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We have a special feature for this week’s IQ Weekly Takeaways! We participated in the Global Asset Owners Forum 2020 hosted by Bloomberg on 2nd July and share our key takeaways from the Fireside Chat with Ray Dalio, as well as a panel discussion featuring two notable economists and two CEOs of pension funds. They also uploaded a recording of the session so you can watch it here if you’re interested.
1) Fireside Chat with Ray Dalio
Post Covid 19: Recovery and Opportunities
KEY POINTS AS SUMMARIZED BY IQ: Dalio makes the case for investing in Gold and Stocks. He draws the distinction between the Economy and Financial Markets, and asserts that the Financial Markets will be propped up by Central Banks (because they want to avoid the disastrous consequences of cratering asset prices). If investors hold on to cash, they’ll lose out since Central Banks are printing money (the higher the money supply, the lower the value of money). Meanwhile, bonds are unattractive since interest rates are already so low. So the only options left are reflation assets like Gold and Stocks. Avoid stocks that are sensitive to the economy (i.e. will go bust, are under operational duress). And keep in mind that with risk free rates near zero, the P/E multiple is now essentially the inverse of the equity risk premium. If investors continue to chase returns thus driving down risk premiums, this can lead to an exponential rise in P/E multiples.
We note that Ray Dalio gave a much more bearish outlook on stocks three weeks ago, mentioning that the stock market could be on the verge of a “lost decade” for investors.
2) A Panel Discussion featuring Dr Catherine Mann, Dr Nouriel Roubini, Morten Nilsson, Simon Pilcher
Investing in the Post Pandemic World
- Dr Catherine Mann (Global Chief Economist, Citi)
- Dr. Nouriel Roubini (CEO, Roubini Macro Associates, LLC)
- Morten Nilsson (CEO, BT Pension Scheme)
- Simon Pilcher (CEO, Universities Superannuation Scheme)
KEY POINTS AS SUMMARIZED BY IQ: The consensus view between the two economists is that we are in for a U-shaped recovery, rather than a V-shaped recovery that the financial markets are implying. With markets driven by Central Bank liquidity and low interest rates, the two pension fund managers have suggested owning assets such as infrastructure, utilities, inflation-linked government bonds and ESG-related investments. Inflation looks to be more present in capital markets than in product markets.
1) Fireside chat with Ray Dalio
Post Covid 19: Recovery and Opportunities
During the dialogue, Ray Dalio answered the following questions:
- Views on the current economy.
- Central Banks’ influence on markets.
- Usefulness of traditional valuation metrics like P/E ratios in a market run by Central Banks.
- The best store of wealth now.
- Limits on money printing before Central Banks hit their capacity.
A) Views on the current economy…
3 big forces were already at work before the onset of Covid-19.
- Monetary policy has become a major market driver, as we have reached the part of the debt cycle where interest rates are zero
- Extreme wealth gap and political gap
- Rise of China as a challenger to the US
B) On Central Banks influence on markets…
- Markets are now driven by Central Banks and their coordination with the central government.
- In 2008, action was taken to protect banks, Money Market Funds and Commercial Paper because they were systematically important.
- In the current crisis, what is deemed systematically important has taken a broader meaning, including fallen angels. Central Banks are now the market makers.
- In Europe, the Central Banks will lend to banks at -1%. The Central Banks have a political rather than an economic agenda and will decide whether they want to be paid back based on prevailing conditions.
- We are no longer in a free market, as capital is no longer allocated in the traditional way.
C) On the application of traditional valuation metrics like P/E ratios in a market run by Central Banks…
- It is key to understand that there is a real economy (driven by a supply-demand of goods) and there is a separate financial economy (driven by the supply-demand of money and credit)
- The price of an asset will equal the risk-free return (which is close to zero now) and a risk premium.
- If equity risk premiums go from 4% to 2%, the P/E is just the inverse of that, meaning that the P/E ratio could go from 25x to 50x.
- While it is implausible to many, it is no less implausible than zero interest rates. The risk premium will be driven by the amount of liquidity and multiples shouldn’t be used in the traditional frame of reference.
- Capital markets drive the economy, P/Es and risk premiums more than what the real economy does in driving the capital market.
- A key question is the value of money.
D) What is a store of wealth now?
- Cash and bonds offer poor sources of returns.
- In addition to the already low yields, you are further taxed on the negative real interest rate.
- The Central Bank is also going to print more cash.
- A good store of wealth would be to consider what is the reciprocal of the value of money, which could include gold and stocks. Good examples of periods to look in the past would include:
- March 1933 (suspension of the gold standard)
- Aug 1971 (Nixon suspends the dollar’s convertibility to gold)
- 2012 (Mario Draghi said the ECB will do whatever it takes to save the Euro)
- Nov 2008 (TARP and quantitative easing announced in the US)
- The action of printing money to buy financial assets, to disperse money to corporates and the populace has happened before. You should own reflation assets during this time, which are the financial assets whose risk premiums will be driven down by the extra liquidity being put in the system.
E) Any limits to money printing before Central Bank hit their balance sheet capacity?
- The limiting factor will be the aggregate demand from private investors and the Central Bank for the newly printed debt.
- The most similar period to contextualize the limits of a Central Bank’s balance sheet capacity would be 1930-1945.
- Due to the Great Depression, interest rates were cut to close to zero, there was the printing of money, the Fed bought back government securities and fiscal stimulus was put in place which ran budget deficits.
- This was followed by the war years, where there was a large requirement for dollars and the Central Bank had to take on that debt.
- We will reach the limit if and when we see an erosion of the USD as a reserve currency, with investors switching to an alternative such as gold, stocks or a different foreign currency.
- In such a scenario, the Central Bank will either have to let interest rates rise (which is unlikely to happen anytime soon) or they will have to increase purchases of the country’s debt.
- We are in a fiat monetary system. In 1971, there was a USD devaluation when US could not meet its claims on gold.
- We will have to look at the combination of factors surrounding: 1) monetary policy aspect, 2) wealth, values and political gap, 3) China.
KEY POINTS AS SUMMARIZED BY IQ: Dalio makes the case for investing in Gold and Stocks. He draws the distinction between the Economy and Financial Markets, and asserts that the Financial Markets will be propped up by Central Banks (because they want to avoid the disastrous consequences of cratering asset prices). If investors hold on to cash, they’ll lose out since Central Banks are printing money (money supply increasing while demand will be weak). Meanwhile, bonds are unattractive since interest rates are already so low. So the only options left are Gold and Stocks. Avoid stocks that are sensitive to the economy (i.e. will go bust, are under operational duress). And keep in mind that with risk free rates near zero, the P/E multiple is now essentially the inverse of the equity risk premium. If investors continue to chase returns thus driving down risk premiums, this can lead to an exponential rise in P/E multiples.
2) Investing in the Post Pandemic World
Panel discussion featuring two economists and two CEOs of Pension Funds
Dr Catherine Mann (Global Chief Economist, Citi)
Dr Nouriel Roubini (CEO, Roubini Macro Associates, LLC)
Morten Nilsson (CEO, BT Pension Scheme)
Simon Pilcher (CEO, Universities Superannuation Scheme)
During the dialogue, the following questions were discussed:
- How do you see the state of the current economy and the path to recovery?
- How are you investing in the current environment?
- In a declining rate environment, how should an annuity portfolio be positioned to immunize itself against interest rate movements?
- How do you see the risk of inflation as a result of monetary policy easing?
- Importance of Environmental, Social, Governance (ESG) factors to investors?
- Outlook for EM. How will they perform against DM in this recovery and are there any countries that will be most resilient?
- Does US enjoy an unfair advantage as the World’s Reserve Currency, such that it can print money indefinitely?
- In a climate of more dispersion in both equities and credit, are you inclined to reallocate more to active managers?
- Looking ahead, what about the world will be most different post pandemic?
KEY POINTS AS SUMMARIZED BY IQ: The consensus view between the two economists is that we are in for a U-shaped recovery, rather than a V-shaped recovery that the financial markets are implying. With markets driven by Central Bank liquidity and low interest rates, the two pension fund managers have suggested owning assets such as infrastructure, utilities, inflation-linked government bonds and ESG-related investments. Inflation looks to be more present in capital markets than in product markets.
A) How do you see the state of the current economy and the path to recovery?
Dr Catherine Mann (Economist)
- Disconnect seen between the performance of the financial markets that implies a V-shape economic recovery and economic data that implies a U-shape economic recovery.
- Fiscal and monetary policy are in “life preserver” mode. There has to be a catalyst that drives a return of private and business investment, which will support employment and drive consumer strength, ratifying the recent financial market performance.
Dr Nouriel Roubini (Economist)
- Market is mispricing what is happening in the real economy.
- What unconventional fiscal and monetary policy can do is to prevent a greater recession, leading us into U-shape recovery instead of a L-shape recovery.
- The notion of a V-shape recovery doesn’t make any sense, as the corporate sector is much more leveraged than it was during the Global Financial Crisis and the economy was already fragile before the onset of Covid-19.
- To avoid bankruptcy, companies need to do spend less and save more, which could include cutting labour costs.
- When firms fired and started to rehire after the Global Financial Crisis, companies started to hire more flexible labour such as contract staff.
- We can expect labour income to grow more weakly, which will result in households to become more risk averse and to spend less save more as well. We will start to see less residential investment.
- Even with fiscal stimulus, it will not be able to compensate for an increase in savings rate by the private sector and the reduction in capex spending.
- The freefall of output, demand, spending and sharp rise in unemployment is unprecedented. It took 3 years to play out during the Great Depression and Global Financial Crisis, compared to 3 weeks for the current crisis.
- The aggressive fiscal and monetary policy actions taken have prevented the freefall from continuing and becoming another Great Depression but there are several caveats. The need to deleverage the private sector, heightened uncertainty and the risk aversion will give us at best a U-shaped recovery.
- This U-shape could even end up being a W-shape double dip recession because a second virus wave might arrive in fall/winter and by that time, where effective treatments and vaccines may not be ready yet.
- We also run the risk of Central Banks running out of bullets to monetize the fiscal deficit, negative supply shock of deglobalization, decoupling of US-China, Balkanization of global supply chains and less tech innovation due to the tech war between US-China.
- Monetization of fiscal deficit can help avoid deflation in the short-term but may eventually result in stagflation, similar to the 1970s when there were two negative supply shocks originating from the oil market. Stagflation can then lead to a depression. So, we might see the current V-shape shifting to U-shape by next year, into a W-shape and finally a L-shape by middle of the decade.
B) How are you investing in the current environment?
Simon Pilcher (Pension Fund CEO)
- Important to support management and businesses, and think about the immediate action we can take that is in the interest of the businesses and employees.
- Do not advise adding leverage or making “bold heroic investments”.
- Recent reallocation decisions have been to rotate out of US Treasuries and US TIPs into similar assets in the UK which have not performed as strongly. The Pension Fund also added to Investment-grade Credit.
Morten Nilsson (Pension Fund CEO)
- The Pension Fund has been trying to narrow the possible range of outcomes from the scheme.
- There has been more realignment to the “green recovery” theme and we see structural growth in moving to a net zero carbon target.
C) In a declining rate environment, how should an annuity portfolio be positioned to immunize itself against interest rate movements?
Morten Nilsson (Pension Fund CEO)
- When interest rates decrease, liabilities increase. We try to hedge the liability as much as possible.
- With traditional asset yields declining, we have been moving to more cashflow-aware assets such as infrastructure investments.
Simon Pilcher (Pension Fund CEO)
- The current environment is a challenge for insurance and pension funds, who have made promises to beneficiaries to provide an annuity.
- The Fund has holdings in Inflation-linked Government Bonds, Utilities and recently invested in a social housing enterprise that can deliver inflation-linked returns.
D) How do you see the risk of inflation as a result of monetary policy easing?
Dr Catherine Mann (Economist)
- There are two ways to look at inflation.
- Old theory of inflation that was introduced by Milton Friedman, which looks at inflation as a result of monetary policy, money growth rates and the balance sheet of the Central Bank.
- Another theory of inflation is a micro-theory of inflation, which suggests that inflation is driven by product (goods sold) and labour markets (wages). These will drive the cost structure of firms and their pricing power. However, the Philips curve (that suggests an inverse relationship between unemployment rates and wage growth) has been “dead” in the past decade.
- Inflation is showing up in asset markets, rather than product markets now.
- Inflation hedges may include social housing, infrastructure and utilities.
- Another area to consider would be climate-related investments.
- The European Recovery Fund has put in place supply-side regulatory restrictions which businesses have to comply. Companies have to invest in these areas, in order to make the climate transition happen.
E) Importance of Environmental, Social, Governance (ESG) factors to investors?
Morten Nilsson (Pension Fund CEO)
- It has become more important. Governments have been supporting private companies, with an expectation that these companies will do their duty to be good corporate citizens.
- More people are becoming more open to tax hikes post-covid but less accepting of companies not behaving well.
- Inequality is prevalent now and companies will be expected to address such issues, for example with corporate boycotting of Facebook recently.
- If supported by policy, ESG will be high on the agenda.
Simon Pilcher (Pension Fund CEO)
- Responsible investing is important, the longer the horizon you take.
- There will be political consequences for corporates who are dumping in this environment.
Dr Nouriel Roubini (Economist)
- Disagree with Morten and Simon, as people will be more concerned on jobs and the economy than ESG currently.
- Furthermore, oil prices are low, which makes it more attractive to alternatives.
- Companies will need to survive and will do so by slashing workers to save labour cost. When companies rehire, they will rehire flexible labour.
Dr Catherine Mann (Economist)
- This is where the government should step in.
- For example, putting a carbon tax on company activities that generate negative externalities.
F) Outlook for EM. How will they perform against DM in this recovery and are there any countries that will be most resilient?
Dr Nouriel Roubini (Economist)
- Do not lump all EM countries in the same basket.
- A U-shaped recovery is generally not great for EM export economies.
- EM have less policy space than DMs.
- Debt monetization is not possible for EM, as it will result in high inflation and massive FX depreciation. A lot of EM economies take on hard currency debt, so FX depreciation is not great for them.
- Density of population in some EM countries will also make it tougher to contain the Covid crisis.
- EM countries with high dependence on remittances (e.g. in Central America or North Africa or Middle East), which will see a sharp fall, will be more severe.
- In EM Asia, Korea, Taiwan will be more resilient. Gradual recovery of China will help them.
G) Does US enjoy an unfair advantage as the World’s Reserve Currency, such that it can print money indefinitely?
Dr Catherine Mann (Economist)
- US has a privileged place also because it has the deepest and most liquid Government Bond market. Until that changes, US will continue to have this privilege.
- There will be pushback on the increasing US debt issuance but there are many demanders of USD higher yielding safe sovereign securities as well.
- So even though the US is running a big fiscal deficit, USD will unlikely see massive depreciation or a higher yield that is demanded from investors.
- This US privilege can be eroded but it will take a long time before there is a competitor to the USD and US Government Securities.
Dr Nouriel Roubini (Economist)
- US has used the USD as a tool against its strategic rivals, via trade and financial sanctions to Russia, China, Iran and North Korea.
- Russia and China have been thinking of alternatives to the USD. For example, the use of RMB as a means of payment for international trade, as a reserve currency and an internationalization of Alipay and Wechat Pay to make the RMB a more international currency.
- There is concern of the US freezing China/Russia’s assets. These countries have increased demand for gold to reduce reliance on USD and US debt assets.
- Such moves may be a threat to the USD over time.
H) In a climate of more dispersion in both equities and credit, are you inclined to reallocate more to active managers?
Simon Pilcher (Pension Fund CEO)
- Credit investing requires knowing the credit worthiness of an entity being invested into.
- Passive investing and credit investing are oxymorons, I think it is a dumb way of investing and not something that we will be doing.
- For equity investing, it depends on the purpose and what you are trying to get access to.
- For example, MSCI World is not a risk-free asset but passive investing is a cheap and efficient way to get equity beta.
- We believe environment and social issues will have a long-term impact on investments and hence, we do consider those factors.
Morten Nilsson (Pension Fund CEO)
- We have been moving more towards active managers, using investment mandates with long-term focus and consideration of ESG factors.
I) Looking ahead, what about the world will be most different post pandemic?
Morten Nilsson (Pension Fund CEO)
- Green recovery will be a huge opportunity. If implemented successfully, it can change the world and fuel growth and investment returns.
Dr Nouriel Roubini (Economist)
- Increasing digitalization, impacting how we live, study, work, shop, do business and entertain ourselves.
- Increasing deglobalization, reshoring and protectionist policies as more companies and government move to protect their own interests.
Simon Pilcher (Pension Fund CEO)
- Increasing deglobalization, evidenced by the people’s desire to elect in the current governments of the UK and US.
- This is exacerbated by the move to a green economy, which requires shorter supply lines.
Dr Catherine Mann (Economist)
- Two scenarios can happen.
- Increasing deglobalization accompanied by lower productivity growth and higher inequality, worsening the fissures of what is seen today.
- Enhanced globalization but taking a different form with shorter supply chains with enhanced digitalization and with government policies supporting the transition for people.
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