Perspective

Podcast: Is a regime change imminent?

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Ron Insana:

Good day, everyone. I'm Ron Insana, welcome to this edition of the US Lens. Joining me today to talk about everything that's going on in the world of investments around the world is Adam Farstrup. He is head of multi-asset strategy for the Americas at Schroders and joins us now to take a look at what has been a wild week on Wall Street, and quite frankly, a wild week and series of weeks around the world. Adam, thanks for being with us. Good to have you.

Adam Farstrup:

Good morning, Ron. Thanks for making time for me. I'm looking forward to the conversation. As usual when we get together, there's not much to talk about, so.

Ron Insana:

Yeah, I guess we can leave British politics out of this just in deference, the home office, if you will. Let me just start with where we are. We've seen so much happen, equity revaluations, we've seen over the last several days, bond yields collapse, commodities come down sharply, cryptocurrency is under pressure, global markets still really not indecisive, but certainly confused about the direction of policy. How would you encapsulate what we've seen in the last several weeks?

Adam Farstrup:

So I think what we've seen over the last of couple weeks is you have the markets caught in this cross current between concerns about inflation and normalizing interest rates on the one hand and recession risk on the other. And importantly, this is all said in the context of what we believe is a fundamental regime change where the pressures of inflation are going to be characterized very differently over the next 10 years than what we've seen over the last decade.

Ron Insana:

All right. If you could elaborate on that because what we've experienced over the last decade or even 12 years for that matter has been generally speaking disinflation or inflation that is below central bank targets largely in the west, somewhere below 2% and stubbornly so. Are you suggesting now that inflation will remain elevated, maybe not at current levels, but above where we've been for the last 10, 12 years?

Adam Farstrup:

That's right, Ron. So what we see going forward is the pressures in the global economy, as you've rightly characterized really over the last 20 years have meant that policymakers have been more concerned about creating inflation than battling inflation. And so that's led to load and negative real interest rates. It means that markets have not experienced the kind of macroeconomic cycles to the same degree that you'd see in times where inflation is pressured higher. It means that really markets have been driven by in a way you could characterize it by the microeconomics rather than the macroeconomics. And now what we see is a shift in the environment where we've coming out of the COVID crisis, we've seen policymakers have a very significant rethinking of the resilience of supply chains. We've seen a different approach towards government intervention in different parts of the economy.

Adam Farstrup:

And you also have at the same time, a continued energy transition, complicated by what's happening in Ukraine right now. But that all creates this pulse of more inflationary pressure. Now, I want to be clear, I'm not arguing that we're going back to the 1970s, even though you might be fooled by mustache styles. We're not back in the 1970s here. But we do think that central banks are going to see that inflation runs somewhat above their targets, their neutral targets of around 2%. And that means it's going to be much harder for central banks to cut interest rates to the degree that they did in the past 20 years to support economic growth.

Ron Insana:

It's funny that you mentioned the mustache, there's a New York Yankee that now looks like he played in the 1970s who's one of their lead-off hitters. So it just jarred my memory a little bit, having grown up during that period. But again, unlike the 1970s, I have argued and challenged me if you will, that this is much more like a postwar shock World War II, World War I, where inflation was elevated for a couple of years because of similarly supply chain disruptions. Or if you go back to World War I, the combination of war and plague or pandemic, and there were elevated bouts of inflation bursts of inflation. It actually settled back down rather quickly within one to two years versus the 10 to 15 year experience we had from 1966 to 1981. Is that a fair assessment?

Adam Farstrup:

So I think it's a very difficult assessment to make and to steal a line from Adam Tooze who's a brilliant economist. If you haven't read his pieces, he's termed this as a poly crisis. And what he means by that is we are facing a complex set of crises in the global economy. So you've identified this post-war analogy where you had supply chain disruptions, you add onto it the disruptions that came from the pandemic and battling the pandemic. But we also see challenges coming from de-globalization that haven't been present in the past. We see challenges coming from the energy transition, challenges and opportunities, I should say, coming from the energy transition, which despite the energy crisis that Europe is facing right now, there has been no back away in commitment from European governments over the medium term in pursuing that energy transition.

Adam Farstrup:

And so I do agree with you, Ron, that we will see some of the near term inflationary pressures falling off. And in fact, that's what the market has been reacting to in recent days. You've seen commodity prices coming back, you've seen interest rates coming down over the last week, although seven or eight days ago, we were still at what? 3.1 on the US tenure. So I think the market is really struggling to figure this out and that's leading to this volatility. What I would say is one of the things that you see in more inflationary periods is there's much greater risk of contagion. And so if you think about the cycle that we're talking about, let's just take interest rates coming back as an example, or let's take energy prices coming back as an example, we think there'll be a very quick transmission mechanism whereby if mortgage rates get back close to 5%, I would expect you would see a resurgence in activity in the US housing market.

Adam Farstrup:

And by the way, the US housing market has become quite uneven. So there's still some very strong pockets of demand within the US housing market. And the point of all of this is to say that in this inflationary environment, these price shocks both positive and negative don't happen in isolation, they quickly run through the entire economy, they cross over different sectors. And so that makes this a much more macroeconomic cycle. So to map this out a little bit further, we see inflation coming back off its current peaks sometime in the next several months. So there will be a normalization process where inflation will come down from the current levels, but we think it's more likely to settle above the 2% target that the central banks have. And that means they're going to have to become much more vigilant in how they think about interest rate policy.

Adam Farstrup:

And if I could, you could also think about the analogy to the mid-seventies, even though I said, this isn't the 1970s, the Fed is thinking about the example of the 1970s, because remember what happened is you had a recession starting, I think it was about 1974, and the Fed started cutting interest rates from a very high level down pretty aggressively over the course of 1975. And this was the Arthur Burns Fed and one of the lessons that the Fed took away from that is they missed an opportunity to really nip the structural inflation in the bud in that episode. Right? So they dealt with the recession, but they didn't deal with the long-term inflation pressures. So I think that's in the back of the Fed's head as they think about what do they do from here.

Ron Insana:

Yeah. And this just raises so many questions for me. Now, on one point, Arthur Burns was actually told by President Nixon to cut interest rates, or certainly in prior periods when inflation was starting to percolate, Nixon before he resigned was all over burns, not to raise rates or to cut them. The 74/75 period was interesting in so far as that the economy was running reasonably hot, then inflation fell. We had this stop start policy, as you describe it from the Burns Fed. And while the Fed's cognizant of that today, is it really applicable in an environment where again, that inflation took over 10 years to build to a crescendo versus this one or one and a half year pop that we've seen off the pandemic and deflationary lows of 2020?

Adam Farstrup:

So I agree, it's a different situation, but I think the Fed is very cautious about that. And so this gets us to the path dependency of all of these environments. So if the recession really settles in and I mean more than just a technical recession of two quarters of declining GDP growth or negative GDP growth. What I mean is, do you get a recession where we'd really start to see a reaction in the labor market. Because that's one of the areas that the Fed is watching closely. If that happens this year, the concern is that the Fed is going to be much more reluctant to cut rates this year before they really see sequential signs of inflation coming down.

Adam Farstrup:

And Jay Powell has been very clear about this, that it's not sort of one print or two prints of some lower prices that they need to see. They're very concerned about the signs they had the last couple of months of long-term inflation expectations becoming unanchored. And as a result, they're going to look for a series of data points suggesting to them that actually the long-term inflation expectations are anchored and that it's well controlled in the economy.

Ron Insana:

Adam don't we already have that? I mean, when you look at forward inflation indicators, like the break-evens, the five year break even has fallen a hundred basis points. The 10 year break even has fallen 60 basis points. As you mentioned earlier, commodity prices certainly appear to have rolled over many are down as much as 30% or more from their most recent highs yield. On the 10 year note in the US has gone from nearly 350 to two and three quarters percent on this morning, July 6th, which is a 75 basis point drop, yield curve is flat, although not inverted in the sense that it would be forecasting a recession. And we've seen housing slow equities come in, risk assets have collapsed in the more speculative areas of the market. Is it possible that Fed doesn't need to cut, but maybe just needs to stop and reassess?

Adam Farstrup:

So I think it's very likely that they stop and reassess as we get later in the year. I don't think they're ready to stop yet. They're still well below the neutral rate. So again, this is the challenge where the market has been used to a very different reaction function from the Fed. And I think that's why you see this volatility and some degree of confusion in pricing in the market. And so we're looking past the purely market driven signals, many of which you've just highlighted to the underlying economic signals. So the labor market is still incredibly tight. Yes, there are sectors of the market where we're starting to see layoffs. Do you think that airlines are going to lay anyone offs anytime soon? It doesn't look very likely. In fact, even if they are hit with a substantial slowdown, they're behind the curve in terms of their employees.

Adam Farstrup:

So we see these pockets of demand in the economy that make it much harder for the Fed to become more accommodative. And we don't think they want to pause before they get to a neutral policy rate. So we do think that you're going to continue to see tightening as we head through the summer here, as we head into the fall, the Fed will start to look and see, can I pause? And I think the real debate and the real question is what happens from there? Are they able to simply pause and engineer that soft landing? Or are these inflationary pressures still substantial enough that they feel a need to keep things to go past that with respect to policy?

Ron Insana:

As it relates to what you just described as labor shortages acutely seen, for instance, in the airline industry. No matter what the Fed does, even if it were to raise interest rates to 10%, they cannot print more pilots, they cannot print more people, they can't print ground crew, they can't print staff. They can't do anything to increase the size of the labor force when we have nearly two open jobs for every unemployed person in the United States. And this is true in other countries as well. They can't print computer chips, they can't make more cars, they can't make more homes. How does their policy solve these shortages that are actually putting upward pressure on prices as well?

Adam Farstrup:

Well, I think you've highlighted the point that Fed policy or any central bank policy is a very blunt instrument. So what they can do is they can slow aggregate demand, which ultimately creates some slack in the economy. And then the economy will have to reallocate that slack to the places where that the shortages continued to exist. And I think you've in some ways encapsulated the very challenge that the Fed has right now, these are no longer one off isolated pressures on the Fed. They have to deal with the aggregate demand and then the economy and industry will have to rebalance within that declining aggregate demand.

Ron Insana:

All right. So against that backdrop, it's not very easy to make investment decisions as that transition takes place. So Adam, with respect to what investors should be looking out for, what's your perspective on that?

Adam Farstrup:

What we're seeing right now is we remain cautious about equities. We think that there's further to go in the downturn in equities, we've seen some re-rating of equities, but you really haven't seen the cut in earnings expectations yet in the market. So as we head into earning season, it wouldn't surprise us to see companies kitchen sink their earnings a little bit this quarter to use a technical term. But the point is we think there's further for earnings expectations to be cut and further for equities to re-rate as we get concerned about that economic slowdown, and we would urge investors to remain cautious regarding equities in that respect, particularly the US and Europe. We also really see a neutral position in duration or government bonds at this point. So think about interest rate sensitivity. It bounces around a little bit because really thinking about that view, we were talking about that view when interest rates were on the US tenure at 3.1, having backed off to about 2.8 this week, that makes government bonds more expensive.

Adam Farstrup:

Yet again, as interest rates come back up, I think investors should think very carefully about the role of those government bonds in their portfolio, because you're going to see some price destruction as interest rates go up from here in terms of those government bonds. Although as you approach 3.25 to 3.5 on the US tenure, they start to become much more attractive again, in terms of a hedge in portfolios. Within the commodities market commodities, having done very well over the last 12 months, having been a very important inflation hedge, and we think they retain over the medium term a very attractive role in client's portfolios because they help clients protect themselves against these inflation shocks that you and I, or this inflationary environment, rather that you and I have been talking about. However, in the very near term, you've seen such a sharp move in commodities.

Adam Farstrup:

We've seen them backing off as energy prices, particularly oil prices have come back. We've seen food prices come back. In the near term we do think you could see some pullback in commodities that may create opportunities for investors who hadn't gotten into commodities over the last year to add these into their portfolios as they think about some of those inflation pressures going forward. And then turning to some of the opportunities that we see, one of the areas that we do see opportunities within the equity market is really on the Asian access. So we do like China here. We think that the market has clearly re-rated in terms of valuation and while the risks of the Chinese government's zero COVID policy are not completely past us in terms of the economic risks, what we do see is a gradual loosening of that policy, and we have seen in industrial activity figures, a sharp rebound in industrial activity in China in recent weeks.

Adam Farstrup:

And the Chinese central bank really looking to support the economy rather than trying to tighten to deal with inflation. So we see a very supportive environment in China. Equally, we think Japan looks interesting at these levels. So clearly there's a challenge around the Yen and a challenge that the market might test the bank of Japan around the Yen, but the bank of Japan welcomes this inflationary environment. And we've seen some pretty interesting activity around the Japanese equity market in recent weeks.

Ron Insana:

Yeah, there's something going on in the world that may have collateral impact on other markets, on other parts of the world. And may even in fact, to a certain extent, pose some risk for external economies outside the United States, whether they're emerging market and that is the extraordinary strength of the dollar, which is challenging. Now, the highs that we saw in 2000, 2002, almost back to the levels, not quite, but almost back to the levels in 1985 that prompted the then group of five industrialized nations to devalue the dollar in coordinated terms. What do you make of this strength of the dollar its persistence and how it affects, I should say markets outside the United States?

Adam Farstrup:

So I think it's been an interesting challenge because we have been dollar bowls for some time now, and we retain a pretty constructive view on the dollar, because we do think in the near term, all of these pressures that we've described, where you have a Fed who's focused on price stability, who's focused on normalizing interest rates has in many ways, been more aggressive than you've seen other central banks, particularly in the developed world. Clearly there're questions about the ECB and their policy, and the ECB is unpredictable in that way. We think we're closer to the end of the dollar strength versus say the Euro than maybe some other currencies, because the ECB does need to tackle their price and energy crisis.

Adam Farstrup:

It's confusing for them because they struggle with the periphery and keeping yields on the peripheral markets like Italy and Spain contained relative to the core countries like Germany and France. But the ECB is trying to get back and caught up to the curve as it were. So we think the Euro is closer to its bottom than to the top. But in Asia, we don't think that China is that eager to intervene in their currency markets. They think it's an advantage at the moment to have a weaker economy as they try to reinflate their economy.

Ron Insana:

All right, on that note, and on my pending trip to Lake Coleman, Italy, where I hope the Euro and dollar go to parody, we will leave it. Adam, always a pleasure to talk to you. Adam Farstrup who heads multi-asset strategy in the Americas Schroders joining us today to talk about the world at large. I'm Ron Insana. Thanks for joining us for this edition of US Lens.


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