Inflation and Your Bottom Line

FineMark Radio: Episode 1 Transcription

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David Scaff:

Good morning. This is David Scaff, Market President for FineMark National Bank & Trust, in Palm Beach County today.  Joining me, I have Paul Blatz, CFA, who is a Private Wealth Advisor & Senior Vice President of FineMark Bank, specializing in investments. Good morning, Paul.

Paul Blatz:

Good morning, David. Thanks for having me.

David Scaff:

Today’s topic is inflation. So, Paul, in preparation for this, I was just doing some news searches and I very quickly found over 80 articles in a 24-hour period of time on various media outlets talking about inflation. So today let’s talk about that and find out why the news is covering inflation so much. For starters, why don’t you just talk a little bit about what inflation is?

Paul Blatz:

Absolutely. And to your point, I would say that inflation’s impact on interest rates are the by very far the most important thing on investors’ minds as we kind of navigate this post – well, I guess we’re not quite out of the pandemic yet, but we’re certainly closer to the end I think than the beginning – but to define inflation, it’s really kind of the old adage that our grandparents and parents all talked about. You know, the price of milk when I was a kid was X. And now it’s some high multiple of that. It’s really that the price, in terms of the dollar value, of the goods and services that we pay increases over time. And that’s kind of a natural thing.

And it’s part of growth as an economy. It’s something that you do want, the thing that you must be very careful about is, like what we saw in the seventies and early eighties, until Paul Volcker came in and said that we can really use interest rates to calm down inflation. What you don’t want to have, that I was referencing is, massive inflation, where your currency is essentially devaluing at a greater rate than you can grow.

David Scaff:

Okay. So, to clarify, everybody understands that something costs more. Whether it’s gasoline or groceries and that sort of thing. And that’s worrisome too, with 5% annual inflation, we just about eat up wage gains that people have gotten recently, and that’s concerning for the consumer, but today’s topic since you’re an investment guy, we’re going to talk about inflation and the investor and why the investor should care. So set the stage. Why should an investor care about the level of inflation?

Paul Blatz:

Sure. So there’s a lot to unpack about inflation as a whole, what type of inflation we’re seeing right now, but, you know, generally speaking the risks of long term inflation or higher interest rates, because, like I just, alluded to, when Volcker took over in 82, and then really since then, the fed has been very effective in trying to tame inflation by raising our short term interest rates, which that’s really where the capital markets start, right? Everything is essentially based off what you can get paid off of your cash and CDs at your bank. And you get risk premier for everything that you invest that is kind of a derivative of that, up to corporate bonds and treasuries, and then equities, and even things like your cap rates on real estate, the interest rates paying on your mortgages, all of that is based on essentially what the fed has said is the overall rate.

So that in and of itself is probably the biggest risks that we see as being pervaded through long-term inflation. The other things that inflation touches upon in effects, slower growth, and for equity, the primary concern is that the price to earnings multiple or what you’re willing to pay for stocks based on what they earn can be a lot lower in a higher inflationary environment. And again, why is that? It is essentially because interest rates will have to be raised in order to tame inflation. And again, interest rates are kind of the barometer of what you’re relatively willing to pay for stocks. If you’re in a very low interest rate environment like we’re in right now, a higher priced earnings multiple can be justified. You know, we’re trading right now at about 21-ish, PE on the S&P 500. To many folks, on a historical basis, that is expensive. I mean, over the last 25 years, we’ve ran about 16-17 in that range. However, we’re also at a point in time where the 10-year treasury is only about 1.4 or 1.5, that inverse PE yield is, well almost 70.

David Scaff:

Let’s talk about history a little bit. You mentioned before that Volcker came in, back in the early eighties. I started my career in the early eighties, and I can remember when people were borrowing money in the teens to buy a house. Where people could go to the bank and get 8 or 9% annually on a CD, or where you could get double digits for a municipal bond. Back during those times, savers had it made! If you could just sit back and put your money in a CD for 8% or get a municipal bond that was tax-free for 10%, you know what great times, but what’s happened since 1982?

Paul Blatz:

Well, lots happened and, and I’d be remiss, because of what we just went through regarding the relative pricing of assets, if I didn’t mention that this period of time is also when Warren Buffet really started to generate his unbelievable track record. Because back in those times, when you could get teens on your CDs and you were paying the same thing on your mortgage for your home, that was also when stocks were trading at only 6-8 times earnings. And why would you go buy a stock that was yielding dividends in the low, mid, single digits. And you’re only paying 6-8 times earnings. Why would you do that? Take the risk of equities when you could get equity-like returns? And in today’s parlance from CDs and very low risk investments. So, what has changed?  Well, certainly the power and influence of the Fed has changed a lot with the advent of, you know, Volcker coming in, raising interest rates dramatically in order to combat inflation. That kind of set the stage for things that developed later. Greenspan came in and we had this terminology that came into the foray of the Greenspan put, and that’s kind of evolved essentially into the Fed put.

David Scaff:

Talk to me about what that means because I’m not sure I’m with you on that.

Paul Blatz:

Understood. So, what that means is, developing around the dotcom, bubble era, into this relatively, still young century, there has become a philosophy amongst investors that the Fed is, going to step in and save the market from diving into deep recessionary territory. Certainly, we’ve had about three severe market shocks, most prominently being the great financial crisis in 2008. But in early 2009, you did see the Fed come in and slash interest rates dramatically. So there that Fed put, or what was referred to earlier as the Greenspan put, is that the Fed now takes an activist role in protecting the market. I’m not saying that it’s true and that it’s always going to be there. In fact, one could argue that we are less than a free market environment today, and that the Fed probably needs to take a little bit more of a hands-off approach and let capitalism and free market do its magic.

David Scaff:

Take us through owning bonds. You’re talking about in the eighties, we had pretty good inflation until Volcker came in and raised interest rates quite a bit. And interest rates have trended down for decades. Now reaching about zero. So again, those were good times to be bond investors.

Paul Blatz:

Absolutely. I would say it was the Golden Era.

David Scaff:

Right. So, inflation was in check, interest rates were coming down, which means that you had a bit of a tailwind in the value of your bond portfolio. In view of our topic on inflation, how do you think about investing in safe bonds today with inflation on the horizon?

Paul Blatz:

Well, that’s a tough question, David. For starters, the topic today is in inflation and talking about the fears and risks that surround that. The bond market is not really acting as though it’s scared about inflation. And what I mean by that, again we’ve mentioned several times already this morning that the lever that the Fed pulls to keep inflation at bay is to raise interest rates. Right? Yet month after month, we keep seeing the Treasury bounce around this 1.4 to 1.7 range and it’s staying very low. You would think if bond investors were scared about inflation, that they would be selling bonds because as you know, interest rates are going to go up. The bonds that you’re buying today, the rates that you’re getting are not going to be anywhere close to what rates are going to be when the Fed raises the funds rate to 3.75, which they’ve tried to do several times and likely will at some point in the future. Well, what you’re getting today is pennies.

And unfortunately, as we know, there’s an inverse relationship of bond prices to the bond yield, meaning that if rates go up, price goes down and vice versa. So, it’s kind of a tough outlook and the market’s not necessarily acting based on the fears that we keep hearing about in the journal and seeing. You mentioned that every day, there’s dozens of headlines that are talking about inflation.

David Scaff:

So, I’ve heard the term “transitory inflation”. Is that more how the bond market is reacting to inflation? There seems to be real inflation numbers reported, things are up cost-wise, but yet the bond market is not reacting as if it’s concerned about inflation. Because you wouldn’t want to be a bond buyer if you were really facing inflation. Am I right?

Paul Blatz:

You have absolutely hit the nail on the head. And that bifurcation is really what I’d say a lot of the market strategists’ focus is on today. Whether – and we need to unpack it a bit – whether inflation is permanent or transitory. And there are a lot of factors that are transitory today. A lot of focus has been on things like used car prices. Used car prices are substantially. In fact, the percentage of folks that own a car that significantly more than what they owe today, has jumped. I think it’s like 25-30% in the past year. A lot of that is driven by semiconductor shortages, and that is one of the inputs into new cars. So, there’s actually a significant supply shortage in new cars, which is hopefully subsiding right now.

But again, a lot of that was driven by COVID, right? The COVID situation caused a lot of factories to stop. And there was pent up demand over the last 16 months, and they’re just trying to catch up. So, unfortunately right now we have this temporary situation with auto, same thing with a lot of other headline-grabbing items. For instance, lumber was up, I think, 540% over the past year. Now it has since fallen about 60% off of that high. So, you know, still higher than it was a year ago, but now significantly below that.

David Scaff:

What you could say is that because of the disruption to businesses, and the restarting of the economy, you could say that you’re seeing these 5% numbers and supply chain disruptions, and that is what is driving inflation in goods and services, but that might not be permanent. There’ll be a time when we can catch back up. Is that essentially what you’re saying?

Paul Blatz:

Absolutely. And I’d be remiss if I didn’t bring up the other point, which I think gets missed in a lot of the, the news articles, and that is that right now the general populace is flush with cash. A lot of millennials and other folks moved back in with their parents. They were getting stimulus checks from the government. They were saving a lot of money because they weren’t going out to dinner, out to the movies or spending money, generating that money supply velocity. So, we have a lot of that pent up supply of money that is now coming back into the system. There’s been competition for rent. You know, I read about one apartment that was, I think it was listed at $725 a month, and got bids all the way up to $950. The landlord was of course happy but couldn’t really explain it other than you had a bunch of folks just competing for scarce resources.

David Scaff:

There’s one other thing I read about, that I want to touch on before we wrap up here. So, the bond market seems to think that this inflation will work itself out over time. Hence the interest rates on long-term bonds not going up. But then I also read that we just passed a $1T+ infrastructure bill, and that we’re fast-tracking a $3.5T care bill at some point. Don’t you think that this level of government spending will have an impact on inflation?

Paul Blatz:

Absolutely. Without question, because one of the problems that we continually face from Washington is they’re very antsy to spend money and to offer these programs. But there’s not a lot of thought these days on how are we going to pay for it, right? And one of the other risks that we didn’t even get to mention before is that, we do have this very substantial national debt that over the past couple years, because of the pandemic, has gotten a less air lot less air time in the news. But when interest rates go up, our cost of that national debt also goes up. So not only do we have these trillions, which I was reading a memo the other day that said trillions is probably the word of 2020, at least in the financial, sphere. But, as we have these trillion-dollar programs put into place, we also still have this other, much greater accumulation of debt from all these programs that we put into place over the past 40 years that we still have to pay for. So, there’s that risk on top of it.

David Scaff:

So, we have the bond market that currently thinks that inflation is temporary. And in all my economics training, spending trillions of dollars that we don’t have seems like it will produce inflation in the future. Somebody’s right, and somebody’s wrong. So, we’ll just have to stay tuned to see which side is correct.

Paul, can you talk a little bit about how you’re having these conversations with your clients at FineMark, and how you are helping them position their portfolios, in case, the bond market is currently wrong, and we do indeed have inflation headed down towards us.

Paul Blatz:

Sure, very good question, David. And I think it’s important to state the obvious, that we really don’t know what the future holds and anybody who says otherwise is probably fooling themselves. So, we can really just base everything on what the Fed is saying, what they’ve implemented, and what the risks and rewards are with regard to what the market is presenting. The nice thing about this scenario is that the three things that I’m going to mention, regarding how we’re positioning portfolios, even if we’re wrong and inflation becomes transitory or it becomes permanent, in either case, we still will be positioned to do well.

David Scaff:

Well, that sounds interesting. I want to hear how you win both ways.

Paul Blatz:

Sure, well it’s not to say that it doesn’t come with short-term volatility. So, I would say first and foremost, because we’ve spent a lot of time talking about fixed-income bonds, certainly you have to be a little bit more creative with regard to your fixed-income exposure. A portfolio of just investment-grade credit, your AAA bonds, things that we’ve kind of taken for granted over the past several decades, you’re probably going to have to ameliorate that with some, I don’t want to say high-yield credit, but there are other credits out there. Right now, we’re using some more opportunistic credit strategies, again, to try and enhance the yields that we’re getting on fixed income.

But again, that does come with more risk. The primary hedges against inflation, or ways to combat this would be stocks. It seems a bit counterintuitive, and I talked about the PE, or price to earnings ratio, and how that could shift around, but that tends to be historically a more short-term move. And short-term in this discussion about inflation could be a few years. Over the long run, especially if you’re investing in businesses that can pass on price increases at a higher percentage than others, they’re going to do well. And they’re going to outpace inflation over time, especially companies that can have earnings growth rates that are significantly more than inflation. That kind of velocity effect will dampen inflation over a full market cycle.

The other allocation that we recommend to help combat inflation is commodity-trading advisors or managed futures, which is coined a hedge fund or alternative strategy. But what they’re doing there is using futures, as the name might suggest, to extrapolate trends in the markets. Whether it’s grains or currencies, interest rates, you name it really. There are about 250-260 contracts that they trade on a daily basis. And why is that effectively a very good hedge against inflation? Well, futures were initially created a long time ago to fight things like weather and other unknowns, but also to protect farmers at the very onset against inflation and deflation. Farmers were concerned about their input costs, like the corn and grain that they’re feeding their cattle, to use one example. And they were also concerned about the heads of cattle that they were selling two years or so (I’m not a farmer, so I don’t know the exact timeframe) but I think it’s about two years down the road. They were concerned about, if this is the price today, then I’m making a profit, but I need to ensure that I can lock that in down the road, because if things move against me, Icould be in a very heavy loss position.

David Scaff:

So, what you’re saying is that in fear, or in positioning for potential inflation, if it’s real, and if it’s not just transitory, you’re de-emphasizing traditional high grade bonds, you are increasing allocations to equities and you are making use of futures trading strategies, which on their face are inflation-fighting vehicles.

Paul Blatz:

Yes, that’s correct. And we also do have a small allocation to precious metals currently. I would say that much like we talked about bonds before, that even though gold is the age-old inflation hedge, it’s not referencing fear against inflation at the current moment. Gold last fall hit it’s all-time high of about, $2,063/oz. And that was right after the Fed pumped a lot of stimulus money into the system. Most recently it’s right around $1,700-$1,750/oz. That’s the opposite move you’d expect if investors were really fearful about inflation. You would expect gold to be going up. But nonetheless, we have a very small allocation right now as a defensive posture against the inflation dollar weakening, which is another risk factor that comes along with it. So, in terms of priority – stocks, managed futures and then precious metals as a defense.

David Scaff:

Great. Well, thank you for sharing that, Paul, and thank you for sharing your views today on inflation. We’ll see what happens in the near future.

Paul Blatz:

Absolutely. Thank very much, David.