Animal Spirits Podcast - Talk Your Book: The Carrying Cost of Crazy

Episode Date: March 13, 2023

On today's show, we are joined by Dr. David Kelly, Chief Global Strategist and Head of the Global Market Insights Strategy Team for J.P. Morgan Asset Management about the SVB drama, interest rates moving forward, a slowdown of consumer spending, and much more!   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.      (Wealthcast Media, an affiliate of Ritholtz Wealth Management, received compensation from the sponsor of this advertisement. Inclusion of such advertisements does not constitute or imply endorsement, sponsorship or recommendation thereof, or any affiliation therewith, by the Content Creator or by Ritholtz Wealth Management or any of its employees. Investments in securities involve the risk of loss. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. The information provided on this website (including any information that may be accessed through this website) is not directed at any investor or category of investors and is provided solely as general information.)  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 Carlson work for Ritt Holt's wealth management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Rit Holt's wealth management. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Rithold's wealth management may maintain position. and the Securities Discussed in this podcast. On today's show, in the words of brave results, we had an extra special guest, correct?

Dr. David Kelly, who is the chief global strategist for J.P. Morgan Ascent Management, and we put this in place probably a month ago maybe. We set this date in time, and the timing worked out just perfectly. This was like the best market timing that we've had because so much happened this week. We were recording this on Friday, March 10th. I think this is going to run on Monday, So the timing was perfect. We got it in after Silicon Valley Bank had basically gone under and been taken into receivership, whatever you would call it. We asked him about that.

We asked him about the Fed, about inflation, stocks, bonds. And you and I were excited for this one. Very excited. And he delivered. We didn't cover the dollar. We didn't cover global trade. But we spoke about what do you want to hear about. The labor market, the Fed, stocks versus bonds.

I mean, this was meaty. How long did this go, Ben? It wasn't that long. There's a dense. No, we still hit it all. The stuff on Silicon Valley Bank, he was very level-headed about it, I thought. He said, listen, I'm not a bank expert, but I think his point about the name of the bank itself kind of shows you maybe what happened here.

And I know people are going to see bank failure and start running for the hills potentially and getting really worried. And maybe there is more contagion here. But this also does feel to me like this is something that is tech sector related. and that the tech sector is something that continues to get hammered hard. And I'm not so sure that this necessarily has to go to the rest of the economy. We shall see. I'm a little worried.

I think that this is bigger than the tech sector. A lack of confidence is a very scary thing. And the run on this bank happened in two days. I'm definitely not suggesting that this is going to spill over, that there's going to be run on other banks. But I think it's bigger than that. It's a loss of confidence. It's a tangible crack in the market that the Fed has caused. It's troublesome. We'll get through this.

It's sometimes difficult to predict what the psychological implications are going to be from something like this. I agree. I don't want to underestimate the real impact that this is going to have. To your point, I'm saying sometimes even if this is sort of contained to this one bank and this one group of depositors or whatever, to your point of the dominoes of the psychology behind it, that might not matter, even if it is contained. Enough about us. Here is our conversation with Dr. David Kelly from JP Morgan Asset Management. we are joined today by Dr. David Kelly. Dr. Kelly is the chief global strategist for J.P. Morgan Ascent Management, and it is a huge thrill for us to have you on the show. We're such big fans. We've read your work for a long time, so thank you so much for coming on today.

You're very glad to be here. Well, it is Friday afternoon. It's March 10th, and I think we have to start with Silicon Valley Bank and what's happening around that and why. So in my estimation, The Fed went from 150 miles per hour in 2021 to absolutely jamming on the break. And there was this weird dynamic within the economy and the stock market and consumer spending and all that sort of stuff where it was taking a longer time to ripple through. We had said the Fed is going to break something. Certainly there's been an implosion in tech and the housing market is frozen. But we kept waiting for something to break. And I think maybe today was

today. Be interested to hear your thoughts on all the news surrounding Silicon Valley Bank. I think, first of all, with regard to Silicon Valley Bank, I don't claim to be a huge expert of the bank itself, although I would say that its name tells you this is probably a pretty idiosyncratic issue and not an economy-wide issue. And in general, the banking system is very well capitalized. What we're seeing is the banking system in general is getting more cautious. Delinquencies and defaults are not particularly high, but they are rising. And the banks are being more careful about lending. But unlike the great financial crisis, or even in previous recessions before the great financial crisis, I don't think there's bank constraints

or banking pullbacks are going to be a reason for economic weakness this time around. I just don't think that's at the center of whatever storm is coming for us. I just think that maybe this is bigger than Silicon Valley Bank, only in the sense that it's a crack. It's a tangible crack that we're seeing. And to the extent that there's spillover, maybe I don't disagree with what you're saying, but the stock market is worried. So Schwab, for example, which is very far from Silicon Valley Bank, was down over 10% yesterday and it's down 8% today. So it seems like either there's liquidations or self-first asked questions later. But maybe just talk about that for a second. Obviously, you work for JP Morgan. To your point, this is not 2008 in the sense that banks are very well

capitalized. Maybe when I say the Fed had broken something, one of the things, and again, neither of us are experts on Silicon Valley Bank, was how banks are managing their deposit money and the mismatch between assets and liabilities, that is very much driven by the Fed. So how should we think about maybe some of the unintended consequences or maybe intended consequences? The Fed was trying to do some damage and it's happening. So is that a potential risk just in terms of like the mismatch of assets and liabilities? Or is that really just SVB? There are plenty of risks because we had this long period of time, really from 2008 through 2019 and into the pandemic, where the Federal Reserve kept rates at extraordinary

low levels. And I always thought that was a bad idea because it encouraged a whole pile of speculation and a whole pile of areas that really don't want to see speculation. The carrying cost of crazy was zero. And so a lot of people invested in a lot of things who are very dubious merit. And when you raise interest rates into a normal or even a slightly above normal level, there are going to be some casualties. And you don't necessarily know beforehand where those casualties are going to be, but clearly the most exuberant bets that investors have made in recent years are whether it's going to be the greatest vulnerability. So that is sort of an unavoidable consequence of the Federal Reserve raising rates. It would have happened if the Federal Reserve stopped at four or four and a half or five.

There's still going to be a problem with the Federal Reserve doing that. But I think the problem that I have is that the Federal Reserve is doing too much in terms of what the economy actually needs right now. and driving this economy is, it's kind of like steering a cruise ship into port. I mean, the idea roughly is that you cut the engines, you just sort of drift in. What they're really doing is revving up and heading for the pier here. It's going to cause some damage. They know there are long lags to how monetary policy affects the economy. I'm trying to figure out if they think that their actions affect the data with a long lag,

then why are they so data dependent on numbers that have just come out of the last few months? It's actually a logical mismatch there. They really need to think about why they're doing what they're doing as much as what they're doing. It does seem like the narrative shifts on a weekly basis, maybe a monthly basis, not only for the Fed, but for investors and the economy. And so for a while there, it was everyone's waiting for the hard landing. And then earlier this year, it was, well, actually a soft landing is a possibility. And then these past few weeks, it's been, no wait, the economy is actually ramping up again. And it feels stronger than people thought.

So interest rates were rising. And then today, after what's going on today with the banking system, interest rates are crashing. I guess you can call it a crash. They're falling quite a bit. They are crashing. And so rates are falling. Do you think that this will be a wake-up call for the Fed to say, like, maybe we do need to just chill out for a while and see what the effects are, because maybe we've taken this thing too far? I think that it makes it less likely they'll go 50 basis points. And we've got quite a calm employment report this morning. I think some really interesting things there in the labor market should like to talk about. But overall, it was, I think,

a reassuring employment report. If we get another CBI report which shows that consumer inflation is, again, falling, even if it's not falling in every area, I think the Federal Reserve is more likely to go 25 basis points on March 22nd rather than 50. But I'd like them to go zero, but I don't really think that that's what they're going to do. I think they'll set the 25 basis points. So we're going to come back to the labor stuff in a minute because we definitely want to talk about that. But David, to your point, yesterday, so in the beginning of February, if you look, at the CME Fed watch tool, there was an implied probability of zero that they would go 50 basis points. Everyone had expected them to go just 25. That went all the way up to 70%. And yesterday,

it closed at 68%. It's down to 41%. The 25 basis point expectations went from 32% up to 59%. Ben and I have been talking about this over the last couple of months. Perhaps the reason why the Fed feels like they have to talk as tough as they do is because maybe they feel like they're at the five-yard line or the three-yard line. And for them to go back, would potentially, financial conditions would loosen so quick. And they say, oh, my God, we fumble the football at the one yard that we didn't go hard enough. Now, I think maybe they've got in the message. But I think maybe a pause is unlikely. But if they do go 25, would the market react too swiftly to the doveish tone? And it would be like, oh, great, we did all that hard work just to loosen prematurely. Well, first of all, the feds

target, not the stock market. It should be the economy. And with regard to the economy, they may think that they've driven the ball to the five yard line. The truth is they're up with a stand watching the game. They're not actually driving this economy the way they think they're driving this economy. The only sector that really reacts violently to increase in interest rates is the housing sector. The poor old housing sector has got pumbled by this thing. But the rest of the economy is driven by much more powerful forces. And those were unleashed by fiscal policy and, of course, the constraints caused by the pandemic, and then the Russian invasion of Ukraine, all those things are just working through the system, these massive waves working

through the system, they push inflation up, they are bringing inflation down. It's coming down anyway. Whether the Fed yells louder about bringing it down or not, it's going to come down. It's going to come down at roughly the same pace. I suppose it would come down faster, slightly faster, if they succeeded in pushing the economy inter recession or if the economy did enter a session. But other than that, they're not really having that much impact of the pace of which inflation is coming down. But that's not a problem because inflation is coming down. You mentioned that the labor market remained pretty strong today. We've seemed like we've added 500,000, 300,000, 300,000 jobs every month. And I think the stat I saw today was it's been

10 or 11 months in a row where the forecasters have underestimated the strength of the job market when the job numbers come out. And this is the strongest labor market of my lifetime, for sure. I'm in my early 40s. I don't think we've ever seen anything like this. Has it surprised you how strong it's been in the face of the Fed raising rates? Not particularly, and I think it just needs some interpretation here. The key thing that happened last year is we had a massive amount of job openings relative to unemployed people. You go back to last March, we had two job openings for every unemployed person. That is absolutely unprecedented going back at least 50 years. Nothing like it. Now, think about what that means.

of last year, there are companies who are putting ads on their bulletin boards and the shop windows, and so if it's, please apply for our job, please come work for us. We would love you to work for us. And all year, nobody paid the slightest attention to that. And then come January, suddenly, somebody answered

the ad. And they say, she's sold and sold it. We've got a live one here. Quick hard. Now, let's think about what was actually going on. What really happens is this. You'll look at this on a Nazis and adjusted basis. January is the weakest month in the year for payroll employment by far. The average January, going back in the five years before the

pandemic, employment fell by three million workers, not seasonally adjusted. All that happened this January is employment fell by two and a half million workers, not seasonally adjusted. And that's why you get a now revised slightly, but a 517,000 initial estimate of a job gain. But I think what really happened is a lot of people got laid off and they normally stay laid off, but suddenly they found they could get any job they wanted because there was this hangover of excess demand for labor. So I think it is really, really difficult to forecast employment on a monthly basis, given the just weird situation we have in terms of excess demand for labor and then the C-Sel pattern. So I just wouldn't overestimate the message coming from the job market.

I think you've got to look at the whole mosaic of the economy. And you look at it from a demand side. You look at it from supply side. Either way, it says, we're slow it down. We're going to slow down. It is in the cards. What we're really talking about here is not whether we're going to slow down or not. It's just a slight timing issue. The Federal Reserve should not, although they do seem to overreact to it, they shouldn't. What did you see in the labor market report today and the NFP report that you found so interesting? Wait, truth. Slowing. Well, it's not just slowing, but it's four point six percent year over year for all workers. And I know that sounds like a high number, but we think that the CPI report that comes out next week is going to show about a 6 percent gain

year over year, maybe a 6.1. And that will mark the 23rd consecutive month in which wages have grown more slowly than consumer inflation. And let's think about this. You're just talking about this. This is the strongest labor market that we've seen, the tightest labor market we've seen in over 50 years, and workers can't keep up with inflation? I mean, in theory, wages should actually go up by the sum of inflation plus productivity. But all the productivity gains are going to the companies plus some. This wage increase, is, if you think about it in terms of compensation for past inflation, but it's really how I think workers think about it.

They sort of knock on the bosses' door and say, look, inflation was like 8% last year, whatever it was. I need some compensation. The boss is, I'd love to give you a raise, bus. There must be 50 ways to stiff the workers. And they'll find one. Maybe we think we're ahead of recession, or this is not a good time, or cutbacks. I hope you're happy to work here.

If you're not sure, it was find something else. And workers just don't have that bargaining power. And so what I see here is, you know, it's not a price wage spiral. it's a price wage slinky. It's actually coming down. Price growth and wage growth are coming down just a step at a time. We just should let the process play out. So that's such a great point you make. And I would ask you this, how do we square the circle of what you just mentioned versus the fact that consumers are not slowing down their spending in a material away? It's sort of this dynamic that I'm scratching my head with. So how do you explain the fact that consumers, for whatever

reason, are not responding to inflation pressure and real wage pressure? Consumers are cutting back at some areas, but of course, the pent-up demand for travel and leisure, and we had very good weather in January and February by historical standards, and so we had pretty strong consumer spending, but again, retail sales in January and February are the weakest months of the year. So if you look at actually real consumer spending in the fourth quarter, it was pretty weak, but it seems to have bounced back a bit in January and probably it looks okay in February. But again, I don't think that that's indicative of a huge amount of strength. think that upper-income consumers have got more room to maneuver here than the lower-income

consumers, but there are a large swap of low- and middle-income consumers who had gulfed the benefit of a lot of fiscal stimulus during the pandemic. They spent the way through that. They pay down the credit card debt. They racked the credit card debt back up. They're running out of options, and their spending will slow down over the year ahead. I think at the high-end spending will probably state reasonably okay. I don't think consumer spending is going to be that strong going forward. I think we've just sort of again being able to push out, delay the sort of consumer crunch that I think really is coming here. My pet theory has been that a lot of people who are more well off, they refinance at 3% mortgages. They didn't spend for 12, 15 months. They're going to plow

through no matter what prices are. And they're going to spend regardless, and they have more earnings power. But you kind of mentioned that the housing market is the one thing that has gotten broken. Michael and I have been talking about that a lot too. Do you think that it's going to be easy to unbreak the housing market, if mortgage rates go back to, say, four or five percent, maybe a more reasonable level, is there going to be enough household formation demand for millennials that things will just pick right up? Or do you think that there's going to be some lasting problems with this, the fact that people have these mortgages locked in, they're not going to want to sell? Where is that going to shake out? I think there's going to be a problem in the single-family market

for a long time to come. The problem is where the Federal Reserve kept rates that low for that long, and then the federal government put a whole pile stimulus in the economy, that one, punch caused this massive boom in prices. But anybody who bought it those prices, they can't sell. They'd have to sell it to loss. And meanwhile, the next crop of buyers can't afford to buy at those prices. We're talking about what's going on in the stock market. If they've got to miss pricing, they can fix it in a day. The housing market's not like that. If you're going to miss pricing, it takes years to fix. And so unfortunately, I think home prices in general are too high for a mortgage environment of 6.5 or 7%. This housing market is calibrated to a more rich rate of 4%. That was the

average for the 15 years prior to when the Federal Reserve got going here. And it just cannot function normally at 7%. So I think it's going to be a long time before we have a normally functioning housing market. Meanwhile, multifamily homes are being built rapidly. And I do think that the point about household formation is well taken. The growth of the adult population, population age 18 to 64 in this country or the working age population has really slowed down to a crawl. And it's going to pick up a little bit here. But there is a significant demographic slowdown that has emerged over the last few years. I think that does take some pressure off the housing market.

So I don't think it's a huge macro story at this stage, but it's going to take a while to get back to some sort of normality in housing. I don't want to put words in your mouth, but I think I heard you say something about fiscal stimulus. So I think we might agree that a lot of the inflationary pressures, obviously there was supply side stuff, demand side stuff. But it was really due to the fiscal stimulus and consumers having penned of demand and spending. And so that drove up inflation and the central bank are raising rates to combat inflation. Ultimately, a recession will kill inflation. But paradoxically, the thing that caused inflation, which is the fiscal stimulus, helped to push back the recession because people were just more flush than they otherwise would have been in the course of like a normal economic cycle. So it's been, I don't know, we've been doing this 15 minutes.

We haven't mentioned the recession yet. That seems to be a fade accompli at this point. how do you think about a potential recession and obviously nobody knows when it's going to happen if it's going to happen how shallow how deep it might be but just overall what are your thoughts on that well i think we are on the edge of something i think the key is we're on the edge of a swamp on the edge of a cliff i don't see any structural problems this economy but you're going to cause a sudden spike in the unemployment rate in the way that we saw the great financial crisis the pandemic recession i think you'll see and because of a very tight labor market and frankly a lack of

labor supply, I think the unemployment rate will only move up slowly from here. But we are not going to get any further fiscal stimulus. I mean, I think it is a plague in both houses when it comes to this fiscal stimulus, both under the Trump administration, the Biden administration, we gave money to people who didn't need it in the pandemic. There's a lot of real hardship and need, and there was a lot of social problems which will last forever or for a very long time from the pandemic. But both of my sons got stimulus checks, and both of them were working as hard as they ever worked just remotely. They didn't need it. Frankly, the less lines to buy stuff with, sorry, the less stuff to buy being cooped up at home. So you ended up putting a lot of

money to the economy. The economy didn't need. We could have revived the economy with less stimulus. But the extra stimulus, I think, was what did cause the inflation. But that's the past. And we've now got divided government. And that means even if the economy were to get into a recession, there is going to be no fiscal stimulus before the 2024 election at the earliest because there is no way a Republican House representatives is going to goose up the economy to help out a Democratic administration. Not going to happen. The, I don't know if I'm just a ripple effects. It was an asteroid. COVID coming was an asteroid for the economy. And I think we might still be underestimating the impacts that it had. And so we're seeing all of these

things that have never been seen before in the economic data. A lot of things don't seem to make sense. So I'll throw out a maybe silly question to you. Can we have a recession with unemployment below four, four and a half percent? Can that happen? Yes, but it'd be a pretty mild one. I mean, the way recession is defined by the National Bureau of Economic Research and they get to make their call, they look at payroll employment, they look at household employment, they look at personal income, they look at industrial production, look at real consumer spending, real retail and wholesale sales, if all those numbers start turning negative, and they could all turn negative without pushing that unemployment rate above 4.5%, then you have a mild recession.

I think we could have that. But I think for a lot of people, the issue will not be how deep is a recession, but when are we going to get some real growth going on in the economy again? And the problem is if you start from 3.4% unemployment, if you've got very slow growth in the working age population, you've got mediocre productivity growth, you can't really see long-term growth of 2% from here anyway. I mean, it's going to be less than 2% in the long run anyway. So if we have a small recession, that means the balance fact is going to be pretty mediocre also. You mentioned the Fed sitting on the sideline and inflation coming down anyway. I tend to agree. I never saw the point of trying so hard to put people out of work.

If you wanted to see this pandemic stuff just work its way through and iron it out a little bit, do you think we need a recession to get inflation down? Or do you think we can kind of let things play out a little bit if they take a break and let things normalize and the Fed doesn't need to push us over a cliff if that's what they're trying to do. Absolutely. I don't think we need a recession at all. I think we've seen goods inflation come down. I think there are a lot of long-term forces that were really working over the last 40 years to bring inflation down, things like information technology, which makes markets more competitive, things like the decline in unionization. I mean, only 6% of private sector workers are unionized at this stage.

You've got great inequality, which tends to push up the demand for financial assets, but actually starless of demand for goods and services. All those things are still around. right analogy for inflation is it's a roller coaster. But the thing about a rollercoaster is it may feel awfully scary at the time. You end up getting off where you got on. We got on at 2%. We're going to be able to get off at 2%. It's just going to take a little while.

You've got to let the ride run. And in fact, one of the most dangerous things I suppose to be getting off the roller coaster in the middle of the right, we really should just let it play out. Sometimes the Fed says, oh, well, you know, the people who get hurt most by inflation are the poor. Well, is that really true? I mean, it is true for food inflation,

energy inflation. but if the inflation is in core services, it costs more to get a hotel room and an airline seat, well, actually, upbring of people who get hurt by that, more than poor people. And the one certainty is if we have a recession,

it's people at the bottom who will get hurt most because they're the people who are going to lose their jobs first. So I don't think it makes sense to push the economy to recession, to get inflation to come down any faster than it's going to do anyway. It's going to come down. I mean, I am convinced that by the middle of this decade

we're going to be having the same conversation, we had in the middle of last decade. How did we get inflation back up to do that? All right, David, before we let you get out of here, I'll be remiss if we did not ask you about stocks versus bonds. For my entire career, it was never a discussion. There was no alternative. If you were going to take risk in the bond market or the stock market, I mean, we're going to stick

to the stock market. Now, this is a much different environment. How do you think about the dichotomy or the difference, how should investors think about investing between stocks and bonds? I'm like you. For a long time, the Federal Reserve just tilted the game, so it made no sense to be investing in bonds. I think we have this window of opportunity that looks a little less generous today than it did

a few days ago, but we do a relatively high long-term interest rates, relatively high interest rates in a lot of sectors now that we haven't had for the last 10 to 15 years. And by the way, which we probably won't have in two or three years' time. So I think this is a time where if you want to add fixed income to a portfolio, this is a good time to do it, get it in there. It will resume its negative correlation with stocks. I believe in the long run anyway. But do it now, because if we're right and the Federal Reserve is overdoing it,

and they end up with a situation where inflation's falling, growth is too slow, what's going to happen in 2024? I mean, if the economy does fall in recession or is close to recession, who are you going to call? You can't call on Congress because Congress not going to do anything. So the owners will be on the Federal Reserve to cut rates. They actually show that in their own projections, that they're going to cut rates four times next year and four times the year after that.

You'll probably have to cut faster than that, particularly if they go much higher from here. We kind of know where we are in the medium term year and low rates, low inflation, slow growth. Getting from here to there, I think it's going to involve interest rates coming down. And so I think in a year or two, I'm going to be back to the mantra I had for a long time, which is you might as well be overate equities. But for right now, this is not a bad time to be a balanced investor. Are you surprised at all by the resiliency of the stock market? And we're obviously still kind of in a bare market and stocks have been chopping and going nowhere for a while.

But I think if you would have told someone 18 months ago, you can get five. percent in T-bills and the Fed is going to be raising rates in one of the most aggressive paces in the history over the course of a year, the stock market would get crushed. And it obviously it felt pretty good, but I don't think there was a washout that as many people wanted to see. Does that surprise you at all? No, I mean, I think what we've seen is a healthy washout and some of the more speculative areas of stock markets. So we have seen some problems there, and that's frankly overdue. I mean, things like crypto is down. That's kind of overdue, too. We haven't seen a huge drop of the stock market overall. I think that makes sense, because

I think stock market investors are generally looking down the road. This is a long true investment, and I know rates are relatively high today, but if they come down over the next few years, stocks will do very well. So I think people are just waiting it out. That's something to make sense to me. So if the stock market doesn't overreact to the short run, I mean, frankly, the Federal Reserve should take a lesson from stock market to not overreact themselves. Dr. David Kelly, I cannot tell you how much we were looking forward to this. We had high expectations for this conversation and you over-delivered. So thank you so much for coming on. We really appreciate the time. You're very welcome.

Thank you, Dr. David Kelly, for coming on. You know where to find us, Animal Spiritspot at gmail.com. Everyone enjoy your weekend or your week, and we'll see you on Wednesday.