Global Economic Perspectives from a Pragmatic Capitalist

Cullen Roche, who runs the finance and economics blog, Pragmatic Capitalism, is the ultimate “top-down” investor, and recommends that investors think globally, rather than locally when constructing and managing their investment portfolios.

Cullen’s sophisticated economic views and plain-spoken, common sense-based style make for compelling blog reading for anyone interested in a fresh approach to how to think about the world from a big-picture perspective. He has also published a book, Pragmatic Capitalism (which we reviewed here) , which offers a comprehensive look at his economic and investing philosophy.

Background

Cullen runs Orcam Financial Group, which offers asset management and consulting services and is based on a fee-only model. If you’re considering a global macro manager you should visit the site to learn more. Previous to this, Cullen managed his own investment partnership, which fared well during the financial crisis. He also worked at Merrill Lynch Global Wealth Management where he assisted in managing a $500mm+ portfolio.

Since it’s the beginning of a new investing year, we thought it would be an ideal time to speak with Cullen about his views on global markets.

Interview:

In your book, Pragmatic Capitalism, you discuss how it is important to maintain a macroeconomic perspective when thinking about your own finances. You have said that you are not a highly active asset allocator, but as an economist, do you advocate taking a tactical view on certain global macroeconomies? How can an understanding of country-specific risk help us as we construct global macro investment portfolios?

Cullen: I am a big proponent of understanding relative asset class risks. Using a top down approach can be an excellent risk management tool. For instance, anyone who understood that Europe’s monetary union was fundamentally flawed, as I’ve explained several times over the last 5+ years, was able to sidestep the massive landmines that many European markets have turned out to be. Using a macro view helps you to better conceptualize and analyze micro details. And if you can get the macro picture right then the smaller details tend to fall into place much more easily.

When will the Fed raise rates, and what will happen when they do?

Cullen:  I have been on record saying that I wouldn’t be surprised if the Fed is still at 0% when the next recession hits. But there’s a chance that the US economy is beginning to really heat up. We’ve seen some signs of wage pressures in the Employment Cost Index, but the recent collapse in oil prices gives the Fed much more flexibility. They will be well below their inflation target for 2015 so that likely means a rate hike is coming in late 2015 at the very earliest, but more likely in 2016 or later. And when they do raise rates we could see a punishing bear market in many fixed income markets. 

Emerging markets are near half of global GDP, but some fear many of these are overleveraged. What’s your view?

Cullen:  It depends on where you’re looking specifically, but the emerging markets have huge potential in the coming 30 years. Emerging markets are 60%+ of global GDP, but represent just 13% of global market cap. This means we could be in for a continuing market share reversal where the developed world continues to lose market share to slower high growth countries. It will be uneven in part due to the way many of these emerging market economies are leveraged in various ways, but the added volatility is part of what comes with booming growth – busts are inevitable along the way, right?  But that doesn’t mean we should shun them completely.

Greece is threatening to default again. What would be the implications for European stability?

Cullen:  A Greek default could be extremely unsettling as it could set off a domino effect as they implement a devalued Drachma and become extremely competitive relative to the Euro. This would lead to a short-term crash in the Greek economy, but would establish a long-term floor. If other peripheral countries see that Greece is benefiting from their exit then they too could look for a way out. I just don’t see how this can be allowed to happen though. The EMU is too geographically interdependent to go back to the inefficient use of competing currencies. But they need to integrate more fully which will include a central treasury and governing body. That’s no small step and likely one that will be pieced together over many more years.  

One can make a case that Japan is today involved in a so-called “keynesian end game.” For instance, with debt/GDP ratio of ~250%, Japan far exceeds Reinhart and Rogoff’s “rule of thumb” of a 90% threshold for debt/GDP, beyond which economic growth stalls out. What is your view on Abenomics?

Cullen:  Japan is really fighting a demographic battle as their population ages and shrinks. It’s very difficult to maintain a strong economy when you have a shrinking population and fewer workers. The government can try to offset this with various policies, but unless they start printing people the battle will remain an uphill one. Abenomics can’t fix this problem and it’s likely that Japan is going to continue to experience low and uneven economic conditions.

You have expressed the view that commodities are unproductive assets and don’t generate a real return over long time frames. Yet timber is a commodity that has generated positive real returns for 100 years. Grantham Mayo Von Otterloo has forecast a 5.4% real return for global timber assets for the next 7 years, beating all other asset classes. Is Jeremy Grantham crazy?

Cullen:  Commodities tend to have a high correlation with inflation because they are comprised of cost inputs in the capital structure. It just makes sense that commodities as an asset class don’t beat the rate of inflation over long time periods. This doesn’t mean they can’t be useful assets in a portfolio, however. For instance, any commodity dependent company likely has an interest in using commodities to hedge their business risk. Airlines are the most common example of firms that will use commodities as a hedging mechanism that reduces their modeling uncertainty. Of course, all other investors can use commodities similarly to hedge other assets in a portfolio, but I think it’s generally wise to view commodities as a form of insurance or a hedging tool rather than the core piece of a portfolio. Now might be a particularly good time to be implementing some of these hedges as commodity prices crash and long-term bonds are unlikely to generate the low volatility, high return hedge that they have reliably generated for the last 30 years. Investors who are looking for positive uncorrelated returns could benefit from owning a slice of commodities today.
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Thanks, Cullen. We can’t think of too many people who would be able to address such a diverse group of economic topics in such a straightforward way.