Odd Lots - Bridgewater's Greg Jensen on Why Markets Have Further to Fall

Episode Date: May 23, 2022

Bridgewater's Greg Jensen on Why Markets Have Further to FallInflation 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. See omnystudio.com/listener for privacy information.

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Everything you need under one roof. The National Heavy Equipment Show today and tomorrow. Visit NHES.com for registration. and show details. Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Allaway. And I'm Joe Wisenthall. Joe, you know something that really annoyed me last year?

There are a number of things, I'm sure. Yeah, there's actually a lot. Yeah. Okay, there's a lot. I hear you're annoyed. I hear, I'm, this is part of our daily chatter. No, but keep going, keep going. What I'm annoyed about today.

Yeah. Well, there was a moment early last year where people, 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. Yeah, I think that's right. You know, people, 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.

There's no, you know, that's like, you know, I guess optimistically say that's what makes a market, right? People have a bunch of different views. 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 U.S. 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. 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 holds stocks and bonds. 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 commodities specialists come on here and say, obviously, you know, if inflation is going up, commodity prices are going up by 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. Yeah. The only thing that really works yet, commodity has 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 for a rough ride. 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. Let's go. Greg, thanks so much for coming on all thoughts. Well, great. Thanks for having me. 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 know, you say that name and it has a little bit of mystique around it. 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 100 investors to think through how the global financial system works to build that out into. to 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, as 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 stagnation, 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 tests, whether they've been true in different types of environments. That's been kind of the magic of Ridgewater 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. Is there a core, like, 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, like 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, like what is the sort of like underlying lens through which you view the economy and therefore financial markets? 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 of 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 is 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 real good, produce 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 assets 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 80s or in China today or, you know, know, or in Latin America, in hyperinflations, those frameworks work. You know, they're what we call

timeless universal. Now, the inputs to the frameworks change, but the basic frameworks do. And so that's, 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, et cetera, 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? The de-globalization is a huge deal.

Over the last 40 years, we really haven't been dealing with. And now you've got to deal with it. 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 base on, we can spend all our time on the things we think we're missing and then try to add them into that understanding. 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 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? Yeah, great.

So artificial intelligence is something I'm very passionate about it, 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 has been doing for 40 years 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, or 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 comes along over the last decade and is helpful in that process as well. But it's also a tool and that 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 that 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 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 is 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. So in 500 years, maybe Bridgewater will have a 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 haven'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, like 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? new, a new thing emerges, or maybe it's de-globalization, how do you, what is the process by which you sort of acknowledge or recognize and say, this is something different? Yeah, well, I think our, going back to our frameworks, yeah, right, that you can look at, so why did the, why did the inflation, and now, let's say, slow and 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 in the words, that place, needs different things. But the basic picture is, if you turn back to 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, 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 is strong, the demand is coming at the 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 were laid to COVID, but 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 of 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, et cetera, 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, right? And if you're

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 dynamics 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 kind of. 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 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 you're thinking to your systematic process in that way. 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? 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 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, 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 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 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 income,

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've 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 you have to drop demand, 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 deeper session and a crash, probably in financial markets, down 35, 40 percent 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'd 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, 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 kind of weigh the consequences of bring 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 what is 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. Well, so the Fed has, you know, in theory, it has a goal of getting, you know, inflation back down to 2%, but it's been suggested by others that, okay, if inflation gets down maybe 4% or to 4% or 3%, that it can 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 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.

Like what level of activity maybe gives them a little bit of comfort? Reading how Jay Powell and they are going to, you know, it's not necessarily like, 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 my, if you're asking me, if I were in their shoes, I would be wary, right? I think they're going to, 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. But 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 four will be a better choice. Now, the market stopped to adjust a lot. If you're actually going to have a long-term inflation rate of four, the markets have, 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 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, get that down. But to me, I would consider, you know, them getting it down to four 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. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value in fixed income

is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But on Vanguard, at Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top grade products across the board of of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio. That's vanguard.com slash audio. All investing is subject to risk, Vanguard Marketing Corporation distributor. Eating well shouldn't be.

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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. 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 index 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 that 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 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 can 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. 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 this 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. Banks that were two, the Fed and banks were the reason there were so much money going around last year. The Fed was still buying assets and the banks were buying bonds at record clips, 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 U.S.

You're seeing this, the market action 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. So if we're experiencing a secular change, and look, I would never say in a million years, and I know this, that it's, investing or portfolio management is easy. But it is true that, you know, in the last decade,

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 went 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. 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, like, how you're thinking about, like, portfolio construction. If we're, like, 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? 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. 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. 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? And the difference is the cash flows on equities and bonds are affected by both real growth rates. rates, but also inflation. Now, the real growth rates, stocks and bonds act opposite. So if real growth

is the dominant factor in inflation stable, stocks and bonds are going to be great diversifiers. If inflation, though, inflation is 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 is 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 are 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, and that's really, 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 your short commodities and you're de-globalizing. So you've got to look at the emerging market allies, essentially, that you can reliably provide the things that the world's missing.

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with a massive display of equipment and services, from construction and road building to crushing and screening and the newest innovations. Everything you need under one roof. The National Heavy Equipment Show today and tomorrow. Visit NHES.ca for registration and show details. Can you talk a little bit more about the impact of inflation on stocks and why you see stocks is 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.

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, there's 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 PEs 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, 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, 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 U.S. equity market can only survive essentially with new buyers entering the market because they're not cash flow generating themselves. Wow. And that's near a historic high. That's like basically right in line with 99, 2000. And it exists because the Fed produced liquidity for so long,

you're 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 crypto space as well. like just the removal of macro liquidity is starting to affect the entities everywhere that need the liquidity the most. 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 have 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? I'll start with the first question on how do we share that. And I don't mean to, again, I worry about false precision where all this stuff is rough. But the basic idea is you can, there's always in normal times, there's a churn in financial markets. Some people have to sell their financial market assets because they're spending in the 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 earnings 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. the economy to be okay, but they don't need new liquidity versus the ones that even if the economy is great, they need new liquidity. And that's where that calculation is coming from. The circuit breaker question, like what actually stops the downward spiral evaluations here? Exactly. This is 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

policymakers are unconstrained. So if you take even 2008 as devastating as that was, policymakers, 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 of policymakers. If you look through history, they can always create nominal growth if they don't have a inflation problem, if they don't have a currency problem, and they don't have a bubbles problem. And so you take it 2008 or the COVID thing,

and you see how it works, right? They did a lot more effectively in COVID, which is print the money, spend the money, and you can offset anything. You can 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 policymakers 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. They're going to be, 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 policymakers. 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, you know, it can take out. It can lead to lost decades. 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's the concerns about de-globalization between U.S. 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? 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. 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, the 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 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 the 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 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 demand, a supply shock will. So we're also, I'd expect somewhat of a surge catch up to the supply shock. as if China comes out as eventually 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 U.S. 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 climb.

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 that's the cost of de-globalization. And we've had this wind at our back for so long that people 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

U.S. 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. 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? Yeah, I think it's a, it's a secular drag the same way globalization was a secular benefit to asset prices. This is,

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 U.S., 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, or 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, 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 defunancialization of the U.S., 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, could see this accelerate. But right now, I'd say it's, even if it doesn't accelerate in that

rapid way, it will be a constant grind for a decade. One more question along these lines. You know, this conversation has been very U.S. asset-centric. And you stated in the beginning that investors were so bullish on U.S. 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, I think you said 200 markets around the world or something like that. Is that assumption, like should people think more global in this environment when if we're seeing the assumption break that U.S. stocks can't just take over the entire world? What does this mean for non-US assets? 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 U.S. as a result of everything that's going on in terms of 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 head to Japan and you've got trying to maintain an interest rate pack. So amazing range of circumstances and opportunities. And I think diversifying across those risks. You got a huge risk in the United States is that liquidity that was stuck in the U.S. 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, short term kind of alpha opportunity, I think it's also that that's right. I think a lot of assets outside of the U.S. are more attractive than the U.S., 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 U.S., if you take companies very similar cash flow allocations, you can get them in the rest of the world of those same cash flows for 30, 40% cheaper. That's the issue. The U.S. 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, et cetera, 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 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.

Greg, that was a really fascinating conversation. And yeah, we really appreciate you taking the time to come on all thoughts. Great. Well, I enjoyed it. So thank you both. Thanks, Greg. That was awesome. 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 Duda 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 U.S. markets. Yeah, no, I mean, it's 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 pretty significant question about whether, you know, when all the dust settles on this sort of the pandemic and post-pandemic period, whether those conditions can be returned to. 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

pro's 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. And look, you know, I think we're sort of, you know, a conversation you always here is like, well, okay, what do you buy? What's the right portfolio strategy for this new inflationary environment? What do you, what should we reallocate to? Maybe it's whatever it is. But like, I also think like it's possible that everything is, and I don't know, but like maybe there is not like an optimal portfolio. If the conditions deteriorate, if inflation remains high,

uh, real growth, decelerates, et cetera, 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. Yeah. All right. Well, shall we leave it there? Let's leave it there. This has been another episode of the AllBlots podcast.

I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway. And I'm Joe Wisenthall. You can follow me on Twitter at The Stallwork. Follow our producer, Carmen Rodriguez. She's at Carmen Armin. Follow the Bloomberg head of podcast, Francesca Levy, at Francesca today. And check out all of our podcasts at Bloomberg, under the handle.

at podcasts. Thanks for listening.