Trey Lockerbie (03:12):
Now that point you just brought up is interesting about inflation peaking. You’ve talked on our show a little bit about how, if you think about the creation of money, it’s coming from the fiscal side, meaning we’re running that deficit, and then the QE happens after the fact.

Cullen Roche (03:25):
Yeah.

Trey Lockerbie (03:25):
Which not a lot of people appreciate. But I’m curious to hear what signs you’re seeing. Are you just saying the amount of spending is going down? Are you looking at the fact that lumber chart has corrected? Are you looking at used cars? What are the variables going into that opinion about inflation peaking?

Cullen Roche (03:43):
Yeah. It’s a lot of that. My guess is that the data is going to start… The year-to-year data is going to start to look like the rate of change is probably peaking in Q1, Q2 here, so my guess is that inflation is probably going to remain high well into probably at least may; but by that point, you’ll start seeing the 7% headline CPI roll over to something closer to 5% to 6% by end of summer. We might get as low as 4% or 5% by the end of the year, so these numbers are still… I mean historically speaking, these numbers are still going to be pretty big, they’re going to be big all through the year, but we’re starting to see some signs that a lot of this is easing.

Cullen Roche (04:22):
And you mentioned the big one, in my view, is the fiscal spending side of everything. We’ve seen this with the recent politics around Build Back Better that people and politicians are finally starting to get scared about inflation in a really meaningful way. And COVID was so important to understand relative to the financial crisis; because to me, what the COVID recession really proved, relative to the financial crisis, was that fiscal policy is the big bazooka. The big difference between 2008 and 2020 was that both periods involved the federal reserve implementing these huge balance sheet increases. The difference between the two was that the treasury and the US government spent a ton more money this time around than they did in the financial crisis, and my opinion is that aggregate demand was primarily a result of all of that government spending.

Cullen Roche (05:17):
It’s not that the fed balance sheet and their so-called money printing has no impact; it’s that the real asset creation is initiated at the treasury level. The treasury expands their balance sheet; and then what QE does is it really… it creates this portfolio rebalancing effect where the fed isn’t really printing assets in a technical sense. What they’re doing is really they’re expanding their balance sheet, changing the composition of the private sector’s balance sheet, and this has all sorts of other multiplier and knock-on effects. You could argue that it forces people into other assets, for instance. I mean there’s a multiplier effect through that, for instance.

Cullen Roche (05:54):
But at a pure balance sheet level, it’s the treasury spending that really causes the aggregate balance sheet expansion, and that is why we saw such a difference in the rate of change of inflation in 2020 versus 2008, so we’re seeing that is going to… It’s not going to go negative this year, but it’s peeling back in a huge way. We’re coming back to deficits that are more normalized relative to the pre-COVID period, so big pullback in the relative size of government spending is going to start to really have a meaningful impact going into the summer, and especially the later part of 2022 and 2023.

Cullen Roche (06:32):
And so the other big impact here is that you’re just starting to see the rate change, it’s slowing in a lot of these assets, because frankly they just went up so much. When you look at the rate of change of used cars or lumber, the rate of change was so big on a year-over-year basis, relative to last year, that you had this huge statistical bottoming effect where it was almost like, a good example, is looking at the stock market where when the stock market falls 50% and then recovers back to where it was: if you look at the year-over-year rate of change, you had 100% rate of change basically on a year-over-year basis looking at, “Now, how sustainable is that going forward?” Well, if the market only goes up 20%, the rate of change all of a sudden in the data starts to look like it’s really disinflationary, in inflationary terminology, and that’s a big part of what we’re getting now.

Cullen Roche (07:26):
It’s not that prices are falling or that inflation is going to be low, necessarily. It’s that you’ve got this statistical topping effect that’s going to start having a big, big impact in a lot of these indices going into the later half of this year that is just, by definition, by the statistical nature of it, is going to start to cause a lot of the year-over-year rate of change in this data to start to moderate going forward.

Trey Lockerbie (07:53):
If I’m hearing you correctly, what you’re saying sounds like you think recession risk is very low, but the markets seem very unstable. I mean this start of the year, I just saw a graph, has been the worst start of a year in the S&P 500 I think ever, so they’re very wobbly. What’s the risk of financialization to which financial asset prices can create these negative feedback loops that trickle down into the real economy?

Cullen Roche (08:20):
This is a super interesting topic to me, especially now as the economy has transitioned over, especially the last 30, 40 years, and financial markets have become much more democratized, much more accessible, a much bigger part of our everyday lives. Financial assets and asset prices have become much more important to the way everyone consumes and invests and lives their lives. And so this isn’t the old days where it was like the US economy used to basically just be a bunch of railroads, basically; and when the railroad companies spent too much or whatever, or didn’t spend enough, you had booms and busts.

Cullen Roche (08:57):
And today it’s so weird because, looking at the NASDAQ bubble, you could basically argue that the NASDAQ bubble, and the ensuing recession that occurred, was to a large degree a venture capital recession. It was a corporate-based recession that resulted from essentially too much funding going into bad entities that resulted in a big asset price bubble; and when that bubble, when the air came out of that bubble, it filtered through the economy in a big way that caused a recession in a broader sense across everybody’s balance sheets. And so financial crisis was more of a real economy recession that turned into a financial crisis because of the way that the housing market imploded, but you have similarities between the two of those recessions in today’s market where not only have we had a huge venture capital boom; a huge boom in, you could argue, a lot of nonsense. If you look at a chart of Goldman Sachs’s Non-Profitable Tech Index, thing’s still up. It was up like 400% at one point last year, it’s fallen 50%, but it’s still up 200% or something. Those numbers are crazy.

Cullen Roche (10:06):
If you look at the stack boom, there’s been a lot of money flowing into a lot of things that are now starting to look like they never made any sense, and you could argue that there’s pockets of crypto that look like that, so this is fairly broad. And then you’ve got the housing element on top of all of this where the housing market has boomed in a huge way, looks in my opinion a lot healthier than it did in 2006 mainly because the people that are buying these homes, their balance sheets are dramatically different than the people who were buying homes back in 2006. So you don’t have quite the speculative nature of everything going on, but there is a very plausible scenario here where the stock market falls 25%, house prices fall 5% to 10%, and you get a statistical recession because people stop spending in essence because they got essentially balance sheets that were over-inflated from a lot of what happened in COVID, and you just get some give-back.

Cullen Roche (11:08):
What’s the probability of a recession right now? It looks pretty low, frankly, because the economy looks… it still looks really good in general. But you could get a situation where you have this weird feedback loop where the stock market falls a lot, in part because sometimes it just goes up a lot, so the stock market… I always tell people the stock market needs to go down in the short run sometimes so that it can go up in the long run, and the weird part about that is sometimes people overreact to the stock market going down. So it’s not implausible, in my view, to see a scenario in 2022 or 2023 where you’ve got asset prices falling significantly, creating this feedback loop where consumers are pulling back, and then you have the risk of what’s happening in three minutes with the fed where maybe they do make a policy mistake. Maybe the fed does shock everybody. Maybe they do boost rates to the point where they raise rates to 2%, 3%, 4%, invert the yield curve, and inverted yield curves pretty much always cause these sorts of financialized economies to start getting wobbly.

Cullen Roche (12:10):
And so it’s not that you’ve got recession risk here. It’s that you’ve got a recipe for a lot of things that could transpire that could result in a recession. I wouldn’t say the risk of recession here is zero. In fact, I would say that the boom in asset prices to me maybe doesn’t cause recession worry, but it certainly causes portfolio worry for me.

Trey Lockerbie (12:32):
Now, touching on real estate there, for example, it’s especially interesting you and I both live in California where we’ve seen this unbelievable increase that certainly doesn’t seem sustainable. But to your point about folks’ balance sheets being better off than they’ve almost ever been, what do you attribute that to? Is it the fact that no one’s been traveling and their income’s been going to pay down debt? Is it the fact that the lumber costs did shoot up, and to build a home becomes really expensive, and there’s just less inventory?

Trey Lockerbie (12:59):
Another way to reframe the question is: when I was talking to Kyle Bass, he mentioned that the house price-to-income ratio right now is only about 5.4. Whereas in 2008, I forget the exact number, but it was much, much higher. Meaning as high as these prices have gone, they’re still looking really good on paper, as far as the people who are buying them, and their credit ratings, etc. So what is the main driver? Was it all the stimulus that went into the economy a couple years ago?

Cullen Roche (13:27):
Yeah. You could argue that a lot of it was the government spent a ton of money so… The government’s balance sheet is such a weird thing because the government in aggregate, we all technically do owe… We’re all liable for the government spending in the long run. We pay for it in real terms. We pay for it in inflation, in essence. Those liabilities may not be Trey and Cullen’s technical liability, but we end up being liable for them in other ways. But from a pure balance sheet perspective, when the government sends out truckloads of money, our balance sheet, the private sector’s balance sheet, looks better, so a lot of it is that: a function of corporate profits increase as a result of government spending if households don’t save it, so a lot of it just flows straight to corporations as a result of the government’s deficit, and that resulted in the logical increase in asset prices that we’ve seen across the equity markets.

Cullen Roche (14:24):
And so you’ve had a big boom in the equity side of portfolios in large part because the government had this humongous package that they unfurled to combat COVID; combine that with low interest rates, and you have a scenario where on paper the assets look a lot more valuable than the liabilities now, so people look really good in terms of net worth calculations right now, and combine that with low interest rates and the ability to borrow, it doesn’t surprise me that we’re in this sort of scenario.

Cullen Roche (14:56):
But again, going back to our previous point, how fragile is all of this? How sustainable is everything that has been going on? That to me is a much murkier answer.

Trey Lockerbie (15:11):
Well, I think we’re seeing how fragile it is. Because even the fed, talking about meeting to discuss raising rates, has tanked the market, especially in big tech and other industries. It brings to mind this quote from Jeremy Grantham that just came out, and he’s obviously a big bear very often; but he’s been right, albeit early, very often. And he’s saying that we are in the fourth super bubble of the last century, and we’re basically approaching the end of this extravagant pricing in housing inequities and bonds and commodities. I mean we are in the everything bubble, and he’s calling it a super bubble, that is at its peak or near its peak. As a pragmatist, which I know you are, do you buy into this idea of these super bubbles, and what would you take away from Jeremy’s quote?

Cullen Roche (15:57):
Yeah. By the way, the feds kept rates unchanged.

Trey Lockerbie (16:00):
You heard it here.

Cullen Roche (16:01):
Nothing super shocking, I don’t think. I don’t know how the markets are responding in real-time, but I’m sure they’ll do… They tend to go up and down and be crazy on Fed Days, so who knows where they’ll settle. So yeah, we can stop worrying about the fed at least for 24 hours, until we start talking about the next meeting.

Cullen Roche (16:18):
The Grantham comments are super interesting. I mean it is crazy. The thing that I can’t wrap my head around with COVID is: yeah, from a fundamental level, I guess the government’s deficits add to corporate profits, American households don’t save, so it makes sense that all of this flowed to the corporate balance sheets and boosted equity prices, but that stimulus is a one-time shock. And so it’s interesting to think of this not only in terms of the stock market’s rate of change, but in terms of the future inflation rate of change, because you think of this government stimulus as having caused this one-time shock to the economy across this 24 or 36 month period. Well, you would expect some give-back at some point because the rate of change just isn’t sustainable, so this huge boom…

Cullen Roche (17:07):
You know, it’s crazy to look at the S&P 500 from where it was before COVID, and then the trough of COVID, and to see now we’re still up like 100% from the bottom. There’s this weird scenario here where you can make a really reasonable argument that the stock market could give back 20%, 25% of its gains, and where are we? We would still be above the pre-COVID level, which is wild to think about, when you think of especially in terms of the economy. What has really changed that much in the last two years?

Cullen Roche (17:42):
Super bubble, I don’t know. I hate thinking in extremes like this because I think that what… When you start talking about things like market crashes and booms, and these really crazy boom/bust cycles, I think that tends to result in people having these really hyperbolic reactions in their portfolios where if they feel like, “Oh. Well, Jeremy Grantham’s calling for a bubble to burst here that’s going to be catastrophic. That means that I probably shouldn’t own any equities,” for instance, and I just tend to think that sort of thinking in extremes is… It tends to be a hyper form of market timing that just very rarely plays out the way people expect it to, across the time horizons over which they expect it to. So me personally, when I look at this sort of an environment, I think the range of potential outcomes here…

Cullen Roche (18:39):
For the record, I think this is one of the hardest investing environments I’ve ever seen. I mean there are certain periods where you can look at things like… For a long time, I’ve been looking at bonds, for instance, saying it’s a no-brainer to own bonds at above like 4%, whereas today it’s like that’s a lot more difficult conversation to be having, especially when you look at things in real terms. But today specifically, the range of potential outcomes looks so disparate to me, meaning that I can see a scenario where the stock market just continues to fluter higher, or maybe it continues to… maybe it just muddles through. Maybe we return to more of a 2010/2020 type of environment. Or I could see a scenario where Grantham ends up being right, and you get this…

Cullen Roche (19:27):
What if we get a deflation? What if home prices fall more than people to expect? What if we get some sort of weird exogenous shock? You know, China invades Taiwan, and Russia invades Ukraine, and all the shit hits the fan all at once around the whole global economy? You could start getting a lot of weird stuff happening here where you do get this big exogenous shock that causes a recession, or a big geopolitical crisis where you get this big downturn, fear-based downturn in financial assets, that turns into this snowball effect that we were alluding to earlier, but I don’t know. That’s the thing that’s so confusing about this particular environment. We had such a big seemingly irrational boom here that it has facets of totally irrationality, and facets of rationality based on the basic accounting of it all, and the government stimulus, where I think… I mean personally today, I think that I’m much more aligned with a Ray Dalio type of all-weather approach to this sort of environment versus someone like Grantham, who tends to be very strictly equity focused and really hyper-focused on trying to pick the right places to be inside of the equity market.

Cullen Roche (20:44):
Me personally, I think this is the perfect environment for just ultra diversification because I don’t think anyone really knows what the next two, three, four years are going to hold. And the potential outcomes are so broad, broader than I think they’ve ever been in terms of what the actual outcomes could be.

Trey Lockerbie (21:07):
Well, you brought up bonds and how they are getting harder and harder to understand, or to find a reason to invest, so I’d like to turn the attention to bonds for a little bit. Since yields have been so low for so long, it’s obviously easy to see why so many investors consider bonds almost like this endangered species. I mean if you read Twitter or if you read the news, a lot of people have this in narrative. But I know, for example, what you’re talking about in your own ETF, for example, it’s very diversified. You do hold bonds. Now that inflation has reared its head, even though it might be peaking, do bonds serve less and less of a purpose in a portfolio? And if not, then why?

Cullen Roche (21:42):
It depends. The way I like to think of bonds is basically if you own high-quality bonds, bonds are basically cash-like instruments that pay you, in today’s environment, a much higher rate of return than cash will over time, so it’s tricky. I think that you need to be very specific about your time horizon if you’re owning any type of fixed income instrument because bonds are… they’re not just fixed income instruments, they’re fixed maturation instruments, meaning that they are fixed across specific time horizons. Me personally, I’m a big fan of asset liability matching portfolio management strategies where you’re taking… Let’s say that you want to buy a house in Southern California today and you just happen to be lucky enough to have the $20 million it takes to actually be able to afford that home, you’ve got to be able to bucket that money for a down payment across a specific time horizon.

Cullen Roche (22:38):
Let’s say that you’ve got this unknown say two to three year time horizon, it could make sense to… If you have the flexibility where you’re saying, “Oh, I don’t want to leave that in the bank for the next three to five years because I know it’s going to earn zero,” it could make sense to buy a three to five year bond where you’re likely to earn some interest across that time horizon and not take the principle risk, the credit in it, that you would have in say a junk bond or the stock market portfolio. When you bucket things across specific time horizons, it makes a lot of sense to own bonds for specific time horizons. The other thing is that bonds are just… even in an environment where they generate really low amp in the equity market risk, well earning a rate of return that is at least positive relative to cash.

Cullen Roche (23:33):
It’s interesting to look at even a period like 1940 to 1980. If you look at that period, interest rates rose the whole time; so people have this misconception that even if interest rates rise, that that means that bonds have to lose money. And in fact, a 10-year treasury bond… if you owned a constant 10-year treasury ETF, for instance, from 1940 to 1980… you just clipped a 2.5% coupon the whole time. In a balanced portfolio, it dampened the equity market volatility in that portfolio by 50%. You earned a lower rate of return, but you beat the pants off of cash, and you dampened your equity market volatility inside that portfolio. So if you’re somebody that wanted a diversified portfolio, you still wanted to earn: even as measly as 2.5% is, it was better than zero, and it certainly was better than exposing yourself to the hypervolatility of the 1970s, for instance, and all the behavioral biases that potentially come with that.

Cullen Roche (24:30):
The answer is it depends. But in my view bonds aren’t dead. Bonds will never be dead because there’ll always be demand from people who want to earn a nominal return that’s superior or cash. And yeah, it’s true: from 1940 to 1980, they get walloped in real terms. I mean that’s just part of what happens in a rising interest rate environment. But the kicker is that if you built a diversified portfolio, your equity piece over that time, especially if you owned commodities or any other diversified asset classes, your aggregate portfolio beat the rate of inflation over that time period, so you kind of… This is why this sort of an environment to me is so great for all-weather style approaches, because you can have your cake and eat it too through these approaches.

Cullen Roche (25:15):
You can have nominal stability through either, even if it’s cash or bonds, across certain time horizons, you can have exposure to the equity market if things continue to go up and be strong in the long run, and you can own other assets that protect you from inflation specifically in certain ways. I think people love to pick and choose, and the reality is that people have different needs, different time horizons. And if you have these shorter-term time horizons… and especially if you have behavioral biases relative to thinking, for instance, that the stock market is overvalued… bonds as a dampening asset class in that portfolio make a ton of sense, just because they’re less volatile relative to the stock market.

Trey Lockerbie (26:00):
One narrative that I’d be curious to hear your opinion on is the fact that foreign governments are buying less and less of our treasuries. Because if you look at it right now, foreign treasuries I think make up 13%, 14% of the national debt we have. The treasuries they hold, China is only in the 3.5% range. A lot of people think, I think, they hold a lot more than they do. But are those percentages dwarfed because of the fact the fed is buying so many? Meaning is there a base effect, so to speak, of what’s happening in those percentages that make it look like they’re owning less and less, or are they truly buying less and less treasury bonds?

Cullen Roche (26:34):
They are buying less in a relative sense; I’m not sure how much it really matters in the long run. People like to think of bonds, government bonds especially, as having some degree of credit risk; and people think that, a lot of people think that, the US government is going to somehow go bankrupt, even though it can literally print US dollars. The default risk on US government bonds is zero. The example that I like to use though to understand this is that imagine if the treasury just financed all of their spending by literally printing actual physical dollars, or sending people actual deposits. Say the bond market wasn’t involved in any of this, and that the federal reserve couldn’t even do QE because if the treasury just issued dollars straight up from the beginning, issued a deposit straight into people’s bank accounts, there would be no QE to do. It’s interesting to think if the feds did that, would people say… would people have the same logical thought process about the demand for this stuff that they do about the bond market?

Cullen Roche (27:39):
If the treasury went out and dumped a big dump truck of cash out in front of the US Capitol tomorrow, is there an environment where people would say the demand for those things is going to be zero? And I think the answer is: sure, maybe in a hyperinflation environment, but specifically you’re making an inflation argument. You’re not making an interest rate argument in the traditional bond sense of rising interest rates where the credit quality of an instrument or entity is declining. You’re making, when it comes to government currency and government liabilities, in that instance you’re making specifically an inflation argument, and you’re predicting that inflation is going to be very, very high, where the demand for those dollars is going to be low relative to everything else.

Cullen Roche (28:26):
But the kicker, the point I’m really getting at, is that the US government cannot and will not lose control of the interest rates on its own liabilities because it has the ability to definitively structure those liabilities in a way that only they can control whether or not interest rates rise. Literally, if the federal reserve came out and was like, “We’re setting the rate on 30-year treasury bonds at zero,” overnight the 30-year treasury bond would go to 0%. Treasury combined with this policy would come in and probably say, “Okay, we’re not issuing any more bonds. Now we’re going to do what Cullen actually said. We’re going to only issue deposits. We’re going to only issue cash. Our interest rates on everything now are zero.” The interest rate, by definition, it would have to fall to zero because the US government doesn’t have to pay you interest. The US government chooses to pay us interest.

Cullen Roche (29:24):
The fed choose to implement rising interest rate policy over time. There’s no market force that says they have to do this. You can make arguments that if the rate of inflation is very high that they should; but even with double-digit inflation, Paul Volcker didn’t have to raise interest rates in that environment. So there’s a lot of I think nuance in understanding the specifics of government finance that a lot of people relate to a household that, at a basic level, when you’re the dominant liability-issuing entity in the entire global economy, it’s different. You literally have an exorbitant privilege.

Trey Lockerbie (30:07):
They do have that ability, as you put it, but you’ve also mentioned that they’re like a guy walking a dog where they can control how they reign the dog in, and oftentimes they overshoot it.

Cullen Roche (30:19):
Yeah.

Trey Lockerbie (30:20):
What is the risk involved of them mismanaging their ability to do what you say?

Cullen Roche (30:24):
What’s the risk of the government making bad decisions? Really high?

Trey Lockerbie (30:31):
Maybe not a fair…

Cullen Roche (30:32):
You can make an argument that like now, for instance, with the rate of inflation where it is, you could argue that the second and third stimulus packages coming out of COVID were big mistakes. And you’ve seen it across history with the fed and rate hikes, that the fed tends to overshoot. They tend to be chasing their own tail, to some degree.

Cullen Roche (30:56):
And I’ve been writing a lot about the Greenspan Conundrum. For people who aren’t aware, the Greenspan Conundrum was the period of basically 2003 coming out of the [inaudible 00:31:05] to 2007 or so, when the fed went on this really epic rate-hiking cycle. I can’t remember where they bottom. Something like 1%. They rose all the way to 5%. And what was really interesting about that environment was that the long end of the curve barely budged this whole time. So what the fed expects is that, in an environment like right now, the fed would like for rate hikes to filter through the whole credit structure, they would like to see the demand for 30-year treasury bonds for instance fall, and that people will go out and start borrowing and using all this money to do other things. And what’s weird is that, in these sorts of environments, the curve doesn’t move at all.

Cullen Roche (31:46):
The fed raises rates a lot, and the yield curve actually flattens. And typically, when the yield curve flattens or inverts, you start getting some financial instability because it becomes a lot less profitable for financial firms, in essence, to expand their balance sheet, that’s the simple math of it. And this causes some instability, or at least slow down in the economy, because of the nature of the flat or inverted yield curve. And so I don’t know about causality there. You can make the argument that it’s not so much causal as much as it’s just that the economy is weaker than the fed actually thinks; and so when invert the curve, that it’s just reflective of the actual nature of the underlying economy.

Cullen Roche (32:29):
But regardless, when you get these environments, like the pre-housings bubble period or pre-financial crisis period, or even like right now, the 30-year treasury’s at about 2%. You can make a really strong argument that if we’re in this Greenspan Conundrum-like scenario, the fed really has very, very little wiggle room where if they don’t get long rates to move up, where it doesn’t look like long rates are moving much… I mean the short end has already moved up about 1%, and the long end basically barely budged, so the yield curve has already started to flatten a lot; it hasn’t gotten perfectly flat or inverted yet, but I think what the long end is saying is this economy is potentially more fragile than the fed thinks. And if you overreact about inflation, you could end up with a deflation or a disinflation that is much more alarming than the inflation ever was, so it’s a risk for certain.

Trey Lockerbie (33:27):
Now with inflation running high and unemployment low, the environment we’re currently in, and having Powell today say they’re not going to do anything, what does that tell you? I mean what environment will we have to be in for them to be more hawkish than they’ve been?

Cullen Roche (33:42):
It’ll be interesting. What’s the outlier upside inflation scenario? That’s the scenario where… Well, what if the wage price spiral theory is a reality? That would be a scenario where wages continue to just spiral higher because maybe our demand is much, much higher coming out of the stimulus than people even expect now. Or you could have another outlier where oil prices and commodities continue to just shoot higher. A lot of this is global in nature, so you could have knock-on effects from that, where you get this scenario where inflation is not just 7%, but potentially even higher than that, and this actually does start to look a lot more like the 1970s maybe. That’s not my base case, so I’m definitely going to look like an idiot if inflation is 7% to 10% by the end of this year, but implausible. Like I was saying before, the range of outcomes in this environment are so broad and so certain that I wouldn’t want to own a portfolio where I wasn’t at least protected from that scenario. So yeah, it’s definitely a big risk.

Trey Lockerbie (34:52):
This instrument isn’t talked about very often on this show at least, but what are your thoughts on the Series-I bonds that seem to match the CPI number? Right now there’s I bonds that are doing 7.12% yields. What is your opinion on parking your cash into something like that as an inflation hedge?

Cullen Roche (35:09):
They’re great to the extent that they can make a meaningful difference for you. There’s really strict limits on how much you can buy; I think it’s something like $10,000 per person, or something like that. For a lot of people, if that’s a meaningful part of your portfolio, that is… On a risk adjusted basis, getting 7% from what is essentially a credit risk-free instrument, is a tremendously good deal, probably the best deal you’re going to find today. Again, I typically… I think of bonds as being a nominal hedge in a portfolio specifically, so I don’t love the approach of thinking of bonds as necessarily protecting you from inflation. I think that people should use specifically other instruments in a portfolio. Bonds are really… they’re a nominal, a principle stability part of your portfolio, where over specific time horizons you know, “Okay, these bonds are going to maintain their principle,” and just clip a small coupon.

Cullen Roche (36:09):
Typically, inflation protected bonds, they tend to be more volatile in the short run than say plain vanilla treasury bonds, specifically in environments where you need them to be stable. So for instance, in a deflation, TIPS and inflation protected bonds do typically really poorly. They look not like the stock market, but a lot more like the stock market than the typical bond market. Whereas plain vanilla treasury bonds, for instance, they typically go up in value significantly in a deflation.

Cullen Roche (36:41):
And touching on our previous point about why somebody would own bonds: if you’re a bond trader in this environment, you can make a strong argument going forward that if we end up in a disinflationary or deflation environment, at some point, even in the next five to 10 years at some point, you have to consider the scenario where interest rates in the US on the long end go to 1% or 0%, and we start looking a lot more like Japan and Germany where interest rates are at 0% on the long end; and in that scenario, your long bond that has zero credit risk, it goes up 20%, 30%, 40%, 50% in that scenario.

Cullen Roche (37:21):
There’s this weird outlier scenario there where if you had the risk of a deflation or disinflation, you could make an argument that owning that instrument actually makes sense because, on a risk adjusted basis, that would be probably the very best trade in this sort of an environment; where for a portion of your portfolio, maybe that outlier long-term treasury bond that everybody seems to hate right now might end up being the best risk-adjusted trade that anybody can make, and weirdly that’s been the best trade for 20, 30 years running. If you could buy a 30-year treasury bond back in 1980 at 12%, 13% on a risk-adjusted basis… You know, there’s a reason why people call Bill Gross and Jeff Gundlach the Bond Kings: it’s because having exposure to that asset class in the last 30 years has been by far the best risk adjusted trade you can make, especially on a credit risk quality basis.

Cullen Roche (38:19):
The risk/reward isn’t nearly the same as it was in 1980, but I feel like I’ve spent my whole career hearing about how you can own anything except treasury bill, and that’s cost people a lot of money, taking that position. I’m not a maximalist on anything; so taking this all-weather approach again, it makes a ton of sense to me.

Trey Lockerbie (38:44):
I love the all-weather approach. I think especially now when you see your portfolio tank, you can definitely be like, “Okay, I quit. I just want to buy index fund.” It’s easy to migrate to that philosophy very quickly. What I’m curious about is say you’re going to ETF or index into a portfolio, are there certain industries that perform better than others in a time like this? Commodities, I’ve heard mixed reviews on, for example. Is there one portion you would allocate or you allocate more towards, given what you know today?

Cullen Roche (39:14):
I mean I’m not a huge advocate of what academics call factor investing, so trying to pick either which segments of the market are… I mean to me, stocks are stocks are stocks, for the most part. And picking and choosing which part of the market to be in, it’s a guessing game, to be honest. Looking at value stocks today still looks like a great relative value relative to growth, especially you’re starting to see this peel back a lot this year. I think value finally outperformed growth by a huge margin last year, so you’re starting to see this maybe reversal, but this is all super… It has to be super customized because everyone’s needs are so personalized.

Cullen Roche (39:58):
But if I was a trader and gunned ahead, and forced to pick, “Where did I want to be?” I’d probably want to be tilted towards high-quality stocks with more of a value tilt, and I’d probably want to be international because the US has been on such a huge tear that has been so growth focused that the risk-adjusted outlook going forward to me looks… it looks a lot dicier if you’re just betting on the momentum trend of US tech, for instance, going forward in perpetuity. But again, I think the kicker with understanding any of these, especially inflation hedges… Inflation hedges are inflation hedges specifically because they’re not principle hedges in the short-term. Typically, with an inflation hedge, even if you look at gold or Bitcoin or the stock market, these tend to be very good long-term inflation hedges, and the trade-off is that you trade short-term nominal principle instability for those things.

Cullen Roche (41:06):
You get periods like this where Bitcoin’s down 25% this year, and the stock market is down 8%, 9%, whatever. You have periods of instability in the short-term where you can make an argument that dollars are the worst thing you can own right now. But you know what? A dollar was worth a dollar on January 1, and it’s still worth a dollar today. And so if you like to sleep well, if you like portfolio stability and balance inside of your portfolio: again, you’re trading long-term inflation instability in a dollar in exchange for short-term nominal principal stability, and that’s just the trade off you have to accept. That’s why everyone owns… Everyone listening to this owns some dollars in their bank account, which is totally rational.

Cullen Roche (41:53):
I own way more cash and short-term bonds than I probably ever should, according to modern portfolio theory. But you know what? I sleep really, really well because of it. And to me personally, I know that it’s, especially as an investment manager, I know cash is trash in the long run, I know that, but cash helps you sleep well; and to me sleep is really important, especially because I’ve got two kids under two and they’re driving me bonkers. It’s highly personalized, but I think understanding that trade-off is really important when you’re building a portfolio because that’s what life is all about: it’s about all these trade-offs, and building balance in things so that you’re not too overweight in certain ways where the downside risk is so asymmetric that it exposes you to a catastrophic short-term overreaction or problem in your life.

Trey Lockerbie (42:47):
When you say a dollar is a dollar, I just want to clarify something. Because yes, you’re correct. And even if you look at the DXY, if you’re comparing it to other currencies: yes, it’s the best out of all the bad currencies. Right? But even Ray Dalio has come out and said that when you’re talking about inflation, how you measure it, you can use the CPI number, for example, but you have to also include financial assets, and that’s coming from Ray Dalio. I found that really interesting. You have to include that. So when you talk about asset appreciation, especially in homes and equities and everything we’ve talked about, does that work its way into your inflation calculation at all?

Cullen Roche (43:21):
This one’s really messy, to be honest, and so this is part of the problem with trying to understand the CPI. Inflation indexes are really messy. It’s so easy to go in and look at the Bureau of Labor Statistics methodology for calculating the CPI, and just be like, “This is terrible. The way they do this doesn’t make sense. This doesn’t reflect my actual rate of inflation,” and that’s just because building a basket deflects the average consumer’s price inflation is… By definition, it’s going to end up being wrong because it doesn’t reflect what any of us actually end buying because we all buy different stuff, and so they’re trying to implement an average. And asset prices are really, really messy inside of all of this because the BLS, and a really any price index, any consumer price index, is trying to measure things that we actually consume.

Cullen Roche (44:15):
For instance, if a hamburger costs $10 today, and it costs $20 tomorrow… Well, if you eat a hamburger, and let’s say hamburgers were the only thing that you eat in the world: if you eat that hamburger, when you buy the hamburger initially you’ve got a $10 asset; but the second you eat it, you’ve consumed it, and so that thing is gone. And tomorrow, if that thing costs $20, it costs 100% more. Your living standards have materially declined because the replacement value of your existing dollars has gone down so much because now it costs more to buy these other things. Whereas with asset prices like with a home…

Cullen Roche (44:54):
A home, for instance, is a huge part of CPI, and a really messy and controversial part of how all this works, because you don’t really consume your home in the same sense that you consume a hamburger. So when the value of shelter increases, for instance, you’re not necessarily worse off. If I build a house for $1 million dollars… and the house, for whatever crazy reason, is $2 million tomorrow,,, I didn’t really consume anything. I invested a lot of money into a $1 million home and it’s worth $2 million tomorrow. I’m actually better off. A lot of the people around me are better off because now my comp makes all the homes around us more valuable. In theory, the whole economy is more valuable because the net worth of all of these homes increasing makes everybody’s balance sheet stronger, so it’s really tricky.

Cullen Roche (45:47):
The CPI is specifically trying to quantify things that we consume and need to replace, and asset prices are just really messy because they don’t… A home technically gets replaced and consumed over a really, really long period of time. Termites are consuming the wood in my home right now, so I’m going to have to replace it. I actually had to rebuild our whole house two years ago because it was literally falling apart from termites, basically. And so you consume a house over very long periods time, but then you also have this weird intangible with it where a house is really just a depreciating block of wood that sits on top of a scarce piece of land; and the land, nobody’s consuming land. Nobody can consume land. We can build more on top of it, but you can’t physically consume it, and so it makes it…

Cullen Roche (46:39):
I don’t love when people talk about asset price inflation because asset price inflation doesn’t necessarily make you worse off in the way that consumer price inflation does. When we consume a hamburger and it goes up in price, you’re definitively worse off. Whereas when the value of a home goes up, and you’ve got this so-called asset price inflation, people aren’t necessarily worse off. Some people might be worse off in a relative sense. For instance, if you’re a renter who was looking to purchase a home, you’re definitively worse off, but in aggregate people aren’t necessarily better or worse off because of asset price inflation. And in fact oftentimes, for instance when the stock market increases in value, typically if you’re a believer in the efficient market hypothesis or rational thought processes, then typically in the long run equity market increases are really good.

Cullen Roche (47:30):
Asset price inflation is not necessarily indicative of things getting worse, and I think that’s the problem that a lot of people have when they talk about asset price inflation, is that it’s this underlying assumption that it’s necessarily bad, where consumer price inflation is definitively bad, especially when it’s very high. Whereas asset price inflation, it’s a lot trickier to quantify whether that’s good or bad, and you can get into all other sorts of tangential arguments where you could argue that right now, based on my conversation, I think there’s been maybe a level of asset price inflation that creates real economic risk. Is that bad? Yeah, it could be in the short term. Will it play out to look rational in the long run? Yeah.

Cullen Roche (48:15):
I mean home prices in 2006, they look pretty rational right now, but in the short term that caused a lot of catastrophic volatility in the economy in the way that all filtered through. So it’s complex, Trey. I don’t have a really, a really simple, clean answer for this one.

Trey Lockerbie (48:32):
That’s right. That’s why we’re here. We like to talk about the complex topics. You know, I raised the question because, going back to the fed, and they’re speculating that they’re going to raise rates… that alone tanked pricing, especially in the high-flying tech stocks, for example… and it’s because: one, it’s hard to value their intangible assets and their cashflows into the future. But if you start thinking about rates and them raising, then it discounts even more the cashflows into the future, and that brings the values down.

Trey Lockerbie (48:59):
And when you’re talking about inflation, like we just were, as an individual I think it’s important to understand what your inflation rate is… what you said, what you consume… because one thing we didn’t talk about is things like healthcare and travel, and other things that you could argue might be consumed, so to speak, and they need to work their way into your equation.

Trey Lockerbie (49:18):
And going back to the Jeremy Grantham quote, I think what’s simple… What’s easy to see is if we do start incorporating other elements of inflation into the picture, then the market looks extremely overvalued. When you talk about this super bubble bursting, it’s easy to understand because just a slight increase in interest rates could bring this market down 50% to 80% probably, so it’s an important topic to discuss.

Trey Lockerbie (49:42):
That does bring up this other idea I’ve heard you talk about around mutual funds, and they don’t… Short stocks, right? But they do buy and sell, and they’ve been net sellers as of late. Do you think there’s something there as far as these trillions of dollars that are programmed to buy and continue buying, that increases the indexes over time, as a backstop for the economy in some way?

Cullen Roche (50:07):
This is a really… This is another one of these academic debates about passive versus active, and how much of the stock market rally is just the result of Vanguard just funneling money into the stock market endlessly, and that’s definitely not an unreasonable argument. I still think that when you look at the fundamentals of a lot of the underlying entities… for instance, in the S&P 500… corporate profits are at record highs today. Even when you make the asset price inflation argument, like yeah, “Has the fed influenced asset prices?” Almost certainly. But there’s also this underlying sense of fundamental reality where corporate profits actually are just crazy high right now. Is there a sense of rationality at all in this where it actually makes a lot of sense that asset prices are where they are? Who knows where they’re going to be in two or three years, and you could make…

Cullen Roche (51:11):
Going back to what I was talking about before, I think you could make an argument that the worrisome thing today is that the rate of change: the fact that it’s been based on, for instance, government spending, to a large degree, in the last two to three years, contributing to corporate profits… Well, if your fundamental argument there is that, “Yeah, this all makes sense going forward,” is the market pricing this in a way that expects this to be the new normal? Is the market expecting the government to run big deficit basically in perpetuity, for instance, and for consumer spending to remain high in perpetuity? And they’re really reasonable arguments to argue that that’s not going to be the case, in which case you have to look at the equity market and consider, “Well, maybe valuations are high for rational reasons, but maybe what the market is overlooking is the potential that a lot of this stuff is, especially the rate of change, is not going to be the same going forward.

Cullen Roche (52:10):
I don’t know. It’s a blend of both, I think, to be honest. There’s really reasonable points to be made about the fed, and the Vanguards of the world are just causing asset prices to go up and remain high. And I think there’s also really reasonable arguments that those flows coming into all these assets make a lot of sense, mainly just because the underlying entities are super strong. If you look at the top companies in the S&P 500, people talk about how Apple and Google, and these big entities, make up so much of the weighting of the entire stock market. Well, these companies are so far head and shoulders above what every other entity in entire global economy is like, in terms of their corporate performance, it just makes a lot of sense. Is that going to change? Who knows?

Cullen Roche (53:01):
One of the reasons I focus on macro is because I think it’s so hard to focus on individual entities, and what the individual entities are going to do in the future. But again, it’s probably a blend of both. The flows make asset prices higher, which creates this snowball effect, but a lot of that underlying flow makes a lot of fundamental sense at the same time.

Trey Lockerbie (53:25):
Now, just for fun, looking at your ETF, I noticed there’s not a crypto element to it. What would it take to put GBTC into something like your discipline fund? I’m curious.

Cullen Roche (53:36):
I hate that ETF. Or it’s not even an ETF, really. I cannot believe that the SEC has not approved, and they’ve allowed that thing and its huge premium. That whole thing makes my head explode. The SEC is somehow trying to do what’s in the best interest of investors, but they’ve allowed the Grayscale Bitcoin Trust to exist, in the nature that it has, not only is an egregious fee, but it’s just not even closely reflecting what at the actual price of the underlying asset does. And this is somehow good for investors? I do not understand that; I never will, I guess. I get increasingly intrigued by [inaudible 00:54:16] market cap ratings of all these assets. The crypto space right now is something like 1%, 2%, something like that, so it’s still really small on a relative basis.

Cullen Roche (54:27):
I probably would have put a crypto piece into the ETF if it hadn’t caused so many insurance and regulatory issues right now, so that’s a…

Cullen Roche (54:39):
To be honest, going back to the whole SEC thing with the Grayscale Trust, right now we’re still so early in the regulatory workout of all of this that we need… For a lot of us, especially the traditional asset managers, for them to adopt all of this, the regulatory structure has to mature a lot more before we can start to even adopt all this stuff in the way that a lot of us probably want to. To be honest, I mean that’s a big part of this, is that the regulators are just… They’re way behind the ball on a lot of this, and they haven’t updated the structures; and that means that a lot of us can’t access a lot of this stuff because, to be honest, it’s way too damn expensive to go into a market like that and expose yourself to the liability risk of not just the compliance side of things, but the insurance side of things and the shareholder risk of everything.

Cullen Roche (55:39):
I’d love to. Who knows what it will end up doing in the next five, 10 years. But I hope the regulators catch up, and I hope they start getting to a point where we can better… My view is that crypto, in the traditional finance world, are going to increasingly blend over time, but we’re still a long ways from being there.

Trey Lockerbie (56:04):
What’s your take on that discount to NAV with GBTC? How is that not getting arbitrage away like every other ETF to its NAV typically is?

Cullen Roche (56:13):
Who knows? I mean it’s a weird thing. And I would have thought that, especially with it has started to look like maybe a spot ETF was going to come to fruition maybe increasingly at some point, so I would have expected, especially because I think Grayscale… I may not have this right, but I think Grayscale is… I think they filed for a spot, right? Yeah. But they’re going to convert. I mean obviously, this whole closed-in fund structure is going to get converted into a new ETF at some point. I don’t know it. To be honest, my guess is it’s a regulatory risk, but I’m not… I don’t know the answer to it, to be honest,

Trey Lockerbie (57:02):
I don’t think anyone does. That’s why I was asking you.

Trey Lockerbie (57:05):
Cullen, before I let you go, I definitely want to make sure I give you a hand-off to talk about your ETF, or where people can find more about you and Pragmatic Capital, and all the resources you’ve shared, because they’re amazing. So let them know where they can find you.

Cullen Roche (57:17):
Yeah. Pragmatic Capitalism is my blog; that’s where, if you’re looking for educational resources, and things like that, the Understanding Money page is a huge resource that I’ve built. That’s a lot of my own work, a lot of outside resources, tons of good stuff there. I typically write once or twice a week on the site. And then company is Discipline Funds, and Discipline Fund ETF is… The ticker is DSCF, and it trades on the New York Stock Exchange. So if you like really boring all-weather type of portfolios, check it out.

Trey Lockerbie (57:49):
Cullen, you’re always a voice of reason. I really appreciate you coming on the show. This was super fun. And this is the first time we got to chat, so thank you for indulging me on some of these. But I just really loved learning and love your pragmatic approach, I really do, so thanks again. It’s always a great time.

Cullen Roche (58:03):
Awesome. Thank you, Trey.

Trey Lockerbie (58:05):
All right, everybody. That’s our show. If you’re enjoying these, please go ahead and follow us on your favorite podcast app, and maybe even leave us a review. You’re welcome to reach me directly on Twitter at Trey Lockerbie, and there’s a whole world of resources available for you at TheInvestorsPodcast.com. Check it out. And with that, we’ll see you again next time.

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Outro (58:38):
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