PDF Summary:How to Listen When Markets Speak, by Lawrence G. McDonald

The global economy is shifting from decades of low inflation and stability to an era of rising prices and geopolitical uncertainty. In How to Listen When Markets Speak, Lawrence G. McDonald explains why disinflationary forces—such as cheap labor from Asia, abundant Russian resources, and US dominance in global affairs—are ending. He identifies new inflationary pressures including energy costs, growing union power, and massive government spending, while warning about risks in the US financial system from mounting debt and weakening demand for Treasury bonds.

McDonald offers guidance on reading market signals to identify regime changes and opportunities. He argues that traditional investment strategies like the 60/40 portfolio no longer work in this environment and explains how to build a more resilient portfolio by shifting from growth stocks to value stocks and hard assets like energy and commodities that perform better during inflation.

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(Shortform note: The relationship between unions, social safety nets, and inflation is complex and varies across countries. In the Nordic countries, strong unions and expansive social programs have coexisted with low inflation for decades. The Calmfors and Driffill hypothesis suggests that highly centralized wage bargaining systems, like those in Scandinavia, can internalize the macroeconomic effects of wage demands, leading to greater wage restraint and price stability. Additionally, credible inflation-targeting central banks can anchor inflation expectations, reducing the risk of wage-price spirals even in economies with strong labor protections.)

The pandemic shifted the power balance in U.S. businesses from owners to workers. 44% of the U.S. dollars currently circulating were printed in 2020 and 2021. Inflation is caused by a rise in both the money supply and its velocity. If the government created a trillion dollars and stored it securely for ten years, inflation would remain unchanged. However, if they directly added a trillion or more into the bank accounts of millions of Americans, inflation would skyrocket. This is precisely what occurred from 2020 to 2022.

(Shortform note: Not all economists agree with McDonald’s analysis of the causes of inflation. In The Deficit Myth, Stephanie Kelton argues that inflation occurs when total spending in the economy outpaces its capacity to produce real goods and services. She explains that the government can manage inflation by using fiscal policy tools like taxes, public investment, and regulation to balance overall demand with available resources. Kelton argues that the key is to focus on the economy’s real productive capacity rather than arbitrary limits on government spending or the sheer quantity of money created.)

In 2022, Western governments took the unconventional step of supporting energy demand amid a crisis of rising inflation. California distributed $23 billion in "inflation relief" checks, mainly to offset increasing energy costs. Italy allocated $14 billion for similar measures. The largest energy demand subsidies were cost-of-living adjustments (COLA) added to Social Security and federal retirement checks in America. In 2023, the cost-of-living adjustment rose to 8.7%, the largest increase in four decades.

(Shortform note: During the 1970s oil crises, many governments intervened to shield households from fuel-price spikes. The 2022 inflation relief checks and COLA increases continue this long-standing political pattern of cushioning energy demand during inflationary shocks. While the scale and mechanisms have evolved, the underlying political logic remains consistent: Governments often prioritize short-term economic stability over long-term market signals, even when facing inflationary pressures.)

COLA is determined based on CPI numbers, which largely reflect energy costs since crude oil affects nearly all products. Through Social Security alone, the federal government provided an additional $207 billion to retirees to make up for lost purchasing power during 2022 and 2023. COLA funds circulate throughout the economy, purchasing necessities, and contribute to ongoing inflation. After COVID-19, the overall safety-net programs have expanded significantly. SNAP benefits offer a revealing perspective on enduring inflation. In the years of the pandemic, recipients increased by 25% to reach 42 million nationwide. The figure in 2001 was 16 million people, making up 5.6% of the U.S. populace. Based on Pew Research data, 41.9 million individuals were getting SNAP benefits as of April 2023.

How the CPI Is Calculated

The U.S. Bureau of Labor Statistics (BLS) calculates the Consumer Price Index (CPI) by tracking the prices of thousands of goods and services that urban consumers buy. The BLS assigns different weights to each category based on how much people spend on them. For example, housing costs make up about 30% of the CPI, while food and transportation each account for around 15%. Medical care and energy costs are each about 10% of the index. This means that changes in any of these categories can affect the overall CPI. So, while energy prices do play a role in the CPI, they are just one part of a much larger picture. This means that COLA adjustments are influenced by a wide range of prices, not just energy costs.

Financial System Risks & Responses

McDonald claims that the U.S. financial system faces significant risks from rising debt and declining interest in Treasuries. The U.S. government owes $33 trillion, with $11 trillion needing repayment in the upcoming two years. It will need to refinance this debt at higher interest rates, raising annual debt servicing costs by hundreds of billions. Additionally, the Social Security trust fund is expected to be depleted by 2033, forcing the government to cover all Social Security expenses with tax revenues. This will further drain government resources, reducing the funds available for optional expenditures, like defense, building infrastructure, schooling, and research and development.

(Shortform note: In The Deficit Myth, economist Stephanie Kelton challenges the idea that rising debt and the Social Security timetable will inevitably crowd out the optional spending categories McDonald lists. She argues that the federal government, as the issuer of the US dollar, does not face a finite pot of money and cannot “run out” of dollars in the way a household or business can. Therefore, the government’s spending is not constrained by tax revenues or bond sales in any mechanical sense. The true constraint on public spending is the availability of real resources and the risk of inflation, not the size of the deficit or the level of outstanding Treasury securities.)

This might require increased taxation or issuing additional debt. McDonald adds that the appeal of American Treasury securities is waning. The Federal Reserve is divesting instead of purchasing Treasuries, and the Social Security fund is no longer buying them either. Foreign investors, especially those in Saudi Arabia and China, are reducing their reliance on the dollar and no longer increasing their U.S. debt holdings. Historically the biggest purchaser of Treasuries, Japan isn't acquiring as many anymore. The Eurozone is currently in competition with the U.S. for funding, and China will probably exchange more of its dollars for euros. The U.S. government will need to make some difficult decisions. With its present spending patterns, it can't sustain elevated rates, so something major will need to be cut.

The Clientele for U.S. Treasury Securities

One group of buyers that McDonald doesn't mention is domestic financial institutions. According to economists Arvind Krishnamurthy and Annette Vissing-Jorgensen, the primary clientele for U.S. Treasury securities includes financial institutions such as commercial banks, insurance companies, mutual funds, and pension funds. These institutions hold Treasuries in large quantities because these securities provide superior safety and liquidity services, function as key collateral in financial transactions, and help institutions meet regulatory and capital requirements. This creates a strong and relatively inelastic demand for Treasury debt from domestic investors.

McDonald also argues that regional financial institutions are endangered due to their vulnerability from commercial property lending. Regional banks are four times as exposed to commercial real estate as large banks. These loans make up 30% of the assets at regional financial institutions, compared to 6% at big banks.

Over the past ten years, loans for commercial real estate have doubled and were made at 1.5% to 3% interest rates. Should the Fed maintain the funds rate around 5% for five or six more months, the resulting losses will be enormous. A federal bailout could become necessary.

The Impact of the Pandemic on Commercial Real Estate

The pandemic’s impact on commercial real estate has been profound, with remote work and e-commerce reducing demand for office and retail space. This has led to higher vacancy rates and lower rental income, making it difficult for property owners to service their debt. Regional banks, which hold a significant portion of these loans, are particularly vulnerable. A prolonged period of high interest rates would exacerbate this situation by increasing borrowing costs and further depressing property values. This could lead to a wave of defaults and foreclosures, putting additional strain on regional banks’ balance sheets.

Investment Strategies for a Shifting World Order

McDonald argues that in times of inflation, value stocks generally outperform growth stocks. Value equities are businesses whose earnings have lower valuations. In contrast, stocks geared towards growth trade at higher multiples because investors expect them to earn more in the future.

Value stocks are less affected by inflation because they have a lower price-to-earnings ratio and are often in the commodity space, which tends to appreciate during inflation. Stocks focused on growth are more affected by rising prices because they rely on low-cost borrowing to sustain them until they become profitable. When inflation rises, debt costs increase, making it harder for these companies to survive.

Inflation and Equity Style Performance

In Expected Returns, Antti Ilmanen notes that the impact of inflation on equity style performance is largely conditional on what happens to real interest rates, growth expectations, and firms’ pricing power rather than on inflation alone. He argues that equity styles are not tied to fixed macro outcomes, and there is no unconditional rule that one always benefits and another always suffers from inflation. When inflationary periods coincide with low or falling real discount rates and when many companies classified as “growth” have strong competitive positions, high margins, and the ability to pass higher input costs through to customers, such growth stocks can prove remarkably resilient and may even outperform more traditional value sectors despite the inflationary backdrop.

Next, McDonald explains how to identify market signals of regime change and construct a resilient portfolio for a different era.

Identifying Market Signals of Regime Change

Key Cross-Asset Signals

McDonald believes that cross-asset indicators can reveal market opportunities. These signals are divergences between distinct categories of assets, such as bonds and stocks. For instance, if a company with significant leverage sees its bonds rising while its stock remains steady, this indicates an optimistic forecast for those holding equity. Conversely, a bearish outlook is signaled if bonds are underperforming and experiencing selling pressure. This is because creditors have more influence than equity holders in a company that's heavily leveraged.

The Relationship Between Bond Prices and Stock Prices

The relationship between a company's bond prices and its stock prices is complex, but finance researchers have found that changes in bond prices can often signal future movements in stock prices, especially for companies with high leverage. This is because bond investors are primarily concerned with the company's ability to meet its debt obligations, so they react quickly to any news that might affect the company's solvency. When bond prices rise, it suggests that investors believe the company is less likely to default, which can be a positive sign for the company's overall financial health. Conversely, falling bond prices may indicate concerns about the company's ability to service its debt, which could eventually impact its stock price.

Strategic Implications of Economic Indicators

According to McDonald, market signals can indicate potential economic downturns or recoveries. A case in point is a 3% drop in stocks after a stretch of low volatility frequently suggests upcoming issues. In February 2020, the Nasdaq fell 4%, the S&P lost 12%, and the market dropped 12% in a single day. At the end of March, the S&P 500 fell 35%.

The Fed responded by reducing rates to zero and rolling out a quantitative-easing and emergency-lending program. The US government also increased spending, passing the CARES Act, a $2.2 trillion package. The market began to rebound, though it was unclear if it would continue to recover or become more volatile. The 21 Lehman systemic risk indicators signaled increased risk, indicating that investors were raising their risk by purchasing stocks, bonds, and other assets. This indicated positive outcomes for investors.

Regime Shifts in the Stock Market

Andrew Ang and Allan Timmermann says that, in Markov-switching models of equity returns, shifts from a low-volatility to a high-volatility regime tend to be triggered by unusually large negative return realizations, and once the market enters the high-volatility regime it is characterized by persistently higher return variance and lower average returns than in the preceding calm regime. This empirical finding supports McDonald’s claim that a 3% drop in stocks after a stretch of low volatility frequently suggests upcoming issues, as such a drop may signal a regime shift to a more turbulent market environment.

Constructing a Resilient Portfolio During an Evolving Era

McDonald argues that the traditional 60/40 portfolio isn't effective anymore, and a new approach is needed for the 2020–2030 era. The 60/40 portfolio is considered a "risk parity" approach, consisting of 60% stocks and 40% bonds. It was favored by those seeking lower financial risk from 2010 through 2020.

(Shortform note: In Expected Returns, Antti Ilmanen explains that in a risk parity portfolio, the allocation is determined so that each major asset class contributes roughly equally to the total portfolio risk, usually defined in terms of volatility, which in practice means scaling down high-volatility assets and leveraging low-volatility assets until their contributions to overall risk are broadly balanced. This approach aims to create a more balanced risk profile across different market conditions.)

Next, McDonald discusses portfolio rebalancing and targeted asset categories.

Portfolio Rebalancing for Inflation and Geopolitics

McDonald claims that investors are shifting from technology stocks to hard assets to handle sustained inflation and higher energy prices. In early 2022, technology stocks made up 43% of the Standard and Poor's 500. But as inflation increased, investors began shifting their focus from tech and growth equities to hard assets. Between the COVID-19 bottom and the close of 2022, the Energy Select Sector SPDR ETF (XLE) rose by 325%, the Sprott Uranium Miners ETF (URNM) climbed 318%, the Global X Copper Miners ETF (COPX) increased by 260%, and the SPDR S&P Metals and Mining ETF (XME) also rose by 260%.

(Shortform note: While shifting from technology stocks to hard assets can be a strategic move in response to inflation and rising energy prices, it also introduces significant concentration risk. By heavily investing in specific sectors like energy, uranium, copper, and metals, you expose your portfolio to the volatility and cyclical nature of these industries. These sectors often experience periods of rapid growth followed by extended downturns, making it challenging to time your entry and exit points effectively. For example, the energy sector has historically shown boom-and-bust cycles, with periods of high returns often followed by years of underperformance.)

McDonald believes oil equities remain in the beginning stages, and the next several years should see these companies receive billions in investments. Oil production in the U.S. has been decreasing, and demand is projected to increase by 20 million barrels daily over the coming decade. Loan expenses will increase, and affordable fossil fuel prices will soon become a thing of the past.

(Shortform note: The [World Energy Outlook 2023](https://www.oecd.org/en/publications/world-energy-outlook-2023827374a6-en.html)_ report from the International Energy Agency (IEA) projects that global oil demand will peak before 2030 in all of its main scenarios. This suggests that McDonald’s prediction of a 20 million barrel per day increase in demand over the next decade may not be accurate. Additionally, recent data from the IEA indicates that US oil production has reached record highs in 2023, rather than declining as McDonald suggests.)

Targeted Asset Classes for a World With Multiple Power Centers

McDonald argues that in a multipolar world, it's more advantageous to have fossil fuel reserves nearby. Reserves located in distant areas could become embroiled in geopolitical conflict or be reclaimed by governments in other countries. For example, in 2022, the U.S. and Europe sanctioned Russia, causing the termination of every partnership between international oil giants and Russia's government. BP faced a $25 billion loss when it withdrew from its 20% investment in Rosneft, a Russian company, which accounted for nearly 50% of BP's reserves. Shell suffered a loss after it withdrew from its partnership with Gazprom of Russia to fund Nord Stream 2.

The Risk of Stranded Assets

While it may be more advantageous to have fossil fuel reserves nearby in a multipolar world, this strategy can also have drawbacks. For example, in The Carbon Bubble, Jeff Rubin argues that the value of fossil fuel reserves is at risk of being stranded due to the global transition to a low-carbon economy. He explains that as governments implement policies to reduce carbon emissions, the demand for fossil fuels will decline, making it uneconomical to extract and use these reserves. This could lead to significant financial losses for companies and countries that have invested heavily in fossil fuel reserves, as they may be unable to recoup their investments.