The Endgame

Summary

On May 4, 2016, Druckenmiller took the stage at the 21st Annual Ira Sohn Investment Conference with a slide deck titled simply "The Endgame." His premise: the policy response to the 2008 crisis had not repaired the global economy but frozen it in place — preventing deleveraging, punishing reform, and borrowing consumption from the future on an unprecedented scale. Three years after using the same stage to draw a bullish intermediate conclusion from the central-bank liquidity wave, he announced that the weight of the evidence had shifted: the bull market was exhausting itself.

The speech is the fullest formal statement of the systemic critique that runs through everything Druckenmiller said in the following decade. It moves from the Fed (the longest dovish deviation from historical norms in his career) to corporate America (debt-fueled buybacks crowding out productive investment) to China (credit growing by a Brazilian GDP per year with collapsing marginal returns), and closes with the trade that made headlines worldwide: gold as his largest currency allocation.

Full Text

When I started Duquesne in February of 1981, the risk free rate of return, 5 year treasuries, was 15%. Real rates were close to 5%. We were setting up for one of the greatest bull markets in financial history as assets were priced incredibly cheaply to compete with risk free rates and Volcker's brutal monetary squeeze forced much needed restructuring at the macro and micro level. It is not a coincidence that strange bedfellows Tip O'Neill and Ronald Reagan produced the last major reforms in social security and taxes shortly thereafter. Moreover, the 15% hurdle rate forced corporations to invest their capital wisely and engage in their own structural reform. If this led to one of the greatest investment environments ever, how can the mirror of it, which is where we are today, also be a great investment environment? Not a week goes by without someone extolling the virtues of the equity market because "there is no alternative" with rates at zero. The view has become so widely held it has its own acronym, "TINA".

No more room to increase leverage

Not only valuations were low back in 1981 but financial leverage was less than half of what it is today. The capacity of credit inspired growth was still ahead of us. The policy response to the global crisis was, and more importantly, remains so forceful that it has prevented any real deleveraging from happening. Leverage has actually increased globally. Ironically from where I stand, that has been the intended goal of most policymakers today.

Source: Board of Governors of the Federal Reserve System The Fed has borrowed from future consumption more than ever before Deviations from standard Taylor Rules Greenspan Bernanke / Yellen Volcker

Let me focus on two of the main policies that have not only prevented a cleanup of past excesses in developed markets but also led to an explosion in leverage in Emerging markets. The first of these policies has been spearheaded by the Federal Reserve Bank in the US. By most objective measures, we are deep into the longest period ever of excessively easy monetary policies. During the great recession, rates were set at zero and they expanded their balance sheet by $1.4T. More to the point, after the great recession ended, the Fed continued to expand their balance sheet another $2.2T. Today, with unemployment below 5% and inflation close to 2%, the Fed's radical dovishness continues. If the Fed was using an average of Volcker and Greenspan's response to data as implied by standard Taylor rules, Fed Funds would be close to 3% today. In other words, and quite ironically, this is the least "data dependent" Fed we have had in history. Simply put, this is the biggest and longest dovish deviation from historical norms I have seen in my career. The Fed has borrowed more from future consumption than ever before. And despite the US global outperformance, we currently have the most negative real rates in the G-7.

At the 2005 Ira Sohn Conference, looking at a more muted but similar deviation, I argued that the Greenspan Fed was sowing the seeds of an historical housing bubble fed by reckless subprime borrowing that would end very badly. Those policy excesses pale in comparison to the duration and extent of today's monetary experiment.

The obsession with short-term stimuli contrasts with the structural reform mindset back in the early 80s. Volcker was willing to sacrifice near term pain to rid the economy of inflation and drive reform. The turbulence he engineered led to a productivity boom, a surge in real growth, and a 25 year bull market. The myopia of today's central bankers is leading to the opposite, reckless behavior at the government and corporate level. Five years ago, one could have argued it was in search of "escape velocity." But the subpar economic growth we are experiencing in the 8th year of a radical monetary experiment and in Japan after more than 20 years has blown that theory out of the water. And smoothing growth over a cycle should not be confused with consistently attempting to borrow consumption from the future. The Fed has no end game. The Fed's objective seems to be getting by another 6 months without a 20% decline in the S&P and avoiding a recession over the near term. In doing so, they are enabling the opposite of needed reform and increasing, not lowering, the odds of the economic tail risk they are trying to avoid. At the government level, the impeding of market signals has allowed politicians to continue to ignore badly needed entitlement and tax reform.

And the peak in profits is past.

Look at the slide. The doves keep asking where is the evidence of malinvestment? As you can see, the growth in operating cash flow peaked 5 years ago and turned negative year over year recently even as net debt continues to grow at an incredibly high pace. Never in the postWorld War II period has this happened. Until the cycle preceding the great recession, the peaks had been pretty much coincident. Even during that cycle, they only diverged for 2 years, and by the time EBITDA turned negative year over year, as it has today, growth in net debt had been declining for over 2 years. Again, the current 5year divergence is unprecedented in financial history!

US Corporate debt was not used productively

And if this wasn't disturbing enough, take a look at the use of that debt in this cycle. While the debt in the 1990's financed the construction of the internet, most of the debt today has been used for financial engineering, not productive investments. This is very clear in this slide. The purple in the graph represents buybacks and M/A vs. the green which represents capital expenditure. Notice how the green dominates in the 1990's and is totally dominated by the purple in the current cycle. Think about this. Last year, buybacks and M&A were $2T. All R&D and office equipment spending was $1.8T. And the reckless behavior has grown in a non-linear fashion after 8 years of free money. In 2012, buybacks and M&A were $1.25T while all R&D and office equipment spending was $1.55T. As valuations rose since then, R&D and office equipment grew by only $250b, but financial engineering grew $750b, or 3x this! You can only live on your seed corn so long. Despite no increase in their interest costs while growing their net borrowing by $1.7T, the profit share of the corporate sector peaked in 2012. The corporate sector today is stuck in a vicious cycle of earnings management, questionable allocation of capital, low productivity, declining margins, and growing indebtedness. And we are paying 18X for the asset class.

A second source of myopic policies is now coming fromChina. In response to the global financial crisis, China embarked on a $4 trillion stimulus program. However, because they had engaged in massive infrastructure investment the previous 10 years, and that was the primary stimulus pipe they chose; this only aggravated the overcapacity in the investment side of their economy. Not surprisingly, this only provided a short term pop in nominal growth. While we were worried about bank assets to GDP in 2012, incredibly, credit has increased by 70% of GDP in the 4 years since then. Just to put this in perspective, this means that since 2012 the Chinese banking sector has allowed credit to grow by the amount of the entire Brazilian GDP per year! Picture the entire Brazilian production in new houses and infrastructure. Incredibly, all this credit growth has been accompanied by a fall in nominal GDP growth from 15% to 5%. This is an extremely toxic cocktail for companies that have borrowed at 10% expecting 15% sales growth. Our strong suspicion therefore is that a large part of this growth is just credit flowing to otherwise insolvent borrowers. How else to explain the lack of NPL problem in heavy industries hit by lower prices and sales growth?

As a result, unlike the pre-stimulus period, when it took $1.50 to generate a $1.00 of GDP, it now takes $7. This is extremely rare and dangerous. The most recent historical analogue was the U.S. in the mid-2000's when the debt needed to generate a $ of GDP increased from $1.50 to $6 during the subprime mania. Two years ago, we had hope the Chinese were ready to accept a slowdown in exchange for reform. Unfortunately, with the encouragement of the G-7, they have opted for another investment focused fiscal stimulus which may buy them some time but will exacerbate their problem. They do not need more debt and more houses.

As the chart shows, this will remove a major cylinder from the engine of world growth.

Without Chinese restructuring, the engine of global investment will not return

I have argued that myopic policy makers have no end game, they stumble from one short term fiscal or monetary stimulus to the next, despite overwhelming evidence that they only produce an ephemeral sugar high and grow unproductive debt that impedes long term growth. Moreover, the continued decline of global growth despite unprecedented stimulus the past decade suggests we have borrowed so much from our future for so long the chickens are coming home to roost. Three years ago on this stage I criticized the rationale of fed policy but drew a bullish intermediate conclusion as the weight of the evidence suggested the tidal wave of central bank money worldwide would still propel financial assets higher. I now feel the weight of the evidence has shifted the other way higher valuations, three more years of unproductive corporate behavior, limits to further easing and excessive borrowing from the future suggest that the bull market is exhausting itself.

"Dangerous Inaction" ?? Japan's Fiscal and Monetary Balance sheets

If we have borrowed more from our future than any time in history and markets value the future, we should be selling at a discount, not a premium to historic valuations. It is hard to avoid the comparison with 1982 when the market sold for 7x depressed earnings with dozens of rate cuts and productivity rising going forward vs. 18x inflated earnings, productivity declining and no further ammo on interest rates.

The lack of progress and volatility in global equity markets the past year, which often precedes a major trend change, suggests that their risk/ reward is negative without substantially lower prices and/or structural reform. Don't hold your breath for the latter. While policymakers have no end game, markets do.

On a final note, what was the one asset you did not want to own when I started Duquesne in 1981? Hint...it has traded for 5000 years and for the first time has a positive carry in many parts of the globe as bankers are now experimenting with the absurd notion of negative interest rates. Some regard it as a metal, we regard it as a currency and it remains our largest currency allocation.

Policymakers have no endgame, markets do.

Key Themes

This speech is the origin text of The Endgame as a systemic view, and the fullest application of liquidity analysis to a bearish conclusion: the same framework that kept him long in 2013 now told him the liquidity wave was spent. The China and buyback sections are top-down macro at its purest — credit math and capital allocation before any company-level opinion — while the gold call is asymmetric risk/reward applied to currencies: a 5,000-year asset with positive carry for the first time, against central banks with no exit.

Context & Significance

The Endgame address matters for three reasons beyond its content. First, timing: it came eighteen months before the last major leg of the bull market and four years before the policy regime he described reached its logical extreme in 2020–21 — making it a case study in how early a correct macro thesis can be, and why Druckenmiller treats such theses as regime frameworks rather than trade timers. Second, method: it is his most complete public demonstration that the liquidity framework works in both directions — the same man, same stage, bullish in 2013, bearish in 2016, with the variable changed rather than the ideology. Third, legacy: nearly every later appearance — the 2021 WSJ op-ed, the 2022–23 Sohn conversations, the USC address — is an update to this speech's ledger of deferred costs.

The gold recommendation dominated coverage and marked a rare moment when Druckenmiller let the public see his positioning as directly as his reasoning. Within this KB it anchors the family-office period's bearish thread, complementing the offensive concentration doctrine of the Lost Tree speech with its defensive, systemic counterpart.