This is “ReSolve’s Riffs” – live on YouTube every Friday afternoon to debate the most relevant investment topics of the day.

Ever lower interest rates and debt-fueled growth have been the major driving force for asset price appreciation over the last four decades. Many have now come to believe that the system is close to a breaking point, teetering at the edge due to a virtually unpayable debt overhang that has created multiple asset bubbles across the world. To make sense of the current macroeconomic backdrop and where we might go from here, we had the pleasure of hosting Diego Parrilla (Managing Partner at Quadriga Asset Managers). Topics included:

  • His previous life as an energy analyst and his thesis on The Energy World is Flat
  • Bubbles and Anti-Bubbles
  • Central banks, monetary expansion and inflation – how to boil a frog
  • False diversification, correlations breaking down and constructing true balance
  • Soccer teams can’t depend on 11 strikers – how his strategy creates positive convexity to become an effective goalie for a diversified portfolio

His concerns over inflationary pressures in the coming years and his asset allocation approach reminded us of our own Risk Parity framework. While the topic proved initially contentious, we eventually found common ground in the principles that will help drive positive outcomes for investors in the coming years.

Thank you for watching and listening. See you next week.

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Diego Parrilla
Managing Partner, Quadriga Asset Managers

Diego Parrilla, Managing Partner Quadriga Asset Managers,€1.8b alternative asset manager with headquarters in Madrid. Prior to joining Quadriga, Diego worked in London, New York, and Singapore for over two decades and held senior leadership roles across macro/commodity markets at JP Morgan, Goldman Sachs, Merrill Lynch, BlueCrest Capital and Dymon Asia, amongst others. In addition to his experience on the buy and sell side, Diego is co-author with Daniel Lacalle of best-seller “The Energy World is Flat: Opportunities from the End of Peak Oil” (Wiley, 2014), published in English, Spanish, and Chinese, and sole author of “The Anti-Bubbles: Opportunities heading into Lehman Squared and Gold´s Perfect Storm” (BEP, 2017), which led to two Financial Times Insight Columns, in addition to other selective collaborations with the media, such as CNBC Squawk Box, CNN, Bloomberg TV, Real Vision TV, or El Mundo, amongst others. Diego earned his Master of Science in Mineral Economics from the Colorado School of Mines, Master of Science in Petroleum Economics and Management from the French Institute of Petroleum in Paris, and Master and Bachelor of Science in Mining and Petroleum Engineering from the Polytechnic University of Madrid.

TRANSCRIPT

Rod00:00:00Second wave, the COVID thing, is it any better, any worse? Like I don’t, I haven’t. Like, I should have been following.

Diego00:00:07Quite political. We have, you know, things should be back in lockdown. Light lockdown by this evening in Madrid, and certain parts of the city. So the central government is trying to impose some measures on the local government. And that’s it. I mean, it’s not great. But you know, it’s what it is. So we are all. It’s the last thing we needed as an economy and people are really a bit fed up. And, you know, to the extent that we’re all trying to get back to normal. Yeah, this is a bit of a, quite frustrating to be honest. But yeah, we’re all trying to do the best, whether it’s from home or the office. But yeah, I think today is a particularly interesting day because there’s this clash politically taking place in Madrid City.

Rod00:01:10Interesting. Okay so, just so that, we’re live now, and for those who haven’t heard Diego Parilla, Diego is from Madrid in Spain, and he’s a managing partner at Quadriga Asset Management. Diego, why don’t you give us a little bit of your background? For those who haven’t heard. I think our audience is less global macro and more quantitative. So they may not have been exposed to you and your thoughts. So why don’t you take it away?

Richard00:01:36Just before he does, Rod, maybe we get Mike to give us the compliance, informational entertainment?

Mike00:01:46And I see sadly, Diego. This is usually a happy hour event, and you’re probably sipping a nice glass of cognac or wine. We’re all teetotaling today.

Rod00:01:59This is full of scotch.

Richard00:02:03This may or may not be G&T. So.

Mike00:02:07I do. I’m in the coffee club. But as always, when we host these riffs, really, it’s about having really wide ranging conversations. It’s not meant to be taken as investment advice. Please get investment advice in whatever jurisdiction you’re in if you’re going to do any investing, especially in these wild and crazy markets. I think it’s going to be very insightful. And Diego has some particularly novel and insightful views. So with that said, way would go.

Backgrounder

Diego00:02:37Well, thank you for the invitation. It’s great to join you guys. And yeah, for those who don’t know me, I’m originally from Spain. I’m a mining and petroleum engineer. I did my thesis in Mineral Economics at the Colorado School of Mines, and the French Institute of Petroleum in Paris. And I did my thesis in something called Real Options, which effectively valued real assets such as a mine, using options theory. And that was in the mid-late 90s. And that caught the eye of JP Morgan. So I was heading into the engineering world, but somehow I ended up with my first job in trading commodities and currencies in London. And I spent pretty much half of my career in investment banking on the sales and trading with JP Morgan, Goldman Sachs and Merrill Lynch, where I was eventually Global Head in Management Committee. And the second half of my career was more on the buy side. So I have my own Asset Management. I work for some large macros such as Blue Crest Capital or Diamond. Always in the interface between macro and commodities with… and then I have a third facet, which is… this happened between London, New York, Singapore, where I lived for seven years before I moved back to Madrid about four years ago. And in addition to this experience, where I’ve always been kind of a first mover into solutions and strategies, I’m also a best selling author. So I wrote two books. The first one is called The Energy World is Flat. It was published in English, in Spanish and Chinese. It was a very contrarian thesis back in 2014, 15, and we had a $120 oil, 200 Peak Oil theory, and together with my good friend and co author, Daniel Lacallier, we were arguing for the flattening of the energy world, and sort of 30 to 50 oil, which sounded like science fiction at the time. But the thesis has been reinforced with the passage of time. And I learned a lot through the process of writing. And I kept that discipline which led on to a second book called The Anti Bubbles, or anti-bubbles, potato-potahto, where I coined the concept of anti-bubble, which is a very contrarian framework. Once again, that is, I implement along with my strategy, which is a very defensive strategy that is up about 40% this year. And yeah, I use, a very active user of options. I’ve spent my entire career dealing with options. And we do this in a way that, which is buy options, where you know, effectively trying to be the best goalkeeper. For those who follow soccer, or football, we’re trying to be the goalkeeper of the team. So we don’t aspire to be, we don’t pretend that we have a crystal ball that we’re particularly, you know, clever. One way or another, we have a job to do. And our job is to protect the capital and make money during poor stock markets. And that’s what we try to do. So the career has been, I think there’s been a continuum throughout the beginning academically throughout my experience that led us here. And so yeah. That’s a brief summary of who I am.

Rod00:06:49That’s great. So do you like… I actually want to go all the way back to the initial book, because I first started following you when you wrote the book, The Energy World is Flat. What led you? Because I’m really trying to understand how individuals like you come at problems that the general zeitgeist seems to have wrong, where used… How do you attack a problem like that, from first principles? Like, what made you go down that path with the first book, and then eventually the second book?

The Energy World is Flat, and Lego

Diego00:07:24Well, the first thing I’d say is that, to me, it was a very natural process. So you, you know, we’re all in a way. And if you’re managing risk, you’re also an analyst, we’re all, you know, analyzing the markets. And I happen to be wired very contrarian. I, you know, also, as an engineer, I think about, you know, forces and equilibriums. And it’s happened several times where you find effectively situations that are highly unstable equilibriums, or meta stable equilibriums, where things might be in equilibrium, but you know, that if they get taken out, then you enter in a totally new regime. And so in that sense, I started developing these views. And as I was managing money, I used to, I was talking to people about, you know, certain dynamics. And I was always shocked that my views were coming out as so different in the sense that, things that to me were so obvious, like, you know, what’s happening with shale, or what’s happening with, you know, the battle for demand, supply. And so, you know, as you structure your thoughts and your thesis, I found, and that was something that didn’t come that naturally to me. I’m an engineer, I’m a formulas guy, you know. But I’m particularly not, I’ve never been particularly interested in writing per se. It was actually pretty painful for me. So, the way I, we approached this, as I was in discussions with my good friend Daniel Lacallier. He had written already some books. And my thesis was very well articulated at that time, already quite deep. And I said, “Look, Daniel,” you know? We talked a lot about energy markets and stuff. I said, “I have these views. I,” you know, “I think it might be potentially material for a book,” and he said, “Wow, yeah, let’s do it together!” And so I, you know, his input and my input, and that process was fascinating because to me writing a book is a bit like, you know, if I throw you now, you know, 500 pieces of Lego, right, and you put them on top of the table. So the question is, “Tell me your story.” Right? Those are your ideas. So for me, writing the book was really about structuring those thoughts. And there are multiple ways in which I can tell you a story. The most obvious for me would be to put all those pieces into colors. So I would go, you know, “There’s the yellow pieces, the red pieces, the blue.” So I would order things by color. And when you do it by color, you realize, “Oh, there’s no green.” And then people would, you know, you would wonder why there’s no green. And you would dig into that and how it fits. But you could also, let’s say, put the pieces into shapes or sizes. So I’m going to put all the big pieces, I’m going to put the shapes, and then you’ll realize that there’s no round pieces, and there’s no… And as you challenge that model, and you go deep, in my case, for example, I was already quite deeply into the book. And we were, it was very structured. And then someone came up and said, “Okay,” because it was a very ambitious book. I mean, historically, if you think about energy books, energy has always been dealt in a very siloed way. So you had fantastic books about oil, you have fantastic books about coal, or natural gas or renewables. But there was no real book that would do a cross section across them, and that would effectively apply these forces. And so someone came up and said, “How about renewables?” And my answer was like, “Exactly, how about renewables?” And it was basically testing the thesis. And what was extraordinary is that how it fit perfectly, and how it actually reinforced this. It would be a little bit like, you know, Mendeleyev, you know, laying out the Table of the Periodic Elements, and predicting that there must be an element with an atomic weight of X. And you put the model first, and then someone makes a discovery, and it fits, and you’re like, “Oh, my god!” And that’s the feeling I had, you know, when we did this. So by the time I finished writing the book, I knew way more than I did when I started. And I found that process so powerful. And I recommend everybody that they write their thoughts, because it’s that process of structuring your thoughts, challenging the thesis, and things will either… Everything will help you. Either knock it down, in which case you were wrong to start with. Or reinforce it. And that was just fascinating for me. So later on, things happened again. I mean, we had a negative interest rates. And I was like, “Really?”

Rod00:12:42So this is. The book was, 2014 when you wrote first book?

Diego00:12:46Correct.

Rod00:12:47And then 2009 when you saw the negative interest rate environment.

Diego00:12:42Well, this happened later. 2017, I published but I started writing earlier. I mean, it was sort of 2015, 16 when. I mean, these books take a long time. I mean, The Energy book was about a year of just you know. But these ideas evolved throughout the years. In the case of the second book, The Anti-Bubbles, you know, there’s also, I would argue a catchy element of how you want to present this. So the first book was very much inspired. If you look at the title, The Energy World is Flat, it was very much inspired by Thomas Friedman’s  “The World is Flat”. And that book was just fascinating because I remember reading it. It must have been 2003, or you know, shortly after the .com bust. And it was a fascinating time because those of us who lived this in first person, we were left with a very bitter feeling after the bubble. And his perspective was so incredible because he was basically saying, “Look, we have this game changer technology.” It attracts all this capital, all these investment, you know, wires the oceans with things like broadband. And then overcapacity eventually creates this bubble to burst. And then the miracle happens, because you have a game changer technology in ginormous size for free. And I remember that sort of click in my head to say, “Wow!” How something as bad as the .com or the feeling that you have of, you know, of this bitter feeling of the bubble and the consequences. Suddenly it opened this world of all the possibilities. It was, and I remember that. And so when Fukushima happened, I had that moment where you realize that you had a game changer technology in the US in the form of shale, you know, fracking and horizontal drilling, which was a true game changer. But natural gas would have been historically a very regional fragmented commodity because as a gas, you needed either the pipes or the infrastructure through LNG. And so you have a very fragmented market. And then when Fukushima happened, and he sent, you know. Japan shut all nuclear overnight. They were forced to effectively burn something else to keep the lights on. And that meant they could, they have to get their hands on anything including, you know, coal or natural gas, or even oil. And what happened is as Japan soaked all this LNG, you created the situation that was the equivalent of the .com. You had a, you know, effectively a lot of natural gas at $2 an MBTU, you know, like $12 a barrel equivalent of oil. And then you have Japan paying 10 times that for a very long period of time. And so this was like a major call on the market, where you saw Australia saying, “Wait a minute, I have all this natural gas stranded. With this sort of prices, I can build all the infrastructure.” And effectively what happened is, you have exactly the same call that we have in the .com, where everybody that was building this broadband was obviously doing it because they were, they thought they were the only guys doing it, and that they would make millions from it. And this is very common. And everybody thinks they’re the only guys building LNG. So what became very clear to me is like, look, within three years, you’re going to have this world of natural gas, you’re going to have this thing, the situation in Japan improving, so demand goes down, you have this world of supply, with this game changer technology. And you’re going to have natural gas trading globally converging at the lower end, and for the first time in history being effectively a global commodity that trades. And that’s why, where I coined the term of” energy broadband”. LNG became like the energy broadband because we literally wired the oceans with LNG, where historically you had to make a 10 billion investment to go from point A to B on a take or pay basis. So now, you have effectively… It was like a market with exact number of male and female, there was no market. Then you have suddenly, lots of, you know, people that were like Qatar and others. So what happened is, as the market developed this, you have, for the first time, abundant, reliable, cheap, clean, natural gas. And it became very obvious to me that natural gas would compete with oil, as in transportation, you know, whether it’s tank, tankers or others. And this dynamic of oil having competition, which is, you know, led to many other thoughts and concepts, you know. The success of OPEC historically has always been, “Look, I control the oil, therefore, I control the price.” This is, the theory said that OPEC success was driven by an oligopoly of supply, right? The reality is there’s lots of oligopolies that have not succeeded. The reality is that they had a monopoly of demand. The real reason why Saudi and OPEC was successful is they have a monopoly over transportation demand. What it means is we drive our cars with gasoline, diesel, you know, our trains, our boats, you know, our planes, it’s all oil products. So the real reason they could keep a strong grasp is because they have a monopoly of transportation demand. And this was challenging that. And I used the example. I took a wild bet. Not so wild to me. But anyway, when Warren Buffett bought the railway company in the US, it was an oil trade. I said, “Guys, this is an oil trade.” He bought this thing, that where he’s paying $150 a barrel for diesel. Never mind that the trains are the second largest consumer of oil in North America behind the military.

Rod00:19:10Really?

Diego00:19:11Yeah, like single client, right? They were all running on diesel. And suddenly, you have trains that are paying $150 a barrel for diesel that you can turn into natural gas for $12 a barrel equivalent in your size, equally clean, more reliable. You don’t need to worry about Middle East and whatever. Of course, you’re going to do it, but you’re going to do it quietly. You’re not going to go and say, “By the way, so you know, I’m going to change everything. I’m going to let the margin stay there.” So for me, Warren Buffett who’s, we’re going to talk about how smart he is. To me it was an oil trade. I said of course he’s doing that because he’s going to change his trains from diesel to, nat gas. That’s what he should do. And I think in some way, that’s what he did. And so effectively, it’s fascinating how, you know. I guess my brain connects things and that connection became very clear. It helped us coin stuff. But yeah, it was fascinating.

Energy Broadband

Rod00:20:06It was, I remember the room I was in, what I was looking at the moment that I heard your framework, because it also clicked for me like that. It was, starting with the broadband networks, the amount of money that went into that. The amount of money that people could raise in debt in order to finance the infrastructure development. And when they went bust, the companies went bust, but the infrastructure stayed and allowed the vast majority of the population and, you basically democratized the Internet, and made it available for us to consume at a very cheap level. And therefore, you know, the demand wasn’t that, the cost of it was going to go way down. And that framework, I think, is now something you can use in everything going forward. It’s not just something that happened to work in broadband, or happens to work in oil and gas, but there will be opportunities to apply that framework to something else. So that’s what I was… It was an amazing time for me in terms of understanding the dynamics of the world. So I think, thank you for putting it together.

Diego00:21:11I think the big thing is that obviously The World is Flat was a post mortem analysis. He wrote that after the fact. But it was so brilliant that that concept stayed. So the beauty of The Energy World is Flat is that we made the call before it happened. We said, “Listen,” and we actually drew a total parallel between the .com bubble and the energy bubble, if, you know, one by one saying who is who. Okay, who are the telecoms? What is broadband? What is this? And when you do that, and this is something that I use that a lot, is you basically take a problem, and you can apply it to understand it better. You can apply either historical context so you could analyze the same problem at different points in time. That’s why history is said to be “Magistra Vitae,” right? The teacher of life. But you could also apply across industries, or across people, you know? What would Warren Buffett do in my situation? What would, what’s happened in the other industry? And I think these lessons, once you have the ability to translate these problems. And it’s a reflexive process because you can learn in both directions. It’s extraordinarily powerful. And I think it fits that picture of the Lego that I was talking about, which is, you know, analyzing these problems from all these different dimensions. And, you know, with me it happened with Daniel, right? In generally, we had a similar view of the world, but sometimes it was like, “Hey mate, that’s clearly a circle.” And he’s like, “No, it’s pretty clearly a rectangle.” And I was like, “What are you talking about?” I mean, and once we talk more, we were both looking at a cylinder. And we’re both right. And so by combining these views, you know, the equity view, the commodity view, these different perspectives, you get a way better perspective of reality. And I think this is something that, again, you get through going through this process and forcing yourself to structure your thoughts and test them and be humbled, to be proven wrong. And it’s a very healthy process, which I encourage everybody to follow. And I continue to.

Mike00:23:33What’s nice about writing too is that unlike verbiage or just speaking, it’s written and thus, you may have an opinion. And you will have these articulated thoughts which may come to pass, or may not come to pass, and you have a record of them to continue to iterate and improve. I also thought that the .com bubble was very similar to the railroad bubble, right? There was a, you know, a railroad bubble in the US. Many towns were bankrupt. Everyone had to have a spur on the railroad to be successful. There was mass over-expansion, lots of bankruptcy. But at the end of the day, you could go from San Francisco to New York in three to four days on a train. And so, you know, the costs were absorbed by everybody, but there was a major leap forward in technology for America, in that realm. So it’s just another one of those The World Is Flat concepts. And I wonder, because it’s interesting. We haven’t had this kind of concentration of wealth since the robber barons, which were a massive, you know, sort of evolution in technology for human civilization. And so, and then you obviously, after the robber barons, you go through the 20s, the 30s. You have the monetary implications of all of that. I wonder if there’s any lines that we can draw from that history that-

Rod00:25:02Elon Musk has taken us to the moon, baby.

Richard00:25:05Or Mars?

Rod00:25:09And the electric cars.

Diego00:25:12Yeah.

Mike00:25:13So I wonder.

Rod00:25:15Can I? Sorry.

Mike00:25:15I would love your thoughts Diego on that, is do you think of this as is? Are we now incrementalists in the improvement? Or are we seeing full scale change? Like, you know, going from pre the industrial age to making cars, making cars better, like a car … car that’s kind of incremental. Is there, do you see revolutionary change that can save us from our current, you know, fiscal and monetary doldrums potentially?

Incrementalism

Diego00:25:48Well, that’s a pretty loaded question. And I think this is a lot to think about. I would start by saying that I’m a huge believer in technology, and that I believe in the transformational power of technology. And I would say that The Energy World is Flat was in a way, you know, basically a compliment to my fellow engineers, right? As one of my former colleagues at Goldman would say, “If you give enough time and money to an engineer, he will solve the problem. You give enough time and money to a politician, and he will get you bankrupt.” Right? So I think in that sense, I believe in technology. But you know, the common theme between, and this is very important, the two books that I wrote, The Energy World is Flat, and The Anti-Bubbles go into something quite deep, which is ultimately the greatest simplicity, which is, I’ve done a lot of work on bubbles. I coined the concept of anti-bubble. And the important thing with many of these moves is, you know, I like to borrow Soros’ definition of bubbles, okay? He says bubbles are effectively, artificially expensive assets that are supported by a belief that is false. That it’s a misconception. So, we are really dealing with a situation where the Emperor had no clothes, okay? These are real bubbles, whether is, “Because I’m going to make a trillion making this expansion,” or this technology is whatever. So, if the key is to look for the belief and the misconception, if you find the belief and the misconception, you know. The incremental thing that I did with the anti-bubbles is I said, “Look, I agree that misconceptions can distort reality, but not only with artificially high valuations, you could create artificially low valuations,” okay? A misconception can actually result in things being artificially expensive or artificially cheap. And these things are effectively mirror images of each other. And in a way, what happened with The Energy World is Flat is, for the longest time we lived into this world where oil was on its own, okay? You have no challengers. It was very difficult. Think about, you know, what would it take to have natural gas competing with oil or electric or others? But once that technology came, and that certain of those beliefs were challenged, then the Emperor had no clothes. And then effectively you get this bubblistic dynamic. And I think that this could… Your question could go into several dimensions. I think if we go into the monetary side, one of the big ones is Bitcoin, right? You could argue that the technology, the financial technology that, “Is this really a game changer? Or does the Emperor have no clothes?” Is this, we’re always looking at… We know the problem. We know it. But is this, you know. Are we having a leap in the process that, “Is this really the right solution or not?” And what you have is, you see a lot of a process where what Soros called the twilight period, right? Where both beliefs and misconceptions live together and until eventually things calm down. And I think, you know, the biggest problems we’re seeing and is related to your point on wealth concentration, and as a result, inequality is, and this is the biggest issue we’re facing and what I’m obsessed about, and what I wrote about at length, is the belief that you can actually solve problems by printing money and taking debt.  And in a way, this belief is supported by

things like, Never Fight the Fed. Okay? Never Fight the Fed, or whatever it takes, or China’s PBOC’s in control. Okay? These are beliefs that are incredibly anchored into people’s mindsets, but they’re not true. Because, the Fed is not… By printing and lending, and the governments by borrowing and spending, this situation where you’re effectively testing the limits of monetary policy and fiscal policy is not solving the problems. Okay? It’s not solving the problems. It’s doing four things. Okay. The first one is kicking the can down the road. It’s delaying the problem by effectively… through that. Okay. The second thing is transferring the problem. So, you have a situation where country A, by printing infinite amount of their money, is trying to dilute the value of their currency. It creates currency wars. It’s passing the problem to the neighbor. And these currency wars effectively lead to trade wars, which is the mirror image. Don’t devalue by 20%. If you do, I’m just not going to let my companies send you my money, my investments, send you my jobs, send you my technology, just because you’re 20% cheaper. I’m not going to let that happen. So, you know what, if you devalue by 20%, I will tariff you buy 20%. Right? So, trade wars is a mirror image of currency wars, which is effectively what’s happening when you try to transfer the problem to somebody else. The third thing that happens is we are transforming this problem, from bubbles to inflation. And this is… and eventually enlarging it. So, when I summarize global macro, it’s pretty simple. I mean, the last 10 years is the transformation of risk-free interest into interest-free risk. We haven’t really solved anything. All we’ve done is we’ve brought interest rates from, let’s say, 5%, your 10-year Bund, your 10 year Treasury, was happily paying you 5% a year. And there was this concept in the textbook called Rf, Risk for Interest, which have two great things about it. The first one is you could earn 5% nominal with no risk in a low inflation environment. So, you are actually making positive real returns. Thank you very much. The second thing that was happening is your 60-40 balanced portfolio, if there was a crisis and yields went to zero, your 10-year bond or Treasury Bund would make you 50% capital gains. So, you have a great defender in the portfolio. Okay? In a world where interest rates have gone from 5% in the 10-year to 30% negative… I mean, 30 years, sorry… negative nominal yields like the Bund, you no longer have the risk-free interest. Okay? We’ve been bullied into extending the duration. You no longer have the defender because, obviously, there’s a limit to how far you can go in negative interest rates. And third, and most importantly, you have created bubbles without precedent because the math’s pretty simple. If you invested in a business… Hey, Rodrigo comes with this great idea. Look, let’s buy this stuff. And it’s going to pay us $100 in 10 years, 20 years, and 30 years. In a world of 5% interest rates, the PV of the 10-year would be 61, the PV of the 20-year would be 36. The PV of the 30-year would be 21. Today, they’re 100, 100, 100. So—

Richard00:34:01This is part of also, I think, one of the issues that you didn’t mention, but is a consequence of maybe your first point, which is there’s an intergenerational transfer of wealth. And I think that fuels some of the discontent and some of the tensions that we’re seeing across the globe, with a lot of people protesting. Obviously, there are several layers and components to that. But I think part of that is that the millennials and the Gen Z-ers, they’re not seeing anywhere near the opportunities as the previous generations have. And I think a lot of that has to do with debt overhang, right, this idea that we’ve borrowed too much to …. So, I was curious as to, obviously, you see the actions of central banks as a big issue. What is the endgame here? I mean, obviously, you’re expecting some form of inflation, specifically in asset prices. We’ve seen it, so I know that you are big on gold, and you sort of tangentially touch upon crypto. But what do you see the end game being here?

Mike00:35:02Maybe as you cover that, Diego, just cover the fourth point of the outcomes because you got to three, I think. And there was a fourth—

Diego00:35:09It’s related, it’s related to this. So, the fourth point is you’re enlarging the problem. So, you’re not really fixing anything, you’re making the problem bigger. And we get into this trap because, obviously, when you have the crisis in 2008, you are forced to step in with monetary and less fiscal. You are creating this intergenerational issue. And then, as we went into COVID, you were effectively into what economists called pre-existing fragility. So, you already had a very fragile situation, then this exacerbated it. But to follow up and answer the question about the end game, I summarized the next, just like the previous 10 years where the transformation of risk-free interest into interest-free risk, the next 10 years is the transformation of bubbles too big to fail into inflation. And effectively, we need to understand. And I explained this, and I get the question again, because people are so hardly wired that it doesn’t come across, so I’m going to say it as quick as clearly as I can. We have a situation where artificially low-interest rates have created bubbles across every single asset that are so huge, that they are now systemic, and they are the real enemy. So historically, if you take the textbook, the textbook says, “Look, if inflation comes, interest rates go up, bonds go down.” This is what the textbook says. And most people think this is written in stone. The reality today is we cannot increase interest rates. It’s science fiction that you can increase interest rates because, if you increase interest rates, the whole world implodes. Equities, credit, fixed income, anything that is—

Richard00:37:22Real estate.

Diego00:37:24The whole thing implodes, the whole thing implodes, everything. Okay? So, we’re in a situation where you cannot hike interest rates. And then you have these problems, which they tend to try once over and again to fix by printing, and by money printing and debt. And effectively, what you’re doing is, and this is, again, the central banks are playing this game saying, “well, the enemy’s deflation, and we need to print all this money.” And when you think about inflation, one of the critical things to understand is that inflation is not about the value of your house going up, or the value of oil going up, or the value of bread going up. Inflation is about the value of the money with which you buy your house or oil or bread going down. But somehow, we’re wired to think that my hundred dollars will be $100 in 10 years. But the reality is that this is what I call the frog in the boiling water. Right? A 2% inflation target is not a coincidence. It’s calculated scientifically, in my view, to effectively dilute you as fast as possible without creating unrest, right? So, we are frogs in the monetary pot because that when you throw a frog into boiling water, it jumps; if you throw a frog into water that is mild and you just boil it up, it will die. At 2% per annum after 10 years, you’ve been diluted by 20% plus compounding. After 20 years, you’ve been diluted at 40 plus compounded, right? So, 20 years is, for me, is not what it used to be, okay. 20 years used to be a long time, not anymore. And you think about how much you’re being stolen directly through that, with inflation of 2%, let alone real inflation. So, the next thing is CPI is complete bullshit, if I may say so.

Rod00:39:29You may.

Diego00:39:29In the sense that, they fooled, and they create this perception that inflation is just one number. Look, the four of us have four different inflation baskets. I mean, someone might have babies and has nappies, one of us has kids in universities. And so, inflation is not a single number. They somehow frame this into the CPI. And I use the analogy of global warming. I mean, we could debate at length, whether there’s global warming or not. But I can guarantee that if we give the thermometer to determine whether there’s global warming in the world to Donald Trump, there’s no global warming. And this is what happens with CPI. Come on guys, there’s deflation. Now, all these… Let’s not fool ourselves. There are huge deflationary pressures in the system, starting by unemployment, technology, demographics, overcapacity bubbles, etc. All these huge deflationary forces are real. But this deflationary hole is being filled with money being printed at a pace that is unprecedented. And that effectively is diluting the value of money. And that will lead to a situation which is, what I think is the next 10 years, which is the transformation of bubbles too big to fail into inflation. And this goes very closely to your point on inequality and to your point on wealth, etc.

Rod00:40:54So, can I just pass on that? So, you mentioned 2%, 20%, over x years. Are you saying that this inflationary pressure… I mean, I know how you’re structured— how your thinking is structured, and it has to do with options. Is this a type of end game that’s going to be the frog being boiled slowly? Or is this going to be a massive one time, two time, three time event that you’re either prepared for it or you’re not?

Richard00:41:21           Do you expect an acceleration? Right?

QE and the Euro

Diego00:41:24This is the key question. Central banks are crossing their fingers that the boil, the frogs will stay in the water, and they can engineer some sort of… they can basically solve, deflate their way out of the problem quietly and nobody really noticing. The problem is this is a relative and contagious game. Okay? If you think about monetary policy and the effectiveness of monetary policy, they sell it to us as a domestic decision. Think about QE in the US, right? It’s broadly being sold to the world as a big success. How did it work? Okay, we had a problem. So, Mr. Citibank, Mr. Bank of America, Mr. Goldman Sachs, whatever, guys. They sit everybody around the table in 2008 and said “How big is your hole?” 100 billion, 150 billion, 200 billion. Okay. 600-billion problem; let’s print 700. Problem solved. We print the money; we give it to these guys. And everybody was like screaming “Oh, my god, you’re printing money. Inflation is going to go through the moon” and blah, blah, blah. Okay? And that QE 1 was incredibly effective, because it cut that tail risk on the downside, it avoided the systemic stuff. It was needed and justified. The problem was with QE 2, and then QE 3, so called QE infinity, you know? You start, it’s subject to the law of diminishing returns. So, you have to print way bigger size to the point that QE 3 was “I’ll do whatever it takes. It’s not good enough. If we just say 3 trillion, then the market will ignore it.” And then, guess what happened. While the US is printing its way out, it sends Euro-Dollar to 150. Alongside with it, you have Dollar-China pegged. So, guess what? Europe ends up being the good citizen, it was hiking rates in the middle of Bear Stearns blowing up. Right? And basically, we have a situation where Europe loses enormous competitiveness versus both the US and China. Surprise, surprise. Four years later, Europe blows up. Of course, it blows up. It had its own issues. But effectively, it blew up because of the US passing some of these problems to Europe. So, when Draghi walks in and says, “I’ll do whatever it takes.” He says, “I’ll do whatever it takes to save the Euro and send it to parity.” What do you need to do? What do you need to do to send the Euro to parity? Negative interest rates, zero interest rates was not enough. We would have never had negative interest rates in Europe if the Fed had been at 2%. And this is my point that monetary is relative and contagious. The problem is everybody’s doing the same thing. And look at it now. I mean, the biggest driver in global markets today, we’re not in risk-on, risk-off, we’re not on inflation on and off.  It’s longer, long dollar or short dollar. That’s the driver. Everything’s moving like that. And the minute… I mean, obviously, the US, both the Fed and the US government, have plenty of room to engineer a devaluation of the dollar. I mean, 10-year treasury yields are still 67 basis points. And the 30-year is 140. A huge amount of room to send this to zero. They have huge amount of room. They just need a handshake and get 2.2 trillion of fiscal expansion by increasing the debt and diluting the dollar further. They have huge amount of room to do it. It’s so consensus and so obvious what’s happening, that the market gets very carried away. And then obviously, Euro-Dollar goes to 120. And Europe raise, “Guys, we’re watching. We’ve seen this movie before.” The problem is, what else can Europe do? Dude, you’re already at negative rates, you already have this huge spend. And so this process, unfortunately for Europe, it’s screwed because if we send the Euro-Dollar to 120, 125, 130, not only you have all these underlying issues, now you’re losing competitiveness. And then, you blow up and the Euro goes down, because you blew up even more. And so, this is the point I’m making, that we’re not really solving anything. Everybody is in the right mind, thinking, “Oh, let’s solve.” And you know, there was a question on the intergenerational debate. Most of the problems in life are trade-offs between short term and long term. I want to eat this cake, but I’ll be fat. You know? I want to have fun now, but then I want to do this. I want to… So, same thing. It’s very human nature.

Richard00:46:21And in comes COVID, right? In comes COVID, it accelerates and exacerbates a lot of the problems that we’ve been seeing since the crisis and everything that monetary authorities have had to do. And now, monetary policy is exhausted. They need fiscal policy. It seems like it’s one of the few bipartisan agreements in the US. Europe needs to do it as well. How do you see the lack of cohesion? I mean, Germany, took steps recently to sort of allow there to be some form of fiscal union. Not exactly, but they’re working their way towards that. Whereas the US, I think, might have power to spend more fiscally. How do you see that dynamic at play in maybe how Japan and China, the other two major poles, might interact in terms of where we go from here?

Diego00:47:17Well look. Very different than Amex, I think the US is the most dynamic, they have more room monetarily. They have plenty of room still. And obviously, a shake of hands gives you this. Whereas in Europe, you have all sorts of issues, which to be honest, they are there for the right reasons. Okay. Thanks, God. I mean, otherwise Spain would be Venezuela by now. Thanks, God, there’s someone like watching you and making sure you’re not abusing this. So, they’re good safety mechanisms that prevent you from going completely nuts and crazy. So, I think the problem here is that the guys that behave properly are being penalized. And from a game theory perspective, what do I do? Do I do the right thing and stay orthodox and stuff? Or? I need to defend myself. And so, I think the US has a very dynamic, very powerful set up, that can lead to this weaker dollar. Europe has more barriers, which are there for the right reasons. But Europe has learned the lesson from 2008. And I think it’s been very proactive. They could see this coming. I mean, this is not a coincidence that you have Lagarde and de Guindos at the top of the ECB. They’re both ex-finance guys. Okay? They knew that the next phase was fiscal. And therefore, you put the right guys to be able to do this. And I think Japan is a slightly different story, but perhaps to touch on China and to spice things up a little bit in terms of controversy, I think it’s, in my humble opinion, one of the biggest bubbles in history. And right now, you have this perception of the Yuan being a stable currency pretending to position itself as a safe-haven currency or whatever. It’s not as easy as that. I think the model that they’ve run, they know exactly what they need to do. But every time a crisis comes, they go back to… And they know what to do. I need to quit smoking, but every time something goes wrong, they go… you know. It’s what’s happening, right? So, every single crisis is met by more of the same. They print, they lend, they nationalize. And it was interesting. Recently, there was a tweet where they were basically the tweet read that they were injecting $7 billion into the Chinese banks. And I said, “No, they’re not. They’re injecting 50 billion Yuan.” It’s a very different thing. You can print 50 billion Yuan, or a gazillion Bolivars. Okay? And you can inject them into banks and pretend there’s no problem. The reality is, you’re not really fixing stuff. Okay? You are diluting this. And I think, when you have a closed system and this dynamic where you want the economy to grow at 8.8, we’re going to build more roundabouts, and more stuff, and more… it rings the bell. I mean, we saw that without the central government. We saw this liquidity flowing like water into infrastructure and real estate bubbles in Spain. And we knew what happened. And here you have a similar situation to a much larger scale, but I think it’s all artificial. And I think the degree of freedom, it’s a big devaluation of the Yuan. But it’s all the same. We keep going back in circles where this dynamic where you have problems, you’re not willing to take the hit, the easiest thing is to print a bit more and lend a bit more. And this becomes something that is, once it reaches the point of no return, which I think it’s way past for places like Japan or Europe, then it’s very difficult to unwind. And when I wrote the book, I had a chapter on the anti-bubbles. I love this book from El-Erian called The Only Game in Town. And he introduced the concept that, it was new for me at the time, is the idea of a pre-mortem analysis. Okay? We’re all very familiar with the concept of post-mortem, right? So, a building collapses, and you send engineers, and they look at it, and they say, “Oh, the pillars were done of this material. And then, the heat and the humidity, and oh, this is what happened.” Right? There’s something called a pre-mortem analysis, which is the building is standing, and we just go, “The building just collapsed.” “No, it didn’t. It’s there.” “No, no, it just did. Okay? It just did.” And then suddenly, “oh, it just collapsed?” And you start developing “How could this collapse?” Right? So, when you think of— This is an incredibly powerful framework. Okay? You could use it to do anything you want. “My wife will never leave me.” And then it’s like, “she just did,” and like, “Oh, shit,” whatever bad thing you want to think about. This pre-mortem analysis, applied to global markets, was “what do we need to do to get out of this?” What do we need to see for the world to normalize? Okay. And the path required was, effectively, the normalization of monetary policy. And QE 4, 2018, was the moment when, boom, the bluff became obvious. The US tried to normalize, we went from four hikes to four cuts… someone like Goldman, right… in a week. Okay? People thought, “Oh, this is normal, we can normalize.” No, you can’t normalize. And ever since, we’ve had a set of pre-emptive policies, where central banks are trying to stay ahead of the curve, because the minute this thing goes a little bit out of control, and COVID was an example, it’s boom, game over. And it keeps getting bigger. So, it’s very, um… I’m sorry if my analogy was unfortunate. But anyway, you can use another.

Rod00:53:43No, no, no. I mean, the question is… you mentioned how Japan was a point of no return. The question is, given what you just said, isn’t the US at a point of no return as well? And if not, then how could they turn the ship around?

Diego00:53:55It is now. It is now.

Rod00:53:57And if they could, do you see any way for them, for this whole scenario, to turn around? Because time and time again, in the global macro space, you see this fear, like it’s going to end today.

Diego00:54:06Not anymore. Not anymore.

Rod00:54:08In 2009, I heard this narrative, I’ve heard it my whole career. And we’re kind of… I’m seeing the pain points now, after COVID. They’ve always found a way. Right? Whatever it takes. Whatever it takes.

Diego00:54:20Yeah, you’ve been exhorting… The thing is they… I’m a very cynical contrarian. And I would say that rule number one of the investment game is they will change the rules. Okay. So, the reason we thought…. you’re talking about 2009 with a mindset, which is “these were the rules of the game.” I mean, think about, at that point in time, someone told you were going to have $17 trillion of debt at negative yields, you would have… I don’t know if you would have laughed or cried, but you’d be like, “No way.” I mean, what are you talking about? And today, no one’s blinking. Right? So, how far can you go? And by the way, I think the comment on crypto, I’m very skeptical. Okay? I don’t want to come across,  I’m a big believer in technology, I’m not necessarily a big believer. Even if I think that technology has lots of merits, I am so cynical that I know exactly how valuable this is for central banks and governments and why they’re not going to let this precious thing called seigniorage go away. Seigniorage is the difference between how much it cost you to create $100 note and how much it’s worth. And this privilege, they’re not going to let it go by creating. So, something as easy as making these things illegal and you go to jail or whatever. I mean, we’ve saw… I think at least twice in history, we’ve seen government supplied death penalty for not accepting paper currency. Death penalty. I mean, when people ask me, “Oh, my God, yeah, crypto, you know, okay, what could central banks do? How far could they go?” Death penalty. It’s happened, okay? This is how desperate central banks are. So, it’s a very tricky situation for where we’re going. But I think to your point, the rules keep changing, and they keep going. But they’re not solving the problems. We’re creating way bigger and bigger and bigger problems. And this is why I think Ray Dalio and, to a point earlier, inequality, the really sad thing about all these people that you were saying that they’re very unhappy and revolts, which I agree with you, there’s a common denominator. No one will point to the central banks as guilty, no one. Absolutely nobody. They will blame, and they will find scapegoats. And let’s see what Trump comes up with next. But it’s this bully mentality of it’s always somebody else’s fault and finding people to blame. This is a situation where it’s like a movie of Hollywood where the bad guy of the movie is the policeman. I mean, the central bank’s number one job is financial stability of the system. That’s the job. Dude, you need to keep the financial stability of the system. Yet, they’ve created the biggest bubble in financial history.

Mike00:57:35Yeah, and they’re not elected officials. You have all of this power in appointed officials. You have this massive regulatory hazard that is layered on top of this, which is a whole ‘nother interesting dynamic. I wonder, because we’re getting on an hour, I wonder if we might just shift gears a little bit. We’ve got a pretty good understanding of macro, as good as you can get, the understanding that there’s been massive overconfidence driven to the 60-40 portfolio by this constant and persistent supply of capital and downward pressure on interest rates. So, you have a world of investors who are probably over-invested and overconfident in the 60-40 portfolio. As Rodrigo alluded to, they’ve just been saved so many times, they’re the quintessential turkey roaming around the farmer’s yard, thinking that “man, am I ever getting fed well” with Thanksgiving just around the corner. And so, I think this dovetails well into how you approach this problem in your portfolio, how your portfolio complements the 60-40. Maybe walk us through that, because I think that has real value to the listeners.

Complementary Portfolios and Soccer

Rod00:58:46Yeah, in the context of global macro, it has great stories. But oftentimes, you can have the thesis right, but the bet wrong. And I think, this is one of the challenges of being a global macro manager. And I think you have done a good job of solving that problem. So, if you could, how does the rubber meet the road here?

Diego00:59:06Okay, first, very important point is that I use this analogy. I mean, I find that the industry tends to be very polarized between bulls and bears. But if you go into Twitter or whatever, it’s all about, I’m right, you’re wrong, black or white, up or down. It’s all polarized. I’m a team player, and my view is that your portfolio is a team. And I mean, the team in the sports sense, okay? In soccer, you might argue who the best player in the world is maybe Lionel Messi. Okay. Now, if you build a team with 11 Lionel Messi’s, you are destroyed. I mean, and I’m sorry to say this but, every other corner they would score a header because he’s like 1and 60-something, right? So, the fact that he’s the best player in the world doesn’t mean that your team, a team of 11 Messi’s, will be great. So, the way most people play this game, and there’s a few messages I want to pass across. The first message I want to pass across is this idea that investing is about making money. It’s the equivalent of, if you’re playing sports, it’s about scoring goals. Okay? Anybody who’s played any sports knows it’s about offense and defense.

 I mean, take someone like Roger Federer, okay. Everybody knows his attack. He’s an insane defender. Okay. And he’s faster than anybody, and he’s insane. Right? It’s not just the flashy forehand. He’s an incredible defender, right. And that applies to many. So many people think that investing is about making money, and  are building portfolios with 11 strikers. Every single piece of the portfolio is trying to make income and capital gains, and this is partially due to this mindset, and partially due to this, the central bank having my back and the complacency. Now, the way we think about this is we think about it as a team, so you need strikers. And the ideal striker is a call option on equity. Okay, something that will pay you handsomely in a risk on market that will protect the downside. Yeah. And then you have defenders and goalkeepers which are effectively ideally, put options. Okay, so they score you, they make a lot of money in the crisis, and they won’t blow you up when things go wrong. So you want to have a team where you have a you know. Why is Barcelona or Real Madrid? We’re so good. Well, Luis Suarez has five chances, he scores two or three, and they shoot 10 times and the goalkeeper saves nine. I mean, that’s how you win the match, right? So effectively, you need the best strikers, the best goalkeepers. And then you need to embrace the volatility and the stupidity of the market. Okay, most people think this is about having a black box, or sorry, a crystal ball that, you know, I have the ability to time the market perfectly blah blah. No, this is more about the opposite. It’s about embracing this volatility and saying, Look, I have strikers I have goalkeepers, I find that the neutral position which might be 50-50. And there will be times where this goes 60-40 or 70-30. And there are times it goes the other way. But the idea is you just go back to neutral, you just buy cheap, sell expensive, sell expensive, buy cheap. So in that portfolio construct, we are the goalkeeper, okay. And there are other people out there that they are more pretending that look, if the market’s up 30% I’ll make your money, if the markets down 30% I’ll make your money. To me, it’s a bit easier. That’s pretending to score all the goals and do all the saves. To me it is a bit easier just to play one role and to do your job really well. Okay, and that’s it, we are goalkeepers and this is what we do. So we’re up, call it 10% in 2018, flat 2019, up 40% in 2020. If you complement that with someone that does the opposite, and you can rebalance, you’re in business. Okay, so the 60-40 balance, I’m going to tie it up with something else. So the first concept is you need a team, and you need a team at all times. So in Barcelona or Real Madrid play a third division team, they still have a goalkeeper. They still have four defenders. It’s not like, oh, this is such an easy match that you know, let’s just put the strikers, we will win seven zero. No, you have goalkeepers, you have defenders, you have midfielders, you have strikers. And this will happen pretty much in any match. Right? And so it’s this idea of thinking about your team. And there might be you know, if you could build a team with a great bull like Michael Jordan and a great bear like Singletary, then it’s better than then you know just having them fight each other. So this is very important. Now in the context of all the macro discussion we’ve had, what is the right striker? What is the right midfielder, what is the right defender and goalkeeper? And I think the next 10 years, we really need to put this inflation hat on. So to me, equities are a better striker than credit. Because if you buy Telefonica 20 year bond that will pay me 100 euros in 20 years, guess what? I don’t think those 100 euros in 20 years are going to bite me much at all. Okay, so my credit may have given me some income, but the reality is this game has three levels. First, we need to make money in nominal terms, which is not easy. Your hundred dollars should be worth more in the future. Second, it’s, you need to make money in real terms. So even if you make 5%, if inflation is 20%, it’s pointless, because you still lost 15 in real terms. And so.

Mike01:05:23It’s sort of like a coin flip, where heads you lose, tails you tie.

Diego01:05:29Exactly. And then worse, the third level of the game is after tax. So you either get stolen through inflation, or you get stolen from taxes. It is incredibly difficult. So you have to win in nominal, real and after tax. Right. So in that sense, when you build this team, you need the best striker you can, which in my view, I favor equities to credit. The midfielders, I favor real assets to cash. You don’t need to be a genius to understand that in a world where interest rates are not going up, and inflation’s coming, and you have real estate paying you some yield, it should be better than cash which are being been diluted. And to your question, Richard, then we have the goalkeepers. And here, I think anti-bubbles like gold or TIPS or options and the strategy that I run are superior to the conventional defenders, such as fixed income. And I use this analogy. I called it the German Bund. I call it Beckenbauer, which may mean nothing to you guys. But it was this unbelievable legendary defender that Germany had in the, it may have been even West Germany at the time, that won the World Cup in 1974. And that he was an unbelievable defender, but he’s now 74, 75 years old. So yes, Beckenbauer was a great defender, but not anymore. The Bund was a great defender, not anymore. And therefore, I think when you put this, you know, there are multiple ways in which you could analyze the portfolio. I mean, people like Chris Khol look at the world, you’re either long vol or short vol. That’s it, everything is long, short, long vol, short vol, while other people might be risk on, risk off. Other people might be whatever. I think we need to add one dimension to this game, which is you’re either long inflation or short inflation. And I think when you build this portfolio over the medium long term, you need to have the team, you need the best strikers you can, the best midfielders, the best goalkeepers. But within that, you need to apply this framework, and understand that this is a game of, there are two rules. And I love Warren Buffett has a saying, very famous, there are two rules for investing. Everybody knows them right? First, never lose any money. And second, never forget rule number one, right? And then he comes and loses 50% or 60% in a crisis, right? And I always ask which rules were you playing by, with all due respect? With all due respect, which rules were you playing by? And the fact is that what he really means is that the first rule of this game is protect your capital. And the second rule is compound returns on your capital.

Richard01:08:32Sounds like you’re describing risk parity there almost.

Diego01:08:35No, no, there’s a big problem with risk parity. And this is a big part of where we tend to make a lot of money, right? There are anti bubbles, there are assets that are grossly artificially cheap. And one of them is volatility. The two big moves we have in the last two years, Q4 ’18 and Q1 2020 where the VIX exploded. In both cases, we had the VIX going from about 10, 11. So, artificially low volatility, creates this perception of low risk. I compare it to driving a car at 200 miles an hour when the speedometer says 80. Okay, if you have an accident, boom. What do you feel? You feel the real speed you were running, regardless of what the speedometer was telling you. Well, guess what? Volatility is the speedometer of the markets. If you bought, going back to your turkey analogy, you bought a stock that is barely moving, and it’s just going up, you don’t have a feeling of how much risk you’re really running. But the turkey could come and you go boom, in one day, right? Call it. So implied and realized volatility could be artificially low. They contribute to risk in both qualitative and quantitative ways. But the problem with risk parity was correlations. They were relying on correlations in a way that something that worked historically has been extrapolated. So perhaps their analysis told them that if equities, you know, the yield in the Bund would go to minus 5%. Sorry, might go to minus five, you have all the downside in the equity, you have a downside. So, what happens when you have artificially low volatility and artificially local relations is that you’re running hidden leverage. And when shit hits the fan, both move at the same time. Volatility explodes, correlations move. You know, I bought some options in February that were S&P puts contingent on the dollar higher. And the vanilla would have cost around 7%. I paid 60 basis points for this. Okay, so I got a 90% discount on a vanilla put by adding one condition, which is dollar up. In that case, dollar yen. Okay, the market said, No way. If S&P collapses, then obviously, the yen is going to rally, dollar yen is going to collapse. And that was true in phase one when you had, because in March, we went through about four phases. So DEF CON one was vol goes up, and all the carry trades boom, unwound. So Aussie-Yen, went from whatever 75 to 55. And dollar-yen went from 109, 110 to 101. But then came the next wave. And then we started to see the stress on the US markets and euro and the yen collapse. And we have this situation where things that were not supposed to happen, happened. And then the S&P is down 3% and dollar yen is up 3%. And all the models are going like, What the hell is happening, this was not supposed to happen. And as an engineer, you know, this is effectively what happens in fluid mechanics, okay? You have a laminar regime, a world where relationships are linear, and you go into turbulent regime when things happen, okay. And this is, in a way, the gross, the big blow ups that you’ve seen in trading and risk management, they always come from a either leverage, you know, either direct or hidden. And very often from these positions like artificially low volatility, artificially low correlations. And this was what blew up Dalio and Company in March, because of this reliance. And I think I’m going to make another point here for the listeners, which is, you know, we’re up 40%. Without leverage, without any short and only buying options. Why? This is the most concern, as a goalkeeper, you have to be the most conservative you can. Leverage, you know, if you, I have this, I have this article in the front page of the FT, where I was calling for three to 5000 gold within three to five years when gold was at 1,100 – 1,200. Okay. And at that point in time, you know, the view was very similar to what we’ve discussed today was I’m just I’m a chess player. So I was just a bit early, I could see what was happening. And so people might say, Diego, wow, why don’t you sell your house buy gold, lever it up in futures and you’ll be a millionaire or gazillionaire, or whatever you want? And the answer is no, I’m going to be bankrupt. Because when you lever yourself a lot, and you know, the market will take you out. So leverage in linear form, no. Long/ short. Okay, Brent, WTI, Tesla, Ford, okay, whatever. Yeah, people were like, Okay, Tesla is a terrible investment, I’m going to go short. And, you know, you could either do a long/short, which is a bit of a problem, or you could say, and this is another typical problem is, I’m going to buy puts, and I’m going to finance my puts by selling calls. And my answer is always, Dude, you’re not financing anything. You’re long puts and you’re short calls, and you just blew up. And this idea of financing zero premium, effectively creates hidden leverage, you know, either direct, which is not hidden at all, or long short, which creates these blow-ups through volatility and correlation. Okay, or through option structures where you’re short options. And this is the reason why. Trust me, I know how to sell options. I could do that. It’s not that hard, okay. But it’s self-imposed discipline to create a process where you need to find the cheapest available option that will be the most explosive with the best carry. And this is what we set out to do as a goalkeeper. And what hopefully we’ll continue to do as a goalkeeper. It’s not easy. And it’s very, it’s very tough

Mike01:15:12When you’re creating that, that that structure that you mentioned the, you know, sort of the short dollar, short markets, are you doing that through listed options? Are you doing that through a combination of option contracts and futures? Or do you buy a non-listed option that you source through a bank?

Diego01:15:36Yeah, we source that through banks. If you think about the tools available for us, as investors, both to trade the market and to have information about the market, there are multiple dimensions. The first one is pretty simple, is spot trading. Yeah, you just buy and sell something. And that’s it. Gold, up or down? You buy your future. There’s not a lot to discuss, right? How much information do you get from gold price action? Whatever. The second thing you can look at is the term structure. Are we in contango or in backwardation? Shall I play time spreads? You know, and you put positions that effectively give you more information about what’s happening, you know. In commodity markets, once you go into backwardation, generally, it’s a very, very big signal. The third level is options markets, which is going to give you an estimation of the probability distribution, and the shape of the curve and the skews and what is effectively being priced in. So you know where you are, you know what the financing conditions are, you know, the supply and demand of insurance. And then you can go on and on. And you could actually add the fourth dimension, which is called correlation. So, think, for example, about one asset called gold, dollar gold, and another asset called euro dollar. Okay, what’s the relationship between gold and euro? Okay, I know what gold is, the term structure, how it moves. And then I know what the Euro is, the term structure and how it moves and the options market. How does gold and euro behave? And if you think about gold and euro, in order to understand how gold and euro behaves, you need to make some assumptions on correlation, which might be rolling correlation, how has it moved in the last six months or whatever. And here, you have two scenarios that are very interesting. One is, the market is highly correlated. So gold and the Euro are the same thing. This is what’s happening today. Okay, the high correlation in the markets, we’re just trading the dollar, either long or short. And you have this dynamic where the S&P and gold and the Euro are the same thing. As far as I know, they’re not the same thing. Okay. And there are times when these relationships change. And if the correlation went from plus one to minus one, you would have something like this. And the time when these things, these correlations tend to break during crisis, not only correlations break, volatility explodes. So you go from something that looks super stable, like gold and euro, low vol, high correlation to effectively things blowing up, volatilities explode, correlations break, and these little tiny things can go boom. Okay, that’s why we make five to one, 10 to one, 20 to one, 50 to one in our bets, right? Because it’s about in order to make 50 to one, you need to buy something incredibly cheap, right, that has the potential to do that. By construction, a 50 to one, the market is given an implied probability of 2%. Which may be implied by what the market thinks, but might be under a laminar regime under certain assumptions.

 

Bubbles, Anti-bubbles and Risk Parity

Richard01:19:11Diego, I think there’s a lot of merit in the way that you describe the methodology and the convexity that you get out of some of the trades. But I want to kind of circle back on your earlier point, because when I asked you about risk parity, it was sort of a provocation, because I’ve heard you talk about risk parity before. But it sounds like it’s a little bit of a straw man version of risk parity, sort of a levered bond portfolio, which –  and obviously, the devil is always in the details, right? So it’s how you implement it, it’s what matters. So if you’re talking about a risk parity portfolio where you’re also adding components like real estate, or gold and commodities and things like that in emerging market assets, I think a lot of the, as well as updating your correlations and volatility estimates, frequently as opposed to sort of maybe the anti-cyclical version, which is for balancing back to predetermined weights for those historical asset classes. Once you add those layers, it sounds like maybe the perception that you have, or the opinion about risk parity, actually could use a little bit of an updating, and we can actually have a lot of the midfielders that you were describing earlier, right. The idea of.

Diego01:20:20Let me make an important point here is, I have no issues with risk parity as a concept. The point I’m making is what I call hidden leverage. Okay, hidden leverage is leverage that you have, but you’re not aware of. Okay, it’s risk that you’re taking, that you’re not aware you’re taking. And therefore, this is how you blow up, because you didn’t even see it coming. You were not even aware that this thing could happen. Okay. Look, Brent-WTI, two crude oils, right, they’re like, chemically the same thing, you know, and they’re expected to move this way. Who would have thought that you one could go up so much, and the other collapse? The people who blow up, they’re not the guys that are trading the spread on a small amount. The problem is, you think you have such little risk. Let me put it differently. If you’re a flat price trader in oil, you might take a position of 100 lots. Okay, because oil moves a lot. But you know what position the spread trader takes, the guy who trades Brent-WTI? 1,000 lots. Why? Because he thinks that his 1,000 lots have less risk or similar risk to the 100 lots at lot price. But as a risk manager, what I would tell you is, no, you’re long 1,000 lots of one thing, and you’re short a thousand lots of the other thing. No, no.

Richard01:22:10The issue is leverage.

Diego01:23:03The correlation is very high. Once you rely on your correlation for risk management. That’s why when I talk about the worst case scenario, it’s the worst case scenario. Oh, come on Diego. You’re exaggerating? No, no, what’s your worst case scenario? That will never happen? What’s your absolute worst case scenario? Okay, so let’s look at Tesla. Who thought on the short side, this thing was going to go 800%? What was their worst case scenario in their mind? Who would have thought that they could lose? I mean, it just doesn’t happen. It doesn’t register? And you do this long /short for Tesla. And you think you’re okay, and I’ll do $100? How much can I lose in the long/short $100 for Tesla. He could lose infinity. Now, come on, that’s never gonna happen. Whatever. This could cost you 800 just to start. And this is why people blow up. My point, it is the same thing with CTAs. Right? Or others? My point is, do you understand the risk you’re taking? Do you understand it? And under what circumstances do your conditions hold, and risk parity held on throughout the toughest conditions, including 2008. Because it had room with rates at 5%. But these condition’s change. And the March test was not expected to happen. But it did happen. Because they were still relying on correlation. So to the extent that risk parity led them to lever themselves up, they blew up. But if you do it in a way that you don’t let that reliance on volatility and correlation to fool you, then you’re safe. And that’s why. Does it makes sense. What I’m saying.

Rod01:23:55Yeah, I think the nuance here is that the definition I think of blowing up, you know, when they’re.

Diego01:24:04Blowing up means you’re taken out by the market, you don’t get to see the end of the match. You’re out.

Rod01:24:07Right. That’s not that’s not what happened, like risk parity didn’t get taken out by the market. They had a bad drawdown. Right. Having said that, the correlation I mean, I think anybody who’s a risk parity practitioner has gone through the math or you can, this is one of the things that you can go back 100 years and know what you’re getting into. And I think there’s not a single risk parity practitioner that doesn’t know that a liquidity, a negative liquidity event is going to lead to your things that used to be non correlated to become correlated. So we saw that in March, right, you saw it was risk parity actually held in quite nicely. Beckenbauer showed up beautifully for a little bit there. Gold was really strong. And then there was a period where both equities, gold, and treasuries, all went down, where you were correlation.

Diego01:24:54Blow up is when you’re taken out of positions, you’re forced liquidation. Anything that forces to liquidate is a blow up, because you cannot withstand conditions, you don’t get to see the match, because, and this might be, you might say, this investment didn’t go to zero, but you have permanent loss of capital. Okay, when you’re taken out.

Rod01:25:18Did risk parity have permanent?

Diego01:25:20I think so. Some of them.

Rod01:25:18Well, I want to dig in, I just want to understand what you mean by that. Because I’m with you, I think risk parity would benefit tremendously from a goalie, because it is those periods when the correlations that have existed 99% of the time between commodities, bonds and equities, are there, there’s a one or 2% of the time where they go away. And there’s nothing but being long volatility, or long convexity that can save you during those periods. Right. So far, risk parity implementations across the board would have benefited from your fund, plus risk parity, no doubt about it. But those that, the funds that exist out there have recovered in or above high watermark for the year from the drawdown that was fully expected going back 100 years. Right. So I think, again, I think you have, you’re missing a piece in risk parity, which is that liquidity event. And the reason that most recruiting practitioners don’t add that tail protection, is because they have this belief that there’s this massive negative carry. I think you’ve addressed a lot of the reasons why you can have positive carry in this.

Diego01:26:25I think, look, I’m not. Let’s not to get the point wrong. I’m talking about risk management, and things that happen during crisis and, and understanding your risk management and being able to survive and thrive. I mean, that high watermark, think about Fukushima, right? Who would have thought that I mean, this nuclear plant had, you know, a wall that would have effectively been able to withstand the biggest tsunami ever recorded in the history of Japan, right, but by a margin, until this thing happened, right. And now every single new power plant will require this new high watermark. And to a certain extent, this is just part of the game. Right? So to what extent that event was meant to happen all over, and they knew, but you’re left with a Fukushima. But the other point, which I find a bit disturbing, sometimes, is this idea, from particularly value investors that they say, Yeah, but I never sold. I never sold. Yeah, the problem is you sold because you know, you’re a chicken. Well, guess what, maybe I had to sell because I needed the money or, or whatever. Or maybe or some people maybe were caught in some sort of leverage. I think. And the problem, I’m saying it’s not easy. I mean, the goalkeeper doesn’t give you something as reliable as gold, or even the VIX. I mean, we’ve had instances recently where, you know, strange things are happening. And so I’m not saying that, oh, the VIX will be the perfect goalkeeper or gold because if you only had that, then you would have not suffered then. This is forward looking. And to the extent that you will have a leverage in one way or another that relies on things like volatility and correlation, we just need to be mindful that it may or may not work. I’m not picking particularly in risk pairty, in the sense that and plus I’m not being fair by overgeneralizing, there’s thousands of ways in which this plays out. I am trying to pick on the, from a risk management perspective, get the listeners to think about things that they might not be aware, and they might not think are possible, but that… look, silver. People say, I like gold, therefore I like gold miners. I like silver. Gold is a great defender. Then if I could only have it three times levered in this ETF, then if one time levered is a great defender, three times levered must be a kick ass defender. Well guess what? Guess what? Your three time levered gold miner ETF, Junior, whatever. And I don’t know the numbers exactly. But let’s say went from 100 to you know, you lose 30% times three, and daily rebalance, this thing goes to 10 cents on the dollar. Yes, gold miners have more than doubled since, which means you’re at 20 cents. And this is what I mean by permanent loss of capital is, because you’ve been taken out, your 100% in capital no longer is 100% in capital, because you’ve been taken out through forced liquidation. And because you now have 10 cents, you don’t get to enjoy the rest of the match because you are red carded, and you just go to 20 cents, and it might take you 10 years or 20 years or forever. So is this jump in logic that says, gold is great, gold miners are levered play, they’re all fantastic defenders, if I could only just lever it. Look, equities are down, I will go up. No. You need to think about these two legs as totally independent, that correlations might break, and that they might take you out. And this is something that I keep emphasizing, and I’m not making wood of a fallen tree, I’m just saying, I’ve seen as Global Head of, you know, Commodities and Risk Management, I’ve seen people with $1 million dollars of VAR lose 50. Okay.

Rod01:30:45For sure.

Diego01:30:46These things happen, right. And this is all I want to pass on to people because this is a game of capital preservation and compounding on capital preservation. If you want to win, you must first not lose. And I’m not saying we are the best goalkeeper in the world, I think people need many goalkeepers. And they need many strikers. And I think this idea is this portfolio team and construction where you’re not, you’re humble about the markets, you’re not going crazy and you enjoy this volatility. I personally think it is safer and more successful than trying to make too much money too quickly and being caught in direct or indirect ways in leverage.

Mike01:31:30Yeah, what’s so complementary in the way you’ve approached the problem is that, one of the you know, very large sort of elephant in the room is the instability of the correlation to provide the defense that you would expect, whether it’s, you know, long term changes in the discount rate that can have an impact on risk parity. Right. So now what you’re doing is you’re creating trades, that have this massive upside, because you’re harnessing the inaccuracy of those correlations between those asset classes, and thus getting your put on whatever underlying asset class at an insanely low price because you’ve mapped it to some other asset class, which is precisely the thing that will break when you have a crash type event, which then makes the strategy so complementary to many other strategies that are more anything.

Rodrigo01:32:25Yeah, I think you know, we’re coming in an hour and a half. I do want to wrap it up. But I think a takeaway that I have here because we’ve interviewed a lot of people thinking about convexity and tail protection, and a lot of it you know, when you start with a very simple process of, “I got my S&P exposure, I want to hedge my S&P”. And people think about it that way. Like, I just need to do that one thing and hedge against that loss. I think what’s unique about this, your approach, Diego is, you know, the framework that you have is, understand the things that you thought, you know. What is Mark Twain’s quote, It ain’t what you don’t know that gets you into trouble, it is what you know for sure that, in your case, blows it up”. The idea here is not about trying to protect against an S&P 500 draw. The idea is you want to understand the possible scenarios. And understand that in order to hedge against those possible scenarios, because nobody’s thinking about it, you can get that really cheap, versus trying to just buy a put in the S&P. And it’ll create an outcome of protection, not just for one scenario, but a series of scenarios, whether it’s high inflation, deflation, equities going down or whatever.

Diego01:33:32Challenge. Let me make this point clear because look, there’s nothing better in the world than a vanilla put in the S&P. It just doesn’t exist. Okay, if you can buy it cheap. So, if you’re long the S&P, and you can buy a cheap vanilla put on the S&P. Done, you don’t need to worry about anything, you have zero basis risk, you’re covered. You have a synthetic call, you’re okay. And the ironic thing of the anti-bubble framework is that the market was giving you the cheapest insurance when you needed it the most. Because at 3,400, you could buy the put at 10 vol. It’s the complacency of the market that sends vol lower that brings this higher. So at that point in time, you don’t need to go complicated. You don’t need to do any correlation. You don’t need to do anything. You just buy artificially cheap insurance. The challenge becomes now, you have your, your accident has happened, the VIX is more fairly priced. You’re at 30, 35. This thing is negative carry, this is really challenging. Okay, but if you want to sleep at night, bite the bullet and buy the S&P put, and that would be the best thing you can do. Unfortunately, over the last few years, it may have not worked very well because you’ve bled so much that it’s really become an issue, and that’s why people sold the vol and they looked cheap. So don’t get me wrong. Please do not overcomplicate the portfolio, this the best anti-bubble in the system. It is artificially low volatility and therefore, you have to buy the simplest and most effective option, which is a vanilla put on what you own. I’m long gold, buy a vanilla put on gold, I’m long the S&P buy a vanilla put on the S&P. Unfortunately, because of the carry and other considerations, you may need to complement that with other things. And the point I was making with all these dimensions, is that sometimes, and these things come with a risk, okay? It’s not like we are, oh this always works, you know, and S&P down, dollar up. It could not work. I mean, this last month, you had very strange things happening. But I have 77 options in my portfolio today. And they are trying to cover as much space as possible, including a China blow up. When your S&P collapse, could well happen because of a China blow up. Or you have inflation picking up or you have it’s an S&P move, or is it gold or isn’t it. So, what we do is just a humble approach of being a goalkeeper, we’re not pretending to be the all singing, all dancing for everybody. We just think we could be a nice complement and addition. But that’s what we try to do. But look, it’s that eternal search for, and I would flip this problem the other way around. It’s like, guys, look for strikers that look more like call options. Okay, don’t be complacent by just being on a Delta One, just because. You want your striker to be the best call option you can, which means three things. Give me as much upside as possible, with the least downside as possible, with the best carry possible. That’s what you want. Okay, and flip the same thing for the goalkeepers. If you could only do that, you’re in business, because then you’re actually able to balance them out. And this is the big challenge, and I think the framework that we bring forward, which is not fighting with the strikers, because bulls and bears is, Dude, you miss the striker incredibly valuable, just make sure when the opportunity comes, score the goal, and don’t get red carded. Okay, and the goalkeeper and the defenders will try to do the saves. And I think that’s the key, but the degree of complexity and what we do comes with some risks, and that basis, you know. I don’t have a magic formula. I’m just saying, Look, if you can buy these cheap options, great. If they’re not available, we need to find the right balance and find those odds, so that the objective is to buy options that are low premium, explosive payout, low carry. If you can do that by buying S&P puts at 10 vol, done, okay?

Richard01:37:48If not creative conditionality for carry.

Diego01:37:53You need to have other ways in which you do that. But under no circumstances, you should be so creative, that you didn’t achieve your objective, that would be a disaster. So that’s why this is the challenge, and this is what makes this so difficult, so difficult. And we’re just humble students, we’re trying to do our best. And that’s it.

Rod01:38:12Well, you’ve done a great job so far, as you always say, I’ve heard you say before, what you’ve done has actually been what you put in the tin. What you expect to happen has happened. So you know, kudos to you and your team. And always, you know, love hearing your thoughts about everything beyond anti-bubble. So hopefully we can have you back another time. Maybe with your next book.

Mike01:38:36I want, on the next one, I want to hear about how, once the tail hits, how do you prevent the tail from wagging the portfolio dog? How quickly do you rebalance? How do you think of all those things? Because there’s talking about it conceptually and then get hitting the tails right, and you hit the tail, and now your investors are coming in and you.

Diego01:38:55This is all about, you know, you need to design the you know, the like the fireman, right. The fireman does not improvise on which boots do I put and which. So, effectively one thing that was very successful for us in you know, after making call it 40%, 45% in Q1, we were actually up in Q2. Okay, I think that kind of shocked a lot of people is you need to have, by construction is the equivalent of a goalkeeper that just did the save and stood up and got ready for the next shot. Okay, you can’t just stay down there lying, because you just did the save and they’re not going to shoot again. What it means for us is our strategy has roughly 50% precious, 50% treasuries and TIPS, and 25% in options. Those weights are meant to be relatively stable, okay, so that if someone invested two years ago or two months ago or two hours ago, they know what they’re buying. What happened in March is my 25% options portfolio went to 30-35, 40-45. That’s really where we made the money. And it’s the discipline of bringing that back to, taking profits on that, and reinvesting, so that you go back to 50-25-25. And you do this in a forward looking basis. So, in that sense, by taking profits on the insurance that works, and going back to call it neutral, you’re always constantly ready for the next save. And that’s why we do what it says in the tin. Because it’s not like, Oh, I thought you were 50-25-25, and turns out that you were 80-10-10. No, we’re 50-25-25. And if you have these options that you’re only long, I can only lose 25. But if I have a long/short volatility profile, that 25 could lose you 500. So this is the reason why we operate the way we do and why it’s predictable. And why as a goalkeeper, you need to do that. So it’s that, this is not something you improvise. This is something that you’ve planned into this because, you know. I always said you’re as good as your last crisis. And I stand by that, okay, because as a manager, you know, a monkey can make money under certain market conditions, you know, in my particular job is to do thing, and that’s the bar we hold ourselves up to. And listen, we’re not foolproof, okay. This month has been challenging for us. It’s been, in fact, the first month that, you know, equities are down and we’re down in our life. Okay? Because gold got trashed, the starting point in the VIX wasn’t good enough, it didn’t move. Then we’re still incredibly well positioned, I think, into the balance of the year. But it doesn’t mean that being a good goalkeeper means you will never receive goals. That would be fool. And it goes to my point on leverage, Oh, you’re such a reliable goalkeeper that I’ll ever you 50 times. No, please don’t, you know, because then we fall into the trap we’re trying to avoid. So I think in that sense, you know, this is just something that having been through multiple crises through my career, I mean, we’re all very young, all of us, but somehow we managed to be in multiple, starting in my case from ‘97, ‘98, I was already in the job. And every crisis teaches you something. And I’ve been a humble student of this crisis and hopefully, will continue to learn, because the game keeps changing. And what we’re experiencing today is, just keeps challenging the rules, and it forces this thinking outside of the box on how we approach insurance and other things that are, you know, are a solution hopefully to a very, very, very big problem.

Rod01:43:00Fantastic, Diego. Amazing having you as a guest. Good luck there in Madrid with all the COVID and political issues that you’re seeing.

Richard01:43:14And yeah, this was awesome. Atletico or Real, Diego.

Diego01:43:15Atletico. I’m a very weird specimen because my father played for Atletico, and I’ve been raised on Atletico, but my father was also a big football fan, big lover of football, and we’ve always appreciated football. So don’t, what I’m going to say will shock some people, but it will show you my personality, which is I’m an Atletico Madrid first, Real second. And this is generally considered to be like, madness. So I perhaps don’t make friends on either side. But I am from Madrid. I love it. Having spent 20 plus years out of Spain, I developed some love for Real Madrid, which wasn’t there before. But I love the game. I love the game and you know I think there’s lots of things to enjoy and learn. But look guys, it’s been an absolute pleasure. Best of luck with everything else over there. And I look forward to continuing the dialogue and, and yeah, stay healthy.

Rodrigo01:44:23You got a great weekend. Thanks for joining.

Diego01:44:27 Cheers.

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