DBS Economics & StrategyKopi Time E132 - GIC’s Prakash Kannan on Global Macro and Asset Allocation
Prakash Kannan, Chief Economist and Director of the Economics & Investment Strategy department at GIC, returns to Kopi Time to talk about evolving macro developments and implications for asset allocation. We cover it all in this discussion, from Fed outlook to EM resiliency, global liquidity to China policy, yen carry trade to gold, and how a portfolio suitable for the past decade is unlikely to bear similar fruit going forward. Lots of insights.
Hello, this is uh Copy Time, a podcast series on Markets and Economies from DVS Group Research. I'm Turbe, chief economist, welcoming you to our 132nd episode.
Today we have with us Dr Prakash Kanan, chief economist and director of the Economics and Investment Strategy Department at G IC. One of two key sovereign wealth funds of the government of Singapore. Prakash is responsible for developing the top down view on the investment environment as well as the asset allocation strategy for G IC. Prior to joining G IC in 2012, uh Prakash worked with the International Monetary Fund.
I know him from those days, the Central Bank of Malaysia, Bangarra and GTES Pension Fund, Prakash, Shaan. Welcome back to Copy time. It's been a while.
Thanks J Good to be back. I can't believe it's been four years,
August 2020. These were the early days of cooking time when you were kind enough to join me. Uh Lots has happened since then. Prakash and Macro remains exciting
and no, first. Congratulations. Uh I think the podcast has definitely gone from strength to strength. Uh I think it was, yeah, it was hit what episode? 24? I believe I was now. It's 100 and change. So, congratulations.
Uh II, I have been able to run it because I've had, you know, friends and colleagues like you come and support it. So again, Prakash, thanks for coming back today. And like I said, back in 2020 I think most of the podcast was about dealing with pandemic economics. We can hopefully put that aside, not if not even behind for the time being.
Uh Prakash. Uh Let's start with some macro discussion. And then I do want to hear about your views on asset allocation in this environment, but to set the trajectory, uh let's start with the US. Uh lots of chat about Jerome Powell's Jacksonville speech. September is probably most likely the, you know, beginning of the rate cut in this cycle and people are trying to price in the 2024 2025 scenario. Your thoughts.
No, thanks man. And look, I think it's a great place to start. Um you know, for better or for worse. I think uh what the fed does really matters, not just for the US, but I think for the rest of the world. Um I think, you know, really thinking about the question, we, we have to take both
uh the expected path of rate but also the outlook for the economy uh and inflation uh together, you know, sometimes you have these discussions where people just focus on the rates but, but ignore actually what's happening in the uh in the macro context. Uh So if I start by looking actually at what's price, then
you have about 220 basis points of cuts between now and the end of 2025 which is, you know, roughly 100 for this year and about 100 and 20 for next year. Now, you rarely see this kind of extent of cuts outside of a recession.
So in that sense, uh it really is a very strong uh kind of a degree of monetary policy kind of easing that's being priced into the market. So when I look at that and then I try and square it with my central view uh of the of the economy uh that the amount of cuts being priced in seems a little excessive. Uh Our baseline is still for a uh a soft landing.
Uh but importantly, with a slightly sticky path for uh for inflation uh such that it would likely end 2025 still with a, with a two handle.
Um And so if you take that into context, uh you know, we think likely that um you're not gonna get this amount of uh uh cut um that the market is currently pricing it. But of course, you know, that's the central scenario, the the alternative scenarios around it. Um We do actually place a relatively high uh probability and a recession scenario about 30 to 35%. Uh This is, you know, about twice the kind of unconditional mean.
Uh And a large part of that is just based on the, the dynamics that you're seeing in the, uh, in the labor market. Uh Now if you do get that scenario, then, then I do think actually the fed has a lot of ammunition. Uh, and I think they will actually act, uh in a fairly aggressive manner.
Uh The other scenario is of course, that, that actually we are wrong on inflation and actually it comes down a lot faster. Uh that I think is a bit more consistent with what the market is, is pricing in, not too bad, not too bad on growth, but actually very fast disinflation process.
And of course, you know, we have to talk about the elephant in the room, which is the, the US election.
Um you know, depending on how that pans out. Um You know, I think there is a scenario where the FED may just want to pause and wait until you get some clarity on uh on policies because across both candidates, you know, a lot of the discussion has been
uh you know, on, on kind of broader issues, let's say immigration, uh uh crime, the economy, et cetera, but, but very little kind of clarity in terms of what exactly uh type of policies they would uh deliver. Uh So that again, I think would, would probably lead to a bit more caution, I think from the fed, uh, relative to what, uh, what's priced in.
Right. And I, I think I am very much in line with you that, to
prognosticate about uh, recession, just, just around the corner sounds really a bit far fetched to me, uh, in the past for, gosh, I mean, we've only had proper recessions with proper shocks which are, you know, by definition, not really predictable like the pandemic or the financial stability issues are on 0809 and the market can't predict that. So in it, if it's pricing it, in that narrative, in my view doesn't carry a lot of weight. Whereas to your point that if inflation starts surprising on the downside,
uh then just the fact that, you know, we don't need to have such high real rates makes sense. Uh But still, it has to be combined with some degree of weakness in the labor market, what you say because if labor market does not weaken materially and we rule out of recession, then sustained cuts could lead to undue uh you know, softening of financial conditions and create financial stability issues on the other end, like a melt up scenario.
No, I think, I think, I think that's, that's absolutely right. Um You know, the, the one thing unique about the US is that there actually is a bit of an asymmetry with regards to uh the sensitivity to interest rates, uh mostly because a lot of uh economic entities in the US actually have optionality when it comes to uh uh refinancing, right? So, so as interest rates go up,
um you know, as you know, a lot of households are on kind of fixed rate mortgages which have very long duration relative to other parts of the world. Uh Corporates actually also have turned out their debt such that, that pass through of higher interest rates to balance sheets is a, is a lot slower. But if you invert the process,
um actually, then you suddenly could get the uh opportunity for households to refinance uh uh much faster uh households to even take uh potentially uh home equity uh uh uh withdrawals. So, so you could get actually an, an asymmetric response to cuts, um which I think going to, your point would lead to, I think to, to a bit of uh uh uh uh a melt up scenario. And, and I think here, you know, the, the, the risk is that
um there's perhaps too much emphasis I think placed on, uh you know, this concept of a neutral uh uh interest rate of this house car, uh which is, you know, as, you know, uh unobservable. Um And so, if there is a belief that uh policy is quote unquote tight, just because it's relative to this um conceptual uh uh our star
that, that pressure to cut may actually be a lot more than uh uh what, what uh uh is actually necessary for, for the economy. So, so, yeah, I agree with you. I think that, that, that there could be that scenario, uh where, you know, the, the fed kind of in a way underestimates, um uh how much actually our car has uh, has increased over the past few years.
That's right. I want to talk a little bit about the treasury. Uh I've seen some articles lately talking about the fact that the treasury focus on issuing bonds at the short end of the spectrum, as well as the long end constitute some sort of a QE which has sort of offset the feds qt. Do you, do you have any view on this issue?
Yeah. You know, I mean, um, I, I think um uh
the challenge with the, with the Treasury is that they actually have to do a lot of uh a lot of issuance. Um And, you know, that's, that's the function of uh the large amount of deficits that, that actually is being done.
Um, you know, we have kind of reached a tricky position where, you know, kind of treasury auction announcements have been uh, almost seem to be like market moving uh uh events. Um I think, uh I think that there will be a time where they will need to issue a lot more duration.
Um, in a sense, they are kind of getting up to the 20 25% amount of uh uh kind of bills relative to overall uh uh issuance that I think uh is roughly their, their sweet spot. Um Having said that, you know, it has actually helped uh the balance of liquidity uh uh in the market.
Um because, you know, by, by issuing much on the shorter end, actually, they have in a way, uh uh as you were saying, offset the amount of uh qt that, that is uh has been going on. Uh our own estimate is that um as you know, QT is already uh uh reduced in, in, in magnitude. Um But we think that runs probably until about the middle of next year. Uh and then that too will, will eventually stop. And perhaps at that time, the fed can actually extend the duration of uh of their borrowing,
right? I, I also think that some of the stuff that the treasury is doing as much as the market would like to follow minute by minute. I think it is fairly predictable, it is fairly stable and I think they're focusing on the short end of the curve does not reveal any desire to sort of offset the fed's moves. And to your point, we also estimate that at the current pace by the middle of next year might be the longest.
The fed can go a final word on global liquidity uh precaution, not just uh fed's operations, but the things that are happening at the Bank of England P BC Bank of Japan. And uh one concern that I hear going into 2025 is that the FED may be doing its thing, but there are other things happening elsewhere which might constitute somewhat of a liquidity crunch uh for
banks and financial institutions. Uh and, and the private sector in general. Uh your your sense, do you have any concern with respect to liquidity?
Yeah, you know, I think uh I mean, we looked at this a bit and uh my sense is that uh the both awareness by um uh central banks on this issue as well as actually the, the existence of new tools
uh I think do actually limit the uh the likelihood of, of any kind of uh uh sharp liquidity uh shock. I think the standing repo facility, uh the fed of course, is something new um relative to the, the last uh uh kind of repo uh scam. And, and I think this actually does uh will help uh to be a little bit of a, of an offset. And plus, you know, I think um
uh there is a lot more kind of discussion with uh um with uh kind of market participants. Um There is actually also, you know, uh Laurie Logan, who's now the um uh Fed president over in uh the Dallas Fed uh also carries, I think a kind of a wealth of knowledge uh with her. Uh And so, you know, in fact, uh we pay, we pay a lot of attention to, to her speeches, I think on, on the balance sheet. And uh
and I think she, she also has a good pulse of, of what actually is kind of the the true demand for uh for reserve assets from the bank. So I think in general, both the awareness as well as the tools that are out there, uh We think actually limit the likelihood of a, of a big liquidity scare
because the awareness that you're talking about uh beyond the US, when you talk to central bankers in other industrial and emerging economies, do you feel that they are picking up that cue from the FED and would probably be amen, amenable toward more activist intervention with respect to liquidity going forward?
Yeah, I think, I think that that uh uh definitely is there. I mean, you, you see it in the, in the ECB uh uh as well. Uh I think those, those discussions are, are, are happening and I think in the previous um I would say two years or so. II, I think that
that emphasis on while doing QT but also kind of making sure that uh you know, liquid institution of the banks uh are are kind of adequate, I think has been uh has been quite uh uh I would say a key input towards the way that they've been actually structuring. Um you know, the various uh degrees of uh asset purchase programs that the ECB has been doing.
Uh So I do think it is, it is top of mind uh for, for a lot of the policymakers and, and I do think that uh they, they do have the tools to, to kind of overcome that,
right. Uh I do this chart Prakash, which is a G four central bank balance sheet as a share of G four GDP. And from that metric, we're not that far from going back to the prepa levels of liquidity. So in dollar terms, of course, it's much, much bigger
but nominal GDP has expanded quite a bit. So I I hope that, you know, not just the fed but other central banks including the ECB, but also probably Bank of Japan and others are taking note of that.
Yeah, but I think, I think the important thing is it's not so much GDP actually, you have to look at bank assets. Um And I think that that part in a way that credit creation process has actually been not as strong as, as GDP, right? So um you know, I mean that when when we look at what we think is would be the kind of adequate level of reserves scaling it by by bank assets, we think kind of forms a bit of a better, a better base and, and
uh which is, which kind of goes back a little bit to the earlier discussion because the cycle has been very unique Right. It's not, it's not been a credit driven cycle but, but it's actually been income. Right. And, and it's income in a sense of transfers from the state to, to, to private entities. And so, you know, that's, in fact, that's one reason why when interest rates went up so much, you didn't have that kind of,
uh, a large uh contraction effect on, on real economies just because uh balance sheets were in general a bit of a better shape. Um So, so, you know, in that sense, um uh you know, how much uh reserves banks need actually may, may be a little bit less than, than I think if you were just to scale it relative to GDP,
right? Unless of course, you know, we see finally a resumption of the credit cycle and then the ratios could evolve quite dramatically going forward. Uh Yeah, I guess that's a 2025 story. And we are thinking and hoping um from a banking perspective that as rates come down, uh there might be a little more intermediation even if it is not in the US elsewhere. Uh There is certainly a lot of impulse coming from the government for the investment sector to pick up. So maybe it will happen um progress. So
staying with the story outside the US, uh thinking about Asian uh economies, uh my take is that, you know, eight months into the year they have held up pretty well. Trade has done better than what I would have feared coming to 2024. Consumption is decent. Uh What's your assessment of the performance of Asian economies this year?
No, actually, I'm very glad you brought this up because I think it actually is a, is a, is an unappreciated uh fact, uh in the sense of the degree of uh resilience across a lot of emerging markets, uh you know, we were competing the other day, this metric, which is, you know, let's say you strip out China and you look at EMX China growth relative to developed markets, you know, in the early two thousands, uh this kind of EMX China uh cohort
uh actually was outpacing developed market growth about 4% points.
Then actually, after the global financial crisis, um that actually fell quite, quite rapidly. Um And you had, you know, at some point, even less than 1% point uh in terms of the out performance relative to, to develop markets.
Uh and, and this is just, you know, I mean, it kind of goes against all our usual convergence uh uh thinking with regards to, you know, ems kind of growing at a much faster pace than, than D MS. And so, you know, I always feel like when we look back at that post GFC period, a lot of people talk about secular stagnation in the US, but actually the the secular stagnation was happening in the, in the emerging market space. Um and, and that also actually passed on to equity returns.
We did a decomposition of equity returns over the last decade. Just kind of seeing why did Ems perform so badly? And the biggest piece of why Ems perform badly was just that earnings just didn't grow. Um And, and so, you know, I think what we have seen, not just for the first eight months of this year, but also actually uh last year uh has actually been quite phenomenal. So that, that differential between
EMX China and, and developed markets has now gone back up to 2% points. Um And if you, you know, if you use some proxy of new orders and et cetera, uh uh coming out in PM, I actually, you know, that that could be forecast to, to go back up to about 3%.
So, so that out performance of uh
uh uh EMS relative to, to D MS is actually uh picking up and, and I mean, you know, we, we, we, we know at least structurally why uh that's been the case. I mean, I think the national balance sheets, I think has been, have been a lot uh a lot stronger. Uh there's a much more um kind of reduced reliance on, on foreign flows.
Um And uh you know, I think there's just in general uh fewer, fewer imbalances. Uh but, you know, I mean, there is also a cyclical story, I think, uh you know, as you know, a lot of the countries, especially in Asia, uh I think outside of, of Singapore, not a lot of countries actually did uh uh you know, fiscal stimulus to the extent that you saw in, you know, the US, uh Europe, et cetera. And, and so, you know, the output gaps, I think was still
quite negative, uh you know, coming into 2022. Uh And so, in that sense, you know, I mean, I think there was a little bit of, of uh of uh uh slack that, that the economy could uh could grow into.
And then I think the other thing is um you know, the, the resilience of EMS uh particularly Asia is the flip side of the resilience of the US, right? Um You know, the, the one thing which is um uh you know, been, been very positive in the US has actually just been manufacturing capa um and manufacturing Capex and, and structures usually, uh uh you know, kind of helps uh em exports. Uh you've seen it in, in uh uh in, in Korea
uh is in this part of the world. So, so, you know, I think, I think that that part of um
uh the kind of resilience of the U SI think has, has also helped uh helped this part of the world. But, you know, it, you're right, it, it is actually a really underappreciated uh uh phenomenon. Uh and, and actually, even, even if you look at the, the turmoil that happened in early August.
Um Once again, you know, I mean, ems in general did, did, OK. I mean, you, you had the bifurcation between the Latin American uh economies which were the kind of recipient of the carry trade flows. Uh and, and those currencies unwound quite sharply.
But in this part of the world, actually, you know, suddenly you, you had uh, number one, the prospect of the Fed uh actually uh uh cutting uh and two, you had uh the yen appreciating.
Um And so, you know, you had Malaysian Ringgit Ruia one actually uh uh appreciating quite uh quite a bit of this in this region. So II, I do think that um uh you know, the EMS are definitely in a much better position uh now than, than they were, I think post post GFC.
Absolutely. So,
you know that uh uh we at D BS did a collaboration with uh B and company and an Council looking at Substation over the next decade and one of the points we made in this report and I think it is reflected very clearly by what you just said is that the last decade or two, somewhat underwhelming performance should not be construed as a marker of things to come. Because during that time,
balance sheets have improved, the quality of human capital has improved and a lot of stars are aligned, so to speak for the region, with respect to China plus one. So the next 10 years in my view actually looks pretty good, particularly from an earnings perspective. Uh, I would not look at the lackluster performance of the past decade as a market for things to come at all. So glad to know that you're on the same page.
Yeah. Yeah. You know, I, I think, um, I mean, the challenge for EMS of, particularly investors in the EMS has always been uh how do you get access to uh to the growth? Right. So, you know, I mean, you'd be hard pressed to find the kind of growth numbers you get in this part of the world. Uh literally any anywhere else.
Um But at the same time, like at least on the list of equity space, you know, returns have just not been uh not been that great uh especially for, for a a. Um and, and so I think, uh you know, really kind of being uh uh selective thinking about, you know, the particular sectors. Um and then, and then I think, um um you know, of course India is, is uh one of the few markets where,
you know, markets have been compounding at 12 to 14% a year actually since the nineties, right? So kind of through any uh any administration. Uh So really, I think you gotta, you gotta pick your spots uh
uh pre spots
well
here,
right? But also that industry is so instructive for policymakers in ASEAN that when you have that virtual cycle, virtual cycle, if you will of capital markets, dynamic, growing very fast, creates as entrepreneurs,
energy, which then becomes so fulfilling. And that's what we're seeing in India, you know, on a regular basis, tremendous wealth creation, which itself is feeding into innovation and new companies and new ideas. Uh And it's hardening to watch that. I think ASEAN used to be like that pre 1997.
No, you're right. You know, I actually, I, I um I, I think it's, it still is, right. I mean, um you know, if you look at, of course, Indonesia has some of the more um kind of well known uh start up whether it's uh you know, Gojek to BP. Uh And uh but actually, even if you look at Malaysia, I think the entrepreneurial spirit that is actually phenomenally strong.
Um And so that ecosystem around, you know, that kind of China plus one strategy, I think uh is actually uh thriving and back to your point. I think that to me is the
kind of the, the raw ingredients that you need to then actually build, you know, capital markets, et cetera. Uh uh around. Uh and, you know, at least on, on paper that they have a lot of these good policies are really trying to help the small midcap um uh uh space kind of get uh better access to, to financing uh promoting a venture capital ecosystem
So things like this, I think um you know, once it's really well developed, I think we'll, we'll capture even global investor interests,
right?
And I think in the region there's some frustration about like we need deeper capital markets and better stock markets. But I think
I, I heard someone say that, you know, without good companies, you can't have good markets. It's not necessarily a chicken and egg thing, you have to have good exciting companies first. Uh So, so yeah, I'm looking forward to the next round of entrepreneurs and next round of value creation in this region. Um progress. Let's talk a little bit about China.
Uh We have had a couple of years now where a steady drip of policy easing has been the characteristic of the Chinese economy. Uh but concerns around property sector consolidation is still substantial. And now lately, very recently, we've also seen this issue related to this, this sharp decline in interest rates around everybody crowding into the Chinese government market. So some, some thoughts around China.
Yeah, look, I I think um uh the starting point uh for thinking about China is really that
uh trend growth has, has come down, right? Um You know, one of the reasons I talked about uh you know, doing that E MD M comparison in terms of growth rates, kind of excluding China uh is because you don't want to kind of take that huge decline in trend growth uh to, to distort that that relationship. Uh So as, you know, China, uh you know, 1015 years ago was growing between 8 to 10%.
Uh We now have trend growth at about four in change. Uh And we think that actually falls to about three and change in the next decade. Uh So it's really is a very sharp uh uh fall in, in trend growth and a large part of that is just uh it's just demographics. Uh and, and also actually a moderation in uh in, in productivity. Um And so, you know, that, that I feel kind of needs to recalibrate in terms of actually how fast we think China could grow.
And to me, the way I read uh uh policymakers read of the economy is that actually they've also kind of incorporated that the fact that that trend growth is lower in the way that they are thinking about uh about stimulus. Um So, you know, is, is a uh kind of a 5% growth uh if they achieve that
this year, um is that really uh uh an, an underperformance or, or is that kind of, you know, in line with where with, where trend growth uh uh is? Uh And I think, I think I, in some sense, uh it is actually already uh going down to, to where trend growth is. Uh And I, and that's why I don't expect kind of a big uh Bazooka type uh stimulus that, that they will do. But ha but having said that I, I do think that
um there is an issue of um, kind of uh lack of animal spirits. Uh that's, that's, uh you know, if, if not addressed, well, I think could, could potentially lead to uh, you know, kind of a sharper fall in growth and, and uh a bit more deflationary uh uh dynamics.
Um What, what I think, um uh there, you know, if I, if I look at the uh uh kind of the output from the third plenum, also the July Politburo meeting, it looks like these issues are, are front and, and center. Um You know, I was surprised just to hear how much, you know, like the phrase kind of supporting consumption uh has come up, I think in recent uh policy uh statements.
So, so I think that knowledge of what needs to be done, uh you know, everything from supporting consumption to improving the uh balance between center and local government finances, improving land reform uh with regards to mobility of, of people uh improving urbanization. And I think all these things are definitely the right direction of travel. Um So to me, it really is just kind of a an execution
uh issue that uh uh that, that is, is a little bit lucky.
I just want to throw in one nerdy economics question, putting markets aside for a second Prakash, which is this whole notion that the US Treasury has brought to the fore, the China overcapacity argument and its role in destabilizing global markets and creating deflation risk. Although I thought the US Treasury would worry about inflation risk, but overcapacity seems to be the other end of the argument. What's your sense of overcapacity?
Yeah, you know, it's uh uh you know, it's funny as much as we think about um this kind of lack of animal spirits in, in China, I think in the sectors uh for which China is thriving. Um you know, EVs batteries solar, I mean, the competition is absolutely fierce. Um You know, I, I uh
we've seen, you know, we've met companies where, you know, that, that the margin squeeze has just been uh quite uh uh striking across these sectors just because there's a very strong competition and the quality of the products that they're, that they're putting out, I think is, is just uh quite, quite phenomenal. Um You know, I've, I've seen kind of autonomous driving developments in China, which I think is much better than, than anywhere else. Uh uh you feel uh in the world. So uh II I find it um
uh uh hard to, to, to think really in terms of uh of overcapacity, I think uh uh in, in that sense, I mean, as you know, the the world needs a lot of these uh kind of green uh uh green products. Um I think the challenge uh really here is uh what happens if more and more countries put up barriers uh with regards to, to China, uh which I think then uh
in a way it's gonna feed a little bit back more into the deflationary uh challenges that you have in uh uh in China. Uh ultimately, as we know, uh we just need to find ways to boost demand. Um And uh I think that's where, you know, that whole emphasis on consumption. Uh if it actually gets um uh gets more traction, I think that will be a better way of solving this, you know, kind of quote unquote overcapacity problem uh than I think really trying to, to
limit limit their, their exports.
OK. In case our listeners missed it. Uh I just want to reiterate the point you made in a different way because that's a really cool one which is concerns about overcapacity with trade restriction measures and treating domestic supply chains would actually compound overcapacity problem on a global systemic scale.
Yeah, I think so. Yeah.
Yeah. Yeah. Well, put uh I think uh this issue came up in the context of India's ambition to have its own solar industry when the Chinese were supplying those solar cells with the rock bottom prices. And I think my initial inflation was exactly that, that if you want to have even more solar cells in the world, how does it help uh from a global capacity perspective? I think
at least in the countries of India Prakash, I see a little more calibrated approach to dealing with China and its production in the last year or so. Uh, not necessarily tariff barriers and protection but other ways of making the relationship a bit more balanced, which I like, I would like to see some of that from the US, but I think independent of December, November's election outcome, I don't think the US policy on China is going to change much.
Yeah. No, I think, I think you're right. Um I think um uh I in a way the,
as much as uh you know, the current administration is trying to focus on the small yard high fence uh approach. Uh to me, the risk is, is twofold, one is that you are introducing actually new policies. Um for example, you know, uh restrictions on the outward flow of capital. Uh And once I think you introduce new policies, I think that the risk is always that, that, you know, that uh these things start start expanding.
Uh and, and second is I think um from a financial investor perspective, uh you know, I think there, there is actually already uh uh among a lot of uh uh kind of us institutional investors, you know, some form of financial decoupling.
Uh that's, that's happening between the US and China and, and I think that's, that's very unfortunate. Um So, so, you know, that, that part of it, I think um uh you're right, I think would be relatively robust to uh to the different administration. But, you know, II I think that
in theory that that more targeted approach is still better than I think, you know, a large blanket tariff for uh all such policies which I think will uh hurt not just um
uh uh uh Chinese manufacturers, but, but also us, us consumers. Um and you know, it's probably uh with the saliency of inflation, I think still in the background, I I think this could really put the fed in a very difficult position if us policy kind of goes down that path.
Yes, yes, definitely
concur
um speaking of uh issues that sort of afflict the market and one is, of course, you know, the issue related to the US election, but the other one is around currency market, you touched upon this briefly earlier percussion, let's expand on that. So what are your thoughts on this currency market volatility that we experienced in late July, early August? And if you think that the conditions that made that happen are still very much in place and therefore we could have a recurrence.
Yeah. So, so um
you know, I think what's very unique in this um uh in this cycle is really uh both cyclical as well as uh uh kind of in a way structural uh uh divergence across the major economies, right? So, you know, you've got the uh the US which uh you know, it kind of operating above capacity kind of coming back uh towards uh you know, some concept of, of equilibrium.
And then you've got uh uh Japan which, you know, is kind of exiting uh deflation and kind of, you know, starting a normalization process. And then you've got China, which is, you know, as I saying, kind of dealing with, with this slowing trend growth. Um you know, it's funny when you, when you go to Japan,
um people actually talk about the wage price spiral in a very positive uh light. And in fact, it's something that they're trying to encourage. Uh whereas, you know, if you go to Europe, uh you know, the conversation, that is what we are trying to avoid the, the wage price spiral. So I think ultimately, when you, when you're faced with this kind of uh uh both cyclical and policy uh divergence, uh it is going to be currency markets that,
that play a lot of the um uh the, the adjustments. Um and I think central to that, uh I think really is the uh uh the yen um uh you know, for, for historical reasons, et cetera. But, but also the fact that it was one of the markets where you really had the largest uh policy divergence uh between, between the US and uh and Japan.
Um And so, you know, I think that uh direction of uh of unwind, uh we think uh still has a little bit uh ways to go. Um because, you know, we do think that, that um uh the BOJ actually still, still normalizes um uh from, from where they are uh today. Um You know, I mean, if, if Japan does manage to get a 2% inflation,
we estimate their trend growth at, you know, slightly below 1% real. So that's, that's an economy that's operating at about a 3% nominal growth rate. Uh It's not too
unreasonable to have a policy rate that, you know, is around 1% or, or even up to 1.5% in the long run. Um And actually, if you look at the, the way that the J GB curve is priced, you know, at the back end of the curve, actually, there is a lot of, of uh uh hikes that's been priced in the 10 year tenure rate is, you know, kind of north of 2.5% right. So, so in that sense, we do think that, um you are gonna continue to, to get this, um, uh divergence where, where we think back to Japan is kind of,
you know, interests are going to be going upwards and, and the fed is going to be going, going downwards. Um So, you know, while, while the bulk of the moves have happened, uh we do still think that that actually the yen uh could potentially uh appreciate a bit further from here. Uh But like I was saying, you know, I think actually for our part of the world, uh it's actually a good thing.
Um It's a good thing in the sense that uh I think it does give room for regional currencies here uh to appreciate. Uh because as, you know, the, the, the big thing about Asian economies is that we're all net surplus economies. Uh and the, the thing with net surplus economies is that, uh I mean, outside of uh uh India and Indonesia, um we are, we, we tend to be low yielders.
Uh And I think in that low yielded environment, it was just very difficult uh to kind of uh you know, get exchange rates on a stable or appreciating trend uh when us interest rates were north of 5%. So I think, I think uh um with FED coming down, but also with the yen appreciating, I think it does give this region a lot more policy space. Um and kind of going back to China.
Uh I think it gives them a lot more freedom to uh to cut interest rates. Uh Then I think um it was the case maybe about
two months or so back.
Right. No, absolutely.
Uh And also, I mean, one observation and one follow up question, one observation is that unlike the two previous episodes in the past quarter of a century, when the BOJ tried to do lift off and had to scale back its ambition immediately because the economy fell apart. I think things are fundamentally quite different. I mean, Japan's industrial sector for the first time in a quarter century seems energized and new investments are taking place.
So I think there is a fundamental underpinning to the growth story than just G PM feeding exports. But my follow up question was on your observation on low yield uh Prakash the cherry trade story. Uh We had a lot of, you know, borrowing yen and invest in us tech story, uh We have elsewhere in Asia. There is also elements of Cherry Trade. Uh how big or meaningful is this dynamic?
Yeah, you know, it's a um it's, it's a very difficult number to, to, to estimate. Um you know, I think even our own estimates prior to, you know, what happened in the first week of August. Uh I think the moves that you see in the market were a lot faster and a and a lot more wide ranging than, than even we uh we had thought um I think you do have a lot of um um hedge funds that were
uh kind of funding themselves uh from yen. Um And in, in the sense, you know, you, you uh whatever the funds we're investing in, you know, we were quite broad ranging um relative to just the usual,
you know, um Yen uh Mexico or Yen Brazil uh type types of trades. Uh So I do think it is, it is actually quite uh quite extensive. And I, and I do think that it's uh uh it's, it's just very, very hard to uh to monitor. I mean, if you take the uh
Chinese Renminbi, for example, you know, it was a little bit of a, of a crowded trade as well because, you know, if you had the view that the uh Chinese policy was going to be easing the economy is slowing, uh that you had a view that the exchange rate was going to depreciate. Uh you were paid to, to hedge the currency. Um And so, you know, in that sense, it was a pretty crowded trade.
Um And so when that, when that whole thing um unwound uh you know, once again, you, you, you, you, you get that appreciation in the, the Renminbi and, and so, so I think, um you know, really trying to, to trace down where, where all the flows were going uh in this kind of more opaque market has just been very difficult. Uh I mean, I think, I think even Malaysian policymakers were surprised that
the extent to which the ring get appreciated, it was actually quite a phenomenal thing. But as I was saying, you know, it's, it's in line with what they were trying to achieve and,
and I think um uh with that, it does take actually it does give them uh as well as the whole region. I think a lot more uh breeding room.
Yeah, just
things are becoming a little more balanced and I like that very much too because you might remember from our graduate school days, this paper by Guillermo Calvo called varieties of capital market crisis. I think that was the first paper I read on uh uh sort of contemporary financial crisis building on, you know, the stuff that Putman had done earlier in that previous decade.
So one point that have made was that, you know, portfolio managers have a bunch of positions and they try to balance it. And sometimes when they have a negative view on one asset, it manifests in them selling in other assets. So that rebalancing approach then manifests in all sorts of things.
So the reason I bring it up is because it is really through the next two questions and these are the two final questions of this discussion. So first one is on gold, the kind of rise in gold that we have seen, does it reflect this portfolio rebalancing thing that KVO was alluding to in his paper?
Um iii I think actually it um uh the drivers that I feel are are slightly different. Um you know, prior to
2022 you know, there was a very tight link between um gold and uh and real interest rates. Um and, and, you know, for, for right reasons, right? You know, I mean, um you could, you could think of real interest rates as being the kind of opportunity cost of, of holding gold, which doesn't give you any yield. And so when, when, when interest rates go up, actually the price of gold goes down. Um And then, you know, just after, uh the,
uh you know, I would say about March 2022 you, you had this, this um this decoupling. Um Now it's, it's interesting because around that time, uh of course, the fed started hiking uh rates. And so, you know, the presumption was that actually gold prices were, were, were gonna fall,
but he also had the Russian invasion of uh of Ukraine. Um And, you know, I think that in a way catalyzed AAA new driver uh for gold, which I think was very different from the traditional drivers, which is real interest rates and, and the dollar. Um And, and this driver was actually from, from central banks.
Um And so if you look across uh you know, the data that comes up from the World Gold Council, you know, demand for gold by central banks actually really, really shut up uh from that period.
And uh and I think that at the margin has been, you know, uh kind of a big, a big support for um uh for gold. Uh which is interesting because we look at the uh ETF flows um on um uh like GLD, for example, actually, actually that, that's been, that's been flat to, to kind of uh uh coming down. So, so um it has been, I think a lot more central bank flows and then recently a bit more retail flows as well. Um uh
So I think it's uh it's been a very different uh uh driver and uh to, to a certain extent, I think probably keying off a bit more on kind of geopolitical uh risk uh than this about, about portfolio uh rebalance. But, you know, II I uh uh of late, you, you do find that the correlation has kind of come back a little bit more. Uh But with the dollar, um so, you know, as the dollar has been falling,
um you know, you've seen that, that kind of being a, a support for uh for gold,
right? It's like a headset win tails, you lose for gold rates go up, the goal goes up because of your political concerns and rates come down, then the old relationship comes back. Uh OK. So this, this brings me to the portfolio construction question. Uh Prakash. Uh How do you design a portfolio? Uh given everything that we just talked about across uh duration and asset classes?
No, no, I think that's a, that's a good question. I mean, you know, at least uh in a way that's, that's where the rubber hits the road. Um I think, uh you know, we've just kind of been through a,
a very unique decade, right where um actually diversification uh hasn't paid off at all. Um You know, not only would you, uh, would you have wanted to be in a fully equity centric portfolio? But actually you wanted to be fully in the US. Um And in fact, you know, I think most managers, you go around talking to the question is
why, why bother diversifying, uh why bother buying anything other than, than the SNP. Um But, but I do think that, that we have kind of uh gotten to a point where, um, you know, diversification, I think is, is actually gonna uh matter uh uh a lot more, you know, the one, the one positive thing I, I take away from the
episode that we saw in, uh in early August is that, you know, when actually faced with the growth scare, uh you know, where, where the market was, you know, for, you can argue reasonable, not reasonable, putting more weight on a recession scenario, actually, bonds, bonds did their job, uh and, and rates uh rates uh rallied, right. So, so I think, uh uh what we, you know, we are thinking about and what I think, uh uh most investors are thinking about is actually that this is the time,
uh that you do actually want to do a lot more uh diversification. Um you know, part of the uh uh uh story in a way, even if you have a um kind of a soft landing uh baseline scenario, risk premier are actually quite uh quite tight. Um So, you know, whatever measure of, of valuations you want to do for the US relative to where real rates are.
Uh Even if you look at credit spreads uh by and large, actually, you're not getting compensated for uh for a lot of risk. Uh But I do think actually um uh you know, kind of diversifying uh the portfolio and kind of going back to the discussion on, on the
emerging markets. You know, if you do get that soft landing scenario where the fed is cutting because inflation is falling rather than, than growth and the dollar comes down. I mean, historically, this has been a great period for, for Ems.
Um So I think, I think that's one aspect, the other one I think is that, you know, some of the most structural forces that, um you know, we didn't, we didn't get a chance to talk about, you know, whether it's
climate change and the energy transition, uh a whole range of industrial policy, uh you know, build out of Capex related to A I, you know, a lot of these things, um you know, in a way, push out the investment curve a lot more. Um And then, you know, when you think about how much the governments are spending, you know, we bring back the the savings curve. So
they put two economies in a room and you always have to talk about uh curves at some point. Um So, so I think if you look at that intersection between savings and investment. Uh you know, I, I think in general rates uh uh uh in terms of equilibrium a bit higher, but I think in general they are also a bit more inflationary. Uh
um And so, you know, finding ways to protect your portfolio from higher inflation, uh I think is uh a place uh that, that you should be focused. And I think, you know, I know we said uh heads you in uh tails you in a thing for gold. But, but I do think actually, uh you know, in that, in that scenario of um
uh you know, kind of a more monetary led uh inflation, I think gold actually uh does well. Uh but I also think, um you know, adding a little bit more uh commodities, real assets, I think to the portfolio. Uh I think do make a lot of sense of this uh uh in this environment because um you know, we are likely to be faced with a lot more supply shortages. Um And, you know, this is the kind of uh environment where
I think getting that bit more um uh
balance or support for your kind of uh core equity uh position, I think will, will, will pay off a lot more.
I think that's a great astute observation Prakash because when I talk to investors to your point that uh dominant view is, you know, what's the point of, you know, investing beyond the US, it's been so great. Uh But the sands are shifting
and if we don't take positioning now, it could be that, you know, we look back and say, well, this was the time to make the adjustment. So I really appreciate your view on that uh progress. Final, final question is on the private space, the public markets have done their thing. We've seen good equity performance in the West. We've seen fixed income rally around expectation of stump soft lending.
Uh But then there's this intrigue around whether there's a lot of leverage build up in the private markets because they are not subject to market to market. Maybe we don't really know how big the damage is. Uh But so far with almost two years and counting of high rates, we haven't seen any accidents in the private space. So are we out of the woods?
Yeah, look, I mean, uh um in some sense, I think that the rebound in the public market space has uh has, has helped uh just in terms of, of anchoring valuations uh for the for the private space. But I think going forward, uh if you think of um uh you know, returns uh in private assets coming from, as you mentioned, uh leverage second is actually uh kind of valuation uh rating
and the third is actually kind of value creation, you know, kind of getting better uh ebita growth. Uh What we're seeing is that we don't you know, you just can't rely on the first two forces anymore. Uh And it really has to be about, about value creation. Um So I think that that would be the big uh challenge for the private market space. Uh Is that if you were actually just resorting to the first two
uh uh pieces, uh you're just not gonna get the kind of growth that uh that you did uh uh in the past. Uh So, what we've been doing actually with a lot of our portfolio companies um as well as uh via the, the GPS is actually putting more emphasis on uh on, on the 3rd, 3rd part. And, and this is, I think the,
the, the kind of true strength of, of uh private markets, particularly private equity in that you actually have a controlled premium, right? You, you, you do have the ability to uh to, to make those changes and actually help create that uh that value.
Um So it is, it is uh going to be a tough period, I think uh uh going forward for the space. Um But I think it will actually lead to in a way, the way I think about it, actually a more sustainable uh growth trajectory for um uh for, for this, this universe.
That's a very good point to end. Uh PS Kan. Thank you very much for your time and insights. Thanks for coming back to COVID time.
Thanks tomorrow. Take care.
Good to have you. Thanks to our listeners and viewers as well. Copy Time was produced by Ken Delbridge at Spy studios. Violet Le and Daisy Sharon provided additional assistance. It is for information only and does not represent any trade recommendations. All 132 episodes of the podcast are available on youtube and all major podcast platforms including Apple and Spotify. As for our research publications, webinars and live streams, you can find them all by Googling P research library. Have a great day.
