Watch this 2022 market outlook discussion with Christopher J. Wolfe, Chief Investment Officer of First Republic Private Wealth Management, and Mike Selfridge, Chief Banking Officer of First Republic Bank. They will address the economy, U.S. policy, financial markets and investment opportunities as we enter the new year.
Read below for a full transcript of the conversation.
Mike Selfridge - Well, good afternoon everyone. And thank you again for joining us today. This is our quarterly markets update and it's always my privilege and pleasure to host Christopher Wolfe. My name is Mike Selfridge. I am the chief banking officer at First Republic Bank. And again, I'm delighted to have Christopher Wolfe, our chief investment officer join us. Christopher is the chief investment officer of First Republic Investment Management. And there, he oversees our research and strategy for the investment management group, which as of the end of 2021, topped 279 billion in assets under management, another record year and Christopher, a testament to you and the team and all the great work you're doing on behalf of First Republic clients. Christopher is in an influencer in the role of economics and money management. He is frequently featured on television and in many publications, and Christopher, we have quite a following now on this venue. So always good to have you back. I just want to remind folks that if you're on the line, please submit any questions in the Q&A button, you'll see that at the bottom of your screen. I'll go ahead and ask questions and then I will try to as best I can intertwine those questions into our conversation. So, Chris, here we are. The last time we got together, I think it was just mid October, maybe a little bit early October. Lots of things were brewing. I'm going to start with the theme that you had last year and the theme you have for 2022, I'll remind you of the theme for 2021. It was called A Tale of Two Bridges, as you know, and the first bridge was stimulus. The second was healthcare or vaccination. And of course the COVID-19. What is on your plate for this year's theme?
Chris Wolfe - Well this year, I think it's really a new wave. And while some people may view that with a little bit of dread, it's a new wave of COVID. I think what we're really in is for a new wave of markets and that new wave really gets to the idea that the central bank in the United States is going to be changing its tune to a great degree in our view. And so that new wave is going to set off opportunities, but even some important risks in markets over the course of 2022 and beyond. So that's really the crux of where we are we're by no means dismissing any of the risks associated with COVID at this point, given that we've seen, and we were just a little too early, frankly, in talking about those bridges being built, we've seen the Delta and the Omicron wave hit right at the end of 2021 and beginning of 2022. So we think the challenges are still there and there are some signs that COVID maybe becoming more endemic, and that's going to change some of the ways that we think about policy responses, which to date have largely been focused on protecting hospital capacity. So why that brings us full circle to of a new wave is we think we're going to be in a new place. We're embarking on this wave in 2022 that we think will be driven by a number of things change in fed policy, the continuation of companies that will employ technology to keep their margins very high. And I think the last piece of the puzzle is we should see this wave expand globally. We were a little early. Again in 2021 didn't see it happen much in Europe nor in Japan, but this is the year where some things start to align for policy moves, not just in the US, but around the world to have greater similarity.
Mike - So Chris, we have a lot of ground to cover fed action, inflation, debt, deficits, things we always cover, but always seems new and unique. But I just want to start with the kind of the GDP backdrop, the big one for the macro United States in 2022. And if you're still bold, how did the look for 2023? I thought a lot of people have lowered their expectations. Some are talking recession. What are you thinking?
Chris - You know, 2022 hard to see a recession here. I think the probability is very low, something under 10%, at least at this point. And a lot of that is driven by the fact that the consumer is in a really good place, the balance sheets in a good place. There's more jobs than people, at least in terms of the employment base right now, some of that could change later this year, but we're in a really good place with respect to the consumer, there's a big pent up pool of savings as well. We'll talk about savings a little bit later as well. The bottom line is that's a good place and very hard to talk about. Well, the recession forecast is X, Y or Z, except something that's very low. I think beyond 2022, the picture is quite murky and it's murky because the midterm elections could mean something for the way we think about policy developing. Don't think there's going to be a lot of tax increases. That's something that we thought would happen in the first part of 2021 on a build back, better agenda, but that got stalled and that meant all the tax increases behind it got stalled as well. So I think the 23 story is going to be one where we need to see the path of inflation and how fast it's going to cool. And ultimately whether or not it's going to have an impact on consumers, through sentiment spending job growth, et cetera. So right now I don't think there' a high probability of recession, but it's higher in 23 than it is in 22. That's an important trajectory. Right now, I think it's a 4% kind of number three and a half to four and change, is where GDP ends up for 2022. That's not bad coming off, very strong numbers in 23, sorry, in 21. And I think the inflation story is probably going to be the bigger one. In fact, I suspect it's going to dominate almost all the headlines, either inflation's high or the fed is behind, and there'll be lots of hand ringing and gnashing of teeth in markets that's going to show up as volatility, but I think inflation ultimately starting at 7%, probably prints a few more high six low seven type numbers in the first part of this year, driven by energy, but then starts to come down and potentially comes down pretty hard by Q4 of this year. So we get somewhere closer to 4%. Now a lot of things can happen between in here and there, but that arc of inflation slowing is another key feature of 2022, and argue.
Mike - Let me drill down a little bit more on inflation because that is the hot topic of the day. And of course that could drive fed action or will drive fed action, and that'll be my second question, but in terms of inflation, you touched on it. You look at the 7.9% CPI in February, that was up 7.9% year over year. Granted the fed looks at the PCE or the personal consumption expenditures, which excludes food and excludes energy because they're considered volatile. They have an not been volatile. They've been actually up and to the right. So inflation is up there and it's impacting different segments of the population. Even at 4%, the fed has always talked about 2% and then averaging 2%. Now it seems we're comfortable with the number that's twice that, what are your thoughts again on inflation and the picture as you look out areas like supply chain for the rest of the year?
Chris - Yeah, it's a messy story it's a little bit difficult, I think as right now, most folks want to just assume inflation's going to stay at seven for the rest of the year or move higher. And, gosh, that fed is so far behind. They should raise rates a whole percentage point all at once, there's a lot of bombast out there, but I think a couple of things are important. On the difficult side, it's the fact that inflation has so many contributors, it's supply chain issues, it's energy, it's food. And by the way, higher energy prices impact food prices and a bunch of other kind of parts of the primary and the core parts of the supply chains, those elements, it's also higher wages. Those elements are mean that a one-trick pony are a one-stop-shop, the fed just being able to do one thing and control it all is kind of a silly wish by markets, it's going to be harder to control. And ultimately it's going to require more than just, I think raising interest rates, we may have to talk about quantitative tightening. That's just the fed selling its balance sheet down at some point this year in order to start cooling the economy a bit, at least with respect to inflation. But I think the roots of inflation are the thing that we'd want to talk about whether or not it's going to stay in the system, not just to higher wages translate into higher prices. Do we see higher goods prices, intermediate prices, producer prices, everything starting to move up? And some of the contributors to inflation are likely to abate this year in our view, number one. There's a natural rollover effect of energy prices. Remember there almost 65, 70% in a very short period. So while energy prices spiked, they've gotta go up again another 65%, oil at 150, let's say, now that's possible in a Russian invasion, not going to say never to anything, but the reality is there's a lot of oil rigs starting to come online.
We may see supplies start to pick up quite a bit. So I think it's pretty difficult without some other external factor to talk about energy, staying this high on a sustained basis, we could see spikes to 1/10, 1/20 on market volatility, but as more supply comes online, we'd expect oil prices to come back down a little bit. That's one. I think two is what we see contributing on the housing market is something that's starting to reach a peak here, at least in certain markets. Keep in mind that the housing market in the United States is very variegated, housing in San Francisco is not the same as housing in Nebraska. And that's not any way a difficult thing to say as much as it's kind of where the supply and demand is. And in places where there's a lot of demand, keep in mind, we have lots of money sloshing around in the system and lots of folks with kind of jobs and looking to spend that money. A home is historically not a bad investment and many folks are being priced out of markets that they want to be in. There's still lots of opportunities, but those markets particularly in the major urban areas have become in suburban areas have become incredibly pricey. I think one interesting statistics, there was a quote on Bloomberg Westchester County in New York is almost out of houses. So if you're talking about the tightness of the real estate market, at this point, you're getting to a big enough gap between affordability and kind of valuation that we'd expect some cooling in the housing market as the year goes on. The last piece of this story is a supply chain and supply chain in this part have many features to them, but kind of the bottom line here is, we need to move more of the goods from where they are, which is in the coastal areas into the middle of the country, that's going to take more truckers. That's going to take more people doing those same kind of jobs.
And ultimately I think capitalism has an answer for a lot of what this is, which is to pay higher wages. So here's the challenge. You can resolve some of these issues with a combination of higher wages, benefits, et cetera, and a lot of things to some degree. But I think the real question is what is either going to be the challenge to profit margins. So they come in a little bit. It create a bigger trajectory for use of technology in companies we think it does, or is this just well too bad? The inflation's going to pump through the system and that's where it's going to go. If you put those three features together for us, if we put those three features together, sorry, I think you end up with a story with inflation cooling a little bit because you have some of the supply chain issues resolved by the end of the year. Chipsets, probably not. That's a 23 story, but you do have some of the supply chains resolving by the end of the year. You have a little bit more mild energy prices. I think the housing market starts to cool a little bit, and that gets you to the seven to four kind of arc, but it doesn't get you seven to two because I don't think inflation's headed all the way back to two. And that's probably the biggest challenge for the fed in 2022.
Mike - Seven to four is interesting. There's a lot going on in the labor market as well, but let's get into the fed action. It's the last time we spoke did change granted from the feds perspective, but it was lower for longer. For most of last year, we were going to have rates pretty much stay flat through at least 2022. Now we're, depending on the predictions, looking at three to five rate hikes, how many rate hikes are you looking at in 2022?
Chris - Three to four. And our expectation, this is important is that the fed will just stay on the 25 basis point pathway. They can change. They've changed pathways from 25 basis points in the path. I think you gotta go back to 2004 to find the last time that they did that, where they kind of jolt the markets. The markets are very much of the mind at this point that the fed is in is so far behind the curve that they're going to have to do five of hikes. In fact, that's what's implied or priced into markets right now, 5, 25 basis point hikes. And what the lean seems to be for market participants is the Fed's going to shock the markets on March with a 50 basis point hike, so we want to call timeout, not sure that we're going to see 50 basis points. You gotta go back pretty far in history for the fed to shock the market and put 50 basis points up there. I think that's a low probability event given that I think where we are today is we have a fed that's in a very delicate position. A, inflation's not transitory, because it didn't go away in just a couple of quarters, B, you're in a place where there's a lot of gearing that the market has to changes in fed policy. Meaning it's very sensitive to changes in fed policy. We can observe this directly in bond market volatility. So as the fed has started to talk about doing things, bonds have getting jump have become more jumpier, but more volatile. And if you think about where we've been in the 10 year bond, the lowest put in and August of 2020, and it's just kind of been a steady tick back up as the fed has really started to talk that interest rates need to move higher, so why is this important? Well, the bond market can do some of the Fed's work, not all of it, but some of it in terms of higher rates in helping to kind of cool speculative fervor.
But I think the other piece of the puzzle is for the fed to jolt markets in a way that most investors don't expect, that creates another element of uncertainty. It would probably do a lot more challenging or difficult or bad things to the stock market. At least in the near term is investors have to readjust their expectations, not only for the surprise 50 basis point hike, but what it means, which is, "Oh my God, the fed really is far behind." Now, they've got an army of PhDs and others looking at a lot of the data. And I think our expectation is not shared with the fed that, it's going to head back to 2% inflation, but it's going to be on a downward arc through the balance of 2022, and that gives the fed some room. And I think if they're weighing, "Geez, do we fight inflation before it comes rooted? Or do we actually not shock the system where we don't need to?" It's the first rule of crisis, don't create one if you don't need to. So if you're in a place where you have to make those trade offs, I think it's fairly difficult. First of all, you already know how to cure runaway inflation and it's an awful cure, but it works. You create a recession. I don't think we're headed there, but there's a known cure. It's not like there's an unknown. What's unknown is what's the market reaction function if the fed decides to create a whole new approach to how they're going to handle inflation, when they've already indicated we're going to move slow and steady and keep it very slow and steady? I think meeting those market expectations right now is not the worst thing in the world if they're just perceived to be behind inflation a little bit, I think the main risk and I'll close this point here is that there's a pretty ugly CPI print coming in February, maybe again in March, just on the way energy markets are behaving and the translation of energy prices into food, food and energy are really going to be driving CPI for the next couple months, at least. And I think that's where we're going to see just a lot more volatility in bond and stock markets because it'll be, "Feds behind, they're going to raise 50." And then I think you'll hear people talking about 75 or 100, and like I said earlier, we just want to call time out on that.
Mike - Yeah, it's interesting, your thoughts on the fed and sort of a glide path, 25 bits here and there every, every quarter. So up, I want to, talk further about the fed, getting a little behind because the fed really has two important jobs, price stability, and we're a little higher than what we think might be stable.
Chris - Yeah.
Mike - And full employment. And right now on the headline basis, the unemployment rates 4%, that looks fabulous. January had a blowout jobs number. We had, I think 467,000 non-farm payroll jobs created, a lot higher than people expected. But if you peel back the onion a little bit, there's a lot going on, there's still three, almost three, a little more than three and a half people not working that were working in February 2020, there's 11 million jobs available. There's kind of the disenfranchised labor force, particularly those that might come back at age 55 and over, they're not coming back to the labor force to participate. And that seems to be the area where maybe the fed got a little bit behind. So I'd love to talk further about the action you said that the fed could use, which could cause a recession, but they raise rates at a quicker pace. Do you see that as a possibility if they can't control number one and two jobs?
Chris - I think that anything's a possibility, but rather than give a platitude, I think it's a very low probability, at least right now. I think what is easy to expect are things around food and energy price inflation, but it's very difficult for the fed to control that with the price of money, those things aren't necessarily controlled by the price of money as much more of a supply demand and an infrastructure issue associated with those. So to the extent they kind of gotta roll through the system, you're going to have to take a lot of people out of the labor force. If you want to start talking about cooling those two specific items, it's one of the reasons the fed looks at PCE. I'm not saying we should ignore food and energy, because it's going to feel pretty difficult I think over the course of the next couple months, and it's going to look like, "Ah, we're going to have to have a panic moment," but we want to just be a bit patient steady hand on the wheel I think all the way through the first half of the year, just we expect that volatility. So I think the other part that you're getting at Mike is the idea that the fed not just behind the curve and has to make a trade off here. Well, they've pivoted a couple times back and forth, which do we favor? Do we favor jobs? Do we favor priceability, jobs priceability,? And at this point, the job state is still a bit messy. The big gain in January, if you peel back the onion, a lot of it was a seasonal adjustment and there was a whole bunch of other things going on inside there. It was a strong report, I'm not downplaying it so much, but let's not a overdo it. And B, you know, some of the inflation numbers, as we've just talked about do have a natural kind of year-over-year effect that will likely translate into some of this coming down. So I think it's really hard at this moment, not to react to all of the headline numbers, which just look really challenging. But I think the steadier hand right here is still the path that we want to keep on with respect to the fed trajectory and ultimately what it means for investments.
Mike - Chris, there's this notion of a sort of monetary policy that's stimulative, and that, that is that a big headwind to the economy, the historic fed funds rate, if you go back for decades, spend about five and a half percent. We're at 25 basis points, so putting it in perspective, even if they hike five times, we got a fed funds rate of 150. I mean, we seem to be so panic about rates going up, but you can't have them at near zero forever. Where do you sort of think the line in terms of a neutral monetary policy for the fed?
Chris - Well, the simplest estimate that most economists will give you is that some combination of without getting into tailor rule and all the modifications is how do you estimate GDP, because that can be a baseline for how do you think about interest rates and the cost of money? And our challenge here is that the GDP estimators are anchored on things like population growth and they're anchored on productivity growth. Those two things are reasonably good, very long term proxies, not perfect, but reasonably good proxies for GDP growth. And I think as folks may be kind of looking at some of the census data, the population growth in the United States has been on a meaningful downswing. Now in 2020, and in 2021, the data was really weak. And a lot of that had to do with COVID. COVID took out there's a lot of excess deaths and we can get into the math on how to count all that stuff. But the reality was we're down at point, point, not even... there's no one handle, it's less than 1% growth, we're either 0.4% in 2020, and 0.1% in 21. Now a combination of things are driving leak, population growth and without belaboring it, it's COVID, the immigration numbers that have come way down. And you kind of in this place where it's a challenging expectation to think that will head right up to kind of one, two, three, 4% about some meaningful changes in either immigration policy, or the way we're going to think about healthcare, particularly with respect to dealing with viruses and things like that. For productivity growth though, story is a little bit interesting because productivity growth historically was driven by cost savings. Lot of good papers around that cost cuttings and the idea that robots for people, little glib way of seeing, more technology and company helps to keep their profit margins very high operating leverage high.
We totally buy into that, we are going to see that. But I think the idea here is that the productivity cycle needs to accelerate wildly from here, wildly. And that's hard to see given A, it's hard to measure and B, most of the legacy of productivity growth was cost cutting. So either we're going to get into a wild acceleration with some cost cutting and less labor, okay, that's not good for the economy overall growth. How does that feed into the kind of... it's a very difficult set of and circular set of expectations, but if you have wheat population growth and you don't have wild productivity growth, you can't have... it's very hard to talk about very strong GDP growth. So GDP on a real basis after inflation, like at two and a half isn't unreasonable because you're talking about historic productivity at two, population at 0.5, give or take without some meaningful changes or rebounds in some of the numbers, so could that happen? I think there's room for that to accelerate mostly because the pace of innovation in the United States is just at a very high level. And I think as we've talked in other calls, we continue to see examples all over, not jus the coastal areas, but all over the country of the gap between ideas and getting them to market and getting close to money, just get to zero, it's almost like next day kind of thing. That's very exciting, you talk to entrepreneurs or others in innovative fields. That's a very exciting development that suggests that the productivity story may have another wave to it over the course of the next five or 10 years. So I'm a little more constructive than where the fed is and where the models are.
Mike - That's good. And I feel like I'm asking you questions about all the headwinds and we'll get the headwinds out of the way and get to the tailwinds like innovation. But this topic you brought on population, it was obviously exacerbated by the pandemic, but we've been on a decade long decline in birth rates in the United States, international migration is down. Death rates are up and these all contribute to the net growth and population. But a little over 330 million people growing, you said, 0.1% when historically, maybe you wanted to see 1%, we've got work to be done in terms of the population. Again, the downside on population growth, and you look at country like Japan, where describe how devastating it could be if populations are not growing.
Chris - Yeah, it could be extremely difficult, particularly if you're sitting on a lot of debt, like the United States is, at least debt or debt in total debt per capita. So, part of the challenge here is you end up with some very funky effects. You have different parts of the economy that have wild inflation, other parts of the economy that are not inflationary and all you end up having to invent all sorts of new monetary policies. Japan has been through this over the last 30 plus years. And a lot of that, I think foreign economists would say driven by the immigration issues, but the reality is it's immigration plus population growth. You have a baby boom that moves through the system and as kind of boomers retire and they get older and a lot of things happen. The death rates are likely to head higher for that group. COVID exacerbated them. COVID also put people in a different mindset about what their futures look like in a more uncertain future in some ways, driven by endemic viruses changes the way that people think about making long term commitments I think to a certain degree, there's some studies that seem to be indicating this, but that said, I think where you are right now is a situation where the US is heading in a pathway that has similarities to Japan beginning in the mid 1990s. Now that wasn't necessarily awful for markets, the economy and the stock market are different. Economy kind of slung slug along at just very low levels at that point, the stock markets can do different things because the companies may be tied to different revenue drivers global, in fact, in some ways. So I think the opportunity set, we wouldn't want to confuse between the economy and the market and the bottom line here is, well, the US may be heading on an economic path towards Japan, hard to see that the stock market ends up just like the Japanese stock market. There's still a lot of main major differences between that.
Mike - I'm going to start weaving in some of the audience questions on your investment strategies, Chris, if you don't mind, but first let's go into some, what I think could be some tailwinds for us, you mentioned consumer earlier, consumer net worth right now is an all time high, I think is about 150 trillion that prior to the pandemic was about 115 trillion.
Chris - Yeah.
Mike - So it went from 115 to 150. In other words, consumer balance sheets are pretty darn strong. Excess consumer savings is out there. And the consumers drives about 70% of the GDP. Confidence level of consumer, I'll let you answer that, but how much is the consumer going to be a potential tailwind for us as you look at economic growth for 22 and 23?
Chris - As long as the job data remains relatively strong, I think they're a strong tailwind. And well, you mentioned some of those numbers that were growth. The real benefit here is when the entirety of the end income spectrum is actually moving up, and in fact, what we've seen is that the lower deciles of the income distribution in this country have actually made some of the biggest percentage gains. That's an important thing. We need to see that continue and know that's not a source of a wage spiral. A wage spiral is when finance, insurance, real estate, tech and all the big ones start asking for a lot more, I think the wage spiral problems that throughout were endemic in the '60s, '70s, were not likely to see those given the use of technology and still labor has a relatively weak bargaining power. But that said great resignation showing that in certain industries, particularly retail hospitality and those kinds of things, there is definitely a room to see these types of compensation levels come up. I think that's a wonderful thing, that gives us confidence that the consumer story is in pretty good place for the balance of 2022 and gives us more confidence that we don't see a recession around all that. So I agree with you. And I think that's something that we've been talking about for strength this year and kind of where the markets, where the economy's likely to add.
Mike - And then you see wage inflation, but that goes to consumers who could spend more potentially create a virtuous circle. So here's the question let's get into equities, fixed income and real estate. So on the equity side, just looking, it's been a little bumpy and choppy was the word you used. Hasn't been good returns for the Dow Jones, for the SP500 this year. And particularly for the tech stocks that have been hammered pretty hard. Do you think valuations are just coming back to more of a normalized acceptable level or has there been too much air out of the tire in terms of equity valuations?
Chris - I think we've begun... Equities are usually late to the party. Like I said, they bond market bottomed in August of 2020. So a couple years equities figured out, "Oh, hey, we're in an adjustment period." I think this is a longer normalization period. I think it will be hard to return to the kind of days of, "Well, the normal market price earnings multiples 30," it's not, that's nonsensical. It requires a lot of things to be true, for example. And I don't think going forward, those same things will be true. Money will be mispriced to the same degree. Energy will be mispriced to the same degree, et cetera. So I think that leaves us in a place where markets that normalize really see multiples change on more structural basis, they come down, they compress, we call it derating. The fancy way of saying de-risking is when you have a correction and we're going to re-risk, because all things are going to be good again. But as we talk about the bond market, driving the cost of money to higher levels, it changes the cost of capital. And very simply put that should I think for some of the highest valued companies in terms of multiples compressed those valuations doesn't mean the companies are bad. It just means the price you're paying for all those earnings in the future requires so many wonderful things to be true that, "Okay, maybe they're just not as wonderful," still true, but not as wonderful meaning cost of money may stay low, but not free for a very long time period.
So why is this important? Because we've seen a fair bit, I would say something between a third to a half of the kind of strong speculation that's been in markets or parts of the market be rung out. It's not quite there yet, I'll give you a quick example. At one point in 2021, there are more than 60 companies treating at 10 times sales or more. Some companies treating at 20 times sales and a few crazy evaluations at 30 time sales, like this is 1999 fiber optic nonsense kind of levels. Now we didn't own a lot of those in portfolios. I'm not overly concerned about client performance, but many of them have come back to earth. We're now down to only about 33 companies that are at those kind of excessive valuations. So it's being rung out at this point, you've seen the correction, which really started in many cases and to some parts of the markets like the equity markets and biotech, it's more of a bear market started in November of last year. I think a lot of that speculation has been rung out. Not all of it, mostly because we still have to make greater adjustments on the cost of capital as the fed raises interest rates. But I think that normalization process brings us closer to things being in balance. And that's not a bad environment. That just means you don't buy the market, put it on leverage, cross your arms and go home. It means you gotta be a bit more active, a bit more thoughtful about where to go. And for us, we talked to clients about being more sectorally oriented, whether it's the finance, some of the tech, some the healthcare, and even some of the industrials type companies that should do well in an environment like this one that will benefit from some of the midstream price, inflation, for energy as well, by the way, that will benefit from some of the end market price inflation, but should also benefit from technology enhancements.
Keep in mind that for some of the sectors, I just talked about a big chunk of the revenue comes from Europe, which has just been absolutely dormant for the last couple years and starting to ease restrictions here. If you read the headlines in Denmark and a few other countries, that's a good thing. So yeah, small country, but indicative in some ways of not just COVID fatigue, but maybe there's a sense that we can release some of the close it down and constrict all sorts of economic activity doesn't mean we're going to return exactly where we were in 2017, but lifting some of that up should also provide a bit of a tailwind. And I think to the point you made earlier, Mike, I think it's positive for sentiment when people feel less restricted and less about the fighting of a mask or not a mask or this or not that and more about, "Okay, it's not an issue anymore. Let's move on to something else." That's a good thing.
Mike - So if I summarize, you're still fairly constructive on equities, you just have to work a little bit harder to find the diamonds in the rough.
Chris - Yeah, this year could be three yards on a cloud of dust, sorry for the Ohio State football reference, if you don't get it, but we just might see a lot of volatility between here and the end of the year. And the index averages may be up a little bit, but I think what you're going to see is big divergences. So great example is kind of energy versus biotech. One's up to 20 some odd percent that's energy and one's down 30-some odd percent. And boy, just that one small all decision, being one place and not the other is a wild performance difference.
Mike - Yeah. How about fixed income, bonds, munis, those types of investments from a portfolio perspective?
Chris - Yeah. The asset class, everybody loves to hate, don't hate them. I think there's a lot of interesting things going on in fixed income, but the brutal truth is that it's very hard to earn an in a return above inflation. I think what you have to expect is our arc of inflation is reasonably accurate. We obviously put it out there. There's some scenarios where inflation stays higher or even comes down harder. But I think the reality is that a closer to four means that you probably still want to keep your bond portfolio a bit short. If you have a little extra cash in your bond portfolio, that's okay too. And where you get opportunities, they seem to be starting to pick up somewhere into credit market. Maybe we see some more noise in the munis market. We've seen a little bit of that lately. There are some opportunities to pick them off. I think the one interesting thing is that for high tax bracket investors, they still look relatively attractive. Our expectation, which turned out to be wrong, not true at this point is we see far more redistributive tax policies on the back of a lot of the fiscal plans. And once those went by the wayside, wow, all that tax discussion just went by the wayside as well. And given the way history indicates midterm elections go, I think it's a very reasonable view that you're not going to see any tax issues between here and 2024.
Mike - So, a lot of this is you mentioned liquidity, which we'll get into, there's still a lot of liquidity out there looking for yield. And this is driving interest in areas that you mentioned innovation, which is venture private equity, but getting into your perspective on alternative investments, so things like energy, things like real estate, things like private equity, what are your thoughts there?
Chris - So we're big fans for clients that are qualified, comfortable with the risks of liquidity here. That innovation pace is something that drives our thinking about markets. But the fact that we have not democratized every single investment in the country is not a bad thing. It means some of them still require kind of special access through types of private vehicles, whether it's real estate and kind of lending opportunities and geographic sub segments of the United States like the Southeast, if it's redevelopment opportunities in the Northeast, those things tend to be more targeted, more specific. They tend to have higher risk, but as we already observe, they tend to have higher returns. There's lots of interesting things out there in private markets that we think represent good compliments to your public markets exposure. So given that opportunity set, and the fact that there's a several trillion sloshing around just in the private markets, looking for these opportunities, we think that you'll see some of these trends that we've observed recently continue. Now, I think where there's going to be some challenges in the private markets and some of the unicorn valuations. because they'll because the ones that are closer to closing the gap between becoming private to public, they're going to have some influence of how private public markets will determine valuations. And as we've seen in some of the corrections here, multiples have come down in some cases. But that said, I think we're very comfortable in this space. The bigger question you you're asking Mike, which I think is an important one and we're going to be releasing something probably in the next 45 days around us is the idea of real and financial assets. And what role do they play in portfolios? So you mentioned a few things here, commodities, for example, was one piece.
I think you just touched on the fringe, but real estate and other aspects of real assets, we're going to want to have more of those types of things in client portfolios to kind of weather what may be a bit more volatility, but also an opportunity set that has ties back to, well, if every country's going on their own, that means everybody's going to be looking for resources on their own, number one. Number two, if part of every country going on their own is supply chains change, they get shorter and safer. There's going to be redevelopment opportunities that will, I think, tie back to that and incremental demand for certain types of commodities. And I think point number three is when we look at the real asset story, historically periods of messy financial markets have been relatively good for real assets. And that's something that may a compliment for most individual investment plans.
Mike - Questions around real estate, specifically, Chris, I'm just looking at residential prices. They were up 15% last year. This is broadly across the United States, existing home sales, just over 6 million on an annual basis. That's a 15 year high. So it looks like at least residential's robust, maybe toppy. So if you're going into real estate, are there certain categories and even geographies that you might find attractive from an alternative investment perspective?
Chris - Yeah. Single family without kind of redevelopment can be a little challenging. You gotta find the right geographies and the right redevelopment approaches, that's typically a migration that need to follow, but we like the logistics story. The whole idea that COVID displaced workers put them in different places. Now you need a lot of maybe smaller, but a lot more warehouses hubs. If you want to have the same kind of convenience function that everyone seems to be willing to pay for, you gotta put the goods closer to the people. Otherwise you don't have the convenience I think folks are expecting. So till that expectation changes, and it's not clear that it is, you're going to see the logistics sector, I think continue to do relatively well. And finally, at least on residential, there's not enough houses for the people that want houses. And there's certainly not enough for in markets where people really want houses. So I think you're going to see multifamily and other types of developments continue to do relatively well in 2022 and beyond. So we'd still be investing in some of those areas. Yes, cap rates aren't super attractive. They're not 10, they're not 12 in many cases, but if you're underwriting to high single digits, now have a little bit of leverage with something that you have high confidence in not a bad story, particularly if you can throw off at least net to investors between four and 7%. And in some cases, not all can be a tax preferred yield because you're returning your capital. So sorry for all the weeds and the details, but for investors thinking about this space, there's actually more to the calculus than what's my instant cash return. There's more pieces that can be valuable there.
Mike - On the energy side, Chris, you touched on oil. We had historically been sort of 40, 50, 60 bucks a barrel, we're 90 today, you just threw out, I think 150,
Chris - That's a crisis.
Mike - Yeah. What these good investment you got a whole movement towards climate and areas like fracking that are not necessarily climate friendly, but help the energy independence of the United States. But at some point it it's more profitable to just pump the way we pump and go after crude. So what dynamics are in play with energy at 90 bucks a barrel.
Chris - A lot, actually. So on the downside, it's 90 bucks of barrels, $4 gas, $4 gas is a tax on everybody that kind of lowers the consumption story. That's part of your higher inflation. On the upside, it's monster profits for the energy sector. And they're probably going to beat expectations for the next couple quarters in our view. Here's kind of the interesting piece of it. The strange case of excessive profits in the energy industry right now has a lot to do with discipline. Whether it's been foisted upon the industry by environmental concerns, that's part of what's happening, but also the wow shareholders have said stop making crazy capital decisions and give us some money back, dividend, cash flow, buybacks, et cetera. And I think a combination of those two things is helping to keep a lot of the discipline in the energy industry, relatively high it's kind of let energy prices stay high as a result, $90 oil, historically would've been met with a lot of new supply and we're just not seeing it yet. It's starting to ramp up. You watch things like rig counts and kind of crew counts and that type of stuff. And they're just not at the same levels as they were say, several years ago, they've got double from here. It's kind of where they headed after head. And right now they're marching up kind of slow and steady. But I think that's one of the reasons that we have some confidence. We're not going to see all of the things being equal oil at $100 all the way through the year. And then it likely starts to taper off as the year goes on, but the energy story is more than just, "Oh energy at 90, oil at 90, oil at 70, oil at 90." And that's my profitability. It's about transformation.
Most of the major energy companies have announced transformational plans to get into new areas, whether it's renewables, solar, whatever, but also joint ventures. In many cases, they're also looking at analytics on their fields and whether or not they should be repurposed or not used at all in some cases, that could be a little bit scary, but I think the last piece of the puzzle, and this is kind of important is beyond the energy industry, I think if you just look at the very basic math of where hydrocarbons are on the planet and where all the metals that are needed to get to kind of an electric future or a battery-driven future hydrocarbon and hydrocarbon energy density, no moving into a hydrocarbons to a metals and a metal density function. It's not the same thing. And there's not enough of all of the metals to replicate the entire hydro hydrocarbon infrastructure system we have on the planet, that sounds bombastic, but it's actually two things. One is we're probably going to see a lot more metals inflation at least to the balance of this year and all the way into 23 and beyond the more we continue to push the electric future. But I suspect we also have something else that have been some very interesting announcements around turbocharging. Yes, that's an ice engine, but coming out of Germany, and I believe Japan, if I'm not mistaken, that could be very interesting. I don't know if people remember the '70s and high energy prices, energy efficiency is where we went. So part of the pathway to electric vehicles, maybe the energy efficiency is part of what the glide looks like. That could be very interesting because that's now technology helping to address what that glide path looks like. And I think that actually continues a longer story, particularly around how we're looking at energy companies. So all hydrocarbons aren't all bad all the time. It's just when they get into the atmosphere, they were recapture in other technologies. Oh, like the one in Iceland, yes, small scale, but wow, proof of concept, it actually works. So the idea here is that there are other technologies that may come online as this long pathway from ice engines over to some type of electric or battery functions is where we're headed.
Mike - Chris, couple of questions around your investment strategy around inflation. Let's say it doesn't hit the 74, 72 arc that you mentioned, but it stays at 789. How would you invest your money? So appreciation, I should say.
Chris - So we have talked for the last year in our investment committees about inflation and nothing else. because if we figured if we got this wrong, nothing else would really matter. So in all humility, this scenarios are really that, there's three of them. One is we're really wrong. It's a seven print or higher from most of the year. It's endemic, we already know what the answer to that is. The fed will just cause a recession that you'll get a Volker answer and no one's going to like it. It will be abrupt. It will be awful, but it may create the biggest buying opportunity of a very long period of time. The trick is to try to get out of the way of that steam roller. And that will take a couple more months data to observe. The other side of the story is we've really misunderstood what debt and deflation look like and ultimately how the repayment of debt will tax the system. And that's where the arc of inflation comes down really hard. That's harder to see given some of the structural things that we talked about, but I think, that would also be another thing that we'd want to consider. Probability wise, t's like 60, 65 in the middle of our seven to four. Maybe there's a 25% chance that it's much higher. And then there's a small chance that it's much lower. How would you invest in those scenarios? Well, in the seven to four, just like how we are now, which is short duration, looking for opportunities that bond volatility will create for us to buy things that maybe we wouldn't have in the past, whether it's a... excuse me, a little bit lower quality bond that got blipped up. Maybe it's a little bit something that's off the run. That's where the opportunistic or be more sector focused. That's where the opportunities in the bond market come from. In a seven to seven world, let's just say, there's no change in the inflation story. Then two things happen. And the first is I would skip the bond story and go right to the equity story because the fed will have to start jolting the market, not one, but maybe 250 basis point hikes. If we're printing sevens all the way to August or September, I think that's your marker. There's no way that fed can't be doing 50 basis points at a clip. There's just no way, they'll be too far behind. And even if they don't, the market will do it for them, you'll start to see rates rise. And I think you'll see much greater compression in valuation multiples, particularly in the high flying sectors. And you'd talk about a stock market that would probably be entering correction to bare phase at that point.
Mike - Interesting, looking at interest rates and if the fed is stuck with hiking too quickly and the 10 year doesn't follow you, would they hike to the point of inverting, the yield curve, which I think has been 95% accurate in predicting a recession?
Chris - Single best indicator in the last 75 years inverted yield curve, it's the single highest predict. I think the fed is extremely well aware of that. All fed chairman get schooled in bubbles and signals and their army of PhDs will help them with that. Are they infallible? No. Is it possible that they have to make a trade off that they deem at the time acceptable, such as inverting the curve? Possible. I don't think at this juncture, the Fed's language nor their actions have indicated that they're headed down that pathway. It's much more likely that the market does some of the work for them, and keep in mind, the fed can do a fair bit of that work by just selling the long end of of their bond portfolio, not just doing this, let the mortgages roll off. They can actually sell treasuries. Remember they have trillions of dollars in their balance sheet that they can use with respect to trying to make the curve not invert as part of that story. So while they're busy raising rates, they can do the quantitative tightening story. And that will have the likely effect of shifting the curve up. Now they're going to have to change some rules about what banks can buy and what investors will look at and some taxation and a few other things, sorry for the picking in details, but it's not inconceivable that the fed has reasonably strong management ability of, of a fair part of the curve, at least at this point.
Mike - So one way to look at that is the two year treasury and the 10 year treasury, I think the two year today is just over 1.3%, 10 year, just under 2%, but it's flattened a lot. There's about a 63 basis point spread-
Chris - On the lower end of that historical spread, yes.
Mike - I'm just curious if it inverts, how much of a harbinger is that or how much time then after that inversion does it typically take to create a recession in the cases that are 95% probable?
Chris - The 95% probability is less than 18 months. And I think most of the pieces are inside of 12 months. That's helpful.
Mike - I got a lot of questions here, Christopher, and it's always the obligatory crypto question. Your thoughts on crypto, we've had a wild ride in crypto. I think we're $43,000 of Bitcoin, we hit a high 61. We've hit higher than that, the last month, I think it went down as low as 36,000. Is this an asset class you look at, I know you look at digital assets and I'd love to hear your thoughts on digital assets in general, but in terms of Bitcoin and crypto, any thoughts there?
Chris - So, on digital assets, we like it, invest in it, have owned companies in some of the funds that we've sponsored and talk to clients about that invest in the space. So, keep that in mind that this isn't a fear, uncertainty, doubt the flood paper the team wrote last year, but I think the crypto and particularly cryptocurrencies are far more challenging. The feds announcements in the last several months of, I think, continue to indicate the pathway that they're taking both in terms of taxation, how you think about the transparency, the seizure today of the Bitcoin hack in 2016, those two people in New York that were just picked up with 3.6 or 4.5 billion worth. Crypto as an alternative to fiat money, just stop. No! Is it a use case where there are others that you would expect to be interested in it? Possibly, but to me it looks a lot like a company trading at 30 time sales, there's not evaluation premise per se. There's much more of something else related to, "Okay, I'm looking for someone else or sentiment, et cetera." I think the bottom line though on crypto for many of these things, even though that there is use in certain stable coin and certain types of transactional LM is that we are still a very long way from making a compelling case for crypto as a currency that can be used in a broad a broad set of applications and by broad set of applications, I mean, where you can run visa level type, transaction speeds and volume, and you are orders of magnitude away from that, if not a decade because of the infrastructure required to build those kinds of things.
Now, I think a lot of folks in this space will say none of the techs coming the techs coming, but keep in mind what has had to happen to get us to crypto was the meaningful, a decade's worth of mispricing of fiat money, free money, and a very long period of the mispricing of energy, the cost to get the crypto out there. So as long as money and energy are mispriced, you're going to get lots of weird things, but energy and money are unlikely to be mispriced to the same degree in the next 10 years. And I think that's the function that it gets missed by most of the crowd here. So from that perspective, I would say we're a bit cautious. The reality is that these things move around in ways that are quite unexpected. They have far more correlation to the equity market than we would've expected mostly on the downside. And that's not a diversifier, that's just an adder to your problems if you're looking for a benefit around it. And I think the last piece of it is I think some data out of Cambridge that suggests that something like 72 to 75% of all the cryptos owned by just a few people, that's not really a democratization function. That's just, I don't know a dream of some people that just shows how aggregation can work, and it proves the case that we are in an age of hyper aggregation, so not huge investors here. We don't have them in model portfolios, crypto. We understand clients own them. We think they're more trading vehicles and because they can trade on things like sentiment and kind of rules, a machine based trading, there are trading opportunities in these things. So I don't want to count that out, but that's different than I want to buy something as an investment over a very long period. That investment case becomes much more cloudy when money and energy are priced differently, which I think they will be in the future.
Mike - That's a great perspective, Chris, thank you. A lot of questions around the government debt and this always comes up and the last time we spoke, there was the debt ceiling in, got passed in December. And I think they increased it by two and a half trillion dollars. So you look at all US national debt. I hope I have my numbers right, but that ceiling is now just under 31 and a half trillion dollars. And I think we just top 30 trillion. So you do the math and it sort of gets you out conveniently past the midterm elections on November 8th, but just doing the math country that makes $4 trillion, and we spend 6.8 trillion dollars, 60 plus percent of that is not discretionary. It has to be spent every year, social security, Medicare, et cetera, so we're just sort of digging a whole of 2.8 to $3 trillion every year. You do the math on this, right. You've got your debt to GDP today at about one in a quarter on that 30 trillion, you go 10 years out, you're at 1.8, like where does this stop? How does this end, or do we just keep printing the money and financing the debt the way we're doing now?
Chris - Despite what the popular press says, I think we're all modern monetary theorist now. And that the debt doesn't matter-
Mike - Explain what that is, Chris.
Chris - Yeah, just in a nutshell, I'm going to say glibly, the debt doesn't really matter. It's ultimately a question, a political question. And since you owe most of the money to yourself, you can satisfy it through a function called senior age. You can print your own money to pay your own debts to your own self, just kind of moving money around, but where Japan was to a certain degree in the '90s. As we learned with places like Greece and Puerto Rico, it's when you owe money to other people, that's when there's a problem. I think look where we are today is most economists don't spend a lot of time on this issue. They just focus on the financing of the debt. As long as interest rates are low, it's going to be fine. Net debt payments now have actually been lower than what we would've thought. Net debt payments were 350, 400 billion, rough justice, from the US treasury, but as interest rates move higher, the net function because there's a gross interest payment than what you pay yourself and it all. So the net payments could head towards a five, six, 700 billion range. And that starts to have a crimp on the overall budget. So relative to the 6 trillion, by the time you get to 10%, you start having to think about where the choices are, but let's draw the circle now complete. If you're a modern monetary theorist, you don't have to make those choices; you end up just issuing debt because you go as far as markets will pay for it. Well, those things have historically ended badly. Interestingly enough, I have recently heard more talk of debt Jubilee.
That's the cancellation of debt by the way, by the lender. Now, we're bank, that's not us. That's just, those are things that pop up when you have excess amounts of debt, what is unknown because the US economy or the largest in the world, this kind of debt, how ultimately the disposition of this will affect our fiscal and monetary policies, and at this point, most folks seems to be just saying, "That's a problem for the future. That's not a problem for the moment." It becomes a problem for the moment I think when you have the crowding out issue and we thought that would happen a little bit sooner, but frankly, the fed has kept interest rates lower and quantitative easing a number of things. Rule changes have meant that those days of having to adjust to that reality are still well ahead of us. They're not here right now. So that's why I say we're modern monetary theorists for the time being. I think the resolution to that, let me kind of end on this point. I don't think is a gigantic monetary bang that blows up the entire financial system and you have to get on a rocket, get off the planet. I do think though that the resolution to that will have to have a number of features. It's not a simple problem. Just do one thing, it's fine. US government is not a household. It's not like a credit card debt that it's not how things work, happy to talk about it offline. It's a very detailed explanation. But the bottom line is investors believed in the faith, the independent of the US economy, the independence of the fed and ultimately value the currency and the investments tied to that, including the debt of the government in a positive way. So we either need some meaningful alternative that's big enough to create an attraction or you need to be able to invest in Mars or some other place. And we're just a long ways away from that at this point. So it becomes back to the very beginning point. It's a financing question, at least for the foreseeable future and we can finance the debt.
Mike - So Christopher, let's just go back big picture, your theme, a new wave this year, and we're not talking music genre out of the '80s. We are talking a new wave here. So do you want to just summarize for everyone 22 and 23, in your opinion again, from a growth perspective of rates, et cetera.
Chris - Yeah, I think the new wave is all about a new wave of kind of inflation, wage growth and ultimately kind economic growth in the United States. The whole story around COVID is one that is going to have lasting effects, there's some inflationary aspects to it. But our view is that we have seen meaningful changes in the way labor markets have developed. Consumers are benefiting from this to a degree. And that it gives us confidence that a recession's not in the cards for 2022 and still less that a meaningful probability for 23, where I think we head from this new wave is a place where you have to adapt to your portfolio. You're going to be looking for things that may be more sensitive to kind of real economy, that's the commodity and private asset story. You're going to want to be more thoughtful around where your equity exposures are. Particularly if you end up with markets that have built in a lot of good news, and now you gotta look underneath the covers. I think there's going to be a lot of that. And finally, the last piece of this puzzle, where we were early on at last year, that's a positive way to say it is the new wave may be for the markets outside the US, the valuation gaps between US and everywhere else are gigantic. Now it's not the only reason, but I mean, they are really big. And if we're talking about COVID relief and kind of the COVID fatigue and return to any kind of normalcy that has a bigger benefit outside the US than inside the US. So something we'll watch closely, we're not ready to give up our stay at home strategy, but we're going to be starting to tilt that way if the signs that COVID relief on this wave are stronger outside the US.
Mike - Christopher Wolfe, chief investment officer, First Republic Investment Management, it is always a privilege and a pleasure. And I truly enjoy these updates and there's always something exciting going on. As a client of First Republic, if you are interested in further information or research from Christopher, please reach out to your wealth advisor or your relationship manager, and we will make that happen. Have a great week, everyone. Thank you.
Chris - Thank you.
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