Debating the Next Moves for Inflation, Growth and Rates

Transcript:

Stephen Dover:  Sonal, let’s start with you and the topic of inflation. What’s your near-term outlook, and what do you see as we look ahead into 2022?

Sonal Desai: So, we don't think that inflation comes down. I think for the first half of next year, we continue to anticipate inflation, not at the rates we're seeing this year, which are really in the four [%] range, and in the last couple of quarters, we probably will continue to see four handles on inflation. First, two quarters of next year, we think you could still see four and high threes. As you get closer towards the end of the year, I'd say the higher end of the two to the low threes because we do think we're seeing the beginnings of what really does look and feel and smell like second-round effects, and those tend to have more staying power.

Stephen Dover: John, what about you, what’s your view on inflation right now and over the next year?

John Bellows:  I think there is no question that inflation has surprised on the upside. However, I think that, you know, you think about the nature, the character of this inflation upside, it's not obvious to us that it's all that problematic. And I guess I want to make three distinct points here. The first is that I think supply constraints are a big part of this. And I think that we actually know what the supply constraints are. Right now we're going through the effects of having the Delta wave shut down factories in South Asia. That then feeds into the ability to produce goods in factories. And that shows up here in terms of bottlenecks and higher prices. Same thing with [semiconductor] chips and autos. You know, we can go through the list and we can actually point to what is causing the supply constraint. I think that, you know, it's easy to kind of get overwhelmed by all the stuff that's going on, but each one of these does have a very concrete supply constraint behind it. And, those things don't last, you know, those things do resolve itself. So, that's the first point is that I do think these supply constraints are a big part of it, and we shouldn't lose sight of that.

Second point and this kind of dovetails with something that Sonal said is there's been a big demand component of this as well. You know, demand has been stronger than expected this year, big fiscal stimulus in March. However, I think a lot of that's now behind us. Growth is now slowing the United States. Yes, slowing from very high levels, but nonetheless slowing. Whatever we'll talk about in terms of the next run of fiscal policy is not going to be anywhere near as large as the last one. So fiscal policy is actually going to flip, and we're starting to get kind of past the, kind of reopening surge and growth looks a little bit slower. So, to the extent that demand was boosting inflation early in the year, I think we may be past that.

My third and final point about why the inflation we've seen is not obviously problematic is that the longer-term disinflationary headwinds still appear like they're going to be an issue once we get past the pandemic. And I have in mind there things like globalization of technology, and you think about the amount that people have invested in technology over the last year is really a lot. And the potential of that boost productivity, thereby allowing for a little bit of cooling in prices I think is very high. So, we haven't addressed those kind of longer-term forces. So again, I’d just start with the observation inflation has surprised on the upside, both in terms of the magnitude and how long it's lasted, but really when you get down into it, we do not think it's going to be all that problematic because the supply constraints are likely to be addressed. The demand boost, while significant, does appear like it's waning somewhat. And those long-term disinflationary forces, I think are still very much with us.

Stephen Dover:  Gene, we welcome you in now. Tell us how you assess inflation, and what your view on it is going forward?

Gene Podkaminer: We look at inflation from both the supply and demand perspective, and if I could take a step back, a year and a half ago, everybody was wringing their hands about the trajectory of growth, which I understand we'll talk about later. And that transition to what do we do about inflation? What is driving inflation? Is it being driven by the supply side? Are there constraints on supply chains, logistics, or is it being driven by the demand side as the mix of goods and services change and there's a lot of latent demand in the system as well? So, as we try to disentangle that a little bit and understand the interplay between the supply side and demand side, what that means for inflation in general, our feeling is that there will be elevated inflation going forward, but it's going to be largely temporary and we're not using the word transitory as much anymore. I still see it out there, but transitory seems like a wonky word. Temporary appears to be perhaps a better descriptor of how we see inflation playing out. With the normal supply and demand balance normalizing over time, it seems likely that a lot of the kinks are going to get worked out of the systems, both the supply side and the demand side. And also, I need to ask myself as an investor and as a market observer, what is inflation telling us? Do we have inflation because the economy is heating up because growth is doing well, and potentially we need to tamp down that a little bit in terms of policy response? Or, is inflation materializing because again, there's issues on the supply side, which would be a very different type of environment.

So just like with cholesterol, the good cholesterol, bad cholesterol, there's good inflation and there’s bad inflation. Good inflation being caused by a healthy economy running well, maybe a little bit too well, central banks can help us take care of that. Bad inflation coming from again, that supply side it's a much different question. We see, again, supply and demand normalizing over time, inflation being somewhat higher, but again, temporary. So, as we look out over the next year, maybe a higher inflation print than we would expect typically, but having that normalized down over time. So, are we worried about inflation in the longer term? Not as much as we're worried about other factors. In the short term, is it an issue? Could it be an issue? It's something to watch for sure, but I don't think that we're going to see the kind of year-over-year, or month-over-month growth in particular types of inflation categories that you've seen in the past. You can only have used and new car prices go up by, you know, X percent, so many times in a row, before it starts to normalize. Same thing with some of the other anecdotal points out there.

Stephen Dover: Gene, given that view on inflation, are you adjusting your investment strategies at all to defend against inflation, especially in the near term?

Gene Podkaminer: Absolutely. So, inflation protection ought to be part of any portfolio, full-stop, no matter what the inflationary regime, no matter what the inflationary expectations are. If you have exposure to real assets, like some TIPS [Treasury Inflation-Protected Securities], commodities, real estate, there's probably a whole host of other ones as well, they tie your portfolio back to the real economy, not the financial economy. And that's a really useful thing to have in any portfolio, again, at any time. It seems like investors episodically start worrying about inflation exposure in their portfolios when inflation rears its head. At that point, it's probably too late. And so, a better approach would be to be thinking about inflation all the time, have some inflation exposure in your portfolio all the time. Now, there are issues with each one of the assets that we could stack against inflation. TIPS have a duration component to them, which sometimes interferes with how they transmit inflation. There's a supply and demand dynamic with TIPS as well in terms of pricing. Are they perfect? No. Are they mechanically linked to CPI [Consumer Price Index]? Yes. And that is helpful. You see the same thing with commodity futures, and to a longer time horizon extent with real estate also. Should these inflation sensitive assets be part of any portfolio mix most of the time? I do believe so. Are people talking about them more now than they were say a year or two ago? Probably, but that heightened interest will probably help portfolios later on as well.

Stephen Dover: John, right now we are seeing much higher energy prices, particularly oil prices. How do you factor that into the inflation picture as well as your investment strategy?

John Bellows: So, I think the higher energy prices are a fairly clear example of the supply constraints that are affecting prices. And one of the big supply issues going on the oil market is the fairly tepid rebound in US shale oil supply. And, you know, you look at rig counts. Rig counts are half of what they were pre-pandemic, even though oil prices are higher—a number of reasons for that, whether that's higher cost of capital, some of these energy companies were downgraded, maybe it's a more conservative approach. Whatever it is, there is more constrained supply, than what we had pre-pandemic. And that’s pushed up prices. So, I do think that's another example of how the supply constraints do affect prices.

I do think that Gene makes a very interesting point about inflation sensitivity in portfolios and I really liked the way he said that. Rather than inflation protection or inflation hedging, you know, inflation sensitivity, you have to be thoughtful about different inflation outcomes when you're constructing portfolios. And, I think an important point here is you want to have portfolios that do well in a number of different environments. And, just thinking that inflation is out there and therefore I'm going to buy inflation protection may not always be the right way to do that. A good example of this is if you look at TIPS. TIPS since the end of the first quarter, have had this odd behavior, which is inflation surprised on the upside a lot, and yet, TIPS breakevens have actually fallen over the last, you know, 3-6 months.

So, what's going on there? Well, TIPS got ahead of themselves. So, breakeven inflation was too high at the end of the first quarter. So even as the data came through, the market price was wrong for that hedge. And so, I think that's kind of a really important point, is just having some inflation sensitivity is appropriate. It doesn't mean you have to go out and kind of buy expensive hedges. So, an alternative way to have this exposure in your portfolios would have been through something like, you know, not necessarily commodities, but say oil company credit, [investment grade] IG credit in oil companies. That's actually performed quite well over the last six months, as you have had this firming in oil prices supported by good fundamentals, supported by the income component. And so, I like the framework, let's have inflation sensitivity, let’s be thoughtful about higher inflation as an outcome, but that doesn't necessarily mean buying expensive hedges. And there are ways to construct portfolios that have that sensitivity as part of the consideration that you can actually do better over time than buying expensive hedges.

Gene Podkaminer: And if I could just jump in there real quick, John. There's also a question of what kind of inflation- sensitive assets one could put into a portfolio and likely, just having TIPS or other inflation-linked assets may not be just the optimal way to do it say through fixed income. So like you were saying, maybe there's an equity component to it. Maybe there's a commodities component to it. I would argue maybe there's a real estate component to it as well. Which one will perform optimally in any environment is not clear in advance. So, having some of each probably makes sense for inflation sensitivity. And with regard to energy, it's both the supply story, but also a demand story. It's hard to ignore reopening, and again, that remixing of goods versus services, what folks are shopping for, what kinds of services they're demanding and how that impacts energy pricing as well. So, it's, again, both what's happening on the supply side, certainly with constraints, with OPEC, swing producers and everything that goes into that, but also the demand side, where are people demanding goods and services that are perhaps more energy intensive than they were a year ago or year and a half ago.

Sonal Desai: To just add a little bit to what John and Gene just spoke about, I think I have a lot of sympathy for what John said in terms of TIPS being far from, I would say, an ideal inflation protection mechanism. But I would note one other thing and that is that at this point, the Fed [US Federal Reserve] owns almost a quarter of the TIPS market and over a fifth of the underlying Treasuries market, which means, of course, that pricing on breakevens, to some extent, is somewhat controlled, which to me implies that it's an imperfect mechanism to either get a gauge of what true market inflation expectations are, or indeed, to perfectly hedge against inflation, which takes us to the issue of commodities. And, I would just note that within the commodity spectrum, we spoke about IG oil credits and other energy-sensitive sectors, but apart from that, I will also point towards emerging markets, hard currency debt and commodity rich emerging markets. Less direct, certainly, but also an area which we have used to look at effectively, indirectly, inflation hedging because these are countries whose underlying bonds tend to do well. And you have a situation such as the current state of the oil market.

Stephen Dover:  Sonal, what about inflation in other parts of the world compared to the US?

Sonal Desai: Globally, we are seeing more inflation. In the eurozone, they're seeing inflation in countries like Germany, who are enormously sensitive to inflation. And I think the impact of this on a case-by-case basis is really going to be looking at different countries to try and understand if they're going to be central banks that are a bit more aggressive than the Fed. I think in emerging markets, we have already started seeing that in certain emerging markets, but the central banks have started taking moves since they don't have the luxury that the developed world has in terms of central bank flexibility. So yes, globally, this is something we're looking at quite carefully.

Stephen Dover: So how does this all fit into economic growth? Gene, is the US going to continue to be the leading growth engine, or where do you see growth happening, and at what levels?

Gene Podkaminer: So, growth is inextricably linked with some of the other macro factors, including what the policy response to that growth is and also inflation. In stacking up the different regions and countries, ideally one would favor regions where you still have strong growth and maybe not as tight of a monetary policy quite yet.

So again, just looking through the lens of growth and not necessarily overall economic health, there are regions like the eurozone, Japan and Australia, where you still see strong growth, but not the same sort of muscular tightening that has been communicated in the US, specifically, and Canada. So, when looking at those types of countries and at the interplay of growth versus rates versus inflation, at this point, there are arguments to be made for some risks in China in terms of inflation and growth, eurozone seems to be pretty well positioned over the next year-ish or so, in terms of growth. And again, that rate-setting equation, and most of the other regions we see in the middle, including US, Canada, UK, Australia, Japan, and some of the other emerging markets, ex-Japan.

So, will growth be stronger than what we have seen in the past? Depends on how you define the past. Will it be stronger than what we've seen over the last 18 months? Probably not. That was quite the recovery. Will it come in stronger than what we've observed say over the last 10 or 15 years? Probably. So, growth is still on a high trajectory, but that trajectory is starting to be less steep as it normalizes. Over a longer period of time, do we think growth will come back to trend, that longer-term trend, which has been slowing down over the last couple of decades? That's likely to be the case as well. But, how concerned should we be about growth going from extraordinarily good to just really, really, really good? That's the question that investors need to ask themselves as they position their portfolios to be responsive to economic growth.

Stephen Dover:  John, how concerned are you about global growth slowing, especially in China, where there’s a lot of concern about the economy.

John Bellows: So, I think at a high level, the characterization that  growth is slowing, but it's still at a high level is right. You know, we did have very, very high growth in the first half of the year and it has slowed a little bit. That, kind of, second derivative, how much is it slowing is really the question. That's the one that markets are really going to key off of and has the potential to move markets. And on that, I think we need to be, fairly thoughtful about the downside there in the sense that if growth is slowing more than people anticipated, what are the ramifications there?

I kind of start with the observation that growth in the third quarter slowed a lot. In the US, it now looks like growth in the third quarter is going to be around 3%. You know, two months ago, most people thought growth in the third quarter was to be 7%. That’s a big move down from 7% to 3% and broad-based. PCs [personal computers] lower, auto consumption is quite a bit lower, supply chains are part of that, Delta is part of that. But whatever the reason, you know, there's been a big slowdown in growth in the United States from again, 7% rate down to 3%.

Similarly, in China, you know, China, it’s possible that China had zero growth in the third quarter, and to have 20% of the world economy have 0% growth in the third quarter is a big deal. When you think about what's on in China, there was a large focus on Evergrande and the potential for a Lehman moment. That may not be the bigger story, though. The bigger story in China may be slowing growth as their regulatory backdrop does tighten a little bit. That weighs on the property market, and property markets then have linkages to the rest of the economy as we know in the United States, having been through a very, very clear example of that. So even if China does manage to successfully navigate its way through this Evergrande situation, which seems like a likely outcome, the risks are still there, and in particular, the growth risks are still there.

So, you know, as we go through this, again, I don't disagree at all with the characterization that growth started at a very high level and is slowing a little bit, but I do think we need to be thoughtful about the downside risks. US growth is a lot slower. Chinese growth is a lot slower.

I think there's good reasons to think that maybe they rebound a little bit in the fourth quarter, but I think we're kind of in a moment where you shouldn't take that for granted, and instead you should construct portfolios being mindful of that downside risk, that maybe growth slows a little bit more than expected.

I guess I just want to, kind of, put in here though, I don't think that's necessarily a bad thing. I think actually you could end up with a situation where slowing and growth ends up being kind of a good thing overall because it takes some of the heat out of the global economy. One of the risks—and Sonal had been on this and give her credit for being honest— was that there was too much heat in the global economy that was going to lead to more inflation than was desirable that was going to cause central banks to tighten more than was anticipated. And so, in some sense if growth, growth does slow a bit on its own that could end up being a good thing, taking that heat off, but it’s kind of a delicate moment. You're hoping it slows to take some of that heat out, you're hoping it doesn't slow too much and I think it's an important moment to be thoughtful about those downside risks to growth.

Gene Podkaminer: John, I would also ask all of us and ask the investors out there, is it sustainable for a large, developed economy like the US to grow at 7% or 6% or even 5%? Those numbers seem to be, first of all, unsustainable, and second of all, would probably elicit a really strong policy response if that was the norm going on. So, was it an aberration? Was it a response from the trough from COVID? Probably. Should we expect that kind of growth going forward as rational investors in this type of environment from a large, developed economy? Probably not.

John Bellows: 7% growth in the United States is not sustainable. I do worry though, if we've seen the recovery. If the recovery has now run its course, and now we're heading back to 2 to 3% growth, you know, on the one hand that is more sustainable and taking some heat out, as I said. The concern though is that we're leaving some kind of important pieces of the recovery undone. And, in particular, in the labor market, you know, we still have 8 million jobs below where the labor market should be if we hadn't had this pandemic. And so, if growth were to slow today and the recovery were to be over, it leaves a lot of distress in the labor market. A lot of people who do not have jobs, who should have jobs in a more normal environment, and that would be a longer-term concern.

Stephen Dover:  So John, what’s the next move by the Fed in the US, regarding tapering and changes in interest rates?

John Bellows: You know, I think by now the taper announcement and timeline has been very well communicated. I think it's kind of broadly consensus. It's unlikely to surprise anybody. You know, I expect them to announce a taper decision at their next meeting in early November, announce monthly reduction in their purchases and wind up taper or wind down taper by the middle of 2022. Powell basically said as much in the last press conference, that's not going to surprise anybody. But that actually sets up something kind of interesting, which is as follows is that during that period—so from now until mid-22—the Fed's policies are relatively predetermined, you know, can they shift them? Yes, they could. But the bar to shifting policies during the next, you know, nine to 12 months is pretty high. And so the Fed is kind of out of it for the next nine to 12 months. And so, they've kind of played their hand, that's what they're going to do and they're not going to adjust policy all that much in those 12 months. Obviously in the extremes, they can make an adjustment, but I think the bar is pretty high.

What that means next is that mean outcomes in the next, you know, nine to 12 months are unlikely to really matter all that much for policies. So, let's say inflation doesn't come down by the end of the year, but instead stays high to the first quarter of next year. Not obvious that matters much for the Fed—again, during this period, they've already predetermined their policy. So, that means the Fed can be relatively insensitive to inflation and unemployment. And so, I would agree with comments that are made, inflation could stay higher for longer. I would also agree with the comment that the labor market's kind of baffling right now, but again, it's not obvious that either one of those facts is all that relevant for the Fed over the next nine to 12 months.

Where it will matter is what happens after that. So as we think forward to late 2022, early 2023, that's when the Fed is going to be making their decision to raise interest rates. That's where the economic data matters again. So, I think the Fed’s constructed it this way, because by late 22, early 23, we are going to be over, kind of, these supply chain disruptions. The labor market will have a much better read of some of those issues that Gene was talking about, and we'll just be in a very different place.

And so, I think that's kind of a very important point, is the Fed is kind of predetermined for the next nine to 12 months. That means they're going to be not as sensitive to the economic data over the next nine to 12 months. Yes, inflation could be high. The labor markets could continue to be baffling, but what matters is what happens on the other side, you know, late 22, early 23. And I think that it’s a reasonable base case that by then the inflation pressures will have subsided and will still be a long ways from full employment. And I think those are going to be what matters by late 22 or early 23.

Gene Podkaminer: John, I think you're right in calling the direction, but the magnitude is important as well. So directionally speaking, investors and observers seem to agree that the Fed has determined a direction, and that's where we'll go for the next several quarters and years. But what about the magnitude? What speed do we get there? Will they need to read the economic tea leaves in order to determine how fast to tighten and how to communicate those decisions based on what's going on with the strength of the economy and inflation as well? So, I would agree that we are moving in the direction of tighter monetary policy, but how we will get there, the path is still a little bit open to interpretation, and there's still some policy errors that could be made along the way, not just in the US, but for some of the other central banks. And I don't want to lose that subtlety that yes, we have a path, but how we meander down that path is still critically important.

Stephen Dover: Sonal, as you look around the world, where do you see action taking place, and what’s your timeline for looking at that?

Sonal Desai: So I think the Bank of England has the luxury of being able to spin on a dime and I'd be willing to bet that they’re probably the first out of the gates because it's a small country, they have their own currency, they can actually turn policy around much faster than a lot of other central banks. I think the ECB is caught in a bit of a bind because it has different constituents with very different needs. Having said that, as the economies continue to grow in Europe and you do get inflationary pressures, a lot of Northern Europeans are less likely to differentiate between short-term, supply driven inflationary numbers, and inflation is a very political problem in some of these countries. So I think the ECB, I’d put a question mark over them, though they insist they're going to be very, very slow, but I’d put a question mark there.

Coming to the US, I would say John is absolutely right. What the Fed actually does, I'd say from now, till the middle of next year, it's a predetermined path. It's just literally per month, whether it's five billion, more or less simply because, they need to cover it over a period of time. However, in that intervening period, John, I think that if inflation continued to show unusual levels of strength, and I would say unusual levels would be, if we did have a rather scary holiday season in terms of pricing and so on, if we saw this market pricing or future rate hikes might move in advance of the Fed telegraphing anything. And I think that's something which we need to be aware of. So curve steepening the long end or a bear flattening on the short end, as people go out and try to determine whether indeed it will be late 2022, early 2023, or it could, as Gene alluded to, be a slightly more rapid pace of interest rate hikes. But all of this does of course come down to that inflation backdrop and labor market. So despite the Fed not literally being in play probably for the next many months, I think the data is very much in play.

Stephen Dover: Gene, you look across all asset classes, so how are you looking at the landscape within fixed income but also across asset classes?

Gene Podkaminer: As we look across not just fixed income but all of the different asset classes, we ask ourselves, “Is paying attention to growth important?” Yes. Is paying attention to inflation and the trajectory of inflation important? Yes. Is paying attention to rates and how central bank response functions change important to portfolio construction? Yes. So, you can't get away from some of these macro-economic factors that we've spent some time talking about. How you put them together really does require some nimble management. And being able to actively understand which consideration is perhaps most important at a given time and allocate assets that are aware of that particular factor: growth, inflation, rates, and others is going to be paramount and it's going to be tricky. It's an interesting environment that we find ourselves in. Interesting for the economists out there, I think nerve-racking for the investors. But, as we look through fixed income, we ask ourselves, “What's going on with duration? What's going on with the trajectory of rates? What about spreads, which are of course, tied to equities, also?” So, the mixture that we have right now is definitely putting a little bit less emphasis on global investment grade, looking at the shorter end of, especially, the US curve as a place where we want to be again, because we see tapering coming and of course the duration impact and the pricing impact that that would have on fixed income. So, trying to be aware of that. But more broadly, looking across, say equities versus fixed income. There's a more, I think, a more challenging trade to be made there, which is, valuation-wise, equities look, let's say, fairly priced for the moment.

Fixed income may be a little bit rich depending on how you see tapering playing out. But, when you only have these two broad categories to mix with, equities versus fixed income, it's sometimes hard to make a choice because you have to accept the consequences. If you don't like fixed income because of what's going to happen in terms of rates, and also in terms of inflation, do you then go heavier into equities with all of the challenges that equities have in terms of their exposure to global growth? So, understanding the motivations for how to put together the portfolio, just in terms of those two broad assets, is going to be really important.

Stephen Dover:  Gene Podkaminer, Sonal Desai and John Bellows, a great discussion, thanks for joining us.

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