Back

Market Update: Spring 2022 Crossroads

First Republic Private Wealth Management
April 21, 2022

Check out 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.

Read below for a full transcript of the conversation. 

Mike Selfridge - Well, good afternoon everyone. And thank you for joining us again for our quarterly market update. It's my pleasure to host our Markets Update with Christopher Wolfe. My name is Mike Selfridge. I am the Chief Banking Officer at First Republic Bank, and I am always delighted to be joined by Christopher Wolfe. He is our Chief Investment Officer at First Republic Investment Management, and he oversee the research and strategy for the first Republican investment management group, which as the end of last quarter, first quarter of 2022, top 274 billion in assets center management. Chris is an influencer in the world of economics money management. He's frequently featured on television and quoted in many publications. So we're delighted to have Christopher talk about our events going on today and looking forward for the remainder of the year. I just want to remind you if you'd like to ask Christopher a question, I'll go through my questions for about 20, 25 minutes, and then just submit your questions using the Q&A button on the bottom. Christopher, great to see you and always a pleasure to do this. I think we've been doing this for almost six and a half years, and the last time we did this was February, and I'm always thinking we're going to get a reprieve of stability and that's not the case. There's always headwinds, there's tailwinds. And as I put those together, it just seems to create turbulence. So Christopher, I'd love to just sort of recap year to date. And if I sort of reflect on the things that have transpired since our last February market update, it's been a lot, the geopolitical risks with the Russian invasion in the Ukraine, fed lift off the first rate hike in March. The first one that fed has done since 2018, much more hawkish tone coming out of the fed for future rate increases, inflation, gasoline prices, probability of recessions. So let's mix all that together and get your recap on where we are so far, and then we can move forward on the remainder of the year and maybe look out two years, if that's okay with you.

Chris Wolfe - Sure. Well, I guess we'll start with markets. Maybe the easiest way to think about what's transpired this year is it's commodity importers versus commodity exporters. So if you export any kind of commodity, your economy does, your stock markets have done pretty well this year, Brazil, Canada, Australia, you name it, except for the Russian markets, but if you're an importer you've done relative degrees of poorly. If you think about US down a little bit, Europe down a lot big importer of commodities, particularly around natural gas and energy. So stock markets have responded, I think, to the growing challenges that the rise in energy prices, a part of the commodity market have made for economic growth going forward, and Europe is energy dependent, much like Japan is, and a number of other countries are, we'll talk about the US in the moment, but that linkage the ongoing Russia/Ukraine war. And when it's done through a combination of self-imposed sanctions, as well as the market reaction function has really created an environment where the risks of a recession in Europe in particular have gone very strongly up, maybe even dragging into 2023, depending on how additional policy measures are taken such as additional sanctions banning outright, for example, Russian oil or Russian gas completely, because they're still buying some. But we also see that the effects have not just been limited to Europe, we've seen kind of slow downs in Japan. We've seen China dealing, not just with commodity importation issues, but also with its own version of COVID lockdown, that's created all sorts of, as you mentioned earlier, Mike, incremental turbine, it's turbulence in the global growth story.

This is all culminated into something that I think the world trade organization, and a few other kind of global entities have really succinctly put it is that global growth is going to be much less than we originally anticipated in the beginning of 2022, there was a school of thought of which we were part of it. That would be somewhere north of 5%, maybe even 6% in global growth, but we are rapidly coming down to the 3% range and potentially may even end up a bit lower lot will hinge on what China and the United States do. But nonetheless, the risks of a risk recession in Europe now kind of topping 50 much lower in the US, maybe closer to 25%, but regions of the world now, particularly the ones that are importing many of the commodities and natural resources, much likely to experience that rising inflation risk. And as a result, the calibration that most world organizations are making around economic growth is really coming under stress. The way see that in the United States is probably a little bit more acute. And the reason it's acute is because we see it typically through the gasoline prices. Gasoline prices have an interesting link to consumer sentiment. Consumer sentiment has not been great because gasoline prices have been stuck at relatively high levels. You've seen the president take numerous efforts, releasing oil from the strategic petroleum reserve, as well as potentially going against some of his own promises on the campaign trail. I think Mike, you had mentioned that with respect to drilling in different areas in order to address the stubbornly high gasoline prices. And it's fairly complicated story on why if the US is energy independence, not really, we end up in a place where gasoline prices are stubbornly high. And I think the challenge around all of that is that without getting into the weeds at this moment, we'll talk a little bit later.

It's unlikely that gasoline prices are going to come rapidly down anytime in the near future, they're going to stay high and that's going to create a tax if you will, a burden on overall growth environment. So I think we're in a similar view that our original expectations are going to be off the mark. We're going to end up with growth a bit lower this year. And as a result, the gap between growth, which will be lower than we thought and inflation, which is staying stubbornly higher, is going to create additional turbulence throughout the year. Some are going so far as to say, "Well, that's going to be stagflation and it's all sorts of bad things happen." And I think we'd call time out on that view just yet, because there are still a number of other policy maneuvers that either the fed or even potentially Congress could be taking either in front of, or after the midterms before we want to to call stagflation and that's exactly what's going to happen. So while that gap is problematic, high and stubborn, inflation and growth coming in lower than expected, we do want to be on the watch for it. But I think there are still ways that we'll talk about portfolio positioning and managing through that gap in an environment that I think will continue to be, as you mentioned earlier, pretty turbulent for of the balance of the year.

Mike - Yeah, that's a lot of great information, Chris. I was going to sort of get into the specifics on equity and real estate and alternatives, and we will do that, but you sort of jumped to the big question that leads to inflation. But before that oil and I want to talk about the politics of oil, you mentioned it briefly and the White House has been in a bind here. They campaign promises, no new leases of oil fields, no public land could be used for new oil field leases. That just changed, they open it up, I think starts Monday. They'll begin accepting leases in nine states. Oil's still over $100 barrel. It's off 5% today, but it's still stubbornly high. The US is now in a fortunate position to be the largest producer of petroleum in the world, but they had been laying the groundwork for two decades to take that position. So as you think about sort of oil and politics and the gasoline prices, you mentioned, which in some cities here in Northern California have touched $6 a gallon.

Chris - Yeah.

Mike - That's not going to work too well with the political midterms coming up. You want to just dig into that a little bit and how do they sort of correct this while abiding to some of the administration promises that were made of the campaign start?

Chris - Yeah. On your last point, it's going to be tough. It's very hard to move a lot of things that go on in the energy industry by policy. It takes a very long runway to do do that. And we use something called rig counts to help measure whether or not companies have enough incentive or feel like they do in order to put new crews, drill new land and drill new oil wells in order to make profit. And you would think with oil at $100 a barrel, that would be the case. However, many energy companies these days are so saddled with debt, that in a place where they have to focus more on managing their capital structure than they can with respect to putting new new oil wells into production. I think one way to consider what's going on in the energy market is by looking at it in three parts, crude oil or the exploration and production of oil is one piece of the puzzle. Then there's kind of a transportation function. You gotta move the oil from a place to another and kind of refine it and market it. So you gotta change the oil into something else. You gotta change it into jet fuel. You gotta change it into diesel. You gotta change it into kerosene. You gotta change it into gasoline. You gotta change... et cetera. So the idea is that the crude oil starts as one state. It needs to be in other states for humans to use it. And the cost of making it into that new state refining it essentially is actually been rising. So while crude oil is one part of the cost function for gasoline, it's also other things that are going on. There's things like everybody's going back on crudes.

The demand for diesel oil is up quite a bit, the demand for all sorts of other fuels coming from the same barrel of oil, because the barrel of oil can make different things. It can make a lot of kerosene. It can make a little bit of gasoline. And the idea here is that there's a demand that's been very high for the barrels of oil, and while it's coming from different areas, it's pretty broad based jet kerosene, diesel fuel as well as gasoline. And that's important because not only is oil used for fuel, it's a feed stock for other things, many chemical processes in the United States require crude oil or oil based components in order to make them all work. A lot of plastics, for example. So without getting into all the details, the energy industry, it's important to note that as the economy is reviving, things are moving along very well. The kind of mask mandates coming down recently on planes and trains and automobiles. The idea here is that economic growth is really part of the answer for why we're seeing such strong demand for all sorts of petrochemical products. And that's really been one of the gaps that we don't think will close very quickly as companies focus on not necessarily the drilling, but we have to have more refining capacity. We have to have more transportation. There's trucking issues, for example, getting oil from one place to another. So kind of the simple answer is it's complicated and it's unlikely that all of these things can be resolved A quickly, or B by presidential fiat. It's just not going to happen. So our expectation is we just have to continue to build capacity across energy infrastructure in the United States in order to get prices lower, either that, or we gotta have a recession in order to take the demand down so hard that the current supply could meet the demand that's out there. And we don't think there's a recession in the cards just yet for the US.

That's maybe at the discussion I did more for 2023, but I think right now we're just going to be living in this place of very strong demand. And we just don't have the supply there. Now you might say why wouldn't OPEC help us out or help everybody out? And the reality is they're looking at a lot of the self-imposed sanctions, the supply chain disruptions as being, not in their control. That was actually part of one of their most recent statements, and as a result, they're trying to focus in what they deem as the balance of supply and demand so that they don't get way too much supply drive oil back to $10 that doesn't help OPEC helps United States, but also not have it be so high that you create what economists call demand destruction, you know, oil gasoline, for example, at $9 a gas on the United States, which would imply oil was close 140 or 150 a barrel. And so that kind of management as OPEC sees it is all about how much extra supply should they put on the market relative to the global demand. Now, keep in mind that high oil prices tend to create recessions, at least in countries that import a lot of the energy. And right now, Europe is in the cross hairs of what that may look like. So I think you put all this in investment context. And even though there's a lot of politics going on here, and it's unlikely, at least in the near term for Europe to escape some of these challenges out a lot of other things happening, and that is unlikely for gasoline prices United States to come down. And I think that's going to continue to weigh on sentiment. It will affect the elections, I think, to a degree. And ultimately from an investing standpoint, it argues at least in our view for continuing to look in the energy space for opportunities, we can talk about the long term energy trajectory in the US. We will not have a com complete switch over to all electric anytime soon. There'll always be some, at least for our investing lifetimes, the next 30 or 40 years, hopefully it's that long, some kind of hybrid technology. And we can talk about why that is. So we're going to need more around energy infrastructure, energy security, for example, in order to ensure that we can make those transitions. Otherwise we offer a lot of the vagaries of oil price movements that are hard for any president to control.

Mike - Yeah, that's it, Chris, thank you for that. And one last thing on oil because it is important, and as you mentioned, it affects consumer sentiment. We'll get into the consumer because the consumer drives the economy, but I'd love your thoughts on just the US position and energy, the Permian Basin I saw issued more permits in March than they ever had about a little over 900 oil drilling permits, the shale innovation that's happening. And again, I mentioned the US is in a very enviable position as it relates to the classic petroleum production. So we just sort of ride this wave for a little bit and then convert to your point to cleaner technology. And it is the beginning of Earth Week, I should remind you.

Chris - It is, and look, it would be incredible if we could just flip a switch and move from one thing to another. And by no means to my commentary meant to construe that it's all an energy heavy piece, but it's kind of simple. The energy contained in hydrocarbons oil, natural gas is very, very rich. You can use them a lot in many different ways as I just explained earlier, but if we're going to switch from a hydrocarbon based economy and that's how we get our energy and try to keep the cost low to something that's more metals based, which is what batteries are based on. You end up having to understand kind of the energy dynamics of one versus the other. And you cannot nor would it be feasible to turn off all hydrocarbon demand switch instantly to all metal demand without creating incredibly large price increases like 10 times, 20 times, 100 times for the metals that are in there, because there just aren't that many of them. So the technology and the metal space has not advanced to a sufficient level to make a switch type of transition. And I think as we're learning what we're seeing as a result in the markets that we observe, particularly commodity markets, that the prices are adjusting rapidly and in some cases three, five, 10 times or more, and they may be sustainable that way, whether it's cobalt, lithium or other kind of core elements. And we are hearing companies, whether it's Rivian or even Tesla saying, "We need to figure out this battery situation." What they're really saying is, "We need to figure out our supply chain and what's going on with all the metals that go in the batteries," because boy, A, they're in places that are hard to get at; B, they're not always countries friendly to the United States, and C, our business model is completely dependent on them.

So we need to figure this out. So yes, I do think from an earth day perspective, but also from an investing perspective, this transition's going to be long in nature and it's going to have many important developments, but it would be one that I think from an investor's standpoint, we wouldn't want to misunderstand. So for example, energy efficiency, particularly relative to a internal combustion engines is still important, more turbocharges, smaller energy, more recapture of gust gases, a lot of ways that we can continue to use internal combustion, but not be as polluting are still potential opportunities because at the end of the day, this is all about reduction and ultimately trying to get to zero, getting there in a very fast way, say who or three years or in five years. Well, it may be I think a stated goal. And I understand what the IPCC, the UN Council has talked about. The reality is it will be incredibly, incredibly difficult and at a minimum disruptive. And the disruption I think is something that is hard to understand, it'll be easier in the US, it an outright disaster in other parts of the world, whether it's Myanmar or India or all parts of Africa, it'd be an utter disaster.

Mike - That's great. And Chris, I know your team does a lot of research on investment opportunities in the energy related fields and innovation and clean technology. Let's switch gears to-

Chris - Well, to be clear, Mike, we're investing there.

Mike - You are, yes.

Chris - We continue to invest in solar wind and other things and advise our clients actually look at these opportunities and we'll see a few more of those in the coming 12 months, actually.

Mike - That's great. That's great. And the point was, we make it available to clients.

Chris - Absolutely.

Mike - Chris, rates obviously going up, they've gone up one tick. I mentioned the hawkish tone of the fed. The bond market tea leaves, it's been a disaster for bond investors, really tough. I think the worst since 1980 and we had the two year and the 10 year flirt with inversion that typically suggests a recession. But if you look at other metrics like the fed funds today at 50 basis points in the 10 year at 290, it's actually a pretty steep yield curve. So as you sort of the fed and the bond market, what's the projection for the next 12 to 24 months?

Chris - Well, I think the easy projection is that savers will continue to be punished interest rates do not in any way, make up for inflation running at eight and a half percent. So a little glib, but I think the short answer is we're going to be living in a world though where bond market turbulence caused by the energy prices, the high inflation story is not going to be something that we're going to see be met in the bond market, at least in the treasury market or in the traditional corporate markets, or even in the muni markets. You may have to kind of get out into private credit to see even returns of that nature or do something else like leverage or borrow in fixed income. And that's usually a dicey proposition when rates are both volatile and rising. So a couple things, one is, the fed is in a very difficult spot. They're in a spot now where the market has been leading them around little bit by the nose and has indicated that we've gotta get to much higher interest rates to cool the economy without creating a recession. But the market also is recognizing that, boy, the fence likely to go too far, so interestingly enough, if you look at the way the market in the future, the forward market of interest rates, it's creating a curve like interest will go up, the federal will make a mistake and then right back down again, it's a very strange outcome.

By the way, forward markets are not always the best predictor of where interest rates go, but I would share, I think the following two things, the fed is two tools it's using. One is interest rates. It's making the cost of money outright go up. And two, it's called quantitative tightening. It's a fancy way of saying, "Hey, we, the fed have a lot of bonds. We're just keep selling them to you, all investors, hope you buy them more or less." By putting that money out there, the fed is going to demand capital back from investors and take that money out of the system. So that's quantitative tightening in some ways. One of the interesting things about how stock and bond markets respond is when the fed takes away liquidity, that's what they're doing, nobody tends to like that, everybody likes to be well drunk at the party. So the fed is really trying to sober markets up relatively quickly. And I think where markets are interpreting the Fed's comments is they're moving very quickly. Now, fed governors are saying they could go even faster, a 50 basis point hike or a 75 basis point bike as a Governor Evans was talking about potentially. But the reality is the fed has to consider a lot of data here. And one of the interesting things that's happening is that between here and July of this year, the numbers on inflation are likely to start heading down because year over year will likely see some of those effects be incorporated, number one. Number two, there already seem to be some signs that things are cooling a bit. There is a bit of demand destruction in terms of say miles driven, industrial production. I've seen some reactions in the housing market, meaning the cost of a mortgage these days has actually gone up a bit and that's cooled some of the fringe buyers, if you will. And that's important because these consequences, the fed has to take into account.

There are a long set of consequences, but the market is just looking at the next week next month, next quarter, that type of thing. Here's the net result in our view, we'd expect the bond market turbulence to be a primary contributor to stock market turbulence between here and the end of the year, policy is going to normalize in our view, which is a second point, around where long term inflation is, not where inflation of the moment is, so long term inflation is about where expectations are and is measured in surveys, and some of the other data that's out there, looks like it's around three, three and a quarter is where things may be heading. So it's a pretty good view that we'd see the 10 year bond kind of moving to that range. What would we expect though? Well, the bond market driven by kind of computerized investing is probably going to overshoot some of that. I don't think it's going to overshoot to five or 6%. That's not what we're saying, but I do think you're going to see a lot of noise on a lot of volatility as the kind of 10 year yield, for example, continues to creep up, there's some opportunities, maybe around a 3% level. That's really our kind of our official forecast now. But I think we're going to be looking at it over the summer and how inflation comes down. If inflation comes down fast enough, I think we'll keep the forecast, but be looking at the second half of the year, inflation stays stubbornly high, then long term expectations will probably continue to creep up and we'll have to make some adjustments. But I think the simple answer for investors is two things. The first is higher rates in the US have contributed to a stronger dollar, interestingly enough, we're now kind of leading the charge relative to most other currencies, most other interest rates around the world. And number two is that volatility piece, because rates, as I said at the outset will continue to be a form of punishment for savers, at least versus inflation is going to be around for the remainder of this year, maybe into the first part of next year, until some combination of things happen, meaning a slower growth trajectory in the US or some of the inflation rollover numbers start to take effect. That's probably not even in the cards until the end of this year at this point.

Mike - You talked a little bit about the fed typically overshooting in the past and most expansionary periods, from the research I've seen from you, they can last for five years to 15, we're certainly 10 years into it. And so if you're thinking the probability recession is still low, one is coming, cycles happen. But it's interesting you mentioned that the high probability of Europe going into recession, China is struggling right now, especially with lockdowns in Shanghai. At some point, these become too much of a headwind for the United States to avoid a recession in your opinion?

Chris - You know, one of the great strengths in the United States is the consumer. Our ability, meaning just collectively to spend is a huge bull work against the, oh my gosh hand ringing the US's headed off a cliff, et cetera, counting the US consumer down or out is got something like a 90 plus percent fail rate as a viewpoint. The US consumer typically over intermediate periods of time, at 12, 18 or 24 months is typically increasing their spending, 90 plus percent of the time. So to assume that they're just going to throw up their hands and quit, that's a silly assumption. And if that's what anchors review that us is going to go to stagflation and it's all bad. That's also a silly view in the way I think we'd look at it. I think the idea though that the consumer story is actually a pretty good one is all about where wage growth is happening. If you're kind of in the hospitality and kind of some of the lower income strata brackets wage, inflation's a good thing. It's kind of up eight 10, 12, 15, 20, some odd percent in some cases. And if inflation's running at eight, you're actually making it ahead. I think folks that worry about a wage spiral. I think that's a tougher thing to understand at the moment. There is some concern about that, but I think we'd frame it as if you're looking at the lower ends of the income strata, typically seeing strong wage increases, two things tend to happen. One is some of them will cross over into tax paying status. That's a good thing, more tax payers is a good thing. We know this because when we look at the budgets for California, for New York and for many states, as you've seen some of these increases that tax rules have increased, number one.

Number two, that should help the federal budget deficit. I'm not saying that's the be all end all, but that's a positive that people miss, number one. Number two is you end up in a place where we're still mismatched relative jobs to people. There's more jobs than people, at least relative to the labor force. That's important because it will lead to the, I think view that some of wage growth will be sustained as the year goes by. It's very hard to close a 5 million job gap in a month or two months or even six months. It takes quite a while to do that. We wouldn't see that at the current run rates until the fourth quarter of this year. So this durability of the wage story is a pretty good one. Now let's bring it back full circle. It is possible and it's happened in the past that you get these kind of wage-driven inflationary stories, but you also have to have a couple other things happen. We've gotta have supply chains, stay disrupted and not get fixed in a strong way between here and the end of the year. We've gotta have oil continue to rise, because we're talking about supply coming on OPEC's adding more rigs are coming by the time we get to the end of the year, these things might converge to a certain degree. So the whole wage spiral and kind of, it's going to go out of control. I think we'd want to just temper that view a lot and say, "Look, the risks of recession are rising. If the consumer gets more frustrated around high gasoline prices and they don't continue to see the wage gains that they've been joined at least in the last several months." So right now, not a bad spot actually with respect to the consumer. And that's such a huge bull walk against all the other things going on around the world, which frankly look a little bit more challenging. I'd sum it up this way. Part of what we've done with clients over the last 12 months is to revert back to our stay at home strategy with the US still being the preferred place to be overweight in your asset allocation as a result of kind of the durability of us consumer spending the strength in the job market and our ability to kind of handle the energy inflation that other areas are just not processing well.

Mike - Chris, you mentioned the consumer about 70% of our economy. The latest numbers that came out from University of Michigan were actually up, it was about a three month high. And so it was down year, over year, but still up from three months ago. And so it does feel like there's a little bit of momentum. There's some still some excess savings in the consumer pocket's still somewhere around 2 trillion. You see that as a positive going forward? And if so, I heard you say equities in the us are still a favorable investment.

Chris - I think a couple things are pretty important here. The first is that we have observed time and time again, that US companies are incredibly good, particularly larger ones at managing their cost structures, managing their cost structures in terms of not just kind of people employment, but also technology, et cetera. So the fact that we've seen revenue growth actually kind of come in in a decent way. It's not I think anything to write home about, but companies continue to put up good profit numbers. We'd be very encouraged that the ability for them to preserve margin, which I think is the key to the story will remain intact to the balance of this year. And I think what we frame from our equity team is that it's a little bit of kind of the battle of profit margins, which we think will remain relatively durable. They may come under some pressure here, but against the higher cost of capital, and ultimately that's margins against multiples that's really what it looks like. We've seen the earnings multiples for the market broadly come in as the cost of money has risen, but it's really not been really due to the margin story, which has remained relatively robust. So to your point, Mike, I think our expectation is this will continue because companies have learned how to be much more aggressive, managing their costs, pick on the energy industry for a moment until very recently many oil rig workers, won fixed contracts on long term employment, it's great for the company to have them be more temporary, work, more spot, not great for the employee, but that's a form of cost management for those companies. And ultimately it's one that allow them to kind of navigate their excess debt burdens, for example. So just a way to think about how companies have changed everything about how they operate in order to manage that margin story to a very fine degree.

Mike - Chris, you have an acronym called Angie. I want you to describe it and then answer it just because it's an alternative to equities. And given that bond prices have collapsed, at some point, bonds are going to be a fairly attractive investment or some form of fixed income. I'd love your thought on Angie and when fixed income starts to look attractive or bond investing.

Chris - So Angie, it's just a catchy narrative. So it stands for alternative's not good enough yet. It's another version of it is called Tina, which is there is no alternative and it's mostly bent to indicate that the equity risk premium, the extra return you get for investing in something that's risky is enough against other choices, meaning alternatives like, hey, for example, bonds. So equity risk premium right now by our measure is somewhere in a kind of 5% range, and if bonds are only paying you 2.9%, well, you get a premium there about two, two and a half percent. Historically that's about average, but it's a premium, I think that's good enough to continue along the lines of having a balanced portfolio. Are these good enough to get past inflation? Well, not really, as we can see the returns that we've seen this year, I think the challenge is that for clients or investors wanted to, "Hey, we'll just put our money in cash and wait," well, you're going to have your purchasing power eroded at a minimum and then there's taxes and all those other things. So I think the reality here is that part of the messaging for dealing with a market environment like this one is about repositioning portfolios, looking for ways to be maybe more oriented towards sectors that have stronger growth rates, better margin management, maybe not so expensive. Now that we've seen the cost of money come in and lower the valuation multiples shift some of your exposure for example, in terms of fixed income into private markets, where we can see some combination of kind of where banks don't go, others may go, they can still manage the credit well. And with a little bit of borrow, they can make returns in the seven to 10% range. Those are private investments for clients who are qualified, but that diversification of income story for example, is one that I think resonates well. So at the end of the day, the viewpoint around where this volatility leads us I think is to remain committed to the idea that there are opportunities in markets and that it's part of our job. But I think our investors would value this to look for those opportunities and respond appropriately with your wealth manager in your portfolio.

Mike - That's interesting. What about alternatives? And by that I don't mean Angie, I mean, true alternatives, private equity, venture capital. They've had incredible fundraising years and last quarter, things have slowed, but there's still something like 1.9 trillion worth of dry powder, seems to be a lot of appetite. And so what's your view from a First Republic client perspective for the appetite for alternatives and what types of alternatives are you looking at?

Chris- So I think the appetite remains relatively strong. Our view is that we're going to continue to see markets capture the effect of symmetry. The idea that there's public credit, private credit, public equity, private equity, all of that, the private markets are highly symmetric now. They just lack the same degree of liquidity, but the opportunity sets are not equally as large, but they're very large in the private space. So we continue to look for ways to add those opportunities to client portfolios. I think we go down a road of maybe two or three things that are worth discussing, the first is we continue to see real estate opportunities. There's been a migration of people, both within the country and without, so we're going to continue to try to capture that. Underneath that migration of people has been the Amazon application of different types of basically the pay for convenience is what it is, growth in logistics and warehousing spaces, where the people are going, so you can think in the south, for example, in Southeast where folks have been migrating, there's been a huge demand for those kinds of services. So kind of picking up on the population movements is one thing that's been successful in real estate. I think in the credit markets, the cost of money rising, here's going to create a lot of interesting opportunities, companies that can't get refinancing in traditional ways will go to the private sector. They'll probably have to pay a pretty big premium for that. We're seeing that in some of the deals that are coming out with not a lot of leverage, but you're getting on the run coupons or distribution yields in the 7, 8, 9, 10% range. So while those aren't riskless, but the idea is that if you're willing to tie your money up to get those kinds of returns, they can be available.

We've seen that in a number of instances. So the credit story, I think will continue to be a pretty good one to be actively managing. And I think the last piece I'll call more opportunistic. We have for the last several years, been focused around the venture capital space, really on the idea that we would see the gap between money and innovation close. So the cost of money is very low. All sorts of things get reinvested in or invested in. And that remains largely our view. Even with interest rates moving higher, it would take something north of six or 7%, at least with risk back to the 10 year bond have very high cost of money to shut down a lot of the VC opportunities that we see because the marginal cost to run many of these business is just so low that you end up in a place where it takes a really stunningly high cost of money to change the economics of those businesses. So while I think a lot of folks in the industry worry and fret, there's still money looking in that Angie framework for opportunities to invest. That includes other things that related to points we made earlier, we continue to look for ideas and thematic elements associated with renewable energy and those will continue to be a feature of what we invest in through the next couple of years.

Mike - Pardon the pun, we got a, speaking of opportunity, a question from Gary on this call here, opportunity zone investments. Are you looking at those as attractive opportunities?

Chris - Those will probably weigh in importance over the next 12 months or so, there's some ways that the economics work around those investments that may make them less attractive for taxable investors as time goes on. What we're finding is that many of the opportunity zone investments, or at least the best ones were often right next to other commercial zones. And more importantly, they already had a lot of infrastructure built into them, which is why a lot of the opportunity zone investments often had incentives to build structure, like build a road, put some lighting, put some sewers and other things in there. Our expectation though, this will be around probably for at least another one or two years. We have to ensure that the legislation is not fiddled with at least in the next congressional session and that it kind of stays in place. But that said, we see a lot of real estate investment shops have really gone to town, sorry for the pun, on these types of investments. And a lot of them seem to have been picked up or at least examined or reviewed. And I think where we'd want to go from here, if we're going to do more of these things is either in a very big way where we're kind of looking for safety in terms of very large investments, or much more narrow, very targeted almost city by city approach. And those two seem to be the ways that we would look at them going forward.

Mike - Yeah, Chris, how about investment opportunities outside of the US in both developed markets and emerging markets? Are you finding attractive opportunities in either of those or maybe waiting one towards the other?

Chris - So the valuations are, they're just inarguable cheap, realistically, absolute a fancy way of saying that if you have something traded nine times forward earnings or eight times, you're in very, very cheap space. But I think what it's indicating is that the earnings numbers haven't come down enough yet the probability of the oil induced recession is just not being fully accounted for in many cases. So I think though that's the most compelling argument I can make is that the margin story in the US is starting to permeate globally, and while margins, as we've seen in emerging markets to a greater degree have starting to come back, some of the main the developed markets in Europe and Japan, for example, have not come up as much, but nonetheless, they are higher than they have been historically. So for these markets to preserve those margins and avoid a recession, well, those markets then would actually be very cheap. But given our view that we're going to see some of those recession risks materialize and are not fully priced in, we want a bit more thoughtful about allocating to those regions. I think if someone has a much longer horizon, let's call it 10 years, they can close their eyes or even between five and 10 years, can close their eyes not look, there are some interesting places to be. The main caveat I think is we look at the way the world has started to shift. I think Ian Bremmer did a very good job, kind of linking the G0 theme that he's had for the last 15 years into kind of regional implications. It may create some opportunities that we just don't see or understand yet to invest in either hemispheric or regional treating zones or partners, et cetera. I think the old model of just kind of spread your money around is the index does though for a US-based investors, one that needs closer examination to see if it fits well. because a combination of currency movements, big interest rate differentials, changes interest rate policies, coupled with all the volatility that we're seeing may make that strategy really hard to digest at least over the intermediate term, the next two, three, four years at a minimum.

Mike - Yeah. And I just want to remind everyone on the line, if you have a quite pop it into the Q&A, I'm going to start taking some client questions here, Chris, one is expanding on real estate. This specifically says residential real estate in your outlook, but you mentioned industrial and other attractive opportunities on real estate. So maybe your thoughts on residential and broadly some asset classes beyond that borrowing, or not borrowing, but noting we've come through a cycle of mid teens, residential real estate, real estate home price increases. So that obviously can't last forever, but it still could be an attractive investment.

Chris - Yeah. Well, I'm going to start with a cliche and move on. So the easy money's been made, that's kind of where we are. I think the industry's going to need to transform along three lines. The first is we're going to see, I think, smaller, more picky deals, that type of thing, the Zillow experience, where there were corporate buyers out there buying homes to flip to rent, et cetera, I think has changed the way you think about residential. That's one thing, two is there are still pockets of area pockets and geographic areas that look relatively attractive, typically near centers, the combination of youth money and kind of the ability to commune has always been attractive from a real estate perspective. And you see that continuing to go on in places like Stanford, Connecticut, parts of Virginia, Norfolk is another example, and certainly in large parts of Florida where you're seeing those combination of things come together, and those markets are actually relatively strong for residential, but particularly multifamily as an example where you're looking at the cost entry cost being a bit lower. I think the last piece is we're going to see a change in the way that real estate investors think about leverage the cost of money here relative decap rates in many cases, not all, but in many cases, starting to get flat or even get underwater, and that's going to change some of the economics. It's going to, I think, argue for some of the bigger investors to use their structure, to subsidize the cost. And it may argue for the smaller investors to get a bit more focused around the types of investments they want to see. From our perspective, residential's not the first place that we would go for a real estate. It is near kind of one of the top five, but I think we look more at warehouse logistics, et cetera, as being the first place we go, given the people migration, the residential of a particularly apartment kind of approaches and multifamily would be the place that we would spend time and focus on.

Mike - Couple of questions you can pass on this, if you want, on the series I government bonds are those good investments? And one person ask, do we have a risk of US default here? So I don't even know if you look at that as investment options for our clients.

Chris - So savings bonds, the only series and those kinds of things, they can be good investments. You're going to get the treasury rate minus give or take is kind of a return there, relative to inflation right now, not so great. And what you really have to hope is that at the rate of inflation comes down enough and stays low enough that you can actually, even though you'll be behind now, make it all up somewhere later on down the road. And I think that's a bit of a challenging opportunity right now, also depends on kind of what your personal situation is, what your tax bracket is, what you think your kids will be in. There's a lot of calculus that can was in there, how old they are, if that's what you're using them for in terms of savings is typically the way that most people think about it. But if the underlying premises, the US government is going to default, my personal view is that there's a very low risk of that. So from that perspective, I think you can look at it in a positive way.

Mike - Question from Joel here, Christopher, it says, sounds like you're investment advice for the average investor would be "stay in America". Is that where you're putting your dollars these days?

Chris - We are increasingly looking at opportunities inside the US. We have in fact invested outside the US at least in private markets, we continue to recommend a diversified allocation, mostly to capture kind of value, capture business trends, capture risks, and opportunities that you just can't get in the US, particularly for example, European energy markets, as a way to think about something that looks terrible right now, but is likely to recover somewhere in the future. But the US story is pretty compelling. It's a huge economy. It's well diversified. There's lots of internal dynamics that make kind of the, not only the movement of people, but movement of capital very interesting for us to consider how to invest. And as a hub of innovation, US is hard to beat and that's led to a lot of very interesting things, whether it's kind of clean tech all the way to all sorts of little SAS models, software as a service that companies have done very well with. So I don't think we're going to change our perspective anywhere in the next several years, the US opportunities that still looks relatively compelling. To get us off that dime, I think we'd have to see either some combination of more policies stability, a lot less of the geopolitical risk in Europe, for example. And when I say policy, I mean energy policy stability and that combination of high margins and lower valuations that would create an attractive enough opportunity set to say, we need to reallocate capital outside the US to compensate for all the risks, but that said, those opportunities, I think are there, we don't start with the US only view, we just start with a favor of the US view.

Mike - Chris, you've touched on the midterms coming up and from an economic perspective, what kind of risk is at hand if we do get to the point where maybe the house turns back to the Republicans and there's a bit of gridlock in the system?

Chris - Wow, history and the pundits, at least currently, as they speak today, a view that as a foregone conclusion, that midterm elections are reversal and that you end up in a place where the reversal some degree of it is, is really kind of what's important. Is there enough out there for a Senate and House and kind of filibuster proof approach? I don't think so. None of the political consultants at we use frame it that way, but that's certainly a risk. I think the opportunity on that side is if that were the case, if Republicans control both house and Senate, I think it's very unlikely that we will see any type of tax increases anywhere. In fact, we may see proposals for additional changes to the US tax code. So I think folks worried about kind of using trust or a state issues, et cetera, can take a little bit of a breath and kind of as the election develops, just given what seems to be shaping up at this side. I think the other piece of the puzzle though, is it would be an interesting development from the midterms to get a clear energy security policy across all the lines that are kind of being discussed, whether it's so simple around hydrocarbons, or if it's something more designed around how we invest in wind solar, et cetera, and you know, whether or not we move away from pure subsidy to a different type of an approach, that remain to be seen. But under my understanding from what we read in here is that those may be some of the talking points in the way that policy could evolve, but that speculative at this point, because we're still ways away. And there are still a number of things that may affect the way the midterms turn out.

Mike - Yeah. More questions on the fed and rates and really around how high does the fed go. I mean, if you look at the Fed's neutral accommodative fed funds rate, isn't it somewhere between two and 3%, which is still a long way off from where we are today at 50 basis points.

Chris - So we had speaker Jeff Sherman, who's on Doubleline Capital on recently and he reminded me of a great quote. And I can't remember who was the first person who stated, is it the two year forecast where a fed policy goes, so the two year is currently, which I will, excuse my trustee market data here, is 2.6%, which is kind of where the fed funds rate is likely to head. And that's basically where the Euro dollar future, another forecasting market seem to indicate the fed is likely to head. So is that sufficient if inflation is still running seven or percent? Well, of course not. But the reality is that there are many things in the economy, particularly the cost of capital that work, not just on what the fed funds is, but what banks do and what other lenders do they keep adding premiums. I mean, mortgage rates in some markets are at four or 5% and you're also seeing, in some markets access to credit is getting a bit more difficult unless you're willing to pay eight or nine or 10%. So if you're an investor, that's great. But if you're the company, that's not so great or an individual borrower. So I guess I'd bring all that back with the idea that the rate story here is the fed is likely to go far enough as it takes to either get to the edge of a recession or ultimately if they don't observe the signs, which happens most of the time, we may end up in a recession.

It will be an incredibly delicate balancing act for the fed who's controlling two tools: interest rates and the amount of supply of capital through quantitative tightening to get both of them exactly right. We wish them well. We wish that they are successful for this because a soft landing is what it would be called. It would be outstanding for durability of growth in the United States and would be a strong signal for kind of risk assets. I think equities would do very well, but history says otherwise. And I think the challenge when we talk about how inflation has developed and how fed policy has historically reacted, if we're not seeing the inflation numbers start to abate, meaning head towards 6%, by the time we get to June or July, and maybe five, by the time we're in October, the fed will be called into question increasingly by markets and policy makers for not doing more. And it will be very difficult for them not to move in 50 or as Governor Evans is indicating 75 bases of increments. And those kind of surprises have historically not been received well by market, so I'd put it this way, the fed has a difficult job. At a minimum, we're going to expect bond market volatility. There's opportunity to reposition in that and stock market volatility to come from the fed actions throughout the remainder of 2022.

Mike - Yeah, that's interesting. If you were a fed chair for a year and you mentioned the signs, what would you be looking for that would indicate a recession?

Chris - I'd be looking for the weakness in consumer confidence. I'd be looking at the job data, by the way, I'm just saying what your phone pall has said, because I would do what he's doing. I'd be looking at not just the jobs market, but I was looking at industrial production numbers, the cost of capital, a lending base in the United States. I'd be looking at what investors are saying and whether or not the risk appetite is changing in the overall economy. And right now markets are telling us that, "Hey, we can deal with all this, but a lot further if we're not seeing some of those changes and it may set a new precedent." I don't think we're there quite yet, like I said, our view is that we're going to see somewhere over the summer, there's devolution in the inflation story, which may create a bit of a respite, a sigh of relief, if you will, between here and let's call it, June, July, period. The question is, how much do we get? And as I indicated earlier, there are so many things going on there, energy market that, we could be completely wrong by the time we to get to June or July.

Mike - Yeah. Now let's just remind everyone that rising rates typically is a sign of a good thing, right? An economy that's moving along in this case, it's curved a little bit by inflation and trying to quash that inflation number. So the fed's in a bit of a bind, but rates can't be fed fund zero to 25 basis points forever. And that's what we're headed. Jay asked a question here back to natural resources. Chris, your comments on metals demand for electric vehicles wants to know if we're in the beginning of a commodity supercycle?

Chris - We recently talked to our wealth managers and shared, I think, some views with our clients in some of our right and pieces about the commodity story. And if you just go back to the kind of hydrocarbon energy density and metals, even to begin this replacement, we're going to start to see a lot of changes in the way supply chains work. So one of the things we're looking for is where are governments looking to secure a procure supply and whether or not that changes some of the pricing dynamics? At this point, some of the commodity effects are likely to be temporal, things that are agriculture related, planting seasons, et cetera, the whole the war Ukraine, taking Ukraine out in terms of weed production, as an example is one way that commodity markets have responded much higher prices you see in corn actually move up in the US. There are some waterfall type effects that happen when one of agricultural commodity is very hard to supply than, or you don't have as much supply. And then the price gets too high, and the substitution effect you move to other commodities, at least in the ag chain where you can. I don't think that's possible to the same degree in metals, at least in the battery sector, if you're looking at that most analysts that we follow have written extensively about this. So our view is that the super cycle may be a bit more specific to the metal side, but it is something that driven by electric vehicle technology, for example, we expect to persist and it's going to be policy driven if Norway and the EU go down a road of all electric cars by 2030, and then the manufacturers are going to do it by 2025 to 2027 anyway, that already changes the demand function and the supply chain function.

So our expectation is that the metals prices in particular will probably be very durable. The energy story, I think also will be durable for some of the complicated reasons we discussed earlier. I think the ag story is probably the one that's going to have more variability at least over the near term. So looking at commodity prices, the big challenge here is that the speculators run them up. They've already risen... They've already come up a very strong amount in a very short period of time. That looks a little eye popping to buy commodities here. But I think the opportunity set between here in the next five or 10 years, if the world ends up moving into this hemispheric or more regional block approach, is that there'll be the kind of richest blocks can pay the most for the commodities, and that's a little bit difficult to say, but that may keep the prices higher for longer than most people expect. So we would continue to advocate building small positions in portfolio.

Mike - Yeah, Chris, the question here, just back to the tragedy and the Russian invasion of the Ukraine, and I think we all think of oil as the natural commodity that's going to get disrupted. You touched on wheat though. I don't think people realize Russia is the number one exporter of wheat and the Ukraine's number five. So what impact is this prolonged war going to have in areas that we're not looking at as it relates to your thesis and research?

Chris - So the links here are hard and what has not happened yet is I think the most dire outcome that I think some folks are looking at, which is for Russia to weaponize food exports and kind of withhold. And it seems to be a little bit of talk around that, but that's a very, very difficult thing to understand. For Russia to claim territory or take territory over in Ukraine, a fair bit of it has both natural resources, both in terms of energy and very fertile ground. So Ukraine got a lot of opportunity if Russia ends up seizing the land to add to Russia's ability to control market prices, potentially for things like wheat and natural gas. So to the extent that they do that, they become a marginal price center. It's in Russia's interest to keep the prices high for a lot of different reasons. But the reality here is that the commodity story has many intertwined effects, not all of them centered on Ukraine, but I think the wheat story is an important one because the primary importers of exported wheat include many countries in the Middle East, Italy as well. And a number of other places you wouldn't expect and why that's important is disrupting any kind of food supply is always a very, very difficult and very problematic thing. So with Ukraine, not having a strong planting season now for obvious reasons, we end up in a place where there's going to have to be some recalibration and maybe realignment in order to secure food and wheat exports in particular.

Mike - Devastating situation, we hope that gets resolved. Few questions on crypto, are you at the point where you're in recommending crypto as an asset class for clients?

Chris - I think what we've tried to do is talk about the blockchain story and as part of an alternatives allocation, that's part of it. I think where we get a little bit hung up is on the crypto piece and kind of what's interesting, Bitcoin's still the biggest part of the crypto argument. There's investors know thousands of coins at this point. Not all of them possess the same level of security or transportability or payment functions that are out there. But I think the simple reality is that I'm happy on one case, and I think for investors, there's an opportunity going forward. I'm happy that I think mostly the notion that we're going to see Bitcoin replace the us dollar is the currency of the realm is out the window. because that's nonsense on its face for a whole bunch of reasons, many of which we've discussed and written about. But I think the other part of the story, and this is good for crypto is now becoming an accepted medium in many places and in an accepted medium, not just of exchange, but potentially store value. Yeah, there's still a lot of challenges, too many whales control too much of the crypto that's out there and it's still kind of lottery type of volatility. So as a mode for kind of everyday use, not so strong, but as a medium for other uses, whether it's NFTs, as we've seen the growth there, those use cases continue to... the longer they last, the more they continue to argue the case for this is an accepted medium because ultimately that's how all those things work. It's not just governments making rules, it's what people are willing to accept, and as acceptance for these things broadens out, it continues to be, I think, a positive for some of the crypto stories. Where do we think crypto goes, we don't make forecasts around Bitcoin at 60,000 or 30, that's not something we spend a lot of time on. We're focused more on where to use the technology. And in our venture capital discussions, I mentioned earlier, that is one area that we've been investing in. So many of the firms that we work with are in this space and that's part of an overall allocation that we would make for clients interested and qualified to invest in alternatives.

Mike - Yeah. Well, Chris, as we close up here, and I hope next quarter's going to be a smoother one when we get back together, but you had said early on a theme called a new wave and maybe just summarize you still sticking to the theme for the rest of 2022 on a new wave, and what does that mean?

Chris - Yeah, look, we started with two bridges, which was last year. It was all about the healthcare and the fiscal bridge, we get through COVID. We get to a place where I think in 2022, the new wave here is all about the wave associated with the cost of money, because we've lived for a very long period of time with the cost of money being zero and all sorts of interesting thing happen. A wave that has the cost of money being more accurately priced or more prices associated with kind of where supply and demand and where policy makers and inflation argue for it is going to reset a lot of things. So that wave, I think, is going to wash over the world, meaning the kind of cost of money repricing that we'll see. And it's going to create a lot of interesting opportunities, both in public and in private markets. And I'm pretty constructive on that when we talk to our wealth managers and clients about what those opportunities make, it's not just kind of hide in a box and wait for everything to be all clear. Nobody rings the bell either before getting in the box or when to get out of the box. So it's all about where can we engage and where are those opportunities?

We've mentioned a few, the innovation space and venture capital, the kind of logistics in real estate, the quality and margin durability story in the US, the dividend story that's part of that, for example, bond markets being much more active in your management, you might think a ladder is a great idea, but we might call time out and say, "Maybe you should be a bit more active as an example." Yes, there's bargains outside the United States and particularly in Europe and increasingly in Japan, a combination of terrible currencies and cheap valuations means maybe longer term investors should be rebalancing a little bit of their portfolios there. But as we mentioned earlier, we still want to keep the focus on the US. So that opportunity set still looks like it's in a pretty good place. And if you think about what it's led to in the first quarter of this year, a 60/40 portfolio didn't do so great. You're down about 7%, but if you were diversified with alternatives, you used active management kind of on the main, we actually didn't go down that much. And your risk management function was a little bit more compelling. Now am I saying getting rid of all your ETFs? No. But is there an opportunity to rethink what your portfolio might look like? Because some of the things that worked really well in a free cost of money regime don't work so well, it can work, but not as well when the cost of money, cost of energy, everything is priced in a more indicative and accurate way.

Mike - Chris, I really want to thank you for your latest thinking. It's always refreshing and great to hear from you. Christopher Wolfe, chief investment officer First Republic Investment Management. If you're interested in getting Chris and his team research, contact your First Republic wealth advisor or your relationship manager, and we will take care of you. So with that, Chris, have a great day and thank you again.

Chris - Mike, thank you. Thank you everyone.

First Republic does not provide tax or legal advice - Client’s tax and legal affairs are their own responsibility. Clients should consult their own attorneys or other tax advisors in order to understand the tax and legal consequences of any strategies mentioned in this webinar. Opinions expressed by the guest speaker(s) are solely their own and do not necessarily reflect those of First Republic. This information is governed by our Terms and Conditions of Use.