>>JAMIE MCDONALD: Welcome to Investor Tutorials. This is the beginning of a very important journey. We're going to examine the different asset classes that collectively make up the building blocks of our financial system. The purpose of this series is to explain these individual asset classes and their unique characteristics. But perhaps more importantly, to examine how these building blocks fit together and interact with one another.

>>In this episode, we'll focus on driving home the big picture of cross asset frameworks. And then in future episodes, we'll dive deeper into the individual asset classes to look more specifically at their idiosyncrasies and the interactions between them.

>>And that's really exactly where I'd like to begin, with the interconnectedness of financial assets. Now, the best way to think about this is that the financial world operates a little like the natural world, and that they're both global ecosystems. Changes to one element or asset class always has some influence on the others. The magnitude and direction depends on what that change was. We, the humans, simply exist within each of them.

>>Another way to think about it is that we need reliable building blocks to have a functioning financial system, just like the natural world consists of flora and fauna. If any of those were disrupted, then you would have an ecosystem in a state of distress with all the building blocks feeling that disruption, and it's the same in finance.

>>So, let's begin with what are the building blocks of the financial world before we explain their roles. We break these down into four general categories. We have equities, fixed income, commodities, and currencies. Now right away, many of you might recoil that we have not mentioned crypto or real estate. Indeed, many of you might have huge portions of your wealth invested here.

>>Well, for crypto, ultimately, it's something that's just too early to label as an asset class. And quite honestly, the world of digital currencies and digital assets seem like it may be closer to the next generation of the ecosystem rather than its own unique asset class. If crypto is here to stay, it isn't just an asset class, it's well, to extend the metaphor, it means we've colonized Mars, but more on that later.

>>We've excluded real estate as its own asset class for entirely different reasons. Firstly, because it has aspects of both fixed income and equity. The aspect of income earned from rent makes it much more like a traditional fixed income, while the potential for price appreciation and initial downpayment make it like equity. And secondly, in most circumstances, is just too geographically localized to speak broadly about in the same context as the other asset classes. In extreme circumstances like the real estate bubble in 2008, it does become important in its own, but for now, let's focus on the Big Four.

>>Our first building block is equities. This is probably the one almost all of us are familiar with. An equity is really any investment that gives you the right to future cash flows of a company after the claims of the debt holders. And of course, it gives you an ownership stake and potential voting rights too. It’s higher risk than the debt of that company as you sit further back in line should anything go wrong, but also has a potentially higher return in most circumstances.

>>The classic equity products are publicly traded stocks or shares. But you also have private equity investment that, as the name suggests, does not trade on any exchange. Investing in a restaurant or a startup, for example, would fall into this last category. And generally speaking, traditional exchange listed stocks, venture capital and private equity investments are all considered to be long GDP. In other words, they benefit from the growth in the economy. And this is important to understand for diversification purposes.

>>There are also products known as convertibles, which are a hybrid of equity and fixed income, giving you some characteristics of each. We'll examine these unique individual cases much more closely later in the series. But for now, it segues us nicely into our next asset class, fixed income.

>>Fixed Income products are ultimately loans or debt instruments, which again, as the name suggests, delivers you a fixed amount of interest income over the duration of that loan. Now typically, these loans are to fund growth and are backed by something of value, whether it be an asset like a house, or a car or equity or even the government, but they're certainly less risky as an investment than equities, therefore have a typically lower reward.

>>There are many types of fixed income securities. The most dominant are government bonds, corporate credit, mortgage bonds, Eurodollar markets and interbank lending. Additionally, there are fixed income securities that are secured by anything. There are fixed income products which don't pay any interest at all. And there's fixed income that is just a bundle of a bunch of different individual fixed income claims. Now, all these differences may be hard to wrap your head around now. But we'll examine each of these cases as we move through this series. The bottom line is there are loan products with an expected return.

>>Commodities make up our third building block and to oversimplify, they refer to any raw material that can be traded, and most can. This is everything from gold and oil to water, orange juice, and poultry, and everything in between. The commodity complex breaks down into four key areas. You have base metals, things like copper, and aluminum used to build things in the economy. Then you have energy like gasoline and natural gas, things used to power the economy.

>>Then you have agriculture, grains, soft commodities and livestock used to feed the economy. And then you have precious metals like gold and silver that have some utility but are also used for their own monetary value. And this takes us back to the global ecosystem comparison. If it were not for an efficiently functioning commodity market, the world would be harvesting and consuming raw materials to such an inefficient level that’s to be detrimental to society.

>>Everything we consume physically finds its core in commodities, even as our consumption becomes more digital. The devices like computers and smartphones, cables and satellites that we use to access these digital products and services, they still rely on commodities to enable that digital consumption.

>>And lastly, we have currencies and cash equivalents which essentially are the oil that grease the entire machine. Forex is an often overlooked asset class, but it is in fact, the largest and most liquid asset class with a daily volume of $6 trillion to $7 trillion. You cannot buy anything on this planet without having to use a currency. Whether you're buying food or a stock or a barrel of oil, you have to use some form of currency. And that makes the Forex market incredibly sensitive to the ebbs and flows of the global economy. And it has historically been one of the main tools in the toolkits of traders and global macro investors.

>>We will talk about liquidity, of course, but having cash and a global currency exchange system allows easy buying and selling of goods and labor across borders. And there are variations here too. You have the main G7 currencies like the dollar, the euro and the yen. Then you have emerging market currencies like the Russian ruble or Turkish Lira. There are even currencies like the Canadian dollar and Australian dollar, which people often refer to as commodity currencies because of how closely their value is linked to the price fluctuations of the commodities they export.

>>Because we live in a world where there are multiple sovereign countries and regions with their own currency, and increasingly in the case of cryptocurrencies, decentralized and nonsovereign issuers of currencies, there are differences in the relative value of these currencies. Think fluctuating exchange rates, but also there are fluctuations in the purchasing power to buy those real things like commodities or goods and services. Think inflation, or deflation.

>>The fluctuations in both of these two aspects are driven by so many factors, some of which are not even entirely understood. But from an investment point of view, the correct analysis of these factors can reward you with substantial gains by owning the right currency, and in some cases, protect you from the destruction of value.

>>So, in summary, equities are the ownership and the upside, which incentivize people to start businesses develop property and try and create value. Fixed income allows businesses and countries to grow and to invest in new projects without giving up that ownership. Commodities are the building blocks of the physical world and the products we consume. And currencies are the vehicle to facilitate it all. So, you see, finance truly is an ecosystem and it's imperative you see it as such when it comes to understanding how to invest.

>>Now, the best way to help you understand how interconnected or asset groups are is to walk through an example. But just before we do that, we need to highlight an exoticness factor in all of this. And that's, well, us, the consumers, the voters, the investors, the people who shaped the landscape that the whole ecosystem exists upon. And just like the natural world, we are key players in the financial world too, given it’s us that vote in the policymakers, it's us that pick the products and services we buy. And it's us who decides where capital should flow.

>>Let's take policy as our main example here. It's the job of policymakers to create rules that all the players in the ecosystem must follow. Now, we won't go too much down that path as it's never ending but it's important to note that unpredictable events can happen that require policymakers to step in, and try to restore order, natural disasters, pandemics, overpopulation, under population, emerging bubbles, etc., etc. Generally, they all result in some government intervention. And that affects assets too, of course.

>>Let's look at an example of how these exogenous factors can come into play, and how it sends ripple effects through the Big Four we've already laid out. Now, the common thinking is something like this, and we'll use the dollar as it's the world's reserve currency and therefore has the most global impact. Let's say the Federal Reserve raised overnight interest rates from 1% to 3%, because they suddenly got scared that the economy was overheating. Now, don't worry, this is very unlikely to happen as we currently stand in late 2021. Well, the very first thing that happens is that everyone who has variable rate debt or is looking to take out new debt is going to have to pay more for it.

>>Homeowners with variable mortgage rates are now paying three times more each month, which as you can imagine, is bad news for equities, because businesses want consumers to be spending their money and if their disposable income is being eaten away by mortgage payments, than they aren’t buying clothes and eating in restaurants as much. Additionally, new mortgage origination will also suffer due to the increased monthly rate, the effect on the dollar will also likely be profound, which will likely reverberate across the global economy.

>>Now, it isn't so simple as interest rates up equals stocks down. It depends why they were going up in the first place. If they were rising gently because the economy is going well, the impact may be minimal. Rates could go up into seemingly identical environments. But equities react differently each time. The point is they will react. In the case above, the interest rate hike will also make it harder to fund the type of growth investments that can be commodity intensive, and thus commodities fall. You won't always know which way it will go, so it is important to pay attention to trends and their evolution when these major events occur.

>>Similarly, currencies are bound to react to a large interest rate hike, as the relative attractiveness of us fixed income makes money pour into US markets, thus strengthening the dollar. During COVID, the Chinese renminbi benefited from China not being as aggressive with rate cuts and maintaining some of the only positive real interest rates in the world. So, you see, everything is connected, and it's important to know what knock-on effects are likely. But here's the important point. These knock-on effects differ each time depending on what the cause was of the initial move and the conditions at the time.

>>In short, I hope you can see how all asset classes need to stay healthy for the world to operate financially. But not only that, there's no asset that operates in isolation. And that means the key takeaway from this episode is that no matter what you have in your portfolio, you need to pay attention to all the building blocks as risks looming in other corners of the market could be devastating.