Endgames and escalations of the US and Japan's expensive debt problem – Itay Vinik

Itay Vinik is the cofounder and Chief Investment Officer of Equi, an alternatives investment fund that deeply considers rare market conditions in its investment strategies. He was was the cofounder of a long/short volatility hedge fund which made a famous bet on the 2018 volmageddon event.

Transcript

Rai 00:00:56

Welcome to the Sentinel podcast, where top forecasters discuss ongoing events with a view toward global catastrophic risks. I'm your host Ry, and I'm joined by Sentinel co-founder and forecaster Nuno Sempere, and Sentinel forecaster Lisa.

Our guest today is Itay Vinik. Itay is the co-founder and Chief Investment Officer of Equi, an alternatives investment fund that deeply considers rare market conditions in its investment strategies. He was also the co-founder of a long-short volatility hedge fund, which made a famous bet on the 2018 Volmageddon event. Welcome, Itay.

Itay 00:01:32

Great, thank you.

Rai 00:01:33

Today, we will discuss recent indications of global economic uncertainty, primarily in sovereign debt markets. This is important because large economic struggles—like sovereign debt crises, austerity, and significant inflation in the world's largest economies—can cause shifts in political power and state capacity. These shifts can ultimately affect the trajectory of technology development, political doctrine, and war.

As a recap, weak demand for sovereign bonds sent 30-year US Treasury yields briefly above 5%, German 30-year bond yields to roughly 3%, and Japanese 30-year bond yields to record highs. Many factors were at play: sticky inflation, significant government borrowing in recent years, a costly bill passed by the US House of Representatives, and Moody's recent downgrading of US debt.

Persistent debt issues can put a lot of pressure on societies. What types of political shifts might we see in a world where financing this debt is not cheap?

Itay, since Sentinel and Equi are both concerned with escalations into longer-tail outcomes, what are some of the more impactful economic issues we might see from here?

Itay 00:02:43

The "bad outcomes" that can happen include a haircut default-type cycle. In this scenario, if governments let the market operate freely, higher real yields (yields above the inflation rate) would kill long-term investment. There would be less incentive to invest, and capital would flow back into Treasuries. This typically results in deflation, naturally resolving the debt through defaults. Yields would eventually come down, but with devastating economic consequences.

The second choice, seemingly more popular with policymakers, is to inflate the debt away. By devaluing money, they effectively "kick the can down the road." These are the two main choices.

In my opinion, given the option, policymakers will always choose to kick the can down the road. However, in extreme tail-event scenarios, policymakers might not have that choice. We can discuss that; it's an edge case, but possible.

Lisa 00:03:54

Itay, could you ever see a scenario with an actual default or a haircut on US Treasuries? Personally, I can't envision that. I'd like to hear your opinion.

Itay 00:04:06

I don't really foresee that. The US is quite different from the rest of the world because, at least for now, it has the global reserve currency. As long as the US can create the global reserve currency, the likelihood of a default on US Treasuries is minimal.

However, in the distant future, if that were not the case, a default would certainly be possible.

Lisa 00:04:26

Yet, we see the prices of credit default swaps on U.S. Treasuries going up, so apparently not everyone feels that way. You're saying there's very little risk as long as the dollar remains the world's reserve currency, but we're seeing the world start to pull back from the dollar.

Personally, when I look out over the next decade, I see a very low risk. Over extremely long time horizons, I think that could change, obviously. But at least for the short to medium-term future, that doesn't look like a serious risk to me.

Rai 00:05:06

Let's go around to the forecasters and get a preliminary forecast. It's tough to operationalize this for the US, in particular, because they could monetize the debt. But let's try for some fuzzy operationalization of what a US default might entail.

Lisa 00:05:17

You mean a US default, a straight-up default of some sort?

Rai 00:05:22

Yes, but does that fully capture our concern? They could technically avoid a default by monetizing the debt. However, if the US monetizes the debt, that's still a scenario we're worried about.

Nuño 00:05:33

When you say monetizing the debt, what does that mean?

Lisa 00:05:36

Inflating it away.

Nuño 00:05:37

Okay.

Lisa 00:05:37

To me, inflating it away is infinitely less dangerous than investors taking a haircut. That would destroy Treasuries as a safe-haven asset.

Itay 00:05:50

Consider what we saw this past April: what I call a "triple yazoo" moment, a term coined after the Japanese crash, where the stock market, currency, and bond market crashed simultaneously. That is pretty unusual for the United States. There was also a moment concerning the basis trade, which is how hedge funds lever up with long-dated Treasuries.

If you compare this to other crises, like 2008-2009 or 2011, it's different. 2011 is particularly interesting. In August 2011, S&P downgraded US credit for the first time. The stock market crashed 20%, while TLT, a good measure of long-term bonds, went up 15-20%.

Contrast that with recent events after "Liberation Day": the US bond market sold off hard, along with stocks and the US dollar. This is an unusual scenario.

Lisa 00:06:50

I completely agree that was extremely unusual. But we didn't come to the brink of an actual default. To me, an actual default means a "not getting your money back" type of scenario. I'm not talking about merely losing money in the bond market.

Itay 00:07:08

I'm thinking about the safe-haven aspect and the typical investor mindset where assets are anti-correlated—when one goes up, the other goes down. These correlations broke.

Typically, long-end bonds would do well because when stocks crash, the Fed is expected to cut rates and the economy to slow down, meaning bond yields should go lower. We haven't seen that in this recent move, which is concerning because it suggests the bond market is more fragile than usual.

And I agree entirely: the risk of an actual US default, US Treasuries taking a haircut, or the US losing its reserve currency status is, at this point and for the foreseeable future, minuscule to non-existent.

Nuño 00:08:04

I'm less familiar with the numbers, but I'd initially estimate 0.5% or 0.1% a year. Does that seem significantly off, or would you suggest less than 0.1%?

Lisa 00:08:16

What actual default rate are you considering?

Itay 00:08:19

It's hard to say, but I'd consider it an edge case, probably around 0.1%.

The global financial system's infrastructure and plumbing are fully built on U.S. dollars. Approximately 65% to 70% of all FX reserves are still in U.S. dollars. Furthermore, 80% to 90% of transactions in commodities markets and other infrastructure are conducted in dollars.

Saudi Arabia's recent deal with the United States reinforces the petrodollar system, ensuring dollars continue to be used for oil exchange. For example, if a Norwegian company digs for oil in the North Sea and borrows money, they most likely borrow and secure it in dollars.

A vast amount of dollar-denominated debt is also held between countries and by emerging markets with U.S. banks. Because this entire system operates in U.S. dollars, replacing it is extremely difficult and will likely take many years.

When people discuss the end of the U.S. dollar, the question becomes: what is the alternative? What could replace the vast existing dollar-based infrastructure? Currently, no pure substitute exists. It would be a very slow unwinding of the current system. This is a matter of decades or more, not something in the near term.

Nuño 00:09:54

Regarding the long or medium term, how do you define those? Is it a couple of years? Five years?

Are we looking at 0.1% for five years, or for 50 years? As a trader, what do you mean by long term and medium term?

Itay 00:10:11

It's somewhat arbitrary, but the longer the time frame, the greater the uncertainty and the higher the probability of unlikely events. For the next five years, I'd estimate 0.1%, increasing thereafter. It probably wouldn't be significantly more for 10 years. Beyond 10 years enters the medium term.

Twenty to thirty years from now, all bets are off; it's very difficult to predict. Global reserve currencies have historically lasted between 120 and 200 years. However, things are moving faster now.

Before the U.S. dollar, the British pound was the reserve currency, used in transactions. The Netherlands and Spain also had periods where their currencies were dominant. These shifts occur based on the dominant global power of the era.

For now, what business or company would agree to transact in, say, the Chinese yuan at scale? Perhaps Russia is compelled to due to sanctions, but widespread adoption by others is unlikely. It's hard to imagine companies widely adopting a substitute for the U.S. dollar.

However, we are slowly transitioning from an American-dominated world to a more multipolar one, offering more alternatives and options. But I don't see an immediate systematic threat that could dismantle the current system.

That said, high debt levels and bond yields do pose a substantial threat to the economy.

Rai 00:11:45

We've discussed the U.S., Itay. What are your thoughts on the situation in Japan?

What is the impact for Japanese investors and policymakers? What do you foresee?

Itay 00:11:59

This is a very loaded and complicated topic.

In historical context, Japan, the third or fourth largest economy in the world—it fluctuates a bit, and also depends on the exchange rate—is the first to experiment. When I say 'first to experiment,' I'm referring to their early adoption of Keynesian economics, the first quantitative easing (QE) programs, zero interest rate policy, and negative interest rate policy. They were the first to try these because they experienced no growth for long periods.

There was a massive boom in the 1980s, arguably the world's biggest bubble. In 1989, the land value of the Imperial Palace in Tokyo was reportedly worth the same as all real estate in California. Things were absolutely crazy. The bubble popped in 1989, which was devastating, and Japan entered the 'lost decade'—a long period of stagnation, lost generation, and numerous issues.

Policymakers responded by taking interest rates to zero and injecting money into the economy using quantitative easing, putting them ahead of the West. Japan is also ahead of the West in demographics. They have a falling birth rate; today, it's around 1.1 or 1.2, while the population replacement rate is 2.1.

A lot of inflation and economic growth comes from demographics. More people having children leads to more home buying, large purchases, and car sales. For instance, the high inflation in the U.S. in the late 1970s and early 1980s was associated with peak Baby Boomers entering the workforce and household formation age. This demographic shift arguably contributed to inflation. Inflation isn't purely monetary; it can be organic due to increased physical demand for goods.

Japan was early to these trends. Some predicted other developed economies would face a Japan-like climate 10 to 20 years later, and we've seen some of that happen.

What's happening in Japan today is quite interesting. Since the early 1990s, there has been no inflation, resulting in complete behavioral shifts. Consumers don't rush to spend because they anticipate prices might be lower next month or won't rise.

Real estate values are not expected to rise. It's not common to buy land or a house expecting an automatic increase in value. The consumer mindset is quite different there.

Thirdly, because Japanese government bonds yielded close to zero for a long time and rates were so low, the yen became a global funding currency. People could borrow in yen and invest elsewhere—the carry trade—expecting a positive yield.

What is different this time is that Japan has inflation. I've been a trader for a while, and shorting Japanese government bonds was always known as the 'Widowmaker' trade because it never succeeded. It's notable that the situation is changing now, as that trade never actually worked out before.

The Japanese market never imploded because the assumption was that with so much debt and yields at zero for so long, even at extremely low rates, about 15% of all tax revenue was already servicing existing debt a couple of years ago. The idea was that if rates reached a certain level, the portion of tax revenue needed to cover debt would become substantial. At current rates, it might already be 40% to 50%, though I haven't verified this.

This is the potential end game of Keynesian economics: reaching a point where you can't continue because there's too much debt. Even small interest rate increases can make it impossible to cover the debt. Then, more debt must be issued to service existing debt, consuming too much tax revenue and leading to a debt death spiral.

Nuño 00:16:37

If people borrow money in yen to invest elsewhere, that depresses the value of the yen. How does that play into this?

Itay 00:16:45

Correct. You're effectively short yen, which is beneficial. If you borrow in yen and its value falls, you pay back less yen on your loan, resulting in a net gain. You're making money in two ways: from the yen's depreciation and from the appreciation of your other investments.

For example, if you borrowed yen to buy U.S. Treasuries before the recent rise in yields, you might make 5% on a U.S. bond while borrowing at 1% in Japan. You'd earn 4% on the interest rate differential, plus an extra amount if the yen depreciated, say from 140 to 150 per dollar. Many people have been doing this.

Nuño 00:17:33

How has the value of the yen been changing recently? Is it becoming more valuable now that interest rates are greater, or how is it changing?

Itay 00:17:43

The yen appreciated back to the 140 range and is currently around 145. It recently peaked around 160, then strengthened towards 140, and is now at 145.

What you're bringing up is actually the bigger risk. One of the biggest risks today is that we don't know the full value and size of this carry trade. We don't fully know how much money was borrowed globally to buy bonds, equities, or even real estate. It's very hard to quantify.

Some estimates are a few trillion dollars, possibly higher, depending on how it's tracked. For a known figure, the total Japanese holding of U.S. Treasuries is around 1.7 trillion, I believe.

Rai 00:18:42

It's about 1 trillion.

Itay 00:18:43

Okay, so take that as an example. Currently, the difference between a 30-year Japanese bond and a U.S. 30-year bond is not that high. Typically, that spread is 3-4%, but now it's less than 2%.

Keep in mind that some Japanese investors, like insurance companies, hedge currency differentials. When hedging, they pay a certain amount, perhaps 100 to 150 basis points. At this point, it may not even make sense for them to buy U.S. Treasuries.

A big tail risk is that Japanese investors decide to repatriate their money and buy Japanese bonds. This would cause the yen to appreciate as all that capital flows back into Japan.

Lisa 00:19:25

The big question for me is: one, how far up will Japanese bond yields go? Two, to what extent does the Bank of Japan want to intervene? And at some point, can they intervene to stop a drastic increase in yields?

The Bank of Japan commented yesterday that they would change their future bond offerings, which calmed yields a little bit on long-term Japanese bonds. But what's the future here? How likely is it that things will get radically out of control with Japanese bond yields?

I think the Bank of Japan is likely to intervene before that happens, and I believe they still can. However, there's a non-zero risk here of things getting out of control.

I also wonder how big the impact of that will be on bond markets globally. I suspect the impact would be substantial but not extreme. I'd be interested to hear your take on that.

Itay 00:20:28

I generally agree, but the tail risks are extreme here. The idea behind the Austrian school of economics is that when you continue this course of action, you eventually reach the endgame. Based on the Austrian idea, the endgame is reaching a place where you cannot continue because of inflation.

They might have to make a choice. Tokyo inflation came out in April at 3.4%, which is still much higher than the Japanese central bank rate. The Bank of Japan may decide to intervene and resume its QE programs.

The Bank of Japan already owns over 50% of the entire Japanese government bond market. Before 2024, they had yield curve control.

Nuño 00:21:16

The Bank of Japan owns 50% of the stock market?

Itay 00:21:20

54% of the Japanese government bond market.

Nuño 00:21:23

Of the bond market.

Itay 00:21:25

Yes. Because of their policy of yield curve control, they wanted to suppress yield on the long end for years. They kept buying bonds at those prices to ensure lower yields on the back end. That's how they kept their rates so low on both the front and long ends of the curve.

The problem is, it's almost like nationalizing that market, and that was one reason the yen kept appreciating for so many years. The issue now is if Tokyo has real inflation for the first time in decades—which recent evidence suggests, as their inflation rate is 3.4%—they're running a real risk.

They can intervene, and likely will. They can decide not to raise rates anymore or even resume yield curve control. But if they do, they'll sacrifice their currency. The message they send is the yen is going to 200, and they won't be able to stop it, leading to a currency crash. This is because they would need to create an insane amount of yen to make that happen; they will need to print a ton of money.

So, they can do it, but they will sacrifice their currency. Currently, they have a hard choice between their currency market and their bond market. They have a very difficult job to walk the line in a way that can save both.

In theory, Japanese inflation can go back to 2% and stay there. Their problem was they didn't have inflation at all; it was zero or negative. They want some inflation, but not too much. They finally got what they wanted, but they got too much of it.

Lisa 00:23:02

They have a complete catch-22. Can you envision a scenario in which yields keep going up and they don't intervene?

Itay 00:23:11

That would happen if inflation starts spiking out of control in Japan. Consider rice prices and the CPI in Tokyo, which is 3.4%. I was in Japan in March, and people there are still conditioned by decades of deflation.

For instance, one person told me he was delaying renting an apartment because the price went up, expecting it to come back down as it always has. The idea of deflation is so ingrained that the concept of persistently rising prices is something many can't comprehend.

This makes it very interesting because we'll see if this inflation in Japan is transitory. If it's not, it's a structural shift that's almost unprecedented.

To give you an idea, based on data from about two years ago, household savings in Japan are close to 14 or 15 trillion dollars. A massive 55% of that is in cash. Imagine that money starting to move. This reflects a very conservative, deflationary mindset: keep cash because prices will be lower tomorrow.

Changes of this magnitude in such an economy could be instrumental. The global implications are also significant. For instance, a much stronger yen could cause asset prices worldwide to sell off aggressively.

The tail risks are on both sides: an extreme tail with the yen going to 100 or below, or to 200. It's unlikely to stay within the current range unless the Bank of Japan gets very lucky and stabilizes it.

Lisa 00:25:01

Is it likely that Japan will face some sort of crisis here? If so, on what timescale might that happen?

Itay 00:25:10

Historically, I would have said this is something everyone predicts but never happens. It's the well-known 'widow-maker' trade; many traders have tried to short Japanese bonds without success.

But now, for the first time I've seen, Japanese yields are genuinely imploding. It's signaling real risk to the market. The longer the time frame, the more real this risk becomes.

To give you an idea, consider total debt numbers and country defaults. The statistic is that of 42 countries reaching a debt-to-GDP ratio of 130% or 140% or higher, 41 have defaulted on their debt. Japan is the sole exception; it's the one country that reached that level without defaulting.

Rai 00:25:56

And Japan is at higher than 260% debt-to-GDP.

Itay 00:26:00

People have been trying to understand how this is possible. The reason is that much of the Japanese bond market is owned internally—by insurance companies and the public. There are very few outside investors causing significant capital outflows.

So, it's hard to say. But there's significant risk on both sides. If inflation persists in Japan, policymakers will have to choose the lesser of two evils: inflation and yen devaluation, or a very difficult economic time.

If they experience a recession and stagflation simultaneously, then tariffs couldn't have come at a worse time for them.

Lisa 00:26:42

We're just piling these impending crises on top of each other.

Itay 00:26:48

The stock market is still at, or very close to, 6,000 in this recent recovery. So it hasn't cared all that much.

Lisa 00:26:56

Very true.

Nuño 00:26:56

If you think about the tax burden in my native Spain, it's significantly higher than in the US. However, nothing is breaking over the short term. This does lead to brain drain and various undesirable effects, but Spain is still limping along.

So, why can't the US gradually move its tax burden, hidden or otherwise, to a level corresponding to Spain?

Itay 00:27:20

Spain's inflation rate is actually not—

Nuño 00:27:23

No, the tax rate. The tax rate is.

Itay 00:27:25

Oh, the tax rate is very, very high. If the U.S. increases taxes, you're right, it would potentially close the deficit.

Nuño 00:27:33

I'm thinking about the combined tax rate: the actual tax rate plus the hidden inflation tax. If you gradually increase your actual tax rate to the levels of Spain, nothing breaks.

If you gradually increase your combined tax rate—actual tax plus inflation tax—to that level, where in this process do you get a crisis? Or do you just get progressively worse standards of living?

Itay 00:27:58

Governments should do something to rein in reckless spending and bring in more revenue. However, there is a concept that has been very hard to anchor: the Laffer curve. This is the idea economists have explored concerning how much tax is the right amount, an age-old question.

Nuño 00:28:21

Right.

Itay 00:28:21

The Laffer curve suggests that if you have too much tax, the government collects less money. This is because fewer businesses form, as entrepreneurs start businesses elsewhere to avoid high taxes, leading to less economic activity. Consequently, even with a higher tax rate, the government nets less tax revenue.

Conversely, if taxes are too low, economic productivity might boom, but the government collects a smaller percentage of that larger amount. There's an optimal amount, but it's difficult to determine precisely; it's likely a floating, not fixed, number.

It is known that the US still enjoys a very strong technological moat. Most innovations and large-scale breakthroughs have been happening in the United States since the 19th century, from the invention of the telephone, electricity, and the light bulb, to modern advancements in AI with companies like Nvidia.

The US still provides a very good climate for entrepreneurs and innovation. There would be a substantial risk in trying to remove that, as it's one of the key factors giving the US a massive competitive edge globally.

Nuño 00:29:31

Great.

Itay 00:29:32

What we're discussing in this political era of populism is not dissimilar to the 1910s and 1920s. When people's standard of living decreases, there tends to be a movement toward more extreme political parties on both the right and the left.

During periods of prosperity and economic stability, public opinion tends to cluster more in the center. This is a politically neutral observation supported by a lot of statistical work.

Lisa 00:30:11

That's absolutely true. On one hand, when conditions worsen for the population, their politics shift to greater extremes. Yet, this is perhaps when moderation is needed most.

When discussing restraining budget deficits and getting budgets under control, as Itay mentioned, there are primarily two levers: taxes versus spending. In the US, we're seeing additional proposals for tax cuts for the rich. The size of these tax cuts is so large they will drastically increase the US budget deficit and debt burden over time, which becomes problematic.

There are these trade-offs, and it's up to society as a whole to choose the final outcome. As Itay brings up, unfortunately, the population's choices become more extreme as conditions deteriorate. This leads to a difficult situation and potential tail-end risks.

Itay 00:31:30

One potentially easier solution is getting a hold of the interest payments. Interest payments are so much greater than any individual tax programs or tax cuts.

The US spends roughly 1.2 trillion on servicing the debt. If that number could be cut in half, it would solve many problems.

Lisa 00:32:00

Instead, interest payments are escalating due to these increasing yields. Then there's the risk posed by the Japanese bond market potentially exacerbating the situation, and the whole carry trade imploding.

Itay 00:32:14

Ironically, the healthiest thing in the long run might be the most painful in the short run: a recession. If we had an economic downturn now, with a good amount of U.S. treasuries needing to be refinanced, a recession could kill short-term inflationary pressures. This would allow the Fed to lower interest rates.

Lisa 00:32:36

This is true.

Itay 00:32:37

The Bank of Japan could also lower interest rates. We would be able to refinance the debt, potentially saving 500 to 600 billion a year and locking in lower coupons for 10, 20, or 30 years. This would solve a lot of problems.

Lisa 00:32:51

This wouldn't just help the U.S. economy. What happens in the U.S. does not stay in the U.S.; U.S. Treasury yields affect yields all over the world. If U.S. borrowing costs are high, it has a rippling effect globally. This is a worldwide problem because all our economies are linked.

However, you will never publicly hear a politician or central banker say they want to see a recession.

Itay 00:33:30

Hidden under the surface may be a desire among policymakers to trigger a recession. This might sound like a conspiracy theory. If I were the Fed, understanding the mechanics—and the Fed has repeatedly complained about unsustainable US government finances, as Powell recently reiterated—I would keep rates high right now. This is despite some softness in economic surveys, a higher probability of recession, and tariffs.

Consider the trade wars with China. The Bank of China significantly reduced rates and is using liquidity measures to fight the trade war. The Fed is doing none of that; it's keeping rates high. While reducing quantitative tightening, it's not truly aiding the US in its trade war, maintaining an apolitical stance, perhaps believing tariffs pose an inflation risk.

The longer the Fed keeps real yields positive, thereby sucking liquidity from the economy, the greater the probability of a recession. If I were Powell, I might want to trigger a small recession—one that hopefully doesn't escalate—to allow for rate reductions, assist the fiscal side, and cool potential persistent inflation. This might explain why Powell isn't signaling an imminent easing of policy.

Rai 00:35:04

If yields stay high, and the U.S., Japan, and potentially others deal with some combination of austerity or currency devaluation, what are the geopolitical implications? Could it potentially affect defense spending, which in turn impacts the balance of power?

Itay 00:35:22

Interesting question.

Nuño 00:35:23

The US and its allies would see their ability to coordinate and build further diminish, reducing their willingness and capacity to fight an actual war. Paradoxically, in such a situation, a war might even be seen as a way to kickstart the economy.

Itay 00:35:39

World War II is an example; it took the US out of the Depression.

Nuño 00:35:44

In a perverse way, that logic can hold.

Lisa 00:35:47

Good economically, but not in any other way.

Itay 00:35:50

War is only stimulative to the economy as long as it's not fought on your own soil.

Lisa 00:35:55

Exactly.

Itay 00:35:57

The US benefited so much from World War II because the war was fought across the ocean, allowing the US to become a giant factory for the world.

Lisa 00:36:05

Right.

Rai 00:36:05

World War II also allowed for significant capacity build-out. The crucial factor is whether there's exploitable slack in the system, including an industrial base with room for expansion.

If an economy is already at its efficient frontier, increasing demand for these non-productive assets becomes problematic, as it diverts investment from other areas.

Itay 00:36:30

Additionally, I doubt the US currently has the capacity to build anything substantial. For instance, approximately 96-97% of all shipbuilding now occurs in Asia.

Lisa 00:36:41

It's enormous.

Itay 00:36:42

Many critical items cannot be built domestically. From a national security perspective, in a potential war with China, the US might hold a paper advantage, but over time, it would face significant logistical and manufacturing challenges.

Lisa 00:37:01

A modern war between the US and China would involve many factors beyond direct military conflict, such as cyber attacks.

Itay 00:37:18

Some of that is already happening.

Lisa 00:37:21

Regarding the impact of unhealthy bond markets and increased government austerity, an obvious consequence is that any government experiencing this would be weaker in addressing crises.

Itay 00:37:41

Yes.

Lisa 00:37:42

The U.S., in particular, would be in a weaker position to address global conflicts. Concurrently, the US has signaled less interest in such engagements, so significant changes are underway.

If Western economies struggle, addressing a potential conflict in Europe between NATO and Russia would become harder. Similarly, a conflict between the US and China would be more difficult to manage.

When economies struggle, growth is hindered, and the capability to address any crisis—be it geopolitical conflict or a new pandemic—diminishes, making solutions more difficult.

Itay 00:38:45

Furthermore, protectionist policies often lead to increased conflict and isolationism and have historically resulted in hot wars. While we lack a sufficient sample size to definitively predict a hot war, history suggests this deglobalization trend could usher in a 10- to 20-year period of conflict.

Lisa 00:39:09

More economic integration among countries reduces the risk of conflict. Conversely, more isolationism increases that risk.

Itay 00:39:21

I recall the democratic peace theory, which posits that two genuine democracies have never gone to war with each other. I believe that theory still holds.

Nuño 00:39:33

Looking at population pyramids, the US is in a decent position; its pyramid appears reasonably rectangular despite an aging older cohort.

In contrast, some European countries, like Spain, grapple with a significant debt burden. Their options include inflating the debt away, increasing taxes, or attempting to raise productivity. These nations face a growing debt burden, an aging population, and fewer young people entering the labor force.

This creates a spectrum: Paraguay, for instance, has an approximately 40% debt-to-GDP ratio and a favorable population pyramid. South Korea has less of a debt problem but a very challenging demographic outlook. Some European countries face the worst of both: high debt and poor demographics. Any thoughts on this?

Itay 00:40:29

It's a huge problem, especially in Europe. As I mentioned, Japan dealt with that problem earlier, with Europe about 10 to 15 years behind. The difference in Europe is that European countries like Spain, Portugal, or Italy don't have independent control over their monetary policy.

This lack of control is one reason for the structural pressure on the Euro over many years. In theory, Spain maintains its debt levels without much higher bond yields due to its Eurozone membership and the power of the integrated euro area.

Imagine if Spain were on its own with its own currency. Given its debt load, what would its bond yields be? Today, Spain's bond yields are lower than those in the United States.

Nuño 00:41:25

What are a few possible endgames here?

Itay 00:41:28

There are many ways this situation could resolve. The demographic challenge, for example, is a major issue. The US doesn't face it to the same extent because it generally accepts large amounts of immigration, which contributes to population growth.

Nuño 00:41:43

Spain, in particular, does benefit from that because we have a massive Latin American population that is culturally similar enough. Germany, for instance, doesn't have access to such a large pool of German-speaking immigrants.

Itay 00:41:56

What is the percentage of immigrants in Spain?

Nuño 00:41:59

Around 20%.

Itay 00:42:00

That's pretty high; I didn't realize it was that high. Spain might be a little different then.

Nuño 00:42:03

I also didn't realize until very recently.

Itay 00:42:05

That's a lot higher than I expected. Most of them are probably from Latin America, speak the language, and integrate well.

Nuño 00:42:11

They do speak the language.

Itay 00:42:12

That's pretty great. This immigration could be a good solution for Spain, but it does have a high debt load.

Productivity growth will also be substantial. And this brings us to AI; we've gone an hour and a half without mentioning it, so it's time.

Nuño 00:42:30

AI plays into the factors Lisa was mentioning. If AI is propping up productivity in the United States and elsewhere, that increases the US's strategic advantage in that scenario.

Itay 00:42:46

AI is the ultimate X-factor. In a more linear world without such technological optionality, demographics would be destiny: an aging, retiring population and insufficient workforce.

However, AI might mitigate this. If one person can do the job of ten, the dire population pyramids in Western countries might not be as critical. Perhaps it won't matter as much.

Rai 00:43:12

Itay, thanks for coming on. Can you tell the audience about Equi and what you're working on?

Itay 00:43:17

We are a multi-manager absolute return hedge fund. We focus on what we call "absolute return"—creating a consistent outcome not necessarily correlated to market beta or general market movements. This means your financial outcome isn't solely determined by concerns about equities or bond markets.

The idea is to create an alternative return stream through absolute return. Our goal with these products is to generate a certain level of return. As a portfolio allocation, it can act as a diversifier, though not strictly a hedge, against global market events.

Basic portfolio theory and the efficient frontier suggest that more risk typically yields more return. However, with uncorrelated assets, you can shift that efficient frontier to the left, achieving the same unit of return while reducing risk.

We effectively build funds and products that give clients the ability to shift their efficient frontier to the left. We primarily work with accredited investors, qualified purchasers, registered investment advisors, and multi-family offices. We offer a combination of off-the-shelf products and custom solutions built for our clients.

Rai 00:44:44

Great. Thanks again for coming on.

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