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By Eric Jacobson | 04-27-2017 03:00 PM

Tail Risks That Keep a Bond Manager Up at Night

BlackRock's Rick Rieder on watching the downside, including China, European elections, fiscal policy, and geopolitics.

Eric Jacobson: Hi, this is Eric Jacobson for Morningstar. We're at the Morningstar conference today, and I have the pleasure of talking with Rick Rieder of BlackRock.

Rick, thank you so much for joining us.

Rick Rieder: Thank you, Eric. Good to be here.

Jacobson: So, let me ask you this. As a bond person, I tend to think in terms of risks and where are they hiding. And as you know, the lingo has been "tail risks" for many years now. Where do you see the tail risks that worry you the most or that would keep you up at night as a bond manager?

Rieder: So, you bring up the right question, because for bond people, it's either par or worse. So, we always have to watch, what is the downside. There are a couple of big downsides. I mean, we talked earlier about China. China is arguably the biggest--what it did in the markets last year. And people forget when they started to get the capital flight, that is a system that is overlevered and has grossed the monetary supply of too much to try and get through and try and grow faster. At some point, it is going to be an issue and the risk gets into the financial system. That to me is by far the biggest. It's untenable to grow at the rate that they are growing and to keep that leverage as high. So, that's the one we watch. And it's an opaque economy which makes it really hard. That's one. But everybody who said to me, is that going to happen, is that going to be an issue in 2017? I don't think so. I mean, they have got real reasons to keep that economy growing. But it is one that is out there and it's the one, we watch that capital flight or the potential capital flight closely.

I think as you get, the one that's going to keep picking up, we just went through the French which was a big deal in terms of a tail risk. Now that that's gone, we've got a German election, well, I don't think that will be as significant, but the Italian election is going to come up and that is one that is going to--you've got a party that's leading there in terms of the polls that is very much in favor of the potential dissolution of Europe or Italy's leaving the EU. That is one that will create some duress. And my sense is, it won't be till the beginning of next year, but that's one we keep an eye on.

And then the other one that is just so hard--we've got to watch fiscal policy closely and how does that manifest itself. But I'm pretty sanguine about U.S. growth and growth around the world. But the other one we've got to watch is, you can't get away from the geopolitical, moreso today. North Korea is an unstable situation, Syria, etc. So, you have to keep an eye on that and we do. So, those are the ones that certainly are keeping me--I don't sleep a lot, but certainly keeping me more awake than otherwise.

Jacobson: Let me ask you this about China. We talk to people about it quite a bit. The answer is very similar in most cases, although I would say the average manager we talk to is not as keyed in on the risk as you said. But when they talk about the ability of the government to contain things--so the two questions are, what is it that the government can do to help stave that off from happening? And assuming, let's just say for the sake of argument that something does go wrong there, especially if you're talking about all that debt and so forth, what's the mechanism that causes the most trouble for them if things go bad?

Rieder: Yeah, it's a great question. So, there are a couple of things. One, you have a sovereign that today, the sovereign in and of itself doesn't have that much leverage. The sovereign entity is unlevered. But it is if you assume de facto, the leverage behind the SOEs, the leverage behind the banking system. So, heretofore, as long as the reserves stay where they are …

Jacobson: Just to be clear though, because if I understand correctly, most of the debt that does exist at whatever level is domestic debt, is that correct?

Rieder: That is correct. But they do have international liabilities and it is something that you have to watch. And if the reserve base--and people have put out numbers of what is a stable reserve number and I'm not sure there's a perfect answer, I actually think it's the rate of acceleration if it were to decline that creates a problem--but their ability to control the economy to a large extent, their banking system to a large extent and then use their debt to do it, I think, is a pretty big deal. And they build current account on a regular basis. So, they have a lot of tools, more than any other economy.

You think about watching our economic system, our political system work, there you've got a system that can work efficiently in what I would argue is an unstable financial dynamic. So, what happens, and if you do were to create a significant slowdown and then a reserve decline, where does it manifest itself. You have to be careful about the financial system and the intertwined nature of the financial system that banking is arguably depending on how you measure it, almost double the size of the U.S. banking system on an economy that's what's 60%, or sorry, 40% smaller than the U.S.

And if you believe nonperforming loans is 7% to 10% and you think about it, it took a much, much smaller number to create a subprime crisis in this country. That's the place that I think you got to be really careful is if the financial engine were to start to unwind and the impact that can have on the global financial system. The intertwined derivative nature of global economy I think is really dangerous. So, we will watch it carefully. 

People ask all the time about U.S. inflation and the risk of deflating. The deflation is not coming from the U.S. It's going to come from there. And they are a 100% of the growth in demand for commodities--aluminum, iron ore, copper, nickel, zinc--and boy, if their economy starts to sink and you worry about deflation in the U.S., it's not coming from the U.S.

Jacobson: That's where it's coming from.

Rieder: Yeah.

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