The End of Risk Parity: Bonds, Stocks, and the U.S. Dollar (w/ Raoul Pal & Dan Tapiero)
DAN TAPIERO: You can really say that they really even haven't begun a wholesale easing process, that they've stopped the rot for now. That makes me think, and we've talked about this before, but that makes me think that the government bond curve does come all the way down and maybe it's 20 basis points flat all the way up to 30 years, or maybe it's 10 basis points. Now, I don't think for an institution that's a great bet to buy bonds at 60 bps for a move to 30 or 20 or zero. I think in that environment, they're going to need more protection, a different type of hedge than just government bonds. I mentioned this and I get into this now because I think we're beginning-- there's a new narrative that maybe just developing, which is that government bonds as an asset class are losing their efficiency or productivity. Once we get down to zero, I think it gets very hard for bonds in the portfolio to act as the hedge and I'm thinking again, for portfolios that are 70/30, 65/35 and that I think there begins to be a little bit of a possible transition towards gold, which doesn't have a cap on it. It has unlimited upside in a period where the authorities are going to be adding stimulus for a long time. RAOUL PAL: Make sense because bonds just don't offer the-- there's no capital gains now. All it does is act like cash. Well, fine, you'd use cash then, there's no point having a bond market. You're right, you need something that can offset with gains to create that all-weather style portfolio or a portfolio hedge of some sort because it's no bones. DAN TAPIERO: Just think about since 1980, every time we've had the downdraft in the periods we were discussing before, there were massive gains in bonds. You and I both in early 2000, I was loaded up on two years, the whole year was made on US 2-year notes. That goes for every time we had one of those periods and so that would offset the losses on the acid side of your portfolio. We don't have that now. I think if there's an existential crisis, from an investor standpoint, again, putting aside the virus and the oil and all of that is that in the next five years, what can replace bonds? RAOUL PAL: Well, if you're a pension fund manager, and I know you sit on an Advisory Board of endowments, or whatever it is, these are real meaningful questions now that everybody's going to have to have is, and I don't know the answer, we should think about this because Europe and Japan have gone through this. How did their pension system cope, and what did they do? DAN TAPIERO: Well, they've gotten killed. I know German insurance companies, they have to put their money into negative bunds, and they have to pay out what they have to pay out based on their policy. I don't know, maybe the central bank is supporting that industry. I really don't know. RAOUL PAL: It makes me think that most people just leave the equity market. Because if you don't have a way of taking intelligent balanced risk over a long term time horizon, and if I look at the European stock markets and the Japanese stock markets, they obviously never recovered again. Which is one of my core thesis that I don't think the US market recovers for an extraordinary time until the demographic blows through. Because they're part of this. How do you run intelligent risk in an equity portfolio for a pension? Now, it's difficult. DAN TAPIERO: Where does it go then? This is the common refrain. If you pull from the equity, are you putting it into commercial real estate and hoping that you'll make some return? RAOUL PAL: Or do you get the government guarantee the pension system and you just put it into cash? It's all going to end up in the government balance sheet and the central bank balance sheet in the end, whichever way you cut it. DAN TAPIERO: It could. It could. I also think that's a very long term thing, that doesn't happen overnight. For the equity market to become not a place where you can have exposure to the asset side, to assets into growth in the economy, I don't know even what's what liquid enough to replace it. I understand what you're saying. You would need the government and also industry and business to say the equity markets don't work for us, we need it all guaranteed. That's really, you're very close to the socialist, a socialist system. RAOUL PAL: They're buying their bond market because it's on the books of the pension funds and the life insurance companies. DAN TAPIERO: I missed that. You said Europeans? RAOUL PAL: Sorry, the Japanese. DAN TAPIERO: Oh, the Japanese. RAOUL PAL: ETFs, which are basically the equity portfolios and the life insurances and the pension funds to try and prop up returns because there's no bond return. It becomes a very complicated world because we've all made promises we actually can't match because all promises the entire pension system is built on never once assume that bond yields are zero in the point that you're raising. DAN TAPIERO: Right, but how about a different thought? How about, we always talk about all this debt, et cetera, and I remember in the mid-80s and late '80s, people talking about how Reagan had leveraged up too much, we'd had too much debt, and that the US economy, I think there was a Book Day of Reckoning or something like this, it was going to default and all of this business. What ended up happening in the '90s was that we reflated the asset side of the balance sheet, of the country's balance sheet. Maybe when we think about what are the models, the frameworks of the future, maybe they've gone unlimited right away. Maybe, maybe you're right, maybe the government is going to support the equity markets to a greater degree than we could ever imagine. How much pressure is the debt side of the balance sheet if let's say the S&P doubles from here? Let's say the next three years, often you get inflationary episodes after there's a panic spike that forces the hands of authorities. It's not impossible that we have an inflationary episode where the risks of the S&P doesn't go up, the nominal value of the S&P goes up. Also, connected to this, and this is maybe something contrary to what you've been thinking is that, look, Americans only care really about the equity market. No one cares about the value of the currency. This is a perfect situation where if the dollar went down 20%, 30% here, wouldn't be that big a deal because especially if it happened over time? I would say most Americans wouldn't care, wouldn't know, it wouldn't matter I think over a five, six-year period, you could probably have it go down 50%. Look, it went down from 2000 to '03, that was a huge run for macro guys like us, that dollar selloff. It was because of that dollar selloff that we could recover from the NASDAQ collapse, which really was a gigantic collapse. RAOUL PAL: One of my core ideas I'm floating around my head is the 1920s. We've got the US essentially and the UK and France eventually and Germany out of the troubles that they were in was currency devaluation. The US were quite late in repayment because the dollar was very strong. They kept accumulating gold reserves, gold reserves, gold reserves, and eventually, they said, listen, even though we're accumulating reserves, we have to weaken our currency. Almost the moment they weakened it, the economy turned around. DAN TAPIERO: Right, and I think it's exactly the same. We're at the place where-- we've discussed this, look, the dollar in theory, in theory, it could still rally a bit, I don't know, but I think it's late in the game. You could have, if we have another episode where the markets are saying the Fed's not adding enough liquidity, the package stimulus is not getting through enough, the markets correct again, let's say in the next few weeks, and you have another huge dollar up move. That's possible. I think this is an ending move, but that in-- it may be a few weeks, it may be a few months, I don't know. I think the next 30%, 40% is to the downside. That's because I think that's really the only thing, also that will get Europe to be more aggressive on stimulus because if the Euro heads up to 135, they're going to have to do a lot more. Also, China. China still has 3% government bond rates, or 2.75%, or whatever it is, that should be down at 1%. We have to force China also to be more aggressive. If everyone is being more aggressive, because we're going to either actively intervene in the dollar or naturally because of all the excess stimulus, the dollar heads into a bear market. I think you could be in a situation that's like the '20s, where it really is rip roaring. I'm just saying this is a model I'm working with. I see you're 1920, the '29 framework where things could be-- I think that's more likely if the authorities give up and don't do the right thing. RAOUL PAL: My view on that is, and again, we're all holding a lot of different scenarios in our heads because we have very unprecedented times. I just think that the probability of a larger solvency crisis based on slow growth is pretty high. In that situation, I think it's almost impossible to stop the dollar. I think the dollar is these two windows. One is this now period and I agree, I really don't know whether the Fed are going to do enough to stop the dollar rising. Maybe if they do, that's it squirts up again. They try and smash it back down. Okay, fine. My fear is actually give us six months' time in September, October when economic growth hasn't really picked up, but we've got this real debt issue, so you've got negative cash flows and negative earnings out of corporations and debt. Like Ford just got downgraded to junk, we start going through the debt cycle. Now, the worst is obviously abroad because they need dollars, and they don't get access to the Fed. The borrowers in the US can get access to the Fed in some way, shape or form, the foreigners don't get it. That's what drives the dollar. My fear is there is still a larger potential dollar cycle that is even more toxic. Who knows?