You Need to Stop Fighting Inflation

On this episode of The Long View, Michael Santoli discusses inflation, interest rates, and corporate spending.

Here are a few excerpts from Santoli’s conversation with Morningstar’s Christine Benz and Jeff Ptak.

Is a Recession Coming?

Benz: I wanted to switch over to discuss the broader economy, which you’ve already alluded to in your previous responses. But the market is kind of at a hinge point, where inflation fears seem to be giving way to concerns about a recession. So, a two-part question. Has inflation peaked, and where do you think it will settle? And also, with respect to the economy, will we have a recession, and if so, how deep do you think it will be?

Santoli: I guess, I wouldn’t argue with the way the markets are pricing the inflation path at this point, which is to say that, yes, year-over-year inflation levels have almost certainly peaked. We can just see that in gasoline prices. I mean, that’s really the main input in terms of headline inflation, in terms of the way you would run the models. I think the big question for me and for everybody is where is it heading to and how quickly and where will this settle out?

I’ve seen some relatively persuasive work that says that in the next few months core inflation maybe gets down to the 3% year-over-year type levels. That would be a tremendous win. I also like to remind folks that right before we got into this inflationary, kind of, upward spiral, the Fed was busy revamping its entire kind of methodology with regard to inflation to allow it to remain higher than previously targeted for longer because they were too worried about their inability to accommodate enough inflation. So, clearly, that was the absolute extent of the pendulum swinging toward disinflation. But that being said, that framework remains in place. I’m not of the opinion that the Fed says it’s 2% or bust. It’s kind of like if we’re getting close enough there, if the economic risks are higher, if we’re at neutral with our rates, we’re probably OK. I think the next few months will see a sharp deceleration in inflation. I do not know if it gets down to a comfortable level.

Now, in terms of the recession question, I think almost like what’s the difference if we’re technically in a recession or not. What I mean by that is, the bond market is acting as if it’s a high likelihood with the way the yield curve is set up. The consumer-sentiment survey work is there just about. The ISM Manufacturing survey, those types of diffusion index indicators are pointing in that direction. It could be a distinction without a difference as to whether in real terms we are in a bit of a recessionary phase or if we are about to go into one. Again, I go back to the nominal growth story. The difference between 2011 and now is that back then, when the real economy was at stall speed, in nominal terms, you were also at zero. And now, I think that there is a little more of a nuance about nominal growth being a little bit better, and theoretically, that could make it feel different.

I don’t have a prediction on this. I certainly don’t have my own economic models. I don’t pretend to have that kind of strategy framework. But I do like to track the big overarching preoccupations or narrative tendencies in the market. And I got into this thing in the early 90s when the term jobless recovery was coined. And why did it get coined? Because economists who were trained on this kind of sort of relatively short-cycle boom/bust were confused that the economy was growing in every observable way, and yet employment was not responding in a way that they were used to in terms of adding net jobs. It was a different type of recovery. And obviously, there were productivity initiatives going on; it was demographic and all the rest. But I wonder right now if we could have something of the obverse of that, which might be, yes, the economy has to reset lower because we did come out of the pandemic in this aggressive way. We are dealing with a big fiscal drag this year. Let’s remember the Fed is being very aggressive. The financial condition is tightening a lot. The economy is going to respond to all those things and in real terms might decline. But because of demographics, because of the fact that we’re coming out of labor scarcity, it would seem to me that you could have a softer landing for employment than we have become used to in prior recessions over the last 20, 30 years, just because that’s not really where the excesses were built up, I guess, in a systemic way.

I look at things like consumer balance sheets, the household debt service ratio. That’s very, very low and manageable. It would seem like there’s been a little bit of padding that’s been put in place right there. I have a feeling that when we do a lot of the retrospective research work on the impact of the pandemic-related fiscal measures, and I’ve seen some of this already done. But for the average person, getting the checks in the mail was an opportunity to essentially do revolving debt paydown and to kind of build themselves a little bit of breathing room. You’ve seen what happened in consumer credit; it really just crashed during the pandemic. It’s being rebuilt now, but not even back up to trend. You have to have these asterisks in place that say, yes, recession, but it might really not follow along. And I don’t know if we’re going to get another shoe dropping. I don’t know if it could be like the early 2000s, where it was a relatively mild recession in terms of employment and whatnot, but on the corporate level and on the market level it was devastating because you actually had overvaluation and a lot of things going on in corporate overinvestment that just had to have some payback along with it.

How Can You Hedge Inflation?

Ptak: I wanted to go back to inflation and something that we’ve observed at Morningstar, people tending to fight the last war, which means they’re scrambling for inflation hedges. Do you think they’re better off just sort of spreading out, diversifying in stocks, which over the long haul have tended to do a good job of combating inflation? Or do you think perhaps this time is different and maybe some additional steps are needed where they actually go and allocate a little bit more to something that’s a supposed inflation hedge?

Santoli: I tend to think that simply taking advantage of the fact that equities have tended to reap some benefits from inflationary periods that they obviously are nominal assets and things like dividend growth can help you out if inflation is going to be with us for a while. I’m much more in that camp than I am to say, “Look, we have to tear up the textbook and find these new targeted vehicles to specifically capture inflation.” I don’t know what those would really look like. Obviously, we have inflation-protected securities. Obviously, the world chased the series I savings bond to the extent possible. But yeah, to me, it’s much more about like just let the asset classes do what they’re supposed to do in this environment.

What I find interesting is, if I look at things as far as we can tell in terms of retail-investor or private-client-type asset allocations, equity allocations still remain relatively elevated by historical standards, but fixed income is way below average. I look at things like Bank of America’s private-client survey and the American Association of Individual Investors, and my observation is that, for the typical investor, they hate bonds more than they fear stocks at these levels. I don’t know what the sentiment takeaway from that is, if people have to maybe reduce equities more before there’s some kind of enduring bottom, or if that just tells you that a lot of the repositioning has been done that basically for so long people expected yields to go higher, that we’ve kind of already gotten to that place. And maybe it means cash is now giving you something in nominal terms and maybe that’s enough to have people say, “Why do I want to bother with longer-term fixed income at this point?” Meanwhile, of course, it’s been rallying for a few weeks right now in the face of what most people expected.

Supply Chain Disruptions and Industry Impact

Benz: Speaking of inflation, what inning are we in, would you say, with respect to these supply chain disruptions? It seems like the automotive industry is still being impacted. But are there other industries where you’ve noted big improvements?

Santoli: Well, it would seem that smaller-ticket goods have definitely flushed, meaning you’ve had the inventory—I’ve heard it there’s warehouses full of bicycles now; we couldn’t get bicycles in 2020. So, I do think that in general we’re on the path of improvement. I know that the semiconductor issue is very tricky, because now, all of a sudden, it’s involving not just genuine supply chain or shipping glitches; there’s a geopolitical element and there’s the China lockdown element to it. So, that to me is mostly about automotive. But the handset side, all that stuff seems like they’ve managed through it at this point. Is it still a source of sticky inflation? Perhaps, but I really think that at this point, it’s mostly yesterday’s issue, at least in terms of the way I view things typically, which is, its capacity to destabilize the markets or to confound current expectations. I really do agree with what you guys said earlier, which is we’ve fully shifted over to being concerned about growth in aggregate demand rather than the ability to produce enough and deliver enough product out there.

Risk and Rising Interest Rates

Ptak: I wanted to shift and talk about risk and rising rates and the interrelationship between the two. One thing that clearly appears to have changed the market’s tolerance for red ink for a while, investors who are willing to look the other way toward some of these very speculative types of enterprises, but not anymore, judging from the way some of the least profitable, most speculative stocks spared last year and earlier this year. What changed in your opinion? Was it as simple as real yields pushing off the lows and investors having to recalibrate? Or was there more going on?

Santoli: I think that was certainly an issue, that was an element of it. I’ve generally been a skeptic of the idea that the market in its aggregate infinite wisdom was doing a real-time discounted cash flow analysis at every moment, and that’s why they bought GameStop and that’s why they paid up for every hot new software IPO that was coming out. Obviously, there is a crowd psychology element of it. There was without a doubt an exacerbating factor was the real economy was kind of on its back and impaired by what was happening in 2020. And so, you had a lot of capital chasing the scarcity of growth, and that sort of fed on itself and snowballed. And then, the market had a bunch of these impulses to price in an aggressive reopening beginning actually in June 2020, there probably were four or five of them. Over that period of time, what we saw is, well, we’re going to have massive fiscal response. The Fed is still all out trying to accommodate, and the real economy was responding, and therefore, growth wasn’t scarce. You wanted to capture the cycle. And that’s why the old economy and a lot of the real economy plays started to work. And I think that’s a typical dynamic when it comes to growth versus value. This is just almost an extreme case of that. At the same time, nobody wanted real value stocks that were playing auto parts companies or something like that.

And so, I think you’ve recoiled back from that. I think, in general, that creates a risk appetite reset. That means we’re not just going to say assume that liquidity is going to take all of our concept stocks up. I do like this one analyst Jeff deGraaf at Renaissance Macro, who coined the term concept finance, which can capture everything from SPACs to some IPOs. And one of my favorite things to do during that 2020 period was to look at the brokerage analysts who are covering the new companies that were coming out and look at what the peer groups that they assumed they should be in. And so, you’d see a thing like the Robinhood HOOD IPO or the Coinbase COIN IPO, and they were using comparable companies that would be like PayPal PYPL and Shopify SHOP—in other words, the best of the new class of growth stocks, whatever their valuations were, we were going to retrofit them onto a financial-services company that was mostly about the capital markets ebb and flow.

So, I think, that whole psychological dynamic got unwound. And yeah, when times are tough and you have to go back to free cash flow, the ability to service debt, the ability to pay dividends, to me, it is just the way that the cosmic pendulum swings. And then, this week, we have Uber UBER touting its free cash flow generation. Even if on an accounting basis, it’s questionable, it’s clear that they believe that investors want to hear about that as opposed to want to hear about the total addressable market and the open-ended growth that they’re pursuing.

Why Have Interest Rates Fallen?

Benz: It’s been a while since investors have had to grapple with the reality of rising interest rates. How much of the market’s rise do you attribute to the fact that rates have recently fallen? And to what extent is the market vulnerable to further losses if rates resume their rise?

Santoli: It’s interesting. I do think that right now rates in the sense of market yields, if to the extent that they’re a proxy for how aggressive the Fed will continue to have to be, yields coming down are supportive of equity valuations, and that’s been a whole part of the last several weeks. You’ve had this loosening of financial conditions. It only works if credit spreads remain tame, and they have. They’ve improved from their worst levels recently. Otherwise, if you’re having yields come down in government bonds and credit spreads blowing out, that has the opposite effect on equity valuations. So, I think it’s somewhat encouraging that you’ve had this return to bonds providing some diversification value at the same time that stocks are saying, “OK, look, the cost of capital, no matter how you look at it, or the cost of financing the economy needs has been reduced.” If you see how mortgage rates have come off the boil and obviously, corporate rates, it’s been modestly beneficial. I think, really, because the yield curve itself is a source of pressure, or at least a source of worry for a lot of investors, that can go only so far. So, if the 10-year Treasury yield goes down at 2% and it’s because people are becoming more confident that it’s a recession and the Fed is going to have to start cutting aggressively, it’s not clear to me that that’s going to help out on the equity side of things.

I do think there’s a pretty good debate to be had right now as to whether things like corporate credit have built in enough of a margin of safety and they start to look OK again. Once again, I go back to the nominal growth and the ability to kind of service that and keep default rates in check, that could be a decent bullish case for some segments of corporate credit that have definitely been cheapened a bit.