The Best Way to Fight Inflation: Nick Recce

If you want to think about it somewhat cynically, you could think, well, the Fed's response to inflation is, we're going to cause a recession. That's kind of the only thing that we can do, is to kill demand. One of the concerns is that there's going to be a big impact on the housing sector and I think we're already seeing that. What would be much better is to see a return of the supply side as well. Anything that can be done to increase supply is going to be both disinflationary and pro-growth. Anything that can be done from a regulatory standpoint to encourage domestic energy production would be a big one. Good evening. Welcome to NTD's Fresh Look America. I'm Paul Graney. Nick Reese is the VP of Macro Research and Investment Strategy at Merck Investments. Throughout the COVID pandemic, his analysis and forecasts were among the most accurate that we came upon. So we're delighted to have him today to discuss the economic situation facing the United States. Nick, it's great to see you. Great to be with you, Paul. So Nick, I think recession is the big key word over the past few months. How serious do you expect the economic downturn to be? Well, I think to back up for a second, it's still important to ask how probable a recession is and I would say it's more likely than not over the next year or let's say between now and the end of the calendar year of 2023. I'd put the probability around, let's say, two-thirds chance, but there is still some chance that we could see what's called the soft landing, meaning that we don't go into recession and we kind of muddle through what would ultimately maybe be looked back on as a mid-cycle slowdown. Again, that's not my base case scenario, but we do want to keep in mind that possibility. Certain things would have to happen to allow that outcome and we can talk more about that. But in terms of depth, you know, I don't think, and of course it's very hard to say, so there's a lot of uncertainty about the outlook and it's a very difficult question to answer about the depth, but I would say I wouldn't think about it in terms of being as deep as the Great Recession or the COVID crisis that we had, which were exceptionally deep recessions. One of course very short, that was the COVID recession, one very long, which was the Great Recession. So, this could be more along the lines of the early 90s recession, something more of what we might call a garden variety recession. We hear that the Fed may kind of tame its interest rate hikes because potentially of a potential slowdown or recession. What do you think they're watching most closely to judge that? Well, that's a very good question and I think the framework that they've laid out, and to back up, part of the reason that they've laid out this very aggressive framework is because they did get it wrong in hindsight last year. They should have been hiking rates last year and removing accommodation from their response to the COVID crisis. And they were late to doing that. Remember, they called inflation transitory as late as August of last year and it's really kept surprising them on the upside. So now they feel like, okay, there's a risk that the public is going to lose confidence in our ability to fight inflation and we have to show that we have the resolve to fight it. And instead of making sort of projections about the future and forecast about what's going to happen to inflation because they got it wrong in the past and because they've been surprised, they're kind of saying, we're going to keep tightening until we actually see inflation come down. And the risk there, and this is one of the reasons why I think recession is more likely than not, is that they over-tighten because inflation is a lagging indicator. There are a number of processes that are in motion now that result from the rate hikes that they've done that are slowly passing through into inflation. So to give you an example, the housing data, the home price data, let's say the Case-Shiller Index, showed the first month-over-month decline in over 10 years. And that's a very good leading indicator as to what's going to happen with rent inflation. So your base case is a recession. Looking at the strength of the economy and each of its components, where do you see that recession manifesting most prominently? Well, I think one of the concerns is that there's going to be a big impact on the housing sector, and I think we're already seeing that. So we're seeing house prices come down, but before that we saw housing activity in terms of number of sales, new constructions, things like that falling. So that part of the economy, I think, is already feeling a certain amount of pain, and historically that sector in the economy is a pretty good long-leading indicator for the rest of the economy. So I would think mortgage bankers or real estate agents or home construction would be starting to soften at this point. I think we are seeing that. But what's encouraging is that for the audience that's out there, I would say it's still a very encouraging labor market. There are about 10 million job openings and about 6 million people that are looking for jobs currently. And there are a lot of people we know that left the labor force because of COVID that still haven't come back. So what's good is that the labor market remains strong. It's still a good time to look for a job, to get a job. And I think it's important that that happen, and that would be something that could potentially avoid a recession coming. If you think about this inflation that we've faced, and of course the Fed's response to it, which is really creating problems in the economy, that inflation was caused by fundamentally two forces, one on the supply side and one on the demand side. When COVID hit, that was a negative supply shock. You had people getting thrown out of work. You had all this disruption in terms of global supply chains. And then on the demand side, you had a lot of fiscal stimulus and a lot of monetary stimulus. So the Fed cut rates to zero and engaged in quantitative easing where they're buying bonds every month, which just loosens financial conditions, it lowers borrowing rates. But I'd say even more powerfully than that was the fiscal stimulus, the many trillions that was going out in the forms of PPP loans or checks in the mail or enhanced unemployment benefits. And that may be warranted, of course, at least to some extent under the circumstances and at the time, but really what that combination does when you increase nominal purchasing power by putting more money in the system and into people's pockets, in the context of a capped supply side, that's a recipe for inflation. And the Fed is sort of tasked with the job of maintaining price stability is what they officially call it. And they target a 2% annual rate of inflation. But they don't necessarily have the best tools to actually achieve that outcome. The fiscal tools are very, very powerful. So when the Fed is being told by everybody and expected, hey, inflation is your job, you've got to fight this inflation. The only tool they really have is to raise interest rates. And that's affecting the demand side of the equation. And so in some ways, if you want to think about it somewhat cynically, you could think, well, the Fed's response to inflation is we're going to cause a recession. That's kind of the only thing that we can do is to kill demand. But that's not an ideal outcome. What would be much better is to see a return of the supply side as well. And of course, we want to see maybe both of those things. And the Fed would like to see the supply side improve. But this is an interesting point, because you correctly say the Fed has very few tools, despite what they say, other than raising interest rates. But could potentially raising interest rates hurt the supply side of the economy as well while they're doing it? It's a very good question. And the answer that the Fed gives to this question, and I think it's reasonable, and this really comes from the Fed, from the Minneapolis Fed President, Neil Kashkari, who was formerly at Treasury. And what he said in answer to that question is that, yes, of course, as you raise interest rates, you're creating problems for producers as well, because the financing costs are going up and makes it hard to go out and engage in projects and increase the productive capacity of the economy. To build more houses, to build more factories and things like that. The way that they look at it is that that is a long-term effect. And that raising rates is going to do more to hinder demand in the short term than it is going to hurt supply, because they're looking at it in the short term. Their framework is, we need to get inflation down now. So they're very concerned that if inflation stays high, that could have a knock-on effect into inflation expectations. And that if inflation expectations become what they call de-anchored, then you run into this problem that they're very scared of, which was attributed as one of the dynamics of the 1970s, in that stagflationary period of the 1970s, that there is this self-fulfilling prophecy of, if you expect higher inflation, people are going to ask for higher prices, people are going to ask for higher wages, people are going to be paying higher prices, and that there's this feedback loop, this self-perpetuating cycle, that you just don't want to have that psychology of inflation in the psyche of households and firms. And so that's why they're so concerned about bringing inflation down now. And I think the way they're thinking about it is that a recession now that kills inflation is actually better than letting it run hot and then having perhaps a bigger recession down the road. Well, looking historically, because as you mentioned, the Fed can really affect the demand side of the equation, you know, put less money in people's pockets, et cetera, et cetera, try and bring inflation down that way. Has there been a Fed chairman in the past who's had to deal with these type of supply side challenges, even de-globalization, for example? Yeah, that's a great question, and I think that Volcker is the guy that people think about in terms of history, and he was in the late 70s and really early, I mean, he was from the late 70s to the late 80s, but people think about his time mostly late 70s, early 80s, and fighting the very high inflation and kind of taking rates to levels that people thought wouldn't happen, and then we've been in this long decline of falling inflation and falling interest rates. Now part of that the Fed likes to think is because they have credibility and because they're so good at what they do that that's why there's been this so-called great moderation of very low and very stable inflation. A big part of it, I do think, has been globalization, and that didn't really start until, I'd say, the late 80s with the fall of the Soviet Union and the liberalization of China, and there's been massive disinflationary forces in terms of a lot of this offshoring that's taken place. Outsourcing production to China, for example, I mean, think about television sets, any kind of durable goods, the prices have actually, not only has there been low inflation, there's been deflation. Prices have actually gone down over time, and that's been a big driver of this moderate inflation that we've seen. Now I do think we see this genuine trend of concerns about the global supply chains, this trend of onshoring supply lines, making supply lines perhaps a little bit more redundant with some built-in robustness that wasn't there and was clearly made evident by the COVID crisis. And so to the extent that we see that trend, and that could take five to 10 years for that to get built out, I mean, for example, the semiconductor chip manufacturing plants in the American Southwest are getting built now, but they're not going to have actual chip production for a few years. So it will take some time. So I do think it's reasonable to expect that this decade is going to have higher trend inflation rates than the last decade. You mentioned fiscal policy earlier and how it can be perhaps even a stronger weapon than the tools that the Fed has. How exactly should the government be facing inflation and perhaps adapting their fiscal policy to fight it? Well, there are a number of things that can be done, and I would come back to that framework that the real solution, the best solution to this inflation is on the supply side. So anything that can be done to increase supply is going to be both disinflationary and pro-growth. And that's different from bringing down demand, because bringing down demand is disinflationary, but it's negative for growth. So supply-side solutions are the best, and supply-side solutions are really under the umbrella of fiscal policy. So there are a couple of main categories. One is that anything that can be done from a regulatory standpoint to encourage domestic energy production would be a big one. We know that the Biden administration is releasing these barrels from the Strategic Petroleum Reserve, and to be fair, that is a supply-side solution. Now, you could say it's not the best because there's a limited inventory there and it's going to run out, and you would want to just be producing that domestically and encouraging through regulations that kind of domestic production. And the other one, and I think that this is one that no politicians really want to talk about, so there isn't a lot of leadership on it on either side of the aisle, is that we have this big labor shortage, and yet we kind of know that there are so many people that want to live and work in America that are highly qualified, and that's across the skill spectrum. So when I think about things like a 65,000 cap on H-1B visas in the context of this massive labor shortage, I think that's a real tool that can be, that cap could be increased, it could be tripled or more, or green card processing, or there are different levels of work visas, low-skilled, high-skilled, the whole gamut. So anything like that would be sort of on the real economy side of things, bringing new supply into the equation and helping us to bring down inflation, but also maintain economic growth. Now we're here, we have the inflation and the Fed have started to hike. They do acknowledge that the effects of their hiking can take, what, 12 to 18 months sometimes even to show up. So what is potentially the worst-case scenario if the Fed has overdone it and they don't realize it for 12 months or 8 months and they keep hiking? Well I think the worst-case scenario is that you get a recession and then inflation is still going because it's not reacting to that economic downturn quite in real time, that that's showing up with a lag, and that's historically what happens, is that you'll get an economic downturn, inflation will stay high for a while, and the Fed will be very reluctant to ease policy or might even continue to tighten policy, exacerbating the recession, exacerbating the downturn, and then not cut policy until they actually see inflation break, which would happen with a lag. So that would make for a deeper and longer recession than if they're incorporating those lags into their thinking. Sounds a little bit like stagflation. It would be. It would be at least for a while. Now even in the stagflationary period of the 1970s, the recessions that occurred during that decade did bring inflation down, they brought it down with a lag, but then inflation troughed and went back up and the thinking was that, well the Fed never stayed with it long enough. And Larry Summers has likened it to antibiotics, that you've got to run the full course or else it doesn't do the job. And so he's kind of advocating for the Fed to really remain vigilant, remain tight. And I think there's some wisdom in that, but I also think there's a risk to it. And I think this is a different situation than the 1970s, but Powell is very, very afraid of being thought of like another Arthur Burns. Like if that's his legacy from his time at the Fed, Arthur Burns has not looked back on kindly by the history books. He's kind of criticized for never being tight enough and being too cozy with Washington and cutting rates too soon. And I think some of that is deserved, but I think some of that's also unfair. If that's Powell's framework and lesson from history, then he is going to remain tight and remain higher for longer in terms of Fed rates, which could create a deeper recession. Jamie Dimon recently said we may be facing something worse than a recession. Do you think he's just trying to put a little pressure on the Fed to not hike so quickly? Well, it's interesting. He's been very outspoken over the past several months in terms of his comments, and they've gotten a lot of attention in the media, and rightly so. I mean, he sits at the top of the most important bank in America and has a unique insight and view on what's going on in the world. I do think that, as I said, there is a risk that the Fed's framework right now, and given the mistakes they made last year of not tightening, that the risk is that they over-tighten. It's just like, you know, we can all think of examples where we make a course correction and we overdo it, and then we overcompensate in the other way. And I do think that that's the risk that the Fed is running right now, is that they stay tight for too long, that they're too aggressive. But on the flip side, if we do see inflation come down as a result of that, and that very well may happen only in the context of a recession. I mean, it may take a recession to bring inflation down, but I do think the recession would bring the inflation down. Anything that can be done to help on the supply side should be done, and I think some things are starting to improve. Interesting points. On the stock market, it's been a pretty rough year so far. You expecting any upside? I think the problem in the stock, I think the problem when we think about the stock market right now is that this recession risk is hanging over the market. The equity market historically typically bottoms in a recession rather than before a recession. Now, there are some historical exceptions to that, and of course, no amount of historical examples means it's a guarantee about what's going to happen in the future. But we do look at history as a guide, and so I think that's a cloud that's hanging over the market. Now, in terms of where we are, this bear market in the S&P 500 started right at the beginning of the year. We're now in the fourth quarter, so this is approaching a year old. The max depth on the drawdown we recently hit was about 25 percent down. So we're approaching what has historically been the central tendency of bear markets in terms of depth and duration. Probably have a little more to go both in terms of time and price on that, in terms of the historical context, but more importantly, like I said, it's likely not going to see a final low until we're in a recession, and historically the market's down in the first half of a recession, up in the second half, and the market's not fully pricing in a recession yet. Now, as I said, we have to think probabilistically about these things always. There is some chance that we could see what's called the soft landing, and so we want to be mindful of that and just see how the Fed acts over the next few months and how the inflation data comes in. There could be, there could be, but I think that, I think the risk is that the path of least resistance for now is still lower. The risks are skewed to the downside for the market, but the good news is that I don't think the ultimate low is going to be too much lower than what we've seen so far, which is about 25 percent down. How are you readjusting your portfolio? Well, one of the things, I mean, at this point I think you want to be careful about being too underweight to equities. I mean, what happens behaviorally, and there's an expression that I sometimes reference, that everyone's a disciplined long-term investor until the market goes down, and the problem is you don't want to be selling at the bottom and then in cash when stocks are in a new bull market. So you want to be mindful of these behavioral, psychological trapdoors that are out there. So it really depends on the individual. I would say that if you have a disciplined sort of portfolio process and you're rebalancing it on a regular basis or you work with an advisor that's doing that, probably the best thing to do is, sometimes the best thing to do is to do nothing. But for more active investors or for the sake of kind of providing some commentary on where I think parts of the market that look more interesting, one of the things is that there are these securities called Treasury Inflation Protected Securities. Now, they've suffered like everything else in the past six months because of this rise in interest rates. But the problem there is that bonds, like any nominal bond, these Treasury Inflation Protected Bonds, as yield goes up, price goes down, and that's exactly what's happened. So if investors wanted to invest in Inflation Protected Securities, I would suggest doing it on what's called shorter duration or shorter time to maturity, less interest rate risk. And the way they work is that right now we have these positive real interest rates, about 2% positive, which is historically pretty high. And what that means is that if you buy an individual bond and you hold it to maturity, you buy it today, the stated yield of maturity is 2% in real terms. Whatever inflation is, let's say you buy a one-year bond and it's a 2% real yield. Whatever inflation is, you're going to get 2% on top of that. So if inflation is 5% over the next year, you're going to get a 7% real return and there's no credit risk in that. That's guaranteed by the U.S. government. And so that's one idea that people can think about are these short duration Treasury Inflation Protected Securities. And you're recommending this in the short term until we get through the kind of uncertainty? Yeah, it would be a more tactical asset allocation, more conservative, but also benefits for portfolio diversification because the thing, as we've seen over this past year, the thing that hurts traditional stocks and bonds the most is inflation and is higher than expected inflation. And that's what these securities protect against. We see some of the tech stocks, it's just been a bloodbath. I think Snap now is down 80%, 85% in the year. Are you seeing any opportunities in these drawdowns? Well, I think the drawdown, you know, the problem with these drawdowns is that these stocks can still fall 100%, you know. And so even though these seem like, well, hey, it's down 85%, 95%, how much further can it go? Well, it can go all the way. You know, it can go all the way to zero. Some of these companies, you know, might not survive. Of course, companies, individual stocks, they can go to zero, companies can go bankrupt. But I do think we are getting pretty far along in this tech bear market. The problem is we're still seeing interest rates rising. We're still making new multi-decade highs today on the 10-year yields, and not just in nominal terms, but in real terms. So the real interest rate is moving up and nominal interest rates are moving up. And what that does is that really punishes cash flows that are far out into the future. And so when you think about these growth companies, these technology companies, a lot of them don't produce cash flow today. They're valued based on these projected cash flows that are going to come in the future. And so with higher interest rates, those get discounted back to present at a lower value. That's the, you know, that's corporate finance 101. That's discounted cash flow analysis. And that's a good framework for thinking about investing. So I still think, based on where interest rates are and the risk that they move higher, that there is risk still in growth stocks. But we've made a lot of progress over the past really year and a half. You know, a lot of those growth stocks, a lot of those sectors peaked in February of 2021. I mean, we're talking about a full 18 months of this bear market for that category. So I do think if we analogize it to the dot-com bust, we're kind of following that playbook, you know. So we've got, I'd say maybe a little bit more to go in terms of time and a little bit more to go in terms of downside. But you could start to think constructively, let's say, over the next year in some of the growthier parts of the market. But the key thing is going to be, is the Fed done with their hiking cycle? Are nominal interest rates actually going to start to decline? Is inflation going to start to really decline? I mean, those are the big macroeconomic drivers of investments in growth stocks. Nick Raiz, Merck Investments. Thanks, Nick. Thanks, Paul.