Naufal Sanaullah - Inflation: Not So Certain
Naufal Sanaullah is the macro advisor at EIA Alpha Partners. EIA is a minority-owned firm that has realized very impressive results since inception. Among its many awards, EIA boasts the following (see https://eiaalphapartners.com/):
#1 Net Returns of Top Performing Relative Value Strategies Hedge Funds in 2019
#3 Net Returns of 2017-Inception Hedge Funds in 2019
#4 Net Returns of Top Performing Volatility Trading Hedge Funds in 2019
#5 Net Returns of Top Performing Hedge Funds in 2019 with Less than $100mn in AUM
#8 Net Returns of Top Performing North America-Based Hedge Funds in 2019
#16 Net Returns of Top Performing Hedge Funds in 2019
Naufal is responsible for macro strategy, macro trading, and overall portfolio management at EIA. Prior to EIA, he was involved in portfolio construction and macro strategy at Li Global Investors, a macro hedge fund in New York City. He studied mathematics at University of Michigan and Stony Brook University. His macro research has been highlighted in various media platforms, including Bloomberg, Business Insider, and Financial Times. He enjoys spending his free time producing hip-hop instrumentals and nurturing his puppy Nas.
In this episode Naufal joins Bill to discuss Naufal's view on inflation, policy efficacy, and what to watch for going forward. Bill, historically an Austrian leaning investor, found it interesting to listen to Naufal describe his view of the world, which is far more Keynesian and could be called Modern Monetary Theory driven.
The Business Brew is proud to feature this conversation for many reasons. One of which is the discussion is counter to the current market narrative/pricing on/of future inflation. If you like to consider both sides of an issue, this is a must listen macro episode.
Also, please consider donating to https://www.publicolor.org/ if Naufal's message resonates with you.
Album art photo taken by Mike Ando.
Thank you to Mathew Passy for the podcast production. You can find Mathew at @MathewPassy on Twitter or at thepodcastconsultant.com
+ Transcript
Bill: Ladies and gentlemen, welcome to The Business Brew. I'm your host, Bill Brewster, joined with Naufal Sanaullah today. Super amped to get to have my first macro conversation and to get to have it with him is something that I didn't think would happen only what, six weeks ago, seven weeks ago, whatever, when this whole thing started, maybe it's a little longer than that, who really cares? End of the day, I love how Naufal looks at the world from what I've been able to decipher some of the Twitter stuff I can't even make out. It looks like hieroglyphics to me, but I know it makes sense to him. Let's see.
None of this is investment advice. Do your own due diligence. We're not your advisors. We're not your fiduciaries. I'm not anybody's fiduciary. That's it. Hope you enjoy the ride. Naufal, how you doing, man?
Naufal: Oh, great, bro, how you doing?
Bill: I'm good. I'm psyched to talk to you. Dan speaks very highly of you and I’ve got a ton of people that were like, “Who's the guy that Dan said to listen to?”
Naufal: [chuckles]
Bill: Now they get to listen to him.
Naufal: Well, thanks for having me. Yeah, Dan's one in a million. Always very high praise coming from him. I'm glad he got us in touch.
Bill: Indeed. You want to give people a little bit of a background on who you are and what your firm does?
Naufal: Yeah, sure. I work at EIA All Weather Alpha Partners. We're a bit different than most funds. Our core product is a global long/short. The core part of our product is a global long/short, equity portfolio. Then, I'm responsible for a macro-overlay, as well as for portfolio construction and risk management on top. It's kind of cool, because a lot of the risk management portfolio construction stuff is really influenced by how folks approach things in the macro space, which I think has been a value add for us and our macro views sometimes play a role in terms of how we position the long/short. It's really cool back and forth, it's like Redman & Method Man, I know you're a hip hop fan, because me personally, because I'm a macro guy, I cut my teeth during the financial crisis, I'm always looking for some big move and I'll catch the nine out of the three calls or something.
Bill: [chuckles] Yeah.
Naufal: I'm always looking for huge moves, and blah, blah. So, it's really nice having a long/short book that I'm trading against or on top of that is not always looking for blowups. We've only had one regime shift signal so far since our inception in 2017, where we really grossed down the long/short and let the macro book really just take over for a while. That was during the COVID crash, and that was really just from, I think, second week of February to third week of March or second week of March. It was four to five weeks since inception. The rest of the time [unintelligible [00:02:45] because a lot of what I'm doing is smoothing their returns or adding some interesting asymmetries to different risks profile event they may have. Then on the other side, it doesn't matter if I'm always looking for a bubble or a crash, because there's other side of the book that's a lot more fundamentals oriented, that's just chugging along. Yeah, that's what we do and why I'm excited to be part of it.
The last part about it is, we're all young, and we're all minorities, so it's kind of cool. It's something a little bit different. It seems to be working well for us to date, knock on wood. We're trying to do the best we can by our investors.
Bill: I think it's pretty cool. I don't think sort of cool captures what it is. Andrew, he seems he's got a value bent to what he does. I don't mean that in a statistical value. It just seems he's more of an intrinsic value guy, and then you're the macro voice in the room that maybe sets-- this is the field that we see we're playing on and then he goes out and picks the tactical assets to express that. Is that fair?
Naufal: Well. I think that that type of approach where it’s just the macro guy tells you where the 10-year yield’s going, and then that becomes the input for the models for the equity guys, that I don't think is the optimal approach. I think you need to have a Rosetta Stone between the two sides and have the information flow work in both directions for it to really be optimizing. Because if I'm wrong, then everything they're doing bleeds into their models, and then they end up wrong. It's definitely a two-way street, especially when I have very high conviction, they're going to take it seriously. It'll influence their worldview. It's not as mechanical, like not a bank, where the interest rate strategist feeds the risk-free rate or the discount rates for the equity analysts.
Yeah, so it's me, Andrew Middlebrooks and Charles Chen. Charles actually has the most traditional value bent in his philosophy and his worldview, because he's from Nebraska originally. So, Warren Buffett, blah, blah.
Bill: Yeah, you almost get it through osmosis.
Naufal: Exactly. Andrew definitely a believer in value, but he has a little bit different approach. A lot of the really good equity guys that I've met over the years, they can look at a growth company at a very high multiple and consider it value play, just because of looking a little bit further out and looking at moats and looking at how the competitive landscape looks, and all those things. Even though it's all technically value in his mind, he's definitely not looking for cigar butts left and right. He loves the [unintelligible [00:05:05] too. A lot of the value stuff we do, too, and on the option side to make sure that the risk and return profiles aren't getting crazy. It's a lot more fun having a core long/short and trading macro and options on top, than it is about finding reasons to trade macro and options. [chuckles]
Bill: Yeah, no, that makes sense. I want to get into all this. First, I want to make sure to highlight Publicolor, is the charity that you're working with? I think that it makes some sense to put that upfront so that people hear about it.
Naufal: I really appreciate that, Bill. I did a podcast recently with Jim O'Shaughnessy, where he let me wax poetic about that, too. So, it's really cool and sweet of you guys both to give me the opportunity to talk about this because it's very near and dear to my heart. I'm on the junior board of a nonprofit here in New York called Publicolor. What we're designed to do is we focus on the most at-risk kids in New York City schools. Basically, the most disengaged kids at the worst performing schools here in New York. We try to use a variety of tools, but especially influenced by the notion of design, which are known to help them achieve educational and professional outcomes that they weren't necessarily on track to. It's very different than a lot of the other nonprofits, especially in the city, that focus on the cream of the crop academic overachieving outperformers at [unintelligible [00:06:15] schools. Those folks definitely deserve to be elevated and they definitely deserve to have the resources to further their skill sets and their talents and be heard.
There's a lot of folks who have a lot of skill sets of talents that just haven't shown up on transcripts, or attendance or any of this stuff yet, because a lot of these kids, they're around different drug issues, domestic violence issues, single-parent households, whatever. Even the folks who don't, it's not like how I grew up, so I can only imagine how difficult it is to be motivated in middle school, in high school in a tougher environment. It's tough as it is to be motivated.
Yeah, it's really, really cool, because these kids really beat all the odds. It's something like 60%, 65% of their peers graduate high school on time. Last year, for example, 100% of them graduated high school on time, and 99% of them matriculated into either college or post-secondary. A good chunk of our students end up becoming alumni to come back to be involved one way or another. Some of the things we do are, we have these paint days, for example, where we'll go out on a Saturday morning and turn some drab high school hallway or hospital lobby, or even a park or basketball court, it's very colorful, and exciting type of designs often influenced by professional artists. We're spending our Saturday mornings doing that. It's pretty productive and it's really cool I get to know them. It's really fun hearing about their tastes in hip hop these days. Once in a while you find out some of them, they know all the words to some of the songs, I was listening, too, I was there. It's like, okay, some of this stuff ended up being classics. We'll do a lot of stuff like that.
Bill: It's nice to hear.
Naufal: Yeah, it makes me feel a lot less old and very old at the same time.
Bill: [laughs] Oh, dang, you were there when OutKast dropped that album? That's crazy.
Naufal: Exactly. Totally. The other thing we do is workshops will come in and junior board member or someone else who's interested, and we’ll just teach a class of 20, 30 kids for an hour or so. I did one where it was about economics, I handed out candy to let them trade it to determine supply demand and marginal prices.
Bill: Oh, that's tight.
Naufal: Oh, yeah. It was really cool. I'd love to say there was definitely some emergent bubble behavior for the Skittles. The Skittles in particular were turned into a--
Bill: [laughs]
Naufal: [crosstalk] -the demand rose and the price rose. I had some speculator minds in the classroom and definitely some hoarding behavior, for example, too.
Bill: That's cool. Then did you break that down and talk to them about that, be like, “Okay, well, this is how markets can work in certain times.”
Naufal: Yeah. The coolest part is what I was talking about this notion of leveling goods, and this notion of people having a higher value as the price goes up, and having more demand as the price goes up, whether it's for financial speculation or social status, immediately, three kids raise their hand and they're like, “Oh, so you mean like Supreme?” I was like, “Yeah, you got it. Just like Supreme.” The brand Supreme, the skateboard Supreme. If you have a red sweatshirt, you get for five bucks and you put the Supreme logo and sell for $50. It was really cool to see them immediately latch on to a specific brand example, to the notion of leveling good and where supply and demand curves can be a little bit different than usual.
I was a hip hop producer before I started trading, that's how I funded my first personal account. I did one with hip hop, so I brought in my little mini keyboard, and I just put a basic chord progression down and then each person in the class came up and did a different instrument, kick, hi-hat, snare, electric piano, strings, brass, whatever. At the end, we have a beat. It was really cool. Then, we had a couple kids in the class freestyle battle each other on top of the beat. That was really cool for them to make a song from scratch in an hour. Then, I did a couple recently, one was about disinformation with respect to especially the Capitol Hill insurrection, which they were very sensitive to, especially because a lot of our kids are from black and brown communities and they saw what happened a lot of times from authority figures over the summer last year, so they were really interested in describing the dichotomy of the response that they observed, and really delving into the disinformation aspect because these kids are on social media all day, so it's really important to investigate how to really identify misinformation.
Then the last one I did was about financial markets more generally, but they're all trying to talk about GameStop and Robinhood and bitcoin, so that was another thing where-- just trying to get them the lay of the land, “Here are some things that you might not see on TikTok.” It's amazing how well informed they are, way beyond where I was at their age. Just giving them a little bit extra in terms of, again, going back to finding ways to identify and slip through disinformation. We do those workshops and a variety of other things, too.
The last thing I'll say about it is we recently did a food drive for them, because something like two-thirds of our kids suffer from food insecurity. The pandemic obviously made it far, far worse. I'm trying our best to put together a campaign on a junior board that was specifically for funding food distribution and bringing meals to these kids and their families. A lot of these kids are working during the pandemic, because their parents have different conditions, and it was really cool, because we gave ourselves like a moderate target, we came up with this really quickly right into the holiday season, especially the contributions [unintelligible [00:11:14]. We got a lot of folks who were really signal boosting the cause, a lot of really big checks came in, and a couple billionaires even helped out with the cause. Mike Novogratz is a billionaire. I'm pretty sure by now he has given us crypto holdings. It was really cool. They were so pleased. They have enough problems, at least they have food on the table. All those things are very near and dear to my heart, especially in this pandemic season. Then, the results speak for themselves. These kids defy all the odds. The least we can do is make sure they have food on the table.
Bill: Yeah, no doubt. How do you define at risk? When you say they're the most at-risk kids, how does as an organization, how do you guys figure out who's at risk versus who's not?
Naufal: Well, first of all, this is an opt-in program. It's not like, if people want to be in it, we're not forcing you. This isn't a punishment.
Bill: You're not doing community service or anything like that.
Naufal: Right. Exactly.
Bill: Like for prison, right?
Naufal: Right. Like I said, the most disengaged kids at the worst performing schools. Look across the schools that have the least resources and may be plagued with a variety of things. Then talking to the administrative staff and looking within the roles to see who's not showing up to class or who has some family problems at home, who's clearly really smart, but just doesn't care, has no motivation. Those are the kids that we really target. It's just amazing seeing-- it's more than amazing, it's honestly inspirational to just see them take initiative to do something they do and adapt and grow how quickly they do. It really makes me look in the mirror and be like, “Alright, what are you doing with yourself, bro?” I'm sitting here in Dumbo, I'm chilling. I have no excuse. It's a really great way to keep myself humble and it's really great to be part of something that I'm really proud of, and shows results, especially proud of being a small little part of the crazy progression that these kids are able to generate for themselves.
Bill: It's got to be cool for them to see a macro guy in Wall Street or whatever, however they want to frame it, to then watch you come in and produce hip hop and do stuff with them and connect in that way. It's got to erode some of the barriers between maybe their perception of what you do, but adds a human element too, I think that is relatable.
Naufal: Yeah, I think that's definitely the case, especially some of the younger when it comes to investors and that whole game. I will say though that it's so funny, because I'll walk in, and I'll be like, “Okay, look, I'm the younger macro guy who likes hip hop, so these kids are going to love me,” and they will [unintelligible [00:13:46] on me all day. It's so funny, like in that little rap battle thing I was talking about, one of the kids, who is just my favorite, I love this kid. He was totally, totally just making fun of my clothes I was wearing that day. I was like, “Wow, I'm really old.” [laughs]
Bill: Yeah, dude, if they're making fun of you, that means they like you.
Naufal: Totally. It was a blast. He and I, in particular, are really close. He's been really transparent and opened up a lot about things he may not otherwise open up about because of the relationship we cultivated. Well, yeah, it is cool. It's cool to see people of color who are a little bit younger, who don't talk the same way as they expect us to talk to be just examples, not role models, but just examples that they may not otherwise see. A lot of times, it's like-- look, I grew up in a place in elementary middle school where there wasn't a lot of doctors around. By the time, I was in high school, everyone's parents around me were doctors, lawyers, and stuff. It was a lot easier for me to just aim higher because it was like I'm not that impressed by these parents, I see what they do, and it's great what they do, but they're just people, too. It's having examples of that around, I think is really cool, especially when it's like the way I talk isn't always stodgy, older person and so just explain it's not out of reach and it's not that crazy different.
Bill: Well, if people are interested in the cause, where should they go to and how can they maybe connect with somebody at the organization and/or yourself?
Naufal: Totally. Thanks again for let me talk about this. publicolor.org is where you can go. P-U-B-L-I-C-O-L-O-R dot org. The Outcome Stats and the About page are really cool to look at just because it'll blow your mind, it shouldn't be this big of a success. It just shows you how low hanging some of the fruit is if people just care and are able to provide the resources. Then if you scroll through and into the Contact page, you can definitely reach out to us if you're interested in contributions, there's a Donate page as well, and you're allowed to say like, “I want this specifically for food.” I want this specifically for school supplies, or administrative budgets, or whatever. Then, yeah, if you follow me on Twitter, or follow Publicolor on Twitter, you can reach out there as well. There's always room for new junior board members as well. If you're like a younger professional in New York City, and this seems interesting, maybe you hop on our next Zoom call or something and get to know us. If something makes sense, we can talk about you joining, or you coming to do a workshop or this or that. Those are the best avenues to learn more about the organization. If you have any questions and you follow me on Twitter, feel free to reach out to me and I'll get back to you for sure.
Bill: All right, cool. Well, people, do your part, go check that out. I'm telling you, he's a mathematics major, so if he's telling you that the outcomes are impressive from a statistical standpoint, I bet that they probably are. Do your own due diligence, but please trust and verify what he's saying.
Naufal: [laughs] Totally.
Bill: Again, check out Publicolor. Now, we're going to get to the finance stuff. I've been listening to your past interviews and reading some of your letters. One of the things that is really hard for someone like me to understand right now, and I'm going to borrow thoughts from McMurtrie here, but it feels as though a huge day of reckoning should be coming. Yes, prices puked, but the policy response appears to have been actually effective this time. I think it's maybe creating some cognitive dissonance in people's heads, and they're waiting for some huge shoe to drop, because I think that people are remembering ‘09 a little bit. I guess the other side of it's like, well, look at the markets at all-time highs, so how can you even say that? But I do feel there's this looming sense of what's next around the corner. How do you see what's going on and assess where we are from a policy perspective? If I can ask a second question as part of that, when you see everything that appears to be speculative, such as baseball cards, real estate seems to be ripping, bitcoin’s ripping, people are talking about gold, should we be really concerned about inflation here, and we let a cat out of the bag that we're never going to get back. Those are the two high-level things, I'm sure that we're going to have to decouple the questions, but those are my most pressing thoughts, given where I know your views are.
Naufal: Totally. If you want to just keep the second question in the back of your head in case I rant too long and forget what it was. Actually, I'm going to follow your lead and borrow something that Dan McMurtrie said on your podcast, which is one of the big first steps he takes in his research is forget the actionable trade initially and just think about what's the bear case and bull case and be able to argue both sides really well. I do a lot of that in terms of policy thinking because I'm a big believer in context matters. I'm very non-ideological about policy. For example, given the initial conditions, given the backdrop that we've had for most of my life-- I was born in 1989, most of my life, the backdrop has been a secular disinflationary regime, rising inequality, and this impulse from globalization and technology and aging demographics that all feeds together to both drive and amplify this disinflation and inequality. With that set of initial conditions, you can't spend enough really.
You really have to look at fiscal policy in a very different framing, than, say, the 70s, for example, where the boomers are really kicking into gear in household formation and getting mortgages. Back then, there was very high oil intensity of outputs across the value chains and various sectors, oil prices were big input. We had these geopolitical events that were creating these rolling oil shocks. Private sector debt was way lower. So, there wasn't this deleveraging thing going on. The globalization hadn't really kicked off to the extent that has now. We didn't have this rise in the digital technology trends. In that scenario, you want to be approaching the private versus public sector efficiency in a very different framing. That's why basically since I've been trading, I started trading January of ‘08, I've been really of the view that policy's just so ridiculously inefficient. If you look at the last cycle we had from the financial crisis until COVID, there's a great example of that, especially earlier on in the cycle, we have rolling shocks. First European debt crisis, then we have oil prices crash. Then, we have the Renminbi shock. We had a taper tantrum before that. All those things really represented to me that these are all just like left tails of policy didn't chop off. They could have, but the political will wasn’t there, and the state of the economic academia wasn’t there.
I noticed a lot starting in 2015 or so, and it really kicked off into high gear after President Trump was elected, that the academic space really started to move a lot. NMT became this big thing. Stephanie Kelton has been a friend of mine for a long time. It was really cool to see her get her day in the spotlight. It's been really great. The notion just became, you stop thinking like Kenneth Rogoff, who cares about debt to GDP when inflation is so low?
Bill: This isn't my area of expertise, but just as a layperson, there's almost something in that statement that offends me. Why should we not worry about this? Look at the deficit? How can this go wrong? The feeling that I have, and I know that that's not databased, but it's visceral. What would you say to somebody that has that feeling, that maybe has this Austrian economics bent or whatever that just doesn't understand conceptually, how you can have all this spending without inflation? I know that you went through some of it, so I don't mean to ask you to repeat, but I just want to--
Naufal: I'm happy to. The key concept is something called monetary sovereignty. What monetary sovereignty means is that your public sector debts are in your currency, and you have monopoly control over the issuance of your currency. You have deep and liquid capital markets to accommodate whatever you need to do, and you aren't running against real economy constraints, by which I mean if you want to induce a trillion dollars of demand into the economy, if you are constrained on the supply side and resource wise, then that could be inflationary. An advanced economy like the US, for example, that's not really an issue until you get into much, much, much bigger amounts. That's the concept, but to break it down into even simpler terms, and this is something that Dr. Kelton has been really instrumental in evangelizing, is you can't really compare household budget with a federal budget in a monetary sovereign economy. The reason is, because if I have a mortgage, and I can't meet my payments next month, I have to cut my spending or find some other source of income or debt refinancing, but the federal government can just print because its debts are denominated in a currency that it can literally just print.
So, the constraint isn't really about, “Oh, people are going to dump government bonds, and we're going to have an interest rate shock,” because if that starts to happen, the Fed can just buy it. Look what happened with Japan, they have like double the debt to GDP we have, and they have 0% 10-year rates, and they've never had any problem with inflation. In fact, in 2016, they had to nudge up their 10-year yield to steepen the curve to not screw over their financial sector, which is very different than the Austrian framing. A lot of the Austrian framing actually comes from before we left the gold standard. When we were under the gold standard, we were not monetary sovereign, because you can't print gold, but in a fiat system that you can print, you're not constrained by how much debt the government has, or you're not constrained by bond vigilantes. Where you're constrained by is inflation, and specifically inflation that's driven by demand being met with an economy that cannot accommodate it on the supply side.
Our economy for decades has been characterized by excess capacity, not a lack of capacity, but excess capacity. That type of backdrop is the window for things like climate stimulus or redistribution, even reparations. Reparations, for example, would be stimulative to the economy here and now, and it probably would have been in the 70s too, but not as much so, and that's the difference in why the key is to really think about to what extent is the demand that we're driving by spending and spending and spending and the Fed backstopping it and accommodating it, to what extent is that demand still going to be accommodated by the capacity and the labor out in the market, in the labor and capital markets.
Until those things are really, really tight, spend away. Once those constraints started getting hit, then you get to a point where inflation starts to rise. As inflation starts to rise, and especially if it starts to develop a feedback loop where it's rising and then it's going too far so people [unintelligible [00:24:58] as dollar which drives inflation higher and it creates a feedback loop, you want to get ahead of that, which just seems so far away right now. The way you do it is by typical tools. You raise taxes and you raise interest rates. Until you're at that point, you're negotiating against yourself basically, by getting ahead of this. All last cycle, every time something good would happen, the US exceptionalism trade would kick in, the US dollar would rise, and it would short circuit the global recovery. Then, the Fed would have to go back and lower rates again. All of this could have been prevented if we had trillions of dollars coming out of the stimulus packages out of the financial crisis.
But the political will wasn't there. The Overton window hadn’t shifted yet. What really shifted the Overton Window one was this shift in academic economics, which I think that folks like Dr. Kelton, and even a few folks at Bloomberg, like Matt Bowser and Joe Weisenthal, really popularized and pushed and challenged the economic policymakers to defend their views against. Ultimately, we got to this point where that was the new viewpoint is, “Yeah, we are demand constrained. We're not in a supply-constrained economy, so we don't have to think about these things the way we've been thinking about them.” Then, the other thing was when President Trump blew out the deficit, and usually you don't blow out the deficit mid cycle, like he did, but he blew up the deficit mid cycle. It didn't do anything, in fact, because it was corporate tax cuts, and it wasn't really going to move the needle on growth, buying bonds in early 2017 was a great trade and it worked until literally last summer. That was another shift where it's like, the last of the bottom vigilantes just got really smoked.
Yeah, that's what's really changed, I think, with this cycle is that the policy apparatus has chopped off the left tail. I mean this globally. For example, the US fiscally, we're talking multiples of the amount of money we spent coming out of the financial crisis, especially after the Georgia elections. You listened to the President Biden's recent foreign policy speech, and he's talking about racial equity, and then talking about whole of government response, that tells you that they want this to be an inequality-reducing recovery. You listen to what Secretary Yellen says and what Chair Powell has said. The Fed started its regime shift-- actually before COVID, they had this notion of the Phillips curve, which is this tradeoff between lower unemployment and higher inflation. When you have these secular disinflationary forces, that's what flattens the Phillips curve, which means that you have to go further and further and further lower and unemployment, before you can even begin to see inflation.
The Fed is no longer preempting inflation risk based on its models, but it's actually waiting for realize inflation. It's not looking anticipatory anymore. That was a big shift that happened in the US. That really just chopped off the left tail, because now you know that if something bad happens, you have a policy response coming out of it, and after the Georgia runoff elections, there's going to be the votes. The votes will be there in Congress to get stuff done to short circuit stuff. Europe, they have the NGEU, which is the Next Generation European Union package, which is basically for the first time, they're issuing debt as a common union. When you have a Eurozone that does not have a common budget, each of the individual countries are basically under different gold standards, because none of them can print money.
The Germans and the French really determine when money gets printed. Under Mario Draghi, they were able to really converge those economies together but the NGEU is really codifying it. Because it's Europe, it'll be slow, gradual, and most likely in response to shocks and crises, but that's another big regime shift. These are the things that we were all waiting for all through last cycle, and all of us became cynical about to an extent, but now it's actually happening. It makes sense to me that the left tail is chopped off. In terms of--
Bill: Let me just summarize that real quick-
Naufal: Please.
Bill: -to make sure that I'm keeping up with you here. Just as a summary, in my own head, which may be somewhat off, but I hear you saying globalization has created an abundance of labor generally, technology is disinflationary by nature of how it can scale and do away with the need for some people's jobs. The spending side can supplement some of the slack, for lack of a better term. I believe you would argue to put that spending into people's hands that can actually spend the money to stimulate some of the demand. Is that fair?
Naufal: Yeah, totally, for example, to your point about technology, and even the way we did globalization, besides the displacing labor and being disinflationary, it's also inherently a very concentrating force. There's a reason why it's the FANGs. There's a reason why there's so much dominance at scale. These companies are so big and yet growing so fast to this day, and that gives you a huge window to redistribute. Because the folks who are making money, folks who are long Apple for the last 20 years, they're probably pretty wealthy and they probably don't spend a lot of what they make anymore. A lot of it just gets reinvested, as opposed to somebody who's hands them out, that money gets directly put right back into the economy.
One of the ways I frame it, and this is where the traditional view and the heterodox view can work together is, look, globalization created a ton of wealth for the United States. It just hasn't been distributed across the United States. So, you need that fiscal policy offset. I think that was President Clinton's biggest mistake, was he balanced the budget into a globalization shock. What do you expect is going to happen? In fact, I would argue that actually led to the housing bubble, because it got to a point where not only are you balancing the budget against a globalization shock, what's happening in Asia with globalization? After the financial crisis that they had in the late 90s, they were like, “Okay, we want to put our money into safe assets like US Treasuries.” If you balance the budget in the late 90s, then there's such a small supply of treasuries left for Europe and Asia to buy on a flow basis. What happens? Wall Street will always make up supply-demand differences, and they ramped up the MBS securitization machine. I think that played a big role in the housing bubble was the fiscal policy of President Clinton.
Bill: That's interesting. If I've heard you correctly in the past, and I think you said it earlier, you are not even saying that you need to tax right now within the spending framework. I think you're saying spend more and spend effectively, get it to people who will then spend the money in a high efficacy way, I think I'm saying that correctly. If I'm not, I apologize. But then, you can worry about some of the taxes and negative implications down the road. Is that fair?
Naufal: Yeah, totally. It's like how the Fed is waiting for the eyes of inflation, the whites of the eyes before it hikes rates. I think the same thing applies to taxes. I will say one thing, I think the notion that you can just tax the rich to spend for redistribution, it makes sense from a democratic lens in terms of democratizing the political landscape more and limiting the influence of money in terms of dominance in our electoral system and political system. But macro economically, if you have inflation, again, those wealthy folks aren't really spending. That's not going to be enough to really fight inflation, you're going to need to do two things. One is, you're going to need to look at just making the tax code more progressive. You might need to-- if we generate inflation to the extent where it matters, it means that we’ve really succeeded in redistribution. In that environment, yeah, you can normalize some tax rates for the middle class or something.
But also, the supply side matters, too. You look around the country, you look at a CPI index or something, where's all the inflation? The lion's share of inflation of the last 20 years has been housing, health care, education, childcare, and all those are supply constrained. It's not that they have excess demand, they just have artificial scarcity. Housing with zoning. American healthcare system is a joke. For example, like a single-payer health care system could actually increase our fiscal capacity despite requiring $10 trillion over 10 years, or whatever. Those are the levers I would pull, if I put my policy hat on is, at least increasing the supply response to prices in those sectors. But then, yeah, you get to a point where the economy's actually running hot. Then you can just raise rates, raise taxes, and have your cycle shakeout. We're going to get some transitory inflation second half this year probably. Because of the one-time shock to prices, there's some shortages, whether it's chips, or autos, or whatever. Shipping prices have risen a lot, too. You can see some inflation creep in, but it's going to be transitory because there's still a lot of excess capacity and a lot of underutilization of labor.
Then, later on in the cycle, you probably get to a point where it's like, okay, we're starting to see things pick up. Unemployment is low enough. Capacity utilization is really gotten higher. We're breaking out of the downtrend of capacity utilization that we've been in for decades. The Fed will start messaging a little bit differently, but it's not hiking yet. Then, we're at or above target inflation for a year or so and they're like, “Okay, let's call it mission accomplished for now, and start throwing in some hikes, start throwing in some taxes, and make sure we cool things down.” That's the way I look at it. I don't expect hikes to happen until probably mid-2023 and that is reflective of my view that we're probably not going to see durably above-target inflation until then. We have a lot of under-target inflation accumulated over the last 20 years to catch up to and to reverse and offset. So, we're still far from the point where-- I'm thinking like Larry Summers about we're overheating the economy. I just don't see that being the case right now.
Bill: There's this voice inside my head that says like, yeah, but how can you say this, because let's say the inflation Genie gets out of the bottle, look at where asset prices are, and if rates go up, what's that going to do to asset prices? Then what is that reflexivity on the downside say and I guess that it comes back to this thought of like, “Are you playing with fire that you really don't want to play with?” I guess is the real question that is screaming in my head.
Naufal: You are for savers and for wealthy folks and capitalists, yeah, our expected returns are going to go down. That's the trade-off and that's redistribution. Inflation is the best tax, if you try using capital gains tax or this or that, those go to the Caymans or whatever, go to Singapore, you can't escape inflation. In the meantime, we are definitely rerating everything higher in this Goldilocks period. If we succeed with fiscal policy, there will be a point in time where capitalists are probably going to take a hit. You're going to need to know to get out before the music stops. But I don't know the extent to which it'll lead to real economy reflexivity because it's the opposite of the 2009 to 2020. Actually 2009 to the present, markets booming, and the real economy is underperforming. The opposite can happen, the real economy can really start to accelerate, when the markets are just muddling through for a decade. Yeah, I do expect because we've chopped off the left tail to policy, the tradeoff of what we're doing is exactly that, the right tail could open up in financial markets, and we just pull forward a bunch of future gains in the markets. It's a fiesta, but the back end, yeah, you're probably left with very low expected returns for a while. The point is, that's okay, because wage growth is accelerating. We've had our data sound since Reagan, so it's okay if things are a little bit harder for us.
Bill: Yeah. When you said that it really hit me in a way that I understood. There's this concept, I'm pretty sure Chris Cole popularized it, where you can suppress volatility in one way, but it will escape what you're trying to suppress. I think of it like a balloon, if you put your hand down, the air just goes somewhere else, but the balloon doesn't really lose any air. To your point, I think that, yes, we have chopped off the left tail potentially for financial market participants, but the volatility or risk there has gone into politics as a result. Potentially, if the wealthy or whatever were to take a hit, capital markets, you might even see a more robust society.
Naufal: Personally, I think that the best use case for taxing the wealthy isn't to raise revenue, it's to democratize us further, like not have this super unlevel playing field in terms of politics. The greatest ROI investments in America is lobbying. You pay someone a million bucks, and they'll get you $100 million contract, especially like defense companies, they do this all the time. To your point with respect to Chris Cole, it's the laws of thermodynamics where energy is neither created nor destroyed, is just transferred. I think volatility is similar. It's neither created nor destroyed, it's just transferred. If you think about that through the time vector as well, we've chopped off the left tail, and it's opening up the right tail. Eventually, it gets to a point where it leads to these booms where then whenever we do start to tighten, the initial conditions are far more vulnerable in the financial markets.
I think we'll be in a bubble if we get to Microsoft at 50 P/E or something, because that's a 2% earnings yield and that's around a 0% equity risk premium. During the dotcom bubble, you’ve got negative 2%, negative 3% equity risk premium for the biggest stocks in the index. Look, I hear you with just this instinct of like, “Are we going too far in the markets?” I have been beholden to this the whole time, basically. In fact, this is why having this long/short book behind me so helpful, is I caught the rebound back in March really well, but from 2100, that's peaked to 3000, I just wasn't participating, because I was-- things are getting ahead of themselves and you see these anecdotal squeezes began. This is before we had any vaccines or any clarity, really, of course. The irony is that I was really pounding the table that this time is different with fiscal policy. Unemployment insurance enhancement, for example, last year, made folks whole, for the very, very low end of the distribution, income distribution. Some folks even got pay raises. That's super, super juiced up effective policy.
Then there's this whole notion of, “Well, are you disincentivizing work?” Then the empirics are like, there was no difference in the reemployments of the folks who had a pay raise and unemployment insurance versus folks who didn't get one. It had no effect on labor supply, because unemployment shares and the checks are not permanent. You still need a career in the backend. You'll trade off a couple 100 bucks a month for a few months for having long-term income prospects. There wasn't any shock. There was no disincentivization. All that stuff was ended up being just a right-wing meme. Yeah, and then we had the second and third COVID waves, but the market just kept looking through it. that's one of the things that low interest rates do, is they move everyone's lens toward longer and longer dated cash flows as a function of duration. It didn't matter. What are things going to be like after we get a vaccine?
Now, we got the vaccine. In November, we started buying a ton of cyclicals, we got some put spreads and more cyclical exposure, going into the Georgia elections and we push forward as well. Yeah, they keep moving, and every single week try coming up with a reason to tactically hedge. Every time I do, I trail out of my shorts. I will say tactically here, and again, this is probably the same as every time I say this, but tactically here things do look a bit stretched, and we are getting a little bit of an amplification from what's happening in the option space. I'm interested to see what happens after this following holiday shortened week, that which includes both VIX and options expiration, maybe we get a little bit of give back, but probably not too much even if it happens.
The main things I'd be thinking about are this, in terms of bigger picture, and getting real corrections. One is the extent to which new variants matter. New variants should pop up into the US case data in the next four weeks or so. There's great decline in case and hospitalization rates. It could decelerate a little bit, I don't think it'll reverse, but it could decelerate a little bit. The key will be two things. One, to what extent these new variants can drive reinfection of previously infected folks, especially milder infections or asymptomatic infections, because that could just--
Bill: Yeah, that throws a wrench in everything, doesn't it? All your assumptions could change.
Naufal: Yeah. It messes with the denominators when you're doing the math sometimes, because it's like, you're not just thinking by the amount of people that are there, but the amount of infections those people can have isn't just one or max two. There's that element. I think that we could see some signs of that emerging and it might worry the markets a little bit, especially when they start to see the deceleration of hospitalization rates, and that could be a little shakeout. We have these little pockets of access, maybe that is an impulse to drain some of that excess. In and of itself, I'm not sure it's enough, because the number two, which is as long as the vaccines are efficacious to the new strains in time, whether it's the current vaccines have enough efficacy, and they can provide a bridge to updated vaccines in the fall that will be upgraded for the new strains, as long as that's the case, then the underlying trend is there. If the vaccine story gets a real derailment, then batten down the hatches again, and then I'm back similar to literally a year ago today is when I put out our Valentine's Day note last year about the window is approaching to validate or invalidate this notion that this is a China-only story, and if it's not, then sell everything. Then later that week, the South Korean case count got exponential, that was our regime shift signal. That would happen again, to a smaller extent, but to a certain extent if the vaccines started losing efficacy, and we started to see even vaccinated populations being not resilient to these new variants, which isn't my base case, but something to keep an eye on.
The third question, I think, I have in my mind is, all right, so we've all been locked at home, trading stocks on Robinhood, or whatever, and a huge amount of pent-up savings, between the nature of the shock, which is we're all at home, and there's not a lot of places we could spend the money, especially in terms of tourism, combined with the very strong fiscal response, we have this huge stock of pent-up savings. As we reopen, does that end up being a drain of liquidity from financial markets into the real economy. Now, of course, that generates earnings for companies that participate in the real economy, so it's not as simple as a black and white thing. But I'm interested to see what that does to some of the more bubbly stuff. I'm interested to see what that does to cyclicals and should be the beneficiaries on EPS trajectories. It'll be a really good test to see if they're too frothy because if they're getting hit by liquidity being drained to be spent at their companies, then that tells you it's more of a market frothiness than it is about the right tail just starting to get priced in. I actually lean toward, it's still the right tail getting priced in, which isn't priced in yet, but it's a good test. I always like to give myself little windows in the calendar and catalysts to provide big tests to falsify or not falsify different views, because that's when you get really good feedback from the markets in the real economy.
Then the last thing I'm thinking about too, and this might be more tactically, at least right now, because of what I was talking about with respect to the inflation trajectory earlier. I'm a big chart guy, a lot of what I do is marrying charts to narratives policy. Actually, that's basically all I do, is marrying charts to narratives to policy in a framework that works for me and tries to get my own psychology out of my own way. That's my strategy in a nutshell. The bond market looks like it could break down. They had a chance, I think, to get a little squeezed and people might be getting ahead of themselves or whatever. We had the first test earlier this year where the bonds sold off after Georgia, growth stocks took a little bit of a hit, but they were bought back up. Since then, the moment we finished COVID stimulus, and we got infrastructure coming up next.
Bill: I love infrastructure week, Naufal. I've heard about it for so long, I can't wait for it to actually come around.
[laughter]
Naufal: I think the funniest thing would be if infrastructure week began, the week we signed the COVID bill. It’s just like if the Biden administration is just saying like, “Uh-uh, no excuses, no one's going to get in our way. Infrastructure week starts the week that COVID stimulus week ends.”
Bill: There would be something quite poetic about that, right?
Naufal: Totally. One of the big things I think they're trying to do is draw as visceral of a black and white difference to the President Trump administration as possible. This is one of those things I think where they want to get right to it, and they need to build up that political capital so that they get good midterm results, and then we can talk about the taxing rich stuff afterwards.
Bill: Dude, I’ve got to tell you if you're going to troll a troll passing infrastructure week in a symbolic way, that is a great way to troll a troll.
Naufal: Totally. Secretary of Transportation, Buttigieg, especially being a [unintelligible [00:45:56] guy, young guy and results oriented dude, very interesting person to be running the show there. If the bond market breaks down, just because stocks keep ripping and the right tails opening up on the fiscal policy side--
Bill: I'm sorry, because you said it twice and I'm not sure I really understand what you mean about the bond market breaking down. Could you just articulate exactly what that means to you?
Naufal: Totally. It just means that yields rise. We've been in a downtrend but a holding pattern. Basically, what happened is, the Georgia elections occurred, and yield shot up. Then people were like, “Well, we'll see how much of it gets through. We'll see how much of it matters against the backdrop of the economy.” So, yields went back down and retested where they broke out on the Georgia elections. Then, they've been climbing higher ever since. Part of the reason is because the stock market was resilient to the first yield shock after Georgia. We're seeing a lot more clarity on the fiscal side. And the US is crushing it on the vaccination side. A lot of folks were really skeptical, like how quickly will we get folks vaccinated, but we're at a 2 million dose a day run rate right now. We're crushing it.
Bill: Yeah, that's big.
Naufal: It's basically the best-case scenario for distribution of vaccine that itself is a best-case scenario in terms of efficacy. We never expected mid-90s efficacy rates back in last summer. We'd be happy with like 60% as a game changer. You’ve got mid-90s efficacy rate vaccines being distributed with the best-case distribution that matters to the timing of reopening. Again, just left tails keep getting chopped off. Yields are starting to creep back higher again and we're at a point now where just on the charts, it seems if stocks stay stable or higher, we could see yields break their post-Georgia highs, and maybe they have a mini pop, maybe a little swift, quick, serious pop, nothing crazy, we get to 2.2, 2.3% in the third year, that's not out of the question in my mind.
Bill: How would the equity market stay strong in that scenario? We talked earlier about how low rates are incentivizing long-dated thinking or people taking duration. Well, if rates go up and you’re longer duration, you would think that prices should come down, or what am I missing there?
Naufal: You're not. This is why I'm saying this is my fourth question in my head is, how resilient will the stock market be to that type of dynamic? If that's the path of least resistance and the stock market isn't undoing its own froth by itself, then could that be a catalyst for it? There was a 30 bip backup or so 20,30 bips on Georgia elections, and the market was able to be resilient through that. Would it be resilient again for another 20, 30 bips. We're not talking about 100 bips or moving up 1% or 2% in yields. We're talking about fractions of that. But could that be something that shake some froth out of the market? Definitely something I'm keeping an eye on, for sure. I'll throw on some punts to position myself for it, and if it starts to materialize, I'll take it seriously and then turbo exposure on to keep our large, short book risk managed. The way I'm looking at it right now, if I had a gun to my head, is that the archetypal names, the really hyper growth, fanatic stuff that has huge inflows, price insensitive inflows, really story stock, to the point where it's become meme-ish now, those I think could be interesting in terms of how resilient they could be to a mini rate shock. This isn't like a taper tantrum. We're only talking 20,30 bips. If that were to happen, I think those names are probably most vulnerable. Whereas the FANG names, they haven't gone anywhere since last summer or early fall.
Bill: Well, they have real cash flow under them. That's not as much as story, as much as they're just like beast businesses.
Naufal: Totally. I can see a dichotomy within the growth space between the mega cap throwing 40% growth at 40% margins on a huge scale type of companies versus the story stocks that look five years ahead, look 10 years ahead, and you have these huge inflows and it's gotten to the point now where some of these ARK ETFs, don't get me wrong, Cathie Wood crushed a cycle. In fact, a lot of our long/short book in 20--
Bill: No, dude, I know what you're saying, you're not talking shit about. You're just saying that there's been a lot of flows going that way and they could come out, I think.
Naufal: Yeah, totally. Not to mention that it's gotten to the point now where because of the market cap of some of these companies, they're huge holders. They're the marginal supply and demand. You get some of these kinds of microstructure impacts as well. Then you also coming in--
Bill: Yeah, dude, it's like catastrophic success. They nailed it so well, that now they're in a weird spot where it's like, “Well, now you can't get out,” potentially, at least that's what I see people saying, and it seems to make sense to me.
Naufal: Yeah, there's nothing that elegant, and it's tough especially because when you grow that fast, you may not always have the experience or capacity to know how to deal with that. It happens lots of hedge funds too, which is why we like to grow at our own pace with the right people and we prefer to grow organically than through big inflows. But yeah, so that's something that's in the back of my mind, for sure. Then, the other thing that is that the initial conditions right now is that hedge fund, gross and net leverage are at 99 percentiles, and one of the reasons that net leverage is there is because basically, since last summer, we've just seen the flows into hedge fund shorts, hedge fund short exposure just one way street down, and they're really--
Bill: Yeah, how can you be sure? You get blown up.
Naufal: Totally, especially when a lot of typical hedge funds, with a lot of AUM these days, they're long FANGy names, or ARKy names, and they're short brick and mortar or this or that, that's just not going to work as well. It's not going to be as clear as a short, in this environment where you have the left tail chopped off by policy, and the right tail opening up by vaccines. Going into the election, one of the big things we were looking at was Goldman Sachs’ most shorted and most bought VIP short, VIP long hedge fund baskets, as well as the short momentum/long momentum baskets. This is potentially a big deal for rotation. We've seen a lot of that, because of that-- and then GameStop really accelerated it. We're at a point now where there's just not that much shorter exposure out there and the longer exposure it is in a lot of stuff that could be sensitive to this stuff. I'm always looking for downside risk because of my job, because I cut my teeth during the financial crisis. Most of my biggest months are always during crashes or quick breakdowns, whether it was February 2018, with the VIX stuff, we were short XIV, or during COVID, we went into a short a bunch of spooze and crude futures, or any of that stuff. I'm always looking for that stuff. I'm wrong all the time, because markets just go up. Those are the four lenses through which I'm looking at, could these things matter? If they start to matter, I feel I'm a step ahead. I just want to stay a step ahead until the conditions change.
The only one of those things that could really derail the bull market more structurally would be if the new variants just screwed up the vaccine story. I'm skeptical about that, but we won't really know until at least next month.
Bill: Yeah. Man, it's been interesting running my own book, I'm terrified because never in my wildest dreams, could I think that my last 12 months results would be this good. I hate talking returns, but it's only my own book, and the future isn't the past. I run two accounts, one’s my own, one’s my wife's. The one that's my account, it's two thirds of what I run, it's up like 54%. My wife's is up 38%. I'm not that good. I'm worried that I'm on like, the wrong side of all this smart money that's needing to come out of one side of it and I'm getting a bid. I'm just worried that the jaws are going to collapse on me. I see a lot of what's going on in-- I don't know, I see lumber prices, I see housing. I'm hearing stories right now, where people are writing above-ask bids with escalators embedded in an above-ask bid to close a deal in real estate in Scottsdale, and they can't even get the deal. It's hard to see this much froth and look at my performance and not be like, “Man, there's a day of reckoning coming.” On the other hand, I am sort of in this camp, that we're on the other side of an economic catastrophe, and really set up for a nice long run here. I guess that summarizing it, I do think that if today's not a stock pickers market, then I don't think it ever will be.
Naufal: Totally. One of our big things we keep trying to remind ourselves is the end cycle multiples this time are going to be insane. They're going to be way beyond what any of us expect. Yeah, on the other side of that, like I said, expect really poor expected returns. That's going to be a great environment for-- for example, Dan McMurtrie will crush it in an environment like that, because you can't just buy meme stocks, or you can't just buy whatever is going to be huge. 20 years from now, you got to be looking at what's the value. I think that that's the nature, that's the tradeoff that's being made on a social level, on a sociopolitical level. I think it's fair, we got to be prepared for that. Yeah, I think things will get crazy in the financial markets by the time the cycle ends because the Fed and Congress are telling us that's the tradeoff they're going to make so they can finally help the labor class, they can help the working class for the first time since I was born.
The other thing I would say is, in terms of housing, I think we talked about this a little bit before, too, over DMs. Look, a lot of what I do, a lot of the big picture themes I have--
Bill: Please don't bring up the Restoration Hardware bottom tick, because you're going to trigger me.
Naufal: [laughs]
Bill: I already got triggered, when you're just talking about the DMs, I was like, “Ah, he's going to bring up what my biggest miss was.”
Naufal: It wasn't a bottom tick, but it was a good trade.
Bill: It was pretty close, man.
Naufal: It was a good trade. Yeah, but I'll explain what my thoughts were behind it. One of the big picture themes I have, a lot of is borrowed from talking to other folks and just really stress testing stuff, so a light bulb clicks. I don't know how much original thoughts I really have. I don't think I'm that smart. For example, with housing, one of the big things all through last cycle that I would talk with and investigate with a lot of folks who are doing a lot of great data work, and I would do my own as well and we would have conversations, it'd be back and forth. I wasn't just stealing the stuff, but we just got to this point where we were expecting like a million and a half starts as we start to normalize out the housing crisis, but it became clear that demographics just weren't there, because millennials weren't forming households yet. So, I came to this conclusion that the real window for the housing market to really accelerate and normalize a new normal and exit the post-financial crisis regime, in terms of housing starts and housing demand was going to be in the 2020 until 2025 window. Mark Dow on Twitter, Logan Mohtashami on Twitter, both of them are very helpful and instrumental in me getting to this view. This is actually one of Logan's big picture claims to fame, is he's been pounding the table. 2020 to 2024 was his window. He's really, really sharp. Talk about crushing it, his PA was up 300 something percent last year.
Bill: Yeah, I saw that. Didn’t he retire last year?
Naufal: He retired.
Bill: Yeah, good for him.
Naufal: Shoutout to him, because when COVID hit, he froze all of his renter rent payments, and every time I dropped something on public, he'll throw thousand bucks immediately. He is to me a true damn American patriot. He is an optimist about America and does his work and takes advantage of what he was able to accomplish in the markets to help folks who need it in America. I have the utmost respect for him. He had this view of 2020 to 2024, my math extended to ‘25, which is where millennials form households get married, have kids, move out of renting, get houses. Belayed-onset adulthood, because variety of reasons, both cultural and financial reasons, could be on a financial crisis. The way I was looking at it in March of last year was, okay, we're having this financial market crash, and everyone's stuck at home, this is going to be an excellent opportunity to hop in to ride this housing cycle.
The way I equated it to my partners was, go buy the most operationally leveraged stuff to growth and housing and furnishing right now, because doing that right now is buying the same thing in the cloud space coming out of the financial crisis. The window of opportunity was going to be there, whether or not we had a crash to give us cheap entries, but since we got that, it's like the perfect cycle alignment, and then just ignore me every time I say, I don't know, maybe he's gone too far. Because I'm going to keep saying that, and just ignore me, stick to your guns, do your fundamental work, I don't know anything about stocks. Like Restoration Hardware was a play there, Wayfair was a play there and some of the home builders, and it's been working really well for us. So, yeah, housing is going to get frothy, especially in certain regions. One of the things that Logan really brings up a lot too, is the problem with this is going to be prices will get too high in certain regions, for sure.
Bill: Yeah, I would argue some are there, I don't know.
Naufal: Yeah, totally. I guess we'll see. This year, my friend, Connor [unintelligible [00:58:53] and I, we chat about how this could be the first year, ever, where the US and China both put 7% GDP growth. What is the post pandemic new norm of growth rates, and income growth, and the distribution of it? If we're out of this new normal 2% equilibrium of growth, then maybe there's a little bit more frothiness you can expect in some of those markets, and maybe they're not at their craziest, but that is true. Yeah, housing is going to be expensive and getting expensiver in a lot of key regions. I don't know if that's going to be a signal for markets hop, though. Well, that's what I'm getting at is a lot of this stuff is, you're seeing pockets of access that can get far more excessive, but I'll call it a bubble with Microsoft at a 50 P/E. [laughs]
Bill: Yeah, well, it's funny that you say that. I've often said when Apple's 5 trillion [crosstalk] we're stretched. For actually quite a similar reason, something that is resonating in my head, when you're talking is housing is one of these supply-constrained markets. If to the extent that these prices signal more entrance into building houses, the multiplier effect on everything that's housing related is pretty large.
Naufal: Totally. One of the things we did is we transitioned a little bit from housing and housing assets to construction and infrastructure. Part of that, of course, was the political stuff, but part of it was just now we can talk about the supply response, as opposed to the price response, and the demand stuff. There's a lot of stuff in the construction and engineering and infrastructure space that has taken the baton from some of our housing stuff. Don't get me wrong, we still have some Wayfair leaps and stuff. Even though that's one of those unprofitable companies that just keeps going higher and higher, but that's how we've been thinking about it in terms of what's next, it's still within the same theme. Our transition could be incorrect in time drawn, but that's another way where we try to keep a pulse on the market and maybe manage risk a little bit. But yeah, that's how we're thinking about that aspect of things. If I had the liquidity, I would have definitely been scooping up real estate in Utah or something back last spring. But I'm still young and bootstrapping a hedge fund, so here we are.
[chuckles]
Bill: Well, hopefully your hedge fund can grow and then you can have the liquidity.
Naufal: I appreciate that. I would love to be priced out by them. I can wait for the next crash. [laughs]
Bill: I tell you what, man, you guys put up good enough results, it won't matter. I'm rooting for you guys. It's a cool firm.
Naufal: I really appreciate that.
Bill: Yeah. Well, you're an easy guy to talk to, so you're easy to root for, that's how it works.
Naufal: [laughs] I like that.
Bill: The Restoration Hardware thing, man, I got scared about liquidity, but it was funny because I said to my friends, I was like, “People are going to spend money. They're locked in their house.” If you have kids, how quickly your kids are destroying everything that you own, it's like the replacement cycle just got accelerated, big time.
Naufal: Totally. This, I think, speaks to the notion of mental capital mattering sometimes even more than financial capital, because, yeah--
Bill: Well, I didn't make money on it, by the way, but I was right, but it doesn't do me any good.
Naufal: Look, being right about something is still something to-- One, be proud of it. But two, this lesson to learn for the future. You can figure out, like, how did I get to the right decision, but I guess what I was trying to say is, first of all, you have this intersection of cycles, where you have this pandemic cycle where people are locked at home and they’ve got to basically reconfigure their homes for stay at home, work from home. At the same time, as you have this secular housing cycle, that's a demographic trend. But I will say if we took a hit in the market during the crash in our hedge fund, then we would have had far less risk appetite to try trades like this. That's what I mean by psychological capital, mental capital is, if I'm doing my job to capture enough downside capture and big volatility stocks, then my partners have the mental capital to continue to take risks in a clear, objective way, as opposed to worrying about liquidity or facing psychological hurdles, like paralysis, or I don't know what's going on. Our best month since inception was March 2020. We had a lot of dry powder and we were able to be confident with our risk appetite, even though-- we can afford to take a drawdown on the front end on stuff that we really, really love, because we have that buffer built in. We're not turning a bad quarter into a disaster or anything. We're turning a great quarter into a less great quarter, whatever, it doesn't matter. They were able to keep that same pulse and that same energy when a lot of other folks were either financially or psychologically in a very different place.
Bill: Shell shocked. Yeah, no doubt.
Naufal: That's why mental capital is so important, at least for what I do, I use a lot of stop loss orders, my hit rate is not super high. My main thing is if I preserve my mental capital, when I see the thread on the baseball is right down the play, I'm going to have the balls to have a home run swing, and I have very streaky returns in my side of the book. Very, very streaky in a clustered and feedback loop gamma type of P&L profiles. Then a lot of times I'm just shopping around. Whereas the return profile, my partners is a lot different because they ride the extensive of cycles and I'm trying to find big, big inflections. Here and there just do tactical, I had a quick put spread and ultras and then long-term treasuries right before the Georgia elections and added a little bit after, and like great. It didn't end up hitting stocks, but if it did, it would have hedged out, it didn't so great return, we had to start the year. But because I'm so paranoid about things that can go wrong, I'm always looking for downside. My partners always are complaining, like, I'm the party pooper. I never let them have the size they want. We realize about 50% of the slippage, so I built into my risk models, they're basically saying, we could have had twice as much as the size of each of these positions and wouldn't have been breaking our rules. I'm like, “Yeah Well, too bad. I'm the risk manager.”
You need that check for confidence and overconfidence because, one, especially as you scale, liquidity becomes tougher, so you’re going to have to change your approach overnight in terms of slippage risk. Two, when things get crazy, they get really crazy. Liquidity is only there when you don't need it. I'm always thinking about that regime. Then three, if I am this party pooper who's just like the old uncle, always playing risk management and telling them, “Oh, I'm sorry, you have to size this down or tighten your stops,” then it gives them the freedom to be themselves. I don't remember who it was, I think it was Picasso or maybe someone else who said, like, “If you give me a blank white sheet of paper, and somebody says draw or paint something, it's boring. If you tell me, I can only use one shape, one color, one quarter piece of paper, and you box me in, that's where my creativity can come out.” That's the philosophy behind our approach.
I really think that one of our biggest edges is synergy is a really bad word in our industry. It's almost always BS. Synergies are very tough to come by this game. Especially Andrew Middlebrooks and I, we have a Rosetta Stone where he understands macro, he worked on the hill, studied fiscal monetary policy at Johns Hopkins in graduate level. He's in the weeds on policy, he might not be at a point where he's having crazy out there ideas like me, that once in a while to get validated by the market, everyone thinks I'm crazy. Like when I went on Bloomberg and said Bernie Sanders is good for pre-tax corporate profits. That's why I wasn't surprised when Democrats sweep the election and I'm like, “Yeah, we're going to get huge growth and markets going to rip.”
Bill: Why did you say that because that is a very contrarian opinion?
Naufal: I think that a lot of macroeconomics actually just boils down to identities, like axiomatic stuff, which is why it's not like physics, you can't model it and have excellent predictive values using really hardcore statistics. It's more useful to look at it conceptually, and in terms of identities. Looking at it descriptively, and then having an idea of the distribution of possibilities prescriptively. There's something called the Cholesky-Levi equation, which is basically a macroeconomic identity for how corporate profits are generated. It'll take things like fixed investment, dividends, government deficits, all these things, and it adds them all up to say, flow of funds, axiomatically, 100% of the time, this is where corporate profits come from. Each of those little sectors have different multipliers, and they all interlink together. It's not formulaic, but it is an identity. Just based on that identity, if you ramp up the deficit, and you do it in a way that generates demand, on the lower end of the income distribution, then you will also generate fixed investment. If you have the fiscal impulse there in terms of government dissaving and you have the fixed investment impulse there from corporate CapEx, by definition, someone is going to have profits from there.
It's interesting the difference between micro and macro because when a company spends on CapEx, it's depleting their profits, it's not accruing to their profits. In the long run, they want an ROI, of course, but in the short run, their CapEx is an outflow from their cash flow. However, it's some other company's inflow, and that's the point is when you aggregate it, when you think about an aggregate sense. I think one of the most useful conceptual frameworks to think about is the fallacy of composition, which is that the dynamics that exist on a small scale don't just equally and proportionally transfer to the larger scale. For example, if all of us decided we want to save at once, all of our individual savings rates go up, but our aggregate savings rate will go down because there's just less spending in the economy and the multipliers would work in such a way that there's less income to generate that savings. That's the interesting thing about macro versus micro. But because we do have that Rosetta Stone and that two-way street of information flow and just philosophies, that I think becomes one of our edges. Like I said, man, Method Man, Redman, we're back and forth, like Red and Meth. It's really cool. The same way like John Lennon and Paul McCartney, some songs are written by John, some songs are written by Paul, but each of those songs when you look at the songwriting credits, it's both of them. That's a philosophy for our hedge fund as well.
Bill: Dude, how much do you guys get into-- because you're a math major, how much rigidity is in your process for this creativity? Everything you're talking about is extremely creative, so obviously, creativity is a large component. If I were going to answer my own question, I'd say, “Well, he just talked about how he's reducing position size and saying we got a trim here.” That's probably the answer, but I'm just curious to hear you articulate it.
Naufal: Totally. We get this question a lot from prospective LPs too. Before I answer that, I just want to say real quick, when it comes to creativity, I get a lot of media appearances, and I have my Twitter followers and stuff. So, a lot of folks hear most about my creativity or the tailwinds I provide for our returns. I’ve got to give a shoutout to my partner Andrew Middlebrooks. He's the most creative person I know in the long/short space, and not creative in terms of like financial engineering, or how could I pump something? He says things I think are crazy, and then two years later, I'm like, “Oh, wow, this is my big theme.” I’ve got to give props to him sometimes, just because I often end up being the media face, folks just hear the macro side. That's just one part of the stuff that he does on the long/short side is, it's just stunning to me. He’s a really, really cool, a very, very creative individual. In terms of--
Bill: Well, if he wants to come on even though I mispronounced his last name, or actually got it wrong, forget about mispronounce, just totally fucking butchered it. I'll have him on. I’d love to.
Naufal: Yeah, I'm sure he would love that. Thanks as always for giving us this platform. In terms of this notion between systematic and discretionary and qualitative versus quantitative, look, just as a disclaimer, yeah, I studied math, I tried a graduate program in mathematics, I just realized, I'm never going to be the guy who gets a PhD. I don't even know if I should have been accepted into the program in the first place. I could speak the language and I get the concepts. But when it gets the real deep dive stuff, I'm not the rocket scientist, that someone at RenTech can get, just to make that clear.
We have a lot of quantitative tools in our process, Andrew built out what we call GLM Analytics, which is our in-house analytics and modeling engine for single-name equities. It's like an in-house analyst. Again, it's not this systematic thing where they pump out the score and then we just buy whatever has the highest score short, whatever has the lowest score. It's really a two-way street between the human and the computer in terms of what are we seeing on a meta level? Are we seeing scores 0 to 10 and that being actually really primed for short squeezes, and then we configure the model, or Andrew really likes to stock, it scores really poorly, he's like, “Okay, am I wrong? Or is the engine wrong?” Then you just iterate from there both ways. You iterate your human approach, as well as you iterate the model to be better optimized. Yeah, it does a lot of the work for Andrew on a top-down level quick to get to like, “What's the stuff I should really focus on with this broader theme?” One thing that's really cool about it is, he has different models for each industry within each sector. You might want to value a bank off price of book, but a SaaS company is very different metrics and KPIs.
Bill: Yeah, book doesn't matter too much.
Naufal: [laughs] Yeah, if it did, we wouldn't have the market we have.
Bill: That’s right.
Naufal: Those types of things really helped him develop a systematic approach to first personality in terms of analysis. Then, from there, it's like, okay, you’ve got a pulse on the industry, you’ve got a pulse on the companies that play a role in the industry. From there, a lot of qualitative stuff can come into play. On my end, everything I do is very qualitative, but influenced by-- I have my macro models, I have my conceptual frameworks, which even if they're not super quantitative, they're relatively written in stone, little heuristics. But the most systematic element of our processes is risk management. That's the one part where it's like, we don't want the human involved, we can write the rules beforehand as human beings, and then agree upon them as partners. Then after that, that's going to be our guardrails.
One of the things that we do is, we are an all-weather fund, so which means that we're not allowed to use market conditions as an excuse for poor performance, which is really tough. Sometimes, of course, it'll happen, even in really great markets or in really shitty markets, we're never going to just knock it out of the park month in and month out. One thing I do is, I score every position on one-on-one basis, across a variety of what I call vector spaces. A lot of people do this kind of factor-based risk management, but I like to really build out what I call these vector spaces. One vector space could be factors, momentum, growth, value, whatever. Style factors like small, mid, large cap, all that stuff. We'll score each position through all those factors and we'll aim to have the portfolio overall to be relatively balanced across those factors, and then have skews that are permitted within bounds that reflect their biases. Those factors, that's just one vector space.
Another vector space to me is macroeconomic conditions, higher and lower growth, and inflation, yields, higher lower yields, higher lower US dollar, DXY, all those things. Another one is time horizons, short, medium, long term. We want to be balanced across those so that we're not having cycle amplitudes amplify themselves. We want a peak of one cycle to be offsetting the trough of another type of thing. There's a bunch of them, I don't want to give them all away, because this is part of our process. That part is really systematic, and it's like a green light, yellow light, orange light, red light system. Once it gets to orange lights, Andrew, do it now. If it's red light, I'm doing it myself. We maintain discipline along those lines. Then, when it comes to the way I deal with it, the first step of my process, if I have to risk manage something, let's say, he's in this trade that's been crushing it, and it's getting our exposures out of bound in one vector, the first thing I'll try to do this, can I find an idiosyncratically attractive asymmetric exposure that can balance those exposures. If I can, I'll hit that, that's what's so cool about having a long/short book behind me is, if that doesn't work, it doesn't matter what mental capital at all, because I had to do it.
Then, the second layer would be forcing them to trailer tighten up stops, including the slippage that we realize about half of, 50% of. Then, if neither of those things are happening, then sorry, bro, take some size down, and then yell at me, whatever. That's the kind of dynamic we have, and that's where the quantitative meets a qualitative in a systematic means of discretionary.
Bill: That’s cool, man. I love talking to people like you because I'm so different. I think part of the reason that I'm not comfortable with my returns, I don't even know who I am. I really need to have somebody go through what I've done over the last three years forensically and tell me, am I just a guy that buys beta at the right time? Am I a guy that switched factor exposure at the right time? Or, do I actually generate some alpha? The tough thing is, I'm just sitting here investing, right? I think there's a balance for how I look at the world because I pray to the church of Buffett and Munger, and there is a part of me that says, “Well, buy cheap businesses bet big when you see the bet, and just let it go.” But there's this other part inside me that's like, “No, man, you need something that's more--” I know that I have some skill. I don't know how much skill I have. If you can't measure it, how can you get better? It's cool to listen to how you guys work back and forth like Method Man & Redman, man, I need to figure out who the hell I am.
Naufal: We’ll be taking this for the children.
Bill: That's right. I don't know, but it's cool to listen to.
Naufal: My perspective on that is this, one, great way to learn who you are, lose a shit ton of money, you'll learn who you are. That'll help a lot. Big drawdowns are-- I don't think there's that many folks who can be excellent long-term investors without taking big drawdowns at some point in their career. Another big thing, I think, like you mentioned, the forensic approach is really important to get a better sense of what you've been doing to generate the returns. You were asking about you have this Buffett-Munger backdrop, and do I need more? Do I need to last, or whatever? My whole view is figure out what works for you, what makes you comfortable, what preserves your mental capital, what preserves your psychological capital. If you're somebody who needs to take 30% drawdowns in your book to do things your way the right way, that's great, because whatever risk-return profile that you generate, that works best for you, that's what you should do, because it's different than someone else's. Ultimately, it'll provide some level of diversification of someone else's, if you are true to yourself. If you try to stray from that, then the market will definitely punish you, because it'll mess with your psychological capital. At that point, it doesn't matter how good your analysis is, it just won't matter. It's really about getting to know who you are and then figuring out a strategy that's designed for your temperament.
What works for me is very, very different than what works for Andrew. It took us a long time, and a lot of work before I joined to find a way to synergize those processes because-- to be honest, that itself wouldn't have occurred if Andrew and I didn't get along. If we didn't have a personality synergy to begin with, then we could have had all the hedge fund consultants in the world, it just would have never worked. Those things, I think, are really important and it doesn't have to be about like, I want to replicate RenTech’s tax returns. If you want to replicate RenTech’s tax returns, then replicate Jim Simon's personality, temperament, and knowledge sense.
Bill: [chuckles] Yeah. That’s right. Then just become Jim. Then you're good.
Naufal: You got to find a strategy that works for you and tweak it over time by believing it, and even stuff like mindfulness really helps there. It also helps to have a mom and a girlfriend who will kick your ass anytime you get a little cocky about anything. That's always helpful as well. I know you have a wife, so she'll keep you alive. [chuckles]
Bill: Well, yeah, man. The other thing is, I almost feel embarrassing, they're my returns, because they're not. They're the network of people that I work with. I owe everything to them, and I owe my thinking to FinTwit now. I came in, I have my own general framework, but everyone that I've interacted with has pushed me. It's an output of a lot of smart people. It's not me at all.
Naufal: The same thing applies to me, man. I don't know how much primary original research I actually do. It is your returns because one, none of that stuff is investment advice. They always say do your own due diligence, and two, it's about how you apply it to a strategy that fits your temperament, fits your goals, and executions own that because owning your gains also means owning your losses. That's how you get better as an investor, I think.
Bill: Yeah, that's fair. I do think I have-- for the first time in my life, I got real confidence. I do think a lot of those returns are for the right reasons lately. I’ve got to keep it up, man. You don't know who you are as an investor until-- the next one can always blow you up.
Naufal: Totally.
Bill: There's no time to enjoy anything, but it has been nice to prove some of my own negative self-voice wrong. More importantly than me though, your base case was for a Q1 pullback. Were you satisfied by January's price action?
Naufal: No, man. Both at the first little tech drop after the Georgia elections, and then the de-grossing events after GameStop, I was able to get lucky and catch most of that and get trailed out without losing too much of that downside capture. I think actually both of those trailing stops were hit on Sunday evenings in the futures markets. So, it was the classic, everything is done, the last week's over, new week’s here, everyone's going to buy everything, stocks are only going to go up, and that's what happened both times, I think. But I was not satisfied, that didn't meet-- to date, my view of Q1 washout has not been validated at all. It could be something that ends up being invalidated. My next window is probably going to start positioning sometime between Wednesday and Friday and between VIX expiration and options expiration. The backdrop I'm looking at is retail seems to be very loaded, hedge funds, their net and gross leverage is very high. If you look at some of the dark pool flows, which are institutional flow, as opposed to stock a flow. It's been pretty weak in the last four weeks. And then the dealer tailwinds, dealer, delta and gamma hedging, that really dissipates after VIX expiration, and especially after options expiration. That setup leads me to believe, all right, I need to try play for them some downside, maybe now we get a little correction, especially if yields are rising into that type of thing. Maybe we have a cocktail of circumstances. But yeah, if we have just like a small dip, or we don't get any dip, and it's March 31, nothing happened, then my view is just wrong. It is what it is. I'm wrong all the time. So far, those little dips that we've gotten are not what I was projecting. They're too small.
Bill: Yeah, they feel too small. I was all excited during some of that de-grossing, but what I was waiting for never occurred.
Naufal: Yeah, it's interesting. I was very surprised that hedge funds were able to regross up their long book so quickly, it definitely seems some of the losses may have been pretty concentrated. That was probably my main conceptual mistake was thinking that it was a little bit more disperse of short squeezes. But yeah, they did not grow up their short books, people are just too scared. That type of microstructure can lend itself to little pockets of volatility. Even the de-grossing event, the VIX got close to 40 and we're barely down, so we could see small, random stuff like that happen. Those are just run-of-the-mill pullbacks in bull markets is what I'm talking about. We didn't even get that much. The broader story, I think, can only be really derailed if we see the vax story get substantially hit, because otherwise the left tail is gone, the right tails just now beginning to open up in the markets.
Bill: One thing that you had said on the Odd Lots on podcasts that I've been ruminating on and I think it's super fascinating is whether or not the addition of technology is going to create more of a structural deflationary force in the service industry. Now that I'm talking to you, and I'm listening to how you put all that together, that could be a really big deal, huh?
Naufal: Yeah, man. The way I framed it was, when China entered the World Trade Organization, that was a permanent shock to the labor intensity of goods output, which means it was a shock to how many employees are required to generate a dollar of output in the goods industry, you could just use cheaper labor to generate those goods. There wasn't as much of a labor intensity for the output. Same thing applies to technology to a certain extent, like automation, all these things, just require less labor compensation to generate the same amount of output. I'm curious if the nature of the COVID shock and the timing of it in this period of time where it accelerated the adoption of digital and cloud-based technologies among industries that hadn't really gone there yet. I wonder if COVID ends up as a permanent shock to the labor intensity of services output. Like restaurants, do they need to have the same amount of workers and employment compensation to generate the same amount of output as they used to?
Bill: Can I ask you, though, how would that change? Right now, people aren't going to restaurants. Once you're going to a restaurant, you need to have a server to serve you. What are you thinking through where the real potential for tech to disrupt is in that industry?
Naufal: Yeah, there's just various efficiencies. A lot of the restaurants, they're just stuck in place right now, that's probably one thing they're focused on is cost cuts, and figuring out how to make things more efficient, whether it's on the back end, the suppliers, and the distribution of stuff and cooking processes, or whatever, or just on the front end. Just like McDonald's has kiosks, or something more or whatever, just that whole process. You're right, we're really not going to know until we see the post reopening new normal equilibrium, and then we can see like, okay, services are surging back in terms of output, are we seeing a proportional response in terms of employment? Or, have things gotten more streamlined? That's an open question. Different service industries are just structurally going to require labor, you can't avoid it. I'm not going to try to get too creative with how it can work, because I'm not that knowledgeable about industries and individual companies. It just something I have in the back of my mind because if that were to materialize, then there's a Goldilocks of spend, spend, spend, but no inflation and low rates will just persist for that much longer.
Bill: It's exactly what I was thinking about. I was like, “Man, how much could you spend if that thesis or sort of thought proves true under your framework?” I would imagine there's a lot bigger deficits that you could run or spending or whatever.
Naufal: Yeah, and a lot more access that generate in the financial markets before we get the tightening. All that stuff really matters to me. Another thing I would mention too, is one of my big picture crazy views right now is-- look, man, since I've been around, it's been this story of global imbalances. China produces too much, America consumes too much, inequality rises in the US, and blah, blah. I think that we're in the beginning of an actual global rebalancing because China's currency markets are a lot more based on market forces now. They don't undercut their exchange rate anymore. Number two, they open up their bond market and there's a one-way flow of massive amounts of capital coming into China.
Remember, last cycle, how the US was the only yield in town. Now, that's China. The US is creeping back up a little bit in that regard but China's got a huge yield premium and is open up its bond markets and it's just one-way flow of institutional capital into their bond markets, because they are monetary sovereign now. When their economy gets hit, their interest rates go down. When their economy does really well, their yields go up. They're no longer in emerging market type of correlation between risk and government bonds. They are a safe government bond market now. There's a huge amount of money coming in that's driving up the Renminbi, vis a vis dollar, which is being depressed by this new Fed reaction function and all these deficits. And a little bit, too, because Europe is now an actual European Union zone, they have some common issuance the breakup risk, that tail risk has really gone to a large extent. All these things need to believe that we're in a secular bear market in the US dollar, especially gets Renminbi. Yeah, I wouldn't be surprised if Chinese consumer demand really gets going and in [unintelligible [01:26:29] Chinese consumer tech names, and I wouldn't be surprised if US manufacturing comes back. It won't be bringing back the same type of jobs as were exported. I can have this view, why can't Apple build a semiconductor fab here in the States one day?
Bill: Did you tweet that? I think I saw you tweet that.
Naufal: Yeah. It's becoming this meme now too. I'm not the only person that come to this view, a lot of people have come to this view, four or five years down the line or whatever. It's interesting, the politics of it too, because this automaker chip shortage that's happening, I think, is a lot more of a political story than an economic one. Toyota is not having a problem producing, but this is a great entrance for Tim Cook to really align Apple to an American industrial policy with the government. Stars are aligning, I think, policy wise on both global and domestic lenses to make this the global rebalancing in action. I don't think that people see it that way. I think people are still looking at it in terms of, we're using an anti-inequality response to the COVID shock, which is true, but I think it has long-term implications, even geopolitical implications. I think that it'll be really interesting to see what happens with respect to the US and China with this backdrop. In the meantime, I think it's like the biggest story in the world that we haven't really accepted yet.
Bill: How do you think through some of the Trump administration's policies as it pertains to trade? Did you think that they had that more right than maybe, I guess, I would perceive that you would think it because they did seem to wield a big stick when it came to technology transfer and stuff like that? Were those the right things to look at, do you think?
Naufal: I think the fact that they started that conversation was really good. I would have to compare it to the counterfactual. I always expect that even if it was President Hillary Clinton, that 2016 would be a moment, that cycle would be the moment where the China story would be countered in the US because they were doing things like Made in China 2020, because Xi Jinping, the second term of Obama's administration, consolidating so much power and beginning this big shift in their economic strategy, it was inevitable. But I think President Trump accelerated that with his bluster, but I always expected that the actual execution to just be like complete nonsense and mean nothing, because a lot of his biggest donors are folks who need China. The biggest part of the trade deal was that the Chinese financial market was opened up to Wall Street basically. Stephen Schwarzman is very excited about that. Stephen Schwarzman is one of his biggest donors.
Similarly, whenever things would get to a potential halting point, and this trade war could really accelerate into something bigger, I would always fade that because his biggest donor was Sheldon Adelson, who needs his Macau license renewed by the Chinese governments in 2022. There's no way he was going to allow that to occur. I think that a lot of folks got trolled by the media about this stuff when it was really just a lot of bark and no bite. At the end of the day, what was the outcome of a trade deal? Yes, we have these tariffs. Yes, we have a lot of this IP stuff, although I think a lot of that focus was a little bit backward looking. It wasn't really thinking about the future of where China was trying to go. It was more like fighting last decade’s battles. Although don't get me wrong, there was a lot of sketchy stuff that occurred and still occurs, I don't want to trivialize that. I'm definitely a Tanky. Yeah, it was just very misguided approach in my opinion and the ultimate result., the biggest part of it in my opinion, was the fact that Wall Street has access to Chinese financial products and markets now, I'm sure Wall Street played a role in restructuring some of China's private sector NPLs. It's a win-win for American elites and Chinese elites, none of that really moved the needle in terms of the bilateral trade deficits or domestic wage growth in the US, that was a much more of an elite game. It was just sold as a popular escape.
Bill: Why do you think you ended up seeing the lower part of the income distribution started to catch a bid in wages?
Naufal: There wasn't that much of it compared to what you would expect given the length of the cycle. President Trump inherited a working cycle, and unemployment was going down. Inequality by some metrics peaked in 2014, 2015, especially in the lower end of the distribution. I'm sure the COVID shock probably changed some of those numbers. We got to the point where we were starting to see folks who were pushed out of labor market finally find a way to get back in. That's always going to be the lowest set of distributions in wage and acceleration. There were a couple other factors too. One, was everyone talks about Trump's tax cuts. That didn't really move the needle, but he did also pass a huge government spending bill. It's kind of that thing where Republicans will only be austere when Democrats are the President. That spending package did matter. A lot of it went to defense, a lot of that went to here and there, but it was still big enough to move the needle in terms of-- it was still a fiscal stimulus.
Bill: Well, defense has a multiplier effect, right?
Naufal: Yeah. It's not the same as like childcare tax credit or something, but, yeah, it's definitely going to move the needle. It's going to be a stimulus, it's not going to be nothing. Some of that a lot of that rolled off 2018, 2019. Yeah, that happened. Then the second thing was, in fact, I would say that the wage acceleration just based on the length of the cycle, and the length of unemployment decline actually occurred later than I expected, which I don't think it was President Trump's fault as much as that's just how long the cycle had to go before we could see the lower end finally start to see wage growth pick up. Then, the last thing I think played a role is the fact that the Federal Reserve had a complete rethink after the 2018 failure of your tightening cycle. They saw wages accelerating, they saw them play really low, they saw inflation start to finally take up. So, they started to tighten, and it just short circuited everything again. Then, they had their strategic policy review, and the outcome of that was, “All right, we're going to be reactive, not proactive to inflation,” and that also helped to chop off left tails and keep the cycle going longer than otherwise. Then, of course, COVID happened.
That's how we answered that question. I don't think that the mechanics flowed the trade channel or the trade policy, because if it did, you would have seen much stronger manufacturing employment growth, you would have seen that wage acceleration and unemployment rate decline happen in a much faster pace than the pre-trade war dynamic.
Bill: Yeah, that makes sense, I think.
Naufal: [laughs]
Bill: It makes sense to me.
Naufal: I'm putting on my economist hat here right now.
Bill: Yeah. Well, I think the way you see macro, it's almost hard to decouple those things. I don't think that you can-- it all is inherently political and economic and all that, right?
Bill: Yeah, policy matters. I think one thing that we've learned is that a lot of outcomes are really just dependent on the amount of policy you throw at it. There are always tradeoffs, but that doesn't mean that tradeoffs have to be symmetric. You can have asymmetric tradeoffs all the time. Yeah, a lot of the money I made, during the last cycle would be during periods of time where-- like the debt ceiling crisis, it's a policy failure. Whatever your political views are, if that's not considered a policy failure, and you can’t anticipate it being a policy failure, then your economic mechanics are incorrect. Yeah, at some point, there becomes this interlinkage between your politics and your economic policy mechanics, but that's why I keep trying to think in terms of circumstantial and contextual analysis, maybe I'm more right wing-ish or a supply sider in the 70s given the backdrop. Maybe I'm like balls to the wall, Bernie Sanders-AOC in 2018 given the backdrop, that's what's really important to me is, the way to keep your policy views from being beholden to some sort of ideological political view is to understand the context in which different ideologies work best. That's one of the reasons why the folks who made a lot of money during Reagan and are older now, they're sitting back kind of like old men on the stoop yelling at all these deficits and getting smoked, trying to short the bond market because they allowed their political ideology to become some sort of axiomatic policy response that works in every circumstance. But the context really matters. Look at the inflation rate, look at the demographics, look at the technological backdrop, look at the globalization backdrop. All those things will tell you which cocktail policies will have what type of effects. It's not a one size fits all model, because the only constant in this world is that it changes.
Bill: Yeah, that makes sense. Can you elaborate a little bit on your statement that the Fed does not inject liquidity, it injects reserves, and that risk cycles aren't driven by rates, they're driven by greed or envy?
Naufal: Yeah.
Bill: I added the greed and envy part but that’s what I interpret you saying, is that fair?
Naufal: Yeah, I'll dig into that a little bit. I owe lot to Mark Dow for really breaking this down for me because when I was a little young whippersnapper, when I first started trading, I did not realize this stuff. A lot of what I was learning was like-- with all Austrian economists were saying, but the notion behind it is this, I should have been more precise when I said the Fed does not inject liquidity, because in moments of crisis, it is injecting liquidity. But just generally speaking QE, for example, isn't necessarily an injection of liquidity because what it's doing is, it's just creating reserves to put into the banking system and it's swapping out the treasuries that the banking system owns for those reserves. It's just an asset swap. It's not a net liquidity injection. It gets a little bit more complicated when you talk about when non-banks are selling the treasuries or MBS to the Fed, because if there's a creation of deposits, at those non-banks. If BlackRock sells mortgage-backed securities to the Fed, then what happens is the Fed gets an MBS on their asset side. On the liability side, they give a reserve to BlackRock’s bank, BlackRock’s bank gets a reserve on their asset side, and on their liability side, they get a deposit. On BlackRock’s side, that becomes the new deposit on BlackRock’s asset base.
Now, what will they do with that deposit. They could keep it cash as dry powder, they could put it right back into treasuries or MBS, or they could move it further out the risk curve? If they move out it further out the risk curve, then that is moving risk assets, but that depends on their risk appetite to begin with. It's not a mechanical injection of money. It's really just an asset swap and then you guys don’t know[?] what to do with that, non-bond, just a cash asset. Now, in terms of risk appetite, the frothiest parts of the housing bubble, frothiest part of the dotcom bubble were 4%, 5%, 6%, 7% interest rates. Then we had zero rates all through Obama, and we never got risk appetite off the ground. Psychology really matters here. You were saying, in terms of greed, seeing your neighbors get rich, that's how risk appetite starts.
One thing that happened, that I wrote about in our March note that I wish I would have taken more seriously. This is the thing. You could be writing and just not execute on it properly, is I was talking about how this could be a big handoff to millennials running the country. This could be RIP boomer markets, and millennials hopping into markets. The thing is, younger folks don't have the same psychological scars as older folks did from the financial crisis, or the savings and loan crisis, or even when they're younger at our age during the inflation crisis, they don't have those same scars, especially the financial crisis, because a lot of that was in housing, which is the main asset base that consumers have, the households have in America, housing asset is a lot more dispersed in stocks in the American populace because a lot of people have a home equity. A lot of these folks, generationally, were getting to the point where they were seeing their friends get rich, and they were buying-- they were taking on bigger, bigger mortgages and spending more and more money. They were at a point where their kids are going to college and they're thinking about retirement and they have very high hopes, and then suddenly all that comes crashing down. That psychological scar, I think, was a big part of the permabearishness that the boomer generation had coming out of it, and why there was this big push toward Austrian economics. All these billionaire hedge fund managers telling Bernanke, he's going to cause hyperinflation where we barely ever got above our inflation target after 10 years ago. Just rarely, it's the government Tea Party, blah, blah.
Whereas millennials had a much fresher psychological backdrop. Wven the TikTok teams, we're making money for the first time in our lives, like real money, you're taking jobs that are more senior, building equity and different things, like building retirement, this and that, and feel like we have a really good pulse on this new work from home, digital economy, it was different than the folks who bought GE and stuff for all their lives. It was a transfer of assets, at least a transfer the marginal bid and offer to a generation with far more risk appetite. Then, social media and staying at home just accelerated the hell out of it. Then now, what do you see? You see, plenty of folks-- we've put up really, really good returns. We had a triple digit year last year. In spite of that, there's plenty of folks I look around that are just friends, it's like, “Damn, they're making a lot of money right now,” and you get that psychological FOMO.
Bill: [laughs] Yeah.
Naufal: You get the Keeping Up With the Joneses dynamic, that's one of the reasons why we have these wristbands for protocols that are so systematized is, we can't allow that stuff to get in the way. That's human psychology and that is a risk appetite cycle in a nutshell. Yeah, now we have risk appetite. Now, the low rates have a much higher multiplier, so how does that impact financial assets? People will look at further and further durations of cash flows and the way they weren't able to do in 2014 or something. That matters more than interest rates. Interest rates can accommodate it, they can try to help generate it. Most importantly, they can prevent short circuiting of it. But ultimately, this was more of a psychological endogenous, behavioral dynamic that created this risk appetite. During the dotcom bubble, like I said, the biggest companies in the world were trading at-- S&P had a negative 2% equity risk premium, which means its earnings yield was 2% lower than the 10-year Treasury. The yields were not the story, it was not that we had zero rates or anything, it was risk appetite. Microstructure of the markets definitely play a role in it too.
Bill: What do you mean by microstructure for people that may not know?
Naufal: We have this active to passive dynamic that's occurring, that Mike Green talks a lot about, that changes the marginal bid and ask from someone who's price sensitive, to somebody who's not price sensitive, somebody who's just like, “If money comes into my fund, I immediately deploy it on a systematic basis to these assets irrespective of what their P/E is,” versus a discretionary active mutual fund manager may take an inflow into his fund as dry powder or buy something that is lower weighted in the index or something. During the dotcom bubble, you had a bunch of high market cap and very low float stocks, because so much of the shares outstanding were tied up with the executives like Bill Gates. He had access to control so much of the overall shares outstanding and the actual real float in the market was really tight, which lent itself to boom-bust type of dynamics. I'm not an expert on this microstructure stuff.
In fact, Mike Green is somebody who I've talked with a lot about this stuff and he really helped me draw this analogy between the indexation boom of the dotcom bubble and pass it to active the passive boom, this time around. But all these things are just more amplifying. The specific source cause, the proximate cause of the risk appetite stuff is psychology behavioral dynamics and sociological dynamics and demographic dynamics. That's something that I think it's not all about the Fed.
Bill: Yeah, well, I think a lot of people want to say it is, and I have fallen in that trap in the past. The more I've learned, the more I realized I didn't know anything. I'm still trying to get less stupid. Long way to go.
Naufal: I think the Fed is going to end this though. I think that's going to be what cracks it. The longer the cycle goes, the longer it takes to reflate and really offset some of our disinflation misses, the higher multiples will be and the more sensitive they'll be to whenever we do tighten.
Bill: Yeah, that makes sense. You almost create fragility the longer it goes, but also, there's still potentially much higher to go until that point, but the higher it goes, the more fragile you understand what I'm saying?
Naufal: Totally.
Bill: Does that make any sense?
Naufal: It makes tons of sense. I hear you, it's really difficult to express and articulate, which is why I think that it's not the easiest market, but it can be very profitable, and hopefully is profitable for everyone on the back end if they're able to catch the downside capture.
Bill: Well, dude, more than that, hopefully, society, hopefully this inequality comes in because we need a society that's robust more than we need a market that goes up.
Naufal: Totally. If we get that, then we can get back to American capitalism, then it's not as case shaped and stuff, but we have a long way to go. But this is an unprecedented policy shift. It should change how you look at the markets, too.
Bill: Yeah. Well, somebody smart said, “The most interesting time in macro is right now.”
Naufal: [chuckles] That's what I said, right? [laughs]
Bill: That's right. [chuckles] That is what you say.
Naufal: I'm pretty sure I quoted someone else, but it's definitely the truth.
Bill: Well, the first rule of marketing is if you repeat it enough, it becomes yours.
Naufal: [chuckles] Right.
Bill: Now that we're almost two hours in or a little bit over, we got to get to the important stuff. Why Kendrick Lamar is your avatar?
Naufal: Look, I'm a hip hop aficionado, I used to make hip hop instrumentals. I still do. Listening to music and playing music is very fundamental to my investment process. I really can't get into a creative zone without just Saturday night jamming on the keys really loud and drums and stuff. That's always what gets me into the best mindset. Some people exercise, some people do sports stuff, some people play with the kids or whatever. That's always been my getting me into flow state. When I get in that flow state, I become really annoying to everybody because I will start yelling raps out really loud, I'll start just having long diatribe about macroeconomics. It's literally my process. It's really annoying to most people, but I love it. It's just one of my favorite things to do. Yeah, Kendrick Lamar, to me is the epitome of an MC. I look at the progression of MCs of rappers as like, Big Daddy Kane, and then Rakim took that and evolved it and brought his own spin. Then Nas during Illmatic, brought his own spin, and kept evolving. He kept adding on top more skill sets. Then, I would say Big L and then I would say Jay Z and then I would say Eminem, then I would say Kendrick Lamar. I think that's the progression of the really, really, really top-notch innovative MCs.
Bill: You do know that you just skipped Biggie and Tupac, right?
Naufal: Yeah, I was about to say that. I don't think that Biggie or Tupac, either of them are on that level of technical proficiency. Look, don't get me wrong, Biggie has flow dripping like butter. He's so influential to me and he's definitely in my top five, for example, but in terms of just pure technical ability, which is only one part of being an MC, and then Pac, his storytelling, but it was his energy--
Bill: Yeah, man, that guy was a straight-up poet.
Naufal: His energy more than his poetry even is what really-- that was the most irreplaceable element about him. Yeah, in terms of the science of emceeing, I think that's been the progression in terms of turning hip hop into hip hippity hoppity, just really corny lyrics and flows to really multisyllabic stuff that wins Kendrick Lamar a Pulitzer, for example, Kendrick to me is the epitome of that, but he also is the epitome to me of this notion of unpretentious social justice. A lot of the videos and imagery he puts out in his music videos is really important to me, especially as a minority who's been brutalized by the police before, as somebody who has a black girlfriend or somebody who has a black business partner, this stuff really, really hits home to me. My avatar is from Kendrick Lamar, like VMA, or Grammy appears, and he's got the red twists in the braids. He's got the image isn't what you would always expect, but it doesn't matter, he's just that talented and he gets out there. It's no BS, he means what he says, he represents a philosophy that I really believe in. He had a dream when he was a kid that Tupac came to him and said, “I'm passing the torch to you.” I think that happened. I think that became a self-fulfilling prophecy to an extent.
Bill: It's wild how stuff like that can happen.
Naufal: Totally. When I listen to Kendrick Lamar, my energy levels just shoot through the roof. I get inspired to be just great. You can read like Seneca or someone or you can read Marcus Aurelius, like a lot of folks get that sense of like, “I read meditations and now I'm going to take over myself and master myself.” Those books are great, but Kendrick Lamar really does that for me personally, and he has his line in the Mask Off Remix, where he says, “Who let the braids on the TV? Who let the hood at the table?” That's the coolest thing, man. Barack Obama invited Kendrick Lamar to the White House and seeing them shake hands to me was like that's why I'm such an optimist in America. A lot of lefties like me are just permanently cynical. I consider myself as a Pakistani immigrant and person of color and left-leaning guy in America to be more optimistic than most Americans about America. Kendrick Lamar song, How Much a Dollar Cost was Obama's favorite song in 2015. I would encourage everyone to listen to that because that notion that he describes where he's out in South Africa, and there's a beggar asking for $1. He's sitting there like, “I'm a big star and now I’ve got these panhandlers asking me for money.” “Every dollar is all of mines,” is what he says, “Crumbs and pennies, I need all of mines. and I recognize this type of panhandlin' all the time.” As the song progresses, the panhandler, he says something like, he quotes a passage from the Bible and says, “By the way, you know who you've been talking to? You've been talking to God.” A notion of he allowed himself to talk about how that experience humbled him, and how his original approach was much more selfish and it humbled him. Even though he came from Compton, he was still sensitive to those trappings of fame and money and success. That type of philosophy really influences what I do with Publicolor, all of us need stuff to keep us grounded, because I don't think we can do it ourselves. No matter how great of people we are. Jim O'Shaughnessy says, “We still have human OS 1.” None of that's changed in hundreds of thousands and millions of years. All that to say like, he's somebody who I consider very, very near and dear to my heart, somebody who I believe represents me and makes me a better person, motivates the hell out of me, and just makes life a lot more fun. That's why he's my avatar. Before that, it was Hyman Minsky, who's a cool economist, but I like to switch it up.
Bill: Kendrick’s got a better feel.
Naufal: He's definitely got a better feel. Then you also know what you're signing up for when you follow my Twitter because you're going to get some aggressive rants sometimes, you're going to get some hip-hop stuff sometimes. Then sometimes you just get macro stuff, whatever.
Bill: That's fair. Well, that's a much more meaningful answer than maybe I was anticipating and completely ruin my idea of putting Cal Scruby as mine.
Naufal: No, dude, he's great, man. I love his hustle, man. He can spit, bro.
Bill: I know. He's got a sick flow. The reason I try to promote him is he's doing his own thing and it's like, here's a kid that's mostly independent. I'm sure he's got some distribution deals somewhere, but not with a major label. He's out there making YouTube videos for himself. I mean, I respect what he's doing. He's got a lot of hustle.
Naufal: Everyone, get them some streams this weekend. [crosstalk]
Bill: Listen to I Told You.
Naufal: Yeah, man. Listen to I Told You, absolutely. The cool thing about Cal Scruby is, look, man, he's a white boy from Ohio who can spit, legitimately spit, and he gets really into being vulnerable. He'll talk about--
Bill: My Anxiety is a great song.
Naufal: My Anxiety is excellent song. How the West Was Won is an excellent song. He talks about real life stuff and in an unpretentious way. He talks about how he's progressed in the industry and how it leads to different addictions or personality shifts, and he's really open about it. But at the same time, it goes hard and it's badass. It's not just sob stories, and his flows are great, man. He's another person who I consider-- he studied the game. He could play the lyricism game really well to the point now where he could probably hop on a freestyle and just hit multiple syllables each line without a problem, that's the whole dedication, and not just a mastery of your art--
Bill: Yeah, he cares about the craft.
Naufal: Yeah, totally.
Bill: Yeah, that dude is super crisp. All right, man. Well, I'm going to wrap it up. We've covered a lot. If you ever want to come back on, you have an evergreen invitation.
Naufal: I appreciate that, man.
Bill: If you got anything to say, let me know. Thank you for your time.
Naufal: Thanks so much for your time and thanks, especially for the platform for Publicolor. Really appreciate that. both you and Jim O'Shaughnessy has been so generous with providing me a little window into talking about that to folks. Thanks for taking the time. Thanks for having me on. I hope you have a great Valentine's Day, man.
Bill: For sure, you too.
Naufal: Thanks, bro. Take care.
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