Tim Graf (TG): This is Street Signals, a weekly conversation about markets and macro brought to you by State Street Markets. I'm your host, Tim Graf, head of Macro Strategy for Europe. Each week, we talk about the latest insights from our award-winning research, as well as the current thinking from our strategists, traders, business leaders, clients and other experts from financial markets.

If you listen to us and like what you're hearing, please subscribe, leave us a good review, get in touch, it all helps us to improve what we offer. With that, here's what's on our minds this week.

For the last few weeks in North America and Europe, and for the next two weeks in Asia, we are running our annual series of research events for State Street Markets, bringing to our clients a wide range of topics, such as how much of a threat artificial intelligence really is for labor markets, how to use statistical techniques to make better informed predictions about economic data in real time, whether we're starting to see tariff-related inflation coming through again using real-time measures we capture using online prices.

And of course, we bring you the views of my colleagues on the Macro Strategy team as part of the bargain, as well as our counterparts in other parts of State Street. And that's where this week's podcast comes from. I will not belabor the introduction. You'll hear plenty more on that in a moment, other than to say at our London event, I chaired a panel discussing with a couple of regular guests of the podcast, the fractured environment in the global political economy, and what the implications for portfolio construction are for asset owners and asset managers.

Joining me were Elliot Hentov, head of Macro Policy Research and the Chief Geopolitical Strategist at State Street Global Advisors. His work links the policy impulses in the political economy to financial market outcomes. Elliot is joined by Ramu Thiagarajan, who's head of Thought Leadership at State Street. And he looks after a research agenda that covers long-term industry and market trends, working in collaboration with other teams around the firm, including my own.

So here you go.

We are going to start very, very big picture. We have a polling question, though, to get us started, so hopefully your phones are not too far away. We are asking you the question, “Which force will disrupt global capital markets over the next five years?” So please, as we're setting up, give us your answers.

I'll confess that the title of this panel, Navigating Markets in the Age of Disruption, I did get from ChatGPT. I think we have to mention ChatGPT in every presentation. That alone should tell you the limitations of large language models, because that is a title to a panel that could have applied at any point, I think, in the last 500 years of financial markets.

But fragmentation, that's an interesting answer. I'm very pleased to see that pop up as the top answer. That notion of fragmentation is what my panelists and I are about to talk about. It is the key, I think, to markets. And we're thinking about markets in an age of disruption, but also where fragmentation in policy cycles, rate cycles, economic data.

In chatting to clients about this over the last couple of months, it's been referred to a couple of times that this is a macro environment much more akin to the 1980s and the 1990s as opposed to the 30 years since then. And one of the questions we want to talk about in managing money and asset allocation is the breakdown of longstanding relationships that we've kind of, I think, come to take for granted in some senses over the last 30 years.

So Elliot, maybe to start with you, as an opening question, how much do some of these relationships like, say, the relationship of real rates to gold or rates in the dollar was a big one we had to think about a lot in FX markets in the first few months of the year.

How much do you think these breakdowns are now permanent features? And how much do you suspect they'll just maybe be aberrations that return to the norm eventually?

Elliot Hentov (EH): Yeah, I was also pleased to see fragmentation come up as the top choice. It means my job prospects, employment security remain robust. So first of all, thank you for that. I think the news headlines speak for themselves. Fragmentation is a process that's ongoing. But can you fragment forever? No, you cannot fragment forever. Eventually, you find a new equilibrium.

The problem is we are in a transition period. Transition periods historically last, they're not very long, but we're talking years, maybe one or two decades until you resettle. During this process, the correlations do not work. And we basically have to reinvent kind of our guidebook or our roadmap as to what happens.

And I think we should be clear, what does fragmentation mean from a capital markets perspective? We're talking about two major processes. One is supply disruption, supply shocks. I think that's the conventional sense that we know. So it's the supply side that gets impaired, but in a nonlinear fashion, which is why these correlations don't work in the same way because it breaks and trends.

And then the second one is distortions. You have active market distortions that take place, where basically you have an exogenous force that's messing around with how markets would actually otherwise be pricing. And so, do you think distortions are anywhere close to ending tomorrow? Probably not. And so therefore, it will take, we're still in a period of many, many years of where basically we do not find an equilibrium where we have basically a fixed set of correlations of, we can go back to portfolio construction.

TG: In taking that multi-year perspective, Ramu and the folks that you talked to on our client base, I mean, what adaptations do you see both asset owners and asset managers making in response, and do they differ?

Ramu Thiagarajan (RT): Well, I think the set of tectonic shocks that the world economy has seen has resulted in a lot of rethinking of how to think about asset allocation in markets, right? What does, you know, as you said, correlations have broken down. We have some history of how these things have evolved in the 80s, but this time is slightly different.

What happened in the 80s, as Elliot said, there were supply shocks that took place that resulted in higher inflation, and the monetary policy authorities felt that the only way to sort of bring that and bring inflation under control was to engineer a recession, so to speak. Therefore, at that time, rates sold off, and because growth prospects were poor, so did equities, and therefore, there was this, the positive correlation that we saw during high-inflation regimes.

Now, the question that we have is that, is that where we are likely to end up? So, the answer in my mind partly depends on what is the market expectation with respect to how the, how the central bank will engineer this landing, so to speak. So, if the expectation as it is today is that it is relatively a soft landing, then I do think correlations are likely to come back, albeit with an over a longer period of time. That also depends on the credibility of the central bank itself, which is also come under discussion.

So, what are our clients doing? For the large part, what they are doing is to try to think about counterfactuals that they have not thought about in coming up with risk scenarios, right? The standard risk models have this covariance matrix of built on correlations that have worked in the last 20 years. And the correlations that we are seeing today, some of which you have highlighted in your question, are not something that we have seen.

So, what needs to happen is to, what certainly I'm hearing from clients is that we are now trying to stress test portfolios for scenarios, canonical scenarios that we have not experienced in the past. And what is likely to be the loss in those situations? Should we look elsewhere for diversifying assets? Those are some of the things that I think.

TG: You bring up the stock bond correlation. I mean, 2022, that was the experience in spades, right? We did have almost sort of a Volcker-like shock to monetary policy that then, as a consequence of a high inflation environment, drove that positive correlation of returns in a negative sense, both of them going down in stocks and bonds, that is.

But of course, since then, we've seen equities in the current episode very briefly be positively correlated with fixed income returns, but now we've almost not reverted to the pre-COVID correlation structure, but we have seen equities far more resilient, especially in the last couple of months. Despite the fact that uncertainty, as we've seen on the screen a lot today, uncertainty remains very, very high. And I think monetary policy uncertainty, you can map to that as being very high.

The stability of equities, though, is where I want to, in a very long winded way, I want to get to here, because I'm wondering if we need to now reassess equity risk premium. And Elliot, I'll start with you.

I'm curious if you have any thoughts as to whether that is a reality and if it's a permanent reality.

EH: Now being, being a macro guy, for me, equity risk premium is just a derivative of where yields sit. Yields obviously have to be higher. You would imagine the equity risk premium would be a derivative, and therefore equity returns should be lower. But that's, you're asking about stability. And so we really have to think about what's the nature of the shocks to the system that we're getting, where are they landing and we've had them obviously through the rate channels, through inflation and rates. That's obviously very, bonds are hypersensitive to that.

And one could say equities are just a derivative, so a little bit more insulated. We've had them to global trade. So that's particularly goods. So I'd say equities that are dependent on complex supply chains, complex goods trade, clearly should be vulnerable to a reset in the trading system. But that means a large chunk of the equity market is probably a little bit more insulated. Particularly, obviously, US tech comes to mind.

If you're thinking about, if what we try to do sometimes is identify geopolitical risk specifically in portfolios, and the paradox is that large US service companies have less of that. Once you rotate out of into other sectors in the US market or non-US, you're taking on geopolitical risk. Yes, in April, that looked like a great choice, and in Q1, and there's an argument from a return perspective, but you should be very clear that you're taking on risk into your stability point. Some of that in recent weeks is illusory. It's very fragile. Whereas I think there's a part of the equity market that does indeed have a protective layer around it in terms of its earning structure, its cash balances, dependency and exposure to supply chain and so forth.

TG: That US centricity, Ramu, I wanted to ask you about, and I will say, our last session of the day with Kayla and Maria, we are going to talk a lot about kind of US exceptionalism in stocks, but I think it's important from an asset allocation, very, very long-term thinking perspective insofar as that was the theme of Q1. Even really at the start of, sorry, at the end of last year, you started to see this rotation as a consequence of European fiscal policy amongst other factors.

In what you're talking to clients of the firm about, do you see this as a lasting theme or as Elliot noted, is it more illusory and kind of temporary, one of those reallocation trades away from the US really coming to a halt?

RT: I think there is a lot more thought now with respect to thinking about alternatives to the US. If you think about it in terms of realized returns, the US has done exceptionally well. I mean, in the last several years and the standard financial arguments of either small stock premium or emerging market premium have just not existed in the market period, has defied expectations, has not worked at all. So I've talked to many asset owners who have made this allocation to emerging markets and have got burned, right?

So what has happened in terms of realized returns have done extraordinary, US has done extraordinarily well. Part of it is exceptionalism. And if you look at the Mag 7, and Maria knows more about this and we'll talk about it, the growth has been around 30 percent, which has been extraordinary, right? It defies sort of fundamental economics as a firm scales up the returns, the margin should come down. No, it's actually gone up for a number of reasons due to inorganic acquisitions and so forth.

So I don't think the stability comes from the fact there's a ton of cash on the sidelines. So bonds are seen to be a higher risk asset for sure. I mean, because term premium has gone up and it is seen, there is, of course, there's talk about what is likely to happen as a result of a lot of issuance that's coming to the market, present is premium going up. So bonds are seen to be the riskier asset here. Therefore, by default, there is a little bit of a rotation into the US, into equities.

And your question is, is that likely to continue? I do think there's some fragility risk here. As Elliot noted, we are seeing my earnings growth sort of come down somewhat from what we're seeing in the top seven stocks. And there is concern, other concerns coming from geopolitical risk and policy uncertainty. So I think there is discussion now, so should we go to LatAm? For example, equity risk premium is very, very, very high in LatAm. People are thinking about other markets that potentially give you diversification away from the risks that US is subject to.

TG: Fixed income is where I wanted to take this. And actually, you've given me the perfect segue in that, in talking about term premia, but also talking about issuance. Because of course, it's all well and good to think about rotating more from bonds to equities. But when the bond market is growing to the extent that it is, that's quite a big hurdle to get over.

Elliot, can you start us off maybe thinking about how far along we are in that process, if we've made any progress in that process and what you think, where you think that long-term asset allocation decision needs to go?

EH: I'm not going to start you off - I mean, you might have to cut me off because we're in my sweet spot.

TG: Well, the clock is there.

EH: Because I co-wrote a paper with Ramu last year, a year ago titled, “Who Will Buy All These Treasuries?”. We did a simple model, basically some basic assumptions. Assuming policy was neutral, again, that was a big assumption. We came up with the discovery that the model suggested the risk premium had to be 95 basis points higher.

That's not a hard flag in the sand, but it was a rough barometer.

Since then, I'd say the market has come about half way, maybe two-thirds from where we were last year. But the reality is we have not yet adjusted to the world where we're in, where supply issuance carries on. Actually, the slope steepens a little bit.

Most importantly, global supply issuance, not only the US, the global supply of safe assets is rising at a faster pace than it was in recent years. At the same time, how you want to measure it, global demand for safe assets is actually slowing down. It's somewhat flattish. After a decade where we had a big steep rise from all sorts of new buyers, central banks, QE and so forth, that obviously is no longer with us.

And so what you get now is really a very different dynamic in bond markets, which suggests that our model was very conservative, starting with the fact that we thought policy would be neutral. But I did pull out a few numbers because I do want to stress this. And my colleagues are sick of me hearing this. They know I'm a bond bear for long-term bonds for good reason. When something looks unsustainable, it probably is.

The reality is the US is on an unsustainable fiscal path. That does not mean an acute crisis is imminent, but it means the price clearing has to be at a higher level.

TG: Absolutely.

EH: So, yes, my bond colleagues got excited. They said, hey, the term premium is back to 20-year highs. And I'm like, yes, for very good reasons. And we have not seen the end of it. In fact, I know you want to cut me off, but I did pull up some numbers. I'm just getting warmed up, to be very honest.

The term premium, 20-year highs, it's roughly where it was between the late 90s and 2008. What was happening in the US back then? The debt stock was half of what it was today. On all the sovereign metrics, I used to be at S&P's sovereign group when the US got downgraded in 2011. On all of our classic sovereign metrics, roughly half or today's double as bad as it was before, whether it's interest payments as a share of revenue, whatever you want to take, any flow metric, it's twice as bad as it was before.

And what was the term premium doing during that period? Or the primary deficit? What was the primary deficit? Today it’s at 3 percent. [Then], we didn't have one. It was a primary surplus.

TG: We had a negative term premium as well.

EV: Well, the term premium was roughly a little small, but it's comparable. Today we were at a primary deficit at levels, the highest in US history outside of a war and recession, and the highest for any industrialized country ever outside of a war and recession. These things, I tend to believe in these heuristics that they tell me, well, the price clearing level has to be structurally higher, even higher where it is today.

I think we still have some ways to climb, and I'll just finish off on one thing, just because I did pull out this data before I came to the panel.

TG: Well, we've got to use it then.

EH: In sovereign analysis, you also look at how the debt is structured, maturity profiles and so forth. The US has made some very, very risky endeavors in recent years. It has to roll over close to a third of its debt stock in every calendar year. That compares to about 13 percent, 14 percent for Italy. That compares to about 8 percent for the UK.

The short-term share of stock is over a fifth of US stock because they issued a lot of bills into the market. That makes the sovereign hyper vulnerable to changes in market conditions.

So I do think we don't get a crisis, but we do get a reset coming this year, where I think there will be a widespread acknowledgment that the 10 years probably should be closer to five than to four for a prolonged period, possibly higher.

TG: Ramu, can you follow that up and talk about what you think that will look like in market terms? And I guess it gets to this question, and Elliot's kind of answered it, but do issuers who issue in their own currency, do they have the potential for debt crisis? A very simple question, but a very loaded question. And then what does that look like when things go wrong?

RT: Well, the question is, are we at the tipping point on some of this? And I think the answer is not quite, but as he said, the risk premium has to be higher. In the OECD countries, US$17 trillion is going to be issued in 2025. That's up from US$14 trillion. The world is awash in sovereign debt and it's likely going higher.
So the title of our paper was, who's going to buy these and at what price? And as he said, it is true that you're going to have to higher risk premium to offload these things. And also, what part of the yield curve are we going to issue it on? That's another aspect to it too, right?

So are we at a tipping point? I don't think we are at a tipping point to the extent that there could result in a crisis, in a major crisis, but I do think there is going to be significant repricing. Two things, right? One is that the price insensitive buyers have walked away from the marketplace, right? So for the large part, the Fed is not buying, the central banks are not buying, and Japan and China have started, are not buying anymore, and their holdings have stalled, so to speak. Japan's slightly higher than China. So given that the market is dominated by the price-sensitive buyers, you get to have a higher risk premium. I don't think we're at a tipping point.

There is, on the demand side, one thing I would say is that the demographics is something that will kick in as an effect. If you sort of rolled your time out to the next five, ten years, this is something that will result in a demand for safe paper, so particularly at something that can get you a decent yield. So are we at a tipping point? No, but there is enough policy uncertainty in the place that people are concerned about bail risk situations of that sort.

TG: And this is for either of you, whoever wants to answer it. Do you have a sense of...It's a similar question to the question I asked about equities, but during the most recent period of volatility, you had corporate and high-yield spreads relatively well-behaved. Do we need to think about spread product differently as part of this broader question of asset allocation as well? Are the fundamentals of corporates more trustworthy, in other words, relative to governments?

RT: I mean, look, the fundamentals have been very strong. The corporate fundamentals have been very strong, right? In terms of whether it be cash on the balance sheet or levels of debt servicing capability, it's been quite strong. And in terms, like you said, so the spreads have been pretty well-behaved. Now, we are now in the high-yield around 7.6 percent with OAS of around 300 basis points or treasuries, and that's very reasonable given where we are.

So fundamentals, corporate fundamentals are pretty good, but there is this issue on the sovereign side. And that risk can translate on the corporate side through channels that he is talking about. But at this point, the corporate bond market is reasonably well-behaved. And I think the expectation is that it will continue given that the fundamentals, particularly in the US, are not that bad.

EH: I think on that point, I would just add, if you have an orderly resetting of the sovereign risk curve, then the spread product will perform fine. The risk is that the tail risk of something going wrong has fattened quite a bit. And that's what I'm getting to, is like, why? And why is that not captured in kind of your conventional kind of spread metrics? That's maybe a question for the credit guys to ask. Because it certainly has. There's no question about it. The risks of something going wrong have fattened and that should be reflected somewhere.

TG: Yeah.

RT: Yeah, I do think that the tail risk, the probability of a tail risk has certainly gone up. So, what is happening in many asset owner communities are thinking about tail risk scenarios for a complete blowout on some of these markets and what portfolios will behave like. But with not a very clear idea of the timeline as to when that might happen. But those conversations are becoming more frequent. That's to the point of the tail having flattened.

TG: I'm going to finish before I go to audience questions and I'll grab the laptop here in a second. But Elliot, if you can talk a little bit about the dollar and what role that is playing in currency hedging in particular. We're seeing in our indicators, and I think Lee will talk a little bit about this in a moment, a higher degree of dollar hedging by foreigners of US assets, but particularly of US owners of foreign assets hedging back to dollars less.

Do you have a sense of how much further this can extend and not necessarily thinking about de-dollarization - I don't think that's the conversation to have right now, but just how greater is the propensity of the clients you talk to hedge away dollar risk?

EH: Yeah, I think I'll answer that anecdotally. I don't know, I spent years talking to American clients coming in. We have EM, we have all these beautiful things outside of the US, any interest, and they were just like, nah, no, no thank you.

And that literally, that conversation has flipped so quickly in Q1 this year, even before April, that conversation with US clients is a lot about, well actually it makes sense, particularly from the FX angle too, just to have a much higher non-US dollar exposure somewhere across all asset classes.

And the flip side is with clients, what I call Eurasia broadly is about, well, we've had this kind of constant simple recipe, well, any new inflows that we get as a pension fund, you know, boom, send a lot of it into the US stocks and then figure out what to do with the residual. And now it's a much more, the conversation is much more tempered about, well, I think we'll still continue to allocate, but we're going to allocate less. And what do we do with what we keep?

It seems to be a bit of a rising home bias. So what you see here is anecdotally, and I think the data is now bearing it out, it's first in the hedging, but I think we'll see it in the flow data in the coming months, is you'll see higher US capital flows outward, and you'll see lower flows, lower inflows. Again, I don't think the direction changes, I think it's the magnitude that shifts, and that is obviously dollar negative on both fronts, beyond a doubt. And so I think that is why the dollar, short dollar is kind of the most crowded trade.

TG: Ramu, can you talk about what that means for us as a bank? You have any thoughts on that?

RT: I think for us as a bank, given the macro flows that he just outlined, which is very much something that I'm hearing from clients as well, having products and services to facilitate that effect is really important. We have that, right? We have on the asset management side, we have products and products that can do that. In terms of servicing assets outside the US, whatever form they are, we have that, and we have that capability.

The other thing that I do want to say is that we have talked a lot about higher rate environments is the flow into private markets. I do think that, given the expectation that rates are likely to remain higher, longer, certainly in the US also, is that there is a hunt for assets that in expectation give you higher yield and higher return in private. So private markets has become the logical choice. In realized terms, that's not happened. We all know that.

We just know that in the last 10 years and so forth, public markets have done a lot better on aggregate compared to private markets, let alone the smoothing arguments and so forth. But what it is true is that the flows, we have never seen flows or discussions about private markets as much as we are seeing now. That's also driven by the expected rate environment. I think, again, that's an area that we can certainly service in a big way to facilitate that with our clients.

TG: We have about five minutes. I'm going to quickly go grab the laptop. But in the meantime, if there's any questions from you in the audience, please do raise your hand. We've got mics.

Guest 1: Hi, thanks. I'm not talking my (own) book or anything, but I just want to give a bit of push back on the bond blowout thing. I mean, I would just say that, you know, you've kind of, we've seen the concepts of things being too big to fail.

You would start to see governments could easily manipulate the markets through incentivizing things by taxation or forcing reserve quality or what have you. You've got plenty of tools to prevent that from happening. So I just thought, what are your thoughts on that?

EH: I think that's a great question. My standard presentation has this bullet point number two, financial repression, because that's a logical consequence. If there's not enough demand growth, you create it. To a degree, I think that's part of this reset, which is why I'm still in the camp that I think it should be orderly. We'll just have slightly higher yields than we've had in the past.

The pathway to get there, to avoid a crisis is you, through regulatory means, you create more demand. You allow perhaps above average inflation. You may have the central bank involved in bond buying. All these are part of the mix to make sure that the path is orderly and you don't get a bond blow up, because it's not necessary. You are a sovereign issuer in a reserve currency, so you do have tools to avoid that. But those unconventional measures are certainly part of the package.

TG: Cayla.

Guest 2: So we talked a little bit about rising term premium, especially in the US. But kind of a conversation that we continue to have with clients is the story of US exceptionalism. Is that at risk? And we'll probably see rising term premiums, especially at the long end.

What about term premiums outside of the US? Should they also be rising? And if so, does that just mean the US is still maybe the safest bet? It's just the overall risk is rising everywhere?

RT: Well, I think that the notion of bond issuance, the world being awash in sovereign debt is true, not just in the US, but in other markets as well. So I do think that the need to finance, because a big part of the COVID and post-COVID recovery in many of these economies came from fiscal policies, which required financing. So I think the answer to your question is yes. I do think you should expect term premium to be higher in these markets as well, depending on the economy.

It can vary from market to market, but depending on that, you should expect term premium to go up for longer duration bonds in most markets. The US is, of course, is the deepest, most liquid market. And the fact that the US term premium goes up also has an effect on other markets. So I think the broad answer is yes, I think you should expect term premium to go higher across most markets.

EH: I would add a nuance to that, that if you look at US exceptionalism the past decade and disaggregate the source of it, yes, there's an innovation premium, yes, there's higher business investment, but the majority of the growth differential over the past 10 years has been because of fiscal excess. That's going to have to come down, and so therefore, there is going to be a shrinkage of that exceptionalism story. The question is, how much does it shrink?

I think it will shrink quite considerably, even though you'll still get a little bit, particularly that innovation premium that comes out of it.

RT: I'll add one quick point to this. There was a fascinating paper by Cram et al in the Jackson Hole Conference, I think last year, where they did a very interesting event study to see what really happened to the market when there was fiscal policy announcements. And what you find is that, intertemporally, fiscal announcements by any of the government, starting with the US government, has resulted in a significant increase in risk premia around those times.

So what that tells you is the market has become very attuned to what is happening on the fiscal side. And I think that is going to result absolutely in higher volatility and potentially higher risk premia.

TG: Pete.

Guest 3: How long can the US keep running 6 percent fiscal deficits annually and what's going to change it?

EH: The headline doesn't concern me. It can run 6 percent indefinitely with some side effects. I'm more concerned about the primary deficit, which is close to three. That's the deficit before interest payments. And that, for an economy, if you're running 3 percent primary deficit, you better have a very high fast-powered economy, which the US does not have to that degree.

So the math is very simple. I can explain it to my teenagers at home, even how the US will eventually run out of steam. It's like the coyote off the cliff. And so the question is, what does that adjustment process look like? How do we get to a smaller deficit?

Do we get it through responsible politics and consensus policymaking? I think that's not the credible path. Or do you get it through higher inflation? That's one angle it can happen, although that has its own problems and doesn't solve the issue. Or do you get it through market pressure that eventually compels the deficit smaller?

RT: Or do you get it through rewriting social contracts that are starting to surface now, which is a very big issue. In terms of the benefits that you get for, whether it be healthcare benefits or pension benefits, I'm starting to hear a lot more of that, which was the third rail, which people never wanted to talk about it. Now, there is discussion about variations of how do we do COLA adjustments, cost of living adjustments on these things, because that sucks billions of dollars. So all of this are fair game at this point.

TG: That might be next year's research conference, I think, to talk about that. Sadly though, this session, at this year's conference, we're out of time. But thank you very much to my panelists, to Mark as well for this session. Very much appreciate your time and your thoughts.

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