Inflation is at its highest in four decades and the Federal Reserve is raising rates at the fastest pace since 2000. Inflation and a slowing economy are a toxic mix for markets, and in recent days we've seen both stocks and bonds hit hard. So how do you actually invest in this type of macro environment, or model big themes like supply chain disruption and deglobalization? On this episode, we speak with Greg Jensen, the co-chief investment officer of Bridgewater Associates, about how he's thinking about the risks of inflation and slower growth, what it all means for markets, and how Bridgewater is preparing for it. As he puts it, market prices are still too optimistic relative to the secular change that's taking place within them. Transcripts have been lightly edited for clarity.
Points of interest in the pod:
On Bridgewater’s investing framework — 06:15
HowBridgewater uses AI and machine-learning — 10:18
On sticky inflation and the lack of historical data — 14:49
The impact of higher interest rates on markets — 19:38
What the market is pricing in — 26:10
Building a portfolio when bonds and stocks are down — 30:11
On stocks being sustained by inflows — 33:20
The importance of diversification — 48:43
Tracy: (00:10)
Hello, and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe: (00:14)
And I'm Joe Weisenthal.
Tracy: (00:16)
Joe, you know, something that really annoyed me last year.
Joe: (00:19)
There are a number of things I'm sure.
Tracy: (00:22)
Yeah. There's actually a lot. Okay. There's a lot.
Joe: (00:26)
It’s part of our daily chatter. No, but keep going, keep going.
Tracy: (00:32)
‘What I'm annoyed about today’? Yeah, well, there was a moment early last year where people were talking about stagflation and it wasn't the risk of stagflation. People were talking about, ‘oh, we're in a stagflationary environment,’ which really bothered me because yes, you know, prices were going up, but economic growth was still relatively strong. And so there was no way you could have said that last year there was stagflation happening.
Joe: (00:58)
Yeah. I think that's right. You know, people say this kind of stuff all the time, people throw out any terms. It's the seventies, it's the eighties. It's 1994. It's 2002. People are always reaching for something. There's no, you know, I guess optimistically you say that's what makes a market, right? People have a bunch of different views.
Tracy: (01:17)
This is very true. Well, I have to say, you know, some of the people who were accurately talking about the risks of stagflation, not stagflation actually happening in that particular moment, I feel like they've been sort of borne out by events and the US economy is still going relatively strong. It's not shrinking by any means, but with the Federal Reserve raising rates, the question clearly on everyone's mind is whether or not we're going to get a soft landing, whether or not it's possible to have prices start to come down, but also maintain economic growth.
Joe: (01:52)
Well, what I would say is for sure, whatever you want to call the environment of this year and sort of the last quarter of last year, the second half of last year, it's been a really toxic brew, so to speak, for financial assets, for asset prices. So, you know, the economy is still growing, it appears. And you know, the jobs are still being added. But this mix that we have right now of very high inflation relative to the last couple decades or last several years, and concerns about whether it could be brought down without clobbering growth, it's pretty rough for anyone who own stocks and bonds.
Tracy: (02:33)
Yeah. It is a tough time for markets. And the other thing I would say is, you know, we hear people talk about these big picture, macro ideas, like stagflation or recessionary risk or whatever. But then I feel like we don't actually hear that much about how you translate that into a cohesive trading strategy. So, you know, we've had some commodity specialists come on here and say, obviously, if inflation is going up, commodity prices are going up, buy commodities. But beyond that, it's not exactly clear to me how you actually invest in that type of environment, because as you mentioned, it just feels like it's bad for everything.
Joe: (03:12)
Yeah. The only thing that really works, commodities sort of worked, holding dollars has worked ironically given the level of inflation, but this is an environment where typical portfolio strategies and most assets that people own, whether it's stocks or bonds, have really been in for a rough ride.
Tracy: (03:28)
Yeah. All right. Well, on that note, we are going to be talking with someone who is basically all about forming a cohesive trading strategy around the macro picture. We're going to be speaking with Greg Jensen. He is of course the co-CIO of Bridgewater. And we're going to get into it. Greg, thanks so much for coming on Odd Lots.
Greg: (03:48)
Thanks for having me.
Tracy: (03:50)
Just to begin with, you could give us a, a short summary of what exactly it is that you do at Bridgewater and what makes Bridgewater, I guess, different to other types of funds? Because I feel like Bridgewater, you know, you say that name, and it has a little bit of mystique around it.
Greg: (04:08)
Yeah. Great. So, you know, I'm one of the three co-chief investment officers with Ray Dalio and Bob Prince. And we are focused on working with a team of over a hundred investors to think through how the global financial system works to build that out into algorithms, to predict what's next. It starts with really looking at the world and trying to process how all these things, the concepts you guys were talking about before growth inflation, how the money flows into financial markets as a result of those things and how to predict what's next. And so I am passionate about taking those types of big picture ideas, thinking through how you'll translate your thinking about them into rules that you could apply across time and across countries. And as we develop that, our team develops that, we work hard to say, okay, this is how we think this works.
If you're talking about the dynamic of stagflation, why would that happen? How does it happen? How do you measure whether it's happening or not? And what do you do if it does happen? And by, you know, starting with human intuition and logic, but forcing the discipline of pulling out what's going on in your brain, translating that into rules that you can apply and therefore stress test whether they've been true in different types of environments. That's been kind of the magic of Bridgewater, is having a community of people that are passionate about that understanding, building up what we call that compound understanding, the algorithms that suggest that, and then constantly thinking about what's changing and what you might be wrong about.
Joe: (05:42)
Is there a core framework that you use? So obviously there are all kinds of inputs when thinking about the global economy, inflation and energy prices and trade imbalances and domestic savings or domestic debt or national debt. All these different things that are always going up and down, but would you say that Bridgewater or you have like a core framework that you then put all those factors into? What is the sort of underlying lens through which you view the economy and therefore financial markets?
Greg: (06:15)
Yeah. Well, I mean, starting with the financial markets and then I'll go to the economy. But I'd say on both the basic picture of the financial markets is that every price is discounting a future. And if you can understand what future that's discounting and compare it to what you think the future will be, which I'll come back to the economy and markets and cash flows, and then how do you, it’s really changes in people's perception of that future that drives changes in asset classes. So that's one framework and I'll get into that a little bit, but understanding what markets are saying about the likely cash flow of assets and the discounting of those cash flows, and then how those things are going to change.
And the second thing I'd say is that we think a lot in terms of buyers and sellers, essentially knowing how many dollars there are to buy an asset relative to the supply of that asset. And that whole world, there's so much in there of understanding why people buy things, what causes them to do that, where the dollars come from to do that and how different types of things are produced, whether it's a financial assets produced one way, or a real good produce, a totally different way. Butt that's the kind of lens that we're constantly looking at. Do we understand all the buyers in a market, what their motivations are? Do we understand how that asset's produced and what the motivations of the producers are? And so those are the two frameworks for which we've spent 45 years building up layers and layers of understanding beneath that. But those things we think, and you can go in any economy, whether it's in the Soviet Union in the eighties or in China today, or, you know, or in Latin America in hyperinflations, those frameworks work. They're what we call timeless and universal.
Now the inputs of the frameworks change, but the basic frameworks do. And so that's kind of the starting point. And now in terms of the economy, that understanding what's going to happen next to cash flows, we think a lot in terms of the transactions that drive the economy, how does it actually work? Where does the money come from when somebody buys something, or somebody sells something? Understanding, the bottom line mechanics of that, and all the incentives that run through the process at the simple level of interest rates and monetary policy, but other types of incentives, tax policy, etc., that affect those outcomes. And so again, we've been building that model of saying, okay, well, who are all the buyers and sellers in the real economy? And what's motivating them and what's the ability to produce. And where's the demand coming from? Those types of questions.
That's the framework that we're doing. And then just constantly thinking about what's going on and what we're then going to do about that systematically. So we're always, because we're predicting 200 different markets and economic stats of hundreds of different things, there's always the feedback loop of missing stuff, which you then go through and say, okay, well, what am I missing? How am I dealing with, as an example today, de-globalization is a huge deal. Over the last 40 years, we really haven't been dealing with, you know, and now you've got to deal with it. And you've got to have a perspective on how to think about supply chains differently and the rebuilding of them and all of these questions. And because we have a good process that we're building from the baseline, we can spend all our time on the things we think we're missing, and then try to add them into that understanding.
Tracy: (09:27)
So I definitely want to get into de-globalization and what you're seeing with supply chains and things like that. But just before we do, just so we understand the framework a little bit better, I'm curious how machine learning and artificial intelligence fits into all of this. Because on the one hand, I can understand if you're looking at economic data points, trying to find signs of where things are going or looking at the market, trying to figure out whether or not things are under or overvalued, that machine learning could play a role in that. But when you talk about things like incentives, I tend to think of that as much more of a, you know, human emotion, what's actually driving people to do this. And I don't necessarily automatically think of that as something that lends itself to modeling or machine learning and things like that. So could you maybe talk a little bit more of that aspect of your strategy?
Greg: (10:18)
Yeah. Great. So artificial intelligence is something I'm very passionate about, but it's a broad category of things for which machine learning is a subset. So let me start at the artificial intelligence level. The thing that Bridgewater's been doing for 40 years and is one of the most unique laboratories of, is what would be considered old style artificial intelligence, which is an expert system. So everything that we're doing in markets is happening through algorithms that we've produced. We produced them in what was the original thought of how AI would work, which is experts thinking about what's going on, writing down what they're learning, writing down what their rules are, and because we've invested massively in that process, and we've been doing it for a long time and have great expertise that we're able to execute trades across 200 markets, 24 hours a day. All of those things, algorithmically, reflecting, everything that we've learned.
So we have this big AI process that's like humans and machines where the humans are looking at the machines, think about what's wrong, but keep programming that in. And over time, there's more and more done with computers and now machine learning, you know, comes along over the last decade and is helpful in that process as well. But it's also a tool and you have to be very careful. And to your point on what machine learning can help with and what it can't, at least in the current situation, is that when the data that you can plug into a machine learning model is representative of the data in the future, it can be very helpful. You have to have a lot of it and you have to have, but it has to be representative of the data in the future. What's so interesting about economies and markets is it never works that way because even just the existence of machine learning itself changes the future. So the future data points aren't going to be like the past data points because machine learning exists.
And this is a game in which the players are affected by the tools. It's not like physics. It's not something physical where it doesn't matter if you're watching it. It matters completely that people are using machine learning techniques, make machine learning techniques themselves dangerous. If they're using data from the pre-machine learning era as an example. And so A) understanding that, right? So there's a lot that machine learning can be helpful on, data cleansing other things, but it's wrong to think of it as a landscape that's actually good for machine learning. You have to be super careful because the data from the past is not like the data from the future. And almost by definition, anything like this changes the future relative to the past.
More generally, there's so little sample size in global economies. We have a couple of debt cycles over the last hundred years. We have a world that was, as we're saying globalizing, the last 40 years is one big cycle of lower and lower interest rates and declining inflation. So you have to be incredibly careful to use those techniques that are so valuable in certain ways in the economy and other things in our industry because of those challenges. Now over time, I mean, I'm optimistic that machine learning can take great strides, and we do, we're working on different ways to use machine learning, to help researchers and other things. And I think that over time, computers will keep doing more and more that humans can do, but handling that in a knowledgeable way and not using the fanciest optimizer of the day, which today machine learning's the fanciest optimizer of the day. But all through history, optimizers have in markets, have failed for the same reason, which is the past -- if you don't understand it extremely well, isn't going to be the way to get the data. The data itself doesn't tell the story. You have to actually understand the human motivations on the other side of markets.
Joe: (13:57)
So in 500 years, maybe, Bridgewater will have, you know, machine learning algorithms that have seen 20 great financial crises and 20 big debt cycles and 20 high inflationary periods. But as you note here in 2022, there just hasn’t been that much data yet, hard to get out of sample data for some of this stuff. But what do, you know, let's talk about right now for a moment and thinking about what you just said, we are experiencing, it appears, a reversal of a 40-year pattern in interest rates. It does appear that we're certainly experiencing inflation, the likes of which we haven't seen in several decades. So how do you adjust as a new thing emerges? Or maybe it's de-globalization? What is the process by which you sort of acknowledge or recognize and say, this is something different?
Greg: (14:49)
Yeah. Well, I think, going back to our frameworks that you can look at. So why did the inflation, and now let's say slowing growth with inflation, I agree with what you're saying in the introduction of getting stuck on the words, inflation needs different things. But the basic picture is if you turn back the clock, Covid accelerated something that we expected to happen over a decade, which was this combination of fiscal and monetary policy. We thought that would happen because it's necessary. Monetary policy, quantitative easing by itself was getting stuck in assets, was worsening the wealth divide, eventually that in order to turn around some of the economic ills that had been stretched over that 40 year period, that you would need to combine fiscal and monetary policy. That happened in warp speed during the Covid crisis.
And it showed the power of it that printing money and getting that money into the hands of people that would spend it in the real economy worked massively well. It was a way more effective way to ease policy than anything that had been tried before lowering of interest rates or quantitative easing. But what it did was instantly create demand without creating supply. Normally when the economy's strong, the demand is coming at the same time the supply is coming, in the sense that somebody gets hired and they're supplying a good at the same time, they're getting paid and demanding a good, so you got demand without supply instantly in terms of Covid. Now it took a little while to play out because the lockdowns and other things related to Covid, that had this huge inflationary effect. Right? And if you just think about the framework I was saying before, if you just look at well, how many dollars are available to spend relative to the supply, whether that was the supply of meme stocks or the supply of used cars, right?
Nothing kept up in that phase that the demand rose so quickly, the supply of assets. And didn't keep up now as time goes, assets that are easy to print, meme stocks, etc., the supply of those increased quickly, the things that are harder to supply are still lagging that demand shot. And so you get this inflation and now the inflation becomes sticky. When you end up in where I think we are, which is now this wage price combo, because wages are now, the thing that we're most short on in the United States is actually labor at this point and wages are rising and goods prices are rising and they cycle on each other, the wages drive up goods prices, and they drive up the demand for goods because incomes are rising as a result of the wages. And so you've got that cycle and that we think that cycle's pretty sticky, although we'll see, that's certainly the place you'd be looking is whether that cycle turns out not to be sticky.
So we're measuring that phenomenon, right? And if you try to do that statistically with so little sample and you looked at the last 40 years, you almost never see that spot. You'd have to go back to other periods in history. So statistically, you would be looking for inflation to revert because the last 40 years, it mostly has. Now in this case, though, we think that if you measure that dynamic at a physics level and you look at what's happening to incomes as a result of the wage inflation and what that means for spending and where production and other things will be, we think you're stuck in a more stubborn inflation spiral. Now that's all coming from algorithms that we've produced, but they're not the same as the algorithms that would be produced through a machine learning process, particularly if it weighted the last 40 years significantly. And that's the difference, knowing that difference, being able to tune your algorithms in the way that you think things worked rather than the way that they've worked over most of the history.
And that's the freedom you have as a human to look at that history and understand it, and therefore say, well, I haven't seen this before, but I know the physics of how it would work and you get different answers as a result. Now, I don't think that's impossible that you could imagine someday, machine learning [being] capable of seeing those differences and whatever, but it's extremely difficult. And so in any event, that's where the expertise comes in to understand those different types of situations, which one you're in and tune your algorithms. And you're thinking to your systematic process in that way.
Tracy: (18:58)
Hmm. So you mentioned the potential stickiness of inflation as we get this sort of wage price spiral. And obviously this is something that is concerning to the Federal Reserve, and that's why we're seeing them hike interest rates at the moment. Could you walk us through exactly how you see interest rate hikes impacting inflation at the moment? Like when you walk through that as a trading strategy or when you're trying to gauge the impact of what that could be on the economy and on broader markets, what exactly are you seeing?
Greg: (19:38)
Yeah. So this is a great example of coming back to the framework, right? So we look at if the Fed raises short-term interest rates, how much will that cut the dollars spent on goods and services. If you're trying to estimate inflation relative to what's going to happen to the production of those goods and services. And when you look at that, this is the tough thing for the Fed that if you take the last decade, what the Fed did was drove up asset prices so much more than the economy itself, such that there's a huge gap between asset prices and the cash flows available to those assets in the real economy. And that gaps in unsustainable gaps. Somehow you have to pay for the assets with cash flows generated in the real economy. One person's asset is another draw on somebody else's future income. So the incomes and the assets have to align at some point.
Now that could take a very long time, but the last decade was extreme. It was one of the most extreme periods of assets doing well relative to the nominal cash flows today. The Fed's trying to deal with the aftermath of that. The aftermath of that is we got a tremendous amount of paper wealth. We got a tremendous amount of demand relative to the ability of the economy to supply it. And now the Fed has two choices. If you said, what is it going to take to get inflation back to target? You know, and it's not, I don't want to give the sense of false precision, but if we said, well, how much do you have to drop demand and change the labor market to get it? You're looking at a short-term interest rate of five, five and a half percent and a recession, a deep recession, and a crash probably in financial markets down 35, 40%. If you choose to go that direction.
I don't think the Fed will do that. I think the Fed will instead watch as growth starts -- one of the things you were saying, Tracy, in the intro that I quibble with a little bit, is I think growth is slowing right now. Now it's just starting to show up, but I think you're going to see negative growth in the next year or two -- real growth, now different than nominal growth. And so this gets complicated and nominal growth will be high and real growth will be slow, and that's going to be a dilemma. And how fast the Fed deals with that dilemma of do they actually raise rates? Are they serious about 2% inflation or are they going to kind of weigh the consequences of bringing inflation down as quickly as markets currently expect against that consequence in the real economy?
That's where we suspect the Fed will actually go slower. They're not going to go to 5% or at least if they do, they're going to go there slowly. And so we think they'd need to tighten a lot more to get inflation down, but likely they won't choose to bring inflation down because they'll be weighing that trade off and be cautious along the way. But I don't know for sure. That's another good example of why data matching or whatever's very tough. This is in the hands of a few policymakers. They're going to make those decisions of how important inflation is to them relative to how important the ramifications of fighting inflation are.
Joe: (22:32)
Well, so the Fed has, you know, in theory it has a goal of getting inflation back down to 2%, but it's been suggested by others that, okay, if inflation gets down maybe 4% or 3%, that it could start breathing a little bit, that maybe it doesn't have to go as aggressively in that last one or 2%, if the direction is right. Is there like a level of either inflation or either inflation improving or real growth decelerating that you would suspect would be consistent with saying, you know what, the Fed, like, we're not going to go as hard as maybe we had planned. What level of activity maybe gives them a little bit of comfort?
Greg: (23:17)
Reading how Jay Powell and they're going to, you know, I don't know that I have any particular insight on that other than that they seem to be lagging and somewhat backward looking. But if you're asking me if I were in their shoes, I would be wary, right? They're in this dilemma. And it's due to a lot of reasons. It's not the fault of the current Fed per se. If you go back to the debt bubble prior to 2008, and you're still living the ramifications of that debt bubble, we've gone through transferring that debt to the government. We've gone through inflating it away to a certain degree. And we're in this process that is a long process that normally would end with inflation. And so the current Fed is in a very difficult spot, but it's a spot that's been set up over 15, 20 years and so they're making choices between bad outcomes here.
The outcome, my guess is they're going to try to carve the middle of that, that in the end, there's no magic to a 2% inflation target. Like you're saying lower and reasonably stable, probably four will be a better choice. Now the market’s got to adjust a lot. If you're actually going to have a long term inflation rate of 4%, the markets have to, they're not pricing that in. That's a lot of adjustment from here. It's particularly bearish for bonds, but it’s somewhat bearish for equities as the discount rate evolves in that direction. But I think that, like you're saying, the goal would be to get it down a bit while maintaining as much as you can, the economy in reasonable shape. Now that's going to be very difficult to get. And right now, unless they raise interest rates more than expected and hit markets harder, we still think you're going to be above five in core inflation, you know, going out the next 12 months. So something's got to change even further than it has in order for them to get that down. But to me, I would consider, you know, them getting it down to four and maintaining reasonable, you know, very slow economic growth, a big success. And if they try to get more than that, I think they're going to pay a lot on one side or the other.
Tracy: (25:37)
Just on the idea of markets. And you mentioned earlier that a lot of what you do is sort of trying to figure out discounted cash flows or trying to figure out what the market is actually discounting in terms of the future. What are markets seeing right now? Because it feels at the moment like people are simultaneously positioned for higher inflation, but also there is this expectation of recession. And, you know, to the point that Joe is making, at some point you would kind of expect those two to start impacting each other and potentially cancel each other out.
Greg: (26:10)
I'd say the markets are pricing in actually a pretty darn smooth landing here. That if you look at the break-even inflation curve, the difference between inflation-indexed bonds and nominal bonds, you see what the markets are expecting for inflation. And they expect inflation to come down over the next 18 months to 2.7%. And at the same time, while equities are down, it can feel like a big thing has happened in the stock market. Not much has actually happened. Stocks have dropped mostly in line with the interest rate rise, such that up until the last couple weeks, cash flows projected in the equity market actually had gone up, not down, over the period of equity weakness, because the cash flows have to make up for the discount rate increase.
So now you're starting to see the market price in less liquidity and the fact that the cash flows are going to be a bit worse, that growth’s going to slow, but it's still extremely optimistic pricing in the equity market about future cash flows. So overall, I'd say if you track what the markets are saying, they're essentially saying we're going to get the decline in inflation. The Fed's going to tighten to about 3% and then be done, and it's going to flatten out there. And that the economy at that point will be good. And that's kind of, that's the betting line. You think about that as the line. Now, if it's better than that, if inflation falls further with growth being better than that, markets will go up. And if it's worse than that, if inflation's more sticky and you have to hit growth harder, assets are going to fall from here. And our view would be on the second, that it's going to be much tougher.
That that is still very optimistic pricing, even though it can feel like, oh my gosh, stocks are down almost 20% or whatever from their peak, it feels like a recession is being priced in, but all that's really changed is the discount rate on assets. And you're going into a period where the liquidity hole is getting bigger. The Fed's going to start running down their balance sheet. The Fed and banks were the reason there was so much money going around last year. The Fed was still buying assets and the banks were buying bonds at record clips in almost a crazy fashion in my mind, because they had so much excess deposits. All that's reversing. They're not buying bonds anymore. The Fed's actually going to roll off their thing, banks aren't because they essentially bought an excess of bonds.
And now the market has to clear, and for the bond market to clear with private sector buyers, they need to draw those assets from other assets. And there's so many assets in the US. You're seeing this, the market action the last couple weeks, the assets that need liquidity the most, that don't themselves have cash flows are getting killed because liquidity is being withdrawn from the aggregate system and those assets that require kind of Ponzi-like ongoing purchases to support the assets, are getting hit the hardest. And so I think today's market pricing is still overly optimistic. It's been a small move relative to the secular change that we're actually experiencing.
Joe: (29:13)
So if we're experiencing a secular change and look, I would never say in a million years, and I know this, that investing or portfolio management is easy, but it is true that, you know, in the last decade, and maybe before, A) stocks mostly just went up and also investors had the luxury of this other asset class – Treasuries -- that sort of acted as a natural hedge. They also end up over time, but they usually on a short-term basis were moving inverse relationship to stocks. So that had an effect of volatility smoothing until you could buy a bunch of stocks and buy a bunch of bonds and you don't always make money, but both generally went up and they also sort of canceled each other out in the short term. So I'm curious, like how you're thinking about portfolio construction, if we're shifting to a new regime, if inflation, let's say it comes down but it still remains for a while above this 2% goal or target. Like, how do you approach the general problem of building a portfolio?
Greg: (30:11)
Yeah. Great question. So, I mean, you start with, like, you're saying that the lessons of the last 20 years in particular, in terms of portfolio construction, you really have to understand the reason for them and then think about whether those reasons exist. So you made the point about both assets doing great, you know, since the financial crisis you've had this incredible run where diversification was actually almost always bad, all you wanted was U.S. assets and U.S. equity assets, and everything else was a drag. Now that's not going to go on forever. It's kind of obviously true U.S. equities can't take over everything in the world. And yet they were on pace for that. And most portfolios are still dominated based on what's been great for the last decade. And like you said, the relationships change as a result of the impacts on the cash flows, right?
So if you say, why are stocks and bonds going to be negatively correlated in the future if they were positively correlated in the last 20 years? Well, and the difference is the cash flows on equities and bonds are affected by both real growth rates, but also inflation. Now the real growth rates, stocks and bonds act opposite. So if real growth is the dominant factor and inflation’s stable, stocks and bonds are going to be great diversifiers. If inflation though, inflation's bad for bonds and to some extent bad for stocks, although we get into that, all of a sudden they're no longer good diversifiers when inflation's more volatile than growth. So if you look at history, hundreds of years of history, stocks and bonds are always negatively correlated, good diversifiers when inflation is stable and low, and they're bad diversifiers when inflation is high and that's just a function of the cash flows.
And so if you don't think in terms of the correlation, but think in terms of the actual physical cash flows, you can start to see in different types of environments, what the good diversifiers are. So if you take today and you say what diversifies stocks and bonds if they're not good diversifiers for each other, well naturally, you want to be careful and figure out ways to take a view on inflation and break even inflation – the difference between inflation index bonds and nominal bonds is one way, you mentioned commodities in the intro and commodities is one way. But you need those things. And we think also looking at certain emerging markets that have what the developed world needs. You have a world where you’re short labor and you’re short commodities and you're de-globalizing. So you've got to look at the emerging market allies, essentially that can reliably provide the things that the world's missing, those places are the places to diversify. The problem that's going on in the stock and bond market is that they are more and more correlated rather than diversifying.
Tracy: (33:01)
Can you talk a little bit more about the impact of inflation on stocks and why you see stocks as not necessarily outperforming or performing reasonably well in an inflationary environment? Because I think this is an ongoing debate in markets, whether or not equities actually have that pricing power.
Greg: (33:20)
Yeah. So if you look at periods of inflation, right, I mean, stocks can often be better than cash in inflation periods, but lose a lot in real terms. And why does that happen? A) stocks are a function of both the cash flows and the way those cash flows are discounted. So if you take periods of high inflation, if you take the seventies as an example, cash flows were decent for companies, but they were hit by a significant rise in the discount rate and the uncertainty, essentially a higher uncertainty risk premium when you have higher and more volatile inflation. So cash flows were fine, but PEs dropped a lot during the seventies, and that's a function of the higher discount rate and the higher risk premium. And what you see is these big divergences and more volatile corporate situations, and generally lost productivity as a result of the instability of inflation and the price future.
But basically stocks cut both ways. The cash flows generally stay in line, profits a little bit less so because margins are hit to a certain degree, but the biggest thing is that the risk premium and the discount rate, all of a sudden, if you have a risk-free rate of government bond yielding 15%, what are you going to demand out of your equities? And that's been the history of it, is that. And when the Fed tries to then battle the inflation, of course, that's particularly bad for equities because you get a growth slowdown, you get the disinflation effect and you get this lack of liquidity. So the second point that's making stocks really bad in this inflation period, this period over the last four months, it's the lack of liquidity. The Fed had been providing tremendous liquidity up until this calendar year.
You see how many stocks needed that liquidity because they needed new buyers. And right now we'd calculate about 40% of the US equity market can only survive essentially with new buyers entering the market because they're not cashflow generating themselves. And that's near a historic high, that's like basically right in line with ‘99, 2000. And it exists because, because the Fed produced liquidity for so long, you had declining, real rates, high levels of liquidity. You get the reverse. And you're seeing that squeeze the stocks that need that liquidity are getting hit the hardest. And that's happening quite quickly. You also see that to some extent you need constantly new buyers in the crypto space as well. And just the removal of macro liquidity is starting to affect the entities everywhere that need the liquidity the most.
Tracy (36:00):
So this is really interesting, and that's a stunning stat, and it's sort of one of my pet theories, which is that something changed after the 2008 crisis, which is that in an environment of low growth, people started chasing momentum as a way to outperform. You just followed wherever the money went and money going into something basically helped inflate the valuation. And then that attracted more money. And so you had this really bad cycle. So two things here, how do you calculate that 40% number exactly? And then secondly, what happens as this starts to reverse as the momentum goes in the other direction. I mean, for the past 10 years or so, it would've been that as the markets were going down, the Fed might, you know, step in and start easing again. And then that would be the circuit breaker, but what's the circuit breaker on valuations in this environment?
Greg: (36:57)
I'll start with the first question on how do we that, and I don't mean to, again, I worry about false precision. All this stuff is rough, but the basic idea is you can, there's always, in normal time, there's a churn in financial markets. Some people have to sell their financial market assets because they're spending in their real economy. They're retiring, whatever the reasons are, and assets in aggregate are going to go up. If there's more money available to buy than that constant churn rate to sell many companies provide enough cash flow that they don't require new buyers. They can offset that selling, let's say 5% of holders want to sell on a normal basis every year. Well, you need an asset that has 5% cash flow in order to offset that either by doing buybacks themselves or dividends or whatever, to create that cash flow that's there, that you can then look at the companies across the market and see how many of them can essentially through the money they're earning satisfy the liquidity needs of the basic rate of sellers, versus those that need a constant flow of new buyers.
And that's how we look at those assets and break them into those that can make it that are subject to what happens in nominal GDP. They need actually the profits and the cash flows. They need the economy to be okay, but they don't need new liquidity versus the ones that even if the economy's great, they need new liquidity. And that's where that calculation's coming from.
Tracy: (38:26)
The circuit breaker question, like what actually stops the downward spiral evaluations here?
Greg: (38:32)
Exactly this again, a great example of where you'd have to have an incredibly smart machine learning system to recognize the difference between this downturn and the 2008 downturn or the 2000 or the Covid downturn or whatever, where there is a huge difference in downturns when policy makers are unconstrained. So if you take even 2008, as devastating as that was policy makers, because inflation was low, they could print as much money and spend as much money as they were willing to do. Like there wasn't a constraint, basically there's three constraints on policy makers. If you look through history, they can always create nominal growth. If they don't have an inflation problem, if they don't have a currency problem and they don't have a bubbles problem. And so you take a 2008 or the Covi thing and you see how it works, right? They did it a lot more effectively in Covid, which is print the money, spend the money, and you can offset anything.
You could shut down the whole global economy. And within a month you could offset that with printing money and spending money. And when we went through that, that's when I sort of went through, oh my gosh, you know, it's so obvious policymakers to any deflationary shock can offset it. What you see in history is they always eventually do. It might take a while, whether it's the great depression coming off the gold standard or whatever. It might take a while, but they can do that. But if you look at history and you look at when policy makers are constrained, it's when it's inflationary, therefore you can't use that printing and spending and you have a much more difficult thing. So basically you could buy, you'd want to buy dips when the central bank is able to essentially be that shock absorber. But when inflation is stubbornly high into weakening assets, you can't, the Fed's not going to be there.
In fact, they want the asset prices to fall to a certain degree. And even if they fall more than they want them to, they're weighing the inflation picture against that. So all of a sudden you've got a much bigger dip possibility before you get relief from policy makers. And in fact, the dip has to become disinflationary in order to do that. And so that's why the drawdowns and the loss in real terms in the 1970s and early eighties was so much worse than most of those other drawdowns in terms of the duration over which it lasted. And you see that across economies, that when policy makers are constrained by inflation or currency, you know, it can take out it, it can lead to lost decades.
Joe: (41:00)
Can we pivot a little bit? So we've been talking about this new regime, the new macro regime, the difficulty of asset prices in higher inflation, but obviously the other big story, and you mentioned at the beginning is what's going on geopolitically. And of course there is the concern about de-globalization between the US and China. There is the war that's taking place with Russia's invasion of Ukraine. How does this sort of geopolitical reset perhaps is the word, I don't know the word. How do you incorporate that into your thinking?
Greg: (41:33)
Yeah, well, we try to incorporate it in the same way I was describing before, which is what does it mean for the production of goods and services and for the availability of money and credit to purchase those things and what you see if you come back, I kind of laid the intro to the inflation that you had, this huge demand shock, because you created demand without creating supply. Supply actually was reasonable post-Covid. And a lot of people were blaming the inflation on supply when it was actually this massive increase in demand that accelerated so much faster than supply could keep up. Then you go into this phase, Russia invading Ukraine, which really put de-globalization into fast forward, that was happening. It was in the background also happening. But now this is in fast forward and on the, you know, the front burner of so many companies and you get a real supply shock.
So in the case of the Russia invasion of Ukraine, you have a massive commodity supply shock now, that's starting to play out. Russia's commodity supply, they'll shift. They won't sell to Europe, their energy or whatever. They'll try to sell to India and China and such. And they'll do that to some degree, but the bigger picture is Russia's oil production is going to fall. It needs the Western technology to do that. So you added some demand shock into a supply shock, and that has big impacts on essentially the ability to supply the global economy. And right now we're actually in a lull of seeing that because you also have one of the biggest shutdowns of commodity-producing economy ever, China shutdown, and the impact that has on commodity demand is massive. And yet it's not really showing up because you have an offsetting supply shock simultaneously, but the Chinese demand shock will fade in our view anyway, a lot faster than the Russia/Ukraine supply shock will.
So we're also I'd expect somewhat of a surge catch up to the supply shock if China comes out as eventually it will, out of its Covid zero policies. So A) that's going on. Now, secularly, as you're describing, there's this big trend of de-globalization that one of the lessons that US corporations or European corporations have taken is wow, we need a much more reliable secure supply chain and we need to build that. And that's building for resiliency rather than building for efficiency. And that's part of the inflation story. If you take the last 30 years, everything in the global economy was built for efficiency, almost nothing was built for resiliency. And it was part of the disinflation story that now you're going the opposite direction. You've got to build semiconductors in your own economy. You've got to get energy from sources that you can rely on.
You've got to do raw materials, production in places that you know you'll be able to access it. And this is part of the reason that you'll actually have demand for capital expenditures, even if the economy starts to turn down. So that's going to create pressure on nominal GDP, even if profits are starting to decline, normally capital expenditures go up and down with profits, but you've got to rebuild an economy. And this is where you have the impact of stranded assets that all of this capacity to export to the world in China and all of the Capex that went there, it's got to get replaced over time and that's costly without creating wealth in a sense because it's offsetting stranded assets and that's going to be a big phenomenon that is an inflationary phenomenon because it's going to create higher nominal GDP, but without, let's say creating new wealth, it's offsetting lost wealth.
And so those are the, that's the cost of de-globalization. And we've had this wind at our back for so long that people even forget, it's a wind in a sense. And now you've got the wind in your face as you go through the process of unwinding the incredible efficiency of the global economy over the last 30 years and building something more resilient. And we don't think that's going to stop. There's the pressures between the US and China are such that you're almost certainly on a path to two largely separated economies. They'll have an interface in trade and other things, but they won't be so tightly linked as they have been. And that's, that's a very big deal.
Joe: (46:00)
Is there a predictable inflation or growth effect of this or is this like a, okay, there's going to be some period where things have to reset and supply chains are reoriented, but then things settle down or is this like a permanent sort of regime shift that then, you know, goes into what we talked about in the first half of the discussion about, you know, rethinking asset prices?
Greg: (46:25)
Yeah, I think it's a secular drag the same way globalization was a secular benefit to asset prices. The benefit to asset prices over the last 30 years was it led to lower real interest rates, led the glut in savings in China and other places, came into the US, drove assets up. Those things are changing. You're not going to have the lower and lower the disinflationary impact of tapping into the most efficient pools. And you're not going to have the excess liquidity transfer back to the United States’ assets. So as a result of that, I think you see a trend in rising real yields, a trend in higher more stubborn inflation, because it's less efficient. Those things I think you get.
Now you get some benefits too, because certainly from a social cohesion perspective, all of a sudden kind of the losers of globalization get the benefit. That's the higher wages. So a lot of this discussion is focused on the negatives to the financial markets, which the financial markets benefited massively from globalization. The average worker in the United States did not, and now the reversal will do the same. It's kind of the de-financialization of the US, which arguably is good for a social good, but is a very difficult environment for assets, just offsetting the incredibly great environment assets have had. So those things I think are sticky and will play out secularly. Now they could play out very quickly. The Russian Ukraine type thing creates a shock in that direction. That's a weakening growth, rising inflation shock. So obviously if China moves on Taiwan or something like that, you could see this accelerate, but right now, I'd say, even if it doesn't accelerate in that rapid way, it will be a constant grind for a decade.
Joe: (48:07)
One more question along these lines. You know, this conversation has been very US-asset centric. And you stated in the beginning that investors were so bullish on US assets post-GFC, that they were on pace to take over everything in the entire world. But as you noted, you know, you're not just following -- you're following, I think you said 200 markets around the world or something like that. Is that assumption, should people think more global in this environment if we are seeing the assumption break -- that US stocks can't just take over the entire world? What does this mean for non-US assets?
Greg: (48:43)
Yeah. Well, I think that one thing strategically, most investors should focus on that hasn't been a big deal over the last decade is diversification. So I think there are issues. You go around the world and there are big issues. Europe's going into a significant recession, probably worse than the US as a result of everything that's going on in terms of the supply shock there and the war and the impact of that. And at the same time, they're going to have a massive fiscal spending to try to change their infrastructure and rebuild militaries. So you've got stress, significant stress there. You've got significant stress around the world, Chinese assets while I think they're at a totally different part of the cycle. They have a disinflation, they have a very weak economy and a central bank and government that's prepared to stimulate, totally different set of circumstances. And then you add to Japan … So amazing range of circumstances and opportunities.
And I think diversifying across those risks, you’ve got a huge risk in the United States is that liquidity that was stuck in the US assets comes out. To us, most investors would be way better off having a much more global mix of assets than they currently have. So that would be one. In terms of the short-term kind of alpha opportunities, I think it's also that that's right. I think a lot of assets outside of the US are more attractive than the US, although there's risks everywhere, but the pricing's so different. We talked about the pricing of cash flows. The pricing of cash flows in the US, if you take companies with very similar cash flow allocations, you can get them in the rest of the world -- those same cash flows for 30, 40% cheaper.
That's the issue. The US has done so much better and whatever for so long that it's being extrapolated, right? China is the most extreme of that. And for reasons that you can understand given the regulation, etc., but if you just take the reasonably expected cash flows and you compare that to a similarly situated American company, you're seeing these huge differences. Now the huge differences can have merit there's reasons there's bigger risk premiums in assets in different parts of the world. There's more even more risk in the war spilling over in Europe. There's China, obviously even more risk of regulatory or inability to invest in China, all of those things. So there's reasons, but on net, we think you're certainly going to want a much more diversified portfolio going forward than you have today.
Tracy: (51:06)
Greg, that was a really fascinating conversation. And, yeah, we really appreciate you taking the time to come on Odd Lots.
Greg: (51:12)
Great. Well, I enjoyed it. So thank you both.
Joe: (51:14)
Thanks Greg. That was awesome.
Tracy: (51:30)
So, Joe, that was really interesting, first of all. And secondly, I think it was kind of a good foil to the macro discussion that we had a little while ago with Neil Dutta and Luke Kawa as well. So I guess this is sort of, I mean, this is pretty bearish, the idea that you could get a 30% drop in US markets. Yeah. That's pretty bad.
Joe: (51:52)
Yeah, no, I mean, it is definitely, yeah, this idea that the market is still, even with all the volatility that we've seen pricing in a pretty soft landing was striking. And then of course this idea that like, look, you know, we've had this incredible run for risk assets prior to. And the conditions were just right. And I thought Greg laid out a very good sort of like simple way of thinking. Not just that the conditions were right, but why the conditions in particular were right for investors buying stocks or bonds. And I think, you know, it's like a pretty significant question about whether you know, when all the dust settles on the pandemic and post-pandemic period, whether those conditions can be returned to.
Tracy: (52:35)
Absolutely. And also just this idea, and we've discussed it before, I think with Matt King, from Citigroup on this podcast, but this idea of, I mean, it's sort of the flows before pros idea, the idea of flows attract inflows and that's how you get to these really lofty valuations. And when the conditions that sustain those start to turn -- to Greg's point -- there's not really anything that can underpin them anymore. Like to his point, the cash flows aren't really there.
Joe: (53:05)
And look, you know, I think we're sort of, you know, a conversation you always hear is like, well, okay, what do you buy? What's the right portfolio strategy for this new inflationary environment? What should we reallocate to? Maybe it was whatever it is. But like, I also thin it's possible that everything is, and I don't know, but like maybe there is not an optimal portfolio. If the conditions deteriorate, if inflation remains high, real growth decelerates etc. And I don't know if it will, but maybe like, you know, bad news, like asset prices, aren't going to go up in that environment. And if asset prices aren't going up, then there's not going to be some like magic portfolio construction that makes it easy.
Tracy: (53:44)
Yeah. All right. Well, shall we leave it
Joe: (53:45)
Let's leave it there.