Once again, hope is rising that the Federal Reserve will take a milder stance on monetary policy. Jim Bianco doesn’t think so. The strategist and President of Bianco Research argues that the era of low inflation and low interest rates is over for good. In an in-depth interview, he explains how to navigate the new environment.
The pattern is all too familiar. Hopes grow for a cooling of inflation, investors speculate on a slightly softer monetary policy, stock prices rise, the Fed intervenes and the market goes down again.
Will it happen again this time after weaker CPI data for the month of October ignited a new rally last week?
For Jim Bianco, the answer is clear. «It looks like inflation might have peaked, but that’s the least important piece of information you can give me,» says the President and founder of Chicago-based investment advisor Bianco Research. «The real question is how far inflation is going to go down on its own,» he adds.
In an in-depth interview with The Market NZZ, which has been slightly edited for clarity, Mr. Bianco explains why he believes inflation will remain at a significantly higher level than before the pandemic. He tells what that means for the Fed’s interest rate policy, which investments promise success under these new market conditions - and why investing is often like tennis.
Mr. Bianco, it looks like consumer price inflation in the US has peaked. Is this the beginning of the end of the massive surge in inflation in the aftermath of the pandemic?
This was only the third time in the last twenty months that the CPI data have come in below expectations. It was a downside surprise, but for most of the time inflation has beaten expectations consistently. So you don’t want to make too big of a deal on month-to-month data, but someone should tell this to the market because it’s making a big deal out of it.
So what’s in store for the markets?
It looks like inflation might have peaked, but that’s the least important piece of information you can give me. It better have peaked, because if we are going to be consistently in an 8% or 9% CPI world, I won’t be employed the next time you want to talk to me, and Zoom might not work. We would be in a world of hurt. The real question is how far inflation is going to go down on its own. Is it going to go down all the way back to 2%? Or does it stop at some higher level?
What do you think?
I think that the long-term average for inflation will probably be closer to 3.5 or 4%. If we go down to 2%, it’s only because we have a bad recession which killed demand, and this would probably be just a cyclical low that only lasts until the economy recovers and inflation moves back up.
What does this mean for investors?
The Federal Reserve likes to say that the neutral level of the Fed funds rate is about half of a percentage point above the inflation rate. So if inflation is going to settle out at 3.5% to 4%, then neutral is 4% to 4.5%. Right now, the Fed funds rate is at 3.75 to 4%, which means we’re still not even at neutral yet. And, if the Fed goes all the way to 5%, which is what the forward market is projecting, monetary policy would be just barely restrictive. In other words, if inflation is going to stay at 3.5% or 4%, the Fed has ways to go with hiking rates in order to bring inflation in. But that’s not the way the market wants to see it.
We’re just about at the one-year anniversary when Fed Chair Jay Powell said it’s time to retire the word «transitory» when talking about inflation. I agree, we should have retired that word, but we never did. The vast majority of people still think that this bulge of inflation was a one-time event around the reopening of the economy. They don’t see inflation as a persistent problem, so they don’t understand why the Fed is being so aggressive. They worry that Powell is going too far and causing a lot of damage. So after he retired the term «transitory», they started producing different words for the same thing: The Fed is going to «pause», the Fed is going to «pivot», and now the Fed is going to «step down» the pace of rate hikes. These terms mean all the same thing: Inflation is transitory, and that continues to be the consensus belief. People want to believe that this nightmare is over, we’re going to go back down to low interest rates, turn on the money printer and have the stock market «moon».
Why do you doubt that and think inflation will remain persistently high?
Every pandemic brings a major change in human behavior. It doesn’t create a new trend, but it accelerates trends. Covid accelerated three trends. The first one is the end of cheap labor because people have a different attitude about life. If you want to get workers, you have to pay up. Secondly, the end of cheap goods. That’s the political strife we’re having with China and Asia. The talk about re-shoring is real, it’s not going to go away. Add to that the end of cheap energy. Bottom line, we no longer have cheap goods, cheap labor and cheap energy which means we no longer have 2% inflation. So even if we still have technology and demographics working in favor of keeping inflation down, inflation is going to be more persistent.
What would have to happen to change your mind?
To get inflation down, we have to restructure the economy. But instead of doing that, we’re wasting time and want to have a debate about it. The historical analogy is probably the end of World War II. When the war ended in September 1945, everybody knew that we were going to transition to a peacetime economy. In 1947, no one was asking for their job back to make fighter planes or tanks, people knew that area was over. During that restructuring process, we had three recessions in ten years, and an episode of 20% inflation, and one of 10% inflation. But right after this process was over, the economy boomed for twenty years.
In 2022, we don’t want to do that. We’re hoping that the supply chain is going to miraculously heal itself, that people are going back to work five days a week in the office, that «things are going back to normal.» But this is it. This is the post-pandemic normal. And just to be clear: It is not dystopian, it is not terrible, but it’s different, and we need an economy that is restructured for this new area.
However, for the markets, everything is currently revolving around the hoped-for pivot in monetary policy. Since the recent setback following Fed Chair Powell’s press conference in early November, stocks have already rallied again. How does the Fed perceive this rally?
Powell couldn’t have been more clear, and I give you two recent examples. When the market was rallying nearly 20% off the June low, he went to Jackson Hole and basically said: I’m just going to keep jamming rates higher and higher until the market goes down. Right after that, the market fell apart. Same message at his press conference after the recent FOMC meeting. When a reporter mistakenly told Powell the market was up, he let off the greatest hits of every hawkish argument you can come up with. So nothing has changed. Powell believes he is going to rein in inflation by creating a reverse wealth effect: Make everybody poor, so we stop spending money.
What does this imply for the next FOMC decision on December 14?
Powell is probably going to be ok with stepping down to a 50 basis points hike in December. But if the S&P 500 blasts through 4000, and is on its way to 4200, it wouldn’t shock me if he flirted with the idea of putting 75 basis points back on the table. So this might be just another bear market rally. It could still last until the end of the year, or it could be over just two days from now.
To bring inflation under control, the Fed has tightened interest rates decisively. Will the members of the FOMC continue to take such a cohesive approach as signs of an economic downturn accumulate?
There are 19 members on the FOMC, and I think the most hawkish member is Jay Powell. Interestingly, the most dovish member, or very close to that, is Vice Chair Lael Brainard. So from a policy standpoint, the Chair and the Vice Chair are as far apart as it can get. As such, you see a lot of discord at the Fed. After the last FOMC meeting, they put the words «cumulative tightening» into the policy statement, and they said that monetary policy affects the economy with «lags». Then, 30 minutes later, Powell completely undid the statement in his press conference. This tells you there is no agreement within the Fed on what they should do. But the way monetary policy works is that the Fed Chair gets what the Fed Chair wants.
Then again, can the Fed really follow through on this tough stance when people are losing their jobs and the housing market is in full collapse?
That’s exactly it: He can talk tough, say he has resolve, and the Fed is going to raise rates until it gets the job done. That’s easy to say when the economy is creating 261,000 jobs a month, initial jobless claims have been in a downtrend for the last five months, and the Atlanta Fed GDPNow tracker signals that we’re on track for 4% growth in Q4. But if you throw up negative job growth, soaring claims, and negative GDP, then it becomes more difficult. So now, you hear mainstream brokerage firms casually predict that the US will be in a recession next year. That’s highly surprising because this used to be the verboten thing you were never allowed to say if you worked as an economist at a big shop on Wall Street. But now, they throw it out like it’s a statement of fact.
How high is the probability of a recession? The yield curve is deeply inverted, which is usually a reliable harbinger of a downturn.
I’m in that camp too, we’re probably going to have a recession. From a signalling standpoint, the yield curve economists like to look at is the ten-year note minus the three-month treasury bill. That yield curve is 8 for 8 in predicting the last eight recessions since the mid-1960s. On average, it inverts about nine months before the recession starts. But importantly, it needs to show a persistent inversion which I define as ten consecutive days in negative territory. This Thursday was day six, so the earliest that this yield curve would be consistently inverted would be next week.
Historically, the Fed raises interest rates until something breaks. At the moment, a lot is breaking in the crypto sector. How great is the threat that the crisis surrounding FTX will spill over into the regular financial markets?
If there is contagion, it might be in the more speculative tech world. It might leak into the VC space or start to show up in some stocks that are perceived to be associated with crypto, like MicroStrategy, the Grayscale Bitcoin Trust, ARK Invest, Robinhood or Tesla. There is also Silvergate Bank based in San Diego, a traditional lender in the crypto space. So you might see it in various pockets all over the place. But I’m not so sure it will rise to a level where it will kill the Nasdaq or the S&P 500, or cause a risk-off rally in bonds. But the whole «degen» attitude, basically a phrase for degenerate gambler, is definitely gone in the crypto space. And if people don’t know it yet, they are going to learn real fast that it’s gone.
Even apart from the crash in the crypto sector, conditions in financial markets are not easy. How can investors best navigate this challenging environment?
This has been an extraordinarily difficult year for investors. In terms of broad asset classes, there is almost nowhere where you could have gone to hide: You lost money in the stock market, the bond market, emerging markets, crypto, and in most of the alternative markets. The driver of all of that has been inflation. Inflation is the great game changer; it has completely changed the outlook of the economy and the structure of the markets. So I’m not going to sugarcoat this. I think investors must continue to expect a struggling environment.
Where do you see opportunities for promising investments?
The first place you might find some relief in order to make some money is going to be the bond market. As I said earlier, we might see interest rates parallel shift higher to 5%, and by the first quarter we should be pretty close to this point. So if bond prices stop going down and you can get a 5% or 6% coupon in a bond fund, you can make 6%. Maybe prices rally a little bit to make an additional return. But even if they just hold steady, you will still be making money.
And how about stocks?
In the stock market, there will be a secondary opportunity. But we’re only going to have a sustainable, multi-month rally in stocks when the Fed is done with restrictive measures and we feel confident that they are no longer going to fight this market. That’s still ways off, and it might be not until mid-2023 before we see something along these lines.
What is the best way to be positioned until then?
The place where you can make money now is short-term sovereigns. If you buy a T-bill with a nearly 4% yield, you have the safest creditor in the world, the U.S. Treasury, and you will get your money back in a period of months. But make no mistake: The era where the Fed is going to drop rates to 1%, turn on the printing press and we have another «everything rally» where stocks, bonds, crypto, the art market, the housing market and every other asset class goes up big, is over. That era ended because of persistent inflation.
What does this mean for a successful long-term investment strategy?
For many years, I had been one of the biggest critics of actively managed equity portfolios. But not anymore. This might be the environment for the next Peter Lynch to show up. By that I mean don’t wait for the market to go up, but have somebody figure out which stocks to pick. Because if we no longer have cheap goods, cheap energy and cheap labor, there is going to be a lot of alpha in the market. For instance, don’t buy the energy ETF and just wait for all energy stocks to go up. Instead, you buy specific energy companies that will do better than others. The problem is that until 2022, stock picking didn’t matter, because you just had to be in the right sector. So active management is coming back as an art form, but it’s been a long time since we’ve had to be good stock pickers. There might not be many of them out there right now.
What about commodities? Shouldn’t investments in hard assets such as energy, metals or agricultural goods pay off in a persistently inflationary environment?
Yes and no: Yes, commodities and various commodity funds can be a good idea. But prior to the FTX meltdown, the volatility in the commodities markets was even greater than in crypto currencies. So if you think commodities is the place to play, you must be braced that the next thing you know is that you’re down 15% in three days. If you’re comfortable with that then go for it. If not, then you better put a very small weighting in commodities, because this is not a market for the faint of heart. Especially as a European investor, you also have to keep in mind that the dollar can move 2% a day which means that the actual currency adjusted volatility is even higher.
So what’s needed most at the moment are strong nerves?
Investing is a lot like playing tennis. Even if you’re Roger Federer or Rafael Nadal, you only win 55% of the points. It’s a very tough game. And if you watch tennis players, they can be utterly emotionless when they make an unforced error. That’s kind of the way investing works: If you’re not making mistakes, you’re not investing. The key is not to not make mistakes, it’s to recognize that something is a mistake.
What do you mean by that exactly?
In tennis, I have to recognize that I don’t want to hit the ball to the other player’s backhand because it’s too good. I have to figure out something else and adjust. So as an investor in this environment, don’t kick yourself if you’re down. Just like in a tennis match, focus on the next point, the next set. There will be other opportunities, so you want to stay in the game. I just gave you a lot of themes and I’ve broken down a lot of things. Some of that stuff is going to be dead wrong, and some of that is going to be dead right. What I spend my day doing is trying to figure out where I’m wrong and where I’m right. It’s ok to be wrong. Just don’t get pigheaded about it and make it all tied up with your ego that you can’t admit you made a mistake.