#34 - Jeffrey Sherman: Fixed Income, Market Outlook

24:42You're not going to be the superstar. but you're going to have a long career. Investing, it's the same way, right? If you're good enough, if you can outperform that venture by just a little bit every year, well, guess what? In 10 years, wow, if you didn't have these ups and downs, these big swings, you didn't blow up along the way, you didn't have this big donut hole in your portfolio for a while, then you're going to have a pretty strong tracker because people tend to gravitate that. They don't manage the risk, they let the risk manage itself. And so it's that idea of letting the winner run. There's nothing wrong with letting the winner run if the winner keeps winning.

25:18And you have a thesis for why it should keep winning and it should keep doing it, especially in the equity world. And so in the bond world, if we buy a good bond, you know, we get back in maturity, we get back far, right? So at the end of the day, you just got to be good enough, just make sure that that company or that security or that asset type, it survives. And so the balance is that you want to have different things that work at different times. Investors love to look at their portfolio and see everything up, right? I mean, you would agree. You don't mind that, right? I mean, it's great to do a client review.

25:51Yeah, everything's up. We're so brilliant. But if everything's up, you have some form of correlation. You may not be that diversified, right? You don't have some balance in there. And so, and then you also know when you've been in there and you have 30 line lines in the portfolio and 2900 positive, the clients go, what was this one, right? What is this one that was negative? And I'll say that's the diversifier, right? But that's the idea is that you want the things to work together. And you see, I'm using my hands to do all this. And like, it's a multidimensional puzzle. And so the more things you can bring into the portfolio that help offset risk or at least diversify them is a good thing.

26:29Now, we've kind of used a phrase around the double line train desk that we call it risk integration. And so I don't like to hedge. Hedge costs money. The sayings, there's no perfect hedge except in the Japanese garden, right? And so if I can find things that offset each other, but also pay me and have a positive expected return, those are things I want to have in my portfolio. said in mathematical speak, things that have low correlation, right? Or, you know, have negative correlation, they're going to be different. If you buy two negatively correlated assets, one should go up, one should go down, maybe not every day, but through a period of time.

27:06So you're guaranteed to have a loser, but the portfolio can be much more resilient. And that's something that I try to teach my younger quants and they're not so young anymore. And then how do you think about balancing your thinking? So, and what I mean by that is, is if you're a quantitative type of person, maybe you want to spend more time studying fundamentals. I always think it's helpful to be a student of history so you can balance your actual experience with all the other things that have happened in the past, understanding behavioral biases, understanding your own biases. Would you talk about how you think about all that?

27:42Yeah, I mean, that's a lot. I think that, you know, the easiest thing to do is find opinions different than yours and read them and try to figure out why their argument makes some sense. don't come in with that inherent bias. I'm right. You're wrong. I'm going to read yours. I'm going to poke every hole on it. Actually try to find out why they could be right or why they're absolutely wrong, right? But make sure you're listening to the other side. Tell me where I'm wrong. I like this idea. Tell me where it goes wrong, right? And is that a risk we're willing to take? So I think that's very important, especially when you're doing research.

28:18In research, the inherent thing is to really find a confirmation bias. Read someone who has the same opinion as you, go out there and read their stuff and say, yes, see, now it's exactly right. This is why I had this idea. I think it is extremely beneficial to try to read the other side. The behavioral aspect is exactly what we're talking about here, right? You're seeking like-minded individuals because it makes us feel good, right? We have this positive affirmation. It's reinforcing and it allows us to, you know, just allot ourselves and our brilliance, right? At the end of it. And so I think that's important.

28:58I think it's history to understand that, as you said, you know, working with long data series, like going back and what's different about this market versus another one? Does it rhyme? And I know people like overlays. Like I keep seeing it now. Like here's the NASDAQ bubble. And if you take NVIDIA back 22 years, you overlay it. Here's where we are. But is that really the same environment we're in? Is that really the same story to the single stock that it was for this overall market? And I think the answer is probably no. And so, you know, the behavioral side is very difficult because, you know, we always look for that affirmation.

29:35And look, the scoreboard is there every day in the investment business, right? Every day, there's either a positive or negative experience you have. And, you know, I think the worst part is when you have just nothing but failures. right um yeah i'd like the the collective you know repetitive success is great of course but those days where it's like look this is just not working it's not why isn't it working and then the question is do you get out of it now or is it about to work right and so you have to you have to kind of re-underwrite too but the behavioral thing i think is important for any young investor and new to this to understand what we've done and we talked about it right like i I have an inherent bias of my vintage of when I started in the business, right?

30:18I know that. So what do I do? I'm one of the guys that just goes and buys equities and just doesn't think about it. I don't ever try to trade it. I have systematic strategies that we use. I like all of those because they make sense to me. And I'm just kind of a steady buyer of those, right? Another thing I do, and it's probably where a lot of us are guilty of this these days, is I bought, I buy venture capital and private equity was a lot of my equity money. Why? I don't know what they're doing. I can't get in there and have an opinion about this stuff. And you know what? It tends to work. Okay.

30:51And I'm like, you know what? Let, let those guys do that. So it's also understanding your weaknesses and trying to play into them, but anything you can do to kind of round yourself out. And that's why I think it's always good to have, you know, go have these dinners with a bunch of people and just discuss ideas. Don't get a bunch of people who all think the same thing and do that. Those are fun dinners, don't get me wrong. But it's always good to have someone in there. So I think that's what's helping bring in the balance. But in today's world where, you know, we can find, you know, new sources that are targeted to exactly whatever we're thinking, I'm not talking about left versus right, I'm talking about very narrow corners of things.

31:31It's much more difficult. And I think too many people are, they succumb to that. And maybe that's why we have a bit of the kind of polarization we have in some of these areas is because of that. Right. It's like, no, I'm absolutely right. I know 18 other people on here that say I'm absolutely right. Our venue is all that matters. And forget the other, you know, 8 billion people in the world. Right. So anyway, I think all these things are very important. History is a guide. There's a Buffett quote I like. Everybody loves Warren Buffett. One of my favorite quotes from him was that if history was all there was, and I'm paraphrasing because I don't remember exactly, but if history was all there was to investing, the richest people in the world would be librarians.

32:13So let that sink in. I like it. Let's transition to your outlook. Obviously, you spent a lot of time thinking about that. And let me start with kind of high level. As a bond investor, what do you think about the US and other major developed economies, printing money and debasing the currency at unprecedented levels. It seems every day we get closer to a tipping point. And obviously, it seems like it's not a problem until it becomes the most important thing, that tipping point. And are there signs you're looking forward to try to get a head start on the market? So to answer it very concisely, the answer is, yes, I'm concerned.

32:55Because again, we're taught fiscal austerity. You're taught to, you know, as a individual, I have to be austere. I can't spend more than I make, right? Or I just won't survive, right? Unless I've got good people around me to lend me money all the time for free. And so I think the difference that we see is that there's a lot of arguments of debt to GDP. Is that the right kind of measure? Because GDP is the assets. That's kind of how we think about it. But GDP is not the only asset. is the unfortunate thing. Look around your neighborhood. There's a lot of houses out there, right? Those aren't in GDP, right?

33:33But they're assets, right? So that's another, I think the debt to asset ratio is probably a little bit better to think through things. And that includes financial assets. That includes the sofa that's behind you. It's everything. As you think about it, those are the overall assets. So I am concerned about it. I think it's been reckless. There's no semblance of trying to slow this down. And look, it's coordinated globally, which is why I don't think there's been there hasn't really been a debasement of the US dollar, for instance. Right. Because we're all pursuing similar kind of strategies. And so from that standpoint, it's not you said it best.

34:13It's not a problem until it is. And, you know, it's like the it's the old like great Gatsby quote. Right. How'd you go bankrupt? It was like very slowly. Then all of a sudden. Right. And so what's the telltale sign? We all know what the spending is going to be, right? The Treasury told you that they're going to borrow$740 billion in the next three months, right? That was the quarterly refunding announcement that came out this week. We all know that. What's the bond market do so far? It's rallying, right? Why? Well, there's something else driving it. So when you know, it's probably too late. It's the slowly part we're in, and then the sudden will happen.

34:50And I'll credit my friend, Jim Bianco, on this, who's the economist out of Chicago that has his own research shop. And he said it to me very nicely. It looks like the UK guilt crisis. It's that a policy comes out and the bond market pukes. And there was a lot of talk of this last summer, right? If you remember from that July to kind of like, you know, late September, early October, every headline was about the deficit, right? The reason bond yields are going up, the untenability of this, the unsustainable nature. And that's not what happened in the gilts market. Yes, the 10-year went up like 140 basis points from the trough to the peak last year.

35:32But it happened over like 10, 11 weeks. that movement happened in the gilts market in days right so i think and that was in response to liz trust coming out and saying we're going to fight inflation by cutting taxes and doing more quantitative easing right to stimulative policies and the bond market said no you're not now you could argue that it's a tighter market the pension schemes over in the uk they tend to all invest in long bonds like they have guilt linkers which is inflation linked long bonds They do a little bit of leverage because of the shape of the curve. That's always been somewhat beneficial over the long period of time.

36:10What also another way of saying it, it's a crowded trade. Alex, you consult to a lot of folks here in the US, right? Think about our pensions schemes that we call pension plans. Scheme sounds dirty in the American language, right? But the defined benefit plans that are out there that are hedging this, what do they own? They own long treasuries. They own long corporate bonds, right? They're in a very similar position. So this idea that it can't happen here because we have a bigger economy, a bigger system, I disagree with. If that trade starts unwinding, it's problematic. And so I think that you'll recognize it from the bond market.

36:49I was on a conference call with some very well-known investors. Somehow they accidentally invited me. I don't think they meant to. And I was listening to them talk. I won't drop any names. and they were saying, you know what, for our politicians to pay attention, the law and bond needs to get to six. And, you know, I was listening to this and that's what's going to be held. That's the bond vigilantism. And they're from a different generation. They've been through the true bond vigilantism. But I kind of chuckled. You know, it was early on the West Coast. It was like 530 and I'm still drinking coffee listening.

37:24And I chuckled. And someone said, why did you laugh? And I said, do you think any of our political leaders know what the long bond is? Have you looked at Congress lately, right? And so, you know, but I said, look, I respect your guys' opinion. It's just that I'm not really sure that that happens. I think it has to be over a longer period of time. It has to hit the budget. It has to go through. And look, we just published a paper. one of our analysts on our macro team put something out about the estimates and how horrible it looks out there. And it will be a problem one day. And there's one way out.

38:03Well, there's not one way out. There's many ways out. The best way out of it, you grow your way through it. You increase nominal GDP by more than this, and it gets through it. So that is the answer. If we can't get there, then the answer is devaluation or it's inflation. And then there's the worst one of all, there's default. And I've heard this from our emerging markets team for the last 15 years. Like, well, the EM world, it's a better story. It's a secular growth story. And I agree with all that. And their financial houses are better. They're better at managing. I'm like, hold on. That I can't agree with.

38:42They're in a better financial position today, but they've also defaulted to get to that position. So I'm not here to say the US is defaulting. So please don't make that someone listen to this and becomes a headline out there. But I mean, maybe it is some form of jubilee. Maybe we just have to have some fiscal austerity and try to grow our way through it. So I don't know the answer, but I think you'll recognize the signs from the market. And at one point, the market will rebel and that will change things. But so far, so good. But that doesn't mean we should keep doing it just because it worked.

39:20Right. And you're talking more in nominal terms. So the 10-year treasury may start to drift upwards as the pressure starts to mount. But how do you think about real interest rates in that type of environment? It depends on what the relief valve is. If the relief valve is the dollar, then maybe you still have decent real yield. but maybe you have negative real yields because it is putting pressure on inflation there too. And so that means that probably if you get that, then the nominals have to continue to rise, right? Because at some point investors will say, why would I buy this worthless piece of paper, right?

39:57That doesn't even outstrip inflation. I'll just take my chances elsewhere. And so real yields historically vacillate between the 1 % and 2 % range. If you go back and you study kind of the series I grew up on back then was called the Ibbotson series, right? The SBBI series, stocks, bonds, bills, and inflation. And if you go back to that, it's kind of what you figure out. And then I kind of always use the post-World War II era. I was kind of taught that, that a lot happened during the wars and everything there. So that's kind of the way to think about the economy. But if you were sitting in the markets in 2020, and let's say you were getting to being a mature investor, you've been in the markets for 12 years, you'd say, no, real yields are zero because they were for that entire period.

40:46So I think what would happen there is because inflation was so muted that people were comfortable. You didn't need compensation for that inflation premium because it didn't exist. But now we've seen it again, right? We've seen inflation again. So when you start to see some symbols, I think traders will trade it much quicker because now versus being a student of history, say, well, that just happened in the 70s and 80s. Those crazies, what were they thinking, right? Well, it's got the gold standard. That drove inflation, right? So we have nothing to worry about. We all coordinate this 2%. Well, maybe that period was the aberration, the post-GFC to the pandemic.

41:25And I'm a believer of that. I think these are more normalized markets. So I think investors are going to demand that real yield there. And we have it today. And I know the bond markets rallied a lot today on the day we're reporting this. This is the day after the Fed meeting, too. There's a little bit of weak manufacturing data that kind of continue to rally. But in general, I think that what you see out there is that, you know, investors aren't used to seeing these type of environments. And so just remember the age cohort that's come in, a lot of them had never seen rate hikes before, right? Never saw them, right?

42:01We used to joke about that in the mid-teens, right? Like in the 2010s, you haven't even seen a rate hike. What do you even know about, right? Now you see it. Now I'm like, I never saw 9 % inflation in my career. Now I have, right? And so this is, again, a function of experience that helps you. But I think that under that scenario, I think, you know, it's kind of like, what do people do in Argentina and Venezuela? You buy stocks because they're nominally linked, right? At least prices are nominal, right? And so earnings can be nominal. So you may not be keeping pace with things, but there are things you want to tie that are tied to more nominal assets.

42:39And so I think that's part of it. And like real estate, right? I think you want to own real things in that environment. But in that environment, you probably don't want to own the 30-year long bond. Right. If we were to zoom out and look at the bond market, and we look at the last several decades, so you had this extended period of falling interest rates. So you had this falling rate tailwind from the early 80s to the GFC. Then we had a decade plus of near zero or zero rates. And so do you view us in a new regime today relative to the last 40 years? You know, I didn't, I've lived through the whole 40-year bond bull market, but I didn't invest in it, right?

43:19I wasn't those, you know, prodigies that were like six years old saying I was picking stocks or anything. I'll be honest, I never bought a bond until I was in my 20s. So I can't say I benefited from it. But the difference is, I think, is that, you know, there's so much made of that. And it's easy to look at a chart and say that. But I don't know. I mean, I started in 21, right? I watched that. I watched rates go down, right? I mean, like rates went down meaningfully in 2003. I remember the agency mortgage market, I think the prepay speeds that year were like 80%. Like we got this big refi wave too.

43:54Rates came down, but then all of a sudden rates went back up. So even at this 40-year bull market, well, it's great if you got the 40-year horizon, but you got to live through it. You got to invest through it. And so, you know, I think what it is, is that I think we need to be a little more discerning now. And would you buy a negative yielding bond today, Alex? No. But how many people did six years ago, right? I mean, it's crazy to think that that was the world we live in. So are we in a new regime? I don't think we're in a new regime. I think we're in a more normalized regime. And I know some people are calling new normal.

44:31I don't think there's such thing. I think there's so many parallels to the 2000 period, right? You got a credit boom. The GDP is growing. We're not growing as much because we're on a lower trajectory because of the debt burden and everything. But there's a lot of similarities, you know, yields where they are, you know, credit spreads where they are. And so I feel like this is more of kind of the earlier part of my career than that middle part. And I think there's, it's a better market, right? At least, you know, I know that if I sit in cash today, I'm going to earn 5 % plus. Even if the Fed cuts, I'm still going to earn 5%.

45:09That's a lot, right? And it's not a lot to your high-octane investor. But where I compare that to, if you go back into like, I think it was August of 21. That's not that long ago, right? We're talking three years ago. The high-yield bond market yielded like 3.5, 3.75. That was yield, not spread. Actually, most of it was spread. They were very similar numbers because the yield was so low. But think about that. Today, a T-bill yields more than the entire junky part of the bond market back three years ago. And so I think that needs to be recognized. And it changes the playbook. It changes the playbook because you don't have to be super aggressive to get mid to high single digit returns now.

45:56You don't have to go off the reservation. You don't have to blindly buy pools of assets, you have no idea what's in them. And so I think that the dynamics are better today, but I don't think it's much different than what I would call, at least what I thought of as a typical cycle. And it begs the question, where are we at this cycle? Look, there's still a lot of liquidity out there, right? We've rented a lot of money. You can't expect to give, inject the currency, increase the currency float by$7 trillion and nothing happened, It's going to go places. It's going to find levels. It's going to go in the housing market.

46:31It's going to go in stocks. It's going to speculate. It's going to buy things. It's going to buy experiences. And so I think that's part of it. And I think the difference here, some of us missed early on and why there's been these calls for recession for a long period of time is that I think the Fed transmission mechanisms work. And I think what a lot of people have missed that I've really started to appreciate is it's not the credit component. Obviously, credit is more expensive, right? You want to borrow money in a house, car, auto, I'm sorry, credit card, student loan, they're higher. Corporate America is paying a higher rate than it was before.

47:10But a lot of us have our debt stock finance like mortgages in the 2 % range, 3 % range, right? So the new rates don't affect us on those purchases, right? So the credit component worked. The Fed was able to achieve that. what hasn't happened is that increased savings component, right? And this is something that I struggled with for the last 18 months. I'm trying to figure out why. And 18 months ago, I just said, well, it's obvious, Alex. You know what the deal is? Is that people don't think their 4.5 % cash rate that they're getting is enough to outstrip inflation. So I understand that. You're not going to save because you know what?

47:49You can go spend the money because the money's eroding much quicker. But now I'm like, well, inflation's down. Price levels are still elevated, as we all know. We won't accept deflation, so they're going to stay elevated. But why aren't people saving more today? Why don't we see a significant increase in savings rate? Maybe it's because the prices are expensive. Maybe that's what it is. Maybe the other component is people are actually keeping their savings in a savings account, and they're getting these basis points. So you know what? They're saying, look, my inflation rate's high. Since the pandemic, my inflation is over 20%.

48:25I'm getting basis points. Let's just go take the trip to Italy, right? Let's just go to Disney World, right? You know, let's pack up the car and go. And so I think there's some of that component where people who don't have that enough literacy to understand this, and it's not their fault. They just haven't been educated on it, right? That they are suffering or they're not being able to take advantage of it, right? And so I think that's part of the transmission mechanism that hasn't applied. I don't think it's broken, but the banking system isn't passing that through unless you ask. And if you don't know to ask, you don't know.

49:03And so I think that's part of what's changed in this environment, which is let this kind of economy go on a bit longer and why spending has stayed elevated throughout this cycle. And look, maybe the Fed's engineering a soft landing. Maybe this is a good thing that's happening that they're going to cut rates and do that because, you know, it's hurting those lower income strata and the lower quality borrowers. It's hurting small business. And so maybe that's why we're doing it. It's not the aggregate they're looking at. They're looking at that targeted area. And so, you know, these are all the kind of things as you kind of zoom out and try to figure out what's going on in the economy is that, you know, look, the consumption data is there and it will be there until people lose their jobs.

49:47And so that's the thing to really, I think, for all investors to focus on. And, you know, we got unemployment claims today. They were a little weaker or there's more claims than we've seen in a while. And so we'll have to see, is this a trend or is it something, is it just kind of aberration in the data? I know I went on a long tangent on that, but. That's okay. One thing that you quickly reference is this whole notion of an inverted yield curve, which you've had for two years. and that has surprised a lot of economists and investors because when you look backwards, at least for the last 40 years, whenever you've had that, you ended up with a recession and we haven't had a recession.

50:25And I think part of it is what you described with loans getting extended out, but also part of it is the boom was largely fueled by fiscal transfers and sending people checks and spending some of that excess savings. And it'll be interesting to see how long that plays out. Yeah, I agree with that. And look, I think that, again, when I look at it, I look at kind of just the aggregate too on the M2. And if you plot the level of that, we're still way above the trend line. Because, I mean, we increased the monetary base by like 30 some percent, you know, in 2020 and 21. I mean, it was unreal. It's literally unprecedented, you know.

51:03And so from that standpoint, it's got to find a home. And, you know, look, maybe people are looking at the high-sert house and going, yeah, I feel okay. I could sell this if I have to. I don't know. I mean, I don't know how often you look at Zillow. I really don't. But I can't imagine people marking the mark and going, oh, I'm going to go out to a nice dinner tonight because Zillow says my house is up. But I think there's some of that just going around. And like at the end of the day, I think also our taste and preferences have changed. And that's what you won't find by looking in a historical data set.

51:35This is where you need some experience. You need to know people who have lived through it. Because if you look through the data set and you just looked over the last 10 years, you'd say, wow, something weird happened in 20. But then, man, they just figured it all out and all got together. But also, I think our behaviors have all changed. Well, not all of us, but in general, I think there's a higher valuation on doing things, right? Or people value that more. And you're seeing that. The service data, we've always been, for the last 20 years, we've been a service-based economy. But it's becoming more and more reliant on it.

52:07And I think some of that is just the change that we've seen because, again, we lock people down for a while. And so that's the thing that's hard to look at a data set and say, what's happened? So you got to go pull some news clippings, pull some covers of magazines, try to figure out what happened in that era that changed that dynamic. And again, no one can really relate to it unless you've truly experienced it. And so that's the thing that I'm trying to figure out as well is that are we different people now? And what we value and what we cherish more, is that driving some of this as well? And two other things that I think about in terms of surprises that may come in the future, obviously always thinking about what we're missing.

52:57One is the Fed's reaction function. Now that inflation is a real concern, we haven't really had that problem for a long time. And second is where default rates may go. When you look at default rates in a fall and re-end environment, that may understate the risk because you can refinance easier and extend your debt. How do you think about those two? Well, the latter, I think, is something that most of us haven't seen because we'll talk about the 40-year bull market there, right? The high-yield market wasn't invented until we had the bull market, right? I mean, it really took off in the early 80s.

53:31And so from thinking about that, it's never really went through this long secular period of 10 years of rising rates, right? And so you're absolutely correct with that. Maybe the default experience, especially as of late, is understated. I think there's another culprit, which is understanding default rates today. And it's private credit. And that that's been a backstop that if a company is really struggling, you sell your sold to the PE firm or the, you know, that's, that's going to take you private, you know, take all some of your equity away, get some warrants, do all these things. They're going to restructure it for you and let you survive for a period of time.

54:08And so I think some of that's happening. We've seen that in the loan market too, where the loans look like they're about to default and they just get pulled into the private market. And so the secular rate rise would be very interesting to see how defaults behave because, Because the one thing about the post-GFC to the pandemic is that we didn't really have a true business cycle. Anytime there was any sort of wobbliness in the economy, it's like we did some form of stimulus, right? A lot of it was monetary and not fiscal. But we did that. And so by repressing rates, and I don't know if I love the financial repression phrase, but I'll use it here.

54:48But by keeping rates, let's say, abnormally low or maybe below where they should be, we let companies survive that shouldn't. The whole business cycle component is that we have excesses. And so the excesses need to get worked off. And that's through the default cycle. I mean, look, I think if Uber would have came out in the mid-2000s, it probably wouldn't have survived. Right. You couldn't have used all this private money to be able to subsidize it, to grow it and get the base that they needed to do. That same for Lyft as well. Again, no criticism of either of those companies, just that they have cheap financing, access to capital.

55:28I mean, look, you can't tell me that Uber should be cheaper than the taxi. Right. You know, it just doesn't make sense. It can't be half the price. Right. You know, there's something wrong with one of the business models somewhere, but it was being subsidized. So I think that the default cycle will look different if we go into these rights. And remember, there's still parts of the high yield market that have very low coupon, right? And so they don't want higher rates for that same reason. Most high yield bonds don't ever pay off. They get rolled over, right? It's not like they pay down that debt.

56:02So I think that's a very important thing to think through through the cycle. And I forgot the first part of the question because I got so obsessed with the high yield. No worries. the Fed's reaction function and how they may be different? I think no one wants zero rates again. I don't think really anybody does, at least from the invest. I don't think the Fed does either. I think what you see the Fed's reaction function in terminal, right? What we call the terminal rate. So you go to the dot plot. The terminal rate just means where does the Fed end up in kind of normal times? It's not where it actually ends in a cycle.

56:33It's defined. It's like R star. It's kind of defined to be, what is the rate that's neither contractionary nor expansion? And so if you look at the dot plots and the long-term estimates that come out of those, they've moved up over the last five years, right? And so, or at least over the last three. And so that I think is that the Fed's reaction function is going to be that, okay, we're still going to get some level of inflation. And it may be a little bit more than our comfort level is. Thus, we need a little bit higher rate. Plus, we need some premium on there to incentivize investment. So I think that's why the kind of terminal rate has went up.

57:13But still, I mean, look, will they cut below what is terminal? If they need to, they would. But I do think that that's kind of reflected in those dots. And if you go out and you can go like the euro dollar market, the SOFR futures market and look at it, it's kind of what the market has said. The market has gravitated to those dot plots and says that's effectively where we're going. The path may not look the same as the Fed's dots, right? But that's what it says. So I think it just depends, right? If we get inflation, if we're having a recession, they cut rates, and then they see this massive deluge of fiscal stimulus, maybe they do react faster to the other ones.

57:52So I think we just need to be prepared that if we have a recession and you start to see that response, I think you and I are going to have to react quicker, irrespective of the Fed, and we're to think about the implications there. Because I think Congress realized last time when bad things happen, if we throw a lot of money at it, we're going to get reelected. And look, it's a fact of the nature of the job. So you alluded to this earlier, but one of the ways to get out of your debt problems, massive fiscal deficit problems is to inflate your way out. And so there is some incentive to have maybe higher inflation than we've seen for the last 30 or 40 years.

58:37So based on that, what's your outlook for inflation over the short term and over the long term? Yeah, well, the Fed has to get us to two first, right? Because you can't you can't say we've missed our target. So we're changing the target. Well, you can, right? You lose some credibility if you do that. That's the thing. And they need credibility to, because it's not just the credibility of you and I, it's the credibility of the world. It's the stability of the dollar. It's the treasury market. They have to convey that. So I think there should be an acceptance for a little bit higher level of inflation.

59:10Like Alex, why is price stability defined to be 2 % inflation a year? I thought price stability would be zero inflation, right? I mean, if you really think about it, That's truly price stability. But the problem is, is that the Fed is worried about deflation. They're always worried about contraction. And to you and I, deflation is a great thing as someone who's going to buy something. But if you're a seller of goods and services, you don't want deflation, right? Because ultimately, you have to charge less. And so it's less value to your product, especially if you produced it earlier. So there's this weird asymmetry within kind of how the Fed has to think about things.

59:53And so deflation's evil. 2 % inflation is like optimal. But three, is it really that evil? I don't think so. And I like to remind people that before the financial crisis, and we all kind of lived through it, know what happened there. But if you go back to the inflation rate back in like 06 and 07, they were between three and 4%. You're like, no, no way. You're crazy. No, they were. We didn't explicitly target these 2 % inflation numbers, right? It's something that was created along the way. And so there's this dynamic of like, this is how we've always done it. The answer is no. And some level of inflation is good.

1:00:37But the problem is it's a regressive tax. And the problem is that you hurt the lower income strata. You hurt the impoverished. It hits them the most because inflation, if it's rampant and it's everywhere, they get penalized the most. A billionaire doesn't care about inflation. Well, they're going to tell you they do. They're going to complain about it, but they're still going to consume the way they consume. I've had this debate. Well, two, three, does it really matter? And over 10 years, it does, right? Because that purchasing power erodes a lot quicker. So, you know, I think that we've seen a different dynamic.

1:01:14I feel that we will have higher levels of inflation than we had during that GFC to pandemic period. But I don't know if it's going to be rampant. You know, I think it's just maybe that, you know, maybe we value a worker better. Maybe we have an appreciation for that lower income strata. We say we need to get them more things so they can consume more. Remember, the economy did pretty damn well when we create all that inflation. Now, you didn't feel like it, but asset prices did well. People were going out. People were buying things. And so, again, there's got to be a happy medium in there. It can't be living on the extrema.

1:01:51But I do think that we could see a higher level of inflation cycle because we have seen it. And we say, you know what? Two and a half, three, it's really not that big a deal. And again, I understand it is regressive. And I know I've said that multiple times, but I just feel that, you know, the Fed can't change it. And I actually think that why does the central bank target inflation rate? And I know it's that we're trying to bring price stability, trying to help everybody out. But I think the next kind of Fed review, I think the idea that's going to be floated the next time is nominal GDP targeting.

1:02:28We want to get to six, right? Six because we grow nominally, right? We got to grow our way out of this. So if we target six, now there's nothing that says we'll achieve it. Does it matter if it's three and a half real, two and a half inflation or three real, three inflation? Probably not that much different, right? But if we're so obsessed with that 2 % number and the two and a half is just way too much, well, maybe then we stimulate. It's just inefficient use of capital. So it's hard to see what it looks like. And I think we're going to have to see how our fiscal authorities behave and can they rein it in.

1:03:10And if they can't rein it in, then I think we're probably going back to a little bit of a higher inflation rate than we even have today. One question that I had is how you think about today's just general environment relative to the 1970s, particularly this notion that inflation is going to come back down towards that 2 % to 3 % target. And it is pretty fascinating when you look at inflation jumped to 9 % plus, yet nobody expected it to stay there. The market's always pricing it to come back down. And so how is that related to what we experienced in the 70s where it continued to surprise to the upside?

1:03:49Yeah, well, you had the wage price spiral there. You didn't really have it in this instance. And this is why I put a slide like this in my last webcast I did a few weeks ago. And again, I'll admit I cherry picked the date. And I did it because I was trying to tell a story. And I put it from June of 2020 through current. and I showed CPI and I showed average hourly earnings. And they're essentially neck and neck, right? CPI is a little bit higher. If I was a politician, I'd say, well, there you go. That's why the economy stinks, right? But the reason I didn't use just early, like let's say December of 19 was because during the pandemic, average hourly earnings spiked in March.

1:04:35And it's like, wait, all these people lost their jobs. How did earnings go up? Well, the bottom income cohorts dropped out. Right. They're the ones that that couldn't work where the blue collar or the white collar worker was still getting paid. So it distorted the mix of it. So that's why I kind of chose that date. But if you kind of think about it during that 70s experience, wages were continuing to go up somewhat commensurate with inflation at that time. And so I think what's happened in this in this market is that we haven't really succumbed meaningfully to that wage price spiral. I think at first, the big 9 % inflation number you got was goods, right?

1:05:16There was truly supply chains, not supply side, but the supply chains, the lack of being able to find things. I mean, look at auto prices, look at appliances, look at delivery time. Everything was a disaster. And then once we opened back up, the excess savings, the stimulus, all the checks everybody got were then put to work in other things, right? It's like, let's go spend. So services came up, but also housing is the big piece there. And so I think that's what most people saw in the inflation data is that it's owner's equivalent rent. That is the kind of shorthand for saying rents and kind of housing in general.

1:05:54And that number should roll over eventually, right? And so I think that is the difference. It's where the inflation's coming from. In the 70s, it was significantly more focused on goods and you had this wage price spiral. And you're not really seeing that in today's market. So I think that's the differences here and why the market has been much more sanguine and confident about that coming down. I don't remember the peak in 10-year break-evens, but I want to say it was like 325. It was like a three-handle, even when we were at 9 % inflation, right? Because it was not the belief that we would get there.

1:06:32I think two years got to like the two-year break even got to like 4 % during that period. But now they're all just coiled around this kind of two and a quarter to 240 number. And so I think the reason is, is that you look at the components of it, it's a different level of inflation. Also, we're not dealing with an oil price problem, right? That's what's kind of missing from this one as well too, is that this inflation wasn't commodity driven. In early 08, we had a lot of inflation. Why? Oil prices hit$150 a barrel, 42 gallons, right? So they hit a barrel. That was in June of 2008, right? As we're in the precipice of a recession, right?

1:07:11And a lot of times, recessions are caused by oil price spikes, right? And that's a big difference, I think, about this market too. Prices have been relatively well-contained in the oil market. And I think somehow, even with geopolitical tensions that we've had for a long creative time. Oil hasn't really responded to most of those. And I think a lot of it is because the U.S. is a big producer now, right? And we're an exporter and we've balanced that supply. So back to your balance of risk and the portfolio, I think the oil market's more balanced that way as well. So I do think they're different.

1:07:45Double line launch just after the GFC. And at that time, you found many amazing opportunities. Since then, you've had a pretty benign credit environment. Do you generally think that it's harder to find great trades in that environment? And how do you see that evolving? Yeah, no, it is harder. It's meaningfully harder because when everybody's happy, spreads are tight. When everybody's scared, that's when it's the best time to buy, right? And so it's definitely a tighter time right now. The difference in that period of time in late 2009, early 2010, was that the mortgage market was so roiled at that point.

1:08:26and investors had zero confidence in it. They saw how bad it went down. They wouldn't believe your analytical framework. They wouldn't believe that these bonds would ever return any of the money that you put into them at 40 cents on the dollar, right? And they were completely analyzable. And so, man, there was ways of balancing that out. So when you get a dislocated market, there are things you can do. The problem is that they're not popular And that's why the market gets dislocated. And look, there's a lot of smart people that made a lot of money at that point in time. And there were very obvious things to do.

1:09:05I remember a few years ago going back and I was cleaning out my inbox and I had all these archives. I'm like, why do I have this stuff archived? And I went into the archives and I was sending out emails to people saying, look, we can build you this customized portfolio to conserve a subject. And the A-heal is like 10. And, you know, like, look, you know, in a bad thing, here's kind of scenario analysis. They're like, I don't know. It's got too many mortgages and I don't like it. You know, like, oh, man, to live in those days again. Right. But I think, you know, there will be another opportunity.

1:09:35I think the commercial real estate market will, I don't know if it experiences a similar thing that the resi did back in that period of time, but we're not anywhere near the bottom in that market yet. We haven't even seen, you know, buildings come out and be available. So I think there will be some very good opportunities. And look, they'll be in the public market. Some of those deals will happen. A lot of them will happen in the private market. But in today's environment where spreads are tighter, they're tight for a reason. They're tight because the economy's done okay. The companies are generating cash flows.

1:10:09And by the way, the debt service coverage is high because their coupons are low. Now, does that mean that that company is great for the next 20 years? No, that company is great until the bonds roll over. right? And then we'll have to figure it out. So I think it's trying to think to that. And so what our below investment grade team on corporate bonds is doing today is saying, okay, do I want to own a loan? If I have a loan and a bond, what do I want to own? And do I think this company can make it through the cycle, right? And that is an important thing to think through as an investor. It's like, okay, if we have a downturn, what happens to this business?

1:10:46And so I think today's market is a little bit more idiosyncratic is where the good ideas are. The on the run stuff, everybody knows it. Everybody's well trafficked in it. And those things are tight and they're tight for a reason. You know, lending to Microsoft or Amazon, you're not going to probably lose money on that, right? They're going to pay you back, but you're not going to get a lot of money for it. So I think you have to be patient. And that's another thing is that, you know, I learned a lot of times that you can't force trades. You can't force into markets. Sometimes you have to buy in a market.

1:11:19Alex, you guys send us 100 million bucks. We've got to spend it. That's our job. We have a perspective. We have a mandate. We have to buy it. But we have to exercise discretion in doing so. And so I think it's very important to say you shouldn't get more bullish just because prices are up, right? A lot of times in bonds, you should actually kind of think a little bit the other way. But just because prices went up doesn't mean you should get negative either. And so I think what you see in the opportunity set, it's waiting for it to develop. Last year was a great time to invest in fixed income. And then we had this big challenge of we backloaded our returns all last year in the last two months.

1:11:58And the yields got low. And so it's a rough start to the year. But returns have been good. If you look at a two-year return on fixed income, it's pretty good, right? And so I think it's being patient. It's being diligent. But it's not just reaching. And that's where you get in trouble. And that's the whole blowout path. If you can manage the risk and be good enough, I think today's market's a good enough market. It's not the risk seekers market. And so I hope there's going to be a time we can talk. And it is the risk seekers market. And look, last summer was pretty good. Or in the fall, I should say.

1:12:33September and October, the phone was ringing off the hook. The emails were flying. People wanted to put stuff together. and look, you want to take risk? We could have built you a below-investigated portfolio in the 11, 12 range easy and felt comfortable with it, right? Because spreads were wide. And you're at like near five, right? We had, there was this opportunity step and the institutional community was out there. They were rampant. And then we got the rally and everybody's like, well, I don't know anything, right? And that's kind of where we are right now. And it's like, I'll just wait. But if you're waiting, you need to be calculated on how you do it and you have to have a plan.

1:13:11And right now the plan is to figure out is the labor market cracking? And if so, you want to own more rates probably than most people own today. And if it's not, then there's nothing wrong with owning that tight spread product. And guess what? I don't know which one it is, Alex, right now. I have an inclination that's probably more sanguine than I'm pessimistic. But you know what? I can buy both sides. I'll dilute your return down a little bit. But you know what? I'll feel very comfortable doing it. And it's better than indexing the product. So that's how I'm thinking about today's market. And let me ask you quickly about the Fed.

1:13:50So COVID hit and they threw the kitchen sink at the problem. With hindsight, it seems obvious they were too stimulative for too long. Then we had the highest inflation in 40 years and they aggressively tightened. What's next? They're going to cut. They're going to get back to kind of normalized rates. Jay told you, you know, for the last few meetings, he said it that they last summer, he's like, they were tight. They're intentionally tight. Now that he thought they were overly tight, right? So he's setting it up for the cut. He's probably going to deliver a cut. The market thinks they're cutting each of the three meetings at this point for the rest of the year.

1:14:28And I don't know, it seems a little little aggressive to me. I feel like they want to step into it. I feel like they want to go like the quarterly cutting cycle just to wait and see a little bit. And they accelerate it. They need to accelerate it. But the next path is to cut rates and they're going to do it. Is it 100 over the next year? Is it 150? I don't know. They'd have to cut it every meeting to get close to that 150. I kind of feel like it's more quarterly right now because they don't want to start to do that. Asset prices stimulate. That leads to people wanting to spend more money. If the wealth effect does exist, I'm on the fence about that.

1:15:05I'm not really convinced it does. But if that's the case and inflation takes off, then they have to hike again, right? So I think they want to be patient. The good news, why I think that too, is that they've been patient. They had to hike quickly because they were way behind. People have been calling for cuts. They've been calling for cuts for a year, right? I mean, the market's dead, the economy's dead. Economy still did pretty well in the second quarter from what I just saw in the first release. So I think that the idea here is I think the market's a little aggressive in thinking they're going to cut as quickly as they are.

1:15:41And I don't think they have to just get completely back to neutral. I think they can have a glide path. It doesn't need to be every meeting, but maybe they do the every meeting just to get us there quicker and then hit the brakes, right? And we'll have to wait and see. But as an investor, does it really matter if they cut 100 over a year or 100 in like six months? If that's where we're going, the market will sniff that out one way or the other. And so does it change the economy? No. Does it change the dynamics of some of the floaters? Of course. But you can blend this all together and put some floaters in there, put some fixed rate asset in there, have some rate exposure, have some more exotic credit exposure in there.

1:16:24and all of them mixed together, things will work in all those environments. It's just that if the Fed's slow to respond and they ignore the signs from the labor market, if that's what's deteriorating, that's when we have the problem because they're now talking about the labor market and they're talking about a little bit of weakness there. And remember the beige book is what they're talking about. Jay talks to lots of business leaders around the country. And I think that's the thing to focus on. It's not inflation anymore. It's the labor market and how robust is it? And the bond market seems to think it's not a problem, that everything's moderating and we'll have to wait and see.

1:17:02But I do think that the Fed will start to cut. They're going to bring those rate cuts through 25. And just where they end, I'm not convinced yet, because I think it also depends on the outcome of the election, right? And that's going to dictate something because the policies will be pretty different depending on the outcome there. And I think that's something that, you know, we can all have our own crystal ball and everything. But look, there's a scenario where you get a sweep from one side, and all of a sudden, now you're jamming policies down, you know, that the whole dynamic changes. And so that's something that has to be in the back of investors' mind right now.

1:17:42And that's why we're like, well, what are they doing 25? I say, let me get through the first Tuesday in November. Hopefully, we know Tuesday night. Hopefully it doesn't take us a week plus like the last time. I guess that's still quicker than the Bush election, right? Back in, what was that? 04, right? And we'll have to see what happens. And so that's why I want to pause through a little bit of this because there could be something extreme that comes out of that. And an investor needs to think through that. And I don't like to reverse trades. I don't like to have something on and then have to change it.

1:18:19I like to build things that can go over longer periods of time. And that's just the discipline we try to bring. This is great. Jeffrey, I've known you for over a decade and you've always had infinite energy, which was on full display today. But I know your time is finite. So I appreciate you spending about an hour and a half with us sharing your insights. Thank you. Yeah. Great to be here, Alex. As always, it's a pleasure talking to you. And as usual, I enjoy the conversation. Usually I'm asking the questions. A lot of times in our reviews, it's me giving you this energy, but it's great to share it with your listeners.

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