by Stephen H. Dover, CFA, Franklin Templeton Investments
Listen to our “Talking Markets” podcast. A transcript follows.
Transcript
Stephen Dover: Let’s start off with Mark from Western. Mark, what are your views on the short-term and long-term interest rate environment and inflation over the next few years?
Mark Lindbloom: This is the most important topic that we are talking about at Western Asset Management, and I’m sure that all of us are discussing for sure.
A very uncertain landscape we live in and I’ll divide my answer into two parts, the cyclical—or the what we’re seeing now, the shorter term—and the secular. And I’ll start by saying that a Western has an out-of-consensus view on this right now, and over the last six, seven weeks, we’ve certainly been feeling that out- of-consensus view.
I’ll start with the short term. We are keeping a very open mind, Stephen. There are some extraordinary things that are going on that we have not seen in a long, long time. And, we know for sure that, in the short run, inflation is going to be going higher, mostly because of the so-called base effects. And that is, specifically, that one year ago, as we were all dealing with the onset of COVID-19, we were seeing some very, very weak inflation prints.
You know, people were worried about disinflation and deflation, not inflation. Those, of course, are dropping off in the next several months. Based upon that, the inflation numbers are going to be well in excess to 2%. This is not a surprise.
But, this is something that we are all dealing with and has impacted expectations to a certain extent, very, very recently. These will be dropping off in the future, but needless to say, it’s important right now from a cyclical point of view.
However, beyond that, I think is the bigger debate that we’ve got going on right now, with COVID-19 diminishing—we hope, we all hope—strong service demand, as we can all get out there and do what we’d like to do later in the year, for sure. The Federal Reserve who promises not to take the punchbowl away. And most people believing that for the most part. And also, with fiscal policies that will be ramping up far beyond what we thought they were prior to the Georgia elections, there is obviously some possibility that we’re going to see that inflation is going to be moving somewhat higher.
So, all in all, we’ve seen a rise recently in nominal. We’ve seen a rise in the real interest rates, particularly in the long part of the yield curve. And, we accept that. We understand that. Where we are having a more difficult problem is on that longer term, as you asked about, the more secular. And specifically on that, we are not convinced at all at Western Asset that we are entering a bear market in terms of interest rates based upon higher inflation, or that we’re going to see persistently higher inflation—emphasis there on persistent, not just the cyclical short-term impacts.
And, for example, on the fiscal sides, whether the fiscal spending will lead to higher inflation is an open question in our minds. Witness: Japan. Witness: Europe. This is a global conversation. We have to be mindful of how that fiscal will be spent and whether it will be more borrowing growth from the future, a huge debt overhang, and not to forget the impacts that we’re seeing on demographics globally, the aging of our populations, the benefits of technology, and global trade, for example.
So we are on our back heels, Stephen, for sure, in the last seven weeks. We’ve heard, 10 years ago, inflation is going up. Five years ago, inflation’s going up. It could be possible given the extraordinary things that we’re all seeing currently. Our bottom line, though, is we’re not convinced yet that we’re going to see that persistent increase in inflation, at least over the next year or so.
Stephen Dover: Mike, let’s step to you at ClearBridge. How do you see interest rates affecting the equity markets and also any likely inflation, and how are you looking at it?
Michael Clarfeld: As Mark mentioned, there have been several false starts on higher rates, or higher inflation, or concerns about that, really, ever since the financial crisis, and it hasn’t materialised yet. And there’s some good reasons for that, potentially. Before the COVID-19 crisis, we’re talking about secular stagnation.
So, all these bigger-picture things that we’re wrestling with, and we’re considering those and trying to keep an open mind and also marry those with what we’re doing at a stock level and at a portfolio level. And I think what we’re trying to do is position for multiple different outcomes. And I think that’s what investors need to think about, right?
So, keeping an open mind about what the impacts of rising rates could be if they happen, understanding what that means for valuations in a world, which is not just equity markets, obviously, but everywhere where evaluations are used by such low interest rates, keeping an open mind on that and making sure that your portfolio is not, you know, overly positioned on things that are reliant on rates staying so low to ensure their valuations, but also not jumping the gun and getting too far down the road of saying that it’s clear we’re in a high inflation or rising-rate world because, you know, to Mark’s point, base effects matter. And, a big part of this is just where we’re coming from, and interest rates have come up a lot, but we’re obviously still below 1.5% on the 10-year [US Treasury].
As we think bigger picture about equities, I think a couple of things that are relevant in all of this, if rates really rise and if inflation really picks up it’ll weigh on all asset classes, right? So, you know, inflation isn’t really good for anything and rising rates are headwind to everywhere, but equities will be relatively well-positioned in that regard, in the sense of the ability for companies to raise prices, growing earnings, and then as dividend investors, we think through what that means to dividends. And again, from a big-picture perspective, you know, we’re not rooting for higher rates or higher inflation because of the negative effects that it has across everything. But from a dividend perspective, you know, dividends will do well in that environment in the sense that higher inflation should flow through to higher earnings through prices and stuff. And dividends will give you a bit of a hedge on rising rates and enable you to keep up with it. So, that’s, sort of, how we’re thinking about it, but it really is an interesting time in the sense that we’re wrestling with these big-picture issues. And it’s important that investors remaining humble and also open-minded.
Stephen Dover: Gene, you’re looking at investment solutions, you’re looking at multi-asset and complete portfolios, both for institutional investors, as well as individual investors. What’s your perspective long-term on interest rates and inflation?
Gene Podkaminer: For a full multi-asset portfolio, you don’t just care about how rates and how inflation flow through the fixed income allocation. Actually, you care about how they hit everything. And let me start with saying that this low-interest-rate environment, this is not a new regime, right? Interest rates have been low for a while now. We’ve almost become used to it. As we forecast our capital market expectations, going forward, that interest rates will probably be low for the foreseeable future, and importantly, those interest rates impact asset classes differently. So, as we talked about earlier for fixed income, that’s a very mechanical connection for both interest rates and inflation rates, but for equities, it’s a little bit more nuanced and it’s indirect. But also, we need to keep in mind that interest rates and inflation hit real estate, they hit commodities, they’ll hit infrastructure. Any asset class in a portfolio is really dependent on what happens at the interest rate level and the inflation level.
As we think about what the implications for portfolio construction are, we first need to ask ourselves what is the role of the different asset classes in the portfolio? So let me start with an easy one. What’s the role of fixed income? Is it to reduce the overall risk of the portfolio? Is it to minimise the difference between the asset portfolio and some liabilities that we’re funding? Once we answer that question, we then begin to understand how inflation, how real interest rates impact the portfolio.
And one thing to keep in mind as we go down that path of questioning is that if the point of fixed income in a particular investor’s portfolio is actually to provide some diversification for the equity allocation or diversification for some of the alternative allocations, which are now even more important.
We need to keep in mind that as we invest in higher-spread fixed income assets, so those like high yield or emerging market debt, they’re going to be more correlated with equities and other parts of the portfolio than is government debt, plain old Treasuries, which has less common-factor exposure with equities. So, this is a really key point for the long-term portfolio construction impact of rates and inflation.
What we’ve observed over the last couple of decades is that investors have really been reaching for return. And they’ve been doing this in two ways, changing the degree of fixed income that they have in their portfolio and changing the kind of fixed income that they have in their portfolio. By degree, I just need the absolute allocation. It used to be the 60% equity, 40% fixed income portfolio was sufficient to meet a lot of investor needs. And that certainly changed, especially for institutional investors over time where 60/40 gradually became 70/30, 80/20, maybe even 90/10. So that’s the degree of fixed income changing in the portfolio.
And, in terms of the kind of fixed income that’s held, it’s gone from pretty boring, plain vanilla Treasuries and government bonds to things that have more spread in them, as I mentioned earlier, high yield and EMD [emerging market debt]. So when we think about how shocks to interest rates or inflation, or for that matter, how the current regime filters through the portfolio, it’s important that we keep in mind what kind of fixed income is in there. When we consider the long-term implications for the real-rate environment and the inflation environment, we think that government bond term premia is going to remain below historical averages. We see some performance potential from government bonds, but for the most part, it’s going to drag down asset returns.
When we think about the long-term picture we see, we’re focused on debt accumulation, and this is something that [US Treasury Secretary] Janet Yellen has talked about recently, and that is on the mind, I think, of every policymaker globally. Debt levels look a lot different now than they did in the last crisis.
Now, debt service levels are a bit of a different story in that interest rates are a lot lower as well, but global policy makers are trying to offset the effects of the current recession, and they’re doing it with all the tools that they have available, monetary and fiscal policy. And as rates begin to get cut towards their lower bound, policy coordination is even more important between monetary and fiscal and also between different regions trying to coordinate their policy. But, it’s pretty clear that fiscal policy is playing an even bigger role.
Shorter term, we are concerned about what what’s going to be happening with interest rates and inflation-wise, you know, inflation is something that folks really weren’t concerned about a couple of years ago. But for those of us that have been in the industry long enough to remember what inflation feels like—it’s really painful to watch and not a lot of portfolios are set up to really be sensitive to inflation. So if you look at any portfolio and you take a look at the different assets in it, and you ask which of these really moves with inflation, which of these is going to help me in an inflationary environment? The answer is probably a pretty small amount.
Stephen Dover: Great. Thanks, Gene.
So let’s turn to Mike. And of course, Mike, the question we have is—the stock market surged to near record highs. It’s cooled off a little bit, but we’re still at near record highs. Is that performance sustainable, especially, with this back-up in Treasury yields?
And then, specifically, we’re seeing a tech selloff. How long do you think that will continue and where do you see the opportunities in the equity markets right now, Mike?
Michael Clarfeld: So, you know, it’s an interesting time in the sense that I think our bullishness on the fundamental economy is the most it’s ever been. Right? Because, obviously, again, we’re coming from such a terrible year in 2020, but the combination of hopefully good progress on the vaccine, people being to get out and about again, the people have a tremendous amount of savings from all the money they couldn’t spend last year, and then, you know, the government sort of stimulus programs, and then you have stimulus coming again. So, we’re the most bullish on the economy and on GDP [gross domestic product] that we’ve ever been. But then, you’d say, “well, how does that drop down to the stock market?”
And the answer is twofold. The first thing is earnings will be terrific. There shouldn’t be much doubt about that, given how strong the economy is going. but then what do you pay for the stocks? And I think that, there, the answer is more nuanced and coming back to this idea, none of us expected 2020 to be as good as it was. And because of that, it’s pulled forward a lot of the returns that we would have expected over a longer timeframe.
And then I think the key question it comes back to is interest rates, which is what we’re all wrestling with. And I think, we believe that the stock market overall can definitely handle rising rates so long as it happens at a measured gradual pace. We’ve had a huge move in rates so far, but we’re still obviously only 1.35% 1.40% on the 10-year [US Treasury], which would be the lowest it’s ever been, except for a handful of months at different points in crises. So rates are still very supportive, and we think that even if rates move slowly and steadily up to, you know, 2.5%, 3%, the market can definitely handle it.
What would concern us more is a major dislocation in rates. In other words, if things move much more quickly, if sort of people perceive that the Fed [Federal Reserve] has lost control or just sort of a buyer’s strike, something like that would concern us.
The question about tech is sort of a microcosm of the markets overall. So, the fundamentals of technology will continue to be terrific. The comps will be tougher this year. So, you know, maybe on a year-over-year basis, won’t look quite as good, but the tech companies that have had a lot of success are some of the best companies the world’s ever seen and the fundamental drivers remain in place. So, from a fundamental perspective, the answer is we absolutely expect them to continue to do well, but at the stock perspective, we’re a little more cautious given again, how much of the returns were pulled forward in 2020. What we’re trying to find here, given this overall dynamic I’m talking about, is where again, we’re very bullish on the economy, but then what stocks don’t already reflect that or discount that?
And so, what we’re trying to find is companies and sectors with a lot of leverage to recovery in the economy, a lot of upside, and also where there’s still a bit of investor pessimism. And so, two areas that we’ve been focused on a bit have been financials—interest-rate sensitive financials, and energy—both areas where there’s a lot of leverage to the upside where interest rates are rising, still very low, but rising—the [yield] curve has steepened. On banks and the like you’re going to have big loan growth from a rising economy coming from a very low level. And, generally speaking, people haven’t been flocking to banks for the last many years, right? But given a slow recovery from the crisis, rise in regulation, there’s been a general apathy towards banks.
Similarly, on the energy side, you’re coming from a very low place on the commodity prices. Obviously, that’s rising and investor disdain for energy is at sort of remarkable highs or has been until a month or two ago, in the sense that I think, just to couple months ago, energy was 2.5% of the S&P 500, the lowest it’s ever been. So what we’re seeing is, the economy is expected to be terrific everywhere. Much of that got pulled forward in 2020, so we’re a little more cautious on the potential capital appreciation in [20]21, and then trying to find areas where there’s still some pessimism that enables opportunities for the stocks.
Stephen Dover: Mike, specifically, you have some expertise on the energy sector and in pipeline stocks, maybe you could explain first what they are and your view on them at this point. That’s very high yield and probably not in favour right now.
Michael Clarfeld: Yeah. So that’s a good point. So, the energy industry in the United States has obviously been a key area of change in dynamism in the global energy patch over the last 10, 15 years. So, if we went back 30 or 40 years ago, the US was a huge energy producer. It was secular decline for a long time. And then with the advent of shale, the US has become the largest energy producer in the world. And as that happened, what we saw was that there was a big need to build pipelines and infrastructure to move the oil and gas. It was an area that was highly favoured and highly valued in the early part of the 2010 decade. And then when commodities rolled over in 2015, 2016 fell out of favour. We believe that actually that the US will continue to play a big role in energy production, and that from a climate-change perspective and sort of decarbonisation, that’s going to play out over decades, you know, unfortunately from a environmental perspective, it’s going to take a very long time. And then, because of that, there’s a high visibility that the US will continue to be a big producer and that you’re going to need this infrastructure.
The reason that the attractiveness that we believe still exists is the combination of number one this pessimism towards energy that’s been there, you know, energy stocks have been out of favour and these pipeline companies are out of favour given sort of the downturn you had several years ago. And then, obviously you had some weakness, material weakness, in the commodities last year. So, it sets up for a doubly recovery in the sense that we expect improving fundamentals. And then we think that investors will come back to these areas as they realise that that the pessimism is overdone.
Stephen Dover: Great, thank you. So, the question I’m going to throw out to Gene is what if we’re wrong? What if inflation actually is taking off? What if interest rates really are rising?
Gene Podkaminer: Maybe the question should be when we’re wrong, not if we’re wrong, right? Just look at how difficult it is to try to forecast interest rates. It is virtually impossible, if you look back at the history and the different point forecasts, at different points in time. And the question is how do we build resilient and robust portfolios that aren’t brittle? And that don’t get destroyed when we are wrong about whether it be interest rates or inflation or the level of economic growth. And the way that we do that is by combining different asset classes and asset types together that provide some level of support and resiliency.
So if we, even if we think that economic growth is going to be amazing this year, that does not mean that we should ignore assets that perform okay, when economic growth isn’t. Or if we think that inflation isn’t going to be that big of a deal this year, we should still have inflation-sensitive assets. I feel pretty strongly about that one. And in terms of interest rates One of my concerns with trimming down fixed income allocations, you know, down to the bone, you’re going to feel every bump in the road, and it’s going to be painful.
Stephen Dover: Well, this has been a great pleasure for me, and I hope for the audience. Thank you very much to Gene, Mike, and Mark for giving us a dynamic conversation today.
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