«The bond bear market is just a question of time»

Strategist Dylan Grice recommends minimizing duration risks und says what he thinks about private equity, factor investing and gold.

He has never felt comfortable with macro investing and forecasting says Dylan Grice. This sounds like a confession coming from someone like him who spent years providing investors with in-depth macro analysis and forecasts when he was an independent strategist with Société Générale. Since he learnt what it means to invest instead of only writing about it, Grice has stopped making big macro calls.

«The only thing I know is that bond yields will at some point start to rise again», says Grice. All long-duration assets would be at risk, he told «Finanz und Wirtschaft».

Mr. Grice, bond yields are at record lows and equity valuations stretched. What can investors do in this situation which is sometimes called the «everything bubble»?
The new real challenge for asset allocators is how to build a portfolio that is protected from a bond bear market. Falling bond yields and a duration bull market have defined my career and that of my contemporaries. I think that it will be a duration bear market which will define the rest of my career.

You expect interest rates to rise. But at the moment, the big central banks are moving into another direction.
I don’t consider myself a forecaster. I don’t know when the duration bear market begins, if we are already in it or if it will take years. All I know is that it is the biggest risk out there. Everyone knows it, a bond bear market is the elephant in the room. People act like this: We know that when bond yields rise for a longer period of time, we are all screwed. So let’s just hope it does not happen.

Rising interest rates would of course hurt bond investors. What about equities and other asset classes?
All assets with long duration that have profited for the last centuries will go down. Long duration is not only a bond concept. The whole illiquid spectrum like private equity, venture capital and buy-outs have a very long duration and are sensitive to higher rates.

What about the illiquidity premium and the alpha generating skills of private equity managers?
That’s what they want us to believe and it still works. Private equity has done so phenomenally well over decades. It is now a core allocation. When I was at university, everyone wanted to work for Goldman Sachs (GS 237.08 -0.53%) or another famous Investment Bank, today they all want to go to a private equity shop. I do not have the data, but I am quite sure that most of the returns from private equity investments come from lower rates that push up valuations.

But listed equities are also long duration and would be hurt in a bond bear market, wouldn’t they?
Of course, every type of equity is kind of infinite duration. No matter what cash flows you expect, when rates go up, the discount rate goes up and the net present value of those cash flows collapses. The same happens for private equity, with the difference that the money is locked in. I think the illiquidity premium could actually become negative for this asset class in the event of a duration bear market. Public equities are a liquid asset and don’t have any illiquidity premium, so I’d expect private equity to go down by more than public equity in a duration bear market.

What will happen to real estate assets in a duration bear market?
Real estate also has a very long duration. The effects of a bond bear market are ambiguous. The valuations would adjust with higher rates. But on the other hand, it’s a real asset and that could actually help when rates rise because of inflation.

Growth stocks have outperformed value stocks for years. Low rates and falling bond yields could be a reason. Has the time come for value investors?
The term value investing does not make a lot of sense to me. Everybody who is in investing is looking for value. It is like saying someone is a fast sprinter.

And if value investing is defined as buying stocks that have, for example, a low price-to-earnings ratio?
Then it does not make a lot of sense. Buying something at a low PE does not mean you get value. A stock with a PE of 9 could be worth even less. On the other hand, a stock with a PE of 30 can be value for investors if it’s worth a PE of 40.

But the existence of a value premium is an empirical finding.
Only because buying cheap stocks once worked does not mean that there is something like a value premium. The excess return found in the data was an anomaly. It worked 50 years ago because the market was much less efficient. Today, everybody can sort stocks by their PE on free websites and you buy books about value investing at every airport. To find cheap stocks is no longer a valuable information. 50 years ago, compiling value measures was hard work and only super brains like Warren Buffett were able to do it properly. Today, there are thousands of so called value investors and even ETF. Of course, they are not successful. Because they did not need to work hard for the data. The only people who make above average return are people who work hard for the data.

What about other styles and factors like momentum and minimum variance?
Maybe you find such premiums in the data. But these are not real premiums, these are anomalies. How could it be otherwise? How can people believe that a strategy that people chuck so much money at will make the same returns as it made when nobody did it. Through arbitrage, prices will converge to a new equilibrium where there is no arbitrage. That is what happened to the value anomaly over the last 50 years. I wonder what kind of planet all these people are on who belief in the existence of style premiums.

Which premiums are real then?
There is a real premium for duration-, credit- and equity risk for example. And there is an illiquidity premium. You can also find premiums for modelling risks or catastrophe risks and many more.

You said you would not want to take too much duration risk. What about credit and equity? Which risk is better rewarded?
Equities are more attractive than corporate bonds. With bonds you know what you get: You just take the spread over treasury bonds and subtract the expected default rate. Credit spreads are not at record lows – in 2006 the market was even tighter  – but they are way below the historical mean.

But aren’t the expected returns from equities also low?
I don’t say that equities are attractive on a total return basis. But the total return is something you are not really in control of, because it is driven by the risk free short term rate. When it is low, returns on government bonds are low too and so are all other expected returns including those from equities. But relative to the poor alternatives, they look quite attractive.

How exactly do you come to this conclusion?
To illustrate the thinking, invert the Shiller-PE to get a normalised earnings yield of 3%. Add real expected growth to those earnings of 1,5%, that gives you an expected real return of 4,5%. Now deduct from that the expected real return of treasuries, which is at best around -0.5%, which comes from 1,5% yield less 2% inflation. That gives us an expected excess return of equities of around 5% which is roughly the same as the excess return equities have enjoyed over bonds over the very long term.

Does gold have a place in a portfolio with low duration risk?
I think there are a lot of reasons to own gold. It is the ultimate hard currency. That is an advantage in times when bad and dangerous ideas such as the Modern Monetary Theory gain acceptance. The argument against gold has always been that it has no yield. But this is now also true for government bonds. While with bonds you have a huge amount of inflation risk, with gold you haven’t. So, choose your poison! I don’t think it is a bad idea to own some gold.

After the financial crisis, your ex-colleague at Société Générale, Albert Edwards and you were supporting the ice-age-theory. The gloomy predictions proved right and bond yields are much lower than in 2009, but equities went up too. What did you underestimate?
The ice-age-theory, which basically is saying that developed economies will be suffering deflation with lower rates and falling equity prices was always Alberts thesis. I was much more worried about the thread of inflation. That was my biggest mistake. When the yields went lower and lower I told Albert to stop it. I said, you got to pull a plug on this, you had a great run. But look, yields are at 2%, they cannot go any lower. But I was completely wrong and Albert was absolutely right. With long-term Japanese or German government bonds you made better returns than with most equities, especially when the investment was leveraged by funding it with short term bonds.

Was this fundamental dissent the reason you left the French bank in 2013?
No, the reason Albert and I went so well together was that there was not a SocGen view everyone had to align to. We were independent. Actually everything was perfect. But I thought it was time to see something else than banking in London. I took the opportunity to work as a strategist for a private investment firm in Zurich. Soon I moved on into equity portfolio management.

That must have been a big change for you. How did it go?
Very well, actually. I learnt what it means to invest, to be responsible for it and to lead a team. At Société Générale, it was all about writing and narrative construction which is a very different thing from investing.  In the near future, I want to do both. With a friend of mine who has a quantitative and systematic background, I am setting up a new company called Calderwood. It consist of two businesses, a hedge fund and a research business.

Your wife works in the crypto valley in Zug. Does the future belong to crypto currencies and blockchain?
My wife has been very involved in crypto. Her company did one of the first initial coin offerings just as the bubble went crazy. We had the front row seats and saw the whole thing go up and down.  It was insane. I have seen bubbles in my time, but I have not seen anything like that and probably ever won’t. It did not have the wider social consequences because it happened in a niche. Now the bubble has burst and the market is much healthier. The projects must have something real now to get funding. A lot of good ideas like blockchain are struggling for legitimacy. But like after the internet hype and the burst of the tech bubble some ideas will survive and be playing a huge role. And different from other start-up-industries, it is almost untouched by venture capital.

What is wrong with venture capital funding?
My guess is we are going to see a lot of problems in the venture capital market. The debacle around “We work” was just the beginning. Softbanks Vision Fund is simply buying everything. It is a whale in the market, backed by dumb money, that has inflated the entire market. Only a few people understand how to do venture capital. My experience is that a lot of people who I have questions marks over their investment acumen, have suddenly become venture capitalists. It is very cool to do venture. And in addition, you have this big dumb-money whale inflating valuations everywhere. That’s a bad combination.