Uncertainty Leads to Caution: Adjusting Investment Strategies While Taking Down Risk

Transcript:

Stephen Dover: We are going to start our discussion around the war in Ukraine, let's turn to you first, Dr. Michael Hasenstab and your views around supply chain impacts, particularly around food and energy markets.

Michael Hasenstab: There's been many implications from the war. I think the food implications, they are going to be felt for some time. Ukraine was the breadbasket for most of Europe. And so, not only has current food not been able to really get out of Ukraine, there has not been an ability to plant for next season. So, this isn't just an effect that we will feel this year, but it's an effect that we're going to feel the following year.

And you can see that in the demand for alternative grains and soybeans to other agricultural products, that this is going to have a big ripple effect. And it's putting inflation on top of already preexisting inflationary trends. And I think this is where many of these dynamics actually are accelerants of things that were already underway and that just made them worse. And so, I think that is one. The energy markets, obviously have had the significant effect and have the potential, should there be continued escalation that probably poses one of the biggest risks to broader markets. Because if they were to continue to escalate, natural gas would be shut off to Europe or other, you know, sort of extreme measures, you could see that be the transmission, the mechanism that probably poses some of the biggest risks. And I think what we're seeing from this and the risks about, you know, having reliance upon a place like Russia, highlights concerns about having reliance on any country in this regionalization trend, I think that was underway before the war, has been further exacerbated by the war. So, we would expect greater and greater regionalization as one of the consequences.

Stephen Dover: Francis, let's turn to you. So, Michael's just talking about, sort of, increased regionalization and you recently described the world as multi-polar, and I'm just wondering if you could elaborate on that. But also, just see how you see the path now, going back towards supply chain normalization or not—how you see it changing.

Francis Scotland: I mean, this is the second major existential threat that we've all had to deal with in two years. First, it was the pandemic and now it's the threat of nuclear war. So, in this context of the very narrow lens of a macro perspective, in terms of responding to this question, we were, I guess up until several years ago, living in what I would describe as a unipolar world dominated by a relatively benign hegemon, at least from a Western perspective, in the form of the United States. And gradually as US GDP has shrunk relative to the rest of the world, as the rest of the world's gotten larger, it's a very natural order of things for more and more countries to begin to take decisions with respect to at least international affairs that are in their self-interest independent of being beholding to any particular power. So, while these things tend to happen in discrete intervals of time, there's been a natural progression in terms of economic activity, towards a world that would be less hegemonic. If there was a definite statement that the world has changed, it came during the Beijing Olympics when the world's two most powerful autocrats got together and said, “yeah, we're going to work towards a new world order.” So, this is really a defining moment in the sense that the world has shifted.

We entered ’22 with this great collision between expansionary demand policies led mainly by the United States, and global supply constraints caused by the pandemic. The Ukraine-Russian war, in my opinion, exacerbates the supply constraint side of it. Michael talked a little bit about it, and I think, to the extent that there's a dynamic that's involved between these two, it's going to sustain the peak in inflation for a while longer. We may be there already, I'm not sure. But there's all kinds of other aftereffects that will transmit, that are part of that whole supply constraint macro story. So I think it just basically intensifies a lot of the macro trends that we saw coming into ‘22. It extends them a little bit longer.

Stephen Dover: Gene, let's turn to you. And you have done a lot of research that’s been published in academic journals about how inflation, interest rate, and growth shocks impact particularly multi-asset portfolios. So, I'm wondering if you could give us some of your gleanings from that.

Gene Podkaminer: You're right that we've been authoring a series of papers over the last four years on shocks to growth, shocks to interest rates, and shocks to inflation. And, boy, did we not see anything like this coming when we were writing in 2019 about inflation. It is definitely a sea change that we've seen, certainly something really interesting academically to look at and to try to unpack a little bit. I think the big takeaways from a lot of our research is that, when we think about shocks to growth and we look back, let's say in the period just before World War II through now, we can think about mapping shocks to growth on a really simple two by two matrix. Is it short term or long term? Is it local or global? So, you can think about the different shocks to growth, whether they're hot conflicts or more like the great financial crisis, less of a loss of life and more of a financial construct. And you can start grouping them into these different areas.

It's pretty clear that what we see right now falls into the quadrant that is global. The repercussions are clearly global and it's going to have long-term impacts as we unwind all of this. And that's different from what we've experienced over the last many decades with shocks that have been either very much localized or shorter term. Inflation has been difficult to forecast over the last couple of years now, primarily because of COVID, but the difficulty was really that inflation was being pulled by demand. A lot of folks wanted to buy a lot of stuff and it was hard to get that stuff to them, to put it in simple terms. That demand-led inflation isn't necessarily a bad thing for the economy. But what we've seen with the war in Ukraine is that the passing of the baton from a demand-led inflationary environment to a supply-led inflationary environment. And those are two very different things. And it's changed in a way that demands a different type of response from policymakers and from the central bankers.

So, when we think about shocks to inflation, the way that we deal with them is by having policymakers make intelligent decisions about what needs to happen, not just today, but going forward with the path of interest rates, which is really under their control. So, the interest-rate environment has been relatively benign over the past couple of years. And of course, as we saw in reading the Fed [Federal Reserve] minutes, there is very much more of a hawkish tone now with quantitative tightening and Fed hikes that could be 50 basis points, multiple times this year. So, all of this provides the backdrop for a pretty challenging macroeconomic environment and political environment as well. Briefly, the way that we're thinking about multi-asset portfolios at the top level is taking some of the risk off of the table, just because there's so many challenges and so many questions around what may happen across multiple dimensions, not just growth, not just inflation, not just rates and not just politics. And obviously not just supply chains.

In terms of rebalancing within global equities, within global fixed income, we're gravitating towards countries that have strong internal markets, that have good fundamentals, and that have perhaps some commodity story as well. And that goes into the supply chain piece. In fixed income, we're thinking about what does the rate environment mean for sovereigns, and for US Treasuries, and it's not really a pretty story. And also, what does it mean for credit and for high yield where spreads are now? And we're starting to take a little bit of that off of the table as well, and then, of course, with emerging markets.

From a supply chain perspective, the last part of your question, in addition to what Michael was talking about with impact on agriculture, on fertilizer, on energy, on metals, the conflict really starts to hit lots of different sectors and industries—some of which are only tangentially related. Wiring harnesses from Ukraine go into autos, neon gas goes into semiconductor production. So, all of these seemingly unrelated areas are actually impacted. And what that means for supply chains could auger a retrenchment from something that we had been setting up over the last many, many decades with “just in time” supply chains, to something more like “just in case.” So, supply chains that are much more robust, less brittle and perhaps even a bit more onshoring as well.

Stephen Dover: Francis, you know, we've had quite a few conversations over the last year, you feel that there's an elevated risk of stagflation and so maybe you can tell us a little bit about that.

Francis Scotland: Yeah, I think what the supply constraint effects from the Ukraine/Russia war will exaggerate the inflation peak for a brief while further, but not much. And I think between now and July 4th and no later than Labor Day, there's going to be a lot more recession worries than there will be in inflation worries. The other big pivot of course that we've had is we've seen an absolutely aggressive 180 degree turn in monetary policy in the United States.

So, this is really significant because, in my view, the current administration of the Federal Reserve has made some major blunders in judgment over the course of the last four years. Fed Chair Powell viewed that the neutral rate was a lot higher in 2018 and then Fed Chair Powell's hanging on to the inflation transitory story throughout most of last year. Now everybody's flipped and they've gone completely hawkish. We've seen an extreme switch in the attitude of the Federal Reserve with respect to tightening money, just as the real economy is already slowing. We've seen a meaningful slowdown in the real economy. Nominal GDP growth is still on a peak here because inflation is holding up at a very high level. But with the real economy already slowing, the lagged effects of this erosion in real purchasing power caused by the inflation and now the Fed stepping up and getting really hawkish, you know, by Labor Day, we may be looking at a Fed funds at 1.5%, maybe more. They will start to drain the balance sheet. And by the end of the year, I still believe that inflation will be falling, perhaps much more so than many forecasters or investors might think right now.

Stephen Dover: Gene, let's turn to you. Boy, there was a lot in what Francis said. It seems to me like the discussion around a growth scare has increased.

Gene Podkaminer: It seems like inflation really is driving a lot of the economic risk, but we can't keep our eye off of growth either. And, our view is that growth is slowing to trend. And I want to decompose that sentence because the components are really important, right? Growth is slowing, so it's positive, not negative, back to trend. And trend over the last 10, 15, 20 years has been a healthy, but not gigantic number. It's been something that we wish was a little bit higher, but it's certainly worked out okay. And this is important because we're not saying that growth is slowing to zero or growth is slowing to negative, but growth is slowing back to trend. So, in the US trend starts with a two handle, two point something GDP growth, and that's down from the fours and the fives that we've seen over the last couple of years. So yes, growth absolutely is slowing. Is it a disaster? I wouldn't call it that.

We don't think that there's going to be a burst of growth that we're not anticipating. If anything, it may be a little bit worse than what forecasters are expecting. But consumers, especially in developed economies, still remain in a really strong financial position. And that's certainly what's driving part of the demand-led inflation and part of inflation writ large. If consumers didn't want to buy as much stuff or weren't capable of buying as much stuff, some, not all, but some of the supply chain woes that we've been talking about, wouldn't be as significant. But because there’s still robust consumer demand in developed economies that exacerbates what we're seeing on the supply chain side pretty significantly. When we think about how inflation impacts portfolios and impacts different asset classes, one of the things we keep in mind is how long is your horizon.

If you have a relatively short horizon, there certainly are assets that are mechanically tuned to inflation. So, if you think about TIPS, Treasury Inflation-Protected Securities, and their analogs in other markets, we have similar inflation-protected securities in the UK and in Europe and in other markets as well. They pass through a mechanical amount of inflation that's linked to CPI [Consumer Price Index] back to the holder. So, that's something that, again, has a very direct drive linkage. Other assets like equities, over long periods of time, we've shown actually do have a response function to inflation and may be good inflation hedges, but again, horizon really matters. The Cliff Notes version here is that things like equities and private real estate and commodities, and TIPS tend to provide inflation exposure that's helpful to a portfolio. They help link the financial portfolio back to the real economy.

Stephen Dover: Michael, let's turn to you. We've had a lot of conversation over the last few minutes from Francis and Gene about inflation and growth. So, if you could give your view on where you see that, and if you see stagflation.

Michael Hasenstab: Yeah. I mean, I think the labor market and the housing market are probably two of the most important dynamics related to the US, but I think it's also important to note, when we talk about inflation, it varies country by country quite dramatically. There are some places that are getting just purely an energy shock causing what would be more of a temporary spike in inflation. And then there are others at the different extremes, say here in the US, which have drivers that have more permanence. And, and we wrote last year that if we're going to have an inflation problem, and it was not a certainty, but if, it would be a function of really stuff that happened in the labor market. And I think just the shortage of people in the labor market, combination of factors, both, you know, lack of immigration, some distortions and expensive nature of certain housing markets pushing people out of those areas, early retirement, participation not coming back after COVID.

All those factors have led to just a real shortage of people in the labor market. And when we look through US history or we look more contemporarily through other countries in the world, when you get inflation driven by shortages in the labor market or indexation of wages, things that happen in the labor market wage dynamics, those tend to be more permanent. And I think the challenge in the US is you have this toxic combination of a shortage in the labor market and a shortage in the housing market. And both of those are big drivers. I mean, the rents going into CPI are a major contributor and those have, you know, steadily been increasing and a lot of studies out there showing there's just a shortage of units for people to live in. And that then creates even more distortions in the labor market. As I mentioned, certain people can't live in areas where there's already a shortage and the shortage gets greater, the houses are too expensive and rents are getting too expensive. So, you know, I think there's some permanence here that that will take a little bit more time to get through. But I also think what's important to remember is, as I said at the beginning, it's not the same everywhere. And what's been interesting is the reaction function of some countries has been very aggressive in the early stages of inflation. So typically, you would see the world follows the Fed, but in this case, other parts of the world, particularly say in Latin America, they had inflation go up and they were very proactive and aggressive in hiking rates well in advance of what the Fed started to do. So, inflation dynamics have been very different, and I think create a lot of opportunities if we go sort of just outside the US.

Stephen Dover: Gene, let's talk about where you see opportunities. You talked about that a little bit when you last spoke, but if I may set some parameters for you. Let's talk about the investor who has, let's say three-, five-year horizon what they should be looking at.

Gene Podkaminer: It's important to mention that, at the top line and across all of the different asset classes that we look at, we've pretty much taken risk down. So that is, I think, an important place to start, more uncertainty, especially with wages and with the supply-led inflation, as we mentioned earlier on, has caused us to trim back risk in general. And that moderation at the top line also means that we're reshuffling portfolio components. So for instance, within equities, we favor US, Canada, and Japan, but for different reasons. For the US, consumer and corporate balance sheets are the main driver. Canada benefits a lot from the US and the commodity story, And Japan is a region where we've seen really strong growth and really easy monetary policy. So when we talk about the difference between how different countries are reacting to inflation, the central bank of Japan has done it a little bit differently than some of the other countries. Now, also there is attractive sector exposure in Japan. So, when you think about autos and machinery, so those are some of our preferred regions. We're still examining the impact of COVID on China's really restrictive policies and what that means for global growth and supply chains as well. So we're not as optimistic in that market. And then thinking about Europe and emerging markets, Europe faces some real headwinds from higher energy prices, from inflation, uncertainty around the war. And also, China, in addition to the COVID issue, also has some relatively restrictive monetary policies now, and other emerging markets are negatively affected again by rising commodity prices and also lower vaccination rates.

We've definitely seen volatility in both the equity markets and the fixed income markets, like there's nowhere to hide. And so it becomes a little bit of a question of what's the least worst place to be? Which is not always a question we like to ask ourselves, but that seems to be where we're at now. We think it's probably least worst to be in equities versus fixed income. The pain in fixed income looks like it's fairly mechanical, and equities, there's still hope out there. In terms of commodities, commodities have seen a fairly meteoric rise over the last couple of quarters, so commodity futures. And if you track commodities over long periods of time, say starting in the sixties or so, you'll see that when inflation spikes the way that it has now, commodities tend to perform really well, because they're tied to what happens in the real economy. The challenge is, for those periods, they can last decades of relatively benign inflation, commodities don't perform really well. So, it's almost like a bit of an insurance policy. You're paying a premium for them when you hold them in benign inflation environments. But when a dislocation happens, when a market shock happens, they tend to perform really well. And so, it takes a bit of nuance and thought to figure out how to structure that into a portfolio that makes sense for whichever investor you happen to be working with. Commodities are not a panacea, right? They're not a silver bullet. They have real risks involved in them in that they're very volatile. So just saying, in hindsight, hold commodities, and you'll be protected in an inflationary environment, it isn't quite true because there's so many times when commodities will likely detract from your performance going forward as well.

Stephen Dover: Michael, where do you see opportunities and concerns now?

Michael Hasenstab: You know, there's just a lot of risk in many of the longer-duration fixed income assets, not true about every one of them. It's not uniform statement, but in big pockets, I think that is an area to protect capital. And on the opportunity side, it's not without risk, anytime there's a return potential, you have risk, but Latin America has been really interesting. They've had a combination of very positive factors. One, this very aggressive central bank hiking has increased nominal rates quite significantly over the last year and gives a significant yield advantage. Additionally, they're getting this commodity tailwind that was already in play earlier in the year, and then further exacerbated by the dynamics going on in Russia. And so, you get the commodity exposure, plus the carry, has been, I think, a really interesting space for us. So, typically you would think that, oh, Latin America is considered a risk asset and therefore if risk assets sell off, it should sell off too. But earlier in the year, it actually was the reverse because of those unique dynamics. So, we can't think about risk uniform across, sort of, all markets, but it does have different dynamics. And then Asia, we also find as an attractive region with its relatively higher growth, relatively better fiscal accounts, relatively better trade accounts, and relatively higher rates versus Europe or the US. So, Asia, Latin America, and underweight duration would be three kind of main tenants.

Stephen Dover: Great. Thank you, Michael. Thank you, Gene. Thank you, Francis. I'm Stephen Dover. Thank you very much.

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