Asset Allocation | Equities | FX
This is an edited transcript of our podcast episode with Gavyn Davies, published 12 May 2023. Gavyn is a Founder and the Chairman of Fulcrum – a $5bn independent asset management firm. Prior to Fulcrum, Gavyn was Chairman of the BBC from 2001. He joined Goldman Sachs in 1986 and became Partner in 1988 when he also became the Chief Economist as well as Chairman of the Research Department until he left in 2001. Gavyn was a member of H.M. Treasury Independent Forecasting Panel (1992-1997). He joined the Government’s Policy Unit as an Economist (1974) and was an Economic Policy Adviser to the British Prime Minister (1976-1979). Gavyn graduated in Economics from Cambridge in 1972 followed by two years of research at Oxford. In this podcast, we discuss the difference between public and private sector economics, whether governments should listen to markets, what explains low productivity, and much more. While we have tried to make the transcript as accurate as possible, if you do notice any errors, let me know by email.
Welcome to Macro Hive Conversations with Bilal Hafeez. Macro Hive helps educate investors and provide investment insights for all markets, from equities to bonds to FX. For our latest views visit macrohive.com. Before I start my conversation, I have three requests. First, please make sure to subscribe to this podcast show on Apple, Spotify, or wherever you listen to podcasts. Leave some nice feedback and let your friends know about the show. My second request is that you sign up to our free weekly newsletter that contains marketing insights and unlocked content. You can sign up for that at macrohive.com/free. All of these can make a big difference to me and make the effort of putting these podcasts together well worth the time.
Finally, and my third request is that if you are a professional or institutional investor, do get in touch with me. We have a very high-octane research and analytics offering that includes access to our world-class research team, our model portfolio, trade ideas, machine learning models, and much, much more. You can email me at firstname.lastname@example.org or you can message me at Bloomberg for more details. Now onto this episode’s guest, Gavyn Davies. Gavyn is the founder and chairman of Fulcrum, a $5 billion independent asset management firm. Prior to Fulcrum, Gavyn was chairman of the BBC from 2001. Before that he had joined Goldman Sachs in 1986 and became partner in 1988 when he also became the chief economist, as well as chairman of the research department until he left in 2001. Now onto our conversation. So greetings and welcome Gavyn. It’s great to have you on the podcast show.
Gavyn Davies (00:01:32):
Thank you, Bilal, and it’s a privilege to be on. Congratulations on making your podcasts essential listening for me every weekend. Dominique’s phenomenal, by the way.
Bilal Hafeez (00:01:43):
Great, I appreciate that and I agree on Dominique as well. But before we get into our conversation, I do always like to ask my guests something about their origin stories. It’d be great to learn a bit more about your background, what you studied at university. Was it inevitable you’d end up in finance and then public policy as you had over your long career? Tell us something about your story.
Gavyn Davies (00:02:05):
Thanks, Bilal. It was a longstanding ambition to be an economist, so I think I was always likely to do that even from being a teenager. I studied economics at Cambridge St. John’s, and then I did graduate work at Bayley Oxford, and I started out then as a professional economist in the government in Number 10, working for two prime ministers in the late 1970s. And in the eighties I moved into the financial markets. And in those days there were not many of us actually professional macroeconomists in the market. So I had an early start, early mover advantage, I think in the markets and was at Goldman Sachs from the mid-eighties to the early part of this century, built the macroeconomics team with many other wonderful colleagues, all of whom have gone on to incredible things in hedge funds and government, et cetera. And early after the turn of the century I decided, like a lot of Goldman people, that I wanted to do a public service job. It was slightly off centre.
I became the chairman of the BBC, the British Broadcasting Corporation in the UK. Did that and fell out with the then Blair government rather seriously, and resigned over the coverage of the Iraq war and decided then that I wanted to become more entrepreneurial. And I set up with colleagues from Goldman, actually a series of different asset managers, Fulcrum being one that I’ve spent most of my time in, which is a macro manager, but also two private equity funds called Active and Anthos and a hedge fund funder called Prisma. And as I say, nearly all of those colleagues were formally, we worked together at Goldman so some good things do come out of Goldman Sachs.
Bilal Hafeez (00:04:11):
That’s good to hear. You’ve had quite an accomplished career, I have to say. And you said you did economics at St. John’s Cambridge. I actually did economics at St. John’s Cambridge as well, but in the 1990s, so a bit later than you so I have very fond memories of college.
Gavyn Davies (00:04:25):
I did know that. We were very lucky people to be at St. John’s, Bilal.
Difference Between Public and Private Sector Economics
Bilal Hafeez (00:04:29):
Yeah, no, I agree. And you started off doing economics in the public sector for the treasury and then you moved to the private sector. What did you find was the big difference between the two?
Gavyn Davies (00:04:41):
It’s the difference between normative and positive economics. So it’s the difference between the verb should, the verb will, and I think it’s very important not to mix those two things up actually. In the public arena you are trying to maximise the benefits of economic policy for the nation as a whole or for a subset of the nation. And it’s all about what will be effective in order to further welfare and what should governments do to do that. The financial markets and as an asset manager or an economic analyst in the financial markets, don’t really reward you for should. You can be the wisest advisor to public policy on earth, but if the politicians and the central bankers do something different, you will lose money. And your clients are not interested in your views, they’re not interested in your politics, they’re not interested in ultimately what you think might work in public policy.
What they are interested in is whether you can understand what politicians and central bankers will actually do to move markets and what the other forces on those markets are. So the big difference is positive will not, normative should, and also you have a referee in the financial sector, which is the market itself, and you either do well in the market or you do not. And ultimately most clients, as long as you’re honest and decent and respectful and all of the good things that I hope our firms are, they want you to give them a good return per unit of risk taken. That’s great because ultimately if you don’t do that, they’ll move on.
Should Governments Listen to Markets?
Bilal Hafeez (00:06:32):
Yeah, it’s very clear cut there. And just on that public policy side or public economics for the government on the policy side, I mean do you think that because of the difference in the objectives of economics in financial firms and the governments, do you think governments listen too much to people in markets in some way. Markets, economists just have a different objective function, yet they’re very influential and so there’s a tendency to say listen to the markets.
Gavyn Davies (00:07:02):
I think that is a good point, Bilal and I don’t think the market has any point of view at all actually. It’s just a group of different people and there are as many different points of view in the market as there are among any of your friends. So I do not think the market has a point of view. Often people talk about the market as if it’s a personality of some kind. I think that politicians, central bankers need to pay attention to messages from market prices when the investor community is saying, look, this is going to be inflationary or this is going to end in a recession and are putting their money behind that thesis because that can then become disruptive for the objectives that governments have.
And I mean a recent example was the Trust government in the UK, which seemed to almost revel in changing the orthodoxy that they believed was built into the markets about debt and deficits, government debt and deficits. And were almost reckless I think, in ignoring the early signs of trouble that were developing in the markets. The first government I worked for in the 1970s, the Labour government in the middle of the 1970s made the same mistakes-
Bilal Hafeez (00:08:27):
Was that the Wilson government or was that Callaghan?
Gavyn Davies (00:08:29):
Well, it was initially the Wilson government and then secondarily Callaghan came in and the common factor was Denis Healey was the Chancellor of the Exchequer. And I just think that the political backdrop of the time meant that risks were taken with financial confidence that really came back to haunt the Labour Party for a long period of time and the government for a long period of time. So mistakes of that type in ignoring market signals I do think are serious. But it’s like any business person. Ultimately at the end of the day you want the government to do what benefits your business and politicians need to be very careful because when they ask what a business thinks about the exchange rate, exporters will want it down, importers will want it up, and that will be the basis of their advice. So you need to be careful in interpreting, but big damaging, volatile moves in markets are a flashing amber light for governments.
What Explains Low Productivity
Bilal Hafeez (00:09:40):
And I guess Trust and perhaps before that, Boris and this rise in populism, there’s obviously a cultural political dynamic to that all. But there is an economic component which is that something’s gone wrong in the economy, whether it’s income inequalities, widening too much, productivities have been way too low. I mean the UK’s had this perennial productivity problem, for God knows how long. And other countries have that as well. Do you have a diagnosis for that? Why is productivity so low in a country like the UK and how would you fix it if that’s too much to ask?
Gavyn Davies (00:10:10):
Yeah, I wish I knew Bilal. I don’t think macroeconomists have been very good at influencing productivity growth so I always worry about supply side economics as enunciated by macroeconomists. It’s been tried a lot of times. Most chancellors have had productivity objectives and the productivity growth rate has continued as usual in the face of most of it. In the Trust case, she clearly believed that lower taxation would boost British productivity growth and maybe she’s right. I mean it’s possible, but the evidence suggests that there isn’t a direct link between marginal tax rates and productivity growth, at least in the short term.
But where she went wrong I think was just ignoring the confidence effects. So lower taxes paid for appropriately by a budget so funded taxes, tax reductions I don’t think would’ve caused any trouble at all and might have done good in the medium term. But it was ignoring that message of profligacy with the government accounts that really caused trouble. And it was the first example for maybe a decade or so, probably since the Italian crisis in the Euro shock that markets said to a government, a major developed government, actually government debt and government budget deficits do matter. And it’s in those areas that I think macroeconomists might be more helpful, not so much on the supply side.
Do Macro Traders Have an Edge?
Bilal Hafeez (00:11:49):
And then if we flip this to the other side with your asset management hat on now there’s another question which is what edge do we have in asset management or fund management on the financial market side. There’s the whole idea of just follow the index. Can active managers outperform? Obviously there’s factor investing and risk premium, so on. And then on the macro side, can you really beat what rates are telling you or not? So what are your thoughts on active versus passable or what’s the edge that investors can-
Gavyn Davies (00:12:19):
Well, I think a macro investor, certainly a macro hedge funder which we’re not, we think of ourselves as investors using macro information and macro thinking. But certainly macro traders more or less have to believe they have an edge in beating the market because otherwise what’s the point? I mean it’s just a waste of time trying if you don’t believe you can do it. So you have to be somewhat confident that your views over time will do better than completely neutral positions in markets. And if you look back at the history of macro hedge funds, they tend to do well in a couple of good ways.
They tend to do well when other markets are doing bad or when financial asset prices are doing badly. And they tend to structure those funds so that the gains are really quite big and the losses, although they do happen, are not as big although they are quite frequent. So you tend to get these big spikes and then small periods of loss and the big spikes coincide with the markets going down. I think macro funds in general are a bit better at trading pessimistic environments than they are at trading ops. It’s bond traders, bond traders tend to be pessimist. I don’t know if you’ve noticed.
Bilal Hafeez (00:13:43):
Yeah, I’ve found that as well. Equity guys are optimistic.
Gavyn Davies (00:13:47):
Yes. So in general, macro hedge funds do better in those types of environment, which is helpful. So even if over time those funds give you, let’s say average market returns, they may hedge the rest of your portfolio. And I think we’ve just seen a big example of that in 2021 too, where the macro funds, at least until the end of last year did really well in an environment where everything else in your portfolio, everything, equity funds and a lot of the time even trend funds, et cetera, were doing badly, the discretionary macro guys did well. So I think you can contribute that to a portfolio and you probably need to try to get right, a difficult mix between confidence that over time you can help manage money and maybe beat markets with humility in the face of markets.
It’s a difficult mix to have because in order to trade at all, you have to believe you can ultimately beat the market over time. But if you believe that you are some kind of superhuman that can see the future you are rapidly going to come to grief I can tell you. One of the big danger periods that we all have in markets, analysts, economists, investors, traders, when we’ve had a good time for a year or two, we tend to become overconfident and often give it all back. So it’s that combination of can you be confident in your views while also being cautious and humble in the face of the market because the market knows a heck of a lot and many people in the market in any given situation know as much or more than you do.
Framework for Asset Allocation
Bilal Hafeez (00:15:34):
Yeah, I totally agree with that. And you said that you are not a macro fund instead you are, you have a macro kind of view that informs your investment process. I mean, could you talk more to that, what your framework is?
Gavyn Davies (00:15:47):
Yeah, so Fulcrum has developed over two decades now into a fund that emphasises a big absolute return product which lies at the centre of the fund. And that is designed to give returns of about cash plus 4% over time with a vol of about eight. So it’s, and with low draw downs and with draw downs that are not positively correlated with markets so certainly with equity markets. And in order to do that we use macroeconomics in a series of different ways. So we have a sizable chunk of the portfolio run by an asset allocation system, which is relatively slow moving and is designed to allocate some large part of our assets between equities, bonds, currencies, commodities and cash. And that is really one of the bedrocks of what we do and that is very macro driven. So those asset allocation are very macro driven, but a medium term I would say.
Bilal Hafeez (00:17:01):
And is that the big discretionary? Is it quantitative? Is it somewhere in between?
Gavyn Davies (00:17:06):
It’s our basic style in managing money in markets is we like to be as rigorous and quantitative as we can be. So we will throw the kitchen sink at the problem. And we have really an outstanding group of researchers led by Juan Antolin-Diaz, who’s been, came out of the ECBs, been with us for more than a decade and is extraordinary at building models and using them to understand the economies and then the markets. But we don’t allow them to work in an entirely hands off way. So we ask what they’re telling us and we decide discretionarily whether we want to make adjustments to them or indeed ignore them altogether. We do have a component that is pretty much systematic, but it’s not the full works by any means of the fund. So what we tell our investors is you are getting human beings, but they are informed by the best modelling we can do.
So there’s that chunk. Then we also have what you would think of more as macro trading. So we have a shorter term macro views part of the portfolio which is run by Suhail Shaikh, who’s our CIO, Nabeel Abdoula and others. And you would think of that as a macro fund I think, but it’s only a component of what we do. And then the third bit of what we do is diversifying strategies so hedging and there is a trend part of the fund as well. And we think that that combination of asset allocation, macro trading and diversifying strategies, meaning hedging and trend works well when put together into a fund. And we’ve found that it has made money over time. It’s given a sharp of about 0.7 over roughly 15 years. And the big advantage is again, very low draw downs and not correlated with equities.
Bilal Hafeez (00:19:07):
Yeah, and on the asset allocation, is it like a business cycle approach or is it sort of a thematic approach?
Gavyn Davies (00:19:13):
No, so now we’re talking about what I called at the beginning, the medium term asset allocation.
Bilal Hafeez (00:19:19):
Yeah. Okay. Yeah. Yeah.
Gavyn Davies (00:19:21):
Yeah. Okay. So the beginning of that is a model which is based on a VAR system that forecasts the economy. And then the, I think innovative part of what Juan has done is he’s bolted onto a VAR model of the economy and asset’s an allocation system. So it’s a little bit like having a Black-Litterman asset allocation system with an up to date macro model attached. If you remember, the Litterman framework didn’t have a forecasting system, an economic forecasting system attached. It did have a very sophisticated asset allocation mechanism.
And what we’ve tried to do, what Juan’s insight was, was we could join that all up together. So that is how that works. And if that then produces signals that we are not as discretionary macro people comfortable with, we will offset that elsewhere in the portfolio. So the ultimate portfolio is that asset allocation component along with discretionary trading and the discretionary trading can be really quite short term. So I could tell you today where we are positioned relative to the Fed, but even in a week or two we might not be positioned in that part of the portfolio the same. We’re quite active in overlay positions that add to in our view the asset allocation model.
Bilal Hafeez (00:20:52):
And you mentioned VAR, presumably you mean vector autoregressive models?
Gavyn Davies (00:20:57):
Bilal Hafeez (00:20:57):
Yeah. So that’s just an economic-
Gavyn Davies (00:20:57):
Bilal Hafeez (00:20:59):
The benefit of the audience is it’s an econometric model where you can introduce disturbances and then see sort of the impact on the economy.
Gavyn Davies (00:21:07):
Exactly, so we focus that part of our work mostly on the US because we think everything else in asset markets is driven primarily from the United States economy and the Fed obviously with the additions for different views in different parts of the world, especially China. But we probably have a, let’s say a 10 or 15 equation or a bit more model of the US economy and then that gives us all of the drivers of the main asset classes. We then have return forecasts for each of the main asset classes. And then our asset allocation model builds us inverted commas here, PLL, an optimal portfolio, you know what I mean? It doesn’t have to be the best ever, but it is optimal according to the models’ concepts.
Changes to Investment Approach Since COVID
Bilal Hafeez (00:21:59):
And so you, you’ve had this framework for two decades now. We had COVID, obviously a big shock, suddenly we’re in an inflation regime, which we haven’t seen since probably the early eighties and obviously going back to the seventies. Did that change anything in terms of the framework, your thinking? Did you have to change your process?
Gavyn Davies (00:22:17):
Actually, we certainly have changed some parts of our process because one thing that happened in COVID was that data that we have been accustomed to use for a long period of time moved a lot more quickly. So we’ve spent a lot of time building Nowcast models, which are quite fashionable currently. And we think we do it in as good a way as it can be done. But going into COVID in March 2020, the most frequent data we put into those models was weekly and most of it was monthly. And of course what we found in the nose dive that occurred in the economies in April, May 2020 was those models were too slow, they moved too slowly. So our Nowcast did not nose dive with what we could see happening in front of our very eyes. And over that summer we built more real-time models.
So we started using more daily information than we had in the past, some of which actually only became available because of COVID Google information that hadn’t previously been published. And we tried to make our Nowcast models more up to date. And those models have survived and they’re still absolutely still in use. So that was one thing. And of course the second thing was that the extent of the fiscal and monetary stimulus that was thrown at COVID had really not been seen before. So that was not so much something that was easy to model actually because there were not a lot of previous examples enabling you to do that. But it immediately caused issues with how is this going to pan out?
And we have had good and bad periods in responding in that we did not lose any money at any stage really to speak of, I mean not a lot of money. And we made money positively for the most part. And I suppose the big test in a sense was 2022 or I would say mid ’21 through to about the third quarter of ’22 when we had a really, really big energy shock. We had excess demand in the developed markets and adverse supply shocks in the goods market as well leading to unprecedented in the last 40 years inflation. And a big test for models was, can you navigate this? And I’m happy to say generally speaking, we have navigated that pretty well. The last nine months where some of those shocks have reversed we’ve been kind of ho-hum, not brilliant, not terrible, but relatively relieved I must say to say that in the difficult period we did pretty well.
Bilal Hafeez (00:25:20):
Yeah. And you mentioned inflation, of course. I have to ask you then, I mean, what is your view on inflation going forward putting your economist hat on?
Why Inflation Will Stay Higher Than Many Think
Gavyn Davies (00:25:28):
Okay, well my economist hat is this, do not underestimate oil, energy and their impact on inflation. So number one, I think number one, you have to ask whether you think that any elements of the energy shock is going to reassert itself. And I think it’s quite likely it will actually. So I would say point number one is the benign phase that we’ve had in inflation from the third quarter of ’22 until now, which I believe has been the bedrock of recent market performance. Because if you look across the whole world, equities have rallied, the equities that have rallied are interest rates, sensitive equities.
So we’ve seen growth rallying relative to value. Europe has rallied more than most other markets because it had been damaged mostly by energy. So a heck of a lot of what we’ve seen lately, meaning the last nine months, has been energy driven I think. And I’m worried about that. I think energy markets are going to struggle to remain as cheap as they are today for a series of reasons related to the supply side in energy. So I’m worried that there may be a renewed not as big as ’22, but a renewed adverse shock from energy.
Bilal Hafeez (00:26:52):
And on the supply side is that to do with OPEC cuts, Russian production maintenance or phases and just less production from that side and so on?
Gavyn Davies (00:27:01):
Yeah. So looking at the energy markets and analysts that work in energy, they’ve been troublesome for macro people this year because on the whole, most of the expectations have been bearish for oil prices and they’ve been not true. Basically oil prices have continued to print recent lows actually again in the last week or two. So you have to ask why. And I think that two big reasons have applied, maybe three. One is China has recovered but not in terms of its energy demand. So we have had a significant move up in PMIs and business indicators in China, but they’ve been mostly in services, have not driven manufacturing and construction in quite the same way that we’ve seen previously in Chinese recoveries and that hasn’t been as impactful on energy demand as previously. Secondly, I do fear and believe that quite a lot of Russian oil, I say fear because I don’t want the Russians to get the revenue has trickled into the market via India, maybe via China.
And so the attempts to freeze Russian oil supply out of the energy market probably haven’t been as successful from the point of view of the US and the EU as they were expecting and hoping and that analysts were expecting and hoping. And then the third thing is the Americans have been using their strategic petroleum reserve as well to cushion the market. And OPEC hasn’t done much until lately either. So some of that may change. What may change? Well China’s growth rate may spread out into manufacturing and construction and the demand for energy may rise from that source. The SPR in the US probably won’t be drawn down any further and might be reversed. And of course the Saudis are promising suggesting that they might reduce oil supply into the market. In addition, the sort of longstanding story in energy markets is one of under-investment in energy supply, brown energy for good reasons by the way, good green climate related reasons.
But you don’t need much, I think, of a pickup in the world economy and oil demand to put upward pressure on oil prices because we don’t have on tap the amount of supply now forward-looking that we will need to meet demand as we currently see it. We have to do something more to cut demand or prices will go up. So I’m a little worried about that. I don’t want to sound panicked, I’m not. But I do think the benign phase, which has really helped the world economy and markets since last October has question marks against it. And then the second big area of course is wages. What’s happening to wage inflation and labour markets probably differs here between the UK, sorry, the US and the EU. But in no case in any of the developed markets do I see a labour market that has yet adjusted enough to be consistent with the inflation target.
So as Dominique says, nearly every week, yes the labour market is easing, notably in the US, yes we are seeing some very slight signs that wage inflation is dropping a bit, vacancies are dropping, but the tightness of the market measured by, for example, unemployment easing at all, unemployment is near the low point for the entire cycle. And most labour market indicators are well above actually previous cyclical peaks, not averages, right, previous cyclical peaks. So we are seeing some good news, we’re seeing a return of participation by prime workers, we’re seeing them come back into jobs, but we have not got a labour market that is in balance. So it is likely, I think that we will have to slow the labour market more before we will see wages, wage inflation come down consistent with the price target for the Fed. So I’m worried about those two things together.
I’m worried about energy on the one hand and wages staying higher for longer. I don’t think we are going to see anything like double-digit inflation like we had a year ago. What we’re more likely to see is sort of four or 5% becomes a bit endemic in the system and then the Fed eventually can’t ease in the way that’s currently priced. Because if you look at the way the markets are pricing themselves now, they either think that inflation is going to drop spontaneously, which I don’t think it is really from here, or they think there’s going to be a recession, which I don’t see around the corner now even with the credit crunch, I don’t see a recession around the corner, in order to justify that Fed easing. More likely we don’t get that and the Fed does not do the easing.
Bilal Hafeez (00:32:25):
Yeah, I mean the Fed, the market’s pricing of the Fed is quite interesting at the moment because at least the S&P 500 doesn’t seem to be saying that that we’re in a recession.
Gavyn Davies (00:32:35):
No, nor does the credit-
Bilal Hafeez (00:32:36):
Yeah, correct. Yeah. And yet we have all these easings pricing and one thing I’ve been thinking about is whether the market is somehow trying to price a bimodal outcome where it’s either on hold or we have a sharp recession because of a credit crunch that may appear. So it’s not a typical pricing, you could say, it’s almost like two outcomes. The market’s not quite sure. The current pricing somewhere in between, but that’s not really what the market expects because it’s either or.
Gavyn Davies (00:33:02):
Yeah, exactly. I think it is bimodal in exactly that way. So that doesn’t mean of course the market is right. If you take a different view of the probabilities to be attached to the two modes then you’ve got a different view of the market. So my own judgement at the moment would be that a hard landing scenario is probably less likely than the markets bimodal expectation expects and a soft landing higher inflation scenario is more likely at least until the Fed does more. And in terms of the debate among the leading thinkers in the US economics profession, I’m more with Larry Summers than I am with Paul Krugman on this. I think Larry’s been generally speaking pretty darn good on this inflation shock and its persistence. And on the whole, I think team persistent with Larry as its team captain has so far proven sort of more accurate than team transitory and Paul was one of many, many excellent kinds of economists who believe that the shock would be transitory including Jerome Powell himself obviously.
And I still fear that persistence is going to show up again. So in my version of the bimodal outcome for the Fed, I’d put more weight on higher for longer inflation leading to stable for longer Fed. That assumes Bilal that we had a big debate on our investment committee today on this that does assume that what we are seeing in the loan offices surveys on both sides of the Atlantic is too pessimistic because in both of the bank lending surveys that we’ve seen in the last 10 days, the numbers that we have seen are consistent with recession already. So I have to admit that. But I think they are outliers relative to all of the other information that we have about the way the economies are growing at the moment. And I think they overestimate the downside risk from the regional bank shock and from I suppose still the Credit Suisse shock in Europe. So I’m not expecting those surveys to persist and be accurate. If I did then I’d be more with the pessimists on the economy.
Why Bank Crisis Is Not the Same as Global Financial Crisis
Bilal Hafeez (00:35:38):
On the banking crisis side, I’m not sure if it was correct to call it a crisis, but bank failure say, what makes you think that we are not in a global financial crisis, GFC sort of environment right now. This is just like a Bear Stearns event or something and a year later we’re going to be looking back to say this was the beginning of the big crisis.
Gavyn Davies (00:35:57):
So I suppose a series of things, it’s localised to a big locality in the sense of the regional banks in the US is pretty big, but it is not the whole of the US credit system by any means. Obviously the big banks have so far escaped entirely from any pressure and a large amount of disintermediation of the banking system has occurred in the last couple of years anyway, three or four years anyway with non-bank credit providers providing a lot of the loans to the system. So I think we are seeing a specific shock to a quite big but not massive part of the credit mechanism. And then the second thing is that so far the shock seems to be dampening down. Now you may say, don’t be stupid. Look, we just saw two big regional banks equity being nearly wiped last week after First Republic, so you must be being complacent.
But in terms of the flows out of the deposits of the regional banks in general, they’ve definitely slowed down. I mean they were very big for a couple of weeks and have now markedly returned towards normal flows into money markets, so not remaining at emergency levels. And the Fed’s balance sheet, the support operations that the Fed announced are not seeing explosive growth. So what Jerome Powell said last week was really interesting to me actually. Kind of stuck his neck out a bit, was that he thought the regional banking issue had improved since the previous FOMC meeting. I thought he might be more cautious, but he actually said he really did think it had improved. And I think that as well from the data that I’m looking at, so I’m not seeing it spread.
And then on the wider issues of is it going to envelop the whole of the banking system, I do think the banking system is better capitalised definitely in Europe than it was in 2008 and with a big exception of the commercial real estate market, and even with that taken into account, I don’t see the dangers that became visible in 2008. Now you might well say, well actually Mr. Davis, nobody saw it coming last time either, but that doesn’t mean it has to happen this time. And I think we are more likely to see a lengthy period of constraint both on the supply side for credit and more particularly actually on the demand side with demand for corporate lending dropping quite sharply.
And it reminds me a little bit more actually of the savings and loans crisis in the early nineties, late eighties than of the 2008 crisis. That still is not good Bilal. I mean nobody’s saying this is a great idea or a great event, but relative to a lot of other things that are going on to keep the economy firm, so fiscal policy which remains supportive in the US and the continuingly large amount of liquid balances that the household sector has and the generally good strong position of non-financial corporates in the US, will this localised regional squeeze more than offset all of those issues? Best guess, no, but I’m watching it like a hawk, and I might be wrong on this.
Views on Private Equity and Venture
Bilal Hafeez (00:39:45):
You mentioned commercial real estate as one area obviously that’s a bit vulnerable here. What do you think about venture capital or private equity, which have had a really good run for the last 10 years or so, had somewhat of a boom after COVID as well. Do you think those areas are also vulnerable as well?
Gavyn Davies (00:40:01):
Well, I’ve actually been very engaged in Silicon Valley over the last decade because one of the firms that I co-founded with some of my Goldman colleagues was called Anthos Capital and has been a successful growth capital fund in the US. It’s on its fifth fund now. So we saw it up close in late 2021 when more or less, almost in as soon as Powell really finally gave the signal that he did get it, that inflation was going to be quite persistent November really, ’21, we really did see, as you can imagine, a dramatic change in the conditions and the pricing of the market. I think it has taken the bubble element out of the market. I’m not a particularly big fan, I suspect you are Bilal, but I’m not of crypto. I’m not going to call it a bubble because I will get too much abusive email.
But am I really persuaded that it’s a $27,000 valued asset today than I really. I want to leave that open. I’d rather have gold personally as one of my safe asset hedges. And so some of that element has come out of the market. FinTech was overvalued and has clearly come down. A lot of the consumer IT type companies, the delivery companies, et cetera, have clearly fallen sharply. Now I think they have come down to realistic values. Not all of them have been marked fully by the private equity funds, so we have not seen the full shakeout occurring, but I think the worst of the meltdown phase is probably over. It’s been very severe and it’s probably over and good companies are surviving and thriving, companies that are anywhere near profits can be refunded. It’s just the frothy element that’s gone out of it.
Bilal Hafeez (00:42:05):
Yeah, and where does that leave you on equities in general then? Because you sound a bit sceptical earlier on, but at the same time if we’re not talking about the hard landing then doesn’t that give us a positive outlook?
Gavyn Davies (00:42:18):
Yeah. Yeah, I’m a bit schizophrenic on this right now. So in terms of what I call our asset allocation bucket in our fund, we are slightly underweight equities relative to what we think of as a benchmark. But where we are very different from the benchmark currently is we have a lot of cash and very little fixed income. Now you may, i.e., duration, you may think, well why, because there might be a recession, we think, and the model thinks that five and a quarter percent on the front end is quite a hurdle for duration to overcome with a three and a half percent 10 year bond yield. So the shape of the curve has put us into a position where we are long cash relative to duration or long short bonds relative to longer dated bonds, sort of a little bit underweight equities and a little bit overweight commodities.
We don’t want to ditch all our equities for the reason that you’ve just said, equities tend to give obviously positive returns over time, we all know that and are quite hard to forecast as well. So the model knows that any forecast is uncertain and doesn’t want to and we don’t want to either ditch them completely and give up the possibility of a continuing rally because in the last nine months, equities have been a very strong asset against a background where nearly everybody has been super bearish. So we need to be consistently cautious about being completely absent from a market that is climbing a wall of worry as people say and that has been the case in equities. So as I say, slightly schizophrenic, but we come out wanting some equities, but we’re not in any way bullish relative to our benchmark.
Thoughts on ChatGPT
Bilal Hafeez (00:44:23):
Yeah, yeah. And I’m sympathetic to that view. I did want to ask you about AI, ChatGPT, large language models and so on. I think to some extent it could possibly be influencing tech valuations right now. It seems like there’s this kind of boom, but more generally, are you using ChatGPT, Fulcrum or you yourself in your various different endeavours. Do you have any thoughts on is this a revolutionary technology? Will it lead to lots of job losses and so on?
Gavyn Davies (00:44:51):
Well, I do think it’s revolutionary. We’re using it in a low-key way. We’re not currently using it to build models for us and are sceptical about doing that. Maybe some of the coding can be done fairly easily by those systems. I wouldn’t want to delegate any real judgement calls to ChatGPT because it doesn’t know whether it’s accurate or… I mean, it’s just repeating what it’s read on the web in a clever way. So I don’t think that element of human judgement, including that element of human judgement in building a model can be delegated to ChatGPT, but I think some low-grade coding commentary actually can sensibly be, you can write a first draught relatively easily and then check it for accuracy and judgement and rewrite bits. So that sort of thing is important.
The golden study on this, as you recall, was much more bullish about the long-term productivity effects of this than normally, than the normal sort of breakthrough in technology where there’s a great hype, it has a big effect on consumer behaviour and you don’t see it in the productivity statistics at all or not for a very long period of time. Goldman says this time it could actually boost global GDP by seven percentage points. It may not sound much, but that is just gigantic. If any new technology can do that, it’s going to have a big effect on the world. And I’m persuaded what I read that it could have that sort of order of magnitude effect over let’s say one or two decades. And that will be a big reallocation of labour away from the sectors where the productivity gains are biggest towards either leisure or other sectors. Can we do that as a society?
We’ve done it before, we’ve moved out of agriculture and we’ve moved out of manufacturing in the UK anyway, but with difficulties. And I think it will create difficulties for some sectors of the population, but be quite a big macro event actually over some years. And there will undoubtedly, I suspect, be very big gainers in the corporate sector. I think they may be mostly the same old folk that are players already, Microsoft, Google, and Facebook obviously among others. But there’ll be a new ecology of startups that will do well as well and probably be acquired by those companies. So from the point of view of a tech investor, the early stage tech investor, it’s pretty exciting and we can see already that those investors are allocating big money to this enterprise.
Bilal Hafeez (00:47:58):
Gavyn Davies (00:47:58):
Normally, as I say, you remember Paul Krugman said in, what did he say famously in 1996? I hate to remind Paul if he’s ever going to hear this, that, what did he say? The internet was going to have the same impact on the world economy as the fax machine. And it’s one of those things I’ve said many things by the way I wish I’d never said, but it’s one of those things you wish you’d never said. I don’t think that will be the case this time. I think this is going to have a pretty significant impact on societies and economies.
Bilal Hafeez (00:48:34):
Yeah, no, I’d agree as well. I mean I’m finding everyone in our firm at Macro Hive, everyone’s using it in one way or the other. We’re kind of adding this experimental sort of phase where we’re finding all sorts of interesting uses for it. So this really does feel very real and-
Gavyn Davies (00:48:48):
No, I’ve got a nasty feeling actually about all that. You and I might be among the losers here. I don’t want to make-
Bilal Hafeez (00:48:54):
I think you could be right. Yeah.
Gavyn Davies (00:48:56):
But we could have skills that are easy to replace. So better be careful, get some new ones.
Why Has UK Economy Performed Better Than Expected
Bilal Hafeez (00:49:01):
Exactly. Yeah. Yeah. I did want to ask you about the UK economy. Just at a very sort of simple level, people came into this year very bearish on the UK. Every investor I speak to was super bearish on the UK. The economy’s kind of probably done a bit better than people thought. What did we all miss? Why do you think that’s happened?
Gavyn Davies (00:49:21):
Well, I would say a couple of things. We’ve introduced a very sensible macro framework. The new government, Rishi Sunak from Goldman and Chancellor Hunt are no dummies, I can tell you. And I think that they put in place a rigorous, realistic framework, which took a decent amount of the risk premium away from currency markets and some from, some of the risk premium out of bonds as well. The Bank of England did a good job in doing that as well. So the panic subsided and then the world economy did better. The world economy was at its low point for this little mini cycle in November of last year. And since then services globally have recovered sharply and are now growing above trend actually. And manufacturing has recovered a bit and is growing a bit below trend. So GDP globally is growing up trend, it’s not in recession and that helped the UK.
And the consumer has remained pretty robust actually. So as soon as the panic was over, the consumer went back to a firm labour market with lots of liquid balances and fiscal policy was expansionary, but in a sensible way. And I think all of that has helped. And the Bank of England hasn’t had to do as draconian a tightening as may have been feared. Now we speak the day before a meeting of the bank so I don’t know what they’ll do tomorrow, but I don’t think they have to slam on the brakes currently. The worry about the economy is if you have to pick one developed economy where inflation does seem to be becoming persistent, dug in at the level that is uncomfortably high, it probably would be the UK. So the bank may have more work to do over time and may tip the economy over eventually but it hasn’t been as, I suppose, panic driven as we were thinking last October.
Does BBC Have a Place in Streaming World
Bilal Hafeez (00:51:42):
Yeah. Now I did want to pivot topics, given your background about the BBC, I did want to ask you a question about the media industry at the moment. I’m not sure if you still follow the media industry like Netflix and the streaming wars and so on. Do you have a viewpoint on just how that sector’s developed over the years and what the place is for an institution like the BBC when you have Netflix, Amazon, Apple, I mean these giants with huge budgets and then you have-
Gavyn Davies (00:52:10):
Yes. I definitely do Bilal. I think it is difficult for the BBC with a, I did an annual budget now about 5 billion, I think something like that to retain its waterfront coverage across all sectors of broadcasting that it’s always had in the past. So I think it will find it increasingly difficult to bid for rights that are really expensive. Now those rights include sports rights where the BBC has had to be much more selective. Still, I think it creates a great deal of value by having free to air sports coverage of a high quality, but in much smaller doses than we used to have it at the BBC. And I think we’re seeing the same thing happening in drama. The very best script writers, the most famous actors, the best directors, goes right down camera people, everything are a bit away. So the BBC can still do wonderful drama, but in smaller amounts I would say, and maybe more in areas that are not fully served by the free market.
So it may have to go back to its original purpose of providing, or a purpose anyway of providing a service that the market cannot provide or chooses not to provide. That’s still really valuable and I think can give enormous value to British households at the current licence fee. News is critical. So I think, one of the reasons that I had a big falling out when I was chairman of the BBC with the then Number 10 press secretary was that I thought the BBC had to be completely independent. The BBC is not the state broadcaster, the BBC is the public’s broadcaster. There is a big difference between the state and the public, and it can’t be the state’s mouthpiece. In some other countries, the public broadcaster sort of morphs too close to being the government broadcaster or the state broadcaster. And in the BBC we’ve always really been careful to avoid that and that’s why the BBC retains value.
And in the future it’s going to become more difficult to decipher what is at all impartial or true. We’re going to be bombarded and AI is another reason why this will occur with stuff that is really partisan, tells lies and is designed to create trouble. And I think that the generation of my kids and younger can have a problem in deciphering the truth from that noise. Now, the BBC absolutely is not guaranteed to tell the truth, but it will try to, and it is not guaranteed to be impartial, but it works very hard to be impartial. So one way that it will distinguish itself, I think, is through those qualities. And it has a brand where the people working for it are expected to live up to those qualities and where the viewers and listeners and online do expect the BBC to deliver that.
And that’s why they become so irate when the BBC fails to deliver that in their view. So those things I think are return on virtues of the BBC. I don’t think it’s gone away. I think it still justifies the licence fee. I note that whenever any government seeks to change the fundamental system of the BBC that funds it and manages it and runs it, the public doesn’t like that. Governments tend to back off. So yes, the market has changed dramatically, but not sufficiently to wipe out the uses and value of a public broadcaster.
Bilal Hafeez (00:56:17):
No, that’s a great point about where the BBC could stand out in the global landscape. Just one question on the independence, the public versus the state. In your case you did step down in protest, but I mean, is that in some way a sign of how strong the state is or was that a sign of how independent the BBC was, because this was in regard to kind of the coverage of the Iraq war and so on and so which way round, how would you-
Gavyn Davies (00:56:46):
I’d rather take the self-serving choice there Bilal. I remember the moments where I was thinking about resigning from the position. It’s not tenable for the chairman of the BBC to be in a perennial conflict with any political party, including the governing political party. That person has to be seen as independent. And the situation had got me into, rather than I had got into a position where I just don’t think, it wouldn’t have been feasible having taken the position that we took as governors, not just me to then say, okay, another day tomorrow I’ll go back to work and I’ll be Mr. Impartial again. It just wouldn’t have been feasible, I don’t think. By the way, I don’t believe I ever was not impartial, but I think people would’ve thought so.
Bilal Hafeez (00:57:42):
Yeah, correct. Now, I did want to ask just a couple of personal questions. You mentioned children. So what advice would you give to youngsters at university who are leaving university to enter the sort of job market? Any advice to them? Obviously the world’s changed a lot, is changing I should say.
Gavyn Davies (00:57:57):
Yeah, I think one of the problems with this question is you sort of set yourself up as somebody who is worth listening to and I don’t know about life stories, whether I’m the right guy, although I’ve had a very happy life. I’m going to quote somebody that I heard at the weekend, a little older than me called Charlie Munger, is 99.
Bilal Hafeez (00:58:19):
I’ve heard of him.
Gavyn Davies (00:58:22):
And Charlie was asked at the Omaha meeting of Berkshire Hathaway by a 15 year old, what advice would you give? And he gave two little bit pieces of advice. One was, if you are an investor, start young and live to a very old age because then assets will accumulate nicely over that period of time. And when faced with getting entangled with a toxic person, disentangle yourself immediately, either in your personal life or your business life because toxic people can become a big drain and it’s hard to disentangle. Now, I’ve had very few involvements in them, none in my personal life ever, but I can see the point of that. I think try to… I’ll put it more positively. Try to congregate and do business with people you admire and respect and who are better than you, hopefully at everything. And you’ll go far.
Bilal Hafeez (00:59:21):
Yeah, no, that’s great advice actually. You’ve got both very good pieces of advice so good that you relayed that and shifted it to Charlie. Final question, books, any books that have really influenced you or have you read recently that you’ve been inspired by?
Gavyn Davies (00:59:37):
I’ll tell you two that I’m reading. Okay. I love both of them. Lasse Heje Pedersen at AQR wrote about three years ago actually a book called Efficiently Inefficient. And it’s about the efficiency of markets, about great traders. He’s interviewed quite a few of them for the book and it’s a rigorous book. So it takes the rigours of financial economics and asks how they can be applied to what hedge funds do and what asset managers do so that you can try to beat markets, but in a way that makes sense. It’s not just for crapshoot. And AQR is, if I’d only invented one thing in my life, I wish it had been AQR, but unfortunately it was Cliff Asness, colleague of mine at Goldman.
But no, look, they’re great. I think it’s a great book about how to understand markets trading and how you may be able to beat them from time to time. So I recommend that, Efficiently Inefficient. And the other one, look, everyone’s got to read Martin Wolf all the time. I wrote for the FT for, I don’t know, much more than a decade. So I was kind of an outside colleague of Martins and came to enormously admire him, not just from his writing, but as a human being. And he’s written a great book called his magnum opus by his reviewers called The Crisis in Democratic Capitalism. And he’s magisterial in the way he can sweepingly summarise and understand issues from politics to the banking system, to the distribution of income, to the tax system, to the voting system.
And he starts by being, telling his own story as the family of immigrants coming to the United Kingdom during the war, I think from Europe, mainland Europe, and how he doesn’t want to go back to those very uncertain and troublesome, really threatening times. He’s not saying we will, he’s saying there are some bad signs out there and we should pay attention to them and try to reform our behaviour before we get that far. And he does actually have good ideas about how to improve the supply side in the financial system and the labour market and the distribution of income. And I strongly recommend anyone who cares about democratic capitalism, which we all benefit from every day of our lives, read that book.
Bilal Hafeez (01:02:17):
Yeah, no, Martin’s great. I’ve actually had him as guest before and he’s amazing. His breadth of knowledge, his ability to articulate things, he’s quite an exceptional person, exceptional mind.
Gavyn Davies (01:02:29):
He is. And very annoying if you’re trying to write in the same field as him, because living up to him is not easy, I could say.
Bilal Hafeez (01:02:35):
Yeah. Well that’s great. Is there any way for people to follow you and your thoughts or…
Gavyn Davies (01:02:41):
I’ve stopped writing for the FT since actually just during the pandemic. So I’m now writing mostly for our own output at Fulcrum. We’re relaunching our website, Fulcrum Asset Management, revamping it, and I think within a few weeks we’ll be having regular pieces that I will contribute. So I’d encourage anyone who’s interested in macro actually, market macro, not policy macro to take a look in a week or two or a few weeks time and hopefully there’ll be stuff.
Bilal Hafeez (01:03:12):
Yeah, I’ll include the link on the show notes as well. So with that, Gavyn, that was an excellent conversation. I really enjoyed it and-
Gavyn Davies (01:03:17):
Thanks. So did I. Thank you very much.
Bilal Hafeez (01:03:22):
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