David Lebovitz:Welcome to the Center for Investment Excellence, a production of JPMorgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. 

Today's episode is on inflation and the Fed's response and has been recorded for institutional and professional investors.

I'm David Lebovitz, Global Market Strategist and host of the Center for Investment Excellence. With me today is Jared Gross, Head of Institutional Portfolio Strategy.

The last time we spoke was the asset allocation draft and obviously a lot has happened since then. It seems like in the current environment, the dispersion of views around the outlook for growth, the outlook for inflation and subsequently, the outlook for Fed policy have gotten wider and wider and wider. 

And so I'm hoping today that we can spend a little bit of time, providing some clarity around the arguments that we're hearing from our clients in the current environment. And why don't we start with inflation here? 

So, Jared, maybe I’ll turn it over to you to kind of set the stage and we can dive right in? 

Jared Gross:Thank you, David, and it's a pleasure to be here. And thinking about sort of a framework for today's conversation, I think you're right, inflation is probably the most useful entry point. It provides kind of a macro backdrop for a lot of what's taking place in the market today. 

And I thought we can speak to inflation a little bit. We can then maybe pivot to Fed, the reaction function, how we see the Fed's response transpiring over the next year or two, a little bit more on sort of the market's reaction to the Fed and where there may be some vulnerabilities and certain market pricing, and then maybe conclude with a bit of a discussion around investment strategy and how investors can position themselves both for the near-term shift in interest rates but also longer term. 

So with that in mind, let's kind of get back to inflation. I think you're very well positioned to offer the kind of baseline macro perspective from JPMorgan Asset Management. And what we're seeing right now, a lot of data coming out; what are you looking at, what's got your attention right now? 

David Lebovitz:Absolutely. So I think the first thing to acknowledge is that inflation is running hot. But when we take a step back and we think about where a lot of the inflation has come from up until this point, it's very much been driven by disruptions on the supply side. Used car prices I think are an excellent example. We are seeing inflation begin to broaden out, and particularly in last week's inflation report, you saw really firm numbers coming out of the housing side of things, you saw broadening out into services. 

Obviously food and energy are doing the majority of the heavy lifting and that's certainly catching the attention of a lot of the folks that we speak with. But I think that there is a story here where inflation gradually cools off over the course of the next 18 to 24 months. 

Now I'm not in the camp of we're going to be back at 2% inflation by the end of 2022 but I do think that inflation could have - to handle by the end of 2023. And there are a couple things that lead me to have that view. First of all, headline inflation is going to remain elevated, mathematically, just given where food and energy prices are today. 

But given that lower-income individuals see a greater share of their spending go to food and energy, that could actually allow core inflation to begin to cool a bit more rapidly into the end of the year than a lot of people had originally thought. 

You couple that dynamic with some resolution and some healing with global supply chains, you know, a little bit of disinflation, if not, outright deflation in the price of certain goods and, you know, again, we are talking about inflation that probably starts to the fore in December of 2022. 

But I do believe that over the course of 2023, particularly if the Fed hikes somewhere close to what markets are pricing in, that will lead inflation to normalize to levels that are a bit more comfortable than where we are today. But like I said at the outset, there's huge dispersion here. So, Jared, how do you see the other side of that coin? What keeps inflation stickier than a lot of people currently think? 

Jared Gross:Yes, it's a fascinating debate and I'm probably going to take the slightly contrarian view. It's a great reminder right now of why students of inflation and people in the market who watch this separate headline from core. We want to separate headlines for the reason that food and energy are highly volatile and they also tend to be substitutable and mean-reverting. And so the head-fake of a high-inflation print at the headline level is not something that should alarm us too much because they tend to go away after time. 

Now as you said, there's a lot of things happening right now with respect to energy supplies and the food supply which may be something other than a short-term blip. But broadly, we should expect those prices to come down. 

The flipside, however, is that we also pay attention to core inflation as its own economic indicator because those prices are stickier and they tend to get built into longer-term decision making and contracting and other things that by definition are sticky. 

And so the fear with higher core inflation - and this had been such a long time since this was front and center in our economic consciousness. But the fear of course is that becomes self-reinforcing. And it's not quite clear that we're there yet but we have core CPI north of 6. We're probably going to get core PCE north of 5. Those are numbers that are alarmingly high by any recent historical standard. 

And so I think we have to be careful about assuming that those will just fade along with headline. There's some other data out there if you look at some of other kind of non-traditional inflation metrics like the trimmed mean or the sticky-price index. They're all kind of flashing red right now. 

And so that tells me the path of inflation while, yes, it's going to be downwards from here, it may be a much longer, slower down slope and that implies that investors buying fixed income particularly at current yields are almost certainly not going to receive a positive real return, and if interest rates rise significantly, the potential damage in terms of prices could be significant. So we have to be very careful about it. 

David Lebovitz:I completely agree. And one of the things that I’ve been trying to think about and it's really not clear but can companies pass on higher wages, right? To me, that's how the wage price spiral really begins to evolve. It's very clear that they can pass on higher input costs in the form of transportation costs or raw material costs. The wage issue was a little bit more nebulous. 

And so if I were to take a step onto your side of the line, I think part of what would get me more concerned about inflation is concrete evidence that that wage price spiral is really beginning to take hold. And obviously that's something which we're going to learn a lot about over the course of the next, call it, nine or so months. 

 Jared Gross:And on that point, I think some of the more interesting data is coming from the JOLTS survey. And when you look at some of the ancillary data around the wage increases for people who are staying in their jobs relative to people who leave for other jobs, they're both running very high. Even those who are not leaving are getting wage increases. And those who leave are getting bigger wage increases. 

And so the net effect on wages is to sort of drag them upwards across the board. And yes, to your point, can those wage price increases be passed onto consumers at the final goods price and will companies maintain their margins? Or will this lead to margin pressure and presumably lower profitability going forward? I mean, those are key questions we still don’t have answers to. 

So maybe let's pivot to kind of the second phase which is the Fed's response function. So we're going to get a meeting later this week. We'll obviously get a lot of discussion around not just the decision about where they move rates but the press conference afterwards and all the things that Chairman Powell will be sharing with us. 

What's your current over-under on the path of the Fed funds rate over the next year or two? 

David Lebovitz:Of course. So clearly the Fed is going to get going here on Wednesday at their March meeting. I frankly think that they'll hike three times sequentially. So I see them going in March. I see them going in May. I see them going again in June. 

At that point, I do think that they're going to come up for some air, take a look around and see the hand that they've been dealt as they look to the second half of 2022. There are a lot of questions in the current environment about how long food and energy prices will remain elevated, how pervasive is inflation becoming across the economy, what will be the impact on growth, can consumers really absorb this energy and food price shock or is it going to lead economic activities to begin to slow here? 

It's relatively clear by my lights that the Fed is going to hike, call it, three to four times this y ear. I'm not terribly sure that they'll be able to get the full seven in but if they're given the opportunity to continue hiking during the second half, I think that they're going to take that opportunity. I think that the Fed is clearly rubbed to the wrong way by what's happening. Jay Powell seems like he feels responsible for the inflation that we're currently seeing. And so I think it's again about that window of opportunity. But I still think this is a Fed which errs on the side of caution. 

And, you know, I was thinking the other day that as somebody who has been in the business for a little bit more than a decade, I’ve only ever known the zero bound, right? I don’t really know a world of capital markets where real interest rates are positive. And so maybe I'm too dovish on this issue but the counterpoint to that is maybe I have a better understanding of the Fed's reaction function because I wasn’t dealing with 40 years where interest rates were steadily falling. 

So, Jared, maybe for somebody with a little more experience, tell me where I'm wrong here. 

Jared Gross:Thank you for making me feel old. I actually began my career during the Fed's 1994 rate hiking cycle which was universally panned as a - kind of a disaster for the markets. And it is interesting; I mean, right now, like, just take a step back. We've got inflation north of 7 and a Fed's funds rate at zero. I mean, those two things do not (compete) right. 

And the Fed is clearly behind the curve. Their credibility is clearly at stake. They made a lot of noise a year ago with this idea of an inflation was transitory. So increasingly, it seems like that was just sort of gaslighting the market about where they thought inflation was going. I'm not really sure. That decision has aged well as they say. 

And so I think right now you have this potential scope for much larger Fed action if they choose to. And I think to your point, when you talk about taking a breather, what I find really interesting is this idea of what are they actually looking at when they do that? Short-term interest rates, in an era of supply driven inflation, are unlikely to have a very significant near-term impact.

So if they hike once, twice, three times, four times, five times, is that going to directly impact the price of food when we have supply shortages coming from the Ukraine? Is it going to impact the price of gas? I mean, yes, at the margin very slightly but it's going to take a while. 

I think what the Fed is really going to be looking at is the markets. Is market volatility going to rise? Is there going to be a selloff on the back of this, of sufficient magnitude that they have to be concerned about, financial stability and wealth effects and things like that that have in the past drawn them back in this idea of sort of the Fed put. 

And so I think that's going to be really interesting to watch. And so to your point, if the markets stay stable, reasonably stable, and again that's a somewhat subjective judgment, I think the Fed could very easily hike much more quickly and more significantly in the near term than your baseline suggests. 

However, if the markets do wobble, and that could come both from the direct effect of the Fed raising rates or just other exogenous geopolitical noise that's going on, then I think they will pause because I think they will have at least moved a little bit of altitude to sort of the Fed funds rate. They can bring it back down if they wish. They obviously have the balance sheet to play with. And maybe that's a good transition. Let's talk a little bit about the balance sheet. You know, right now, everyone's focused at the front end of the curve. There's also this idea that at some point in the near future, we're going to move out of quantitative easing into quantitative tightening. What does that look like? Is it just a simple roll-off or do they get more aggressive and actually sell securities?

David Lebovitz:So I think it's a great question. And we have limited experience with quantitative tightening because as I’ve shared with you on a number of occasions, I think the Fed made a policy error at the end of the last cycle. They just got away with it because they had to cut rates in response to COVID before anybody could see that emperor had no clothes. 

So what does quantitative tightening look like this time around? Well, it’s clear that the Fed wants to reduce the amount of assets that it holds on its balance sheet. And there are limits to the amount that they can reduce given the currency and circulation. But this is something that they very much want to get going. 

And so I think that if they get those three rate hikes in through June, they start to allow the balance sheet to passively run off at the beginning of the second half. If things are going smoothly, I do think that they could become an active seller of some of these securities. 

And I think about it in very simple terms, right? It’s basically treasuries and mortgages. I know that they have some other stuff there. But you made a very astute point earlier that hiking rates into a supply side-driven inflation environment can be very ineffective. You look at the housing market. That actually has a combination of supply and demand, right? We have a limited supply of housing. Home prices have risen as a result because consumer preferences are changing. 

I’m the perfect example. I moved my family out of New York City into the suburbs. There are now no homes for sale in the town where we live and there’s still tremendous demand. 

And so I do think that the Fed can cool economic activities. They were to actively put upward pressure on mortgage rates. And so to me, if they’re given an opportunity to become an active seller, maybe they start by selling some of those mortgages and gradually allow the treasury to just continue running off over time. 

The question then becomes, if the Fed commits a policy error, do they turn around and start buying all over again? And I think the unfortunate reality here is yes, I think that we’ve definitely taken the genie out of the bottle and quantitative easing has firmly planted itself in the toolkit of central bankers for any time there’s a period of market or economic stress. 

I do think that the Fed may not do quantitative easing as aggressively as what we saw in response to the pandemic or response to the financial crisis. But I think you would certainly see them pause, if not reaccelerate whatever normalization was going on at that point in time. 

Jared Gross: Yes, I don’t disagree and I think the span of history even just the last 10, 15 years have shown us that with each passing instance of a Fed stepping into the market, it has grown in magnitude and it has grown in sort of the diversity of what they’re willing to own. And it’s not really clear why that would change going forward If we get either a geopolitically-induced recession or a Fed-induced recession, again the ability of the front-end interest rate market to save the day is limited. 

David Lebovitz:Right 

Jared Gross:They have grown accustomed to buying treasuries and mortgages and at least to some extent credit assets. Is it so farfetched to think that the equity market is that far behind or other risk asset categories? Other central banks have done it and the Fed is certainly aware of that. 

So I don’t want to make it a projection but it certainly feels like the trend is pretty clear that central banks who once operated in a very restricted space of short-term government fixed income have sort of loosed the bounds of whatever constrained them in the past. 

And if the Fed wants to be effective and so I think it’s not much of a critique of this potential policy but just as a recognition that if your goal is to support the financial markets, lowering front-end Fed funds rates is a very blunt instrument and essentially very ineffective whereas going directly at the problem and buying assets is a much more effective and direct way to do it. And I don’t think it’s necessarily a bad thing but we should at least be willing to acknowledge it’s a possibility. 

So maybe that’s a good segue to the market. So we’ve talked about inflation. We’ve talked about the Fed’s response function. Let’s talk a little bit about the market. 

Now maybe we’ll start with fixed income and specifically the curve. The shape of the curve right now is a little interesting. It’s obviously very steep at the front end, anticipating a lot of Fed hikes. Very flat to the back end which to me says not a lot of concern about inflation but there’s a lot of ways to read that. So what’s your reading of the yield curve right now? 

David Lebovitz: So my thought on the curve and I actually think there’s a tie in here with the conversation we were just having about quantitative tightening, to me, the long end of the curve is beholden to really two things. COVID is still in the picture like it or not. Just look at what’s going on in Southeast Asia today. And I think until we can really sound the all clear and say, “We’ve gone from pandemic to endemic,” you’re going to see the long end of the curve be way down to an extent by the presence of the virus. 

The other thing is just the uncertainty around the pace of economic growth going forward, how much are these higher food and energy prices going to weigh on consumption and what does that mean in terms of the outlook for growth. I think until the market gets past those two things, we’re probably looking at a curve that’s relatively flat on the longer end but maybe that’s another reason why the Fed goes out and starts selling assets, right? The Fed doesn’t want to invert the curve. 

And so if they feel like they’re going to do that during the second half, I do see room for them to be actively selling maybe not just mortgages but treasuries as well in an effort to boost long end yields and maintain some sort of upward slope in terms of the curve. 

Jared Gross:Yes. Well, you know, I mentioned early on it’s sort of this kind of does not compute mentality around the Fed funds rate being at zero while inflation is north of 7. 

Perhaps even more strongly this does not compute when you look at the long end of the curve being between 2% and 3% and inflation being where it is. 

And so it feels like there’s almost the sort of binary outcome that the market is trying to figure out which is on one hand, inflation stays high and rates are going to have to rise probably significantly. 

On the other hand, there’s a policy mistake and we wind up in a recession. And therefore, the long end is fairly priced, if not essentially has room to fall. 

And there’s probably an implied probability of those two events that’s baked into that long-term interest rate right now. And there’s just so much uncertainty around which of those two paths we go down and we won’t know until, as you said, the Fed gets a couple of hikes under its belt and we start to see the reaction of the market to that sort of movement up in interest rate. 

So we’ve been at the zero-bound for a very long time, as you noted. There’s lots of areas in the economy and in the markets where low interest rates have led to leverage and embedded risk taking and we won’t really know exactly how that unwinds until we see it in practice. 

And so I think the market is rightly uncertain about how to read that. Just on the face of it, it seems if the face value way to read the yield curve is the Fed hike is the front end, the long end stays flat; therefore, implying that the Fed gets the handle on inflation and everything works out okay, that seems a little optimistic right now. So it’s probably more likely we break one way or the other. 

So maybe let’s talk about interest rate movements. Let’s just pause it for a minute. The curve steepens a lot, could be inflation driven, could be driven by quantitative tightening, whatever gets you there. What do you see as being the more vulnerable sectors to rising long-term interest rates? 

David Lebovitz:I think the easy answer is anything with duration. That means one thing on the fixed income side and one thing on the equity side. I do think obviously government bonds coming off of these very low levels it’s going to be a bumpy ride. You’ve already seen some repricing in credit and spreads have widened out here. That should help smooth things out particularly as you go further down the quality spectrum. 

But the reality here is that fixed income is going to be challenged going forward and one of the things we were talking about on the Guide to Alternatives call earlier this morning is how do you play defense in your portfolio when stocks and bonds are selling off together which is very much what we’ve seen so far this year 

Now growth stocks, you know, the technology stocks, the things that have done so well over the past ten years, I do think that those will come under pressure or remain under pressure rather in the short to medium term. I do believe though that at some point here the market begins to differentiate between profitable and unprofitable companies. 

Somebody said to me recently, you know, a very large technology company, they’re going to make money whether the ten years at two, three or four. The question is the multiple that you’re willing to put on it.

And so I do see some opportunity in those names longer term. But I think the baby is going to get thrown out with the bathwater much like it has so far year-to-date as interest rates continued to rise. 

In terms of where you want to be and I love to get your thoughts on this, Jared, as well, I think it reinforces the case for things like core real assets and uncorrelated sources of income as well as private credit and specifically direct lending. You know, you’re taking some of that economic volatility out of the equation, introducing accounting volatility and on the point of core real assets, things like infrastructure particularly regulated utilities, they have that direct pass-through of higher cost to the end consumer. 

And so you get the income you’re looking for. You get it without the equity correlation. And on the case of private credit, these tend to be much higher-quality assets than are available in the high yield market or the bank loan market. 

Again I think what’s so interesting to me about this environment is if we stop after the macro discussion, people would probably feel a bit uncomfortable. But when you continue it into, well, what do you do in your portfolio, there are actually a number of doors that have been opened up here given what we expect from an inflation and an interest rate perspective going forward. 

Jared Gross: I agree. And I’ll start with your first comment, which is duration is not your friend in this environment. And I think for a lot of investors, the simplest thing to do is to reduce duration in your fixed income portfolio. 

And we would certainly agree with that I think moving from either a traditional core to something shorter to make a lot of sense particularly if you can preserve some of those active decision-making opportunities, whether it’s positioning along the front end of the curve to capture real yields, whether it’s looking for attractive sources of spread at the front end, whether it’s using floating rate bonds as opposed to fixed rate bonds. There’s a lot of ways that an active manager can position -- even a fairly defensive portfolio -- to generate a modest amount of excess return.

It matters because we are in an inflationary environment and negative real yields will kind of bleed you to death over time. 

And so we want to be careful to preserve whatever yield and return we can even in defensive portfolios, which is why going all the way to sort of through cash is both probably unnecessary but also kind of punitive in terms of its return potential, you know. 

And again anything that’s floating rate with a spread is going to look attractive. So you mentioned sort of direct lending which is often LIBOR based or some floating rate plus the spread. Those are really interesting opportunities right now. 

You also talked about real assets. It’s an interesting debate right now with inflation being so visible and how to play that. On one hand, you know, TIPS have done reasonably well as you have very high (CBI) prints and interest rates have not yet risen very much. 

But I feel like we’re at an inflection point for that sector whereas rates do start to rise, we have to remember that TIPS have nominal duration as well as a real rate of return and you can still lose capital holding those, maybe a little bit less the nominal treasuries but there still is a vulnerability there. And investors have to be very careful about that. 

Commodities have done very well recently. Obviously, there’s a lot of noise around Russia and Ukraine which is driving some of that. But even things like gold have done well recently. But history suggests that gold is highly imperfect as an inflation hedge and if you didn’t own it already, you’d probably miss that trade. So to go in at this point is courting disaster. 

I think the idea of the broader real asset conversation is to find assets that have cash flows that reset with nominal GDP that have a linkage to - meaning sort of pass-through of inflation and growth that have attractive returns that will allow you to stay ahead of inflation over the longer horizon, not just, quote-unquote, “hedge it” in the short term. 

Most investors don’t have liabilities that are denominated in CPI. They don’t need to own a pure inflation hedge in the short term. Those liabilities will roll up on them over a very long horizon. And the single most important thing is out-earning inflation, not hedging it in a narrowly-defined sense. 

And so, yes, real estate, transportation, infrastructure, even things like timber, which is certainly more illiquid under the spectrum but has some very attractive characteristics in an inflationary environment. All of those things start to look a lot more attractive right now. 

David Lebovitz:Well, this has been a great conversation. So, Jared, thanks again for joining us and looking forward to having you back for another episode sometime soon. 

Jared Gross:Yes. David, thanks so much. 

Man:Thank you for joining us today on JPMorgan Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcast and on our Web site. Thank you. 

Recorded on March 14, 2022.