RHP Market Talk

Inflation and Indigestion

March 22, 2021 Royal Harbor Partners Episode 6
RHP Market Talk
Inflation and Indigestion
Show Notes Transcript Chapter Markers

In our second podcast for 2021Glenn Royal and Natalie Picha discuss the most recent U.S. Market numbers on 10 year treasury yields, jobless claims and the Fed's inflation targets.

How will this news affect the overall U.S. economy?

Could deficit spending kill the recovery?

Listen in on their in depth conversation.

Get to know us at: www.royalharborpartners.com

Natalie Picha:

Hello and welcome to Royal Harbor Partners Market Talk. I'm Natalie Picha here today with my partner and our portfolio manager, Glenn Royal, to discuss our thoughts and outlook on current market conditions. Today, we want to jump right into some numbers. Just out this morning, such as the 10 year U.S. Treasury yield, jobless claims and the Fed's inflation targets. Good morning, Glenn, how are you?

Glenn Royal:

I'm well Natalie. Good see you.

Natalie Picha:

So as of this morning, the ten-year treasury note hit 1.73%. That puts us right back at pre-COVID levels. I'd love to hear your thoughts on what this really means for the economy as a whole.

Glenn Royal:

Yeah. It's caused a lot of indigestion, consternation, you know , whatever you call it. I mean, we got a lot of calls from clients, right? It's all over the press , hyperinflation and inflation and all these different things we hadn't seen in really a long, long time. But you know, our stance on this is that with this reopening of the economy, this pent up demand, that's been, we've been sitting in our homes for the last year, globally. That is we reopened that's going to put demand on goods and products. And with the little bit of the slow down in the supply chains and the things we've had in the last year is going to create a little bit of shortages in those goods. So you're seeing that bubble up into these inflationary numbers, these expectations that inflation is going to go higher, but our position is we think it's transitory. We actually don't think that it's going to be a permanent new round of inflation. Much like if you hold a bubble or a balloon underneath the surface of a water, and then you let go, it comes up to the top very quickly and then it settles down. We think that's what we are going to see as this economy reopens a big lift up and economic demand. And then it normalizes back to its long run projections.

Natalie Picha:

So we're talking a little bit about the historically low interest rates since the crisis, but also what that means for our traditionally balanced portfolios. Right? We talk about planning and how we work through risk in a portfolio. And we think about offsetting equity risk, right? With the , with the bond side or the fixed income side of our portfolios. You know, it's, it's difficult when you're looking at historical low interest rates. It's not like the you're getting interest payments, right? You're not getting those coupons in the mail all the time.

Glenn Royal:

Yeah, and that's part of the issue. The 60/40 that's been under attack and you're seeing it a lot in the press. Historically that, as you point out, that offset of fixed income that paid us two, three, four, five, six percent in the past, and higher, that was a cushion offset, should something happen in the stock market. Was rates went to zero and the feds got the funds rates targeted to zero, right now. That took away the benefit of having that income on the fixed income side, insurgent debt inflation, all that that's percolating right now in the markets putting additional pressures on prices in that space. But, we think a little different. We think the 60/40 portfolio, even in a world where bonds aren't getting any return, still has its purpose because it's still a store of less volatility value, kind of a safety valve, if you will, on the portfolio. While we may not make any money in a rising rate environment, and there's different ways we can play that. And I'll go into that here in a second. But you still have that ability that if the equity market comes into severe correction, bonds is where people are going to go and that's not going to change. Now, if I can get 40% of my portfolio just holding flat at zero or slightly down one or two, that's what you're getting with the 64/40 portfolio, if you're concerned about equity risk. It still has its benefit within the bond market. And this is the part where we talk about, you know, earlier, you know, making some comments that how, how mysterious the bond market is to the average investor, they know it's out there. It's so large, it dominates everything, but it is a bit mysterious. But there's ways in the bond market. We have a background in trading bonds now for 35 years. And so what we've been doing in the bond market , if you think of, picture whip in your hand, I always liked this analogy, a switch, and you put that switch around the longest 30 year bonds are at the tip of the switch. The shortest maturities are CDs, you know, two year treasury notes, and then , are near your hand. When you visually whip that switch around, you can see the most price action it's going to be on the long end and the materials as opposed to the shorter, just simply because they're going to pay us off very soon at par. They're not going to trade very far from a hundred bucks that they mature at . So what we've done is understanding that price sensitivity of bonds have during rising rates environments. We can actually measure that calculation, called duration. It's the price sensitivity movement for interest rates. So I know mathematically in a bond portfolio, bonds are about math, right? It's all math. I know that for every percentage point increase in interest rates based on this duration measure, what the principal value of my bond is going to do. So if you have a typical average ag bond portfolio, that's got a duration of about eight on it. Those rates go up for every percentage point increase. The principal value is going to decline by eight percentage points. So now you're a hundred dollars bonds worth 92 bucks. You're still getting your one or 2% coupon on top of that helps a little bit. But you can still see where you can get negative returns of a bond market just simply because rates are going up. So what we do to combat that rate increase risk, is we come in with shorter maturities and that's where we are right now. We have a much shorter duration target on the portfolio of around two and a half. So that gives us that less of a sensitivity to rising rates. The downside is those shorter coupons pay you less income right than the longer ones? Right ? So our income is a little shy, but we're more in a camp right now, you know, protecting principal, get a little bit income and just kind of hide out in here a little bit. And then as rates continue to rise and, and just like stocks, bonds can be oversold overbought . There'll be a point when bonds are over sold and we'll be coming back into the bond market. Now what's cool about the 60/40. And what we have right now is as cheap as bonds were around the world, there is negative yielding debt everywhere. So you had this kind of counter activity at work is the U. S . Rates come up, you're going to have foreign demand. That's going to come and buy our bonds, which is going to keep our yields low. So I don't have expectations that the bond market's going to sell off greatly kind of fade in here. If the bond markets say principal values down 2% and I've got a 2% coupon or interest payment I'm flat. And that's kind of how we're trading it right now. Now I can't say this is a little different scenario because of the expectations of growth that we all have, that we're saying that fed just raised the GDP forecast yesterday for 2021, from 4.2% that they were seeing in December to yesterday to six and a half percent. We haven't seen those kinds of numbers since the Korean war. This is explosive growth to the upside. So the bond is going to have to be dealing with that growth and the inflationary implications as a result, cause that erodes your purchasing power bonds, fixed payments. But what I'm seeing in there though is the corporate balance sheets. You know, it's very exciting to hear the sentiment from CEO and consumers as well. They're very bullish on the outlook here that strength, that those balance sheets, bodes well for investment grade bonds and bodes well for collateralized loan obligations, which we picked up some recently through the senior loan products. So, I feel like I've got a good bit in the bond market in terms of corporates. Now we'll peel the onion back again. One of my favorite saying , we'll go back a little bit deeper here. There's also a spread component in investment grade bonds or corporate bonds, meaning, we price corporate bonds and relationships, the comparable maturity treasury. So if the U. S. ten-year treasury is paying me 1.7%, I might expect, in the old days, when I first got in, I might expected an extra 1.4% for investment grade bonds on top of that, ten-year treasury. Well, as we've had this big boom and all this, the last few years, that's collapsed down to about a half a percent over a 10 year treasuries. So there's a couple of functions there is, you know , if we get a little concerned about the credit quality of the bond, the ability for them to, you know , balance sheet growth stability, you could see that credit spread widening, which also affects the price of the bond negatively. So those are some things we're looking at. The credit spreads are historical tight levels and all this rally that we've seen that come down really, really tight to the treasury. So that's, that's something that you keep an eye on, you know, one of them watch that in that space, but again, how do you handle that? You stay with short maturity bonds, corporate bonds mature in five years, and then just kind of hang out. There's some markers we'll get into at some point it has to do with the real rates whenever, you know , take of the difference between inflation with the nominal yield is, and I look at these things and right now the negative real rate in the bond market is about, it's a difference between when inflation is running right now versus , as measured by CPI , and the tenure note treasury note using that as the reference. And then earlier this year, we were at about a negative 1% real rates. And these negative rates is fuel the fire for stocks, because the bond market is not paying anything. So it goes to stocks, right. And those negative rates really lift the equity risk assets up. We've seen these negative rates in this since the beginning of this year from a negative 1%, which another way of saying that is if I bought a 10 year bond a day with a negative 1% real yield , I'm losing 1% purchasing powered inflation, I just baked into the cake right now. That negative yields lifting as this broader economy is lifting is now negative six tenths of 1%. That gives me encouragement by a lot of things. The fact that I still have negative, real yields with the very easy financial conditions gives me back over to stocks . I lot of optimism. So the point I want to bring out kind of bounced around a little bit, but you have the bond market now it's awake right now and it dominates everything. And I, you know, I've always thought that the secret to being a good stock investor is knowing what the bond market is doing. So we're paying close attention to it.

Natalie Picha:

Right. So that kind of brings me to that, exactly where I was going is that what's happening in the bond market is really the signal for what's going to happen in the equity market. That's where we're going.

Glenn Royal:

Yeah. The cost of capital.

Natalie Picha:

Exactly. So where are we going from here? And I know that we've got a lot of conversation around the divided economy. Right? There were winners and losers during COVID, but we're coming to the other side of COVID and the great rotation, right. We've rotated out of what we think of the big growth stocks, we will be coming back to the cyclicals and the industrials and things like that. So, let's talk a little bit about that, and this is a conversation that I'm having with clients on a pretty regular basis. It's like, "well, we're at all time highs, we can't go any higher." "There's no way we're deficit spending." Then there is, "we're, you know, we're going to kill this economy," but all the indicators on the bond market, just like you said, say otherwise. And as we see this pent up demand coming. We are seeing those balance sheets. We're seeing all these signals really in the economy. What are you thinking in terms of where is this next growth in the next 12 to 18 months?

Glenn Royal:

I think that trade started when we jumped on it back November last year, you know , we were talking about in these podcasts, we were actually starting to underweight technology and moving over towards lower , early benefactors of an opening economy, which were cyclical stocks, a little bit of value stocks. You've heard these, terms, cyclical stocks, there's materials, you're industrials, chemical companies, things like that , autos. So that set up is with us today. And it's really taking off. I mean, the market has really bought into the economy being reflated , lifted up through all these stimulus programs and it's going to lift all boats. And that's kind of getting back a little bit with what happens with technology stocks. You know, those were the big winners last year, the work from home, the acceleration of adoption of technology , ZOOM and all these things that we've done, which gave us basically a five-year pull forward. And it greatly enhanced our productivity. And it's really exciting to see how much we got out of that because when it gets to inflation, what matters is that your productivity growth is outpacing your wages. And so when we look at the big picture about inflation, we're getting tying all this together is that if I look at the unemployment rate as measured by U6, which is the broadest measure, basically under employment , the part-timers that want full-time, those that are thinking about it and the unemployed, it stands at 11.1% in the country today. The fed has a dual mandate not only fighting inflation, which is the only mandate of all other central bankers in the world. We're dealing with the dual, we have to find inflation, but we also have to for full employment. So the fed sees all these inflationaries is just a transitory pass. And they're focusing on that full employment, that 11% under employment . So they're gas on, very accommodating financial conditions. Now what happens with tech stocks? We consider tech stocks just by their nature. We call it a long duration asset . So I talked about that duration in the bond market, the longer duration or the bonds are the ones that are getting hurt and rising rates take that same concept. If I own a technology stock, not so much the big ones, the Googles, Alphabets, those Microsoft's , they paid dividends, things of that nature. It has to do with that concept of when do I get my cash flows back. So if I'm a brand new tech company, startup got everything going , I don't pay dividends. I replow all my earnings back into growing the company. I'm not buying necessarily shares back. I'm growing that business. So it's going to be a while before investors start getting a payout of the earnings of that business. Now they can get stock price appreciation. We get that, but that earn out investor earnings. So it's considered a long duration asset. That's what you're seeing this year. As the rates rise, all these tech stocks that did so well , are having pressure coming under pressure because of the rise in interest rates. So that's caused us to go underweight. We could kind of see this stuff coming here a few months ago. And we, our last podcast, we were underweight tech. Now you always have that risk as a portfolio manager because in the short run it does what it does, but we're looking out six months, a year down the road. And when we base these investments. So , we're lighter on tech, we're moving more towards , as the fed has been trying to fight deflationary forces , through all these means stimulus programs was fiscal and monetary stimulus to the government. We think they're going to succeed this time and , and inflating this economy. I think that It's still transitory, you know, it just , the fed itself raised their forecast up to six and a half percent GDP in '21 and '22. They went only one 10th increase from 3.2 to 3.3 and '23. They forecast it actually decrease from 2.4 to 2.2. And then their long run expectations for GDPs remain at 1.8. So the fed is seeing this all is transitory too. They're willing to let inflation run a little hot. They're not worried about it, but all those things, feedback loop affects tech stocks and that long duration trade . So I'd be really you leary there, unless I would, you know , and we have been taking advantage of this added 30% pullback in tech this year. Kathy Woods ARK Fund has been pretty interesting to watch. She's a brilliant manager, very, very good, but she's a sector. She , you know, that one innovative tech, right. Very, very concentrated portfolio, big positions. So you're , you were watching that with interest. She, she was up 25% year to date through the 1st of February and then lost all that. It's all gone. So now what we're doing is we're taking advantage of that and going in and looking at the Googles and the Microsofts and those big mega cap decks and adding that for that long-term growth that they add to the portfolio. You take those and you pair it with what we've done with these companies that are benefactors, industrials, materials, these type of companies, and we barbelled this portfolio. So it starts to kind of work and ratchets one way or the other kind of like a , maybe a , one of those mechanical roller coasters. It's kind of lifting you up. One goes down, wheels up. Next thing its up and away we go.

Natalie Picha:

Well, I think what's interesting when we talk to clients, we get a lot of people hear a soundbite here, soundbite there, but all of these things that we're talking about are so tightly correlated. So, inflation and jobless claims and wage growth and the bond market, to the equity market. And that's part of our job, right. Is to watch all of these metrics, all the numbers, and really get in there and digest how this is all affecting, all these different, different pieces. Something we have not talked about, but, we had a conversation this morning about emerging markets and in consumption, the consumer has saved more money in recent months, than ever before. And there's fixing to be this huge kind of exuberant release. I mean we're hearing about it all the time. Everybody's booking a trip, or getting ready to get out and buy this or that, or do something. So how does that kind of work into this whole story that we're talking about with the interest rates and the rebates ?

Glenn Royal:

Well , it's feeding to this inflation scare. Everybody knows you got this pent-up demand and people are chomping at the bit. You know , anecdotally, I saw a story where someone tried to book a campground for the summer and all national parks are booked for the next two months. I can't get any place. So everyone's ready to get out. So that tells me there's going to be a lot of there's a lot of ambition, you know, to get out, do things, or start up businesses, all these different things that are going on, we are ready to re-engage. Right. So that is going to , uh, you know that's what market is pricing in right now. It's acknowledging that we're going to get that lift in the economy and it's going to be a boom . I think what can happen though, is this is a year where the economy does better than the market. It happens. The market's a leading indicator last year, we were pricing in what we're getting into right now. We saw it coming. So now that it's upon us, we're looking okay, that trade's over, what's next? So we're looking a little bit further down the road and we still see these benefactors, the reflationary, but the story does get a little murkier and less opaque. Because we get out a few years. We'll have to see.

Natalie Picha:

So what does that mean for emerging markets? What are you thinking about?

Glenn Royal:

That's an area that we've, you know, our investment case was that, they were going to be a big benefactor, right? As the globalization reawakening , their, their main products are either cheap labor or commodities. And so people want more demand for goods and services. They'd be benefiting from that. But this may be different. So a lot of us had the less emerging market period at paradigm in our thinking, which was, they were, you know, China woke up and they were 10, 12 years ago. And they were sucking all the commodities from these EM's out of the ground. Right? They were booming. That may not be the case this time. You know, China's not on that great growth curve that it was a dozen years ago, 10 years ago, it's still on the growth curve. So we're looking at that and thinking , maybe EM , won't repeat what it did, but it can give you inline market returns. What I see, is still with six and a half percent expected, GDP growth, private and economists are more at the seven. The place to be is going to be in the United States still. It's still going to be, you know, we are the leading driver, we've got the world's reserve currency, the strong dollar, you know, all the, the dollar had been weaker. It's kind of strengthening again a little bit and a strong dollar does go against emerging markets. And that's another thing we're aware of. You've had a little bit of strengthening with rates going up kind of tied closely with interest rates , the dollar string . So, I think it deserves a spot in the portfolio, but maybe not as much in terms of you think it's going to be a big one or now I'd probably look more into Western Europe, I'd look into, you know , developed nations. We, you know, we like an investment , The All Country World Index , ACWI, it's an index of a global developed , companies that includes the U.S. So there's ACWI inclusive of the U.S. And ACWX, which excludes the U. S . We liked that the inclusion of the U.S. So we're looking at, when we look at international, we're looking at the global, including the U.S. Not just X.

Natalie Picha:

Right? Right. So, speaking of the dollar, I'm going to throw this one out there because it has come our way. It's been a question that's come up a couple of times. There's a few theories being floated out there about the U. S . dollar being replaced as the global currency. What are your initial thoughts on that?

Glenn Royal:

You know, if you can replace the United States in that equation, then I'd say, yeah, you're probably right. Tell me where you have the rule of law. You know, you have the ability to come start a business. Feel secure that's not going to be taken away from you. That if you're a foreign investor and you invest in our treasury debt, you're going to get your money back plus interest. You know, there's so much going on for the U.S. In addition to six and a half percent potential GDP , that I just don't see it. There's been arguments for it . That's why the EU was created around the Euro. I mean, it was created. And in terms to have a competitor to the dollar, I think probably the bigger the implication, if anything were to occur would be a currency, basket. YEN. EURO. I'm sure there RENMINBI would like to get in there , the dollar, and then you have a composite basket and it gets, back a lot of people, you know, if I'm an emerging economy and I need to buy crude, I've got to buy U. S . Dollars. Crude trades in dollars. It doesn't trade in Euro. Doesn't trade in YEN. So those are, those are issues I think, are going to be with us a long time. So I don't think the dollar is going to fade anytime soon. I probably, in my lifetime, frankly , the Bitcoin, you hear a lot about the Bitcoin, all the digital currencies. And I, you know , I look at that and I think that's all fascinating, but how do you, how does the government tax that? You know? How did it get the taxes on this Bitcoin? Hmm . There's little questions like that . Now what I can see is the U.S. Treasury saying, Hey, virtual currency, the concept's a great idea. Let's do it for the dollar. Let's do it for the EURO. Let's do it for the YEN. And now I've got central bank currency competing against a collectible. That's pretty cool. The small group of people that monetize it . So until, you know, until they figure out how to. So I don't think there's any risks for the U.S. Dollar. Not anytime soon..

Natalie Picha:

Well, I think we'll wrap it up with that. Thank you, Glenn. I always really appreciate your comments. And I know that we get great feedback every time we put a podcast out. So to our listeners, thank you so much for listening, but we also appreciate your feedback and we absolutely appreciate your questions. Because your questions are what kind of feed our conversations here on the team. And then that feeds the topics for our next podcast. So , send them our way. We want to hear them. So , as I close out, I just, I just want to remind everyone that, you know, our team wants you to feel confident of your financial future. We're devoted to our relationships with multi-generational families, for the creation of successful legacies, through our one-on-one conversations, we can help you shape and execute your personal wealth management and investment plan. Give us a call today or visit our website at royalharborpartners.com to start your conversation. Thank you.

Disclosure:

Royal Harbor Partners is a registered investment advisor and the opinions expressed by Royal Harbor Partners on this show are their own. All statements and opinions expressed are based upon information considered reliable. Although it should not be relied upon as such any statements or opinions are subject to change without notice. Information presented is for educational purposes only, and does not intend to make an offer or solicitation for the sale or purchase of any specific securities investment or investment strategies. Investments involve risk. And unless otherwise stated are not guaranteed. Information express does not take into account your specific situation or objectives and is not intended as recommendations appropriate for any individual listeners are encouraged to seek advice from a qualified tax legal or investment advisor to determine whether any information presented may be suitable for their specific situation. Past performance is not indicative of future performance.

Introduction
This Morning's Numbers
Low Interest Rates and Our Portfolios
The Bond Market
Expectations of Growth
Negative Rates
Inflating the Economy
Emerging Markets
Replacing the U.S. Dollar
Closing
Disclosure Statement