By Nicholas Jasinski
The year has been dominated by big-picture thinking. Central bank policy, geopolitics, and debates over what comes next for the global economy have done more to drive stock and bond returns than fundamentals.
Richard Bernstein has spent his 40-plus year career focusing on the macro picture. Following stints at E.F. Hutton and Chase Econometrics/IDC, he moved to Merrill Lynch in 1988, as interest rates climbed under newly appointed Federal Reserve Chairman Alan Greenspan; Bernstein rose to chief investment strategist for the bank. In 2009, he set out on his own, founding Richard Bernstein Advisors.
RBA manages some $15 billion, employing global macro-based strategies and investing primarily in exchange-traded funds. Bernstein serves as CEO and chief investment officer, heading RBA's investment committee.
Barron's recently sat down with Bernstein in his midtown Manhattan office overlooking Rockefeller Center to discuss the Fed, the outlook for inflation, and where to invest over the coming year and next decade. An edited version of our conversation follows.
Barron's: The word on everyone's minds these days is " recession." Can the Fed engineer a soft landing?
Richard Bernstein: I think it's a little bit of a false dichotomy when people say it's a hard landing or soft landing. My third alternative is that we don't land. Now, people are gonna say, well, that's ridiculous; we're already in a recession. And I think you can have a mathematical recession, where we have two quarters of negative GDP growth. That can happen because of things like inventory problems, trade problems.
But here's the important point: Most people are expecting that recession to derail inflation. If the labor market stays as tight as it is, that technical recession is going to do nothing to curtail inflation. This could be the tightest labor market since World War II. It's going to take a lot to get this labor market to ease up and have an impact on inflation.
How high might the Fed have to raise interest rates?
For my entire career, economists would talk about the real [inflation adjusted] fed-funds rate. And they would say, if the real fed-funds rate was positive, it meant the Fed was working to control inflation and against the economy. If the real fed-funds rate was negative, the Fed was trying to stoke the economy.
Well, right now, the real fed-funds rate is close to historically negative, near negative 7%. Under [Fed Chairman Paul] Volcker, it peaked at plus 10%. The fed-funds rate was 10 percentage points higher than inflation. That's what people don't realize -- that the fed-funds rate is seven percentage points below inflation.
The Fed is so far behind inflation that I believe that maybe we just don't land. Maybe we'll slow the real economy, but not the nominal economy.
This isn't Volcker's Fed.
No, it's not. The Fed has gone from being an inflation fighter to being a savior of the economy. When I started my career in the early 1980s, the story was, we had to kill inflation, we had to rid the economy of inflation. And the Fed was thought of as leaning toward that hawkish side. Now, the Fed is viewed as leaning toward saving the day. That's a very different type of central bank that we have.
Is that necessarily bad?
No, it's not. Because when bad things happen, you want the Federal Reserve to react. I'm not one of those people who thinks that no matter what's going on, you have to have tight monetary policy. But the Fed has increasingly coddled the economy. We panic, they react and do something and save the day. But then they're very bad at moving back to a more normal monetary-policy stance.
The markets have realized that asymmetry, which was originally called the Greenspan put. Now, there's no more Alan Greenspan, so it's called the Fed put. But I think it's worse than that: The markets understand that there's a predilection to stimulating the economy and keeping interest rates abnormally low, regardless of the consequences. The financial markets have sniffed that out, and that's just as damaging to the economy as high inflation. It's just that, in our industry, we don't care about it because financial-asset inflation is called a bull market.
It seems pretty simple, with unemployment at 3.6% and annual inflation at 9.1% -- rates have to go up.
Rates have to go up, and rates have to go up a lot. And that's unfortunate. By delaying and delaying and delaying, the Fed has made it inevitable that the pain has to be worse. Their range of actions have been so skewed toward stimulating the economy that they don't realize that there's a bad side to that. When you think of the amount of fiscal stimulus that we were getting during the pandemic, the Fed was far from the only game in town, yet they were acting as though they were the only game in town.
So, interest rates on the way up, inflation high, unemployment low, and a deceleration at least in the real economy, if not the nominal economy. How do you invest in that environment?
I think you have to consider secular inflation, meaning what will inflation be over the next five or 10 years. Most forecasts range between 2% and 3%, which makes sense because the long-term inflation rate in the U.S. is about 2.5%. So, it's not like people are going out on a limb here.
As an investor, I think you have to make an over/under bet: Is it going to be 3% or more, or 2% or less? Most investors right now are betting 2% or less. You can see that in the enthusiasm for long-duration equities [such as growth stocks]. They're down a lot, but people are asking me when to get back in. So, there's still a lot of interest there, which shows that people are still expecting 2% or less inflation.
But in an environment where globalization is contracting, labor markets are tight, and all these other things, we think it's a good bet to take the over.
What kind of assets will work if you're right about inflation?
Pro-inflation assets include commodities, commodity-related countries, energy, materials, and industrials.
The energy sector right now in the U.S. is the No. 1 sector for dividend yield and the No. 1 sector for long-term growth. If you look at analysts' consensus estimates, the energy sector right now has almost twice the growth rate of the tech sector. [Bernstein's favored exchange-traded funds for those areas: Energy Select Sector SPDR (ticker: XLE) and SPDR S&P Global Natural Resources $(GNR)$.]
What about over a shorter time frame, like the coming year?
We're going to see the Fed tightening and profits decelerating. Those are two pretty certain things. What works in that environment is the defensive stuff. We're overweight consumer staples, utilities, healthcare, China, Japan. Anything that has countercyclical possibilities. [His favored ETFs: iShares Global Consumer Staples $(KXI)$, Utilities Select Sector SPDR $(XLU)$, Health Care Select Sector SPDR $(XLV)$, iShares Global Healthcare $(IXJ)$, iShares MSCI China $(MCHI)$.]
Will the S&P 500 be higher or lower one year from now?
As much as I think there's still downside risk today, we'll be higher a year from now. The more the market goes down in the near term, the easier it gets to say that.
But I don't feel confident saying we've seen the bottom. For that to happen, you need to see people under their desks in a fetal position. The No. 1 question I'm asked is, "Tech is down so much, isn't it about time to get back in?" That's not good. I want to hear people asking questions like, "Who would ever own stocks again?" When you start hearing that, it's probably a good time to start speculating again.
Chinese stocks don't have a lot of fans. What's the bull case there?
We follow three guideposts here at RBA. We follow profits, we follow liquidity, and we follow sentiment and valuation. Everything we do revolves around those three things.
So, let's talk about liquidity. The Chinese central bank is easing monetary policy just as Western central banks are either tightening or considering tightening. Next, as corporate-profit cycles in developed markets are beginning to peak, it looks like the Chinese profit cycle is starting to bottom as they exit Covid lockdowns. And then sentiment: People hate China, as you prefaced in your question.
What's attractive on the fixed-income side of the portfolio?
The main drivers of corporate-credit performance are cash flows and profitability. So, if we're on the downside of a profit cycle, that means you want to shy away from credit. On the upside of a cycle, you want all the cyclicality you can get in your portfolio. For a fixed-income investor, that means go buy junk bonds -- the junkier the better. Because as profits go up, the risk of default goes down and their values increase.
On the downside of a profit cycle, that reverses and the risk of default and bankruptcy goes up. Corporate balance sheets are strong right now, but on the margin you'll still have these effects and the market will reflect that. So, we've been repositioning our portfolios away from credit, certainly away from junk. We still have investment grade, but we've been moving up the quality spectrum. [Bernstein favors iShares iBoxx $ Investment Grade Corporate Bond $(LQD)$.]
It's the same story for municipals or sovereign debt. Anything where revenue is going to be under duress, you probably want to shy away from.
It has been the worst start to a year for the 60/40 stock/bond portfolio ever, and many say that allocation is dead. What do you think?
I disagree strongly. Stock and bond correlations have gone way up, because stocks that were outperforming were a very narrow group of long-duration and very interest-rate-sensitive equities. Now that rates are up, the stock market went down just like bonds.
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