Persistent Inflation Is Going to Be More Problematic Than Everybody Thinks: Jim Bianco

Deutsche Version

The countdown is on. At its upcoming meeting on November 3, the Federal Reserve will most likely give the go-ahead for the tapering of its asset purchases. It will be the first time since the outbreak of the pandemic that the world’s most powerful central bank is scaling back its gargantuan stimulus program.

What does this mean for investors? «The Fed is showing a lot more flexibility, and the market is expecting that flexibility from them,» says Jim Bianco. Therefore, the founder and chief strategist at Chicago-based Bianco Research doesn’t expect monetary policy to automatically tighten, as it was the case in the last cycle, which led to severe tremors at the end of 2018.

Nevertheless, he sees considerable risks. The main reason is that the narrative is shifting to the idea that inflation rates will remain high next year. Accordingly, the Fed could be forced to tighten interest rates much earlier than planned.

In this in-depth interview with The Market/NZZ, which has been edited and condensed for clarity, the influential market strategist discusses the fight in Washington over a new stimulus package and the consequences of the economic slowdown in China. He also explains why he advises to invest in growth stocks in an inflationary environment and why fintech and blockchain innovations could trigger a new revolution similar to the emergence of the Internet in the early Nineties.

Mr. Bianco, the stock market has recovered quickly from its setback. In the U.S., the S&P 500 closed at a new record high on Thursday. How do you assess the outlook for investors?

Typically, you will get about two 5% corrections a year. We had one back in March, and we’ve just had another one now. So far, even minor pullbacks have been a signal for traders to buy the dip during the pandemic. It looks like this dip, as has been the case with most, was very short-lived. To that aspect, if you look at it technically, the market hasn’t done anything, at least yet, that would get you more concerned.

Does this mean investors can sit back and look forward to further gains?

There is a narrative that is more worrisome, and it’s around inflation: The «transitory» debate is starting to shift to more persistent. As we’ve seen with the CPI data last week, the current year-over-year rate of inflation is 5.4% on the headline number and 4% on the core number. That is elevated, and it should come down. However, the more persistent non-reopening and acyclical components continue to trend higher. For instance, owners’ equivalent rent or how much an owner of a property would have to pay to rent it, just recorded its largest monthly gain since June 2006. That’s leading to the idea that next year the rate of inflation might only come down to a high 2% or maybe a low 3% number – and that’s too high for the Fed.

All indications are that the Federal Reserve will soon start to taper its gigantic asset purchases. How well will the stock market digest this?

They stated that they are going to taper because the job market has made «substantial further progress». So they are going to probably reduce the bond purchases of $120 billion a month by $15 billion a month. Accordingly, they will be down to about zero on purchases by mid-year 2022. But here’s the thing: The market is starting to price in two rate hikes before the end of 2022. Why? Because inflation will probably stay uncomfortably high and push the Fed towards raising rates in the second half of next year. Given all that, I’m not surprised that there is this increasing concern that inflation is not as transitory as the Fed thinks.

Two rate hikes by the end of 2022 look rather ambitious compared to the last cycle during which the Fed moved much slower.

Yes, it’s ambitious relative to history. But what’s different is that they learned from the experience in 2018. Remember, in December of 2018, the Fed had already finished tapering, and they were reducing the size of the balance sheet. They called it «automatic pilot» and «watching paint dry», but the market did not like that. It freaked out, sold off to Christmas Day in 2018, and then in early January 2019 Powell came out and said that the Fed would be «patient» and «flexible», a move known as the «Powell Pivot».

What does this mean for the market?

The market understands that the Fed is a lot more flexible. In 2014 or 2016 you would have thought «Ok, they made the decision to taper. That’s it, they’re tapering every month.» But this time, they are going to start tapering in November, and every six weeks they are going to ask the question if they should stop or speed up because circumstances have changed. Therefore, the market thinks that the Fed will adjust along the way. But the adjustment might be that they have to speed the taper up because of persistent inflation. It could also mean that if inflation heats up, they go right into rate hikes. Then again, if the stock market corrects a lot and/or the economy turns south, the taper could end on a dime. So it looks like an ambitious schedule, but the Fed is showing a lot more flexibility, and the market is expecting that flexibility from them.

Do financial markets even know how to deal with inflation anymore? Interest rates have been falling steadily since the early 1980s, and some economists declared inflation dead as early as the mid-1990s.

If we are going to get persistent inflation, that’s a game changer. Usually, the Fed has a full range of tools they can apply: Quantitative easing, purchases of other assets like corporate bonds or whatever they need to do to help advance the economy. But if we get persistent inflation and rates start to rise, the market’s response is going to be: «Fed, do something about that!». And that means they don’t have these tools to stimulate the economy anymore. That’s why the Fed could get caught in a very difficult situation in the second half of next year with inflation being too persistent and interest rates going up.

Why would such a development be problematic for the Fed?

Let’s assume Jay Powell is still at the helm by then. What is he going to do to stop persistent inflation? The obvious answer is raising rates. But the stock market may not like that, so maybe he will not raise rates. But then, the bond market doesn’t like it because it wants the Fed to address inflation. That’s the basic problem with persistent inflation.

The worst-case scenario would therefore probably be stagflation: a combination of a stagnating economy and high inflation.

Stagflation has become a loaded word on Wall Street, so let me give you a non-emotional definition: Can we have above average inflation and below average growth simultaneously? Yes, I think this could happen. The term stagflation tends to make you believe in runaway inflation and a recession. I’m not sure I’m going to these extremes at this point, but I could see elevated inflation coming and also growth slowing.

The data already point to a slowdown in the economy. GDPNow, the real-time indicator of the Atlanta Fed, shows economic growth of only 0.5% for the third quarter.

It is difficult to ignore the huge reduction in GDP estimates for Q3. But the pandemic has also changed attitudes in ways that most people don’t understand, and Wall Street really doesn’t understand. According to the latest JOLTS report, 4.2 million people in the U.S. or 2.9% of the workforce quit their job in the month of August. A lot of them quit because they did get a better opportunity: higher pay, a better career path or something like that. But a lot of people just walked away. That suggests that labor is in the driver’s seat, and people want specific types of jobs. According to a recent Harris poll, 76% of the American workforce want hybrid work where they can work from home for a couple days a week, if not five days a week. But Wall Street doesn’t get this because the industry pushing the hardest to get everybody back into the office for five days a week is banking and financial services. So all the analysts sit in their office and think everybody else is going to be like them. But that’s not the case. Firms like JPMorgan and Goldman Sachs are the outlier.

And what does that have to do with the weakening of the economy?

The labor market has changed. Either you have to give your employees remote work or you pay up. Bank of America has already announced that their minimum wage is going from $21 to $25 an hour in 2025. That means we’re way past the debate about a minimum wage of $15 an hour. Amazon is also hinting that they might have jobs starting at $22 an hour. So if you want people to go back to an office or back to a factory or a fulfillment center, you have to pay a lot. I don’t think the statistics are ready to measure that. They are going to show weakness in the economy, and that’s why I’m not surprised by these disappointing payroll numbers relative to what’s expected because the pandemic has taken a toll on economists’ abilities to provide accurate nowcasts.

Meanwhile, the stakes are high in Washington. Could the planned stimulus program inject new momentum into the economy?

It used to be called the $3.5 trillion spending program which is now somewhere at a 2-trillion handle, and they’re still trying to debate that. There’s also an infrastructure bill, and a budget and the debt ceiling. Each one of these alone is a tall task to pass, but Congress has to pass all four of them by December 3th. Good look with that!

Then again, the Democrats control the government and both chambers of Congress. Why isn’t President Biden moving faster with his program?

The problem is that President Biden’s poll numbers have been falling significantly for about two months, and they’re not showing any sign of bottoming. If his poll numbers stay down, then the different fractions of the Democratic Party will wage war with each other because the President doesn’t have the political capital to say: «This is what we are going to do, everybody votes for it, you don’t want to defy me.» Hence, this is going to be a lot harder than people think. Sure, at the end of the day, they have to pass a bill to raise the debt ceiling, but that doesn’t mean it won’t be messy before we get there. Also, keep in mind that when the spending packages fall down then that could actually be a tightening in terms of economic policy, because people were expecting fiscal spending, and then they are going to wind up getting less.

As if the situation were not already complicated enough, there is also the economic slowdown in China. How big is this risk factor?

High yield spreads of China’s non-investment grade bonds are back to where they were during the global financial crisis of 2008-09. But a lot of that stuff is not owned by western financial institutions. So there isn’t enough of it out there that it could wind up sinking western financial markets. But it is a problem for the Chinese economy and Chinas’ financial markets. Their stock market and their bond market have been performing very poorly, and it is an impediment on their growth.

The fact that growth in China is slowing down was just confirmed by disappointing GDP figures. What would be the global consequences of a severe economic slowdown in the People’s Republic?

We are in the process of re-opening the world economy, and we are demanding so much stuff that we have a supply-chain problem. A lot of stuff comes from China, and if they’re slowing and making less stuff then this whole thing of bringing supply and demand back into balance is going to get even more difficult.

With the quarterly results season upon us, more and more companies are already warning of supply difficulties. What does this mean for earnings outlook?

If you look at traditional valuation metrics – P/E ratios, market cap to GDP or cash flow to price – the stock market is at best fully valued and maybe slightly overvalued. But the market was able to shake that off, because even with those enormous multiples investors had to pay for stocks, 80% or 90% of the companies beat estimates in the first and the second quarter. Their earnings growth was way higher than anybody thought. But it’s still an open question if we are going to see that in the third quarter. So all of a sudden, investors have to ask themselves why they are paying up for stocks when companies aren’t delivering as much. But that’s likely not going to be a disastrous problem, it’s more of a churn-sideways, no-new-highs type of situation.

At the same time, bond yields are trending upward. The yield on ten-year Treasuries is approaching 1.7% for the first time since the end of March. How should investors respond given these conditions?

I think we are going to get higher treasury yields off the back of what people will perceive as persistent inflation – and that is going to be more problematic than everybody thinks. But ultimately, I’m going out of the box and defy the common wisdom: Where you probably want to stay invested is in growth stocks and technology. I know, Wall Street thinks that higher rates mean that tech stocks will suffer because they are long-duration assets. But they only became that a year ago. I think it’s a spurious correlation and that it’s going to go away. So I would rather own the work from home stocks than the auto stocks and the re-opening stocks if interest rates are going up.

That does sound out of the box.

I know that everybody has cut it the other way around. We’re told to buy value stocks when rates are going up because the Wall Street assumption is that there is only one reason that interest rates are going to go up: We are getting real growth, things are getting better, and that’s why everybody cheers higher rates. If that’s the case, then the value stocks, the autos, the consumer cyclicals will do better. But if it’s really just about inflation going up, those consumer cyclicals, those value stocks and even some of those financial stocks will struggle. That’s why I would rather be in growth stocks. They will do better, even though the narrative is exactly the opposite. Once we get going on this, and we start realizing it’s persistent inflation, I would rather own Zoom Video than GM.

However, growth companies often have a rich valuation. Many are also unprofitable. Won’t that become a problem when interest rates rise?

Here’s the part nobody gets: Yes, you have the discounted-cash-flow problem with interest rates. But they are growth stocks, they are supposed to offset whatever concerns you have about higher interest rates, discounted cash flows etc. If they’re real growth stocks which I believe they are, then that’s not going to be a problem for them. But just remember: When we’re talking about growth companies, we are talking about high beta companies: When they go up, they go up a ton. And when they go down, it’s painful. There is no 8% advance, 3% decline, a little sideways.

What would you advise investors to do apart from that?

Here’s another controversial call: I don’t want to have anything to do with traditional financial companies, especially banks. There are eleven sectors in the S&P 500, and the sector that is either the last or second to last over the last twenty, ten and five years has been the financial sector. And the banks themselves have even underperformed the financial sector. It’s amazing to me how the standard call on Wall Street is that the banks are cheap and you have to buy their stocks. Do you know how many careers have been wrecked in the investment world because people have inherently bought banks only to watch their chops go away? Bank stocks have been a disastrous investment over the last twenty years.

However, the weak performance of the sector also has to do with the fact that thirteen years ago we experienced the worst financial crisis of the post-war period.

There is a better explanation: The banking system has never been disrupted; it has not changed. It’s old, antiquated, expensive and slow. Now, you have FinTech and decentralized finance coming at it. Yes, the banks have done very well this year, but that’s because they have been so bad the years before. If you bought them 14 years ago, you haven’t made any money, even though the S&P 500 is up 300%. With European banks it’s even worse, and Japanese banks are the worst of them all. The Japanese bank stock index is below 1987 levels. So if you bought Japanese banks after the stock market crash at the low of 1987 and held them for 34 years, you haven’t made any money. That’s how awful they have been.

But don’t rising interest rates – or rather a steeper yield curve – speak in favor of financial stocks?

Again: The banks are slow, inefficient, expensive and ripe for disruption, and it’s coming right at them. So if you ask me what to buy, it’s anything but financials. I get it, maybe if interest rates go up people might think that their margins will expand, and there might be a little bit of an outperformance for a while. But if you’re thinking long-term, that industry is going to get wrecked by what’s coming in terms of technological improvements through FinTech and decentralized finance.

What will this fundamental change look like?

I’m a rational financial guy, but open your mind to what’s happening in the DeFi and the crypto space. It is going to be as big a disruption as we’ve seen since the Internet itself. It isn’t there now, but you can see where it’s going, and you can see there could be a world of banking without banks, trading without exchanges or insurance without insurance companies or brokering without brokerage companies. That is a very real possibility. A lot of people look at what’s happening in cryptos, and they cannot get past the wild volatility of all these tokens. But if you get past that and you understand the protocols and stuff like Web3, you can come away thinking: Wow, this is like the very early 90s in the Internet sector, and it might even be better!

How can investors position themselves for this disruption?

It’s hard to invest in it right now, unless you want to buy some of these tokens. But the first thing you need to do is to educate yourself and not dismiss it. It’s like with the Internet in the early Nineties: Even if you were 100% sure that the Internet is going to be the biggest thing ever, you had a hard time investing in it. There wasn’t a Google for another ten years, there wasn’t a Yahoo for another five years. You didn’t have all the B2B stocks for another six or seven years. But it was still a technology that you needed to understand. It was coming and it was going to be big. And the same thing is happening now in the financial industry.

Jim Bianco

Jim Bianco is President and Macro Strategist at Bianco Research, L.L.C. Since 1990 his commentaries have offered a unique perspective on the global economy and financial markets. Unencumbered by the biases of traditional Wall Street research, he has built a decades long reputation for objective, incisive commentary that challenges consensus thinking. In nearly 20 years at Bianco Research, his wide-ranging commentaries have addressed monetary policy, the intersection of markets and politics, the role of government in the economy, fund flows and positioning in financial markets. Recently, he also started the podcast Talking Data where he shares his insights into the financial markets and economic developments Prior to joining Arbor and Bianco Research, Mr. Bianco was a Market Strategist in equity and fixed income research at UBS Securities and Equity Technical Analyst at First Boston and Shearson Lehman Brothers. He is a Chartered Market Technician (CMT) and a member of the Market Technicians Association (MTA). He has a Bachelor of Science degree in Finance from Marquette University (1984) and an MBA from Fordham University (1989). In May 2019, Mr. Bianco was interviewed by the White House for one of the open positions on the Board of Fed Governors.

Source: https://themarket.ch/interview/persistent-inflation-is-going-to-be-more-problematic-than-everybody-thinks-ld.5266