26 July 2020

On today’s show we bring back investment expert Cullen Roche to talk about stock picks during inflationary periods and COVID-19 impacts.

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  • The main advantage of centralized currencies.
  • Why the risk of inflation is more likely to come from the Treasury than from the Federal Reserve.
  • Why growth stocks typically perform better in a low inflation environment and value stocks perform better in a high inflation environment.
  • Where to find value in international equities.
  • How should investors navigate the current market conditions?
  • Ask The Investors: What is the relationship between inflation, interest rates, and house prices?


Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

Intro  00:00
You’re listening to TIP. 

Preston Pysh  00:02
On today’s show, we have our good friend, Cullen Roche, with us. Cullen has managed hundreds of millions of dollars for the past two decades and he always comes with unique insights. 

During the 2008 financial crash, Cullen’s private investment partnership was up 15% for the year. He is the founder of Pragmatic Capitalism, the author of multiple investing books, and a regular guest on Bloomberg and major financial news outlets. 

On the show today, we talk about the current market conditions and various trade ideas for navigating this landscape. So with that, let’s go ahead and get started. 

Intro  00:36
You’re listening to The Investor’s Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. 

Stig Brodersen  00:56
Welcome to today’s show. I’m your host, Stig Brodersen, and as always, I’m here with my co-host, Preston Pysh. On today’s show, we’ll be talking about equities, inflation, and what to expect in the financial markets. Therefore, we’re also excited to bring back one of my favorite guests, Cullen Roche. 

Cullen, thank you so much for joining us today. 

Cullen Roche  01:18
Hey, guys! Thanks for having me. 

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Stig Brodersen  01:21
Cullen, we talked a lot about the potential of a new monetary system here on our show. We discussed the scenario of a fiat-based system with the US dollar as the most important global reserve currency and the probability of having that system for at least a few more decades. That’s basically the system we have today.

On the other side of the spectrum, we also discussed the opposite scenario with a new monetary system that might come sooner than most people expect. I guess our listeners can say that for 300 episodes, we talked about everything in between, but we’re really curious to hear how you see this. How do you expect the monetary system to look like in 5 years or 20 years from now? 

Cullen Roche  02:07
I’ve thought about this a lot, especially with the rise of Bitcoin and the whole concept of decentralized money. My view basically is that it’s never going to be an either-or scenario that plays out. 

My thinking is that people want something that is more decentralized that they have a little more control over, they have a little more anonymity over, and something that is really more convenient for online and peer-to-peer transactions. 

Here’s the big kicker. The big thing that I have trouble with any decentralized form of money is that the reason we use centralized forms of money like the US dollar to a large degree is it’s backed by a government that enforces it. I don’t mean men with guns. I mean people are able to take other people to court, basically. 

From the beginning of time, all money is credit. All money is basically an agreement between two parties. In the ancient times, the monetary system was basically developed from agrarian agreements where a farmer, for instance, would agree to lend a certain amount of seed to somebody else who needed to grow some crops. They would have this financial agreement between the two of them to next season deliver a certain amount of seed back to the farmer. 

For instance, if you needed 100 acres of corn grown, you would lend to the amount of seed to make that doable. The agreement would be that, in the future, that other farmer has to deliver even more corn seed or something like that. You’d have this unwritten agreement back then that, over time, essentially evolved into written contracts. 

The thing that makes a government somewhat essential in all of this is that if those two parties ever have a disagreement, Farmer A can take Farmer B to court, and he can enforce that contract. It makes the money more credible.

The debt contracts that we all create between each other, they’re enforceable. That creates an inherent amount of trust inside of the money that we use because you know that it’s good. It’s good because it’s enforceable. You know that the value of it is something that you can recoup in the future if the other party tries to nullify the contract for some reason. That’s the thing that I have trouble with. 

A lot of decentralized money, they don’t have that inherent degree of trust in them because there is no real way to enforce the contracts if there’s ever a crime. That’s the thing that I think is somewhat hard to decipher with something like Bitcoin. Ultimately, it’s very hard to create debt contracts because A, it’s not very stable, and B, it’s somewhat hard to enforce.

Therefore, I think what will ultimately happen is that there’s still going to be demand for these other forms of decentralized money, but it’s very hard to see a future where something like the US dollar or the centralized-based types of money goes away. 

I think that the legal system and the enforceability of these contracts is such an important part of the structure in any modern economy. It’s hard for me to see that going away in the future. That said, I could see the two systems kind of running parallel to each other, but neither one necessarily going away or overtaking the other.

Stig Brodersen  05:59
Thank you for the insightful response. I think it’s very interesting that, to you, it’s not an either-or, which it is for a lot of people, but that we can have two systems. 

Cullen Roche  06:09
You see that all the time, even in today’s system. You have a lot of non-financial firms that create things that are sort of money. Even stocks and bonds that are issued by corporations are very money-like. They’re just financial contracts, just like any monetary contract is. All of these systems are created by the private sector, and they kind of run parallel to the US dollar system, in essence. 

Preston Pysh  06:37
Cullen, to continue issuing debt, the US has to convince investors that the debt will not only be paid back, but that the buying power of the returned currency will be retained. What are the arguments for and against investors continuing to trust US treasuries? 

Cullen Roche  06:53
The way that I like to think of treasuries is that treasury bonds or most government-issued debt, they’re really money-like instruments. For instance, what’s the big difference between a 1-month treasury bill that yields 0% and a cash note? There really is not much of a difference between these two instruments. 

The Treasury bill, in my view, is almost as close to cash as the actual cash note is, and the spectrum of moneyness, along which all of these instruments exist, is just a matter of maturity duration and what the interest rate is on it. 

So, a 30-year treasury bond is just a really illiquid form of cash, basically. You can’t go to Walmart and buy things with a 30-year treasury bond, so the degree of moneyness in that instrument is relatively low compared to a cash bill. 

However, I think the kicker is that it all comes back to inflation and the level of trust. What is the level of demand for these things? I, oftentimes, see people say that there’s a low demand for treasury bonds or that the US government debt probably can’t be trusted in the future. 

To me, if that ever happens, you’ll see an increase in inflation. If the government were to go out and try to finance a whole bunch of spending by just printing cash, they could dump a whole bunch of money on the street, and people have to sell real goods and services for that money at some point.

Whether or not you fund government spending through dumping bills on a street or issuing bonds, [it] is sort of an institutional or technical operational part of the whole process. The government doesn’t have to do either-or. They could donate money on the street. They could sell bonds if they want to. 

In either case, the non-government sector funds that spending by putting a price on the instrument. If the government were to go out and dump bills on the street, the price that we would see is the rate of inflation, in essence. 

Therefore, if you ever saw that the US government looked like it was losing credibility, that demand for the government’s financial assets was declining, you’d see a big increase in the rate of inflation as the demand for money versus all other things declined. 

I think people sometimes make this differentiation between debt and cash, which, at a very technical level, is a useful distinction, but at a government funding level, I don’t see it as being the key driver. The government can set interest rates on 30-year treasury bonds at zero in perpetuity if they want to. The non-government can’t make them raise interest rates. 

The non-government can change the value of that thing, though, versus all other goods and services. That would show up as the rate of inflation increasing. That’s really the number to keep an eye on. We haven’t seen signs of that yet, but we’re in a pretty interesting experiment right now where the US government ran an $865 billion deficit last month.

Therefore, we’re talking about big, big, big numbers here. The US government is talking about a new stimulus program, so we’ll see how inflationary all of this government spending is in the coming years. 

Stig Brodersen  10:42
Let’s talk more about inflation, Cullen, because when most people talk about inflation, they say that there’s low or no inflation in the US because they look at the CPI number. You also have a small group of people saying we might have much higher inflation because they primarily look at the government increasing money supply. How do you measure inflation? 

Cullen Roche  11:04
This goes back to our original discussion. I see some Austrian economists refer to inflation as an increase in the money supply. I think economists who understand the idea of a credit-based monetary system don’t like that, because they know that the money supply, in the long term, will always increase because you have more and more farmers who are trying to get seed for next season. These are just basic mathematical facts. 

With population growth and some basic increases in productivity and things like that; output growing in general, you’re going to have more and more of all of these debt contracts in the long term no matter what. 

As people are interacting more, they’re creating more financial agreements. To be specific, the money supply is mostly created by private banks. Private banks create loans, which creates deposits, and deposits are money. 

The reason why those loans are typically always increasing in the long term is just because of those basic underlying economic drivers. The population growth and growth, generally, is increasing in the long term as productivity increases. 

To me, it doesn’t tell you anything to say that the money supply is going to grow because that’s just an operational reality of the way we’ve structured a debt-based financial system. The amount of debt, the amount of deposits, and the amount of loans are always going to grow in the long term.

At a more technical level, that’s why I think a lot of economists prefer to refer to inflation as an increase in the price level. We usually use a basket of goods, and inflation measures the rate at which the price of those goods is increasing over certain periods. 

I think one of the things that economists also don’t like is when people cherry-pick an instrument inside of the good or the inside of the basket. For instance, you could look at housing inside of the CPI, and you could argue that inflation is higher because of that. That, technically, doesn’t represent inflation. It doesn’t represent the entire basket of goods. That’s the argument. 

It would be like looking at the S&P 500, and saying, “Apple has done so well over the years. There’s asset inflation,” but then, when you look at the whole basket, you realize, “Oh, well. The whole basket hasn’t actually done that much.” 

The whole basket is a better representation of what’s happening in the aggregate than cherry-picking one or two items out of it. Even if those items are important, they don’t reflect the whole aggregated basket of prices. That’s the really weird dichotomy or bifurcation of what we’ve seen in the last couple of decades. 

You have these extremes where technology and highly deflationary things are falling in price a lot, and a lot of these other more valuable services and goods like healthcare and real estate have really surged in price. It’s created a really difficult way to assess if this is good or bad. 

However, at the aggregate level, the way that most economists calculate something like the CPI, it aggregates out to not a huge change in prices. Whether or not they’ve constructed the CPI correctly, I think that’s for somebody else to assess. But when you look at the aggregate prices, inflation has been low, and that seems to be reflected across a lot of financial markets. 

I was pointing out commodities. It’s amazing to look at commodity markets that are down 70% from their 2008 highs and think that inflation is high. There’s a lot of confirming evidence that shows that inflation really has been low. It’s not just these deflationary tech trends. 

Preston Pysh  15:03
Cullen, you’ve said that the risk of inflation is more likely to come from the Treasury and not from the Fed. I would like to explore that statement a bit more. 

Could you explain the responsibilities of each of the two institutions and then transition into a discussion of where inflation could most likely come from? 

Cullen Roche  15:20
This ties into everything we’ve been talking about like the Fed and a lot of the money creation that we’ve seen. The way that I think of the Fed is the Federal Reserve, or any central bank, is really just a bank for banks. I think this is what confuses a lot of people. 

When the Fed implements programs like quantitative easing, they’re really trying to liquefy the banking system to some degree. They’re not necessarily dumping money on the streets for people to go pick up, but I think that’s the vision that a lot of people have. 

What the Federal Reserve is really doing at the most basic level, like, with quantitative easing, for instance, is creating new money. What they’re doing is they’re creating central bank reserves. 

Central Bank reserves are the deposits that other banks use. Only banks use those reserves. No one else can access the Federal Reserve System. It’s a closed deposit system for the banks. 

When the Fed implements something like quantitative easing, they’re literally swapping. They’re using a reserve they’re creating from thin air and purchasing a treasury bond, and the treasury bond leaves the private sector. 

Therefore, the way I’ve always thought about it, and the reason I’ve always described QE as being a non-inflationary event, is because what the Fed is doing is, at the private sector level, swapping the composition of the private sector’s financial assets. 

They’re trading, basically, an interest-bearing treasury bond, which is a very safe instrument, and they’re swapping it out for a non-interest bearing or lower-interest bearing cash reserve. Therefore, the private sector doesn’t have more financial assets because of this. They have the same quantity of financial assets. It’s just that their composition has changed. 

The kicker is that the Fed, again, being just the bank for banks, doesn’t operate in the private sector. It’s not going out and competing for goods and services at Walmart. When they take that treasury bond out of the private sector, that financial asset is as good as retired, at least temporarily. That’s a big part of why I think people have sometimes confused the Fed’s programs for this idea of money printing. 

The Treasury importantly comes into this because the Treasury is the entity that’s creating excess financial assets or net financial assets for the non-government sector. They do that by running a deficit, basically. 

For instance, the $864 billion that I mentioned earlier is net new financial assets for the non-government. In my view, that’s important to understand because the Treasury is the entity that really prints the money. It’s not that the Fed sort of accommodates everything the Treasury does, and the Fed accommodates what the banking system does. The Treasury is the entity with the big bazooka here. They’re the entity that could potentially create inflation. 

I’ve said this in a number of interviews in the last few months. I think that there’s a real risk in the amount of spending that the Treasury is doing. Even given the depth and scope of the pandemic, there’s a real risk that you could see inflation. 

It won’t necessarily be like the 1970s, but the inflation could look a lot like the ’90s or even the early 2000s, where you had like 3-5% inflation in various readings, which I think would be shocking to the Fed. It could have them on their heels.

I wouldn’t be shocked if you saw rates of inflation like that in 2022 or so. We probably won’t see it this year. The economy’s way too weak. Everything’s way too depressed this year and probably into even the early parts of next year to see something like that. But I think you can get into 2022 and have the Fed on their heels a little bit, trying to backtrack on some of these programs and stuff, and trying to control inflation. 

Stig Brodersen  19:31
Cullen, you argued that growth stocks typically perform better in a low-inflation environment, and value stocks perform better in a high-inflation environment. Given everything that you just said here and some of your expectations about future inflation, how do stock investors apply that principle?

Cullen Roche  19:48
Inflation is such a big driver of all financial assets. It drives the bond market, obviously, and to a large degree stocks in an almost counterintuitive way. What inflation does for businesses that are [at a] very operational level is it determines the amount of certainty that businesses have going forward. 

What happens in periods like the 1970s, or during any high-inflation or moderately high-inflation like that, is you get a lot of business uncertainty in the way consumers are spending because inflation reflects so much uncertainty about what the future of the financial system is going to look like. That creates a lot of volatility in the financial markets, and in the stock market, in particular, because the stock market hates uncertainty about the future. 

The thing about low inflation that is so good for stocks is that it just creates a huge amount of certainty going forward because entities are able to structure and better-predict what their cash flows are going to look like [and] what consumer spending is likely to look like.

What becomes so problematic with the growth stock versus value stock debate is that growth stocks tend to be firms like Tesla, which has an unreliable balance sheet as a lot of the income statement items are sort of sketchy or uncertain. 

They’re typically uncertain balance sheets and income statements to a large degree. That’s really what a growth stock is. It’s why it deserves its premiums. There’s a huge amount of risk and uncertainty about what its future financial prospects are going to be, and inflation can be very disruptive to something like that. Inflation will magnify the amount of uncertainty going forward. 

You’ve seen this in the last 30 years. Growth stocks just beat the pants off of value stocks because to a large degree, they’re able to earn this huge premium, these huge revenues, and huge earnings multiples. [This is] because the amount of uncertainty is declining across time in the economy. 

If you see an uptick in inflation, you should see a reversion to the mean to some degree because, in essence, value stocks, they’re all boring-style companies. They become much more reliable. They become much more dependent in a higher-inflation environment, in a relative sense, just because the amount of uncertainty that the growth businesses have to operate within is going to increase so much.

This will reduce the amount of demand for their stocks and should ultimately reflect the balance sheets as well. It should result in not necessarily lower earnings, but certainly a lot more unstable earnings, which should reflect, especially on a risk-adjusted return much lower returns.

Preston Pysh  22:51
Cullen, I’ve heard you argue that the stock market is a better hedge of inflation than gold. I’m sure a lot of Warren Buffett-style value investors would agree with you. I’m just curious if you can elaborate a little bit more on this. 

Cullen Roche  23:05
I guess it depends on what your definition of better is. I like to look at it from a risk-adjusted perspective. For instance, if you look at the stock market over any fairly long-time horizon, the stock market beats inflation by generally a pretty healthy margin. The stock market even tends to perform pretty well in a hyperinflation. You see this in places like the Weimar Republic or more recently in places like Venezuela. 

Even in a somewhat stable inflationary environment, like we’ve seen, for instance, in the USA in the last 50 to 100 years, the stock market is a good inflation hedge in that it typically beats the rate of inflation by at least 2-5%, in most cases, across any 10-year or 15-year rolling period. 

The *inaudible* concerning gold is that it’s not necessarily a better nominal inflation hedge, especially during periods where inflation is rising. It’s a better risk-adjusted inflation hedge in that, for instance, over the last 40 years, gold in stocks have actually done very similarly, in terms of their total returns. 

The difference is that the path that gold has taken to get there has been dramatically different from the stock market. The stock market, even with the big downturns that we’ve seen in the last 15-20 years, is just much, much more stable. 

I think the standard deviation on the stock market in the last 40 years is something like 17 or 18. The standard deviation on gold in the last 40-45 years is like 30. So, even if you’re getting the same unit of return, you’re taking the higher unit of risk, or at least you’re enduring a much higher amount of variability in the returns across time by owning gold. 

That said, you could look at it on a nominal basis and argue that they’ve generated the same basic total return over long periods, which is true. But from a risk-adjusted perspective [and] from a cash flow management perspective, the stock market’s actually been a better hedge because it’s giving you more certainty across that entire period of return horizon. 

Stig Brodersen  25:27
Let’s continue talking a bit more about this environment we’re in now and COVID and everything that plays out. We’ve seen subsidies to corporations at unprecedented levels in the past few months. 

On one hand, you have people saying that you must bail out close to all corporations since COVID-19 is nobody’s fault, and then, on the other hand, you have people asking for the market to be less manipulated. What are your thoughts? 

Cullen Roche  25:55
I see both sides of the argument, and I think that I’m going to end up agreeing with both sides of the argument before this is all said and done. When this thing really flared up back in March and April, my view was that it made sense for the government to step in and be highly involved because, like you said, this thing wasn’t anybody’s fault. It was almost like we got hit by a natural disaster. 

To say that we required some sort of market outcome that was as if this was the result of bad actors or something, to me, was sort of a false comparison. This wasn’t like the financial crises where I was really vehemently against all bank bailouts and a lot of the stuff that happened in 2008. To me, a lot of that was just bad decision-making that resulted in a big boom. You had to have a bust after all that, so a lot of banks, they deserved to fail.

To me, this is just different. This is more like a meteorite hitting New York City and with all this collateral damage. I don’t think you can just sit around and say, “Well, the Bank of New York deserves to fail because this meteorite hit them.” I think, as a community, we had a responsibility, at least at first, to step in and try to help where we couldn’t.

Therefore, I thought it made a lot of sense for the government to step in and try to be highly involved, especially given the cost of funding. The low rate of inflation made government spending, I think, a lot more viable. 

The aggregate amount of pain this was going to cause to other people by spending some extra money at the government level was not going to cause hyperinflation or anything like that. That said, at first, I thought that it made sense for the government to be really involved to try to build a bridge to get us to the summer or a point down the line where you could then begin to peel a lot of this stuff off and the impact of this natural disaster kind of started to at least go away a little bit. It’s crazy now that this thing is still around. 

The argument gets a lot more difficult because the more and more we spend on this thing, and the longer and longer we do it, the higher the risk of inflation is. That will create a different kind of pain down the road for everyone because inflation destroys our purchasing power. It creates an aggregate amount of pain that the government could ultimately be the cause of. 

We’re nearing that point, I think, where the government has to start making, potentially, some tough decisions about how they are going to navigate the rest of this. You could have a scenario here –let’s just be crazy for instance and say that COVID becomes a seasonal thing; that this thing is always around every year for the rest of our lives and that it just mutates; and it kills a hundred thousand people every year for the rest of our lives. 

Are we going to spend $4 trillion at the government level every year because of that? Maybe that’s an unrealistic scenario, but a scenario that we have to start to seriously consider the longer and longer this thing plays out. 

I think we’re nearing the point where people are starting to maybe consider that maybe we’ll never have a vaccine for this. Maybe we’ll have a seasonal vaccine for this, and it might become less dangerous, but we can’t spend $4-6 trillion every year on this thing and expect that we’ll never have any sort of negative repercussions. 

That said, in the beginning, I think I was fully on board with it, saying, “Hey, it’s worth the risk, given the low risk of inflation up front, that we should spend a truckload of money on this and be compassionate and support the economy as best we can.” 

However, as we kind of moved further and further along this thing, I think I’m more transitioning into the other camp where I’m now beginning to say, “Look, we’ve done a lot and at some point, we have to accept the potential reality that you can’t just spend insane amounts of money on this in perpetuity and expect that there’s going to be no negative repercussions.” 

Preston Pysh  30:05
So, Cullen, financial news seems to be more and more reported like it’s a sporting event. Like sports, the state of the economy is, unfortunately, often oversimplified. What is a prevalent narrative of the US economy that you hear right now that’s just wrong? 

Cullen Roche  30:25
God! I mean, there’s a million of them. If you turn on financial news, you’re totally right. Part of why I think podcasts like yours are growing so much and it becomes so popular is because we’re having an informed meaningful discussion about things here. We’re trying to educate people. We’re trying to spread real fact-based information and help people understand the world for what it is. 

The problem with a lot of financial media is that they don’t give a crap about that. They don’t care if you’re informed. They just want to drive eyeballs to whatever is the hot thing today. If you turn on financial news these days, like, CNBC is probably all Tesla all day today. It’s all anyone’s talking about because it just happens to be a random company that’s increasing in value a lot, and it’s somewhat controversial because the CEO says some stupid things every once in a while. It’s just a nonsense talking point, though. 

The impact of Tesla on the aggregate economy is not really important in the long run, whereas the conversations that we’re having about these things today, these things touch everybody, and they impact people and their decision-making in the future across the entire economy. 

It’s a totally different approach to discussing financial news than something like an eyeball-driven media machine that has to meet a certain amount of profit or revenue every year, that has shareholders and lots of different conflicts of interest.

The financial media is, in a lot of ways, fake news. I’d argue that 95% of the stuff that’s reported daily is not even newsworthy. It’s not important stuff. It’s just filling space and getting eyeballs. In a lot of cases, it’s scaremongering. That would be my big complaint about the majority of financial news. 

Stig Brodersen  32:06
I think you’re absolutely right. It’s interesting, sitting here in Europe and reading the financial news in Europe. It seems like here the narrative is the US market moves because of Europe. Then, I read the US financial news, and they’re all about European financial markets moving because of what’s happening here in the US. I guess that was just one example of how simplified things can often be and that recency and availability bias. 

Let’s look internationally. Growing the money supply and subsidizing everyone or close to everyone is not a US phenomenon, as we’ve seen in the rest of the world. They haven’t been shy of doing that either. Knowing that, which currencies do you think could break out significantly from the current trading range for the US dollar? 

Cullen Roche  33:14
Gosh, the dollar has been so strong that I actually think there’s a reasonable argument to make that the majority of currencies could be strong, in a relative sense, in the next decade. Going back to our whole discussion about inflation, if you start to see the US government’s impact on the rate of inflation, you should see this filter into the ForEx markets. You should start to see if there’s even an uptick of inflation to 3-4%. It should whack the dollar pretty good. 

A realistic scenario where the European economy remains in this sort of very low inflationary environment– They look a lot like Japan to me in terms of their demographics. The way that the EMU is structured makes it much harder to implement big fiscal policies in the EMU because of their political structure. If you were to see an uptick in inflation in the next, say, 2-4 years, I think you could see the dollar get hit pretty hard. 

I know you’ve had some guests like Luke Roman and people like that, who have talked about this. We disagree on some of the technicalities about, for instance, rising interest rates on bonds and things like that, but I think we see the risk similarly. I just view it through the rate of inflation, whereas he might see it through rising interest rates or something like that. 

I don’t think you’ll actually see it in rising interest rates necessarily, at least at the Fed level. I think there’s a decent chance that the Fed could keep rates at 0% and be way behind the curve, even as inflation rises. 

However, you’ll see it in the rate of inflation if the risk increases. If that happens, you’re going to see a lot of these big long-term trends reverse. It’s this same sort of thinking along the lines of the value investor trade. 

The value stocks become a better relative investment in a rising inflationary environment, while the dollar should become a worse relative option, versus, virtually, most currencies as inflation rises in a relative sense. 

Preston Pysh  35:25
So, Cullen, where do you see value in international stocks? 

Cullen Roche  35:29
I’m of the view that a lot of Europe is not necessarily dead money, but very low-growth money for a long time. I think that the political structure of the EMU makes it very difficult for them to fix a lot of the problems that we’ve seen in the last decade from the euro crisis.

In my opinion, it was never really resolved. I don’t want to get too deep in the weeds about this, but the EMU just is a deficient monetary union because it does not have a centralized Treasury and a way to fund the various entities at an aggregate level, really. 

That’s very problematic from an economic perspective, because you’re always going to have depressed levels of aggregate demand in certain places like Italy or Greece. [This is] because they’re going to have trouble funding a lot of their spending to a large degree. They have necessarily sort of austere government programs going on across time. 

It’s hard for me to look at the United States and be super bullish just because we’ve been on such a huge tear. The tear is so central to a handful of tech companies. Also, I think there’s a big opportunity for a lot of Asian and Southeast Asian economies to really take a lot of global market share in the next couple of decades. You kind of have started to see this trend play out with the growth of China and India and places like that, and I just don’t believe that that trend is even remotely close to finish.

I think Asian and Southeast Asian economies are becoming more and more capitalist. As they do that, it’s hard for me to imagine that they won’t become the center of the global economy over time and that the USA’s market share, especially as a share of the market cap of total equities doesn’t decline over time. It won’t necessarily go away. 

The US market doesn’t have to perform terribly over time. But in a relative sense, I think that Southeast Asia is really positioned so well to benefit from so many long-term trends in the coming decades. To me, it makes it just a must-hold for the long-term as part of an equity portfolio. 

Preston Pysh  37:55
If that plays out, how do you put on a position with that knowledge? 

Cullen Roche  38:00
I guess you could do it in a lot of ways. Again, so much of this is tied to inflation and the way the dollar performs. A lot of people look at international equities in the last 10 years or so, and say, “They haven’t performed very well. I should have known these things.” 

However, a lot of that is just that the dollar has been so strong that, in domestic terms, the US market just looks like such a good relative play, in large part, because you’ve had so many favorable tailwinds. 

Again, inflation is a big one, regarding all of this. If you were to see that reverse, this is all kind of tied into that same sort of trade that I’ve been alluding to, the inflation trade, where, if the dollar goes down and you see inflation go up to even a little bit, even just to 3-4%, you’re going to have a big reversal in the relative value of domestic versus international equities. 

That’s the other big kicker. Owning international equities, to some degree, is an inflation hedge. It helps you better diversify a portfolio, not just because it better reflects the global stock market, but because it better protects you from inflation to some degree. That said, international equities aren’t just a way to diversify your stock market risk. They’re a way, in a large degree, to diversify your currency risk.

I don’t know if I actually answered your question. I can’t recommend specific instruments just because I’m a portfolio manager. However, emerging markets are very attractive on a long-term, even valuation-based basis. 

I’m also a big fan of index funds. I don’t get into stock-picking a lot. Virtually, any of the big low-cost index funds give you access to this. You do have to be careful because these things are risky, but that’s where a lot of the long-term premium will come from.

The fact that these things are riskier, you’ve got to be willing to hold them for the long term and go through potentially 5-10 year periods where they don’t perform very well like they have in the last 5-10 years. The tendency, though, will be that, at least in my view, holding a chunk of these will diversify a global stock market portfolio in a meaningfully important way in the coming 10-30 years. 

Stig Brodersen  40:31
Let’s jump back to one of the things you said about inflation. You mentioned that inflation could go up to 3-5%. In that case, how would the Fed look at this? And how would the Treasury, for that matter, look at that? 

Clearly, they’re targeting higher inflation than today, but is that a nice way to start wiping off some of that debt like we’ve seen historically, where inflation has been used like that? Or will it be combated right away with a higher interest rate and then everything that follows from high-interest rate ensures other asset prices going down? 

Cullen Roche  41:05
I view the Fed and most central banks as somewhat impotent when it comes to trying to control inflation just because the mechanism through which they do it is so imprecise. It’s so indirect. 

Going back to the beginning of the conversation, the Fed is just a bank for banks. Therefore, when the Fed tries to, for instance, control the rate of inflation, they typically will raise interest rates, which basically raises the interest rates that banks are going to ultimately be trying to pass on to other customers. 

The weird thing is that what this oftentimes does is it actually hurts the banking system itself to a large degree, which makes it a little more difficult for banks to lend. You see this in periods like the early 2000s, where the Fed’s trying to raise interest rates to try to mitigate some of the inflation that they’re seeing in the economy. They’re really trying to get a hold on the housing market, and they just can’t seem to do it. They can’t seem to stop people from wanting to buy homes. 

That’s the thing with so many of these policies. You can’t stop people from doing crazy things like bidding up the NASDAQ in 1999. You can’t stop them. Raising interest rates isn’t going to stop people necessarily from buying homes in 2006. You see the same thing time and time again. These government policies tend to be very reactive in the way that they actually impact things. 

All that said, going forward if we start to see some uptick in inflation, I think the Fed would do what it’s been doing in the last few episodes where they’ll raise interest rates, they’ll be behind the curve, and they’ll probably reduce the balance sheet. I think the balance sheet has become the main course of action for the way that they’re trying to control things now. 

Like I was saying, controlling the balance sheet is just basically exchanging financial assets across the composition of the private sector, which is, in my view, an even more imprecise and meaningless way to impact the rate of inflation than interest rate changes even are. 

I think the tools that the Fed uses for fighting inflation going forward are very blunt. I think that if you saw an uptick in inflation, in order for the government to try to get real control of it, you’d have to start seeing a change at the Treasury’s level. The amount of spending that they’re doing [and] the amount of new debt they’re issuing, I don’t know how politically feasible all that is. 

A lot of the narratives, at least in the USA, seem to be trending in the direction of bigger and bigger government programs like the Green New Deal and universal basic income (UBI), and things like that. I don’t know. It’s hard for me to imagine a scenario where we don’t see more progressive policies implemented across the next 10-20 years. 

Preston Pysh  44:10
Cullen, here’s the million-dollar question. How can investors outperform today’s market but also have protection from these violent downward moves that we’ve seen? 

Cullen Roche  44:22
Being really patient is going to be the ultimate diversifier in the coming 10-20 years. I think you’ve got to be patient with a lot of different instruments. The world looks so uncertain. It’s arguably the most uncertain that I’ve seen it in my career. 

When I started out in this business, it was easy to generate. I remember you could put money in the bank, and you could earn 4% a year in it. Generating a 4% return was a cakewalk 20 years ago. 

Whereas now, the whole bond market looks incredibly difficult to generate a real return from the stock market, arguably. Especially with the big surge in the last few months from a valuation perspective, it looks not necessarily really bleak, but certainly I would argue low return going forward. 

That said, I think it’s very difficult to build a portfolio that’s going to generate a stable and steady return going forward. I think you have to be opportunistic going forward. You have to be patient. You’re going to have to let some of these markets ebb and flow. The stock market is going to see big downturns again. At some point, I wouldn’t be surprised if the bond market does too. I think you’ve got to be patient. You’ve got to be really well diversified.

There’s a strong argument that alternative types of assets are more attractive now than they’ve been in a really really long time. Things like commodities and gold and holding some cash and holding real assets and things like those, I wouldn’t be surprised if things like real estate or even commodities, which have been demolished in the last 10 years, become the best performing assets in the next 10 years. It’s going to be just so important to be diversified.

Additionally, one thing that I’m such a big advocate of is that people in a low-return environment need to be so much more mindful of their taxes and their fees because the taxes and fees are the things that you can control. You can control your mentality and you can control taxes and fees. Those are the only things that, going forward, are going to generate certain additions to your total returns.

A lot of people can’t control total returns. They won’t control them, but in an environment where, let’s say, we only earn 4-5%, if you’re paying high fees and you’re paying a lot in taxes and you’re being undisciplined and you’re hyperactive in your portfolio and you’re creating all these taxes and fees because of that, you’re cutting your return potentially by 1-2%. In the grand scheme of things, that’s cutting your total return potentially in half and it’s going to have a huge multiplier impact across a 30- or 40-year time horizon. 

Stig Brodersen  47:22
Cullen, this has been absolutely amazing. I’ll definitely give you a chance to get a handoff where the audience can learn more about you, Pragmatic Capitalism, and Orcam Group. 

Cullen Roche  47:33
My firm is Orcam Group. I write a lot of material on PragCap, which is Pragmatic Capitalism. The URL is pragcap.com. I write a lot about the nuts and bolts of the financial system. Go to the education section if you want to learn a lot about it. 

There’s a huge page at Orcam Group, which is my financial firm, where I’ve listed all of my favorite videos and outside resources. A lot of the material that I’ve written about revolves around how the monetary system works and how I sort of think about things. You can find most of it there. 

I also love to interact with people and help where I can. I don’t know everything, but I like to think I know at least a little bit. I’d be happy to try to help people and give back a little bit to educating people about things because it’s a tough, tough thing to understand. Money is a big confusing topic, and I don’t think anyone really fully understands it. However, we can all kind of help each other out by trying to have good thoughtful conversations like this one. 

Stig Brodersen  48:40
I can say, Cullen, that your pragcap.com is a fantastic resource because you’re basically doing what you’re also doing here on the show. You’re making something like money, that is so complex and so abstract, simplified, but not too much. 

Cullen, again, thank you so much for taking time out of your busy schedule to be speaking with Preston and me here today on The Investor’s Podcast. We’re really excited already to bring you back again in the latter part of 2020. 

Cullen Roche  49:08
Awesome! Well, thank you, guys. 

Stig Brodersen  49:10
All right, guys. At this point in time in the show, we will play a question from the audience, and this question comes from Nick.

Nick  49:17
Hi, Preston and Stig. It’s Nick from the UK here. I’m a huge fan of the show. My question is about interest rate, inflation, and house prices. I heard what you said on the show, recently, that you expected house prices to potentially go down in the next 12 months due to increased interest rates caused by inflation. I thought inflation was inversely correlated to interest rates, so I’m not entirely sure how that works. I’d be really interested if you could unpack it for us. 

Stig Brodersen  49:47
Nick, that’s a great question and a very timely question. When we talk about real estate prices, generally, lower interest rates make prices of real estate go up, while higher interest rates may create real estate prices to go down. 

The reason is simply that, as a homeowner, you have a finite amount of money. If your installment goes up because of high-interest rates, your house price must go down. The latter is true even if you personally fixed your installment because the influx of new buyers with new terms will then lower the overall demand. 

Interest rates are used to control inflation in society. Though, as Cullen Roche mentioned here in the episode, it’s not a perfect tool to do so, but it is due to the same principle of supply and demand. If you want to lower inflation, we can hype the interest rate because it decreases the money supply in society, which leads to falling prices and vice versa. 

When you asked me whether I think real estate prices will go down in the next 12 months, I think yes, we’ll see a large drop. I’m not as familiar with the UK as I am with the US. I imagine it would be similar in the UK, but it won’t be so much because of the interest rate. 

Actually, if we look at the interest rate right now, which is very hard to predict, I don’t see that being high in the next, say, 12 months because of the weak economy both in the UK and the US. 

However, I see lower prices because of COVID-19. You have a lot of people who are struggling to make payments on their homes, and some of them are either going to foreclosure or going on sale. This process just takes a long time to play out because most people typically want to make sure that they’re not losing their homes. Even if their home is eventually put on sale, they typically have a higher reservation price that they will slowly lower, which also contributes to why it takes us a long time for this scenario.

The other thing that you also have to include in this is that when we’re talking about the prices of assets like this, they’re always complex when you consider how many factors influence demand and supply. Therefore, the response whenever we talk about the impact of inflation, fiscal stimuli, interest rate, is really at everything-else-equal perspective. 

There are many different factors. Just one could be that this is an election year in the US and because there’s so much political capital invested into fiscal stimulus because of COVID-19, that’s just another element you have to account for. 

Preston Pysh  52:24
Nick, just to add on to what Stig said, I think it’s important to realize that real estate is very local. You can go into different cities and different regions, and real estate prices can act in very different ways. It depends on how much land remains for the amount of buildings that are being constructed. It depends on how much industries flow into and out of a specific region. There are just a ton of factors that go into this. 

I would argue that if you have a pretty steady population, an amount of land that’s fairly steady as far as the supply and demand of it, and this geopolitical factor around that community that’s somewhat stable as far as the economics around that area are stable, you can use the generalization that when interest rates go down, the prices will go up, and vice versa. 

As you can see, there are a lot of factors and a lot of variables that go into this. I think the most dangerous thing that a person can do is sometimes to simplify it too much, and say, “Oh, well, because of X happening, Y is going to be the outcome.” I think that you have to really reserve against that. 

Stig’s comment about the COVID-19 impacts and a lot of people being out of their jobs and particular industries being impacted heavily by COVID-19, those are going to impact the real estate market, as well. I think it’s a really great question you asked. It’s something that depends a lot on the region that you’re specifically talking about, and all the factors that are at play then. 

Nick, for asking such a great question, we’re going to give you a free subscription to our TIP Finance Tool on our site. All you have to do, if anyone’s looking to learn more about TIP Finance, is just go to Google and type in “TIP Finance.” 

If you go to our The Investor’s Podcast website, you can see it there in the navigation bar. Just click on Finance. We’re excited to be able to give this to you. If anybody else out there wants to ask a question and get it played on the show, go to asktheinvestors.com. If your question gets played on the show, you’ll get a free subscription to our TIP Finance Tool.

Stig Brodersen  54:33
All right, guys. Preston and I really hope you enjoyed this episode of The Investor’s Podcast. We’ll see each other again next week! 

Outro 54:41
Thank you for listening to TIP. To access our show notes, courses, or forums, go to theinvestorspodcast.com. This show is for entertainment purposes only. 

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