Rob Almeida

Welcome to another edition of the MFS Strategist Corner podcast. My name is Rob Almeida, Chief Investment Strategist and Multi-Asset Portfolio Manager.

Disclosure Voice

The views expressed are those of the speaker and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as an offer of securities or investment advice. No forecast can be guaranteed. Past performance is no guarantee of future results.

Rob Almeida

In this episode, I chat with our chief economist, Erik Weisman, where we discuss that while New Year economic, rate, and market forecasts are usually proved wrong just a few months into the New Year, how 2022 became the new example for wildly wrong forecasts, followed by a discussion on recession risk for 2023 and our long-term perspective on risk assets.

Rob Almeida

Erik, how are you?

Erik Weisman

I'm fine and dandy.

Rob Almeida

Welcome. You know, it's funny you say that because I see you every single day.

Erik Weisman

Yes, indeed.

Rob Almeida

All right. So how did forecasters get 2022 inflation and interest rates so wrong? All right. Let me rephrase that. Give us some perspective on the magnitude of the error of forecast this year.

Erik Weisman

So to give you a sense of that, we'll use Bob Uecker: just a little outside. So coming into the year, expectations were that the Fed would raise rates to 1%, something like that. Inflation would wind up being a heck of a lot lower than it wound up being at its peak. That ten-year yields would be a lot lower than four, four and 25, which is what we saw at the peak - wildly off. And yet we enter into 2023 and everybody knows what's happening next.

Rob Almeida

They want to do it again.

Erik Weisman

That's right. So what's going to happen next? The Fed is going to raise rates 50 basis points in a few weeks and then it's going to raise rates 25 in February and maybe March and maybe May. And then we'll wait a few months, three months, six months, nine months, whatever. And then the Fed will start cutting and we'll see. Is it a soft landing? A soft, hard landing? A hard, hard landing. But that's how it's going to work, right? Rates are going to go bit higher. They're going to go sideways and then they're going to go lower. End of story. Print it. Just as we did when we were thinking about how 2022 would progress. So why are we so confident? Perhaps we should have a little more imagination and allow for a wider window of possibilities.

Rob Almeida

When you think about risk, it's probability of event and then impact in magnitude. And it just seems and when we say we, we're talking about Wall Street, not specifically. It just seems like we investors have enormous confidence, if not hubris in our forecast and don't allow for those tails. But it's usually those tails where maybe it's a low probability, but it's a big impact and it's just not factored enough into models. Do you think it's hubris? Is it confidence? Is it it's just the future has no facts are all the above?

Erik Weisman

I think people feel like they know what's going to happen and I think they feel like they can look to something in the past. In general, I think it's unwarranted. And if we sit here long enough, I'm sure we can come up with all sorts of scenarios that nobody's thinking about. So maybe the Fed doesn't raise rates beyond December and maybe they're cutting in a handful of months. Maybe the Fed has to raise rates well beyond May and they keep them higher and then they realize we haven't raised them enough and they have to pivot again and raise rates even higher. Maybe we wind up having a mild recession. Maybe we wind up having a horrible recession. There are so many different outcomes and so many different paths for the Fed and thus so many different paths that nominal rates can take. You know, when you're looking at markets, when you're looking at forward metrics, that tells you what all the forward curves are telling you. Well, it's a bunch of different people who have different ideas. And when you average them together, maybe you get something that seems uninteresting, but yet you've got some people who think that you're going to get one extreme and some people who think you're going to get another extreme. And it can mask all of those different possibilities. But those people who aren't involved in actually either making those surveys or are not market makers and aren't involved in that number itself, look at the number and say, oh, well, this is what's going to happen. No, no. There are lots of opinions out there.

Rob Almeida

Well, it gets back to a point or rather a presentation you made at one of our investment roundtables years ago. I forget what year it was. 7-8-9-10, but be careful what you think you know, and I think, you know, not to - as a commercial for MFS, but I think that's what we do a good job of here. At least we're incented to think about what we don't know and it just seems sometimes with these forecasts that investors, particularly sell side, who make a living on printing forecasts just anchor really really hard to these things and don't give enough ample room for a wild card event which is what 2022 brought.

Erik Weisman

Absolutely.

Rob Almeida

Do you think there's too much emphasis on short rates? In other words, too much emphasis on what the men and women at the Federal Reserve are going to do and not enough emphasis on really what matters over five or ten years for interest rates as illustrated by the shape of the curve today?

Erik Weisman

Almost certainly. Right. I mean, markets have become increasingly myopic. It's all about what's the next quarterly earnings report. Everybody's paid based on this - 'course, we're not paid based on that. We're paid based on long term forecasting. But you know, long term forecasting is going to be made up of a series of short-term forecasts. So you can't really get around that - but there probably isn't enough questioning of where do you land when all of the dust settles? And by that I mean fine. The Fed's going to do what it's going to do. It's either going to cause a recession or it's not going to cause a recession. Then you're going to wind up having a period, in all likelihood, where the Fed does cut rates because rates will be too high. Then you're going to wind up having some sort of a recovery or rebound depending on whether we have a recession or not. What does it look like after that? What is the next business cycle look like? What are its foundations? What's driving it? What's driving the economy? What's driving inflation? And I think people aren't really focusing on that at the moment. Maybe that makes a lot of sense because we're in the midst of some kind of a paradigm shift here and it makes it harder to focus on 1 to 3 years out.

Erik Weisman

You have less visibility, but at the end of the day, that's what's going to wind up driving assets and returns.

Rob Almeida

Well, let's get into that, because I think you're right. You're in the transition, so it's harder to see out - and we think you're in the midst of a paradigm shift and people are anchoring to the great moderation and the stagnation. But now the rules of the game are changing. So the shape of the yield curve is telling us something - not just 2's, 10's, but like you've made the point whether it's 3's 10's, 2's 10's, three, it's all inverted and deeply inverted. So as the dust starts to shake out and I think we - you've particularly been pretty consistent on this, that growth will be a little bit better, inflation will be a little bit higher. Do you still hold that view? What does this look like? Really post-recession.

Erik Weisman

So post-recession and then post whatever the recovery looks like - might be jobless. It might not be. I think we're going to live in a world where we're throwing a lot more capital at the system. Physical capital. What's changed? Right. So you think about the last business cycle. There's an awful lot of talk about this transition from physical capital to intangible capital. And the call on intangible capital demands less actual funding. Right? So I've got a great idea. It rhymes with Airbnb. Well, you know, I'll buy six computers, hire four people, I'll tell them all to work from home. And I've created a company. I think that we're going to transition in the next business cycle to one that demands a greater call on physical capital. So green technology for energy, dirty energy to allow for that sort of transition, far more money that's spent on the military, a lot more capital that's necessary in order to create these redundant supply chains and moving from just in time to just in case, that's going to demand, I think a lot more capital than what we witnessed in the last business cycle.

Rob Almeida

And capital that's a lot more expensive.

Erik Weisman

It's more expensive. It's physical capital, which means you actually need the dollars as opposed to the intangible capital. And I have this question as to what's the run rate of savings look like in the next business cycle. And I think the run rate, while still positive, is likely to be slower than it was in the previous business cycle. If not the last several business cycles. So if the call on physical capital is rising at a faster rate and the rise in savings is falling, still positive, but falling, seems to me that that rhymes with higher inflation, higher interest rates. And the capital itself, though, I think will give us a slightly higher real GDP growth level,

Rob Almeida

Which makes sense. And because you're the economist, I'm not - so when I think of

Erik Weisman

And lucky for you

Rob Almeida

Stagnation, right? So the post GFC secular stagnation, great moderation, whatever economists want to call it to me that occurs when savings exceeds investment. Is that a simple is that a fair, simple assumption?

Erik Weisman

Sure.

Rob Almeida

So what you're describing. Sure. Okay, Rob, fine. But in what you're describing is something that's not stagnation, something where spending is higher, and savings is lower, at least relative to the post GFC era.

Erik Weisman

That's it. That's right. Now, you know, given that I'm the economist, I can bring out as many hands as I want. So I got another hand

Rob Almeida

like an octopus?

Erik Weisman

at least. At least. You know, one caveat to this is we've got a tremendous amount of public sector debt. We've got higher interest rates. You're going to be spending more money on interest on the public debt. And theoretically, this could crowd out private capital. In practice, I'm just not so sure that actually happens that way. Other things need to happen as well, and an awful lot of that is going to be whether or not the banking system is willing to lend capital, right? So is credit going to go out the door? And I think banks are in relatively pretty good shape and they're going to be very excited to be on the other side of whatever this softness is, whether it's a recession or not. And I think we will see that credit and capital will get out the door even if the federal government has to spend more money on paying interest on the public debt.

Rob Almeida

Yeah, let's transition, because I think investors often conflate GDP, the economy, with risk assets. So how do you think this translates into risk assets? So we've got a better growth environment, potentially, a little bit higher inflation, more capital spend, presumably better pay for labor, all those things you would think on the surface would translate into better returns on capital. Maybe it will. Maybe won't. How do you think about that? It's not tomorrow, but looking at the next five, ten years versus the post GFC era.

Erik Weisman

I think it's complicated. So to your point, how much are we going to pay labor? Yeah. And how much labor scarcity is there? What are we going to do with our immigration policy? What are we going to do in terms of allowing people to cross the border? And if you tell me that labor is going to get a larger piece of the pie? Well, I mean, you're the one that will talk about that all day long. Right. That's just not accretive for corporate America. And I think we're probably going to wind up seeing corporate America a little bit more in the crosshairs from both political parties because now it becomes politically expedient. So I'm a little bit worried that it's not going to be quite as beneficial to the bottom line for corporate America. It could, on the other hand, though, be quite beneficial to labor. Yeah. So it's a little bit of a double edged sword, right? If labor is doing well, well, you may be able to have a quite extended business cycle, but corporate America might not benefit from that as much as it would have in a world where labor doesn't maybe get quite as much from that pie.

Rob Almeida

Well, to that point, you know, you just decompose the accelerating growth of margins, EBITDA, profit, however you want to look at it over the last two decades, it is unquestionably a big chunk of that came from lower taxes, balance sheet financialization, offshoring, suppression of labor and all that's reversing. So yeah, I think people sometimes confuse our less than rosy outlook on maybe economics or risk markets relative to other firms, as it's bad for risk assets in aggregate. And that's just not the case. It's going to be, I think, meaningfully bad for, let's call them bad risk assets or a company that can't survive in that more difficult environment where labor costs more, you're being forced by investors to spend more to green-ify your business, if you will. And never mind, maybe like you mentioned, a politically or tax challenged environment and that should lead to greater profit dispersion. And some assets do really well or some companies do really well and some companies don't.

Erik Weisman

And to that point, I think the next business cycle you're going to see companies that are forced to spend more on capital to stand still. Right? So that's not good for productivity. That's not good for the bottom line. It could be good, though, for GDP. Right? Right. You need to spend more capital in that. Capital is going to need more labor. So it might be one of these moments where the economy looks better than what you would think that would map into in terms of asset valuations.

Rob Almeida

Sort of the inverse of the post GFC era where - Right, exactly. You know, if you were to go back in 2007 and tell someone, look, economic growth is going to be well below average, it's going to be the longest but weakest growth cycle in 150 years. But risk assets will be up 200 to 300%. I think most people would have thought, well, that's just another wildly off forecast like how we started this conversation.

Erik Weisman

I mean, if you say that the next business cycle is going to reward Main Street more than Wall Street, you know, that's a winner as far as politics are concerned. And it's a winner in terms of most of the population.

Rob Almeida

Yeah. So when we think about moral hazard, what's the probability? Because it's not zero. What's the probability that central banks are able to execute the same playbook for the last 10 to 15 years and reflate their balance sheets and socialize losses like they have in the past? Because what I've been talking about is it just becomes a more difficult operating environment and there isn't going to be the, let's call it the Fed put - or a social safety net from central banks, because you can't do that with inflation. It's not going to be at 8%. But even if it's something at three or 4%, they're not going to be able to leverage the same playbook they had in the past. Where am I wrong in that?

Erik Weisman

So the combination of relatively loose monetary policy and really quite loose fiscal policy, not always, right? It ebbs and flows, but that combination, I think, is going to be very, very difficult to replicate going forward. At some point, the market is going to say to the public sector, you're carrying way too much debt and maybe they'll say it to the private sector as well. But we have seen deleveraging in banks. We've seen deleveraging in households, less so on the corporate balance sheet. But I think markets will only allow sovereigns to carry so much debt. And to this notion of growth rates that are slowing down, our population growth rate is slowing down. The labor force growth rate is slowing down. So not only do we have more debt to GDP, we have yet even more debt that is on the backs of a labor force that's growing more and more slowly. So - one way to think about it is how much debt is on the back of each hour worked by the labor force. And it's an increasingly increasing amount. At some point that's got to break down. And the way that you then address that is you need to have true kind of fiscal austerity. Well, good luck getting fiscal austerity going in this political environment. Oddly enough, the way to address that is ding, ding, ding, ding, ding, inflation. Right? So that's a magic cure all, although it's not one that everybody finds equally appealing.

Rob Almeida

Right. So let's sum this up. We're not going to make 2023 forecasts because we know what that's worth. But you've been talking internally, I think externally about rising odds of recession. So that's coming, whether it's in 23 or after that. But post that: growth a little bit better, inflation a little bit higher, economic output a little bit better. What should I add to that list?

Erik Weisman

So a lot of that's going to wind up being a 2024 or 25 story. And both of those, I think, as we think about them and use interest rates as a baseline. So whether you want to think of five year treasuries, ten year treasuries, if I'm right and there's a little more growth than the last business cycle, remember, the last business cycle was the 2% growth cycle. I think you're looking at something a little higher. The last business cycle was inflation that averaged one and three quarters. I think we're more likely to average two and three quarters, three and a quarter something higher. So a little bit more growth, maybe another percent plus of inflation. And then we talk about this magical thing that no one really understands called the term premium. How much are you demanding to hold these treasuries? We've had term premia based on these black box models that would say tenured term premia are negative, which essentially says that I'm going to pay for the privilege to own treasuries the further I go out in the curve, which seemingly doesn't make sense. I think that will also reverse which all would suggest that as we get into the sweet spot of the next business cycle, if in fact we have a recession, we're going to wind up seeing that interest rates are considerably higher than what they averaged in the last business cycle. So how do we transition into that? The transition itself could be challenging for those companies that have relied upon really, really low interest rates. But once you acclimate yourself to those higher interest rates, if they're relatively steady, it's not such a bad world. It's a world that good companies will have no problem acclimating themselves to. And if you're a bond holder and you're told, all right, I'm going to own a corporate bond, I'm going to get 100 basis points over a ten-year treasury. And the ten-year Treasury is 325. So I'm getting 425 just for holding a bond. Well, I like that. Cut me that coupon. So give me the 425. Give me an equity market that's giving me mid-single digits and I'm just throwing that out there. That's your purview, not mine. It doesn't sound so bad.

Rob Almeida

Well, that's right. When you add up those numbers. So let's call it a, you know, three handle Treasury and 100-150 over for corporate bonds and a 400 basis points of equity risk premium. I mean, you're looking at reasonable mid-single digit returns. And I think that's where people confuse our bearish seemingly soundingly bearish comments. But when we look out longer term for those companies that can acclimate successfully, I like the way you describe that - you're looking at risk premia that is pretty attractive for those institutions and enterprises that are doing the right things and can provide - that can generate economic return, not at the expense of some sort of stakeholder. Whether that's the environment. Whether that's a labor, whether that's a bondholder, but they're creating an equitable amount of return for all. And I think that's pretty good.

Erik Weisman

It's not too bad. And again, if we're going to have a recession, we're probably talking about 2024 for that.

Rob Almeida

Yeah, we've got to get through that first.

Erik Weisman

Right. If there is a recession, you know, my guess is we're going to be spending much of the second half of 2023 dealing with that recession. You know, for another podcast, we could talk about, well, when do equities find a bottom? When should you be trying to jump in if you think that there is in fact going to be a recession? And, you know, historically, the answer is relatively early on in the recession, you hit the bottom. And you have visibility to the end of that recession and then you wind up putting money into risky assets.

Rob Almeida

Yeah. And during that process what tends to happen is cash flows disappoint, earnings disappoint, equities underperform, and bond yields fall. So bonds outperform equities. And that's how I'm positioning my portfolios. So. All right, Eric, thank you. Happy New Year. Oh, before I let you go, you and I have our own little private mini book club. So I think I know the answer to this question. But for the audience, any holiday vacation reading, what are you reading right now? What do you think the audience might be interested?

Erik Weisman

So I'm reading right now. David Blight's, a biography that won the Pulitzer, Frederick Douglass, American Prophet or Profit of freedom? I think it's a prophet of freedom. And it is a tome, but it is pretty extraordinary. And a couple of months ago, I read a book called The Age of Acrimony, which looks through the lens of a member of the House of Representatives and his daughter from post-Civil War through to pre-World War One, and essentially asked the question, how did the United States transition from a democracy that was entirely broken to one that seemed to work again, where the idea, as we currently seem to be in the midst of a democracy that's entirely broken, how might we learn lessons from that period so that we can get our democracy working again?

Rob Almeida

Shocker how these things repeat.

Erik Weisman

Indeed.

Rob Almeida

All right. Thanks, Eric.

Erik Weisman

Thank you.

Rob Almeida

Thank you for listening. And thank you, more importantly, all year for listening to this series of podcasts. We look forward to 2023 and wish you all a very happy New Year.

53310.1