#73 - Greg Sharenow: Inflation History, Outlook, and Hedging

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0:38Today, I'm in beautiful Newport Beach, California in PIMCO's spectacular studio. If you're listening to this podcast on audio only, you should check out the video version on YouTube or Spotify. Today's guest is Greg Chernow. Greg is the managing director and portfolio manager at PIMCO, and he focuses on commodities, real assets, and inflation solutions. He leads PIMCO's Commodity Portfolio Management Group, and he's been at PIMCO since 2011. I couldn't think of a better guest to cover today's topic, which is inflation. Greg, thank you for joining us. Thank you for having me. So let's go back to the beginning.

1:20What originally inspired you to focus on inflation and real assets? A paycheck. Okay. I was in university, obviously, in Northwestern and looking for a job and banking, investment banking, consulting, a variety of recruiters would come to campus. And I was thinking, what can I do for consulting? I don't know anything yet. And research at a bank seemed like a good place to start learning something about the world, the markets. So I actually got hired at that time to be a quantitative portfolio analyst, writing CIO targeted level research at Goldman Sachs. Steve Strungan happened to know some of my professors from Chicago Fed days and offered me a job.

2:02So I called up a friend of my dad's and said, should I take this job? He's like, you have an offer to work at Goldman Sachs. Why are you calling me? I'm questioning your sanity at this moment. At that time, Steve Strungan also ran the Commodity Research Group. And while I was doing research on the Quonset, I was supporting some of the GSCI, Goldman Sachs Commodity Index research at the time. And then when PetRocks.com and every internet stock took over, I ended up migrating out of what became no longer interesting, which is CIO targeted level research and moved into the commodity research group, which was for me very fortuitous because at a fairly young age, I found something that was perfect for me.

2:39You know, if you think about inflation, you think about commodities, it's a mixture of microeconomics, macroeconomics, history, politics. And when you, I think back, one of my favorite books I read in college was Daniel Juergen's The Prize. And also I did love reading like From Beirut to Jerusalem. And I had a real interest in the history of the Middle East, the history of the commodity markets kind of like became a launching ground. So it just ended up being a great opportunity for me in the end. And 26 years later, I'm still in that business. Well, you spent time at Goldman Sachs, D.E. Shaw, Hartree, and now over a decade at PIMCO.

3:16What would you say are the most important lessons you've learned about managing money before we get into inflation? Yeah, so I think there's the normal answers of be humble, diversification. You know, one of the things that I did learn early on in sort of the research I did in the quant research focus was that if you're right 53, 54 % of the time, like you're distinguished, you know, you need to have smart portfolio construction. But in the grand scheme of things, what I feel like I realized is that there is a misalignment a lot of times in incentives in our business. and being in a place where you have stable capital, being in a place where your incentives are aligned with your clients and long-term performance enables one to sort of manage through a lot of that volatility that comes.

4:02You never know when volatility is gonna jump, but you wanna be in a place where you have that ability to look through that day, that moment. You're not worrying about being tapped on your shoulders. And I've been very lucky in my career because everywhere you mentioned there, has a very long-term view. And not a lot of people are as lucky as that. So when I think about when I walk in at the beginning of every day, I'm not worried that my clients are going to be upset that I lost them 50 basis points today. What we're looking for is to create retirement income and retirement results where people are thinking 5, 10, 15 years down the road.

4:37Now, that may be too long for incentivizing portfolio managers, but the point being is that stability of capital is a very key attribute to being able to, I think, succeed in my industry, particularly because commodities are one of the most volatile asset classes around. When the rates markets start moving 10 basis points, 15 basis points a day, and everyone gets very excited about it, I'm like, eh, that's just a normal day in our land. How would you say your investment philosophy has evolved as you've lived through several macroeconomic shifts in your career? So I think probably the first and foremost is just to make sure that you understand that your ability to call any one factor is going to be very limited.

5:18So what you want to do is always think about portfolio construction, understanding also what you will do ahead of time should something really change that challenges your reasons for that portfolio. What do I mean by that specifically? I didn't see COVID coming. I didn't see the Russian invasion. Those are things that really changed the fundamental backdrop. Like just prices changing in a day does not mean you have to react. But when the world changes, you have to be thoughtful. And where that implication comes really to the forefront to me, and this, again, happened in global financial crisis.

5:55You could even, in the commodity market specifically, when OPEC moved to a more market share-driven view of 2014. If you don't change at all, my guess is the vols in your portfolio has gone up, your concentrations have gone up, your correlations have changed. And you have to be very thoughtful and articulate about what you want to do when those things happen. So, for example, when oil or European gas went up seven times, if you didn't change your position, chances are you're having way larger risk than you would have done before. So I think a simplest way of saying is sometimes you need to be able to re-underwrite and regularly re-underwrite.

6:32And if the vols are changing significantly and you're not changing your position, you've just assumed a much higher level of confidence than you would have had otherwise. And I think that's very important. So when the conditions change, you have to be with a game plan ready to change. And I guess at the same time, you have to be sensitive to overreacting. So I guess it's more about taking in the new information, reassessing. And maybe the answer is don't do anything, but at least you need to reanalyze. Correct. You know, it's going back to what I said, you know, initially it was that having stability of capital is important.

7:05Like you don't always have to over, you know, react, but you have to have some game plans and understanding like, well, if I have 150 basis points in a 10 % vol targeted fund in this trade, and now all of a sudden prices go up four times and vol doubles, do I really have 700 basis points of confidence in that trade? Is that inconsistent with my clients and their interest? So you have to really be ready and proactive in dealing with that happening, but recognize that you just don't want to react as prices move. So today's topic is inflation, a hot topic in the world, as you know. Would you give us a brief history of inflation and the key factors that have driven major inflationary episodes in the past?

7:47And we recently had one post-COVID. Yeah. So inflation is going to generate when there's an imbalance between supply and demand. When demand is exceeding supply, higher prices you would expect to either disincentivize demand or incentivize new supplies. So when you have inflationary episodes, the genesis of the backdrop to those are really just that imbalance. Now, some of them are slower boil. If you look at the early 2000s, for example, when commodity prices in particular, and I'll focus on commodity because it's the most volatile component of inflation, but most of what I can say could be applied more broadly to any economic driver's inflation, whether it be real estate or whatnot.

8:32When you look in 2000s, it was China growth that steadily exceeded expectations that ended up whittling away at any of the surplus supply capacity that existed in the market. And then you needed to get much higher prices to disincentivize demand and increase supply. Or you could have examples like in the 70s or post-COVID, let's say, or certainly the Russian invasion where you have a supply shock where there is a contraction of supply. That tends to be a very challenging environment, but then you end up with higher prices as well. But from an investor standpoint, there's something we discovered or rather we were discussing at a secular forum a few years ago.

9:13So Secular is our annual three-day conference where we get out of the mindset of thinking about what's the next six or 12 months. And we try to think of what's like next three to five years and beyond. And we had a speaker who talked about how important your year of birth was at determining your sensitivity to different inputs or your views on certain markets. So if you were born post, you know, mid-70s, you don't know inflation. You don't remember inflation. It doesn't inform your understanding of the world. And the vast majority of people on Wall Street sitting on any trade floor right now will fall into that bucket.

9:48But if you ask someone before, they have a much different expectation and understanding of what inflation can mean. It's very different living through it than it is reading about it. Oh, for sure. I didn't have to go through gasoline lines. I was born in the late 70s. So I got to avoid that experience. So why that's important is because if you're going to be thinking about where your biases are in your investment process and where your bias is in your expectations of what cost of living could be, you have to really kind of like vet it against your starting points. And it's amazing how predictive that year of birth is in something like inflation.

10:24And it also then informs a lot of what portfolio construction is today, because a lot of it was generated after the mid-80s where stocks and bonds were uncorrelated or diversifying. And a lot of that was due to the fact that we just didn't have inflation. One common belief is that stocks are a good inflation hedge. Did you agree with that sentiment? On a short-term basis, in our mind, no. And we have a fairly strong empirical result that I'll share with you. So if you assume the markets are efficient, the current valuation should reflect the forward earnings, P ratios, growth potentials, and inflation outlook.

11:09So if you look at what the impact of inflation could be on your portfolio, you could look at surprises of inflation. So since the late 90s, you have forward expectations of what inflation was in the tips market. But before then, you could take a survey of professional forecasters and say, how did they do relative to the subsequent realized inflation? And what you see is that for a 1 % positive surprise to inflation, stocks and bonds both average in the United States about a minus 2 % return. This is from the early 70s and on. So basically, if you had a positive surprise of inflation like we had in COVID, post-COVID, you would expect stocks and bonds both to react negatively to it.

11:53And it's very much consistent with the empirical estimates ahead of time were very consistent with what you ended up realizing afterwards. Now, on a global basis, it's a little bit different because it has a much higher natural resource equity component, and which actually kind of goes to probably one of the issues facing investors in the United States today is natural resource equities are a very small percentage of the overall market cap in the S &P now relative to where they were, let's call it 25 or 30 years ago. But in general, on a short-term basis, very few sectors could have offered any sort of major portfolio diversification.

12:32Now, over a longer term, the sectors that benefit from higher inflation, whether it be real estate, which tends to end up having a very good real asset component and will benefit from higher prices, higher wages, higher income over a longer run. Over a longer term, they will be able to recruit some of that benefit. But on the short-term horizon, the duration in equities, the duration in private real assets even, will end up impacting the ability to insulate from inflation, and particularly inflation surprises, which is really from an investor standpoint, you want to be able to hedge those inflation surprises because in the case of what happened in 2022, what was the assets that you could sell to rebalance and buy the equities that it sold off?

13:17really was something like commodities, which really was an inflation-sensitive asset. Stock did not do that for your portfolio. Right. So let's talk about inflation surprises. And then I want to get into your outlook a little bit. So we've had decades, you just described since basically the early 80s, where inflation has been low and stable. Is your sense that we're approaching a major structural inflection point where inflation volatility may pick up looking forward? Yeah, our general view is that we have moved out of a period where the forces of globalization, the peace dividend, central banks having increasing credibility is still there.

13:58But the inflation targeting that it came out provided a period of relatively low and relatively stable inflation. But a lot of those forces are going in reverse now. Certainly, deglobalization is making it so that we're not looking to invest in the lowest cost location, but we're willing to accept the fact whether we for security reason. I'm not saying any of it is purely a bad idea by itself, but there are implications of that. Yeah, there's a tradeoff. Exactly. And that tradeoff is real. Some of the net zero goals or the energy transition in the short term, as in the next three to five years and maybe even longer, tends to be relatively inflationary because of the energy and commodity intensity of creating even something like a windmill, like the amount of cement that goes into it, plus the amount of commodities that go into it.

14:54In the U.S., we have some shorter-term unique implications, which is tariffs, which has a potential to actually have higher inflation. Also, the volatility of those tariffs are increasing the volatility of an estimated inflation market. I think last week, we had a 25 or 30 basis point move in the one-year break. I mean, these are pretty meaningful challenges to sort of what would normally be a rather stable outlook for inflation in the grand scheme of things. Because they're significant factors that are highly unpredictable. Correct. But I do think the longer term also of the fiscal stimulus that is likely to come down, the pike is also another area.

15:39So we think inflation is going to be higher and more volatile in the secular horizon than it has been. But what ultimately will be the keys, and this is mentioned before, like the difference between the demand side driven inflation and the supply side is pretty meaningful in terms of how the market corrects. Because when you get the supply side, hiking central bank rates, which is helpful to slow the demand side to allow supply to come up, is not nearly as effective than if it's a demand side. There's real challenges when you have a supply side inflation shock. You need to be able to make capex.

16:18And sometimes the capex, certainly in the commodity side, is a three - and five-year process. There are real challenges embedded in how you actually address it when you get the inflation. And certainly, if we are making the markets less efficient, if we're bifurcating markets, and we haven't even talked in the geopolitics of it. Because if you look over the last five or 10 years, the amount of, I don't want to describe a regional, but block-related trading, where Russia trades with China and India and Venezuela kind of ends up trading with us, but not with us anymore or not with Europe, creates real rigidities also in the system that have an implicit cost to it.

16:58So you put all that together and you're trying to look forward and project where inflation may play out relative to what's discounted. And what's discounted isn't very high to begin with. You could see the volatility of where it's going to transpire versus what's discounted and the range of outcomes. And you talked earlier about surprises. That's what really moves markets, that the odds are just greater that you'll have surprises one way or the other. Correct. Well, historically, inflation on average, if there was a surprise, is to the upside. But certainly when you look at, let's say, the five-year starting, five-year break-even or sort of implied inflation for CPI in the United States, which if you start out a few years for your listeners, you get away from some of the near-term tariff noise and some of the near-term price movements and commodities.

17:44So focusing on a way of saying market expectations, it implies in the tips mark is implying a 2.2 % CPI, 2.3. It moves a lot on a daily basis now as you mentioned. But that on a core PCE or a PCE basis, which is what's the central bank's benchmark, is exactly that they're going to be effective at keeping inflation anchored. And in our mind, if you do believe that there is a right tail to inflation that is currently not being appropriately priced, the tips market is a perfect example of where that is true today. Now, it's amazing if you look at the University of Michigan, which I know it's a small survey and there's a lot of volatility in that.

18:27But still, there are sensitivities to inflation right now. That sensitivity is a little more dependent on what party you belong to. When you look under the surface, the University of Michigan, the Democrats are very worried about inflation and the Republicans are still more worried than they were, but less so. It still points to the fact that like there's an understanding that inflation is higher. Not all asset classes are pricing it. How do you view the impact of artificial intelligence on inflation, both short term and long term? That is a question we spent a lot of time talking about last week and then emails subsequent where a lot of our colleagues or my colleagues are arguing their case one another.

19:05I think artificial intelligence, I'll start off with who I can say the most concrete. Investing in the data centers, running the data centers are incredibly energy and materials intensive. So from an inflation standpoint, I feel very confident to say that when you add the AI tailwinds from an investment in a CapEx on top of the energy transition on a global basis, you have real positive materials and energy demand. And I'll put a number or two on this. If you look at power demand in the United States and in Europe and most developed markets, we averaged between 20 and 25 basis points per annum growth in power demand.

19:53You could be looking in the next 15 years at like 2%. Our systems are old. They're rigid. I'm sure all your listeners found out about the Iberian Peninsula blackout. We've had problems in Texas. There's real constraints on being able to deliver this. So if we really build out all this extra demand for the materials that go into construction or for the energy that needs to run, there's an inflationary component to that. Now, with regards to broader determinants of inflation, like is AI ultimately going to be productivity enhancing? Will the AI be able to create technology improvements, which is certainly one of the bigger hopes that I would have, so that we could end up bringing on new energy supplies or new industries or just do things a lot better?

20:42There's a lot of hope for it. But the uncertainty bands on the impact of that is just fairly wide and estimates are very uncertain depending on how you estimate a variety of inputs that it's hard to say definitively. But what I do feel like I can say, which matters to me and my investors on a three-year or five-year horizon, is that the build-out to that destination is incredibly commodity intensive. which is interesting because my sense is most people think of AI as being deflationary in terms of its impact. And what you just described is more of an inflationary impact over the near term, which is oftentimes what markets price.

21:24Yeah. And much like estimating productivity is a lot of art. I mean, I don't think economists have a very robust history of doing that well. understanding how something of this nature and at what time it's going to happen. Like you can clearly imagine a world in which it's very productivity enhancing in five-year to 10-year windows and not zero to five-year window, where it would actually mean something on a macro aggregate scale. While on the near term, I can say on a micro and macro aggregate scale in the next three years, I have an investment CapEx horizon that is pretty meaningful. And to give a parallel, China's copper demand did not fall despite the fact that their real estate market was in contraction for much of the last five years.

22:15Taking statistics as a rough guess of what's happening there, clearly their real estate's been in a very traumatic situation. But the energy transition alone was able to fuel and offset that. Now you add AI, which is piling on top of the energy transition. These are meaningful tailwinds and real constraints without a supply side capex self-evident to make it. What would you say is your outlook for inflation hedge asset performance over the next three or five years, given the backdrop you just described? So I can lean on a few things. We have our market forecasts under RCMAs that have between a 4.5 % and a 6 % return for whether it be the S &P or whether it be TIPS or commodities.

23:02The fact that they've merged so close is actually kind of interesting to me. It really suggests that the time for portfolio diversification, if you go back a couple years ago, fixed income was more challenged because of the initial starting conditions. And now the initial starting conditions have really changed. And if we get back to a world where inflation is not the only thing driving markets, which today there's a lot of things driving, but you can get a little more natural diversification between owning fixed income as well as on top of your equities. But even then, if you look at TIPS with, let's call it the 10-year real yield, so basically how much you would earn above inflation implied by the TIPS market of like 220 basis points, let's say, that's the highest we've been in 15 years.

23:48So the initial starting conditions for real assets are more attractive than they've been. Now, the one commodity, and this is deeply ironic from I'm sure what we're going to talk about next or soon, is gold is probably the lowest ranked in our capital markets assumptions, in part because of the massive outperformance it's already had for other real assets. So if you think of gold as a store of value real asset, I mean, it's gone up twofold in the last couple of years, while real rates and nominal assets have sold off a lot. So that's the one area where we have a lower capital market assumption, but there's good reasons why gold has outperformed and could very well continue to.

24:27But the rigor around that modeling, to be honest and candid, is challenging given the massive outperformance we've had. It is an interesting time because earlier you described potential inflection point where you're reaching an environment where inflation volatility may be greater. there's a lot of uncertainty in terms of global economies. So it seems like a good environment to be more diversified rather than less diversified. Yeah. When you look at most portfolios, they're less diversified than they probably were 10 years ago, more concentrated in stocks, more concentrated in US stocks, even though US stocks are more concentrated than a handful of companies.

25:06And then you just walk through your capital market assumptions looking forward, and you have not much difference between all these diversifying asset classes. I assume the conclusion of all that analysis is investors should allocate more to inflation hedge assets given everything that we just described. Would you agree with that? Yes, for sure. The problem you get in a lot of these analysis is that there are definitely periods where real assets have underperformed. Talking about our priors, for example, and like when I was born, I'm not a gold bug. Like I entered the market in the late 90s. Gold had been a poor asset to invest in for the previous 15 years.

25:52It lasted for another five years and then it became interesting. I approached some of these markets with like a real hesitancy in part because of that experience. But then I sit there and I say to myself, the portfolios that we have to construct today are definitely experiencing a different environment than what they had for that informative period of my career. And gold, I probably changed my view on meaningfully after 2022. And the main catalyst of that was when the US and Western European government started seizing Russian assets. And that was a real stark moment for the global financial system in my mind.

26:41And it's dramatically changed the way in which central banks and it dramatically changed the way in which ultra high net worth individuals viewed the sanctity of their investments, the safety of their investments. If honing a house in the southern, a chateau in the southern France was a way in which you stored your wealth before, do you have the same level of trust in that today? Because you saw what could happen. Exactly. So when I start thinking about like the overall portfolio construction and going back to what we were talking about in terms of inflation having a higher tail, I think the way things are priced today, I think the uncertainty around policy, the uncertainty around macroeconomic outcomes, you know, and if you think about tariffs.

27:24itself, like it's in the US, it's viewed as like almost stagflationary. Not that I'm recalling for stagflation, but we've reduced our GDP outlook while increasing our inflation. So those directionally are going in those two directions. Real assets just become that much more important to portfolio construction and portfolio diversification. What I've experienced, and I think part of it is the last couple of decades, is there's a viewpoint that you get high returns from stocks. And if you go into those other assets, they're diversifying, but they lower your return. And your capital market assumptions looking forward would argue that not only do you not give up returns, you may actually improve returns depending on which way things go.