Counsel Views – Macro insights

Stu Morrow:

Hello, everyone, and welcome to Counsel Views. I’m very excited to introduce my special guest today. It’s Barry Knapp from Ironside Macroeconomics. For those of you who are not familiar with Barry, he is the Managing Partner of Ironside Macroeconomics and also the Senior Advisor to Macro Risk Advisors. Barry was most recently a Senior Managing Director and Head of Macro & Public Strategy at Guggenheim Securities. His previous roles included Managing Director and Head of Thematic Strategies for BlackRock Fundamental Fixed Income; Managing Director and Chief U.S. Equity Strategist at Barclays Capital; and Managing Director in principal trading and equity derivatives at Lehman Brothers. You may have seen him appear on CNBC, Bloomberg Markets, or other traditional and social media outlets as well.

I followed Barry’s research throughout my career as a student of the market. He’s always well-read and his research provides practical connections between the global economy and global markets. And true to form, Barry’s reports are published under the title, It’s Never Different This Time, underscoring his use of historical analogs to better inform where we could be in the business cycle and to also inform readers on underappreciated risks in the markets.

Barry Knapp, welcome to Counsel Views.

Barry Knapp:

Thank you for having me.

Stu Morrow:

So, a lot to talk about, and we try to keep these to a reasonable time frame for our clients, of course. But perhaps a good place to start is the outlook for inflation. We know we feel it at the grocery store and the gas pump. Certainly, however we measure our housing costs these days, we perhaps feel it there too. And we hear about worker shortages, not only in the U.S., but also in Canada, which would imply future wage pressure.

So, the questions for you, Barry. What are the puts and takes today for inflation over the next year or so?

Barry Knapp:

A little bit of history because that’s how I’m prone to approach things, but I think it’s really relevant here. Inasmuch as when you look back over the last two to three decades, this period of disinflation that began with the Volcker Fed in the early ’80s as we wound down the great inflation of the 70s, there were a couple of factors that are vastly underappreciated by policymakers and market participants.

In addition to Volcker’s inflation jihad, if you will, there was a big deregulatory environment that contributed to it. But the real dynamic factor—and you can really see this if you break inflation into core services inflation, core goods inflation, and energy inflation—the real disinflationary impulse that reached its maximum negative pressure, downward pressure on prices, is goods prices. And that can be largely traced to the biggest labour supply shock increase in the history of mankind.

In 1990, there were some 750 million industrialized workers; by 2010, there were 2 billion. This is the work of Charles Goodhart and Manoj Pradhan, who initially published a paper at the BIS and then later wrote a book on this, about three demographic trends that were shifting.

So that giant labour supply shock you could generally refer to as the China shock because it was the integration of China and the Soviet Block and the global supply chains, put downward pressure on wages through the world, and the U.S. in particular lost 5 million manufacturing jobs. That spilled over to excess labour in the services sector.

And when, again, you go back and you look at those measures of inflation through the 2000s, first of all, that negative price impulse from goods reached its low in about two years after China was admitted to the WTO, so in the early 2000s. But it’s run persistently negative, while services inflation has run above three the entire time period. I often argued that the Fed was meeting their mandate because they had some degree of control over services inflation but had no control over goods inflation because that was attributable to this labour supply shock.

Roundabout the early 2010s, most of the economics of that cheap labour in emerging markets, in China in particular, had been exploited. Places like the Boston Consulting Group were arguing in reports called the Tipping Point and follow-ons that the economics were largely gone, that supply chain risks, exchange rate risks, relative energy costs, productivity-adjusted labour costs, all those things had largely equalized. But to get businesses to up and stop manufacturing in China to ship around the rest of the world, you needed probably a series of supply shocks.

Well, those began in 2011 with the greatest Japan earthquake and tsunami that shut down the auto industry. We had floods in Thailand the same year. Then we had the trade war; then the mother of all supply chain shocks, the pandemic. So, my broad argument here would be that we’re going from just-in-time inventory management to just-in-case, and we won’t have that negative impulse from goods prices.

Right now, goods prices are the main source of inflation, right? It’s running at over 10% per year here in the U.S. Energy’s a whole other story. We had a big negative shock last cycle. We’re unlikely to have one this cycle. We had the least amount of exploration finds in some three decades last year. But I’ll leave energy aside for now and just focus on this goods-versus-inflation dynamic.

Most market participants, arguably the rates market, although that’s a little distorted, and Fed officials expect supply chains to clear and those goods prices to come down. As that happens, though, we’re going to move from the pandemic effects to the pandemic policy effects.

And I describe services inflation as transitory disinflation, right? So we saw housing costs, because of rent moratoriums, look fairly moribund for much of the early part of 2021, but now they’re starting to surge. We know that house prices are increasing better than 1% per month; peaking at 20%. Rents are surging at some 13 to 14% per year, based on which measure you look at. And the way those measures are constructed in CPI or core PCED, we’ve got six months of gains already baked in the cake. That’ll be important when we come back and we talk about Fed policy a little bit.

Nevertheless, we also had transitory disinflation in education and in medical care. Medical care is starting to increase. It’s at about 2.2 or 2.3%. It should go back up to its long-term trend of 3.5 or so. Education’s running at 1.6. That’s going to go back up. And so, all of those policy steps that were taken, that increased medical care coverage—I understand the situation in the U.S. and Canada are quite different—but nonetheless, we’re going to start to see those measures start to surge.

And so, as I said, we go from the direct pandemic effects to the effect of the policy response, and services inflation is likely to be on an upward trajectory through the course of the year, leaving the Fed well behind the curve.

The key issue here is, can we settle in with a trend above or below 4%. Four percent was the level in 1968 that, when we got above 4, it got embedded in the household expectations, it started to pressure margins, and put pressure on equity market valuations. So we’re obviously above that level now. The question is, as these goods prices cool off does trend settle in above or below 4. The Fed thinks it’s going back to a little below 3 by the end of the year. Even Powell had to admit he probably has to increase his estimate at the next summary of economic projections in March. And very few people believe we’re going back anywhere near their target anytime soon.

So, that’s the broad inflation picture. And the question is, are we moving into a period like the ’60s which was reflationary after a disinflationary era? Or are we skipping straight to the ’70s? My inclination is to think that we won’t skip the ’60s, and that’ll be a pretty good environment for financial assets, equities mostly. But that’s that key issue for—one of the key issues for 2022.

Stu Morrow:

And you touched on the Fed, and we heard from the Federal Reserve recently, also the Bank of Canada. But we’ve started to see bond markets already start to price in at least four interest rate hikes for the federal reserve this year. I kind of want to get your take on that.

And in the most recent outlook, the most recent meeting from the Fed, they seem to be willing to, more than in the past perhaps to say, fight inflation or admit there’s inflation to fight. And maybe you want to talk about that for a moment.

Barry Knapp:

Sure. It was a very frustrating meeting. In particular, it was a frustrating meeting because Chairman Powell and the FOMC seem to have no plan to address their balance sheet. And the balance sheet is the key issue.

Last cycle, their sequencing was slow and then the asset purchases, so taper, raise rates, and then go to balance sheet contraction. The yield curve flattened through that entire process. Now, in the middle of 2010s, a flatter yield curve was—from an economic perspective at least, the first-order effect was fine. We had impaired demand for housing, impaired demand for autos, any of the durables, any of the interest-sensitive sectors, because household balance sheets were still under repair from the global financial crisis.

The opposite is true today. Household net worth is up 26% from the pre-pandemic level. Demand for housing, autos, and durables is surging. The most effective way the Fed could cool off inflation is by shrinking their mortgage holdings and raising the spread between mortgages and treasuries to crowd financial buyers out of the housing market, cool off house prices and rents.

Stu Morrow:

Yep. Do you think, then, that taking, like you said, sort of the feedback from the Street or around concurrently shrinking the balance sheet as they raise rates, do you think that they’re in a position to hear that feedback and actually change kind of course, I guess, if that’s the course they’re taking?

Barry Knapp:

Yes. They’re all very intelligent people. Unfortunately, there’s no one on the FOMC, whoever was even in the same building, as someone trading a bond. Rich Clarett is gone; Rob Kaplan’s gone. So I’m a little frustrated by that. They’re a little too academically oriented. And the President of the New York Fed is not—I mean, Bill Dudley, I know, and Bill Dudley gets it; he worked at Goldman Sachs. John Williams is an academic economist, so. And that’s the key Federal Reserve Bank. But I do think that they’ll get it, and I think they’ll sort this out.

And I do think that the market had had an appropriate adjustment, equity market had had an appropriate adjustment to this hawkish policy pivot. I was personally just frustrated that they could have done this so much more elegantly, and gotten the yield curve to steepen, and mitigated some of those arguments that the Fed is tightening into a slowing growth environment. Because when the curve flattens, investors get worried that we’re headed towards a recession. They could have done that better. So, it wasn’t Powell’s—I’d give him about a D on his performance.

Stu Morrow:

Okay. Wow. Yeah. That’s a tough grade. You talked about kind of the response you’ve seen. Anything surprise you in the kind of reaction you’ve seen so far in the bond market and in the equity market year to date? Is it what you would expect when you get this change in monetary policy regime? Like, you switch from accommodative to less accommodative?

Barry Knapp:

This is some work I’ve done—I’ve been doing for quite a long time, going back to my Barclays equity strategy days. I think it’s a little unique; I haven’t heard anyone else try and approach it this way.

But I went through every business cycle since World War II. I identified one Fed policy normalization-related correction. At the point when the Fed gained enough confidence the economy had achieved what Muhammad El-Erian calls escape velocity and started to normalize policy, every one of those business cycles, all the way through 2004, had one of these uncertainty shocks. And I call them uncertainty shocks because, depending on how aggressive the Fed was, the bond market could have variable reactions. We had a very aggressive policy normalization cycle in 1994, a much more “measured” —right—

Stu Morrow:

Yep

Barry Knapp:

—removal of policy accommodation in ‘04. So the bond market will react differently. But the stock market reactions are very homogeneous, roughly 8%. And they lasted for about two months, and then they’d rebound, consolidate for a quarter or two, and then go on their merry way. It was never terminal for the business cycle or the associated bull market.

After the QE era began, we had eight of these. So the end of QE1, QE2, Operation Twist, QE3, so on and so forth. They got larger, undoubtedly because of the Fed’s involvement in the back end of the bond market and mortgage market. And what that did to volatility, now they started to average 11%.

I made a forecast last year when it became clear they were going to slow the—or taper the asset purchases, that we would get a 10 to 12% drawdown last fall. We only got 6, partially because of the favourable seasonality; we got into the fourth quarter and things tend to act better. But I still felt like we were going to get a 10 to 12% likely in this year. And I was not surprised at all that the first trade out of the gate was a 10 to 12% drawdown.

This is very similar to when the Fed ended zero rate policy in 2015. Dec 15, 2015, they announced it. The market hung in through January 31st, Santa Clause aided—rallied through the end of the year, and then dropped 12%, 12.8% to be precise, over the first 20 days of 2016. The market rebounded back about 50% of that by early Feb, made a marginal new low by Feb 10th or so, and then the bull market resumed.

So it’s very similar to that. I did expect one of these Fed policy normalization-related shocks. The accompanied reaction in the volatility markets, which is the way I gauge sentiment, generally, I prefer it to sentiment surveys, what they’ll pay for portfolio insurance rather than what they say to me is more reliable; as you noted, I’ve spent a lot of time in equity derivatives. But that notwithstanding, all those measures really met the parameters of what I would think would have been an appropriate adjustment to the Fed hawkish pivot. So, I think the worst of the selling is over and we should make a bottom here; it’s probably a pretty good entry point.

Stu Morrow:

Great. How do you think—we try to think as best as we can, of course, about looking past some of the short-term ups and downs that we see in both bond and equity markets, and we try to keep a perspective on things. So, how do you think about, today, the longer-term outlook for equities and bonds? What are your sort of things that we should be thinking about in terms of risks and opportunities, even?

Barry Knapp:

So I mentioned one of the key questions for 2022, which is, where does trend inflation settle. Does it settle above or below 4? As I mentioned, 4 was the level in 1968 that really started to cause things to come unglued. There was also a very interesting paper by a Fed staffer earlier this year named Jeremy Rud, who talked about whether we should even care about inflation expectations. He ended the note with a caveat saying, well, if we go above 4, all bets are off. Right?

Stu Morrow:

Yep

Barry Knapp:

And so that 4% level is key. But another key issue is productivity.

So when the pandemic hit, I had two very strong counterintuitive and contrarian views. One was that the pandemic was an inflationary shock, not a deflationary shock, so the antithesis of the global financial crisis; and that it was a positive productivity shock, not a negative productivity shock like the global financial crisis.

And part of the reason I viewed it as a positive productivity shock was, A, we’d had very weak capital formation last decade. The last cycle’s trend CapEx was the second slowest of any business cycle since World War II, the slowest being a very brief one in the late ’50s. I thought that there was a strong case for rebuilding the U.S. capital stock, not having supply chains stretched all over the world. We already talked about that issue a little bit. I also felt that you could see—or I had already observed in late 2018—or in 2018 and 2019, that productivity had accelerated primarily in the services sector due to technology innovation adoption.

So I’ll give a great anecdote for this. Starbucks’ comp sales were stuck at zero in the middle 2010s. They had an assembly line problem. Baristas could only serve coffee so fast. We’ve all seen the lines at Starbucks since the pandemic hit. They invested a lot of money in their technology and now have a third of their customers buying the coffee before they get there, online, picking the coffee up and leaving. So that’s technology innovation that’s substituting capital for labour, and that’s a more efficient way to deliver services. And their comps went to 5% per year all of a sudden.

So, you’ve seen that throughout the services sector, throughout the household consumer sector. It may explain why consumer discretionary was such a strong sector last cycle, because big retailers went to omni-channel and became much more efficient in delivering consumer goods and services. I expect to see that broaden out to health care, industrial sector, really leaning on the Internet of Things, financial services, and just really diffuse throughout the economy such that the benefits of that whole digitization movement to the cloud accrue from the producers of that technology to the consumers of that technology.

So, if you think about productivity in 2022 and beyond, we could have capital deepening, right, so capital investment. We could have stronger labour productivity because of turnover in the labour market, which is going at record pace. Presumably, all those quits are people going to get jobs they really want to do, that should ultimately make them more productive. And there’s a good body of academic work around this. Takes some time, but that’s a way to push wages forward without driving inflation, right? And then technology or total factor productivity.

Those are the three inputs to productivity. Those should all be firing in 2022 and beyond.

Margins typically peak three quarters before a recession. I don’t think they’ve peaked, actually. And they’re performing well this quarter. I think productivity is going to make a big difference, and that will extend the business cycle, and is really, to me, the big issue for equity investors in 2022. 2023, it’ll pertain to the length of the business cycle.

Stu Morrow:

Yep. No, and I definitely agree. Barry, thank you so much for sitting down with me virtually to talk about the global U.S. economy and your outlook as well. I really appreciate your input and taking the time to speak to our clients, so thank you.

Barry Knapp:

You’re certainly welcome.

Stu Morrow:

Yeah. No, thank you, Barry. And to our listeners, thank you for spending the time to listen with us today. If you have any questions about what you’ve heard here, please reach out to your Investment Counsellor at any time. Take care.