Like a lighthouse surveying the waters for signs of distress, investors are challenged to shield their portfolios from potential turmoil in financial markets. But uncovering risks before they reveal themselves is a monumental task—even for the most savvy investors. Fault lines lurking in the banking sector came into view in the aftermath of Silicon Valley Bank’s collapse. As a consequence of the pivot from years of ultra-low rates to the sudden tightening of monetary policy, investors must be on the lookout for new cracks that may form.

Part 1

In the first installment of our two-part episode, we take a closer look at the fallout from the bank crisis and where other risks could arise. Rob Kaplan, former President of the Dallas Fed, and George Patterson, Chief Investment Officer of PGIM Quantitative Solutions, discuss lessons learned from banking turmoil, the difficult path ahead for central banks, and where investors can find longer-term opportunities amid an uncertain environment.

Part 2

The final installment of our two-part episode in which we further examine what sparked the latest bank crisis and whether it was a canary in the coal mine. Robert Armstrong, US financial commentator and writer of Unhedged for the Financial Times, and John Cochrane, senior fellow at the Hoover Institution and author of The Fiscal Theory of the Price Level, join us to discuss the implications of banking fragilities, keeping a long-term investment horizon amid market volatility, and how swelling government debts could set the stage for new market risks.

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>> One January night in 1996, in the Atlantic Ocean, just off the coast of Newfoundland, Canada, a U.S. Navy ship narrowly escaped what could have been a catastrophic collision with a Canadian vessel. Years later, thanks to the Freedom of Information Act, the ship's radio transcript was released revealing just how close the ship came to a tragic end. Shortly after midnight, a dense fog rolled in, quickly blanketing the shoreline. A beam of light in the distance was barely visible to the captain.

>> This is the captain, please divert your course 15 degrees to the north to avoid a collision.

>> Recommend you divert your course 15 degrees to the south to avoid a collision.

>> This is the captain of the U.S. Navy ship, I say again, divert your course.

>> No, I say again, you divert your course.

>> This is the aircraft carrier, USS Abraham Lincoln, the second largest ship in the United States Atlantic Fleet. I demand that you change your course 15 degrees north. That's 1-5 degrees north or countermeasures will be undertaken to ensure the safety of this ship.

>> This is a lighthouse. You call.

>> This cautionary tale is actually an urban myth and it's more than a century old but its lessons remain true; in times of stress, it's especially crucial to be on the watch for hidden risks. Adaptability and responsiveness can often make up for bad judgment and cognitive error, but in the face of uncertainty, situational awareness is crucial. To understand today's investment landscape, it's important to know how we got here. This is The OUTThinking Investor, a podcast from PGIM that examines the past, the present day opportunities, and the future possibilities across global capital markets. In this episode, we're looking for hidden risks in areas where investors might least expect them. Two experts good our search; Rob Caplan is co-chair of the Draper Richards Caplan Foundation, a global venture philanthropy firm, and former president and CEO of the Federal Reserve Bank of Dallas. George Patterson is chief investment officer for PGIM Quantitative Solutions. The U.S., like much of the global economy, is pivoting sharply away from a decade and a half of low interest rates and added liquidity from COVID stimulus packages. The challenge for investors will be to keep an eye out for all forms of risk, as market conditions evolve. Treasuries, for example, can be a beacon of safety, or, like the lighthouse in our story, their fixed rate status can obstruct other risks, like duration and liquidity. As liquidity dries up, hidden risks become exposed and work their way through the financial system. Will the Federal Reserve stay on track to shrinking its balance sheet, even if market stress escalates? Rob Caplan worries about the implications.

>> I think it would be very important for the Fed to be able to reduce its balance sheet. We were at 800 billion around 2006, went to 4 trillion in response to the global financial crisis, whittled that down modestly in '17 and '18, and stopped at the end of '18, and then in the aftermath of COVID, went all the way from 4 trillion to 9 trillion. My concern is that is now in the neighborhood of in excess of 40 percent of GDP, my worry is there may be practical limits to how big you can grow that balance sheet in dealing with future crises. The challenge in reducing the balance sheet 95 billion a month, as the Fed is now doing, is we have an enormous amount of leverage in the financial system and by reducing the balance sheet, what you do is ultimately drain liquidity from the system and we're seeing some evidence of that now, as you raise rates and drain liquidity you start to cause bank deposits to leave the banking system, you cause losses on long-term bond portfolios and treasuries, and mortgage backed securities, and you start to create stress in the financial system. So I don't know how far the Fed is going to be able to go ultimately in reducing the balance sheet and we're seeing in response to the current banking situation, they're having to increase the balance sheet, at least in the near term, again through the discount window and other programs.

>> Of course this has all happened in a dynamic system with so many variables impacting each other. And, as George Patterson explains, in an incredibly short period of time.

>> COVID is not over, it's just in a different phase and one that will continue to impact us for probably several more years. Because parts of the economy move very quickly and parts of the economy move slowly, you can't change companies overnight and supply lines, et cetera, all take time to adapt. So it was really an amazing social change in many ways that occurred. We've had an economic cycle in a record amount of time, we've gone from crisis, interest rate cuts, monetary and fiscal stimulus, unemployment at levels that we'd not seen in ages, to then all of a sudden stoking inflation and now we're in the process of trying to get that under control.

>> The risk reward/reward calculation has shifted rapidly. Market appear confident about long-term outcomes but, as with any other downturn, there will be some financial damage along the way.

>> Yields on so many things essentially went to zero. And there are many people that will then stretch for yield, right? They will take extra risk in order to pick up a small amount of additional performance by taking that risk. What they don't appreciate is that, that is all conditional on liquidity. But then when sentiment changes, when liquidity dries up, oftentimes you find that those trades will blow up on you and just will be a really a source of hidden risk and you see that with some of the challenges with banks that have had mismatched portfolios in terms of the duration.

>> Isolated stress points have shown up in some regional banks in the U.S. and of course Credit Suisse in Europe. Will the remedy be worse than the disease?

>> So, the problem in the United States to some extent has been we maybe are not as vigilant about financial issues in the system. So what's an example? We just started in '07-'08 to stress test the big banks and that means we're in much better shape with the big banks on counterparty risk and degree of leverage and having enough capital in the downside. But we've had a tendency over a long period of time to wait for some type of dislocation or crisis before we take those actions and when we face that crisis, we then tend to bring in the fire truck and use government funds and yeah, there's the concern at the time of dealing with the crisis we create moral hazard because we give people the impression that the government will come in and create some kind of safety net that might encourage over the longer run, risk taking. I think the answer is to be vigilant and you have to accept, maybe we need more vigilance, more regulation, more oversight, broader stress testing among a broader swath of banks, and then you can avoid the situation where you have an issue come up where you have to act or you're going to destabilize the entire financial system. It may mean slower growth, by the way, in the near term, and a little bit less credit extension, but it might be worth it in terms of risk management. But that's a tradeoff that we're going to have to weigh.

>> One important distinction is between the regional banks and the big national banks, known as G-SIBS, or Global Systematically Important Banks.

>> If we're not careful, you'll have 10 banks let's say, in the country, six G-SIBS and maybe three or four other big banks where a person would be willing or a company would be willing to keep deposits on excess of $250 thousand for their payroll account or some other purpose. And then you'll have literally 4,700 other banks where you're going to be very reticent to keep more than $250 thousand. And while individuals might be able to manage that, small, mid-size companies keep much more than that in any individual bank in order just to manage their payroll. If you leave things as they are right now, most rational companies and CEOs I talk to, and certainly individuals, are going to be very reluctant to keep in excess of $250 thousand unless it's sub-allocated out these insured cash sweep provisions where a bank says, I'll piece out your deposit to other banks, but otherwise, most people I've talked to are going to want to keep their money at either a G-SIB bank, one of the top six or at least one of the top 10, and the concern I have right now is it means you're going to have deposit outflows from literally thousands of regional banks that provide the bulk of the credit financing to small mid-size businesses in this country. There's three categories of people I'm talking to right now, they've either moved their deposits already, they're in the process of actively considering moving their deposits, or they're saying, we're not doing anything right now but we're watching it carefully and if we see signs of more stress, we may act. And banks are doing a lot to sub-allocate this insured cash sweep, and trying to do everything they can to manage this.

>> The first order of business with a loss of confidence is to stabilize the banking system, to try to minimize harm and lower the risk of contagion, while continuing to fight inflation. Then comes the question of how to shore up the system to avoid future crises.

>> I think what comes with stabling it and insure deposits more broadly is tougher regulation on big and small banks, probably a number of banks will need to go out and raise more capital, but this will give them time to do it and you're going to see more mergers and consolidations I would guess, in the banking system. But my concern is, if you don't take this action, you're going to have continued instability here, particularly as the Fed is raising rates and trying to slow the economy. And I'd say the best of a bunch of bad options is doing something to insure deposits across the system, increase FDIC fees, don't use taxpayer money if you can avoid it, have the banks pay for it. But I think you need a stable banking system, particularly in light of the fact, we're in the middle of an inflation fight and we've got to fight it by tightening financial conditions and slowing nominal GDP growth which, by definition, is likely to create more stress, not less stress. You want to make sure that there's good confidence in the banking system.

>> Financial stress is not limited to the banking system, and we really don't know how this might be impacted by the financialization that took place across the U.S. and global economy over the past several decades.

>> The regulators have pretty good information on the banks, and so there really shouldn't be an excuse, in my opinion, for not seeing looming risks in the banking system. The part that I don't think we have a good grip on is the non-bank financial sector. And a lot of financial assets in the world over the last 15 or 20 years, have flowed out of the banking sector into the non-bank financial sector, i.e. the unregulated sector. And my experience is I don't think there's good information or good transparency on the non-bank financial sector and the regulators don't have great clarity on the risk being taken there.

>> George Patterson agrees that time will tell. In particular, he's watching out for how commercial real estate will adapt to a new world.

>> There's still several things that we haven't seen yet, but I think real estate is the one where there's probably the most uncertainty about how that's going to play out. Now on the good side, the real estate industry in general moves very slowly, because oftentimes buildings or offices are leased for years, they're financed on a longer term basis, and a lot of times the underlying client is really somebody that's fully cognizant of the risks and is well-matched with the type of investment. So, I don't think there's going to be a crisis as a result of that, but it is going to be painful and I think commercial real estate is one of the areas where we will see another shoe drop, but it's going to happen in slow motion over the next few years. Essentially, the way you figure out your hurdle rate is going to be very different when rates are zero versus rates at 6 or 7 percent. And unfortunately, some of the decisions that were made when rates are zero, are no longer to be good decisions in today's environment.

>> There are certainly looming macroeconomic risks that will influence investor decisions, but how much risk has already been priced into the markets?

>> It seems to me what's already in the markets is that the Fed Funds Rate is going to get up to plus or minus 5 percent. What the Treasury curve though is also saying is they believe GDP growth is going to slow and that's why the 10-year Treasury is in the mid-threes, and so they're assuming we're going to have to have elevated Fed Funds Rate, at least for a couple of years, and then eventually it's going to start to drift down. And we really don't know by industry, how much margins are going to erode. And then there's a whole range of businesses that are losing pricing power but yet their costs continue to rise, particularly labor costs, and they're getting squeezed. I think there's an enormous amount of uncertainty what the margin erosion is going to be, what's the level of it, and by, and what industries, and that's probably what's not priced in.

>> Some sectors, like technology and travel, were clearly elevated by the macroeconomic impact of COVID.

>> We saw some of the Mega-Cap tech names pull, what I like to say is, they pulled their future earnings forward. So earnings that they might have gotten in '23 or '24 or '25, as companies were naturally moving towards kind of more digital presence, were all of a sudden pulled forward. In 2019, no one on my department was using Microsoft Teams. In the middle of 2020, everyone was using Microsoft Teams. Everyone was using Zoom. A lot of the earnings that were going to happen over the future, were all of a sudden pulled forward. A number of companies hired in response to that and of course no you're seeing unwinding of some of that because they mistakenly thought that demand was a real permanent shift in demand, it was really in my mind, just a rearranging of the deck chairs, where earnings that they were going to get in the future were just pulled forward. Consequently some companies; travel, leisure companies, were basically shut down, went to zero. Those earnings were really pushed into the future. But then you're seeing them come back now where restaurants, travel, extremely busy, people are just desperate to get out there and return to that.

>> The U.S. economy overall has been resilient and so has the equity market, generally, despite a lot of volatility. Process have remained on the high side compared with markets outside the U.S.

>> The U.S. market has really held up, earnings multiples have remained towards their high range. It's not to say that there aren't pockets of the market that are not weak, but it's really just been a very large disparity, so when we think about opportunities, particularly in equities, we tend to be much more focused on Europe or Ex UK emerging markets. The other thing that's very interesting in the U.S. particularly is that there's been a huge disparity between growth and value stocks. So during the pandemic, growth stocks really took off and they went to just extreme multiples and value stocks, which probably made sense, were basically left for dead. This was anything that was asset intensive, transportation, cruise ships, airlines, went to kind of record low multiples and we've seen that rebound but it's really only come back part of the way when we look on a long-term historical basis. People in the U.S. are still willing to pay a very high price for growth, that's still a very large spread between the valuation of growers and Mega-Cap, versus the valuation of kind of asset intensive, traditional value companies. And that's something that we think just really is a long-term opportunity that will have some bumps along the way. I mean in the current environment we're in, I can understand if people are concerned bat a slowdown, that value may take some lumps along the way, but there's really just so much opportunity there that we think that over the long-term, having some exposure to that segment of the U.S. market makes a lot of sense.

>> But like the lighthouse in our story, risk can come from unexpected sources. Situational awareness can help to identify hidden risks. Investors should be prepared to adapt as circumstances change. Join us for Part 2 of this episode of The OUTThinking Investor, when we continue the discussion on hidden risks with Robert Armstrong, U.S. financial commentator at the Financial Times, and John Cochrane, senior fellow at the Hoover Institution. Thanks to our experts; Rob Caplan and George Patterson, for their insights on hidden risks in Part 1 of this episode. The OUTThinking Investor is a podcast from PGIM. Follow, subscribe, and if you like what you hear, go ahead and give us a review.

>> This podcast is intended solely for professional investor use. Past performance is not a guarantee of future results. All investments involve risk, including the loss of capital. PGIM is not acting as your fiduciary. The contents are for informational purposes only, are based on information available when created, and are subject to change. It is not intended as investment, legal, or tax advice and does not consider our recipient's financial objectives. This podcast includes the views and opinions of the authors and may not reflect PGIM's views. PGIM and its related entities may make investment decisions that are inconsistent with the views expressed herein. This podcast should not be reproduced without PGIM's prior written consent. No liability is accepted for any direct, indirect, or consequential loss that may arise from any use of the information contained in or derived from this podcast. This material is not for distribution to any recipient located in any jurisdiction where such distribution is unlawful. PGIM is the global asset management business of Prudential Financial Inc., which is not affiliated in any manner with Prudential PLC incorporated in the United Kingdom, or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom. Copyright 2022. The PGIM logo and the rock symbols are service marks of PGIM's parent and its related entities registered in many jurisdictions worldwide.

>> Welcome to Part 2 of this episode on hidden risks. As in the cautionary tale of the lighthouse in Part 1, risk can come from unexpected sources. It can seem obvious in the rearview mirror but it's not always so easy to spot these risks in real-time. Some of the current risks have remained hidden because it's been cheap and easy for companies and governments to rollover debt for the past decade and a half. Other risks have gone unnoticed because leverage bets just kept making money year after year. In Part 2 of this episode, we continue the discussion with 2 more experts. John Cochran is a senior fellow at the Hoover Institution and author of "The Fiscal Theory of the Price Level". Robert Armstrong is U.S. financial commentator at the "Financial Times". Silicon Valley Bank may have been the canary in the coalmine signaling a new regime of risk. Now the question on everyone's mind is how many other problems are lurking in the financial system. Rob Armstrong has an answer.

>> Silicon Valley Bank and a small handful of other banks were extreme examples of balance sheet mismanagement that made them very sensitive to the changing rate environment. But there is certainly pressure on everyone. In other words, I don't think we're going to see and I don't think we have seen a rash of bank failures. But what happened with the failures of [inaudible] is symptomatic of pressure that all banks are feeling. So what's the next shoe to drop? Well, one answer that at least deserves attention now is commercial real estate for 2 reasons. First reason, midsize banks like Silicon Valley Bank depend very heavily on commercial real estate lending on the assets side of their balance sheet. And after the scare at Silicon Valley and the pressure they're seeing on their deposit costs and the fall in value they're seeing in their long-term assets on their balance sheets, they're are all going to pull in their horns a little bit, be a little bit more conservative, and this will have an impact on their tendency to make loans into commercial real estate. At the same time, commercial real estate borrowers what with higher interest rates are seeing the value of their assets go down, too, so they're kind of getting a double whammy. Their lenders are getting more conservative and their own assets are getting less valuable. So the ones, the commercial real estate entrepreneurs and investors who are the most exposed to those 2 things that need the most funding and had the most, perhaps overvalued or highly-valued or highly-leveraged properties are going to come under pressure. So one question we're asking is, what is going to happen to commercial real estate values, you know, in the next 12 or 24 months, and what's going to happen to funding of commercial real estate assets? I think there's going to be some pressure there.

>> Demand has dropped due to the work from home trend and continued rise of e-commerce. A number of firms are also expecting to downsize their workforce, lowering the need for space. This drop in demand has combined with an increase in supply of commercial real estate space. Given the long lead times for property leases and construction, income and valuations are just starting to get hit. This is all very bad news for regional banks, which have high-concentration risk to commercial real estate as a whole. Loans held by regional banks have soared over the past decade. These small and midsized banks depend on income and valuation of commercial properties, both of which may decline. With the fed tightening its balance sheet, liquidity is also decreasing. Does that mean we should be concerned about the potential for a broader credit crisis? John Cochran knows the difficulty of foreseeing a crisis.

>> So I think the way these things work is that, that stumbles along until something bad happens. Now, it's very hard to predict the future and scenarios are hard. But usually a crisis comes about when there's something horrible that happens and then you discover that you were closer to the edge then people run. I mean, Silicon Valley Bank was as it turns out insolvent for a long time and then one Friday afternoon, everybody decided let's go get our money. So it's kind of hard to tell when does the run break out.

>> The U. S. is no stranger to financial crises in the modern era but are regulators learning from these events to make future crises less frequent or at least less extreme? No 2 crises are ever exactly the same. But the lesson of protecting depositors certainly seems to have been heated. Rob Armstrong wonders if that is a double-edged sword.

>> In the last 2 baking crises, depositors, uninsured depositors in American banks were also protected. So in the S&L crisis in the eighties and nineties, Continental Illinois and et cetera, depositors were protected by the government. In the Great Financial Crisis, uninsured depositors were protected by the government, so the fact that [inaudible] depositors, and specifically their uninsured depositors, have been backed by the U. S. Government is not an historical anomaly. But I think the question of moral hazard stands, in other words, if word gets out that the government will always back up depositors and that your money is at zero risk when you put it into an American bank, will that remove a kind of market discipline from the system.

>> Of course, the same is true of sovereign debt. Governments can experience similar credit crises, and the consequences can be much greater.

>> Let me give you a scenario that I worry about. Suppose China blockades Taiwan, all Pacific trade comes to a halt. This will mean a massive financial shock, a mass economic shock, financial shock. What will our governments do? Ten trillion of bailout, everything right, left and center, and stimulus and so forth. And this time they'll also be borrowing money to finance a looming war. So you know what happens when the U. S. Government goes to the market and says "We need 10 trillion dollars of money" not just 5 trillion like last time and Europe is doing the same thing? Well that could be the time when markets finally say "How are you going to pay this back?" And then interest rates rise because people don't want to give the government money at the current low rates. And you can see bad stuff happens from here on in involving interest rates, financial repression. That's that the kind of event that I think could spark a crisis. So what you need is you need gas stored in the basement and you need a spark. So we've got the gas stored in the basement and an unsustainable debt situation. And then you need a spark and I don't know what that spark's going to be but that's the kind of event I worry about.

[ Music ]

>> We've already seen a few sparks in the U.S. in Europe, Credit Suisse may be a different kind of catalyst. The Swiss government did something unexpected when the bank was on the verge of collapse. And it has to do with the firm's additional Tier 1 bonds known as AT1 bonds. These bonds are sometimes referred to as loss-absorbing bonds and even more informally, CoCo bonds or contingent convertibles. No matter the name, all of these bonds are expected to have higher risk and higher yield than many other types of issues. As institutional investors reached for yield over the past decade and a half, they acquired quite a lot of these bonds, especially it appears in Europe and Asia. What unfolded with Credit Suisse AT1 bonds is still being teased out.

>> There's a whole separate set of questions surrounding the collapse of Credit Suisse and the acquisition of the remaining pieces. What is particularly worrisome in that case is the fact that in the resolution of Credit Suisse, a special class of bondholders known as CoCo bondholders or AT1 bondholders were completely wiped out and the equity holders got something. And what's kind of worrisome about that is that the kind of loss-absorbing bonds, these AT1 bonds or CoCo bonds, it wasn't clear that they were actually, should have been behind the equity in the capital structure. And the Swiss government sort of threw its weight around, in this case, protecting those shareholders to a certain degree. And does this mean that loss-absorbing bonds now have to carry a higher risk premium because in a failure type of situation, it's not clear what priority they have in a bankruptcy? I think the actions of the Swiss government somewhat through that market into question and into turmoil. So that's an important issue and it's particularly important because in Europe, banking is such an important source of credit relative to the entire credit market as compared to the United States where we have a much deeper and wider bond market to provide businesses with capital. Banking is more important in Europe and an important part of the structure of the European banking system is these loss-absorbing bonds. And so there is an important question about whether that market has been thrown into turmoil and in general, the way bank resolution and bank capitalization in Europe works.

>> Credit Suisse was the first real test of these bonds, which were developed in response to the global financial crisis. It looks like the largest banks of China have significant exposure to AT1 bonds. They've also been facing a supply glut of commercial space. If China's banks spiral into a credit crisis that the government cannot quickly resolve, how might that affect the global economy? It's hard to imagine, almost as unthinkable as a default of the U.S. treasury. But these are exactly the kinds of risks that investors should contemplate.

>> Let's go back to my scenario of a real catastrophe, you know, something like an invasion, another financial crisis, a time when our government says "We need to borrow a lot more money." and markets are not willing to roll over the current debts. You know, you could get that kind of thing. You could get being forced to hold government debt one way or another. You could get a forced conversion, a rollover, a haircut, that sort of thing. Our government could choose to do that. Now it's a political question when you have an economy in freefall and congress is saying, "Well, we're either going to send checks to needy voters, or who may be actually needy or we're going to roll over the debts of Wall Street fat cats. I wouldn't trust that treasury debt will be completely [inaudible]. You know, that would also come with some sort of wealth taxation, you know, grabbing the wealth one way or the other thing so that kind of unpleasantness could happen with the U.S. Now we have the choice to inflate it away as well as default, which is something that is more likely for the U,S. but just as unpleasant for bondholders you know, you just had a default. You are holding on to long-term U.S. government bonds. You had the economic equivalent of default. You are going to be paid back in money that is roughly 15 or 20% less valuable than what you thought it was going to be when you pay your bonds. That's how, you know, we default through gone debts, our government defaults on debts by inflating them away and that could certainly happen again if we get into a situation where bond markets just don't want to give the government that much real resources.

>> Does this economic equivalent of a default make the potential of a technical default in U.S. Treasury more or less alarming? The debt ceiling quagmire is looming in the not too distant future.

>> So I think the worry here is that the [inaudible] in Congress because we've had the good fortune to get the deal done in the past will only extend further and closer and closer to the midnight hour, and that this might, by mistake almost, lead to a technical default by the United States. Now I think ultimately the country will pay its bills, but even a confusing few hours or days in which it appears that the sovereign debt of the United States is not being serviced promptly could be quite damaging to the financial system and could have quite far-reaching implications for the debt cost for the United States, for the stability of other markets. So many markets are, as it were, built on top of the Treasury market. The Treasury securities are the kind of the ultimate financing mechanism for so many other markets that a dumb, temporary mistake could be quite meaningful here. And though I wouldn't describe that outcome as a sovereign debt crisis, it could be a mighty big mess that would need some mopping up afterwards.

>> Judging by the volatility and yield curve of the bond market, it seems that interest rate risk is mostly priced in. That may not be the case for other asset classes, including equity. That's caught Rob Armstrong's attention.

>> The bond markets are showing inflation risk as live. I think the shape of the yield curve is telling us that a recession is fairly likely. I think that events like the ones we've seen recently within the financial system, the banking problems, in particular, make the probability of recession higher. So I wonder if we aren't in for more volatility in the equity markets, which have been a little too resilient for my comfort in the last couple of months. That doesn't mean that there are not, you know, good values emerging in equity markets. It just means it's all the more important right now to make sure that you are diversified, both within your equity portfolio and diversifying equities with fixed income and cash. And I think it's especially important now to know that volatility is going to be a feature of the equity markets in months to come and to have a plan in place for how you're going to respond to that volatility.

>> John Cochran is a true believer of the efficient markets theory, but that doesn't mean markets can see into the future.

>> They're certainly not clairvoyant and they missed a lot of things. So a lot of people say, "Oh, you know, markets aren't seeing inflation [inaudible] inflation." Well, markets didn't see inflation coming, even as it was beginning to burn and it's an interesting fact that the federal reserve, the markets, the survey of professional forecasters, did not see this inflation come. But you go back in history and like look at the 1970s and 1980s. The long-term Treasuries never saw inflation coming and they never saw inflation going away. What risks are there that people aren't thinking enough about and I would say the risks of sovereign debt difficulties is still one that we take for granted. And everybody knows Argentina, you know, could always go one way or the other, but that the U.S. and Europe could run into rollover difficulties, could run into inflation breaking out even worse than it has sort of a general flight from what we used to think of as the safe assets into real estate, commodities, stocks, other a general distrust of sovereign debt. That is, I think, the possibility that people aren't thinking enough about. Europe has that as well. The structure of the ECB is really, that's one of the big questions that is in turmoil right now with the ECB is guaranteeing 20 countries' sovereign debts. They really haven't solved the problem of 20 separate feet [inaudible] who can access the accelerator pedal and only one that can pull on the brake.

>> Could Europe plunge into another sovereign debt crisis? There are certainly pockets of risk. What happens to Italy, for example, with its debt to GDP ratio of 160% as interest rates continue to rise or remain high?

>> Plus the fact of Europe that Italian bonds are stuffed in Italian banks and Greek bonds are stuffed in Greek banks, so each country kind of has its own banking system as a hostage. And then hoping that the ECB will come up and print up enough money to stop the whole thing from exploding. That's an unstable system whose architecture's not clear to me what's going on. I spot something that looks to me like trouble that I don't understand and I'm not sure anyone else understands. And that's what, you know, risks are about, where is there something nobody, you know, could there be a bank somewhere in Silicon Valley that happened to have 90% uninsured depositors and a huge treasure trove of long-term treasuries that it doesn't mark to market and nobody thinks about that. The Federal Reserve, the stress test didn't even ask banks "What happens when interest rates go up?" That's like we're going to jump out the plane and we don't ask, "Did we put the parachute on first?" So you can see a pattern of people not thinking about risk. Are people thinking about the risks of higher interest rates? Well, I think today they are, but all sorts of people who you would think would have been thinking about this for the last year were not. So that's the general problem of the next risk is always one that nobody's thinking about right now.

>> There's no question, we've entered a remarkable time for markets, one that calls for careful navigation.

>> I think the current environment is interesting in that while we're experiencing a lot of volatility right now and some [inaudible] event right now, what we're seeing in a way is simply a return to normal after years in which inflation all but disappeared and partly as a result of that, interest rates were just extraordinarily low. And I don't think inflation is the whole story there. There is global demographic issues and there was issues with central banking that contributed. But we had this weird period where money was sort of free and that is ending now and that is good for the long run. It means that risk premia are more rational. It means diversified portfolios work better now, there'll be less need to make insane reaches for yield. But we sort of have to get through to that normal point and there will be this volatility and these terrify events in the meantime. And so the challenge is don't panic while this transition takes place. Keep eyes on your long-term goal, and instead of merely running to safety, being opportunistic about valuations of assets that are suddenly becoming attractive.

>> Sage advice. Long-term investors know that every crisis can be an opportunity, so long as they have the right combination of risk management and cash to take advantage of fire sales. The current risk environment should remind us that there is no such thing as a free lunch. Payment is now due for the decade and a half of easy money. The key is to remain vigilant, but cautiously optimistic. Otherwise, we risk missing out when opportunities do arise. Thanks to our experts, John Cochran and Robert Armstrong for their insights on hidden risks. Join us for the next episode of "The Outthinking Investor" when our special guests will be David Hunt, CEO of PGIM and David Rubenstein, the renowned philanthropist and co-founder of the Carlyle Group. "The Outthinking Investor" is a podcast from PGIM. Follow, subscribe and if you like what you hear, go ahead and give us a review.

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