You are reading a sample from the Cash Only newsletter, in which Martin Jašminský, Zuzana Kubátová, Jiří Zatloukal and Jiří Nádoba comment on events in Czech business every Friday. If you are interested in Cash Only, subscribe to the newsletter.
I came across Pavol Poval’s name while reading Michael Howell’s book Capital Wars: The Rise of Global Liquidity. Howell is a veteran of the financial markets who started with legends like Henry Kaufman, and in the introduction to his book, he mentions that Povala is among the people who have greatly influenced him. All that was left was to contact the Slovak economist.
“Howell was one of my PhD students and at some point I realized he was quite the star. It was a very unusual situation when you are thirty years old and your PhD student is once that old. But it was extremely interesting because my perspective was academic and he really lived those thirty years in the markets,” says Povala from his London office at Norges Bank Investment Management, the firm that manages Norway’s $1.6 trillion state pension fund.
Povala left his academic career at Birkbeck University in London three years after completing his dissertation and started working for the Norwegian state fund, where he gradually worked his way up to head of research. The Norwegian fund is the largest sovereign fund in the world, ahead of Chinese funds and oil funds from the Persian Gulf. It manages historic oil and gas revenues for the Norwegian state and its investment horizon is “infinite”.
Povala is responsible for ensuring that the fund brings a good return, and together with a colleague she leads the team that decides where to invest. “We deal with the strategic allocation of assets for the entire Norwegian fund, how much we should have invested, in which asset classes, how we should optimally set the portfolio within broad parameters,” says Povala, who in Slovakia holds an honorary position in the Government Council for Science, Technology and innovation and in the past participated in the pension reform there or for example the liquidity issues of the Slovak national debt.
The Second Cold War
“The starting point for our investments is diversification and diversification again. Investing in all asset classes that are big enough and just not making big bets (on individual stocks, bonds, etc.). That principle is based on the fact that it is very difficult to significantly beat the market,” continues Povala.
There are a lot of players in the financial market gathering information, so it is very difficult to beat the market unless an investor is strictly focused on a specific asset class, geographic area or sector. “We’re not trying to find the next Tesla or the next Amazon and put a bunch of money into these stocks,” he says.
Photo: List of News
The Norwegian sovereign fund brings decent returns.
It focuses even more on potential systemic risks that could significantly reduce the value of the fund’s portfolio. Povala and his team create portfolio stress tests in which they model potential negative macroeconomic scenarios.
“We were looking at, for example, if the situation between China and Taiwan worsened – internally we called it ‘the second cold war’ – that the world would again be divided into two blocs, Chinese and American. Today, the main risk does not lie in a direct war conflict, but, for example, in the fact that there will be restrictions on semiconductors, on certain industries, and the world will separate,” he says.
It would be an analogous situation that occurred after the Russian invasion of Ukraine in Russia, but on a much larger scale. Investors who had capital in Russia could write it off straight away, as the chance of ever seeing it in full again was greatly reduced. We saw this live with domestic financial groups, for example PPF or J&T, which sold their assets in Russia significantly below the pre-war price.
The second scenario is a debt crisis due to high real interest rates and high indebtedness. “Imagine that indebted countries have a problem with debt refinancing, and at the same time China has a debt problem in the real estate sector, and the combination of these things will cause a protracted and deep recession in the West, where the countries are heavily indebted, and in China itself,” lists Povala.
The last relevant scenario is an overestimation of the risk of current premiums in stocks that are at historically low levels today. (The equity risk premium refers to the excess return that an investment in the stock market brings compared to the risk-free rate in, for example, a government bond.)
“Historically, the risk premium on shares was around 3, 4 or 5%. However, if you look at estimates of the risk premium for investing in stocks, it is close to zero in some markets, particularly in America. That’s why the stock price is so high. But imagine that the premium returns to its historic levels. This is something that is one of the big risks for the next few years,” says Povala. All these risk scenarios would cause financial markets to fall not by units but by tens of percent. A massive stock selloff would begin.
On the periphery
The Norwegian sovereign wealth fund mainly trades in the developed markets of America, Europe and Japan, which are deep and can buy large volumes of assets on them without significantly “twisting” the market. However, the capital flows of free liquidity, which Howell refers to in his book as hot money, have an even greater impact on financially underdeveloped countries such as the Czech Republic, Slovakia, and South Africa.
Capital movements are triggered by the actions of major central banks led by the Federal Reserve System, the European Central Bank, the Japanese and sometimes the Chinese. These banks set the interest rate in the economy or buy and sell assets, which is called quantitative easing. “They give impetus to the rest of the financial system, and capital flows gradually go to smaller and smaller markets, so in the shorter term it can be a big problem in underdeveloped markets,” says Povala.
It is therefore very important how companies or government debt are financed and where the capital that finances the economy comes from. According to Povaly, the defense against capital outflow is to “have a developed domestic financial market” and also to have enough capital in the domestic economy. “I think we generally underestimate – especially for smaller economies – the importance of a country having well-financed debt, or having a lot of domestic capital and a developed domestic financial market,” he says.
Sweden or Singapore, for example, have succeeded in this, Switzerland has a historically strong capital among small countries. These states have been able to create an entire ecosystem that finances the domestic economy without having to rely on external investors whose moods are fickle.
According to Povaly, however, the economic orthodoxy, which until recently proclaimed that capital is international and should not have borders, is gradually changing. Even in the International Monetary Fund, there are now people who have studied capital flows all their lives, so the fund’s rhetoric is different today than it was ten or fifteen years ago. In their studies, they show that capital controls are no longer taboo, and that capital that quickly flows into the economy needs to be kept in it for some time, so that it does not cause significant damage.
“One of the proposals is that if you want to take the capital out of the Czech Republic after a year, for example, you will pay some kind of tax at the exit. But if you leave it in the Czech Republic for 10 years, you don’t have to pay anything,” adds the financier, who lives in London but travels to Slovakia two or three times a year, for example for the recent presidential elections.
The danger of hot capital concerns the Czech Republic, for example, in the case of government bonds, some of which are held by foreign investors, or, more recently, in the case of fluctuations in the eurozone interbank market, where banks go to borrow resources against the massive euro loans they provided in previous years.
Are you interested in investments in healthcare, the situation of car companies or energy reforms? Subscribe to Cash Only and you will receive the complete newsletter in your inbox every Friday.
