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Jacob Wolinsky
Jacob Wolinsky
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Full Transcipt and Video: Francois Trahan Interview with Consuelo Mack

CONSUELO MACK: This week on WealthTrack, economic and market lessons from Wall Street’s top strategist. Financial Thought Leader Francois Trahan describes “the new era of uncertainty,” why so many of the old economic rules aren’t working, and what has replaced them as market drivers, next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack, at the Museum of American Finance in the heart of the Financial District on Wall Street. No matter where you look, there is mounting evidence that the global economy is slowing. Research boutique Wolfe Trahan pointed out recently that “most global leading economic indicators are in contraction territory already.” There are a few exceptions such as Norway, Denmark and the Czech Republic, which are still showing signs of expansion. But economies such as India, Japan, Germany and the U.S. appear close to contraction; and in countries ranging from Russia and China, to France and Turkey, to South Africa and Australia, they are there already.

The slowdown is being reflected in world stock markets. As independent research firm Strategas reported recently, the trend has turned negative in 19 of the world’s 20 major equity markets, including the U.S. That falling confidence, plus sluggish consumer spending, and a struggling housing market have caused economists across the globe to slash their forecasts for this year and next. In the U.S. alone, economists have gone from a February consensus forecast of 3.2 % GDP growth for the year, to the current median forecast of 1.6%. Even that might be too high. In the first half of the year the economic pace slowed to a sluggish seven tenths of a percent. Even the Federal Reserve has been dramatically behind the curve. In February, the Fed upgraded its growth forecast for 2011 to a range of 3.4-3.9%. Needless to say, that is far above what it is forecasting now.

Why have the vast majority of economists, including those at the Fed, been so wrong?

This week’s WealthTrack guest is one of the few economists who have gotten it right. He predicted this year’s global slowdown and commensurate market dangers here on WealthTrack nearly two years ago. He is Francois Trahan, vice chairman, chief investment strategist and head of quantitative research at Wolfe Trahan. He has been ranked the street’s number one portfolio strategist by Institutional Investors for the past three years. He is also the co-author of the recently published book,

The Era of Uncertainty: Global Investment Strategies for Inflation, Deflation, and the Middle Ground, which I highly recommend. Trahan believes the economy is now fundamentally different from what we grew up with. I asked him what’s changed.

FRANCOIS TRAHAN:Well, I would say there’s three main things that are dramatically different- so, trends that we had in place for several decades that have now changed. So, we had consumers willing to lever, take on credit and debt, for 70 years in the U.S. And since 2008, it’s been the opposite. And what the political landscape shows you, I think, this summer, with the debt ceiling debate, is that the word “debt” now has a negative connotation attached to it. So we have consumer deleveraging, which is different than anything that I’ve experienced, certainly in my career. Government deleveraging, or government austerity. “Austerity,” people think is a bad word. I call it reality. It’s already happening at the state and local level. So if you look at government payrolls over the last half-century, what you see is that, for 50 years, month after month, governments would hire more and more people.

CONSUELO MACK:And this is local, state and federal.

FRANCOIS TRAHAN:Exactly. And since 2008, almost every single month, what you see is governments are shedding labor to address their budget issues. So, that’s dramatically different than what we had in the past. And then the last one, I would say, is that the Fed is now ineffective. Fifteen years ago, when the Fed cuts rates, the economy improves. When the Fed raises rates, the economy decelerates. When the Fed funds rates at zero, there’s not a whole lot that the Fed can do. So to me, that makes today’s backdrop dramatically different than what we’ve all experienced in our careers.

CONSUELO MACK:So why is it that the Fed is not effective? What’s changed to make it much less potent than it has been in the past?

FRANCOIS TRAHAN:Well, I mean, what haven’t they done at this point? They’ve taken the Fed funds rate down to zero, and that’s the most powerful tool they have. And I think what QE2 teaches us is that we’ve reached the limits of monetary policy, because they thought QE2 would be good for the economy. Unfortunately, what it did is it led to a big decline in the U.S. dollar, which meant a big rise in everything we import- the price of gasoline, heating oil, clothing, food, everything sold at Wal-Mart. And what it did is it imposed a tax on consumers. So something that they thought was a form of easing ended up really being a form of tightening, you know, in the form of higher inflation. So I think we’ve just reached the limits of what the Fed can do here.

CONSUELO MACK:So, let’s talk about inflation, because you think that that is the key variable to understanding what’s going to happen in the economy and the markets. And you call inflation the new Fed funds rate. Explain that.

FRANCOIS TRAHAN:That’s right. Well, as I said earlier, 15 years ago, the Fed changes the Fed funds rate, and that’s what really determines the cyclical outlook for the U.S. economy. And the Fed fund rate’s at zero today, so it can’t play that role. And what you find is that it is inflation that is starting to play that role. Inflation went up last year, and now the economy is slowing. Inflation goes down, what’s going to happen is consumers are going to find themselves with more money in their pockets.

So I’m not a believer that deflation is the bogeyman that a lot of people believe it is, a lot of economists believe it is. I think, if the federal government can’t put money in consumers’ pockets because they’re broke, and the Federal Reserve can’t do anything, one way to do it would be to sink commodity prices. Get oil prices to come down to $40 a barrel. Everyone around the country all of a sudden’s going to find themselves with more disposable income. So to me, that is one way to help consumer deleveraging, to help people meet mortgage payments, credit card payments, et cetera. So, you know, inflation, CPI, has become the new Fed funds rate.

CONSUELO MACK:Now if you talk to the Fed, for instance, the Fed would say, number one, yes, consumer prices, the core inflation, has gone up over the last six months consecutively. But it’s still well within our target rate, so therefore it’s not really penalizing us yet. You’re saying not so, that inflation is a real concern now.

FRANCOIS TRAHAN:In my family, we eat food, we drive cars, we heat the house, we wear clothing. You know, so nominal CPI is what matters to consumption. It’s not core CPI. I understand why the Fed looks at core, you know, and historically, the reason why it made sense in the ‘80s and ‘90s is because the U.S. economy used to be the price-setter of commodities. So if you’re Fed chairman of an economy that sets prices for commodities, you’re going to think of commodity as being noise on your growth. So you’re going to say, let’s look at core inflation trends. But that world ended a decade ago. And so I think it’s time for the Fed to acknowledge that, and to change the Fed mandate. In my opinion, that’s the first step that they should take.

CONSUELO MACK:And the Fed mandate being this double mandate of full employment and stable prices. You’re saying that that is no longer applicable.

FRANCOIS TRAHAN:You know, it all depends on how you define prices. I think core inflation is the wrong benchmark. I think nominal inflation is the right benchmark now.

CONSUELO MACK:So what should they be doing now to target nominal CPI?

FRANCOIS TRAHAN:Well, what they would want to do would be to limit runaway inflation. And so, you’d want to limit a big appreciation, if you’re talking nominal CPI, a big appreciation in commodity prices. Because when commodity prices go up, people, you know, pay more to fill their gas tank. They have less disposable income left in their pockets. And so, you know, it would be targeting nominal as opposed to core trends. It’d be targeting things that actually people consume.

CONSUELO MACK:So, how does the Fed target nominal CPI?

FRANCOIS TRAHAN:Well, you raise rates when inflation goes up, and you slow the rate of inflation. And so, you’re basically, you know, preventing inflation from eroding people’s pockets. That’s the way to think about it.

CONSUELO MACK:So, right now, then, what they should be doing is raising rates?

FRANCOIS TRAHAN:Well, we’re staring at a downturn. So, think about it this way. In the last year, the Fed did not raise rates. But we had tightening in the U.S. economy nonetheless, because inflation went up. That’s a form of tightening. So whether you do it with short rates or you let the markets do it, it happened regardless. So you could do it proactively, or it can be out of your control. I mean, that’s the choices for the Fed as I see it.

CONSUELO MACK:The vast majority of your Wall Street peers completely missed the fact that this economy was going to slow as much as it has this year. And you were dead on, as far as your forecast and your predictions that, in fact, the economy was in more trouble than people realized, and that it was going to slow. So you say that what we’re witnessing is the death of traditional economics. What’s dead about traditional economics? You know, what are the most significant changes? What are your peers missing that you see so clearly?

FRANCOIS TRAHAN:Yeah, and it’s not just Wall Street. I mean, it’s the Fed. It’s the Congressional Budget Office. It’s everybody who’s been trained in economics. You know, when you’re trained in economics, you’re trained to look at tools that have worked over a long period of time.

CONSUELO MACK:Right. Post-World War II.

FRANCOIS TRAHAN:Post-World War II. So, slope of the yield curve, post-World War II, is a fantastic predictor of the economy. Except, when short rates go to zero, what you’ll find, studying Japan, is that the slope of the yield curve loses its predictive abilities. So, pretty good example, the slope of the yield curve in Japan’s been steep for 20 years. And the Japanese economy’s been horrible.

CONSUELO MACK:And when we talk about the slope of the yield curve, we’re talking about what interest rates are from Treasury bills, for instance, up to 30-year bonds. So, how is--

FRANCOIS TRAHAN:Correct. So the short end to the long end. And when official rates go to zero- because it’s basically the short end that tends to dictate the slope of the yield curve- what you’ll find is, it’s just not helpful at forecasting GDP any longer. So, economists- I’m a trained economist- you know, we’ve all been taught to look at the slope of the yield curve, and it’s served us well. It worked very well for a long period of time. In today’s world, it just does not work. So the message you’re getting today from the slope of the yield curve is, it’s still steep. The economy should be great. Unfortunately, it is not. One exercise--

CONSUELO MACK:All right. So we’ve pulled that out of our toolkit.

FRANCOIS TRAHAN:Well, one thing that we’ve found is that you can restore its effectiveness. When the Fed takes the Fed funds rate down to zero, or the BoJ does the same with official rates in Japan, the slope of the yield curve becomes meaningless. But you can restore its efficacy by doing one thing. Instead of using short rates, replace that with inflation. So, if you replace that with inflation in the U.S., your short end is no longer zero. It is now 3.6. Your long end, you look at the 10-year Treasury bond yield, is now 2.

CONSUELO MACK:So it’s inverted.

FRANCOIS TRAHAN:It’s inverted. So the economy is going into a slowdown, a downturn, possibly a recession. So that’s how you restore the efficacy of the yield curve.

Corporate profits. You know, there used to be a strong relationship between corporate profits and employment. And that broke down about 10 years ago. So, in a GDP model, you would have corporate profits in there. And, prior to 10 years ago, corporate profits went up, employment went up. That created economic activity. That doesn’t work any longer.

CONSUELO MACK:So, why doesn’t it work? What’s changed?

FRANCOIS TRAHAN:Well, you know, it’s globalization. You know, companies are still generating profits, and it leads to employment. It leads to employment elsewhere, unfortunately, in today’s world. And so, if you’re trying to forecast U.S. GDP, I think you’re going to err on, basically on the side of error. Much like, you know, the economics community has done this year. They were expecting this year to be a great year for growth, and in the first half, you know, we generated .6 percent economic growth in the U.S. The expectations were three-plus. That’s not a miss. A miss is expecting three and getting 2.7. You know, that’s enormous.

CONSUELO MACK:Another thing that you’ve said is that, in a slow economy, as we have now, that employment is absolutely key. And it’s a key driver of the economy. And so now we have a situation where we’ve got a slow economy and obviously we now have, what, two consecutive jobless recoveries. So what does that tell you about the future for the economy right now?

FRANCOIS TRAHAN:It’s not just a slow economy. I would say it’s a world where you don’t have credit. You know, what’s unusual about this recovery is that consumer credit hasn’t recovered. You know, it’s gone down, despite the fact that the economy grew a little bit. And so, when you don’t have credit- and, you know, our economy is 71% consumption- so if you don’t have credit, it means that you’re that much more dependent on employment than you were historically. Employment’s always been important, but its importance gets magnified when credit is hindered. And so, today, we know credit is hindered. It means that, if we can’t create jobs, we just can’t grow the economy, period.

CONSUELO MACK:So, your outlook for the economy right now is what?

FRANCOIS TRAHAN:Atrocious. You know, basically I think the stock market is beginning to price in a slowdown. With the stock market going down, bond yields moving lower. You look at sector leadership in the marketplace, utilities is the top-performing sector in the S&P. Not something I’ve seen very often in my career, not a good sign of things to come for the U.S. economy. To me, you know, people don’t like to call this a double-dip, but I think you call it what it is. You look at all these economics charts. I mean, they had a dip, and now they look like they’re rolling over. And so, I don’t know if we’ll meet the technical definition of a recession, which is two consecutive negative quarters, but it’s clear to me that we’re going to see negative GDP in the U.S.

CONSUELO MACK:Let me talk a little bit about your book, which is called The Era of Uncertainty: Global Investment Strategies for Inflation, Deflation, and the Middle Ground.And I happened to be delighted to write a recommendation on the book cover for it as well. And one of the things about the Era of Uncertainty that you talk about is that we better get used to the fact that we are going to see these tail risks. We’re going to see events, kind of outsized events, that are going to affect us. So why is this Era of Uncertainty, this is going to be our future?

FRANCOIS TRAHAN:We’re already in it, in my opinion. You look at the last decade. You know, we’ve had three boom-busts now. If you look at the 50-year period prior to that, you didn’t live through a 10-year period where you had so many boom busts. You remember, in the ‘90s, we used to believe that you could extend these business cycles forever.

CONSUELO MACK:Goldilocks economy.

FRANCOIS TRAHAN:Goldilocks economy, you know, which really is the anomaly, in my opinion, to a certain degree. You know, there were special circumstances explaining it. So now, we’re vulnerable to shocks taking place around the world, and it’s even more true for the stock market than it is for the U.S. economy. The U.S. economy exports 12% of GDP, but the stock market derives 40% of its revenues abroad. So stocks are much more susceptible to the rest of the world than the U.S. economy is. So, you have to take that into consideration.

Last year, events that initially started in Greece showed us that we weren’t impervious to things taking place, you know, in a country that most people in the U.S. have never been to. So, you know, when you’re going into a global slowdown, you have to start thinking about what can go wrong. You know, what is the weakest link that will break? And it’s not just, you know, the weakest link in the U.S. Is it going to be the muni market? Is there a pension crisis? Is there a budget crisis? But you have to compile a list of what can go wrong around the world.

CONSUELO MACK:So, give us, you know, your top candidate for, what’s the weakest link now that could affect us?

FRANCOIS TRAHAN:Yeah. Well, you know, there’s a long list of potential candidates. I would say Europe, I think, is very vulnerable. And so, I wonder if the euro will exist a year from now, in its current form?


FRANCOIS TRAHAN:Yeah. I would put strong odds that it does not.

CONSUELO MACK:So, what would substitute? What would be substituted for it? If we don’t have the euro-- maybe fewer participants? Or…

FRANCOIS TRAHAN:Well, fewer participants is probably the likeliest scenario. You know, maybe Greece drops out. Who knows? Maybe Italy drops out. You know, who knows?

CONSUELO MACK:So, Francois, listening to this, I mean, you know, I feel like I should get into my bunker and just go into cash or Treasuries. And in fact, I mean, you’re an investment strategist, top-ranked investment strategist. So the strategy that you have been recommending is what you call the safety trade. So, tell us about what strategy you’re recommending right now to your clients.

FRANCOIS TRAHAN:It’s the same thing. I think what has worked will continue to work.


FRANCOIS TRAHAN:Meaning stability, safety, defensiveness. So, when investors get a sense that the economy is about to slow, what they do is they gravitate towards stability. So in asset allocation, you know, it’s away from stocks, toward bonds. So the Treasury market has done remarkably well this year, because investors have flocked towards stability, at the sector level. You know, I talked earlier about the utilities sector being the top-performing sector in the S&P.

CONSUELO MACK:Year to date.

FRANCOIS TRAHAN:Year to date. Followed by staples, followed by health care. So three sectors that offer relative stability for investors.

CONSUELO MACK:Right, consumer staples. The things that we need all the time. Right.

FRANCOIS TRAHAN:Exactly. They’re the only three that are up on an absolute basis as well this year. You know, you look at the Treasury market, you know, the 10-year Treasury bond yield, trading as low as 190.

CONSUELO MACK:Literally, except for you and a few other people, most people have-- I’ve been hearing this for, like, four years. The Treasury market, you know, is just overvalued. You know, it’s been a vilified security and class, and yet…

FRANCOIS TRAHAN:And yet, going into a downturn, it sounds pretty darn good. So that’s a phenomenal return this year. You know, those are all things that are part of a portfolio that protects you from a downturn in the economy.

CONSUELO MACK:What about gold?

FRANCOIS TRAHAN:Well, gold is kind of the anti-currency. Gold tends to work best when you have inflation. We’ve had inflation. I think in a global downturn, inflation will probably wane, which would be the normal pattern. So, instinctively, I think gold’s best days are probably behind us for a while. But, in a world where nobody likes the euro, nobody likes the dollar, you know, gold’s a pretty good alternative. So, I don’t know that it will go down a whole lot, but it’s not at the top of my list any longer.

CONSUELO MACK:What about currencies, other currencies other than the dollar? I mean, the Swiss franc, for instance. The Swiss are saying that they’re going to, you know, cap the franc’s appreciation against the euro. So, are there other alternative, you know, currencies as well, that offer stability that are still accessible to us?

FRANCOIS TRAHAN:There’s not that many, because the currencies that seem fairly stable also happen to be very cyclical in nature- Australia, Canada, New Zealand, et cetera. So, I think what might be the bigger surprise here- you know, much like bonds have behaved fairly defensively, I think the U.S. dollar might just behave somewhat defensively going forward. So, I think it’s probably time to be dollar bullish at this juncture. In a global slowdown, people flock towards stability, and the U.S. might look better than other parts of the world, believe it or not.

CONSUELO MACK:I’m so surprised to hear you say that, because I know for a long time, and correctly, you have said that the dollar would depreciate as it has, and lost its value. But now, again, in times of trouble, it’s still…

FRANCOIS TRAHAN:In times of stress, you know, I think it is still-- you know, we’ve seen this in big down days in the stock market recently. What you’ve seen is, the dollar has appreciated. And what that says to me is that a lot of investors still view it as a relatively safe asset. Same thing as Treasuries. Might not last forever. I think in 2011, it will work.

CONSUELO MACK:So, let’s talk about 2012, because one of the things, again, listening to you, you know, instead of me thinking that I should just be all in safe assets, that what this is setting us up for, this slowdown in the global economy is setting us up for a recovery. So, why are you more optimistic about 2012 than you were about this year?

FRANCOIS TRAHAN:Because we had tightening, you know, going into this year. Central banks around the world were tightening policy, and in the U.S., we had tightening in the form of higher inflation. So, we’ve seen Brazil now cut rates, and it’s one central bank, but it’s, you know, a central bank from a pretty big country. And I think you’re going to see a lot more going forward. So I think you’re going to start to see the beginning of an easing cycle around the world. And in the U.S., I suspect we will get easing in the form of lower inflation, stronger dollar- will bring about lower commodity prices, put money in consumers’ pockets. And I think all that, you know, sets the stage for a better economy. It might not be a great one, but, you know, stocks are priced at the margin.

And so, when I say 2012 will be a better year than 2011, 2011 might not be a good year at all. You know, so the bar’s going to be pretty low. But I would say right now, the early evidence, for me, looks pretty good on 2012. If you get CPI to come down in the U.S., you get central banks around the world to cut rates, you’re going to be putting stimulus into the system, and I think what you will have next year is an economic recovery. You know, that starts later in the year, but something that stocks hopefully begin to discount earlier in the year.

CONSUELO MACK:Right. So, stocks do tend to discount things earlier in the year.


CONSUELO MACK:So, when do you start, you know, making that sector rotation into more cyclical investments, then?

FRANCOIS TRAHAN:You do it when leading indicators of the economy find the footing. So right now, they’re all falling, you know, pretty significantly. So, when you feel like that turning point is upon us, that is the time to move into, well, move more aggressively into equities, but into the cyclical sectors of the market: the financials, the technology, those types of stocks that have lagged this year. And that will be the time, I think, to sell your Treasuries finally, and to, again, consider more cyclical currencies around the world. Between now and then, I think it’s going to be pretty painful, unfortunately.

CONSUELO MACK:Financials. You know, we’ve talked to a well-known money manager who has bet very heavily on financials. Would you touch them right now? I mean, you know, do you mind being early? Or do you think it’s, like, way too early to be in financial stocks at this point?

FRANCOIS TRAHAN:I think it is still too early to be in financial stocks. It’s our worst-performing sector year to date, down 24, 25%, something like that. You know, what I’m concerned with is that the worst part of every cycle is often the last part of every cycle. And so, I don’t think there is a fourth quarter rally coming this year. I’m worried that it might be a fourth quarter meltdown, to be quite honest. And so, financials, they’ve come down a lot, but they’re very cyclical. And they are stocks that are associated with a lot of the ills that we have in this country. And so, I believe it is still too early. I think that’s a 2012 story.

CONSUELO MACK:The One Investment for a long-term diversified portfolio that all of us should own some of? And I will say, in the past, you made a very good commodity call, where commodities were a very good asset to buy, and also energy was another asset that you recommended. So, what would you recommend at this point?

FRANCOIS TRAHAN:Yeah. I still like that story long-term. You know, in a global--


FRANCOIS TRAHAN:Well, in the long term, yes. I believe the emerging market consumer story. You know, but we’re talking about something that’s going to last 10, 20 years. You know, the problem is that we’re in this boom-bust type of environment and it’s difficult to think that way. So, in my opinion, if you’re trying to protect your portfolio, you know, and you’re trying to think about what’s going to happen in the next six months or so, I would say stick with Treasuries. That’s one of the best-performing asset classes, you know, so far this year, and I think that’s where you can make absolute returns in this type of backdrop. There’s a lot of ways to play the investment cycle in the slowdown, but that’s one way that’s easy for investors to do it.

CONSUELO MACK:And when you’re talking about Treasuries, 10-year Treasury? I mean, would you go out--

FRANCOIS TRAHAN:Sure. Ten-year Treasury, trading at about 2% today. The 10-year Treasury that everybody told us was about to rise, and the Treasury yield was about to rise significantly earlier this year, it’s behaving in a very classic manner. Going into a downturn, it is rallying. And so, stick with what works.

CONSUELO MACK:So, Francois Trahan, it’s so great to have you on Wealth Track, from Wolfe Trahan, and also with your wonderful book, The Era of Uncertainty Thanks for joining us.


CONSUELO MACK:I agree with Francois that uncertainty and volatility are going to be two of the key and constant story lines of our financial lives. Our Action Point this week picks up on his theme of sticking with safety in at least part of your portfolio. This week’s Action Point: have a portion of your savings in safe and liquid investments. That means in much maligned U.S. Treasuries, no matter how low the yield; in TIPS, those treasury inflation protected securities that will keep up with inflation; and cash equivalents, even with practically non-existent yields. Safety nets are always essential no matter what the market conditions.

I hope you can join us next week. I will have a rare interview with First Eagle Funds’ investment great Jean-Marie Eveillard who will discuss his personal perspectives and strategies in today’s turbulent markets.

About the author:

Jacob Wolinsky
My investment ideas have been inspired by many of value investors including Benjamin Graham, Charles Royce, John Neff, Joel Greenblatt, Peter Lynch, Seth Klarman,Martin Whitman and Bruce Greenwald. .I live with my wife and daughter in Monsey, NY. I can be contacted jacobwolinsky(AT)gmail.com and my blog is www.valuewalk.com

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