Podcast Transcript: John Butler on Stagflation, Financial Instability, and World Wars

This is an edited transcript of our podcast episode with John Butler, published 22 April 2022. John is a commodity guru amongst other things. He has 25 years of experience in international finance. He has served as a Managing Director for 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 Brothers. He has advised some of the world’s largest institutional and private investors in matters ranging from wealth preservation to enhancing returns through a wide variety of innovative strategies, and he has been ranked the #1 Investment Strategist by Institutional Investor magazine. In the podcast, we discuss the growing risks of financial instability, whether we are in a commodity supercycle, how to protect your investments, 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.

Introduction

Bilal Hafeez (00:00): 

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Now, onto this episode’s guest John Butler. John is a commodity and gold guru amongst other things. He has 25 years’ experience in international finance. He served as managing director for various bulge bracket investment banks on both sides of the Atlantic, research, strategy, asset allocation, and product development roles, including Deutsche Bank and Lehman’s. He’s advised some of the world’s largest institutional and private investors in matters ranging from wealth preservation to enhancing returns through a wide variety of innovative strategies. He’s also been ranked number one investment strategist by Institutional Investor Magazine. He’s also written a number of books, including the Golden Revolution and the Golden Revolution Revisited, now onto the podcast.

Greetings John, it’s great to have you back. I think the last time we spoke on the podcast, it must have been over a year ago, I think it was.

John Butler (02:39):

Yes. I think it was. I think it was prior to most, if not all, of the major events and surprises we’ve had more recently.

Bilal Hafeez (02:47):

Yeah. And I recall from that conversation, your big theme that you were pushing very articulately and very clearly was that we’re entering an era or phase of stagflation with echoes of what we had in 1970s. And it appears that a lot of what you said has panned out, but in your own words, I mean, how would you characterise what we’ve seen in recent months or, in fact, the past say six to 12 months?

John Butler (03:11):

I think I created a good framework for understanding the situation that we’ve ended up in. I mean, history repeats rather than rhyme, so I don’t want to suggest that I was in any way able to predict the specifics of what’s going on. And yet the framework, I think, was a helpful one, and basically it came down to this is that when we entered our COVID lockdown world, I saw it as a self-imposed negative supply shock that is shutting down at least partially, and at least temporarily, all kinds of key supply chains in ways that anyone couldn’t really see, couldn’t really forecast, couldn’t really grapple what the ultimate effects of those policies were going to be. Yet, I just knew, and to be fair, that there’s a little bit of instinct in all of these things. I had a bit of gut instinct that the overall negative supply shock impact of this was going to be far higher than people were thinking, because they just had no experience of it.

The ’70s were a long time ago, people have short memories, even I, of course, struggle to remember the 1970s. Being I was alive, and I do remember a few things like waiting in long gasoline lines in California when they impose rationing, and that creates a real impression on a young person in any event. The COVID part, I thought I got pretty well because you had to combine this negative supply shock, which I thought people were underestimating with the huge demand support. And so in classic monetarist Freedman’s fashion, we were having more money, chasing fewer goods, we were mis-allocating resources, and that was a very, very stagflationary mix in my opinion.

But no, I hardly foresaw what’s happened more recently with China reentering lockdowns at least temporarily. Obviously, the Ukraine war not only kicking off, but becoming, now, sadly what looks like might be a prolonged conflict, which seriously mucks up all manner of things, fertiliser, agriculture, chemicals, and of course, transportation throughout that region of all of the above and everything else. It’s a real mess now, and so it’s an order of magnitude larger than I would’ve expected at this point.

Bilal Hafeez (05:21):

And on the Ukraine Russia situation, you alluded to some of the markets that are being affected by it, but can you give us a bit more detail about how you think this is magnifying everything?

John Butler (05:32):

The problem is that prices are set at the margin. So let’s say you have a supply shock, which affects, I don’t know, 10% of global output, 20% of global output, whatever, of some critical important input into all kinds of things. And again, there are so many that are affected now, fertiliser being in the front row practically. But then if you get just another 2% or another 1%, because you’re approaching the margin where the supply elasticity and demand elasticity and whatnot, all that stuff that goes into the micro of pricing in real time and space, you start to get exponential effects in price, and that’s where we’ve got to now. And I think that’s the only way you can begin to understand why producer price inflation in Germany is now over 30% year over year.

It’s hard for us having lived through such a prolonged period of generally low and stable prices, to even begin to contemplate how on earth in such a short period of time, you go from actual price stability to 30% year over year, that can only be explained through the non-linear effect of having basically sailed too close to the wind or got too close to the margin around critical markets.

The true impact of the Russia-Ukraine on commodities

Bilal Hafeez (06:54):

And there is a lot of talk about various players in the world have led by the US in different ways to try to make up for the impediments on the supply side, whether it’s the SPR, the strategic petroleum reserve releases, obviously the US is a big ag producer. So is there enough spare capacity, so to speak, globally where authorities or countries like US could activate them to make up the shortfall that we’re seeing in Russian and Ukraine?

John Butler (07:23):

I don’t believe there is a spare capacity that there used to be. Remember for a long time back in the hay-day of China, India, and other emerging markets pursuing blatantly mercantilist growth policies of maintaining weak currencies, export led growth, accumulating capital and reserves from the rest of the world and so on and so forth. They’ve come a long way now and their populations require, and this is social dynamic at play here, their populations require some sort of participation in all the progress that they’ve made economically through the decades. And what that means for your average worker, your average household, is that they can now demand, with some success, higher wages as a result of their higher productivity. You’ve made a lot more capital per worker in that part of the world over the past generation.

And that does create potential for the workers to benefit and they should benefit. And so I think the idea now that these countries simply continue to pass along deflationary forces through their manufacturing growth automatically, that’s not so true anymore. And so I think that what happened through the years is that all the spare capacity and the perception that your typical emerging market worker would continue to accept living hand to mouth, even when they were operating cutting edge machinery, that just wasn’t realistic. It wasn’t going to continue forever and it hasn’t. And so I think that’s what has resulted in this shock being as large as it has been in price terms, because you just don’t have the same flexibility amongst your emerging market labour force today that you did 30 or 40 years ago.

Bilal Hafeez (09:15):

And one of the things I’ve been thinking about is the parallels and also the differences in the 1970s, and two differences seem to be important, one is that workers had more bargaining power back in the ’70s due to unions and other such structures. And we don’t really have that today, it still seems like, although people say labour markets are tight and so on, there isn’t really this collective union type structures or these sorts of worker cartels of different kinds. So it still feels like the microstructure of the business world still leads to power being in the hold of the employers rather than employees. So that’s one thing I’m thinking is different to the ’70s. And then the other one is just the rise of financial markets, financial markets today are much, much bigger than they were in the ’70s, so you have this outlet for inflation to run off into the financial markets rather than in the real economy. I mean, what do you think about those two potential differences to the ’70s?

John Butler (10:09):

I think they’re both correct observations Bilal, but what I said a moment ago about the typical emerging market manufacturer now expecting higher wages as a result of dramatic increases in local productivity, I think that largely if not completely, offsets what you’re talking about regarding the de unionisation of the developed world. Look, there are consequences, good and bad, of shifting your manufacturing base to other countries. You can benefit for some period of time from lower import costs, although that won’t last forever as the standard of living gaps eventually longer term have to close. But yes, there can be certain benefits from that, but we’ve come a long way, as I mentioned. And then regarding the financial markets, you’re absolutely right, but didn’t we go through over a decade of really, really rampant asset price inflation coming out of the shock of 2008, 2009.

So that was going on, and the colosal amounts of money printing and public debt expenditure and spending so on and so forth that took place during that time got bottled up in asset prices, for sure. I mean, how else do you explain zero or negative bond yields? How else do you explain price earnings multiples that are in, not just the double digits, but I mean, in some cases, well into the 20s, well out of line with historical comparisons with, obviously, a couple exceptions, like the peak of the 1929 bubble, the peak of the 2000 bubble and so on. So that does help to explain these things, but we’ve come through that now. In my opinion, asset price multiples and whatnot are at levels that, in my opinion, simply not sustainable, especially, if you start to become a bit risk averse and we’ve had some events over the past couple of years, COVID, war, et cetera, also some political earthquakes occurring closer to home. That definitely, I think, have the potential to raise the risk aversion perception of markets quite dramatically.

The Fed at potential turning point on credibility

Bilal Hafeez (12:08):

Well, we’ll come back to the politics later on. But on the inflation side, I mean, what do you think about central banks? It does seem like they have pivoted, at least, the Fed has, some ways the leader of the pack in terms of setting the tone, they’ve gone from being very dovish focusing on transitory, now, they’re talking about inflation being the biggest problem. There’s talk of 50 basis point hikes by the Fed multiple hikes of that nature. Some talk of 75 basis points. So, I mean, what’s your take on the Fed right now?

John Butler (12:36):

Well, the Fed is under more public scrutiny today than it’s been since the early 1980s obviously, I think that’s pretty clear now. And so the idea that they could just keep on doing what they were doing, I think is really not plausible. First of all, let’s face it. They got things badly wrong, they really went all in, at least temporarily, on this idea that inflation was going to be transitory and that it was going to be pretty low nevertheless, that was obviously wrong. And so they burned through some credibility by getting that as blatantly wrong as they did. And so at a minimum, they have to admit that and they have, and I mean, obviously they’re blaming external factors and shocks as policymakers tend to do in that situation, but it’s not possible for them to completely escape some sense of just having been clueless about what’s happened.

And so that’s a problem. But the other problem is, at some point you need to start to choose whether you’re really going to position yourself for the longer term as a credible institution or whether you’re going to burn through what remaining credibility you have without addressing the mistakes you’ve already made, and clearly there has been a reassessment along those lines at the most senior levels. And it’s not just the Fed, as you say, they might be in the lead, but it’s beginning to happen at the Bank of England, to a lesser extent it’s beginning even to happen around the margins at the ECB although they have a far more complicated situation for reasons we can get into when we get into the politics.

So I do think we’re going to go through this hawkish moment, and I call it a moment. We’re going to go through a hawkish moment when central banks are going to see just how much hawkish, rhetoric, and policy action they can get away with before they are staring yet another potentially large financial crisis in the face as a result of how over leveraged over indebted markets tend to resort to long, long periods of excess liquidity when that liquidity is suddenly shut off. So they’re going to try to do what they can do. Now, this is a very difficult job, I don’t think they can pull it off without some sort of accident as people say. And the metaphor I like to use, well actually, it’s a mixed metaphor, I like to say that the Fed and other central banks, as a result of past policy actions have effectively been walking backwards on a tight rope into a corner.

It’s been a delicate balancing act the entire time, and yet the way in which they’ve done it, in my opinion, has only backed them further into a corner. Nobody likes to be in that situation and so I do think it’s the hawkish moment as it were, will only be short-lived before they blink and try once again to see they can find a way to rescue a system without reflating, I should say, another bubble.

What could limit further rises in bond yields

Bilal Hafeez (15:25):

And how high do you think bond yields could go?

John Butler (15:27):

I mean, in a way, in nominal terms, the sky is the limit. If the inflation keeps rising, now that’s sad, we’ve come a long way. I think it’s difficult to see inflation rising too much farther from here before the momentum slows down. I mentioned a moment ago that producer prices in Germany have soared over 30% year on year, and obviously some of that’s going to get passed through, but not all of it is. So I think that probably there’s limited scope for nominal bond yields to reach those sorts of levels. I don’t think we’re going to see that. However, I do think they can get higher from here temporarily, but only temporarily if we start going through this hawkish moment.

And that really just comes down to yield curve dynamics, you just run the numbers, you run the math. And as long as central banks look like they’re going to do something somewhat decisive in the short term, the long end is not going to be able to rise a whole lot. But when you’re talking about the two year yield, if central banks start to get religious, there might be a couple more percentage points to run at the short end, but I’m not sure the long end’s going to respond by much, if at all.

How overall debt has increased since the GFC

Bilal Hafeez (16:32):

You talk about this financial accident. I mean, one thing many people have been talking about, and this is obviously the classic era or thing that people will come back to, but they argue that this time’s different, because household balance sheets appear to be healthier than before, bank balance sheets are healthier as well. So if you look at stretch balance sheets, it looks like government balance sheets are the ones where there’s probably most leverage, you could say. So when you hear that, what do you think in the context of a potential accident?

John Butler (17:00):

It is a legacy of 2008, 2009, that the public sector in various ways effectively assumed a lot of the leverage that had previously existed on private sector balance sheets, and that’s true of financials, it’s true of corporations, and it’s true of households all in varying degrees. The problem is though, is that the collective pile of debt and leverage, public and private, relative to income is higher today. So you’ve created and the system has still grown, and you could say, oh, but the government side or the public side is basically risk free so there’s nothing to worry about there. Well, you can’t have your cake you needed two. You can’t tell me on the one hand that central banks have got to come to terms with inflation and then on the other hand, the public sector is not going to have its finances impacted by that.

And so, I think the risk here could be actually, this time round, somewhat on the public side, that is that government financing costs really begin to soar. And the only way to then deal with that might be fresh discussion of tax rises. Well, that’s not exactly going to go over well when it comes to financial asset valuations if people start pushing for higher taxes, as we’re pummeling into a stagflationary recession, and that could lead to a negative shock. So I think there’s many ways in which it could happen, but the fact is the leverage is there, the debt is there, it’s a shell game. You can move the marble from one place to another, but if the marble keeps growing in size, at some point, the shell’s not going to be big enough to cover it up anymore, people will notice that and that gain will be over.

Whether we are in a commodity super cycle

Bilal Hafeez (18:34):

Within this all, many people have, again, talked about super cycles and commodities. So if there is one market that could continue to go up, what could make the case of commodities is that. And I remember the last time we spoke, I think you had some doubts about out the whole super cycle thesis, how do you see that now?

John Butler (18:54):

Well, I think the concept of a super cycle ultimately is one that is growth driven and demand driven rather than inflation driven and supply shock driven. This one is more the latter, I wouldn’t really characterise it as a super cycle. And I also thought the original big super cycles from the ’90s and 2000s was somewhat overplayed. That people gave a bit too much credit to the demand side only and they didn’t pay as much attention as they might have done to the fact that the supply side was actually pretty good at keeping up with the growing demand. And the reason why prices were rising actually had more to do with just inflation than it did with growth, even in that case. But today, I think, it’s even more obvious that what’s happening is less a demand driven super cycle of real growth and more just, again, the stagflationary effects that we’re seeing due to a result of negative supply shocks, which originally were COVID related, but now they seem related to a number of things and lots of artificial, the demand being thrown at the problem resulting in simply a higher price level.

Why gold hasn’t risen by more

Bilal Hafeez (19:57):

And where does gold fit into all of this? Is gold in this environment where you see inflation, whether it’s CPI, PPI, whichever measure of inflation you look at, shooting higher. One would’ve thought gold would be much, much higher, but it hasn’t gone up as much as many people thought. I mean, how do you think about the dynamics of gold?

John Butler (20:14):

I think there’s two reasons why it hasn’t moved by more. The first is the dollar of itself has been strong and other factors equal gold struggles to rise in dollar terms in a dollar strength environment. If you look at gold in currency basket terms, it’s actually done all right, but the dollar has been very, very strong. And so that part of the explanation, I don’t think that’s sustainable by the way. The amount of dollar strength we’re seeing, I don’t think is going to continue. Then there is the issue of risk aversion, while we have obviously seen risk aversion tick up, we’ve seen it in bond markets, we’ve seen it in equity markets, in a historical comparison it’s still not particularly high. And I think for gold to get a real kick higher from here, we’re going to need to see equity markets telling you that the consequences of COVID lockdowns and negative supply shocks, the consequences of the war in Ukraine, the consequences of populous politics in much of the world are going to be much more severe and prolonged in terms of their impact on corporate profitability.

That begins to happen, and you’re still in this stagflationary environment and yet you’re concerned about corporate profits. Investors have to start looking for a place to hide. How do you protect yourself against the inflation while still reducing your allocation to equities? And there’s only one real answer to that, real ultimate answer to that, and that’s gold. And that’s one reason, of course, why gold did so well in the ’70s. So not withstanding many things being different today than they were in the 1970s. Gold can get propelled dramatically higher, in my opinion, in that environment as indeed it was during the 1970s.

Why the dollar is vulnerable

Bilal Hafeez (21:55):

And you mentioned you’re sceptical of this recent dollar strength lasting, why do you think the dollar isn’t in some multiyear up trend?

John Butler (22:03):

I think there is this perception, which is partly correct, but I just think it’s overplayed, that the United States still has all of these unique advantages. There’s a war now in Eastern Europe and north America is a long way from there, the US is less energy dependent than much of the rest of the world on imports because it produces so much domestically. So you’re seeing the yen get absolutely hammered by what’s becoming a global energy crisis, you’re seeing Germany get absolutely hammered by perceptions that it’s going to be cut off from Russian gas. The US can claim that it has, and investors in the US can claim that the risks of disruptions are therefore much, much lower. And I do believe that’s true, but what I’m saying is, I think it was pretty much already priced in.

I believe the US has enjoyed this premium of greater self-sufficiency in energy, in food, in a lot of the things that are being affected by this series of unfortunate events that we’ve been going through. So I just think it’s already in the prices it works. So it is really more about that than about denying that that fundamental perception is, in fact, correct to a large extent.

Why reserve managers will prefer commodities like gold over crypto

Bilal Hafeez (23:14):

And what do you make of the sanctioning of Russian reserves in terms of the fate of the dollar?

John Butler (23:21):

Well, this is really opening Pandora’s box, choose your metaphor, but I think the United States is playing an increasingly dangerous game by, on the one hand, weaponizing the dollar through general sanctions on trade and whatnot. And on the other hand, now, basically trying to outright freeze and confiscate Russia’s reserves. I mean, that’s really, really one farther step potentially into the unknown. And at that point, this is what I say about it, it gives a mixed metaphors, the US outright freezing, possibly confiscating Russia’s foreign exchange reserves, is a shot across the bow to other aspirate countries in the world, such as China and India, but also therefore a shot in the United States own foot because the US is so dependent on foreign financing to run its twin deficits. And so China and India and others, no doubt, are working on this one thinking, okay, what if it happens to us someday, we need to be prepared.

Do we still want to be holding a lot of dollar reserves? Maybe not. Perhaps we should slow our accumulation thereof. Well, okay, if you’re going to slow your accumulation of dollar reserves, but you’re still a net exporter, then you’re going to have to start shifting some of that stuff around. I mean, that’s going to reduce the demand function for dollars, that’s going to put upward pressure on dollar interest rates. And is that really what the United States wants? So I think this is a very dangerous game to play, but the United States, I guess, has chosen that the conflict in Ukraine and the more general geopolitical rival we with Russia and Syria, all around the black sea region, all around the Baltic, maybe they’ve just decided that this is something that is so important, they’ve got to go there. But it’s a very dangerous game to play.

Bilal Hafeez (25:12):

I mean, some people talk about crypto being as potential alternative to the dollar in this context of a reserve confiscation and so on and more generally as a refuge in a crisis period?

John Butler (25:24):

I think from the perspective of an individual investor, it’s certainly worth considering digital assets. But if you are a nation state, a physical entity looking to trade in physical resources with other nation states, and you want to be able to conduct that in a way that is going to maximise trust, maximise credibility, and is going to, therefore, give you the greatest possible freedom of action from any possible sanctions or other policies that’ll be implemented electronically through the banking system, you really do want to try and implement something which is tried and tested and known to work throughout history. And that’s to rely on gold, that’s to rely on something physical, or simply barter trade in kind, agree a gas oil exchange rate, as it were to be able to trade oil for gas or gas for oil. Or what about food? Agree or rate at which you’re going to exchange wheat for oil or whatever it might be.

Now, obviously barter is hugely cumbersome, but that’s where gold comes in. Gold is an deal medium of exchange for that sort of thing, if you decide you want to base your trade in a currency in a medium of exchange, as it were, which cannot be manipulated by any one country as an instrument of financial sanctions or other economic warfare. And it’s no surprise to me that this discussion has already kicked off. I mean, there have been multiple reports coming out of Russia, China, India, Turkey, and a few other places that there are people working on how they could perhaps rely a little bit more on gold for cross border trade and a little bit less on the dollar and other national Fiat currencies, generally

Risks of escalating global conflicts and parallels to World War One and Two

Bilal Hafeez (27:05):

Underlying all of this is this undercurrent of huge political changes and we’ve touched on some of that. If you step back, is there a way of bringing it all together? We’ve got this Russia Ukraine thing kicking off, there’s obviously the rise of China and India with our own way of doing things, you have this race for energy or commodity independence from each other, there’s polarisation in the US and other parts of the world. I mean, there’s so much going on it seems, there’s the reaction against all the COVID policies that we’ve had over the last couple of years. How do you look at all of this at a normal systemic level?

John Butler (27:37):

Well, as the Chinese curse goes, maybe you live in interesting times, this is not a pretty picture. I mean, as you just describe it, it’s almost as if we’re heading into yet another round of global resource wars going from being cold resource wars to being hot resource wars as happened in 1914 and has happened in 1939. Don’t get me wrong, I mean, there were all kinds of other political factors at play, but it’s not lost on most historians of the 20th century. That both world wars had very, very specific geopolitical rivalries around access to critical natural resources, coal, steel, oil, and also the various transportation choke points around the world.

Bilal Hafeez (28:22):

What was the 1939 one? Because 1914, it was the great game, I guess, but 1939, what was the big resource element of that?

John Butler (28:31):

The problem was that because of the dismemberment of Germany following the first World War and also the disillusion of the Ottoman Empire, they no longer had an easily accessible land bridge to the oil fields through the Balkans, into the middle east, they no longer had that. And so they were going to have to somehow acquire natural resources through very, very significant territorial acquisitions. And so they head into north Africa, they head into the caucuses region. And so, in my opinion, it really is a push for the oil field, a push for the Suez Canal, which of course, would help to transport the oil back to Europe. I’m pretty sure that was a part of it. And keep in mind that within the German high command, one of the biggest disputes with Hitler early on in the conduct of the war, was already in 1942 when they started to say, look, we’re not spending enough resources getting to the oil, we’re trying to accomplish too many things at once.

And Hitler never was fully convinced of that, but he did redirect some of the Germans military resources to those attempts to get to the oil producing regions and the Suez Canal to bring the oil home.

Bilal Hafeez (29:47):

So that’s really interesting context. I mean, that’s probably a side of the second World War we probably don’t learn enough about, at least, at school, where most of us learn these sorts of things, but it’s fascinating. So in some ways there’s parallels to that, there’s this global resource war, and could this get a serious as a World War?

John Butler (30:02):

Well, God, I hope not, but this is the most serious things that have been for a long time. Look, I don’t want to catastrophize here or anything like that. But Russia, in my opinion, would not be doing what they are doing unless they thought that there was a mortal threat posed here by Ukraine potentially joining NATO. If you take a look at a map, you can understand why they’re so concerned. And indeed we just discussed the World War II, it’s not lost on the Russian military, that the bulk of the German army passed through Ukraine on its way to Stalingrad and trying to get onto the oil fields. But also significant portion of that army then also went northwards towards Moscow to try and decapitate the Russian leadership at the time. And the idea that they’re going to let Ukraine join NATO, I think, is an absolute nonstarter.

I think we mentioned on a call two years ago, maybe now Bilal, when I offered my opinion regarding the unrest and Belarus, and I said, if the government in Belarus falls, Russia is also going to go in and set up their own puppet government again. I don’t think Russia will allow Ukraine or Belarus to become NATO members or defacto NATO controlled states, they just won’t do it. And so having made that clear, it does concern me that NATO is still pushing this one as hard as they are. So leave aside the good guys, bad guys narrative, I don’t think it’s helpful here. If you simply want to form an opinion about whether an escalation of this conflict to a global level is likely or not likely, I think you have to conclude it, it’s increasingly likely, regardless of who are the good guys and the bad guys here. So that needs to be appreciated, I think, by all observers of the conflict.

Bilal Hafeez (31:50):

And then more generally, if we situate this in terms of some of the polarisation we’re seeing in Western countries, what do you think is behind some of that and the aftershocks of COVID? That also seems to be leading to context where you could have more unrest in liberal Western democracies where this type of stuff isn’t supposed to happen?

John Butler (32:08):

Well, this is what I’m most afraid of, I’m afraid that what’s happened post 2008 is, there’s good evidence to show that inequality normally as measured by the genie coefficients, while it has been trending higher for quite a long time, it really accelerated post 2008 in much of the developed world. And that is something that I don’t think has gone unnoticed by the working middle class. I think, the working middle class in many countries feel squeezed. And then COVID hits, and at least at first, people were properly frightened about it and whatnot, but now it’s cleared out and they take a look at all of these unprecedented policy actions that were taken, some of which were probably way overdone and caused a lot of economic harm in the process. And yet the people that made those decisions don’t seem to have suffered any consequences. That just adds fuel to the fire, in my opinion, for people that were already concerned that the system was not representing them in their small business, small household working class interest very well.

And there’s this growing perception that there is an elite that was simply able to work from home throughout, whereas an awful lot of hardworking people doing very difficult jobs, simply did not have that option. So I don’t think COVID helped, and now, of course, you have this war, which is potentially escalating, and if you really want to get people populist, all you have to do now is reinstate the draught. I mean, gosh, if something like that happens, then we’re going to see riots in the streets just about anywhere, if you ask me. So I’m not predicting that will happen, I’m just saying that the potential for social unrest in previously stable countries is far higher today than it’s been in my lifetime. And all you have to do is look at what happened in Canada. And my word, when the Canadians start to riot something is badly wrong.

Bilal Hafeez (34:02):

Yeah, that does tell us something’s up. And we did see with the Arab Spring, there was a spike in food prices which led to those revolutions. And now basically we’re seeing the equivalent of food spike in the Arab Spring, much broader, larger version of that hitting every single country in the world. So people do really feel a big increase in cost of living and that hurts them in their day to day lives.

John Butler (34:26):

It absolutely does. And this only compounds the central banker’s dilemma, because as you may recall, in the 1970s, there was this perception in policy circles that it was okay to accommodate the oil shocks and whatnot up to a point, and that would be okay and would help to take the pressure off the economy and help to avoid a severe recession and whatnot. But by the early 1980s or already the very late ’70s, inflation was simply too high already. It was too high and it was already leading to social unrest. And so inflation had become a political issue. Ronald Reagan in the US and Margaret Thatcher in the UK were both elected in large part because the general working public had simply become so fed up with these high rates of inflation squeezing the cost of living, and they demanded a political solution to that, which was implemented by Paul Volcker at the Fed among others.

And we’re starting to end up in a position that looks eerily similar to that where inflation is becoming not just a political issue, but maybe the political issue that will decide the next election. And if so, that makes life for central bankers extremely difficult, because even Paul Volcker did not have free reign to do what he wanted. And he received tremendous criticism from the US Congress from time to time for doing what he was doing. And anyway, it’s going to make their life very, very hard.

Germany’s dilemma and how to solve it

Bilal Hafeez (35:58):

Yeah. I know you look at Germany as well and you’ve spent time out there. Germany is an interesting case where they seem to be very reliant on, say, Russian energy and they’re making policies, decisions which suggest that they might end their dependence on Russian energy, but not immediately, not right now. So it’s something in the future but not right now. They’re obviously the biggest voice in Europe. I mean, what do you think is going on there?

John Butler (36:24):

I think Germany is in an extremely difficult position, and it’s a position that comes about largely by geography. They do occupy the middle of Europe. And here they really are stuck between the EU, which they have obviously wanted to build into a useful, credible uniting institution to bring Europe together. And yet, on the other hand, the energy input to allow Germany to do that comes from Russia, and so Germany has arguably the most difficult hand to play here. And sometimes I see the choice as a very, very difficult one without an obvious solution. I will offer a solution in the moment, but first let me describe the dilemma. Germany’s economy needs to support the rest of the EU or the EU will not survive in its current form. If Germany goes into a severe prolonged recession, there’s no way the EU is going to survive in its current form.

It relies too much on the health of the German economy. Of course, that also means the Euro itself. I find it hard to believe that Germany is going to be able to endure a period in which the EU economy is in shambles, and the ECB just keeps trying to inflate its way out of it. I think that the political culture of Germany will rebel at that at some point and not allow it to proceed in that way, and that may spell the end of the Euro. So both the EU, in general, and the euro specifically are endangered as a result of Germany’s precarious position in this conflict. So is there a solution? I think there is, but I think it’s an extremely controversial one that does not make me very popular at dinner parties. And basically it’s this, Germany needs to do what France did in the ’60s.

They need to develop their own independent nuclear force so that Russia will never mess with them. And then they will be able to negotiate with Russia on equal security terms, make sure that Russia does not get overly aggressive in Eastern Europe, and once that is done, they’ll be able to continue trading in oil, gas, food stuffs, metals, you name it, with the security that they’re never going to be held hostage by Russia ever again in any issue such as this one. Now the EU will have to play ball with that, they’ll have to support Germany going nuclear the way France did in the ’60s, but in my opinion, that is the most elegant if hugely controversial solution to Germany’s dilemma, which have not resolved, potentially destroys the Euro and the EU, the stakes are high.

Bilal Hafeez (39:01):

But don’t you think that the US cover gives Germany that credibility in terms of the nuclear, the military capabilities or not?

John Butler (39:10):

Well, Germany may not be a pawn in the chess game between the United States and Russia. It may be a knight, it may be a bishop, but it’s not the queen, and it will be sacrificed if necessary. I don’t think that Germany can tolerate that sort of relationship with the United States anymore.

Bilal Hafeez (39:28):

That’s a fair point. Actually listening to all of this conversation, I mean, it just sounds really quite frightening in terms of the politics in the coming few years.

John Butler (39:36):

Given how high the stakes are, I actually am confident that cooler heads will prevail. But from where I look right now, from where I sit right now, I’m more frightened than I thought I’d be. I actually thought this conflict would’ve been over very quickly, I thought Russia would’ve done something very limited, I thought we’d already be at the negotiating table. It hasn’t happened and that concerns me a great deal

How to protect your investments

Bilal Hafeez (39:57):

In terms of investors and how they cope in this type of environment. I mean, what would your suggestions be given that we’ve had this decades of bond markets rallying and equities doing well and so on, and now we’re suddenly this stagflationary environment, high level of geopolitical risk, resource wars, and so on. What would you suggest investors should do to that portfolio?

John Butler (40:16):

Well, this is the thing you have to make the best out of a bad situation. We are in a capital preservation environment, when I talk about capital preservation, I mean, capital preservation in real inflation cost of living adjusted terms, because, of course, the price level is screaming higher as I speak. And so really, I believe we need to not, only look at the ’70s, but consider the possibility because the overall debt and leverage in the system is an order of magnitude higher than back in the ’70s, that we might end up in an even more severe stagflation prolonged this time round than that time round. And if that’s true, then investors need to get aggressively into defensive assets. Now, normally one thinks of bonds as being defensive assets, but in the stagflationary environment bonds are not defensive assets.

So, what you want to do is you want to get into raw commodities and of course, raw chemicals, and fertiliser, basically you want to get low on the value chain. This is what I say, these may be very low margin businesses in good times or bad, but the margins will be stable even in a highly inflationary environment. You can’t tell me that a typical sulfuric acid producer is not still going to say, look, this is our operating cost, if we don’t get this, we’re not going to sell to you. That conversation will still take place in a very, very stagflationary environment. Whereas the tech company trying to sell you their latest gadget, that’s going to be one of the first things that is the not necessarily going to sell in an inflationary environment, because it’s highly discretionary. So stay away from intangibles, get light on discretionary assets based on discretionary spending, and retreat into very basic industries with very low margins, perhaps, but at least stable margins that have strong pricing power.

That includes, again, commodities, chemicals, things such as that, of course, gold is super, super, super defensive, but it will not pay a dividend the way other companies will that I just mentioned, basic industries and whatnot. And that’s the best you can do, I think that’s the best way to try to ride this out. It will, at least, preserve your capital if not grow it. And then, of course, look, come on, history goes in cycles, we’ll eventually get through this one, it might take a few years. And when we do emerge, then you’ll have fresh capital to deploy into more speculative and tangible, longer term, whatever it is, opportunities, but now is not the time in my opinion to be doing that.

Bilal Hafeez (42:53):

They all sound like really reasonable perspectives. And I guess, as you said, best of a bad situation is really the way you have to think about it rather than expecting some easy wins in this type of environment.

John Butler (43:04):

Indeed.

Bilal Hafeez (43:06):

So that’s excellent. I think we’ve covered a lot of ground, a lot to digest, thank you a lot for all your insights. And what’s the best way for people to follow your opinions?

John Butler (43:15):

I do tweet now and again, as those of us who hold somewhat alternative views in economics do, and my Twitter handle is @ButlerGoldRevo, one word, GoldRevo is short from my book, The Golden Revolution Revisited, which, in fact, actually touches on some of these topic here regarding, especially, international monetary relations, but also some of the economic implications of negative supply shocks and whatnot. So that’s an easy way to follow me and learn more about what I’m up to.

Bilal Hafeez (43:47):

Great. Okay. I’ll include the Twitter link and also the book link in the show notes as well. So with that, it was great chatting to you and thanks a lot for coming on the show.

John Butler (43:55):

Thank you Bilal, my pleasure.

Bilal Hafeez (43:57):

Thanks for listening to the episodes. Please subscribe to the podcast show, Apple, Spotify, or wherever you listen to podcast, leave a five star rating, a nice comment, and let other people know about the show, we’ll be super grateful. Finally, sign up to become a member of Macro Hive at macrohive.com. We’ll be back soon, so tune in then.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)