The Great Rebalancing: Why Debt, Demographics, and Politics Will Crush Forward Returns | Sony Kapoor

0:00Demetri Kofinas:What's up, everybody? My name is Demetri Kofinas, and you're listening to Hidden Forces, a podcast that inspires investors, entrepreneurs, and everyday citizens to challenge consensus narratives and learn how to think critically about the systems of power shaping our world. My guest on this episode of Hidden Forces is Sonny Kapoor, an economist, policy advisor, and investor who began his career in leveraged finance and derivatives at Lehman Brothers and went on to advise roughly 20 governments, including Norway, Sweden, and Germany, as well as some of the world's largest sovereign wealth and pension funds.

0:38Demetri Kofinas:We spend the first hour of this conversation unpacking the theses explored by Sonny in two of his papers, Winter is Coming, and the case for a great rebalancing, in which he argues that global capital has been increasingly misallocated due to factors such as the growth of passive indexation, maladaptive benchmarking, and an excessive focus on short-term performance at the expense of long-term returns. We explore how demographic tailwinds and advanced economies have flipped into headwinds, whether AI-driven productivity gains can realistically offset the drag of declining birth rates, why accommodative post-GFC monetary and fiscal policies undermine political stability in developed countries, and what recent stresses, including dollar weakness, treasury market liquidity scares, and an increased reliance on short-term debt financing, suggest about looming financial repression, fiscal dominance, and a rotation out of US capital markets.

1:35Demetri Kofinas:The second hour is devoted to a conversation about investor incentives, market structure, future, investment opportunities in emerging markets, and how to construct a more diversified portfolio suitable for the world that is coming into being. We discuss why political and currency risks may now be lower for a diversified emerging markets basket than for a similarly diversified portfolio of developed market assets. We discuss what a re-weighting toward emerging markets could look like, why India stands out given its digital public rails and domestic demand engine, and how places like Indonesia, Brazil, and Nigeria fit into a rebalancing, and how to think about geopolitics, U.S.

2:16Demetri Kofinas:policy risk, and portfolio construction in this new paradigm. If you want access to all of this conversation, go to hiddenforces.io slash subscribe and join our premium feed, which you can listen to on your mobile device using your favorite podcast app, just like you're listening to this episode right now. If you want to join in on the conversation and become a member of the Hidden Forces Genius community, which includes Q &A calls with guests, discounted access to third-party research and analysis, and in-person events like our intimate dinners and weekend retreats. You can also do that on our subscriber page.

2:52Demetri Kofinas:If you still have questions, feel free to send an email to info at hiddenforces.io, and I or someone from our team will get right back to you. Lastly, because this conversation deals with investing, nothing we say on this podcast can or should be viewed as financial advice. All opinions expressed by me and my guests are solely our own opinions and should not be relied upon as the basis for financial decisions. And with that, please enjoy this wide-ranging and in-depth conversation with my guest, Sony Kapoor.

3:32Demetri Kofinas:Sonny Kapoor, welcome to Hidden Forces. Thank you for having me. It's great having you on. I was telling you, Sonny, that I could swear that I first came across lectures of yours and interviews of yours back in 2011 or so, like in the years after the great financial crisis. Before we start today's conversation, which was precipitated by a paper that you published actually a while ago in 2016, and you followed it up on that paper with a different paper in 2024, where you explored many of the themes that you talked about in that paper. We're going to talk about that because I think it's something that the audience will find very interesting.

4:07Demetri Kofinas:But before we get into the meat of today's conversation, just brush me up on your life, your story, your career arc, and why do I remember you from that period post-2008? Oh, it's a hard one. Well, I've followed a rather unusual career trajectory. And, you know, nowadays, it's fashionable to call it a portfolio career. But I think I sort of accidentally stumbled upon a portfolio career before it became fashionable. And that was as far back as I think, 23 odd years back, when having started life as an investment banker doing leverage finance and private equity for Lehman, and then I traded derivatives, I sort of, you know, got pretty disillusioned rather quickly with what I saw inside the financial markets.

5:00And I decided that, you know, in general, I mean, the insight I think I got back then was what is well paid is often neither very interesting nor very important. And often some of the most important and interesting stuff is not very well paid. And so if I part by design, part by accident, have hit upon this portfolio career model since then, where I work for money for about one, two days a week, and then three, four days a week, I do pro bono and charity stuff, the important stuff, you know, and that has sort of taken me everywhere. So I've worked with governments. I've been advised to the Norwegian, the Swedish, the German governments, you know, about 20 governments in all.

5:52I've worked with some of the largest sovereign wealth funds in the world. I've advised pension funds, but I've also worked with Christian Aid and Oxfam and charities. I've helped set up several main non-profits. I sit on boards. I ran one of the most influential think tanks in the EU for about a decade or so called Redefine. And sort of I've been there, done that. And, you know, in a world of sort of super specialists we live in, most people's career as this sort of goes along, they focus more and more narrowly. And I think this has created both a need and a space for someone like me, who I think primarily out of just natural curiosity, my interests in life have just gotten broader and broader the older I get.

6:42And perhaps one last point. So, you know, I went to one of the Indian Institute of Technology, these elite engineering institutions in India, and I started life as, you know, many of the folks do as a rather cocksure, overconfident, quite quantitatively sort of focused young man who hadn't seen the world and didn't appreciate the subtleties and the complexities and the nuances. And I had an overtly deterministic view of the world. And perhaps, if I'm honest, had you asked the 20-year-old me, I might have sounded arrogant on things like arts and music and history and anthropology and cultural studies and, you know, these softer issues.

7:33And the older I have gotten, I think perhaps the more wise, you know, I have gotten, but of course I have still much to learn. The more I've seen of the world, the more humble I have got, the more I have known smart people, the less certain I am of things. And the more I appreciate not the black and whites, which almost always are ridiculously inaccurate and lead to, you know, very false premises, but I appreciate the shades of gray and the nuances. And so much so that perhaps, you know, by some measure, I've gone the other extreme while I have the competence to, you know, do all the quantitative stuff and look at equations and not have my eyes glaze over.

8:18But I don't like looking at equations anymore, you know, even in my work on climate, etc. I mean, there's only so much that a data driven, you know, supposedly quantitative approach can deliver in a world that is only partly driven by numeric deterministic forces. And I think the biggest risk we face is in a world driven by an excessively data-driven quantitative approach dominated by the supposed promise of AI, etc., is to lose our connection with the real world, with our humanity, with the uncertainties and the shades of gray that actually define real life. So that kind of sums me up.

9:10Demetri Kofinas:Boy, you were just pulling on the heartstrings of our audience towards a crescendo right there. Sonia, you're going to fit right into this conversation. So let's get right into it. I mentioned that you published two papers that I read. One was Winter is Coming in 2016. You actually published this, I believe this was under NorFund. You did it for NorFund, a Norwegian investment fund. Is that right? Yes, that's right. Yeah. What is NorFund for those who don't know, including me? Yeah. So the backstory to that is that I was a strategy advisor to the Norwegian government for a while around the financial crisis.

9:42And one of the things I did was the then finance minister asked me to look at revisiting the investment strategy and the governance structure of the Norwegian Sovereign Wealth Fund, which I believe is the largest sovereign wealth fund in the world. It's now about$1.9 trillion. And I made a number of recommendations. And it's become one of those sort of hobby projects where I hate leaving unfinished tasks. So every few years, I would sort of revisit that and check where things have been. So I published a report on the investment landscape that was covered by the economists in 2013. And this was one of those revisitations.

10:23Then this time, it was done under the rubric of NoorFund, which is the equivalent of the DFC in the US, the Development Finance Corporation, which invests US capital, or at least pre-Trump used to, into economically productive projects in emerging economies with a dual mandate of financial return and a positive developmental impact. So, they were sort of the sponsors of the study, but the main focus was on the broader investment landscape of the kind that the Norwegian sovereign wealth fund inhabits.

10:58Demetri Kofinas:Got it. So, that paper was titled Winter is Coming. As I said, you published it in 2016, and then you published another paper recently called The Case for Great Rebalancing. That was in 2024. Let's talk about Winter is Coming, and then we can discuss the other article when we look at how events in the last decade have validated or invalidated the thesis that you put forward in that 2016 paper. So what is that core thesis that you put forward in Winter is Coming? Can you tell us? The core thesis, I think, was that the capital allocation through the financial system globally had increasingly lost touch with real productive investment opportunities globally.

11:42And it was driven by a series of idiosyncrasies with which the financial system works, of which relative performance, index tracking, short-termism, et cetera, are just a few, plus a fairly outdated worldview that still reflected, let's call them the glory days of developed markets, the times, particularly post-World War II decades of significant gains in economic productivity, significant expansion of capital stock, robust growth rates that were part driven by very favorable demographics, etc. And many of those forces that drove sort of that golden age in the relative rise of developed markets and recovery in post-World War II Europe had sort of run their course mostly by the end of the 90s.

12:45And so, you know, had markets tracked the real economy and productive potential, then there ought to have been a sort of great rebalancing that should have begun away from the excessive investment in rich economies towards the so-called emerging economies already at the turn of the century. So, you know, roughly around 2000s, but fueled by one development or the other, you know, was it the internet mania? It was the real estate bubble. Then, you know, rather counterintuitively, despite the fact that it was the U.S. that sort of, you know, inflicted the financial crisis on the rest of the world.

13:29It was the U.S. that also led the recovery. And that was partly because of the very robust fiscal and monetary response in the US, which, again, counterintuitively attracted even more capital to the place that had, you know, through misallocation of capital at scale, inflicted a financial crisis on the rest of the world. And then every single time it would seem that, you know, the economic case would finally lead to the financial sector starting to change its allocation and focus. Something or the other would happen. And the most recent examples, because there was another paper I published in the interim, and that was called Winter Has Come.

14:12And I think that was just at the cusp of the corona crisis breaking out. And I said, and if you remember, 2019 was not a particularly good year for financial markets. So that was in 2019. And I said, OK, now finally, the rebalancing has begun. But of course, in corona, it was the rich markets that were able to drive the most robust fiscal and monetary policy response. We saw new bouts of quantitative easing, which further inflamed the very same drivers of asset prices that had made rich country financial markets, but in particular, American markets, look attractive on a year-by-year financial return basis.

14:58And so one way or the other, we've gotten further and further away from what is an economically sensible, productively enhancing global allocation of capital. And in 2025, mid 2025, we've never been further away from that equilibrium as we are today, at least in living memory. And my present thesis is, I think, as Hemingway's rumored to have said, when asked about going bankrupt, he said, first, slowly, and then suddenly. And I think we are at the cusp of first slowly and then a sudden rebalancing of financial markets and capital allocation away in particular from the US, which is heavily overweighted, but more generally from developed economies towards emerging economies where most growth potential, most human capital, most productively enhancing investments lie.

16:03Demetri Kofinas:Do you think we started to see that after Trump's inauguration and also when he held his Liberation Day rally? Is that the first time that we really began to see that great rotation or rebalancing out of US markets? There have been several signs, right? I mean, again, I might be getting this wrong. I'm not up to date on my economic history, but Keynes is rumored to have said something along the lines of, the market can stay irrational longer than I can stay solvent or something to that effect. And, you know, I have been wrong in the timing before, but I think I've never felt as confident as today that this has actually begun.

16:45I mean, in terms of actual signs, there've been at least, I think, three, let's call them incidents that lasted from a few days to a few weeks since Trump's inauguration that have included, you know, unforeseen disturbances, sudden liquidity black holes in US Treasury markets, a significant, I think around 10 % decline in the value of the dollar, which previously had been sort of the great attractor, right? Because I think the dollar saw, what, 30, 40 % rise in a weighted average value over the past several years, to the point where I think as much as 80 % of international capital investments in the US financial markets from the Europeans, the Japanese, the Asians, etc., have more or less been unhedged.

17:42Something very few financial investors would ever seek to do in any other markets. That's because they benefited from the outsized supernormal S &P returns year after year, combined with this massive rise in the value of the dollar. Now, whatever worked with the tailwind in one direction is possibly likely to unfold even faster going in the opposite direction. Because as much as the speed of investments into the fashionable theme of the day, such as AI, et cetera, can gain momentum, exits are almost always more rapid. And I think this is one of those self-perpetuating things where, so as an example, I think S &P 500 has done reasonably well in dollar terms, right?

18:37But if I recall correctly, for euro and sterling-based investors, the annual return has either been negative or at least much closer to zero than for US dollars invested because of the dollar valuation, right? Over what timeframe are you describing this? Since Trump's inauguration, right? Or since the beginning of the year. And there's not that huge difference between those two. And so once you question what has been a running assumption of a strong dollar, and you think that further devaluation, depreciation of the dollar is a real possibility, you immediately either reduce your exposure by beginning to underway what has been an overweighted allocation to the US and slash or you start hedging part of your dollar portfolio risk, right?

19:30In which case, that process of hedging, because of the way hedging works, in itself drives a further depreciation of the dollar, which further increases the case for hedging, etc. So I think we're at the cusp of that. The inertia of markets, the fact that we have market valuation-based indices being the great attractor of investment flows, etc. means that any movement in this, it's going to be, there's a lot of inertia in moving away from current allocation. So even if everyone, let's say, 70 % of large asset managers would have sort of changed their mind about future prospects for dollar and S &P returns, it is to be expected that the numbers in terms of outflows, changes in valuation, allocation, et cetera, would take several months to show.

20:28And I think we are at the beginning of that, but the evidence is not conclusive yet. But one would hope for the sake of the rest of the world, for the sake of globally efficient capital allocation, for the sake of capitalism itself, that this great balancing has finally, if belatedly, begun.

20:47Demetri Kofinas:So I want to flesh out this thesis and the existential crisis that you say faces pension funds and the larger crisis facing institutional investors that you write about in the Winter is Coming paper. You've already mentioned two of the drivers, I think. one of them is the investment approach. You mentioned short-termism. There's also indexation, how are managers benchmarking, risk management, the definition of risk. These are all variables that inform an investor's approach. You also spoke a little bit about the investment policy response to the great financial crisis, which is also, I think, a driver that you highlight in the paper.

21:23Demetri Kofinas:And there are also long-running structural challenges like demographics, debt, And I suppose, I don't know if you would agree with this, but I suppose we could throw into that bucket political sclerosis driven by the policy choices made over several decades that have led to the political climate that is facing not just America, but many countries in the West. Let's go through all three of these, if you don't mind. Maybe we can start with the structural challenges? Well, I mean, one big structural challenge, perhaps the biggest one, is the demographic challenge, right? So, so much of headlines in American and European press have been focused on the demographic decline, and particularly in the US right-wing pod sphere, Right.

22:16Everybody from Elon Musk to other lesser known people have opined on how to increase U.S. birth rates, particularly referring to, let's call them, you know, a particular kind of ethnicity. Right. This has been a huge obsession in the far right governments in Europe, in particular in Hungary, also in the previous government in Poland, etc. And the reason this is so important is, again, if you look at that golden age of the West, post-World War II, right up to the beginning of the century, a bit more than half of all the growth, increase in prosperity, etc., and increase in GDP was driven by an actual increase in the number of workers employed in the West.

23:07And that was owing to these favorable demographics, baby boomers, etc. And productivity growth, which often gets a lot of attention, only accounted for about half of those gains. Now, what was a tailwind in driving these fantastic productivity gains in the West, fantastic GDP gains in the West, has, in the case of the US, which has slightly better demographics than us on this side of the Atlantic, or particularly than Japan and South Korea, has stopped being a tailwind. So, US-born workers are either not contributing at all to an actual increase in the amount of US GDP or marginally and fairly soon to turn negative.

23:55And in the case of Germany, Italy, Japan, Korea, etc., tailwind has already become a headwind. So a declining demographic trend is likely to pull down estimated annual GDP growth potential in the West by between one and one and a half percent every single year. And there's no running away from it because many different policies have been tried, including very generous policies around taxation, around benefits for couples with three children and more in various European countries and East Asia, etc. And frankly, none of them have worked. So there isn't yet globally a single policy that has been tried anywhere in the developed world to substantially reverse the long term decline in birth rates to a less than replacement level.

24:54And it's not a marginal decline, right? I mean, I think the decline has gone so far, the birth rate in, I think, South Korea. The replacement rate is supposed to be 2.1 kids per woman, and it's fallen to like 0.7 or something. In Japan, for the past more than 10 years, the sale for adult nappies against incontinence has far exceeded the sale for diapers and nappies for children, right? Just as, you know, something that'll sort of stick in your mind. So there is no getting away from these very unfavorable demographics and the massive headwind disposes both in terms of possible GDP growth, financial returns, but also in the very unfavorable debt dynamics that is accounting for a significant and expected further rise in the debt to GDP ratio in rich economies.

25:50Demetri Kofinas:So I'm curious how much you've actually looked into the demographic numbers and explanations for why some of these countries have seen such a collapse, like South Korea, for example, which is at 0.72 today, the last I checked. Actually, it's probably less than that. That was a 2023 number. And South Korea is really a stunning chart to look at because their birth rate in the 1960s was six children per family, which essentially means that the parents were part of a six-child family on average, and their children either have one or no kids at all. What explains a collapse in a country like that, which was actually in the developing world and was seeing major upward trends in economic growth?

26:33Demetri Kofinas:And does that run counter to the narrative that we have maybe here in Western countries that lower birth rates are strictly a result of economic underperformance and a rising wealth and income gap? Um, there's so many cultural differences across even South Korea and Japan, you know, which is sort of near neighbors and have a lot of cultural affinity, that it would be beyond my level of expertise to get into, you know, nuanced details and opine intelligently. But there are some idiosyncratic factors, at least. And I think some of them are the very real career penalty that exists in most rich economies from any, you know, half promising career that a woman has to, you know, as soon as they become mothers, the career penalty can be anywhere between five to 10 years.

27:32And, you know, as you know, I now live in Norway, which together with Sweden and Denmark has some of the most, you know, supposedly progressive, you know, couple, female-friendly, child-friendly policies in the world. And yet I see it in my peer group, you know, part of the Norwegian elite, even in a place like Norway that has no lack of money, that has policies, you know, designed to be family-friendly. You get a full year of fully paid parental leave, for example. There are flexi-work arrangements to accommodate mothers and so on and so forth. Even here, there is a career penalty, right? So if even a place like Norway and Sweden has been unable to eliminate that, Korea, I think, lies on together with perhaps the United States for different reasons on the other side of that spectrum.

28:27A second big reason, again, in sort of Korea and the developed world in general, is the significant delay in the age that couples settle down, right? And that's partly owing to the significantly higher education that women go for now. And I think it's universally across the development. It's hard for me to think of any country where women in present cohorts are not on average significantly better educated and achieve higher educational degrees and better grades than men across the spectrum. So the delay also comes with actual fertility loss, which declines quite sharply between mid-25s and mid-35s.

29:16And that can be another factor. And there is one more issue around having to care for aging parents in societies where the state has not provided an adequate structure for all age care, which is universal again. So there's a number of factors, pressures on time, incentive structures, delayed choice in settling down, etc. And that's one of the reasons why there isn't a simple policy wand. You can just swipe and undo these many complicated, multi-layer structural changes that have driven the decline in birth rates. And so, I think this is here to stay. Excellent answer. Again, very complete answer,

30:06Demetri Kofinas:Sonny. So, let me pose one sort of counter thesis to the discussion about demographics, And then let's get into some of the other drivers of structural challenges before we get into the policy response from the great financial crisis and investors' approaches. What about the thesis that AI productivity, a boom driven by AI and the diffusion of AI technology as a general purpose technology, not unlike the internet or even more impactful, could supplant or mitigate the fall in birth rates and therefore essentially bridge the gap in growth that would otherwise result from these poor demographic figures that you cited earlier?

30:50Well, so was there a boom case for the railways in the 19th century? Yes. I think peak market capitalization, I might have this wrong, but if memory serves me right, railway firms or railway adjacent firms in the US stock markets at one point accounted for more than half of market capitalization in the United States, right? And I believe the current figure must be less than 1 % or something. We all lived through it. I think you and I came of age in the internet bubble of the 2000s, right? And clearly, something similar is going on with AI. One famous quote, I think, was it Krugman who said that?