WEBINAR REPLAY: Inflation

Hear from FEG Chief Investment Officer Greg Dowling, Director of Fixed Income Keith Berlin, and Director of Real Assets Christian Busken as they cover recent inflation and where they see it going, as well as potential investment considerations given the current market environment. 

 

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Full Transcript Below:

Greg Dowling (00:02):

Welcome to FEG's Fall Webinar on inflation.

I'm Greg Dowling, CIO and Head of Research and I'm joined by Keith Berlin, Director of Fixed Income, and Christian Busken, Director of Real Assets. We are donning our 1974 Whip Inflation Now buttons as we try to address some common client questions on inflation. We'll talk a little bit about the drivers of inflation are, we'll talk about how inflation may impact both equity, fixed income and real assets, portfolios. How high inflation may get and how long it might last.

We'll talk about the impact of the Fed. We'll talk about whether the infrastructure bill will increase inflation or decrease inflationary pressures. And then we'll also hit on how energy fits into the equation. I'll conclude with a few final thoughts on portfolio construction, and then we will open it up to Q&A. Please use the Q&A function to submit your questions at any time.

Container Ship (01:11):

No picture best represents what is going on than this. This is a container ship, probably going across the Pacific Ocean to one of our West Coast ports. As the US economy has shifted from a manufacturing based economy to being more of a service based economy. We don't make a lot of things from start to finish here. Where we might design something in California, its pieces are probably manufactured in China, Malaysia, or Vietnam, shipped across the ocean to Mexico, where they're assembled and then sold in Tennessee.

And so any impact in the global supply chain, this just in time system, has huge ripple effects. We saw this at the beginning of the pandemic, when we could not get enough medical supplies to our first responders. And we're seeing it again now. As we have this global disorderly restart, where the US which is more advanced its vaccine rates are starting to spend money. And there's demand, but there's not supply.

Dollar Tree and Dunkin Donuts (02:20):

A few other pictures that we really loved. How about this, Dollar Tree. Dollar Tree recently made news by saying they're breaking the buck. They're raising prices, they basically admitted that you can't sell anything for a dollar anymore.

We also like this one, Dunkin Donuts. This is a domestic donut maker, they are not waiting for microchips from Taiwan, but they're still having supply chain issues. And there are no doughnuts for sale today. I'm sure everybody has seen these and maybe passed them around to colleagues.

Client Feedback Drives Webinar Topic (03:08):

It's not a surprise that when we pulled you that the overwhelming response was we want to hear more about inflation. So 40% of respondents wanted to hear more. That was more than China, more than the energy transition, public policy, and even private capital. So let's give you a short history of inflation.

A Short History of U.S. Inflation (03:34):

From a modern perspective, we really just had one major period of inflation. Some people call it the great inflation. It was from 1965 to 1982. And there are some similarities from what's going on now. But there also are a lot of differences. Maybe what's similar is the amount of spending. So spending, especially that domestic spending really ramps up starting with Kennedy and his new frontier. That's followed by the Great Society of Johnson. And then you throw in increased defense spending due to Vietnam.

Then we have Nixon taking us off the gold standard, throw in an oil embargo and Iranian Revolution, and you have double digit inflation. And it took Paul Volcker, the Fed chair at the time, to increase rates to such a high level to break the back of inflation. But there was a lot of collateral damage. We put the economy basically in a couple of recessions.

Any younger people on this call ask an older colleague, if they bought a house in the 1980s or late 70s what their first mortgage rate was, I bet you'd be very surprised. But that led to a period of disinflation. So then we get to this other period call inflation targeting. This is really a Goldilocks period. A lot of this was Alan Greenspan, when he basically said what dis-inflation or deflation is bad, and inflation is bad. So let's go to a little bit of inflation and, we're going to explicitly target 2%. And for the most part, they did, especially core inflation.

This was certainly helped by China entered the WTO in the 90s, or early 2000s, as that had some deflationary pressures that were put on. And everything goes just fine until the COVID pandemic. Just recently, we had a 5.4% annual reading in September, so we are back to inflation.

Drivers of Inflation (5:45):

Now, what are the drivers of inflation? I'm going to give you more of the academic textbook type of response here. There are two and spoiler alert, we have both right now.

Cost Push Inflation

So the first one is cost push inflation. And from a historical perspective, the poster child is the 1970s oil embargoes, the gas lines. And so cost push inflation is caused by a decrease in the supply of a good, which then increases the price of that good. And also anything else that uses that good. So right now, maybe you can think of microchips. There's a huge microchip shortage. So that's impacting everything, from consumer electronics, to phones, to even cars. And we just can't get enough chips and everything has a chip in it.

But we've been talking about this now, for, I don't know, it feels like last few months, it's been really in the news and headlines, but this started about a year ago.

Supply Chain Disruptions Increase Pricing Pressures (6:55):

So this is a chart from the Institute of Supply Management. So almost a year ago, the suppliers were starting to announce major backlogs of orders, 18% over 20%, and then over 30%, and this continued all the way through to the summer. So when you hear about it in the news, it probably already happened. And this has been building for a very, very long time. And it's going to probably take a while to resolve.

Transitory Means At Least 2022 (7:34)

How long will it take to unwind some of these supply chain disruptions? We talked to a bunch of people, but I think this is a great chart.

So this is a survey results from the Wall Street Journal where they polled 67 different economists. And only 3% thought it'd be done by the end of this year, another 3% by the first quarter. A third said it would be the second quarter of '22. And then another 59% if you add the next three columns together say it's going to be later than the second quarter of '22. So the Fed says that we're going to have this transitory inflation. And that might be right. But transitory, at least as it relates to the supply chain means probably six to 18 months.

Demand Pull Inflation (08:29):

All right, the other type of inflation is demand pull inflation. So from a textbook perspective, this is really caused by an expanding economy, increase government spending or overseas growth. So this is kind of that run up in the mid 60s, in the late 60s, where you had a lot of spending on domestic programs. And I'd say today, we have two out of the three. We have a pretty robust growing economy. So prior to our latest read of 2%, we had reads of over 6%. Fourth quarter seems like it may be a little bit low. But if you look at some of the outlying GDP forecasts, it looks like we're going to be growing back, again, above trend.

Immense is an Understatement (09:16):

And we have a lot of government spending, a lot. So this is just the fiscal response, Keith Berlin will talk a little bit more about some of the monetary response, but just the fiscal response was a mess. So if we look at it versus 2008, and the great financial crisis, our response was even bigger than that. And by the way, the great financial crisis, our response there was bigger than anything since the Great Depression. Chairman Bernanke he was a student of the Great Depression and they didn't respond quick enough, or big enough. So he learned his lesson. So we had a huge response, but in COVID, our response was even greater. 10% of GDP in both '20 and '21.

Damage to the Labor Market (10:07):

And that allowed our employment ratio to really drop to levels we haven't even seen since the early 80s. And that's because people were just flush with money. So some of the estimates say that only about a third of the money that was mailed out has been spent. About a third has been saved, and a third has been invested. Invested, I don't know, maybe in meme stocks or crypto, who knows. But perhaps about two thirds are ready, or still available to be spent.

In some ways, that's good. Because there were a lot of people that may have lost jobs that were in travel, lodging or leisure. Or maybe they had health conditions, or maybe they had childcare problems. But there certainly were another portion that just were flush with cash and didn't need to work and didn't want to work. And right now, it seems like from all the indications that we're about 5 million people short for the jobs that are open. So the question is whether we will see wage inflation.

 

Where Are We Seeing Inflation? How Will It Impact A Fixed Income Portfolio? (Keith Berlin)  (11:17):

Now we're going to transition, I'm going to hand it off to Keith Berlin, he's going to break down inflation a little bit more. But then also talk about how it'll impact your fixed income portfolios.

Inflation is not Uniform Among CPI Categories (11:27):

Thanks, Greg. First, let's level set a little bit and look at the key components of headline inflation within the Consumer Price Index. The chart focuses on the top five categories that comprise CPI. Shelter and rent, education, medical care services, food and motor fuel. Together, these comprise a 64% weighting for all CPI, but they've accounted for 100% of all inflation over the last 25 years.

Let's dig a little bit deeper. If we look at just the top three of these categories, we can see their importance to the CPI reading. Shelter and rent jumps right out as the most meaningful followed by education and medical care services. These three categories have seen inflation near or above 3% over the last 20 years, with shelter and rent prices moving materially higher over the past 18 months.

Education and medical care services have been more sticky during this time period. It's important to note that shelter and rent prices, which are also known as owners' equivalent rent tend to show up in CPI with a lag of about one to two years due primarily to the sticky nature of rent inflation. So given that run up in housing prices I mentioned earlier, that we've experienced over the past 18 months, this could have a meaningful impact on CPI throughout 2022.

And, more recently, the biggest challenge for consumers has been in the food and motor fuel categories, which exhibited a higher degree of volatility and higher prices due to supply chain issues.

Wage Inflation (13:01):

Now let's take a look at wage inflation which Greg mentioned earlier. Here we see a picture of a McDonald's that's offering a $500 sign on bonus. Wage inflation is definitely a real thing right now.

For anybody that's traveled recently or gone to a restaurant, you've seen firsthand the under staffing issues of both hotels and restaurants. And this is presenting a very real challenge across the country. Just last week, in fact, McDonald's announced it would be hiking prices of its menu items to offset wage increases and supply costs. McDonald's employee wages are up 10% this year, and they can't hire enough people to operate under regular hours.

Companies like McDonald's that or pass on wage inflation to consumers is part and parcel of the inflationary story. In the short term, consumers feel like their dollars not going as far as it had in the past, which is true. But wage inflation does offset these higher costs somewhat over time with a lagged effect. As people who have salaries, pensions or Social Security benefits that are tied to CPI for annual adjustments will ultimately see higher wages to offset inflation somewhat.

Econ 101: Supply and Demand Lines (14:12):

Now let's dig out the old econ 101 textbook and go back to the basics with some macroeconomics. This should help us as we consider how the Fed may be thinking about the supply shock facing the US and how it believes that will only lead to transitory inflation. So first we have the X axis, which is the aggregate output of the economy. And then we have the Y axis which shows the aggregate price level for the economy.

In blue, we have the downward sloping aggregate demand curve. And in red, we have the upward sloping aggregate supply curve. The red dot marks the clearing price and output of the economy. So think of this point in time as pre-COVID or 2019. As the economy closed down and throughout 2020, the aggregate supply curve shifted up and to the left as denoted by the yellow line. Here we can see a new clearing price and lower output for the economy.

And the price is much higher along with the shortage of output. While demand has been relatively stable throughout this period, although one could argue that it has increased in some areas, we do anticipate that over time, the initial supply shock, and the shortages associated with it will gradually dissipate. Perhaps not as quickly as everybody would like as in 2022, or '23, as Greg noted earlier, but ultimately, we should see the aggregate supply curve shift back down and to the right. And this should lead us to a new aggregate supply curve that's shown in dark blue with the blue dot denoting the lower clearing price and output point.

So the key takeaway here is that this new price point is higher than it was in 2019, pre-COVID, but it's lower than where we are today. And this is what we think the Fed means by transitory. Now let's shift gears a bit and talk about the upcoming tapering of the Fed's balance sheet.

Fed for the Long Run (16:07):

The market has been caught up in the taper story throughout 2021. The will they or won't they? And if so, and by how much? When and by how much? We want to make a bigger picture point about this situation. And the point we want to make is that the taper doesn't really matter that much in the grand scheme of things. Why not? Why doesn't it matter very much?

Well, it's important, particularly for the investment professionals who've only been in the business for 10 or 12 years, or maybe even less than that. It's important for these professionals to understand that the investment world really has changed since the great financial crisis, also known as the GFC. So let's take a look at the chart.

We can see in the bottom left that prior to the GFC the Fed's balance sheet was less than $1 trillion, about 925 billion at its peak, in fact, and it was rarely discussed at all by investors. The first quantitative easing program helped stabilize the collapsing financial system during the GFC. And we can see that this $1.4 trillion QE program from 2008 to 2010 accounted for 9% of US GDP at the time.

Then a second QE program came about for an additional $560 billion in late 2010 to 2011. And that was 3% of GDP. Finally, a third QE program, amounting to a whopping $1.7 trillion, or 8% of GDP came about from 2013 to 2015. Also, in 2013, was the year of the infamous taper tantrum. When the 10 year Treasury rose from 2% to 3% from May to December. As you can see in the chart, the taper tantrum had little to no impact on reducing the Fed's balance sheet. The balance sheet actually increased over that time period.

And by the way, we didn't know all this was going to work during the great financial crisis. But the Fed's actions did keep the US financial system and the economy from ruin. But the tally for all of these QE programs was a Fed balance sheet that was nearly five times larger than it was pre-GFC at $4.5 trillion by 2015.

So having successfully established new tools during the GFC, and also to combat the fear of a recession, or possibly even a depression, from shutting down the economy due to COVID in early 2020, the Fed once again utilized some of these tools, and added another $4 trillion dollars or so to the balance sheet. And these actions accounted for roughly 13% of 2020 GDP. And as you can see, the result is a Fed balance sheet that's now at a whopping $8.6 trillion. So what should we take away from all this, particularly for the younger investment professionals?

Well, we can talk about the Fed tapering bond purchases until we're blue in the face. But the bottom line from our view is that the Fed is here for... They're here to stay for the long run, they're not going anywhere. And we may not like it. But this is how it works, and how it's likely to continue to work until one day when it doesn't. And that hopefully is a story for another day, maybe one for our children or our grandchildren to deal with.

And hopefully the economy will grow sufficiently enough from here that we may have enough lingering inflation that the Fed can begin to increase rates in the next year or two. But we'd be willing to bet for the next time we have a crisis and we seem to have one at least every decade or so, the size of the Fed's balance sheet will balloon yet again, because the Fed is the lender of last resort. And who knows maybe that'll take the Fed's balance sheet to 10 or 12 trillion or even more. We'll see how it all plays out.

But let's just not get too caught up in all the tapering talk, because the impact on its balance sheet is only going to be modest.

Is M2 Inflationary? (19:56):

And many of you may have wondered if all this stimulus created by the Fed inflationary. Now we'll take a look at the M2 chart. And remember, M2 includes cash, checking deposits and easily convertible near money. It's generally considered to be an indicator, both the money supply and future inflation. We see the massive increase in the money supply that was created by the Fed during COVID, which is the blue line superimposed over the collapsing money velocity, which is the red line.

So why have the Fed actions not created an increase in money velocity, which is simply the number of times money moves over a given time period? And why is it not led to an increase in inflation? Well, it has actually. We believe much of this money is trapped in the financial markets through asset price inflation. And we also believe that decline in money velocity student is due to an increase in consumer savings and uncertainty, which we believe is likely to continue for the foreseeable future.

So why do we believe this? Well ask yourself if these stimulus programs are really needed if things are going well, the answer is that things are not going very well, which leads to more savings and more uncertainty. On a related point, let's consider the work of economist Lacy Hunt. He notes that in large, highly indebted economies such as the US, Europe and Japan, that the more indebted they became over time, the marginal revenue product of each unit of incremental debt added by the stimulus programs also led to lower below trend GDP over time.

Economies do benefit from the initial boost of growth from these big stimulus programs, which help us come out of the economic ditch that we find ourselves in during a recession. But these boosts tend to be short lived and are ultimately followed by below trend growth. And that's what happened after the GFC. And what we expect will likely happen during this recovery over the next few years. Some recent research data from the Federal Reserve Bank of Philadelphia confirms this as well as the recent third quarter GDP miss which is in line with our thought process.

As we see GDP projections for 2021 or 6.1%, 4.4% for '22, 2.5% percent for '23 and 2% for 2024. This is the kind of below trend growth that investors can expect going forward after the Fed doubled the size of their balance sheet in 2020. So all of this together suggests to us we're in a lower for longer environment for US interest rates.

Market Already Accounting for the Higher Inflation (22:28):

That leads us to the fixed income part of the question from earlier. So first, let's take a look at the TIPS market. And by the way, TIPS stand for treasury inflation protected securities, just in case you're not a fixed income wonk. The primary way a fixed income investor looks at inflation is through what's being implied by the nominal treasury and TIPS markets. Here we see three lines the orange five year, the light blue 10 year and the dark blue 30 year break evens. And break evens are just the difference between the 5, 10 and 30 year nominal treasury bond yield and the comparable TIPS yield.

What we see in this chart is that inflation expectations have been rising over the past year across the three curves, which is normal coming out of a deflationary environment. However, inflation expectations remain more elevated when looking at the five year breakeven. If the market expected inflation to be higher for longer than five years, we would expect a higher breakeven rate for the 10 year and 30 year lines. To us this action is in line with the Fed's transitory argument for inflation. And today, TIPS don't really look like an area that we want to make a new allocation. Perhaps it's a hold here if you already own them, but we don't think TIPS warrant a new add at these levels.

Large Increase of Implied Rate Hikes Since Last Year (23:45):

Now let's take a look at what interest rate hikes may hold over the next two to three years based on what's priced into the market and what that might mean for your fixed income portfolios. So the 10 year's around 1.55% today. Looking at the chart moving out 24 months there are four to five rate hikes priced in by October 2023, which would bring the Fed funds rate to 1% to 1.25%. Looking at a little further 36 months there are 5.2 hikes priced in, which gets us closer to a 1.25% to 1.5% Fed funds rate. It's our view that the bond market has begun to price in some of the upcoming tapering as well as a possible first rate hike, which we've seen in recent market action with rates trending higher into this week's Fed meeting and taper announcement.

Now there is an alternative view to the concept of sequential rate hikes once they do ultimately begin. And that view incorporates the idea that I mentioned earlier, that economic growth is likely to slow down in the second half of the year versus the first half, as well as that gradual year over year decline in GDP over the next few years. So as you might be thinking, and we would tend to agree this is not really the kind of environment that's conducive to meaningful, sequential rates hikes over the next few years. But it is, however consistent with past periods of massive government stimulus programs that have led to short term bumps in GDP, only to be followed by a return to below trend growth.

Which suggests again, a lower for longer rate environment. Rates could rise a little bit. But we still think that we're in a lower for longer environment going forward, and we'll see how it all plays out.

Fixed Income Takeaways (25:24):

Some of the key takeaways I want to leave you with. First, we continue to recommend shifting traditional fixed income portfolios away from the Bloomberg Barclays aggregate index. That index has about a six and a half to seven year duration. As a reminder, duration is just a term for interest rate sensitivity.

And we recommend investors shift to an intermediate version of the Agg, which has a duration that's closer to four years. If you do this, it will keep fixed portfolios from declining substantially if interest rates rise further from current levels. It's actually worked out very well thus far in 2021 because the Agg is down 1.6% year to date, versus the intermediate Agg, which has lost only 60 basis points. And that would have saved investors about 100 basis points in fixed income performance, which that can be very useful if you think about it, because fixed income portfolios can be up to 20% of your overall portfolio. So it's pretty important.

Also, shifting to an intermediate fixed income portfolio should cost less than core fixed income due to the lower risk profile. So in our view, less rate risk and lower fees are attractive. Some other things that we could consider right now include shorter duration strategies, such as structured products or bank loans, which offered lower rate risk and higher yield opportunities than traditional fixed income portfolios.

And finally, we also like private debt, particularly lending strategies due to the material illiquidity premium that's in place today. And now, I'd like to turn it over to Christian Busken, who's going to talk about the potential inflationary impact of the infrastructure package and energy.

 

Will the Infrastructure Package Lead to More Inflation? (Christian Busken) (27:01):

Thanks, Keith. Let's start with a quick look at the infrastructure bill.

What’s In the Bill:

This is a summary of the various components of the bill as well as those that could impact the infrastructure investment landscape. On the left, we see that these include power generation, focused on clean energy, digital infrastructure, water infrastructure, and transportation infrastructure with a focus on electrification.

It's important to point out that the bill is still a working process, and continues to be modified from its original form.

Infrastructure Spending Later, Tax Increase Now (27:35):

One of the key questions for investors is will the infrastructure bill be inflationary? And it's important to note that infrastructure spending would be implemented over a multi-year period. And while certain tax increases would be potentially more immediate, they'd impact all sectors of the economy which would pressure reinflation. Therefore, we don't see the infrastructure spending package as near term inflationary.

 

How Has Energy Shifted?

Let's turn to an area though, where we're all definitely seeing inflation and that's energy.

An About Face for Oil (28:16):

Energy markets have seen a dramatic reversal over the past 18 months since the downturn in the early stages of the pandemic. Oil prices average $20 A barrel in 2020. In October of this year, topped $80 a barrel. As many may recall, oil prices crashed in March and April of 2020 due to massive demand destruction and oil prices actually went negative in April of 2020 for the first time ever, multiple companies faced bankruptcy because the sector was forced to restructure.

Fast forward to October of 2021 and we're seeing a very different picture today, and it appears that we may have turned the corner. As I mentioned, oil is trading above $80 a barrel, with rising prices being driven by multiple factors, including reopening of economies from the pandemic shutdowns and worries about major energy producers' inability to ramp up output, along with challenges in the shift to renewable energy sources.

Oil Prices Are Climbing, But Not the Rig Count (29:26):

In addition to increased demand, we're seeing slow growth in the rig count, which remains below pre-pandemic levels and has created supply pressures. Global oil demand is approaching normal levels of around 100 million barrels per day, while natural gas demand has already exceeded 2019 levels. According to OPEX latest estimate global oil demand in 2022 should average just over 100 million barrels per day exceeding pre-COVID levels. The rig count, however, has not rebounded in line with oil prices.

The Lack of Capex in Energy (30:05):

As the price of oil declined, so did capital expenditures in the upstream energy sector, and this lack of investment may hinder the ability of energy producer to meet rising demand. To put this in perspective, capital investment in the US oil sector this year is projected to come in at its lowest level since 2004. Oil companies cut spending to an estimated 55 billion this year compared with 60 billion last year, and 108 billion in 2019.

Going further back, US oil field investments GE did about 180 billion in 2014.

Natural Gas Prices Skyrocket (30:50):

Similarly, we've seen a significant move up in natural gas prices this year. A gain of 86% year to date through the end of October. A combination of surging demand, limited supply, rapidly depleting inventories, coupled with a period of under investment over the last seven years has pushed natural gas prices to multi-year highs in the US. Also US liquid natural gas exports increased 150% year over year, driven by demand from Asia and Europe and European exports actually fell by 20% according to data from the International Energy Agency. Also, as energy companies have cut back on crude oil production there's been a significant decline in the associated natural gas and natural gas liquids, which are produced alongside oil.

The Energy Situation in Europe (31:46):

We've heard a lot about the energy crisis in Europe over the last couple of months where prices have soared as a result of the region's increased reliance on intermittent sources of power generation like wind energy. The region has also faced concerns about having sufficient natural gas heading into the winter months and record high gasoline prices. A key question is will the US face the same situation as Europe?

The answer is probably not. Because the US has abundant supplies of natural gas. It's worth noting, however, that like oil production, natural gas production has been scaled back and building the necessary infrastructure remains a challenge in some regions. For example, despite being located just a few hundred miles from the Marcellus Shale, one of the world's largest natural gas fields, Massachusetts has relied on imported natural gas.

Most importantly, however, as we see here, Europe relies on Russia for a significant portion of its natural gas while we rely on places like Texas. Circling back to infrastructure as we look at the broader landscape of investment options, how might investors allocate capital? The main categories of infrastructure are telecommunications, that would be cell towers and satellites, power generation and utilities, which includes renewables, midstream energy, and transportation.

Equity Infrastructure Investment Options (33:19):

This slide shows the various ways investors can allocate infrastructure. First, there's publicly traded listed infrastructure, which offer exposure to companies across a broad range of sectors, or alternatively on the private side there are core value add or opportunistic infrastructure funds. We believe the highest returns are available with sector specialists in opportunistic infrastructure. However, the trade off is that these vehicles typically come with a multi-year time horizon and are illiquid.

Energy and Infrastructure Takeaways (33:54):

Now to conclude and tie this together. First, there's a growing consensus or acceptance that inflationary pressures may not be transitory, and investors are looking to protect their portfolios. So what can they do? FEG continues to recommend a broad range of real assets to provide protection against inflation. This includes real estate, natural resources and selected infrastructure investments, and allocation to infrastructure and provide exposure to essential assets with some degree of inflation protection, offering stable cash flows across a broad range of sectors.

Some infrastructure areas may benefit from the infrastructure bill. Finally, it's worth mentioning that given multi-year, distress and dislocation, traditional energy could offer potentially compelling returns as the sector has stabilized and is improving. Now I'll turn it back over to Greg for some concluding remarks.

 

Is Inflation Good for Equities? (Greg Dowling) (34:56):

All right, so we talked about fixed income, now real assets. We need to talk a little bit about equities. Equities are the biggest portion of most clients' portfolio. So is inflation good for equities? Well, it's a bit of a mixed bag. See, a little bit of inflation is actually good for companies, because inflation usually means a growing economy.

Alternatively, deflation isn't good. So if you have anything below 2% from a deflationary perspective, that's not great. But that zero to three, sort of that moderate period, that supports the highest valuations. It falls off just a little bit, when you get to three to five, it's really where you get over 5%, and that really needs to be sustained, that you see multiples fall off. And although we've seen a above five print, for this past quarter, based on everything else that we've kind of mentioned, we don't think that it's going to be above five for a long period of time. Definitely above two, and maybe probably up above the historical trend of the last decade or so. But it's going to be hard to be over five.

Low and Stable Inflation is Best (36:13):

So we think equities will provide some protection for inflation. But it's important to note that it's not just the absolute level, it is the volatility of inflation. And really, markets don't like uncertainty. And corporate management doesn't like uncertainty. We have some of the greatest corporate managers in the world. They've managed through the great financial crisis, and even the pandemic where most of their workforce was at home. It's only when things change and change rapidly, that you see it really impact the PE are multiples of what you pay for earnings of a company. And so if you have low stable, inflation, it's okay. It's only one it kind of swings wildly. It our guess is that because inflation is so front and center, we're not going to be surprised by any new inflation.

Mosaic of Investments (37:19):

All right, so how do we put this all together from a portfolio construction perspective. I know a lot of clients have asked me, if there's going to be growing inflation, what do I need to? Should I massively change my portfolio, should I swing around a little bit? Well, there really isn't any magic bullet or silver bullet to take care of inflation. The best thing you can do is just diversify. And I'm going to show you that.

Devising an Inflation Minded Portfolio – Liquid Options (37:48):

Here, on the left hand side, you see many asset classes, some of which you would think would be a great hedge for inflation. And then we look at correlation and beta. And two correlations here, both to expected and unexpected. And correlation is really just the co-movement. And we would say that a strong movement is anything above 0.7. And from a moderate perspective, probably be .5 or so. So that's medium strength. And commodities, in terms of unexpected inflation, fall just below .5, rounding up maybe .5. But if you look at expected, it's .14. And it goes down from there, natural resources, equities, global, listed infrastructure.

And they'll look at the difference of the bottom on US Treasuries between expected and unexpected inflation. So assets act very differently between expected and unexpected, and none of them are a perfect hedge. So therefore, we think there are a lot of little adjustments that you can make to help your portfolio. But if you have a diversified, balanced portfolio, you should do just fine with a little bit of moderate inflation.

 

Final Thoughts (39:11):

All right, let's put this all together. On the macro environment, supply chain issues are likely to last well into '22. And this will lead to continued inflationary pressure, at least on the supply chain side. But we don't think we're going to have any sustained hyperinflation, certainly nothing like we saw in the 70s. There were a lot of things that happened during the 70s, going off the gold standard, oil embargos that we just don't have here today, at least for now. Knock on wood. We also don't have any velocity of money.

So even though the money supply as measured by M2 has gone up, there hasn't been any velocity. And we need to have a lot of velocity to have sustained inflation, so we think we're going to have inflation, it's going to be higher than normal. But it should fade after a while, not completely. Our guess is that it never goes... It doesn't go quite back to the level we had pre-pandemic, but some new level, as Keith has demonstrated.

On the fixed income side. Now, there might be a lot of some noise around tapering. And there might be a little bit of market impact as it tries to figure out but from a broader perspective, we don't see it as that big of a deal. We think the market will work through it, and that what balance sheets are going to remain high for a long time, and probably get higher in the next crisis. But there are things you can do. So think about shortening your duration, just a little bit, and favor yield. Anything that has credit, and privates if you can.

From the real asset side, the infrastructure bill, it's only a small portion of the proposed total spending package. So by itself, it's not going to be inflationary, but we're also going to have a lot of fiscal drag. At the same time, what will be inflationary is energy, because energy is bleeding asset. If you don't continue to invest in it, you can't even maintain your current production levels. So energy prices are probably going to remain elevated.

On the equity side, stocks do okay if we have a little bit of inflation. And corporate management's great, they can deal with it. It would only be if you have some surprise inflation that we have some difficulty. And we don't think we're going to have that. And then finally, from a portfolio management perspective, unfortunately, there's no perfect hedge for inflation. There are things you can do, but you don't want to oversteer the boat. Maintain broad diversification, make sure you have some exposure to real assets, but you don't have to dramatically increase your exposure to real assets or get rid of fixed income, you can ride out the storm. And in fact, because of the different reactions to both expected, unexpected, you want a little bit of everything.

 

Upcoming Opportunities (42:09):

Now, let's give you a little bit of a commercial on a few other FEG upcoming events.

So even though it wasn't your top, you did want to hear about China, and you did want to hear about infrastructure and politics. So we're going to give that to you, in addition. So on December 8, at 9:30am, Eastern Standard Time, we're going to have a manager panel on China. So we're going to talk a little bit about property markets, some of the regulatory crackdown, everything that's going on. And a little one on one too, we'll talk a little bit about A-shares. And we're going to have three managers with two already confirmed, and it should be great. So we'll do a panel.

But then we'll also do breakout sessions where investors can then talk one on one in a smaller group with just that manager. And then released this week, we have a podcast with Dan Clifton, Dan is great. For any of our clients that have been to the FEG forum is always a fan favorite. And he breaks down what's going on in DC. We tried to do a little bit more of a longer view. So this would have a longer shelf life. So not just what a talking head said on MSNBC or Fox News last week, or today. We're really talking about what are the parties trying to do. And that should shape a lot of the action that we see going forward.

We'll also talk about the debt ceiling, who the next venture may be, China, and then give a little bit of a early prediction on who might run for 2024 presidential elections. So please listen, I think you'll enjoy it.

 

Question & Answer (43:51):

With that, we're going to open it up to Q&A. And we do have a few questions already sent in from earlier.

Q: One of the first questions that we received was on stagflation.

A: I'm going to take the first part of that and then hand off other part of that to Keith, but from a technical standpoint, yes, the answer is yes, we do have stagflation. Stagflation as defined by slower growth and increasing inflation.

But we think we're probably at peak stagflation talk, either now, or sometime here in the fourth quarter. Because GDP should rebound. So we had pretty strong reads in the first part of the year, fell off a little bit here for the third quarter with a 2% rate. Fourth quarter estimates for GDP are all over the place. They're pretty wide from I've seen eight to below two. So we'll see where that comes in at. But my guess is it'll be slightly better than what we had So it should have some growing GDP.

But then as Keith mentioned, as you go further out, especially into next year, we should see strong growth, especially as we work through some of the supply chain issues in the first part of the year. So we think growth goes up, and then inflation pressure goes down. And so therefore, we're probably at peak stagflation. But there was a second part of that question. I'm going to let Keith rephrase it and answer it.

Q: And the second part of that question was, if we believe inflation will be persistent and not transitory, will rates rise? Or will the Fed continue to suppress rates?

A: (Greg) So as we laid out in the presentation, we expect inflation will be transitory, as the Fed expects, with a higher final price point than in 2019, but lower than where we are today. And nobody knows where rates will go for sure. We think rates could rise a little bit in the next couple of years in conjunction with the Fed raising overnight Fed funds.

Overnight Fed funds tend to act as the anchor for interest rates. So as the Fed ultimately hikes rates, the rest of the curve should move incrementally higher. And ideally for everyone, this would be like watching the paint dry. And we mentioned also that rates should be lower for longer. And investors should think about that as kind of a trading rate. There have been several decades in the past, where rates stayed low in really a whole decade and didn't move up from here. So that's kind of our out look.

Q: Gotcha. Well, that's good. There was another question that talks about just a slowing population growth, and whether that will have an impact on US GDP for the long run. So is it possible that we average less than 2%?

A: (Keith) Yeah, I think that speaks to the points I made earlier about the massive stimulus program. These programs have created further indebtedness that just make it more and more unlikely, over time that we can grow our way out of all this debt. The QE programs in the past coming out of the GFC, they weren't successful in creating sustainable above trend growth. And weak demographics were part of the story then. And they're part of the story now. So we think it's going to be really hard to grow above 2% going forward.

Q: Another question is on the velocity of money, and what does it really mean in today's modern economy?

A: (Greg) And it's a great question that there is a kind of growing body of work that suggests that some of the older economic ratios that we've all learned in school from productivity to like Phillips Curve, which doesn't seem to work right now. You need to take them with a grain of salt. I think that's probably true with velocity.

Maybe in a digital age, we're not capturing all of the velocity of money, but it's still probably directionally correct. And so while it might not be perfect, I would definitely say that it's probably directionally correct in that a lot of money is just trapped on the Fed's balance sheet, or sitting in reserves through the banking system. So I think you're probably right, but I don't know how material of an impact is. I think we'll be probably okay.

Q: There was another question that came out regarding Bitcoin, and whether Bitcoin is a inflation hedge.

A: (Greg) And I'm going to just say... I think I'm going to take the easy way out of this one to say, I don't know. I don't think anybody knows, because it hasn't been around in an inflationary period. This is the first time that we've had any sort of inflation while Bitcoin was a thing. But I will give you a little tidbit because it's something that Christian and I talked a lot about last week, in terms of this whole ETF structure. And it kind of relates to commodities, which are part of how people hedge for inflation. So Christian what about this new Bitcoin ETF?

(Christian) Yeah, so the Bitcoin ETF gets exposure to Bitcoin through futures. And the thing to keep in mind with investing in futures is you can run into an issue of negative roll yield when the Futures Curve is in contango. And all that means is that the future price is above spot price. So in order to maintain that ongoing continuous exposure to Bitcoin, or this could apply to commodities, as well, and we've seen this happen, we've seen this play out in the commodities markets over the years. You have to continuously roll that futures contract over. And when you do that, at a higher price, it can create negative roll yield and effectively, a loss on your position. And so that's the one thing that I think many investors may not be cognizant of with the new Bitcoin ETF.

(Greg) That's right. So it's an interesting tidbit. Just if you've like Bitcoin and you've said, I can't wait to put it in my portfolio, maybe you're doing it for a small account, you're probably paying a little bit of tax in a negative roll yield. So just wanted maybe to share that. But we have no idea whether Bitcoin will have any... Whether it's digital gold. It may be, but it's hard to say for sure.

 

Conclusion (50:25)

It looks like we don't have any more questions. I just wanted to thank everybody for being on this call with us today. We have a new fancy mic, I heard a little bit of feedback that maybe there was some glitches here or there. So apologize for that, hope your audio was okay. We appreciate it. And if you have any additional questions, please feel free to reach out to any of us offline. We'd be happy to talk to you or answer any of your questions. So thank you and enjoy the rest of your day.