Click the play button below to listen to a new conversation between hedge fund manager and MacroVoices podcast host Erik Townsend and Hedgeye CEO Keith McCullough. (Click here to get a special offer on Hedgeye's "Best Deal of the Year.") Below is a brief excerpt from this interview.
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Erik Townsend: Your next slide seems to have a summary of the three macro themes that you’re focusing on in the final quarter of 2017. Please give our listeners a summary of what’s on your mind here.
Keith McCullough: I think the first one’s the most nuanced, if you will. So what we call Quad 1, Quad 2, Quad 3, Quad 4 – that’s our four-quadrant framework. So when we’re talking about our model, this is our model. You’re either in the first quadrant, second, or third, or fourth quadrant.
(Growth accelerating, Inflation slowing (QUAD 1); Growth accelerating, Inflation accelerating (QUAD 2); Growth slowing, Inflation accelerating (QUAD 3); Growth slowing, Inflation slowing (QUAD 4).)
Now, when you’re in the fourth quadrant, that’s awful. That’s when you have both growth and inflation slowing at the same time, commonly called deflation. So Quad 4 equals deflation. When a central planner sees that – whether it be in the UK, or here, or in Japan, or in Europe for that matter – they automatically go dovish, devalue the currency, create a massive money supply. Rainbows and puppy dogs, etc.
But what they actually get is asset price inflation and a stagflation in the economy. So, inflation in asset prices, but real growth is still slow. That’s Quad 3. Stagflation.
Where we currently have us tracking into the second – really the first half of 2018 – is the first quadrant. So the debate here in Q4 is Quad 1 or Quad 2, where you get a sequential or a month-over-month and quarter-over-quarter rise in inflation. You can see that most easily with oil prices. But you can see it more broadly across the CRB index, which is 19 commodities. You can see it in wage inflation for example.
What we have is actually this three to four month period where we’re trying to debate with our subscribers whether or not it’s investible to stay with the reflation trade, and for how long. So that’s really the first theme.
And it’s really an ongoing debate. I think that a lot of things in macro you should debate, because they’re clearly not easy to nail all of the time.
The second one is a very obvious one that we’ve already discussed, which is where does the profit cycle start to peak relative to the tax reform expectations starting to pick up? And I think we’re obviously right in the heart of that. So, again, tax reform is a tough one. I have absolutely no crystal ball to tell you that this is going to happen with 100% certainty.
I’d say that it’s better than a coin toss that the market expects some form of tax reform. So if you don’t get it, that’s going to be a problem. That’s not been our call, nor would it be because I have no data to support that. Again, that might just be a moment in time in the market. So that could obviously be a market risk inasmuch as it could be a reward.
And then, finally, the third theme, which I think is probably the most divergent – pardon the pun, given it’s called global divergences – synchronized global divergences – what I’m trying to do is kind of make fun of the consensus out there. It’s pretty obvious looking in the rearview mirror that we had a globally synchronized recovery. You can read that in the Wall Street Journal every single day. You can read that from your local consensus economists every other day.
That’s not what 2018 is going to look like. In fact, China, which is a pretty big part of the globally synchronized recovery, is already slowing. So that’s the easiest one to call, on the old China part. So that’s that.
And the south of Europe is a major concern for us. We’ve already seen inflation rates start to slow across most European countries. And they’re certainly lower than the level of inflation that we see here in the US (headline and otherwise). They have no wage inflation in Europe. Consumption and retail sales growth is slowing in places like Italy, Spain, Portugal – so we’re quite bearish on the 2018 forward outlook on the south of Europe. And, like I said, China.
So that gives you a much different setup from a global demand or a global economic growth scenario than what consensus is currently expecting.
Erik Townsend: Do you think the Kyle Bass scenario of China having a major credit event that sends a wave of deflation and creates the next global financial crisis – is there any merit to that? Is that a concern that you pay attention to?
Keith McCullough: I definitely have paid attention to his work. I always do. I have a lot of respect for Kyle Bass. I just have disagreed with him, obviously, for the last couple of years. Thankfully so, because China, of course, had quite the opposite last year.
They had the biggest stimulus in the history of China, which is a fairly long history, going back. And you had a major catalyst, which we didn’t want to be short of, which was the Communist Congress, which they finally held in October. So there are a lot of reasons not to be bearish on China.
I think, if you’re going to make that call, you’ve got to get the timing. He might argue otherwise, because he’ll say, eventually it’s going to happen. That’s not tight enough for me. My subscribers would fire me for that. I have to get the timing right within at least a three to six month window.
And the big difference on China, I think, is that (A) they have a closed capital account, and (B) they don’t have – partly as a function of that, but also more generally – their deposit system on their banks is much different than what we have here in the US. I think if you’re going to make the big-bang USA-style credit call – just because we had it and they have insipient signals that would suggest you should be paying attention to the risks – I don’t think that that’s an event you can time and/or structurally can actually see right away. So that’s what we would say on that.
What we do focus on, which will help Kyle’s case, is China is slowing as opposed to accelerating. So, again, I always go back to what’s the economy doing? In sharp contrast to 2016, really, China’s growth peaked in Q1 of 2017. So this year it peaked, in terms of the rate of change.
So now we have China slowing, and I think that – if Kyle’s looking for a real reason that could be a catalyst or a causal factor – there’s some negative things happening, because, bad things happen when growth is slowing. Now he at least has that.
