Rich Lyons is the first chief innovation and entrepreneurship officer for the University of California, Berkeley. Before that, he spent a decade as the dean of Berkley's Haas School of Business. He joined Motley Fool contributor Rachel Warren to discuss:
- How the Federal Reserve could hit a "hard brake" with higher interest rates.
- A venture capital view about the future of crypto.
- How universities are creating a generational tailwind for the economy.
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This video was recorded on July 24, 2022.
Rich Lyons: An important part of where long-term equity returns come from is punctuated updrafts. It's the bang upward. Something moves quickly in a couple of weeks. It's like, "Wow, 10% in a couple of weeks," this kind of thing. It's not like you just need to get in and then there's a steady trend. No, it's these punctuated updrafts and nobody knows when those are going to happen.
Chris Hill: I'm Chris Hill and that's Rich Lyons. After spending a decade as the dean of the Haas School of Business at UC Berkeley, Lyons has become the school's first chief innovation and entrepreneurship officer. He joined Motley Fool contributor Rachel Warren to talk about the Fed, finding strong companies during a downturn, and a generational tailwind for the American economy.
Rachel Warren: I wanted to start off by hearing your insights and talking about a topic that I know is on a lot of investors' minds, a lot of minds of those in our audience. That's the impact of inflation and current market headwinds on investing as we head into the second half of 2022 and beyond. I'm curious to know from your vantage point, in what ways do you see the rapid rising rate of inflation in the current market dynamics as impacting investing through the next quarter?
Rich Lyons: The next quarter, and as we look forward, most economists would say inflation per se if it's just stable and everybody is living with it, doesn't necessarily have to have any foreboding consequences for investing over a quarter or any particular horizon. The real issue here is that it's spiked up so far, especially relative to expectations a year ago that the Fed is reacting, and it's that Fed reaction, the short-term interest rates, so-called Fed funds rate, and some of the other things that are just going to slow down the economy. They're designed to slow down the economy, not because that's the goal, but because that's the way you wring inflation out of an economy.
People have been watching the Fed as they always do, but we're especially watching right now. That short-term interest rate is likely in three weeks to go up another 75 basis points, three-quarters of a percent, and further beyond that. Where they will stop, everybody's guessing. The risk of a recession, negative real growth two quarters in a row or longer, is getting very high. Now, markets are rational. Markets do their very best to forecast. They're already impounding the fact that the Fed is raising interest rates and it's going to continue to.
In terms of the outlook over the next three months, part of what you're trying to figure out is is the market still a little too optimistic [laughs] or is the market a little too pessimistic at this point? Everybody has their view on that, but it's not enough just to say interest rates are going up, inflation risk is high, and therefore, returns over the next three months are going to be low. That's too simplistic. The question is, is the market overreacting or underreacting? My own view is that the Fed has got some more raising to do. I think I'm not very optimistic about near-term asset value. I think the Fed, to really get the interest rate in the economy to a place where inflation comes down, that short-term interest rate has to go up a good deal further and that's going to be painful.
Rachel Warren: Something that I think has come up a lot in the discussion in recent months has been this idea that we continue to see inflation rise, we see the very aggressive actions the Fed is taking by raising rates to try to curb inflation. That has been the favored tool for a very long time to reduce inflation. But many of the factors we've been seeing that have fed into the current inflationary environment aren't necessarily all under the purview of the Fed. Is there a specific reason that raising rates is that favored tool? Are there other tools in the Fed's toolkit, or is this essentially what they can do?
Rich Lyons: Well, that's a fun question. The short-term interest rate and the one that most specifically the Fed controls that I mentioned before, the so-called Fed funds rate, has been the traditional central, main instrument of monetary policy, it's how you adjust the pacing of the economy and thereby adjust the pacing of inflation. Quantitative easing. We've just gone through a period where in fact we were trying to stimulate the economy. Back when I took macroeconomics in college, quantitative easing wasn't even a thing. This whole idea that the Fed could adjust its balance sheet separately from the interest rate and have an effect on the economy. But quantitative easing is a very dull instrument, the interest rate is really the key.
Most people would say the Fed didn't cause this inflation. We've had a lot of shocks hit the economy. The Russian invasion of Ukraine, the war, the supply chain and general disruption that was going on even before the war due to COVID and other factors. This has been a worldwide thing. It's not just a U.S. thing. You can look at what's going on in the U.S. and see what happened, it's all the Fed's fault because inflation is going up through Europe and many other places. The Fed's job though is, given where we are and given these shocks and the Fed didn't cause Ukraine, and Fed didn't cause COVID, but they are at the helm and they need to do something. If I were Jerome Powell, I'll put it that way, it's, "Your reputation is on the line." I think he and the other Fed governors are going to react still pretty strongly.
Rachel Warren: I think another question that comes up in this conversation is we're seeing a decrease in capital flowing into a variety of sectors right now, and then as we're looking at the current market dynamics, are there any specific industries or industry-specific tailwinds that you see as presenting some of the most interesting and investable opportunities at this point in time?
Rich Lyons: The way I think about a question like that is maybe a little bit different than some others. I think about it a little bit more in terms of asset classes. You could say that's one level up from the question, but I do a lot, as you mentioned in the intro, around innovation and entrepreneurship, at the university level, but even more broadly. We interact as a research university with lots of founders and venture funders and so forth. I would point to the whole private assets category. This is not a new point, but private assets and venture assets, I'm in a board, too, and the investment committees and the idea is what percentage should be going into alternatives and private assets in particular. Of course, we've had a great run in a number of private asset categories, but I think there's still a secular movement toward private assets that's going to continue.
I don't see it reversing even if in the near-term returns to venture have gone down most recently and so forth. I think of it a little bit more that way that private assets, venture investing moving further upstream in the economic value that's getting created in this very dynamic economy. That's where I see it. For example, if you thought about science-intensive companies, a lot of entrepreneurship out there. But the entrepreneurship that's attracting a lot of private capital, a lot of it is science-based. It's like CRISPR. Berkeley recently won a Nobel prize, Jennifer Doudna on CRISPR. It's like gene editing, it's like, wow, we've just begun as an economy to write the story of what CRISPR technology is going to do in the economy. CRISPR wasn't just an amazing scientific discovery. There's a lot of economic benefits. Now CRISPR was the original invention. It's 12 years old. It's like, "Show me." Well, it's very often in the life sciences that it's that year from 10-20 from the original discovery that you start seeing the major impact and that's likely to show up in the private asset category first.
Rachel Warren: I think it's exciting when we look at the age of innovation we live in. It does present a lot of opportunities that extend far beyond the current dynamics that we're seeing. That brings me to another area that you commentate on frequently, which is the crypto space. I know this is also a segment that many members of our audience follow closely. We've seen a lot of popular cryptos and crypto-centric investments tumble in recent months. This has seemingly disproved the idea that I believe had been out there before the crypto could be a hedge against inflation. I know there's still some mixed consensus about that. What insights can you share about the future of crypto based on your experience in this space, do you think the value of start-ups and other companies operating in the crypto segment will remain steady in the future? Do you think regulation poses a key headwind here -- what are your thoughts?
Rich Lyons: Well, it's a lovely question and it's a big category. I teach this stuff. In my class I teach international finance mostly, and you just can't teach international finance without talking about crypto and stablecoins and things like that, so that's where I come from. I'm not just a massive advocate for the category, but one of the things that I do hear sometimes is the naysayers, it's like, "You see? Look what's happened. Blown off a bunch of value." The idea is I look at the whole crypto or blockchain founded space as the way I think, at least the smart money was thinking about the internet in 1998. Look, a lot of those companies didn't make it. A lot of those values lost a lot of value. What do we have today? We have Amazon. [laughs] Did the world get transformed? Yes. It's still getting transformed. I think of it as a very skewed distribution. There are going to be some really big winners. There's going to be some transformation, folks. There's no question about it. Pooh-poohing the whole category is ridiculous and naive in my view.
But the idea that they're all going to work or all not going to work. That's not the right way to think about. There's going to be some very big winners and the others are for the most part going to go by the board. It's a different distribution. It's like the distribution in venture. The ideas. You're making venture capital investments, you just need one or two of those to pay off big. You don't expect any of them to work. That's just not what a venture portfolio looks like. I think that's what the crypto world looks like. Another point that I would add here is look. Has crypto blown off some value? Yes. But so has the Nasdaq, [laughs] you took a look at all the asset categories, it's not like yeah, they had what's coming to them as like yeah, you're a publicly traded tech portfolio or what have you. Look, we have to be careful in any new asset domain and crypto certainly requires that care, but I'm still overall an optimist so long as people keep thinking about this idea that it's going to be a small group with very big winners at the 10-plus-year horizon.
Rachel Warren: I'm curious, we've seen a lot of common mixed reactions to growing talk about regulation in the crypto space. Do you think this will help or hinder companies that are in this area? Because as you mentioned, there's probably going to be a few really key winners and a lot that get a lot of hype and then fall by the wayside.
Rich Lyons: Ultimately, I think big-time scaling, you can say look, Bitcoin is scaled, it's like there's a global marketplace or whatever you point to here. But I think like deep integration into the economy is going to require it. Before coming in, when Tesla came out and said we're going to start taking our revenues in cryptocurrencies and so forth. Things like know your customer, anti-money laundering and some of these other things, I think that's going to enable the crypto world to be central to the world economy. I mean central, central. There's a scaling opportunity. I think a lot of people think of regulation bad, we're trying to unfetter this brand-new market. I get that argument at some level, not all regulation is a good thing, but the idea that we create standards like there have been a lot of industries in the past but when you think about video and other things, it's like once a standard gets set then the whole market can start to innovate against that standard. I think if we thought about regulate some of the regulations that's coming no more surely as being standard setting that creates platforms on which we can now collectively innovate and create private value that we can fully capture. I'm an optimist in that space. I think there's more upside potential than downside potential.
Rachel Warren: Yeah, I think it's a really helpful way to look at it. Something else you touched upon earlier than I wanted to lean into a little bit this concept that great companies are often born in a downturn. I think it's something that a lot of investors are pondering these days. We live in a time of unprecedented innovation and that's very exciting. It presents a lot of opportunities for investors but I think it also requires investors to look carefully before they invest in a company, especially as the market continues to be highly turbulent. As investors, what can we look for to evaluate and find those truly great businesses in choppy and increasingly competitive markets?
Rich Lyons: When we think about a down market, or if we think about recession scenarios and things like that. Those are disrupted scenarios. I think that's part of why asset values blow off so much value. It's like this isn't just a small shock. Go into a place where some fundamental stuff is going to get realigned and changed and we say yes. It's a dislocation. That dislocation creates opportunities. I think that's part of it. It's like when we start, there's this whole idea in economics called history. But imagine I had a cup in my hand. This cup is sitting in my hand. You apply a force to that cup and then you remove the force, the cup bends over a little bit, but then it rights itself. But if you apply too much of a force, it changes state and it's not coming back up when you take the force off of it. I think that's part of when we think about the disruption that's happening in what's currently happening.
The flip side of disruption is opportunity. I think that would be one answer to it, is look for where disruption is happening and look for people who are opportunistically going after the other side of that disruption, the opportunity that's getting created. The second thing I would point to, I'll be quicker on this one, but I think the second one is talent that's getting freed up. It's not just people are now unemployed, even if people will continue to be employed have more bandwidth. But some people are actually saying, "Enough of that, I'm going to launch myself." I think for a lot of people investing in new opportunities, they're investing in the person as much as other things. So look for people whose bandwidth and it is getting freed up and try and invest in people and teams that are getting freed up in the disruption.
Rachel Warren: We've seen very, I think, mixed responses from individual and retail investors understandably reacting to the current state of the markets. There's been anxiety. We've seen reports about how the fear index is at an all-time high. There's been worry about the future of investments in companies across a range of sectors. I wonder if maybe you can talk through a bit about the importance of taking a long-term view in investments versus giving into that often natural knee-jerk reaction to rising interest rates and falling stock prices. Then on top of that, how can investors differentiate between good businesses in a turbulent market versus businesses that have actually taken a turn for a valid reason and that's correlating to the stock price?
Rich Lyons: Yeah, those are two good questions. I'll get to the second one. I think for the first one and now I'm going to sound like the academic. Here comes the textbook, but the idea is look, patient capital. Study after study says people trade too much, they don't beat the market. Look, all of us have this instinct in us, all of us trying to time the market, if you were being disciplined and you looked at your own account and you really were honest about whether you're able to beat the market with your timing, you will find that you aren't. There might be one Warren Buffett outlier in a million. I'll use the phrase a fool's errand. But it is a very hard thing to do. Here's part of why it's a hard thing to do. It's like, OK, I've heard that before.
But here's why, if you look at the data on equity returns and so forth, an important part of where long-term equity returns come from is punctuated updrafts. It's the bang upward. Something moves quickly in a couple of weeks. It's like, "Wow, 10% in a couple of weeks," this kind of thing. It's not like you just need to get in and then there's a steady trend. No, it's these punctuated updrafts and nobody knows when those are going to happen. If you are out when those happen, you've lost out and if you take out the punctuated updrafts from the returns to equities or other asset classes, your returns are a lot, lot lower. Anyways, that's really part of it. Look, if you want to trade for consumption reasons, I'm just having fun and I'm not trading anything that really matters for my family or for my retirement, have fun. But if you're trading assets that matter, don't do it. Go long horizon.
Rachel Warren: I think it's a really important thing to remember as well. Then when we're looking at the volatility in the market, are there some key hallmarks to look for to differentiate good businesses with falling share prices versus businesses that perhaps fundamentally weren't as strong to begin with and there is actually a valid reason why that stock is fumbling in the current market?
Rich Lyons: Good question, hard one to answer as you know I think it was a Warren Buffett quote but somebody smart said, "When the tide goes out, we find out who was swimming without a bathing suit." It's a fun quote in part because there's so much wisdom in it. For example, in the area that I'm closest to is venture investing because of the role that I played at UC Berkeley. I think part there is look, have you been capital-efficient? For a lot of start-up founders, the ideas. We haven't lost that much money. If you're the CEO of name your company, public company. If you said yesterday, we haven't lost any money until it's, how are your stock price is 25% down? It's 25% down.
Deal with it. But for a start-up founder are like, "We're the same company, we haven't lost this?" Asset prices have fallen. You're worth 25% less, you can't deny it. But for a lot of venture founders, they're saying, we don't need to do financing at that price, it's too low price. It's probably not maybe, but move on. I think part of it has to do with coming back to the capital efficiency ideas. When markets start to get tight and you start asking, what are the ingredients that are gating factors on this company getting healthy again, and regaining its momentum. Access to capital is very often one of those. Part of the question there is, how soon does this company is going to need capital? Can it survive from six months to a year without new capital? Maybe I'm a little too much fat capital-focused, but I think the way companies, their vulnerability to capital access is going to be an important factor over the next year.
Rachel Warren: I think that's very key. As well, one of the things that plays into this discussion that I think is very relevant to us as investors but also as consumers. You touched upon earlier is this idea of whether or not a recession might be around the corner. We've had economists predicting yes it is, and we've had others saying no, probably not. I think probably the truth is that no one knows. I'm curious to hear your take if you want to share it. But beyond that, how can we reconcile the idea that the economy is fundamentally strong with some of the current turbulence that we're seeing in the economy as well as the stock market as a backdrop against that.
Rich Lyons: Real quickly on hard-to-forecast recessions. [laughs] I don't have a lot more information than anybody else, I just have a little bit of experience thinking about the macro economy. I think look, the bet is just how tough is the Fed going to be with that short-term industry. If you're talking about a recession in the U.S. as opposed to Europe or elsewhere or outright. But if we go in the next meeting of the Federal Open Market Committee from 175 basis points to 250. Because if they move 75 basis points, and then the next time they move 50 and there are three and then there are 350 and then there are four, could the Fed take us to a 4% fed funds rate? That's quite possible.
Under those scenarios, because when inflation is running well above four, think about it this way, do we have the brakes on or do we still have the accelerator pushed? Wow, we're going to go from 1.75-4%? That's crazy breaking. But it's not like, if the inflation rate is six and the nominal interest rate is four that's a negative real interest rate. It's just economics 101. That's not a hard brake on the economy. That's more of a brake than what you had before, but that's still a negative real interest rate. It's not until you start getting to positive real interest rates that you really start braking. When you frame it that way, it's like there's a lot of headroom in Fed increases before the economy is really going to slow down. Many people feel the slowdown is going to be needed to get inflation down. I think that's the fundamental way to think about that. For the second part of your question, tell me.
Rachel Warren: Yeah. Just looking at this backdrop right now in what we're seeing in the market, does that reflect a strong economy, some of the turbulence that we're seeing in the market? I think it's clear that obviously the economy and the stock market are two separate things, but the movements of the market do often occur in response to the economy. As investors, how do we look at that?
Rich Lyons: There are really a lot of strong points. The labor market is incredibly strong. That's part of what's pushing inflation up. Even if you said there's no Russian invasion of Ukraine and there's no COVID, you get an unemployment rate that's down as low as the U.S. unemployment rate is, and that puts upward pressure on inflation. If you are a supplier of labor, you have more bargaining power, that just stands to reason. That's a very positive thing. If we had an unemployment rate at 8% or 9%, which through some of the '80s disinflation, '70s, and '80s, you had much higher unemployment rates. That's even tougher. It's like well, the Fed's tightening and we've got a 7% or 8% unemployment rate, that's really tough.
The fact that the labor market is quite healthy by historical standards is a super positive thing. It's a positive thing for the economy and so forth. I think if you thought about still the innovation energy on it. But I'll give you one small example, COVID is a little bit close to home, but I'll toss it. Because one of the, I'm going to call it a generational tailwind, pushing us forward super positive when you start thinking about private assets in new companies and entrepreneurship and so forth. You should see what had happened to your nation's, those of you that are Americans, your nation's universities. Because I'm just going to use Berkeley as an example but it's wow, if you look at the innovation and entrepreneurship ecosystem at UC Berkeley and we've created a time-lapse. Look at it in the year 2000, '05, 2010, 2015, 2020 we've got links on our website it's wow.
Universities, 20 years ago, even 10 years ago, many of them, it's innovation and entrepreneurship, we do science, we do patenting, we do licensing, but it's certainly, we have some classes in entrepreneurship. But it's no, research universities part of their impact on society is being juiced in a major way by this commitment to innovation and entrepreneurship, keeping consistent with their missions. But I see that as one of these fundamental powerful forces. This isn't just one or two or three universities it's across. That mindset, the way we're teaching our students, the opportunities we're giving our students, have you thought about it? That is the ultimate engine room. I'm being a little bit obviously affected by my own view here, but I think that's a terrific medium- and long-term engine to be heard.
Chris Hill: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against them, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill, thanks for listening. We'll see you tomorrow.