It’s the job of a financial executive to calculate the unknowns.

Tensions are rising across the globe as the war in Ukraine grinds on, conflicts envelops the Middle East and concern builds about China and Taiwan. Investors are also uncertain about the state of the economy, income inequality and a divisive US presidential election just months away.

But even with all these risks in plain sight, prominent Wall Street leaders are thinking about the long-term challenges not yet on the financial world’s radar. We spoke with three who’ve managed money for years about the next big risk they see coming: Wes Edens, a co-founder of Fortress Investment Group who now runs New Fortress Energy; Katie Koch, chief executive officer of asset manager TCW Group Inc.; and Ray McGuire, president of investment bank Lazard Inc.

Their comments have been edited for length and clarity.

Perilous Time
WES EDENS
Founder,  New Fortress Energy

The risk that I think about all the time is geopolitical risk, the rise of that risk over the last several years and what the real risks would be broadly, should there be any real conflation of that.

Fifty percent of the world’s population is going to elect a new leader next year, so it’s a particularly charged time. There’s been so much growth economically in the last 20 to 30 years with globalization, and I feel like we’re in the big de-globalization trade.

Everyone seems to think all these regional conflicts — whether it’s Israel-Hamas, or China and Taiwan, Russia-Ukraine — are going to be contained. I don’t think they’re really pricing in the possibility that something greater could happen. So it’s a perilous time for both economies as well as individuals.

I’m worried about what could happen if one of these things went from a regional conflict into something much broader. Obviously these are all complicated and they’re all heartbreaking stories in terms of the people involved. But the challenge is how do you keep this just a regional issue and not turn into something more broad-based.

The US obviously is a cornerstone of economic activity. Dollars are the reserve currency of the world, and we should think through what would happen to liquidity and returns if there were real problems that escalated. The simple way of thinking about it is that globalization was the source of a lot of growth without inflation. De-globalization is kind of the opposite. And so of course that could mean higher inflation, higher costs, higher interest rates.

The consensus — which is not always right, but in this case I agree with it —  is that rates are likely to come down over the course of the year, as it seems like the Fed has done a great job in trying to manage the balance between growth and inflation. That said, the monetary policies of the US, as well as other countries, are kind of the opposite. The U.S.’s current deficit is $34 trillion dollars. What that means in terms of people and consumers is that there’s competition for borrowing and for capital. And if the governments are going to be your biggest competitor, it’s likely you’re going to have much higher rates for a much longer period of time, perhaps after the short reset. The risk of higher interest rates is one that people don’t think about as much as they should.

Geopolitical risk can actually add to that. Instability in the world is likely to have significant swings in this. When I started working on Wall Street many years ago, current coupons were 12%, 13%, 14%, 15%. I think people have become used to these much, much lower rates. And the question I would ask investors is, “What happens in a world where rates are actually much higher for a longer period of time?” I think that can be very destabilizing.

We have to take a hard look at where do you want to have your capital exposed. We want to be as unleveraged as possible, and we’re in businesses that generate a lot of cash flow. And so you’re going to end up reinvesting that in your balance sheet to bring down leverage in a fairly significant way. I think businesses that rely on a lot of leverage — and will rely on it going forward — they just have a lot more exposure to it.

Silver Tsunami
KATIE KOCH
CEO, TCW  Group Inc.

At TCW, we think about large risks through the eyes of our clients, and a very large part of our business is helping beneficiaries and plan participants retire with dignity and security. Against that backdrop, the largest risk that we see, and the one that we spend the most time on, is longevity risk.

There are various aspects of that. First is that lifespan is increasing. Second is that anytime you have a mega-trend like this, which has been dubbed the silver tsunami, there are immediate impacts in how you position your portfolio. But most important for our clients is how are we going to work with them to fund what is now going to be a much longer retirement.

We now have a lifespan that’s 20 years longer than it was in 1960. As of 2020, for the first time, we had more people over the age of 60 than under the age of five, and this is going to continue. If we look out over the next decade, 100% of baby boomers will be 65 and over.

There’s also the possibility that advances in health care will add another six years of high-quality life. So it’s really good news for humanity. At the same time, it’s creating interesting disruptions for investments and challenges to saving for retirement.

For much of the last 100 years the burden of retirement for Americans was really dealt with by the government after the creation of Social Security, and also by corporations through defined-benefit pension plans. As late as 1980, 60% of Americans had access to a defined-benefit pension plan, which provides lifetime guaranteed income. The burden of that has now switched to the individual. And if you look at that number today, only 3% of Americans have access to such a plan.

And at the very moment when that burden has transferred to individuals, we’ve seen and will continue to see a migration of some of the most attractive income-producing assets from public to private markets. So there are quite a number of challenges.

There are a lot of solutions to these challenges around retirement. First, people could work longer. That will close some of the gap, but not all. The second is that we have to reimagine defined-contribution plans. One solution could be adding an insurance component, basically taking the defined-contribution plan and making it look more like a defined-benefit plan because if you add annuities to it, you can produce lifetime income.

The third challenge is that we have to hunt more for income-producing assets, and we need to incorporate some of the things that have gone to private markets into retirement portfolios for clients.

If we look at the US public equity market, there are 50% less  listed companies now than there were 20 years ago. And I think we are at the very early stages of fixed income being disrupted. We’ve seen that in the rise of private credit. Pre-global financial crisis, that asset class basically didn’t exist, and now it’s well over $1 trillion and taking share from the bank syndicated-loan market. And then there’s the securitized market, asset-based finance, which used to be largely publicly listed, and now many of the opportunities are private.

We are going to have to create more product for the defined-contribution space that can give dedicated exposure to some of these less liquid assets that may have higher income production than what’s available in public markets.

There are some very important investment implications for how we position portfolios today. Health care is obviously one, with artificial intelligence opening the doorway for personalized medicine and targeted gene therapies. We’re seeing a massive inflection in the cost curve around how this happens. One less obvious one is how we’re thinking about navigating the real estate landscape. We’re very positive on residential real estate, both through credit as well as equity. One reason for that is we have a very undersupplied market by about 10 million units.

Longevity is also a key tenant of this investment thesis for us. And the reason for that is that the older population is staying in their homes longer. In fact, homeownership rates for people 65 and over are 80%. That compares with 65% for overall homeownership rates in America and 40% for people ages 35 and under. And so longevity is actually exacerbating that supply-demand dynamic and underpinning our positive view on why to be overweight residential.

When it comes to commercial real estate, we’ve been quite public in our concerns that one of the largest components of that sector, which is office, is a near-term risk over the next couple of years. Still, there are other types of commercial real estate that are of interest to us, including senior living. That would include independent senior living, assisted senior living, memory-care facilities, lab space, hospitals, all of the things that are going to require new square footage to address this longevity trend.

The American Dream
RAY MCGUIRE
President, Lazard Inc.

The issue that will determine how our country fares both locally and globally is education. It’s at the core of whether we have the opportunity to realize the American Dream. It’s also at the core of whether America can remain in the lead of innovation and competitiveness.

And the returns that we’re generating are unremarkable at best. At the national level, we spend $800-plus billion dollars, which may sound like a lot. That’s 3% to 5% of the budget. And we spend maybe 20% on defense. Both are obviously important, but you can see the delta.

Not withstanding the amount of dollars that we’ve spent, we’ve dropped on a global stage. It used to be that we were in a premier position, now we’re in a secondary position. If I look at degrees that are conferred in the higher technologies, most don’t go to Americans. In 10 years, we’ll see that there’s an erosion in our competitiveness.

We’re creating a permanent underclass. It used to be that education afforded us the opportunity to realize the American Dream. Today, it’s so stratified that a significant percentage of our population will never realize it.

In New York City, the largest public school system in the country, we spend $35 billion to $37 billion a year. If I look at the latest nation’s report card on the performance of Black and Brown students in the city, 60% to 70% are below proficient. So I look at that and say “We need new investors.”

Illiteracy today reflects the abject failure of leaders in the educational world. The crisis is today. And so we need to be urgent.

At Lazard, have a program called New Visions for 11th- and 12th-grade public school students. Last year, we had 21 or so schools represented — 300 and some-odd students — exposing them to the opportunities that exist in the world of finance and elsewhere. It’s these kind of public private partnerships that will allow those who are reliant on the public school system to get educated.

The crisis in education has become more intergenerational and parents need more support — more emotional support, more economic support. We need to invest from the state universities to the private ones, from the Georgia Techs to the Caltechs, from CUNY and SUNY to Yale and Harvard. And we need to have the best.

We begin to care when it begins to impact our lives, when those who have less hope begin to encroach on neighborhoods where hope is clearly reflected. When we see what’s happening in the urban world get closer to the suburban world, then we’ll attend to it. But it’ll be too late, as the boundaries get crossed between those who are educated and those who are uneducated, who have no hope.

You can see the impact that it’s having, especially on Black and Brown communities. It’s a matter of race and economic circumstances. We tried to combat this in 1954. And where are we today? Looks as if we’ve gone backward on every metric. It’ll have an impact on rural White communities that aren’t being educated.

A fundamental worry I have is that unless we address this with urgency, it worsens. We’re already in a catastrophic phase with systemic challenges abounding. This is the most fundamental right that we have as a country, which is to educate our population. We’ve taken it for granted and we can no longer do that.

This article was provided by Bloomberg News.