Podcast Transcript: Fabio Natalucci on COVID, Crypto and Climate

This is an edited transcript of our podcast episode with Fabio Natalucci, recorded on 30 November 2021 and first published on 3 December 2021.

Bilal Hafeez (00:00):

Welcome to Macro Hive Conversations with Bilal Hafeez. Macro Hive brings you the best analysis to successfully invest in markets from crypto to equities, to bonds. For our latest views on analysis, visit macrohive.com.

We’re all grappling with implications of the new Omicron variant of COVID. We’ve published a bunch of notes this week on the topic, but by far on this popular offering has been our webinar with Professor Justin Stebbing of Imperial College London who gave us the low down on what we do and don’t know about this new variant. You can watch the webinar on YouTube or you can listen to it as a podcast on this channel. It’s well worth a listen. And outside of COVID, we continue to enhance our research on crypto markets. We’ve now launched a new series of crypto indices that allow you to track the performance of different themes like the metaverse, DeFi and smart contract platforms. It helps bring some order to the wild west of crypto. We also update our views on Ethereum.

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Now onto this episode’s guest, Fabio Natalucci. Fabio is deputy director of Monetary and Capital Markets Department at the IMF. He’s responsible for the Global Financial Stability report that gives the IMF’s assessment of global financial stability risks. And before the IMF, Fabio was a Senior Associate Director at the Federal Reserve Board and between 2016 and 2017, Fabio was deputy assistant director for International Financial Stability and Regulation at the U.S. Department of Treasury. Now onto our conversation.

So, greetings and welcome Fabio, to the podcast show. I’ve been looking forward to our conversation.

Fabio Natalucci (02:17):

No, thank you for having me. Pleasure to be here.

Bilal Hafeez (02:19):

Well, before we go into the meat of our conversation, I always like to ask our guests something about their origin story. So where did you go to university? What did you study? Was inevitable you’d go into economics and policy making? And what was your journey to the IMF?

Fabio Natalucci (02:33):

So I grew up in Italy, in a small town called Spoleto. Spoleto is famous for it’s called the Art Fest called the Festival of two worlds because it’s like a sister city here in the U.S in Charleston in the Carolinas. And I grew up there through Century High School. And like all teenager I want to get out from a small town in Italy. Spoleto is in Umbria which is the green half of Italy. And so I was just counting the days to leave and go to a big city. And so I went to undergrad to a private university in Rome, it’s called Luiss and I did economics there. So in Italy, but this is back then. A while ago when I was younger, you had to pick in some sense a major when you were going to college. So I pick economics. There were a few couple of years where essentially everyone has the same classes, then you have to create a specialisation. And so I was indecisive until the last minute between finance and economics, then somehow ended up picking economics. One of the reason was that I always love history and philosophy. And so I thought I could do some of it by doing economics and studying, I don’t know, history of economic thoughts and the stuff, tried to bridge the two, but history has always been one of my passions. So I did economics and it was more on the theory side. So modelling and that kind of stuff. And so then from there, I had a bunch of young professors who had just done a PhD in the U.S. And so they encouraged me to apply for a PhD in the U.S.

Honestly, I applied to way too many in retrospect, including because I have no clue where I was applying. So some places I picked them just because of ranking of the econ department. And then when I start receiving some of the acceptances, I just located them on the map. And some of them found some very appealing in some sense. And so I ended up going to New York.

Bilal Hafeez (04:17):

Okay. A very scientific approach, I can tell.

Fabio Natalucci (04:19):

A very scientific, but the beginning was scientific, right? The ranking was scientific and then locating on the map I was like, “Is anyone going to ever visit me from Italy to there? No.” So okay, dropped. So I ended up going to New York University, NYU. So I did a PhD there in economics and my advisor was Mark Gertler, which turned out to be quite opportunity life because he was working with Ben Bernanke at that time.

I knew Ben from grad school and also the stuff I was working with him and it ended up being the topic. So my thesis was to essentially the role of financial markets in, if you want amplifying shocks, right? So what’s called a financial accelerator. And with all the caveats of linear models, how you apply to life. But I think the framework of thinking the interaction between financial markets and real economic activity, real economy, I think this set me well when I then ended up working at the Fed. So I finished, I graduated, I started the fed in Washington at the Federal Reserve Board. I studied International Finance. I cover emerging markets, the beginning, emerging Asia and Eastern Europe. Then I moved to a small group called domestic banking, essentially starting the transmission channel monetary policy. And then in May, 2007, because banking was quite boring honestly, back then nothing was happening in commercial banking, I decided brilliant idea moving to a little new group that was just critical monitoring financial stability. And that was about two months before the financial crisis arrived. And then from there that defined my career because in the timing of writing, academic papers disappear very quickly. And so I was thrown into the real world of trying to understand, I don’t know, what is the CDO? That unit became the residual group, right? If there was stuff then no one had any idea what that was it was like, “Okay, go out and learn.” And that, I don’t know, shaped my career there. Then I got involved with this window, the liquidity facilities, ended up working on essentially interaction between monetary policy, financial stability and financial regulation until 2016. In October, 2016, I joined the U.S. Treasury as the deputy assistant secretary for International Financial Stability and Regulation.

Back then there was a lot of work on financial regulation. And so the idea was to transition the outgoing Obama administration into a new administration, particularly to assist return to a G20 work on financial regulation stuff. Of course I was called in by the Obama administration. So I suspect there was some expectation that the incoming administration be democratic administration, which didn’t happen. So I stayed. I actually really enjoy working at treasury. It was one of probably the best experience in my working life. I represented treasury at the FSB. I did a bunch of work on financial stability for financial markets, and then the staffing was very thin. So you had much more exposure internally and externally that I think normally you wouldn’t have. So personally it was a fantastic experience. I love working at treasury and I left a lot of friends there.

Then when my period expired, I had the choice either go back to the fed or do something else. The fed is a very, it’s a fantastic world, but it’s very specific what you do. Treasury was a complete opposite, right? So it was 10,000 and the portfolio was huge but you didn’t have time to do a lot of analytical in there. Work just, there was no time. And so I applied to IMF and it felt like in the middles in some sense, analytical work, but more topics, more international, which is what I was doing at treasury compared to the Fed.

It felt phenominal the right time to go back to the international work. So I did work with the job here at the IMF as the deputy director in the Monetary and Capital Markets. And what I do now, I essentially run one of the flagship, the Global Financial Stability Report. And I am responsible for global financial markets. So we have one person in New York, three London, one in Hong Kong, one in Singapore and produce a bunch of internal products three a day.

So in the morning out of London, one at 9:00 AM here in U.S. and then closing of trading business in U.S. So I spend most of my time essentially talking to private sector, people like you, and that’s become my job. So you can see from the pre moving to the little unit when I was writing paper. So I do now that’s been started at this continuity. But it’s been a fantastic experience so I’m really happy to be here.

Bilal Hafeez (08:44):

Yeah, no, that’s great. It’s a great story there. And you’ve obviously got a lot of experience in some of the biggest institutions in financial markets and the economy.

Fabio Natalucci (08:53):

It’s still funny going back thinking of when I was in high school, in the little town, I don’t think I was planning to do this.

Bilal Hafeez (08:58):

Yeah. Quite a big change. I was going to say that. The work you’ve done on the Global Financial Stability Report has been really good. One of the things I’m impressed by is just how you are communicating the message, everything’s snappier, it’s more accessible. I think that’s been really quite good work that you’ve done since you’ve taken over the helm of that reports.

Fabio Natalucci (09:16):

So we tried to do two things, right? When I came in, in some sense the mandate was one to provide a more formal analytical framework. And so what we have done, we have introduced this, what we call the growth risk model, right? So we essentially tried to separate shocks from financial condition, from financial vulnerabilities, from output. Honestly, I don’t want to be in the business of forecasting shocks.

You can go back to the October 2019, GFSR and obviously pandemic was not something we were thinking of, right? So forecasting the future is really, I don’t think where my value added is, but what we can do once the shock hit, we can track how that impact finds your conditions, right? So we have a bunch of indices, we look at components across this so that you can actually identify different kind of shocks that have different impact on the components.

We can monitor financial vulnerabilities, whether this is as evaluation or whether this is financial vulnerabilities like leverage, liquidity interconnectedness because those become the amplifier of the shock, right? Shock hit financial condition tighten then you have this amplifier, they magnify impact. And then in terms of output, we look at the full GDP distribution and the left tail. So the downside risk, and that’s our quantitative measure of financial stability risk.

So that was introducing this framework that would allow us to compare every six months where financial stability risk were, how that evolved, and also allows to track the financial vulnerabilities. Those are the medium term vulnerabilities. They are some of them structural and allows us to make sure the financial system is able to absorb shocks as opposed to becoming amplified. So that was one, the mandate. I think the other one was to, as you said, to get messages out in a snappy way, that was something I had to learn. The most successful performance, the Fed, when you do minutes or a financial statement is like you don’t move markets, right? And you’re like an invisible bureaucrat, if you want. You don’t have to go out, you don’t give speeches, you’re not on social media. So learning to do that, to do the press conference, which is a live event with, I don’t know. At least when we’re in person with hundred plus journalists in the room, when you do right blog, when you do podcasts like here, when you do TV interviews, that was something that the Fed honestly did not prepare me for. And so they were very good here. They make me take some classes. You have advice from communication people. And that has become a big part though I think how do we communicate. And part is because we are not central bank, right? We don’t set interest rate. So the way we communicate the message is to have a story. So having a story is crucial here. And then also being able to reach different audiences, right? Not just central bankers, not just Wall Street, also the broader audience. And broader audience requires different tools with different parts of the audience. So we spent quite a bit of time in terms of thinking about messaging, the visual of the messaging and how to do it. So that was, I think the other part of the mandate.

How COVID shocks transmit to markets and the economy

Bilal Hafeez (12:05):

I think it’s been great, great work on all those fronts. And your most recent report which came out October, so it had a nice catchy subtitle COVID crypto, climate 3C, which I thought was quite apt you in terms of three big topics for this year. And perhaps you could start with COVID and maybe look back a bit, as well as having some sense of… We’re obviously in the middle of Omicron and we’ll see what that means. But once a pandemic unfolded, and obviously we’ve had about a year and a half now of just coming up to two almost, what happened that was expected just on your framework and what was unexpected given if you were told about the shock?

Fabio Natalucci (12:40):

Yeah. So we spent quite a bit of time trying to understand how this shock was different, right? And so the obvious comparison is always the GFC, right? Because it’s close to us and because some of us were involved with that crisis. So it’s an obvious… I don’t know, it’s almost like a comfort zone, right? It’s easy to go there where you’re more familiar. And so thinking about the comparison, for example, the shocks itself is different, right? So the GFC was a financial shock. It hit the banking system in U.S. at the core of the financial system, propagated to the peripheral of U.S. financial system than to the rest of the world. This is a real shock, it’s pandemic originated somewhere else in the world, but still became a global shock because it propagated the rest of the world. So different shock implies different transmission channel, implies affecting different potential vulnerabilities.

The second difference was the response by central banks in terms of timing much faster, obviously than the GFC. When we have a chat on global financial conditions you see they spike very quickly, but they also come down very quickly, not only fast but also the magnitude was larger, right? Central bank cut rates very fast. They start doing asset purchase very fast. They set up liquidity facility.

Look at the Fed, right? They redid the entire playbook of the GFC plus, right? They went into credit and a bunch of stuff, but very quickly, very massively. And that was very effective. The third piece was, and that was the big difference I think with the GFC, the fiscal policy played a large role here. And that was the missing part in sense. Right in the end of Obama administration, fiscal pack back there was much more compared to what has been done here, not just in the U.S. but globally here in emerging markets.

And so that makes us think about the pandemic in a different way. And so without looking through the lenses of this, if you go back and you say, you can imagine that you forecast the equity markets would be depressed for a while, that the credit cycle that would be spike in the fourth. And we did all that. And we had forecasts and looking at where I don’t know, spreads, how wide could be or the default rates would be, but clearly we played out differently and the reason why we’re able to get out the global economy out from the fall, I think is because of the policy response, but fiscal, monetary, and also financial policy, right? Some of the relaxation of some of the financial regulatory rules and use.

Bilal Hafeez (14:46):

And on the policy response. One debate, I guess, is still ongoing is could we have had a response where interest rates were not cut so much and we didn’t necessarily have QE, but we had some kind of backstop of the financial system and we had a large fiscal stimulus. So if we had not pulled all of the levers, do you think that could have worked?

Fabio Natalucci (15:08):

So I don’t know what is the optimal policy mix honestly. I think it depends on the country, right? That’s two consideration. I think one advanced economy is obvious that more policy space for fiscal policy and they abuse it. You can see they abuse it, right? Not just the U.S., Europe, UK, other countries. For emerging markets that’s less so an option, right? So the policy mix is different, but structurally different.

The second reason I to go in the order that the country have gone like monetary policy rates, asset purchase, and the fiscal policy because central bank can respond immediately, right? They can have a meeting today, cut zero, announce asset purchases. Fiscal policy that is a legislative process. You need to find partisan or bipartisan approach if you can think about how you want to look at the money. So it’s a much lengthier process.

This is why the signalling approach I think of monetary policy is so powerful because you can step in immediately and even before you actually start… Look at the fed, you start getting impact on credit markets, even before they even set up the facility. And it just the announcement of fact, and that’s something that only central banks can do. You not going to be able to do fiscal policy. But having fiscal policy allowed sometimes then hand over all the responsibilities, right? So you can find the right policy mix where perhaps rates don’t have to stay as low, as long as otherwise without fiscal policy. So I think that makes a huge difference. Now it fills into the debate on inflationary pressure. How much this is driven by fiscal policy or not, right? And you can debate at length. But I think personally that the response is the right response. The first thing you want to do, where I grew up in terms of career, the first thing you do, you put the fire down and then you start thinking about other issues.

Why haven’t bankruptcies picked up?

Bilal Hafeez (16:47):

Yeah. And I guess ex-post, when the fire is settled down is easy to be nitpicky and say, “Oh, this particular thing they shouldn’t have done and this.” But in the heat of the moment, it was hard to say. The thing that was surprising was just the lack of bankruptcies and defaults. Were you surprised about that or not?

Fabio Natalucci (17:04):

Honestly, yes. In the sense that if you asked me a year ago, we were all thinking about where the defaults would go, how bankruptcy would be widespread, particularly for SMEs, right? Large companies always trickier because once the fed or central banks step in, they reopen markets, those who have access to markets, and that’s what they did. They took advantage of reopening of markets. They rebuild liquidity buffer, they fixed their balance sheets and large companies can do that.

The issue that I think the concern was more for the lower rated companies of this day high yield, because they took longer for those markets to reopen, including emerging markets. So the emerging market followed the same pattern, right? So it reopened later and then reopened with IG and then high yield. And then the concern was for those who don’t have access to markets and they’re more bank dependent, for example like SMEs. So I think that’s where a lot of concern was including because a big chunk of the employment is generated by SMEs, even in the U.S. Right? I was surprised to learn what share of employment factor in the U.S. is generated by SMEs. But that’s where the concern was. And I think, again, that’s where fiscal policy helped, right? Because monetary policy that less tech can do for those, reopening markets is great for a listed company.

It’s less obvious for a firm that you can actually benefit from that. And that’s why I think some of the fiscal measure helped because they kept some of this SMEs alive. Now, of course, the bet has always been all this is going to be a bridge to a recovery, right? So we can withdraw every fiscal and monetary policy we have and we hope the recovery will start quickly so then we can hand over to the regular economic activity. That’s where the bet was. And I think the bet turned out to be effective.

The SMEs, there is still a difference though, between say the U.S. and Japan versus Europe, right? So we have seen the bankruptcy coming down across the board, firm size in U.S. and sectors, similar pattern in Japan. In Europe, the bankruptcy for SMEs has not come down as much as it’s here. In fact, that’s continue to increase. Different reason, right? You can think of, I don’t know, different policy mix. You can think because there are more bank dependent, there have less access to market because the recovery has been lagging. There’s a lot of different interpretation but as a fact, there was a chart I think we had in the GFSR showing that the bankruptcy in fact have not come down in Europe as much in the U.S.

Bilal Hafeez (19:20):

And in terms of the business cycle right now, how would you characterise it in terms of the recovery? It seems like we have had this handoff as you’ve said, there’s been a noticeable improvement, in the labour market wages are picking up. If anything, there’s signs of overheating with inflationary pressures. So how would you characterise where we are in the cycle right now?

Fabio Natalucci (19:40):

Yeah. So maybe I’ll start… One last thing that I forgot to mention before just important. Another reason I think why the recovery perhaps has been faster in U.S. because there is also distress to that market, right? So some of this company also managed to get funding in distress debt. Now you pay up, obviously the yield you pay, whether you do through prefer equity or you follow through senior loans, it’s expensive, but it’s an option, right? You don’t have to shut down. And then I think, give you another bridge to the recovery.

The business cycle, maybe one way to think about it is the credit cycle, right? So it looks like this credit cycle is very elongated, right? Doesn’t seem to have followed the pattern that you normally would follow. And that goes back to the bankruptcy, not materialising or defaults coming down. And so the true question there to me is how much is this elongated credit cycle is due to the fact that there is policy support and what will happen to this credit cycle once policy support be removed.

There was a lot of focus on, for example, the banking sector, right? So a lot of many fiscal measures including moratoria and credit guarantee, right? So what would happen to banking behaviour once this policy support is removed, would they become more conservative? Would they land into the recovery? And that’s where we are paying attention quite a bit now because I think it’s going to shape, again, going to give you a good sense of what the shape of the recovery is in terms of credit.

Bilal Hafeez (20:59):

And at this stage, I suppose it’s too early to say.

Fabio Natalucci (21:02):

They just started to remove. There was, if I remember correctly an ECB, a bank lending survey coming out, I think there was encouraging sign of the demand picking up that shows that credit would follow with the record if we continue to support. This is a big difference, again, with the GFC banks have now been the source of the programme sometimes have been part to the solution so far, the issue is what we’ll do. As we start to remove the support, will they jump in and continue to provide support, more banking in centre of Europe, more capital markets in the U.S. Perhaps it’s a slight and different discussion.

In terms of the recovery. I think we’re going through an interesting assessment of what is the impact of this waves of pandemics, right? So we call it alpha through the alphabet soup, and now we’re on the ground. And so trying to understand, I think three pieces of this, maybe focusing on Omicron, which we don’t know much. So we are in complete speculation now. But maybe that’s why it’s fun. One would be intact on demand, right? Would be a drag on demand or not. And you can learn something looking back at the Delta and the other variants. It looks like that the economic impact of this is progressively getting shorter and you can see market reaction too, right? When the news comes out, you get this drop in risk assets, but they recover very quickly. So if the pandemic follow the same pattern, that’s something that at least we can look back at and learn from that.

Now condition two things. One is what is the actual virus evolution, right? For example, will it take over like Delta did and become the main variant out there or not? And to condition importantly what the vaccine effectiveness would be. I think the diminishing part on the variants has been very clear in part, at least on the vaccine being out there, the vaccinated, hospitalisation rates down, less impact on mobility at the same time the sensitivity of economic activity mobility being lower. So will it follow the same pattern or not? I think those are just question at this point, for which we don’t have answer. The second piece on the table is the impact on inflation. And I think it gets trickier here in the sense that we can see what we have learned from the past and in this different variant but we also, we are the stage where inflation pressure at risk, right? And so what are the impact now when we already have supply bottleneck, right? What happens if I don’t know, producer in Asia, for example, to shutdown, or if there are lockdown measure there. That could become an amplifier of this bottleneck and so the expectation that the bottleneck will go away over time, that’s something to consider, what would be ultimately the impact on inflationary pressure? And there seems to be two ways in that, that one more benign, which is okay, maybe this is going to slow down demand, it’s going to take some pressure on the supply side and so the inflation pressure may actually lessen, or because this is coming at a time when inflation pressure is so high, even if demands slow, it will amplify inflation or depression, unless it’s a real hit on the recovery, which we all don’t want to happen.

Then the third piece of this is what does it mean for monetary policy, right? We are at a very unique juncture, at least in advanced economies, whether it’s discussion going on normalisation, tapering the time of the first hike. And we have seen in the U.S., in the UK and the RBA among various advanced economies. So what would be the impact of that debate at this point coming out of Omicron? So those are the three lenses I think, at least, I’m trying to look to what I talk to people, I’ll try to learn as much as I can. I demand back on inflation, what it means from modern policy at this point.

How to know if inflation will be transitory

Bilal Hafeez (24:28):

And just on inflation, obviously this has been a big heated discussion. There’s been big debates around transitory or not. And have you define all of this? I suppose one definition of transitory is that inflation doesn’t go back to 2% in the next, say, 12 months or so. So over the course of 2022, there should be an expectation that inflation should in the U.S., in eurozone start to go back down to 2%, and also inflation shouldn’t broaden out all sectors. At the moment there’s a very heavy concentration in commodity related sectors of CPI, inflation and goods, but it hasn’t really spread out that dramatically. How do you define transitory or is this a silly debate to have?

Fabio Natalucci (25:11):

To be honest, I never like the definition transitory versus permanent for one reason, because as an ex-central banker, I know what central banks mean by transitory, right? They look at their forecast, right? If you look at forecast of the Fed they have, TC at two point… I forgot the exact number but 2.2, let’s say for 2022 and then core at 2.3, right? So by that standard, you could argue that is temporary. It always shoots at four plus percent and then comes back at the end of 2022.

The problem is if two people in markets like you, I would argue that one year, it sounds much less temporary than maybe it sounds to a central banker, right? Then if you talk to a person that is going food shopping, 12 months is a long time to have elevated prices, right? So I never like the use of those word because the meaning is so different to different people that I’m not sure it helps the communication from a policy standpoint.

Of course, it could turn out to be not so permanent, right? There are a number of assumption predicated back into that. That is not going to really fit into the underlying dynamics. And so there is a nice handover between goods inflation to services. And so bottleneck at some point go away, at that time people switch spending from goods to services, and one component comes down when the other component goes up. And on average, you start seeing some decline that somehow an assumption that is not essentially broadening up to various components of inflation indices, that it doesn’t fit in wage dynamics too much. So it doesn’t get entrenched into the wage discussion.

And then three, importantly, for central banks that the long-term inflation expectations don’t get the anchor, right? They don’t move away from the target. That’s where all the debate is, how much is broad and beyond good to services? Have we seen this handover or not? How much the wage pressure are in specific sector that were affected by the pandemic or much broader than that. And they seem to be saying that they’re broadening inflationary pressure and the wage pressure seems to be broadening.

Now on the long-term inflation expectation, I don’t think that there’s not many signs so far of the anchoring of those. The signs you get from markets are more mixed perhaps, right? So if you look at the inflation breaks, for example, here in U.S. or Europe, yeah, they’ve rebounded as you would expect, right? You are in a hole, from an economic standpoint. So you would expect to rebound part of it was simplified by liquidity issue. So rebounding comes with the recovery.

There have been commodity prices increase, energy and other component of the commodity complex. So some increase in the front end of zero to five years is suspected not much signs of the anchoring so far. The break-even forward rates is declining. It’s downwards on sloping, which means market expect inflation took come down. I think where you get more concern is perhaps on the options market, where if you look at the caps and floor, the distribution, particularly in the U.S. and the UK seems to assign a significant, not significant, but meaningful mass on inflationary outcomes above 3%, perhaps that’s a more, I don’t know, concerning sign. Investor clearly seems to be focused on this. If you look at the flows here in U.S. into TIPS fund, they have been strong. So clearly there’s an attempt at least to hedge possible future inflation outcome.

Bilal Hafeez (28:24):

And on the inflation expectation side, there was a paper by the feds on how inflation expectations aren’t as important for the formation of inflation. Obviously that’s just one view. Do you have a view on inflation expectations as an important channel for inflation?

Fabio Natalucci (28:40):

Personally I think they matter. We can debate whether they get extracted from market signal through different specific sophisticated models, whether we put in too much emphasis on assumptions or not, but there are different way to look at, right? You can look at surveys, you can look at other measure. I think what central bank care is that the long term, and you can define long term however you want. They’re not really moving away from their inflation targeting number, right? From that 2% or whatever the number is from central bank. And the concern is that, because if that happens, then it fits back into the waste on average, for example, right? So if your expectation of price is moving higher, then you start asking for higher wages. Now it’s much looser link between wage inflation and price inflation, because for example, there’s no indexation, right? So the impact of prices and wages not directed, it used to be in the, I don’t know, the seventies, for example. Personally, I think the inflation expectation do matter. That’s my own view.

Bilal Hafeez (29:33):

And then I guess also for wages to inflation there’s also question of productivity, I suppose, as well, if you think about things in unit labour cost terms.

Fabio Natalucci (29:41):

Yeah. If you want to be concerned about productivity, you look at the real rates here in the U.S. Right? So you have the five year at almost -200 basis points. And even the 30 year I was just looking at yesterday, it was almost -50 basis points. If you use that as a proxy for where market thinks potential growth could be, then I think we are in trouble. So hopefully those measure are somewhat distorted by market liquidity and the fed buying into a tips market, because that’s a little depressing view of what long-term productivity of an economy is, if you take those.

How leveraged are markets?

Bilal Hafeez (30:14):

The other side of the equation has been in terms of what we’ve seen over the past year is just asset price inflation. Obviously we’ve seen equity markets have done incredibly well, especially the U.S. equity market. We’ve seen housing prices go up a lot. Now, is that a concern for you in terms of financial stability or not? How do you think about asset price inflation?

Fabio Natalucci (30:37):

Again, going back to the framework we have, right? We have shock financier condition then vulnerabilities. And we divide the vulnerabilities as evaluation and structural vulnerabilities, right? As valuations play a role in the foreign sense, right? Suppose there is a shock financial condition tighten. If equity markets are way higher than fundamental values, then the adjustment and need to go through to go move back to a fundamental it’s larger, right? And so that larger move has an impact, obviously on economic activity. Makes funding costs higher, borrowing costs and so on. So we run a bunch of models on for say, equity markets. Now, all those models now will tell you with very few exception that the gap between current valuation is fundamental it’s quite large. One of the driver of this is that considering the uncertainty, if you want about future earnings, valuation are too high. That’s one way to put it. There is so much uncertainty about economic outlook and valuation should be lower. That’s one important driver of the misalignment.

I would take this with some grain of salt in the sense, and I think they’re very helpful qualitatively. On a specific number, you always have question about how good this model can do to incorporate the unconventional policies, right? Not just the negative rates, but the asset purchases, the signalling impact. And so those are very hard to formalise from an economic standpoint. So I like to look at those from it qualitatively, whether the S&P it’s over value X or Y honestly, I have the luxury now, I haven’t put money on that. So it provide important signal, I think the way we think about it. But again, quantifying the impact of policy, it’s something that is particularly different in this model. And we can do some similar exercise with corporate bond spreads, for example, right? How much of this is driven by the level of rates? How much is driven by risk appetite? One thing to say all this stuff though, is that take equity from here, right? So think about the equity prices as the future discount value, a bunch of future earnings, right? So one of the reason why I think valuations are so high is because that the real discount factor, the real rates are so negative. And sometimes that seems to trump any little change over time in the Euro expectation of earnings, right? And this is where I think in terms of thinking, how effective policies has been, they provide such a strong magnet in terms of discounting of future earnings, that if you have the five year -200 basis point, obviously valuation are elevated, right?

There’s nowhere else to put money in other words, right? And so yes, eventually central bank will normalise. They will taper, they will move rate, but the backdrop remains still a very, very accommodated sense of policy and a huge amount of liquidity. I think that’s one of reason why risk assets seems to be, so far at least resistant.

Bilal Hafeez (33:33):

And you mentioned the structural side, leverage and so on, how does that fit into the equation?

Fabio Natalucci (33:36):

So those become another amplifier. So if you need to adjust say yes, and we need to adjust by 15%, I’m just making up a number, that would’ve be amplifying a drop in terms of speed and magnitude, if, for example, investors are using leverage, right? Because then you get the typical de-leveraging processes, liquidation, collateral and so on. So the combination, if you want of the tool that all valuation of misalignment with the use of leverage, for example, made the adjustment much more abrupt and eventually also overshooting the adjustment. That’s how we look at this. And leverage it’s one of course, we look at liquidity show mutual funds and liquidity was the big theme during-

Bilal Hafeez (34:14):

And how does it look at the moment that side of it?

Fabio Natalucci (34:17):

So we think that banks are doing relatively well. They came mean to the crisis with high level of quality and level of capital and liquidity. So I think banks are with position where we have seen and we have highlighted vulnerability, and we have a box that we have a rate map. If you want vulnerabilities, where we look at vulnerability are primarily in the sovereign sector obviously. We have seen large deficit increase in public debt. We have seen some improvement in nonfinancial firm sector, right? They rebuilt their liquidity buffer, some of the net leverage is coming down, also continue to see vulnerabilities in non-bank financial intermediation. So what could be the NBFI sector.

Lots of use has been on the asset management industry, particularly open-end during the pandemic. That’s where we continue to put some attention. We have an interesting box. We look at the life insurance, for example. And what would help any rates move higher and how much of a hit, particularly inflation environment would be for these firms. And then of course, we do the same exercise. This is at the global level. Then we do the same exercise at the country level, right? The differentiating between advanced economies and emerging markets. So you can get, say for country, United States, you can look across this different sector where we see vulnerabilities and how they have changed.

Bilal Hafeez (35:33):

And how does the U.S. look on that side?

Fabio Natalucci (35:35):

The U.S. we see in terms of quantile, so ranking, if you want over time, we see vulnerabilities in the sovereign, because there’s been a significant buildup on the financial side. We see banking, they’re doing very well. We see something vulnerability increase in the insurance sector, as I mentioned. And so then relatively elevated in the other non-bank financial intermediation sector.

What are the risks to China?

Bilal Hafeez (35:56):

And how does China look on that metric?

Fabio Natalucci (35:58):

So, China, we have highlighted a number of vulnerabilities, particularly in the non-financial corporate sector, in the household sector, increasing house prices, particularly in borrowing. And also I think the big difference is on the bank sector. I think the vulnerability we assess them to be more elevated in the Chinese banking sector, more so than other jurisdictions. It’s not necessarily the largest big state bank, but it’s the distribution of banks that we look at, particularly the smaller banks with particularly geographical location, perhaps more exposure to weaker parts of the country, and look at essentially the interconnectedness between those smaller banks, local governments, and corporates that particularly to the lenses of state-owned enterprise.

Bilal Hafeez (36:42):

How are you looking at China more generally? Of course, we’ve had clamp down on the real estate sector. There’s been some restrictions in the tech sector. So it seems like China is trying to deleverage the economy actively. And obviously there’s some unexpected outcomes as well, but it seems quite an active policy to try to de level the economy, which is then associated with lower growth. And then there could be a potential spiral here where growth is too low, which means they have to pull back. And so there’s some uncertainty at the moment. How are you looking at China?

Fabio Natalucci (37:12):

So from a policy accommodation standpoint, we have made this point to consist lower time, that we have support of the authorities attempt to reduce life financial energy in the financial sector, shadow banking, so wealth management product and other coronary of the system. So we have been supportive and we continue to be supportive of that. There is the issue of Evergrande and the property developers. And we have a box in the GFSI where we try to walk the reader through possible channel.

I think the assessment was that contagion risk were relatively limited. Although there was some intensification of the stress beyond individual names. Obviously the authorities have the tools to step in and take action and fix both the financial sector fragilities as well, minimise the impact on the economy. And we try to frame the trade of the policy maker frame in terms of policy choices, in terms of how much to intervene and interfere with choice, right?

So you can take target measure to support specific institution or support the economy more broader, you intervene today or you can wait a little longer if you are instilled market discipline, that’s a trade off in terms of magnitude, extent of measure and it’s time of timing than I think they’re facing. How much you want to do and when you want to do that, you can still indiscipline vis-a-vis, potentially having unintended consequences if you wait too long.

That’s how we are trying to frame. We identify essentially three channels, transmission of stress. One is through the domestic financial sector, again from the poverty developer to other sector, right? We have seen pressure in our funding offshore or funding markets, just even beyond the property developer, right? So to the ideal market, to some investment grade. And so one is the exposure banks, right? What is the exposure banks to the sector.

Not necessarily at the aggregate level, but also is there a weak tail of banks that’s exposed to the sector? The second one is the exposure of the non-bank financial institution, right? So whether it’s world management product, whether this is trust loans trust funds, trust companies, and then the interconnectedness between these MBFIs and the banking sector itself. And the contingent guarantees the sound the same may offer. For example, guarantee on wealth management product that they have offered.

Then there is the domestic more macro channel, traditional chat, right? So a real estate is, I don’t know, a quarter of the GDP. When you put it together, so if house price decline sale price goes down, those are important revenues for government. What is the impact on the global macro economy? And then feedback into the financial sector and having a financial condition. And then the third channel is the international channel, right? Both through some global risk appetite channel, as we saw in September through the offshore door funding markets. So originating of dollars and more broadly inclusion of China into global indices, right? Both equity and fixed income industries and what’s the exposure of the large, for example, asset management names in the industry, through China, through that channel.

You can do some work on Bloomberg, there are some information available. So who the names are and we try to do that will come up with some quantitative number. But only a fraction of that is actually reported there. So you just to your claims, essentially to at least to give an assessment qualitatively how the channel could work. That’s where we were on the property developer challenges.

Now, of course, we need to see what Omicron does, not just to China, but to the global economies as well, right? One of the concern again, is that amplification of this bottleneck and supply chain issue, especially if you were the only into lockdown again, different jurisdiction are taken different approaches in terms of vaccine versus lockdown, but paying close attention, whether this would become an additional strain on the supply chain.

How stable are stablecoins?

Bilal Hafeez (40:46):

And I wanted to pivot to crypto, because I know that the IMF in the global financial stability report, you’re focusing a bit more on crypto. From a very high level, what’s the good and the bad of crypto from your perspective?

Fabio Natalucci (40:58):

Yeah. So we try to frame in a way, first of all, to provide a description of the ecosystem, right? Crypto’s ecosystem. Try to differentiate between, I don’t know, specific crypto ecosystem that’s like Bitcoin or some of those vis-a-vis stable coin, make clarity on the differences there, what kind of micro financial stability issue it might be, for example, a stable coin and then take the angle of emerging markets, right? Should some of the emerging market countries adopt any of this crypto and what would be the issue.

There was less of an interest in taking this particularly strong view on valuations. I think we tried to do that in the past. We did about two years ago, three years ago, back then we did a bunch of, I don’t know, correlations. And the interesting point was that the correlation were low with other asset classes and the return adjust for volatility. That’s what we look at sharp ratios essentially.

I think this issue of correlation has increased now; the correlation is relatively higher with other asset classes. And of course, they were smaller before they’re much larger now, but the shutter is really not about taking a standup evaluation themselves it’s more like, for example, when Cyber coin, taking a view on it’s important to know what the busk of the reserve is composed of, right? Are they raising issue related to the money fund industry that we are all aware back in the GFC and some of the strains we have seen more recently? What kind of reserve they are, what is backing that? How transparent they are, and could that become a run issue like we have seen with money market fund. With the extra layer of concern is that if this are a used as payment system within the payment system could become another channel. That could be another channel of mitigation stress.

Bilal Hafeez (42:40):

And do you think the current state of the stable coin market does pose a risk that we need to consider or is it just too small right now?

Fabio Natalucci (42:49):

No, I think today this relatively small, the issue is how fast this is going to get bigger. And how stable are the stable coin? And so what has been behind the reserve and so information on that more clarity, more transparency and make sure… So we had a chart that was interesting looking at the backing of some of the names. So without necessarily naming specific stable coins, but one of them had essentially almost 100% in cash bank deposit and treasury bills. And then another one at about third, and then a big chunk was commercial paper and corporate bonds and Yankee CDs.

Those are not necessarily as liquid, right? It’s bank deposit. And so can you convert that instantly? And importantly again, how much transparency there is, how much do we know, what is there being held, is that all it did it verified. And so what kind of approach in terms of financial regulation should be taken? An additional point to make again, where I say it is, this is a global phenomena, right? And so one thing to avoid is fragmentation, not just on market, but also fragmentation regulatory responses. So the need for corporation and possibly some global standard. I think that would be helpful in this world.

The investment challenge for climate policy

Bilal Hafeez (44:00):

And the other big topic is climate. And there’s lots of different ways one can look at climate. But I suppose the fundamental one is, do we have the right amount of investment in renewables and alternative energy sources or not? And how does one go about guessing that investment?

Fabio Natalucci (44:17):

So the big question here is, how can you get to a net zero, say by 2050? What kind of investment do you need? And the numbers says different estimates. So I don’t need to pick one, but the numbers are huge, right? And so it seems obvious to me that the public sector cannot provide that scale of investment by itself. So there’s clearly an important role for private finance. And so how do we incentivise private finance to actually contribute to net zero 2050 and what role can they play? And so we have a chapter where we look at a subset of private finance, which is the investment fund sector and how that sector in terms of risk and opportunities, by in terms of how can you contribute. So we look at this, we had a database quite interestingly of about 150 trillion of total asset under management.

We look at how much of that is sustainable finance or ESG. That was about 3.6 trillion as of the end of 2020. But if you narrow down to what are just climate funds, that was just very small number, it was 130 billion, which is 0.3% of that. So tiny, right? So it’s growing fast, but credit doesn’t need to scale that up rather rapidly if you really want private financial contribute.

Then we try to look at what role can they play? What are positive? And I think we highlight three. One is that from a financial stability perspective, it seems to be that investor and these funds are less running, fewer, less sensitive to returns, right? So probably maybe because they have medium time objective, they don’t respond as quickly to up and down on prices. So that could be a mitigation factor in terms of financial stability. And then they can play two role one in terms of providing financing to green project. And we find evidence essentially that they encourage issuance of securities by firms who are more favourable sustaining rating. So essentially they provide financing for the development of renewable energy. The second part that I think they can play a role in terms of up investors stewardship. And so essentially they seems to be more keen to support climate rate resolution. And so they seem to support the adoption of renewable energy, clean energy.

So I think overall, those were good signs. Now, is that an issue here in terms how you do scale it up? What needs to be done? One interesting finding was that the labels matters. So we try to control for a bunch of other factor like ESG scoring performance. In the end, even if you control for that, labels are still a deciding factor for investor, which is a good thing in some sense, but it’s also raise a number of issue, which is we need to make sure then what is labelled as green is actually green, right? Avoid greenwashing.

What measure can be taken to improve the availability of quality data? So comparable data across jurisdiction. How do we make sure that we have some classification so that the markets are not climate classification, global fragmentation of market and then standards? And I think that’s been quite a bit of progress going to COP26 on this, which is after we published. But on the, I don’t know, the IFRS Foundation, the announcement on the international sustain standard boards, lot of work being done now on this classification, for example, we are doing work with the World Bank and the OCD to come up with some principle. And then on the data side, I co-chair NGFS or Network For Greening the Financial System, work on closing the climate data gap. So looking at data use and data availability, what can be done to make data available to stakeholders. So I think there’s a lot of progress, but again, it’s an important point because if investors do get attracted by labels, we want to make sure that those label represent essentially what is being sold to them. And so the firms can be essentially accountable for what they’re coming into.

Bilal Hafeez (47:53):

Yeah. And that’s very true. Yeah. It seems in Europe, they’re making some quite big moves in this direction with the taxonomy and some penalties for greenwashing and so on. So maybe that will be an example for the rest of the world. In terms of investment, I’m just thinking if there’s a climate Cryptocoin that only attract a trillion dollars, just like that.

Fabio Natalucci (48:11):

The other thing that’s interesting, I follow that closely until lately. It’s not just listed companies, right? So even private markets here in U.S., private equity, private debt, the role of ESG or sustainable finance is growing quite rapidly. And so same issue there though how to make sure there is transparency, availability of information. I think there’s no way to get to 2050 without the role played by the private sector, that right finance. And so how to make sure that we get the best out of it, how we set the rules in place for transparency, accountability, and so on. I think that’s a big job for us in terms of… And then the private sector is to do what the private sector only can do, which is provide financing in the right places, the right prices as much as possible.

Bilal Hafeez (48:53):

Now I did want to round up a conversation with a few personal questions. One I always like to ask is how do you manage your informational research flow? Because I know you have to keep on top of economic news, financial news, you provide all these daily updates, quarterlies and so on. Do you have a system? Or what’s your approach?

Fabio Natalucci (49:10):

The main driver to me that I love following markets. And so, I would read everything that’s out there. So my phone here, I have essentially every positive information you can have from programme, well say journal FT, the economies, and you go down the list of access. So we have a bunch of industry publicly. So I try to read as much as I can, including various social media. The risk is always overflow. You read too much and then at the end of the day, you’re like, “Well, what did I read today?” And so I try to, I don’t know. Usually when I think of it, the Omicron is a good example, right? Before I start reading the amount of stuff it’s available there every day, try to think about what are the question I like to get some answer today? And so I have, I don’t know, two, three questions that I think, help me think about these issues, Omicron was the main impact of macro inflation policy. And then when I read stuff, I tend to categorise the stuff based on, I don’t know, the buckets pressing ahead, there’s so much information out there.

So there’s a need to first of all, distinguish good quality information from poor quality information. But even within the good quality information then how are they relevant to you? Right? Otherwise, you just spend the day reading. And so this is why I try to remind some, I don’t know, what would I like to learn when I spend my next 12 hours reading or interacting with people? And I try to just as much as I can link what I learned to what the question I had and I’m trying to answer now, I’m oversimplifying obviously.

But the other thing is, I think to be open minded that’s often you don’t ask the right question, you don’t thinking the right thing you should asking. And so being open minded and thinking, I’m like, “Okay, maybe I’m not asking the right question here. I should be asking something else.” And that the last thing is to talk to as many of you as possible. I think that’s the only way to shape your views. Otherwise, you’d go into the confirmation bias that you just ask people what you want to hear and their reports, your views. And I think being open minded, that was one big lesson during the financial crisis 10 plus years ago.

Bilal Hafeez (51:05):

Yep. I agree with all of those things actually, it’s I think it’s really important to, yeah, think about questions. So you have at least some filter where you get to all the information of… And you’re right, changing the question as well is helpful.

Fabio Natalucci (51:16):

The other thing is not getting stuck into… There’s a tendency to not admit you made a mistake, right? Or you are not interpreting the right way and you just double down and keep digging. And so at some point you don’t have to cut losses and move on, right? And so that’s hard to do because you need admit that you are wrong, but I think it’s important. And the information you got every day, that helps because you can recalibrate. There’s never going to be the perfect piece of news that is going to make change your mind, right? You need to be, I don’t know, humble and nimble enough, I think to just adjust your position as you learn more.

Books that influenced Fabio

Barbarians at the Gate (Burrough, Helyar), The Divine Comedy (Dante)

Bilal Hafeez (51:46):

And you mentioned you like reading, are there any books that have really influenced you over your career or anything you read recently that you’ll recommend to others?

Fabio Natalucci (51:54):

So one book that I love reading and it was part of my moving away from, I don’t know, being and writing paper and being more academic and being thrown into the real life, was the Barbarians at the Gate, because when I start reading, I realised one is like how human psychology makes a huge difference, right? And it’s an important driver. That is not something at least when I went to grad school was really top of the list. So the things you learn in those classes also, because I think I realised that I need to get out the building and learn more, how the real world, the financial sector work. And so that one, they always struck me. That sector, the LBOs, the leverage buyout, leverage finance, it’s a sector, I was always been fascinating. I think it’s really an important barometer of risk taking and greed and where the state of financial markets are. And I continued to follow the market through the financial crisis 10 years ago. I was following leverage finance distributional side of leverage financing LBOs. And I remember the fed send me to New York to learn more because we know a lot of it about the banking piece of it, but not so much a distributional piece of the leverage loan.

So I went to New York, I talked to CLO manager, at her desk. And those were people that they spoke a language very different than what you learn in grad school. So I don’t know. The book I always thought the markets gives you good sense of risk appetite and risk taking markets. So I’d be kept following the markets for I don’t know, for a long time now. And that book always struck me as a boy. I really don’t understand what these people are saying. Maybe another book that… I’m an art reader so I love the Divine Comedy by Dante Alighieri.

I just re-read it lately. This was the 700 years from his death. And so re-reading, I always found that book, it gives you a good sense of I don’t know, continuous search, you go from hell to heaven, right? So continue search to improve.

Bilal Hafeez (53:48):

Is there a good translation for that book? An English translation or not, or you presumably you read it in Italian?

Fabio Natalucci (53:53):

I read the Italian. But it’s always a good symbol of, I don’t know the evolution of your life and you always trying to move higher, right? From lower to higher. And it was also an important point, I think in the moving toward humanism in Europe. And so from the dark ages to different sides. So I always found that book to be… Of course, you need to adjust it to the current world, but all is there, I don’t know, the aspiration of doing better moving higher. I always found that book to be quite inspiring.

Bilal Hafeez (54:23):

Okay. Yeah. Yeah. You are the first person to mention the Divine Comedy, Dante on Monday. So it’s great. Barbarians at the Gate and Dante. That’s a good combination there. So all about the human journey and human nature. So yeah, that’s great. And if people wanted to follow your work or your division’s work, where’s the best place for them to search out?

Fabio Natalucci (54:45):

Everything we put out, I put on my LinkedIn account and then the IMF has it’s own LinkedIn account, particularly the modern capital markets department, where we put out all major products that we produce, including the GFSR, but beyond the GFSR. I try to use my own account to advertise the work that we do as well.

Bilal Hafeez (55:03):

Okay, great. I’ll include links to that in the show notes. Yeah. So with that, thanks a lot for this excellent and wide ranging conversation. It’s been a great pleasure to speak to you.

Fabio Natalucci (55:11):

No, thank you so much. Thanks for having me. I really appreciate it.

Bilal Hafeez (55:13):

Thanks for listening to the episode. Please subscribe to the podcast show on Apple, Spotify, or wherever you listen to podcasts and leave a five star rating, a nice comment and let other people know about the show. We’d be super grateful. We’ll be back soon, so tune in then.

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

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