(Bloomberg) -- Investing involves managing risks, and the past year has served up no shortage of warning signs.
From recession fears to the continuing war in Ukraine to geopolitical tensions rippling across the globe, investors have had to navigate a uncertain path in search of returns. And the next decade promises to be just as perilous.
To help gauge the dangers that may lie ahead, we spoke with three prominent investors who’ve managed money for decades about the next big risk they see coming over five to 10 years: Boaz Weinstein, co-founder of Saba Capital Management, a hedge fund that looks to profit when volatility is high; David Rubenstein, the billionaire co-founder of private equity firm Carlyle Group Inc.; and Ida Liu, who is Citigroup Inc.’s global head of private banking.
Their comments have been edited for length and clarity.
Extreme Market Selloffs
Chief Investment Officer, Saba Capital Management
What’s in front of us in the next few years is anyone’s guess. Will there be a recession in 2024? Will there even be a recession?
When we finally do have that selloff, the recession that comes will be different than in the past.
I was speaking with Victor Khosla at an event recently, and he said that in his lifetime, all the recessions were ones where the Fed was able to do extraordinary things to support the market. But because of the excess of zero interest rates, there was malinvestment. There was a lot of money printing, there was a lot of extreme moves by the Fed, including things they’ve never done before. The national debt, not just in the US but also in Japan, is soaring.
And the next time there’s a serious selloff, the Fed will not be able to come to the market’s rescue because of what’s going on now. Quantitative tightening is kind of the opposite of QE. It's like anti-gravity.
In March 2020, when retail investors sold out of ETFs and mutual funds and basically created an avalanche in the bond market, the Fed was there to do amazing things they’d never done before: buy junk bond ETFs, invest not just in lending to companies, but actually in risky things in the financial markets. That was shocking, and I don’t think they’re going to do it again nearly as easily. And so I’m concerned that a selloff for fundamental reasons may actually become exacerbated for technical reasons.
There are risks for sure to the markets and to the economy, because this is not just derivative traders playing games. This is private credit, loans that were made to companies that would’ve not been able to get them were it not for zero rates. A lot of people in the private credit market are very excited now about the opportunity to make loans at 13% interest.
That 13% may sound nice if you’re the investor. How does it sound if you’re the company and you started at 7%, but now you’re at 13% and the economy might be slowing down? There are going to be a big pickup in defaults. I don’t need a crystal ball for that. It’s happening, and it’s happening even absent a recession, and it will grow. The S&P has the default rate doubling into next year off of a pretty modest base.
We could look to the SPAC market as a microcosm. There used to be 600-something SPACs out there. Now there are just some high-dozen number and it’s shrinking by the week. There was malinvestment. There was too much capital because of 0%, and flying car companies and biodegradable shopping bags. These are all beautiful ideas, but do they make money? Can they sustain themselves also, where the cost of debt is not 7%, but it’s 13%.
There is an endpoint, and we’ll see whether the bond market was right that the Fed is going to beat inflation and rates are going to come down starting the middle of next year. Or if the Fed was right that actually we’re not done yet? There is a moment, as Larry Summers said, where the cards are going to be turned over and we’re going to see. A day of reckoning.
Junk bonds, junk loans, junk CLOs, private credit funds: 20 years ago, that world was considered unsuitable for the investor. Now we have private equity firms trying to figure out how to get mom and pop invested into private equity under some idea that it’s unfair that they don’t have access to those things. Well, that’s been that trend for retail.
There’s a behavioral aspect to markets. There’s a psychology. There’s an emotion. Look at the meme stock craze. The psychology has been too easy. We’ve learned lessons that, “Don’t worry. This selloff is a buying opportunity,“ and I fear that the behavioral aspects could flip and exacerbate a selloff. Retail investors sell when the market falls, when they become fearful like they did during COVID. So that daily liquidity avalanche, it goes down, and there's more selling. That's what I'm worried about.
Co-founder, the Carlyle Group Inc.
The biggest overall concern is a clash between the haves and the have-nots. In the West, it’s going to be between the older people and the younger people. People are living longer, but retirement benefits aren’t going to keep up with what they expect or what they need. And the younger people are going to say, “We don’t want to work that much harder just so you have a better retirement.”
You’re going to have Social Security in the US, for example, not being adequately funded. You’re going to have other endowment programs that aren’t adequately funded. And the result is going to be a clash between age groups: the haves who are working hard and want to make more money for themselves, and the have-nots who want more money to be given to them for retirement.
In emerging markets, the have-not nations are going to basically say, “Well, we want some of the wealth of the world, we want more influence in the world. We want to control some of the bodies like the UN and the World Bank.” You’ll see the people who’ve had the power for the last 50 to 70 years fighting with the people who haven’t had the power and now want it.
The people who don’t have the wealth are increasingly exposed to it through social media and other things. They now see what’s possible, how other people are living. And increasingly you’re going to see income inequality greater than it has been. And that’s not a good thing for the world.
In the US, income inequality has increased over the last 10, 20 and 30 years and that’s the opposite of what we really should have as a society. And you’re seeing this same kind of thing in other countries in the world. Social mobility has become a problem. In the US, many people don’t believe any longer in the American Dream, they don’t think they can rise up because there are so many social factors against them. That’s going to produce increasing income inequality.
When I left the White House under President Carter, the total indebtedness of the US was less than $1 trillion. Now it’s roughly $32 trillion. There is no way out of that except essentially inflating your way out. We aren’t going to cut expenses in the government, we aren’t going to increase taxes that much, we aren’t going to go to the IMF for a bailout, and we’re not going to default. The only alternative is to inflate our way out. That’s not a good solution for people at lower income levels, since they deal less well with inflation than wealthier people do.
There’s a lot of lip service being given to the subject. Everybody recognizes there’s an issue there, but what are people doing about it? Politicians recognize it, government officials around the world recognize it, but I don’t think they’re able to do that much about it.
Politics is basically a fight between the haves and the have-nots, and always has been. The reason Congress is dysfunctional in some ways, unable to get things done, is because you have people reflecting the haves, and people reflecting the have-nots. And that’s probably going to continue for some time. I think the whole Donald Trump phenomenon is to some extent a reflection of people who are the have-nots, feeling that society is moving away from them.
The US isn’t destined to lead the world the rest of our lives or even for another 100 years. We’ve been the largest economy in the world since 1870, but China and India are catching up and may pass us in some reasonable period of time in the future.
If the US is not as wealthy as we’ve been relative to other countries, we’ll have a lower lifestyle. So not only the haves will have a lower lifestyle, but the have-nots will have a lower lifestyle than they even have today. That’s a reason why we need to grow the economy and make it much more effective and efficient, but also share the wealth much more than we are.
Global head of private banking, Citigroup Inc.
The ongoing geopolitical concerns that investors have are still on everyone’s mind. What’s going to happen with the US and China? I think that’s the biggest question as we continue to see a lot of the bifurcation and the strained relationships continuing between the two countries, particularly around Taiwan.
What’s going to happen with Taiwan? Is there going to be a potential war between China and the US? I think that’s a very complex and complicated question that’s on people’s minds and could be a black swan event in the future, particularly with Taiwan dominating in semiconductors.
AI is one of the biggest trends we’re seeing, and it’s all driven by the semiconductor industry. And Taiwan clearly dominates the semiconductor business today, particularly the most sophisticated chips. When you think five nanometers and below, 90% of the world supply is from Taiwan. So that’s not to be underestimated. It’s a very complicated geopolitical concern that we’re still monitoring, and it’s something that we have to keep top of mind in the next several years.
This ongoing bifurcation between the US and China actually represents opportunities for our clients to position themselves. Emerging markets today are trading at around a 40% discount to developed markets. We think there’s more upside in emerging markets in the coming years, particularly since we think US dollar strength has peaked.
There could be some very interesting opportunities in emerging markets, and because of this bifurcation, you’re seeing a new sort of pattern in global trade. That means, for example, Mexico is going to continue to benefit from near-shoring with the US. Look at Brazil. China is Brazil’s number one trading partner today.
Look at some of the Southeast Asian countries benefiting from the movement we’re seeing in the diversification of companies based in China. Think Thailand, think Vietnam, think Malaysia. So some opportunities there as well. Not to mention India. We think a lot of different countries will be beneficiaries in the next several years and continue to benefit from the change and the patterns that we’re seeing in global trade.
The aspect that concerns me most is if there is a war, because then we could be talking about truly devastating global consequences. The hope is that it won’t get to that stage, but that’s something investors are certainly concerned about. Just making sure that you have a very globally diverse portfolio will help shield against some of those ramifications, as well as capturing some of the opportunities from the changing patterns of trade between the US and China.
There’s no question that China is an extraordinarily powerful country. It’s the second-largest economy in the world, and that can’t be ignored. If you’re a global investor, you can’t ignore the second-largest economy in the world. There’s so much development and progress that’s still happening in the region, including the advancements that we’re seeing in AI, VR, robotics and even in clean energy. If if you’re an investor, you’re also looking at opportunities for growth and you can’t just ignore those opportunities.
Clearly the US is a dominant force and always will be a dominant force. And I think both economies are very important, and that we’ve got to make sure as investors, that we’re looking at where the most growth opportunities are for our clients and how to position our clients portfolios. And that would include both in the mix.
--With assistance from Peter Cayer and Arielle Berger.
To contact the author of this story:
Sonali Basak in New York at [email protected]