June 28, 2022

Is the Fed a match
for inflation?

Guest: Jason Richey, CFA, Portfolio Manager at Cougar Global Investments

In this episode of Markets in Focus

It would be nice if U.S. equities could find a bottom and recover without a recession. That’s what normal market activity often has looked like in the past. Trouble is, we haven’t had a lot of normal market activity in the last 15 years, says Jason Richey, CFA, Portfolio Manager at Cougar Global Investments. And that now makes it harder for everyone: central banks, corporate management, and investors alike. Richey shares his thoughts on the impact of inflation, the impact on the consumer, and how ultimately, we can position from an investment standpoint.

Subscribe where you listen to podcasts

Subscribe to Markets in Focus Podcast on Apple Podcasts Subscribe to Markets in Focus Podcast on Spotify

Transcript

Matt Orton:
Today I want to focus on arguably the most pernicious force in the economy right now, and that's inflation. During tumultuous periods like we're in now it becomes all too easy to point fingers. In this case, pointing fingers at the Fed for being behind the inflation ball. Inflation is certainly running hot. The Consumer Price Index has held above 5% for more than six consecutive months with the most recent readings coming in over 8%, further shutdowns in China due to COVID have only further disrupted supply chains, and a tight labor market in the U.S. make it pretty easy to jump on the hard landing bandwagon.

There's certainly a lot to be concerned about, but I'd also argue there's a lot of nuance required when assessing the true recessionary probabilities. And a lot of that comes down to the true impact of inflation on the consumer. I've been much more sanguine on the consumer than many other strategists. And up until now, we're seeing that optimism play out in earnings reports and spending on goods and services. But what does that look like 12 months down the road, even six months down the road? To help answer that question I've asked Jason Richey, co-portfolio manager at Cougar Global Investments to join us again and dive deeper into the impact of inflation, the impact on the consumer, and how ultimately we can position from an investment standpoint.

This is Markets in Focus from Carillon Tower Advisers. I'm your host, Matt Orton. Join me and my colleagues as we discuss the latest trends in developments driving the markets. Visit us at marketsinfocuspodcast.com for additional episodes and insights. So, Jason, thank you very much for being here today.

Jason Richey:
Yeah. Thanks Matt. It's great to speak with you again.

Matt Orton:
So why don't we just start with a quick take on inflation and how you think the overall environment has changed over the past year?

Jason Richey:
Well, I think you covered it quite well in your intro. There's certainly plenty of blame to go around. And I think you're right. The Fed is going to take the brunt of it, which is probably not fair, but I think that's just the way it is in today's world. I do find it very intriguing that Fed Chairman Jay Powell opened his last press conference in early May by saying that he wanted to speak directly to the American people. And then he went on to say that inflation is too high. And then he said that the Fed understands the hardship that it's causing. Now that approach was really unusual. There's no question about that. Usually what he does is he has the same exact initial wording about being strongly committed to achieving monetary policy goals or something similar.

Now if you go back and look, he did have a one-liner in March's press conference about the difficulties in Ukraine, but again, he usually opens with this sort of fairly standard and fairly generic statement. It was almost as if he was openly accepting the situation that he finds himself in, meaning he's sort of stuck taking all of the blame that's going to be thrown his way. And it sure feels like he's in this impossible situation. Either the economy is going to slow too much into a recession or grocery prices will stay too high. It's pretty hard to argue that we'll achieve some sort of perfect interest rate equilibrium on the first try. That's not usually how markets work. Now it's a little bit different when you look at things from a fundamental point of view, but from a macro point of view. The economy is not growing as fast as we hoped just a few months ago and outside of a very strong and probably overheated labor market at this point, there are some peaking or even slowing data points.

Matt Orton:
Yeah, I think that's a good point to make. And when we look from the economy, sometimes throughout this entire pandemic, one could argue there's been somewhat of a disconnect between the economy and what's happening in the corporate world, but I think it's helpful to look at what's happening in the corporate world as well when looking at where we might go with respect to the economy. And so I want to touch on earnings because as of last week, we've got 80-plus percent of the S&P 500 reporting earnings. And just about 80% of companies that have reported have beat their expectations. So it's been a strong quarter relative to expectations. Revisions for both U.S. and European companies are back into positive territory. You could say guidance has been a little bit suboptimal, but margins are still good above pre-pandemic levels. So I want to get your thoughts in terms of how markets can recover from where we are right now, given the strong corporate earnings backdrop. And if that really matters going forward, given what's happening with inflation.

Jason Richey:
Yeah, that's right. Revenues were fine also, too, if you want to throw that in and despite everyone's fears of a slowdown, there wasn't a lot to pick on other than perhaps the discretionary sector didn't really have a great quarter, but from a current earnings point of view that is one of those bullish data points, if you're searching for one. Of course, bears have latched onto the future guidance piece. I think you're starting to see some of those future earnings estimates flatten, perhaps even come down a bit. By the way, it's really the same argument from a top-down perspective, too, in that the consumer drives the economy, as we all know. So what economists do is they split consumer spending into durable goods spending versus services spending, and economists were pretty quick to latch onto the idea coming out of the pandemic, because you could see it in the data.

Most of us suffered lockdowns of some sort. We couldn't spend money on a night out. We were flush with savings from government checks. So we remodeled the house and we bought new appliances and that was the goods spending side of the equation. And then the argument was that we, as consumers, we would eventually switch from spending on goods to spending on services as the economy reopened. And we're starting to see that in the data, but there is some debate on the extent to which that's going to happen going forward from here.

So, what I mean is you can't really make up for a lost haircut. You can't make up for a lost restaurant visit. So we might not see that overspend on services, the way that we saw on goods. So if durable spending does go down since we all have new dishwashers, but services only makes it back up to trend or close to trend since we go back to eating out once a week, which is what we've always done, then what you end up with is slower overall GDP growth. And I think from that, you'd see lower future earnings estimates from individual companies as well, which I think there's some element of that in terms of what equity markets are pricing in lately.

Matt Orton:
And do you think equity markets might be a little bit too bearish? Or do you think it's fair where we are given the level of uncertainty?

Jason Richey:
So yeah, I would say it's a bearish environment. There's no question. It's not overly bearish though. There's a lot of market indicators show this is a fairly orderly market decline at least so far. Now we know markets can't go up endlessly. So when you have a three-year annualized return of plus-25% or plus-26% or whatever it was at the end of 2021, there's clearly a lot of positivity priced in. We know it was the fastest and sharpest rebound going back to 1950, lots of rationale for the run that we had, but I don't think it was overly heroic to think that we could have some type of pause or some type of pullback in equity markets on the assumption that we'd have less stimulus and the Fed wouldn't be as helpful as it has been.

But the biggest problem for investors in the current environment is we don't have a lot of comparisons, right? So two of the biggest pullbacks in the last number of years were the pandemic, where there was a sharp rebound after a month, and then you have to go back to the fourth quarter of 2018, where there was a sharp drawdown. And then there was another sharp rebound. And that took about four months. And where we sit today, we've effectively been in drawdown mode the whole year. And so naturally you're starting to hear comparisons going back to 2008, which I don't think that's fair, not yet at least.

So I think the bottom line is we have likely a bit more to go on the downside for equities, if we're either in a recession or if we're headed towards one, but if a recession can be pushed out, then this is really a normal part of market activity. It's just that we haven't had a lot of normal market activity in the last 15 years. So, and I know there's a lot of ifs when you make these type of statements, but if inflation can turn, or if the Fed can dial things down a little bit, or if we get any help on the Russia front, and by the way, I would throw in China in that, if we don't get a surprise out of China, then I think maybe markets can get closer to even, but I think it's hard to see how we get in the green by the end of the year.

Matt Orton:
No, I think those are all very valid points and kind of bring it back to this idea of inflation that I think comes through what you were talking about and the consumer earlier. You mentioned that we're seeing services spending pick up. It's above pre-pandemic levels finally, but the question is around whether or not it can continue to accelerate. We've seen retail sales hold up incredibly well, too, but we're now starting to see revolving credit start to rise. And like you pointed out, there's only so much stuff we can buy. So can we continue to count on the consumer to be a bright spot in the economy?

Jason Richey:
Nominally, yes. I agree. The consumer is in a great spot for now at least. If you switch your lens to real spending, meaning spending after you take into account inflation, I think it's a little bit less clear. There are some categories that are taking some time to come back. You look at movies or hotels, we're still 10% or so under the daily airline passenger numbers, if you looked at TSA data, for example. So yeah, the consumer is switching from spending on things to spending on travel and experience largely on the back of all the excess built-up savings. And we know that there's excess built-up savings because we can measure the savings rate and the savings rate has been falling. It's a little bit below pre-pandemic levels at this point. And so the question now becomes, how quickly are we spending down that accumulated savings?

So now do I think the consumer is safer for another nine or 12 months? Probably. Yes. Especially if none of us go out to restaurants any extra to make up for lost time like I mentioned earlier. So if services spending gets back to its trend line, I think that could elongate that spend-down of the accumulated savings, which means we're not spending that extra that we have saved up. Now, the other side of the equation is debt, right? Now economists will tell you that the consumer has delivered official measures of debt to household income show that that is true, that is the case that consumers are in a much better place today. However, if interest rates continue to rise, then that cushion would fall pretty quickly and all of that consumer, and keep in mind all of that consumer deleveraging that took place since the 2008 financial crisis came during a falling interest rate environment. And we're in a very different interest rate environment today.

Matt Orton:
Right. And so, building on that too, we can't really talk about the consumer without hitting on housing, which also is very impacted by interest rates. You're based in Canada. I'm based in Florida. I think we've seen ground zero for some of the biggest home price increases. So if you've got the combination of the Fed hiking interest rates increasing along with strong price appreciation has pushing affordability to the worst levels that we've really seen since the housing crisis. Now, I guess the most obvious question to ask is whether that coupling of higher rates and rising prices will impact home buyers and or home builders in the near to intermediate term. And could there maybe be some beneficiaries from that inflation that we're seeing in the housing market?

Jason Richey:
Yeah, I think you've highlighted a risk for sure. If you're looking for one, this is one of those areas that I do worry about. Affordability is bad because mortgage rates are at 13-year highs and we haven't quite doubled the 30-year mortgage rate in the U.S. at least. It was pretty close and we did that in less than a year. Now, if you look at home prices year over year, they’re still rising. But I think that's pretty certain to slow over the next six months. It's actually a bit interesting. There's been a trend for economists to look at month-over-month data because of the year-over-year headline data that we all read about in the newspapers has been so corrupted for a couple of years now, by the pandemic and interest rates and stimulus of all sorts, which it's really a tradeoff, right? Because we always talk about looking at smoothed averages rather than looking at any individual data point to try to identify trends. And, but this is just sort of where we're at right now.

So if you go back and look at housing price data month to month, prices look to be close to peaking. And we know that the housing market punches above its weight in terms of its importance to the economy, and of course all the associated feed through. So this is certainly an area we're watching. Now, if you wanted a positive data point, the housing stock, meaning the housing inventory, it's actually so low that we could certainly take a lot of the demand off of the table via higher interest rates, a higher mortgage rates, and still have a relatively healthy housing market.

Now, again, the concern is that this is just a very psychological area for consumers since it's our biggest asset. There's obviously a ton of leverage in a house purchase. So mortgage rates going up 200 basis points from, say, 3% to 5% means a lot more when you do the math on affordability compared to 30-year mortgage rates going from 5% to 7%. So look, best case is the housing prices sort of largely level off for a few years. But I do think that mortgage rates can't go a whole lot higher from here without some level of harm to consumer psychology.

Matt Orton:
Now, I think that's a great point. And one other question I want to ask you on this, because I hear this a lot from some of our clients is a question of whether we're heading into a bubble like we had in 2006, 2007. I want to get your thoughts on that as well.

Jason Richey:
Yeah. So a bubble perspective, it's interesting. We did a podcast together a year ago or so talking about bubbles in various asset classes. And I think a lot of those I'll call them niche asset classes, the bubble has been slowly released. The biggest bubble that you could argue about was the fixed income market. And that had been one building for years. And most strategists got that wrong every year by calling for higher interest rates for five or seven or sometimes 10 years, and then all the higher interest rates finally happened.

And so if you could somehow have avoided the biggest bubble, which is effectively in Treasuries and some argue a bit more from here, but I think yields are back now to the levels where we can say they're somewhat close to stable. Hopefully, if we see yields do a doubling from here, we do have real problems. But if you argue that some of this steam has been let out of the Treasury market and interest rates in general, then combined with all the niche asset classes, there has been a lot of steam taken out a lot of those bubbles that we discussed a year ago.

Matt Orton:
Yeah, well, that's helpful perspective. And Jason, I kind of want to broaden out the conversation now too, from just looking at the U.S. to other asset classes, since you do invest both globally and across the asset class spectrum. So in the inflationary drivers in the U.S. and overseas, I would argue, have been quite different where the U.S. is maybe more rooted in wages and strong demand while overseas, you're seeing much more of a supply problem with labor starting to creep into the equation. International markets, given what's happening in Russia and Ukraine and some of the economic issues, have held up fairly well year to date actually. Do you think there's room from international developed and or emerging markets to fall further, or do you think we've seen the worst? And then if inflation accelerates overseas, how would that impact your investment outlook?

Jason Richey:
Right. And from a return perspective, by the way, if you believe at all in mean reversion you'd think it's time for international stocks to start pulling their weight since we've basically had 15 years of U.S. outperformance versus the rest of the world as a basket. So for last year as a whole 2021 offered the biggest disparity in performance in the history of the MSCI ACWI ex US Index when compared to U.S. stocks, meaning when you compare it to the S&P 500 index. Now anytime you have at least for us something that's that extreme, or that has never happened before, you have to take it into account, you have to pay attention to it when constructing portfolios. And of course, right on cue as you mentioned, international stocks were outperforming domestic stocks, pretty noticeably at the beginning of 2022, right up until the war in late February.

And then things turned, which makes sense, given war is right on Europe's doorstep. So it depends on your timeframe. On a year-to-date basis international looks like it's holding up fine, but since February, the U.S. has pretty meaningfully outperformed. But in terms of economic outlook from here, I think your summary is accurate. It looks like U.S. inflation is stickier because it's tied to demand, because it's tied to wage inflation, and you can see that in the central bank activity, you can see that in the dollar’s performance. The U.S. Fed is tightening probably a bit more than the U.K. And we know emerging market central banks are probably closer to going the other direction since they got their tightening out of the way over the past year. So there's certainly inflation overseas, there's inflation globally, but in developed markets, at least they don't have this element of overheated demand to deal with like we have in the U.S.

Matt Orton:
No, I think that's great perspective, Jason. And you'd mentioned the dollar as well and the dollar’s basically at, or near its highest level since March of 2020 at the outbreak of the COVID pandemic. Do you see that as a problem going forward, especially for U.S. companies with international revenue exposure? When do you think that really starts to bite into earnings, or will it significantly bite into earnings?

Jason Richey:
The U.S. dollar: It's both a plus and a minus. On the surface, the argument is that a stronger dollar makes it tougher for exporters to compete. They have to sell their finished products and that the U.S. goods are more expensive because the dollar is more expensive. And by the way, that's China's argument in how they manage their currency because manufacturing and exporting is such an important part of the Chinese economy. Now, on the other hand, if you're a company that imports a lot of raw materials to create your final goods, then a stronger dollar makes those raw materials cheaper and you can buy more of them, right? So I think a stronger dollar is a factor, but it's not one that U.S. companies can't overcome.

I think, the bigger factors are labor costs and borrowing costs. Those are probably bigger issues for multinational S&P 500 companies. And that's of course, where all roads lead back to the Fed. Now the dollar matters for emerging market investors, particularly country by country, based on terms of trade and based on those countries’ debt exposures, which boils down to effectively commodity exporters versus commodity importers, but on the whole, despite the dollar near 20-year highs and all the headlines, the dollar is one of those safe haven assets, especially during geopolitical events. So I think it's hard to see how the dollar falls dramatically from here. Certainly if the Fed stays hawkish and inflation is a bit stickier than we think.

Matt Orton:
Yeah. And Jason, you mentioned emerging markets. I do want to quickly touch on that because given where the dollar is, they're feeling inflation as well, especially given supply chain issues and their sensitivity to energy markets. What's your outlook for emerging markets going forward? Is it investible right now, or is it something that you'd rather sit on the sidelines and wait and see?

Jason Richey:
So we have had minimal exposure to emerging markets for some time. It depends on what you're considering. We always view, again, when you're constructing portfolios and putting together portfolios the way in which we do it, and we're looking at volatility, you have to know that emerging markets as an asset class is one of those higher volatility asset classes. So what does that mean for us? It means that when you're including it as an asset class in portfolios, we tend to look at it as a basket rather than owning individual countries.

So if you look at it as a basket, you get some of the diversification and you can own the basket as a whole. Of course, we know that China is the overwhelming portion of that basket. With a negative view on China, there's just too many headwinds, the real estate bubble there feels very Florida circa-2005 to me and then you throw in COVID and the supply chain and everything else, it's just been an area that you've had to avoid. Now, there's been pockets of emerging markets that have performed quite well, but as a basket, it's been a struggle for them for a number of years at this point.

Matt Orton:
Great. And Jason, I want to bring all of this together now. So as we look forward, and as you mentioned, volatility, you're a manager with downside risk mitigation as a core ethos. So given what we have seen with respect to downside so far this year and bear sentiment at the highest levels, really since the Global Financial Crisis, or even before, where do you see markets finishing the second half of 2022 and going into ‘23?

Jason Richey:
Yeah. So look, we think, again, it depends on if you're in a recession or you're headed towards a recession, or you can push a recession out a bit longer. And that depends on a number of things going our way, but if we're not yet headed towards a recession, which I think is the ultimate conclusion of all this, it's just timing. Then the market bottom, it feels like you're getting down towards market bottoms. And maybe there's some upturn from here. I don't think again, I don't think we get in the green by the end of the year, but I think that just given the market volatility, the market's trying to carve out a bottom here, right? And you can look at volatility levels haven't really spiked. There's a lot of other sentiment indicators. And then the question becomes what types of asset classes are attractive in a year in which, bonds are down double digits and a lot of equities are down double digits?

And that's where it's very tough to find those non-correlated assets. So a couple of areas we've looked at: Gold, I think it's proven its case against bitcoin. We've been researching other inflation-protected assets, agricultural-related equities, just as an example, the energy sector, which probably won't see a ton of capital investment. And then another area where there are plenty of different and popular choices in the ETF market is dividend payers, a little bit different because usually when interest rates rise, dividend stocks aren't great performers, but again, we're in a different environment today. Out of the last 40 years, interest rate rises typically happen during boom times. And this time around, we have interest rates rising in a slowing economic environment.

So I think investors are choosing some of the safety of large caps and taking that dividend while they wait. And then finally, cash. There's some argument whether cash is trash or cash is king with 8% CPI inflation as we open up the podcast. I think we're starting to feel a little bit better about perhaps putting some of that cash into shorter-term Treasuries now that you can get some type of yield, at least from the front end of the curve.

Matt Orton:
All right, Jason. Well, I think we're just about at time, so I greatly appreciate and I'm sure our listeners greatly appreciate all of your insights. It's great to have you back. So thank you very much and thank you to our listeners. And until next time, take care. Thanks for listening to Markets in Focus from Carillon Tower Advisers. Please find additional episodes and market insights at marketsinfocuspodcast.com. You can also subscribe to our podcast on Apple Podcasts, Spotify, or your favorite podcast app. Until next time, I'm Matt Orton.


Disclosures

Podcasts are for informational purposes only. This channel is not monitored by Carillon Tower Advisers. Please visit marketsinfocuspodcast.com for additional disclosure. This material is a general communication being provided for information purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature, or other purpose in any jurisdiction, nor is it a commitment from Carillon Tower Advisers or any of its affiliates to participate in any of the transactions mentioned here in. Any examples used are generic, hypothetical, and for illustration purposes, only. This material does not contain sufficient information to support an investment decision, and you should not rely on it in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and make their own determinations together with their own professionals in those fields.

Any forecasts, figures, opinions, or investment techniques and strategies set out are for information purposes only based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented here in is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or emission is accepted. It should be noted that investment involves risks. The value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements. And investors may not get back the full amount invested.

Both past performance and yield are not reliable indicators of current and future results. Past performance does not guarantee or indicate future results. There's no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investing involves risk and may incur a profit or loss. Investment returns in principle value will fluctuate so that an investor's portfolio when redeemed may be worth more or less than their original cost. Diversification does not ensure a profit or guarantee against loss.

CTA22-0407 Exp. 6/28/2024