Stewart: Wow, have we got a good one for you today. We have got the inflation guy with us today, Mike Ashton from Enduring Investments. And your visit is very well timed, Mike. Welcome.
Michael: Yeah. Thank you for having me. I mean, I’m glad we’re going to talk about inflation because I’m not sure I know much else.
Stewart: That’s great. This is Stewart Foley. This is The Insurance AUM Journal Podcast. Mike, everybody’s talking about it. Right? Our first quarter edition has a picture on it that says, “Inflation: Insurers’ Doubled Edged Sword.” And as you know well, for insurance companies, inflation erodes the value of their largest asset, which is investment grade bonds, and it increases the value of their largest liability, which is future claims. And so, that creates a particularly difficult situation for insurers. Just to start off, what’s the driver here of the CPI?
Michael: If you go back I think to probably one of the first conversations we had, I don’t remember exactly when our prior episodes were, but, early on in the inflation debacle, used cars were doing a lot of the driving of the underlying figure, and that’s still true. Used cars are still adding quite a bit, but they’ve got a lot of company since then. Back then, you could plausibly say that inflation might be transitory. I didn’t ever believe that, but it might be transitory if this is all about used cars. And now used cars has been joined by the vast majority of the consumption baskets.
So something like 80% of all categories of the weights in the CPI are inflating faster than 4%. And about a third of them are inflating faster than 6%. So it ain’t all used cars, it’s actually, and this is the problem, this is the scary part for the Fed and for investors is that the driver isn’t a component of the CPI. The driver is clearly now outside of the CPI. It’s money. It’s spending. It’s things which are not weird idiosyncratic one offs.
Stewart: And it’s interesting, a lot of different things, right? At least where we live, there are no houses for sale, and when a house comes up for sale, it’s just boom, it’s got bids and offers. And, they show it and they go, “We’re accepting offers on Sunday,” and they’ll have 19 of them, which just seems like people are chasing it, right? Are you concerned about the increase in home values right now? And is that, man, it feels like a bubble to me. It’s my old gray hair and bond guy Spidey-senses. What do you think there?
Michael: If makes you feel any better, then look at it in real terms, right? So if you had this kind of a home price appreciation when inflation was at one or two, it means something different than when inflation is at eight. And wages, personal incomes are now rising at a much faster pace as well, so home prices and rents as they relate to incomes aren’t as stretched as you would think, given what we’ve seen in all the property markets and the rental markets. And there are a couple other ways to sort of look at this. I think I’m actually less concerned about it now than I was six months ago or so, partly because the overall price level’s rising so fast and people’s incomes are rising so fast that it makes it look not quite as stupid.
Stewart: You mentioned in real terms. So can you explain, because you and I are about to geek out on this, I have a feeling.
Michael: I hope so.
Stewart: What’s the real rate on a 10 year treasury investment today? And how do you get there?
Michael: What you really want to look at when you’re looking at real rates for treasuries, what a lot of people will do is they will say, “Okay, the 10 year treasuries are yielding 2%, and so we subtract 8% inflation. You have minus 6% real.” That’s not the right way to do it.
Stewart: See, that’s how I do it in my head. That’s how I’ve always learned it and taught it, frankly. So what’s the right way to look at that?
Michael: Well, if you buy a one year treasury, then that’s a plausible way to look at it. If you’re buying a 10 year treasury, you’ve got a 10 year horizon for that yield. And so you’re demanding 2% compensation. And that compensation covers your expected inflation and it covers the real cost of money, so the real interest rate, but for the aggregate 10 years. If you have horrible inflation for one year, then you have deflation for the next nine years, then you’re still happy with the 2%. So you have to compare those proper horizons.
And so the right way to look at what’s the 10 year real interest rate is to look at where 10 year tips are trading. And that’s minus 90 basis points, or minus 1% or so right now, at the 10 year point. And so even though we have really high real interest rate, a really high inflation, therefore really low real interest rates in an overnight sense, and honestly, minus 1% isn’t exactly—you’re not going to make a million bucks on minus 1% of anything. It’s not as bad.
Now of course, that’s because the flip side of that is long-term inflation expectations are sort of absurdly well behaved here, less well behaved recently. But, 10 year inflation expectations right now are around 3%. So you take the 2% nominal and subtract 3% inflation expectation to get minus 1% real for a 10 year horizon. And if you’re an investor, or if you’re an infrastructure builder, or you’re doing some project for 10 years, you really don’t care about today’s real interest rate. You care about the real interest rate over the life of the product, so you want to look at a longer term real interest rate. And we have inflation link bonds, which give you a nice clear look into that now.
Stewart: And it’s interesting, I just think when you look at a negative real rate and you have regulators that push insurance companies into high grade bonds with very low yield, it creates a really challenging situation for an insurer. And you actually talked about this. I mean, your firm, you run inflation hedging strategies, do you not? Is that part of what you do?
Michael: Oh, that’s all that we do. We help companies address the particular inflation exposures that they have, and we design both, sort of bespoke inflation hedges if they have some. For example, we had a client that was concerned about: they’ve got a low skill workforce. They wanted a hedge for wage inflation, and so we went and figured out kind of the right way to hedge that sort of thing, so we do that sort of thing both on a consulting basis and designing and running these bespoke inflation hedges. And of course, we also run investment money and investment funds and things like that.
Stewart: If the long run inflation 10 year land is built in at 3% and the way you’re getting there is you’ve got a 2% 10 year nominal rate, a negative 1% ten year tips rate, and you go, “Well, there’s 3% in there, that’s the long run rate.” Right? And that means that this current inflation level, the market is saying is not going to continue. That’s how the market is pricing it, right? Is that what you mean when you say it’s transitory? Because I think oftentimes, people hear terms in the news media and they assume they know what it means, and you move on. But I’ve always—What does that really mean?
Michael: Yeah. Well, so the funny part is, the funny part, the only way we can look at 10 year inflation expectations is by looking at these two instruments. Right? But one of those instruments is very clearly controlled by the central bank. The 10 year yields are at 2% only because the central bank has bought a very large proportion of them. And if this was a free market, then we wouldn’t see 10 year yields at 2%. So therefore, you’d see a higher 10 year inflation expectation. Moreover, if you look at 3%, and by the way, 3% until recently, it had never been above 2.70% since tips were issued, and only recently went to 3%.
You look at that, and that’s actually not really sort of the best guess because, and your insurance company listeners will understand this, all the tails are in one direction. If you miss that on the low side maybe at 2% or 2.50%, if you miss it on the high side, maybe it’s 6%. Right?
Michael: And so it should trade—There should be some additional value to that tail. And so break evens should, in fact, trade higher than people actually expect them to be. So, it’s an impure estimate and it’s not a very good estimate. But it’s one of the reasons the Fed has been so calm, is they think this is a really, really important measure. And I just think it’s sort of quasi manipulated, not that they directly manipulated it, but it’s clearly not a free market.
Stewart: Well, and that’s what I was going to ask you. People who listen to this stuff go, “Gee, this sounds like an organic conversation.” That’s because it is. There’s no guideposts here. You and I, for 30 minutes, you and I are going to just geek out on inflation. So this is kind of my point. I always tell my students, I’m like, “Okay, think about a tree branch, and where it’s attached to the tree, that’s the overnight rate. And where it goes out, that’s the long rate.”
Michael: That’s a great analogy.
Stewart: And what the Fed’s doing is they’re holding down that branch.
Stewart: They’re holding it down and they’re keeping rates low. And, there’s also a safety trade or a flight to quality trade, and there’s also a flight to liquidity trade because it’s the largest and deepest market in the world, right? So there’s exogenous downward pressure, look at me go big on the exogenous word.
Michael: That was pretty good. I like it.
Stewart: There are external forces that are forcing that rate to 2% or below. And I think that we would agree that the quote/unquote “natural” level would be higher than 2%, which I go back and say, “Well, if that’s the case, then isn’t the real rate of inflation actually what the prevailing rate would be and then subtract out the negative 1% on tips? Isn’t it higher than 3% because the 2% is artificially low?” Does that make sense?
Michael: No, it does. What you’ve essentially said is that as an investor, you should be buying 10 year break evens at 3% because they’re too low. Of course, I’m saying this at 1% and at 2% as well. I mean, it was a much better deal a year and a half ago. But that’s essentially what you’re saying is that a 3% estimate for 10 year inflation seems too low. By the way, I wholeheartedly agree with that. I think we’ve moved to a new equilibrium. I think there’s a lot of evidence here, partly in the broadening of inflation, but also the length of time we’ve stayed up here. I mean, the last four core inflation numbers have been between .5% and .6% monthly, which was say, a run rate of 6% or 7%. And I think the distribution now that we’ll go back to, the new equilibrium is probably more like 4% or 5%. And we’re not going to see 2% or 3%. That’s going to be very unusual.
And so, if you sort of look at the chart of 10 year inflation expectations, 10 year break evens over a long period of time, you see they kind of go between 2¼, 2¾, 2¼, 2¾. You kind of bounce around like that. And I think what’s going to happen here now we’ve broken above it, I think we’re going to go to a new range and these things are going to live between 3½ and 4½ for a while. We’ll see, but I do think there’s still, especially if you have long-term liabilities and exposure to inflation expectations, I think that they’re still relatively—They’re not expensive yet.
Stewart: I mean, there’s a terrible situation going on in the Ukraine right now. I don’t want to get into the politics of it. But I will tell you anecdotally that there’s a convenience store not far from where I live, and to maintain my sanity from working from home, I drive over there and get a soda every day. And premium fuel just topped five bucks a gallon. Now I’m in there this morning and a fellow that I see all the time is in there saying, he said, and this is the kind of stuff that just drives me bananas. He very loudly says, “It’s over $7 in Canada.” And I’m like, “Yeah, so?”
Michael: I feel better now.
Stewart: But at the end of the day, you go, “Well, prices are going to be higher in fuel.” Okay. And I think a lot of Americans support the Ukrainians and are like, “You know what, if it’s higher gas prices and that’s my sacrifice, then that’s what I’ll do.” But at the same time, there’s a whole lot of folks who aren’t commuting and aren’t driving at all right now, like me. I work out of my house. You work out of yours, I think generally. A lot of people are now, and that’s going to reduce fuel prices, which is tantamount to a tax for most Americans. How do you see all this stuff that you see on the nightly news, everybody’s hysterical about fuel prices, how real is that in terms of this upward shift in a new normal of CPI?
Michael: So there are two things happening in energy with different amplitudes and different periods, I guess. And one of them was happening long before Russia invaded Ukraine. I almost said Kuwait because that’s how old I am. I was thinking about Iraq invading Kuwait, which was the last time we had this kind of thing where you had a big spike in energy prices that didn’t last super long, but it was quite severe. But we already had energy prices going up, and so, that’s sort of the long wave thing here, is that we have right now far more demand than we have supply. And, there’s been a lot of angst spilled about this and a lot of complaining that this is due to policy affecting how much drilling happens and so on.
I don’t have sort of a political opinion on that, but I would say that empirically, it does seem as if there’s certainly less US production than there was a couple of years ago. Right? But that’s a long factor, and that was happening anyway. So I think that expecting higher gasoline prices was kind of in there. And then of course, you have this episode. Now this episode I think is passing. I mean, not right now, but it is something which will pass. And part of, even if we never import Russian energy again, even if nobody in Europe ever does again, then we’re still eventually, unless Russia stops selling energy altogether, it’s a commodity. And so they’ll sell to China, and therefore, China will have to buy less from someone else, which means that Saudi Arabia will now have more to sell to us. So there’s a dislocation, but that eventually washes through.
Stewart: It’ll work itself out.
Michael: Yeah. And that’s why when Iraq invaded Kuwait we had this nice big spike in energy and eventually came back down because it all works itself out. So what concerns me more than the energy side is the food side. The Ukraine is some ridiculous proportion of total production of wheat, the bread basket of Europe. And not only will the Ukraine not be exporting wheat this year, they’re not going to be planting any in the spring. And so that means that we’ve actually had real supply destruction, unlike with energy, where the supply is just being shuffled around. In the Ukraine, we’re actually destroying the capacity to produce wheat for at least a year. And that to me means that you’re going to have this longer lasting effect in food prices. And that’s something which is unusual. Food and energy, we usually factor out because it goes up, it goes down. And so we look at core because there’s a lot of noise and no signal in food and energy. But now you’ve got some things happening which suggest there’s much more signal in those things.
Stewart: It just seems to me that right now, there’s so many geopolitical events, this isn’t being driven by the economy. I mean, although the economic factors, although what you just explained the Ukraine about being the bread basket of Europe. I had no idea of that, and I didn’t realize that there’s going to be that supply shock in wheat.
Michael: By the way, there’s another one that you haven’t heard a lot about. That’s that we find neon comes mostly from Odessa. And why do we care about refined neon? Well, it’s a really important component in making semiconductors. And so that’s something you don’t hear a whole lot about, but something like, I’m making the number exactly, but it’s something like 90% of the refined neon in the world comes from Odessa.
Stewart: That’s amazing.
Michael: There are all kinds of things. We haven’t thought in the past a whole lot about the Ukraine, but it’s a really important, and it’s much more important now than when it was behind the Iron Curtain because we didn’t have as many semiconductors back then. Anyway, there’s a lot of those things going on. And I think the question you were about to ask is, we’ve got all these things going on. And maybe eventually they pass, whatever. But what does the Federal Reserve do? Because we haven’t talked about the Fed yet. And they meet next week, and I’m sure that’s what everyone’s going to be talking about. But I don’t want to tell you what your questions are for me. We just reversed. I became the podcast host and you’re the guest.
Stewart: That’s perfect. No, it’s good. I mean, at the end of the day, there’s things I notice that get my attention and to kind of be a reference point. And when I was teaching at Lake Forest College, the overwhelming majority of internships that we would get for students not in the finance area, but in other areas, 80% of those were unpaid. In finance, we pay people, and the students would get $15, $18 an hour, which was that’s pretty good as a college internship, fine, fine, fine. Now, McDonald’s, every fast food joint’s offering $15. People are offering signing bonuses. There’s no doubt about it that particularly lower skilled wages have gone up substantially. I’ve heard it called the great resignation. I’ve heard it called the great upgrade. What’s going on in wages? And what the hell do we do about it? What’s going to happen? There’s an unbelievable number of open jobs right now. Right? What’s up with it?
Michael: Yeah. What I think is really interesting about wages is that, of course, everyone worries about the wage price spiral. Right? You can get a spike in prices for some idiosyncratic reason, but we don’t really worry about that unless it feeds back into wages. That’s the thought anyway. And we’re seeing wages rise. The Atlanta Fed wage growth tracker, which I think is sort of the best measure of continuous wages, is up at 5.9%. They just released it yesterday, which is far and away the highest it’s been in decades. And that strikes me as happening really quite fast. We had inflation just kind of started getting really serious about the middle of last year. And all of a sudden, we’ve got these wages where they are.
And I wonder if part of the reason that’s happened so fast, and in the old days, what happened is you had unions that would go and negotiate these higher wages, and that’s how we kind of institutionalized the cost of living increases, and that kept inflation high. At least that was the theory. Now unions don’t have quite as much power, but we also have much more transparency into what people earn and what we should be earning, the indeed.com, or monster.com, all these places where you can go look for jobs and advertise jobs. It’s much more public when everybody starts getting paid more.
And so I think, wouldn’t that be interesting, and I don’t really know the answer to this, but maybe the wage price spiral is going to happen faster this time than it did in the past because way back when, you had to wait until your neighbors were getting their raises, that’s how you found out about it. You read something in the paper from time to time. But now you find out about it instantly. I think that’s very interesting and I think the fact that wages are accelerating as quickly as they are is also problematic for the whole view going forward.
Stewart: Is it fair to say that this is a make up, there is some make up in this because they’ve been flat for so long? I mean, is there some correction that has kind of been coming, but there was a catalyst, this COVID-19 crisis was a catalyst for that correction? Or is it just, “Why does everybody quit their job all of a sudden?” Right? And everybody’s like, “I’m not freaking working no more.” I don’t know. I don’t know. What do you see?
Michael: Well, interesting. So I think that when COVID, everybody shut down, and then there was massive government spending, and the Fed printed the money for that spending. And so, suddenly, there was this demand. And so we’ve suddenly got this shortage of workers. And the shortage was kind of manufactured in that they were out there, they just weren’t allowed to go back to work, or they were slow to go back to work, or going back to work was really painful. And so, that sort of created the opportunity then for people to start picking and choosing. So, we had an unemployment rate of 8% or something like that, except that if you were one of those people who started looking for a job, you had all kinds of opportunities. And so, that started a whole bunch of shuffling. And I’m sure somebody’s going to write a great dissertation on this at some point about how that caused the great resignation by just offering, sequentially, offering people as they went back to the workforce, lots of different options.
But then obviously, at the end of the day, you’ve got the fact that prices are going up as fast as they are, and rents and home prices and food and gasoline, means that when you go back, you’ve got to argue for a higher wage, right? And so what’s interesting about the Atlanta Fed wage growth tracker is that they’re tracking people who had a job at the end of the period and at the beginning of the period, so there’s not a composition shift. When you see wage numbers moving around, you say, “Well, how much of that is that you had high wage people going back, or low?” There’s shift in the composition. The Atlanta wage growth tracker doesn’t have that. It says that for somebody who had a job at both ends of the period, they got a 6% pay raise. And that’s pretty phenomenal in and of itself. These aren’t necessarily people who are just coming back to the workforce at higher wages.
Stewart: So we are winding down. And I’ve just got a big question, but we’ve got to make it a quick one. What’s the Fed going to do?
Michael: The market thinks the Fed is going to be super aggressive because back in the ’80s, they would’ve been super aggressive. You have 8% inflation. You should have interest rates 5%, 6%, 7%, 8% at least, right?
Stewart: Paul Volcker became globally famous for breaking the back of inflation and became a legendary Fed chairman, absolutely.
Michael: So the Fed should not only be super aggressive, they should also be shrinking the balance sheet. And frankly, we can go, it’s a long Fed watching discussion, but more important is that they shrink their balance sheet. And so the market has priced all this in. But here’s the thing. Powell is no Volcker. And, Powell has to go in front of the cameras after every meeting, and Powell has to explain to everybody in interviews why it is that they’re hiking rates to throw people out of work because that’s what it’ll sound like. It is much harder to fire somebody than to hire somebody, and so the Fed, now that it’s good and transparent, it is much harder for the Fed to hike rates than it is for the Fed to ease rates. And going in that direction will be more difficult.
I believe what will happen, so right now we’ve priced in six tightenings this year (or something like that). And I suspect what will happen is next week, there’s a Fed meeting and they’ll hike 25 basis points. And then maybe after that they’ll say, “This Ukraine thing, let’s wait and see how it plays out.” Or maybe they’ll hike another 25, and then they’ll say, “Let’s see what happens there because inflation is now coming down. Let’s see how fast it comes down. Let’s take a pause.” And, they’re going to be much more deliberate on the way up than they would be going the other direction, I think.
Stewart: It’s interesting that you bring that up, the transparency, because when I was back in earlier in my career, the Fed used to issue these one paragraph cryptic statements and people would just pore over them. And what do they mean when they say this?
Michael: It was a code.
Stewart: It was code. Right?
Stewart: And now, to your point, I think it’s a great point with the Fed chairman. So my last question, I was talking to somebody last week, and they said, “You got to get a new last question, man. You’re wearing me out with the one you’ve been…” I’m like, “Really?” It’s shocking to me. We’ve had almost 8000 podcast downloads, believe it or not. So I was like, “Holy smokes.” So here’s my question for you today, the ask me anything portion. College graduation is around the corner for many, many, many college students. And man, it is a tumultuous environment. Let’s just say that you are the keynote speaker at your college graduation. What piece of advice would you give that class?
Michael: What piece of advice would I give the graduating class today? It would be: don’t trust anything that you’ve been taught over the last four years.
Stewart: You will not be invited back to another graduation speaker. The president may tackle you right off the podium and go, “Unfortunately, Mike can’t continue his presentation today.”
Michael: I’ve always said that if I ever go back to my university and am asked to give a speech, I’m going to give a speech on why markets are not at all efficient. And it’s complete bologna what they teach you that they’re efficient.
Stewart: That was Warren Buffet, he’s got a quote that he says, “If markets were efficient, I’d be on the street with a tin cup.” That’s one of his quotes. So sorry, I interrupted you. I apologize.
Michael: No, no.
Stewart: You said, “Forget everything that you learned the last four years,” go ahead. I’m sorry.
Michael: Not necessarily just forget you’ve learned it, but don’t give it a whole lot of credence. Don’t treat it as gospel. Question it because even though those are the smartest people you’ve ever met, who’ve been teaching you for four years, they’re wrong on a bunch of things. And we don’t know which things they’re wrong on. But 20 years from now, you’ll know which ones are. But the biggest mistake you could make at this point is to assume that everything they said is absolutely true and operate on that basis with complete confidence because you’re going to get blindsided by something. Whereas if you go into it with the belief that it might not be exactly the way they taught it in school, then you’ll always have an appropriate amount of skepticism and caution. And you will not be blindsided by real life that differs from what you learned in the classroom.
Stewart: Good advice from Mike Ashton, the inflation guy with Enduring Investments. Mike, thanks for being on again, man. You are a frequent guest and we really enjoy having you, so thanks for being on.
Michael: Thank you. It’s always a lot of fun to be here, Stewart.
Stewart: Thank you, and thanks for listening. If you have ideas for a podcast, please email us at email@example.com. My name is Stewart Foley, and this is The Insurance AUM Journal Podcast.