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Link para o artigo original :https://www.bridgewater.com/research-and-insights/co-cio-greg-jensen-on-the-market-implications-of-the-feds-dilemma

May 23, 2022

Bridgewater Co-CIO Greg Jensen joins Bloomberg’s “Odd Lots” podcast hosts Joe Weisenthal and Tracy Alloway to discuss how we arrived in the current inflationary environment, the impact of rising rates on the economy, and how today’s conditions put the Fed in the difficult position of choosing between inflation and growth. They also talk about why investors need to think differently when building a portfolio in the current environment, what the next downturn could look like for assets, the impact of geopolitics on markets and economies, and the importance of geographic diversification.

Transcript
Note: This transcript has been edited for readability.

TRACY ALLOWAY

Hello, and welcome to another episode of the Odd Lots podcast. I’m Tracy Alloway.

JOE WEISENTHAL

And I’m Joe Weisenthal.

TRACY ALLOWAY

Joe, you know something that really annoyed me last year?

JOE WEISENTHAL

There are a number of things, I’m sure.

TRACY ALLOWAY

Yeah. There’s actually a lot. OK. There’s a lot, but there’s one thing I wanted to—

JOE WEISENTHAL

I hear you. This is part of our daily chatter. No, but keep going, keep going.

TRACY ALLOWAY

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, 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 WEISENTHAL

Yeah. I think that’s right. And people say this kind of stuff all the time. People throw out any terms. It’s the ’70s, it’s the ’80s, it’s 1994. It’s 2002. People are always reaching for something. I guess optimistically, you say that’s what makes a market, right? People have a bunch of different views.

TRACY ALLOWAY

This is very true. Well, I have to say, 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 borne out by events. 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 WEISENTHAL

Well, what I would say is for sure, whatever you want to call the environment of this year and the second half of last year, it’s been a really toxic brew, so to speak, for financial assets, for asset prices. The economy is still growing, it appears, and 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 owns stocks and bonds.

TRACY ALLOWAY

Absolutely. Yeah, it is a tough time for markets. And the other thing I would say is 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, 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 WEISENTHAL

Yeah. The only thing that really works—yeah, 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, are really in for a rough ride.

TRACY ALLOWAY

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.

JOE WEISENTHAL

Let’s go.

Chapter 1: How Bridgewater Thinks About Investing

TRACY ALLOWAY

Greg, thanks so much for coming on Odd Lots.

GREG JENSEN

Well, great, thanks for having me.

TRACY ALLOWAY

Maybe, just to begin with, you could give us 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 say that name and it has a little bit of mystique around it.

GREG JENSEN

Yeah. Great. So, 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 100 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 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, as our team develops that, we work hard to say, “OK, 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 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 the magic of Bridgewater. It’s 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 WEISENTHAL

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 a core framework that you then put all those factors into? Like, what is the underlying lens through which you view the economy and therefore financial markets?

GREG JENSEN

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 drive 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 caused them to do that, where the dollars come from to do that, and how different types of things are produced, whether it’s financial assets produced one way or a real good produced a totally different way. But that’s the second 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?

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 ’80s or in China today 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 don’t. And so, that’s the starting point. And now, in terms of the economy, 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, “OK, 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, 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, “OK, well, what am I missing? How am I dealing with this?” As an example, today, the deglobalization is a huge deal over the last 40 years we really haven’t been dealing with. 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 ALLOWAY

So, I definitely want to get into deglobalization 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 fit 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 human emotion, what’s actually driving people to do this. 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 about that aspect of your strategy?

GREG JENSEN

Yeah. Great. So, artificial intelligence is something I’m very passionate about, but it’s a broader 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 humans and machines, where the humans are looking at the machines, thinking about what’s wrong, but keep programming that in. And over time, there’s more and more done with computers. And now machine learning 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 could be very helpful. You have to have a lot of it, 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 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, understanding that—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 100 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’m optimistic that machine learning can take great strides. And as 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 in markets have failed for the same reason, which is the past—if you don’t understand it extremely well, it 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.

Chapter 2: Understanding the New Economic Environment

JOE WEISENTHAL

So, in 500 years, maybe Bridgewater will have 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 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? A new thing emerges, or maybe it’s deglobalization. What is the process by which you sort of acknowledge or recognize and say, this is something different?

GREG JENSEN

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 you. I don’t want to get—agree with what you’re saying in the introduction of getting stuck on the word “stagflation,” it means different things. But the basic picture is, if you turn back the clock to COVID, 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, 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 of the lockdowns and other things related to COVID, but that had this huge inflationary effect. 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, nothing kept up in that phase. The demand rose so quickly, the supply of assets 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 shock. 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 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. But that then—so, we’re measuring that phenomenon. 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 work 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 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 your thinking to your systematic process in that way.

Chapter 3: The Fed’s Difficult Dilemma

TRACY ALLOWAY

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 JENSEN

So, this is a great example of coming back to the framework. So, we look at—if the Fed raises short-term interest rates, how much will that cut the dollar 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. If you take the last decade, what the Fed did was drive 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 gap’s an unsustainable gap. Somehow, you have to pay for the assets with cash flows generated in the real economy. One person’s assets are a 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?” I don’t want to give the sense of false precision, but if we said, well, how much do you have to drop demand, change the labor market to get it? You’re looking at a short-term interest rate of 5%, 5.5% and a recession, a deep recession, and a crash, probably 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 stats—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 are 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 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 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 is very tough. This is in the hands of a few policy makers. 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 WEISENTHAL

So, the Fed, in theory, has a goal of getting inflation back down to 2%, but it’s been suggested by others that, OK, if inflation gets down maybe to 4% or 3%, that it could start breathing a little bit, that maybe it doesn’t have to go as aggressively in that last 1% or 2%, if the direction is right. Is there a level of either inflation improving or real growth decelerating that you would suspect would be consistent with saying, you know what, the Fed, 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 JENSEN

Reading how Jay Powell and they are going to—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. I think 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. So, 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 4% will be a better choice. Now, the markets still have 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 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 5% in core inflation 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 them getting it down to 4% and maintaining reasonable, 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.

Chapter 4: What Markets Are Discounting

TRACY ALLOWAY

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 to the point that Joe was making, at some point, you would expect those two to start impacting each other and potentially cancel each other out.

GREG JENSEN

I’d say the markets are pricing in actually a pretty darn smooth landing here. If you look at the breakeven 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 had actually 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 be 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.” 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. 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’s 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 not—Fed’s actually going to roll off their thing. The banks aren’t because they essentially bought an excess of bonds, and now the market has to clear. For the bond market to clear with private sector buyers, they need to draw those assets from other assets. There’s so many assets in the US, you’re seeing this a lot—the market actually 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. 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.

Chapter 5: Building a Portfolio for the Current Environment

JOE WEISENTHAL

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 in the last decade, and maybe before, 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 went up over time, but they usually, on a short-term basis, were moving in an inverse relationship to stocks. So, that had an effect of volatility smoothing, and so 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 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, how do you approach the general problem of building a portfolio?

GREG JENSEN

Yeah. Great question. So, I mean, you start with, like you’re saying, 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. Since the financial crisis, you’ve had this incredible run where diversification was actually almost always bad. All you wanted was US assets and US equity assets, and everything else was a drag. Now, that’s not going to go on forever. It’s obviously true. US equities can’t take over everything in the world. 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. 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?” The difference is the cash flows on equities and bonds are affected by 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 is 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’ll 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. 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, that’s really—you want to be careful and figure out ways to take a view on inflation and breakeven inflation, the difference between inflation-indexed bonds and nominal bonds is one way. You mentioned commodities in the intro, and commodities is one way, but you need those things. 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 deglobalizing. So, you 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 markets that are more and more correlated rather than diversified.

TRACY ALLOWAY

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 JENSEN

Yeah. So, if you look at periods of inflation, I mean, stocks can often be better than cash in inflation periods but lose a lot in real terms. Why does that happen? 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 ’70s, 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 P/Es dropped a lot during the ’70s, 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. So, 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? 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, 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. 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 cash-flow-generating themselves. That’s near a historic high. That’s basically right in line with ’99, 2000. And it exists because the Fed produced liquidity for so long. You have 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. Just the removal of macro liquidity is starting to affect the entities everywhere that need the liquidity the most.

TRACY ALLOWAY

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. So, you had this really bad cycle. So, two things here: how do you calculate that 40% number exactly? 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 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 JENSEN

I’ll start with the first question on how do we calculate that. I don’t mean to—again, I worry about false precision where all this stuff is rough. But the basic idea is there’s always—in normal times, there’s a churn in financial markets. Some people have to sell their financial 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.

Now, 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. 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 OK, but they don’t need new liquidity, versus the ones that even if the economy’s great, they need new liquidity. That’s where that calculation’s coming from.

Chapter 6: What the Next Downturn Could Look Like for Assets

TRACY ALLOWAY

The circuit-breaker question, like what actually stops the downward spiral of valuations here?

GREG JENSEN

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. 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 2008 or the COVID 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, it’s so obvious policy makers, 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 ’80s 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, it can lead to lost decades.

Chapter 7: The Impact of Geopolitics on Markets and Economies

JOE WEISENTHAL

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 it at the beginning, is what’s going on geopolitically. And of course, there are the concerns about deglobalization between 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 JENSEN

Well, we try to incorporate it in the same way I was describing it 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, the phase of Russia invading Ukraine, which really put deglobalization into fast forward. That was happening—it was in the background also happening, but now this is in fast forward and on 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, while 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 from a 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 a commodity-producing economy ever. China’s 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, I’d expect somewhat of a surge catch-up to the supply shock if China comes out, as it eventually will, of its COVID-zero policies.

So, that’s going on. Now, secularly, as you’re describing, there’s this big trend of deglobalization, 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. All of this capacity to export to the world and 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, that’s the cost of deglobalization. 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. 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 a very big deal.

JOE WEISENTHAL

Is there a predictable inflation or growth effect of this? Or is this, OK, 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 a permanent regime shift that then goes into what we talked about in the first half of the discussion, about rethinking asset prices?

GREG JENSEN

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 to 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 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 that, certainly from a social-cohesion perspective, all of a sudden, 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 definancialization 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 Russia-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.

Chapter 8: Why Geographic Diversification Matters

JOE WEISENTHAL

One more question along these lines. 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’re following, I think you said, 200 markets around the world or something like that. 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 JENSEN

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 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 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 head to Japan, and you’re trying to maintain an interest-rate peg. So, an amazing range of circumstances and opportunities. And I think diversifying across those risks—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 point one.

In terms of the short-term alpha opportunities, I think 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 is so different. We talk 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. 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 are reasons there are bigger risk premiums in assets in different parts of the world. There’s even more risk in the war spilling over in Europe. There’s China, obviously, even more risk of regulatory or the 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 ALLOWAY

Greg, that was a really fascinating conversation. And we really appreciate you taking the time to come on Odd Lots.

GREG JENSEN

Great. Well, I enjoyed it. So, thank you both.

JOE WEISENTHAL

Thanks, Greg. That was awesome.

TRACY ALLOWAY

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 pretty bearish, the idea that you could get a 30% drop in US markets. That’s pretty bad.

JOE WEISENTHAL

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, look, we’ve had this incredible run for risk assets prior and the conditions were just right. And I thought Greg laid out a very good, 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 it’s a pretty significant question about whether, when all the dust settles on the pandemic and post-pandemic period, whether those conditions can be returned to.

TRACY ALLOWAY

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 that 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. To his point, the cash flows aren’t really there.

JOE WEISENTHAL

And look, I think we’re sort of—a conversation you always hear is, “Well, OK, what do you buy? What is the right portfolio strategy for this new inflationary environment? What should we reallocate to?” Whatever it is. But I also think it’s possible that everything is—and I don’t know, but maybe there’s not an optimal portfolio. If the conditions deteriorate, if inflation remains high, real growth decelerates, etc., I don’t know if it will, but maybe, bad news. 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 magic portfolio construction that makes it easy.

TRACY ALLOWAY

Yeah. All right. Well, should we leave it there?

JOE WEISENTHAL

Let’s leave it there.

TRACY ALLOWAY

This has been another episode of the Odd Lots podcast. I’m Tracy Alloway. You can follow me on Twitter @tracyalloway.

JOE WEISENTHAL

And I’m Joe Weisenthal. You can follow me on Twitter @thestalwart. Follow our producer, Carmen Rodriguez, she’s @carmenarmen. Follow the Bloomberg Head of Podcasts Francesca Levy @francescatoday, and check out all of our podcasts at Bloomberg under the handle @podcasts. Thanks for listening.

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