Tad Rivelle, Chief Investment Officer of the Californian bond giant TCW, worries that rising prices for goods and services will not remain a temporary phenomenon. He sees a risk that investors will gradually lose confidence in the dollar and explains why real assets such as commodities make sense in the current market environment.
For the global financial markets, it's the most important question: Will the aftermath of the pandemic lead to a sustained surge in inflation? Or will the economy fall back into the old pattern of weak growth and low interest rates?
Tad Rivelle is banking on the first scenario. The Chief Investment Officer of the California-based asset manager TCW does not expect an immediate escalation like the stagflation crisis of the 1970s. However, the danger of such an outcome is increasing due to the ever-growing volume of monetary and fiscal stimulus measures.
«There will be a point where people no longer can trust you to the same degree,» Mr. Rivelle says. «This runs the risk of a more generalized inflation and maybe a more generalized rebalancing away from the Dollar,» he adds.
In this in-depth interview with The Market NZZ, which has been edited and condensed for clarity, the bond market expert explains why he believes valuations in many asset classes are excessively expensive, where he spots the most serious weaknesses in the credit sector, and what investors should pay particular attention to in the current environment.
Mr. Rivelle, the situation in financial markets remains challenging. Especially «hot» bets like cryptocurrencies, IPOs and fast-growing tech stocks have come under pressure in recent weeks. How do you perceive these developments from a bond investor's point of view?
Markets have been at very speculative pricing levels for some time regarding risk-based assets. What we have seen is that crypto currencies seem to correlate much more with the speculative elements in markets generally versus what you might otherwise expect. Bitcoin hasn’t been behaving so much like an inflation hedge, it’s not really responding to that type of input. So it’s probably fair to attribute some of the sell-off in the cryptos to this withdrawal of sentiment surrounding risk based assets.
Where do the markets go from here?
What comes to mind is the age-old rule «buy the rumor, sell the news». I think we have arrived at a point of peak economic growth in the US. It’s probable that the first quarter is going to be a 7 or 8% annualized type of GDP number which also suggests that a lot of the good news is already in the sauce.
What does this mean for the further outlook?
There's an excessive level of valuation priced into a lot of risk-based assets. In the case of fixed income for instance, you have the high yield market which is almost a misnomer since it’s trading at spreads of 300 basis points approximately. In other words, a majority of the high yield market doesn’t even yield 4%. The notion that you can price a high yield market like that and at the same time tolerate a significant portion of zombie companies that basically have not made money for several years flies in the face of common sense. There have to be changes and restructurings as we ultimately move into the post-pandemic economy. But we have been living in this «kick the can down the road» type of environment in which forbearance from lenders, as it relates to so many asset classes, has been a defining feature.
How much longer can this go on?
To understand a recession, to understand a period like the pandemic, you should take away the lesson that there needs to be change: The economy needs to adapt to changed consumer preferences, it needs to alter itself in terms of both valuation and resources with respect to changed realities like work from home. Just a few weeks ago, «The Economist» claimed that at the peak of the pandemic 60% of work hours in the US were coming at a work from home basis. Before the outbreak of the corona virus, it was maybe 5%. So everybody gets the idea: We’re not going back to 5%, and that has very significant consequences for the pricing of commercial real estate, for the valuation of claims against commercial real estate and for the valuation proposition for a variety of equities in many different sectors.
Where are the most significant risks in this regard?
It’s almost like we froze a lot of non-economic activity in place over the last year. The Federal Reserve has lowered rates, provided liquidity, and fiscal stimulus has allowed people to build hope into their expectations and in their models. Now, some experts argue that the migration towards e-commerce has already peaked, based on the relative cost of moving product through bricks and mortar stores versus through the strained and supply constrained channels in the e-commerce world. So fears about the Retail Apocalypse may be overdone. But in the travel space for instance, there were plenty of hotels that were struggling pre-pandemic. There is no likelihood that they are going to find any better luck in the post-pandemic economy.
Meanwhile, a boom is taking place in the American housing market. How sustainable is this trend?
In the FHA mortgage program, which basically is the government version of subprime lending since the financial crisis, the delinquency on FHA loans is running at about 11%. That’s pretty elevated, and it’s illustrative about the level of stress that exists particularly in the lower rungs of the economy. But even in the Fannie Mae and Freddie Mac world of middle-class type mortgages something like 3% of loans are currently delinquent. That’s very high, since that space typically runs at fractions of 1% delinquencies. So there is a lot to work through there.
Nevertheless, optimism seems to prevail. On Wall Street, the S&P 500 is almost back at its record high from earlier this month.
There is a lot of complacency. Even the European Central Bank made reference to it in a recent report. Critics have said for a long time that the central banks will support asset prices, and then they criticize capital markets for pricing in a speculative structure and warn about the risks. One pundit called it quite accurately: Central banks simultaneously play the role of arsonist and firefighter.
Where will the greatest damage occur if something goes wrong?
The short answer is that it will hit everybody. It hits places like California which is so dependent on equity valuations and tech valuations, in particular the IPO market. But it permeates everywhere. The Fed figured out a long time ago that driving asset prices higher has a tendency to push the whole economy forward. So if the Fed is not able to put Humpty Dumpty back together again, the question is what happens when you get a substantial correction in equities. In this case, you have a high probability that the political market just says: «We told you so, we need more fiscal stimulus». As a result, it's most likely that you get a response function in the economy that starts reinforcing inflationary forces.
Inflation is already a big issue. Is the current rise in prices just temporary as the economy recovers from the turmoil of the pandemic? Or are we at the beginning of a sustained surge in inflation?
Inflation is already all around us. People are experiencing it in their personal life, maybe not necessarily in price rises, but in the form of shortages. For example, people who are trying to remodel their homes can’t get new windows or washers. Yet, the Fed’s view is heavily biased towards wanting to believe that inflation is transitory, so they are not going to take action against it. Then, the big question becomes: What kind of frictions develop that make it difficult for the economy to rebalance itself? In our view, the demand side is still problematic because there are huge balances in people’s bank accounts left over from stimulus payments. On the supply side, we have a highly regulated economy that has come out of the pandemic era with very strange and conflicting rules about the way businesses can operate and reopen.
Then again, if the economy normalizes over time, inflation could also level off again.
This gets us back to the main question: What will be the response function of the political market? In Washington, ever more people think that there is really no problem with fiscal stimulus and that the world will lend America all the money it wants to spend. Until the costs catch up with everybody, the perception will be that it's perfectly reasonable to just spend more money. So the Fed’s statement that the inflation is transitory is a speculative statement on their part. It doesn’t take into account the frictions, and the fact that they have no control over how the fiscal authorities will manage affairs.
Is this risk possibly already reflected in the soft Dollar?
Essentially, the reserve currency status of the Dollar allows the US politicians enormous flexibility in terms of dealing with problems such as the pandemic. That enormous flexibility is supposed to come with responsibility and some degree of thoughtfulness and prudence. But you don't see a lot of that. Taking extraordinary actions in March of last year sort of made sense: If you’re shutting down the whole economy, you need social stability. You don’t want the whole thing to go down the tube. But a year later, we’re still talking about massive fiscal stimulus programs. There’s clearly a logical disconnect.
So is there a danger that confidence in the Dollar could be lost? There was already a moment during last spring's market crash when, contrary to the usual pattern, foreign investors dumped in a risk-off phase.
There was so much going on then. There was also the risk parity trade unwinding as well. We had that day when stocks and bonds were both getting hit extremely hard. When markets are running smoothly, you tend to have fungibility between asset classes. There’s liquidity, and the ability to arbitrage, to make relative value decisions. So it feels like a river. And then, you reach periods like last March or the financial crisis of 2008 where it isn’t a river any longer. It’s almost like you have these little tributaries, little strains where there is particularization in pricing. Basically, you don’t have a market so to speak, you have a segmentation of lots of markets to the point at which you might have a market for Ford Motor credit that exists on the morning of a particular day in March 2020. You get all of these discontinuities and irrationalities.
But what about the Dollar? Is the greenback even replaceable as the world's reserve currency?
We got past it when the Fed pulled out it’s big bazooka as former Treasury Secretary Hank Paulson put it a long time ago. So you did get very low rates in the US by August and September. Even when we started this year, the yield on ten-year treasuries was at 1%. If you’re a Dollar bull, you can basically say: The US system of finance was tested in 2020, the economy was tested and it survived the test which means that for now the reserve currency status of the Dollar is unquestioned - and that’s used for justification to continue the same policies. But there will be a point where people no longer can trust you to the same degree which runs the risk of a more generalized inflation and maybe a more generalized rebalancing away from the Dollar.
Against this background, how serious is the risk of a stagflation crisis like the one in the 1970s, with high inflation, low economic growth and high unemployment?
We may be a few years away from that, but this is a serious risk. It’s reasonable to expect higher inflation. The Fed probably would be happy for a period of time, but then the big question becomes: Can you continue to contain and control it? Can you keep inflation at 4 to 5% without destroying trust in the authorities that are responsible for financial stability? So you can’t get to the 70s-style inflation in one step. But we didn’t do it the last time either. We did it with policy stupidity followed by policy stupidity. We had the Nixon era impose wage and price controls, break the thermometer so to speak, pretend that we’re not inflating. That was followed by things like WIN buttons stating «Whip Inflation Down», typifying the incoherence of policies to control inflation. After that, we had Carter’s credit controls and the selling of gold and things like that. Bottom line: Inflation got out of control because the policy response was inept.
What do you think?
I wouldn't expect that the policy response is going to be any better. The basic problem is that when the world doesn't trust your political or financial leadership, that leadership can no longer solve the problem. You have to change management, and you have to change policy. That’s kind of what happened in the US. What solved it in the end was a combination of change of leadership at the Fed with Volcker combined with structural reform led by the Reagan administration which changed the economic direction of the United States.
How do you think the current Fed Chairman Jay Powell will react if bond yields continue to rise due to increasing inflation expectations? Do you think drastic measures such as yield curve control are a possibility?
Absolutely. If and when the rate on ten-year treasuries starts to move rapidly higher, and it gets to 2 or 2.25% and mortgage rates go up to 3.5%, it’s very plausible that the Fed implements yield curve control. They may call it something different. But they will do what they can to support the asset market and the housing market.
At what level do you think interest rates will be at the end of the year?
Once ten-year treasuries peaked at around 1.75% at the end of March, it had a very adverse effect on some of the housing metrics: That suggests that there is so much leverage already in the system that the impact of even small rate rises can be quite significant, even considering all of the fiscal stimulus. So rates are probably somewhat range bound for now, because when the yield gets to 2% it likely will be slowing the US economy down significantly. But then what happens? If the economy slows, does the administration and congress basically appropriate more stimulus? This heightens the potential for a «Rinse - Lather - Repeat» cycle to government and central bank interventions raising the specter of stagflation. And, that’s where you lose control over where the ten year goes. But we’re not there yet.
How can investors best navigate this environment?
It’s sort of where we were pre-pandemic in most respects. It’s about prudence and caution and taking spread where you can. Because as a bond investor, you should be focused on trying to capture safe spread in a year like this.
Where are opportunities for that?
It’s all about quality, and taking advantage of the Fed. The Fed is also giving you gifts. One gift that they’re giving is in the mortgage agency TBA market where their appetite for mortgage purchases is so huge that they have driven up the near-term market. That makes it very favorable for investors to engage in deferred purchases for the TBA market. You can buy exposure to a Fannie Mae or Freddie Mac thirty-year mortgage with a 2.5% coupon and get maybe 80 basis points of spread. That may not sound exciting, but you get 50 to 75 basis points more because of the negative financing that’s implied in the capital markets because of the Fed. So suddenly, for a very safe asset you have a pretty nice spread.
Given the risk of inflation, could it also be worth investing in real assets such as commodities and gold?
At higher valuation levels like today, it’s prudent to own more insurance. But that’s not to be conflated with the idea that you’re trying to make money on your hedge. In a way, you almost hope to lose money on the hedge. It’s just to protect you in case things go wrong elsewhere in your portfolio. Also, diversification is usually a good strategy. Many years ago, when we were working at Pimco, Bill Gross was sort of the master of one sentence statements. When I was new there, I remember sitting right in front of him, and he’s debating whether to sell a security. Finally, he just tells the dealer: «You know what, no one ever went broke by taking a profit.» So we sold it. In general, maybe that’s good advice.