This is an edited transcript of our podcast episode with commodities expert and top macro strategist John Butler. We discussed stagflation and how to play it, commodity supercycles, gold, bitcoin and the dollar, and risk management. While we have tried to make the transcript as accurate as possible, if you do notice any errors, let me know by email.
John’s Background and Career Path
Bilal Hafeez (01:24):
Now, onto this episode’s guest, John Butler. John’s a returning guest and a regular contributor to Macro Hive. In terms of his background, John has 25 years of experience in international finance. He served as a managing director for a bulge bracket investment banks on both sides of the Atlantic, in research, strategy, asset allocation and product development roles, including at Deutsche Bank and Lehman’s. He’s advised some of the world’s largest institutional and private investors, and he’s been ranked number one by Institutional Investor. His past publications include his popular Amphora Report investment newsletter and The Golden Revolution. Now, onto our conversation.
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This is an edited transcript of our podcast episode with commodities expert and top macro strategist John Butler. We discussed stagflation and how to play it, commodity supercycles, gold, bitcoin and the dollar, and risk management. While we have tried to make the transcript as accurate as possible, if you do notice any errors, let me know by email.
John’s Background and Career Path
Bilal Hafeez (01:24):
Now, onto this episode’s guest, John Butler. John’s a returning guest and a regular contributor to Macro Hive. In terms of his background, John has 25 years of experience in international finance. He served as a managing director for a bulge bracket investment banks on both sides of the Atlantic, in research, strategy, asset allocation and product development roles, including at Deutsche Bank and Lehman’s. He’s advised some of the world’s largest institutional and private investors, and he’s been ranked number one by Institutional Investor. His past publications include his popular Amphora Report investment newsletter and The Golden Revolution. Now, onto our conversation.
So welcome, John. It’s great to have you back on the podcast. I think it’s almost been a year since we last had you on.
John Butler (02:08):
Yes, thank you, Bilal. My pleasure.
Bilal Hafeez (02:09):
And we didn’t do last time was I didn’t get your origin story, so it’d be good to learn a bit more about your background, what did you study at university and was it inevitable that you’ll end up in finance and commodities as you later went on to do?
John Butler (02:23):
Well, it wasn’t inevitable at all. I think like many young people, I was not at all convinced what I wanted to do when I was a teenager, and so when I enrolled at uni in California in 1986, I was actually going to study for a degree in chemical engineering because I was fascinated by the natural sciences But oh, gosh, after a few months in the lab, which was populated by I think only one young lady, the rest were young men, and seeing all the young ladies out in the Los Angeles sunshine, reading their books on God-knows-what topic, I decided that I had to change what I was studying. And so I changed to economics, which is the sort of thing that you can mostly study outside in the sunshine while observing the scenery.
Bilal Hafeez (03:12):
I can kind of see how the pursuit of knowledge was your primary objective at university quite clearly.
John Butler (03:16):
Look, young men are as young men do. Anyway, so I ended up switching to economics, which to be fair, I’m laughing this up a bit, but I actually was truly, truly fascinated by it right from the get-go. And so I ended up majoring in that, and then I ended up getting a master’s in international economics and finance from a there’s a school run by both Tufts and Harvard called The Fletcher School, and they specialize in international interdisciplinary studies. I got a degree in international economics and finance and was on my way to what I thought was going to be a PhD. But the opportunity arose simply to go to Wall Street and join the party, as it were, and so that’s what I ended up doing. And that’s how I entered the business.
Why Stagflation is Here
Bilal Hafeez (03:59):
Okay, great. Good, good. I mean, let’s kind of move on to markets today, and perhaps we can start with your views on the current state of the world. So, we’ve had COVID last year, and we’ve had a whole series of lockdowns, we’ve had huge amounts of quantitative easing by central banks around the world. There’s much more fiscal activism as well, which is probably more than what we saw even after the Global Financial Crisis, and so there’s much more policy activism. We’re seeing signs of growth, of course, some signs of inflation as well. What’s your kind of view of the world?
John Butler (04:32):
Well, look, when COVID hit, I looked at it like everyone else looked at it at first, and I was frightened, right? We were all frightened at first. But when it became clear over the course of a couple of months that while certainly of great concern, COVID was probably not the doomsday bubonic plague that could have happened, I suppose, but didn’t. So I started thinking about, “Well, wait a minute. Okay. What does history tell us about when somewhat heavy-handed top-down measures are taken to generally restrict economic activity?” And it’s not rocket science, but basically what it does is it creates what I wrote up in my initial COVID piece – it creates a negative supply shock. The fact is even if you’re locked down, you’re still going to need food, you’re still going to need clothing, you’re still going to need shelter, and there’s going to have to be a way to make basic goods and services available to households, or else.
And so really, I felt that the biggest impact would be felt not on the demand side, (of course there’d be heavy demand) but on the supply side, where these measures would impact supply chains – they would create bottlenecks, they would misallocate resources in ways that really couldn’t be observed in real-time, only ex-post. And I concluded that it would be stagflationary because the stag part comes from the negative supply shock, but deflationary part would come from the fiscal and monetary expansion, which, as you just mentioned, was and is very substantial in a historical comparison.
So I mean, Milton Friedman, right? What is inflation? It’s too much money chasing too few goods, and I think that’s the situation we have now, or actually quite clearly ended up in. I know that a number of people are saying, “Oh, this is base effects. Oh, it’s transitory.” I disagree, and I’ve disagreed from even before it began. So, I kind of like to think that I have a better understanding of what’s actually unfolding now in the data than many of these people who are just using the same time series model that they’ve always used, notwithstanding these unprecedented disruptions.
The Problem with Large Fiscal and Public Spending Plans
Bilal Hafeez (06:56):
And we before we talk a bit more about the inflation side, because obviously, the most recent CPI data from the US and other parts of the world are showing certainly a big pickup in inflation, but on the stag side of your argument, we’re also seeing that GDP growth numbers are fairly strong and PMI data still quite strong. So while there certainly appears to be a strong case for inflation, the stag side, I think, is also quite an interesting angle that you have because not many people, I think, are looking for meaningfully weak growth. So maybe you can elaborate a bit more on that, on that side?
John Butler (07:32):
Well, the first thing I’ll say is kind of a cheeky dig at people who claim that this bounce, this growth bounce is so impressive. So let me get this straight, the inflation is merely a base effect, but the growth isn’t? I mean, you can’t have it both ways, and you need to try to look through it. Of course, we’re bouncing back. We should be bouncing back, and that’s good, right? That’s good. But when you place these things in context, the growth bounce is not as impressive as it appears. In the same way, yes, the inflation spike is partly due to base effects, but let’s be honest on both sides of this, okay? It makes for a healthier discussion.
However, thinking more generally than that, the fact is that I believe that when the public sector intervenes heavily in private sector commerce, it might mean well and have the best of intentions, but it tends to misallocate resources around the margins, and you never know where at the time. I mean, there’s been so much work done on this, it’s almost unbelievable. And if you want, you can go all the way back to the original socialism versus capitalism debate of the 19th century, Marx versus the German historical school versus the Austrian School. There’s a long, venerable tradition in this, which I guess today is kind of carried on by the Virginia or Public Choice school in the United States.
And again, don’t get me wrong. I mean, the motivations here can all be entirely genuine and lovely, but the fact is, when the public sector, be it war, be it plague, be it Great Society, be it whatever it is, tends to misallocate resources in the real economy in ways that aren’t necessarily easily observed. And so when I take a look at this, I mean, I’m not surprised, right? I’m not surprised. There’s a long, venerable theory behind the view that we’re not only going to get inflation here, as we see, but we’re going to get the stag.
The Moral Hazard of Fed Policy and Biden’s Fiscal Plans
Bilal Hafeez (09:38):
Yeah. Okay, that’s a good point. And then just on the public kind of intervention, I mean, to some extent that, I guess one question is in sort of the less public interventionist periods, say, before COVID or even before the GFC, there was a period of excess financialization, privatization of gain, socialization of losses, even at that period where there was less government intervention. At the same time, it wasn’t necessarily a free market in the pure sense either. So, is it that we have more public intervention today and is that necessarily worse than what we had before?
John Butler (10:12):
Well, this is the thing is that… I mean, Hayek, of course, who won the Nobel Prize in Economics for, among other things, his work on the potentially unnatural nature of business cycles. His most famous work, The Road to Serfdom, is as much a work on the dynamics of public economic policy as it is on economics itself. And basically, Hayek said, “Look, you might have some little intervention around the margins of the economy to try and solve what you think is some problem that needs a solution from the public sector, but that will create one or more unintended consequences, and then the public will clamor for the public sector to intervene to deal with those consequences.” And you get into this iterative cycle, each of which becomes larger than the one before and each of which requires a more heavy-handed public sector than before. And eventually, you end up… Well, he called it The Road to Serfdom. You could call it the road to socialism, call it the road to wherever, the road to hell, good intentions, right?
That’s what he’s getting at, and I think that’s kind of what’s happened. I would not for one second absolve the Federal Reserve or other central banks or other financial regulatory authorities from their role in, in my opinion, facilitating the moral hazard that has clearly infected our financial system over the past few decades. Greenspan himself is willing to kind of admit it now. Look at some of his recent interviews. If you ask him about Long-Term Capital Management and some other things, he kind of scratches his head and goes, “Well, gee. Yeah, maybe we shouldn’t have done that,” and I’m of that opinion too.
Bilal Hafeez (11:59):
Okay. Yeah, and just moving to some of the specifics. President Biden has announced the next wave of fiscal packages, which hasn’t necessarily passed Congress yet, but in some form is likely to. But within there, there’s elements of improving the infrastructure of the country roads, broadband, 5G, those sorts of things. There are some issues on the green side, then there’s certain measures on dealing with inequality, social care, and those sorts of things. I mean, on the surface, a lot of them have some validity. I mean, what’s kind of the case against those sorts of policies? It’s large numbers, $4 trillion overall.
John Butler (12:36):
Yeah, I think it’s kind of funny, right? When you start talking about numbers like that, they’re practically meaningless. So, let’s actually get into what you mentioned, which is kind of the detail a little bit. Look. COVID, not COVID, infrastructure, Green New Deal. You know what? Biden is kind of doing the physical equivalent of the pride flag. I mean, there’s every color. There’s something for everyone, and I mean, it might make good politics, but the fact is you eventually run out of free ice cream, right? You can’t provide it for everyone, and I think that Biden is playing a political game, and it’s one that, to be fair, politicians since time immemorial have over-promised and under-delivered. I mean, Biden’s been in power long enough. He’s seen this game play for a long time. I mean, he’s just doing what he’s learned along the way, in my opinion.
Don’t get me wrong, I think there’s lots of stuff in there that is absolutely sensible, but there’s lots of stuff in there that is just pork. And again, it goes back to this question: When you re-enter the real world, and you’ll get away from this Lala-Land of having a blank cheque that can be 4 or 5, 6 trillion – obviously, the government will always go for the upper limit of that blank check. It’s a blank check. That’s the point. Is that really what makes for a healthy long-term sustainable growth path of businesses investing in the plant, property, equipment and infrastructure that delivers the real goods that people really want at prices they can really afford, or is it all just a product of distortions and subsidies and temporary this and that, that dislocate and distort the capital stock? I think we take some of that stuff for granted, right? There is an important place, even in the most advanced economies in the world, there’s an important place for individual actors to take voluntary action, put their own savings and investments on the line, take risks, and see what happens. The moment the government has your back, who the hell knows what’s going to happen?
Bilal Hafeez (14:47):
That’s a fair point, and I’ve been doing some research into effectiveness of fiscal policy, and one of the things that really stands out is it’s not so much the amount of money that you spend, it’s the execution side that matters the most. And in the case of the US, there’s all sorts of problems around execution, between the difference between federal, state, local and the need coordination between those. You also need coordination across time. Lots of these projects require 5, 10 year planning horizons, and often politicians can’t plan on those horizons, so they end up stuffing all the money into a one year horizon and it ends up going into things that don’t make any sense, and that’s often why some of the East Asian countries tend to do better with public money than the US.
Why Was Inflation Low After the Global Financial Crisis?
Bilal Hafeez (15:27):
But now moving on to the inflation side. I know you have very strong views on this side. One kind of question I have for you is after the Global Financial Crisis in 2008, there was huge amounts of money printing – expansion of the central bank balance sheet, I should say more precisely. But we didn’t really see inflation take off until the COVID period. Why do you think that was the case?
John Butler (15:48):
I think it’s a combination of reasons. First of all, the financial crisis hits at a time when the global economy had been running with structurally low interest rates, real interest rates for a number of years, and I’m talking in particular about China and some of the emerging markets who were clearly following mercantilist export-led growth policies, and building capacity based on that with very, very high domestic savings rates. And once upon a time, Greenspan referred to this as a conundrum, right? How can it be that long-term interest rates are so low? Well the fact is, is that the world was happy to save a lot because their leaders told them that was the right policy. I mean, let’s not belittle this. And again, there’s a silver lining here.
The fact is, during the last couple decades, anywhere from between 1 and 2 billion workers have entered the global economy. That is a huge number. These were people who spent their whole lives on the farm. They were never in a position to trade anything other than basic foodstuffs, clothing, shelter with anyone else, and over the past couple of decades, 1 to 2 billion people, it depends how you measure these things, have entered into the global economy. They are part of the global value add chain, be it manufacturing, services, tech, you name it. Okay. Now, that’s a good thing. However, again, going back to the whole subsidy angle, the fact that China and others followed export-led growth policies meant that when 2008 hit, we had excess capacity.
We had excess capacity for a very, very broad range of consumer goods. We had excess capacity for basic production of oil and other forms of energy, and so yes, you throw a lot of money around and the money absolutely, positively stabilizes the financial system. That was the point. Well done, guys. Take credit and whatever. But what it did not do is it did not, at least not in a short period of time, remove that overcapacity issue. So, inflation remains extremely low, to the extent that people are spending money. They’re spending it primarily because, well, they have it. How do they have it? They have it because they are increasingly borrowing against their existing assets at low interest rates. So, people that already had big property portfolios borrowed against their property at low rates to acquire more. People who already owned profitable businesses borrowed against those businesses assets to acquire new businesses. The net effect that you saw during that decade post-2008 was actually not about adding new capacity at all, it was about concentrating the wealth and the capacity in fewer hands, hence why we’ve seen a general rise in inequality over that period of time. That’s not inflationary. Not at all.
However, fast forward to the present, this time is different. This time, COVID didn’t show up with an overcapacity problem. COVID showed up when the global economy was pretty much firing on all cylinders, was starting to add new capacity, new capex. All these things were hot, hot, hot before it hit. So, it’s very, very different now, and to the extent you are throwing money around, which of course, as you pointed out, we’re throwing a lot of money around, it will get traction now. It will not just flow to those who are in a privileged position to borrow against assets. It will flow to your average everyday household, small business, you name it. They will spend it, it will pump up demand and it will meet the supply constraints we met with earlier and it will lead to surprisingly sharp spikes in realized inflation, both headline and core. Sure enough, it’s happening now.
The Absence of Excess Capacity and Parallels to 1970s
Bilal Hafeez (19:56):
And when you say higher inflation, say, CPI, if you just think headline CPI, on average, it’s hovered between 1.5%-2% during the GFC period. Recently, it has gone up towards 3.5%-4%ish. But on an ongoing basis, do you think we’re going to stay around 4%-ish for the next few years, are we going to go up to 6% or 7%? I mean, do you have kind of a sense of the types of numbers we could see?
John Butler (20:21):
To be fair, many people thought would happen to some degree. They may not have thought it would rise by as much and as quickly as it did, but pretty much everyone thought as a result of both base effects and just general economic activity picking up, we would see an inflation spike. The big debate, of course, is whether or not it’s transitory. The mainstream currently holds the former position. Now I hold the latter, and the reason why is because I believe, as just discussed, we no longer have this excess capacity issue, number one. And number two, which I think is lost on the mainstream of the economics profession, is that there have been very, very significant structural changes in the global economy over the past few decades which are not easily captured with time series analysis.
Now, many years ago when I worked as the macro strategist at Dresdner Bank, I had the pleasure of working with the economics team very closely. And two members of that team, they specialized in structural topics – their job wasn’t to forecast next quarter’s GDP or inflation or whatever, their job was to try to identify those interesting structural developments that might be of longer term interest to investors. And those two economists, by the way, were David Owen and Dylan Grice, and I learned a hell of a lot from these guys. And they’ve had very distinguished careers. In any event, one of the things they taught me was that if you live in a world like we do, and you’re an investor and you’re trying to get an edge – well, if you simply discover the same signal everyone else is discovering, you don’t have an edge. But, if you discover the noise and find that the noise is going to be persistent noise, there’s going to be some persistent noise in the data, some structural shift, and you position around that, wow, then you can really make outsized returns over a sustained period of time.
And so, I worked closely with David and Dylan to develop ideas, thematic structural ideas in this way. And this is where I think the economics mainstream is simply wrong with this current transitory understanding of what’s happening, and it’s this: back in the ’70s when we had the oil shocks (which an answer to the devaluation of the dollar; OPEC decided they didn’t want to be paid in devalued dollars so they were going to collectively push up oil prices and make sure that real returns on their production remained at a satisfactory level), we also had food price shocks and all kinds of shocks rippling through the global economy. Let’s not forget, food is a very energy-intensive industry. And so, what ends up happening is you get this so-called wage price spiral.
Okay, so here you are, be it in Europe or North America, input costs go up, food and energy costs go up, and workers see this and say, “Well, hey, we’re going to demand higher wages,” and they’re unionized and they’re organized, and so by the late ’70s of course, we get into this wage price spiral, and eventually of course, Volcker pulls the plug on it as we know. However, nowadays everyone says, “Oh. Well, we don’t have the rates of union membership now. Oh, wow. Gosh, here in the West, we’re no longer manufacturing-based economies. We source it all from low-cost labor and China, and who knows where.”
Well, okay, that sounds nice on paper, but wait a minute. If you go to China, and you take a look at what’s been happening to wages, they’ve been increasing very, very rapidly in recent years, and now you have this huge spike in energy and food prices occurring in this context where workers’ wages have been rising already. You can’t tell me that the marginal worker in these, subsistence economies are not going to demand higher wages so that they can afford basic food, clothing and shelter for their families.
I mean, they don’t care about being able to afford going to the nail salon, okay? They want basic food, clothing and shelter, and if they start getting squeezed, they will demand higher wages, and it doesn’t matter if they’re part of a union or not. You don’t need a union to tell people to demand higher wages when their kids are starving. It doesn’t work that way, okay? They just do it. And I think that’s kind of what we’re missing here. The global manufacturing base over the past 25 years has migrated to these subsistence emerging markets, and good for them. I mean, I think it’s great. Why shouldn’t they have entered the global economy? Why shouldn’t they be productive? However, they’re going to demand higher wages when they get higher food, clothing and shelter costs. I think it’s a no-brainer.
And so, this idea that there can be some magical disconnect between the cost of labor in these economies and the cost of their subsistence is to me just so wrong. To me, it suggests that we in the West, in the developed West, developed countries in general, have just become disconnected from where this stuff comes from, right? I’m going off on a bit of a tangent here, but just ever so briefly. Kind of in the same way, that sometimes people who drive a Tesla or other EV don’t even begin to think about whether that electricity is coming from a coal plant or a nuclear plant. Let’s face it: Probably 90% of the stuff we consume day-to-day, that is imported from the rest of the world, emerging markets, etc., probably 90% of it, the energy behind it was coal and nuclear.
Now, okay, fine. You can still claim that you’re consuming green, whatever it is, but you’ve got to look beneath the floorboards, you have to look behind the curtain before you can truly make a fully reasoned judgment. So, the same sort of mentality, I think, which doesn’t connect EVs to their actual energy sources is the same sort of mentality that does not connect the prices of our manufactured imported goods to wages for these hard-working emerging market laborers.
The Less Obvious Places to Play A Stagflation Theme
Bilal Hafeez (26:42):
Yeah, point’s kind of well taken. I suppose one thing that people do talk about in this context is that wages could increase in places like China, or even the US and such, but at the same time, profit margins are very high for companies. So, could they just reduce their profit margins and kind of absorb the cost, and not sort of pass on higher prices to the consumer? So, inflation is going to appear in the supply chain, but not at the final consumer’s price points?
John Butler (27:11):
I think that’s an important point, and I think this is where, really, if I were going to pay someone to inform my investment strategy in this sort of environment, I would pay someone to try and sort the bottlenecks where pricing power will remain persistent as we go through this and those places where, as you say, margins will kind of be absorbed. The fact is corporations will not allow their margins to tighten if they can get away with it with pricing power, right? They won’t. I mean, they’re profit maximizing. So, I think you’re right. I think are areas where margins will take the hit, and then okay, what’s the implication for investment strategy? Because anywhere you look right now… Equity analysts, they look at the situation and they’re like, “Oh. Well, profit margins are healthy, growth is strong, yada, yada, yada.” Well hold on. I mean, the moment profit margins start coming down, what’s that going to do to your implied forward P/E? What’s that going to do to your enterprise value to EBITDA?
Oh, gee. By the way, we have record corporate debt on the books vis-à-vis assets vis-à-vis profit. How’s that going to work out for you, especially if interest rates rise even a little bit as a result of slightly higher inflation? You can’t have your cake and eat it too, right? I fully accept that there’s going to be some give and take here on the margin versus cost pass-through. Anyone who can, again, sort the wheat from the chaff there – see where the bottlenecks are, see where the margins will compress, where they won’t. I mean, that’s the holy grail from where we are right now. However, if you’re a general macro investor and you don’t have that game plan at hand ready to go, what do you do? Look, you simply emphasize value over growth. You emphasize food, clothing, shelter, your basic industries and infrastructure over tech growth, whatever it is, a source of the higher growth expectations, and you get defensive.
I mean, it’s not rocket science. Again, I would love to do the rocket science, believe me, and I think that’s where the work should be done now, but the first thing you do is you just retreat. Retreat back to what worked in the ’70s. Now, I know tech was only a small part of the economy in the ’70s, but you can parse it out of the SPX if you want to in the US, and guess what? Tech was unambiguously the worst performing sector in the US during the stagflation. Why? Because businesses just didn’t have the excess funds to invest in future efficiencies and future productivity. They were just trying to survive. They were just trying to keep margins where they could year-to-year, month-to-month, day-to-day. I think we might be about to go through that again.
Is there A Commodity Supercycle?
Bilal Hafeez (30:07):
No, point’s well take. I think you make a really valid point about emphasizing the importance of the kind of the messy real economy, food, energy, and just the basics, and I think often economists forget about there’s a real world out there. And, of course, over the past 12 months or so, we’ve seen big, big increases in many of these commodity markets. Oil price have gone up a lot from negative to above $70 today. We’ve seen all sorts of agricultural prices go up, copper, iron, all go up a lot. What’s your view on some of these commodity trends?
I mean, presuming this is part of what you’ve talked about before in terms of the fact that we don’t have excess capacity. We’ve had a lot of stimulus as well. There’s been some sort of supply chain issues. So, one is what’s your kind of current view of some of these trends, and a related point is many people are talking about supercycles in commodity markets although we’ve seen big percentage change increases in these markets. I mean, is this just the beginning of some kind of multi, even a decade long increase in these commodity markets?
John Butler (31:13):
Right. Well, look, the whole supercycle idea is one that I’ve written about in the past, and look, commodity prices do occasionally go through prolonged periods of rising prices. This is absolutely true. However, I think almost a better term for the supercycle is the semantic cycle because it really, really depends on how you define it. What does supercycle mean? Why are higher prices necessarily a supercycle, and what is meant by that? The funny thing is this, is that back when the supercycle was all the craze and this goes back to what we kind of already talked about, when emerging markets were following a mercantilist export-led growth policy for many years. I mean, yes, of course. I mean, they were building their infrastructure. They needed steel, they needed concrete.
Bilal Hafeez (31:59):
And this was the 2000s, I guess, was the poster boy of this supercycle?
John Butler (32:04):
Well, I mean, this is when Jim O’Neill comes up with term. As I recall, Jim O’Neill was the first one to use it and to bring it to prominence. In any event, when you look at that it’s like, “Well, yeah. Of course. Why shouldn’t commodity prices have gone up?” But there’s something very curious about it, and this is something that David Stockman, former US Budget Director under Reagan once said, he said, “The cure for high oil prices is high oil prices,” and what he means by that… And you can extend that to commodities generally, the cure for high commodities prices is high commodities prices. What he meant was if you just let the economy work its magic, high prices will stimulate new capex and investment in producing whatever the underlying is: oil, food, you name it. And that’s to be expected. Nothing goes in a straight line and things do go in cycles. And so, when you have the supercycle, as Jim O’Neill and others called it back in the 2000s, believe it or not, this is what I was getting at earlier, you wouldn’t imagine how much capacity was responding.
Keep in mind, for reasons that were related to the dot-com bust in the US in the late ’90s, early 2000s, and also the deflationary or at least disinflationary impact of 1 to 2 billion new workers entering the global workforce at the time, Greenspan holds rates low and talks about a conundrum and this and that. This is what was going on. That stimulated the capacity response to the general price increases in commodities. So that when 2008 arrived, you actually had excess capacity. So where are we today? Is it a new supercycle? Have we soaked up all of that excess capacity? Well, I mean, obviously. The fact that I’m an inflationist now, I see it coming. I have a lot of sympathy with that view. However, is it truly a supercycle?
Okay, how do you define supercycle? I’ll do it for you right now. Do industrial commodities generally outperform the price level as maintained by precious metals or not? If it’s truly a structural growth phenomenon, wouldn’t you expect industrial commodities prices to outstrip precious metals? Guess what happened in the 2000s? They didn’t. The fact is gold and silver kept up. I mean, there’s noise in there, of course, but they basically kept up. If it were truly an industrial commodities supercycle in which capacity could not keep pace with demand, there’s no way in hell, in my opinion, industrial commodity prices would have failed to outperform precious metals. But they did. So, was it really a supercycle? Depends on how you define it.
The Future Path of Gold
Bilal Hafeez (34:52):
That’s a very good point, yeah. And I guess that brings us on to sort of gold then and gold is kind of at the intersection of the general commodity story and also a monetary debasement story. How do you think about the drivers of gold?
John Butler (35:08):
Well, I generally think that gold has three main drivers. There are also structural and exogenous factors, but let’s focus on those three at first. Everyone seems to agree, and I certainly agree with this, that long-term real interest rates are the single most important factor. That is, after all, the long-term real-time value of money, and so a stable monetary commodity such as gold should naturally have a very strong relationship with that in the medium to long-term, and it does. Then there’s the long-term cost of energy. The fact is, is that notwithstanding the potential promise of various renewable green energy… Look, if you want to get gold out of the ground, you’re going to have to use oil. I’m sorry, there’s just no other way around it. And I mean, anyone who knows the first thing about precious metals mining knows that the single most important thing in terms of digging a big hole in the ground, be it shallow and wide or deep and narrow, is to have enough local power available, and you got to build a power plant. There’s just no other way to do it. And that power plant is overwhelmingly going to be oil and gas powered. That’s just the way the world works.
Anyway, so gold also has a relationship with long-dated oil prices for that reason. And then there’s a third factor, which I think is harder to model because it has a lot more to do with human sentiment – and this is the risk aversion angle. The fact is, that everybody wants to make money, and if they can make money quickly and easily liquid within their institutional mandate, they’ll do so. And as a result, the overwhelming bias in the investment management industry, public and private, institutional and retail is basically to punch around in the equity market and try to get all the gains you can before you decide to get defensive for whatever reason, think things are overvalued, think your crisis is coming. You really do not look at gold. You just don’t. As long as you’re willing to take risk, gold is the last place you’re going to look.
And so, unless you have elevated risk aversion, low real interest rates and high energy prices actually are not enough to really propel gold higher. You need to have all three in place, right? Low real interest rates, higher energy prices, and elevated risk aversion, and we just haven’t had that mix really, except briefly some months back. And until we get it again, I think gold will struggle to break out of where it currently is.
So I’m basically saying that à la the second half of the ’70s, the early ’80s, not only do you need central banks to still be following negative real interest rate policy, which they are and I think they’ll continue to do, not only do oil prices need to be creeping higher, which they are and I think they’ll continue to do, but you’re going to need risk aversion to return to some sort of elevated level, which I think it will, but I mean, who am I to predict human nature in sentiment? But I think it’s out there. And when that happens, gold has a lot of upside potential. Look at the ratios. Look at the gold price versus money supply growth, look at the gold price versus debt growth, look at the gold price versus almost any reasonable measure of how much liquidity is sloshing around out there, and I think gold can ratchet higher by order of magnitude if people get frightened now.
Bilal Hafeez (38:49):
Okay, so I can tell from what you’re saying is that sort of structurally, you are bullish on gold, but from a timing perspective, at least one of the three things you’ve mentioned isn’t in place, which is the risk aversion. Two of them are, oil and the low real rates, but you do need risk aversion to kind of kick in and that will be kind of a really important trigger for the big move up.
John Butler (39:07):
That’s right. And keep in mind, gold has this bizarre binary response to risk aversion. Go back to 2008, when things started to go badly wrong, everything sells off because everyone simply needs to raise liquidity to reduce leverage, pay down debt, etc. It’s either that or close up shop, and of course, nobody wants to do that. And so gold is sold off with everything else, but the only gold that is sold off is the gold that is highly leveraged and gold simply does not lend itself to the same degree of leverage that the bond market does, that the credit market does, the equity market does. It’s not as big, and it’s not, in my opinion, as open to general speculation. Why? Well, there’s no carry trade in it, right? There’s no carry trade.
Who in their right mind is going to sit on gold for a decade and try to make it as a hedge fund? It’s not going to work. Whereas if you can find a way to sell it all, clip your credit coupon, leverage up on your 20 basis points spread, whatever it is, oh, gee, how nice. You make returns every month, then you get big inflows and earn fat fees, and you’re retired before you’re 40. Gold’s not like that, okay? So, I think that’s kind of what happened in 2008. The levered gold was taken out along with everything else, but what was the first asset to recover? Even in the midst of all the mayhem, October, November, December, guess which asset totally reversed course and started going up again.
It was gold. Gold was months ahead of everything else, months, and by an order of magnitude. Again, timing is unclear, but I think that general dynamic is likely to play out again. If we do get a sudden onslaught of risk aversion, which I think is inevitable, I don’t know when it’ll happen. I do think in the initial wave, gold will sell off with everything else. Leverage gold will have to sell off, but then gold will be right back in the bullish driver’s seat again long before the smoke clears for any other material asset.
Bilal Hafeez (41:18):
And what about silver? I mean, in my mind, I just often think of silver as kind of a high beat to play on gold. I don’t really think of additional factors for silver, but maybe that’s incorrect.
John Butler (41:27):
There are several things I think are important to understand with respect to silver. First of all, silver and gold are not the same. The gold market is huge. There’s a huge underlying bid. That underlying bid is cross-cultural, cross-dimensional. It’s almost hard to imagine just how much fundamental demand there is for gold through time, through space. Silver is very, very different. Silver is a very fickle market. Sometimes silver is trendy, sometimes it’s not, sometimes silver finds a new industrial use such as photovoltaic properties, biomedical properties that suddenly boost demand, but then, hey, you might end up with a surplus when some new technology comes along. So, silver’s carried along with all kinds of trends, and yet it’s a very, very thin market. And so, I think the best way to approach silver is not really just a gold beta, although that’s part of it.
The best way to approach silver is to say, “Okay. Look, silver is a special metal, it has special properties, money isn’t really one of them anymore, however, but it’s a store of value,” and so if silver looks cheap versus gold in a historical comparison, and you believe that some of these new industrial uses are going to continue getting traction, then by all means you should be invested in silver, and indeed, arguably overweight silver if you’re properly convinced of that. But keep in mind silver has asymmetric volatility vis-à-vis gold. Silver’s volatility vis-à-vis gold to the upside is roughly two to one, on the downside roughly three to one. And keep that in mind when you’re punting around. Three to one is a lot and so just keep in mind it is asymmetric that way, and you have to manage your risk according to that asymmetry vis-à-vis gold.
Why Bitcoin Won’t Replace the Dollar (or Gold)
Bilal Hafeez (43:25):
Now I did want to round off our conversation by mentioning the C-word, crypto. Of course, many people now are viewing crypto as digital gold is a common view of it. I know the view is as kind of a disruptive tech innovation. Some people view it as an alternative to the US Dollar, so there’s all sorts of different ways people are looking at Bitcoin, but a large part of it seems to be around some implicit comparison to gold, that you have a scarce resource, Bitcoin, and there’s kind of a network effect, people believe it has value and so it will just go up in the same way as gold would, but it will replace gold because it’s digital. So how do you kind of think about, say, Bitcoin?
John Butler (44:10):
Well, look. I mean, I’m an admirer of blockchain as a concept, and indeed, I started writing about Bitcoin and blockchain in 2014. A friend of mine, fund manager, Detlev Schlichter, he told me over lunch once, he’s like, “John, this Bitcoin is an extremely elegant technology,” and I couldn’t agree more. I mean, it is. However, is that elegant technology well-suited to use as money? And this is where I disagree. I don’t think it is. I think that money, that is a store of value, should not have, heavily negative carry cost, and best I can tell running the numbers, Bitcoin does. And that negative carry cost is happily worn by speculators, but would it be happily worn by people who would regard it as a long-term store of value as a real money? I don’t think so.
And so, I think while Bitcoin represents a fascinating monetary experiment, and indeed, the educational value of Bitcoin is immeasurable. The number of young people, or old people for that matter, who’ve come across Bitcoin and thought about, “Gee, why couldn’t this be money? Maybe it should be money. Maybe fiat currencies aren’t the end-all be-all. Maybe this is a nice alternative. Gee, what should money be?” These are all good questions we should all be asking, and if Bitcoin stimulates that debate, great. But I don’t think Bitcoin will establish itself as a true long-term store of value. I just think it’s too expensive to maintain the network. And again, the miners are happy to wear that as long as they are getting their seigniorage income as they grow the network, but the moment that peters out, and watch out, I’m afraid that Bitcoin will ultimately fail to gain that widespread store of value acceptance. Digital assets, I think, on the one hand, it’s a very clever idea in principle. Why shouldn’t we tokenize things? But the things still have to be things and Bitcoin’s not.
The Importance of Risk Management
Bilal Hafeez (46:22):
No, that’s great. Well, I mean, that’s excellent macro discussion. I did want to end with a few more personal questions. One is a new question. I’m asking my guests now, which is what’s the best investment advice you’ve ever received from somebody?
John Butler (46:34):
I think the best investment advice I ever received was that any investment process should begin, not end with risk management. That is, you actually have to have a very clear idea of what risks you’re taking, and how those risks will be managed. Before you originate and execute or act upon any actual idea, you need to have that in place. Let me give you some numbers. Now, this is based on survey data. I think it goes back to the old… Oh, gosh. Back in the day, the old Merrill Lynch investors survey. I’m trying to recall when this was. They asked investors in a survey, “Roughly what percentage of your positions do you expect to outperform? Winners versus losers,” and it’s amazing where this comes out, right? I mean, basically it comes out less than 60%. So, the fact is, is that professional investors fully expect that an awful lot of what they do is not going to work out, and if they can simply keep it above 50%, well you know what? You’re doing all right. Okay.
However, and this is the other part, of that doing better than 50%, it’s really only 20% of the overall number of bets that deliver that outperformance. 80% are neither here nor there, or they actually go against you. So, let me get this straight. You’ve got 20% winners just to squeeze out slightly more than 50% returns. When you start looking at those numbers very, very carefully, what you realize is this: the difference between holding above that 50% or falling below it actually comes down more to risk management than idea generation. Don’t get me wrong. I’m an idea generator. I generate ideas all day long. I mean, it drives my girlfriend, my children, my friends nuts, but that is not what really gets you over the line, right? So, the best advice I ever heard was that you have to start and finish with risk management. Idea generation is essential, don’t get me wrong, but it’s really not what is going to allow you to outperform in the longer term in a way that is acceptable in risk terms.
Bilal Hafeez (48:58):
I think that’s a really good piece of advice. I mean, I remember years and years ago, I was working with a prop desk, and we were kind of trying to work out who directionally was really good, and what we found in the end was almost half the PnL of the prop desk was entirely due to risk management and money management. And we tested it by just randomly selecting positions for different traders, so whether it was long Euro, short Dollars, long S&P, short… And with some trader, it didn’t matter what position they inherited, they could make money from that position just by their money management skills. So, there’s a lot to be said for that, and it’s a really important point. It’s somewhat less glamorous in some ways than coming up with the big idea, and I think that’s one of the reasons it’s not emphasized enough, but it’s something that’s super, super important.
John’s Productivity Hacks and Book Picks
Bilal Hafeez (49:40):
Now, the other question I wanted to ask was more kind of around personal productivity and managing information. We’re in an era of information overload. Social media to just everything’s available digitally, so it kind of spreads and multiplies. I mean, how do you filter or manage the information flow?
John Butler (49:58):
Yeah, I do have a method for that, believe it or not. Now, the danger, of course, that we all face in this era of ubiquitous social media, etc., is the echo chamber. And it’s only human nature to be around friends and acquaintances with whom you more or less agree with. That’s just human nature. However, that is not how you stay informed. You stay informed by continuously exposing yourself to that with which you disagree. However, I do believe it’s also important to expose yourself to that with which you disagree that is nevertheless from credible, reputable, reliable sources, and so I have personally, in terms of my feed, that is the things that I follow, I kind of have a very eclectic approach. I deliberately follow sources with which I disagree with the bias, disagree with the orientation, because I want to be exposed to it.
But I have a three strikes and you’re out policy, and this is true both of sources that are ideologically aligned with me, as well as those that are not, and it’s the following: If you’re wrong, you need to admit it, own it, and explain it. And that’s the first one. The second one is if you don’t own it, explain it, admit it, then you sure as hell better get the next prediction right. And the third strike is, if you were wrong, if you didn’t own up to it, and you’re wrong again, then I switch you off because at that point, I’m not learning anything, I’m just being distracted. It’s not helpful anymore. So, I’m more than happy to countenance, oh my God, just about anything, but that’s kind of my modus operandi with respect to how I select my sources, who I follow, etc.
Bilal Hafeez (51:54):
That’s great. That’s very useful. And final question, which books have influenced you the most, either kind of in a work context or even personally as well.
John Butler (52:01):
Look, this is going to bore you a little bit, but I’m a bit geeky when it comes to the Austrian School of Economics. So you know that I’m a big fan of the Austrian school, and I know that not everyone is and that’s fine, but even if you’re not an Austrian, it’s kind of difficult to deny the profound influence they had on economics for a sustained period of time. I mean, things we take for granted, right? The idea of a natural theory of interest, that was Frank Fetter; the idea of opportunity costs in terms of savings and investment as well as other areas of economics, that was Böhm Bawerk; predicting the inherent flaws of centralized command economies, that was Hayek and Mises. Anyway, I could go on and on.
There’s a more recent book called Money and Magic by Hans Binswanger. It is one of the most profoundly eye-opening books on economics I have ever read, and I only read it about six years ago. It basically does something that you just won’t believe: It analyzes Goethe’s Faust, arguably the most famous play in the German language, Goethe’s Faust Part Two, and analyzes it from a modern economics perspective. And it is just astonishing how much of our modern world, good and bad, Goethe predicted in detail, in some cases, way back in the 19th century.
Bilal Hafeez (53:37):
So that’s all this stuff in Faust about printing, gold and inflation, and things like that, all those sort of segments of the story?
John Butler (53:44):
But there’s much more detail. There’s much more detail. It’s not just superficial. You’d be amazed how much detail there was. And of course, people scratch their heads like, “Well, wait a minute. Goethe is the German Shakespeare. What on earth is he opining about economics in detail? What’s going on here?” Goethe was also the finance minister of the German government. This guy was pretty savvy, commercially, financially, economically, monetarily. And it’s also very curious that Part Two of Goethe’s Faust was only published posthumously. He didn’t allow it to be published in his own lifetime perhaps because he thought it might impact his social standing à la Greenspan didn’t want to come out as a gold bug while the party was still going. Just fascinating book, I highly recommend it.
Bilal Hafeez (54:31):
Yeah, I’m a big fan of Goethe actually. I think he’s like one of those true renaissance men, so very good. So that’s excellent. I mean, we’ve had really wide-ranging discussion from talking about the ’70s to Goethe to Bitcoin and so on. So, it’s always great to have you on. Now, if people wanted to follow you, what’s the best way people follow you and your thoughts, and so on?
John Butler (54:53):
Well, as you know, I’m a regular contributor to Macro Hive, so my work can be accessed there. I also am an occasional contributor to a handful of other websites, occasionally a newspaper, op ed, whatever it is. I don’t have my own website, but I do have a Twitter handle which one can follow, which is ButlerGoldRevo, GoldRevo being sort of an abbreviation of my book, The Golden Revolution, the revisited edition of which is still available on Amazon. And for those who are interested in these ideas, they’re more than welcome to have a look at what I’ve written, and I appreciate any and all interest in these topics.
Bilal Hafeez (55:33):
I’ll include a link to your Twitter account and also to the book as well in the show notes. So, with that, just thanks a lot, John. It’s always great speaking to you. You always have very strong views and they’re very well thought out, so I really do appreciate our conversations.
John Butler (55:46):
Well, I appreciate it too, Bilal. Thanks for the time.