden: Well, a Great Depression 2 partially depends on policy choices, so basically if you have equity markets sell off and central banks do nothing, and asset prices go viciously downwards, you have a massive deleveraging of everything, you would have widespread bank defaults. But generally, when you start to get those illiquid conditions, they basically come in and prop it up. The challenge that central banks face around the world is death by ice or fire, so do you want things to unravel in a deflationary collapse; or do you want to keep stoking the fire of inflation, by printing currency units to maintain the status quo?
So, in history, the vast majority of fiat currency regimes die by fire, not by ice. When push comes to shove, they print, and it's one of those things where if they don't print, ironically you still get inflation, it's just a different route. Basically, you would have a deflationary collapse until the currency's useless and then it hyperinflates. It all leads in the end towards the weaker currency, and there's just different paths to get there and different timelines to get there.
My base case is, I view each market separately. So, I think the biggest risk going forward, as I see it, is stagflation, so basically where countries are trying to maintain positive GDP growth, and trying to manage high inflation and having, say, energy shortages. I think energy shortages are going to be one of the keys; if we have a really tough decade ahead, I think a lot of it's going to be tied into whether or not we have abundant energy or not. So, if we have energy scarcities, and if we have these policies of energy runup into physical reality, I think you can get some pretty bad outcomes. So, I would watch energy markets pretty closely.
Peter McCormack: Okay, well definitely as someone in Europe, for many reasons I hope the situation in Russia and Ukraine deescalates, because I think that will almost certainly drive the energy crisis in Europe further, so I'm definitely watching that.
Okay, so what does this all mean for Bitcoin, Lyn, because obviously, a lot of bitcoiners don't want Bitcoin to be correlated with the equity markets, and sometimes it is and sometimes it isn't, but it feels like more often it is than it isn't; what are you seeing?
Lyn Alden: So, NYDIG had a really good chart the other day that showed, from 2011 to 2019, Bitcoin was not super-correlated with equities. There were periods where it was, there were periods where it wasn't. Whereas, ever since early 2020, it's been a lot more positively correlated with the equity markets, the US equity market in particular. Part of that, I think, is because of institutional adoption. I think another part of it is because of stimulus, almost everything became correlated, except for fiat and gold, so most other assets just all went up together, so everything became positively correlated.
Another thing to look at is, we've historically pointed out that a lot of the bitcoiners are familiar with the fact that Bitcoin generally does well after a halving happens, right, the bull runs happen after halvings. Another correlation is that all the major bull markets, so 2011, 2013, 2016, 2017 and 2020 into 2021, those were rising PMI environments, Purchasing Managers' Indices, which is a measure of whether an economy, the growth is accelerating or decelerating. So, a PMI averages around 50, and if it's above 50, it means it's expanding. And the higher above 50 it is, the more rapidly it's expanding.
So, when you have a declining PMI, it can still be that your economy is growing, but it's growing at a slower rate. So generally, all those bull markets occurred during accelerated economic growth, whereas the bear markets are generally flat to deceleration growth in the US, and the western world in general. So, Bitcoin has been a traditionally risk-on asset for a lot of its period.
Now, that correlation is a lot different if you look at, say, emerging markets. So, if you look at Brazilian equities or Turkish equities or Chinese equities, you'll have a lot less positive correlation with Bitcoin. So for them, Bitcoin is a diversifier in many cases. It's just that especially for American investors, it's not necessarily been this hedge or uncorrelated asset, it's been this correlated asset. But as it goes through these cycles, because of the qualities it has, it builds its value over time, at least historically, so it's been positively correlated, but stronger.
Peter McCormack: So, how are you feeling about Bitcoin this year? Last year was a weird year, Lyn, and it was like no other year, and I think it's good that it was like no other year, because these predictable market cycles actually I don't think are particularly useful. And in some ways, I know some people wanted $100,000, $200,000, $300,000 Bitcoin, and I understand why they thought it might happen. I'm glad it didn't happen. I would much rather steady growth. But also, because we didn't have that, I don't feel like we're going to have this 80% drawdown this year. I feel like almost Dan's supercycle, or lengthening cycle, is something we're heading into.
Lyn Alden: Yeah, my base case is for less of a drawdown, because there's less of a blowoff top as well, so I've been less bullish than some of the bulls, but less bearish than some of the bears when it comes to Bitcoin. So for example, I was calling for Bitcoin to reach a $1 trillion market cap, we got there; I said that eventually I see it over $100,000, we didn't get there yet, but I've not been calling for near-term $200,000, $300,000 as some of the really big bulls are. But at the same time, I'm not expecting it to drop down 80% or 85%, like some of the prior bear markets did.
It's certainly possible, you could have a liquidity event that really drives that down. You have a leverage capitulation, I'd probably be a buyer of that; that would look like a good opportunity to me. But it's not necessarily something I'm expecting, or looking at as a base case. And generally, my expectation is intermediate term, kind of neutral, because we have that declining PMI environment for 2022 in the US, so it's not a risk-on environment for most assets, as far as it's looking now. So, I think that can give headwinds to Bitcoin.
One way I would describe it is, if you look at demand, demand for Bitcoin really peaked back in the first quarter of 2021, when we had that initial sharp rise. And ever since then, demand's been weaker. So, you've seen that come up in terms of lower on-chain fees, for example; you can look at on-chain indicators and see there's less demand, new demand, flowing into it. At the same time, supply side's been very tight. So, we have a different market structure in this cycle compared to prior cycles. So, there's more people dollar cost averaging into it, miners are holding on to a lot of their own coins, people have more of a price issue to look at and want to hodl it, so more conviction, so the supply side's been extraordinarily tight, while the demand side's lacking.
So basically I think, for the rest of this year, I think a lot of it's going to depend on how strong that dollar cost averaging group is and things like that. And the next big leg up comes whenever you have a risk-on environment and new demand comes in towards that very, very tight supply. So, I think we basically have this dry kindle environment, where there's basically a catalyst for a big move up, but there's no spark, there's no inflow of demand, and you would need to see that to have the next giant leg up.
Peter McCormack: Awesome. All right, listen, that was, as ever, amazing. I'm glad we can let people know we're going to be working together again this year, which is awesome. Looking forward to making a bunch more shows with you, Lyn. Anyone listening, go and sign up to her newsletter. Lyn always hates me saying this, but I don't care, it's amazing. It's the best $200 you'll spend a year. Did you raise the price?
Lyn Alden: No.
Peter McCormack: It's ridiculous.
Lyn Alden: I'm keeping it accessible!
Peter McCormack: Well, I think it's accessible at $400, but I think you're amazing for it anyway. Go and sign up, it's in the show notes, go and check it out. Lyn, always love talking to you and I will see you in February.
Lyn Alden: Sounds good.
Peter McCormack: You take care.
