Tim Graf (TG): This is Street Signals, a weekly conversation about markets and macro brought to you by State Street Global Markets, the Markets and Financing Division of State Street. I'm your host, Tim Graf, European Head of Macro Strategy. Each week, we bring you the latest insights and thought leadership from our award-winning suite of research, as well as the current thinking from our strategists, our traders, our business leaders, and a wide array of external experts in the markets. If you listen to us and like what you're hearing, please do subscribe, leave us a good review, get in touch with us. It all helps us improve what we hope to bring to you. With that, here's what's on our minds this week.

Last week, we talked about how to think about markets for the short run in the immediate aftermath of the US presidential election. This week, we shift to the long-term. Actually, even more than that, we talk about topics in asset allocation and asset valuation that are, if anything, timeless. Applicable over any time horizon.

I do so with a very special guest, someone we wanted to have on the podcast for a very long time. Sébastien Page is head of Global Multi Asset and Chief Investment Officer at T. Rowe Price and has worked in investment management for the past 16 years.

As you'll hear, Sébastien is also the author of a wide range of research on asset allocation, risk and portfolio construction, a lot of which was written, and here's the really fun part, during his time working with us at State Street Associates, where he started his career first as a research associate, before ultimately becoming head of Advisory Research and Currency Management for many, many years, before then moving into buy side roles first at PIMCO and now at T. Rowe Price. Sébastien Page, thank you so much for taking the time to join me on Street Signals this week.

Sébastien Page (SP): Thank you for having me. I'm super excited to reconnect with State Street.

TG: Yeah, that's in fact exactly where I wanted to begin. You are a State Street alumnus, as I have mentioned in the introduction, and I don't think we overlapped too much, maybe a few months. I joined in late 2009, so if we did, it was very, very brief.

But that's where I wanted to start, how you got started in finance and joined State Street. What brought you to us ultimately?

SP: Well, first of all, my father was a finance professor. He's now retired. So let's just say I was influenced into being interested in finance. He actually never pushed me, though. I just came to it on my own, but there was so much passion around it.

You know, I grew up with professors at the dinner table, having conversations about nuances of the capital asset pricing model. I had no idea what it meant, but there was a lot of passion. And so it's in my DNA, if you will.

Coming to State Street was interesting. I grew up speaking French. I studied finance in French. I did my masters in French, all the materials, everything. I started the CFA program, which was in English. But let's just say, my English was not very good, but I wanted to work outside of Quebec, of the French Canadian part of Canada. That was my goal.

And I got an introduction to State Street, but I had to interview with Mark Kritzman, who's still a partner at State Street Associates. I was really nervous because my English was not good. And I flew to Boston, sat down with Mark and you could tell I was kind of wasting his time in his mind. I could, you know, I can read body language. And he was probably busy with other things that day.

And he just looked at me and said, Oh, you know, how was your flight? And I said, you know, it's pretty scary when you're not used to landing in Boston. You arrive and the plane goes down and it's, it's really you know, you get really close to the water before you see the runway. So I said something about that.

And Mark looked at me with a very serious look and said, Well, it's pretty common for most coastal cities. And that's how that's how our interview started. There's a long story behind it. Where (he) ended up being my mentor for 10 years. We ended up being really good friends. And I just absolutely love my experience working with him and working at State Street.

TG: I can hear the tone of voice. And I think you did a very good Mark impersonation there. It was dead on, I think, how that would have sounded, because I've been spoken to by Mark in that way many, many times over the years.

SP: He's actually the kindest, most generous mentor you can get. I'm like that, too. It's just not one for small talk.

TG: Yeah.

SP: Yeah.

TG: No, exactly. I think that is, especially in the field we work in, that is probably quite a common thing. And as you're absolutely right, I've known Mark for 15 years and never known him to be anything other than generous with his time and generous with his intellect, which let's get into that.

I mean, you worked with Mark and team at State Street Associates for 10 years, and I'm curious to hear about some of the work you did and that you're particularly most proud of as part of your work for State Street Associates, if you could talk about that.

SP: Oh, there's so much, you know, 10 years there, but I'll pick one. I was working in Cambridge at the time. You still have your offices in Cambridge and Harvard Square. And I get a call from Mark in the middle of the day, and he goes, can you come over? I need you to look at something.

And usually our meetings were scheduled and I had to prepare for them because I didn't want to waste his time and I wanted to show results from the research we were doing. But this was just completely impromptu. I get to his office and he's got a sheet of paper in front of him and he's frowning at the sheet of paper. And he hands it over to me and goes, can you make sense of this?

It's a sheet of paper with just a bunch of handwritten equations and it turns out it was a fax. Now, this was some time ago, but no one was using faxes anymore. It was a fax from Paul Samuelson, a famous economist, Paul Samuelson. And Paul was writing to Mark to say, look, this whole thing about fat tails, higher moments and issues with higher moments, it's pretty important.

So, you know, in between the math, you could tell this was a big deal for Samuelson and for him to take the time to write to Mark. He was writing to Mark because Mark had just published something showing how neat it was that you could use mean variants for a bunch of different things, like traditional portfolio construction, the Markowitz model. You could use it to model currency hedges. You could use it to separate alpha from beta. It was really in typical Mark style, very clever way of looking at the model.

Samuelson thought we were defending mean variance optimization a little too much. You get to the margin of this handwritten facts, and Samuelson is telling Mark, and therefore you and Markowitz are wrong. Mark thought that was amusing, and he got in touch with Markowitz just to say, Harry, what did you do wrong?

But the idea was these higher moments matter. We embarked on a project to look at what you now call full-scale optimization or direct utility maximization. I'm really proud of the work we did there. We studied hedge funds, which have highly non-normal moments. We studied different utility functions. In other words, how you define investor preferences, how much do they care about different outcomes they can get from their portfolio. And it all came together into this full-scale optimization work, which was, I think, pretty groundbreaking. There's a lot of research that's come out of it.

But that's one. I could go on. There's just different models we worked on that are all used to this day.

TG: Well, that's where I wanted to go next. And it's fascinating that 15 years after you've left, I'll still regularly come across work that cites work that you, Mark and team did or your own work in reading the books that we're about to talk about, just that refer back to those days. And I'm just curious to hear a little bit more.

Some of the things, after State Street, you were at PIMCO for five years and then you went to your present role at T. Rowe Price as CIO and head of Asset Allocation.

And I’m curious to hear more about those kind of building blocks you had back in the day that you worked on here that still carry with you to this day and inform the way you look at markets or talk to clients about asset allocation.

SP: I'm going to give you a totally unsatisfying answer for your podcast. But it's true. Tim, all of it, I use all of it.

These are tools that are helpful for portfolio construction, risk management, investment decision making, back testing. And that's what we do in finance and in money management. So I'm sorry, I could say I use the regime models more. I could say I use full scale optimization more. I could say I use within horizon value at risk. Get all these models, provide a framework and sometimes direct applications for some of the most important decisions that investors make.

So sorry, but my answer is all of them.

TG: Well, you know what? That's a great advertisement for us. So I think we can just stop there.

SP: Yeah, there you go.

TG: You've gotten me what we needed.

SP: Let's end the podcast here.

TG: Absolutely. Will will be happy with that, so we're good.

No, absolutely not. I want a lot more of your time. And I wanted to then talk about your first book, Beyond Diversification. We are about four years after its publication. You talk in the book about how you published it on the cusp of COVID, I believe. And we're going to talk a little bit about how things may have changed since it was written.

But I first wanted to start with kind of the why. What, you know, there's a lot of books written about asset allocation, some of, you know, authors of whom we've already referred to. And I wanted to see kind of what drove you to write it and what were you hoping to add to the canon about work on asset allocation?

SP: Well, two reasons. I wanted to make a contribution to our industry with everything I'd learned over the years. And the second reason is I wanted to make this really accessible. If you read the book, there's maybe three or four equations and they're completely well explained. So this was to reach a broader audience with this research. And I had in mind a financial advisor. To me, like a smart financial advisor who knows investing, who's helping clients with asset allocation, what will they get from this book? And so it was really about making a contribution, but making a broad contribution. So that was the goal.

I don't know if I achieved it. I can tell you that the book was really well received, but there were a couple of reviews that hurt my feelings on Amazon. You know, we pitched the book as a popular book, and really you need to know some finance. Think financial advisor. And so some people just picked up the book without any sort of background and that enticed them to go back on Amazon, put one star and say, I don't understand any of this.

So anyways, there's a story after that, which is I got into financial literacy and financial education with my daughter. Because I thought if I can't explain finance simply to a 10-year-old, then I don't understand it myself. And so that was a follow up to that, to those reviews, and that's why you see this on LinkedIn now. But yeah, those were the goals for that book, to make a contribution and make it accessible.

TG: I think you succeeded on all of those counts in so far as I listened to the book, the audiobook form, and it comes across as well as if you would read it.

SP: Oh, and by the way, the narrator is really good. It's not me. They hired an actor. And I think it has a bit of a Scottish accent. It really doesn't sound like me, but he sounds great.

TG: No, it comes across very well. The videos you mentioned, I mean, that is a quote I often refer to. I think it was Richard Feynman who said, if you can't explain something to a seven or eight-year-old, as you say, you don't understand it. And it comes across very well. And the subject material is timeless. And I think by definition is timeless.

But I'm just wondering, given the timing of it and the fact that we have now thinking, maybe not yet about current markets, we'll get to that. But thinking about how markets have changed in the period since the book was written.

How is your thinking on markets changed? How have your processes maybe changed since you wrote the book? And I guess the question is, if you could update it in any way, what would you throw in there now?

SP: I was finishing the book during the COVID sell-off and its aftermath. At the time, the media latched on to this question, is the 60-40 portfolio dead? And it was such a catchy title for a bunch of financial articles at the time that I contacted my publisher and asked them if I could change the title to, is the 60-40 dead instead of Beyond Diversification. Unfortunately, it was too late to make the change.

Look, from the financial crisis to COVID, we essentially had zero rates or close to zero rates, especially if you look at it after inflation. So someone said studying finance in a zero-rate environment is like studying physics but without the law of gravity. So if you ask me what has changed since COVID, it's the law of gravity is back. We now have a positive real interest rate in the economy.

There isn't anything actually I would change about the book because I anticipated this and talked about the equity risk premiums, so comparing returns on stocks versus bonds, the limitations of zero rates, and topics like the stock bond correlation, which I think we don't talk about enough. But all the applications are still highly relevant, if not more. So there isn't much I would go back and change.

I'd probably add more about what I've been writing since then. For example, I have a few chapters on relative valuation investing for tactical asset allocation. Well, those methods post-COVID have not worked well. Relative valuation, whether you're ranking stocks based on price to book, or whether you're looking at trades between asset classes. So I just put out a paper in the Journal of Portfolio Management for the 50th anniversary titled When Valuation Fails. And so if I could go back, I would add some of those materials.

And why have US growth stocks just continued to do well, and small caps and emerging markets and value stocks have not delivered a risk premium over 10, 15 years? A lot of it has to do with technology and how we account for intangibles on those balance sheets. So that's what I explained in the JPM paper.

TG: Yeah. We're going to come back to that actually. I have a very pertinent current market question about exactly that. There's a couple of other topics though, and in the book, you talk about private assets.

When the book was written, there was a shift, particularly to private equity because it was still in the years before COVID, a zero rate environment, as you allude to, and even 10 years ago, you were starting to see asset allocators thinking much more about sources of alpha, uncorrelated sources of returns, and some yield in lieu of getting that from fixed income markets. But it's really especially private debt that has gotten a lot of attention in recent years.

And I wanted to see if you could elaborate on how you think about that, given it does seem to be a growing part of at least interest, if not overall asset owner portfolios, although I suspect it is the latter. And so just kind of seeing if you can expand on that and see what your thoughts are on that in the current environment.

SP: Well, first of all, if you go back to my book, there is a debate between academics and industry practitioners, investors and consultants on the actual returns that you received historically from private markets. And it's a huge debate. And if you step back and just think about this, this is a little bit crazy. Like, why can't we agree as an industry, what were in the past the returns of an entire asset class? And it turns out we can't.

And a lot of practitioners are touting very large liquidity risk premiums and advantages to investing in private markets. And academics are disagreeing and scrubbing the data very carefully, accounting for zombie valuations in the databases, correcting some remnants of survivorship bias and just doing it really carefully and showing that if you adjust for risk, you're really kind of looking at similar assets. And there are similar assets. Companies, whether they're valued on the private markets or valued on the stock market or real estate investments after you adjust for leverage.

So I'm kind of in the camp of there's no free lunch here. Those asset classes are great though. There is, I think, over time, some illiquidity premium. And, you know, they perform a really important role in markets, given that the size of public markets has gone down over time. But I think there's a lot of hype.

So in my, if you read the chapter in my book, it's a little, and maybe I could rewrite it to be a little less, it's a little bit punchy, Tim, you know, because I really short of, I go and I show claims from published claims of X percent in returns. And then I go and look at the same data from a prominent academic and show X minus 4 percent. So what gives?

I mean, this is the biggest chasm our industry has between practitioners and academics. We've got to resolve this.

TG: I think it's an important question because it is something you read about as a potential flashpoint for markets because that transparency just isn't there.

And it's interesting to hear that the critique of it four or five years ago is much the same that's being made today in terms of the lack of transparency. Quarterly marks, marks that don't move, what to make of that.

SP: Yeah, and you know, it's for a lot of investors, they love not being marked to market, right? And they will tell you that that's part of why they invest in those asset classes. Look, I like these markets. In my personal savings investments, I have maybe 15 percent, 20 percent. I'm a long-term investor in private markets. It's not that I don't like those markets.

It's just that I very much dislike this lack of understanding we have as an industry as to what to expect from those markets. And then you go to the question of, well, what if you get a very skilled private debt or private equity manager? And I think that's a more relevant question. What will a skilled manager be able to deliver? But we can't even agree on the averages, so it's a bit of a Yeah.

TG: Yeah. Well, another, you pricked my ears up because we've talked a lot. And I know Mark and team have done work on stock bond correlation. It's something I've thought quite a lot about that. That whole is 60-40 dead discussion that started five years ago really was about, in some senses, the stock bond correlation. And I'm curious to get your thoughts on that because, of course, we had a regime shift thanks to the COVID era inflation. And I guess the question is really underpinning this is really about inflation, or maybe it's not.

And I'm just curious to get your thoughts as to whether this regime shift we had, where stock and bond returns were negatively correlated for a long period of time, and then that has shifted to positive correlations of returns. If you have any thoughts about how long that persists and how you're talking to your clients about that.

SP: You're right. Is the 60-40 dead is essentially a question about the stock bond correlation. I think we don't talk enough about the stock bond correlation. It's a key component. It's a key assumption we make when we put portfolios together.

But you'll be proud of me, Tim. Last week, I was in the Middle East, and I was doing some media with CNBC International. And I did get to talk about the stock bond correlation on live on CNBC. So, but that's rare.

Look, if you go back and you look at the 12-month correlation by calendar year, you go back for the last 80 years. That correlation has flipped sign 29 different times, from positive to negative, negative to positive. It has ranged from minus 80 percent to plus 80 percent. And here I'm referring to the return correlations. 

But at the same time, there were long regimes when the correlation was mainly positive, think the high inflation volatility of the 70s. And then regimes where the correlation was mainly negative, think the 2000s.

So where are we now? We have higher inflation uncertainty and volatility, and we've had huge interest rate volatility. I mean, we had the mother of all bond bear markets in 22. And as we record this, Tim, the prior quarter bonds had a huge rally, like their second best quarter in the last 30 years. And now roll that forward one more quarter, and they're crashing by bond standard, by bond volatility standard.

So if you ask me, like, what will the stock bond correlation look going forward? It's equivalent to asking, do you think that interest rates will drive volatility in markets or that growth expectations will drive volatility in markets? If you can answer that question, you can forecast the stock bond correlation. Interest rate volatility makes stocks and bonds move together. It makes the correlation positive.

TG: And I think as we record this, we're kind of in this environment where there's a lot of interest rate volatility. And that's something to bring up, I think, is that for those listening, Sébastien and I are recording this literally the day before the US election. The podcast won't go out until after the US election. So we have a distinct challenge here.

SP: So Tim, should we make predictions of what's going to happen? So we're really embarrassed when this comes out?

TG: I think what we should do is record two things, and then I'll edit the one that sounds really smart.

SP: Right.

TG: We won't do that. But for those listening, that is the challenge here. Because the next question I want to ask is following up on your discussion of volatility.

It’s a very simple question in that I want to ask, what kind of volatility regime do you think we are in? And the subsequent question of that then, given what you brought up, is it a rate-driven one, or one where growth takes over and maybe volatility falls in terms of growth-driving rates?

I think you can make a case, and I’ve done a lot of work looking at interest rate, FX volatility in particular. I think you can make the case for both. Implied volatility is very high, but of course, you have huge event risk. Realized volatility is maybe a little bit different.

So I’m curious to see how you think of it, because volatility is another one of these things that goes in regimes. I’m curious to hear your thoughts as to what regime you think we’re in.

SP: Okay. Before I answer this, I need to give you a caveat. I'm on LinkedIn, I'm having a lot of fun posting my thoughts. I never thought I'd be a social media person, but I posted recently three financial markets cliches that I think we should retire.

Let me see if I'll remember them correctly. One is, we live in an era of unprecedented change. You can say that any point in time for the entirety of human history and it will sound smart. It's completely meaningless.

The other one is, we should retire the easy money has been made. When you look at markets, you look back and oh, the easy money has been made. From here on, it's going to be difficult.

And the third one, Tim, which is why I think your question was baiting me a little bit, is, oh, we expect some volatility in the markets for the next six months. Yeah, you can probably say that at any point in time and sound pretty smart.

Specific to the election, you're going to publish this after the election. But going into the election, implied volatilities are really high. What worries me is they're actually low right after they drop really quickly. So, I kind of worry a little bit that the market going into the election is sort of priced in for, yes, uncertainty around the outcome, but then some resolution that would be pretty quick. And maybe that's the base case, right?

But there's always some risks around that. And if there's one thing, one of the lessons I learned from Mark Kritzman is the secret to happiness in life is to have low expectations. And I think the market has some high expectations that vol will go down pretty fast post-election. So, we'll see.

TG: Yeah. That's really the question I'm asking is once you take this out, is which regime do you see us being in? And it sounds like, and I don't want to put words in your mouth, but it sounds like maybe the view is that mean reversion is priced a little bit too aggressively and that the post-election environment is not so easy. The easy money is definitely made and it's all complicated now.

SP: You know, Tim, do you write strategy papers? You should start all of them with, we live in an era of unprecedented change. However, the easy money has been made. But to be clear, from now on, we expect volatility over the next six months.

TG: There you go. There'll be some speed bumps. There'll be some speed bumps along the way, I think, Sébastien.

Well, let's talk about current markets, again, extrapolating from some of these very short-term questions. I wanted to start with a lot of these dynamics between equities and bonds, and how you talk to clients about asset allocation from the, the first part of your book is about return forecasting. I took some very simple rubrics that you talked about there, and just looking at forward earnings yields, and comparing them to the 10-year treasury yield. They're pretty much aligned.

There's probably a little bit of difference based on day-to-day, week-to-week types of valuations, but they're basically aligned in terms of assessing each other's relative valuation, and you mentioned relative valuation, and I want to talk a lot about that the next few minutes, and just the equity versus bond decision.

Where do you think the value is in that very simple distinction between the two?

SP: Let's start with the long-term, and that's where I start in my book. I talk about how you forecast stocks and bonds returns over the long run. I use the simplest models you can think of, and you know what? These simple models work pretty well, and they're hard to improve upon.

Yeah, you mentioned the equity earnings yield is pretty close to the bond yield in the US. The counterintuitive part of this is that if you look at the entire world, it's MSCI All Country World Index. Yes, the price earnings ratio is elevated and it does include the US, but it's not as high as just the US. It's 17, 17.5.

The world's simplest forecasting model for equity returns is you take one over that, and then you add a basic inflation assumption, say 2.5 percent for the world for the next 10 years, and you get about 8 percent equity returns. If you look at the yield for world bonds, you're at 3.5 percent to 4 percent. So while your US data doesn't show an equity risk premium, just the broad world capital markets still show a pretty healthy equity risk premium. It really depends where you look.

And Tim, the equal-weighted all-country world index has a price earnings ratio of 13.5, 13, 14. That's actually right on its 30-year average. So the average stock in the world is not expensive. It's got average valuation. So I think we'll have an equity risk premium. There's some research that's just come out as we record this from Goldman, where they say, look, you're not going to get an equity risk premium. And I think their return for equities is just remarkably low below the current bond yield. I haven't read it, but I think we should expect still over 10 years of positive equity risk.

TG: Yeah. I think that work really, it almost assumed you were going to have a large correction at some point in the next 10 years, which can happen. But that's what it will take to get to their return assumptions.

For equities specifically, we talked a little bit about, and you mentioned growth versus value, and the relative valuation stories that have emerged and potentially been disappointing for investors, the underperformance of value, the underperformance of small and mid-caps relative to large cap equities. I'm just curious to get your outlook here because the value case has been there for a long, long time. Small versus mid cap is not the same. Doing that versus large caps is not the same necessarily as value versus growth, although there are a lot of overlaps.

I wanted to see if you could talk about each of those relative strategies though, and what your thoughts on them are, and maybe, well, we'll come back to maybe what differentiates the two of them, but just the outlook.

SP: Let me start with the short term because the prior question I just covered the long term. Over the next six to 18 months are, if that's the view we take from our asset allocation committee, we are long value stocks, relative to growth stocks in the US. So we expect that extremely stretched valuation spread to revert, and the fundamentals are expected to revert as well.

So year over year earnings growth for value stocks by the end of next year should actually get pretty close to year over year earnings growth for growth stocks, believe it or not, because the comparables are so much easier for the value sector. And you also have, you know, potentially some commodities pressures, potentially some good performance and some value head healthcare stocks, which are stock pickers like industrials. So there are opportunities to overweight value stocks right now in the short run.

We're neutral between small and large in the US., overweight small outside the US. It's interesting because small and mid outside the US have kind of been dragged down with the global small asset class, overall, and a domination of the benefits of scale and winner takes all. But the return on equity of international small caps is about twice the return on equity of US small caps, even though the valuation is as beaten down. So we have a small overweight there.

These aren't large positions, but we're kind of leaning contrary and against the growth stocks freight train. We still love growth stocks. I mean, some of those companies are great and our stock pickers are overweighting them. But you've just gone where the elastic man for the relative valuation is very, very, very stretched. So we're positioned for some sum mean reversion there, and the election could be a catalyst, and fundamentals could be a catalyst as well.

Longer term, Tim, let me just give you an anecdote on this idea of those risk premium that are in the academic textbooks are not there, have not been there. I put together a group of Chief Investment Officers from our industry about a month ago. There's 11 of us, it's closed door meeting, and we're talking about the role of Chief Investment Officer and what we do in markets. It's early in the day and I thought, well, this is going okay, but people are just too serious and prepared and I need to get a discussion going.

So I leaned in and I said, can we all admit that we've all had essentially the same capital markets assumptions for the last 10 years and that we've all been wrong? I mean, take any capital markets assumption for longer term, you probably have built in there for the last 10 years, an emerging market risk premium, a value risk premium, a small cap risk premium. We haven't had any of this for over 10 years. So there's some soul searching to be done, and that's why I just put out that paper when valuation fails. Part of it is technology.

TG: Okay. I was wondering if you could elaborate that.

What is your approximate explanation for why these old models, not old models, they're models that will probably work at some stage in the future, but why has it been so frustrating?

SP: There's several explanations, but I think the most important one is the technology breakthroughs that have led to benefits of scale for those massive mega cap tech companies. And also the fact that they have IP, they spend on research and development, they have very, very big user bases that create network effects. Those aren't traditional assets from an accountants perspective. So their book values, based on what the accountants are calculating, are really small.

And by the way, their earnings also, when adjusted for intangibles, look a bit smaller than they really should because everything is dispensed, as opposed to capitalized as an investment. So you end up with the actual valuation metrics being distorted. And then you have to adjust for just sector composition and innovation. So you can explain it.

You can also cure part of this issue if you use a basic momentum measure. We all know, especially in quant worlds, that combining valuation with shorter term momentum helps a lot in terms of using relative valuation as a signal. The sum of the parts is better if you add momentum.

TG: Thinking about now the fixed income side of things. And this is again, I think, a very short and long term question we have in markets. We've had concerns over deficits, and that is an election issue in the US, of course. Well, last week in the UK, we had the budget, and there's concerns around deficits here, and have been for the last few years, going back to 2022 in the budget that disrupted markets.

And I'm just wondering if you could give your thoughts on fiscal dynamics and how they influence your outlook for fixed income markets on their own, but then also relative to equities with that in mind.

SP: Tim, everyone's heard the analogy of the slow-boiling frog. Does that ring a bell?

TG: Absolutely.

SP: And it's used by often management consultants who want companies to change faster when they're losing market share. The idea is if you put a frog in water and you just slowly increase the temperature, apparently the frog will die before it jumps out all the way to the boiling point. I found out, I was writing a paper about this using the analogy for the slowly and now more and more faster rising debt to GDP ratio. It turns out it's been disproven scientifically. The frog actually jumps out. So there's that. But it's a slow-boiling frog problem.

And I can tell you, I think we're fine with debt to GDP and deficits for the next 12 months, but it is a long-term problem that unless something is done on the growth side, on the spending side or on the inflation side, is really going to get worse and start creating problems.

But there are different ways to look at it and not be too pessimistic about it. First of all, countries can live above 100 percent debt to GDP. The Rogoff and Reinhardt study, this is a fascinating, for anybody who's been an analyst, it's a fascinating story, because these are two extremely prominent economists who put out a paper saying countries experience negative growth once debt to GDP goes above. I can't remember what it was, 100 percent, maybe 120 percent.

TG: Ninety percent, I think, was the threshold.

SP Yeah. It's like minus 0.2 percent on average. Then someone tried to replicate their study and found out that there was an Excel error in their spreadsheet. It's an old story, but headlines will go, the Excel error heard around the world, or Reinhardt and Rogoff, how not to excel at economics. Clearly, financial journalists had fun with this. But those that replicated the study showed that, yes, countries can grow actually at a pretty average rate once their debt to GDP goes above 100 percent, historically across many countries.

Japan is already way higher than the US and it's been for a while. I don't want at all to minimize this problem, but the empirical evidence is that it's not a debt spiral. It can become a debt spiral, it can become problematic, like as happened in the UK when you tried to pass a budget, and the bond markets go, well, we don't want that debt anymore.

The difference with the US is that if US treasuries aren't the safe asset, the reference asset to anchor a portfolio, what is? I mean, these other countries have similar or even higher debt to GDP. There's demand for US debt that could sustain a fairly high debt to GDP ratio. Again, not minimizing, because the thing is, if you look at the debt service, it's going vertical over the next years, and it's getting even the second biggest expense for the government.

In my mind, that's why the Fed actually is so eager to cut rates Economists are telling me not to say that, that the Fed does not cut rates to make US government debt less expensive for the government. But I don't know.

TG: Ultimately, interest on debt becomes fiscal stimulus to a degree, and whatever the political outcome, deficits are probably not going away or not shrinking meaningfully, and are therefore stimulative. And so I wanted to kind of evolve this discussion towards the US economy and the Fed.

And I'm just wondering, as a starting point, if fiscal dynamics give the Fed any reason to actually pause interest rate cuts, not withstanding the argument they want to have lower interest expense for the government, but whether that is just overly stimulative and the Fed has to do something about that.

SP: Look, we're running 6-7 percent of GDP deficits. That is the first time we're doing this outside of a recession. Those are recessionary levels of government spending. And this is because we've gotten used to this coming out of COVID, and we're still normalizing. It's really hard once you start spending to pull back.

So your question is, isn't that stimulative and shouldn't the Fed therefore kind of just leave rates where they are so we don't get back into inflation going up four or five or more percent? Again, this is something the Fed is not supposed to do, you know?

But they certainly look at the economy, and the growth side is important in terms of employment. And in fact, if you look at the employment data, it's been quite strong. A lot of it is government jobs, right? So, I think we're in a cutting cycle. The Fed wants to cut. As long as inflation is under control, it didn't even have to be two percent at this point. I think the Fed will cut anyways.

TG: Relative to elsewhere, this notion of US exceptionalism has been a theme, certainly the previous couple of years in the cycle, it's re-emerging as a theme, as we're getting slower growth data in the UK, the Eurozone.

Do you think it's still a strong relative story for the US as well, and how much of that is priced?

SP: Yeah, that second question is important because in terms of the economy, the US economy is not even slowing right now. I mean, you could say, if you want to be bearish, that unemployment is up 70 basis points from its absolute low of 3.4 percent, so unemployment is rising. You could look at manufacturing PMIs, which are at 47, which indicate a contraction and an expansion. You could say the yield curve has been inverted, which is a recession signal.

But when I look at the broader set of data, I conclude that the US economy is not slowing. The Atlanta Fed GDP now, which is a now cast measure, is higher at say 2.8 percent than it was at the beginning of the year at 1.9 percent. The Citi surprise index is trending up, not down. Unemployment at 4.1 percent, that's actually a very low number by historical standards. Claims are still quite low by historical standards. The employment data is there, there's fiscal stimulus, the Fed is cutting. We can't say really the economy is slowing.

Tim, when I look out 12 months, is it all priced in? A lot of it is priced in, but at the same time, this price earnings ratio of 21.5 for the S&P 500, it is scary. It is high, it takes you back to bubble formation around the Internet in the early 2000s. However, it's different because the return on equity of these companies is gigantic. If you adjust that PE ratio for the return on equity of the market, you're just like 67th percentile. You go back to 2015, 2016, you're just slightly above median. Valuations in the eye of the beholder.

We're neutral between US and non-US stocks at the moment.

TG: I am often accused, usually by myself, of the US starting and dominating the discussion. I'm happy to say it's finished the market discussion here, because there's one more topic that I wanted to talk about with you, which is another book that you've written that is coming out in April of next year, called The Psychology of Leadership, Timeless Principles to Perfect Your Leadership of Individuals and Teams. So we're about to take a complete left turn here and talk about a book that is very different than everything we've talked about so far, I think. We've talked about quantitative techniques and asset allocation and markets.

And so I'm curious as to why you wrote the book at this stage in your career and in your journey.

SP: Look, I wanted to improve myself as a leader. I started looking into research in psychology. I started talking to a sports psychologist and I just got absolutely fascinated with what's in there and completely underappreciated. By the way, in investment management, lots of connections between sports psychology and investing, but in general, in leadership. And so the discoveries are just fascinating, Tim.

I spent my weekends over a year and a half researching and writing about this, and I just discovered that we're just underestimated the positive side of psychology. You know, if you think of psychology as fixing problems, that's what most people think it's for. But there's positive psychology, sports psychology, and personality psychology. All ways to actually thrive, get better, improve as a leader.

TG: Are there any attributes that really stood out to you as hallmarks of great leaders as you did your research?

SP: A lot of it might sound generic. We talked about cliches in financial markets earlier. There are cliches in leadership literature as well. My book is pretty different.

It goes deep into the research in psychology, and some of it is not intuitive. And these are things I've uncovered over time and are supported by research. But let me give you a narrative that's a bit cliche about leadership, right? Well, if you want to be a great leader, you need to be inspiring. You need to be a great communicator, give fantastic speeches. You need to be a great builder of consensus. You need to set very measurable goals. And you need to really not get stressed about things, right?

That's kind of your traditional image of a great leader.

Well, in the book, I started explaining that in a lot of cases, it's the exact opposite of those things. Like leaders should talk less. Listening, the act of listening is an act of leadership, and it's counterintuitive, but it's also an act of communication. So and there's a portrait for me because I like to talk. And by learning to listen, as opposed to being the best communicator, listening is super important for leadership, completely underrated.

On the consensus thing, yeah, you need to be able to build consensus and bring people along, but you know what, when I was studying personality psychology and looked into the trait called agreeableness, you know, I realized you're really not a leader if all you're doing is trying to build consensus. Being a leader means you have to make some really tough decisions that are going to make some people unhappy, and you have to be able to be disagreeable when it comes time to make a tough decision. You're not a leader if all you're trying to do is just build consensus, and you won't be able to resolve conflicts.

Measurable goals, they're awesome, right? This is the target and so on. But you know what? The goal, the most important goals for organizations aren't easily measurable. This is one for investment management. Are we making our process better? Are we getting better at making decisions under uncertainty? You can't really measure that. Is our culture one where people want to perform? Do we have a culture of high performance in a positive way? That's a huge goal for an organization, but it's not measurable. To me, those goals supersede any measurable goals that you can put out. You see how I'm deconstructing the basic stuff I gave you?

The last one about leaders always being calm under pressure and not getting stressed. The research shows a source of motivation, a source of activation in athletes. Don't believe that athletes don't get stressed when they have to make the three-point shot at the end of the game. Forget that. They will get stressed. And sports psychology has this whole approach of finding the optimal performance point, which is not zero stress. If you're zero stress, you're bored. You're not motivated. It's actually a certain level of stress or activation. After which, if you go too high, then you freak out. But there's this curve of stress that leaders need to embrace and organizations need to embrace. There needs to be some organizational stress, if you will, in order for the organization to perform. It's a competitive world in business. So anyways, I'm pontificating, but there are all these traditional ways of looking at leadership, and there's a lot of new things to think about using research and psychology.

TG: Well, to finish, it's a question I often ask when I have traders on, anyone taking risk, in any capacity, I always ask this question. And you kind of alluded, I think, to what you might answer it as.

But I wanted to ask you in terms of what in your role, you lead a big team in a big organization, what do you find you have to work on yourself the most? Kind of what biases do you need to correct? Or the aspects of leadership that you need to work on most in your role?

SP: For me, it's been a very big transition towards spending more time listening. The listening part is key to high level leadership. And what is the job of a leader? What do leaders do? It's actually not that complicated. You're the one setting the goals. If you don't set goals, who will? And one thing I've worked on is setting longer term goals.

Because if you don't set the longer term goals, the direction of travel for the organization, who will? So taking a longer term horizon in setting goals is important. And it's on the number one job of a leader. And then number two is you got to bring people along. You need to understand people's motivation. You need to understand the science of personality and the research behind it. And it can tremendously help in bringing people along.

TG: Fantastic stuff. Well, listen Sébastien, we are sadly, I think I could talk to you for two hours, but we have hit an hour. The Psychology of Leadership is the new book. It's coming out in April of 2025. If it's any bit as readable as your first book, it will be well worth picking up. Sébastien, thank you so much. It's great to catch up with a State Street alumnus and excellent to have you on the podcast.

SP: Tim, thank you so much. The book is available now for pre-orders. That will help me if you get pre-orders done, it will get my publisher's attention. Tim, that was awesome. It was great to reminisce on State Street, and it was just such a great period of my life. And thank you. And thank you to your team. Thank you to everybody involved.

TG: Thanks for listening to this week's edition of Street Signals from the research team at State Street Global Markets. This podcast and all of our research can be found at our web portal Insights. There, you'll be able to find all of our latest thinking on macroeconomics and markets, where we leverage our deep experience in research on investor behavior, inflation, risk and media sentiment, all of which goes into building an award-winning strategy product. If you're a client of State Street, hit us up there at globalmarkets.statestreet.com.

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