Corona, Credit, and Market Outlook (w/ Raoul Pal & Dylan Grice)
RAOUL PAL: You're launching, you're in the process of launching an asset management business in basically a nuclear event. What I really want to do, pick your brains on how you are seeing this event, both from using your macro perspective of which you're very good with that but also, what are the opportunities that it's throwing up as well? Because there's two ways to look at this. There's a whole bunch of risk, as we know, but there's obviously a whole bunch of opportunity, and it's trying to sift through that, then I know that's really your strength. That's your skill set in all of this. DYLAN GRICE: Yeah, well, I think there are two parts of that question, where do we think this is going, and where the interesting opportunity is? I think that the first one is actually a much more difficult question to answer because we all have our views on where we think it's going, and I think maybe we're not so different. I don't know, I'm very concerned that we're about to see the mother of all credit events. RAOUL PAL: Yeah, that's exactly my view. DYLAN GRICE: It hasn't really showed up yet. I think that we've seen a huge rally, and really because of a relief, and maybe even optimism that the stimulus packages are just so enormous. RAOUL PAL: Also, the narrative has now caught up, because it was so far behind the reality. The narrative's caught up and even Donald Trump yesterday saying, well, 200,000 people might die. He's now potentially even overestimating so the narrative has now caught up, therefore you can rally essentially. DYLAN GRICE: That's right. We've fallen so far so fast. It's difficult really to see how many sellers were left, there could well be some technical aspect to it but yeah, it feels like the narrative has caught up. That's exactly it. I think that you've had this relief that the stimulus has arrived, that the stimulus is here, that the speed with which the policymakers have got their act together compared to in 2008 when they seemed to take an age and I think that the numbers are very big. People are, I think, relieved that the numbers are also back. For what it's worth, I just feel that there's-- Jim Deakins talking about these fiscal blockages, and it was just going to take a lot a long time for this money to actually hit the economy. In the meantime, we just fell off a cliff. Those weekly claims were absolutely staggering. Since you asked me, I think nobody really, nobody runs a business, you may stress test your business and think well, if things really, really go wrong, revenues may be down 50 or even 60, 70 but no one really stress tests a business for revenues to go down 100% overnight. RAOUL PAL: For three months. DYLAN GRICE: For three months. I have a suspicion that this pain is going to be substantial and severe, it's going to check [indiscernible] of this credit problem, these credit excesses we're already bigger than ever. RAOUL PAL: My fear within this is if you speak to any market participant, the basic assumption is it's a six weeks to three-month thing, and then we go back. The problem is A, human behavior has changed. The chances of people resuming their consumption patterns, their social patterns and other things quickly is low. The Prime Minister of Singapore made a really good point on this. He's like, look, we're going to keep our borders closed probably for a year and we're going to have to get used to that, and it will affect us. He said, I think this is probably a one or two-year issue. Now, that's all well and good, but if you have negative growth over an extended period of time, and you've got all of the debt to service, it's game over. That's all I think about. I can simplify it all down to if people have sold the tail above three months, they're probably making a big mistake. DYLAN GRICE: Yeah, I think related to that, as the US numbers look completely out of control and you look at the measures they've taken, and they just haven't did not enough. It seems to me when you look at the-- when you rebased the fatality count to once you've had more than 30 or 40, it's America today actually looks far more like Italy and Spain than it does China. I think that I know from my own personal experience, we watched this-- and by the way, I think we were, as a household, I think we were switched on to this I think before most, not because I was perfectly switched on to it but because my wife was, Mona. She got very weary very quickly about this and we actually started stockpiling and canceling trips. This was back in late January. RAOUL PAL: Yeah, we did the same. DYLAN GRICE: I have to confess I didn't really see this coming, but I did feel that this was one of those situations where it was probably rational to panic. Actually, it wasn't irrational to overreact. It was rational to, it was completely rational to overreact. The reason why we came to that conclusion is because that's exactly how your immune system works. There is a biological rationale to overreacting when you're faced with an enemy of uncertain strength. If you don't really know how strong the enemy is, there's no point in going in with that half-baked defense or half-baked attack, there's no point in allowing your enemy the chance to come back stronger. You have to completely obliterate the enemy, you have to completely overreact. That's exactly what your immune system does in the face of-- this is how vaccine works. I felt, okay, let's-- Mona wanted to stockpile, I wasn't so sure, but let's overreact, so we did all of this. Then we watched the numbers come in. We actually started getting a little bit nervous about it, a little bit scared about it, but it was all very abstract. What then happened was it started, it came to Europe, and then it was Italy and then Northern Italy was in lockdown and then suddenly, it was all Europe and then it was here in Switzerland. Then suddenly, we knew people that have it. Now, suddenly we know people who died from it. Suddenly, it's not gone from this abstract thing. It's gone from something very real. That even when we saw it coming, that has actually been quite traumatic. I just feel that that's what America is just about to go through. I struggled to see, really, I still want to see the market doing okay when that hits America. RAOUL PAL: I totally agree. The weird thing is I think my wife's had it. She's in Grand Cayman. I'm in Little Cayman. We couldn't get together. She's been quite ill, but she's over it now. We think a bunch of our staff got it, no tests. Now, the problem is she doesn't even know when she's safe to travel again to come over here. She doesn't know who she can meet, and what she can do. For me, do I have to reset the clock, do I have to go into quarantine again? Even me going to the store is a nightmare now because nobody trusts each other. I just look at the behavior already in how much has changed, and America is going to go through this enormously. It's a real mental scarring for people. I know people, for example, in Southeast Asia who went through SARS, have some mental scarring. This is clearly a lot bigger than SARS was. I just don't think people are factoring in some of the human behavior, because as you said, this has now gone from being abstract to a reality, and it's going to be a defining moment in your life that you will never forget, nor will any of the people around you. That's truly extraordinary. It's like war. DYLAN GRICE: Yeah, I think that's right. It feels as though roughly 25%, 30% peak to trough drawdown doesn't really seem to match that type of emotional scarring. That's why I feel that that's probably-- and I see probably, okay, because we're still on the first question. What do you think is going to happen? I think that that's actually the form of difficult question. RAOUL PAL: Let me just ask you that because there's outcome and then there's time horizon. What is your view in how-- and again, this is all probabilistic analysis, none of us have a clue, but best guess, how do you think this plays out in terms of what the market does? DYLAN GRICE: My best guess-- my very best guess, which again, probably isn't worth very much, but what it's worth I think that as the US loses control of this, or as seem to have lost control, I think it's already lost control, frankly. I think as over the next few days and weeks, these numbers, there will come a point where people see these fatalities and think holy shit, when does this end? When does this end? When does this stop? I think they will probably see new laws then. I think that at the same time, I think you see the consequences of these fiscal blockages, the concept, i.e. you're not getting the money to the economy fast enough. I think you'll also see the consequences of what-- I thought I could be wrong, but I don't quite see how you coordinate a mass forgiveness in the credit markets. You're going to see I think an awful lot of defaults. As I said, these credit excesses were just there for all to see before this even started back in January, with the investment grade and even the selling with investment grade, I think even the higher quality junk, so the BB stuff was trading at or insane at the tights of 2007-2008, so credit markets were ridiculously tight. This was when you've had excesses all over the place. You can see in the loan market the percentage of the leveraged loan market, there was just one grid above C. You could see in the private equity market at least add backs, where they were calculating their EBITDA for the leverage calculations and the prospectuses, there were loads to add back projected savings. Those EBITDA numbers were actually much lower than the ones that will be reported for credit policies, which everyone knew about, and no one seemed to really care. I could go on, the credit market was, I think, due quite a hard fall. It was given a sufficient enough knowledge, and what's actually happened is it's been too open and eat palms right in the back, and it's just been thrown off the cliff. I feel that we haven't really seen the credit problems yet. RAOUL PAL: Is that a-- usually when a credit cycle comes of this potential magnitude, it's an 18-month affair. It's not certain, it's not a three-month, six-month, even nine-month affair normally, it goes on for a while. What do you think? DYLAN GRICE: Yeah, because once you default, then you lay people off. Then your competitors come in and steal a march and then it's actually, then you've got all of a sudden, you're having to restructure your balance sheet and restructure your business and you don't just do that in a month or two. You probably-- and again, I think this idea that this is only going to last for a few months or a few weeks even, those people that have been let go of, you don't just get a job straight away. Again, I can see why we could maybe be wrong here. I certainly hope I'm wrong, but my feeling is we go lower here. I think that that's like my best guess and we're probably 18 months away from-- 18, 24 months away from making new highs, or go to those highs. RAOUL PAL: I think I'm even more conservative on this. I feel like we might be a bit of-- because of the demographics and stuff like that, there might be a secular cycle at play here as well, that concerns me. Because the baby boomers need to divest of a lot of this stuff and a lot of its credit and equity comes out of the time. It's just it's very spectacularly bad timing. I guess we'll see how that plays out. In that situation, where does the opportunity lie? Because it's difficult to short stuff right here. It's difficult to buy stuff. It's one of these weird places that tactically sure, we could punch around, to do anything meaningful-- DYLAN GRICE: This is where maybe I slightly dive out which is I don't have a problem thinking that the market is going to go lower, there's no buying. I find it easier to be a buyer of this market than a seller. The reason for that is, firstly, I think that the valuations actually are starting to look okay. They don't look completely crazy. Now, I know the data points, I know lots of people can say, how can you see it? How can you possibly see it, but what idiot would see that when the Shiller PE ratio is still in the top quintile, and we're still the most expensive equity markets just about over the past century? I understand those data points, and I don't really agree with them. I don't think that they're very useful. I think that there are some data points which are far more useful, and that they are actually flashing green at the moment. I can give you an example, I think on Friday afternoon, the high yield market implied the default rate was over 20%. You're looking at maximum default rates of about 12% in the tech boom for high yield, we're about 10% in 2008, you've got an implied default rate of about 20% high yield right now. It can go much higher, no doubt about that, but that's already there's some return there. There's some good return there. How does an expected default rate translate into an expected return? Well, again, it depends how you measure it, but if you think about the credit, the credit spread that you get is effectively your compensation for being hit with some defaults, obviously. Now, as that credit spread widens, you can absorb more defaults before you actually take a loss. Now, how much would default have to be for you actually to-- we've already seen 22%, let me ask the question a different way. Suppose defaults come in at the worst historical five-year average at rolling default rates which was I think it was actually early 2000s, the rolling average is something like what rolling average five years is about 10%. If we were about to go into that, now, you're still going to make about a 4% return. Now, I'm not saying 4% is spectacular, but with all the stressed scenarios, you make a 4% excess return over whatever you make in treasuries. Now, that's okay. I think that's okay. It's not completely jaw droppingly mouthwateringly failure boot stuff, but that's something you buy, that's not something you look to sell. RAOUL PAL: How do you size up the potential credit event because that has a risk of being maybe a larger credit event than we have lived in our lifetimes through, how do you get a grasp of that tail? Because that's the only way you can price this is, okay, this is what I think the tail is worth. This is where I think it's trading now. Am I compensated for that tail? DYLAN GRICE: I think two things, the first is I think it's very-- and it may be a little bit late, or maybe not. I think it's prudent to have some of those things in your portfolio that people see only ideas having a portfolio, for example, gold, or Bitcoin. Which I know you're a big fan of. We've actually spent most of that whole crypto bubble and we were actually living in Zurich at the time. RAOUL PAL: Mona's in that world, isn't she? DYLAN GRICE: She is, she did one of the first ICOs in Switzerland, I think it was the third ever ICO actually. I think it was late '16 or early '17. We did get front row seats to that whole madness. It was madness. It still is madness actually, but it's something we know a little bit about. I understand why people were squeamish about Bitcoin, but I'd say I don't think it's a dumb thing to have some. I think gold maybe is a bit easier for people to get their head around, and a lot of us see a lot people like that. I think that in the real extremes, I think those things should do very well. Assuming you avoid those tails and you can have quite a nasty environment, a very nasty market without society blowing up, which is the extreme that I think you go with, but I think it's, well, you want some cash.