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Jack Bailey: Wylie, Gene, thanks for being here with us. The markets seem completely indifferent to everything that’s happening in the news, indifferent to protests, indifferent to viruses, in different to riots and looting, indifferent to high unemployment. What do you make of that gap between market performance and social unrest?
Gene Podkaminer: Markets and the economy don’t often move in lockstep. There are very few times where you’ll see an event and look at its market ramification, and you can point to that and say, aha, that’s why the market is up or down. Instead, the market is like a processing function. It takes all of this different information and puts them into an average. And ultimately that’s what you get, the average of everybody’s sentiment, of everybody’s predictions, and of what everybody thinks may happen in the future and what path that will take. That being said, we probably do need to acknowledge that we’re living in really weird times, not just because we’re not in our offices talking into nice microphones, but because there’s a lot of really gut wrenching things happening around the world and specifically in the US and we need to acknowledge that we’re living in that kind of environment now, and that may be a little bit different from what the market is thinking, of course, but unprecedented, coordinated, bipartisan support from policy makers around the world to try to make this recession as easy to bear as possible. So, we’ve seen that from the Fed [Federal Reserve], from their counterparts, central banks in the UK, in Europe, in China, in Japan, on and on in monetary policy terms.
And, the market really does pick up on that. One of the themes that we believe underlies the current market sentiment is that policymakers, at least for now, have our backs, they’re putting a floor on risk asset price levels. They are supporting investments in equities, in credit and in other parts of the financial economy, the big question is how long does that last? Does that go on for a year, two years, five years? And what happens when that’s over?
Wylie Tollette: Yeah, that’s exactly right. The markets are clearly benefiting from the government stimulus that’s taken place, including, for example, the Fed for the first time ever, buying ETFs—bond ETFs—publicly traded, equity instruments, even though they’re basically backed by a portfolio of bonds, it’s the first time that the fed has ever done that. Uh, so directly supporting markets and indirectly through quantitative easing measures, reducing interest rates, and the fiscal stimulus of the Paycheck Protection Program, loans to small businesses, extended unemployment benefits. So as Gene said, the government is pedal to the metal to try to keep the economy moving through the coronavirus crisis.
I think where our investment committee has started to turn its attention is what happens next and what happens when the government starts to sort of turn down the volume of their supportive policies. Because eventually they’re going to have to. Government policy can’t continue in the same way forever. At least all conventional wisdom indicates that it can’t, eventually the real economy has to step in, provide the economic activity that provides the tax base that eventually pays back a lot of that fiscal stimulus that eventually pays down the balance sheet of the Fed. We don’t know when that’s going to happen, but we know that at some point that has to happen. We want to sort of prepare ourselves for that eventuality.
Gene Podkaminer: And so. Wylie mentions the consumer, as part of his response, which in addition to support from policy makers, the consumer, especially in the US, is really a driver in the economy. And we’ve seen that consumer, certainly hurting and holding back over the last couple months, but you also see some green shoots where spending has really increased over the last couple of weeks. And look, the last couple of weeks don’t necessarily make a trend, but if we are at the very beginnings of a recovery or at least in a trough period, you may start to see the consumer come back with a vengeance. So between the support of policymakers, the adaptability of the consumer, and then also the third leg of the stool here, which is, there’s not much of an alternative to equity markets at this point. When you’re balancing out in a multi-asset portfolio and investment in equities, almost any flavor of equities versus fixed income—so rates or credit or even high yield—the trade to us seems fairly stacked in the direction of equities. There’s more going for us in stocks right now than there necessarily is in fixed income.
Jack Bailey: So, you mentioned the consumer and we have got really high unemployment in the US right now and globally as well. If people don’t have paychecks and don’t have jobs, how does that impact the shape of the economic recovery, as opposed to the market recovery?
Gene Podkaminer: So, there is a great concept in economics called creative destruction. Joseph Schumpeter is the one that coined that term, that every time we go through a crisis or an inflection point, there are parts of the economy that get destroyed, but they also get creatively reinvented. And I understand that there is a human cost to this as well, but right now, I am just focusing on the economics of it.
If you look at some of the sectors that have been the most impacted, you ask yourself, can these be restructured? Should they come back the way that they were before? Should they be reformed or streamlined? Those are the kinds of questions that economists and policymakers, and for that matter, CEOs and leaders are going to be asking themselves everywhere. It’s a question of where do we need folks to put their talents now versus where did we need those talents 10 years ago or 20 years ago? So, I don’t think that the economy will be looking at in five or 10 years is going to look like the one that we’ve had over the last five or 10 years. both COVID-19 and the recession, those crises are catalysts for that change and markets and economies know how to, rebuild themselves again, creatively destroying from those kinds of crises.
Jack Bailey: So, Wylie, I was just going to ask you directly about one of the consequences of all this government intervention. I was an English major, but I did take an econ[omics] class. And one of the things I remember from that class is if, if governments start printing a lot of money, the thing that follows from that is inflation. So, can you share with me a little bit about general expectations for inflation.
Wylie Tollette: The headline is that we expect goods inflation, which is traditionally how most economies measure inflation, to continue to be pretty subdued, actually, because, basically many of us have started to question something called the equation of exchange, which was really the core concept, promulgated by a school of economic theory called the monetarists and monetary theory, which is the idea that, basically, the quantity of money times the price, equals the, kind of, GDP [gross domestic product] times velocity. The MV=PY. Milton Friedman was the famous economist who actually had that on his license plate of his 1967 Cadillac and V= PY. He had a famous statement that says inflation is always and everywhere, a monetary phenomenon, but, you know, what’s interesting, despite all this monetary creation, we’ve seen, velocity, the velocity of money, which is basically how rapidly is money moving through the economy and being sort of multiplied through lending activity and consumer activity. It continues to go down interestingly enough. And so, our one theory is that that very low velocity of money is keeping inflation in goods, subdued. And you know, there’s another theory of inflation, which is basically the Keynesian theory of inflation, and that it’s essentially a supply and demand dynamic that when, when demand exceeds supply, prices go up and when supply exceeds demand, prices go down. I think right now the Keynesian seemed to be winning, where there are a lot of goods in the world. Even though there is a lot of money in the world, there are a lot of goods in the world and aggregate demand globally has not really spiked.
In fact, recessions have a tendency to subdue aggregate demand, which would actually be disinflationary. So I think right now, the odds that, you know, we’re going to see low inflation, possibly even deflation, are higher than they were even a year ago prior to all this money creation, because the economy is going through that restructuring that Gene just talked about. Where I think we have seen inflation is really in asset prices. So, a lot of this money creation rather than inflating the price of gasoline or food, you know, or medicines, for example, it seems to be flowing directly into asset prices. And we have certainly seen that over the last few months in equity markets, we’ve seen bond prices and bond valuations measured by their yields really reach historic lows globally. So, basically a different type of inflation, not the type of inflation measured by the consumer price index, for example, but inflation, nonetheless, just showing up in a different place in our economy.
Jack Bailey: Interesting. And so, Gene, what do you think the shape of the recovery would be? And as you talk about the shape of the recovery, you know, contrast inflation with growth and what that means for future expectations.
Gene Podkaminer: So last time that we talked about the shape of the recovery, we were picking from letters of the alphabet. There was a V, there was a U, an L, maybe a W. If we’re just constrained to Latin characters, probably something like a really deep U, so something that would last a while, ultimately would make, maybe if not a complete recovery, then a fairly full recovery, something that would last maybe three quarters or so, and perhaps, we’re starting to see some of the trough of that now. But still in growth terms, a deep shock, a prolonged and slow recovery.
Over the last month, we and many others have seen some positive and optimistic signs coming out of the economy. And we’ve revised our base case forecast up a tiny bit and taken our bear forecast down a little bit as well. And so that’s part of what’s bringing us to this view that risk assets may actually be a good place to be over the next year, 18 months or so, that the recovery is starting in a couple of different sectors. It may be a false start. We’ll see, but we certainly are looking at some economic data that does not appear terrible, which is nice. In terms of the way that inflation and growth play together, we look at a two by two matrix of growth and inflation, and specifically about how those two metrics are doing versus expectations. And right now, we think there is a better- than-even chance that both growth and inflation are slightly above expectations. So, we give that about a 30% chance. If we’re talking about round numbers here, probably a 25% chance that growth is below expectations, but inflation still above and a 25% chance that both growth and inflation below expectations. So that’s not a very happy place to be. And then rounding that out, roughly a 20% chance that growth would be above expectations and inflation below.
So when you put this altogether, 50-50 chance that growth may be above what current expectations are. And by the way, current expectations are not that high. So, 50-50 chance of growth is above, 50% chance of growth is below, and probably about a 55% chance that inflation is somewhat above expectations. And as Wylie mentioned, those expectations again are very muted, and a 45% chance that inflation is below expectations. And it’s important to consider both of those variables together. Growth on its own doesn’t tell you too much unless you understand what the inflation backdrop is, and inflation on its own can be a good thing or a not so good thing, depending on if it’s being driven by growth, if it’s being driven by demand, as Wylie pointed out, or by supply.
Jack Bailey: So, let’s pivot and talk about issues outside the US. Coming out of this pandemic. I’m very curious about your views on China. Many companies have their manufacturing base in China. It’s a low-cost labor source. Talk to me about COVID-19 as maybe a catalyst for change. Is it causing firms to reevaluate their supply chains?
Wylie Tollette: My initial hypothesis was that there was more news about reshoring than there was actually reshoring; reshoring as describing the phenomenon of companies that had outsourced manufacturing and other activities to other countries, and bringing it back home. And I have to say, I think the jury’s still out on whether there’s more news about reshoring, or whether there’s actually reshoring going on, but I would say that even prior to the coronavirus crisis, two things were happening. Number one, China was, was pivoting to becoming more of a domestic economy. In other words, it was seeing increased domestic demand for a variety of goods across the spectrum from basic staples all the way up to luxury goods produced domestically. So that’s a positive thing for China, and it’s actually a positive thing for the global economy because I think what China had basically been doing, as becoming the world’s factory, is they were actually, potentially, sort of, exporting disinflationary pressure, pressure on wages, pressure on employment globally, particularly lower skilled employment. And so, as that, abates somewhat, I think we could hopefully start to see a bit of a recovery in some of those statistics, in other parts of the globe, certainly in other low-cost countries. I think Vietnam is frequently brought up as a beneficiary of, sort of, China pivoting to becoming more of a domestically driven economy. So the reshoring phenomenon is—like I said—the jury’s still out as to how much of that is real, but I do think that there’s something to it because there’s a few things that we think are going to be lasting effects from this coronavirus.
So, you know, people are going to go back into their offices, but maybe not as many because they’re concerned about contagion on public transport, for example. So maybe we don’t need quite as much office space, but then again, social distancing within offices might offset some of that, but perhaps we don’t need as quite as much downtown office space as we used to. That’s certainly a big factor in many commercial real estate portfolios and something to consider. I also think global supply chains will be looked at, and, where people have had “just in time” inventory, that’s dependent on a global supply chain, I think the coronavirus sort of woke up a lot of people to the risks of that. And I suspect there will be some diversification, so maybe they don’t completely reshore manufacturing, but they begin to think about risk and diversifying their supply chains.
And then, last but not least, another sort of longer-term phenomenon that we’re starting to see emerge is savings—individuals in many countries saving more now than they did prior to this crisis, having experienced a very sharp drop off in income spikes and unemployment, unprecedented spikes in unemployment. I think many people have realized the value of having a bit of their own personal safety net. And so, an increased savings rate amongst a population tends to suppress consumption a bit. So, I think it’s one of the reasons that we could look at that Nike swoosh type of recovery versus, you know, a complete rebound is that I think many people will in fact be saving a little bit more post coronavirus than pre-coronavirus and that will suppress the recovery of GDP longer term.
Jack Bailey: I want to touch on changes that you’ve had in the allocation views within the Multi-Asset Solutions team. It looks like you’ve reduced confidence in emerging market [EM] debt. Also, you have reduced confidence in Europe, regionally, and then increased confidence in investment grade, corporate credit.
Gene Podkaminer: So, let’s take the two fixed income sectors first. EM debt with emerging markets being so susceptible to the shocks from coronavirus and supply chains, being able to access consumers, and in general, being able to deal with the virus impacts on their healthcare system. We feel that emerging markets are probably going to suffer for a little while before they rebound. And it’s also compounded by what’s going on with currencies. Some of the major developed market currencies versus emerging market currencies of course have a really big impact in how EM debt is priced. And so that’s a major consideration in terms of the investment-grade corporate credit increase. If we’re looking at risk assets, and as I mentioned earlier, there is hardly an alternative to equities, but looking at risk assets, we would prefer to start legging into investment grade now oftentimes versus rates. And so, that’s more of a corollary to, we feel okay about equities.
We also feel okay-ish about investment-grade credit for this same reasons. Europe as a region entered into this crisis with a weaker economy, certainly a lot less coordination amongst member states about how to deal pretty much with anything. So very fragmented, and because of their interest-rate environment coming in, they also had less powder to deal with what would happen in a recession. And we were talking about these types of implications well, before coronavirus came around and the recession that it ultimately caused and that’s that Europe was just in a weaker state than some of the other developed market economies, especially in North America. And so some of the reduced confidence in Europe has to do exactly from that. What are the boundary lines for policy? How much can actually get done to support the economies there? How much coordination can be done across States, oftentimes with very differing views on debt. And for these reasons we feel a little bit cool on Europe at the moment.
Wylie Tollette: So, if you think about a 12- to 18-month outlook, I completely agree with Gene, that risk assets are actually reasonably well positioned over that. I think it’s, kind of, more the three- to five-year outlook that I think we’re a little bit more concerned about and keeping our eyes open to the possible risks that may have emerged sort of in that intermediate term, as governments start to retract some of that stimulus activity. That’s really what we’re starting to look through to now and starting to think about preparing for.
Jack Bailey: I want to thank you both for taking the time to be here with me on this podcast today.
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