Last updated on August 25, 2023
This podcast episode was released to premium subscribers the same day it was recorded. Become a premium subscriber by signing up on our Substack or Supercast.
Peter Kraus, founder and CEO of Aperture Investors, joins the podcast to discuss his views on the economy, why he expects the ‘soft landing’ to occur, but why it will quickly give way to renewed concerns.
Content Highlights
- An economic soft landing is likely, but will be transitional (1:38);
- The Fed is unlikely to ‘break more stuff’ as this spring’s banking crisis was a short-term liquidity crisis that has since been resolved. But refinancing will be a problem (4:12);
- Inflation will be more persistent and ‘sticky’ than markets are pricing in right now. This doesn’t leave bonds in a very good position (7:20);
- When it comes to stocks, expect volatility until late autumn at which point higher interest rates will start to bite (16:17);
- The consumer, and consumer stocks, will lead the rebound starting as early as December (19:33);
- Background on the guest (26:06);
- China’s driver of commodity prices may be over (35:42).
More About Aperture Investors
- Website: ApertureInvestors.com;
- Twitter: @ApertureInvstrs;
- LinkedIn: Aperture-Investors;
- Instagram: @ApertureInvestors.
Quick Video Highlights From Our YouTube Channel
Transcript
Nathaniel E. Baker 0:35
here with Peter Krause, CEO of Aperture investors in New York. Peter, thank you so much for joining me contrarian investor podcast today. Happy to be here.
Peter Kraus 0:45
Thanks for having me,
Nathaniel E. Baker 0:47
it’s great to have you. You have some contrarian views here, on interest rates, on the economy, and on bond markets. And big picture economy. Of course, we’re all talking about a soft landing, to the point where this is pretty much become the base case. And you’re on board to an extent, but maybe less so for the long term. So I’ll let you talk about this. Tell us your views on the economy and a potential soft landing.
Peter Kraus 1:25
So I think the soft landing concept, which is of course, the objective of the Fed. And as of course, the expectation and hope for every investor, is something that we are likely to see in the next month or so maybe even two months. But it’s very transitional. I don’t actually believe the soft landing can eliminate the impact of a significant growth slowdown, I’m not going to use the recession word, because recession is a highly technical term, as defined by some group of economists who decide that the period you’ve been through is recession or not a recession. But significant growth slowdown is effectively what a recession is. And it could be negative growth, or it could just be significantly negative second derivative changes, both are the same sort of thing. So I do think that we are going to see that significant negative growth, second derivative, I think that’s going to occur. And I think it is in the process of occurring. So right now we’re measuring this and saying, employment is still pretty positive. We see consumers continuing to buy, we see jobs being created, although at a much slower rate. But we’re also seeing signs of growing credit concerns of higher credit card risks and reserves of bank stress, not relative to liquidity, but relative to credit losses. And that’s because the Fed is very aggressively raised rates and continuing to raise rates. Even if it doesn’t take rates up in the next few time periods, it’s still at a relatively high level. So I think what will happen is that that financial constraint that’s caused by the Fed increasing interest rates, and has been lessened significantly, by the stock market rising, which is a liquidity provider, not a liquidity, you know, remover, that that’s going to stop, and the Fed is going to continue to take liquidity out, the Treasury is going to sell lots of securities at the long end of the yield curve, and take more liquidity out of the system. And that’s going to conspire to create this much faster slowdown in growth. And I think that happens by the end of the year.
Nathaniel E. Baker 3:56
Okay, so it sounds like you’re you didn’t say this, but do you think there’s a chance the Fed could rake more stuff we had the bank crisis in the spring seems to have been resolved. But that was one of the things people have pointed to with these higher interest rates. Do you think there’s potentially other things like that looming?
Peter Kraus 4:16
So I don’t think they’re gonna break more stuff. I think what broke is probably the limit of what is going to break. What actually occurred in March and April, was a liquidity crisis on selected bank balance sheets. liquidity crises are acute, deep, fast. So I think most of that has occurred because if it was going to occur, it would have I think the credit issue though, is a much slower Longer, not necessarily more painful, but painful process. And what creates the credit risk is two things, one, lower incomes or revenues and the credit companies or individuals. So inability to pay the interest, which is much higher or more likely in ability to refinance. And it’s, I think, the refinancing issue, that is going to be the biggest problem. And that’s because interest rates are literally 400 basis points higher. And I think that companies are not going to be able to all companies are not able to easily refinance themselves. And that’s going to cause restructurings. And that’s going to cause some some credit losses. And that’s going to cause bank stress. And that’s going to reduce bank lending. And that’s going to make the Feds be a little bit tougher on bank reserves all that’s going to conspire to continue to slow down the economy. And that’s going to create a lower revenue growth. And that’s going to create more challenges in the credit complex. So that is what I expect will happen from the Fed. And I think the Fed would normally counteract that by taking weights down, but can’t because inflation hasn’t been defeated. And that’s why I say it’s hard to have a soft landing, be persistent, because all of these other actions are at work, and they have to play themselves out. And it’s very difficult for them to play themselves out without really having a significant slowdown in growth.
Nathaniel E. Baker 6:39
Okay. Now, you mentioned inflation, and this has come down, it’s not yet at the Feds target rate of 2%. But it’s pretty close. It’s you know, three and so and lessening further, we get a fresh reading tomorrow. But do you think, do you think that doesn’t give the Fed leeway to cut rates?
Peter Kraus 6:59
No, I think the Fed doesn’t look at headline rates, you know, they look at the core rates, which I think are three, nine or 4%. I don’t think we have experienced yet the stickiness of inflation, you have to be probably older than 50, maybe 60, to have lived through a period of inflation, which was sticky, where it took, you know, four years to basically bring inflation down to low numbers, we’ve been fighting inflation for 18 months. It’s possible and the market believes this is possible that the speed at which we’ve seen inflation decrease from you know, called 6% or higher to we’ll call it 4% will continue. But it stands to reason that as you get closer to the target, the speed at which inflation drops slows. And therefore I think, by extension, looking at the speeds it has actually occurred and saying well, that’s going to continue at the same rate is probably up to opportunity. optimistic. Okay,
Nathaniel E. Baker 8:11
and what about, well, this doesn’t really leave bond bonds in a very great position, all this stuff, because you kind of need the Fed to cut rates for bonds to be attractive. What do you make of all that?
Peter Kraus 8:25
Well, I think that’s an excellent point. Quite frankly, I think that part of the challenge in the bond complex today is twofold. One is what’s going to happen to credit spreads and to what’s going to happen to duration, meaning you know, as rates go up, so I think people investors have crowded into two parts of the fixed income market double B’s, so called the high yield space, not triple C’s is some selected triple C’s enjoyed them, but to double B’s are very tight, and investment grade. And because people are searching for safety and investment grade people have some duration. So their duration is probably are using years instead of duration years maturities probably in the middle, you know, five to seven year final maturities. So if if the yield curve, what happens to the yield curve here is obviously going to have a significant effect on those positions. Right now, the carry that’s being earned in those trades is attractive, that’s why people are doing but with carry trades, you always have significant risk to shifts in the yield curve or credit losses. And I think that if you don’t, if you if you don’t own very short securities that are highly rated, ie you’ve got a lot of liquidity and you’re getting less you’re getting less carry than you would in the other two ideas. Then you have your long duration and You’re long credit, which means that if there’s a shift in duration, and credit spreads, meaning they get wider dread spreads in duration, the yield curve steepens, then that’s going to be painful for you. Even if the yield curve goes down and long and goes down, because we have a significant growth sign on, or even a recession, that’s not going to be offset by the credit spread widening, that’s going to be worse for you. You won’t get we won’t get a net positive, the credit spread widening will be offset to some extent by lower interest rates, but not enough. So that carry trade is a risky trade, but that’s where all the money is sitting.
Nathaniel E. Baker 10:40
Yeah. And the yield curve has been inverted for a while, obviously, you know, several instruments, short term yields much higher than long term. Do you think that resolves itself in any way?
Peter Kraus 10:52
Sure, that does. Because it’s not a natural position for the yield curve to be and it’s there, because the Fed is driving interest rates up on the part of the yield curve, it can control, which is the short end. And the long end is reflecting investors expectations about inflation. So well, that’s why I was focusing on what is the long term expectation for inflation, if the long term expectation for inflation is 2%, and that turns out to be accurate, then the long part of the curve will stay pretty much where it is, you know, it said for as long term inflation is two, two and a half, we’ll rates your one and a half, two, that’s, that’s reasonable. And then what happens is the yield curve pivots on the on the Long Point, and the short end comes down. And that’s how it steepens if the low term inflation rate is higher than two, so call it two and a half or three, then that 10 year rate has to go up a little, maybe 50 basis points. And then the yield curve doesn’t just pivot, it actually goes up and goes down at the same time. So I think it’s one of those two things. Mind you, it’s not a great answer to have the long end of the curve, actually rally and rates because that probably means we have a recession. Right. And credit spreads are a lot worse.
Nathaniel E. Baker 12:26
Curious what types of, you know, catalysts? Are you looking for here? You said that we probably have. And to your point, timing is everything. And you said we probably a couple months left of this, you know, soft landing scenario before we had trouble. What kind of stuff? Are you looking at? You mentioned consumer, or you mentioned employment? Is there anything else?
Peter Kraus 12:48
Yeah. So I think the solution about equities and Lissa debt, you know, I think investors would say that the debt markets usually are proceeding the equity markets. It’s a little like, well, if you talk to a credit guy, that’s what they’ll say we talk to an equity person, they’ll say the opposite. So there’s no, there’s no conventional wisdom on that that’s consistent over time. I think that the two things that are challenging in the market is what will happen to credit spreads as the economy slows down. And how will equity investors look through that or not in evaluating how much risk they want to put on in the equity market? So in the first point, I think credit spreads are likely to widen as we move into this slowing, and hit refinancing cycles. And we certainly see that in real estate. And commercial real estate is where there’s the most stress right now. It’s the most palpable, there are clear examples of large borrowers, well known borrowers literally sending the keys into the to the lender. That is unusual when that happens. So I continue to think that that will occur. That’s reflecting an idiosyncratic risk in commercial real estate, in office space, due to COVID change in work habits, and probably the over building in some cities, although the over building is not great. But it’s enough to actually pressure the marketplace. So I think that’s happening now. And you see spreads reacting now. And you see need for reserves on bank balance sheets actually acting now. And I think there was an article today that talked about bank reserves being elevated to a point that they hadn’t seen in three years. So that’s happening as we’re talking. And that’s part of the reason why banks are under pressure. It’s part of the reason why Moody’s is downgrading banks. that’s occurring as we speak. The corporate side of that hasn’t happened yet, because inflation caused nominal growth and nominal growth caused prices to go up and revenues to go up. Even if unit volume wasn’t increasing much, that created more revenues that created more operating earnings that covered the increase in interest rates. And therefore you didn’t see credit spreads act that badly, except for the bank crisis in which they blew out for 18 as give me 45 pairs and then came back. So now we’re looking at, well, what happens to credit when you start refinancing cycles, and you can’t refinance 100% of the credit. And that’s the next event that will cause credit spreads to actually expand how how fast, they will expand ahead of that without those events occurring. Generally, those events have to actually happen before the spreads actually start to react fully. Now, the equity market. So everybody knows the equity market is going up from the bottom of October 22. This year, the s&p is up 17, the NASDAQ’s up 33, that those are big numbers, but they are off of a low base. So let’s not forget that point. The equity market is still not back to where it was at its peak, which is 4800. So what do we make of it? It’s also very, very narrow, we know that there are seven companies that are driving a large part of that valuation. And there’s some idiosyncratic elements to that. We also know that AI is played a significant part in the valuation. So what happens now do the rest of the rest of the market catch up? Or do the leaders that have taken the market up as much as it has shrink back down to where the rest of the market is? That is a conundrum. And frankly, that’s challenging to figure out, what I think is likely to happen is we’re gonna see some volatility here, markets gonna go up and down, you know, until we get into late fall, early winter. And at that point, I would expect the Feds interest rate policy to have to start to have an effect on the things I’ve been talking about refinancing slowing economy be more clear, unemployment rising. And then I think the equity market will look through that to 2425 and start to say, Wow, on a sequential basis, I’m going to see some big increases here. And consumers are likely to see the consumer companies to like see the first effect of that, because the consumer companies already contracted significantly in 22, and then 23. So we’re likely to see expansion in 24 and 25, when that second derivative, so I think consumer companies are going to be the leaders out of this cycle.
Nathaniel E. Baker 18:13
Oh, really? Okay. So they’re gonna bounce as early as next year,
Peter Kraus 18:19
perhaps even later this year, because the equity market will look ahead.
Nathaniel E. Baker 18:24
Okay. Now, where the consumer is concerned this, the consumer has been stubbornly persistent here throughout the last couple of years.
Peter Kraus 18:35
Now, student loans, people are paying them. Right? Yeah, you also have to remember one really big thing when really big thing for any homeowner, any homeowner 90% of which are financed with fixed rate mortgages. They have 30 year mortgages at very low interest rates. So what that means is, you’re not going to see people sell their house, because then they lose the interest rate. But they do have a lot more disposable income. And they’re going to use that to upgrade their house. And you’re seeing that today, in companies that actually service that part of the market. They declined those companies, equities declined significantly in 22. And in early 23, and now they’re recovering, because people are actually not selling their house, but putting a new room and a new deck, a new X, whatever it is, and that I do think the consumer is going to continue to be persistent there.
Nathaniel E. Baker 19:37
Okay, now, the most recent Home Depot earnings actually spoke to the opposite happening a little bit now that’s just one company. I think Lowe’s might have said the same, but they said that they were seeing fewer big ticket item purchases. And you should recall granted those already three months…
Peter Kraus 19:53
No, no, no, I think that’s true. But again, I’m talking about what is the equity, what’s the equity investor going to think so So if you’re seeing those decreases now, yeah, then you have to look out over time and say, Okay, but what do I think is going to happen in the future? And is that rate of change positive, because remember, the equity investor is always looking at the differential. And I’m looking at, you know, what actually happened, did it go down, it did it to go down more or less than the last quarter. And if it went down in the last quarter, and it goes up in this quarter, then I’m interested, because I’m going to see growth. So the fact that Home Depot is reporting weaker sales. That’s, that’s probably what we expect to see.
Nathaniel E. Baker 20:39
Now, the one equation here, the one part of this whole mix is employment, of course, and if you don’t have people employed, then they can’t really make investments in their home or in anything else, and consumption comes down, blah, blah, blah. But it doesn’t sound like you’re expecting very much in terms of the employment figures, or the unemployment figures, I should say,
Peter Kraus 21:00
Well, I think that we’re going to see unemployment go up. It’s way too low. Yeah, I mean, it’s under four. I mean, it’s easy for us to have an unemployment rate at five, you know, until you get to six or seven, you’re not in any stress, an unemployment rate between four and five, as you can argue four to four and a half is full employment. You know, five is, you know, slight softness, and, you know, in the marketplace. So and that’s a big move. You know, that’s a one plus percent increase in the unemployment rate on the nation’s worker force. So that’s a lot of unemployed people. So I expect that that will happen. And I expect that that will have some negative effect on on the consumer, for sure. But that’ll be the end of the cycle. Yeah. Okay. And, and remember, employment is a lagging indicator, right? So the market is going to be ahead of that with by the time you see that the market is going to be up.
Nathaniel E. Baker 22:01
Okay. Interesting. Interesting. Peter Krause very interesting conversation here. I want to take a short break and come back and ask you some more stuff about yourself about your firm. There are some other topics we haven’t talked about yet, including China. That’s been in the news. We want to get into that. But let’s first take a short break, and allow our sponsors to be heard. If you are a premium subscriber, you will not get the break. Do not touch the dial. We’ll be right back. In fact, we already are.
Welcome back everybody here with Peter Krause, the CEO of Aperture investors in New York, Peter, this is the segment of the show where we ask our guests to tell us a little bit more about themselves, how they came to this station in their career. More importantly, how they got interested in investing in the first place. I call this the origin story, to borrow Marvel terms. So what is your story? And how did you get to where you are that you started? Aperture investors? Take us back and tell us about it?
Peter Kraus 23:04
Well, I suspect I’m not dissimilar to many investors. It’s been a lifelong interest. As far back as, in my early teens, I was interested in the stock market. In fact, what I was interested in in the stock market was charting stocks. And then when I was you know, 10, or 11, that was, I’m dating myself in the 60s. You know, there was something called Value Line, which was a book of tear sheets that describe companies. And on the each Tear Sheet was a chart of the stock, I don’t know for how long was it was a year or two years, I can’t remember. And they would do technical analysis on the chart would say, you know, this part of the chart suggests that stock is gonna go down, this part of the charts that she got started is going up. And for some reason, I don’t know why I found that interesting, because it was behavioral. And I think that the market is this weighing machine. And over long periods of time, it’s very efficient, but over short periods of time, it’s inefficient. And so it weighs people’s emotions, meaning fear and greed, meaning, momentum and lack of momentum. And there’s all there’s lots of technical terms word today, but ultimately, it’s the expression of human behavior having an impact on stock prices. And the the actual movement of the stock price over time, reflects that weighing process. So as a younger kid, I used to trade stocks, I didn’t know what I was doing was shorting stocks, and I enjoyed it. And so I just kept doing it. And I just, you know, kept at it over my you know, my adolescence and then in college I was very interested in the stock price movement as well and micro economics And then as a career, I started off as an accountant, as a public accountant, because I was interested in numbers as well, which is obvious from the charting. And then I made a significant move in my career to go work at Goldman Sachs in 1986. I was at Goldman Sachs for a long time, and ultimately retired from the firm as the head of their investment management division and a member of their senior management team. And I decided I would retire and run a public company in the asset management space. And I ran alliancebernstein for almost 10 years, and then retired from there and decided that I still liked stocks, I still liked investing. But I had found over that time period that there were some real maladies in the business. There was a mis conception or a misdirect or a misalignment better said, between the incentives paid to investors, and the objective of the investor. And what I learned over 40 years in the financial industry is that financial investors are very Pavlovian. If you pay them to do something, they will do it. And there’s no mistaking that. And so you need to be thoughtful about aligning how you compensate somebody. Because that incentive system drives their behavior. And behavior drives their investing and investing drives their returns. So I thought there was little attention paid to that alignment in the industry. Where people are basically paid whether or not they perform. And even in the higher fee segments of the industry called the hedge fund industry or the private equity industry, people are still paid a lot to gather assets. And they can gather more and more assets and have their Alpha shrink and still make more money. And you as the investor didn’t hire me, as the portfolio manager to do that. You gave me your money, because you want me to perform, which means beat the index, were beat zero, or whatever the benchmark is. So I thought, the best way to deal with that would be to come up with a different incentive system that actually was focused on incentivizing the manager to actually performed. And I felt that if you did that, at the manager level, you would also attract the best managers, because the best managers know they perform, and they want to get paid for that. And so what you need in investing is incentive alignment, the best talent and the ability to control capacity. Because as assets get bigger, it’s always harder to perform. It is a senior coin, and it’s a principle, it’s like, gravity. So you need an incentive system that says to the manager, look, if you take more assets, it may not be financially rewarding for you to do that. So don’t take more assets, because you’ll make more money if you don’t. So it’s three parts. It’s not just a fee, it’s not just to get the best manager, it’s also control the capacity. And if you have an environment, or an incentive structure that does that, I think you can attract the best people have the best manufacturing facility for alpha, and satisfy the client with an objective that’s consistent with their aspirations. Okay. So that’s why we built aperture to do that.
Nathaniel E. Baker 28:51
Now, you don’t find that? Well, a couple of questions here. And I’ve studied hedge funds for, you know, most of my career and follow them. But I guess first of all, wouldn’t this incentivize excessive risk taking if? Or the the compensation is based on returns?
Peter Kraus 29:09
Well, you know, the funny argument is, you say to people, we’re just going to pay me on returns, don’t pay me any management fee? And of course, then the answer is, well, if you do that, then well, if you don’t perform, how are you going to sustain yourself? So obviously have to have some management fee. So then you say, Well, yeah, but I don’t want to pay you that much on performance, because that could incentivize you to take risks, I’ll give you more advantage. But here’s the sweet spot before you’re giving them so much a management fee that they don’t take any risk because you don’t pay him to take risk. So at the end of the day, you have to hire the manager, who ultimately you believe can control their risk, can perform and will get paid and will make you money because everybody has to take risks. You can’t take risk without you know and, and, and perform or not perform. It’s not past Simple, right? So what you have to find is a manager that you believe understands how to take risk, and how to think about it, because the manager doesn’t want to blow up, that’s not there. That’s not really what they want to do. They want to build a business, they want to do this for the rest of their careers. So they don’t want to take a lot of risk and paid a lot of money. And by the way, the more assets you have, the higher the probability is that that does happen. Because then a manager says, Listen, I’m having the best year of my career, I have lots of assets, if I knock the cover off the ball here, I’m done, I can walk away. That’s not a good position for the investor to be. So I think there’s, it’s a very complex problem, it’s not a simple problem, you can’t just look at one piece of it and say, I can solve that it’s a wheel ecosystem. And you have to understand that ecosystem as an investor, to basically find the best place to put your money.
Nathaniel E. Baker 30:54
Yeah. Do you have? You know, I mean, based on what you just said, this might, you might have already answered this question. But do you have kind of a sweet spot in terms of like management plus, carry? Is it like one in 30? Is a 75? And 24? Yeah.
Peter Kraus 31:09
So I think it’s different for equities and fixed income, right? I think fixed income, the sweet spot is between 75 and 150 basis points and 20 and 30, over a benchmark for equities, you can charge less. So you can you can modulate the performance fee and the base fee. So it’s somewhere between 30 basis points to 1%. On the management fee, and 30% and 20%. We find a lot of people just like one and 20 or 75 and 20. I personally my own personal interest is I think 30 basis points and 30 is I’m happy to pay you a few if you’re making a lot of money. That’s good, I’ll pay you more no problem. Don’t deny another man’s dollar if they’re performing. But do I really want to pay you 100 basis points or 75 basis points when you’re not performing? Not really, I prefer to pay 30? Because I have to pay you something keep the business going?
Nathaniel E. Baker 32:06
Yeah. This kind of begs the question about mutual funds, because mutual funds don’t have the performance fee.
Peter Kraus 32:12
Mutual funds, I tried very hard to create a mutual fund this construct, but the rules around mutual funds really prohibit that from being effective. The disclosure is very complex, the calculation methodology is very complex. And clients have a hard time understanding, actually, financial advisors have a hard time understanding it and don’t want to explain it to their clients. But at the end of the day, you can buy a mutual fund that charges a low management fee, and a effectively a performance fee with that has a cap. So the way it works is you pay 30 basis points for management fee, you pay 30% up to a cap. But that fee that you’re paying is called a variable fee. It’s not called a performance fee. So the fee changes every day. And that’s a hard thing for people to understand. Because they just want to say well, what am I paying? You? Like what am I paying? And that’s why people do the simple thing, which isn’t really in their interest. But it is in their interest because they understand it. So they sacrifice which actually good for them as an investor, because they can internalize what the fee is.
Nathaniel E. Baker 33:27
Oh, that’s interesting. So I didn’t realize there are mutual funds that did that. It’s not a variable fee. Okay.
Peter Kraus 33:32
Yes. It’s called a Hong Kong thing. Okay.
Nathaniel E. Baker 33:35
Interesting. Okay. Um, and so then when did you start aperture?
Peter Kraus 33:41
We started investing at aperture during 2019. So we finished our for our full three year track record at the end of last year.
Nathaniel E. Baker 33:53
Okay. And it sounds like you’re only open to qualified investors. But it’s
Peter Kraus 33:58
actually we have mutual funds. Oh, you do? So you could invest in our mutual funds. We also run private vehicles, which is a predominant amount of business. And we also run funds in Europe with your use these funds. Sure. And those are public vehicles. Right, effectively a European mutual fund, right. In Europe, performance fee calculation is clear, simpler and works.
Nathaniel E. Baker 34:26
Okay. All right. All right. Let’s switch back to markets here and China. Has was in the news. You know, last couple days, we had some bad trade numbers. We had some somewhat shocking deflation numbers. We had some measures new measures by the Biden administration to prohibit investing in certain parts of their economy only private investing, not stocks, you can still buy Chinese stocks. You can still buy ADRs but yeah, and you had some views on the whole China reopening Do you think how do you how do you view that as playing out?
Peter Kraus 35:04
So China is an even tougher story. Because the divergence between what happens in China over the next few months, or even year, and what happened in China over five years, could be dramatically different. Because the Chinese are very long term thinkers are very long term, have very long term horizons, their political cycles are much longer than ours. And so it allows them to have a much longer term focus on what they want to achieve and the time period over which they can achieve it. Which is frustrating to investors who tend to think about their timeframes in much shorter cycles. So I think China is a challenging place to invest right now. And what I what I think we’re not going to see in the future, is the deflationary cycle of China growing and exporting deflation through productivity gains, and higher and higher amounts of production, offset by huge buying of commodities. I think that is over. China’s reached a point where it could impact the marginal price on commodities, because it’s still a big buyer on the margin, but I think its its impact on emerging markets, growth is significantly diminished, not because of anything other than it’s just gotten big. And you can’t move a big thing that fast. I think that’s done. I think investors are wary about the government and how the government behaves. And I think the government is not that focused on the international investor. I think I, they wouldn’t say this, but I think the utility to the government of the of the international investor investing in China does not appear to be high on their list. And since it’s not high on their list, you can’t expect that their behavior is going to be attractive to that cohort. Their behavior is focused on a different cohort, which isn’t internal. And it may not be as easy for us external people to understand. So that’s a lot of uncertainty for investors. And I think, therefore, China’s going to be more challenging as an investment thesis over time. Now, will that resolve itself? It’s very possible, will I be wrong about the importance of the international investor to the government? Could be they certainly are struggling with how do they restart their economy, which I think also is a function of the last 15 years of growth. So they grew by building buildings and building roads and building bridges and doing infrastructure galore. They never really stimulated the economy the way the US does, by creating consumable income for consumers. They may not have the wealth transfer mechanisms, they may not have the incentives, they just may not have the infrastructure or even the experience to do that. And I do think that that’s what they need to do going forward. So if I had an optimistic view of China, it would be to figure out where China’s stimulus is going to go to we start their economy. And what are the were the beneficiaries of that? And I don’t think that’s the previous cycle. I think that’s a new cycle. And what that is, is still unclear.
Nathaniel E. Baker 39:09
Right, but there’s a lot of problems. I mean, a lot of challenges with that, you know, you have this huge bureaucracy for them to pivot quickly. And they’ve been talking about a consumer forever, about how they’re building consumer class and blah, blah.
Peter Kraus 39:24
Yeah, no, exactly. And that’s why I think they want to do it. But as I said, I don’t think they figured out how to do it yet. Right. And it’s not exact. I mean, we take it as a for granted, but it took us us meaning the United States, I don’t know, you know, 100 years to figure that out or 50 years to figure that out. So you got to expect it’s gonna take them some time. But But I think if you’re looking for like, okay, but where do I invest because you can’t just disregard China. You can’t just say look, I’m not investing in China that that’s that doesn’t make any sense. That’s silly. So if you if you want to be in China, because I think you have to You have to figure out well, where are those companies that will ultimately be the beneficiaries of what the government is trying to accomplish. And they talk about consumer, they talk about technology, they talk about AI, they will actually invest in those spaces. And that is where the money is gonna go, it’s not gonna go in real estate, it’s not gonna go in bridges and concrete, it’s just not gonna go there.
Nathaniel E. Baker 40:26
Okay, so the commodities put the commodities plays, basically, because they are the biggest purchaser of commodity purchaser of commodities. Right. So what does that where does it leave commodities if
Peter Kraus 40:36
China’s been the marginal buyer, and so people have gotten used to evaluating what commodities are going to do based on what China does? Well, that may not be all that mean that the commodity cycle shifts, the reasons for price changes over time, sometimes it’s supply and deuced, sometimes demand induced. So today, you know, the oil companies are probably doing poorer than they, you would expect them to do, given their free cash flow. And maybe there’s some attractiveness in the oil companies today, because, well, prices are probably not going to go down much, given the fact that the US has released strategic oil reserves, that the shale production is lower, although as prices go up, it will increase given that the Middle East is controlling oil flow, and given the war in Ukraine, and the constraints on Russia. So, you know, marginal increases in China’s demand for fuel will actually have a bigger effect on the oil price. And oil companies, you know, benefit from that immediately. And so that’s probably, that’s probably a reason an interesting trade.
Nathaniel E. Baker 41:59
Okay, interesting. Yeah, that’s a good one. Okay, cool. Is there anything that keeps you up at night, Peter, that you know, any disaster scenarios via geopolitical or environmental? or what have you that, you know, that you’re worried about here?
Peter Kraus 42:21
I like everybody else, you know, worries about the obvious. You know, is the war in Ukraine going to end or get worse? You know, will there be a kinetic conflict in the Asia Pacific, that would be a disaster. I don’t, I don’t really remember a time in my life, when there wasn’t some risk of those things in the world. Maybe the risks get bigger, maybe the risk gets smaller. But, you know, we’ve never lived really, without those risks. And I think that they remain and I think investors pretty much invest through them unless they become hot. And the Ukraine work became hot. And now it’s kind of like white noise. It could get hotter, that would change people’s investor, you could get colder that would change people’s investors for what it is today, it’s white noise. And I don’t think it’s going to amount to much if China were to invade Taiwan, which I think is highly unlikely, almost remote, where there were some other concentration, which is less remote in that part of the world, that obviously would have a acute effect on markets. But you know, I don’t expect it to be long lasting. I tell you the one scenario that I do worry about, which goes back to this longer term inflation expectation problem. If it turns out that inflation is indeed sticky, and doesn’t really go below three. And investors shift their long term inflation expectations to three, three and a half, and demand a wheel rate of interest of 150 basis points so long, the tenure is four and a half to five. And given the amount of debt that the government has to continue to borrow, not the not the stock of debt, that’s somewhat problematic, but the fact that we run these deficits persistently, and we’re constantly growing that may not be offset by nominal growth in GDP. And I think that could create a condition where bonds continue to do poorly. And growth is not that robust, refinancing risk accelerates. And at some point, we’d have a bigger recession. That’s Okay,
Nathaniel E. Baker 45:00
we’ll worry are potentially stagflation based on what you’re describing?
Peter Kraus 45:04
Yes, you would have stagflation. And then you’d have the recession.
Nathaniel E. Baker 45:09
Okay, what would you if you had the game and our model? And what would you say are the percentages of that versus the other scenario you talked about earlier?
Peter Kraus 45:19
I think that that’s 25%. Chance, maybe 30. But that happens, I think it’s my main, my 50% probability is that you get this soft landing, evolving into a harder landing, whether it’s a recession or not, doesn’t really matter and recovery, and that the inflation rate doesn’t get stuck at three, it gets stuck at two and a half. And we can manage that. And that works just fine.
Nathaniel E. Baker 45:59
All right. All right. It sounds like to not get ahead of ourselves here. But next year, we’re going to be hearing a lot about this election. last
Peter Kraus 46:07
election year, you know, it would be highly unusual for the administration in charge not to spend money, right. So it’s tough to have a recession in an election year. You know, George Bush had one, George Bush the first and contributed to his lack of a second term, not the only reason. But it’s unusual. So you would expect the administration to find ways to spend fiscal spending doesn’t really drop. And it’s really, you know, 2526, where these issues I’m talking about, you know, start to really bite?
Nathaniel E. Baker 46:46
Yeah, yeah, I was gonna say so it sounds like this will likely not happen in a time where it’s dangerous that by
Peter Kraus 46:53
no credit, the credit spread, though credit spread widening that happens in the next six to nine months. Right. I think, you know, bank issues will will come to the fore, we’ll see bankruptcies, we’ll see restructuring, you’re gonna see that in commercial real estate, all that’s going to occur, but the consumer probably, you know, power is the economy through to some growth, as opposed to, you know, a negative growth unless there are more job losses than we’re expecting. Right.
Nathaniel E. Baker 47:22
Right. Right. But even then you would expect the government to flood the
Peter Kraus 47:26
I would expect the government to do that, because it’s an election year. Absolutely.
Nathaniel E. Baker 47:31
Very good. Peter Krause, thank you so much for joining me contrarian investor podcast today. In closing, maybe you can tell our listeners how they can find out more about you more about your firm, whether you’re on the social media, and I will include all this in the show notes so people can access it.
Peter Kraus 47:47
Well, you can find out about aperture investors by googling aperture and going on the website. It’s quite descriptive of the products and firm. And I am on social media, LinkedIn and Instagram and other places. So it’s not hard to find us. Okay.
Nathaniel E. Baker 48:07
I’ll put those links in the show notes. And with that we’re done for today. Thank you all for listening. And thank you, Peter, for making himself available and for all Peters. People who reached out to me and helped me to make a possible greatly appreciated. fascinating conversation. Thank you all for listening. We’ll see you back here again next week. Speak then. Bye.