Submitted by Eric Peters, CIO of One River Asset Management
Stockholm:"How should we think about inflation?” asked the Strategic Asset Allocation Committee. “Is inflation something that should have been much lower were it not for such low interest rates and so much QE? Because if that is so, won’t policy normalization cause deflation? Or has QE created disinflation? Because if it has, won’t its reversal create inflation? How will politics affect inflation? And what should we think of Trump? Who will come next? A socialist? Is Fed independence under attack? And what are we to make of your trade conflict with China?”
Stockholm II:“Our conflict with China is about far more than a trade deficit,” I explained. “It is about slowing China’s rise, economically, militarily. Confronting them on intellectual property, market access.” The committee agreed. “US and EU policy, business, and military circles all seem to believe that this is necessary, overdue, but many are offended by our approach.” The Swedes agreed. “What would have happened if the US had tried to coordinate its European allies to confront China in a multi-lateral way?” I asked them. “Nothing,” they said. And I agreed.
Stockholm III: “US markets are priced for roughly 2% or less inflation every year for 30yrs,” I said. In a world of extraordinary debt, rising deficits, and impossible entitlement liabilities, pricing low and stable inflation when governments print money seems a poor bet.
“Electorates are voting for higher wages, greater income security, less trade and immigration – more balanced division of economic profits between labor and capital. And if the current parties do not deliver this result, they will be replaced by parties that will lift inflation through socialist redistribution.”
Copenhagen: “We’re looking for good diversifying strategies,” said the CIO. I’d come to show him ours. “We own gamma and use risk premia to offset the carry,” continued the Dane, acknowledging risk premia strategies are negatively convex. But with 10yr German bunds yielding 30bps, Europe’s risk-free hedge is dead. The hunt for alternatives is on. “We increasingly buy US Dollars to hedge our risk. As Europeans, the dollar pays us 3% to hold and tends to rise when markets fall.” But the dollar is no longer cheap. And Americans want it lower.
Helsinki: “We have been reducing risk for 2yrs, selling gains in equities and moving to cash,” said the CIO. “Cash is very expensive to hold.” Euro cash rates remain -0.40%. “This requires patience, just as in 2005-2006. But that was the right decision and we did very well.” Picking tops and bottoms is impossible, particularly with such vast pools of capital. “We started buying in 2008 and continued all the way through 2009. This set us up well through this bull market. I recently told my team they can buy again. But they have come back and said, no, no, not yet.”
Denmark: “We match our liabilities with long-term bonds,” said the CIO. “With part of our portfolio we take risk using derivatives and leverage. We translate our private market risks into public market equivalents.” Doing so turns real estate investments into 8-10% annualized volatility risk. Private equity holdings look like public equity holdings from a risk perspective. “We create risk budgets for each asset type and build an advanced risk-parity portfolio using this methodology. We believe that this approach measures risk more honestly.” Indeed, it does.
Denmark II: “We consistently realize lower portfolio volatility than we model,” continued the CIO and his head of public markets. This is because the price of a real estate and private equity portfolio is not marked to market. “US investors over-allocate to private equity and real estate specifically because they have lower reported volatility than risk,” I said, impressed by their honest accounting. The Danes smiled. “Correlations are stochastic,” they said, hinting at the risks of excessive portfolio leverage. “And at this stage in the cycle, they should be expected to shift.”
Scandinavia: What else should I know?” I asked in each meeting. “The Japanese started moving money to Denmark over the past 2-3yrs. They’re indiscriminate buyers, looking for yield and hedging back into Yen.” – “We’re moving money out of US assets because the cost of hedging into Euros costs 3% per year.” – “Regulators just changed the rules to allow Swedish state pensions to increase illiquid portfolios and decrease bond holdings.” – “The greatest risk we see is Italy. It is a far greater risk than Brexit, it is bigger than Lehman,” said everyone I met.
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Anecdote: “We are trying to understand America, Americans,” said the soft-spoken Scandinavians, financial market pillagers. “America has been the world’s moral authority. And okay, so perhaps you have not always lived up to that. But you have tried. And it has been this way for our whole lives.” I nodded. “You have stood as the protector of global trade. Free trade. Democracy. And what is right versus wrong. America has defended the weak.”
One of the many wonderful rewards of travel is to see yourself reflected in foreign eyes. Throughout today’s Scandinavia, America’s reflection looks the same. “It has been this way for many, many of your Presidents. And now it seems that this has all changed.”
Scandinavians are trying to make sense of the changes happening in America. They’re not alone. Americans are trying too. I explained that we had reached a tipping point, driven by income and wealth inequality, amplified by income insecurity, in a technologically-disrupted world transforming faster than at any time in human history. And instead of voting for more of the same, we voted for change. Real change. A redistribution of economic spoils between capital and labor. A redefinition of our relationship with foreigners; neighbors, friends, enemies.
And in the pursuit of these things, we’re attacking orthodox thinking on every front. NATO, trade, immigration, climate change, free speech, economic stimulus, deficit spending, central bank independence. We have also decided to slow China’s ascent. And while no one knows where this will lead, surely it will change the trajectory of the trends that dominated recent decades.
“Well, we see that America has now begun to use its economic and military might to take what it wants. And this returns the world to something we have not seen for a very, very long time - where might makes right. To the law of the jungle.”