Bridgewater’s Rebecca Patterson on the Fed's Unenviable Position

Jennifer Ablan of Pensions & Investments reports on why Bridgewater’s Rebecca Patterson thinks the Fed is in an unenviable position and risks its credibility in the fight against inflation:

Rebecca Patterson, chief investment strategist at Bridgewater Associates, the world's largest hedge fund, sat down with Pensions & Investments for its relaunch of Face to Face, the brand's popular Q&A interview, featuring the best minds on Wall Street.

In an exclusive discussion at Ms. Patterson's Manhattan home (with her cat Thor making a guest appearance), she talked about her "humbling" first 2 1/2 years at Bridgewater, known for its culture of radical transparency famously infused by billionaire founder Ray Dalio.

Since its founding, Bridgewater has grown to about $150 billion in discretionary client assets as of Dec. 31.

Ms. Patterson, one of the most powerful women on Wall Street, said Bridgewater's institutional investors are bracing for a prolonged stagflationary period — an economic condition marked by slowing growth and high inflation — and are looking to protect their portfolios in the event of "sustained bear markets."

That has given risk-mitigating and macro strategies and the hedge funds, such as Bridgewater, that employ them a boost in capital inflows from big institutional investors that want to capitalize on market volatility and generate so-called alpha.

Bridgewater, she said, is bullish on inflation-linked securities and gold, to name a few investments in this environment, as well as Chinese equities, whose valuations she calls "attractive" and "a way to get diversification in a portfolio." Bridgewater is "bearish on equities broadly, including the United States, including Europe," Ms. Patterson said.

Ahead of Federal Reserve Chairman Jerome Powell's Jackson Hole speech on Friday, Ms. Patterson said it is premature to presume that Mr. Powell will pivot into a dovish stance, given commodities and housing have seen some cooling. "The Fed's in a really unenviable place, if they tighten too much, they risk exacerbating the recession," she said. "If they don't tighten enough, they're not going to get inflation where they want it and they could risk their credibility."

She added that Fed officials, so far, are going to raise interest rates until they get inflation to its target, which suggests a big downside risk to growth "that I don't think is reflected in markets."

For more of Ms. Patterson's views and opinions, please read on for the first of two installments of this Face to Face. Questions and answers have been edited for style, clarity and conciseness:

Q: The Fed is expected to stay with its hawkish rate hikes until data figures show further slowing inflation. And we're actually seeing some softening in a couple of inflationary figures. How do you and Bridgewater see the Fed's approach? Where are we in the cycle?

A: Inflation most likely has peaked and it isn't that surprising given that we've had commodity prices coming down for some time, we have supply chains starting to normalize so goods prices are starting to come down some and things like used car prices — that's likely to continue.

However, I think some investors over anchor to those components and forget that there's a lot more to it. And the two pieces of inflation we would focus on that we think are going to be a lot stickier are rents and housing.

So wages, what we're really thinking about is the service sector of the economy, which frankly is much bigger than goods anyway. And right now we're still seeing companies saying, "I can't find enough qualified workers." Fifty percent of companies say they can't find the labor force they need. So the job market is incredibly tight and that means they have to keep raising wages to attract those workers they need. And so we think wage inflation, particularly with the service sector, is likely to be sticky. That's about 30% of the CPI basket.

Now housing, you have to walk through it. We've already seen housing activity slow as mortgage rates have gone up and as houses have gotten less affordable. But what that does is it pushes households out and they rent instead of buy. Rents reset more gradually. And so rent inflation tends to last longer; it's kind of the sticky tail of the housing cycle, if you will. And so between a slower rent inflation cycle and the wage inflation, the two of those together make up 60% of the CPI basket.

We think it's unlikely you're going to get inflation cooling to 2%, 2.5% quickly. It's just going to take longer or it's going to take the Fed tightening a lot more and really undermining demand. So that's the first leg of the stool.

Q: We talked about the backdrop for inflation, what about growth?

A: Right. So that's the second leg of the stool. So in the case of growth, again, it's very bifurcated. We're seeing manufacturing slowing, we're seeing housing activities slowing, but we're seeing consumers well supported. They've run down their excess savings, but now they're just tapping their credit cards. So spending is staying relatively well supported so far and the labor market is incredibly tight.

As long as people have rising wages and strong incomes, they're going to keep spending. And so we need to see that leg of the stool, the consumer, start to roll over before the economy slows quickly. But there are some indications that that point is coming soon. We're starting to see delinquency rates on credit cards tick higher, for example, and we're seeing confidence surveys fall considerably. So we think we're going to see growth slowing, most likely more than discounted.

In fact, our estimates suggest that we could have a modest contraction in 2023. So our growth estimate is below what's priced in, our inflation estimate is above what's priced in. So then what does the Fed do with that? And the Fed's in a really unenviable place, if they tighten too much, they risk exacerbating the recession.

If they don't tighten enough, they're not going to get inflation where they want it and they could risk their credibility. How this plays out in the coming year is really going to depend on how the Fed proceeds. But what they're saying so far is they're going to tighten until they get inflation to target, which suggests a big downside risk to growth that I don't think is reflected in markets.

Q: That is interesting given the fact that we have been seeing the markets rally. Some people have also talked about rate cuts in 2023. It sounds to me that you think we're getting ahead of ourselves?

A. Yes. The markets are already reflecting that the Fed's pivoted and the Fed isn't close to pivoting. In fact, the equity rally that we've seen over the last six weeks or so actually makes it harder for the Fed, they have to tighten even more. And that's another piece. The Fed doesn't target market conditions, but the Fed does look at markets as an input. So if you have stronger equity markets, it creates wealth, it creates confidence and confidence leads to activity.

And so the higher stock markets go, the easier financial conditions get, the more the Fed has to tighten. So this reflection in the markets that the Fed may already have pivoted actually is likely to lead to the Fed tightening even more.

Q: How is Bridgewater counseling clients in this market? This is an unusual slowdown/stagflationary environment.

A: Exactly. I think there are a couple big concerns that our investors have today. And again, our job at Bridgewater is to hopefully generate very attractive returns for our clients, but then also help them solve their biggest challenges. And you just called one of them, which is stagflation.

We're defining it broadly, we're just saying slowing growth and higher than expected inflation. But let's say we're in this environment, how do investors balance their portfolios? Because we saw what happened in the first six months of the year. The returns were horrible because you had declining growth, rising inflation, rising discount rates, rising risk premiums. And if we're in that world where those forces are continuing, albeit to different degrees, it could be really difficult for a traditional, call it 60/40 portfolio.

In the case of stagflation, we've gone back and looked at 100 years of economic scenarios and asset performance. And what we found is in periods where you had falling growth — or growth falling more than expected — inflation higher than expected, the average annual return was around -3%. Contrast that with a scenario where you have growth and inflation, more or less in line with expectations, average annual return, a positive 8%. Obviously a wide variation around those numbers, but directionally you get the idea, stagflation is going to kill you.

So what can you do about it? In those environments, again, looking at 100 years of market performance, the assets that did best in those stagflationary periods tended to be inflation-linked bonds, gold and broad commodities.

What did worse was equities. Equities were the ones that really got hurt from the falling growth, rising inflation dynamic. And then you think, well how likely is this right? Do I really think that stagflation is going to be here in three to five years or is this just a one-off? Maybe it's already behind us. And our view is that we're not sure where inflation settles in three to five years, but the risks are higher today that we have that outcome than we've seen in decades. Mainly for structural reasons, if you think about what's pushing inflation, it's not just the cyclical things we talked about, but there's also huge structural changes in the global economy that, again, we just didn't have.

Globalization, over the last few decades this was a major disinflationary force; today we're in a world with tensions with China, the Russian invasion of Ukraine, the pandemic, all these things have led companies to say, "I need to make sure my supply chains are resilient, not just low-cost."

And that means bringing production home or to nearby countries. That's inflationary and that is a change from what we had in the past. The other thing that's a structural shift is the green transition, climate transition. Which again, it's going to take years and that process is inflationary as we have carbon pricing, which is going to push up the cost of dirtier energy. And as we push and reduce the supply of dirtier energy, it's going to limit that supply, which is going to increase the price.

Both of these things are creating more structural, longer-lasting inflationary pressures that just didn't exist before. So those supports have to be taken into consideration along with the cyclical factors, which makes us think that stagflation is a real risk and people need to take a step back, look at their portfolios and say, "Do I have enough in my portfolio that if that scenario plays out, I'm not going to be vulnerable?"

Q: I love that you brought up gold. Do you have any targets on gold, any price level targets there?

A: We don't, as a rule, have price targets, we're mainly trying to do the best job we can measuring the economic forces that would make an asset price go up or down. And in the case of gold, what's been really interesting is that even with inflation at these high levels, gold has appreciated since we saw a reaction to the pandemic in 2020, but it hasn't moved as much as I think some folks might expect.

I think there's a couple reasons for that. Gold has benefited from the environment, but there have been some offsetting forces. So we've seen yields rise quite significantly over the last year or so, especially the first six months of this year. And gold has no yield so there's an opportunity cost. If interest rates are coming down, that opportunity cost is falling away and that makes gold more attractive.

There's also the jewelry dynamic, (as) 50% of gold demand is jewelry. And the biggest sources of demand for jewelry come from China and India. China's economy has been much more sluggish than folks expected this year, in part because of their COVID-zero policy. India also has had some challenges. So that has been softer than normal, also affecting the price of gold. So I think the interest-rate factor, the jewelry factor and then finally I'd just say inflation expectations.

People want gold as a hedge against inflation, to a degree, that's not the only reason they buy it, but it's a major one. And inflation expectations have risen, but they haven't become unanchored yet, they're really holding three- to five-year expectations at around 3%. And so there is some demand to buy gold as that hedge, but I think it would be much higher if you started to see some of those expectations surveys tick higher. If people thought the Fed was going to lose control of inflation, that would be the environment where I would expect gold would, pardon the pun, really shine.

Q: Innovation is key to the foundation of Bridgewater, any new strategies in the works?

A: As I said earlier, we're always trying to help our clients solve their biggest problems. Stagflation is certainly a challenge they're fearing today and looking ahead. And so we're trying to think about what are different portfolio strategies that they could include or even use as overlays to help them navigate through that.

One of the biggest challenges our clients are trying to figure out how to navigate is the potential for a prolonged stagflationary period. And we've been working in partnership with some of our key clients to help them create bespoke strategies to navigate through that. Something that we think additional clients might benefit from.

Another thing that our clients definitely worry about is just protecting their portfolios if we have sustained bear markets. When you think about the last decade, as bond yields got less and less attractive, people had to add more equity risk to portfolios to meet their return targets, private and public. And now the amount of private equity means they have less room for maneuver and their total equity exposure is so large, you can't get in and out of it easily if we have a bear market.

So what do you do? How do you protect your downside? And there are plenty of tail-risk strategies out there, options strategies. The challenge with those is that in good times, you're paying a premium, it's like an insurance policy. And if you have to go eight years out of 10 where stock markets are going up and you're bleeding money, that premium every year, sometimes that doesn't go down so well with your boards of directors or your stakeholders.

What we've tried to do is say, can we build a strategy that's going to protect our clients in a down market significantly, but also not have that insurance premium the rest of the time? So that's something else we've been working with our clients on.

And then I guess the last thing that comes up again and again and again is sustainability. How do you build a sustainable portfolio? How can you manage return, risk, but also sustainability? So instead of two dimensions, you're really thinking in three dimensions.

We launched a sustainable strategy a few years ago and we're exploring with our clients, are there other types of sustainability strategies that could help them? Those are a couple areas that we're exploring with our clients, partnering with our clients on, sustainability, equity bear markets, given the exposures they have today and trying to balance through stagflation.

Q: Now you brought up bespoke portfolio strategies. Hedge fund managers say they're seeing increased interest from asset owners, pension funds, foundations, endowments and hedge funds as portfolio diversifiers and risk-mitigating macro strategies, given current market conditions. Is Bridgewater seeing significant inflows because of this?

A: Exactly. Well, when you think about what a stagflation environment means, you've got growth slower than expected, falling growth and rising or high inflation. And that is the opposite of what's going to be supportive for a traditional 60/40 portfolio. Equities will benefit when growth is going up, discount rates, risk premiums are going down. Your bond diversifier should benefit if growth is falling and inflation is falling and central banks are easing. But the world we're in now and could be in for quite some time, again, is the opposite.

So your beta portfolio is not helping you, which pushes investors like the ones you're describing, toward alpha. And alpha could come in the form of hedge fund managers like us, it could come in the form of long-only strategies that take a lot of tracking error, that's some alpha on top of their beta. It could come through the alpha that's generated through liquid investments.

But to your point, I think in the world we're in now and again, it could continue for some time, it really is pushing more and more investors to find those sources of alpha to make up for the challenge that beta faces, which could be a sustained challenge.

Note: Part 2 of this discussion on currency and geopolitical risks is available here.

Rebecca Patterson provides a lot of macro and investment insights here and it boils down to this: Bridgewater is bracing for a prolonged stagflationary period and it is focusing on protecting its clients' portfolios from sustained bear markets.

In this environment, she explains why the traditional 60/40 stock/ bond portfolio will not deliver the required returns so clients need to rethink their sources of alpha across public and private markets (liquid and illiquid markets).

In Canada, our large pension investment managers, many of which are clients of Bridgewater, have been shifting a big portion of their assets over many years out of public equities and bonds and into private equity, real estate and infrastructure (real assets), and private debt. Some have also invested in commodities and natural resources.

They have been diversifying their portfolios across asset classes, geographies, sectors, strategies and they're bringing more assets internally to lower the cost of managing these assets.

In short, they have been preparing for all economic scenarios, including a prolonged period of stagflation through proper diversification and active management strategies.

It doesn't mean they're immune to what is going on in equity and credit markets, they're not. 

It just means their portfolios are more resilient during a downturn and they have ample liquidity to capitalize on dislocations across public and private markets as they materialize, generating meaningful value add over the long run. 

Rebecca Patterson and the Fed's Unenviable Position

Back to Rebecca Patterson's comments and the Fed's unenviable position and credibility risk.  

It seems like the Fed heeded her warning today because Chairman Powell was clear in delivering his hawkish message at Jackson Hole that there's no pivot any time soon, warning of some pain ahead as they try to bring down inflation:

Federal Reserve Chairman Jerome Powell delivered a stern commitment Friday to halting inflation, warning that he expects the central bank to continue raising interest rates in a way that will cause “some pain” to the U.S. economy.

In his much-anticipated annual policy speech at Jackson Hole, Wyoming, Powell affirmed that the Fed will “use our tools forcefully” to attack inflation that is still running near its highest level in more than 40 years.

Even with a series of four consecutive interest rate increases totaling 2.25 percentage points, Powell said this is “no place to stop or pause” even though benchmark rates are probably around an area considered neither stimulative nor restrictive to growth.

“While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses,” he said in prepared remarks. “These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”

Stocks fell after the Powell speech, with the Dow Jones Industrial Average off more than 500 points. Treasury yields were off their highs of the session.

The remarks come amid signs that inflation may have peaked but is not showing any marked signs of decline.

Two closely watched gauges, the consumer price index and the personal consumption expenditures price index, showed prices little changed in July, owing largely to a steep drop in energy costs.

At the same time, other areas of the economy are slowing. Housing in particular is falling off rapidly, and economists expect that the huge surge in hiring over the past year and a half is likely to cool.

However, Powell cautioned that the Fed’s focus is broader than a month or two of data, and it will continue pushing ahead until inflation moves down closer to its 2% long-range goal.

“We are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2%,” he said. Looking into the future, the central bank leader added that “restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy.”

The Fed is clearly more concerned about inflation than growth here, drawing on lessons from the past:

The Fed is using a lesson from the past as its guidepost for current policy.

Specifically, Powell said the inflation of 40 years ago provides the current Fed with three lessons: That central banks like the Fed are responsible for managing inflation, that expectations are critical and that “we must keep at it until the job is done.”

Powell noted that the Fed’s failure to act forcefully in the 1970s caused a perpetuation of high inflation expectations that led to the draconian rate hikes of the early 1980s. In that case, then-Fed Chairman Paul Volcker pulled the economy into recession to tame inflation.

While stating repeatedly that he doesn’t think recession is an inevitable outcome for the U.S. economy, Powell noted that managing expectations is critical if the Fed is going to avoid a Volcker-like outcome.

In the early 1980s, “a lengthy period of very restrictive monetary policy was ultimately needed to stem the high inflation and start the process of getting inflation down to the low and stable levels that were the norm until the spring of last year,” Powell said. “Our aim is to avoid that outcome by acting with resolve now.”

One concept molding Powell’s thinking is “rational inattention.” Essentially, that means people pay less attention to inflation when it is low and more when it is high.

“Of course, inflation has just about everyone’s attention right now, which highlights a particular risk today: The longer the current bout of high inflation continues, the greater the chance that expectations of higher inflation will become entrenched,” he said.

This is what spooked markets today, alluding to the 1970s and early 80s and "entrenched inflation expectations" requiring "a lengthy period of very restrictive monetary policy".

Not surprisingly, stocks sold off on Friday led by technology shares and the yield curve inverted further.

So where do we go from here? It all depends on whether or not the Fed can avoid a hard landing.

In his latest weekly comment published on Thursday, before Powell delivered his hawkish message, Francois Trahan of Trahan Macro Research explains why the yield curve has been sending a clear recession signal. 

I note his opener:

The yield curve is one of those things you hear about in academia, but it is usually brief. It also shows up in the media periodically over the course of a career either because it is inverted or is about to invert. That’s the amount of context most market participants have for the yield curve. In my experience, something that happens around yield curve inversions is many pundits start to push the narrative that the yield curve not relevant this time around for one reason or another. I am looking at to you, Chairman Powell. The stats are clear when it comes to the yield curve: the last eight inversions in the yield curve were followed by eight recessions. Whether you understand why this happens or not, the stat is hard to dismiss.

With the yield curve as inverted as it’s been in 40+ years, it seems a bit silly to think that we are still debating soft landing vs recession. Really? It’s stranger to see investment professionals calling the beginning of a new bull market (see reports from prominent market technicians in recent weeks). The reality here is that the yield curve is a proxy of monetary policy. An inversion tells us that policy is now binding for the economy. Worded differently, inversions show that there is enough tightening in the pipeline to engineer a real economic slowdown (i.e., a recession). It is a bit unsettling to think that the yield curve is already deeply inverted, and the Fed is not even done raising rates. As we see it, it is astonishing that some investors are complacent about the inversion of the yield curve. The culprit is the sharp rebound in equities this summer. A rebound in stocks alone does not mark the beginning of a new bull market. 

A new bull market would require a rebound in stocks accompanied by a simultaneous and sustainable recovery in leading economic indicators (LEIs). For the record, LEIs usually bottom about 18 months AFTER a peak in interest rates. Since the peak was just two months ago, this argues we have a way to go with the bear market.

I agree with Francois, it is unsettling to think that the yield curve is already deeply inverted, and the Fed is not even done raising rates.  

You should read the rest of his comment carefully to really appreciate why we are in the early innings of slowdown and different segments of the economy (consumer, housing, auto) are more impacted by the inverted yield curve. He also explains why wage growth is accelerating and that means more rate hikes and a flatter yield curve.

Francois Trahan and his team have published great comments all summer and have stood firm on their bearish views despite an impressive bear market rally. I highly recommend you subscribe to Trahan Macro Research to navigate a really difficult macro environment. 

Alright, let me wrap it up there.

Below, the Federal Reserve Chair Jerome Powell speaks at the Jackson Hole, Wyoming, symposium on Friday. A short and decisively hawkish speech.

And Greg Jensen, co-CIO of Bridgewater Associates, expects that equities are facing a significant drop to align them with the real economy. 

“In aggregate, the asset markets will decline from 20% to 25%,” he said in an interview with Bloomberg Television speaking with Kailey Leinz and Guy Johnson on “Bloomberg Markets.” 

“The market is pricing a decline in inflation to occur in a relatively stable economy,” he said, but isn’t factoring in the impact of higher interest rates and the Federal Reserve’s quantitative tightening.

Jensen expects that QT and rate hikes will drive down both inflation and economic growth, and “unfortunately the inflation will be more stubborn,” resulting in higher interest rates across the curve, particularly on the long end. 

Asset prices will also fall, he said. “They need to decline,” citing a big disconnect between the financial economy and the real economy. “We’re still 25% to 30% above the normal relationship between cash flows and asset prices.”

If the Fed is forced to tighten longer in the face of stubborn inflation and an expected easing in six to nine months doesn’t materialize, he added, this will make “a tough road for assets” in which liquidity dries up as profits and economic growth are weak.

Let's hope he's wrong but if he's right, there will be plenty of opportunities for Canada's large pensions to pick up assets during the next downturn.