June 2024
Here are some key takeaways from their conversation:
• Some people think that when inflation comes down, prices should decrease. That would be “deflation,” which is a concerning economic indicator. Inflation measures how much more expensive goods and services become over a certain period, so when inflation slows down, that means prices won’t increase as much or will stay the same.
• Sasan says the risk of stagflation (when inflation remains high while economic growth slows and unemployment increases) is currently high.
• Because supply chain disruptions were the main driver of inflation in 2021, the Fed’s attempt to slow inflation by raising rates did not have much of an effect.
• The Fed might lower rates if the economy weakens significantly, but they are cautious due to the current economic stability and low unemployment.
• High interest rates have made it difficult for housing development, thus keeping rents and prices high.
• Sasan advises listeners to consider opportunities in private credit markets which may offer equity-like returns with better downside protection.
Watch previous episodes here:
Ep. 89 Buffett's Bet: Exploring International Investments & Japan
Ep. 88 Market Highs Amid Consumer Struggles
Hello everyone and thank you for joining us for another episode of THE FINANCIAL COMMUTE. I'm your host, Chris Galeski, joined by Managing Director of Investments, Sasan Faiz. Sasan, thank you for joining us.
Thanks for having me.
So we're going to talk about the Fed and inflation and before we kind of get into it... you know I was talking with somebody recently and they said oh well inflation's coming down, but prices aren't coming down and that's just sort of a misunderstanding of inflation itself. Inflation is the the rise of prices over time and so even though inflation slows and comes down, that just means that our goods and services aren't getting more expensive over time, but you know, they're not getting any cheaper either because that's deflation.
So let's talk a little bit about the Fed, interest rates. I mean, last call of 15,
18 years, it's felt like the U.S. was sort of in the driver's seat. If we lowered rates, other countries followed. If we put out stimulus or printed money, you know, treasury asset, repurchase programs, whatever, Kiwi, other countries followed. Right now, the Fed decided, hey, we're going to keep rates where they are. But the European Central Bank and the Bank of Canada sort of raised their hand and said, no, we're going to start lowering rates. So it's not a race, but now we're sort of not in the driver's seat, it seems like.
You know, that's a great point, I think, Chris, that you bring it up. Obviously Bank of Canada and the European Central Bank lowered the rates and usually everybody follows the Fed; this time it looks like they're getting ahead of the Fed. But if I can just give a little bit of historic background about monetary policy and I think it hasn't been as effective this time around, is that usually when you're looking at the traditional business cycle, the economy overheats, interest rates are low, there is too much activity in the economy and then the central bank inflation picks up and then central bank wants to lower activity, they raise rates and economy slows down, unemployment goes up and that by itself- the famous saying that the cure for high prices is high prices so basically then inflation comes down and prices come down as well and the economy slows down.
This time around in 2021 when inflation picked up, actually the economy was weak. So basically we had the massive fiscal stimulus post pandemic and then we also had rates at emergency zero level for a long time.
So the Fed's thesis was that we know how to deal with inflation, but we don't know how to deal with deflation. So we're going to run the economy hotter than usual.
And basically what happened was that a lot of supply chain disruptions were the main driver of inflation. Prices went up dramatically. And as the Fed started raising rates,
it hasn't had the usual effects on inflation that it has had in the past, mainly because supply chain disruptions were the main driver.
And as you mentioned, obviously, inflation rate has been slowing down, but price levels are going to stay high because companies really don't have an incentive to cut prices.
The wage inflation has gone up so they have to still pay employees and prices are going to stay high. So that's an issue that we're going to have to deal with. Again, the Fed basically wants to see more of inflation kind of coming down before they do something. But again, we'll see what they do. And when we came into the year, there were expectations for three cuts, what the Fed had promised. And now we're down to maybe one, or even maybe not even that, depending on inflation.
Well, it's so interesting because, I mean, look, obviously people would like rates to come down because then it's cheaper to borrow money. But the Fed's incentivized to lower rates if the economy is not healthy or strong or doing well.
And so, you know, in order for the Fed to be in a position to now have to lower rates from where they are today, which is a lot higher than where they were, but not very high compared to, you know, history or the best call it 50, 70 plus years. The Fed would need to see some pain in the economy. And I think the consumer is feeling pain every time they go to the gas station or they go to the grocery store, but unemployment is still really low. A lot of housing markets across the US are still very strong and prices or rents are still high. In order for the Fed to be in a position where they need to lower rates, we need to see something bad potentially happen. And I'm not so sure people are aware of that.
Yeah, no, I mean, that's a great point. Yeah, I think as you mentioned, I think the consumer is under under a lot of pressure right now,
and that's 70 % of the US economy. But we are seeing some segments of the economy that are more interest rate driven like real estate and financial services are feeling the pain so especially I was at the conference last week and a lot of people were talking about obviously commercial real estate has seen a lot of pain, prices are coming down dramatically but there's more that's going to happen, so if you
look at, you bring in a good point about housing, and housing is about 30 percent of CPI, consumer price index, not as big a component of the PCE,
which is the personal consumption expenditures index, which is what the Fed follows. But think about it, interest rates staying high is going to not be encouraging of construction of new housing.
So basically housing prices are going to stay high and rent inflation is going to stay high.
And that's the part that you and I were sort of talking about at the end of last week is that, you know, the Fed's sort of getting what they want, okay? They were able to raise rates from zero to call it five and a quarter percent without really breaking anything. There's definitely signs of stress and issues out there.
We've had a couple small regional banks get gobbled up by some bigger ones. So I'm not saying that it's been completely rosy, but in markets where there's a supply shortage for housing and inflation is coming down,
but where interest rates are, it doesn't make sense for these builders to build more supply because it doesn't pencil out from a cost perspective, that means that the housing problem which is 30 % of inflation that's likely to stay the same or even get worse so I don't know, it's just fascinating. I don't have a crystal ball but I don't see inflation going to zero or prices resetting anytime soon.
No I think inflation... it's our thesis that if we are going to be in a higher inflationary regime going forward. And I think at some point the Fed is going to have to maybe kind of modify its narrative.
And you know, they have that arbitrary 2% inflation target, which I don't think it's going to be achievable. So at some point they're going to say, maybe the economy is slowing down. And you know, we think that we are going to be, you know, inflation is going to be a little higher than target but we're at the point where we can kind of reduce rates and if we think about it kind of a back-of-the-envelope rule for what short-term rates should be maybe 200 basis points over inflation rate so if inflation right now CPI is running about three and a half but PC is running a little bit lower 2.7 or so, so basically rates can easily be down 50-75 basis points and we still have that cushion of being 175 to 200 basis points over inflation rates so I think that at some point is what the Fed has to pivot to but again that remains to be seen. But I think inflation is coming down and maybe in a couple more months maybe the Fed would be in a position to lower rates.
Yeah, it's just interesting in terms of how housing will play a component of that, especially with regards to inflation, when there's sort of a mismatch of the drivers for causing prices to go higher or rents go higher. Inflation is not fun. The opposite of that, or deflation, is not good either. I mean, there's serious signs when all of a sudden everybody has to lower prices significantly to attract consumers.
That's something that Fed's worried about. And then stagflation, which is the one that no one's really talking about, where inflation is high but nothing else, no incomes really grow and you sort of have deflation everywhere else, that can really hurt an economy and cause a lot of stress.
I think we can easily have that stagflation scenario is where the economy is slowing down and we're seeing the economy is slowing down,
but inflation staying high. So that's actually a big risk right now. Obviously, we had it in the 1970s. It was kind of a worst-case scenario at that time.
But deflation, again, when prices are coming down, or disinflation is where the rate of inflation is slowing down. Disnflation is fine. I think stagflation is definitely a bigger risk right now.
So let's talk a little bit about investing because, you know, when we are investing in the equity markets, we have exposure to U.S. and international stocks. From a price to earnings ratio,
Jon and I were on an episode, I believe last week talking about, you know, value in international markets, comparatively speaking. So if all of a sudden international markets are going to be lowering rates to stimulate their economy to grow faster, do you think right now is a good time to be investing in the international markets?
So I think you're absolutely right. I think valuations are very reasonable in the international markets and even emerging markets.
But that has been the case for a very long time. So we are I think well diversified. We have exposure to international markets but in general with respect to the US equity markets again- equity markets are selling at almost 21 times earnings, US markets are very expensive, that's our view that public equities in the US are expensive, but also when you're looking at the public credit markets so you look at investment
grade it's only selling at like 85 basis points over treasury. So why take the risk being corporate bonds where you can just get a decent rate on risk free rate on treasury?
And then you're looking at the high yield bonds or... they're actually selling at like 300 basis points over again, it's at historic high. But if you take the more distress portion of high yield out,
it's actually selling at almost 225 basis points over treasury. Again, why take the risk with high yield or junk bonds where you can get a decent rate on treasuries?
Where we think opportunity lies right now is more on the private credit side. So that's where I think we're getting compensated very nicely in a senior secured lending position with floating rate instruments that compensate us and at the same time, we're protected on the downside. So, we're getting equity-like returns, but again, our downside is much better protected than if you get any kind of volatility in the public markets.
You can have serious drawdowns, which we don't expect in the private markets. But if you had serious drawdowns, the Fed may lower rates to stimulate the economy. Sasan,
thank you for coming today to talk a little bit about what the Fed is or is not doing right now with regards to raising or lowering rates. They're hitting the pause button. And then even though inflation has come down, that does not mean the prices have come down.
They're just growing at a slower rate.
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