Macro Trader Melkman Sees New Market Regime After Virus (Full Interview)

[00:00:00] Eric Schatzker: Hi, I'm Eric Schatzker, and welcome to Bloomberg's Front Row. Today, I'm talking to Ben Meltman, founder of LightSky Macro. He's a born trader full of big ideas, and in 2019, he was one of the world's best performing macro managers. Ben believes the COVID-19 pandemic has ushered in a generational shift in the economy and in financial markets, one almost perfectly suited to hedge funds. [00:00:31] Ben Meltman: You're talking about going from a world that's almost had fixed exchange rates to one of fixed interest rates, allowing much greater FX volatility, loss of central bank independence, re-emergence of inflation. You know, this is going back to the glory days. [00:00:53] Eric Schatzker: Ben's thesis ranges across timeframes, geographies, and asset classes. Rates staying at zero for decades. The harsh realities of deficit math. Negative returns on stocks and bonds. 1970s style inflation. Here's my conversation with Ben Meltman. Ben, you're an ideas guy, a thematic investor. Tell me about the themes you think will dominate the macro landscape over the next few years. Yeah. [00:01:28] Ben Meltman: You know, I think the environment couldn't be more fertile. We've just gone through a major change to the outlook as a result of COVID and both government and central banks' reaction to them. I find it really amazing, Eric, that in a few short months, we've upended a lot of kind of big truths, if you want. Like, you know, big, really important structures have been around for 30, 40 years, have just been completely upended in the last few months. What do I mean by that? Central bank independence, gone, gone. You know, we had the big inflation of the 70s and 80s. The reaction to that was a movement to central bank independence in the 80s and 90s. All of a sudden, the rebuilding of the deficits, necessary fiscal expenditure that COVID created, has relegated central banks back to their job pre-1980s, which is to essentially monetize the deficits of governments. It's, you know, very similar to the environment post-Second World War. So that's a big deal. And what comes from that? What comes from the debasement of money in that environment? What's the relative difference, you know, between the abuse or not of that, between different countries and how that might affect exchange rates, et cetera? Just the predominance of exchange rates, I think, is going to be a big theme over the next few years. We've been in a world where, you know, over recent years, where interest rates could take the slack of necessary adjustments. If you need, you know, central banks tighten policy, interest rates would move, loosen policies, interest rates would move the other way. In a world where fiscal deficits explode to the level they have, and interest rates not only go to zero, but are forced to stay at zero to accommodate those greatly increased deficits, like you've seen in Japan, you should not expect interest rates to move for the next 20, 30, 40 years. If interest rates are not moving, there are still going to be differences in economies, differences in growth, differences in inflation, different policy paths that emerge. So, where does that volatility express itself, where does that relative value express itself, you should expect FX to be much more volatile and to be much more interesting, therefore, as an asset class, certainly than in recent years. You know, you have the question of debasement of money in general. You have this, you know, which I kind of touched on with central bank independence, unification of monetary and fiscal policy, the kind of emergence, accepted emergence of, you know, what some people might call MMT. You may kind of have a renewed commodity cycle as, as a, you know, as a consequence of that. And then there's a question of, how does equities, how do the equity markets respond to that, you know, at the moment, they're acting as a nominal asset, kind of like gold, etc. Whereas, as people worry about, you know, kind of, there is no alternative, where does the flow of money go, it's creating a big flow into equities. Does that continue? Or does it end like Japan, where if the authorities are not able to create any real growth, that's a kind of false move. And actually, despite zero rates, you know, you can have an environment where asset prices, where asset prices do quite poorly over a very long period of time. And I think that's, you know, potentially ahead of us. So, you know, lots of, lots of questions. And, you know, certainly lots of, lots of big themes to look at over, over, over coming years. [00:05:27] Eric Schatzker: Let's take that last point first. Asset prices do quite poorly over a, I think you said, a relative length of time. What do you mean by that? Not just, so stocks run out of gas. [00:05:40] Ben Meltman: Okay, so let's look at a typical investor profile of years gone by. A 60-40 equity bond portfolio. Bug standard, should do well, and, you know, over a generation, over a period of time. Well, half of that doesn't work because the 40% is zero. The 40% is zero. But not only does it not work, it actually goes from being an asset to a liability, right? You have a long duration asset that's no longer giving you really any income at all and is vulnerable to an inflation shock, right? Your ability to make money in a, in a crisis is gone. You've already essentially PV'd all your potential gains up front, but you're susceptible to the PV of those losses. So what used to be a hedge to your risk asset portfolio is now actually a liability, right? So that 40% is already gone. Now let's look at the, you know, the other asset side of your balance sheet, the 60% on the equity side. You've also brought forward a lot of gains. So, you know, if you look at kind of any equity risk premium model, one of the biggest determinants, and one reason why we've had a very strong equity market, not only over the last few months, but over the last decade, and clearly the interest rate response over the last few months has led to the speed of the recovery that we've seen. One of the biggest determinants of equity valuations is it's a very long duration asset, equities. So at what, at what price do you, you know, do you, do you PV that asset, right? That discount factor. And you've taken that long-run discount factor to as low as it can go, which is a just more complicated way of saying is you've brought forward asset price returns. So if you've, whoever's been fortunate enough to own that 60%, it's great that you've owned it. But what is your expected return going forward now that you've essentially, you know, you've essentially brought forward many future years of asset price returns into this period of time? Like, let's just say it another way, that interest rate factor is not going to go any lower. So unless you're expecting a very high nominal growth rate, and therefore corporate profits to really accelerate, but to justify the kind of valuation levels we have great, but you're certainly not going to get that support from, you know, the discount factor. And in fact, for the same reason that you don't want to own bonds, you could argue you're vulnerable to any reversal. So if the authorities are that successful, that they combat this deflationary pressure they feel and actually create inflation, and you therefore get a reversal in that long-run discount factor, equities will be as vulnerable to that as they're being supported by the compression of interest rates. You know, we're in that point of irony where if they're actually, if the authorities are actually successful in curing the problem that they see, you know, that's actually what, what, what finally, you know, blows up the system to a certain extent. [00:08:51] Eric Schatzker: Most people have looked at the virus and the pandemic and the pandemic response and the crushing slowdown on the economy, and for that matter, policy change as a temporary thing. What you're describing is multi-generational. Yep. Why do you think you're, if not alone, in a small camp there? Is it because the rest of the world just doesn't want to either accept or cannot conceive of the, of the consequences of what's, what's happening right now? [00:09:27] Ben Meltman: I, I, I think it's because when you look at the virus, people want to look at, at the virus. Um, a, in general, people are optimistic about the virus, so, you know, we will get a vaccine and, and, you know, Q4 and great, that's it, move on. Um, and then when you look at the consequences, I think people haven't made the linkage between the policy-making response isn't necessarily linked to the actual outcome of the virus, i.e. the virus was a catalyst, was, uh, that allowed an extreme change in a short period of time, but it's now taken a life of its own. Um, and so even if the optimal, the medical optimists are correct, and even if the virus is not a major part of, um, our lives over, over following years, I still think these changes will be borne out and we're not going from a policy perspective or from a social perspective or from a political perspective back to where we were. Um, and so I think for, for this to bear out, we don't need the virus to stay with us for an elongated period of time, um, I think the horse has bolted, um, and it's going to be very hard to be put in the box, and it's hard to put in the box because we've already let the political cat out of the bag. I mean, we've, you've clearly seen since the virus, these big social movements, um, burst out and these were clearly conflicts that were already simmering under the surface and, um, the environment of, of, of, of, of the virus of quarantine has allowed them to bubble up. Um, and I also think it's, uh, from a policy perspective, it's very hard to put it back because fiscal policy, what matters is rate of change. And so if you've gone and you've blown a 20% deficit in your reaction, how do you put that back in the bottle? You can't go and say virus is gone next year. We go back to zero. It doesn't work like that, right? For, for fiscal policy to have an even trajectory on growth, it needs to stay the same. So if we've had a 20% deficit this year for there to be a zero fiscal impulse, I need a 20% deficit next year. If I even go down to a 15% deficit next year, that's a 5% fiscal impulse contraction. If I tried to go down to a 10% deficit, that's a massive contraction. And so when I think about the debt profile going forward, you need to build out a range of deficits. So even in your most optimistic viral case, right, we're going to have to have a, a period of slowing deficits over many years, which is an expanding, um, you know, which, which is an expanding debt profile for many, many years. And that in itself is going to create a policy environment, right? How can I, uh, adjust front end rates up in an environment where both the fiscal deficit, the, the budget, um, the, the U S federal debt and, and debts and sovereign debts all around the world have exploded to very high levels. How can I raise front end rates when, uh, balance sheets at central banks have exploded? And in this political environment, I'm not sure that you're going to be able to tell Congress that they need to be writing hundreds of billions of dollars into trillion dollar checks to fund paying interest on reserves. Um, to, i.e. you're going to take money out of social security and pension education to pay banks. Good luck with that. [00:13:12] Eric Schatzker: Three of the great trades over the past decade have been long equities, long rates. Well, four, actually, I think you could be long credit, right? Credit spreads compressing. Um, and you could certainly have been short, hard commodities. Yep. What are the next great trades for the coming decade going to be? [00:13:32] Ben Meltman: Uh, if I look over the coming decade, um, I think, I think we're going to be in a, in a very different world. I think the risk parity world that you've, that you've essentially described, um, is, is not going to happen. We've, we've already brought forward all that asset price appreciation. Um, and so I think it means your ability for the equity market to keep on having these gains is going to be very hard because you've eliminated, you've, you've already brought forward that, uh, that big dramatic move lower in the long run discount factor. Um, so, you know, my, my expected return of equities of the next decade is zero or negative in that environment, depending on, um, where that, where that long-term interest rate goes. Um, I think you're going to have front-end rates anchored at zero, um, but you could potentially over the long-term have a pretty dramatic steepening of the yield curve. So that 30-year rate can, can, can certainly re-steepen out, um, probably not as much risk in the very near term. While you've got this, uh, a huge amount of excess capacities built up over recent months, um, but certainly the direction of policy would point to those future inflation risks. Um, that would also tell me that the dollar is extremely vulnerable. Um, you know, we've obviously seen the beginning of the move over the last few months. Um, but again, if I step back, we've just ended a nine-year dollar cycle, um, and the dollar generally works in cycles. So I imagine over the next five, six, seven, eight years, um, the dollar will end up trading significantly weaker. Um, you know, and that against the, uh, you know, the, the usual suspects, the euro, the yen, the, uh, so, so I, I think against the, yeah, so, so, so I think, I think you can look at it in, in two different ways. One is the dollar has become much too high a share of global reserves, and especially with the U.S. taking a step back, becoming a bit more isolationist, um, and the U.S. being a bit less exceptional now than it was over the last nine years. Um, it's, um, no longer has an interest rate advantage, no longer has a real growth advantage, no longer has a political advantage, all the reasons why the dollar grew to such an outside share of, of reserves, um, I think we'll normalize that. And so other reserve currencies should do better, versus the dollar, so that's the euro and yen and Swiss, and obviously we've seen in things like gold. [00:15:59] Eric Schatzker: Talk to me a bit about the social consequences of the world you envision. [00:16:07] Ben Meltman: It's pretty clear from a social perspective, the U.S. just went too far, and although that was a huge benefit to the market, um, and gave the market opportunities, and that create a lot of capital inflow to take advantage of that, you know, extreme market opportunity, um, the political environment is such that we can expect some reversion to mean. And, and, you know, although at the, you know, earlier on this year or the end of last year, it looked like we could have a much more extreme reversion in terms of a Bernie or Elizabeth Warren presidency, um, nonetheless, um, a left-leaning democratic movement is almost certain to become the next government here, um, with a different ideology and an ideology to spread the wealth of the country a bit more evenly. And so, you know, what does it mean on a social basis? I think it, you know, it, it means, uh, uh, some, uh, a movement away from the extreme income inequality, wealth inequality that we've seen, um, it's gonna make the U.S. a bit more European, right? Um, and, and as a result of that, you know, no judgment, that's not that dramatic, it's not gonna be in an extreme fashion. But, therefore, your expected returns here, both in terms of equity market returns, by definition are gonna be less because you're averting some of that support that you've seen over recent years. And, therefore, your expectation of the value of the dollar should be less as all that capital that came in looks to go elsewhere. But on a social basis or a political basis, it's probably not such a bad idea. [00:17:49] Eric Schatzker: What you describe, Ben, sounds to me a bit like the 1970s. [00:17:53] Ben Meltman: Uh, I think what, I think the environment, uh, that we're in is almost like the 60s going into the 70s. Um, where, you know, you had some very large deficits build up post-Second World War, um, a long period of lowflation, policy makers getting very comfortable with that lowflation, and then feeling like there's no consequence to increasing those deficits even further. Um, and, uh, why not, let's experiment with this, you know, the most recent, uh, issue or crisis has been, no matter what we do, we don't create inflation, very similar to the 60s. Well, guess what, if you try hard enough, and if you combine, if you combine, uh, very aggressive monetary with fiscal in the same direction, you can get that done. And that's what happened in the 70s. Um, so I think both from a, uh, economic, from a policy, and as you highlight, social perspective, um, not too dissimilar at all. [00:18:57] Eric Schatzker: Why does it seem as though everyone is starting to freak out about inflation, when for the time being anyway, there still is none? [00:19:06] Ben Meltman: Yeah, um, not only is there none now, I don't think you should expect any, uh, in the near term, you know, in the next 12, 18 months, um, the kind of inflation I think we're talking about will take time to go through the system. Um, it's- Yet gold is at $2,000. Yet gold is at $2,000, because I think people who understand how the economic system works, the reasons why we've been in a low inflation environment for the last decade, um, can see where this is going. And what we're essentially doing is, um, is not only, look, I think a lot of people got very comfortable over the last decade by saying, look, we printed all this money in a QE environment. We had rates at zero, we had rates at zero, we did, you know, trillions of dollars QE, and we didn't get inflation. Therefore, maybe the system doesn't generate inflation anymore. One plus one equals five. And if there's no risk to inflation, why not address some of these issues of our current political system, let's spend, because over the last decade, we had very easy monetary policy, but pretty tight fiscal policy globally. The only exception to that was the last couple of years of the Trump administration, where that looser fiscal was married with tighter monetary policy. Um, we've never had monetary in this, in, in recent years, uh, we've never had monetary and fiscal policy row in the same direction. Um, and, you know, now, of course, as we look forward, we're not only have we really pressed the gas on the monetary side, but we've seen it unify with the fiscal side. And we've seen the, the government policy, uh, the fiscal agents, um, the governments, the treasurers say, well, we have these political problems. Let's just throw money at it. And the central banks will help us finance. And as you said, that feels very 1970s and that feels very dangerous. And even though that might not create inflation in the next six, 12, 18 months, that is a very different structural environment that we've been in the last decade. And that's an environment that will surely debase the value of, you know, of currencies, um, and will necessarily cause inflation versus real assets. [00:21:34] Eric Schatzker: Is the end of American exceptionalism, the end of federal reserve independence, the end of fiscal discipline, if there was any, uh, the end of inflows into the American stock market. Can that be expressed as simply crudely, if you will, as sort of a short U.S. trade in the years ahead? [00:21:56] Ben Meltman: Almost certainly, uh, in the same way that U.S. exceptionalism or the long U.S. trade, the dollar rallied, um, you know, just look what's happened for the last decade. And, and, and, you know, markets are, um, markets are, uh, not unlike, you know, physics, where, um, you know, everything has an equal and opposite reaction. And, um, you know, it's been an unbelievable capital flow into the U.S. over the last nine years, which responded where the, I mean, the U.S. equity market outperformed everything by, you know, by vast magnitudes. Um, you know, the U.S. credits saw unbelievable influence, U.S. private equity, U.S. venture capital, U.S. real estate, um, and the U.S. bond market, uh, and that all drove the dollar to very, very elevated levels. Um, and in this environment, for all the reasons we've spoken about, uh, I can absolutely see, um, you know, many, many parts, if not all of that, um, reversing. Because a lot of that was linked. I mean, even if you take private equity, you know, completely, um, you know, not something, you know, uh, we trade or, or look at. But why was there so much influence to private equity? Well, think about it. You had an ability as a U.S. private equity manager to raise unbelievable amounts of credit at unbelievably cheap levels into a rising stock market. Like, what better environment? And so all of these things are linked. And if you start to take away parts of those pins, other, you know, other parts of the structure will fall. [00:23:28] Eric Schatzker: Ben, discretionary macro has struggled, shall we say, as a strategy in the post-financial crisis period for the last decade or so. 2020 has been a better year. Tell me about the longer term outlook. [00:23:43] Ben Meltman: I mean, just think about the topics we've described here. You're talking about going from a, um, uh, a world that's almost had fixed exchange rates to one of fixed interest rates, allowing much greater FX volatility, loss of central bank independence, re-emergence of inflation. Um, you know, this is going back to the glory days. I mean, this is, you know, major policy mistakes, um, environments where policymakers cannot control the outcomes, uh, because imagine, you know, it's almost like the accelerated change in policy that we've seen since COVID is taking us back, as we've described, to the environments that, you know, that, that, that made macro great, uh, in terms of the, the, you know, as we said, the late seventies, early eighties, um, you know, before central banks kind of controlled, um, you know, the environment. So, um, if, if anything, I think if you look at the, uh, the outlook here, not only for the asset class or the strategy, um, but, you know, the, the volatility of the tradable assets that we, that we represent, I think it's, it's unbelievably exciting. [00:24:58] Eric Schatzker: Eric Ben, you talk about going back to the glory days of macro, the glory days of the late seventies of the eighties, the glory days that gave us Soros and Druckenmiller and Paul Jones. Does that mean we're going back to the glory days of macro returns? [00:25:16] Ben Meltman: Um, I don't see why not, to be honest. Um, you know, I, I think there certainly will be the opportunities there. I think investors will be able to choose from different profiles. I'm sure that there, uh, as there was last cycle with interest rates at zero, there's going to be a community of allocators who are going to want bond-like returns. Like, you know, everything that you saw in the last decade, I don't think it's fair to say it was all the macro hedge funds fault that, that returns went down. Um, because guess what happened after the 2008 crisis, there were large groups of investors who said bond yields is zero. I need a bond replacement. If you can make me four or 5% with very little to no downside, I'll do that in size all day long. Right. And so I think what's important is be honest to what you're trying to do. Be honest with your investors, have your investors be honest with you and work out together. What is your mandate and what are you trying to achieve? Um, because there are definitely going to be investors who are going to want bond or fixed income replacement. Let them have that from those funds that want to consciously provide that. Um, but are there for what you're asking me is, will there be opportunities for those who choose that path, uh, to make very significant double digit returns? Absolutely. There'll be that opportunity without any doubt. The twenties and thirties even? Absolutely. Boy. [00:26:54] Eric Schatzker: And here's this question. [00:26:56] Ben Meltman: I mean, when, when, when just, just to give you a sense, when you're talking about the kind of volatility that I expect in the most liquid markets in the world, um, you know, just, just, just, just to give you a sense, like go back to 2013 in Japan. Like, why was that such a phenomenal trade? It was such a phenomenal trade. Not just because the Nikkei moved a lot or Dolly and moved a lot, but it precisely because it was a Nikkei and Dolly-Yen because these were two of the most liquid markets in the world where Dolly-Yen moved what 40% and the Nikkei moved 50 plus percent, et cetera. The fact that it was such, you got those magnitude of moves in such liquid markets and with such liquid options markets, I mean, the P and L, uh, opportunities were off the charts. Uh, and I think when we're talking about the kind of things we've discussed today, you're talking about potential moves in things like the dollar, the Euro, um, you know, very liquid commodities, et cetera. You're talking about very big moves in very liquid products with very liquid options markets mean the magnitude of P and L you can take out of these markets, um, which certainly makes things like twenties and thirties very achievable. [00:28:11] Eric Schatzker: Um, what's likely to be your most unpleasant surprise? Something that you don't think is going to happen, something that you've discounted heavily that might actually turn out the other way. [00:28:28] Ben Meltman: Um, I mean, I, I think the most likely disappointment. Let me rephrase the question, um, I'd say the most likely disappointment to the big picture story we've talked about today would be, uh, that despite policymakers' best efforts, um, you only have just a bit of a Japanification story. Um, and you know, we've, uh, policymakers just get themselves into a, uh, very enlarged debt profile with nothing to show for it. Um, and that no growth, no inflation, and that debt burden over time has become disinflationary and bond yields, even the long bond just is stuck at zero, uh, for a very long time with no growth equity markets leak lower. Um, and it's just a horrific, um, uh, you know, if, I mean, and which will cause very negative reverberations because in that environment, um, you know, asset holders have bonds yielding no income. Um, equities suffering negative returns year after year, um, and, you know, uh, kind of a negative, uh, nominal growth profile, um, you know, that leaks closer to zero over time matching returns, you know, going to zero or negative over time because you've already pulled forward asset price appreciation over recent years. And so you have nominal growth trending towards zero as asset, um, returns 10 to zero or below, um, you know, and that's, that kind of Japanification potential into a heightened debt is, is, is clearly, is clearly the risk to the story we've talked about today. And so even though you don't see the next decade, I think there's still great ways to make money in that environment. Um, but that's a lot, uh, you know, I mean, it's, uh, that certainly has a potential to be, um, you know, I, I think from a political and social perspective in the U S what's very different in the U S I mean, that would be an environment to be horrific for contingent liabilities here. Um, when you talk about the, the states here, um, and the pension obligations and the kind of hurdle rates they need to keep that system alive. Um, I mean, fast forward that second story I've told you out four, five, seven, eight, 10 years and the unfunded pension obligations that would create. And you have a story of great social and political unrest on that sunny note, Ben, thank you very much. Thank you. It was great to have you here and good to see you as always, Eric. Great to be here.