A $200 billion investor just made ‘a special decision,’ and it highlights a huge risk in the stock market

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Sebastien Page, T. Rowe Price’s head of asset allocation. Fortune

Sebastien Page has crisscrossed the US during his more than 20-year career in investing and risk management.

After working for Boston-based State Street Associates as a senior managing director and head of the portfolio-management group, the Canadian native moved to the West Coast to join PIMCO as an executive vice president.

Page now calls Maryland home. He joined the Baltimore-based investment firm T. Rowe Price in 2015.

Business Insider met up with Page in New York City on February 1 to discuss his outlook for the global economy in 2017. Page began the conversation with an overview of his role at T. Rowe Price, where he overseas more than $200 billion as head of asset allocation.

He told Business Insider that his business consists of strategic asset allocation and tactical asset allocation. On the tactical asset-allocation side, Page said portfolio managers from across the firm come together during monthly meetings to map out their worldview and decide how to shift their investments in different markets. This is the topic on which our conversation begins. This interview has been edited for clarity and length.

Matt Turner: At the January 20 meeting, what was the dominant question that you were all were trying to tackle?

For the first time since the early 2000s we decided to slightly tactically underweight stocks versus bonds.

Sebastien Page: At almost every meeting we will talk about whether we have a generally “risk-on” view or “risk-off” view of the world. And from there we can work positioning into different asset class.

That last meeting was special, because for the first time since the early 2000s we’ve decided to slightly tactically underweight stocks versus bonds. And the last time we did that was in the early 2000s. We did reduce our overweight leading into the crisis, but stayed slightly overweight, and then ramped it back up.

That actually has helped us over the long run. But again, that was a special meeting because of that special decision. So coming out of it, I got together with the cochairs of the committee, and we wrote up a two-page note to summarize what led us to that decision. We had been neutral for a while.

Turner: What you’ve just said makes me think of the two top stories today on our finance page. The first was on Paul Singer warning about the complacency that seems to have swept Wall Street. He is of the opinion that the market is massively underestimating the risk of a spike inflation.

Ray Dalio had a similar letter out last night on the risk around the Trump presidency and how the pro-growth policies he has proposed might be outbalanced by some of the negative effects of currency wars and other things. I think this is the topic everyone is trying to wrap their head around. So how did you come to your conclusion?

Page: This is the outline of the thinking. First, we recognised that fundamentals are improving.

But the market is very richly valued. And we think the market is priced for perfection. We also have long-term headwinds for growth. On the secular basis, there are forces that we tend to forget about. People tend to focus on short-term things like elections and all the volatility in the political sphere, but we are focusing more on the long-term trends that will likely push the economy toward lower growth.

You have richly valued long-term trends working against us, and a list of risks that could materialise under Trump. After we put all these risks together, we came to the conclusion that we want to have some dry powder.

So that’s the framework: We looked at those fundamentals, the rich valuations, long-term headwinds, shorter-term risks. That’s what led us to our decision.

Turner: The rich valuations are sort of self-evident as we can look at the metrics. On the long-term risk, what are the risks you think that will hold GPD growth down over the long term?

Page: So you can start with Trump policies, such as his proposed restrictions on trade and immigration. Those can have long-term impacts on growth. If you impose tariffs and other countries want to impose tariffs as a form of retaliation, that can deteriorate very quickly and can be a 6-to-18-month impediment to growth.

If costs are rising across the supply chain, then you have two possible consequences: lower corporate-profit margins or it becomes inflationary — the costs of goods go up. So that’s the political side.

I guess the point I’m making there is that everyone is looking at the short term. But there are long-term effects of a global shift that are less favourable to trade.

But if you go back to even before the election and ask what kind of environment we were in, from a secular basis you have an ageing of the population. That is significant. I was just reading about that on the train. The UN published a 2015 report and it is pretty interesting.

According to the report, in 2015 we had 900 million people who were 60 and older. Fast-forward to 2050, and now there are 2 billion people 60 and over. And if you look at what it means for the ratio of working-age people to retirees, that ratio goes way down. It goes from 7% in 2015 to 4.9% in 2030. So that’s a big long-term impediment to productivity and to growth.

And it is kind of a global thing. Same with debt. Debt-to-GPD has been rising. McKinsey has data on this. If you go from 2007 to now, debt to global GDP has essentially increased by 17%. It went from 269% to 286%. That’s the increase in debt-to-GDP ratio. And when you drill down, you will see that developed nations have more of a demographic problem and more of a debt problem. So those are the secular forces at play.

Turner: So focusing in on the risks around trade, I get the sense that markets have priced in corporate tax cuts, repatriation, and all the things that are positive about the Trump presidential platform. But they don’t seem to have priced in the border tax, for instance.

Where do you stand on that? You kind of hinted at it a moment ago, but what’s your view on the gap between the risks and the positives of the new administration?

Page: I agree with that analysis. The market is pricing the upside but not the downside; and it’s definitely not pricing in the risk. Now we should keep in mind, though, that even before the election, fundamentals were starting to improve following the so-called earnings recession, which were those five back-to-back quarters of year-over-year negative earnings growth.

But in quarter three of 2016, which is preelection data, you had a turn to positive earnings growth. And the numbers are coming out as we speak. We expect positive earning growth in the fourth quarter. So you had the beginning of a shift in certain fundamentals already happening before the election.

The market is pricing the upside but not the downside; and it’s definitely not pricing in the risk.

I think we perhaps tend to overemphasize the effects of the election and the following change in sentiment. There were other cyclical forces that were improving. And I think it is important to put that in its context.

I don’t know what metrics you look at, but the Shiller CAPE Ratio is at 28, and if you look back at the 150-year history, there were only two other times that it was higher. The tech bubble in the ’90s and then 1929. And it’s actually close to where it was in 1929. We use a bunch of evaluation measures; I use that one just as an example.

This is on US stocks, and it normalizes for 10 years of earnings and it adjusts for inflation, but it does get to your point. Yes, we seem to be pricing in the tax cuts, but not the delays in implementation. We don’t even know how it’s going to be paid for. It might translate into more debt and higher deficits or more inflation.

And we’re not pricing in things like the border tax, which really eat into profit margins very quickly, and not only that, but it can start a domino effect with other countries. That is sort of the uncertainty that is out there.

So we would generally agree with your view. Nonetheless, there is some fundamental data and other data that is encouraging. For instance, you have a CEO confidence that is way up, consumer confidence is way up. That is probably a result of a postelection effect. People think things might get done because of the Republican sweep. We had a piece published back in December regarding the four headwinds of Trump.

Trump infrastructure
Donald Trump. Mark Lyons/Getty Images

One of them was, if you look at the infrastructure spending and tax cuts and previous measures such as Bush tax cuts, those things take a while, and what we are pointing out is that the markets seem to be assuming that the Congress will just go along with everything. And we are talking about Republicans who are not keen on spending.

So for us, this idea of having dry powder in our portfolio is important.

We think if you line up the different risks, there’s a lot of volatility in the political environment. We saw this with the travel ban — the market did not react too well to that, and that’s creating more volatility. And then add to that things like the impact of monetary policy. It’s funny: Preelection, we were all watching monetary policy; postelection, we are all watching fiscal policy.

If the Fed raises rates too fast, we haven’t even reached 2% inflation. That could put a lid on growth very quickly. It raises the cost of borrowing and, all else being equal, it depresses asset prices. Then you get into a spiral. People look at their financial assets and see less money in their accounts, so they have less confidence. Add to that a rising USD, a rise in the dollar, which, you know, is not good for exports, and also the direction of the dollar now is slightly linked to Donald Trump’s Twitter, at least in the short run. So those are risks.

If China experiences a significant growth slowdown, that’s not only a risk but a tail risk. It could be drastic.

And then we tend to forget that China is very important to the whole financial ecosystem. If China experiences a significant growth slowdown, that’s not only risk but it’s a tail risk. It could be drastic. But we’re not really considering it right now because of those high stock valuations. So if you add up all these risks and you say, OK, if some of this materialises and we get a drawdown in risk assets — in particular the stock market — we’d like to be able to look for opportunity.

Turner: How do you weigh up those risks? Consider, for instance, 1929 and the tech bubble. Someone could have bought in when stocks were richly valued and still could have made money. How do you know that you’re not walking away too soon?

Page: That is a very good question and a very important point for us. And it goes back to the distinction between strategic asset allocation and tactical. When I talk about pulling back in stocks, it’s a modest tactical shift away from a long position in stocks for the long run.

So pick an investor who is 25 to 40 years old, a person who is about 30 years from retirement. Well, if you look at our portfolios and our glide paths and how we structure strategic asset allocations, that person will have 70% to 80% of their investments in stocks, if you’re 30 years from retirement. When we say we are pulling back from stock, we are pulling back from that strategic allocation. So the point of tactical asset allocation is to lean and take advantage of relative valuation on a six-to-18-month horizon and, over time, we add value, add alpha, to the portfolio. So it’s not that we don’t like stocks; it’s that we don’t like stocks relative to bonds.

Turner: Regarding inflation: I mentioned the Paul Singer letter that we got hold of. He pointed out that nobody knows how the unwind from zero-interest-rate policies is going to play out. What he was saying was that inflation could pick up faster than anyone expects right now. If inflation starts heading in that direction, you start picking up momentum pretty quickly. How big a risk is that?

Trump had done more for inflation expectation with 2 million red hats that say ‘Make America Great Again’ than years and years of super-aggressive monetary policy.

Page: I would agree. I think inflation is a risk, and I think it can be underestimated, and not only is it a risk but there is also uncertainty around it, so it can accelerate very fast. However, if you think about this zero-interest-rate policy and global monetary policy, it has been incredibly aggressive for a long, long time, and somehow we haven’t generated the inflation.

One of our team members around the election commented that, you know, if you look at the inflation expectations postelection, it looked like Trump had done more for inflation expectations with 2 million red hats that say “Make America Great Again” than years and years of super-aggressive monetary policy. So you have to put it in context. But the fact is, inflation expectations are picking up.

And I would almost call that a tail risk — those are events that don’t have a high probability of occurring but could have devastating effects.

On the bond side, our bond investors are referring to a “moment of truth.” They’re watching the 30-year, the long end of the Treasurys. The interesting thing is the 30-year rate has been anchoring around 3%. And the shorter-term rates have lifted. So you have a flattening of the yield curve.

This means that investors in the long end of the yield curve — granted some of them are pension plans which have to be long — but nonetheless it is anchoring around lower growth and lower inflation. It’s not pricing in either that growth or that inflation that the shorter end of the market and stock market is pricing in.

So they’re looking at this and thinking, “OK, it’s a moment of truth.” Either the long end is right, and we will reprice growth expectations, in which case it’s a good time to get into bonds because all else being equal when risk assets sell off, having Treasurys will pay off. That’s one of the true ways you can diversify your portfolio. Or the curve itself will reprice. But, in general, flattening or inverting of the curve is an indication of recession if the Fed acts too fast.


Turner: Just on the inflation side of things, I remember messaging a macro sales guy right after the election to ask what was happening, and he told me everyone was buying inflation. Has that settled down?

Page: Yes, and if you look at breakevens, for example, postelection they didn’t reprice as much as you would have expected. And for a while, postelection we were actually quite bullish on breakevens. Now our bond investors are moving from a bullish rating to more of a neutral kind of rating, which is still pretty good. The thing with adding inflation protection to a portfolio is it doesn’t pay off necessarily in all markets. But you don’t know when you are going to need it. Having some inflation protection in your portfolio is necessary.

Turner: You mentioned China. It seems like we’ve all stopped talking about China. What is your sense of how things are there? You mentioned if there was a significant slowdown in growth it would bad. How big a risk is that?

Page: The risk is there; the risk is there for emerging markets as a whole. In China, you have currency aspects that are also a risk. And the levels of debt.

So you have a lot of factors that are still there and make us uneasy. If you zoom out and look at emerging markets overall, we have reduced our allocation to emerging markets’ equities. And we started reducing it a bit more postelection as well, because if you look at the factors of what could go wrong versus what could go right with emerging markets.

We are talking about higher US interest rates, we talked about restrictions to trade, a stronger USD, and then you have commodity prices. Going back to this discussion of the earning recession, a lot of the so-called earnings recession was tied to the oil and energy sector. This is still a risk for emerging markets. Our oil people have analysed this with a fine-tooth comb. They literally count the rigs that could come back online at different levels. And their view is that there is a massive oversupply. They’re quite bearish on oil.

So add that all up and the discussions in our committee was that it’s hard to find something to like. Our main way of making decisions is on valuations, so if an asset class is cheaper than another, that’s likely where we will lean. We rarely will overweight something that is expensive or overweight something that is cheap.

Emerging markets might appear cheap under certain valuation measures, but not all of them. It’s not a clear-cut picture on the evaluation-side case for emerging markets.

Turner: What are the reasons for optimism? And where do you think there is value?

We have brought assets back from overweight internationals toward the US.

Page: There are bank loans. That’s an asset class that we like. We have broadened in the equities field. We have brought assets back from overweight internationals toward the US. We started doing that post-Brexit. So these are some sectors that we like.

In general, if you look at our tactical asset allocation, we are running at lower active risk than we normally do. We’ve been neutral on stocks versus bonds. We have a slight underweight on stocks, and we’ve been slightly de-risking our positions by reducing our allocation to emerging-market stocks.

We have been playing the carry fixed income and not adding to high yield because the spreads are getting compressed.

So things like bank loans we’re long. Our fixed-income investors and the committee feels like there is possibly a cap on rates. If you look at the 10-year, for instance. If the 10-year goes to 3%, then depending on what comes with this, whether it’s high inflation or higher growth expectations or just the Fed acting too fast, this might mean that bonds will become more attractive. So we’re watching this more closely.

Turner: You mentioned Brexit. What is your view on the European markets?

Page: So post-Brexit, we downgraded our EU equities, our UK equities, and that’s when we started bringing money back to the US. The view there is that there are structural issues that are hard to overcome, and if you start from the UK, and you get very low interest rates just to stimulate the economy and negative interest rates in other countries, that creates issues with the banking sector.

The banking sector has issues with their loan books and other things but also net interest revenues when the yield curve is so flat — that is sort of a structural issue. And when you get risks like Brexit, which bring interest rates even lower, just the whole mechanism behind the banking and financial sector, despite the Trump rally, still remains a long-term structural issue.

Turner: Are you still bullish on Japan?

Page: Generally.

Frank Chaparro: Even despite its demographic problems?

Page: There is a long-term demographic issue. But there are other things that are positive for Japan, such as a change in the corporate culture. The monetary stimulus is there. When you think of Japan you also need to think about the currency but improving fundamentals, very cheap valuations, so there are some positives there.

Turner: When you go to these meetings, which you say you are having more frequently right now, how hard is it — since it’s all moving so fast — to make sense of it all in real time? You mentioned currency markets moving on tweets, which is something you can’t really predict.

Page: That’s an interesting question. We do take a six-to-18-month horizon. We don’t react to tweets.

We tend to be contrarian, and we tend to move away from the momentum. The committee comprises full-time investors. We are comfortable leaning against the wind.

Turner: That adds another question: What is your No. 1 contrarian view or perspective? Where are you swimming against the tide?

Page: As a general statement, when markets get fearful of stock sell off, we go in. I don’t think we have any major contrarian positioning.

We are definitely leaning more risk off than the market. Ultimately, that’s our biggest contrarian position. But hearing you talk about your last two stories, investors are starting to come around. If you look at our history, if something is undervalued, we tend to go in.

We added high-yield exposures starting in February of last year. We wished we had added more, but it was at the time where, because of oil prices, the spreads were way high. I remember one committee member saying “spreads rarely get that high” and when they do in history you can get in and we did it again in increments. That’s an example of how we would act. We look for valuations that get really stretched, and that’s when we lean in. So right now I would say it’s more risk off.

We look for valuations that get really stretched, and that’s when we lean in.

Turner: You says you guys are risk off. What is the risk that deserves the most attention?

Page: You mentioned inflation. That might be underappreciated, even though it’s starting to get more appreciated. The biggest risk is probably around trade policy. That could have a big impact. Without taking a political view, I think it is relatively uncontroversial that the global political environment is more volatile than it has been, so there is uncertainty there.

People talk about uncertainty versus risk. The geopolitical or trade war … then let’s not forget the risk of Fed being too aggressive on the monetary side. So if you ask me for the ranking right now it’s probably on the political side, first. So trade restriction, tariffs, then maybe monetary policy, because it’s such a huge driver of markets. No. 3, you could get another significant leg down in oil or energy prices. China. That would be roughly my ranking.

Chaparro: You don’t see protectionist policies by Trump being outbalanced by some of his more favourable policies, like lower corporate taxes?

Page: You need to look at the net impact. And what’s happening, going back the original question about whether the market priced for perfection, it seems like the market is not doing the netting … The way I think about it is, the tails have gotten fatter. You can actually get a strong positive outcome to the economy that might even surprise on the upside. But you can also get that on the downside. You can have fatter tails.

Turner: There is more clarity on corporate tax. But we really are still getting to grips with what his trade policies are going to look like.

Page: There is a domino effect. This is more game theory. If you have a tariff and impose it on a country, then that country will impose a tariff, and it can spiral very quickly.

Turner: I am beginning to see people write about that. America’s economy has moved away from the 1950s-type economy that those policies would benefit. There was a great quote where Peter Navarro, an adviser to Donald Trump, said he envisioned having an economy like Germany. But America seems to have moved away from that.

Page: That seems to be the case. The change in the mix between services and manufacturing, that’s here. There’s also automation and robotics. How do you tackle the march of technology? At T-Rowe Price, we talk about disruption and disruption in the technology sphere. That refers to things like automation. And automation takes jobs away.

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