Inflation? Interest Rates? Look to the Longer Term

Scott DiMaggio: Eric, we talk a lot about a recession. Will we get a recession this year? What kind of recession will it be? Soft landing, hard landing, no landing, somewhere in between? What’s our current thinking?

Eric Winograd: It’s a mistake, we think, to extrapolate too far forward from any sort of short-term fluctuation. We want to keep our eye on the longer term. And of course, that is a challenge for markets, in large part because it’s a challenge for monetary policy, too. The world would be a lot easier for central bankers if things moved in a straight line. But because they aren’t, we’re seeing policymakers in the US in particular, but also in other jurisdictions, have to respond.

SD: And of course, that back-and-forth is reflected in bond prices. That Jekyll and Hyde in the data between inflation and disinflation probably continues for the next several quarters at least.

EW: Where we’re going to be uncertain about the destination before it becomes clear that even with that back-and-forth pattern, the underlying trend is still toward disinflation and lower growth.

SD: The job was also made more challenged by a quick China reopening, which injected growth into the economy in a way faster fashion than we initially expected. We should also respect the European data where inflation has run well ahead of the ECB expectations. So I think this phenomenon of just US data being a bit back and forth is also a global dynamic, with the data in Europe showing similar patterns, in Canada showing similar patterns, Australia, etc.

EW: As you say, China has opened much more or has reopened much more rapidly than we would’ve expected. That’s a positive sign for global growth. It frees up the supply chain. It’s making goods travel more freely through the global economy. It’s an additional source of demand. And it’s a reason to be a little bit more optimistic about growth, even if it also has potentially positive consequences for inflation. And positive in this sense means pushing it higher.

And Europe is really very fascinating because I don’t think either of us would’ve believed—I know I wouldn’t have believed—that natural gas prices in Europe would be lower today than they were before the invasion, and yet that’s where we are. And as we transition into 2024, I think the outlook may look a little bit brighter. But for this year, we’re expecting this sort of grinding, slow economic growth scenario while we wait for inflation to come down.

SD: I also think that sets up for us an environment where you want to own duration. And if you’ve been out of duration, if you’ve had ultrashort funds or you’ve had cash on the sidelines, that this is a kind of environment where duration should work. Now, it’s not going to work every day and every month. But we think if we are setting up for an environment where economic growth is going to come down, where inflation will gradually crest over the course of the next several quarters, that buying duration at these levels should work. We’d also translate that into credit as well.

In an environment of low growth, in an environment where eventually central banks get control of the narrative about where inflation is heading, where monetary policy is heading, that should be good to bring down volatility, and that should be an environment where credit, both investment grade and high yield, should start to perform. So we’re pretty optimistic on what we think fixed-income returns will be for the calendar year.

So, Eric, what gives us confidence that inflation will come down? What gives us confidence that as we look three, six months out, that those numbers will be lower than they are today?

EW: If you think about it in three broad buckets, right? The first is goods prices. And this was the initial cause of the inflation. This was related to the supply chain. Anything that had to be made one place and transported to another was very difficult to get for all the reasons that we remember during the pandemic. With China fully reopened now, there’s no evidence that supply chains are still a problem. We’ve made a lot of use of alternative data measures, looking at shipping times, looking at the number of ships backed up outside ports. And if anything, the supply chain looks healthier now than it did pre-pandemic. So we expect goods prices to normalize and to be stable.

Number two is shelter-related inflation. And this is the largest component of the inflation basket. It represents about a third of overall inflation. We know that it responds to changes in house prices with a lag. We also know that house prices peaked last April and are now down, what, 5% or 7% since then. So we expect that as we roll into the spring and into the summer, we have a very high degree of confidence that shelter-related inflation will also come down. And that has been the primary driver of inflation over the last few months.

The sticky wicket is the third bucket, which is everything else, right? It’s core services; it’s all the other things that happen in the economy. And that’s a little bit tougher because the primary cost input to those is wages; it’s labor. And so we believe that it will not be until the labor market weakens that we’ll get true relief on that front. Now, that by itself won’t be enough to keep inflation where it is. It just means, again, that this decline, this disinflation, is going to be gradual and back and forth. The first two parts are going to pull it down. The third part is going to take a little bit more time. But despite the back-and-forth, we still have confidence in the destination.