Consumers with record net worth are spending. Driving both real economic growth and inflation. What effects should we expect?Download PDF
On Oct. 15, 2021, we sat down with Dominic Nolan, CEO of Pacific Asset Management, to get his insights on September market action, Fed controversies, opportunities in fixed income, and whether we’re headed for stagflation.
September saw finally a change in trends with both equities and bonds turning negative as investors are no doubt wondering whether there is more room for volatility. How did September change your expectations for the market?
September was markedly different than most of the year. Equity indices were down—S&P 500 Index lost close to 5%—and bond indices were, at least on the investment-grade side, down. Meanwhile, the 10-year Treasury yield rose 25 basis points, moving from 1.28% to 1.53%.
The root cause, in my opinion, were investors trying to digest the effect of the supply constraints. The world has gotten a big introduction to how delicate the supply chain really is. Most surveys had supply-chain concerns normalizing in the first half of 2022. Now expectations are that normalization is not going to occur until the second half of 2022. What does that do? One, that affects inflation expectations. If you have supply, you can push through pricing. Two, economic growth is not going to be optimized.
Looking at the Atlanta Fed’s GDPNow, their real GDP growth forecast entering the third quarter was 6%. By Sept. 1, it was down to 5%. And as of Oct. 5, that had dropped to just 1.3%. The Delta variant is one of the reasons for this, but supply constraints are playing a major role. Manufacturers just aren’t able to push through as many units as they like. And to some extent, you are seeing some pushback on the demand side.
Now you throw in Fed tapering, debt-ceiling discussions, lack of progress in D.C., and you have uncertainty. And that uncertainty for most investors should, in theory, increase risk premium. In September, we got a dose of that.
The Fed looms large these days. Let’s talk with the two elephants in the room: resignations of two hawkish Fed presidents and the prospects for Jerome Powell’s re-nomination as Fed chair. What are your thoughts about all this?
Dallas Fed President Robert S. Kaplan and Boston Fed President Eric Rosengren stepped down amid controversy. The optics aren’t good, honestly. And then you have Sen. Elizabeth Warren really attacking Powell. She called him a “dangerous man.” Personally, I think the current administration hasn’t really turned their attention yet to Powell and his nomination. The geopolitical aspects in the Middle East and the two large bills before Congress are at the top of the agenda. I believe that Powell will be nominated again. However, given the current agenda in D.C., there’s certainly a camp on the progressive side that’s thinking: We’ll try and use our votes on the infrastructure bills as more leverage in the Powell discussion.
Wall Street initially put the chances of Powell being re-nominated in the 90% range. Now, it’s down to 70% range. While the markets are expecting Powell to be re-nominated, it is not as certain as it was a month ago. There has been recent support from some of the progressives, which should help solidify Powell’s chances.
Do you think the resignations of the two Fed presidents change the time table for tapering or rate hikes?
For tapering, I don’t think it does. The bar on tapering is pretty low. I believe tapering will probably start in November or at least an announcement as to when tapering will begin. As it relates to rate hikes, expectations are now for the first one to occur at the beginning of 2023. Do I believe it’s early ’23? Probably, but let’s be honest, 15 months from now is an eternity.
There’s been increasing talk that stagflation may be on the horizon. Are we headed there?
In a stagflation environment, you typically have inflation with minimal growth. While we may have had that scenario in the third quarter, structurally that’s not the situation we’re in. We’re in a situation where you have both inflation AND economic growth. We are calling that “spendflation,” to coin a term. Nominal GDP is moving quite nicely. The breakdown of how much of it is real is up for debate. The anchor in this “spendflation” have been the central banks. The central banks are the balance sheet that have enabled governments and consumers to spend at historical levels.
Any clues about economic growth when looking at market sectors?
For the economy, I see continued growth and price increases. As for the sectors, here’s what I find interesting. According to Bank of America credit-card data, airline spending was down 18% in August compared to July. That to me is very much Delta-variant related. In September, airline spending has rebounded a little bit, and it’s up 5% compared to August. Lodging was down in August and September back to back. To me, that’s also Delta related. However, since September 2019, merchandise spending is up 25%, clothing up 25%, gas up 20%, and grocery up 10%. I believe that we should expect to see continued growth and inflation.
Do you see anything else in the sectors?
Yes, and these really aren’t in the headlines. Daycare centers in September were up 52% above last year’s levels and only about 10% below 2019. What’s that tell you? It tells you people are getting back to work.
As it relates to household spending, during the 2008-2009 Global Financial Crisis, we pumped a lot of liquidity into the system through the banks. It solidified the balance sheets of the banks, but it didn’t translate into robust GDP growth. During the pandemic, we sent checks directly to consumers, and you can see that reflected in increasing spending. For households that did not receive unemployment checks, they spent close to 25% more relative to 2019. For households that received the extended unemployment checks—which tends to be lower-income households—they were spending 30 to 40% more compared to 2019. But once those unemployment insurance benefits expired last month, spending dropped. Now spending in that area is up only about 10% to where it was two years ago in 2019.
For much of this year, you’ve pointed to bank loans as a key investment opportunity. If that’s still the case, what would you point to as a significant factor in favor of them?
Well, I think everything we just said comes into play. In September, the S&P was down. Within fixed income, the Bloomberg Barclays Aggregate Bond Index was down about 87 basis points. The Bloomberg Barclays High Yield Corporate Bond Index was down about 60 basis points. But year-to-date, bank loans are up over 4.5%. And that is versus the aggregate index, which is down 1.5%.
You still have a tremendous amount of uncertainty with inflation, and you still have a strong corporate story. I want to reiterate that I believe the total-return element is going to be really, driven by the coupon with price appreciation limited. Given that, I view it as defensive against inflation. And as long as that uncertainty looms large, I think that still constitutes an overweight to bank loans.
Okay, time for the lightning round. Short questions, short answers. First question: On a scale of one to 10, what impact will the COVID booster have on the economy?
Six-and-a-half to seven to the positive.
Big Tech seems headed toward more regulation. If this happens, who will be the winners?
Small- and medium-sized tech and international technology. Anytime you regulate, you make an entity less competitive, and that opens up an opportunity.
Facebook, Instagram, and WhatsApp recently crashed for more than five hours, causing disruptions around the world. Any lessons learned?
We are not as good as we think we are.
Did you expect large employers to be quite so emboldened to enact vaccine mandates?
I didn’t. I have been a bit surprised by how many firms are mandating the vaccine. Mind you, we can assume that the firms are acting in their economic interest, whether that be driven by healthcare insurance, legal risk, or a way to reduce the workforce. Whatever the reasons, I still have been surprised by how emboldened they’ve been.
How concerned are you about bottlenecks in the supply chain?
I’m more concerned with each passing day. In fact, we’ve recently released an interesting new episode of our “Getting Credit” podcast that discusses the broken supply chain for semiconductors. It’s a pretty complex situation. It certainly doesn’t feel like the problem will be solved anytime soon. Also, remember supply right now is having trouble keeping up with base demand. So when you think about companies operating, if you’re able to get your hands on the goods you need, a) you want to take care of your current demand, but b) you probably want to store a little more just in case this happens again. So, my guess is the supply chain issues will continue for longer than we think.
To wrap up, will you share a personal reflection?
Sure. It has to do with the last question. We’re in a situation where supply chains are strained. So, if we expect to hop online in late November and start ordering holiday presents, we might be in for some unpleasant surprises. One way to navigate that is to focus on experiences, not material things. This upcoming holiday has the potential to be pretty chaotic and stressful, but much of that can be alleviated by focusing on meaningful experiences with family and friends. That, I think, would be the perfect holiday present this year.
One basis point is equal to 0.01%.
Bloomberg Barclays U.S. Aggregate Bond Index is composed of investment-grade U.S. government bonds, investment-grade corporate bonds, mortgage pass-through securities, and asset-backed securities, and is commonly used to track the performance of U.S. investment-grade bonds.
High-Yield is represented by Bloomberg Barclays US Corporate High-Yield Index, which measures the USD-denominated, high-yield, fixed-rate corporate bond market.
Bank Loans are represented by Credit Suisse Leveraged Loan Index, which is designed to mirror the investable universe of the U.S. senior secure credit(leveraged loan) market.
The S&P500 index is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the U.S. stock market.
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