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Ari Bergmann on risk and the markets

Webonchina. The global response to China’s devaluation of the yuan shows how crucial hedging risk is.

Octavian Report: Can you explain what it is you do at Penso, and how you see that working for investors?

Ari Bergmann: At Penso, our focus is derivatives, macro-strategies, and convexity. Which means we look at the world to find opportunities with convexity — i.e. a limited downside and a leveraged upside. Our focus is macro, and we have two flavors of it, so to speak. We do hedging, but we don’t like the term “tail hedging.” Tail hedging means that you’re hedging very unforeseen, surprising events, and we think that most of the events we hedge are foreseeable. Most of the events we hedge are not that rare, and just because others choose not to see them doesn’t make them tails.

The first flavor is our focus on systemic risk: where there is a situation that the market moves in tandem with correlations becoming plus one or minus one, and risk assets go down and safe assets go up. In other words, diversification won’t help you. We create portfolios which hold trades and positions that will benefit a lot on a leveraged basis if the market falls. Our goal is, basically, to have these hedging strategies pay for themselves. In other words, they can make money — or at least break even — if the market goes higher. They’ll make a lot of money if the market goes down.

The second flavor is our attempt to grab, irrespective of market direction, missed opportunities, to take advantage of big market moves.

OR: Do you tend to make money more when the event you’re hedging actually happens, or do you see the market correct itself anyway, even if the event doesn’t happen?

Bergmann: We don’t need the event to happen. Market perception of the risk drives our gains. We’ll make money when the perception of the risk by the market changes. If the market, right now, is ignoring specific risks, we’ll buy hedges and protection based on those risks. If the perception changes, the pricing changes, and we make money. We sometimes make more money if the event actually happens, but really we’re just assessing the risk probabilities assigned by the market.

OR: You were one of the creators of the CDS, and there’s been a lot written about derivatives themselves being a major systemic risk. How do you think about that issue when you’re putting together your hedges? Or do you think it’s such an outlying risk that it’s not relevant?

Bergmann: Derivatives are powerful tools. They are like nuclear energy. Properly used they are very beneficial, very helpful; improperly used they become very dangerous. That’s why derivatives are very powerful tools, because they have a lot of convexity. They have a lot of leverage. They zero in on risk, which most people misprice, or even ignore, because they don’t understand it fully. Therefore, derivatives are very, very useful, if properly used. If people who don’t know what they’re doing start playing with them, clearly it’s more dangerous.

CDS are a great way of understanding credit risk and of hedging credit risk, but they can be used also to leverage credit risk. When people who don’t understand take those risks, you see what happens, as in 2008.

OR: When you look at the world and at global markets right now, what’s the biggest risk you see?

Bergmann: Our hedging strategies are divided into two categories. One is based on something called proactive risks, the risks that we see on the horizon. Those are the things that we hedge. Let me say here that half of our book consists of what are called reactive hedges. Reactive hedges are trades, positions, that make a lot of money if the market goes down. Irrespective of why it went down. In other words, they are basically reactionary to the market, rather than predictive. But if I look at the market risks on our proactive book, the main things that have us worried are the following.

One issue is clearly China. We have been saying that this is an issue for a long time, and the reason is because the economic and political situation there is unclear. It’s very unclear where its government is trying to go. It’s not an open economy. They’re extremely big, and very important to world trade. Therefore, the mere fact that China’s policy is an unknown — a policy so mixed with politics, run by so few people in such an opaque way — creates in itself a huge risk. I don’t think the risk is internal so much as external, less of China blowing itself up than the people who depend on it for trade: countries, the economies of which are commodity-based, as well as the Asian currencies which depend on exports to China.

China is shifting from an infrastructure economy — an economy that depends on building roads to nowhere, so to speak — to a consumer economy. An infrastructure economy is an imbalanced economy. It’s an economy that produces things. They sell, they keep the money, but they don’t create a consumer base. The natural outgrowth of that is the creation of oversupply. That’s what they’re going through. China is shifting to a consumer economy and a lot of economies that are dependent on the old China are going to get hurt — I mean economies that depend on exporting commodities to China. That works with an infrastructure economy. Not as well on a consumer economy. The risk there is that as this shift is going on, the world is not prepared.

The second big risk is geopolitical risk, as such. The geopolitical risks out there are many and growing. Consider the instability in the Middle East: we see its primary foci as Syria, Iraq, and ISIS. It’s a matter of time before that last group crosses the ocean. Connected to this is the mass migration to Europe we’ve been seeing in the past months. I think this mass migration to Europe creates a different set of risks. It puts even more pressure on Europe, it creates a lot of strain on the European Union. Already we have the issue of economic imbalance within the euro zone; added to this is a phenomenon that will put political strain on union in Europe. I think Europe is a risk, and remains a risk, because of this marriage of countries called the E.U., which lacks any real mechanism for orderly breakup or exits. It’s clearly, to some members, a bad marriage. At some point, I think, this instability will come more prominently to the fore. There’s another specific political risk here, too: the massive migration of Middle Easterners into European countries gives a lot of ammunition to the extreme right. And the extreme right is not a fan of a unified Europe.

Next — and I am not going by order of importance here — is something very real, the shift in U.S. monetary policy. I think the U.S. is going to shift its monetary policy. Our economy is doing much better. Zero rates are not appropriate. The Federal Reserve will take a stance on that. No matter when they do, we are in the process of needing to change that. I think that this upcoming shift in monetary policy is something very new. We have not seen this for many, many, many years, and a lot of people have never seen that, period. I think that this is a problem — a new volatility. I think that this process will continue, and not only now — it will continue until the final unwinding of the monetary policy of the past years has taken place.

OR: So as we gear up for another wait-and-see session with the Fed, do you see central banks beginning to unwind monetary policy in Europe and Japan?

Bergmann: I think that Japan probably, unless something changes, is going to wait until increasing their easing. I think they’re still in the process of easing. I think the ECB will be much more aggressive in easing. I think that this migration issue creates a deflationary pressure, one that’s going to exacerbate the European problem and actually encourage the ECB do more. I think that Europe and Japan are actually easing monetary policy because they are in a different stage of growth. The U.S. is actually taking it down. They are already moving it.

OR: Does that make you bullish on the dollar and bearish on the euro and yen?

Bergmann: Again, that’s a question of timeframe. I think the euro is straining. I think the U.S. dollar is a buy against the euro. Against the yen it’s debatable, because the yen is still a bastion of safety. These questions are a reflection of risks. The risks go higher, the yen appreciates against the dollar. If the market is a risk in the yen’s home environment, Japan could change out its policy. In that case, the yen can actually depreciate. I think the big depreciation risk is the euro. I think the euro has room to go.

OR: Would it be fair to say you’re negative on commodities, and negative on Asian currencies and commodity currencies?

Bergmann: That, again, is a question of timeframe. Regarding the commodities glut, people think that we have come to a bottom. I don’t think that we are at the bottom, but I think we’ll be low for a while. I think that the shift in economic paradigm in China is a real shift. Let’s take oil, for example: a true political commodity. The Arab nations can produce it very cheaply, yes, but they have to have strong export markets because their governments have to spend a lot of money on social programs. It’s very expensive for them. They have, basically, fixed costs: the cost of keeping the population happy and themselves in power is high. They need to go ahead and start pumping more oil; if they start pumping more oil, it becomes an issue of supply.

Now we have Iran coming into the game. Iran and the Saudis are not, to put it mildly, friends. They don’t see eye to eye, so clearly there will be mistrust and consequently there will be a supply problem. They have loans, and the loans have to be revised, and the revision of the loans will force them to hedge — so now you have additional supply. I think there is growth, really serious growth, of supply, growth that’s proving very inelastic, and the demand has shrunk because it was based on a model that’s not there anymore. I think oil risks trading below $30, and that could be a very big risk to a lot of people.

OR: What do you think the ramifications of all this liquidity coming out of the market are? If the Fed begins to raise rates, do you think that the stock market is very vulnerable here? How much do you think it’s been propped up by liquidity alone?

Bergmann: I think that if the Fed tightens and the market can stand it, the market can have a rally on that, because I think a lot of people are thinking in the way you just outlined — that the market has no footing of its own, it’s a liquidity-driven market. I think the Fed actually needs to tighten to prove otherwise. I think that if the Fed does benign tightening at the beginning of the process, this would not be terrible in the markets. I feel the markets could actually rally on that.

OR: Where do you see rates going in the intermediate term?

Bergmann: I think short-term rates are higher, but long-term rates are actually lower. I think the curve flattens. Which in this case is not terrible for equities. I think that equities can actually have a decent run here.

OR: You don’t see a risk of long-term rates backing up?

Bergmann: Unless the economy really takes off, I don’t see inflation being a problem right now. Again, it’s a question of supply and demand, and I don’t see it going out of control.

OR: Do you think the presidential election is a risk at all?

Bergmann: I think that depends on who the final candidates are, but I don’t see that as a major risk right now, no.

OR: Do you think they’ll move the peg on the Hong Kong dollar?

Bergmann: No, I don’t see that as a risk right now. I think that they need the stability. I think they have the ability to withstand headwinds, and I think they have much to gain. I think that there’s a psychological value to keep that peg on as a safety valve for China. I don’t see much of a reason for them to do that right now.

OR: Why do you think the market had such a bad reaction to the Chinese currency depreciation?

Bergmann: Because it was a surprise. Though for me it wasn’t such a surprise. The Chinese government, as I noted, is very opaque. They made this latest currency move in a way that was very inconsistent. To do such a small move makes people think, “What else is there?” In other words, people were afraid of what they suspected were the real reasons for the move. People like transparency.

The move by China on its currency was not as harmful in itself as the way in which it was done. The depreciation created many more questions than answers, and provoked a lot of capital flight. You see a lot of interventions, so you realize the situation that caused them is still ongoing. So it was not a clean, clear move, and when somebody so big does something like that, it creates uncertainty and it creates imbalances among its neighbors and trading partners.

OR: Are you negative on precious metals? Gold? Silver?

Bergmann: I am not negative, but clearly I’m agnostic. I think that gold as a hedge in itself is debatable, but clearly at a time when interest rates are moving higher, and the economy’s doing well, I believe that the opportunity cost of holding gold is too high.

OR: Market observers who sound the alarm about debt, unfunded liabilities, and global money-printing — do you think they’re mere doom-and-gloomers?

Bergmann: At this point, I think that it’s all a question of time. At some point, gold might be good, but right now there’s no reason to own it. The economy’s growing. Gold is a source of safety, in theory, just because it has a limited supply. But anything that you only buy because there is a limited supply of it is in itself questionable. Yes, there is a lot of money-printing, but as long as the world’s economies are growing, the money’s staying in the system, right? It doesn’t go. It’s not that they are giving out money to people, the money’s being lent and put back into the system. It’s just liquidity. Basically what QE has done is to crowd out assets and create not an asset bubble but an asset scarcity there. It created a lot of liquidity. But it’s not real inflation yet. I think right now we have a story of too much supply.

That’s the story of China, right? People creating goods and not consuming them. I think that you need the creation of consumers to balance it out, and consequently I think there is a long way to inflation. I just don’t see where gold comes into place in this environment. There are so many more trajectories to create wealth by investing than believing in a piece of metal that’s getting you nothing.

OR: Yet there’s certainly been inflation in, for example, healthcare and education costs and rent.

Bergmann: Yes, but there were also efficiencies. There is inflation in some costs, but as far as basic needs, a lot of food and technology and transportation — these have come down a lot, and the reason is because technology has improved. You have a lot of people producing for nothing. If you look at what inflation is, i.e. too much money chasing too few goods, I think the situation we’re facing the reverse: too many goods chasing too little money.

OR: What do you think the risks are right now that the market isn’t focused on?

Bergmann: I think the market is extremely complacent about risk. I think the market in many ways is too complacent, despite the big moves. That in itself is a risk, an imbalance risk, in the market. I think the market is too used to the world as it is and is over-dependent on central banks to provide liquidity and to allow asset markets to go higher just by creating this mega-liquidity and consequent demand for assets. I think this is very dangerous. I think the biggest danger is the complacency of the markets and the overreliance on central banks.

I think that this market is a great market for trading because there are great opportunities. There’s so much mispricing because there is a shift in paradigm going on. The world is not growing together, so there is a geographical divergence in economic cycles, in monetary policies. You do have a lot of crowding into the same assets forced by the Fed, so there are great opportunities out there.

OR: Do you think we’re seeing competitive devaluations in currency?

Bergmann: Not overly. But the global economy is like a small cake. The best way to make sure you eat is by grabbing somebody else’s piece of cake, so clearly there is a need to be competitive — and to be competitive with your neighbor. But you can’t create an open war, because open war creates only losers. There is a push to try to get market shares by competitive devaluations.

OR: Are you negative on credit right now?

Bergmann: I think that depends. Commodity credit, I think, is extremely dangerous. Take oil: given that the loans made to all its producers and shareholders are based upon a very steep forward curve, if the curve flattens, I think a lot of people won’t be able to refinance, so I think there is a risk for the market. And I think that volatility, as liquidity is pulled out, will increase and thus increase widened credit spreads.

I think credit spreads are very vulnerable. I think a country like Brazil could technically default. I think there are a lot of people, many imbalances, and many imbalances by people with a lot of leverage. That in itself can create a lot of problems, which means that credit is volatile.

OR: Why do you believe Brazil might default? Because of the commodities construct? Other reasons?

Bergmann: It’s not that I’m saying that Brazil will default. I think there is a risk. It’s a small risk, but there is a risk. The reason is very simple. There are political issues and a lot of imbalances in Brazil. It owes a lot of money. It’s not external debt, it’s internal debt, but it doesn’t matter. There is a monetary issue there. There is inflation and stagflation. I think there is a lot of corruption that needs to be taken out. So if you add up the issues of corruption and the lack of political will and this fragmentation to a country that’s levered and going through a very slow move in its economy, by nature it means that’s all wrong.

Brazilians are well-known to have capital flight; Brazilians are probably the first ones to take the money and run. If there is a run on the bank, a run on the country, clearly that would deplete its reserves, and Brazil just might declare a moratorium. It’s not the first time that Brazil would have done so. I don’t think that this is very foreign to Brazil. They have done it and survived.

OR: Do you think Russia is in danger of defaulting?

Bergmann: I think there is a risk, absolutely. If oil really has a second leg down, and if the sanctions are not lifted — or if they become more onerous because Russia is involved in Syria — that’s a huge geopolitical risk, and I should’ve mentioned before but that’s something we really worry about. The geopolitical risk of Russia is very, very large, and their geopolitics are not only military, they could be monetary, seeing that they did this in 2008. Clearly, Russia is under pressure, and when a country like Russia is under pressure, they do not have to answer back only with military weapons. They could use financial weapons, and one of their financial weapons is creating financial havoc via a default or repudiation. Again, not the first time. They’ve done this time and again. History tends to repeat itself.

OR: What do you think the chances are that there is a market meltdown in the next year?

Bergmann: It’s hard to know, but I think the market structure is extremely vulnerable. I think that people are relying on different models. We’ve seen with China that a little change can cause a big move. There are so many risks out there. The combination of them can create a bad move just because the market is poorly structured. There’s very low liquidity. There’s a lot of crowding in because the central banks force people into them. There is an exhaustion of central banks’ financial tools. They’ve done QE, so what else are they going to do? How much easing can they do? The market is extremely vulnerable, and there are many unforeseen results. There’s a lot of talk now about risk parity, which seems in many ways a flashback to portfolio insurance, meaning there are many market participants who use the market in different ways. They have self-reinforcing strategies at play in a low-liquidity environment. With low liquidity, self-fulfilling, self-reinforcing strategies like risk parity and its cousins coupled with a lot of crowded positions can easily create a dislocation.

OR: Earlier you were saying that you thought that the market would rally in the face of Fed tightening. Is that more of a short-term view?

Bergmann: Yes, short-term and tactical. The idea is that we have to always look at the forest, but focus on the trees. You can’t have a Five Year Plan, Five Year Plans never work. You need to know the risks out there and to have very tactical ways to make money.

OR: Most professional money managers tend to lose money through their hedging. Do you think that the general, traditional hedges are too expensive?

Bergmann: Yes. I think that they’re too expensive. They’re inefficient. I also think that if you approach hedging as a way to spend money and to buy insurance, it never works. If you spend money, you never make money. I think the key for hedging becomes sustainability. The ability to withstand adverse events: people tend to lose patience at the worst times, and they unwind the hedges. For a hedging strategy to be sustainable, it needs to be an alpha strategy. You need to come into it intending to make money. You make money and you make a fortune of money if the market goes wrong. I’ve been hedging for 20 years, and our negatively correlated portfolios are hedging portfolios — but they are negatively correlated alpha.

The goal is to at least break even on the full market cycle, even excluding systemic events. In other words, you’re not spending money. If you’re hedging to buy insurance, you will never make money. It’s very expensive. It’s ineffective. People focus on things that are completely obvious, and they’re already priced in. You’ve got to look at it as an alpha strategy to try to make money no matter what.

OR: Does the current financial landscape remind you of any other period, be it from a long time ago or within your own career? Or do you think we’re in uncharted territory?

Bergmann: It reminds me a lot of 1987. I think what we saw is a market that is complacent and very high, and then you have an unforeseen force in the market that just unravels. At that time it was portfolio insurance, now you have risk parity, CTAs, and all their cousins creating the exact same thing, which is self-reinforcing strategies. In other words, a market which is very high, a market which is crowded, a market which is complacent exacerbated by the deployment of very, very poorly structured, poorly designed strategies that are supposed to hedge. You put this together and you have a situation in which anything can happen. And I think that’s very similar to 1987.

OR: This has been fascinating. Thank you.