Karen Karniol-Tambour on the Challenge of Investing in the Current Environment
December 13, 2022
Bridgewater’s Co-CIO Karen Karniol-Tambour in conversation with Alex Shahidi, co-CIO of Evoke Advisors, describes why today’s environment is so different from what we’ve seen in recent decades and how investors can prepare their portfolios.
In this discussion, which was part of the recent Advisor Perspectives Investment Insights Summit, Karen describes why she thinks we are in a new era of persistently higher inflationary pressures, how investors can prepare their portfolios for this new environment, and the short-term and long-term challenges facing Europe due to higher energy prices. She also talks through some of the pitfalls of current efforts to tackle climate change and create a clean energy transition, and her thoughts on the state of ESG investing.
Transcript
Note: This transcript has been edited for readability.
“If you said to me, ‘What’s the single most important thing that really feels different?’ I would say it is central bank constraint. For any mix of assets that you’re holding, it’s been a huge wind in the back that every time things go wrong, and the risk premiums start expanding and things start going down, and you have a wealth effect, central banks can say, ‘Let me go solve that problem.’ But all of this is under the assumption of one environment, which is the central bank sees a problem, solves it. Growth falls, they can solve it. Now they look extremely constrained in most countries around the world, as constrained as they haven’t looked since about the ’70s, for the simple reason that they want more than they can have. They want multiple things at once that just can’t coexist.” — Co-CIO for Sustainability Karen Karniol-Tambour
JIM HASKEL
I’m Jim Haskel, editor of the Bridgewater Daily Observations. Our listeners might remember our podcast a little while back with Ray Dalio and Jeremy Grantham, and that was co-moderated by one of our clients and friends, Co-CIO of Evoke Advisors Alex Shahidi. Recently, as part of this year’s Advisor Perspectives Investment Insights Summit, Alex had the opportunity to sit down with Bridgewater Co-CIO for Sustainability Karen Karniol-Tambour. And we’re sharing an edited version of that conversation in today’s Daily Observations, because we really thought it was quite good.
You’ll hear Karen describe why she thinks we’re in a new era of persistently higher inflation, how investors can prepare their portfolios for this new environment, as well as the short-term and long-term challenges facing Europe due to higher energy prices. Karen also talks through some of the pitfalls of the current efforts to tackle climate change and create a clean energy transition, and she also shares thoughts on the state of ESG investing.
So, with that, let’s get right into the conversation with Karen Karniol-Tambour and Alex Shahidi.
…
ALEX SHAHIDI
Hi, everyone. I’m Alex Shahidi, co-CIO of Evoke Advisors, which is a large RIA in Los Angeles, and one of my core responsibilities as co-CIO is to identify the investment managers we can find to allocate our client assets to. And about 15+ years ago, I came across Bridgewater, which is the largest hedge fund in the world, and I’ve had the privilege to meet most of their senior professionals. And one person that has really stood out to me is Karen Karniol-Tambour. Thank you for joining us today, Karen.
KAREN KARNIOL-TAMBOUR
So great to be here, Alex. Thanks for having me.
ALEX SHAHIDI
Why don’t we dive into the key topics that we’re going to cover today? The first is inflation and interest rates. This is the big topic today. Everybody’s talking about it. Second, we’ll dive into, given the unique environment in which we live, how should investors think about investing, given the current landscape? And then third, we’ll move into the energy crisis, particularly in Europe, and ESG investing.
Chapter 1: Inflation and Interest Rates
ALEX SHAHIDI
So, inflation and interest rates. Obviously, we’re at the highest inflation in 40 years. But if we zoom out a little bit, I think it’s helpful to think in terms of long-term environments. So if you go back to 1982 all the way until 2008, it was basically one type of environment. We had falling interest rates, falling inflation—called disinflation. Then 2008 happened. We had the global financial crisis. Until the COVID period, we had an environment of slow growth and massive stimulus. And now there’s a consideration of maybe we’re at a new major inflection point. Would you describe how you see that? Are we at a new inflection point, or is this just a blip and we’re going to head back down toward that zero-interest-rate environment?
KAREN KARNIOL-TAMBOUR
I believe we really are at an inflection point, where the years ahead will have a different inflationary backdrop to what happened since the ’80s, and you described it so well. And I think you can think about inflation as sort of having two waves. It has the secular pressure, what happens over decades of time. And those are slow-moving, gradual pressures. And then there’s the regular cyclical stuff, which is obviously, as the cycle goes up and down, that pressures inflation up and down.
So it doesn’t mean that if we’re in a paradigm shift, that you’re not going to have ups and downs in inflation. For example, right now we just recently had a better CPI print that was lower, because you do have some downward pressures on inflation that are cyclical. But from a secular perspective, I think it’s kind of a hard break with what you’ve seen for so many years. And you just had a lot of pressures that were very deflationary, that were in the system and very slow-moving.
One way of thinking about those pressures is that a lot of decisions were able to be made by entities all around the world with the purpose of getting more efficient and reducing costs. So if you go and you outsource your workers to China and all of China comes online, you’re spending money to literally make things cheaper. So globalization, outsourcing, all of these things, these were multiyear processes, multidecade processes that kept lowering and lowering and lowering prices in a way that was very efficient, productive. Companies were doing it because they would say, “I want to move my costs over there because it will be cheaper.”
At the same time, you had this big wind at the back of less power for employees, less labor unions, less anti-competitiveness regulation, less antitrust, more and more things that allowed prices to keep coming down and more and more to go into profits. Big, big, big forces in this direction. And what’s happening today is you’ve kind of let this run its course. There aren’t a lot of pressures that can keep lowering and lowering prices.
One exception to that could be the pace of technological development, which, while it has been very deflationary for many decades, we don’t really know what’s going to happen with it going forward. But I think it’s hard to believe that you’re going to get the same kind of deflationary pressures from technology that you have for the last 40 years. Just look at what technology was like in the ’80s.
At the same time, there are a lot of new pressures that are actually highly inflationary. And so, I’ll start with the ones that are just the flip side of “let’s spend money and do things like outsource.” If you look at what companies want to spend money on today, usually there’s not an impetus to say, “I’m spending money on something that I know is going to lower my costs.” Companies are saying things like, “I need my supply chain to be more resilient.” What does that mean? That means I’m double doing my supply chain. I’m spending money on something that’s not going to make me give you cheaper prices. I just need to—because I’m worried about geopolitical conflict. I’m worried about whether I can get to China. I’m worried about tensions like that.
They’re spending money on things like decarbonization because they have pressures to do so. That’s long-term productive for the economy, but it certainly doesn’t lower their costs tomorrow the way that outsourcing for cheaper labor does. And so you have these pressures to spend on defense, national security, decarbonization—goals that are maybe very important for society but don’t lower your prices automatically, don’t lower your prices immediately, and become more inflationary than that. And then, at the same time, the degree of what’s happened to social pressures, the fact that inequality has gotten where it has, and whatnot, means that the power of labor is increasing again. You really can’t get the same push in de-unionization that you had. You can’t go from a lot of unions to zero again because you’re at zero, but you’re getting pressures the other way, both politically in terms of what policy makers are doing and how they think about inequality.
So there’s a lot of inflationary pressures built up, and it’s coming out of a time that you’ve also generated a huge, huge, huge boom coming out of COVID that was engineered in a way that people literally got the money into their pockets so they could spend it extremely directly and create very strong demand. So those are very long-term pressures, where the pressures we had for so many years to get extremely low inflation, I think, are just behind us. And now you’ll be in a paradigm where, at the very least, inflation is volatile. It’s not just sort of stuck where it is, never moves, because we start getting wage gains, they get sticky, and then that gets passed on, and so on and so forth. And so it’s just very unlikely to me that you’ll see another couple of decades of very, very low, stable, sticky inflation that, honestly, just doesn’t matter very much for investors.
ALEX SHAHIDI
So one of the questions that we’re getting is, what about all the debt that the US economy is saddled with? You know, corporate, government debt obviously has ballooned, household debt, and you look back over the last 100 years, we’re at very high levels, debt to GDP. What type of deflationary pressure does that pose? And how do we know that the inflationary secular trends that you just described outweigh those deflationary pressures?
KAREN KARNIOL-TAMBOUR
Well, I think that the debt question is very real, because the United States has gone through some degree of deleveraging. So a lot of the most over-levered pockets are not there anymore, which sort of allows for these dynamics to happen. But part of what’s kept that under control, to be honest, is the market hasn’t believed yet that inflation is going to be a long-term problem. So you have high debt levels, right? The best thing that could possibly happen to you is if you have inflation today but the market doesn’t believe it will be sustained, because then what happens is that today your inflation kind of disappears. If you have 10% inflation a year, your debt becomes less and less important, because the debt is getting inflated away. But what typically tends to happen, especially in emerging markets, is if the markets say, “Wait a minute, 10% inflation a year, that means I have to charge that in interest rates.” So interest rates start rising. You can’t roll over your debt. And in the long term, people expect and demand to get paid back for that 10% inflation.
We’ve kind of been in this beautiful sweet spot where the debts can keep falling, because somehow interest rates don’t actually rise in line with the inflation. In other words, very negative real interest rates and the firm belief investors have that “Inflation, don’t worry, it’s going back to where it was.” So the key question is, at the point where that turns and interest rates really start rising and make it difficult to roll the debts and become a problem for indebted entities in a way that hasn’t happened materially yet, what are the indebtedness levels going to be then, and how levered are these entities? How big of a deal is it that they run into a debt problem?
And I think in the United States, the answer is not huge. We’ve had some real deleveraging, and this period of high inflation without high interest rates has further brought the debt burdens down. So a lot of the most risky balance sheets are in the best shape they’ve been in so many decades, despite the debt. That’s not true everywhere around the world. And you see strains emerging in pockets of places: Korea, we’ve got China’s deleveraging. Places where there hasn’t been a material deleveraging or any rise in interest rates very quickly starts cutting into the problem that these are very indebted entities that can’t easily handle it.
And I mean, that’s basically what happened in 2008 in the United States. So we know that script. We know what happens when you have a very overindebted economy. Interest rates rise, not even that much, but debts just reach their limit, need to reverse. It’s not where the US is today anymore but depending on how fast the market decides that inflation is here to stay, it could become a problem.
ALEX SHAHIDI
Yeah, that makes a lot of sense. In some ways, it’s kind of similar to the early ’70s in that regard, right? With the view that inflation is transitory and maybe it lasts for a prolonged period.
KAREN KARNIOL-TAMBOUR
Extremely similar. I think there’s a lot of similarities, because you go into the early ’70s and there isn’t a salient memory for investors of what that’s like. And at the same time, no policy maker loves the idea of cutting off growth. And so, if the market’s not believing that inflation is going to be a big problem, you don’t really want to cut off growth. What ends up happening is it takes a really long time to catch up with the reality of what inflation is. It doesn’t happen in one go. The market believes it won’t happen. If you look at the ’70s, the thing you see in terms of being an investor is, first of all, it takes years and years, where bond markets price in less interest rate rises than actually occur, constantly, for years and years.
So it’s not like inflation starts, markets get it, they say inflation is going to be high, that’s it, it all adjusts. Instead of that, it’s like over and over and over again, markets expect it’s not a big deal. Transitory. This is behind us. And interest rates have to rise more than expected, and you still get a cycle. It still goes up and down, because sometimes, the Fed does too much and they’re like, “Oh, no, we slowed the economy.” They change their minds. They do less. They realize inflation is not slowing as much as they wanted it to. It just takes time to realize that sort of new reality you’re in.
And then the second thing you see is equities are pretty much a disaster for reasons that are way bigger than what’s going on with the actual earnings of the companies. Some companies can actually pass on that inflation to their customers. But the risk premium you start demanding when inflation is volatile, and that’s the macroeconomic backdrop, is just higher. So it’s a very tough environment to be investing.
Chapter 2: Investing in the Current Environment
ALEX SHAHIDI
Yeah, so why don’t we transition to how should investors think about investing given the backdrop that you just laid out? Particularly, the part to me that really stands out is, for many years, actually decades, inflation was relatively stable. You didn’t have big surprises to inflation for a long time, but growth surprised to the upside and downside constantly. Now you have volatility in both growth and inflation. So given the volatile economic environment, just generally speaking, how should investors think about investing in a period like this?
KAREN KARNIOL-TAMBOUR
Well, I couldn’t agree more with what you’re saying, that the key issue for investors is that we’ve all lived and invested through a period where inflation was not volatile, and growth was very volatile. That means that we’ve gotten used to what the relationships are like that are driven by growth. If you basically step back and say, “What really drives the assets that you hold?” there are only a few cross-cutting forces that hit everything. There are obviously a lot of idiosyncratic things that happen in any individual assets, and I’m sure we’ll talk about energy afterward, geopolitical things, but across all the assets you’re holding, the big thing that really matters is sort of what happens in the economy, both how fast is the economy growing or growth and prices or the inflation, as well as sort of any future stream of cash flows—how are you discounting it to today?
So what’s the interest rate or the discount rate, which are discounting the cash flows, and how much risk premium are you charging on those? So those are very, very few factors that cut across a lot of assets. And the thing that can get confusing is that if you live through so many years, like we just did, where inflation is a nonissue, you never see what relationships are between assets when inflation is high and volatile. And the most obvious example is the stocks and bonds, where stocks and bonds have been such great diversifiers. When you think about it, the four factors I listed, actually three out of four stocks and bonds don’t diversify. So if you want a higher risk premium on any assets you hold, same for stocks and bonds. Obviously high interest rates, bad for both, and inflation, pretty bad for both of them. Growth is the only thing that really makes stocks and bonds diversifying, because when growth slows and you don’t have an inflation problem, you can cut interest rates, bonds can rally, while stocks can do badly because growth is slowing. And that pretty much is one of four. That’s just been the one thing that has really mattered.
So suddenly seeing yourself in a place where stocks and bonds are not diversifying is a big shock, I think, for a lot of investors, because we’ve lived through it for so many years, and that’s been kind of the most dominant relationship that we’ve had for a long time.
The other piece is just that I think a lot of the relationships we look at have been underpinned by whatever the experience was in the last 40 years and have just not been questioned. Another example I’ll give is, I think a lot of people start thinking of emerging markets as kind of just like a higher-beta version, a higher-risk version of what we have elsewhere. But that’s because emerging markets acted in a certain way in the environment that we were in. Not that they always have to be that way. In the last year or so, they haven’t been, because emerging markets have had a lot more inflation experience than us in the last 40 years. They were a lot more aggressive tightening into this and got less of a boom-bust cycle. It was less aligned with the countries you’d usually invest in because of their inflation experience.
So it kind of requires revisiting what actually underpins the relationships between the assets and debt I’m used to. And why do I think that’s going to sustain in a period that is just fundamentally different than the period that we came out of previously?
ALEX SHAHIDI
Yeah. And the part about what you just described that really stands out to me in working with clients is it seems like there’s a disconnect between what we investment professionals view as long term and the environments that play out versus what investors or clients think about. For us, I started off by saying 1982 to 2008 was basically one environment. That’s 26 years. For most people, one to three years is one environment. That was a long time. And so you could easily look at that and say, “Oh, this strategy worked for a long period of time,” as opposed to thinking of it in terms of, well, that was one environment in which it worked. In a very different environment, maybe it doesn’t work.
If you go back to the 1970s, I don’t think 60/40 was even a topic, because both the 60 and the 40 underperformed cash for a decade. I think that was more born out of the ’80s and ’90s bull market in stocks and bonds. So I think that’s part of the reason why there’s a disconnect. Does that make sense to you?
KAREN KARNIOL-TAMBOUR
Yeah, absolutely. You’re totally right. It’s a weakness in the fact that, even if we have systemized decision making, what’s emotionally salient to us is usually whatever we’ve lived through, and a more recent experience is just more emotionally salient. And so you just don’t have a lot of investors alive today that invested in a period that is fundamentally different than what they have lived through. And as you’re saying, three years can feel like a long time, especially with the roller coaster we just had with COVID, you know, it feels like we’ve been in five environments in a short period of time. But with a longer historical perspective and looking more broadly around the world, since 1980, it’s been, in some sense, one environment until COVID of deflation, lower and lower interest rates, continuous ability to stimulate. Sometimes you need to look at decades to see a real shift.
What I would highlight is if you said to me, “What’s the single most important thing that really feels different in a longer-term perspective?” I would say it is central bank constraint. We have really not seen a time where central banks had any constraints to get what they wanted. And so they could go all out, and we’re all really used to a place where you can say, if things go wrong, central banks can step in. And I would say for any mix of assets that you’re holding and hoping to make risk premiums on over time, it’s been a huge wind in the back that every time things go wrong, and the risk premiums start expanding and things start going down, and you have a wealth effect, central banks can say, “Let me go solve that problem. I don’t want this problem. I’m not constrained.” And that means they kept coming up with more and more creative tools to solve the problem.
So they used the interest rates. Then you get the financial crisis. They say let’s print money, and we all say, “Wow, printing money is really effective. Look at the impact that it had.” You get 10 years after printing money and it’s like, “Wait a minute, there are also downsides to printing money,” which is you’re printing money and buying bonds. That’s going into the financial markets, that’s exacerbating inequality. And COVID hits, and they can really shift their paradigm again to say, “OK, well, again, nothing is stopping us. COVID hit. We don’t like this. We don’t want a slowing economy. So let’s come up with an even more creative tool.” And they revived the tool that hadn’t existed since the war period of basically saying, “We’re not only going to print money, we’re going to work with the fiscal authorities to direct it to people who need it. So we’re going to print money and literally put it in people’s pockets in different ways”—in Europe, more by augmenting their paychecks; in the US, by just literally sending them checks to go use. And we’ve called this Monetary Policy 3, or the third iteration of monetary policy after interest rates and quantitative easing.
But all of this is under the assumption of one environment, which is the central bank sees a problem, solves it; sees a problem, solves it. Growth falls, they can solve it. And when we build our read of how constrained are central banks, they just haven’t been constrained in a very long time—until now. Now they look extremely constrained in most countries around the world, as constrained as they haven’t looked since about the ’70s, for the simple reason that they want more than they can have. They want multiple things at once that just can’t coexist.
And so today, if growth slows, and I believe it will—we’ve just tightened a lot. It doesn’t make a lot of sense to me that growth won’t slow, because all this tightening is coming down the pike. They’re going to say, “I don’t like growth slowing. I have a full employment mandate. At the same time, inflation is not where I want it to be.” Then if it falls from a cyclical perspective, it’ll stay, I don’t know, at 4% or so—not their target. And now I have to choose. Am I willing to keep hurting the economy to engineer a deeper recession, or am I willing to live with inflation that’s higher than I wanted, knowing that it could get out of control? So now I’m feeling real constraints. Now it’s actually very hard.
And you’ve seen that happen first in places like Europe and the UK, which we can talk about in the context of the energy crisis. I think it will increasingly happen in the US as well, and we’re not at the peak of it yet. Right now, the Federal Reserve is still seeing some pretty great growth numbers. And so they’re not feeling between a rock and a hard place. They’re mostly seeing an inflation problem. I think we’re going to get to a spot where they just can’t have everything they want at once. And what that means for an investor is that the savior is not there anymore. It’s OK for assets to do terribly for a long period of time because central banks just can’t get all the things that they want at once. That’s probably the biggest change in what the environment is like and really something we haven’t seen in quite a few decades.
ALEX SHAHIDI
One of the questions that I’m getting here is 60/40 framework is the conventional portfolio. And obviously that allocation doesn’t have any inflation hedges in it. How can investors who use 60/40 as a reference point, because that’s what they have been used to the last couple of decades, how do they practically make changes to their portfolio to account for some of the risks that you described earlier?
KAREN KARNIOL-TAMBOUR
Well, you said it totally right. 60/40, the biggest problem with it is that both stocks and bonds don’t do well when inflation rises. I always say I think the easiest thing investors can do if you’re starting with a 60/40 reference point is just change some of your nominal bonds to inflation-linked, because you’re already comfortable having bonds and what you know is that if inflation prints exactly what’s expected today, if CPI prints exactly what’s expected, you’re going to make the same. You’re going to break even. It’s going to make no difference whether you are in an inflation-linked bond or nominal bond, you’ll make the same. And when you look at what is that breakeven level—what’s called breakeven inflation—it’s not very high inflation. And so if you just make that switch, you pretty much will make the same amount of money if inflation is what it’s expected to be, which is pretty tame, and if it’s above that, you’ll just get paid out whatever CPI is holding those inflation-linked bonds.
And so to me, that’s probably the easiest switch that can be done in the context of starting in 60/40 is to say, “Listen, I’m just going to take some of my bonds and make sure they just pay me out whatever CPI is, because that way, I just know I’ll get paid inflation. I can’t kind of have a problem if inflation comes out higher than expected on my bonds at least.” That doesn’t mean that you’re immune to anything in this environment. There’s still a stream of cash flows that can fall in value just like other bonds. But you’ll break even on what you already hold if inflation is as tame as sort of expected.
And then the more challenging thing is starting to think about inflation hedges that are either leaning more into commodity-producing equities, so you’re getting the more direct pass-through of what are the parts of the economy the most likely to have inflation, going more directly into redenominating into things like gold. That’s where it is trickier because it’s going to be a little further into people’s investment mandates and then you start getting into questions of, well, what are all the ways inflation could show up in the economy, and do I want to be concentrated in one or the other or do I want to have broad exposure?
ALEX SHAHIDI
It is pretty remarkable that I’m sure inflation is one of the most googled terms now in finance. And it’s talked about that it’s the highest inflation in 40 years. It’s the biggest concern of central bankers. And yet there aren’t many inflation hedges in portfolios, at least in portfolios that I see. So there’s a lot of talk about high inflation and concerns about inflation, but investors, generally speaking, aren’t doing much about it in terms of their allocation. And at the same time, markets are discounting inflation to go from 8% or 9% that we have today down to 2% and change next year, which seems very optimistic. So it is interesting how there is that disconnect.
KAREN KARNIOL-TAMBOUR
Absolutely. And I think it’s because it’s, as an investor, more comfortable sometimes to buy assets that have gone up recently rather than ones that are well-valued precisely because they haven’t. And so if you take the example I noted of inflation-linked bonds, if the markets have already said, “Look, obviously this inflation is here to stay and it’s not going anywhere,” then breakeven inflation would already be really high. In other words, interest rates have risen a lot and you’d say, “Well, I don’t really know if I break even between holding the nominal bonds and inflation-linked bonds. It’s pretty high inflation that’s already expected.” But precisely because the market hasn’t done that, you haven’t seen any good performance. It’s not like you’ve made so much money holding these bonds, so there isn’t any performance-chasing that’s going on there. But that means that pricing is actually ripe to be able to pay you if that view does change going forward.
I totally agree with you. It’s just the fact that for so many years, inflation has been a nonissue. So it just hasn’t been high on people’s lists of what to look for.
ALEX SHAHIDI
So let’s zoom in a little bit on this tightening environment. You alluded to it a little bit earlier. So you’ve had rapidly rising interest rates. So the risk-free rate just went from zero, and it’s heading toward 5% or so based on market discounting. And so all assets face a material headwind during that environment. So why should investors even take risk in a period like this? Why shouldn’t they just put their money in a money market, get whatever that risk-free yield is, and then wait until the tightening ends? Is there is a reason to stay fully invested in an environment like this?
KAREN KARNIOL-TAMBOUR
I mean, I think the hardest thing as an investor is separating your confidence in what the environment will be like. Not taking too big of a bet based on your read of conditions. Because I look at Bridgewater, and we have 45 years of experience, a lot of really deep research that we’re building on, a very long track record. And the reality is any view we have is, I don’t know, 55% likely to be right. And when you look at what it’s like to just go and get underinvested, just go to cash, especially if you have a balanced portfolio, it’s very, very hard to time that well. And that is just one investment bet, just like any other investment bet would be, that you can be world-class and have a 55% chance of being right. It’s very, very hard not to leave money on the table if you are trying to make that sort of timing.
So for most investors, I would say you just want to be thoughtful about how big of a bet are you willing to take that you sort of know what the environment would be like so confidently that you want to take money off the table.
Now, I do think it is a really good time to allocate toward more alpha because of the concern about the environment, in the sense that if you think you have access to timing the market, now is a good time to be looking at doing that, especially if you think it’ll be good in this environment. But just going to cash is very, very hard to time well, and it’s just one of many views, so you don’t want to over-dominate your portfolio with that. I’ll say, yes, it has definitely been one of the worst times we’ve seen to be invested in assets. And going forward, I don’t think it looks great, but it also looks in some sense less bad than it did, because a lot of assets already have repriced.
And so if you look at where the interest rates are, to get another move that’s as bad for assets as the one you just got, you’d have to get a move as big, a tightening as big in interest rates, and that seems less likely to me, while possible—and you don’t want to have any one view dominate your views—you did just get such a big, historic move, that to hurt all assets as much as you just hurt them in this year of 2022 would be hard to do. That said, any individual asset can definitely be hurt that much, which is why you don’t want to be concentrated.
So I’ll give the example of just stocks and bonds, which is I just think stock and bond pricing can’t coexist. They just can’t coexist because, to me, either inflation will not come down as much as expected, in which case you’re going to have to go and engineer a slowdown. So equities will have to fall. In other words, growth will have to be weaker, and we’ll have to have a much bigger earnings slowdown than is currently expected and equities will do badly. Or the Federal Reserve will say, “Don’t worry, I’m not going to hurt the economy, but I will live with higher inflation,” in which case it would be a really bad time for bonds, because more inflation will get priced in that currently is expected to go away.
It seems impossible to me that both magically inflation goes away and at the same time you don’t have any kind of slowdown. It doesn’t seem like it could possibly work based on many decades of economic history. You need an economic slowdown to get inflation to come down as much as is expected in bond markets.
And so if you look at that and you say, “OK, well, stock and bond pricing can’t coexist. So I can have my view of which one of them is more likely to be right.” But what I really don’t want to be is overly concentrated in one asset, which is usually, for people, equities. If I had a more balanced portfolio, now my risk is more something structural, like the full path of interest rate changing like what happened in 2022. And while that could happen again, happening as badly as it did in 2022 seems a lot less likely because it’s been such a historically large move already.
Chapter 3: The Energy Crisis and ESG
ALEX SHAHIDI
Why don’t we transition to our third topic of the energy crisis, particularly in Europe, and ESG investing in general? Obviously, Europe is facing very weak growth, the highest inflation in decades. How do you see them coming out of this crisis?
KAREN KARNIOL-TAMBOUR
Well, I think for Europe, they had a structural shock in competitiveness that, in some sense, you don’t, quote, “come out of.” Even if you get through this winter, you’re still in a place where it’s just going to be more expensive to produce things in Europe, because energy prices will stay higher in Europe than elsewhere. So certain industries are just not going to be as competitive in Europe as they were prior to this. And it’s not that different than, say, the UK going through Brexit where you realize that’s a shock, that’s a material change over the medium to long term in terms of what’s competitive in the UK economy. Those are very tough shocks for central banks to deal with because it’s a real shock to the productive capacity of the economy.
So in that sense, I don’t think Europe is, quote, “coming out of it.” I think the great thing that’s happening in Europe is that this is helping Europeans realize, wait a minute, all of this energy stuff, it takes real time and planning. You can’t just sort of cut it off, turn it on. You need to think through incentives and planning through many years and decades. And Europe is very, very, very committed to saying we should decarbonize. They’re very, very, very committed to saying we can curb climate change.
And what that means is that in the near term, they might have to use whatever energy comes their way. It’s a shortage. But medium to long term, they’re realizing that means we have to plan, we have to set ourselves up to have the kind of energy supply that we want for many years to come. Starting today with what are we going to bake in the cake? And energy really does get baked in the cake when you’re in these crises, right? When supply is tight and you have a problem, that’s when there’s incentive to go invest. And the question is, what are you investing in to bring online in the next decade or two based on the pricing today? And so I think Europe is preparing well to say let’s put all the incentives in place to basically build the kind of energy system we want for many years ahead rather than be stuck in this problem over and over again.
The thing that is, again, really tough is that in the United States, we’re not really dealing with kind of painful stagflation. In Europe, it’s very literal stagflation, because you’re getting higher energy prices and it doesn’t matter how high they go, you just literally can’t ration enough to get enough energy to power the economy. So by definition, the economy has to slow and prices are going to go up: stagflation, rising prices and falling growth at the same time because of this crisis. And so that’s a very acute short-term problem that’s then hopefully spurring the medium- to long-term thoughts of how do we build the kind of energy system we want.
ALEX SHAHIDI
So on that train of thought, if we were to zoom out a little bit, and you look at how humanity is trying to tackle climate change, what’s your sense about, generally speaking, what are we getting right? What are we getting wrong?
KAREN KARNIOL-TAMBOUR
Well, the hardest thing is that humanity is obviously not coordinated. It’s not one thing. And you see this in things like COP. I mean, these are lots of players, each with their own interests. It’s not like there’s some business plan for humanity to get out of this. And that means that, by definition, it’s not ever going to be some smooth path. Because it’s not like there’s one plan that powers it all that kind of brings it all together and makes sense. And so you should expect that it’s going to be messy and chaotic.
I think the biggest problem with how it’s been approached is that, in some sense, it was easier to put some pressures in place that led to having an energy supply problem. And so a good example is it’s easier for investors to say, “Well, I don’t want to finance coal anymore.” That doesn’t mean that you’re making sure that you are financing greener energy to replace that coal on the other side. That means you’re not financing coal. So you’ve had a lot of the efforts at curbing climate change be ones that kind of shut off certain energy sources without necessarily contributing to what’s coming out the other end at the same time.
And then, because policy makers are not coordinated and often policy takes a very long time, you also get a paralysis of not knowing where policy is going. You see this in the United States very clearly, with a lot of energy companies saying, “I just don’t understand where regulation is going. It’s a little better after the latest Biden bill, but I’m just not going to invest in any direction because I’m not sure what incentives are going to be set up here.” So you get this paralysis. Meanwhile, that’s another case where you just don’t have enough coming online.
So even before Russia ever invaded Ukraine, you were setting up the situation where you’ve had underinvestment for a really long time in energy from a combination of factors. And some of them have to do with how climate change is being tackled. Some of them are other factors I could talk about, but you’ve kind of set yourself up to say there just won’t be enough energy, which then, of course, causes prices to go up and causes stagflationary pressure that you can’t get enough. And the biggest problem with that is then what you take from that is, “OK, well, I just can’t even solve climate change anymore because I can’t think about this. I’ve got to go solve my energy problem.” So you can lose focus on the goal.
Stepping back, I think if you’re basically saying, look, there’s two broad ways to solve the fact that we need to rely less on fossil fuels. You could make the fossil fuels more expensive, tax them, make them really discouraged in some way or another. Or you could take the things you want instead and basically put carrots around them, make them really attractive, and so on and so forth. And the classic economist answer has always been, of course, just tax the thing you don’t like, right? You can have pollution and you can have this polluting thing that its full costs aren’t being priced in, just put the cost on and then the market will adjust in, quote, “the most efficient way.” And while that’s theoretically really beautiful, it’s never been politically popular, and I think in an environment of rising inflation, it becomes completely impossible. You already have rising inflation; you’re going to add taxes and increase the prices further of things that are already expensive? That seems very unlikely.
So I think the smart shift that we see happening, especially in the United States in Biden’s bill but also elsewhere, is to say, “OK, especially in this inflationary environment, we have to go incentivize the things we want.” We have to go say, “Let’s make the playing field at least even,” because we currently subsidize a lot of fossil fuels, but ideally, more than even. Ideally, we would go and say, “Here are all the incentives we’re going to give you to go move toward the stuff that we’d like to see over time.” And I think that’s going to be kind of our best path.
ALEX SHAHIDI
And that may take some time, I assume.
KAREN KARNIOL-TAMBOUR
Absolutely, because a lot of these things take many years to come online. They’re not something where you can kind of just flip a switch. And investors, I think, have to be practical and thoughtful about what kind of transition do you want that makes sense.
An example I always give is that, when you look at natural gas, a lot of the piping, the physical piping of natural gas can then later be transitioned to even greener forms of energy. And so being religious to say natural gas is not perfect is not very helpful if you’re saying, actually, going from coal to natural gas can be a hugely helpful step, because already you’ve got a lot less emissions than you do with coal. And then you can actually reuse a lot of that infrastructure when you go even greener later on.
So, you have to be thoughtful about where we’re going on a multiyear timeline and how long it takes to build out the infrastructure. And we’ve gotten back to the discussion of the paradigm shift. We’ve gotten used to a world where Instagram gets created as a company and like with a couple of employees and very, very quickly, our world is different. And that’s not how physical infrastructure works. That’s just not how physical infrastructure works. These are much longer investment cycles and choices we make. And once you bake something in the cake—another example I give a lot, which is if you want to actually switch to things like electric vehicles and solar panels and so on, you need to source all the physical materials to make them. And it’s not like you can just flip a switch and you have all the copper in the world. Starting a mine takes time, and you have to actually set it up. And so if you underinvest in some of these things, all the desires in the world won’t help you if you literally can’t make the physical materials you need to go make the transition. And some of these mean very long lead times, and there isn’t a central planner for the world. And so it takes thoughtful incentives.
ALEX SHAHIDI
I have one final question. There’s obviously been a proliferation of ESG strategies and indexes. In your view, what are some of the biggest flaws you’re seeing with the way these are constructed?
KAREN KARNIOL-TAMBOUR
Wow. Well, sometimes I want to say don’t get me started. But no, I think that, look, it’s an industry in its infancy in some sense. And so you’re going to see the natural evolution of things evolving from simple to more complex, sophistication rising, and so on and so forth. But I’d say the early iteration, you saw a lot of things being titled ESG that were so similar to their original index, you’d have to squint to see any possible difference. And so, you can call it what you want, but in my view, if you’re not changing what you’re holding at all, I don’t know if you deserve a special label. And so that’s shifting through time, investors getting more sensitive to saying, “I think I care where my money’s going. It’s going into the exact same place. What could that possibly mean?”
And then now, I think one of the weaknesses is that there’s been such a focus on supporting governments in their attempt to get to net zero and reduce emissions. But there can be confusion about what it means to do that in a portfolio context. And I’ll give you one extreme example, which is there’s just a lot of companies in the world that don’t have much to do with emissions, like amazing companies that make medicines. They don’t naturally emit very much carbon. They don’t pollute very much. Obviously, they’re connected to electricity, but they don’t really control exactly what electricity source they get to use. They’re just not that connected to the problem. So if you just said, “I just want to hold my portfolio with lots of companies that have nothing to do with climate change,” you can have amazing numbers on emissions, but you’re not really related to the problem at all. You’ve just sort of avoided it and gone into parts of the economy that don’t have to do with it. And so, anything that’s a simplistic “let me just tell you one number”—like “let me tell you your final emissions number”—it might be kind of self-defeating related to what the goals are.
So my general thought is I think investors are honing their understanding of what are my goals, what am I really trying to do? And financial products are being created in response that are going to get more sophisticated as they better understand what are these investors really trying to do, and what can I engineer that actually truly meets the goals that they have?
ALEX SHAHIDI
Karen, you’ve been very generous with your time. I appreciate all your insights. I enjoyed the conversation. I hope our listeners did as well. So thank you for being here.
In this discussion, which was part of the recent Advisor Perspectives Investment Insights Summit, Karen describes why she thinks we are in a new era of persistently higher inflationary pressures, how investors can prepare their portfolios for this new environment, and the short-term and long-term challenges facing Europe due to higher energy prices. She also talks through some of the pitfalls of current efforts to tackle climate change and create a clean energy transition, and her thoughts on the state of ESG investing.
Transcript
Note: This transcript has been edited for readability.
“If you said to me, ‘What’s the single most important thing that really feels different?’ I would say it is central bank constraint. For any mix of assets that you’re holding, it’s been a huge wind in the back that every time things go wrong, and the risk premiums start expanding and things start going down, and you have a wealth effect, central banks can say, ‘Let me go solve that problem.’ But all of this is under the assumption of one environment, which is the central bank sees a problem, solves it. Growth falls, they can solve it. Now they look extremely constrained in most countries around the world, as constrained as they haven’t looked since about the ’70s, for the simple reason that they want more than they can have. They want multiple things at once that just can’t coexist.” — Co-CIO for Sustainability Karen Karniol-Tambour
JIM HASKEL
I’m Jim Haskel, editor of the Bridgewater Daily Observations. Our listeners might remember our podcast a little while back with Ray Dalio and Jeremy Grantham, and that was co-moderated by one of our clients and friends, Co-CIO of Evoke Advisors Alex Shahidi. Recently, as part of this year’s Advisor Perspectives Investment Insights Summit, Alex had the opportunity to sit down with Bridgewater Co-CIO for Sustainability Karen Karniol-Tambour. And we’re sharing an edited version of that conversation in today’s Daily Observations, because we really thought it was quite good.
You’ll hear Karen describe why she thinks we’re in a new era of persistently higher inflation, how investors can prepare their portfolios for this new environment, as well as the short-term and long-term challenges facing Europe due to higher energy prices. Karen also talks through some of the pitfalls of the current efforts to tackle climate change and create a clean energy transition, and she also shares thoughts on the state of ESG investing.
So, with that, let’s get right into the conversation with Karen Karniol-Tambour and Alex Shahidi.
…
ALEX SHAHIDI
Hi, everyone. I’m Alex Shahidi, co-CIO of Evoke Advisors, which is a large RIA in Los Angeles, and one of my core responsibilities as co-CIO is to identify the investment managers we can find to allocate our client assets to. And about 15+ years ago, I came across Bridgewater, which is the largest hedge fund in the world, and I’ve had the privilege to meet most of their senior professionals. And one person that has really stood out to me is Karen Karniol-Tambour. Thank you for joining us today, Karen.
KAREN KARNIOL-TAMBOUR
So great to be here, Alex. Thanks for having me.
ALEX SHAHIDI
Why don’t we dive into the key topics that we’re going to cover today? The first is inflation and interest rates. This is the big topic today. Everybody’s talking about it. Second, we’ll dive into, given the unique environment in which we live, how should investors think about investing, given the current landscape? And then third, we’ll move into the energy crisis, particularly in Europe, and ESG investing.
Chapter 1: Inflation and Interest Rates
ALEX SHAHIDI
So, inflation and interest rates. Obviously, we’re at the highest inflation in 40 years. But if we zoom out a little bit, I think it’s helpful to think in terms of long-term environments. So if you go back to 1982 all the way until 2008, it was basically one type of environment. We had falling interest rates, falling inflation—called disinflation. Then 2008 happened. We had the global financial crisis. Until the COVID period, we had an environment of slow growth and massive stimulus. And now there’s a consideration of maybe we’re at a new major inflection point. Would you describe how you see that? Are we at a new inflection point, or is this just a blip and we’re going to head back down toward that zero-interest-rate environment?
KAREN KARNIOL-TAMBOUR
I believe we really are at an inflection point, where the years ahead will have a different inflationary backdrop to what happened since the ’80s, and you described it so well. And I think you can think about inflation as sort of having two waves. It has the secular pressure, what happens over decades of time. And those are slow-moving, gradual pressures. And then there’s the regular cyclical stuff, which is obviously, as the cycle goes up and down, that pressures inflation up and down.
So it doesn’t mean that if we’re in a paradigm shift, that you’re not going to have ups and downs in inflation. For example, right now we just recently had a better CPI print that was lower, because you do have some downward pressures on inflation that are cyclical. But from a secular perspective, I think it’s kind of a hard break with what you’ve seen for so many years. And you just had a lot of pressures that were very deflationary, that were in the system and very slow-moving.
One way of thinking about those pressures is that a lot of decisions were able to be made by entities all around the world with the purpose of getting more efficient and reducing costs. So if you go and you outsource your workers to China and all of China comes online, you’re spending money to literally make things cheaper. So globalization, outsourcing, all of these things, these were multiyear processes, multidecade processes that kept lowering and lowering and lowering prices in a way that was very efficient, productive. Companies were doing it because they would say, “I want to move my costs over there because it will be cheaper.”
At the same time, you had this big wind at the back of less power for employees, less labor unions, less anti-competitiveness regulation, less antitrust, more and more things that allowed prices to keep coming down and more and more to go into profits. Big, big, big forces in this direction. And what’s happening today is you’ve kind of let this run its course. There aren’t a lot of pressures that can keep lowering and lowering prices.
One exception to that could be the pace of technological development, which, while it has been very deflationary for many decades, we don’t really know what’s going to happen with it going forward. But I think it’s hard to believe that you’re going to get the same kind of deflationary pressures from technology that you have for the last 40 years. Just look at what technology was like in the ’80s.
At the same time, there are a lot of new pressures that are actually highly inflationary. And so, I’ll start with the ones that are just the flip side of “let’s spend money and do things like outsource.” If you look at what companies want to spend money on today, usually there’s not an impetus to say, “I’m spending money on something that I know is going to lower my costs.” Companies are saying things like, “I need my supply chain to be more resilient.” What does that mean? That means I’m double doing my supply chain. I’m spending money on something that’s not going to make me give you cheaper prices. I just need to—because I’m worried about geopolitical conflict. I’m worried about whether I can get to China. I’m worried about tensions like that.
They’re spending money on things like decarbonization because they have pressures to do so. That’s long-term productive for the economy, but it certainly doesn’t lower their costs tomorrow the way that outsourcing for cheaper labor does. And so you have these pressures to spend on defense, national security, decarbonization—goals that are maybe very important for society but don’t lower your prices automatically, don’t lower your prices immediately, and become more inflationary than that. And then, at the same time, the degree of what’s happened to social pressures, the fact that inequality has gotten where it has, and whatnot, means that the power of labor is increasing again. You really can’t get the same push in de-unionization that you had. You can’t go from a lot of unions to zero again because you’re at zero, but you’re getting pressures the other way, both politically in terms of what policy makers are doing and how they think about inequality.
So there’s a lot of inflationary pressures built up, and it’s coming out of a time that you’ve also generated a huge, huge, huge boom coming out of COVID that was engineered in a way that people literally got the money into their pockets so they could spend it extremely directly and create very strong demand. So those are very long-term pressures, where the pressures we had for so many years to get extremely low inflation, I think, are just behind us. And now you’ll be in a paradigm where, at the very least, inflation is volatile. It’s not just sort of stuck where it is, never moves, because we start getting wage gains, they get sticky, and then that gets passed on, and so on and so forth. And so it’s just very unlikely to me that you’ll see another couple of decades of very, very low, stable, sticky inflation that, honestly, just doesn’t matter very much for investors.
ALEX SHAHIDI
So one of the questions that we’re getting is, what about all the debt that the US economy is saddled with? You know, corporate, government debt obviously has ballooned, household debt, and you look back over the last 100 years, we’re at very high levels, debt to GDP. What type of deflationary pressure does that pose? And how do we know that the inflationary secular trends that you just described outweigh those deflationary pressures?
KAREN KARNIOL-TAMBOUR
Well, I think that the debt question is very real, because the United States has gone through some degree of deleveraging. So a lot of the most over-levered pockets are not there anymore, which sort of allows for these dynamics to happen. But part of what’s kept that under control, to be honest, is the market hasn’t believed yet that inflation is going to be a long-term problem. So you have high debt levels, right? The best thing that could possibly happen to you is if you have inflation today but the market doesn’t believe it will be sustained, because then what happens is that today your inflation kind of disappears. If you have 10% inflation a year, your debt becomes less and less important, because the debt is getting inflated away. But what typically tends to happen, especially in emerging markets, is if the markets say, “Wait a minute, 10% inflation a year, that means I have to charge that in interest rates.” So interest rates start rising. You can’t roll over your debt. And in the long term, people expect and demand to get paid back for that 10% inflation.
We’ve kind of been in this beautiful sweet spot where the debts can keep falling, because somehow interest rates don’t actually rise in line with the inflation. In other words, very negative real interest rates and the firm belief investors have that “Inflation, don’t worry, it’s going back to where it was.” So the key question is, at the point where that turns and interest rates really start rising and make it difficult to roll the debts and become a problem for indebted entities in a way that hasn’t happened materially yet, what are the indebtedness levels going to be then, and how levered are these entities? How big of a deal is it that they run into a debt problem?
And I think in the United States, the answer is not huge. We’ve had some real deleveraging, and this period of high inflation without high interest rates has further brought the debt burdens down. So a lot of the most risky balance sheets are in the best shape they’ve been in so many decades, despite the debt. That’s not true everywhere around the world. And you see strains emerging in pockets of places: Korea, we’ve got China’s deleveraging. Places where there hasn’t been a material deleveraging or any rise in interest rates very quickly starts cutting into the problem that these are very indebted entities that can’t easily handle it.
And I mean, that’s basically what happened in 2008 in the United States. So we know that script. We know what happens when you have a very overindebted economy. Interest rates rise, not even that much, but debts just reach their limit, need to reverse. It’s not where the US is today anymore but depending on how fast the market decides that inflation is here to stay, it could become a problem.
ALEX SHAHIDI
Yeah, that makes a lot of sense. In some ways, it’s kind of similar to the early ’70s in that regard, right? With the view that inflation is transitory and maybe it lasts for a prolonged period.
KAREN KARNIOL-TAMBOUR
Extremely similar. I think there’s a lot of similarities, because you go into the early ’70s and there isn’t a salient memory for investors of what that’s like. And at the same time, no policy maker loves the idea of cutting off growth. And so, if the market’s not believing that inflation is going to be a big problem, you don’t really want to cut off growth. What ends up happening is it takes a really long time to catch up with the reality of what inflation is. It doesn’t happen in one go. The market believes it won’t happen. If you look at the ’70s, the thing you see in terms of being an investor is, first of all, it takes years and years, where bond markets price in less interest rate rises than actually occur, constantly, for years and years.
So it’s not like inflation starts, markets get it, they say inflation is going to be high, that’s it, it all adjusts. Instead of that, it’s like over and over and over again, markets expect it’s not a big deal. Transitory. This is behind us. And interest rates have to rise more than expected, and you still get a cycle. It still goes up and down, because sometimes, the Fed does too much and they’re like, “Oh, no, we slowed the economy.” They change their minds. They do less. They realize inflation is not slowing as much as they wanted it to. It just takes time to realize that sort of new reality you’re in.
And then the second thing you see is equities are pretty much a disaster for reasons that are way bigger than what’s going on with the actual earnings of the companies. Some companies can actually pass on that inflation to their customers. But the risk premium you start demanding when inflation is volatile, and that’s the macroeconomic backdrop, is just higher. So it’s a very tough environment to be investing.
Chapter 2: Investing in the Current Environment
ALEX SHAHIDI
Yeah, so why don’t we transition to how should investors think about investing given the backdrop that you just laid out? Particularly, the part to me that really stands out is, for many years, actually decades, inflation was relatively stable. You didn’t have big surprises to inflation for a long time, but growth surprised to the upside and downside constantly. Now you have volatility in both growth and inflation. So given the volatile economic environment, just generally speaking, how should investors think about investing in a period like this?
KAREN KARNIOL-TAMBOUR
Well, I couldn’t agree more with what you’re saying, that the key issue for investors is that we’ve all lived and invested through a period where inflation was not volatile, and growth was very volatile. That means that we’ve gotten used to what the relationships are like that are driven by growth. If you basically step back and say, “What really drives the assets that you hold?” there are only a few cross-cutting forces that hit everything. There are obviously a lot of idiosyncratic things that happen in any individual assets, and I’m sure we’ll talk about energy afterward, geopolitical things, but across all the assets you’re holding, the big thing that really matters is sort of what happens in the economy, both how fast is the economy growing or growth and prices or the inflation, as well as sort of any future stream of cash flows—how are you discounting it to today?
So what’s the interest rate or the discount rate, which are discounting the cash flows, and how much risk premium are you charging on those? So those are very, very few factors that cut across a lot of assets. And the thing that can get confusing is that if you live through so many years, like we just did, where inflation is a nonissue, you never see what relationships are between assets when inflation is high and volatile. And the most obvious example is the stocks and bonds, where stocks and bonds have been such great diversifiers. When you think about it, the four factors I listed, actually three out of four stocks and bonds don’t diversify. So if you want a higher risk premium on any assets you hold, same for stocks and bonds. Obviously high interest rates, bad for both, and inflation, pretty bad for both of them. Growth is the only thing that really makes stocks and bonds diversifying, because when growth slows and you don’t have an inflation problem, you can cut interest rates, bonds can rally, while stocks can do badly because growth is slowing. And that pretty much is one of four. That’s just been the one thing that has really mattered.
So suddenly seeing yourself in a place where stocks and bonds are not diversifying is a big shock, I think, for a lot of investors, because we’ve lived through it for so many years, and that’s been kind of the most dominant relationship that we’ve had for a long time.
The other piece is just that I think a lot of the relationships we look at have been underpinned by whatever the experience was in the last 40 years and have just not been questioned. Another example I’ll give is, I think a lot of people start thinking of emerging markets as kind of just like a higher-beta version, a higher-risk version of what we have elsewhere. But that’s because emerging markets acted in a certain way in the environment that we were in. Not that they always have to be that way. In the last year or so, they haven’t been, because emerging markets have had a lot more inflation experience than us in the last 40 years. They were a lot more aggressive tightening into this and got less of a boom-bust cycle. It was less aligned with the countries you’d usually invest in because of their inflation experience.
So it kind of requires revisiting what actually underpins the relationships between the assets and debt I’m used to. And why do I think that’s going to sustain in a period that is just fundamentally different than the period that we came out of previously?
ALEX SHAHIDI
Yeah. And the part about what you just described that really stands out to me in working with clients is it seems like there’s a disconnect between what we investment professionals view as long term and the environments that play out versus what investors or clients think about. For us, I started off by saying 1982 to 2008 was basically one environment. That’s 26 years. For most people, one to three years is one environment. That was a long time. And so you could easily look at that and say, “Oh, this strategy worked for a long period of time,” as opposed to thinking of it in terms of, well, that was one environment in which it worked. In a very different environment, maybe it doesn’t work.
If you go back to the 1970s, I don’t think 60/40 was even a topic, because both the 60 and the 40 underperformed cash for a decade. I think that was more born out of the ’80s and ’90s bull market in stocks and bonds. So I think that’s part of the reason why there’s a disconnect. Does that make sense to you?
KAREN KARNIOL-TAMBOUR
Yeah, absolutely. You’re totally right. It’s a weakness in the fact that, even if we have systemized decision making, what’s emotionally salient to us is usually whatever we’ve lived through, and a more recent experience is just more emotionally salient. And so you just don’t have a lot of investors alive today that invested in a period that is fundamentally different than what they have lived through. And as you’re saying, three years can feel like a long time, especially with the roller coaster we just had with COVID, you know, it feels like we’ve been in five environments in a short period of time. But with a longer historical perspective and looking more broadly around the world, since 1980, it’s been, in some sense, one environment until COVID of deflation, lower and lower interest rates, continuous ability to stimulate. Sometimes you need to look at decades to see a real shift.
What I would highlight is if you said to me, “What’s the single most important thing that really feels different in a longer-term perspective?” I would say it is central bank constraint. We have really not seen a time where central banks had any constraints to get what they wanted. And so they could go all out, and we’re all really used to a place where you can say, if things go wrong, central banks can step in. And I would say for any mix of assets that you’re holding and hoping to make risk premiums on over time, it’s been a huge wind in the back that every time things go wrong, and the risk premiums start expanding and things start going down, and you have a wealth effect, central banks can say, “Let me go solve that problem. I don’t want this problem. I’m not constrained.” And that means they kept coming up with more and more creative tools to solve the problem.
So they used the interest rates. Then you get the financial crisis. They say let’s print money, and we all say, “Wow, printing money is really effective. Look at the impact that it had.” You get 10 years after printing money and it’s like, “Wait a minute, there are also downsides to printing money,” which is you’re printing money and buying bonds. That’s going into the financial markets, that’s exacerbating inequality. And COVID hits, and they can really shift their paradigm again to say, “OK, well, again, nothing is stopping us. COVID hit. We don’t like this. We don’t want a slowing economy. So let’s come up with an even more creative tool.” And they revived the tool that hadn’t existed since the war period of basically saying, “We’re not only going to print money, we’re going to work with the fiscal authorities to direct it to people who need it. So we’re going to print money and literally put it in people’s pockets in different ways”—in Europe, more by augmenting their paychecks; in the US, by just literally sending them checks to go use. And we’ve called this Monetary Policy 3, or the third iteration of monetary policy after interest rates and quantitative easing.
But all of this is under the assumption of one environment, which is the central bank sees a problem, solves it; sees a problem, solves it. Growth falls, they can solve it. And when we build our read of how constrained are central banks, they just haven’t been constrained in a very long time—until now. Now they look extremely constrained in most countries around the world, as constrained as they haven’t looked since about the ’70s, for the simple reason that they want more than they can have. They want multiple things at once that just can’t coexist.
And so today, if growth slows, and I believe it will—we’ve just tightened a lot. It doesn’t make a lot of sense to me that growth won’t slow, because all this tightening is coming down the pike. They’re going to say, “I don’t like growth slowing. I have a full employment mandate. At the same time, inflation is not where I want it to be.” Then if it falls from a cyclical perspective, it’ll stay, I don’t know, at 4% or so—not their target. And now I have to choose. Am I willing to keep hurting the economy to engineer a deeper recession, or am I willing to live with inflation that’s higher than I wanted, knowing that it could get out of control? So now I’m feeling real constraints. Now it’s actually very hard.
And you’ve seen that happen first in places like Europe and the UK, which we can talk about in the context of the energy crisis. I think it will increasingly happen in the US as well, and we’re not at the peak of it yet. Right now, the Federal Reserve is still seeing some pretty great growth numbers. And so they’re not feeling between a rock and a hard place. They’re mostly seeing an inflation problem. I think we’re going to get to a spot where they just can’t have everything they want at once. And what that means for an investor is that the savior is not there anymore. It’s OK for assets to do terribly for a long period of time because central banks just can’t get all the things that they want at once. That’s probably the biggest change in what the environment is like and really something we haven’t seen in quite a few decades.
ALEX SHAHIDI
One of the questions that I’m getting here is 60/40 framework is the conventional portfolio. And obviously that allocation doesn’t have any inflation hedges in it. How can investors who use 60/40 as a reference point, because that’s what they have been used to the last couple of decades, how do they practically make changes to their portfolio to account for some of the risks that you described earlier?
KAREN KARNIOL-TAMBOUR
Well, you said it totally right. 60/40, the biggest problem with it is that both stocks and bonds don’t do well when inflation rises. I always say I think the easiest thing investors can do if you’re starting with a 60/40 reference point is just change some of your nominal bonds to inflation-linked, because you’re already comfortable having bonds and what you know is that if inflation prints exactly what’s expected today, if CPI prints exactly what’s expected, you’re going to make the same. You’re going to break even. It’s going to make no difference whether you are in an inflation-linked bond or nominal bond, you’ll make the same. And when you look at what is that breakeven level—what’s called breakeven inflation—it’s not very high inflation. And so if you just make that switch, you pretty much will make the same amount of money if inflation is what it’s expected to be, which is pretty tame, and if it’s above that, you’ll just get paid out whatever CPI is holding those inflation-linked bonds.
And so to me, that’s probably the easiest switch that can be done in the context of starting in 60/40 is to say, “Listen, I’m just going to take some of my bonds and make sure they just pay me out whatever CPI is, because that way, I just know I’ll get paid inflation. I can’t kind of have a problem if inflation comes out higher than expected on my bonds at least.” That doesn’t mean that you’re immune to anything in this environment. There’s still a stream of cash flows that can fall in value just like other bonds. But you’ll break even on what you already hold if inflation is as tame as sort of expected.
And then the more challenging thing is starting to think about inflation hedges that are either leaning more into commodity-producing equities, so you’re getting the more direct pass-through of what are the parts of the economy the most likely to have inflation, going more directly into redenominating into things like gold. That’s where it is trickier because it’s going to be a little further into people’s investment mandates and then you start getting into questions of, well, what are all the ways inflation could show up in the economy, and do I want to be concentrated in one or the other or do I want to have broad exposure?
ALEX SHAHIDI
It is pretty remarkable that I’m sure inflation is one of the most googled terms now in finance. And it’s talked about that it’s the highest inflation in 40 years. It’s the biggest concern of central bankers. And yet there aren’t many inflation hedges in portfolios, at least in portfolios that I see. So there’s a lot of talk about high inflation and concerns about inflation, but investors, generally speaking, aren’t doing much about it in terms of their allocation. And at the same time, markets are discounting inflation to go from 8% or 9% that we have today down to 2% and change next year, which seems very optimistic. So it is interesting how there is that disconnect.
KAREN KARNIOL-TAMBOUR
Absolutely. And I think it’s because it’s, as an investor, more comfortable sometimes to buy assets that have gone up recently rather than ones that are well-valued precisely because they haven’t. And so if you take the example I noted of inflation-linked bonds, if the markets have already said, “Look, obviously this inflation is here to stay and it’s not going anywhere,” then breakeven inflation would already be really high. In other words, interest rates have risen a lot and you’d say, “Well, I don’t really know if I break even between holding the nominal bonds and inflation-linked bonds. It’s pretty high inflation that’s already expected.” But precisely because the market hasn’t done that, you haven’t seen any good performance. It’s not like you’ve made so much money holding these bonds, so there isn’t any performance-chasing that’s going on there. But that means that pricing is actually ripe to be able to pay you if that view does change going forward.
I totally agree with you. It’s just the fact that for so many years, inflation has been a nonissue. So it just hasn’t been high on people’s lists of what to look for.
ALEX SHAHIDI
So let’s zoom in a little bit on this tightening environment. You alluded to it a little bit earlier. So you’ve had rapidly rising interest rates. So the risk-free rate just went from zero, and it’s heading toward 5% or so based on market discounting. And so all assets face a material headwind during that environment. So why should investors even take risk in a period like this? Why shouldn’t they just put their money in a money market, get whatever that risk-free yield is, and then wait until the tightening ends? Is there is a reason to stay fully invested in an environment like this?
KAREN KARNIOL-TAMBOUR
I mean, I think the hardest thing as an investor is separating your confidence in what the environment will be like. Not taking too big of a bet based on your read of conditions. Because I look at Bridgewater, and we have 45 years of experience, a lot of really deep research that we’re building on, a very long track record. And the reality is any view we have is, I don’t know, 55% likely to be right. And when you look at what it’s like to just go and get underinvested, just go to cash, especially if you have a balanced portfolio, it’s very, very hard to time that well. And that is just one investment bet, just like any other investment bet would be, that you can be world-class and have a 55% chance of being right. It’s very, very hard not to leave money on the table if you are trying to make that sort of timing.
So for most investors, I would say you just want to be thoughtful about how big of a bet are you willing to take that you sort of know what the environment would be like so confidently that you want to take money off the table.
Now, I do think it is a really good time to allocate toward more alpha because of the concern about the environment, in the sense that if you think you have access to timing the market, now is a good time to be looking at doing that, especially if you think it’ll be good in this environment. But just going to cash is very, very hard to time well, and it’s just one of many views, so you don’t want to over-dominate your portfolio with that. I’ll say, yes, it has definitely been one of the worst times we’ve seen to be invested in assets. And going forward, I don’t think it looks great, but it also looks in some sense less bad than it did, because a lot of assets already have repriced.
And so if you look at where the interest rates are, to get another move that’s as bad for assets as the one you just got, you’d have to get a move as big, a tightening as big in interest rates, and that seems less likely to me, while possible—and you don’t want to have any one view dominate your views—you did just get such a big, historic move, that to hurt all assets as much as you just hurt them in this year of 2022 would be hard to do. That said, any individual asset can definitely be hurt that much, which is why you don’t want to be concentrated.
So I’ll give the example of just stocks and bonds, which is I just think stock and bond pricing can’t coexist. They just can’t coexist because, to me, either inflation will not come down as much as expected, in which case you’re going to have to go and engineer a slowdown. So equities will have to fall. In other words, growth will have to be weaker, and we’ll have to have a much bigger earnings slowdown than is currently expected and equities will do badly. Or the Federal Reserve will say, “Don’t worry, I’m not going to hurt the economy, but I will live with higher inflation,” in which case it would be a really bad time for bonds, because more inflation will get priced in that currently is expected to go away.
It seems impossible to me that both magically inflation goes away and at the same time you don’t have any kind of slowdown. It doesn’t seem like it could possibly work based on many decades of economic history. You need an economic slowdown to get inflation to come down as much as is expected in bond markets.
And so if you look at that and you say, “OK, well, stock and bond pricing can’t coexist. So I can have my view of which one of them is more likely to be right.” But what I really don’t want to be is overly concentrated in one asset, which is usually, for people, equities. If I had a more balanced portfolio, now my risk is more something structural, like the full path of interest rate changing like what happened in 2022. And while that could happen again, happening as badly as it did in 2022 seems a lot less likely because it’s been such a historically large move already.
Chapter 3: The Energy Crisis and ESG
ALEX SHAHIDI
Why don’t we transition to our third topic of the energy crisis, particularly in Europe, and ESG investing in general? Obviously, Europe is facing very weak growth, the highest inflation in decades. How do you see them coming out of this crisis?
KAREN KARNIOL-TAMBOUR
Well, I think for Europe, they had a structural shock in competitiveness that, in some sense, you don’t, quote, “come out of.” Even if you get through this winter, you’re still in a place where it’s just going to be more expensive to produce things in Europe, because energy prices will stay higher in Europe than elsewhere. So certain industries are just not going to be as competitive in Europe as they were prior to this. And it’s not that different than, say, the UK going through Brexit where you realize that’s a shock, that’s a material change over the medium to long term in terms of what’s competitive in the UK economy. Those are very tough shocks for central banks to deal with because it’s a real shock to the productive capacity of the economy.
So in that sense, I don’t think Europe is, quote, “coming out of it.” I think the great thing that’s happening in Europe is that this is helping Europeans realize, wait a minute, all of this energy stuff, it takes real time and planning. You can’t just sort of cut it off, turn it on. You need to think through incentives and planning through many years and decades. And Europe is very, very, very committed to saying we should decarbonize. They’re very, very, very committed to saying we can curb climate change.
And what that means is that in the near term, they might have to use whatever energy comes their way. It’s a shortage. But medium to long term, they’re realizing that means we have to plan, we have to set ourselves up to have the kind of energy supply that we want for many years to come. Starting today with what are we going to bake in the cake? And energy really does get baked in the cake when you’re in these crises, right? When supply is tight and you have a problem, that’s when there’s incentive to go invest. And the question is, what are you investing in to bring online in the next decade or two based on the pricing today? And so I think Europe is preparing well to say let’s put all the incentives in place to basically build the kind of energy system we want for many years ahead rather than be stuck in this problem over and over again.
The thing that is, again, really tough is that in the United States, we’re not really dealing with kind of painful stagflation. In Europe, it’s very literal stagflation, because you’re getting higher energy prices and it doesn’t matter how high they go, you just literally can’t ration enough to get enough energy to power the economy. So by definition, the economy has to slow and prices are going to go up: stagflation, rising prices and falling growth at the same time because of this crisis. And so that’s a very acute short-term problem that’s then hopefully spurring the medium- to long-term thoughts of how do we build the kind of energy system we want.
ALEX SHAHIDI
So on that train of thought, if we were to zoom out a little bit, and you look at how humanity is trying to tackle climate change, what’s your sense about, generally speaking, what are we getting right? What are we getting wrong?
KAREN KARNIOL-TAMBOUR
Well, the hardest thing is that humanity is obviously not coordinated. It’s not one thing. And you see this in things like COP. I mean, these are lots of players, each with their own interests. It’s not like there’s some business plan for humanity to get out of this. And that means that, by definition, it’s not ever going to be some smooth path. Because it’s not like there’s one plan that powers it all that kind of brings it all together and makes sense. And so you should expect that it’s going to be messy and chaotic.
I think the biggest problem with how it’s been approached is that, in some sense, it was easier to put some pressures in place that led to having an energy supply problem. And so a good example is it’s easier for investors to say, “Well, I don’t want to finance coal anymore.” That doesn’t mean that you’re making sure that you are financing greener energy to replace that coal on the other side. That means you’re not financing coal. So you’ve had a lot of the efforts at curbing climate change be ones that kind of shut off certain energy sources without necessarily contributing to what’s coming out the other end at the same time.
And then, because policy makers are not coordinated and often policy takes a very long time, you also get a paralysis of not knowing where policy is going. You see this in the United States very clearly, with a lot of energy companies saying, “I just don’t understand where regulation is going. It’s a little better after the latest Biden bill, but I’m just not going to invest in any direction because I’m not sure what incentives are going to be set up here.” So you get this paralysis. Meanwhile, that’s another case where you just don’t have enough coming online.
So even before Russia ever invaded Ukraine, you were setting up the situation where you’ve had underinvestment for a really long time in energy from a combination of factors. And some of them have to do with how climate change is being tackled. Some of them are other factors I could talk about, but you’ve kind of set yourself up to say there just won’t be enough energy, which then, of course, causes prices to go up and causes stagflationary pressure that you can’t get enough. And the biggest problem with that is then what you take from that is, “OK, well, I just can’t even solve climate change anymore because I can’t think about this. I’ve got to go solve my energy problem.” So you can lose focus on the goal.
Stepping back, I think if you’re basically saying, look, there’s two broad ways to solve the fact that we need to rely less on fossil fuels. You could make the fossil fuels more expensive, tax them, make them really discouraged in some way or another. Or you could take the things you want instead and basically put carrots around them, make them really attractive, and so on and so forth. And the classic economist answer has always been, of course, just tax the thing you don’t like, right? You can have pollution and you can have this polluting thing that its full costs aren’t being priced in, just put the cost on and then the market will adjust in, quote, “the most efficient way.” And while that’s theoretically really beautiful, it’s never been politically popular, and I think in an environment of rising inflation, it becomes completely impossible. You already have rising inflation; you’re going to add taxes and increase the prices further of things that are already expensive? That seems very unlikely.
So I think the smart shift that we see happening, especially in the United States in Biden’s bill but also elsewhere, is to say, “OK, especially in this inflationary environment, we have to go incentivize the things we want.” We have to go say, “Let’s make the playing field at least even,” because we currently subsidize a lot of fossil fuels, but ideally, more than even. Ideally, we would go and say, “Here are all the incentives we’re going to give you to go move toward the stuff that we’d like to see over time.” And I think that’s going to be kind of our best path.
ALEX SHAHIDI
And that may take some time, I assume.
KAREN KARNIOL-TAMBOUR
Absolutely, because a lot of these things take many years to come online. They’re not something where you can kind of just flip a switch. And investors, I think, have to be practical and thoughtful about what kind of transition do you want that makes sense.
An example I always give is that, when you look at natural gas, a lot of the piping, the physical piping of natural gas can then later be transitioned to even greener forms of energy. And so being religious to say natural gas is not perfect is not very helpful if you’re saying, actually, going from coal to natural gas can be a hugely helpful step, because already you’ve got a lot less emissions than you do with coal. And then you can actually reuse a lot of that infrastructure when you go even greener later on.
So, you have to be thoughtful about where we’re going on a multiyear timeline and how long it takes to build out the infrastructure. And we’ve gotten back to the discussion of the paradigm shift. We’ve gotten used to a world where Instagram gets created as a company and like with a couple of employees and very, very quickly, our world is different. And that’s not how physical infrastructure works. That’s just not how physical infrastructure works. These are much longer investment cycles and choices we make. And once you bake something in the cake—another example I give a lot, which is if you want to actually switch to things like electric vehicles and solar panels and so on, you need to source all the physical materials to make them. And it’s not like you can just flip a switch and you have all the copper in the world. Starting a mine takes time, and you have to actually set it up. And so if you underinvest in some of these things, all the desires in the world won’t help you if you literally can’t make the physical materials you need to go make the transition. And some of these mean very long lead times, and there isn’t a central planner for the world. And so it takes thoughtful incentives.
ALEX SHAHIDI
I have one final question. There’s obviously been a proliferation of ESG strategies and indexes. In your view, what are some of the biggest flaws you’re seeing with the way these are constructed?
KAREN KARNIOL-TAMBOUR
Wow. Well, sometimes I want to say don’t get me started. But no, I think that, look, it’s an industry in its infancy in some sense. And so you’re going to see the natural evolution of things evolving from simple to more complex, sophistication rising, and so on and so forth. But I’d say the early iteration, you saw a lot of things being titled ESG that were so similar to their original index, you’d have to squint to see any possible difference. And so, you can call it what you want, but in my view, if you’re not changing what you’re holding at all, I don’t know if you deserve a special label. And so that’s shifting through time, investors getting more sensitive to saying, “I think I care where my money’s going. It’s going into the exact same place. What could that possibly mean?”
And then now, I think one of the weaknesses is that there’s been such a focus on supporting governments in their attempt to get to net zero and reduce emissions. But there can be confusion about what it means to do that in a portfolio context. And I’ll give you one extreme example, which is there’s just a lot of companies in the world that don’t have much to do with emissions, like amazing companies that make medicines. They don’t naturally emit very much carbon. They don’t pollute very much. Obviously, they’re connected to electricity, but they don’t really control exactly what electricity source they get to use. They’re just not that connected to the problem. So if you just said, “I just want to hold my portfolio with lots of companies that have nothing to do with climate change,” you can have amazing numbers on emissions, but you’re not really related to the problem at all. You’ve just sort of avoided it and gone into parts of the economy that don’t have to do with it. And so, anything that’s a simplistic “let me just tell you one number”—like “let me tell you your final emissions number”—it might be kind of self-defeating related to what the goals are.
So my general thought is I think investors are honing their understanding of what are my goals, what am I really trying to do? And financial products are being created in response that are going to get more sophisticated as they better understand what are these investors really trying to do, and what can I engineer that actually truly meets the goals that they have?
ALEX SHAHIDI
Karen, you’ve been very generous with your time. I appreciate all your insights. I enjoyed the conversation. I hope our listeners did as well. So thank you for being here.