Norris Bruce
Mar 13, 2020

The Coronavirus and the World Economy With Raoul Pal #686


Bruce Norris is joined this week by Raoul Pal. In the early 90s, Raoul worked at Goldman and Sachs, where he co-managed the hedge fund sales business and equities and equity derivatives in Europe. He then co-managed the GLG Global Macro Fund in London for GLG Partners, one of the world’s largest hedge funds. He retired from managing client money at age 34 in 2004, and since then he has founded Real Vision TV, the world’s first On-Demand TV channel for finance. Raoul has been publishing global macro investors since 2005 to provide original, high quality, quantifiable and easy readable research for the Global Macro Investment Community.

Episode Highlights

  • What does his job as a global macro investor entail?
  • What kind of methods does he use to reach conclusions about the market?
  • Does he believe an impending recession would be global or just in the U.S.?
  • How does he see the coronavirus affecting the global economy?
  • What psychological impact will this have on investors and companies?
  • What was the reaction to the Fed lowering interest rates by half?
  • What is his view on how Bitcoin will play into all this?

Episode Notes

Bruce Norris is joined this week by Raoul Pal. In the early 90s, Raoul worked at Goldman and Sachs, where he co-managed the hedge fund sales business and equities and equity derivatives in Europe. He then co-managed the GLG Global Macro Fund in London for GLG Partners, one of the world’s largest hedge funds. He retired from managing client money at age 34 in 2004, and since then he has founded Real Vision TV, the world’s first On-Demand TV channel for finance. Raoul has been publishing global macro investors since 2005 to provide original, high quality, quantifiable and easy readable research for the Global Macro Investment Community.

Bruce began by asking him what a global macro investor does. Raoul said if you imagine yourself as a real estate investor, that’s your particular expertise. Other people have expertise in credit or stock markets or even sectors of stock markets. As a macro person, he looks at the overall picture that’s driven by the economies, the movements of economies over time and how that affects asset prices. Asset prices could be anything from real estate to equities to bonds to currencies to commodities to credit. He looks at everything across the world, emerging markets and developed countries, and try and piece together the jigsaw puzzle of how movements in those economies will offer opportunities for investment.

One of the things Bruce is most impressed with his he said Raoul has a very honorable process on how he comes to conclusions. He has operated a number of different frameworks. One is a secular framework. What is the big trend? A long term trend. He is talking 10, 20, 30, 40, 50-year trends. So some of those are relatively easy. Demographics is one of the biggest drivers of all. We can follow the demographic wave and understand what that does to asset prices. That was a big driver of real estate, particularly in 2008, as the baby boom generation piled into real estate for their pension plans. It’s the big driver of the cheaper end of the market now as millennials try to find homes that are affordable. It’s the driver of the expensive part of the real estate market, for example, the larger homes where baby boomers want to sell them and there are fewer bids around. That is the long term theme.

We have another big theme within the long term, which is the big global debt bubble, whether that’s at central bank level, corporate level, or whether it’s at the household level. He looks at those things as well. There may be things like the rise of ESG or environmental investing that will probably end up being a secular theme that drives out over a long period of time, or maybe the decline of the oil business. There’s a number of these big things, but the most important thing is the business cycle. That’s the ups and downs of an economy. Generally speaking, economists never forecast the ups and downs of economy. They always extrapolate a linear trend. If you give a small child the graph of GDP in America, it goes up and down. It’s cyclical and we all know that intuitively. BOnce you’re armed with the cyclicality and you also know that asset prices move up and down with the economy, then you know that once the cycle rolls over, it’s likely to be headed down over a few years and that asset prices, once the economy starts going negative, will go negative. On the reverse when we get to the bottom of the cycle coming up, we can extrapolate forwards the returns of certain asset prices.

For over the top with trading and positioning, he uses chart patterns to help him understand human psychology and where we are in the markets themselves. That’s the general framework. Living in the macro world, he has to live in the future. There is no point in trying to assess the markets based on the information you know today because everybody knows it. What you have to do is try and extrapolate out into the future and say, “OK, the business cycle is weakening. Therefore, this will happen.” Right now with the Coronavirus, you have to live in the future and see the probabilities. There are no certainties in anything in the investing game, just a probability. So it’s assessing those probabilities to figure out what the best opportunity is.

Bruce asked him if he has a team of people and practices a version of idea meritocracy or if he meets with himself and battles it out to draw conclusions. He said since he has been doing this a long time, he has his own thought process. He likes to speak to people and is very active on Twitter. He is gathering information and doesn’t read anybody else’s research. The few research pieces he reads now and then he does purposely not to correct his own thinking. Then, he sits down and writes the global macro investor every month, which is about 120 to 130 pages of graphs, some words, and analyses. He lets that flow to try and figure out himself exactly what’s going on. He doesn’t come with a preconception. It’s by looking at all of the data and all of the charts and the narratives that are out there to figure out what’s going on. He has an analyst who helps him put together his database of charts and feeds him some of the information, and himself. That’s it. He has been doing this for 15 years now, and it has just been the two of them.

Bruce knew this would be his answer because he does research in his own little world. He has watched Raoul talk, and it’s almost like when he gets in front of a chart, he is part of the chart. If he could get inside that chart, he would see a lot more than most people. Bruce said for someone that does what he does, he gets a big kick out of watching him do that. Raoul said for him a chart is everything because he understands everything that’s gone before and some probabilities of where the future lies. He got taught this by some of the world’s most famous investors who all use charts. It just helps you understand where we could be going. There’s a story in every chart, and that’s amazing. Bruce loves charts too. Sometimes, he will look at one for 20 years, and then a new explanation comes to him. His son Aaron can tell when he is really amped about something. It’s like a new discovery that cleared up a question.

Bruce asked him if he has anyone he bounces off of if he is about to put something in writing that’s pretty outrageous. He said no. He is in an incredibly flattering position where he gets paid very handsomely to think independently for others. He get paid essentially by the world’s most famous hedge fund managers, sovereign wealth funds, family offices, and asset management firms to think independently. That’s what they want from him. They want to see things that they don’t see. He doesn’t do it to shock anybody because it’s a closed circulation business. It’s a very limited number of people allowed the subscription. It’s very expensive. The point is he needs to be unfettered to allow his own thought process to evolve. They may choose to reject it, but they want to hear the counter-arguments to their own existing views. In his world, it’s not the people’s need to slavishly follow him. He has gotten a very good track record over the 15 years, probably one of the best of all of the kind of research businesses. People are happy to tell him if they don’t agree with him. They may be doing the opposite trade, but they really appreciate understanding where their risks lie.

Bruce wanted people to understand that Raoul is not given to outrageous statements. These are very calculated words that he comes up with, and some of these might be scary today. First, there are interesting things going on right now. Six months ago or so ago, he was looking at the charts and came to a conclusion we were probably headed to a recession. Bruce asked if this was just in the United States or a global slowdown. Raoul said it was a global slowdown. The United States pricked the bubble by raising interest rates even though they didn’t go up a lot. People in the real estate market know that it put the squeeze on several people because the rate of change of interest rates was quite high. That started slowing down the economy, then we had trade tariffs. Trade tariffs were a global event, and we also had a strong dollar, which was pressuring global economies. He thought the global economy was already headed into recession. World trade was negative. Before the Coronavirus hit, we already saw German exports and manufacturing falling apart. He could see some elements of some accelerating weakness in the global economy. That’s where he was coming at before all of this.

Bruce asked him what kind of recession he thought would unfold before the coronavirus. He does we don’t know, but his base case was mild with a risk of something bad because we have a large problem with the baby boom generation hitting retirement age. The average age of the baby boomer in the United States is 66. As they go into retirement, they are overweight risk assets, equities and credit. They have to sell those to realize their retirement income. He thought that that was going to create some problems. The other side of the equation was there was an enormous amount of credit issued by corporations that was also held in their pension plans. He thought there was a risk in a recession that credit spreads could widen, or credit was harder to get and that would cause a big problem. He had been shouting from the rooftops about the retirement crisis, trying to get people up to speed on the risks they’re taking and what is likely to come. He feared something bigger than a mild recession. His base case was mild, and his fear was a 2008 style event. Then the Coronavirus came along, and his base case was 2008 or worse events, and his fear with a high probability is actually depression.

China did something dramatic. They saw the virus, and they saw that its rate of spreading its R.O. was incredibly high. They saw that it overwhelmed their medical system, and also the death rate was high enough to offer concern. If you use the framework of the rates of the virus spread, plus the death rate and look back at the Spanish flu and say, “OK, that is what a worst case unconstrained virus looks like.” It would have killed the equivalent of 68 million people this time. China did what they had to do, which was completely shut down the economy to control the virus. As we’ve seen, the virus spread in China has collapsed because they took the hardest measure of all, which was basically to collapse their economic growth, take the maximum economic pain with no output, no consumption and no supply to contain the virus for the sake of society. South Korea and Singapore did similar, but Italy and Iran were too late. Now they’re all shutting down their economies, but this virus has gone to a pandemic.

What will have to happen is one economy after the other is going to have to shut down entirely. That means no factory output, no demand for goods. We’ve never, ever faced a global demand and supply shock at the same time before. At this point he is not extrapolating to the future. He is talking about what happened yesterday in Italy. They just shut down. Spain will have to follow suit as well as France, Germany, Denmark, and the United States. The United States has been the slowest of all dealing with the spread of the virus, and they have no choice because their voters are baby boomers. This virus is like a nuclear warhead because it kills baby boomers at a higher rate than it kills anybody else. The death rate is much higher for the voting population that happens to own all the wealth. This is why this is an extremely concerning situation.

We are living with hope that maybe the virus dies off in summer, hope that maybe economies can get to grips with this fast enough. But the reality is, it doesn’t look like they are. His fear here is that if they do not get control of this in the next three weeks, then we have something that is a lot longer lasting, a lot more pervasive and a lot more destructive as it starts to unwind the big secular bubbles of debt, the equity bubble, the retirement crisis, and also exacerbate the dollar exploding higher because there’s a huge dollar shortage. His fear is on all of those things.

That’s a lot to consider. We have used that word black swan event, and Bruce wondered if this is the mother of them all. He said it is. He has heard people warn about pandemics before. Bill Gates warned about it. At first, he didn’t get it. However, the moment he saw this, he got it in seconds, luckily from experience. He then extrapolates it out into the future. Nobody would have thought that we’d have a demand and a supply shock at the same time. Throw in an OPEC oil war in the middle of it, trade tariffs, and a U.S. election, this is the worst case possible outcome we could have ever established. We are now praying for a miracle that it doesn’t turn in to the depression and it’s just a two or three-quarter terrible recession like 2008, or a bit worse.

What’s crazy about this is a month ago, this wasn’t even on anybody’s radar. This was because we don’t forget. We had the swine flu, and it was okay. We had the Ebola virus, and we got through that. We had the MERS one. Everyone thought we don’t need to worry about these things. You have one after another. Living in the Caribbean, you know it with hurricanes. People who have lived here long enough get missed by hurricanes every year, and it’s OK. That just means the probability is increasing that you’re going to get another big one soon. People didn’t see that and understand what the risks truly were. This is going to change people’s psyche forever on this stuff.

Bruce said when they closed Italy, that changed his serious outlook of it. That was a shocker right there. Then, when there was no basketball, you really start realizing we have never dealt with anything like this in our lifetime. Raoul has gone back in history and can’t find another time in all history where we have dealt with anything like this. We’ve never taken measures. Nobody’s ever shot economies before, especially rolling shutdowns with one economy after another, city by city. It never happened.

Bruce said when he looks at charts today, naturally he knew the stock market was going to take a hit. Gold, silver, and Bitcoin are also taking a hit. There doesn’t seem to be a a safe haven right at the moment. Even bonds aren’t moving much anymore. Raoul thinks there is a huge liquidation going on from hedge funds, asset management firms. If you think about the standard pension portfolio of 60/40 stocks vs. equities, or 70/30 these days, the idea was the bonds would protect you when equities fell. The problem is the bonds just had a huge rally and they’re almost pricing in zero rates. There’s not much more they can move. You dont get price gains out of bonds. You get a bit more left, maybe, but not much. So no price gains from bonds, that means all the pension plans are holding too much equities. That becomes liquidation events from everybody in this. You see the overlevered hedge funds. There’s a number of players, so they sell anything they can that’s not nailed down to pay margin calls until they sort their portfolios out. That is what is happening to gold and bitcoin.

Bruce next asked what psychological impact this would have on investors and companies and what the ramifications would be. Raoul said to think about it at a societal level. You haven’t yet got it in the US, but very soon everyone’s going to understand that everyone’s going to fear each other. That is truly extraordinary. We’ve only seen that level of fear in the United States in New Orleans with Hurricane Katrina. When people fear each other, that is this kind of scarring. People fear going into public, fear socializing with people, fear going to music concerts or anything like that. That has an ongoing effect.

Also, a lot of this consumption is gone forever. It’s not pent up demand. It just disappears forever. To be able to get through this is very difficult for many people. He feels truly worried for people who own restaurants, shops, and bars and simple things that require people to go and visit them. It’s a catastrophic event because they’re gonna get quarantined. All the staff are going to go home and they’ve got full payroll plus rent to pay and no income. Most businesses probably can’t last two months. That’s what he fears is going to come out the other side of this. If there are a lot of real estate investors listening to this, then they need to understand that the likelihood of people not paying their rent, particularly businesses, is extremely high. People are going to lose jobs, but also people are at home being paid, working from home, and not spending much on other stuff. If you’re renting out apartments, that’s less of an issue. But if you’re renting out to retail, you’ve got a huge problem on your hands.

Bruce started thinking about those dominos last night. He saw a video in Italy, and they were in line for something and they were about five feet apart. That was very interesting. This line took up an enormous amount of lanes just because they were so separated, and whoever was on the recording said that there a there’s a law in place now that if you get closer than 3 feet to somebody, you can be arrested and put in jail for it for 90 days. That’s how serious this is.

Bruce next asked about the dominoes of a stock market declining and how that impacts corporate debt. If the corporate debt starts to have defaults, what does that cause? Raoul calls this the doom loop. In the virtuous loop that preceded it, this was where corporations in America had a ridiculous tax break that allowed them to issue debt and buy back their shares, and it was advantageous for them. That drives their share price higher, obviously, because there’s less shares in existence. The management issued themselves stock options and they all got rich and the shareholders applauded because the share price went up. The reality was they were switching equity for debt. That’s one side of the equation. What drove those corporations was low interest rates. Great. We’ve still got those. And it’s also corporate cash flows. Companies were making record profits and high cash flow so they could afford to service debt. On the other side of the virtuous circle was the pension plans, particularly at state level in places like Illinois and New Jersey, which didn’t have enough money to meet the promises they’d made to retirees. This includes the firemen and the teachers and all of those kind of guys. What they did is they raised taxes and started injecting that tax money into these pension plans, which was a good idea. People did double pay for their pensions, but it’s going to help them in retirement. That was being used to buy corporate credit, so the debt that these companies were issuing was being bought by these, and that was okay.

But then it got worse because the corporations kept going and kept going and kept going. So they, in fact, became the only buyer of equities in the United States. Basically, the entire pension system was selling because of the baby boomers. Younger people weren’t buying stocks, and the pension plans overall were all divesting. So the only buyer was the corporation, and they were issuing more and more debt, which was being being pushed into the corporate pension plan. While these companies are issuing more debt, credit ratings were getting downgraded. $4 trillion of the debts in a number of companies were in the triple B tier, which is the one tier below junk bonds. The reason for this significance is if they got downgraded to junk bonds, they are not able to be held by the pension plans. They have to go to junk bond buyers, which is a much smaller pool. That would completely freeze up junk bonds. As you go into recession like now, with companies like Ford General Motors, the risk of them getting downgraded explodes. The credit markets start seizing. Then, the worst part happens: the doom loop. The doom loop is when corporate cash flows go negative. The corporations now don’t have the capital to service the debt to buy back more shares. So they stop. That means the largest buyer of equities in the building has just left. So, on the other side of the doom loop is the credit guys. The tax receipts were what was buying the credit for these pension plans. Well, tax receipts are also driven by the business cycle. So when the business cycle goes negative as it is now, then tax receipts stop. There is a bit of a lag, then they stop. When tax receipts stop, there’s no buyer of credit left in the world.

You basically have a situation where there is no buyers of equities, no buyers of credit, and the risk of all of these gigantic corporations as triple Bs getting downgraded. That is one of the most concerning situations I’ve ever seen. The reason why it’s so concerning to me is because all of these assets, the equities and the credit is basically held by a bunch of 66 year olds who were about to retire or who have just retired. They’re taking an extraordinary amount of risk considering how old they are, and he fears that they’re going to see their retirement savings entirely wiped out.

There was a movie called the Big Short where people bet against the outcome of other people’s investments in the mortgage backed security world. Bruce asked if there are bets against the outcome of corporate bonds. He said there here. There is HYG, which is a high yield index. You could buy puts on that, or OQD, which is ETF on investment grade. You can buy puts on that. The problem was they were never as cheap as the bet seen in the big shorts. That was an extraordinarily cheap bet. There are bets, and there are plenty of people playing the blow up in credit spreads. Part of that trade was being long bonds, but that’s almost played its way out now and there is less juice in the trades. The stock market obviously is all part of the same doom loop, and then buying shorts or buying puts on stuff like HYG as an ETF.

AIG was the bag holder in 2008. Bruce wondered if there is one particular bag holder in 2020. Raoul thinks it’s entire pension system. He thinks the Fed will have to support the pension system because you cannot reneg on so many people. At the same time, with the 76 million baby boomers, you just cannot renege on them all in one go. If there is a duty of government, it’s not to do quantitative easing to help the financial institutions. It’s to inject, cancel or guarantee the pension system.

When it comes to the stability of the financial system, Raoul was referring to the Federal Reserve. Whether it’s done in cahoots with the government because in times of crisis there is no separation between the Fed and the government, he doesn’t know. We’re seeing that in Europe now that the governments and the ECB are going to have to tie together because the next phase is printing money to pay for fiscal stimulus at each individual country level. We’re going to change the rulebook shortly.

Bruce asked what the reaction was to Feds lowering interest rates by half. Raoul said the bond market is already pricing another 100 basis points of cuts. Unless they deliver that this week or next, the market’s going to crash even further. It’s fully priced in. Rates are going to zero regardless, and they have to do it ultrafast.

Raoul has not been a fan of negative interest rates for the U.S. Bruce asked if we are headed there, which Raoul said we don’t really know. They’ve been running in Europe and Japan for a long time and it didn’t affect them out on the street because if you can pay for storage of your money and it’s safe, you’d rather do that. People will pay 2 percent a year. They pay to have their gold stored. It creates weird things like corporations borrowing at negative rates, but it’s all about the safety of money. We’re pushing our system to its limits, and he thinks it’s going to break in all of this. Can we get to negative interest rates? For sure. But, what we’re trying to do at this point is prop up the final remnants of a system that has now gone wrong. It’s mainly driven by the baby boomers who built all the debt and created this kind of disinflationary deflationary environment. It has made it so hard, so in the end of this, we have to find some different answer. We can’t use the same financial market construct because it won’t absorb the baby boomers moving out of the capital markets.

Bruce asked what the solution would be. Raoul thinks it will be Bitcoin and the whole digital asset world. Gold plays a part in this for sure. It always has and always will. However, if you’re going to construct a new world, it has to be digital. We have already heard from the central banks that they desperately have to get off funding the dollar. It’s not so much the dollar itself, but it’s the plumbing that is causing so much problem that they’re going to switch to digital currencies that allows an onramp and an offramp, allowing people with bitcoin to transact between two, i.e. you can pay your taxes easily from one to the other. So that appeases governments. We’ve seen Facebook building the Libra coin, which is like an SDR special depositary receipt. As a global currency, we’re seeing Bitcoin and Ethereum. We’re seeing all of the developments and the applications all across the financial world. He has never seen a greater hivemind of the smartest people in the world all developing thousands of parts of the financial system at the same time. It is not only the financial system, the kind of system of notarization or verification or trust or ownership or transfer. All of this is being built in front of our eyes. It’s incredible, and everyone knows it’s a race. It’s a race to get this built. The only way to play it easily for people is Bitcoin, which is plummeting currently, but is offering very soon a very, very good opportunity to have a call option on a different world.

When this gentleman says depression, he would not say that word lightly and apparently never has said it in any other situation. This is why Bruce really appreciated him taking the time to join them. Raoul urges people to go and check out Real Vision, which is their very own demands business absolute, which really is the best single source of truthiness in financial markets you’ll find anywhere. They don’t really do news. They do the analysis that you actually need to understand what’s going on. They have the best people in the world, best hedge fund managers, analysts, strategists. It’s not what you would see as financial television. This is like the thing you absolutely must have. As we all get sent home from work and we’ll be working from home, watching stuff like Real Vision really helps. You can just go to realvision.com. There’s a free version of it so you can watch free videos. Or if not, it’s a dollar for a trial for it for 30 days. It’s ridiculously inexpensive compared to the value it’s going to add to everybody.

It has taught Bruce a lot about a broad range of investing, and Raoul introduced Bruce to so many people through that program. When he intereviews people, Bruce can tell they are friends. Raoul knows a lot of people from his career and a lot of very famous investors who would never appear anywhere else. The mission was to give access to these kind of people, people at the very heart of the financial system that the average guy would never get access to without giving them open access. It’s a game changer. You’re not listening to your financial advisor or reading a headline in a newspaper or watching someone on CNBC. You’re actually getting somebody with skin in the game who really knows what’s going on explaining it to you

The Norris Group originates and services loans in California and Florida under California DRE License 01219911, Florida Mortgage Lender License 1577, and NMLS License 1623669.  For more information on hard money lending, go www.thenorrisgroup.com and click the Hard Money tab.

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