Stairway to a Bull Market

With the FOMC meeting dead-ahead, Rareview Capital’s CIO Neil Azous explains why he’s optimistic on the US economy in 2023 given progress the Fed has made towards stabilizing inflation.

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Summary – IBKR Podcasts Ep. 50

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Andrew Wilkinson

Welcome to another IBKR podcast. I’m your host, Andrew Wilkinson. This week’s guest is Rareview Capital’s Chief Investment Officer, Neil Azous. We like to preface upcoming Federal Reserve meetings with an interview with Neil since he follows macro aspects and monetary policy extremely closely. I think an awful lot of Neil and what he’s got to say so, we are delighted to have him here as a guest on the show. Welcome Neil. How are you?

Neil Azous

Thank you for having me Andrew. I’m fine, happy holidays to you and to your audience.

Andrew Wilkinson

Thank you very much and the same back at you. We’re going to talk about the Fed. Let’s put some context on where we stand as we’re recording this podcast. We’re taping this show for the benefit of the audience after Fed chairman Jerome Powell set the equity market alight when he discussed the likelihood of moving from interest rate raises of 75 basis points down to 50 basis points. But we’re recording ahead of the nonfarm payroll data. So Neil, now that investors seem to have softened their fears over the pace of interest rate increases heading into the December FOMC meeting, where does the land life from your perspective now?

Neil Azous

Sure, I think that’s an accurate statement Andrew, for several reasons. Just keeping things very simple, the Fed has come a long way in a very short period. Now I got to put my wonky macro hat on and translate what that means in institutional market-speak about the Fed coming along way. So, as I mentioned to you, I think in previous podcasts or in general there’s a concept called the neutral rate of interest. That’s the prevailing interest rate at which the economy runs at its potential, meaning it’s not overheating or it’s not excessively cooling down. The reason I mentioned that is, is that the Fed has, quote-unquote, demonstrably surpassed that neutral rate. Let me give you a couple of data points about that and why that actually translates into fears of the pace of interest rates decreasing. OK, so the Fed publishes every quarter in their in their economic projections this neutral rate. And their recent quote for that is that they think the equilibrium rate for the economy is around 2 1/2 percent. The market is pricing a terminal rate, as of this morning, right around 5%, so almost double that neutral rate. OK, at one point a few weeks ago that rate got up to 5 1/2%, so even more demonstrably, above that neutral rate. OK, so when you think about being 2 1/2% or 3%? above the neutral rate you kind of have to have a baseline and say to yourself well, what does that mean relative to other past cycles in terms of surpassing that neutral rate. Well, it’s pretty easy. You just go back and look at them and you say, on average that terminal rate or the rate at which the cycle will end tends to max out around 1.2% higher than that Fed neutral rate. So, in this case it would be around 3.7% and there are different variations of that of course. I mean, I think the lowest once was we were 3/4 percent above the neutral rate and the highest was around 1.75% above the neutral rate. The point here is that the max terminal pricing that exceeded this cycle’s neutral rate, as I just mentioned, is around 3% or almost more than 1 1/4% beyond the extreme ever recorded in prior cycles.

So, when we just think about that we’ve overshot at one point here, this equilibrium rate of the economy almost by two times the historical extreme. So, that’s why you’re seeing people starting to have a different sentiment shift that the Fed is much closer to being done because they were in unprecedented territory. But the degree of that unprecedented territory is just enormous at this stage. And then the second reason is that there’s a consensus view now that, this is not coming from me, this is just the market consensus view, that inflation peaked last June. It took four or five months for the consensus to build to reflect that, but that’s where they think CPI peaked last June. So, the next step is for this CPI number to converge below the Fed funds rate. So, if I told you that the market is pricing in around 5% of a terminal rate and that’s where the Fed is headed towards and inflation is at 7%, now it’s starting to converge pretty fast, or that process is starting to gain speed. So, whatever they’re doing, it’s working. So, when you add up the fact that the CPI is on its way to fall below the Fed funds rate, or converge with it, along with the degree of how high we are above that equilibrium neutral rate, you get this change in sentiment. And when you consider those powerful observations, Andrew, the conclusion becomes a bit easier. So, for example, just interest rates are too high above neutral, there’s a downshift in inflation, such as you said, sentiment is turning incrementally positive. And the price action across different asset classes, as we’ve seen over the last two or three weeks is certainly starting to confirm that.

Andrew Wilkinson

So, given that it’s been a harder and faster ride from the Fed than most people expected earlier this year, how does that shape the outlook for 2023?

Neil Azous

So, our working thesis is that that soft inflation that we saw in October is now repeatable and the easing of these price pressures will be enough for the Fed to stop raising interest rates, and then ultimately pull forward interest rate cuts from the year of 2024 to sometime around mid-2023 or the summer of next year.And if that happens or in that instance, that the headwinds that we saw this year, they will transition to positive tailwinds for both stocks and bonds next year. And there’s a dozen or so of these types of headwinds that can transition to tailwinds. But just focus on the big three because they probably drive 70 to 80% of all the risk premium associated in the marketplace, and those are pretty easy. One would just be as we just talked about the pace of Fed tightening, slowing dramatically, or reversing to a cut. The second one being the Russia, Ukraine war. So, you know caveat, that if there’s no nuclear confrontation or escalation. Odds are that you know we’re coming from the abyss. Any semblance of peace, treaty or resolution around that war would be incrementally helpful to sentiment. And then the third one that is pretty obvious out there as just China’s Covid policy where they’ve been on a lockdown. So, if they’ve been on a lockdown for a year, if they move away from a lockdown sometime next year, that should benefit supply chains, global growth, etc.

Andrew Wilkinson

So, I’m sniffing a bit of a soft landing here Neal. What or when does a recession happen? What does it look like for the US?

Neil Azous

Honestly, Andrew. I just dread that question. Well, why? Because I don’t even know what a recession means anymore in today’s world. If you asked me that question pre-2008 before the global financial crisis, I would have defined a recession, at least in economic terms, to me that there was a default cycle occurring, meaning that the Fed’s interest rate hikes, or, you know, their efforts, were designed to lead to some concept of bankruptcy to wash out the bottom quartile of companies that couldn’t exist in the survival of the fittest world. Well, that concept got removed in 2008. So, to the extent the Fed is actually going to revert back to that, then that would dictate a recession for me because it would lead to wider credit spreads, much tighter funding conditions, we would probably see the credit markets lock up, et cetera, and that hasn’t been the case this year. So, for me, I struggle to answer when a recession occurs and what that actually means. I guess if you put a gun to my head, I’m in the camp that the hard landing in markets already occurred this year and that there’s a greater than a 50% chance next year. The markets the, Government they engineer a mild recession AKA a soft landing. And conversely if it turns out that the Fed is forced to resume interest, rate hikes, or take that terminal rate or where the lending rate will be all the way up to 6% or beyond, well, then we’ll be in a deeper recession, and that quote-unquote hard landing scenario. So, that’s kind of how I think about things. Right now. I’m reasonably constructive that we’re going to come out of this.

Andrew Wilkinson

Well, that that that’s a. Great, a great segue into my next question, which is other than the consumer price index or inflation data at large. What data points, then would likely cause the FOMC to feel that the job isn’t really done yet, and then they have to keep on going further than either we expect or to your point that we resume tightening.

Neil Azous

So, one of the things that we’ve been focused on. Here this year is really trying to think keep things very simple. And start at a very high level to use that poor MBA word, or a helicopter view or from 30,000 feet up. And so, our focus here in that spirit has just been simply on inflation and jobs. Everything else, while important, is really a secondary input in how we’re going about things. So, in that spirit, I believe that the other metric that matters most besides CPI is employment. I mean, after all the Fed has a dual mandate of both employment and price stability. So, within employment I’m focused on two precise items. The first one, Andrew, is the unemployment rate. I’m going to take you a little bit for a turn here, so it’s not so much the absolute rate. Did it go up by .2 or .3? And that’s going to signal a recession. For me, what I like to do is think about it in Fed terms where they like to analyze things over a 3 to 6 month viewpoint. So, we like to take the three-month average of the employment rate and traditionally, when the three-month average unemployment rate rises by half a percent. So, in this case, if the low was, say, 3.5%, if the three-month average turns into 4% and it’s above the low of the prior 12 months, which it would be in this case, so, if we went from 3 1/2 to 4%, the economy traditionally is in a recession or it’s about to be. That in our experience, is a fulcrum event for the Fed to raise alarm bells and say, this might be a point for us to pivot or back off or begin to cut interest rates knowing again that it takes a very long time for their blunt instrument to bleed into the system and then at that point they can start to bring that unemployment rate down or recalibrate policy.

The second metric Andrew beyond inflation that we’re looking at within the employment data, is this critical metric of the ratio of job openings to unemployed workers. I’m sure you’ve heard this referred to as before, it’s the JOLTS data, it comes out once per month. It’s not something that I particularly pay a lot of attention to, or our firm does in our investment process, but I’m highlighting it here as a as a secondary metric to watch because Chairman Powell appears to be fixated on this metric and we need him on board for a proper pivot in Fed policy. So, currently this JOLTS data is still high on an absolute level but the recent month-over-month changes are showing declines or widespread. So, it’s starting to move in the right direction for what appears to be the preferred metric of the chairman of the Federal Reserve, those are the two things I’m watching. The unemployment rate, the three-month average, and then the JOLTS data ratio that Powell watches.

Andrew Wilkinson

And just an editorial note here, the 30,000 foot view that you talked about due to inflation is now the 33,000 foot view.

Neil Azous

That’s great. That’s it.

Andrew Wilkinson

Now, Neil you you’ve always done some excellent work regarding the status of the shape of the yield curve and how the money market always starts to price in rate reductions. You’ve mentioned that a couple of times already. How has that conversation shifted during this year? Given that we’re in December, and I think you’ve done a lot faster than anybody expected, there’s still more to come. I  think monetary policy is really taking the market by surprise this year and the curve has also become more inverted right in late November, what’s happening now?

Neil Azous

So, there’s two ways to look at it. There’s the way what I would call the pedestrian view. And then, there’s how professional investors tend to think about the shape of the yield curve and what it means for investment expressions, and I’ll just give you both. So, just generically, this is the first time in at least two decades that the quote-unquote global yield curve is inverted. So, not just the US, if you took an index of all the twos and 10-year slopes of the yield curves in the major G10 countries, that yield curve is now inverted. So, on a global basis, if you believe that the yield curve is a precursor to a recession or has forecasting ability, globally, we’re in a recession. In the US, it’s very similar, but it’s more pronounced and I’ll give you an example. So, yes, the entire US yield curve is inverted and I appreciate that most market agents focus on the traditional ones like the two-year, 10-year slope or if you like to follow the Fed’s preferred measure, they like the three-month versus the 10-year slope of the yield curve. At this stage I would just highlight that the one-month all the way out to the 30-year slope is fully inverted or quote-unquote the entire yield curve, so it’s much more pronounced than that. And then to your point, Andrew, the depth of these inversions is pretty much in unprecedented territory. I suppose you could go back and look at a chart of a standard yield curve and say, oh it got slightly or more deeply inverted in 1979 to the 1982 period, but I’d like to remind people that they were increasing and cutting interest rates every day during that period during by multiple percentage points, whereas now it’s a committee. It’s not driven off of mark-to-market conventions, so it’s a very different world. So, we are in the abyss of inversion in terms of the depth of it, and then in the breadth of it we go from the one-month or 30-year or so, it’s very pronounced and I’m going to end this part of this with what I think the best expression is, but in general, what’s most interesting about the current shape of the yield curve and really sort of the next 18 months, not so much the precursor to a recession or economic impact, is that the Federal Reserve has signaled to the marketplace that once they raise their federal funds rate to a certain level, they’re going to keep it elevated for an extended period of time, so the market actually believes them. And what that means is that we’re still pricing in further interest rate hikes between now and, say the springtime and then between the springtime and, say, September, they have got this pause built into it. The market terminology for that is they got a kink in the curve: A quote-unquote kink. And then after that they start to look at some interest rate cuts in the second-half of next year and then really more forcefully in the year 2024. And the reason that that’s relevant, Andrew, is that traditionally the Fed cuts in interest rate after the last hike. There is no semblance of a pause historically, so the market has this kink in here at the time being so the question becomes is will the data that you referenced earlier, the employment data tomorrow, or the inflation data in mid-September prior to the Fed meeting in December.

Andrew Wilkinson

Mid-December or mid-September?

Neil Azous

No mid-December, I’m sorry. The CPI data for mid-December the inflation data prior to the Fed meeting, will either of those data points be soft enough that makes the market push the Fed? Or force their hand to say OK, we’re going to remove this pause stuff and go back to what we’re traditionally used to, which is once you finish raising an interest rate, on average, you tend to cut that interest rate six months later, and it’s been as quick as almost one-month and as long as 13-months. So, this idea of a pause, we got to get rid of that and that kink in the marketplace. So that’s kind of where we’re at. And then what I think is is really at some point. The yield curve will begin to steepen from this massive inversion or this massive flattening, and as we head into next year, Andrew, I believe wholeheartedly that capturing that transition from the inversion to the steepening will likely be the investment expression of next year based on the amount of capital that can be deployed to that strategy, meaning it’s infinite, given the US Treasury market. So, we’re very focused on when this inversion ends and when the steepening begins. And if you get that right, you’ll probably be in pretty good shape for the year.

Andrew Wilkinson

And that tends to happen. Very, very quickly. Yeah, it’s blinking, you’re missing.

Neil Azous

Very hard to handicap.

Andrew Wilkinson

What so, so Neil? Let’s just do a few quick-fire questions just to end the podcast. What film or song is going to describe best 2022 for you?

Neil Azous

I really like that Top Gun Maverick movie and here’s why. I think after almost 30-years in financial services, I’m still pushing the envelope and confronting any investing ghosts of the past.

Andrew Wilkinson

And there’s been quite a few this year. There’s a lot of investors have not seen this kind of environment. It’s been it’s been a unique year. OK, that’s a good answer. Top Gun. Let’s have a look in your rearview mirror, not your Rareview mirror, but your rearview mirror. What would you trade of the year? Anything you like.

Neil Azous

I’m going to probably give you an answer off the beaten path. My trade of the year was really time management. As our business grew dramatically and most critically within time management, it was reducing my intake of political news. It has not only helped me emotionally to just shut off that noise. But it’s helped me with a. Lot of time and money.

Andrew Wilkinson

Has your blood pressure gone down?

Neil Azous

It has.

Andrew Wilkinson

Who’s your person of the year?

Neil Azous

So, I don’t like to focus on any individual ones. For me, it’s never a person, it’s more of a metaphor and I would say just in this instance, it’s the underdog. I’ve seen many examples this year where the underdog has been successful and I’m just always rooting for them, and if you survive this year and you were a small investor, a small firm, you know my hat’s off to you. It’s been a difficult year. I always root for the underdog.

Andrew Wilkinson

Is that going to extend to the United States and the World Cup?

Neil Azous

That’s a tough one. Wait, Andrew, is the US?

Andrew Wilkinson

What about your event of the year? What’s the most notable event for you now?

Neil Azous

Sure, this one is pretty personal, but an immediate family member, beat cancer and just keeping things real simple and in the spirit of this year, nothing matters more than family and health.

Andrew Wilkinson

Good man, good man. Final question, have we seen peak Trump or not?

Neil Azous

Oh man Andrew, you just never take it easy on me do yeah? The answer for me is yes, and it’s unequivocal and it’s not a political bias. It’s more of electoral math to me. You know, his win back in 2016 did not really come from the 35% of his base that’s going to follow him to the end of the earth and back again. It really came from office park dads and what they call soccer moms and that base which represented 15% or the independent vote or the swing. I just don’t see them voting for him again and furthermore now you know, based on anecdotal conversations from, you know both of those cohorts, I just get the feeling that they want him off the stage altogether.

Andrew Wilkinson

Neil Azous, chief investment officer at Rare View Capital, thank you very much for joining me ahead of the Federal Reserve and enjoy the holidays mate.

Neil Azous

Thank you Andrew. Happy holidays appreciate it.

Andrew Wilkinson

Likewise, and don’t forget folks, thank you for joining me today. Don’t forget to check us out at ibkrpodcast.com or wherever you download those podcasts from. Bye everybody.

Neil Azous

Thank you.