[00:02:05] Rebecca Hotsko: Thank you so much for joining me again today. We have a ton I want to get through with you, and I think a good place to start is with your short-term outlook on markets – how you’re making sense of markets right now, and particularly the recent rally. It seems like it’s been rallying in the midst of these deteriorating economic conditions.

[00:02:30] Rebecca Hotsko: So, I was hoping you could give us a sense of what you’re seeing and what you’re expecting going forward for the year.

[00:02:39] Alfonso Peccatiello: So there was a pretty famous saying in markets that said that the markets can remain irrational longer than you can remain solvent, and I think that’s been the problem for bears so far, at least over the last three to six months. The market has basically traded in a sideways range on the S&P 500 between 3800 and 4200. We’re basically going nowhere for six months.

[00:03:06] Alfonso Peccatiello: Recently, we have rallied from the lows of late last year. And the reason behind that is not that the economy is doing any better, but really the reason is that we have started what’s supposed to be a disinflationary trend, and investors have this muscle memory over the last 10 years to try and anticipate any Fed pivot. You front load a Fed pivot, you make money, because anytime they accommodate, the stock market rips up. So you want to be there before the Fed does that. You want to try and anticipate this Fed pivot to benefit from the stock market rallying on a Fed pivot. That’s exactly what people are trying to do right now.

[00:03:53] Alfonso Peccatiello: They’re trying to anticipate, to front-load the Fed pivot. Now, the reality is that on the ground, the situation is a bit different because the Federal Reserve this time will be forced to wait quite a long time until they can actually pivot because of their mandate. They want to get inflation down to 2%. It’s going to take a while, maybe another six to nine months at least. And the process of getting us there, Rebecca, involves pretty much a recession. So this time, I guess investors need to ask themselves, why am I getting a fat pivot?

[00:04:32] Alfonso Peccatiello: Between 2010 and 2020, you were getting a Fed pivot because the Fed wanted to support markets. It wanted to make sure that people were feeling wealthier, they were spending more, they were stimulating growth, and finally getting inflation to 2%. That’s why the Fed pivoted between 2010 and 2020. This time, if they do pivot, it’s because they’ve managed to get the economy bad enough to bring inflation down to 2%. There is nothing to be happy about front-loading that pivot, if you ask me.

[00:05:07] Rebecca Hotsko: It sounds like it. And I do recall you had a post, I want to say, very early this year, maybe very late in 2021, where you had a projection of where the S&P 500 would be, and really, the post just broke down the earnings multiple and earnings EPS.

[00:05:27] Rebecca Hotsko: It had to come down by about 20 to 30%, and you landed in a range of estimate between 3300 and 3500 for the S&P 500. Now, I know these change all the time. I am just curious to know if this has, if you’ve updated this at all or if this is still your expectation by Q4.

[00:05:50] Alfonso Peccatiello: Look, very recently on the Macro Compass, which is the investment strategy firm that I run, I sent clients an update of that table. So basically, it’s a simple table that looks at the earnings per share estimates and the valuations you are paying for these earnings per share. According to my macro models, the earnings per share a year from now in the S&P 500 are likely to be 10 to 20% lower than today. Analysts expect earnings to be flat or just hover there and not drop. So I already expect earnings to contract, which is a much more bearish call than the average analyst out there. On top of it, I look at the valuations that people will be willing to pay for these earnings. And honestly, today, equities are trading at 19 times forward earnings. So 19 times means that if you invert the P/E and make it a yield, basically in earnings on the future cash flows, you will be making by buying the stocks, the earnings yielded is around 5%. What really surprises me is that the risk-free rate is almost at 5%. Rebecca, if you’re looking to generate the 5% earning yield return, you can just take your money and park it in a T-bill in the United States, three to six months maturity, and you’ll be getting four and a half percent there. The reason I’m saying that is that risk premiums today are pretty low. You can generate the same return by keeping your money in a relatively safe, risk-free short-term T-bill. So the valuations that people are willing to pay today to get these earnings in the future are, in my opinion, relatively high. To sum that up, I expect earnings to be weaker than analysts expect, and I think the S&P should retest its 2022 lows. That’s the path of least resistance. We are talking 3,600. There is a chance it could go lower. Yes, there is, and I think the path to clear first is that we go and retest these lows later this year.

[00:08:09] Rebecca Hotsko: And you did write in one of your recent reports that most of the rally from late 2022 has been completely driven by multiple expansions. Why have these multiples been expanding then when the market knows what’s happening in the economy? Things are expected to get worse. What is driving that higher price in valuations? And then, I guess you kind of touched on this, but what does that have for future implications for earnings valuations?

[00:08:39] Alfonso Peccatiello: Look, it’s really a muscle memory of markets wanting to pay up to front load the fat pivot. This inflationary trend has started, so inflation is still high, but it is at least trending down, and people are happy to pay up. So they pay a higher valuation to buy the stock market because they think the Fed is going to ease, and as the Fed eases, risk-free rates become lower. You can’t make 5% on your T-bills anymore; you can make maybe 2% or 3% at that point. So investors are happy to overpay right now to try and front load the Fed pivot, which will compress risk-free rates and make these earnings yield and PE more attractive.

[00:09:27] Alfonso Peccatiello: So they want to get ahead of the curve and front load that. Honestly, I don’t think it’s necessarily a good idea first because you are expecting that we get an immaculate disinflation. You get no recessions. So earnings stay basically where they are today, and that will allow the Fed to slowly but surely reduce their tightening in markets. Well, this is a very controlled and nice and smooth ride, but honestly, it doesn’t seem very feasible to me.

[00:09:59] Alfonso Peccatiello: The amount of stimulus we have thrown into the economy in 2021 and 2022 is now showing up in strong inflationary pressures. We have also reduced the accommodation really rapidly. The last fiscal stimulus from the United States government was in April 2021, two years ago since the US government has gone with a large fiscal stimulus. So we are removing fiscal accommodation. We are removing monetary accommodation for sure. We start seeing some cracks in the banking sector, in the housing market. How can you expect that such a rapid withdrawal of stimulus can lead to such a linearly predictable disinflationary path ahead?

[00:10:40] Alfonso Peccatiello: Honestly, it doesn’t make sense to me.

[00:10:43] Rebecca Hotsko: And then I guess just on the market’s expectations in regards to the Fed. So you’ve written that you expect that we’re going to, you expect the Fed to cut rates to 0% again in 2024 while the market is pricing in and expecting around 3%, I think, for them to land.

[00:11:00] Rebecca Hotsko: So can you walk us through why your expectation is so much different from the markets? Is it tying into that deflationary narrative? 

[00:11:09] Alfonso Peccatiello: Yes, it is. Look, Rebecca, I find it very funny that people say the amount of stimulus withdrawn from the economy was exaggerated and the Fed was accommodated for too long, and therefore we got this large inflationary and nominal growth expansion in 2022 and the first half of 2022, which was really rapid.

[00:11:31] Alfonso Peccatiello: And so then the Fed had to bring rates all the way up to 5%. Okay, fine. But now let’s look at the other side of the coin. We have also removed accommodation super aggressively, both fiscal and monetary. We are now slowing down the pace of growth really rapidly. The US economy is growing below trend, roughly about 1% annualized growth from the 3-4% levels of 2022 basically. So we are trending down rapidly and the pace can’t be linear on the way down if it was exponential on the way up.

[00:12:08] Alfonso Peccatiello: I mean, people are refusing to see that as we accommodated super aggressively in 2020 and 2021, we got the markets and economy reflecting that in late 2021, beginning of 2022, with market euphoria, with animal spirits running loose. But we also withdrew economic stimulus, monetary, fiscal stimulus very rapidly. So you should expect the same to happen on the way down.

[00:12:33] Alfonso Peccatiello: That is why I think as the Fed has raised interest rates really rapidly to 5%, there will be something systemic breaking. And the banking crisis we saw is not anything systemic yet. That’s a liquidity crisis isolated in some banks that have run poor risk management, to be honest. So people thought that was the systemic risk event, but I don’t think that was the case.

[00:13:00] Alfonso Peccatiello: Where I expect it to happen is somewhere in credit space. So that can be the housing market, that can be commercial real estate. That can be any other largely leveraged markets that we have created as a byproduct of 0% interest rates. Now that interest rates are 5%, those over-leveraged systems clearly will come under stress, and I think the housing market is already showing some evidence of stress, take KKR or take Blackstone.

[00:13:30] Alfonso Peccatiello: Their largest real estate investment trusts are avoiding investors from taking money out. Rebecca, as we speak, if you invested in these real estate investment trusts, you cannot get your money out. They’re getting redemptions. That’s the formal way to say it. So they don’t want redemptions because if they get a lot of redemptions, they have to liquidate their assets.

[00:13:54] Alfonso Peccatiello: Assets are houses, offices, stores that don’t have marginal buyers because mortgage rates are so high. So you see this fragile equilibrium in the housing market is already there. If you get a credit stress somewhere, the Federal Reserve can’t do anything about that. On a liquidity event, the Federal Reserve can backstop the value of the collateral.

[00:14:17] Alfonso Peccatiello: They can say, “Hey, treasury bonds are the problem. Well, just give them to me. Okay, I’ll ignore the market value. You can give me the treasury bonds at a hundred cents. I’ll give you the funding.” They can’t do that with office prices, with stores, with houses. If the value of that collateral goes down, that’s a credit crisis.

[00:14:41] Alfonso Peccatiello: The Federal Reserve can’t do anything about that. I think we’re getting closer to that point than when you get this credit stress, interest rates go back not to two, not to three, not to 4%. They have to go back to zero to make sure the system can somehow restart again.

[00:15:02] Rebecca Hotsko: So then do you think that today is playing out as every other typical recessionary period or downturn has happened, or is there something different about this time?

[00:15:14] Alfonso Peccatiello: Well, it’s a good question because not all recessions are the same, and I think so far, first of all, we are not in one yet. I expect we get into one over the next two to three months. We have very weak growth as we speak. We have basically the last stage of inflationary pressures. They’re receding.

[00:15:38] Alfonso Peccatiello: That makes nominal growth still positive as we speak but trending down. I think we will get into a proper recession later on. How is this path towards the recession looking? Well, this time it’s quite different than usual. I mean, you have had a lot of distortions coming from the pandemic that are very hard to solve.

[00:16:01] Alfonso Peccatiello: Take this, for example, very late in the cycle, you have leisure and hospitality as a sector that is hiring as one of the most aggressive sectors in the economy. You normally don’t have that when growth is lowering down, right? You have at best the acyclical components like healthcare or government or education, those are the sectors hiring the most, not leisure and hospitality.

[00:16:27] Alfonso Peccatiello: Why? These sectors are still today trying to catch up with the reopening, right? I mean, they had to downsize materially during the pandemic, and now they’re trying to catch up. This is just one of the many distortions out there. The other one, which I find very interesting, is that the real estate market is frozen.

[00:16:50] Alfonso Peccatiello: Basically, housing sales are down 30-40% year on year. The housing market is really calm. It’s difficult to make transactions when buyers are priced out because mortgage rates are too high, and sellers are saying, ‘Well then, I’m not going to sell right then. I’m just going to wait.’ So transactions are drying up, and when that happens, Rebecca, historically, hiring trends in the construction area and anything ancillary to the housing market really.

[00:17:19] Alfonso Peccatiello: Tend to come down. Why would you have a hundred new brokers if there are no transactions happening? Right. Have a look. Instead at construction employment, it’s still growing. This is really strange, and I think it is also because during the pandemic, many of these sectors got quite scared by scarcity. You could not hire properly skilled people.

[00:17:38] Alfonso Peccatiello: During the pandemic, there was such a labor shortage as we had stimulated too much and we were reopening at once. So there are some labor hoarding mechanisms going around. I think there is some. Residual from the pandemic that makes this cycle quite different than usual. Overall though, Rebecca, let’s not miss the forest for the trees.

[00:17:56] Alfonso Peccatiello: Again, if you tighten conditions this aggressively and you keep them tight for so long, you are just literally waiting for an accident to happen, and I think we’ll get one relatively soon. 

[00:18:07] Rebecca Hotsko: Okay. And now I want to move on to the longer term cycle, because you’ve talked about this in your macro education series a ton.

[00:18:16] Rebecca Hotsko: And Ray Dalio popularized the term, the long term debt cycle. And so I really want to get into this with you today because he is called this extremely important to understanding how the economy works. And so I was hoping you could start off by explaining what the long-term debt cycle. Is how it works and perhaps the key factors that drive this cycle.

[00:18:39] Alfonso Peccatiello: Really happy to see that you read my macro education series. It’s free for everybody. It’s on the Macro Compass website if they want to go and check it out. So the long-term debt cycle is really something important. And to explain that, we need to take a step back and go back to the seventies. Structural economic growth is really the result of how many people are actually contributing to growth and how productive these people are, as well as how productive the capital that goes through the economy is. So it’s productivity and demographics – those are the two main drivers of structural long-term growth. Why did I say the seventies? Because in that period, both of them were pretty good.

[00:19:28] Alfonso Peccatiello: I mean, after the Second World War, we had quite a demographic boom. It takes, correct me if I’m wrong, but about 20 years to make it 20 years old. So in the seventies, a lot of 20-year-olds were joining the labor force. We had quite a lot of strong labor force growth in the seventies. That’s the first component for creating good economic growth, structural economic growth. On top of it, productivity was doing well. In those years, we were industrializing economies. We were introducing robotization, the very early stages of that. And when you do that, you increase your productivity marginally by a lot because the first productivity announcements are the best ones from a marginal perspective, right?

[00:20:16] Alfonso Peccatiello: So effectively, productivity growth and labor force growth were both very positive. That meant the US economy could grow at almost 4% real GDP growth a year without any financial engineering of any sort, Rebecca. Just structurally, that was pretty good because you didn’t need to lever up. I mean, go have a look at debt-to-GDP in many places. Back then it was very low. Why? Well, you didn’t need it, right? Why would you lever up if you can just grow organically?

[00:20:49] Alfonso Peccatiello: Now let’s move a bit forward, shall we? And let’s go to the nineties. And at that moment, you had both demographics and productivity picking up. So what happened is that most of your productivity announcements, the first moves in productivity announcement practices, were already there and had already penetrated quite some sectors of the economy, so we kept becoming more productive year after year. We do. Technology has helped us even become a bit more productive than before, but the marginal growth in productivity trended down, so productivity went down to the one, one and a half percent area.

[00:21:29] Alfonso Peccatiello: Not too bad. The real driver was population growth. The real driver was labor force growth. Population was aging and birth rates had basically collapsed already between the eighties, nineties, and early two thousands. That meant that labor force growth was much slower than before. Structural economic growth had moved down from 4% to maybe two, two and a half.

[00:21:53] Alfonso Peccatiello: Politicians started thinking, “Well, I want to grow more, so how do I do that?” Well, leverage is the answer. If you can’t afford a house in cash, what do you do? You go to a bank and you ask for credit. You tell the bank, “Hey, I have a fixed income. I will make money for the next 30 years through my salary. Can you please use those future cash flows and give me a bunch of money today against these future cash flows?” You borrow from your future ability to generate earnings and cash flows, right? That’s what the total economy did overall. So if you look at the public sector and the private sector, the debt-to-GDP from the nineties to 2020, all economies in the world, be it by public debt or private sector debt, or a combination of the two, levered up incredibly aggressively. The US total debt-to-GDP was about 200% in the late nineties, went all the way up to 300% in 2020. I can take any other country, and again, it might be public debt like Japan, which used public debt a lot. China used private debt a lot, for example. But all of us went in the same direction.

[00:23:16] Alfonso Peccatiello: Let me pause here for a second.

[00:23:18] Rebecca Hotsko: Yeah. I guess I was going toask you, is this, in terms of where we are in the long-term debt cycle, has it been quite similar for other countries, other major countries? Are they all in this similar stage or is it mostly just the US. 

[00:23:35] Alfonso Peccatiello: If I look at all developed market economies, which basically are defined as economies with an aging population and with productivity trends that have already been exhausted, all these developed markets – so all European countries, Japan, the UK, Australia, Canada, and the US – are effectively in the same boat. They had structural growth slowing down. They used debt to prop up their cyclical growth. They levered up their economies to try and generate some growth.

[00:24:05] Alfonso Peccatiello: Countries like Canada have done it really aggressively. So with private debt, private debt as a percentage of GDP in Canada is over 200%. I mean, those are seriously big numbers. Also, because we as households or corporates cannot print money, the more we are in debt, the more we need our salaries to grow to keep servicing this debt.

[00:24:29] Alfonso Peccatiello: The government, instead, issues the money. I mean, the government is the very entity that issues the money. So how do they refinance their debt? By issuing more debt, right? And the story for the private sector is much more complicated. Go tell your bank if you lose your job that you want another mortgage, or you want to refinance your mortgage based on the fact that you’re going to print money.

[00:24:57] Alfonso Peccatiello: You can’t print money, you need proper cash flows. Private debt is more fragile than public debt in the first place. Some countries have chosen to lever up their private system rather than their government, but everybody has gone there. The only countries which haven’t levered up aggressively yet are emerging market countries that still have quite some strong population growth and still quite some productivity because they’re a bit behind in the growth cycle.

[00:25:27] Rebecca Hotsko: Right. That makes a lot of sense. And I guess you have written that you think we’re in the very late stages, or I think you said the last innings of this long-term debt cycle. So maybe walk us through what that means and what are the implications economically and for financial markets? 

[00:25:47] Alfonso Peccatiello: Yeah, great question.

[00:25:49] Alfonso Peccatiello: So to recap, structural growth goes down, economies lever up. They add debt, either public or private debt, to make sure they can generate some cyclical growth to offset the declining structural growth. What is the trick? How can you lever up an economy from 100% debt to GDP to 300% debt to GDP and still make it sustainable?

[00:26:12] Alfonso Peccatiello: Well, you lower borrowing costs. What mortgage can you afford if you make the same amount of money? Let’s say you make $100,000 a year. You can afford a mortgage for $500,000. If mortgage rates are at 2%, bring mortgage rates to zero, and all of a sudden, you can afford more, can’t you? With the same amount of salary, with the same ability to generate cash flows, the mere fact that borrowing costs are lower makes it so that you can afford more leverage.

[00:26:46] Alfonso Peccatiello: So, we basically lowered interest rates from the 80s to 2020 relentlessly. Real interest rates came down all over the world, decade after decade after decade. Why? To make sure that the next borrower could borrow even more than the previous one, and therefore this cycle could continue and we could create some sort of cyclical growth that would offset structural growth that was declining.

[00:27:12] Alfonso Peccatiello: There is a game stopper there, though. When you cannot lower real interest rates further, when you reach points where borrowing rates are as low as they can be, it becomes tricky to engineer this process because the next guy, the next marginal borrower can’t borrow more unless interest rates are lower. Japan found this out in the late nineties. The real estate bubble in Japan had basically led through the same process of being able to lever up at lower and lower interest rates, had led to a real estate bubble in Japan. When the bubble burst, Japan tried exactly this mechanism, they said, “Well, you know, guys, I’ll give you interest rates as low as they can be. Go and lever up.” And the private sector was like, “No, the rates are already 0%. You can’t make them lower. I don’t have a higher capacity to generate structural cash flows. I’m not going to borrow more.” So basically, Japan has been stagnating effectively for the last 20 years because they reached the point where you cannot lower real interest rates anymore, and the private sector is not willing to lever up more.

[00:28:30] Alfonso Peccatiello: So where do we stand in the long-term cycle? If I look at where real interest rates were before the pandemic, well, in the US, they were negative. In Europe, they were more negative. In the UK, they were even more negative than that. So basically, we were flirting with the boundaries of how low borrowing rates can be, and if you can’t push it any lower, you can’t run the system for a lot more. The risk is that you keep stretching the system until, like in Japan in the nineties, you end up creating too much leverage, and at some point, the bubble bursts. So either via bursting the credit bubble or via effectively not being able to lower interest rates further, you reach the latest stages of the debt cycle.

[00:29:23] Alfonso Peccatiello: I think we went really close to that before the pandemic. And now the problem is as interest rates are much higher than before, people are staying away from levering up. Mortgage applications are down. So what you’re doing is you’re freezing credit in all these sectors and you are risking that there’s going tobe some deleveraging.

[00:29:41] Rebecca Hotsko: Okay. That was going tobe my next question for you. Do you think that we could see a period of deleveraging as happened in 2008 and 1929 in the US as that is typically the last stage of this long-term debt cycle? Or do you think that we’re not going to get there this time? 

[00:30:02] Alfonso Peccatiello: Think policy makers will fight this as hard as they can, Rebecca, because leveraging a fiat system is the way you grow a fiat system if you don’t have the structural capacity to grow it through demographics and productivity.

[00:30:17] Alfonso Peccatiello: If you don’t have that, Then you need to lever up the system. That’s the only way to grow it at socially acceptable, politically acceptable growth rates. So policymakers are not going to volunteer to deleverage the system. Why? They’re not going tobe reelected. Nobody’s going to be reelected if under his or her watch, you’re deleveraging the system.

[00:30:37] Alfonso Peccatiello: De-leveraging means basically you’re doing the inverse process of what we did over the last 40 years. Now try to think at what happened to us asset prices. Over the last 40 years, the stock market went up about 10% a year. House prices, same thing. So everybody felt richer. Is the wealth effect that you can generate through this process now, try to undo that and tell me which politicians is going to volunteer for it.

[00:30:59] Alfonso Peccatiello: The issue is that in Japan also, policy makers in the nineties didn’t want this massive deleveraging. But when it starts and it starts hitting consumers, it is very, very hard to stop and especially very hard. To ask the private system to re-leverage after the deleveraging, which is what happened in Japan.

[00:31:18] Alfonso Peccatiello: People got burned. They don’t want to accumulate more debt. I think policy makers are not going tovolunteer for it, Rebecca, but the chances that it happens are not negligible. 

[00:31:28] Rebecca Hotsko: And then I think largely markets and everyone is expecting a recession. But how does a recessionary scenario differ from a period of deleveraging?

[00:31:39] Alfonso Peccatiello: Well, it’s a good question. Sometimes they coincide. So during the Great Financial Crisis, you had a recession and you added deleveraging. I mean, the housing market was deleveraging really aggressively during the Great Financial Crisis. People were forced basically to liquidate their houses to, and foreclosures went up, etcetera, etcetera.

[00:31:59] Alfonso Peccatiello: So that’s a deleveraging of the housing market. Sometimes though you have a recession without any meaningful deleveraging. So that happens when basically the recession hits particularly the labor market, industrial profits, rather than creating some credit stress somewhere. So the key is how does this recession play out? Does it hit a very leveraged sector? Does it hit the credit market like it did with the housing market in 2008? If it’s directly one of these very leveraged credit sectors, then deleveraging is the obvious thing that happens next. If instead, it’s a domestically driven, consumption-driven recession where the labor market weakens, where people spend less, but not necessarily the household sector in the US is the most in-depth out there. It’s not necessarily so. So it could be that it is just a more orderly consumption labor market-driven recession. In that case, you don’t necessarily have a deleveraging episode as well. So, recessions can take different paths at the end of the day, and it’s not a guarantee that you always get a deleveraging with one.

[00:33:11] Rebecca Hotsko: When I was reading on Ray Elio’s long-term debt cycle, I believe I read that he said a period of deleveraging can occur when interest rate tools are no longer an option, but since central banks do have the option now, at least in the US, they are high enough to go down, as you mentioned, even to the lower zero bound.

[00:33:32] Rebecca Hotsko: Is that a way that we could potentially avoid this episode then? 

[00:33:37] Alfonso Peccatiello: Yes, in principle, that could be the case, although the reasons why the private sector leverages up is not only that interest rates are very low, but also that there is a stable economic environment around, and they haven’t suffered an 11 episode first.

[00:33:55] Alfonso Peccatiello: So to make an example, in Japan in the nineties, the Bank of Japan cut interest rates from basically 5% all the way to zero, and it kept interest rates there forever. Since then, the Japanese private sector has refused to leverage up, even if interest rates dropped so aggressively. Why? Because the deleveraging of the nineties was so painful for them that there was no interest rate cheap enough that could convince them to take on additional debt.

[00:34:26] Alfonso Peccatiello: So it is the process here that matters. If the US can get inflation down to 2%, maybe with a recession, but without a massive deleveraging episode first, then yes, lowering interest rates at 0% will prevent this late-cycle deleveraging episode from happening at all because people will suffer, but they will not be burned by a deleveraging episode first.

[00:34:50] Alfonso Peccatiello: So if you lower interest rates, you can encourage them to leverage up again later in the cycle. But if the US can get this orderly move down and you’ll get a deleveraging episode first when people get burned directly, then you cut interest rates at 0%. It won’t do much, at least for a couple of years before you can convince people. Then getting that back on their balance sheet is something they can afford, so it’s the sequence that matters really.

[00:35:24] Rebecca Hotsko: Okay, that was a very helpful explanation. I do want to move on to de-dollarization now because I still have a lot I want to get through with you. I think this is such an interesting topic.

[00:35:38] Rebecca Hotsko: We’ve been seeing a lot of this being talked about lately. There have been talks between China and Brazil reaching a deal to trade their domestic currencies and closing LNG deals in Yuan, and there are talks of the BRICS countries wanting to trade oil in gold instead of USD. So, I’m just wondering, a lot of these events have led some to believe is the US dollar world over, and if so, what are the potential alternatives that could take this over? ?

[00:36:12] Alfonso Peccatiello: Yeah, that’s something I covered as well in the Macro education series. I think it’s a super important topic. Before we answer this question, I think we need to try and explain a bit how the system works. It is a bit overlooked, I think people take it for granted, but it’s something I would like to refresh for a second for our listeners.

[00:36:37] Alfonso Peccatiello: So what we have basically created is a system where if you are a country outside the US and want to transact with anyone else and you want to maybe sell your goods or services or commodities, whatever you want to sell with another player in the world, you can do that in a streamlined system where we use one denominator of your transactions.

[00:37:03] Alfonso Peccatiello: Everybody uses the same, basically about 70 to 80% of global payments, trade invoices, settlements are done in the same currency that currency is the US dollar. That facilitates quite a lot of things. I mean, counters can transact against each other. They don’t need to worry about domestic currency.

[00:37:23] Alfonso Peccatiello: They don’t need to worry about settlement. It’s all standardized in one currency, okay? That’s how the system works. Now, let’s make an example to understand that being the dollar is actually quite a privilege. But it’s not easy at all either, and that will be the first step to answer your question, what is the alternative?

[00:37:46] Alfonso Peccatiello: Basically, what’s the next system going to look like? Let’s say I’m a Brazilian corporate and I sell soybeans or any other commodity that is very popular in Brazil. When I sell soybeans to China, the trade will today happen in dollars. So I’m Brazil. I have these hard-earned dollars now on my balance sheet because I sold my commodities that I can create as add value in China’s bought them, so I have dollars.

[00:38:16] Alfonso Peccatiello: Okay, so what do I do with these dollars? Those dollars will sit on the asset side of a corporate in Brazil. Right. They have sold soybeans and now have dollars. These dollars will enter the banking system because the corporate will deposit these dollars to a Brazilian bank, right? That’s the only way you can keep your money.

[00:38:39] Alfonso Peccatiello: In our feed system, you deposit it at a bank. That means that dollars have entered the Brazilian banking system. They need to be invested or kept safe somewhere. Right. So the way we do that today is via investing in treasuries. All these foreign players in the world that sell any goods or any services in dollars will get these dollars in and they will recycle them, keeping them safe in US treasuries.

[00:39:09] Alfonso Peccatiello: In order to find a market that welcomes this gigantic amount of money circulating in the world and coming from global trades and global transactions, you need a huge deep market. Out there. It needs to be liquid, it needs to be transactable, it needs to be deep. It needs to have a repo market underlying.

[00:39:31] Alfonso Peccatiello: That’s a lot of ifs and it is not very easy to find one because it also needs to be relatively risk-free. You just need to have a parking, a liquid parking place for your dollars. The treasury market is pretty good at that. I have to say. The thing to consider here is that the US needs to supply the world with an additional amount of these treasuries every year to guarantee that the new dollars generated from trades.

[00:40:03] Alfonso Peccatiello: Trade growth goes up every year in the world. We grow, we trade more with each other, which means there will be more dollars that are looking for a home at the end of the process, which means you need to expand the supply of dollars. You need to expand the supply of an item where people can recycle the dollars.

[00:40:28] Alfonso Peccatiello: You need to issue treasuries. You need to give people the ability to have a deep and expanding treasury market, and the US does that. Via basically running permanent deficits. Running fiscal deficits is a feature if you want to be the global reserve currency in the world. And it is not easy to be the dollar.

[00:40:48] Alfonso Peccatiello: You need to have a deep, liquid repo market, treasury market that you want to expand every year. And now answering the first part of your question, what are the alternatives today? The currency that takes the most share after the dollar is the euro. And that’s the most likely candidate because together with the deep and liquid repo market and treasury market, you need to have the rule of law.

[00:41:17] Alfonso Peccatiello: People don’t want to allocate their hard-earned dollars from transactions into a country. The treasury market of a country like it could be Russia or China, where it is debatable whether you will ever be able to get your money back because of the lack of rule of law or capital controls. So you don’t want that, right?

[00:41:40] Alfonso Peccatiello: You want a democracy, you want the rule of law, you want the liquid market. Europe might have something like that, but it doesn’t have a deep enough bond market. Highly rated AAA government bonds in Europe as a percentage of GDP are a fraction of treasury bonds in the US as a percentage of GDP. So even Europe doesn’t qualify for that role.

[00:42:05] Alfonso Peccatiello: It is hard to be the dollar. It’s a great privilege, but it isn’t easy either because you need to fulfill a lot of roles and as of today, there are not many valid alternatives. Actually, there is no valid alternative.

[00:42:22] Rebecca Hotsko: Okay. And then just quickly tying this back to the discussion on deleveraging in a global credit system that is so tied to the US dollars in leverage to US dollars in the event of an economic downturn and deleveraging scenario, what would the impacts be on the US dollar and this US based system?

[00:42:46] Rebecca Hotsko: And perhaps does this tie into why it’s so hard for countries to switch? 

[00:42:52] Alfonso Peccatiello: Yes, so right, because the other side of the coin we need to look at is debt. Because the system that we have created not only needs an asset where to recycle these dollars, but because this dollar based, a lot of countries that are sitting outside the US have chosen to lever up in dollar.

[00:43:10] Alfonso Peccatiello: So the issued dollar denominated debt, Rebecca, To fund their businesses. I mean, think you’re a Brazilian corporate. You sell soybeans. If you want to lever up your business, you have to issue bonds or debt to borrow money. You will be forced to borrow money in dollars because you sell your commodities in dollars in the first place.

[00:43:30] Alfonso Peccatiello: So you issue dollar denominated bonds despite not having any organic access to the very dollars you need. To service this debt and unless for trade growth, if trade is going fine, if you’re selling more soybeans, if more dollars are coming in, you’re good. You can have dollar debt because dollars are coming in so you can pay, your coupons can service your debt freely.

[00:43:51] Alfonso Peccatiello: We have issued $12 trillion. Of dollar denominated debt from entities that don’t have access to the Fed. They don’t have a liquidity access to these dollars when they need them. The only way to get dollars is via trade growth. That explains a lot of the link between deleveraging end dollar strength that you were referring to before.

[00:44:12] Alfonso Peccatiello: So if trade growth is slowing down, if Brazil cannot get their hands on enough dollars because the world is slowing down and so there is a recession and they can’t sell enough soybeans to China anymore, they don’t get. A lot of dollars coming in, right? The flow, fresh dollar slows down, but you still need to service the other side of your balance sheet, which is that.

[00:44:32] Alfonso Peccatiello: And you have dollar debt you need to service. But where are these dollars, Rebecca? I don’t have, I don’t see these dollars anymore. So the system is built so that if there is a deleveraging, people scramble to the dollars because they need them to pay their debt. So what happens is the dollar goes up, everybody wants fresh cash dollars and they bid them up cause they need them.

[00:44:56] Alfonso Peccatiello: To pay back their debt. Pay better debt means deleveraging. So when you deleverage a system that is so entrenched, then based on the dollar, the dollar appreciates. And this is why if China and Brazil decide to trade against each other in another currency or any other block of countries would decide to do that, all of these countries have dollar denominated debt on their balance sheet.

[00:45:18] Alfonso Peccatiello: All of them. Because they’re so ingrained in the system. They have issued dollar debt. China’s issued dollar debt. Brazil has issued dollar debt. If they decide to trade against each other in one, then Brazil all of a sudden will have less dollars at hand. Right? They’re selling their commodities instead of getting dollars in, they’re getting one, but their debt is still sitting there and it’s denominated in dollars.

[00:45:40] Alfonso Peccatiello: So the reason why I’m saying that is if you walk away from this organic, fresh flow of dollars that you need and want to have to service your liabilities, how are you going toget your dollars? How are you going toservice your liabilities? The only way to get away from this system, the way we have built it is a proper leveraging episode.

[00:45:59] Alfonso Peccatiello: We say, let’s default on the dollars. Let’s forget about it. I don’t want to repay my dollar debt. Okay, so you’re basically defaulting on trillions and trillions and trillions of dollar debt out there. That is not an orderly event. You can choose to do that, Rebecca, but the reason why I chose to write that piece is that people talk to me of a digitalization, like if it can be an organized, orchestrated, fairly orderly event, it cannot be by the way the system is organized.

[00:46:29] Rebecca Hotsko: Okay. That was extremely helpful to hear that explanation because my next question was going tobe, is there a certain amount of global trade that would happen between countries saying, we are switching our global trade, we’re going tobuy commodities and things in gold, yon, Bitcoin, anything else? Would there be a certain nominal amount that would then cause.

[00:46:49] Rebecca Hotsko: Implications for the dollar, but what you just mentioned is that they still have to service that liability side. So as long as that is there, it doesn’t matter how much global trade they do in dollars, they’ll still have to eventually convert those other foreign currencies or assets to dollars eventually.

[00:47:05] Rebecca Hotsko: And that’s why the system keeps going. 

[00:47:09] Alfonso Peccatiello: Look, the thing is, Rebecca, they can choose to, they can decide to do that, but what will happen is that by doing that, either they choose to default on dollars, which means they will basically lose the trust of any other. Country in the world that still transacts in the dollar in the first place.

[00:47:24] Alfonso Peccatiello: So they can choose to do that, but it’s a very tectonic shift. It’s a hard decision for them, right? Them as in a block of country deciding to try and walk away. If they do default on dollar debt, you are defaulting on global obligations, which means who else is going totrust you, right? In this fiat. Debt based system.

[00:47:42] Alfonso Peccatiello: Nobody can trust you if you freely want to default on your global obligations. The other way to do that, it’s the more painful way, which is to deleverage the system first in a relatively orderly fashion, which means you pay back all your debt, all your dollar. Debt, you have to pay it back. There is 12 trillion year after year instead of levering up further in dollars.

[00:48:02] Alfonso Peccatiello: If you’re in Brazil, you pay down your dollar debt, but that means that by paying down your dollar debt, you need I a lot of dollars coming in year after year and you will be trying to pay down this huge 12. Trillion dollar of debt out there, how many dollars do you need to pay down all this debt? So this system basically is quite interesting cause one way or another it needs to some non orderly, non-linear events to morph into something else.

[00:48:30] Alfonso Peccatiello: And orderly. The dollarization is nothing more than a fairytale, it doesn’t exist. And if you look at history, every time you have moved from one global reserve currency system to another reserve currency or to another system whatsoever. A gold back system, a bitcoin back system, any other system, any of these transitions has been quite rough and it has involved almost always proper geopolitical conflicts.

[00:48:55] Alfonso Peccatiello: An orderly digitalization doesn’t exist, and if you get one, it’s going to be quite a rough ride and most likely involving even some worse. That’s what I want to come across with, explain how the system works to want to make people understand why you keep hearing about the digitalization, but it never happens.

[00:49:14] Alfonso Peccatiello: It is very, very difficult to engineer one, and most likely it requires quite a rough path ahead. 

[00:49:22] Rebecca Hotsko: Okay. And I guess one way that we could monitor this going forward as investors is looking to the countries and seeing if their US liability sides are in fact decreasing substantially over time rather than increasing as you would perhaps expect.

[00:49:40] Alfonso Peccatiello: Yes, that’s a good thing to do. So look at the so-called euro dollar system. So how many dollar debt and liabilities are getting issued from entities sitting outside the US? There is a database that you can use to track that, and I also talked about it in the Macro Education series. So if people want to try and find the tools to follow this massive macro shift and see if it’s really happening, there are public sources to do that.

[00:50:13] Alfonso Peccatiello: The other thing is, yeah, if Brazil starts issuing renminbi-denominated bonds, that is interesting, isn’t it? Because that means that Brazil is not only choosing to transact with China in one, but also willing to lever up in renminbi in one. So it’s not only doing the asset side, but also the liability side.

[00:50:35] Alfonso Peccatiello: So far, there has been basically no indication of that because you need Brazil to be willing to transact in one and then get this one back and invest them somewhere as well. So you need China then to open up their bond market. You see how many pieces need to happen together, and some of them also include political shifts that are massive opening up.

[00:51:01] Alfonso Peccatiello: So not having capital controls like China has, for example, lowering your amount of corruption in the political system like Brazil has to make sure that you can invite other countries to invest their foreign reserve assets in Brazil or in China. A lot needs to change to make sure that this can become a more credible threat to the dollar.

[00:51:25] Alfonso Peccatiello: And even if it does, there is still 12 trillion debt that we need to discuss about anyway. So there’s a lot of ifs and there’s a lot of data to follow, but all of that can be and should be followed in a holistic way, and that’s really what I try to do on the macro compass. I know that it sounds fancy to scream that the dollar is going to zero, but what you need really is a grounded level-headed approach to these complex macro topics where you can follow the data really and understand what’s going on.

[00:52:05] Alfonso Peccatiello: That’s what I try to do with the macro compass.

[00:52:09] Rebecca Hotsko: And I absolutely love reading all of your articles on there. The last thing I want to ask you before I let you go today is just what is a practical portfolio implication or strategy that investors can take away after listening to this episode here, 

[00:52:24] Alfonso Peccatiello: I think there is one, I think, which is more short-term, and one more long-term. So short-term, look, if I’m saying that I expect the Federal Reserve to be forced to cut rates to 0% in 2024, and the obvious asset that benefits from it is bonds because bond prices have an inverse relationship to yields. So if yields go down all the way back to zero, if Fed funds go back to zero, then bond prices will benefit from it. So I think that it’s something to consider in your portfolio right now, to have a bit more bonds in it to protect your portfolio against this potential recession we see ahead. So this will be one of the potential practical short-term implications.

[00:53:14] Alfonso Peccatiello: Long-term, look, I think the role of the dollar and gold, both of them in portfolios, is relatively underestimated. If you have dollars in your portfolio every time, Rebecca, you have one of the situations where the world is trying to deleverage, where we are trying to scramble to get dollars because, you know, there are all these dollar liabilities out there. Having an exposure to the dollar in your portfolio will benefit you from that. So it acts like a diversifier in periods when all the rest gets actually hit pretty bad, including the stock market. So having some dollars in your portfolio, even if you believe in the de-dollarization, might interestingly be something good to have.

[00:54:01] Alfonso Peccatiello: And I just explained why the dollar actually needs to basically appreciate in the system before you can bring it all the way down, right? By the way, the system is created gold instead would work against the second layer of this process. Because once you transition away from the dollar, I discussed how hard it is to actually have one currency that three places the dollar. It is basically impossible. Nobody fits all the requirements of the dollar has to be the global reserve currency. So I believe that gold will play a very, very important role like it did last time that we tried to transition away from a Fiat system, which means basically before the seventies. The reason why gold plays that role is that it already sits on the balance sheet of all these institutions. Brazil has gold. China has gold. Russia has gold. Saudi Arabia has gold. All governments in the world, even developed market economies have quite a lot of gold on their balance sheets. Gold has already served this stabilizer role as basically the hard asset underpinning the global credit system, and I do think that investors might consider that it might play that role again in the future.

[00:55:23] Alfonso Peccatiello: Yes, we are a much more technological economy that we were in the fifties and in the sixties. That is true, but I still think that gold can take on that role, or at least the investors might consider that it can lead into an appreciation of gold prices, which can be pretty rapid. I think it’s a good hedge always to consider, to have a relatively, uh, decent allocation to gold in your portfolio to hedge against the second leg of the dollarization.

[00:55:49] Rebecca Hotsko: Okay. Thank you so much for your time today, Alfonso. That was excellent. As always. I never have enough time with you, but can you give a handoff to yourself and where our listeners can go to learn more about you and all of the work that you put out. 

[00:56:03] Alfonso Peccatiello: hank you, Rebecca. The best way to follow what I do is on themacrocompass.com. It’s the website of my investment research and portfolio strategy firm. All I try to do really is basically what we discussed in this conversation. Macro can be pretty complicated, full of jargon, a lot of pieces to put together. The idea is I try to break them down in plain English, give people the data and the sources to go and do the work themselves too. It’s basically one macro learning journey together where people can also get some actionable investment strategy on top of it to steer their portfolio according to which part of the macrocycle we are in. All of that is on the macrocompass.com.

[00:56:51] Rebecca Hotsko: Of course, and I will make sure to link that in the show notes.

[00:56:54] Rebecca Hotsko: Thank you so much again today, Alfonso. 

[00:56:57] Alfonso Peccatiello: Thanks, Rebecca. Talk soon. 

[00:56:58] Rebecca Hotsko: All right. I hope you enjoyed today’s episode. Make sure to follow the show on your favorite podcast app so that you never miss a new episode. And if you’ve been enjoying the podcast, I would really appreciate it if you left a rating or review. This really helps support us and is the best way to help new people discover the show. And if you haven’t already, make sure to sign up for our free newsletter, We Study Markets which goes out daily and will help you understand what’s going on in the markets in just a few minutes. So, with that all said, I will see you again next time. 

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