Barron's Streetwise - Ray Dalio Talks China, Inflation, and US Civil War

Episode Date: December 11, 2021

Plus, Michael Hirson at The Eurasia Group explains why China’s US-listed companies like Alibaba are a target for regulators. Learn more about your ad choices. Visit megaphone.fm/adchoices

This episode is sponsored by Northern Trust Wealth Management. There is more to being a successful entrepreneur than just good business practices. What is it about an entrepreneur's childhood that helped fuel their entrepreneurial spirit? What are entrepreneurs doing to cultivate this spirit in their own children and build a legacy beyond their business? Tune in each month to the Road to Why podcast by the Northern Trust Institute, where host Eric Chappella dives deeper with leading entrepreneurs on these topics and more. Find the Road to Why where you listen to your favorite podcasts. I mean, I'm jarred by this 30% chance of a civil war, but that's a 70% chance of not. No, but I'm saying it's even more concerning than that, because there's a 30% chance of this kind of internal conflict.

And there's, I'd say, a 30% chance of an external conflict with China. Welcome to the Barron Streetwise podcast. I'm Jack Howe. And the voice you just heard, that's Ray Dalio. He runs the world's biggest hedge fund, and he has a book out that discusses some grim possibilities for the coming decade, including what he calls a U.S. civil war and a war between the U.S. and China. I am not the doomsday reporter at Barron's, by the way. I just wanted to talk with Ray about what people should do with their money. He has thoughts on that too. We'll hear some in a moment and we'll talk with another China expert about whether investing there now makes sense. Listening in is our audio producer, Jackson. Hi, Jackson.

Hi, Jack. Give me your top five existential fears for humanity. Go ahead. Number one. It's a nuclear war. You're going old school. Nuclear. Okay, go ahead. Asteroid.

I won't ask whether Bruce Willis or Dwayne Johnson starred in the movie you got that from, but go on. Pandemic. I mean, okay. It's kind of top of mind. Yes. And do you know hippopotamuses kill more people than alligators? Let me stop you at 3.1. Okay.

If you want to sound like a lunatic, tell people that you think the world is getting better. And just between us, there are signs that it is getting better. I mean, there's been a long plunge in the percentage of people worldwide who live in dire poverty. More mothers are surviving pregnancy. More babies are living to reach childhood. There's less famine. There are fewer wars. But in polls, most people are pessimistic. In a YouGov poll five years ago, 65% of Americans said the world is getting worse.

Only 6% said it's getting better. The numbers worldwide were almost as bad. The belief that things are getting worse, that's called declinism. And it's been so common for so long that some people think it's human nature. The Harvard psychologist Steven Pinker says that when people think about risk, they don't think about statistics. They think about images and stories. So, for example, terrorism feels like a leading threat, even though far fewer people die from terrorist attacks than from animal attacks. Meanwhile, in the media, there's a tendency to think of journalists who present negative stories as serious,

thoughtful people, and those who do positive stories as unserious. Plus, negative stories tend to have more compelling photos and videos. That's why the news rushes to cover riots and hurricanes and not the gradual rise in the percentage of people with access to safe drinking water. So the news focuses on the negative, and faced with those images, we conclude that the world is getting worse. Back in my day, things were simpler, we say. But the truth is, back in my day, kids in grade school were still doing drills where we crouched and shielded our eyes so as not to be blinded from flying glass shards in the event of a Soviet nuclear assault. The generation before me even had a cartoon character to teach kids about that.

His name was Bert the Turtle, and his signature jingle was called, Duck and Cover. Hit it, Bert. He did what we all must learn to do. You and you and you and you. Yup. And cover. Things weren't so simple back in the day.

I guess I'm more or less optimistic that humanity will solve its biggest challenges, but lately I feel like I'm hearing more grim predictions than usual from informed people. I'm trying to figure out whether things are actually getting scarier or whether we're just becoming more anxious. Sometimes it's difficult to tell. The stock market is said to climb a wall of worry. This year it's somehow roller skating straight up a cliff of despair. The S&P 500 index is up 26% year-to-date. I recently had a chance to talk about three key big-picture concerns with hedge fund manager Ray Dalio. Nice to see you, Ray. Nice to see you, Jack.

Ray started Bridgewater Associates out of his two-bedroom apartment in 1975. He famously dodged dire stock market downturns in 1987 and in 2008, while pioneering risk management strategies that use currencies, leverage, and short-selling. And he attracted a lot of capital. During last year's ferocious rebound for the stock market, hedge funds in general, and Bridgewater in particular, lagged behind. But over the long run, Bridgewater's returns have been stellar. Today it manages around $150 billion, and Ray has amassed a net worth estimated at between $15 and $20 billion. Ray has a new book out called Principles for Dealing with the Changing World Order,

Why Nations Succeed and Fail. I spoke with him for a Barron's TV show on Fox Business, and we continued the conversation afterward for this podcast. Days earlier, Ray had been asked about human rights in China, including the disappearance from public life of Peng Shui, a Chinese tennis star who made sexual assault allegations against a retired senior Communist Party official. Ray's strict parent to refer to China's behavior and seemed to equate human rights concerns about China with those about the United States, which many listeners found jarring. On TV, I asked Ray to clarify his view, and he said that he had done a lousy job earlier and that he didn't think China and the U.S. operate the same way, and that with the strict parent reference, he was trying to relay the view of a policymaker

he had spoken with in China. He said, it's a difficult issue. This is a situation which is faced by something like 40,000 investors and hundreds of thousands of banks, businesses, and so on that are American businesses that are operating there, they face the same question that we're dealing with. And when we're trying to balance those things, we also realize that if there's disengagement, what that would be like for the society and so on. I take Ray's point. Jamie Dimon is the CEO of America's largest bank, JP Morgan.

I've talked with him in the past, and he comes across as someone who speaks his mind, which is good. But in a recent interview for Boston College, he joked that JP Morgan has been operating in China for 100 years, and that the Communist Party was also 100 years old, and that he'd bet the bank will last longer. He later apologized, saying, quote, I regret my recent comment because it's never right to joke about or denigrate any group of people, whether it's a country, its leadership, or any part of a society or culture. The United Kingdom's Daily Mail called that groveling. Author Nassim Taleb tweeted that, quote, apologies driven by fear or economic interest are not apologies, but genuine expressions of submission.

If you're a CEO or money manager with business in China, and you regularly take questions from the public, good luck. Because criticizing China can put your business there at risk, and if you're too careful to avoid criticizing China, you'll be called out by the media, and that's bad for your image in Western markets. And it's easy to point out the profit motives CEOs and money managers have in China, but the alternative to economic engagement is what America has tried in Cuba for 59 years. How's that going? Then again, China joined the World Trade Organization 20 years ago.

Increased global trade was supposed to expose China to democratic values, not force China's values on American companies. Neither Jamie Dimon nor Ray Dalio need my sympathy. They make enough money to field tough questions. But there's probably a little too much grandstanding going on over business leaders fumbling China questions. I'm sure we'll see plenty more fumbles in the years ahead. I want to come back to China in a moment. Let's turn to the conversation I had with Ray for this podcast. He talked about three main long-term concerns. The first is a rapid rise in U.S. government debt. He says that's creating more supply than demand for bonds and that the Federal Reserve has to make up the difference by

printing money to monetize the debt and that that can lead to an inflationary spiral where investors lose confidence in bonds and the Fed has to print more money and so on. In other words, he thinks higher inflation is here to stay. So I think what we're going to start to see is the pinching of higher levels inflation and the squeezing of growth as lower growth starts to kick in. And I worry about how that'll happen politically and how that'll be dealt with. And I do expect it won't be dealt with with discipline. I would expect that therefore inflation will be a chronic issue.

I asked Ray, what does that mean for the typical 60-40 investor in stocks and bonds? And he said, worry about your 40, the bonds in other words. And he said to worry about cash, which is particularly vulnerable to inflation. One alternative he mentioned is inflation indexed bonds like treasury inflation protected securities or TIPS. They have negative yields at the moment, but they receive ongoing adjustments to keep up with inflation.

So total returns are likely to be solidly positive if inflation remains high. Ray's second big concern is what he calls a U.S. civil war. I asked him what he meant by that. When the causes that people are behind are more important to them than the system, the system is in jeopardy. And so as we go into the 2022 elections, for example, I think you're going to see the move to greater polarity in the primaries and so on, and you're going to see that intensification happen.

And I think it's not surprising now that people are questioning whether rules of who is elected and whether the rules will govern. Ray says states and cities could come into conflict with the federal government. That creates questions of how even the federal government will deal with the states. I do believe there's a risk, a significant risk, that the rule book of how to agree will not be the means by which that's decided. And then it will be power that will determine how that goes down. So it's that kind of civil war that I'm worried about. And that brings us back to China and Ray's third concern. The third is the rise of a competing power, a competing powerful country, to challenge the United States, the existing world order. And the last time that happened was in the 1930s.

China is very different from Russia because Russia was not important economically, but China is a real power. U.S. relations with China are tense. The White House recently announced that it will not send U.S. officials to the Winter Olympics in Beijing. The two countries are locked in a tariff standoff. The U.S. Federal Communications Commission has designated a pair of Chinese telecoms, Huawei and ZTE, national security threats. China's cracking down on its company securing U.S. stock listings. When Didi, which is sometimes called the Uber of China, announced that it would delist from the New York Stock Exchange and pursue a Hong Kong listing, the stock dropped more than 20%. Ray says he's been investing in China for half

his life. I asked him how the risks and opportunities for returns now compare with past decades. Most of their markets used to be closed, and now the markets are what are developed, and so there's greater opportunities to invest there. And then there's this conflict or competition between these two countries. And that when I look at both countries, my principles of diversification are the same. If you have a concentration anywhere in the United States or in China, that that's an issue. To learn more about the risks and rewards of investing in China, I spoke with someone who used to represent the U.S. Treasury there and who now advises investors and businesses looking to put money to work. That's next after this short break.

This episode is sponsored by Northern Trust Wealth Management. There is more to being a successful entrepreneur than just good business practices. What is it about an entrepreneur's childhood that helped fuel their entrepreneurial spirit? What are entrepreneurs doing to cultivate this spirit in their own children and build a legacy beyond their business? Tune in each month to the Road to Why podcast by the Northern Trust Institute,

where host Eric Shepaya dives deeper with leading entrepreneurs on these topics and more. Find the Road to Why where you listen to your favorite podcasts. Welcome back. Jackson, you watching to your favorite podcasts. Welcome back. Jackson, you watching your six for hippos? Always. I want to mention Alibaba because it's probably the best known Chinese stock among U.S. investors.

We did a podcast episode on it at the beginning of this year. It was titled, Where's Jack Ma? That's Alibaba's founder and one of the world's wealthiest people. And he hadn't been seen for months. I'm delighted to say that he has reappeared. But the old Jack Ma met with world leaders without Beijing's approval and said publicly just before going missing that China's financial regulators were stifling innovation. The new Jack Ma keeps pretty quiet. By now, Alibaba's financial

technology company called Alipay was supposed to have gone public. That got canceled. Alibaba's U.S.-listed stock peaked at over $300 a share just before Jack Ma disappeared. Early this year, when it was around $240, I wrote in Barron's Magazine that investors should wait until he reappears before deciding whether the stock is worth the risk. Well, he has technically reappeared, and the stock was recently down to $123. has technically reappeared and the stock was recently down to $123. That puts Alibaba's market value at only about $330 billion. At one point, Bolzer predicted that Alipay alone could be worth $300 billion. If you still believe that, you believe that investors are getting the rest of the Amazon.com of China for close to free. Alibaba remains enormously profitable and revenue continues to grow quickly. The shares trade at 20 times projected free cash flow for the next four quarters.

For comparison, Amazon trades at over 50 times forward free cash projections. trades at over 50 times forward free cash projections. Back when the stock was at its peak, 98% of analysts who covered it said to buy shares. Even now, 89% of them say to buy. But big risks remain. More on those in a moment. Let's hear from Michael Herson, the practice head for China and Northeast Asia for the Eurasia Group. Eurasia Group is a political risk advisory. Our clients are corporations and investors. And on the investor side, it's hedge funds, asset managers, you know, very wide array. I asked Michael to give me a sense of how bad things are now in the China-U.S. relationship, and he said about as bad as during the Trump administration, maybe an eight on a

scale of one to ten, with ten the worst. And then he said maybe a seven and a half now that President Biden and Chinese leader Xi Jinping had a call last month to reduce risks over some issues like Taiwan. I asked why things seem to be boiling over now. It's shifted really significantly in the last two to three years. And there's really two factors behind that. Number one, China has become much more assertive in pushing back on these sensitive political issues. And that's part of the political program of Xi Jinping, who said, look, we are we're strong, we're not going to take bullying anymore. And we're going to stand up for our interests. And then on the US side, you've just seen the downturn in the US China relationship and the more hostile attitudes towards China

have put companies under more pressure, both from, you know, kind of stakeholders in this country, but also directly from the US government in terms of limiting what they can sell to China from investors. You know, there are certain Chinese companies now associated with the military that are off limits to US investors. So you throw in the crackdown on Hong Kong, the crackdown on the Muslim minority population in Xinjiang, and it really adds up to a very difficult set of issues, political issues, to navigate for investors and firms. I asked about the kinds of risks Michael's clients are concerned about, and he said delisting is a common one. For the last 20 years, Chinese firms have listed on U.S. exchanges, and this whole arrangement has been built on a few rather large regulatory gray areas. One gray area is the use of the VIE structure, Variable Interest Entity, which is basically a tool that investors have used to gain access to Chinese

tech companies that has never really been officially recognized by Beijing. And Chinese regulators and U.S. regulators are both increasingly nervous about this structure. You heard Michael mention variable interest entities or VIEs. Alibaba is an example. U.S. investors don't really own shares of Alibaba in China. They own shares of a VIE in the Cayman Islands that has a contract with Alibaba to share in its profits. That way, Alibaba gets access to capital markets overseas, and China can continue to restrict overseas ownership of companies like Alibaba gets access to capital markets overseas and China can continue to restrict overseas ownership of companies like Alibaba that it deems sensitive. Only China never really approved the

VIE structure and it could crack down on it at any time. If that happened, Alibaba might have to delist in the U.S. and trade in Hong Kong like Didi. It's unclear whether that risk is already reflected in Alibaba's share price. Michael says U.S. regulators aren't keen on VIEs either because of opaque reporting and the risk of arbitrary action from China. And that presents a conundrum for investors. The most attractive companies in China for outsiders are arguably the tech giants because they're not viewed as state entities. But that's the very characteristic that makes them a target for China's government. Here's Michael.

You know, you've got to recognize that tech is basically at the center of U.S.-China strategic competition right now. And so the level of comfort in China with these tech firms being listed on U.S. exchanges, being subject to actions by U.S. regulators, and having foreign shareholders, that degree of tolerance has really reduced. So the areas in which Beijing is really gearing up its resources in terms of trying to win these sectors of the future are the areas where it's going to be harder and harder as a foreign shareholder to really participate. It's not impossible, but the geopolitics are really intruding in a very serious way. Michael says he doesn't think the sky is falling, but that he's not optimistic about the U.S.-China

relationship. He says he thinks the chances of a military conflict are pretty low. Take that, Bert the Turtle. Now tell me right out loud, what are you supposed to do when you see the Flash? But Michael says that the two countries are competing for global influence, and that it will take a lot of skill to manage the relationship, and that a tense relationship should be considered the new normal. He also notes that there's a lot of economic activity between the U.S. and China that doesn't involve national security or strategic competition, and that China still has opportunities for investors who are comfortable with the risks. It is a hugely important market and economy. It's the world's second largest economy,

but there are also a lot of challenges. So I don't think that China is uninvestable. These risks are serious. You need to incorporate them. But, you know, I do think that there is a strong case to be made for exposure to China and Chinese companies. But the political factors really have to be part of the investment thesis. Thank you, Ray and Michael, and thank all of you for listening. Jackson Cantrell is our crack producer. What? And by crack producer, I mean outstanding producer of podcasts and not crack. Thank you. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. If you listen on Apple, write us a review. And if you want to find out about new stories and new podcast episodes, you can follow me on Twitter.

It's at Jack Howe, H-O-U-G-H. See you next week. See you next week. This episode is sponsored by Northern Trust Wealth Management. There is more to being a successful entrepreneur than just good business practices. What is it about an entrepreneur's childhood that helped fuel their entrepreneurial spirit? What are entrepreneurs doing to cultivate this spirit in their own children and build a legacy beyond their business? Tune in each month to the Road to Why podcast by the Northern Trust Institute, where host Eric Chappella dives deeper with leading entrepreneurs on these topics and more. Find the Road to Why where you listen to your favorite podcasts.