David Rosenberg, founder of Rosenberg Research, doesn't expect a sustained surge in inflation. In an in-depth interview, he explains how investors can position themselves for a disinflationary market environment and which indicators he’s paying particular attention to.
It's the all-important question for 2022: Will inflation come down again in the course of the coming months, or has a new regime of persistently high inflation begun in the wake of the pandemic?
For David Rosenberg, the case is clear: The economist and investment strategist expects the economy to cool down next year. At the same time, supply bottlenecks will ease as more capacity is built up everywhere.
«My outlook for the economy – for the lack of a better term in two words or less – is muddle through», Mr. Rosenberg says. «And that means inflation will come down next year», he adds.
In this in-depth interview with The Market/NZZ, he explains why he does not believe that the Federal Reserve will raise interest rates anytime soon, how investors can position themselves for a disinflationary market environment, and which economic indicators one should keep a particularly close eye on.
Mr. Rosenberg, inflation in the U.S. has risen to its highest level in thirty years. Is this trend persistent or transitory?
First of all, the definitions of transitory and persistent represent gray areas. So if you believed that transitory meant weeks, months or even quarters, this is obviously not proving to be transitory. But transitory truly defined just means an event that is expected to be short-term or brief in nature. What we’re seeing right now is a very sharp inflationary experience, and its magnitude has altered people’s perception on the duration of this inflationary period. Certainly, inflation rates are higher today than I would have thought several months ago. It also has proven to be a little stickier.
And what happens next?
Where I really differ – more than just on whether this is transitory or persistent – is with the prevailing view that somehow inflation has broadened out substantially. That’s not the case. It’s still narrowly confined to rent and automotive, basically anything with a microchip attached to it. This is still very much part and parcel of all the distortions we’ve seen through the entire pandemic. Therefore, I’m in agreement with Treasury Secretary Janet Yellen that this inflation situation lasts as long as the pandemic lasts. We do have a mismatch between supply and demand. But within the next year, the pandemic likely and hopefully morphs into an endemic, and with that process the supply bottlenecks will resolve.
What does this mean for the economic outlook?
I actually think that the tables are going to be turning on the demand/supply equation. This time next year, demand is going to be quite a bit weaker. Recurring large rounds of fiscal stimulus have been the key component of demand growth, and that is going to decline. People have not appreciated the extent of the fiscal boost on aggregate demand. That is going to dissipate substantially, even with the Biden infrastructure package. At the same time, supply will come back on stream. We know that because that is what history tells us. So to bet on inflation is to bet against human ingenuity – and I’m not willing to do that.
Following President Biden’s infrastructure package, however, Democrats are expected to push another stimulus package through Congress in the coming weeks.
For one thing, investments in physical infrastructure are going to end up improving productivity which is an anti-inflationary supply side development. It would be like saying that Eisenhower’s rollout of the interstate highway system in the 1950s was inflationary. In reality, it was far from that. Also, it’s still unclear what’s going to happen with the social infrastructure part which doesn't have as much support politically as the physical infrastructure part does. In this regard, it’s important to say that there is no such thing as a free lunch. The next round does not come tax free. Any future stimulus will be accompanied by tax increases, and that is going to make it less beneficial for aggregate demand. Perhaps, you get a more just and fair society out of it, but that doesn’t mean it’s going to be a pervasive boost to aggregate demand.
So at what pace will the U.S. economy grow next year?
The economy will likely grow in line with potential, call it roughly 2%. The Fed is at 3.8%, so I’m positioned squarely below, and that’s why I don’t have a very bearish outlook for bonds. Right now, a lot of the Street’s interest rate outlook is premised on inflation, and it’s premised on the Fed starting to raise interest rates by the summer of 2022. I’m pushing back very hard on that prognostication. My outlook for the economy - for the lack of a better term in two words or less - is «muddle through». And that means inflation will come down next year.
What does this mean for your forecast on the Fed’s monetary policy?
In terms of rate hikes next year, I’m at zero. A lot of the reason why the 10-year Treasury note is at 1.6% instead of 1.2% is that the market has aggressively priced in an early return to a rate hike cycle. But I don’t see that happening so quickly. The Fed has told us that it is going to take a flexible policy approach premised on the evolution of the economy relative to its baseline forecast. Importantly, the Fed historically had an institutional bias in its forecast towards growth being stronger than it ultimately proved to be. That’s why I’m in the camp that the economy will expand next year in line with potential. That means capacity pressures will stabilize, and this will provide the backdrop for inflation to come back down towards the Fed’s target.
What would happen if the Fed nevertheless raised rates as early as next summer?
As I said, I don’t see the need for a new rate hiking cycle quickly in the aftermath of the first global pandemic in over a century. There are still way too many uncertainties over the economic outlook. Remember, everything the Fed does in a moment of time has a peak impact on the economy 12 to 18 months later. Thus, raising rates too early in 2022 in what is perceived as a transitory inflation environment - no matter how you define transitory - will risk a recession in 2023.
Then again, the stronger dollar also points to a somewhat tighter monetary policy in the United States, doesn't it?
The dollar had a pickup because of the reset of interest rate expectations by the Fed at a time when the ECB has pushed back on rate hike expectations out of Europe. So part of that strengthening move has happened against the Euro. But it’s been quite broadly based, mostly in view of Fed Chair Powell starting to sound less dovish and more hawkish after the September FOMC meeting. That’s when the U.S. dollar started to circle around. In my view, this dollar rally has a short shelf life because interest rate expectations are going to head in the opposite direction next year. Hence, I am more of a dollar bear than a dollar bull, especially at today’s levels.
What would it take to change your mind?
The one thing that is going to be very important is the labor participation rate. That is where the rubber meets the road on the extent to which the inflation backdrop proves to me more pertinacious than what I’m talking about. I’m not worried about transportation costs or freight rates, and I’m not worried about the semiconductor and the automotive industry. But the biggest risk is if this turns into an accelerating wage cycle.
The only reason why the unemployment rate is at 4.6% and not above 6% is because of the very sluggish performance turned in by the labor force participation rate. In the next several months, it’s going to be critical for the labor participation rate to hook up more forcefully which means that the competition for job openings is going to expand, even with continued job creation. That puts a lid on the wage growth we had over the course of the past several months. This is going to be critical for bond bears and inflationists alike: Their call really stands on the participation rate remaining extremely low.
Why do you assume otherwise?
I like to make the comparison to Canada where the participation rate has gone almost back up to where it was pre-COVID, and wage growth is running at around 2%. In the United States, the participation rate has only reversed 40% of last year’s pandemic and lockdown induced decline. As a result, wage growth in the U.S is running close to 5%. The key difference, of course, is that the vaccination rate in the U.S. is almost 20 percentage points lower than in Canada. I bet that gap will be closing over time meaning people who have been less inclined to go back to work for health concerns will have those concerns alleviated, especially in industries within the sphere of the consumer cyclical sector. Therefore, if the participation rate is going to head back up towards the pre-COVID level, I think the unemployment rate ends up going back towards 7%. And, if that happens, the Fed is not raising rates, wage inflation recedes and the Treasury market embarks on what is otherwise known as a «bull flattener», a yield-rate environment in which long-term rates are decreasing more quickly than short-term rates.
What does it mean for the stock market if monetary policy remains loose for the foreseeable future and speculative mania continues to rise?
There are bubbles everywhere: residential real estate, equities, corporate credit, cryptos. But there is nothing in my interest rate forecast that is bearish for risk assets. Because in the final analysis, the central banks have to offer a policy based on the real economy. Without doubt, the valuations are crazy, and there will be a day of reckoning. It’s just not clear that it will be in the next twelve months.
Against this backdrop, what’s your advice in terms of investment strategy?
What’s interesting to me is that the pundits out there that have the highest inflation forecast and the highest interest rate forecast are also the ones that are most bullish on these risk assets which are long duration in nature. This is a classic case of cognitive dissonance: The people that are most bearish on bonds are the most bullish on stocks, not realizing that they are both joined at the hip. If bond yields really ratchet up, the bull market in equities and almost everything else that is considered risk and long duration is going to come under a serious correction if not an outright bear market.
In other words, U.S. government bonds are an attractive investment?
We can argue if they are a good investment. But if you agree with my view, they will be a good trade. If you have anything remotely close to a contrary antenna, you have to be owning Treasuries right now, I mean the very long end of the curve. That will generate the biggest return.
With the new fiscal stimulus packages, however, government debt in the U.S. will rise even more. At the same time, the Fed is tapering its bond purchases. Aren't these unfavorable conditions for Treasuries?
It’s very interesting. We’ve thrown so much at the treasury market: repeated rounds of fiscal stimulus, ubiquitous inflation, unrelenting growth, the re-opening of the economy and the Fed’s taper. Yet, here we have the 10-year note at below 1.6%. So what do you do for an encore? All the bad news for bonds is already out there. That is telling you a lot about the resilience of the bond market. We’re not at the bottom of a recession with clear skies ahead. We’re coming out of this best part of the growth, with inflation likely peaking.
So how much will 10-year Treasuries yield next year?
A lot of the factors that took us from 1.25% to 1.60% on the 10-year note are going to be unwinding. We are going to see disinflation next year and weaker than expected economic activity. That’s why I’m very bullish on treasuries. In the next twelve months I think the yield on the 10-year note is probably going to be gravitating towards 1.25%. And the long bond, the 30-year, is probably going to head down towards 1.5%. Also, keep in mind: This is a contrarian call which makes it all the more rewarding. All the hedge funds are more underweight treasuries than they ever have been at any point in the past two decades.
And what about the outlook for equities?
Right now, the cyclically adjusted Shiller P/E Ratio of the U.S. equity market is close to 40, and in the past century it’s only been at 40 or higher at 2% of the time. I mean, that’s a three standard deviation event. In the past, when we had the starting point on the multiple for equities this high, forward returns - whether it’s one, three or five years - were negative. So the starting point of the multiple is telling you the same thing as Treasury yields: We’re into a future of anemic expected returns because so much of those returns have already been harvested over the course of the past years. This means that active investing is going to be superior to passive investing, and that the ETF industry might have a tougher time.
But didn’t you just say that the party for risk assets like stocks will go on?
The legendary Wall Street veteran Bob Farrell famously said: Exponentially rising markets can go further than you think, but they don’t correct by going sideways. We’re still in the first part of that sentence. If my interest rate forecast is correct, it means real rates stay negative, and the bubble probably gets bigger. But in the name of prudence, I want to be invested in the sectors that will benefit from a bull flattening in the treasury curve and from slowing growth. That means I want to be positioned in utilities, healthcare and consumer staples.
What, for example, speaks in favor of healthcare stocks?
What I like about healthcare in particular is that it doesn’t have a correlation with GDP growth. If you go through a big slowdown, healthcare will be a very good place to be. What we learned with the pandemic and the variants is that the battle against these sorts of viruses is not going to go away any time soon. We also learned that healthcare has been an underinvested sector, and it will remain a focus for capital spending for an extended period of time. On top of that, healthcare is a secular theme that is tied at the hip with the aging demographic profile of the population. To me, healthcare has secular tailwinds that I want to be involved with at all times. Especially, in a year when we expect a rotation towards the most defensive sectors and out of the more cyclical sectors as GDP growth underperforms expectations.
In this context, how do you assess the risk of drug price regulation?
There is always political risk with investing in healthcare. That’s just the nature of the beast. But it’s not a reason to not have at least a few toes in the sector. And let’s face it, what happens next year is that the Republicans will likely take back the House and the Senate, and we end up with another two years of political gridlock. So I’m not really concerned about that aspect.
When it comes to international investments, your bullish call on India this year turned out great. Where else do you spot opportunities for investments outside the U.S.?
According to our models, valuations are much more compelling in Asia than they are in the United States. Thus, I like Asia over the U.S., particularly in the case of Japan. Japan is one of the most inexpensive stock markets in the world. And, with the recent victory of the Liberal Democratic Party, the political outlook has eliminated a source of uncertainty. What’s more, in the past few months, Japan has done a stellar job in getting their COVID case count down and their vaccination rates up. And of course, the recent cheapening of the Yen is a boon for their large cap exporters.
What is the best way to invest in Japan?
It is still very difficult to get a pulse of the Japanese consumer, but the business sector seems to be in very good shape. I think the industrials will perform well, especially with the upcoming fiscal stimulus and the weakening of the Yen. So large cap exporters will probably benefit the most.
Are there any other opportunities for compelling investments?
If you’re looking for a hard asset that is unloved and underowned, gold and gold mining stocks will be a very good place to be. Very recently, gold has been firming despite a strong U.S. dollar. If I’m right with my forecast and the dollar depreciates next year and real interest rates stay negative, this will be a very important tailwind for gold. There’s also the prospect that China continues to embark on its regulatory crackdown on crypto currencies, which should also be a positive for gold. Finally, you see it on a technical basis: Gold has been breaking out. That’s why I think that what I call the «bond-bullion barbell» will work very well in 2022.