To kick things off for 2022, we welcome back to the show Rob Almeida – Global Investment Strategist and Portfolio Manager for MFS Investment Management. This time around, we recap the highlights and oddities of last year, and address some of the major issues for the New Year. High asset prices, inflation, the Fed…we address it all in this sprawling synopsis of what the heck is going on in capital markets.
So, go sit in traffic – if you can find any, go walk your dog, or relax in your office and plug into this one. Kick off the new year in style. Well, this might not be stylish, but you just might be more informed.
Geremy: Welcome to the podcast Deconstructing Alpha, where we have unscripted conversations with investment managers about timely topics. On this podcast, we respect the art and science of active management and long form journalism. But we don't happen to have too much time these days to actually sit down and read. So hopefully we can digest investment information through the podcast. So I'm your host, Geremy van Arkel with Frontier Asset Management. And I'm joined as usual by Shannen Carroll.
Shannen: How are you today?
Geremy: I'm excellent. Shannen. So Happy New Year.
Shannen: Yeah. Happy New Year.
Geremy: First podcast of the year.
Shannen: It's gonna be a good one.
Geremy: Yeah. So I thought since we're going to start since it's a brand new year, and we're all tied to the calendar. I know that, you know, today is just as important as the last day or some day last year, but we flip through the calendar and we start a new year. And so we're going to start this new year off with a 2022 kickoff. And we're going to interview Rob Almeida, global investment strategist and portfolio manager for MFS investments.
Shannen: Awesome. I can't wait to hear it.
Geremy: Yeah, we interviewed Rob last year. And he was one of our most favorited podcasts. We covered a lot of bases and in sort of macroeconomics, and capital markets and, he's a global strategist and has a similar job to me, but with MFS investments, and so we're going to try to have a conversation, not an interview. And this one is pretty unscripted Shannen, because it was the beginning of the year. And we tried to, you know, jumpstart the year with all of these pertinent topics and a wide range of things we're going to talk about, but we tried to get it out quickly. So Rob was gracious to agree to an unscripted interview. And I think hopefully, he'll be a great sport about this. And, we have just so much information to cover here. So I'm really gonna try to keep it under an hour. It's an action packed year, it was an action packed year last year, it's gonna be an action packed this year, there's so many things to talk about. And I can't think of somebody anybody better than Rob Almeida to talk about this with. So Shannon, before we start this podcast, is there anything you'd like to say to the audience?
Shannen: Yeah, absolutely. Our compliance officer would like everybody to stay on, you know, to hear the disclosures. And at the end of the interview, I'll be asking Geremy some questions about what they talked about.
Geremy: Yeah. And so I think the questions part is going to be important. I do ask the audience to stay on till the end. Because I think this , conversation could go probably pretty deep. And we're going to talk about a lot of topics. We might talk pretty fast about things and have a lively conversation. And so we might need some deconstructing of that later on in the podcast. Without any further ado, ladies and gentlemen, Rob Almeida, global strategist, Portfolio Manager for MFS investments.
Geremy: Rob, welcome back to the podcast. So glad to have you here.
Rob: Thank you. Glad to be here.
Geremy: Excellent. So are you calling in from North Boston again?
Rob: Correct. About 30 miles north of the city.
Geremy: Excellent. And you guys blanketed in snow? Did you get some snow?
Rob: We did. But a lot of it melted yesterday, and now it's just bitter cold.
Geremy: All right. All right. So you're ready to kick off 2022?
Rob: Let's go bring it.
Geremy: Yeah, you're you're one year older, whether you like it. I think we all are, right. Yeah, so we did a poll, we did an informal poll here at Frontier and your podcast from last year was the most popular podcast people liked most. And so if you recall last year, we did sort of a strategist overview of what's going on in the markets and I hope to do that again right now. And I think this is a great, you know, time to have a 2022 kickoff. So and, and especially since tonight, is Georgia Alabama, right. Yeah. Well, since you're in Boston, it's probably not front of mind. Down here in Atlanta. I think it's a holiday. So, alright, so um, I don't know about you, but I'm kind of having a, like a brain melt, trying to put together all of the different themes and all the information that happened last year and looks like is going to continue into next year. And my strategist deck currently it's not final is 52 slides. So I don't I don't know if you're having the same problem assimilating all this information down into like a nice concise theme of what's going on is similar for you.
Rob: Yes and No, I don't know if it's a function of age, COVID, being at home, too much data that is conflating. But to me, it all boils down ultimately to profits. So what will profits be in 2022 and in beyond everything else is an input to that, which makes it incredibly difficult because there's so many inputs, but ultimately, that's what matters. right. What will profits be?
Geremy: Yeah, what will profits be. And so if we were just to kind of recap last year briefly here, profits were surprising. The first thing I guess we can talk about is the US market was a strong performer last year. 27%, I think, for the year, very surprising for me. But it was actually a net contraction in the P/E ratio. Because as you said, profits outstrip the price game.
Rob: So in, when you look at it in, I guess, nominal space or absolute space, it's hard to triangulate +20% profit return post pandemic, but if we maybe strip away the fact that we're coming off a lockdown, vaccines, strip all that away, and just think about what happened. So revenues generally grow 2x GDP, now let's forget how that happened. We know with stimulus driven, but nonetheless, it happened. So GDP up 12% revenue growth up 25%. At the same time, companies were ripping out costs. So you had tremendous operating leverage that flowed right through to the bottom line. And just like you said, profits outstripped the multiple, so the multiple actually contracted, that's how strong profits were. Now, to me that, though it was a function of stimulation, so you had peak stimulus, peak GDP, peak revenues, peak profits, implying it's not going to be peak, it's going to be something lower looking.
Geremy: Right. Okay. So I guess the second big theme from last year, which is probably going to continue into next year, and we can break all these down further, but just let's quickly recap last year, so great year for stocks, US dominated the world in terms of performance. Again, in 2021, there was a big difference between international and US.
Rob: Yep, its profits, right. So what were companies doing, they had greater, not that much greater. So revenue growth outside the US was 20%. Inside the US, it was closer to 30%. So I guess a pretty big Delta, depending on how you cut it. But what are US companies better at doing is ripping out costs, just higher efficiency so that you're, and they're more levered, such as translates into higher profitability. So to me that explains the performance differential.
Geremy: Right, but largely profitable for all parts of the equity markets across the globe some were better than others, but the price discrepancies did seem to be quite large, particularly between US and EM.
Rob: Well, when we look at EM, the other element, too, they didn't benefit from the same sort of stimulation that developed markets did, right. So EM, countries didn't have the fiscal, or let's say, the balance sheet capability to enact the same sort of fiscal and monetary policy that developed markets did.
Geremy: That's a really great point. They did not have nearly the, the m2 growth our the monetary and fiscal stimulus as the US right. So what's which probably gets into the second topic, which is well, is all this stimulus, I mean, is all the stimulus really leading into inflation? So inflation really, you know, surprised the Fed and a lot of people last year by being I guess what they say more persistent than transient.
Rob: Well, and look what's happened in the matter of a few months. The narrative went from one hike to now just in the last few days, the markets discounting for rate hikes, and we're hearing with reserve anywhere from $3 to $4 trillion of balance sheet reduction over the next three to four years. So you know, to me, in hindsight, this shouldn't be a surprise. And maybe just strip away what the Fed has done for a moment, you look back at every single pandemic all the way to the plague 600 plus years ago, what is the scarce resource in a pandemic? It's human capital. So you insert that into the dynamic of whether you want to call it ESG, sustainable investing the wealth inequality gap. But you're at a point now where consumers have excess cash, some of that due to stimulus, some of it's just due to the wealth of wealth effect of higher asset prices, but also just this transition from capital back to labor. And now Labor's demanding higher compensation for their wages. And that's, I think, a change to the Fed's calculus that they weren't discounting three or four months ago.
Geremy: No, it looked like wage growth was just flatlined. And that seems to be the surprising part. And hopefully, we'll get on that a little bit more. But so in, in the face of extremely strong stock market, extremely strong profits globally, and high inflation. Interest rates really hung in there.
Rob: Right. So I think well, I think that was the bond market, swallowing the Fed's narrative, if you will. And then in the last few months, it was the bond market pushing back and saying, wait, I'm not so sure you're right on this.
Geremy: Yeah. But surprisingly, interest rates really did stay low. We and bonds hung in there for the environment, I'm sure you know, some parts of the bond market did lose money, a lot longer dated treasuries, lost a little money last year, but nothing compared to what was possible in this environment. And then we get to the Fed. And so the Fed just standing here, right. Where we're at, you know, here's a statistic I found out is that where the, this is the largest difference between Fed funds rate and inflation ever, at least since I've been tracking.
Rob: That sounds about right. I mean, look, the their balance sheet, we all know what it is, in nominal terms. Let's talk about it in relative terms. So 20 years ago, three, four or 5% of GDP post or during the GFC. Obviously, that took a big jump up. But now post, lockdown, it's close to 40%. It's massive.
Geremy: It is massive, and it's unprecedented. And it really feels like Uncharted Waters. So here we are, right. Yes, that's 2021, we had continuing positivity in the economy, great earnings, ever rising asset prices. We had inflation rear it's had. And looks like it's not going anywhere too soon. We had interest rates actually surprisingly strong, and the bond market hung in there. And we have what I would call a paralyzed fed. So yeah, now it's January 9 here, right, or 10th. And we're gonna go forward we're in. So one of the things I remind investors, despite their fascination with past performance, and despite their investing what I think is really investing based on regret, right. They, wish they had bought all that stuff. And they feel like if they buy it today, they just maybe would get those returns. But that's not how it works. And so we all have to go forward, nobody gets to time travel. So we're going to go forward. So looking forward this year. So I'll just start this part of the conversation with I had a hard time trying to take all this information, as I mentioned, and try to assimilate it into a narrative. And I think I have two themes that you might want to comment on. And maybe they're similar to yours. But the first is, I feel like we're wrestling with high asset prices. Because despite, you know, a really strong economy, the asset prices historically are very high across the board the bonds and stocks and real estate and commodities and everything. And so it's the everything high asset price. Now, versus inflation. So that's, I think the first thing that 2022 Does that sound about right to you?
Rob: Yeah, look, credit spreads, high grade, high yield, they're tighter than where they were before the pandemic hit. And leverages in leverages higher right so companies took on more debt because the Fed allowed that financing to take place. Now granted, they took on more debt in preparation of an extended lock down beyond what they thought, but the point being is spreads are tighter now than where they were before. Now the pushback will be will be GDP is higher fundamentals are better. However, that was a function of stimulus. So I agree with you, what you have now is the face of tighter monetary policy against valuations that are more difficult than they were two years ago. That's a tough calculus.
Geremy: Yeah. So let's talk about let's start with valuations. So, a lot has been said about the s&p 500 in particular, and I think this is where investors have a lot of indigestion over is that the s&p feels like a really simple trade, you know, and historically speaking, it looks very obvious that it's a strong performer. And there are a lot of tailwinds for the s&p. And at times like this, investors really feel inclined to go chasing right. And so, you know, stock valuations to start with the s&p, you know, according to what we look at, it looks like it's about the highest valuation except for 1999. Is that sort of similarto what you're looking at.
Rob: Second highest in 150 years.
Geremy: Yeah. So prices relative to their potential earnings are still very high with the s&p. I think the second thing that's very interesting is the concentration in the s&p, that's obviously a theme that's bubbled up here. You know, we've, so the top 10 holdings of the s&p, I just checked, are now 30% of the market cap of the S&P.
Rob: Yeah, which two things to that one, that is I don't want to say symptomatic or causal, but that it that correlates with late cycle dynamics. So we saw that in the late 90s. But just because we saw it done doesn't mean it's the same situation. However, what I would add to that, though, if you think about the change in the market structure, so when we started the industry 30 years ago, machine Based Investing, passive investing rules based investing, that was 5% of the market, 10% of the market. Now it's over half. So just when you think about the construct of the market, it makes sense to me. Or I'm not surprised, if you will, that the indices are this concentrated in nature, because it's a function of the structure of the benchmark and markets today.
Geremy: That's an interesting point. So when you say machine investing, you mean indexing or quant?
Rob: Yep. Rules, rules base, something programmed to follow a rule. It's a, you know, agnostic, if you will, it's just gonna do what it's told. And ther is nothing wrong with that. But that's just what it is.
Geremy: I'm not sure. I know that there's a higher concentration of investors that are indexing today than in 1999. But I do remember in 1999, that indexing was an extremely popular theme. And it really was, that was probably really where I really got started. And so that is that is similar to 99. So we have similar valuations. And we have similar sort of, well, why don't I just go into the thing that's done the best, and it's the s&p. Now, again, there's been a lot of reasons why it's been good. You know, I believe that the, the actual companies in the s&p are pretty phenomenal. And so it's a well, you know, it's a concise index. And that allows for market cap weighting. Whereas something like efi is not right. It's not as concise and it's more diversified. And so which gets to I guess the second part of this is, you know, so, concentration in the s&p is not only in the stocks within the s&p, but it's in the world's market cap. So 40% of the world's market cap is now US stocks. So where we represent less than 20% of the world's GDP, we have 40% of the world's market cap. So it is a very popular place to be investing, I'd say right now.
Rob: Well, to your point earlier about people chasing yesterday's performance in 2021, the inflows into US equity surpassed the last two decades of inflows combined.
Geremy: Yeah, I forgot that statistic. That was a great one that was in, you know, that started. That was a big theme in the beginning of last year. And it really it ended the year that way, right. So net, I'll repeat that the net deposits of assets into the stock market and money into the stock market exceeded the last 20 years of net asset flows. And so all in one year, so definitely investing is become a part of people's lives.
Rob: Well interesting. And how it differs from the 90s is investing. It's a good thing. I'm not saying this, but it's become democratized. So now my son with his phone can open up you know, pick your app and buy a stock for 10 bucks.
Geremy: Yeah, apps or fractional shares. Yeah, on Robin Hood, he doesn't even have to buy a whole share, right. And so there's actually, I can't remember this. But this is very interesting to me there. Say there's a robo investment company that has a credit card, and that when you charge on their credit card, you get fractional shares of a percentage of what you bought. So if you go to Home Depot, and you spend $100, you get like 0.01% of the Home Depot stock as your benefit. Which is really interesting. So, yeah, so yeah, so investing extremely popular.
Rob: And it's easy to do.
Geremy: And it's easy to do, and performance has been great. And this feels like one of those times and so there's so and then when we mentioned sort of the world's market cap, certainly, looking forward, the valuation differences between US and international seems to be a big theme. And it seems that on paper, that international stocks, particularly emerging market stocks, have lower valuations and higher expected returns than US stocks.
Rob: Yeah. All else equal that that's correct, to me the value because that's what a lot of people use for the non US exposure thesis over the last 10 years. And obviously, it didn't play out. So valuation obviously matters. But it's really the combination or want to call the Venn diagram almost of fundamentals in valuation. So for me, you've got the valuation gap, which is is too wide. But that's not a new argument, perhaps is more extreme than it was before. But it's not new to me, the more important one is the trajectory of profitability. So when I think about the post GFC cycle, why was the Delta in profits between US and non US so wide? And how did it continue to widen then most, maybe most importantly, is it sustainable? And the answer to that is no, that's the latter question. The answer to the former question is, companies were extracting American companies were extracting value in non sustainable ways, right. They were extracting values from underpaying people, they're extracting value from the environment. They were extracting value from bondholders, all those things now, which captured under I'm using quotation marks my fingers ESG. That's reversing. So I think that changes the profit trajectory in that married with the valuation gap that you mentioned to me makes us more attractive.
Geremy: So let's talk about that. So I think most people know that the US has done really well and International has trailed. A lot of some of those people know that the US is profit margins have been better than the international so what would be headwinds for me in the long run, I'm a believer that when you buy stocks, you're buying them for the future earnings stream, which could be dividends, or it could be earnings growth or reinvestment of earnings. And so earnings is the driver. And I think that's the case with any asset. So what would be earnings headwinds to look at or to be concerned about in 2022.
Rob: Costs to it to me, it just comes right down to cost when you think about 2020 and 2021, you had two magical things happen for profitability, which we highlighted earlier, right. So huge stimulus that drove huge GDP that drove revenue growth from where it was for 10 years at 2%, to anywhere from 20 to 30, globally, and at the same time, every company was ripping out costs. So I wasn't getting on a plane, you weren't getting on a plane. And so you had that that magical combination. Now it's reversing. So old costs are coming back online as we transition slowly or quickly back to Office, companies are advertising more, etc. But now new costs are coming back, are coming online in those new costs. To me, the two formative ones are labor, which we highlighted earlier, labor is the scarce resources that 70%-80% of operating expenses for America, that is a big big cost that companies have to deal with. To me, that's a step function change. That's a paradigm shifter right there. The second one is, I mean, it's all part and parcel the same thing, but ESG. So behaving in a more compliance is expensive. So if you're are an athleisure company or an apparel maker, you need to make sure your scope one two scope three emissions that that you know how much carbon you're emitting. What's your supply chain look like from a human rights abuse standpoint, all this stuff's going to cost money. Right, and you can either take care of it on the front end, or you can wait and take care of on the back end, which means your customers fire you. So that to me, it's to me, it's the cost side.
Geremy: Right. So that's actually really, really interesting. So when I, when I think about wages, I think, I mean, sorry, I think about earnings, I think, well, we've had a great period of time here since the Great Depression, right. We like the Great Recession. Since 2008. We've had an easy fed, unbelievably economy, accommodative central banks all over the world. We've had globalization, we've had favorable demographics, right. And we've had really low inflation, and we've had really low interest rates, and all of those factors, so low inflation, low interest rates, positive fed. And then it has been extremely profitable for businesses and globalization. And so if you think about that, you go, what could change? Well, yeah, sounds like it is inflation. It sounds like the Fed is gonna do something. And it's, it's, it sounds like globalization has come to a grinding halt. And, it sounds like wages are problem, right. And, so I, I picked up this new book, and I've been reading it, and it, it really presents this incredibly interesting idea, which is, which is that a lot of the favorable demographics that we've had for wages has been because of Eastern Bloc, Europe, and China come and India coming onto the marketplace at the same time. And so that was, say, 20 years ago, 25 years ago, they just like exploded the supply chain, with over a billion workers. And now we're 20-25 years into that. And they're all retiring. Or they're getting older. And so here in the US alone, last year, we had 3 million people leave the workforce from retirement alone. Yeah, we had 40% of 40% of workers get a new job, which still is just astounding to me. And so there's definitely like, it feels like it feels like when you have more workers, you have more demand. But what this book says is if you have more workers, you have more supply. It's just so logical to me. And I just never thought of it that way.
Rob: Yeah. And I think of it, you know, what, what sort of scarring or what sort of changes does the pandemic bring or has it brought, it's done a lot of things, but for companies, specifically, they about the tailwinds of margin expansion over the last 30 years, or maybe just put it in this perspective in the post GFC era, so from 2009, to the GCR, 2020, you had a 2% economic growth environment yet profits were up 300%. So how do you how do you triangle that or how do you reconcile that so companies were elongating supply chains, you had companies taking just in time delivery to the to the extreme, now, companies are willing to swap out efficiency, and peak margin for lower margin and dependability. So it's better to be able to have something on your shelf to satisfy that customer than to have peak margin to satisfy a shareholder. So the transition to higher wages transition from JIT to let's call it JIC just in case, the transition to be more environmentally friendly, using recycled plastic over virgin plastic, etc, etc. All of that is inflation to spend, and Op- X and CAPEX. And my guess is it's probably deflationary to margin because not all companies are going to be able to pass that those higher prices along.
Geremy: Particularly services. So anyway, so I guess we've just launched we just jumped right into the inflation category here. So inflation is obviously going to be a big theme for 2022. And the only way I could see inflation just kind of surprising on the low side would be that if asset prices had a hiccup, right, so I think a lot of this inflation problem depends on asset prices. I think people tell me how you feel about this. I think people feel wealthier. I think the economy is better. I think there's just so much more money flowing around because asset prices are high. And I think if asset prices don't perform well, since my first point on inflation would be if asset prices don't perform well, we have a hiccup year here, which, you know, of course, the stock market's not supposed to go down. But if we have a hiccup here, I think all bets on inflation are off. I that's what I think. I think that could reset inflation pretty quickly. But how do you feel about that?
Rob: A little bit of both. So I agree and disagree. So I think there is a a wealth effect, that's taking place. So capitalism requires capital accumulation. In order to have a capital accumulation, you have to have a hurdle rate, what the Fed did was take real interest rates and make them negative. So when you take the real cost of capital, or the real hurdle rate, and you make it negative, what it does is it's akin to shutting off gravity, it inflates all asset prices and digital effects to homes to everything. And so you had that happen and that wealth effect makes everyone feel obviously wealthier, richer, and that feeds into capital market. So I think you're right. In that regard. I guess what I would counter a little bit to that is that, despite my let's say, less than constructive view on the trajectory of profits and asset prices, I think the economy itself is fine, in terms of because the consumer is so strong. So wage income is very strong in nominal terms, maybe less so when you when inflation adjusted, there's still large excess savings from the stimulus leftover on household balance sheets, net worth is at an all time high. Now, to your point, that's a function, right, obviously, of asset prices. And then households have plenty of equity in their homes. And finally, most notably, they didn't lever their balance sheet like they did leading up to the GFC. So I still do worry that to the extent that you get a significant drawdown in the equity market, there's still a lot of, you know, it's a good thing to the economy, but there's still a lot of excess savings to be deployed, that can keep you out of a recession. But it doesn't mean that you don't see significant haircut to profitability and markets.
Geremy: Yeah, so I don't really know what's worse if the market did go down. And we continued to have inflation or if the market went down, and we didn't have inflation. It doesn't sound quite right. But let's not bank on the worst case scenario. So the likely case scenario is that inflation is way more persistent, not just kind of more persistent, but way more persistent than originally thought. And, so the persistent factors of inflation, for me seem to be this worker problem. It was really eye opening to me that when you have the that the amount of workers leaving the workforce around the world, when you have your labor force participation rate globally shrinking every year, but that's not necessarily a cost to demand if asset prices are high, and the economy's good. It's a cost of supply. And so the answer to that would be higher wages, and isn't higher wages in the 70s. So exactly what happened in the 70s, you had the 1960s was a time of stimulus. And then the workers sort of revolted a bit and said, I want to get paid more. And that set off a wage price spiral. That was very hard to contain.
Rob: Yeah, and that's the dangerous game that central banks are playing. So you know, I mentioned earlier, the Fed's balance sheet 40% of GDP in Europe, it's almost 2x that and then you mix that in here with a potential wage price spiral, which it's not just a function of the pandemic, I'd argue that the pandemic was just the the fire or that the match that lit the fire. The Tinder was years and years of underpayment. And so that balance of power, like you saw in the 70s, that you mentioned, switching from a capital back to labor, that they've painted themselves in a box here, the central bankers have.
Geremy: I think they have and it has been historically made clear to me through just suddenly in the last three months just cramming on inflation and history is that central banks are seem to always be behind the curve. They just are very afraid to upset asset prices.
Rob: Yeah. Which to me is frustrating because central bank intervention has been the problem masquerading as the solution. So when you debase the money supply, what does that or debase money if you will and extend the money supply, we know what it's intended to do is to create money, velocity and economic wealth. But instead, it just created inflation in asset prices because it signaled to the producer, the economy's weak, don't invest. So companies didn't invest in people property plant equipment, which is what the Fed intended it to do. Instead, it went into balance sheet financialization, which accelerated the wealth gap. And in now, I think we shouldn't be surprised that workers are saying, well, no, I'm not going to go back to that job and risk my health so that pay when I can get a better job better pay elsewhere.
Geremy: Exactly. So which gets to the second part of this, which is the supply chain, and you said something very subtle there is that in an environment when there's a disincentive to invest and the incentive is to really, you know, financial engineer your balance sheet, right. So in simple terms, it feels like businesses spent all their extra money that they had during this profit margin boom, they spent all this extra money, just reinvesting in their own stocks. And they didn't build us enough factories and all that. So now you take the GDP from two to six, right. And the whole system breaks, and then we have this supply chain problem, right. So we don't have enough factories, onshore, we offshore all to one region of the world, who actually seems to be doing a pretty good job getting everything at least to 100 miles off the coast of LA. And then, and then we can't get it to market. And so this supply chain thing, to me just seems like businesses being behind the ball, and not investing their capital correctly.
Rob: That's correct. So it's a function of supply chains that were to stretch. But then more specifically, today, the supply problems aren't a function of companies under investing in the chain itself. It's a function of excess demand, and not enough workers, which to me, is the system pushing back on itself. To me that's symptomatic of a system that was under investing, which gets back to how could profits be 250 to 300%, for 10-11 years, against what was the weakest economic growth cycle, since the US Civil War.
Geremy: It really feels like the natural rate of growth was very slow. The Fed created all this money, and a few participants being businesses and investors gobbled all the money up, it made the problem worse, and now they're sitting on that money. And it, and then you take the economy up to from two to eight, or two to six, and the whole system has an imbalance. So what's the Fed going to do? So we've got this fed who spent 10 years, expanding their balance sheet keeping interest rates at zero, by the way, they're still at zero. And inflation is 6.8% on the CPU. And that's the largest gap in history. So, and I actually went back and studied all that, like how the Fed has kept ahead of inflation, you know, the Fed has two goals is to remind our listeners, the first goal is to keep inflation at 2%, which is now an average somewhere near 2%. They changed our language on that. And then they had a secondary goal they added after the financial crisis, which was to maintain full employment. And both of those have been breached. Well, we're arguably above full employment, and we're arguably way above 2% inflation. So what's the Fed gonna do?
Rob: I, you know, you need to let the market price risk accordingly. So when I think about Central Bank intervention, maybe beyond the changing of interest rates, but when we're talking about quantitative easing, what's that is to me Central Bank's de facto telling the marketplace, me, you, all the listeners, that we can price risk better than you, right, you're pricing risk a certain way. We don't like the way it's being priced. So we're going to manipulate that. So I think of a little bit like an elastic band or a rubber band, you can keep stretching and stretching and stretching it to put off that inevitable pain or price adjustment, but ultimately, you have to let it go. And so I don't know what they're going to do. I guess maybe more important to me, what will they be forced to do? What will the markets force them to do right now over the last several weeks, the bond market is forcing their hand and then it's not even what they will do. It's what the market discounted before it happens in the end. That's what the equity market is now doing the equity market, together with the bond market is discounting a higher hurdle rate a higher cost to capital and you're seeing that start to play out in person.
Geremy: The bond markets finally starting to get a little weak here. So the bond market could be weak for many reasons. It doesn't have to be weak because of inflation. It could be weak just competing capital or or growth outstripping the interest rates. And so there's been really high in my mind, there's been zero weakness in the bond market for years. It's been an unbelievably strong place to be. And, but I guess you're right, that the Fed is signaling to investors. Well, if we're buying bonds, you should buy bonds. That's kind of a simple way of putting it right. And it is amazing that so there are two tools are quantitative easing. And, the Fed funds rate the obvious target would be to stop the quantitative easing, but they haven't.
Rob: Right. They decelerate it. And I think the next I think what the market will be looking out for is not just how many rate hikes so it's gone from two to three to quickly now four in the last few days for expectations of four rate hikes, but how quickly do they go from QE to tapering to QT? Quantitative tightening, and now that is specifically extracting capital out of the system. And that's a very, very different, you know, you've had a number of investors, and we'll put it this way, any investor that's come into the market, post 2009 has been trained by, I guess, the market to believe that central banks can create wealth, they don't create wealth, they just create money.
Geremy: Right. So okay, so it sounds like asset prices are high, but earnings have been incredibly good. Earnings have been good because of an accommodative fed low interest rates, low inflation, positive wage dynamics, and reinvestment of capital into financial engineering, which has all been a function of this prior era that we've lived in COVID happen, which sounds like we're entering into a new era, and this new era looks like inflation, and a tighter fit. So what does that do to asset prices? So we've got stocks, got bonds, that real estate, got a lot of things riding on, on this these new variables.
Rob: Yeah. I guess maybe my answer will be, volatility is nothing more than the market pricing for incorrect assumptions. And I think the assumptions have been that economic growth is strong fundamentals is strong, profit growth is strong, and all of that is sustainable, and ESG is for free. And I guess I would offer those assumptions were perhaps a bit too strong. And so you know, you have peak GDP, peak stimulus, peak revenue growth, peak profit peak, accommodative monetary policy peak, this all of its peak, so it's not going to be peak going forward. And I think what you'll start to see, and is a little bit of pain. So companies that don't have a sustainable value proposition cash flows, durable cash flows. You've already seen it in tech stocks, right. So Mark, the market will it's not going to pay the same premium for concept stocks, or high profit stocks to me high profit concept stocks, when the alternative is a 2 plus 10 year Treasury or wider or higher high yield, high grade bonds, etc.
Geremy: Right. So there would be I guess, in you know, what my language I would say that we're probably in for some form of a compression of the P/E multiple and margins, right. So margins and P/E multiples may be sort of go hand in hand, as margins are expanding P/E multiples are expanding. And so the headwinds that rising interest rates, inflation or a tight Fed could bring would be headwinds to earnings.
Rob: Yeah, it's a dangerous mix. So if you if we just think of the inverse of what's happened, so you had margin surprised to the upside in the form of all time high margins, and interest rates surprise to the downside, which you noted earlier. So that's those are two powerful tailwinds to stock prices. In 2022 what we could get is margins surprise to the downside because revenues decelerate with fading stimulus costs accrue faster than expected for all the reasons we talked about. Combined with higher interest rates. Which equates to lower multiple. So that's a dangerous calculus that I don't think is being discounted. I think the market is starting to discount right now.
Geremy: Yeah. And it feels, you know, it feels like there's a lot of so that feels like there's this change going on here. And the last time I can remember, this change was around 2001-2002, leading into 2008. We had a tightening, tightening fed, and we had an inflation cycle in there, it wasn't nearly like the 70s. But you had a, you know, and that created a lot of change. It wasn't necessarily horrible for asset prices. But it the leadership changed, right, and that's the most near to our history to look at would be for investors to look at 2002 to early 2008, which was when the Fed was tightening, and interest rates were rising. And during that time period, we had emerging market stocks just dominate all other assets. I'm not really sure if it's the same dynamic today, or a but it does feel like the same situation where you have everybody on one side of the canoe and US and service based companies, right. And then inflation comes and they roll to the other side of the canoe, which is industrial resources, weaker, the weaker dollar causes businesses to do better than services and international stocks to maybe have EMstocks specifically to maybe have an advantage.
Rob: Yeah, where I think you might see the same end result. I think we get there a little differently than we did then. So then you had a booming growth rate out of Asia, specifically China that sparked the commodity supercycle so EM being a more cyclically oriented sector had massive, massive operating leverage, right. So huge, huge revenue growth against the fixed cost structure, massive profit growth. And to me that explains that EML performance. This time, I don't think we see that because obviously, the China growth trajectory has changed dramatically, or it's very different from what it was then it won't be nearly the same impulse to global growth the next 20 years as what's in the last 20 years. But to me, the bull case for EM equities is finally it's not to me, it's not dissimilar than US equities 100 years ago, whereas US equities were or US companies, they were a GDP oriented cyclical companies, high fixed costs, and they benefited when you had high GDP growth. And that's still the case, but far, far less, right. They are incrementally looking more like US companies in terms of flexible cost structures, revenues, independent of GDP, ie more technical tech oriented companies, more growth oriented companies, they're not just moving rocks or building buildings, or selling toothpaste, they're more high intellectual property. And so to me, that better margin profile, that higher quality income stream that warrants a tighter multiple to us or develop stocks. And that's where I get my optimism from.
Geremy: Right. So I would characterize that a little bit, maybe in the way I was thinking about it is that it does feel like there's an awful lot of money in one place. I don't think, you know, the worst case always happens. But it feels kind of likely that you would have some money rolling into other areas that also could have a tailwind in this kind of environment. And so I think, I think investors are first thinking, Oh, inflation and tight fed, is the market gonna crash. No, that's not what I'm saying. What I'm saying is, is that wherever the trajectory of the way things have unfolded, could be subject to change. And when that change happens, it might be to something that has been sort of left behind in this environment. So let's talk about the Fed and interest rates, right. So interest rising interest rates are, you know, that's the bond markets enemy. And the Fed feels like it's gonna raise the Fed funds rate here. But you know, the bond markets been surprisingly strong. I mean, this is the first time the 30 year treasuries gone above two in quite some time. And finally, I mean, it's hard to even say that all we're concerned about the bond market because the Treasury, the 30, year Treasury went above two, that just still seems extremely low.
Rob: Right no, and so you know, we're talking about higher rates. But I think we're not talking about materially higher rates, because what hasn't changed is is the growth trajectory. So if you think about it, you mentioned them earlier, what were the things that kept economic growth weak in the post GFC cycle, it was slowing demographics. Globalization, which is is deflationary technology is disinflationary. digitalization and too much debt. Not a lot has changed demographics are worse, digitalization is stronger. And countries or the US is materially more indebted, at least on the public sector side. So, you know, while we're talking about higher rates, I don't think we're talking about a 1994, or something like what you saw in the 70s is just let's just get back to some sort of neutral level, which is a 10 Year Treasury probably north of 2%.
Geremy: Yeah, so, it feels like the Fed can get away with a controlled and measured increase here without decimating interest rates or the bond market. And if we just look back at, you know, in my lifetime, the Fed raised rates in 94, 98. They raise rates, in 03-08, and they raised rates a couple of times, we've actually raised rates like, a bunch of times in 18, but got nowhere. So the nearest the or the nearest rate hike cycle to us today was 2018. And if you recall, the Fed raised rates about I think, nine times and got it to about 2.5% 2.25-2.5, was the guidance, I think. And then stock market dropped, and everybody just went, cried foul, right. They, they almost it almost feels like they twisted the Feds arm back into lowering rates. You know, and, it, you know, I don't want that to be the the model but that's the nearest model to what we had was that the Fed can't raise them too much before it starts to upset asset prices. And before investors and politicians and everybody, because everybody's all in on this, everybody starts complaining.
Rob: Is the economy strong enough to handle a three hand on the 10 year treasury, right, it's I don't think the economy is that strong households are strong consumers are strong. But given those things that we talked about as wages rise that's going to eat into profits, that's going to eat into margins. If it doesn't, it means companies are able to pass that along, and the wage price spiral turns into an inflationary environment. So I think the central bank is going to protect against that. And that's why I just have a hard time envisioning the 10 year treasury, something materially different materially higher than what it was pre Corona.
Geremy: Yeah. And I think a lot depends on this interest rate part. So I think we, you know, while we have an accommodative fed, all the accommodations of the Fed are just to really keep interest rates down. And I think the interest rate, you know, we've become, we're probably more interest rate sensitive today than ever before, because there's more debt and more borrowing. And, so I think it's a powerful tool that they're playing with. And but I would like to see them do some raising of rates here. So for your bond for bond investors, there's two things that at least historically, I've seen when the Fed raises rates, and you can comment on this is that is that the bond market in the marketplace, the bonds that are to years and out. Generally, you know, the marketplace raises discounts or raises the interest rates there before the Fed raises rates. So often, the rates in the marketplace are the rates on mortgages, and the rates on car loans, and all that stuff is already higher, before the Fed raises rates. So maybe that's what we're seeing now. This is the indication that the market saying hey, fed you better raise rates.
Rob: Yeah, well, the two year Treasury pushing 1%, so the markets been doing that steadily over the last several weeks.
Geremy: Yeah. So that says two years from now, the Fed funds rate should be one. And under normal spread, then then that puts, you know, the, the long end three, right. And then often, what happens is the Fed will keep raising because they get a window, and they can do it. And then the yield curve flatness, which is a part that investors, so there's a two part equation here. The market price is what the Fed should be at the Fed moves to that level, and then the long end actually comes down, which is very interesting. So right now it does look like I think the 2 year bond that you mentioned at close to 1%. Sounds about right. So two years from now, the Fed funds rate should be two. That's probably about right.
Rob: Yeah, it feels right, somewhere around that range.
Geremy: Sorry, the two years should be about one. I'm sorry. Yeah, that's what I meant. So the two year bond, meaning two years from now, the Fed funds rate should be about one which doesn't sound dramatic and historic since the Fed has raised rates, you know, between 2% and 3% historically, when they do raise, so they'll go on a campaign. We got a lot going on in 2022. Yeah. So, uh, before we leave. And we've certainly taken some good time here, and I think we've covered the whole battleground. Is there anything you want to leave us with? Is there any point that we didn't talk about or something that you feel like is worthy of talking about that others aren't?
Rob: No, I think we cover all the important things I guess for me. You know, investing is simple, but hard. And we and stop me if I covered this last time, this is me standing on my soapbox. Investing is simple in terms of it's all about cash flows, cash flows, cash flow, and we covered that investing is hard, because the future is uncertain. The future possesses no facts, we have no idea, right. What the future is going to look like. So we don't know what those cash flows are going to be. And I guess if I sort of summarize, the last 18 months where we are where I think we're headed, rising inflation, which is what we've had, it correlates with rising sales, which is what we've had right revenue growth of 20 to 30%. We talked about that. It throughout history, what you see is, okay, you get inflation, you get rising sales growth, but then what happens is post the inflation, you get margin deterioration. So, rising inflation correlates with revenue growth, sales, growth, etc. But inversely correlates with margin, because what happens is, as the inflation fades, and, you know, whether the Feds able to handle the quickly or slowly, regardless, what stays on the books, if you will, is wages or maybe higher input costs. And so I think for those listening, you know, when you get confused, and there's so many external conflating data points, and how to make sense of it all, to me, just, it should always come back to how will this affect profits. And so looking out, I think, I just think you see a deceleration, of revenue growth, because the Fed is going to squeeze that off, it's gonna squeeze that inflation off, but what it's not gonna be able to squeeze off is higher input costs, whether it's from energy, labor, interest rates, etc. And that's gonna lead into a different profit mix and what you've been used to.
Geremy: Yeah. And so that really encapsulates, you know, this sort of the sort of theme of 2022 It feels like, high asset prices driven by great earnings. Versus inflation. And, and so, wow, that was good. You just button that up. So Excellent. All right. Well, I'm so glad to have you back on.
Rob: Yeah. Thank you.
Geremy: I really appreciate you being on here. I think that we really, I think we really covered all the major themes here. I think it's going to be an interesting year, maybe a year of change, maybe a year, more of the same. But I think investors are certainly betting on more of the same, but there could be some changes here. I think, you know, this doesn't have to sound dour or negative. It's just hey, while we're looking at the world and rose colored glasses, it's it's okay to look over here and say, well, what could happen, you know, and so I think this is a little bit of temperament, which is fine in this euphoric environment.
Rob: I think that's right. Well, I think you know, which is what's important is even in the midst of all that, if you own a company, a financial asset that has durable cash flows, it will be fine. Maybe not during the turmoil, but in three years, five years, it'll be just fine. And that's why you know, people hire just pay for discretionary advice put me in something that a chicken coop that's gonna be able to produce eggs.
Geremy: Hopefully, it's a little more complicated than chicken coop versus egg. That's a great analogy, right. We want we want lots of eggs out of our chicken coop and, and the really good ones, we'll be fine. Yeah. And, for our listeners here, you know, in times change in times of volatility. There's always been businesses that have thrived, you know, if you just you just you can look at any, you know, the, the nearest big catastrophe, you know, you just can't bank on the worst case scenario. Almost every time the markets have had hiccups, where valuations has been a big part of it. It hasn't been a huge catastrophe. It's just been a rolling from one out asset to a more valuable asset or something that, you know. So I think that there's the differences in expected returns of assets will become clear. And it won't be necessarily. If we do have volatility and we do have change, it won't be necessarily, you know, I don't feel like it's an environment that it won't still present opportunities and abilities to add value. Yes, it always does. Yeah, it always does. All right. Well, thanks a lot, Rob.
Rob: All right. Thank you.
Geremy: Yep. Hopefully we'll talk again soon.
Rob: All right. Sounds good. Take care.
Geremy: Have a great 2022.
Shannen: Well, Geremy, last year was a great year for the podcast, don't you think?
Geremy: Oh, yeah, absolutely. We covered a lot of ground with different podcasts and everything and thought we came up with a lot of live leaf subjects. But so far, after that interview.
Shannen: Yeah, great kickoff to this year. Yeah, did not disappoint.
Geremy: Did we cover all of the possibilities of things that can happen in 2022? So I think I warned that this would be unscripted and pretty fast paced. And so I tried to slow it down. And I know we had a lot of healthy topics. But it's all relevant. I mean, it just feels like right now. We're just at the cusp of something.
Shannen: Geremy, you're supposed to turn that off. Before we start.
Geremy: It feels right now that we're completely at the cost of something. I mean, I like like, I know that we've been running down a very narrow track with s&p leadership and low interest rates for a long time. And it just feels like we've come to a head here. Like there's just all sorts of points of information butting up against each other.
Shannen: I heard you talk about getting fractional shares when using a credit card. Can you imagine what's going to happen in 10 years If that's happening now.
Geremy: Oh, well, it just it just goes to show the popularity of stock ownership, right. If, you know, generally, I guess with credit cards, your rewards or miles or cash back, but now shares back right. And so it, with technology and ease access of investing and with the negative real interest rates with with savings rates below inflation, why wouldn't everybody invest? You can just invest five bucks. And so I think that investing is it 10 years from now will be just universal. Like, there won't be such a thing as saving. So I mean, there'll be savings, but essentially, everybody will have some form of custodial accounts and money will go directly into their custodial accounts. And they'll just use a credit card or debit card right out of their investment account.
Shannen: Yeah. It's crazy to me. All right, let's recap the wealth effect. When it comes to inflation. I thought that was really interesting part of your guys's conversation.
Geremy: Yeah, thanks for bringing that up. I think it's really interesting to I think it goes on notice, I think that the people think there's some sort of natural force in the economy, which is there is a natural force in the economy, which is people get up, they go to work, they create things, they innovate, they run companies, and they make money. But then there's sort of a tailwind in the economy. And so if if the economy has a large portion of it being savers, and it has a portion of the economy that are in the investor class, and that's, you know, 10 to 20% of the economy are investors, then, if and then, you know, with housing, almost everybody is sort of trying to get into the housing market, everybody needs a place to live. So you don't really have like, almost all of your assets or investments are subject to price change. And so your wealth can change just based on on how well the stock market or the housing market is doing. And then the Fed can influence that. So how well the housing market is clearly influenced by the Fed interest rates. If interest rates are low, the housing market does well. And then everybody feels wealthier. And if everybody feels they spend more money. So what's the rub? Right, what is a nice virtuous circle? So I think the rub is inflation. If you keep doing that long enough, then you can have inflationary pressures.
Shannen: Yeah. So Rob talked about investing is simple but hard. I just feel like that's so true. It's hard. He said, It's hard because the future is uncertain.
Geremy: Correct. Right. So is that one of the there's two there's two things in that statement, I think. And the first is Yeah, it's really easy because now we have an app and like I said, I think people's savings accounts could be attached their investment accounts period pretty soon and, and it'll just be pushing buttons and and everybody can be an investor. So it's very easy to push a button and buy some stock or a mutual fund or an ETF. And but which one to buy? is very difficult, right.
Shannen: Because it's a guessing game.
Geremy: Yeah, well, it's there's some there's some art and science to it too. We don't just guess the average person. We don't just guess over here at Frontier. But yeah, the hard part is that leap from the past to the future. And so all you have to go on is the past, and you collect all this information. That's known information of what has happened. But then you don't know what's going to happen. And I think one of the things that people get caught in one of the loops they get caught in is they, they could say that this stock or this mutual fund, or this capital market, or this ETF has performed really well in the past. But that doesn't necessarily mean it will continue to perform really well in the future. And that future part is what we live in. We don't get to go backwards, the returns we're going to experience are going to be whatever, from the date we purchase something. And we probably purchase it purchased it for some partially due to the past.
Shannen: Yeah, absolutely. Well, I think that was a great kickoff to 2022. Yeah, great interview to start with.
Geremy: I think so too. I think it was, it was a lot of information. And but I think it was all pertinent information. And again, I say, I feel like we've come to a head here. There's a lot of forces that are kind of butting up against each other. I think Rob summarized it really well. When he said we have high asset prices, peak earnings, peak fed, excellent economy, all things are sort of in investing favor. Yet we have inflation. And inflation is a pretty big force. And so maybe, big changes, maybe not. But certainly a lot to think about here on this podcast. So I Shannen, I appreciate you listening to all this.
Shannen: Absolutely. Some of it's above my head, I'm not gonna lie.
Geremy: And I want to thank the audience for listening. And hopefully, there was a lot of good information in here for you to help you plan out your year for investing in 2022. Thank you, everybody.