Animal Spirits Podcast - Talk Your Book: Is the Fed too entrenched?

Episode Date: October 23, 2020

On today's Talk Your Book, Michael and Ben speak with Marvin Loh of State Street Global Markets about all things related to interest rates, the federal reserve, and inflation. Find complete shownotes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Like us on Facebook And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben work for Redholt's wealth management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions, are subject to change based on market and other conditions and factors, and do not reflect the opinion of Renthal's wealth management, state street global markets, and or State Street Corporation on its affiliates. This podcast is for informational purposes only and should not be relied

plan for investment decisions. Clients of rentals, wealth management may maintain positions and the securities discussed in this podcast. We're rejoined today by Marvin Lowe, senior global macro strategist at State Street Global Markets. Marvin, thank you for coming back on with us. Great. Thanks for having me. So let's start here. Is it surprising to you that inflation remains relatively muted in spite of all the spending from the government that we've seen in the first half of the year? I guess I would say not really, not that I'm a sage in this, but ultimately we've had a collapse in demand like we've never seen before. And really the amount of government spending was to keep things going on. Mission accomplished to a certain degree because we were more worried

about deflation. Certainly in March and April, there were views that we were going to have deflation for the next couple of years. But we're back to normal. And now we really are trying to figure out the path as to whether or not we're going to go higher or if it's going to be much like we've seen over the last couple of years. Michael and I were just debating this morning. Does this feel to you like we're having a complete C change where this type of spending is going to be the norm going forward and downturns? Or do you view this as more of a one-off thing? I mean, I think from the monetary side of things, we've heard from various folks at the Fed that the Treasury market has gotten so big that they're going to need to be involved just to make sure that the market

functions. So from a monetary perspective, unfortunately, I think they're with us for the long haul. In terms of fiscal, it's the wins in Washington, certainly depending on who wins this time around and how Congress is set up. We'll be talking about a certain set of circumstances for the next four years, but that does wax and wane. So I wouldn't be convinced that fiscal is going to be part of the equation for the rest of our lives, if you will. So that's kind of where we landed.

I said to Ben that because this was an exogenous shock, that was nobody's fault, there was no fingers to point, really, that people on both sides of the aisle, so we have to do this, we have no choice. But if it was just a garden variety of recession, I don't know that there would be the political will to get this spending. If it was just, you know, if GDP didn't collapse by a third, if it went down by four or five percent, I don't know that that would happen. Oh, and then furthermore, Ben actually had an interesting idea. What if there were some guidelines, say, for example, if unemployment hits 8 percent, then the spending automatically kicks in, something like that. Do you think that something like that is ever possible?

I think it's how Washington is ultimately comprised. I would think 8% unemployment is significant enough of an issue that Washington would take note. Having said that, you've got unemployment program set at the state level that's supposed to be that safety net, if you will. And you certainly don't want Washington to need to debate this when we kind of get to those levels. I don't think the political will ultimately exist for that to be formalized. Washington very much plays not only for the world that exists now, but the world that they might be dealing with in the next four years, eight years, or in certain instances with some of the politicians in the next 25 years. If we've learned anything in this crisis is that the rules-based stuff, especially when it

comes to different levels of government spending, there's no line in the sand. People have been talking about government debt for years. I think that's one of the reasons it makes inflation so hard to predict, because we just don't know what the different levers being pulled, what they actually do. Why is it so hard to predict? And what would you be looking for to understand that maybe it's actually finally happening at some point. Inflation is an incredibly challenging number, single number, if you will, to certainly come up with. Remember that it's not only a function of what we're looking at now, but what consumers expect. Certainly, we can look at what various prices cost, and we could put them in a basket,

and we can come up with an inflation number. You can have a big discussion as to whether or not you're measuring the correct things, which certainly is something that has been debated for a while and probably is more important now, because what we've found is that consumers are buying different things now than they had before March, a COVID basket, if you will. Whether or not that COVID basket continues as the world moves towards normalization will certainly drive the construction of the basket. We've done a bit of work with some of the academic partners that we have here at State Street and they've looked at the COVID basket and the deflationary function in March and April was much less than we saw for the official

data and it bounced back much more quickly. But even more important, particularly with trying to to predict inflation is that inflation is very much about expectations also. Consumers have gotten so used to no inflation that it affects their spending patterns. If they start to go to the store and they see that prices are rising, they might feel the need to buy now rather than wait. There never really has been over the course of the last five years, a reason to rush out and buy things because we could find it at the same price for the most part or potentially cheaper. So putting all those together really makes the whole aspect of trying to predict inflation, very challenging. I don't remember if I asked you this last time, but I was reading a book

called The Great Inflation on Its Aftermath by Robert Samuelson, I believe. Ben, is that the right guy's name? Sounds right, yeah. And he said something that I thought was kind of obvious, but I never really thought about it until I read it. Correct me if I'm wrong. Typically, economists measure inflation year over year, but when you're talking about inflation, don't you compare it sequentially? So when you're thinking about how much things cost, you don't say, oh, last year, milk costs too. dollars and now it's 275, you think, no, what did milk cost two months ago? So why do we measure inflation year over year instead of sequentially? The headline number certainly is year over year. Data is certainly produced on a monthly basis. The real inflation traders, if you

will, people who are kind of diving into the detail, they're looking at month over month data. And there's a lot of seasonality associated with that too. September winds up being a lower inflation month when it comes to clothing because there are school impacts, that impact August when people are getting ready to go back to school, and then they're getting ready for kind of the sales, if you will. So I buy all my VNX in August. You've got a great one on right now. We focus a lot on the U.S., obviously, when it comes to the inflation front.

How do things look in the rest of the world? Obviously, we hear a lot about demographics being poor in some places, but maybe a little better in emerging markets. How do things look at any inflation front developed foreign versus emerging markets, that sort of thing? It's a pretty similar story for the better part of the developed world, if you will. We worry, and the Fed worries about inflation kind of returning back to this one and a half, 1.6 percent PCE level.

That sounds great if you're at the ECB where they're struggling with inflation much closer to zero and really the concern about deflation is creeping back into their story. Japan, that's been a story that was well documented at this point. The emerging markets are different. They are actually seeing inflation come back. And given what we've been through this year, come back pretty strong. The weaker currency is certainly driving some inflation in those markets. It's made kind of investing in the emerging markets, particularly on the sovereign side of things,

a bit challenging just because inflation erodes that kind of fixed interest that you might be getting from those developing market bonds. And certainly it's taking off some of the rate cuts that might want to approach because they're worried about inflation again. That's something I wanted to get into later, but might as well talk about it now. So people looking for yield anywhere comparing the yields and maybe not always the risks, but you see an emerging market bond fund that might have a higher yield than you're getting in anything close to approaching treasuries. What are some of those other risks that people need to be concerned about when going out on the sovereign fund in terms of developing countries? The risk profile is much different than it is within the developed world.

Default risk certainly is something that we've seen in various countries over the course of the last several years. And you kind of go over decades. There are many countries that have defaulted. And then you've got the currency risk, which certainly erodes the amount of your return. Inflation generally will have a direct impact on that currency. So countries that have higher inflation are going to see their currency decline. And you're getting paid in whatever that foreign currency is. And when you convert it back, it's going to be less. So there are ways around it.

You could either hedge that currency exposure. It costs some money to hedge it. A lot of countries also issue debt in hard currencies. So a lot of Latin American countries will issue dollars to nominate the debt. You could certainly go into that market and take some of that risk off the table. And we have seen those hard currency bonds outperform local currency bonds so far this year. It's hard to believe the Greece 10-year was yielding 17% in 2015. Now it's 80 basis points, which seems hard to believe.

Man, Corzine was definitely not wrong just early. That's going to go down there along with buying the 30-year bond back in the 80s when it was 18 or 19% and kind of holding onto that. The power of monetary policy reached real to a certain degree. the power of monetary policy, the ECB being a little bit more aggressive and a little bit more lax in what bonds it buys. And that reach for yield is really strong around the world, particularly with everyone at the zero lower bound. You talked about the fact that the Fed is becoming so in your time with markets that it's going to be hard for them to pull back a little bit. Do you think that they run the risk of becoming too entrenched? So I come to think of a lot of the stuff that

happens in 2009. A lot of it was psychological. Obviously, the Fed was in there and they were buying debt markets, and I think they probably did a lot more this year to help the credit markets function. But a lot of what happens comes from just stuff that they say, that they have the credit markets back. Do you think that those psychological effects could eventually wear off? Investors just become used to the Fed being part of the markets, and it doesn't have the same impact going forward. Are we not completely reliant on them at this point? That's what I was going to say. I bet I could hear people roll their eyes and say, what do you mean one of the risk of being entrenched? If you look at the numbers, didn't the Fed not actually

buy as many corporate or high-yield bonds as they thought it was more than just they said they would? Yeah, most certainly for a lot of the programs that they set up winds up being more of a backstop. They haven't needed to given how much liquidity that they put in the market. But that backstop is there. And if it's not, the markets are going to react to it. So we did hear from some Fed speakers last week who talked about again, as I mentioned, just how big the treasury market has gotten and how they might be in this game just to make sure that the market functions. I had a conversation with my boss and we lamented. Remember when

the free market was ultimately out there and kind of determined prices? They're an ingrained part of the market, whether it's treasuries or whether it's to be there when volatility gets to a point where the markets don't function as well as they should. And you've seen how quickly they rush into it. Certainly what we saw this year is unique, different and let's hope we don't see something like this again. But the longer they're involved in it, these periods of stress wind up, I think, becoming more accentuated the way we've seen it over the course of the last couple of years. Why do you think that is? I want to pull on that thread a little bit more. Why do we think that their involvement of the market is causing the periods of rising volatility?

Certainly with yields the way they are. Your show has delved deeply into risk taking and the reach for yield and leverage associated with it. They set up an environment where you have to do that to generate returns. Let's talk about that for a second. So how does that, their policy push investors farther out onto the risk spectrum. I used to think that it was sort of investors doing this subconsciously. But now, again, with rates at zero, it feels like people need an answer. Bonds, just, what are you going to do? So how are they explicitly encouraging more risk taking? Remember that we're having this conversation in a backdrop, which has existed for the last several years, if it's not a little bit more acute now, where we've got kind of this new

normal growth. The new technology, if you will, is not there. There's not a sector that is ultimately proving the leadership that can kind of pull the broader economy upwards. We're still talking about sub two percent growth, if you will. And when you've got low interest rates the way they are, because they need to, to keep that growth story going to a certain degree, you push investors out the spectrum. You get them reaching for yield and you get them ultimately going further around on the duration curve, whether it's a corporate duration curve from an equity perspective or the normal duration curve when it comes to the bond markets. Question, though, do you think it's normal or not so surprising that a $20 trillion

economy is not growing as quickly as when it was much smaller? Like, our economy is enormous, and in aggregate, maybe the growth isn't spectacular, but there's definitely pockets of explosive growth. Yeah. Do you think the Fed is responsible for this? I think it's a little bit too much. I mean, monetary policy deals with the demographics and kind of the evolution of the economy as it's presented to them.

They certainly have been very aggressive in getting involved when there's been financial stress and financial volatility. I can argue that they should let the markets be a little bit more volatile in that type of environment, but we're really at a point now where the leverage, the rates, and kind of the reliance on them to be a backstop is one where particularly given the economic backdrop now, they're just going to remain involved in it because of that. Obviously, I agree with you the fact that people are pushed out on the risk curve and you're just going to have to learn to accept some form of volatility to earn anything on your capital

the way the rates are. You're going to be basically losing money into inflation. Does it surprise you that money is still pouring into fixed income mutual funds then? The fund flows show that? Or do you think that that's just a fact of demographics and baby boomers that are retiring have to diversify somehow? Because it seems like that demand is still there for fixed income funds, even with the rates so low. I mean, income is still part of the equation. Certainly the demographics support and confirm the need for that income. I think as we get through maybe some of the unknowns in terms of how the economy is going to come back, there might be more movement into credit. There might be more movement into emerging markets, but you're still going to need income. And I think that's what you're seeing in the bond market. There's a diversification factor associated with it also. Treasuries don't provide, let's say, the historical diversification that they have in the past, but they will lower the risk on your portfolio. And the

two of you have talked about what your comfort level is with your listeners often. And part of that is the comfort level. Yeah. I mean, Jason Zweig spoke about this. Listen, we can't manufacture rates where they don't exist, yield to where it doesn't exist. You have a choice. You accept low returns from your bonds or you go reach for return and you might get it. You might not. And not to belabor the point about the Fed and the potential danger that they're creating, but I think people that see all the leverage in the system and all the debt that was issued in the third quarter, we were just talking about this and there's a lot of it. I guess the fear is that because rates are so low, because the Fed is putting them to zero, that borrowing has become so cheap even for crappy companies

and it's not an if, it's a when this all goes cabloy, then what? How realistic are those concerns? I guess the fear is that if and when rates rise, it's all going to come crashing down. Do you think that's hyperbolic? Do you think that's legit? What do you think about that? I think it's hyperbole to think that all of the corporate credit is going to just, just go deep six at the same time. My bigger concern is that you wind up creating zombie companies which have an effect on the economy, which really misallocates resources. So you wind up with a zombie company, if you will. I use examples around some of the department stores that have been on their last breath for the last 10 years. They just want to sell anything as cheaply as possible

because they're not putting money back into their plant. And that keeps inflation low. It really is a misallocation of resources, and it kind of makes this slower growth story become much more ingrained. And we're creating a lot of zombie companies when you kind of look at the amount of corporate debt that's being issued, even on the high yield side of things since March, if you will, record amounts of both corporate investment grade and high yield. And to a degree, some of that is going to companies that probably should not be around. Hey, speaking of which, how is Barnes & Noble still around? How did this not just seal their fate? I didn't know they were still around.

I had thought that they were going through some restructuring issues. I'm sure they got restructured and that winds up being one of the things. You wind up restructuring these companies rather than liquidating them. Okay. So let's talk about these zombie companies that people get very concerned about. Let's just say that there are zombie companies and that these companies, if not for the Fed's actions, they would be gone. Who is that really hurting? And aren't these just a pimple?

Isn't it such a small part of the overall economy of these zombie companies? it's tough to define exactly what it is. Some of the more widely used measures are when EBITDA doesn't cover interest for three years or so, if you will. I've seen recent numbers where that number is as big as 15% of the economy, so it's not that small. It does suppress prices. It sends capital resources potentially to the wrong part of the world. An interesting statistic that I had looked at is Chapter 11 versus Chapter 7 filings. If you don't follow those, 7 is restructuring, 11 is liquidation. The ratio of 7 to 11 is at a level that we've never seen. Actually, it's higher than what we saw during the crisis. So there's so much capital out there effectively that everyone's able

to restructure. Everyone's able to keep that last breath going. We're going to need a chart of that because that would definitely go viral on Permabair Fintwit for sure. Yeah, what? And actually, Chapter 7 companies have done amazing because I think Robin Hood's like the new Fed. We're buying these companies up. I do think that the low inflation, low rate thing is showing in the stock market too. You're talking about the zombie companies, but also I think it's increasing the valuations of these companies that are doing well in growth companies. So you're seeing, I've looked at this where value stocks tend to do better when there's a little bit of inflation and maybe higher rates in growth, obviously because there are such low rates that people are willing to pay up for growth.

People have been trying to figure out, like, what's a catalyst for value to actually come back and do well? Do you think it is as simple as that where we need higher rates and maybe some inflation, or is there other stuff that could happen that would cause the value growth thing to finally flip? I think you need a real sustainable reflationary impulse, and that's why kind of this fiscal discussion is so important. Is a blue wave in Washington really a systemic change in infrastructure investment to a certain degree in a reallocation of resources, how popular or not that is, that that will depend certainly on the listener. But you need that type of inflation. You need that type of higher rates that's being driven by an environment that is really seeing kind of that

reflationary impulse. Otherwise, it just winds up being short-lived. And I think kind of the longer duration, low-yield story kind of comes back to the front. Do you see the bond market reacting at all to the numbers of the polls that we're seeing on the election side? I mean, the 10 years is firming up. I can't believe I'm saying firming up at 76 basis points. Yeah, it's keeping in perspective, right? Yeah. What do you think is going on with the dynamics between the markets, specifically the fixed income markets and the election? I think there is a reaction. I don't necessarily think it's the reaction that a lot of people presume. We've had a moderate increase in yields. Like you said, seven basis points is what rates guys get excited about these days. And you've had a slight steepening of

the yield curve once again within perspective. So that certainly fits within kind of the construct of blue wave coming, higher yields, steeper yield curve, reflation. But it really hasn't been that big of a move. And I think instead it is reacting to the polls, but it's reacting to the polls from the perspective that we might be taking some of the risk that we're going to have a really messy November coming off the table, if you will. So the wider the lead is for Biden, I believe, makes the potential for really messy contested elections less. And you could take the risk premium out of that. There certainly is some view that Biden presidency will try to be more fiscally loose and historically Democrats have spent more particularly when it is a blue wave.

but I don't think the move that we've seen really reflects that. So if you do get a blue wave, where the Senate flips and where Biden wins, I do think that you can get much more of a reaction from the market at that point. And do you think that the Fed has enough ammo to just keep rates low in that situation? Even if we have some inflation come up, do you think the Fed is going to care? Obviously, they said they're going to let things run a little bit. Could they just keep rolling this stuff over in the short term, keep their short term rates low if they're not that concerned about inflation and potentially cap interest rates. Do they have that ability? I think they do. I think they do. I think they still have a balance sheet that can be

leveraged fairly significantly. There remains like you've seen. And we at State Street were able to look at the data within our flows and positioning. And we recently wrote about it in a piece that just came out quarterly where demand for the short end of the treasury curve is still there. And it kind of fits within the bond funds discussion that we just had in terms of how much money is flowing into the market. So the short end is pretty well anchored. I think there is a demand for that safety, if you will. The longer end becomes a little bit more of a challenge, but the Fed kind of pivots to buying more long end securities, which I think is something that they're going to need to do, particularly if Treasury issues a lot more to fund a variety of

stimulus programs, et cetera, but they do have room to keep yields somewhat within a range, if you will. And it's not the short end that I worry about at this point. What do you mean? And based on the demand dynamics, and you mentioned it certainly in the amount of money that bond funds are getting, demand for the short end remains. And it really is with Treasury pivoting to issuing more long data paper that the Fed's probably going to need to get involved. And I expect them to ultimately twist out and start buying a proportionately more amount of longer date securities than they have up to now. Do you think that cash is now or should be considered more of an asset class now? Because we have such a narrow range. between long-dated paper and cash. And cash effectively gives you a hedge if rates ever do rise. I mean, even if whatever, rates rule is 1% from here across the board. They're still really low by historical standards. And cash protects you from that duration risk. And also the yield isn't that much lower. Is that the way people are going to start thinking in terms of a barbell approach

as opposed to trying to fill in the middle? I think that works for now. And it works for now because inflation isn't really an issue, kind of getting back to how we started this conversation, if inflation does actually start to structurally change and we look at like a north of 2% type inflation, then you lose on that cash. And that winds up being the concern. But from a credit safety type of barbell perspective, cash and gold, they fill that role. And I think investors have been approaching it that way. Powell has spoken recently about wealth inequality, which is something that I don't know has been spoken about by previous Fed chairman. Do you think the Fed policies are causing wealth inequality, contributing to it? Hasn't it always been this way? Hasn't there always

been the haves and the haves knots in this country? Yeah, I do think that monetary policy, whether it's the Fed and or the ECB have contributed to the wealth inequality, with best intentions, the only type of inflation I think that the world has seen over the last 10 years consistently is asset inflation. And that has concentrated the, um, the, the, um, the wealth even more, and it's kind of accentuated the differences associated with it. It's a hard area for the Fed to deal with, no doubt. They're going down a route that potentially is one of the bigger concerns for inflation hawks, ultimately. If you've got the federal government spending more and the Fed saying we want unemployment to get back to three and a half percent before we're

concerned with it, that's when the potential for inflation getting out of control starts to arise. Yeah, so I think one of the things that's so dangerous about that is, yeah, things are all well and good now. But if inflation comes, it's really hard to put that toothpaste back in the tube. Yeah, I do think that it's not going to be as shocking as it has been in prior episodes. And, you know, we have to really go back and think about what it was like in the 70s and maybe early 80s to kind of get that shock, if you will. The economy is a lot different now than it was before. Services are a much larger part of kind of that inflation story than it's ever been. We've got close to 8% unemployment.

The Fed wants to see it get back to three and a half, if you will. I think we're going to have markers around whether or not that service labor inflation is bubbling too quickly before we get there. Before we run, can we just talk quickly about, we spoke earlier about CPI. It's such a broad gauge. Obviously, they need to start somewhere and they need to do something, but it depends on what you're buying, where you live. It's so different.

But can you talk about what areas are we actually seeing inflation? The basket has moved around the way demand has moved around. So used car prices, home and building type of products, fitness gear, things like that. Anybody who's trying to buy weights for their basement knows how hard it is. It took me six months to find a dumbbell set for my basement. Oh, I'm still looking. I'll send you a link. But what's not generating inflation is food services.

What's not generating really a lot of inflation is clothing. There's a lot of employment associated with that also. And it does reflect, once again, the haves and have-nots within this recovery that we're seeing. And when you kind of look at food services, when you look at clothing to a certain degree, there's that service component that's associated with it. And that's where the challenges right now for an economy that is very much service-related. So the inflation concern isn't there. We are seeing a bit of normalization around maybe some of the products that people have been looking to get that's now being restopped. But really is that service part of the discussion that needs to drive inflation higher.

Here's a question for you, though. Do you think it would be healthier long term if we have, let's say, five or ten years from now, if we have higher inflation or deflation? Don't you think even though inflation is a risk, we would rather have that scenario? Yeah, absolutely. It's hard to get back from a deflationary spiral. And ultimately, that's why the Fed kind of picked 2%, because it's close enough down to an area where you start talking about deflation if you go lower. And they're really, really concerned with that. Yes. And remember, inflation does help. It drives wages higher to a certain degree. it's a healthy aspect of an economy that continues, that should continue to grow. Marvin, thanks again for coming on. We appreciate it. We'll look to some of your pieces in the show notes. We appreciate having it on again. Thanks a lot.

Always happy to be here.