Michael Howell: AI Will Fuel Inflation, And Markets Aren’t Ready
Summary
Michael Howell, Managing Director at GL Indexes, warns that the global liquidity cycle is rolling over — just as AI spending, …
Transcript
We're in speculation now. There's no question about that. We've left calm behind in the short term. Whatever the merits of AI, it's inflationary for the economy. The big driver of gold has not been what has been happening from the Fed or from the ECB. It's basically been China. Hello and welcome to Wealthon. I'm Maggie Lake. Joining me today to discuss global markets is Michael Hal, managing director at GL Indexes. Hello, Michael. Wonderful to have you on again. >> Well, hi Maggie. Great to be here. Lots of lots going on as always. >> Lots going on. And and I want to follow up uh because the last time you and I spoke, you had the odds of a crisis pretty high. I think we were getting near 90% and you you saw some sort of concerns or cracks in the system that you were worried about. What are your liquidity models telling you now? Well, I think there's it's kind of unchanged really. I mean, the uh the evolution that we're talking about is um you know, it's not an instant um an instant correction. It's basically saying that, you know, we're around the top of the cycle in terms of liquidity impulses. Um the cycle actually is beginning to inflict lower. Uh I mean, you can see a chart that I'll I'll put up there which looks at the global liquidity cycle. Uh and this is a measure of the underlying momentum uh in liquidity worldwide. You can see the black line uh on the chart is uh basically indicating the underlying rate of growth uh of liquidity conditions worldwide. Now the fact that that black line is turning lower is not really telling us that liquidity is falling in absolute terms because it isn't. I mean liquidity is still inching higher but the key word is inching. I mean it's not really u moving very fast. And what you've got is a number of crossurrens that are going on. And I think if I sort of um you know outline those those three you can see maybe what the issues are. The first of those is that if you take US US liquidity per se US liquidity is dropping overall liquidity is dropping. Now uh digging into that number what you find is actually the real economy in other words the liquidity that's being used to drive uh manufacturing or service industry in the US is starting to fall off quite noticeably. Now that is really an indication of money shifting from financial markets into the real economy. So it's really testimony to a strong economy uh or an economy which is basically gearing up for growth. So you know all money that is anywhere must be somewhere and if it's in the real economy it's not in the financial sector. So the numbers that we're getting for financial liquidity that you're looking at here uh are really being tested or pulled down by the fact that liquidity is being is exiting financial markets and going much more into real things. So that's I think point number one. Point number two is that the Federal Reserve is actually trying to battle against that uh in cooperation with the Treasury. And what they're trying to do is to maintain stability in financial markets against this sort of headwind. Uh it may be great for the real economy, but it's not necessarily so good for funding uh and for financial market conditions. And really over the last what six months, the Fed itself has put about 600 billion effectively back into money markets, which is a pretty large sum. let's face it. Uh and what's more, the Treasury been acting uh very active in terms of share buybacks and trying to maintain stability in the in the Treasury market. So that's the second element. And then the third element we've got is that China mysteriously, and I I scratched my head, I'm pretty puzzled by this, uh has really hit the brakes in terms of liquidity creation. And we can, you know, dig into this later. Uh it's a baffling fact, but the fact is that it's a fact. and liquidity conditions by the people's bank uh have kind of fallen off a cliff of late. Now, that pretty much coincided with both Trump's visit and maybe the escalation of tensions in Iran in the Iran situation and it may be connected and there's been a lot of stories in the media uh or the sub media about how China's got a speculation problem and maybe the authorities are trying to clamp down on that. whatever the reason liquidity is going down and that's not helpful and I think you can see that already in the gold market. So soup, that's super interesting. Um and and I I do want to dig into that a little bit, but one of the things that jumps out and I think it's worth just stopping for a beat. Uh and and um just really quickly saying that we always talk about liquidity with you because you really um kind of created this understood the role this plays while you were at Solomon and ever since have have really kind of owned this space and and been doing a ton of research on it and and the the simplest way to think about it is that this liquidity is the kind of plumbing of the global financial system, right? So without it, if you've got really healthy financial system, this is flowing through and when you start to see it eb, it causes certain reactions and certain market conditions that we'll talk about. So that's why we we're talking about liquidity for those who are new to it. >> Correct. >> 100% correct. Yeah. >> Right. Um so when you hear something like uh you have liquidity moving from the financial sector to the real economy, I think a lot of people listening to this are going to be like fantastic. That's great. We want economic growth. We want the US economy or, you know, whatever, wherever you're sitting, the European economy to do well. We want that to happen. It's good for everyone. But it sounds like a negative when you say it because we know low liquidity causes ruptures in financial markets. Why is the why is that the case? Why is that no longer a positive? Or is it a positive just not for markets? explain that to me because it's kind of counterintuitive to people I think. >> Well, I think the first thing to say is that I mean actually I' I've just come back from uh from the US and I mean my impressions certainly going up and down the east coast but the economy is really buzzing. Uh I mean inflation looks to me a problem. Uh but activity you know activity levels I mean visually look look fantastic and I think that's kind of uh underscored by the fact that the ISM uh for manufacturing yesterday came out with a big print. So, you know, it's looking as if the economy definitely has got muscle here. Uh, and after all, that's what Scott Besson and and President Trump have been basically angling for. Uh, as we've been arguing over much of the last few few months, uh, you know, the Treasury is undertaking what we call Treasury QE. It's just trying to goose the economy. The deficit's big. You've got the capex boom on top of that. The economy is definitely on a roll. Now, why is that good and why is that bad? It's it's good for the E if you like uh for the earnings number. I mean that's going to be great. Uh and I think you can see those in a lot of knockout earnings numbers that are already being printed right now. Trouble is though that asset prices need another element and that's the PE and the PE tends to come under pressure u when you get um uh liquidity being drained and from another dimension when inflation starts to pick up because the quality of those earnings also deteriorate in a high inflation environment. So you know you got to think of it in in that way. There are there are two moving parts here. The E and the PE and often PE dominates the E. So the E may be the trend but the PE is really the cycle. And what you can see is a deterioration in the PE coming as liquidity conditions start to shift from financial usage to the read economy. The other thing you can see is that the other sort of component of that is what's happening in the fixed income markets. And you know it's often the case that equity markets are so sort of uh in thrral of higher earnings that they kind of miss the bigger story about the bond market and you can see yields pushing up but generally yields are you know yields are rising across the curve here and that's a worrying factor and you know the the US long bond is you know certainly around 5%. Now I think if you take a step back and you start to put this into context and you say well okay what's the nominal growth rate of the American economy right now uh given everything I've said um you know it could easily be in the 7 8% peranom rate now typically over the long term the fixed income markets the yield on the long-term treasury tends to match N GDP growth and if you're talking about 7 to 8% for the economy um then we're talking about a you know prospectively much much higher uh US long-term yields and the pressure's got to be up. Now that's not going to be good news for Scott Besson, is it? Uh uh you know and for funding the deficit and that's a problem. >> That's a huge problem. I mean do do you that's the the direction of travel. Do you think that can actually happen? I mean, there are some who just do not believe that the 30-year or longer duration US treasuries will be allowed to get that high like it would break the system. >> Sure, I agree. I mean, I think there's there's a lot of pro there's a lot of problems here. But the you know the issue that that one has to face and you know it's clearly being faced in the US because the dollar and US treasuries are so critical to the global financial system is that you know the worse the fiscal situation looks uh the more pressure there is on the bond market and the more pressure there is on the bond market the greater the risk of financial stability and that's the dilemma that everyone really now faces. So I think if you look at what's going on beneath the surface, as I said right at the beginning, you've seen evidence of the Federal Reserve injecting a lot of cash into markets uh over the last 6 months. I mean really since late October last year. Uh they put about $600 billion to work. And then on top of that, you've got the Treasury which is actively trying to suppress bond volatility by undertaking share buybacks. Uh sorry, by undertaking treasury buybacks. And this is this is critical. I mean, let let me let me try and evidence that. I'm going to have to sort of shift to uh um uh some charts right down the road here, but if you bear with me for a second. >> Yeah. And while you while you pull that up, I I'll I'm I'm going to sort of rephrase that and I think it's really important that you just said that that that the US Treasury is trying to suppress volatility. Um you can explain that a little bit. different than yield curve control, but there are a lot of people, Michael, in chats and in comments that we get that say, you know, that that the sort of government's intervening in the market, you know, that there's I don't want to use the word manipulation because I'm not sure that's what people are saying, but there's a feeling that things are going on and the market's not truly reflecting the pressures. So, are those two things very different? >> Well, I think abs you you've clearly got intervention. I mean, there's there's no question about it. But I think, you know, you've got to take the view that, you know, are you are you reassured that the Treasury and the Fed have got their thumb over the over the leak. Uh or you can are you worried maybe a bit more like us that the system is starting to see cracks and that's really the the dilemma. So you either the glass is half full or it's half empty. Uh and I'm beginning to think it's more like the latter right now. >> Hi, it's Maggie Le from Wealthon. If you'd like to stress test your portfolio or see if you're on track to meet your financial goals, you can get a free portfolio review from an adviser in our network. Just go to wealthon.comfree. Yeah. Sort of you're handcuffed by the market you have, not the one you know that not the financial conditions you'd like to be operating in when it comes to reform. Hard to reform when you're kind of facing crisis situation, which it sounds like. Um, so let me let me ask you as we as we talk about what this all means for sort of asset allocation. Let me ask you a question. So we have a a bond market that's that authorities are kind of holding together but is feeling the upward pressure that yields the tendency would be for them to move higher if not for extraordinary measures happening from both Treasury and Fed. How does how does AI and this relentless AI rally fit into this at all? >> Well, it does, but you know, I think one's got to one's got to get perspective here. And the perspective is that in the short term, uh, whatever the merits of AI, in the short term, it's inflationary for the economy. I mean, there's there's no question about that. I mean, the scale of the capex boom that is going on, uh, you know, is eyewatering. I mean the these are we're talking about astonishingly large numbers that are going to be spent um and you know rolling out these uh these different you know these different products and the fact is that that is going to be inflationary for the economy uh there's there's no question about that and that's why I think the Federal Reserve has got to be alert now to come back and say well this is deflationary in the long term well you know maybe I mean I accept that I mean it's logical that it would be but we haven't seen the evidence of that yet and I think the Federal Reserve has got to react to uh it shouldn't be anticipating. Uh you know this is almost uh you know it goes against what um what Kevin Walsh is saying about forward guidance. I mean he's uh he's already got a view a fixed view about what this is going to do and I think that's the wrong thing to have. It's inflationary in the short term. We don't know what's going to happen in the in the longer term. Uh the longer term is a long a long time away and we're just going to wait and see. I think one of the things that we know um is that u it is deflationary but it tends to be deflationary for the product itself and you know you just got to go back to the you know I remember back in the time when I was at Salomon brothers and I forget the actual year but Salomon did a monster equity placing an IPO for global crossing and a global crossing was in the fiber cable uh business and that was the you know that was the then AI that was that was the nana if you like uh of uh of investment. Uh it was a you know great great business. Margins were high. Uh product prices were were great. Um and it was good until it wasn't. And what happened in the I think within five years global crossing was bust and the price of fiber cable uh fiber optic cable and this was these were laying transatlantic links. Uh the price of fiber optic cable if I remember rightly fell by 90%. Now you know what that's saying is that we know that technology is deflationary but it's very deflationary for the product itself. Think of PE think of you know PCs. Same thing's happened. You know um you know if you wanted to buy a PC 20 20 years ago it was probably you know dramatically more expensive than you'd pay now and even for a worse you know a worse um um spec. >> So this is the fact. I mean I think AI prices are going to tumble uh because of all this investment. So some people look at this and say this the having a an AI stock up 30% in a day you know these are treating trading like meme stocks this is the sign of a blowoff top like this is the signal that we are we are reaching some sort of tipping point but it sounds like from all the work you do you wouldn't just go on an equity valuation you would you would be looking at other things going on under the hood are they connected or should we not be looking so much at the price of an AI stock, but we should be looking at what's happening in terms of liquidity flows. Are they two separate things we need to look at? >> Well, I think you need to look at the whole picture. You got to put context put it into context, Maggie. I think that, you know, I put a slide up uh now which is looking at the asset allocation cycle schematically. And I think what you the way that we asset allocate is not looking at one single indicator but trying to sort of frame it in terms of what we're seeing uh from many different angles and you know basically at this peak of the liquidity cycle or the fact the liquidity cycle has peaked and is going down what it's been telling us is that the peak of the cycle tends to be uh a time when commodity commodity prices do really well and they have done we you know we've seen a commodity boom. Uh that's for sure. Uh we've come off a period where equities have had, you know, a fantastic two or three years. Uh if you look at that chart on the left, that's the upswing of the cycle. That's when equities do outperform. No question about it. Uh you tend to see through that phase a bare steepening of yield curves and then as you get the inflection, you tend to see a bare flattening of curves. Now the one thing I would say is that the two uh striking features of markets that I would uh you know look to now is one is commodity markets are still strong and the second thing is that you're getting a bare flattening of the yield curve. Now no one has been suggesting that was going to happen. The consensus view among fixed income investors on January 1 this year was you would get basically a bare steepening. Right? You haven't had that. You had a bare flattening. And what that means is that although uh yields are going up across the curve, the short end of the market is rising faster than the long end. So in other words, the whole curve is flattening. That's normally a late cycle sign. Okay. Uh and what you'd also should be seeing is resource stocks outperforming things like energy stocks outperforming. Well, I mean they did now they've sort of stalled a bit. And what's coming in the middle is this big surge in AI. Now, I kind of get the idea that maybe this is connected with great earnings numbers. So, people have got a feel-good factor. you got some big IPOs upcoming and it may well be that the institutions are positioning themselves ready for that by buying into that space and maybe because of the narrow float uh you know as um you know our friend Mike Green says uh you know if you're trying to put you know squeeze a quart into a pint bottle which is what the problem with passive investing is uh and small floats you're going to get big price movements that could be true as well so I think you've got you know let's Think of uh let's try and put that AI surge in context. Liquidity is inflecting and slowing. The economy is redot. Inflation is more of a problem. Commodity prices are racing and you get a bare flattening in the yield curve. All of those are late cycle signs apart from the tech surge. >> So I is the fact that the long that rates are rising more quickly on the short end than the long end. Does it matter if if the Treasury and Fed are keeping volatility down? Do their measures help suppress things on the long end? Is that why we've seen the longer end yields retreat a little bit from that high they hit um just a couple of months ago? And does it matter or is you still see this as an accurate sign that we're in that leg of the cycle? >> Well, I think it's I think it's hard to dismiss. you know, you've got a you've got a lot of um you know, uh you've got a lot of things lining up and you know, as they say, you know, markets very often, if it's yellow and quacks, it's a duck. And uh you know, the fact is that we've got a lot of evidence now coming that you've got strong commodities, strong economy, inflation pressures, bare flattening of the curve, etc. All these things tend to be uh indications that we're we're late cycle. Now, you know, I'm not saying, you know, jump now. uh but with asset allocation you've got to gradually move uh you know it's like a clock it tends to move sequentially and the problem is that you know we tend to see as you can see on the right hand side that you get uh phases of the market so we think of calm speculation turbulence rebound generic names those are sort of quadrants for investing and basically what we say is well look you know we're in speculation now there's no question about that I would say and I think that you know even people that are uh making money out tech would agree that this is a speculative time of the market. Uh for sure that's what it feels like. We've left calm behind. So the easy money has been made. You can make good money in speculation, but it's kind of low quality because volatility is high. You may get positive returns, but you've got to, you know, judge that against the volatility you that you're experiencing. But then the next phase is turbulence. And turbulence is sort of self-explanatory. you tend to lose money and it tends to be a very painful exercise because volatility picks up and you know that's that's the problem. That's where we're heading I think. U but we'll see. So in in in that turbulence I mean we we would expect to see people looking for a safe haven right somewhere to sort of go for safety to protect their money. Is it bonds or is there more competition from gold now given all the concerns that we've discussed around the bond market and the pressures around the bond market? Are those two competing to to be the safe haven? >> Well, I think that the I think the long end it's too early to buy the long end of the bond market yet. I mean, that that would be my view. Uh I think you can basically you can probably move well certainly short but maybe mid duration. Um, you know, if you get into the maths of bonds, I mean, probably given the prospective or likely increases in yields across the curve, the carry you're getting on mid- duration bonds, I mean, 5year bonds is probably enough to protect your downside. So, you wouldn't lose any money there. You might not make much on over 12 months, but you probably got, you know, a reasonable u reasonable protection there up, you know, from, you know, cash right up to about five year duration bonds. Um gold. Yeah, I think gold looks good. I think that uh the issue is why is the gold market uh languishing right now? And I think the answer to that comes back to China. Um my view has been that there's no great debasement trade in the west uh that has been pushing the gold market up. I mean this may have helped a bit. The big one is China. And I'll uh if I can u shift on this presentation, I'll show you uh a little bit later uh what the Chinese data is basically telling us. And that is um uh that is at the moment not great. But let me uh let me just get there one second. Right. Okay. So this is the Chinese central bank, the People's Bank of China. This is showing uh what the People's Bank of China has been doing every day in the markets. Okay. So, just so we're clear on what that this data is showing, this is the change in their net liquidity injections versus a year ago. I've taken it versus a year ago because the Chinese financial system is still a fairly rudimentary system. um there's a lot of seasonality in that and so it's kind of difficult particularly with moving festivals like the Luna New Year to accurately smooth the data. So what I've done is to just take the year-on-year change and put a moving average through it and what you're looking at is net liquidity injections in uh in billions of yuan or RMBB and you can see the slump. I mean they're bas uh trying to goose the system for a long time and they now suddenly turn tail. Now why is that so important? Because it's critical for the gold market. And maybe if I show this chart first. This is the same data on PBOC liquidity, right? But this is actually the level of liquidity that the people's bank uh is been injecting in the markets. You get a much clearer idea of how much they've ramped up their liquidity injections of late. And the orange line is the gold price. Now my view would be is that what the the big driver of gold has not been what has been happening from the Fed or from the ECB or whatever retail investors in in Europe or America. It's basically been China. Uh it's been this is a this is Asian-driven. Uh it's driven in two ways. One by the retail investor uh in China who wants protection against this monetary inflation that's going on. I mean bear in mind that China has capital controls. Uh Chinese residents are not allowed to buy crypto. Uh that's uh that's banned. Uh what they can buy are Chinese stocks, real estate uh or gold. And I think that out of the three uh should the main choice has been gold uh bullion for you know for obvious reasons. Uh they can't export that they can hold it and there's been tremendous demand return demand. So the Shanghai gold exchange now is the marginal price of world of world bullion. I think that's fact. Now what you can see is an inflection in that curve as the gold price has come down. It's come down pretty much uh you know in line with that inflection in PBOC liquidity and as I said the earlier chart was a rate of change. So it looks a bit more dramatic than we've got here. Um, and you know, the other fact is that the Chinese government itself is also buying gold because this is part of its long-term strategy to underpin the remn as an international currency. And simultaneously, you've got the government and you've got Chinese retail buying gold. Now, the problem is in the very short term, if the Chinese authorities hit the brakes uh on liquidity injections, that will uh undermine the gold market. And I think that's what's happening. I think we've got to assess in the long term is does that in liquidity boost continue or is this the end of the game? >> My view is it's going to continue. And I think it's going to continue for two reasons. One is if you look at the government, what the government has to do, China needs a a currency that will compete with the dollar. U you know, you know, my my world is a world of capital wars. And I think this is you know the clash of capitals between America and China. U both are vying for supremacy. I mean clearly we hope America wins but you know China is uh is playing a game here and what it needs is to underpin uh the yuan. So the yuan is used more widely in the international arena. Unfortunately China does not have a big international bond market. It's got a big bond market but that's not really recognized. So it does it lacks the collateral against uh which it can underpin the yuan uh and that's what gold functions as. So they are using gold as the collateral base for the yuan. Doesn't mean they're going to a gold standard. It means that that's just a collateral base. It will give people security a little bit of the old gold standard. Um back pre 1971 no one traded gold. If I wanted gold from Fort Knox I was certainly unable to get it. Um uh if you were a foreign government, a friendly foreign government, it was sort of, you know, a great sucking of teeth from the US Treasury. Maybe reluctantly a few bars would be dished out, but there was no real access. Same with China. That's what they're doing. So you've got that as the dominant a dominant trend and then the Chinese are going to have to get rid of their debt problem. And the only way that you can get rid of debt uh you know history tells you time and time again is to devalue uh your money, print money internally, devalue your currency. And that's what they're doing. Uh they've got the benefit of capital control. So that will basically not transmit to the uh offshore yuan I don't think but you know never say never I suppose but that's what they're trying to do. And if they print money domestically, they will devalue debt and they will basically raise the gold price in nuance significantly. And I think that's what they're trying to do. Uh but they're not doing it as I say right now. But let's watch the data and see if they restart. >> So this is super interesting. And if if your theory plays out, um this will we will see potentially these drop offs in liquidity as they try to squash the speculation, the retail speculation around it pull the price down a bit, but their the the sort of main driver of it and I don't know if it's 8020 or what you think it is, but that but the government buying of it will continue. So we may see gold pull back when the retail part of China has to put the brakes on, but you would expect to see it another leg up as that government continues to build reserves. Is that right? >> Absolutely. And I mean I think the other point to make is that this buying is secretive. I mean it's not it's not the Chinese don't fess up to it. The numbers that they uh they claim to have uh are probably about 2,000 tons. I mean, US Fort Knox is 8,000. Um, so to put that in context, I think the the reality is that China has a lot lot more than 2,000. Uh, more more likely six, but they've effectively, you know, they've they've hidden that. >> So, you're you're saying basically China controls the gold price. >> Yeah. No question about that. So do you think that we if they are if they are on this path and we are in this sort of you know clash of titans in capital wars uh the US collateral we tend to think of it as um based on or the or the reserve system is based on oil or treasuries but also >> yeah US I mean there's a link to oil and there's no question because you know that OPEC uh tends OPEC prices in dollars and it tends to invest in US treasuries. >> Yeah. Is that uh a weakness for the US if we are if you're saying the the increasingly the the buyer of treasuries is hedge funds not other sovereigns? Um is the US vulnerable if that is their collateral base? Well, it's vulnerable, but the I mean the reality is is that you if you've got uh you know in you've got foreign governments who basically are in the situation of or the luxurious situation of having big trade surpluses. What what are they what are they going to invest in? Um they can't put money into the Swiss Frank. It's too small. The euro well possibly, but I think there's you know there are questions clear long-term questions over the euro. Um, and it's, you know, from a legal point of view, it's pretty much in the dollar camp anyway. Uh, so if there are any any sort of sanctions, uh, that America imposes, the Europeans are going to have to impose the same sanctions. So why not just go for the dollar from that perspective? Um, so the, you know, it's it's there's there's no choice. you you've got to put money into dollar assets and that's you know the US commands uh the global financial system still and that is not going to change overnight uh for sure. So I'm still you know very much in the camp that says that the dollar remains dominant. We may be arguing over the level of the dollar but in terms of transactions the dollar is is still king. >> You you you asked a provocative question on Substack. China controls the gold market. Will she also control the oil market? What what did you mean by that? Well, I think that that what that comes back to is maybe uh you know another thought I'll I'll maybe if I if I go back I don't want to shift too much in these go through these slides >> but the but the other thing to try and understand is what's going on uh with oil gold or whatever and you know these are these are these are important um clearly important um uh considerations. Now this is maybe uh coming back to this point that if you look at the gold oil ratio the gold oil ratio is plotted here uh and what you can see is data this is monthly data going all the way back to 1970. Now although economists tend to dismiss this I think many practitioners in the markets tend to look at these ratios uh as a way of trying to understand how markets are working. And what you can see is over the very long term that average of the gold oil ratio. This is an ounce of gold to a barrel of oil has averaged about 20 times. Okay. Now, okay, it fluctuates, but that's the long run average. And you can see on that chart uh a couple of spikes, one COVID and one recently. Now that 20 times ratio has basically existed even when gold in 1970 was 35 bucks an ounce and oil was about two and a what two and a quarter dollar a barrel. Uh and it's persisted all the way through to 2022 when gold was $2,000 an ounce and oil about $100 a barrel 20 times it right through that period. Now what that chart shows is remarkable uh mean reversion. And if you look at it statistically, it comes out, you know, as a uh you know, uh five-star um you know, a five-star example of mean reversion and it occurs within a 2 to three year period. So whenever whenever there's a big displacement, you will see uh that ratio coming down. Now the point I think I was making here is to say that uh you know where are we now? What's the gold price? for the gold price is let's say $4,000 somewhere between $4,000 and $5,000 an ounce. That's probably a long run equilibrium perhaps, but let's assume that is. Divide that by 20. What have you got? Over $200 a barrel of oil. Now, the push back on that statement is remarkable. Uh you know, I've presented this to clients. presented it to recently at a conference with a lot of technical analysts and absolutely nobody thought I was sane uh saying that this gold the oil could go to 200 was such a maverick view uh makes me think that from a contrarian point of view it's worth contemplating and I'm not necessarily forecasting that I'm just saying you you can triangulate this so if you think that that oil gold ratio sticks at 20 and you think that the gold market is underpinned at um $4,000, $5,000 an ounce. Why shouldn't oil go to 200? Uh it's the same thing. Anytime through that time series, you could say, well, okay, let's assume gold is a,000. Uh let's, you know, sitting in 1990, let's assume around uh you know, year 2000 2010 that you get oil at a,000 uh gold at a,000 using that 20 ratio, you say, well, okay, the oil price is going to uh is going to at least double or triple. And people would say, "You're mad. You're mad." But it happened. Okay. >> And it's just a question of thinking this through. Now, why is it that uh that oil shouldn't go to to that to that height of $200 $200? It looks very cheap because of many many comparisons against other commodities in real terms and whatever. So, I think there's, you know, the direction maybe we're we're clear on the level we can debate. Uh but you know why should the 20 times ratio change? I don't know. I mean it seems to hold up. Uh is gold underpinned at $4,000$5,000 an ounce? Well, my view is that China is basically underpinning gold at those levels because it has to keep buying and um that maybe is the the long-term trend upwards in gold. So why shouldn't oil um move a lot higher? And you know, we're told, we're schooled, you know, time and again by analysts to say there's surpluses of oil uh in the system. But if the world economy starts to pick up and China starts to get some traction, those surpluses will start to disappear and the oil market tighten >> and there the by the way, you know, we already know they've drawn down inventories and it's not always the ultimate supply, it's the supply chain. Can you get it where it needs to be? You know, and that is has an influence on price as well. Um it's certainly going to be interesting to watch. Of course, that would just add to the inflationary pressures that >> the Fed and Treasury. >> Yeah. And could the Fed avoid um pushing rates higher? I mean, I anyway think that the Fed is going to have to raise rates in the next 12 months. Uh because I think there is an inflation issue there. >> Do you think the market's accurately pricing that inflation risk right now? >> No. I mean, but you look at you look at the u at the tips market. I just don't think it is. I mean, the tips market, what have we now? We're probably uh implied inflation, 10 year inflation 2.6 or there or thereabouts. I mean, that's basically saying that the Fed hits 2% target more or less with a little bit of a risk premium in there. I mean, I just there's no way. I mean, the the Fed hasn't got anywhere near its target uh for what is it now? 62 months. Um you know, I mean, way back, what was that way back in 2021? I mean, the 2% is fantasy. This is a slight slight departure, but everything is connected as it is. Uh, Bitcoin crypto had just so much negativity around crypto right now. We're seeing it sort of head lower. Does this just feel like a down cycle, especially if you see liquidities turning down, you know, another sort of so-called Bitcoin winter or is there something deeper or more fundamental happening here? We are seeing huge outflows out of Bitcoin ETFs. >> Let me answer the question. I mean this this chart is looking at the movement between liquidity and a basket of cryptos. So bees is Bitcoin, Ethereum, Salana in a 60 30 10 uh% uh split. Okay, so that's the orange line. The black line is changes in liquidity and we've advanced the black line by 13 weeks. Okay, three months. Okay. So, you know, crypto is a fantastic barometer of underlying liquidity conditions >> and liquidity is predicting what's happening to liquidity. It does. So, to to crypto doesn't get every twist and turn, but it's approximately right here. And in actual fact, this chart is probably about 10 days old. And you know, you that orange, if I refresh that, the orange line would be down about halfway down that black line by now. So you know you're starting to see you know more evidence that this is this is true. So you know again that's further evidence to say the liquidity cycle is beginning to roll over and you know as I stress Maggie I mean this is not because the Fed is tightening rather you know far from it the Fed's been pretty generous here into the markets it's happening because the US economy is on a roll and there's a giant sucking sound as money is being drawn out of financial markets. I mean, just think, you know, this this AI spend uh that's going on by the big tech companies. I mean, where have they been getting the money from? They've been taking it out of their treasury departments. And where was that previously? It was in the financial system. So, it's being drawn out and it's being spent in the real economy. All money that is anywhere must be somewhere. So, if it's in the real economy, it's not in the financial system. And we're starting to see the cracks appearing because of that. >> It's so interesting. I always am so struck by this when you talk about this because you know we have these politicians uh everywhere by the way run where they are elected, you know, uh run on campaigns that say we're going to help you and your pocketbook. But the way you set this up, it does not seem like the real economy and the financial economy, stocks and bonds can do well together. can both thrive or do you have to have an equilibrium where like >> they're both a little bit sucky so nothing blows up? >> I think you you got to remember that the you know let's look at the context in terms of inflation. I think if you have a low inflation environment um then I think th those asset classes you know tend to be pretty good hedges for one another. I think once you start to get into a higher inflation environment bonds do badly, stocks do badly. um if you get into a deflationary environment, uh bonds do well, stocks do badly. So, it's only that little window uh where you've got you know low and stable inflation uh that you can see this the sort of the um the benefits of holding stocks and bonds together in a portfolio. Um so anyway, I mean the point >> are stocks and the real economy the same thing? No, they're they're they're not. But they're um um I mean the going back to what I said earlier on, I mean the E is the same for sure. Yeah. >> If you can live by the E alone, so if you hold over the long term, yeah, but we're not in a world where people can hold over the long term. And you got to think people think about performance. And what drives performance is not just the E, it's the PE. And the P can get crushed if inflation picks up and or bond yields spike. And that's really what we're talking about right now. So, you know, the market should be derating um in anticipation of higher inflation and in a response to high yields that we've seen in the Treasury market. >> Yeah, this is this is why inflation matters so much. So, let's end on this, Michael. And given that we are facing all of this difficulty around inflation, what if you could give Kevin Worsh some advice, what would it be? Well, I think the, you know, the sort of bitter truth is that they've got to start tightening pretty quickly in anticipation of a bigger inflation problem. That won't happen, I don't think. Uh, but that's what they they should be doing. It's very difficult politically to do that. And that's why we tend to get inflation problems. Um, and that was why if you look back to the 1970s, I mean, the environment strikes me as remarkably similar to what happened in the 70s. I I was only a student so I I barely remember what was happening. But I do recall that what you saw during that period were a series of supply shocks that people at the time thought were completely unconnected. So oil prices went up. I mean gold had gone up previously, oil prices spiked, then you got coffee prices going up, sugar prices going up, etc. But people didn't really join the dots until they were forced to. And then you could see this big commodity inflation. And that's pretty much what we're seeing now. And I think the you know the evidence would be whether it's um you know uh the fact that you've got um you know the straits of moves being closed and you're getting uh fertilizers being shipped or whatever it may be or helium or whatever it is. This is going to add to the to cost pressures through the system and it looks to me that soft commodities are you know primed to to move a lot higher here. >> He's got his work cut out for him. Michael, thank you so much. It's always fantastic to catch up with you and get a peek inside the good work you do and help us understand uh you know a part of the market that we're not always watching. So, thank you so much. >> Great pleasure, mate. Always a pleasure. Thank you.
Michael Howell: AI Will Fuel Inflation, And Markets Aren’t Ready
Summary
Michael Howell, Managing Director at GL Indexes, warns that the global liquidity cycle is rolling over — just as AI spending, …Transcript
We're in speculation now. There's no question about that. We've left calm behind in the short term. Whatever the merits of AI, it's inflationary for the economy. The big driver of gold has not been what has been happening from the Fed or from the ECB. It's basically been China. Hello and welcome to Wealthon. I'm Maggie Lake. Joining me today to discuss global markets is Michael Hal, managing director at GL Indexes. Hello, Michael. Wonderful to have you on again. >> Well, hi Maggie. Great to be here. Lots of lots going on as always. >> Lots going on. And and I want to follow up uh because the last time you and I spoke, you had the odds of a crisis pretty high. I think we were getting near 90% and you you saw some sort of concerns or cracks in the system that you were worried about. What are your liquidity models telling you now? Well, I think there's it's kind of unchanged really. I mean, the uh the evolution that we're talking about is um you know, it's not an instant um an instant correction. It's basically saying that, you know, we're around the top of the cycle in terms of liquidity impulses. Um the cycle actually is beginning to inflict lower. Uh I mean, you can see a chart that I'll I'll put up there which looks at the global liquidity cycle. Uh and this is a measure of the underlying momentum uh in liquidity worldwide. You can see the black line uh on the chart is uh basically indicating the underlying rate of growth uh of liquidity conditions worldwide. Now the fact that that black line is turning lower is not really telling us that liquidity is falling in absolute terms because it isn't. I mean liquidity is still inching higher but the key word is inching. I mean it's not really u moving very fast. And what you've got is a number of crossurrens that are going on. And I think if I sort of um you know outline those those three you can see maybe what the issues are. The first of those is that if you take US US liquidity per se US liquidity is dropping overall liquidity is dropping. Now uh digging into that number what you find is actually the real economy in other words the liquidity that's being used to drive uh manufacturing or service industry in the US is starting to fall off quite noticeably. Now that is really an indication of money shifting from financial markets into the real economy. So it's really testimony to a strong economy uh or an economy which is basically gearing up for growth. So you know all money that is anywhere must be somewhere and if it's in the real economy it's not in the financial sector. So the numbers that we're getting for financial liquidity that you're looking at here uh are really being tested or pulled down by the fact that liquidity is being is exiting financial markets and going much more into real things. So that's I think point number one. Point number two is that the Federal Reserve is actually trying to battle against that uh in cooperation with the Treasury. And what they're trying to do is to maintain stability in financial markets against this sort of headwind. Uh it may be great for the real economy, but it's not necessarily so good for funding uh and for financial market conditions. And really over the last what six months, the Fed itself has put about 600 billion effectively back into money markets, which is a pretty large sum. let's face it. Uh and what's more, the Treasury been acting uh very active in terms of share buybacks and trying to maintain stability in the in the Treasury market. So that's the second element. And then the third element we've got is that China mysteriously, and I I scratched my head, I'm pretty puzzled by this, uh has really hit the brakes in terms of liquidity creation. And we can, you know, dig into this later. Uh it's a baffling fact, but the fact is that it's a fact. and liquidity conditions by the people's bank uh have kind of fallen off a cliff of late. Now, that pretty much coincided with both Trump's visit and maybe the escalation of tensions in Iran in the Iran situation and it may be connected and there's been a lot of stories in the media uh or the sub media about how China's got a speculation problem and maybe the authorities are trying to clamp down on that. whatever the reason liquidity is going down and that's not helpful and I think you can see that already in the gold market. So soup, that's super interesting. Um and and I I do want to dig into that a little bit, but one of the things that jumps out and I think it's worth just stopping for a beat. Uh and and um just really quickly saying that we always talk about liquidity with you because you really um kind of created this understood the role this plays while you were at Solomon and ever since have have really kind of owned this space and and been doing a ton of research on it and and the the simplest way to think about it is that this liquidity is the kind of plumbing of the global financial system, right? So without it, if you've got really healthy financial system, this is flowing through and when you start to see it eb, it causes certain reactions and certain market conditions that we'll talk about. So that's why we we're talking about liquidity for those who are new to it. >> Correct. >> 100% correct. Yeah. >> Right. Um so when you hear something like uh you have liquidity moving from the financial sector to the real economy, I think a lot of people listening to this are going to be like fantastic. That's great. We want economic growth. We want the US economy or, you know, whatever, wherever you're sitting, the European economy to do well. We want that to happen. It's good for everyone. But it sounds like a negative when you say it because we know low liquidity causes ruptures in financial markets. Why is the why is that the case? Why is that no longer a positive? Or is it a positive just not for markets? explain that to me because it's kind of counterintuitive to people I think. >> Well, I think the first thing to say is that I mean actually I' I've just come back from uh from the US and I mean my impressions certainly going up and down the east coast but the economy is really buzzing. Uh I mean inflation looks to me a problem. Uh but activity you know activity levels I mean visually look look fantastic and I think that's kind of uh underscored by the fact that the ISM uh for manufacturing yesterday came out with a big print. So, you know, it's looking as if the economy definitely has got muscle here. Uh, and after all, that's what Scott Besson and and President Trump have been basically angling for. Uh, as we've been arguing over much of the last few few months, uh, you know, the Treasury is undertaking what we call Treasury QE. It's just trying to goose the economy. The deficit's big. You've got the capex boom on top of that. The economy is definitely on a roll. Now, why is that good and why is that bad? It's it's good for the E if you like uh for the earnings number. I mean that's going to be great. Uh and I think you can see those in a lot of knockout earnings numbers that are already being printed right now. Trouble is though that asset prices need another element and that's the PE and the PE tends to come under pressure u when you get um uh liquidity being drained and from another dimension when inflation starts to pick up because the quality of those earnings also deteriorate in a high inflation environment. So you know you got to think of it in in that way. There are there are two moving parts here. The E and the PE and often PE dominates the E. So the E may be the trend but the PE is really the cycle. And what you can see is a deterioration in the PE coming as liquidity conditions start to shift from financial usage to the read economy. The other thing you can see is that the other sort of component of that is what's happening in the fixed income markets. And you know it's often the case that equity markets are so sort of uh in thrral of higher earnings that they kind of miss the bigger story about the bond market and you can see yields pushing up but generally yields are you know yields are rising across the curve here and that's a worrying factor and you know the the US long bond is you know certainly around 5%. Now I think if you take a step back and you start to put this into context and you say well okay what's the nominal growth rate of the American economy right now uh given everything I've said um you know it could easily be in the 7 8% peranom rate now typically over the long term the fixed income markets the yield on the long-term treasury tends to match N GDP growth and if you're talking about 7 to 8% for the economy um then we're talking about a you know prospectively much much higher uh US long-term yields and the pressure's got to be up. Now that's not going to be good news for Scott Besson, is it? Uh uh you know and for funding the deficit and that's a problem. >> That's a huge problem. I mean do do you that's the the direction of travel. Do you think that can actually happen? I mean, there are some who just do not believe that the 30-year or longer duration US treasuries will be allowed to get that high like it would break the system. >> Sure, I agree. I mean, I think there's there's a lot of pro there's a lot of problems here. But the you know the issue that that one has to face and you know it's clearly being faced in the US because the dollar and US treasuries are so critical to the global financial system is that you know the worse the fiscal situation looks uh the more pressure there is on the bond market and the more pressure there is on the bond market the greater the risk of financial stability and that's the dilemma that everyone really now faces. So I think if you look at what's going on beneath the surface, as I said right at the beginning, you've seen evidence of the Federal Reserve injecting a lot of cash into markets uh over the last 6 months. I mean really since late October last year. Uh they put about $600 billion to work. And then on top of that, you've got the Treasury which is actively trying to suppress bond volatility by undertaking share buybacks. Uh sorry, by undertaking treasury buybacks. And this is this is critical. I mean, let let me let me try and evidence that. I'm going to have to sort of shift to uh um uh some charts right down the road here, but if you bear with me for a second. >> Yeah. And while you while you pull that up, I I'll I'm I'm going to sort of rephrase that and I think it's really important that you just said that that that the US Treasury is trying to suppress volatility. Um you can explain that a little bit. different than yield curve control, but there are a lot of people, Michael, in chats and in comments that we get that say, you know, that that the sort of government's intervening in the market, you know, that there's I don't want to use the word manipulation because I'm not sure that's what people are saying, but there's a feeling that things are going on and the market's not truly reflecting the pressures. So, are those two things very different? >> Well, I think abs you you've clearly got intervention. I mean, there's there's no question about it. But I think, you know, you've got to take the view that, you know, are you are you reassured that the Treasury and the Fed have got their thumb over the over the leak. Uh or you can are you worried maybe a bit more like us that the system is starting to see cracks and that's really the the dilemma. So you either the glass is half full or it's half empty. Uh and I'm beginning to think it's more like the latter right now. >> Hi, it's Maggie Le from Wealthon. If you'd like to stress test your portfolio or see if you're on track to meet your financial goals, you can get a free portfolio review from an adviser in our network. Just go to wealthon.comfree. Yeah. Sort of you're handcuffed by the market you have, not the one you know that not the financial conditions you'd like to be operating in when it comes to reform. Hard to reform when you're kind of facing crisis situation, which it sounds like. Um, so let me let me ask you as we as we talk about what this all means for sort of asset allocation. Let me ask you a question. So we have a a bond market that's that authorities are kind of holding together but is feeling the upward pressure that yields the tendency would be for them to move higher if not for extraordinary measures happening from both Treasury and Fed. How does how does AI and this relentless AI rally fit into this at all? >> Well, it does, but you know, I think one's got to one's got to get perspective here. And the perspective is that in the short term, uh, whatever the merits of AI, in the short term, it's inflationary for the economy. I mean, there's there's no question about that. I mean, the scale of the capex boom that is going on, uh, you know, is eyewatering. I mean the these are we're talking about astonishingly large numbers that are going to be spent um and you know rolling out these uh these different you know these different products and the fact is that that is going to be inflationary for the economy uh there's there's no question about that and that's why I think the Federal Reserve has got to be alert now to come back and say well this is deflationary in the long term well you know maybe I mean I accept that I mean it's logical that it would be but we haven't seen the evidence of that yet and I think the Federal Reserve has got to react to uh it shouldn't be anticipating. Uh you know this is almost uh you know it goes against what um what Kevin Walsh is saying about forward guidance. I mean he's uh he's already got a view a fixed view about what this is going to do and I think that's the wrong thing to have. It's inflationary in the short term. We don't know what's going to happen in the in the longer term. Uh the longer term is a long a long time away and we're just going to wait and see. I think one of the things that we know um is that u it is deflationary but it tends to be deflationary for the product itself and you know you just got to go back to the you know I remember back in the time when I was at Salomon brothers and I forget the actual year but Salomon did a monster equity placing an IPO for global crossing and a global crossing was in the fiber cable uh business and that was the you know that was the then AI that was that was the nana if you like uh of uh of investment. Uh it was a you know great great business. Margins were high. Uh product prices were were great. Um and it was good until it wasn't. And what happened in the I think within five years global crossing was bust and the price of fiber cable uh fiber optic cable and this was these were laying transatlantic links. Uh the price of fiber optic cable if I remember rightly fell by 90%. Now you know what that's saying is that we know that technology is deflationary but it's very deflationary for the product itself. Think of PE think of you know PCs. Same thing's happened. You know um you know if you wanted to buy a PC 20 20 years ago it was probably you know dramatically more expensive than you'd pay now and even for a worse you know a worse um um spec. >> So this is the fact. I mean I think AI prices are going to tumble uh because of all this investment. So some people look at this and say this the having a an AI stock up 30% in a day you know these are treating trading like meme stocks this is the sign of a blowoff top like this is the signal that we are we are reaching some sort of tipping point but it sounds like from all the work you do you wouldn't just go on an equity valuation you would you would be looking at other things going on under the hood are they connected or should we not be looking so much at the price of an AI stock, but we should be looking at what's happening in terms of liquidity flows. Are they two separate things we need to look at? >> Well, I think you need to look at the whole picture. You got to put context put it into context, Maggie. I think that, you know, I put a slide up uh now which is looking at the asset allocation cycle schematically. And I think what you the way that we asset allocate is not looking at one single indicator but trying to sort of frame it in terms of what we're seeing uh from many different angles and you know basically at this peak of the liquidity cycle or the fact the liquidity cycle has peaked and is going down what it's been telling us is that the peak of the cycle tends to be uh a time when commodity commodity prices do really well and they have done we you know we've seen a commodity boom. Uh that's for sure. Uh we've come off a period where equities have had, you know, a fantastic two or three years. Uh if you look at that chart on the left, that's the upswing of the cycle. That's when equities do outperform. No question about it. Uh you tend to see through that phase a bare steepening of yield curves and then as you get the inflection, you tend to see a bare flattening of curves. Now the one thing I would say is that the two uh striking features of markets that I would uh you know look to now is one is commodity markets are still strong and the second thing is that you're getting a bare flattening of the yield curve. Now no one has been suggesting that was going to happen. The consensus view among fixed income investors on January 1 this year was you would get basically a bare steepening. Right? You haven't had that. You had a bare flattening. And what that means is that although uh yields are going up across the curve, the short end of the market is rising faster than the long end. So in other words, the whole curve is flattening. That's normally a late cycle sign. Okay. Uh and what you'd also should be seeing is resource stocks outperforming things like energy stocks outperforming. Well, I mean they did now they've sort of stalled a bit. And what's coming in the middle is this big surge in AI. Now, I kind of get the idea that maybe this is connected with great earnings numbers. So, people have got a feel-good factor. you got some big IPOs upcoming and it may well be that the institutions are positioning themselves ready for that by buying into that space and maybe because of the narrow float uh you know as um you know our friend Mike Green says uh you know if you're trying to put you know squeeze a quart into a pint bottle which is what the problem with passive investing is uh and small floats you're going to get big price movements that could be true as well so I think you've got you know let's Think of uh let's try and put that AI surge in context. Liquidity is inflecting and slowing. The economy is redot. Inflation is more of a problem. Commodity prices are racing and you get a bare flattening in the yield curve. All of those are late cycle signs apart from the tech surge. >> So I is the fact that the long that rates are rising more quickly on the short end than the long end. Does it matter if if the Treasury and Fed are keeping volatility down? Do their measures help suppress things on the long end? Is that why we've seen the longer end yields retreat a little bit from that high they hit um just a couple of months ago? And does it matter or is you still see this as an accurate sign that we're in that leg of the cycle? >> Well, I think it's I think it's hard to dismiss. you know, you've got a you've got a lot of um you know, uh you've got a lot of things lining up and you know, as they say, you know, markets very often, if it's yellow and quacks, it's a duck. And uh you know, the fact is that we've got a lot of evidence now coming that you've got strong commodities, strong economy, inflation pressures, bare flattening of the curve, etc. All these things tend to be uh indications that we're we're late cycle. Now, you know, I'm not saying, you know, jump now. uh but with asset allocation you've got to gradually move uh you know it's like a clock it tends to move sequentially and the problem is that you know we tend to see as you can see on the right hand side that you get uh phases of the market so we think of calm speculation turbulence rebound generic names those are sort of quadrants for investing and basically what we say is well look you know we're in speculation now there's no question about that I would say and I think that you know even people that are uh making money out tech would agree that this is a speculative time of the market. Uh for sure that's what it feels like. We've left calm behind. So the easy money has been made. You can make good money in speculation, but it's kind of low quality because volatility is high. You may get positive returns, but you've got to, you know, judge that against the volatility you that you're experiencing. But then the next phase is turbulence. And turbulence is sort of self-explanatory. you tend to lose money and it tends to be a very painful exercise because volatility picks up and you know that's that's the problem. That's where we're heading I think. U but we'll see. So in in in that turbulence I mean we we would expect to see people looking for a safe haven right somewhere to sort of go for safety to protect their money. Is it bonds or is there more competition from gold now given all the concerns that we've discussed around the bond market and the pressures around the bond market? Are those two competing to to be the safe haven? >> Well, I think that the I think the long end it's too early to buy the long end of the bond market yet. I mean, that that would be my view. Uh I think you can basically you can probably move well certainly short but maybe mid duration. Um, you know, if you get into the maths of bonds, I mean, probably given the prospective or likely increases in yields across the curve, the carry you're getting on mid- duration bonds, I mean, 5year bonds is probably enough to protect your downside. So, you wouldn't lose any money there. You might not make much on over 12 months, but you probably got, you know, a reasonable u reasonable protection there up, you know, from, you know, cash right up to about five year duration bonds. Um gold. Yeah, I think gold looks good. I think that uh the issue is why is the gold market uh languishing right now? And I think the answer to that comes back to China. Um my view has been that there's no great debasement trade in the west uh that has been pushing the gold market up. I mean this may have helped a bit. The big one is China. And I'll uh if I can u shift on this presentation, I'll show you uh a little bit later uh what the Chinese data is basically telling us. And that is um uh that is at the moment not great. But let me uh let me just get there one second. Right. Okay. So this is the Chinese central bank, the People's Bank of China. This is showing uh what the People's Bank of China has been doing every day in the markets. Okay. So, just so we're clear on what that this data is showing, this is the change in their net liquidity injections versus a year ago. I've taken it versus a year ago because the Chinese financial system is still a fairly rudimentary system. um there's a lot of seasonality in that and so it's kind of difficult particularly with moving festivals like the Luna New Year to accurately smooth the data. So what I've done is to just take the year-on-year change and put a moving average through it and what you're looking at is net liquidity injections in uh in billions of yuan or RMBB and you can see the slump. I mean they're bas uh trying to goose the system for a long time and they now suddenly turn tail. Now why is that so important? Because it's critical for the gold market. And maybe if I show this chart first. This is the same data on PBOC liquidity, right? But this is actually the level of liquidity that the people's bank uh is been injecting in the markets. You get a much clearer idea of how much they've ramped up their liquidity injections of late. And the orange line is the gold price. Now my view would be is that what the the big driver of gold has not been what has been happening from the Fed or from the ECB or whatever retail investors in in Europe or America. It's basically been China. Uh it's been this is a this is Asian-driven. Uh it's driven in two ways. One by the retail investor uh in China who wants protection against this monetary inflation that's going on. I mean bear in mind that China has capital controls. Uh Chinese residents are not allowed to buy crypto. Uh that's uh that's banned. Uh what they can buy are Chinese stocks, real estate uh or gold. And I think that out of the three uh should the main choice has been gold uh bullion for you know for obvious reasons. Uh they can't export that they can hold it and there's been tremendous demand return demand. So the Shanghai gold exchange now is the marginal price of world of world bullion. I think that's fact. Now what you can see is an inflection in that curve as the gold price has come down. It's come down pretty much uh you know in line with that inflection in PBOC liquidity and as I said the earlier chart was a rate of change. So it looks a bit more dramatic than we've got here. Um, and you know, the other fact is that the Chinese government itself is also buying gold because this is part of its long-term strategy to underpin the remn as an international currency. And simultaneously, you've got the government and you've got Chinese retail buying gold. Now, the problem is in the very short term, if the Chinese authorities hit the brakes uh on liquidity injections, that will uh undermine the gold market. And I think that's what's happening. I think we've got to assess in the long term is does that in liquidity boost continue or is this the end of the game? >> My view is it's going to continue. And I think it's going to continue for two reasons. One is if you look at the government, what the government has to do, China needs a a currency that will compete with the dollar. U you know, you know, my my world is a world of capital wars. And I think this is you know the clash of capitals between America and China. U both are vying for supremacy. I mean clearly we hope America wins but you know China is uh is playing a game here and what it needs is to underpin uh the yuan. So the yuan is used more widely in the international arena. Unfortunately China does not have a big international bond market. It's got a big bond market but that's not really recognized. So it does it lacks the collateral against uh which it can underpin the yuan uh and that's what gold functions as. So they are using gold as the collateral base for the yuan. Doesn't mean they're going to a gold standard. It means that that's just a collateral base. It will give people security a little bit of the old gold standard. Um back pre 1971 no one traded gold. If I wanted gold from Fort Knox I was certainly unable to get it. Um uh if you were a foreign government, a friendly foreign government, it was sort of, you know, a great sucking of teeth from the US Treasury. Maybe reluctantly a few bars would be dished out, but there was no real access. Same with China. That's what they're doing. So you've got that as the dominant a dominant trend and then the Chinese are going to have to get rid of their debt problem. And the only way that you can get rid of debt uh you know history tells you time and time again is to devalue uh your money, print money internally, devalue your currency. And that's what they're doing. Uh they've got the benefit of capital control. So that will basically not transmit to the uh offshore yuan I don't think but you know never say never I suppose but that's what they're trying to do. And if they print money domestically, they will devalue debt and they will basically raise the gold price in nuance significantly. And I think that's what they're trying to do. Uh but they're not doing it as I say right now. But let's watch the data and see if they restart. >> So this is super interesting. And if if your theory plays out, um this will we will see potentially these drop offs in liquidity as they try to squash the speculation, the retail speculation around it pull the price down a bit, but their the the sort of main driver of it and I don't know if it's 8020 or what you think it is, but that but the government buying of it will continue. So we may see gold pull back when the retail part of China has to put the brakes on, but you would expect to see it another leg up as that government continues to build reserves. Is that right? >> Absolutely. And I mean I think the other point to make is that this buying is secretive. I mean it's not it's not the Chinese don't fess up to it. The numbers that they uh they claim to have uh are probably about 2,000 tons. I mean, US Fort Knox is 8,000. Um, so to put that in context, I think the the reality is that China has a lot lot more than 2,000. Uh, more more likely six, but they've effectively, you know, they've they've hidden that. >> So, you're you're saying basically China controls the gold price. >> Yeah. No question about that. So do you think that we if they are if they are on this path and we are in this sort of you know clash of titans in capital wars uh the US collateral we tend to think of it as um based on or the or the reserve system is based on oil or treasuries but also >> yeah US I mean there's a link to oil and there's no question because you know that OPEC uh tends OPEC prices in dollars and it tends to invest in US treasuries. >> Yeah. Is that uh a weakness for the US if we are if you're saying the the increasingly the the buyer of treasuries is hedge funds not other sovereigns? Um is the US vulnerable if that is their collateral base? Well, it's vulnerable, but the I mean the reality is is that you if you've got uh you know in you've got foreign governments who basically are in the situation of or the luxurious situation of having big trade surpluses. What what are they what are they going to invest in? Um they can't put money into the Swiss Frank. It's too small. The euro well possibly, but I think there's you know there are questions clear long-term questions over the euro. Um, and it's, you know, from a legal point of view, it's pretty much in the dollar camp anyway. Uh, so if there are any any sort of sanctions, uh, that America imposes, the Europeans are going to have to impose the same sanctions. So why not just go for the dollar from that perspective? Um, so the, you know, it's it's there's there's no choice. you you've got to put money into dollar assets and that's you know the US commands uh the global financial system still and that is not going to change overnight uh for sure. So I'm still you know very much in the camp that says that the dollar remains dominant. We may be arguing over the level of the dollar but in terms of transactions the dollar is is still king. >> You you you asked a provocative question on Substack. China controls the gold market. Will she also control the oil market? What what did you mean by that? Well, I think that that what that comes back to is maybe uh you know another thought I'll I'll maybe if I if I go back I don't want to shift too much in these go through these slides >> but the but the other thing to try and understand is what's going on uh with oil gold or whatever and you know these are these are these are important um clearly important um uh considerations. Now this is maybe uh coming back to this point that if you look at the gold oil ratio the gold oil ratio is plotted here uh and what you can see is data this is monthly data going all the way back to 1970. Now although economists tend to dismiss this I think many practitioners in the markets tend to look at these ratios uh as a way of trying to understand how markets are working. And what you can see is over the very long term that average of the gold oil ratio. This is an ounce of gold to a barrel of oil has averaged about 20 times. Okay. Now, okay, it fluctuates, but that's the long run average. And you can see on that chart uh a couple of spikes, one COVID and one recently. Now that 20 times ratio has basically existed even when gold in 1970 was 35 bucks an ounce and oil was about two and a what two and a quarter dollar a barrel. Uh and it's persisted all the way through to 2022 when gold was $2,000 an ounce and oil about $100 a barrel 20 times it right through that period. Now what that chart shows is remarkable uh mean reversion. And if you look at it statistically, it comes out, you know, as a uh you know, uh five-star um you know, a five-star example of mean reversion and it occurs within a 2 to three year period. So whenever whenever there's a big displacement, you will see uh that ratio coming down. Now the point I think I was making here is to say that uh you know where are we now? What's the gold price? for the gold price is let's say $4,000 somewhere between $4,000 and $5,000 an ounce. That's probably a long run equilibrium perhaps, but let's assume that is. Divide that by 20. What have you got? Over $200 a barrel of oil. Now, the push back on that statement is remarkable. Uh you know, I've presented this to clients. presented it to recently at a conference with a lot of technical analysts and absolutely nobody thought I was sane uh saying that this gold the oil could go to 200 was such a maverick view uh makes me think that from a contrarian point of view it's worth contemplating and I'm not necessarily forecasting that I'm just saying you you can triangulate this so if you think that that oil gold ratio sticks at 20 and you think that the gold market is underpinned at um $4,000, $5,000 an ounce. Why shouldn't oil go to 200? Uh it's the same thing. Anytime through that time series, you could say, well, okay, let's assume gold is a,000. Uh let's, you know, sitting in 1990, let's assume around uh you know, year 2000 2010 that you get oil at a,000 uh gold at a,000 using that 20 ratio, you say, well, okay, the oil price is going to uh is going to at least double or triple. And people would say, "You're mad. You're mad." But it happened. Okay. >> And it's just a question of thinking this through. Now, why is it that uh that oil shouldn't go to to that to that height of $200 $200? It looks very cheap because of many many comparisons against other commodities in real terms and whatever. So, I think there's, you know, the direction maybe we're we're clear on the level we can debate. Uh but you know why should the 20 times ratio change? I don't know. I mean it seems to hold up. Uh is gold underpinned at $4,000$5,000 an ounce? Well, my view is that China is basically underpinning gold at those levels because it has to keep buying and um that maybe is the the long-term trend upwards in gold. So why shouldn't oil um move a lot higher? And you know, we're told, we're schooled, you know, time and again by analysts to say there's surpluses of oil uh in the system. But if the world economy starts to pick up and China starts to get some traction, those surpluses will start to disappear and the oil market tighten >> and there the by the way, you know, we already know they've drawn down inventories and it's not always the ultimate supply, it's the supply chain. Can you get it where it needs to be? You know, and that is has an influence on price as well. Um it's certainly going to be interesting to watch. Of course, that would just add to the inflationary pressures that >> the Fed and Treasury. >> Yeah. And could the Fed avoid um pushing rates higher? I mean, I anyway think that the Fed is going to have to raise rates in the next 12 months. Uh because I think there is an inflation issue there. >> Do you think the market's accurately pricing that inflation risk right now? >> No. I mean, but you look at you look at the u at the tips market. I just don't think it is. I mean, the tips market, what have we now? We're probably uh implied inflation, 10 year inflation 2.6 or there or thereabouts. I mean, that's basically saying that the Fed hits 2% target more or less with a little bit of a risk premium in there. I mean, I just there's no way. I mean, the the Fed hasn't got anywhere near its target uh for what is it now? 62 months. Um you know, I mean, way back, what was that way back in 2021? I mean, the 2% is fantasy. This is a slight slight departure, but everything is connected as it is. Uh, Bitcoin crypto had just so much negativity around crypto right now. We're seeing it sort of head lower. Does this just feel like a down cycle, especially if you see liquidities turning down, you know, another sort of so-called Bitcoin winter or is there something deeper or more fundamental happening here? We are seeing huge outflows out of Bitcoin ETFs. >> Let me answer the question. I mean this this chart is looking at the movement between liquidity and a basket of cryptos. So bees is Bitcoin, Ethereum, Salana in a 60 30 10 uh% uh split. Okay, so that's the orange line. The black line is changes in liquidity and we've advanced the black line by 13 weeks. Okay, three months. Okay. So, you know, crypto is a fantastic barometer of underlying liquidity conditions >> and liquidity is predicting what's happening to liquidity. It does. So, to to crypto doesn't get every twist and turn, but it's approximately right here. And in actual fact, this chart is probably about 10 days old. And you know, you that orange, if I refresh that, the orange line would be down about halfway down that black line by now. So you know you're starting to see you know more evidence that this is this is true. So you know again that's further evidence to say the liquidity cycle is beginning to roll over and you know as I stress Maggie I mean this is not because the Fed is tightening rather you know far from it the Fed's been pretty generous here into the markets it's happening because the US economy is on a roll and there's a giant sucking sound as money is being drawn out of financial markets. I mean, just think, you know, this this AI spend uh that's going on by the big tech companies. I mean, where have they been getting the money from? They've been taking it out of their treasury departments. And where was that previously? It was in the financial system. So, it's being drawn out and it's being spent in the real economy. All money that is anywhere must be somewhere. So, if it's in the real economy, it's not in the financial system. And we're starting to see the cracks appearing because of that. >> It's so interesting. I always am so struck by this when you talk about this because you know we have these politicians uh everywhere by the way run where they are elected, you know, uh run on campaigns that say we're going to help you and your pocketbook. But the way you set this up, it does not seem like the real economy and the financial economy, stocks and bonds can do well together. can both thrive or do you have to have an equilibrium where like >> they're both a little bit sucky so nothing blows up? >> I think you you got to remember that the you know let's look at the context in terms of inflation. I think if you have a low inflation environment um then I think th those asset classes you know tend to be pretty good hedges for one another. I think once you start to get into a higher inflation environment bonds do badly, stocks do badly. um if you get into a deflationary environment, uh bonds do well, stocks do badly. So, it's only that little window uh where you've got you know low and stable inflation uh that you can see this the sort of the um the benefits of holding stocks and bonds together in a portfolio. Um so anyway, I mean the point >> are stocks and the real economy the same thing? No, they're they're they're not. But they're um um I mean the going back to what I said earlier on, I mean the E is the same for sure. Yeah. >> If you can live by the E alone, so if you hold over the long term, yeah, but we're not in a world where people can hold over the long term. And you got to think people think about performance. And what drives performance is not just the E, it's the PE. And the P can get crushed if inflation picks up and or bond yields spike. And that's really what we're talking about right now. So, you know, the market should be derating um in anticipation of higher inflation and in a response to high yields that we've seen in the Treasury market. >> Yeah, this is this is why inflation matters so much. So, let's end on this, Michael. And given that we are facing all of this difficulty around inflation, what if you could give Kevin Worsh some advice, what would it be? Well, I think the, you know, the sort of bitter truth is that they've got to start tightening pretty quickly in anticipation of a bigger inflation problem. That won't happen, I don't think. Uh, but that's what they they should be doing. It's very difficult politically to do that. And that's why we tend to get inflation problems. Um, and that was why if you look back to the 1970s, I mean, the environment strikes me as remarkably similar to what happened in the 70s. I I was only a student so I I barely remember what was happening. But I do recall that what you saw during that period were a series of supply shocks that people at the time thought were completely unconnected. So oil prices went up. I mean gold had gone up previously, oil prices spiked, then you got coffee prices going up, sugar prices going up, etc. But people didn't really join the dots until they were forced to. And then you could see this big commodity inflation. And that's pretty much what we're seeing now. And I think the you know the evidence would be whether it's um you know uh the fact that you've got um you know the straits of moves being closed and you're getting uh fertilizers being shipped or whatever it may be or helium or whatever it is. This is going to add to the to cost pressures through the system and it looks to me that soft commodities are you know primed to to move a lot higher here. >> He's got his work cut out for him. Michael, thank you so much. It's always fantastic to catch up with you and get a peek inside the good work you do and help us understand uh you know a part of the market that we're not always watching. So, thank you so much. >> Great pleasure, mate. Always a pleasure. Thank you.