Yung Lim, the Chief Investment Officer at FolioBeyond, has joined the ETF Think Tank in the past to discuss the fixed income space when both rates and inflation started rising. With the Fed potentially getting ready to end its rate hiking cycle soon, it makes sense to bring him back to get his updated lay of the land. This time, he’s brought fellow FolioBeyond strategists, Dean Smith and George Lucaci, to offer their thoughts as well.
Last week’s CPI report got a lot of attention, but did it actually change anything? Lim says that the CPI is just one of many numbers to consider. He was a little surprised that the bond market rallied given the numbers were about what was expected, but the bigger takeaway is the ongoing positive correlation between stocks and bonds. This isn’t helping investors with the ability to diversify risks. Smith adds that it would be unwise to fight the Fed here. There’s been some mixed messaging, but so far, they’ve done everything they said they were going to do. The Fed says it’s going above 5%, but the bond market doesn’t believe it. That gap in expectations can create volatility in the future.
Lucaci notes that one of the biggest themes he sees happening over the next couple years is an increase in protectionism. We’re going to see the U.S. continue to restore manufacturing jobs and he thinks that’s here to stay. That could push the unemployment rate down, but it could also send wages up again. We may see another bout of inflation due to this and a structural change in the labor market could mean it sustains longer-term. Other countries will do this as well. Neighboring countries might have more trade opportunities, but this will be a trend that develops globally.
Is inflation going to be a decade-long problem? Lucaci says that once inflation hits 5%, it can historically take a decade to unwind. His group believes that inflation will start to normalize at higher levels. Smith notes that most people believe that inflation has peaked, but what if it hasn’t? A lot of bullishness is coming from people who’ve never seen a bear market in interest rates. Investors need to manage risk and reduce tail exposures.
Will the Fed be able to follow through on its rate policy plans? Smith says that if Powell backtracks now, the Fed loses all credibility. Unfortunately, we’re still seeing price increases throughout the system. Everybody is getting a pay decrease in real terms. Credit card debt is the highest it’s ever been. Savings rates are at a low. The middle class and 2-income households are the ones that haven’t been able to keep up.
Other key takeaways:
- Where should the unemployment rate be? Historically, 4-5% seems to be the sweet spot for the modern economy. If it happens to move to 6%, that’s still manageable for the economy.
- Smith says that the ideal inflation target should be 0%. Creating a 2% inflation target allows some wiggle room in case something goes wrong, and rates need to be adjusted.
- Lim says that people talk a lot about the 60/40 portfolio, and he believes that it has its merits, but adding a component that is inflation-focused is a good way to diversify risk.
- How will the Fed’s balance sheet look in 2024? Probably not that different. There’s not enough capacity in the market to absorb it without creating a major disruption. The Fed will have trouble getting the balance sheet down.
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