Will Inflation Deflate The Economy?
Is rapidly rising inflation a bump in the economic road or a major detour to a full recovery?Download PDF
On Dec. 6, 2021, we sat down with Dominic Nolan, CEO of Pacific Asset Management, to get his insights on November market action, the Fed’s evolving stance on the economy, opportunities in fixed income, and, of course, inflation.
In November, despite the volatility, markets ended down modestly, and bonds were barely up. What do you make of it?
I would say everything in November seemed to be moving along pretty well, and then, in the last week and a half of the month, we saw the markets flinch, and that volatility has continued into December.
The biggest mover to me was the Federal Reserve. Chair Jerome Powell comments were certainly less dovish or more hawkish around tapering and potential rate hikes, which seemed to drive markets lower.
Also, near the end of the month, we learned about the Omicron COVID variant out of South Africa. I think that spooked markets a little bit as well. The prevailing view was that another COVID variant would really hurt and be even more inflationary in nature because supply chains would be increasingly disrupted.
What stood out to you in the markets’ performance?
What I found interesting was at the end of November, the Russell 2000 Value Index, Russell 1000 Growth Index, and S&P 500 Index had all gained about 23 to 24% for the year. So, they’ve all had great—and, in the end—very similar years in terms of performance.
International equities, measured by the MSCI World Index, had a rough go in November, down almost 5%, but it’s still up nearly 16% for the year. The international markets continue to underperform U.S. markets.
On the fixed-income side, the Bloomberg US Aggregate Bond Index was coupon-like, returning around 30 basis points, but still down for the year.
In the end, returns were dull, but volatility picked up substantially and had a negative tone toward the end of the month.
What are you seeing on what continues to be the hottest topic of conversation, inflation?
In my view, towards the middle to second half of next year, we may see rates of inflation growth that are substantially lower. Yes, prices will probably be higher, but I would expect the rate of inflation growth to be substantially lower.
But where does inflation sit right now? The Consumer Price Index (CPI) is up over 6% year-over-year. That’s huge. Core CPI, which excludes food and energy, is up 4.5%. Of course, some sectors, such as automotive, are experiencing far greater price increases. New vehicles prices are up almost 10% year-over-year. Used vehicles are up almost 26% year-over-year. Most of this is caused by supply-chain disruptions and elevated demand.
Probably my favorite inflation story is Dollar Tree. They raised their price point from $1 to $1.25. You’re talking about a discount chain store that’s branded—down to its name—on having items priced at $1 or less, and they raised the price point to $1.25. But you know what? Most of their customers seem to understand. These are the times we’re living in.
Fed Chairman Powell has recently taken a decidedly less dovish stance. He’s gone as far as retiring the word “transitory” when describing today’s inflation. How do you see the Fed reacting to inflation in 2022?
To me, the Fed still has their foot on the gas. Yes, they’re driving slower, but they haven’t put on the brakes. Look, they are still buying bonds. They started by buying $120 billion worth a month. Then, they said they want to pare that back by $15 billion a month. Now, essentially what you’re hearing is that some Fed voting members are suggesting that the monthly purchase number be reduced even more, which would provide a sooner window to raise rates. The base case is still that tapering finishes by the middle of next year. Then at some point after that, there is a rate hike. But we’re starting to have difference of opinions about whether tapering will end in April, May or June.
What did Chair Powell’s evolving comments at his Nov. 30 press conference convey to the market?
That the Fed is willing to accelerate tapering and eventually get to where they are tightening monetary conditions, possibly as soon as the first half of next year. We’ll see. To me, again, substantial inflation is being driven by lack of supply, and that problem will eventually be fixed. Demand is still there.
Also, keep this in mind: the S&P peaked in ’07 after 14 rate hikes. The S&P peaked again in 2018 after nine rate hikes. So, don’t worry about the first rate hike. Worry about the last one. I know the media loves to hype the first rate hike, but that typicallyis not the one to worry about.
What role do you think the Omicron variant will play in the economy?
It’s too early to worry, and it’s fair to be aware. The media has already jumped on the new variant story and is producing fear bombs. But I think that’s going overboard given the lack of information. Anecdotally, Australia’s chief medical officer recently said of the 300 cases recorded worldwide, all had very mild or no symptoms. Pfizer came out and said it expects its vaccine to be effective against Omicron. And GlaxoSmithKline said the antibody treatments look like they’ll be effective against the new variant.
The reality is that if you have a variant that’s highly contagious, but extremely mild, there’s an argument that that’s a win for the world because you can get some herd immunity without severe cases. But it’s too early to tell right now.
How’s holiday shopping going so far?
Let’s look at Black Friday and Cyber Monday. More than 180 million shoppers made online or in-store purchases from Thanksgiving through Cyber Monday. That is a decline of 4% from 2020. On the surface, fewer people bought. But the number of shoppers was in line with the average over the past four years, and the 180 million shoppers was far more than the 160 million estimated by National Retail Federation. And the NRF still expects 2021 holiday retail sales to increase between 8.5 to 10.5% year-over-year. That’s pretty robust growth. Digging even deeper, Adobe Analytics tracks “out of stock” messages that consumers received. For November, those messages were up about 170% versus pre-pandemic levels. That tell us that the supply is just not there.
Here’s another thing. Retailers are expecting to hire 650,000 people this holiday compared to less than 500,000 last year (vaccines were just being released). That’s a pretty big jump. So, again, the demand is there, but broken supply chains are hampering sales. We also have workforce constraints being fueled by vaccine rules. All these things, I think, are affecting the numbers.
Given all this, where do you see opportunities in fixed income?
My view has been consistent since early this year. The inflation story was uncertain then and is now. The credit story was strong then and is now. Corporations are doing well, and the demand story is still very positive.
Plus, there was $5 trillion in stimulus sent to Americans. Consumers right now have about $4 trillion in savings, which is a very high number historically. There is pent-up demand and dry powder to use once things open up even further.
What does that mean from an investment standpoint? Positioning longer duration because of the inflation story would not be my preference. I think that you want to stay with shorter duration. With the credit story strong, my belief is that you want to be overweight credit. That has been my view for a while.
By the way, in November, the S&P 500 was negative, Russell 2000 was negative, international equities were negative, and loans were down about 15 basis points year-to-date. But over the past three months, floating-rate loans are up 73 basis points and have been among the best fixed-income asset classes this year.
This year, it’s been all about defensive income—defensive against inflation—and I still maintain that view as long as the inflation story is this uncertain. We’ll see if spreads dislocate or rates move higher, then that might leave some room to add duration.
Okay, time for our monthly lightning round. First question: On a scale of 1 to 10, how worried are you about the Omicron variant’s impact on the economy?
Given the information right now, I’d say a two-and-a-half.
The Fed has retired the word “transitory” when describing inflation. What’s a better adjective today?
Will the Fed speed up its tapering and by how much?
Ugh. I will say, “Yes,” perhaps in May, a month earlier than expected.
Predictions on rate hikes in 2022?
One rate hike in the second half of the year.
The economy has faced so many challenges this year, but has still remained strong. What’s been a key factor or two?
One, monetary policy. Hopefully everyone is catching a theme here. It’s been about the central bank. Two, fiscal policy. We’re still running pretty big deficits, so there is a ton of money in the system.
And what surprised you most about 2021?
I’m still surprised that a lot of companies aren’t back in the office and probably a little surprised we’re still wearing masks regularly.
What will be the biggest story in 2022?
Are you a New Year’s resolution maker?
I’m a bad one. That’s probably the best way to put it.
Last question. We’re in the thick of the holiday season. Any thoughts on how to get the most joy out of it?
In my opinion, the best present to give people in my life is time. When I think about Christmas, it isn’t really the gifts. It’s the occasions, the events, the holiday parties, the holiday meals. The time spent together. I try and convey this to my kids: Be in the moment, don’t think about what’s next, and just enjoy being engaged with the people in your life. In other words, give the gift of undistracted energy and time.
One basis point is equal to 0.01%.
Bloomberg US 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.
The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living.
Dry powder is an informal term used for describing highly-liquid marketable securities, cash reserves, or any other securities that can be utilized for investment opportunities, future obligations, and operational expenses.
Duration is often used to measure a bond’s or fund’s sensitivity to interest rates. The longer a fund’s duration, the more sensitive it is to interest-rate risk. The shorter a fund’s duration, the less sensitive it is to interest-rate risk.
Floating-Rate 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 MSCI World Index is a broad global equity index that represents large and mid-cap equity performance across 23 developed-markets countries.
The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-value ratios and higher forecasted growth values.
The Russell 2000 Index measures the performance of the small-cap segment of the US equity universe. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership smallest securities based on a combination of their market cap and current index membership.
The Russell 2000 Value Index is a small-cap stock market index that makes up the smallest 2,000 stocks in the Russell 3000 Index.
The S&P 500 Index is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the U.S. stock market.
Spread refers to option adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return.
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