Inflation Nation with John Wilson

With the cost of living at levels not seen in 20 years, and the shine coming off gold, how should investors hedge against inflation? Ninepoint Partners co-CEO John Wilson says alternative asset classes in the age of negative rate returns will pay dividends for investors.

Michael Hainsworth:

The cost of living in Canada has taken off to levels we haven’t seen in 20 years. It’s even worse in the United States. And it’s got the US Federal Reserve preparing Wall Street for an increase in the overnight lending rate. Gold is often the go-to asset to hedge against inflation, but the shine is off bullion. After its 28-percent rise this year, both Fitch and S&P Global are warning investors their metal is about to be tarnished. So how do we polish a portfolio for success in a rising rate environment? For insight into alternative asset classes in the age of negative rate returns, I turned to John Wilson, the Co-CEO of Ninepoint Partners. We began our conversation by setting expectations: does Wilson agree with the former Bank of Canada governor Stephen Poloz when he says government spending and stimulus aren’t the cause of the spike in the first place?

John Wilson:

I guess I would agree in terms of what's initially caused the re-emergence of inflation after a very, very long time of “Searching for Gadot”. Central banks for the last 40 years have been looking for inflation to get above 2%. And what got us there coming out of COVID obviously were supply bottlenecks and a surge in demand as people suddenly hadn't been able to do things for two years and suddenly wanted to get out and buy things and do things. So yes, in that sense I would agree with him. Actually, Chairman Powell from the US Federal Reserve was testifying to Congress and made the comment that as much as that may have led to what they called the transitory period of inflation, it has started to bleed through into other parts of the economy not related to that. So, in the end, inflation becomes an issue when it becomes part of people's expectations. In other words, I'm going to look for higher wage increases, even more than I got last year, because I think prices are going to be even more than they were last year.

And once you get that expectation component, then you're chasing your tail. And that's what we went through in the 70S and 80s and that's what they've been trying to avoid, I guess, as we come out of this COVID period.

Michael Hainsworth:

So what do you see as the canary in the inflation coal mine? Is it housing prices? Is it the grocery bill?

John Wilson:

It gets back to wages. Most of those things can have a one time reset or a relatively finite reset and price to reflect supply issues or a surge in demand. But when wage gets on that treadmill of constant increases, that's obviously a big input into everything and that gets you on the inflation spiral. So the real secret is going to be watching what happens with wages, which have been rising at a fairly decent clip. And if you want to understand what happens there, you really need to look at participation rate. And that's been one of the big conundrums, certainly, in the United States. Actually in Canada, our participation rate is right back to where it was pre COVID. And as a result, our core inflation rate has been somewhat lower than in the United States. And in fact, our wage inflation has been substantially lower than in the United States.

So I think we're running about 2% wage inflation, the US running over 5%. And the big difference is the US, they're still trying to figure out why participation rate hasn't come back. Now there's a lot of theories, some of which I think are quite good. We generally have a much better safety net, social safety net here than in the United States. And so things like access to childcare, that is something that can keep people out of the workforce when you're coming out of COVID and you don't have good access to childcare and you're worried about your kids maybe getting COVID. Those sorts of things can keep people at home, in particular women. So, the short answer to question is ultimately wages. That's really what you want. And of course, everyone wants their wages to go up, but you want your wages to go up in real terms, not start constantly, it's no good to get a 5% wage increase if inflation is running at eight. And so that's what we're going to be watching here over the next several months.

Michael Hainsworth:

The Bank of Canada expects inflation to peak at the end of this year, and start to decline in the latter half of 2022. If monetary policy can take as much as 18 months to work its way through the economy, does this expectation seem reasonable to you?

John Wilson:

Well, of course there's a number of variables. We're doing this webcast or podcast at a really timely moment with the omicron variant out there, which oddly introduces massive variability in the outcomes both ways. So, if this new virus turns out to be able to avoid the immunity in the vaccines and actually have a more severe disease when people get it, that's obviously going to be a really negative outcome because we're going to be right back to where we started having to develop new vaccines, new antibodies. Now, yes, we'll have a roadmap to do that more quickly than we did the first time, but still you're talking maybe are you going to be back in lockdowns?

All of that sort of stuff would be quite negative for inflation, in which case all of this would be for nothing, but there's also an outcome that this is actually a lot more positive if it's much more transmissible than Delta has been, but the disease is much less severe, which some of the early evidence seems to just suggest, although I would argue way too early, then you could argue that this could displace Delta and sort of morph into more of a flu where, yeah, more people are going to get it, but no one's really going to get that sick. And that might be a much better outcome and a more inflationary outcome because we would see the light at the end of the tunnel and really jump out of this. So, the way I look at the inflation challenge for investors, to your point about the time lag that policy takes, is really twofold. There's no question both the Bank of Canada and the Fed are signaling now very strongly.

One of the things Powell said after his inflation comments is he's effectively indicated they're going to accelerate how quickly they're going to reduce their bond buying so they can prepare to raise rates. The Bank of Canada has already signaled that. So if you're an investor you're going to be facing now two challenges. One is rates are going to be going up and that's a challenge for both traditional fixed income, which goes down out in price as rates go up, but also for things like growth stocks, which have been really popular, right? Stocks that discount cash flows 20 years into the future, if you have to discount it at a higher rate of interest as rates go up, then the value of those stocks goes down and we've seen that every time there's been a rate fear. So, that's one challenge. And then the second challenge is the policy lag you mentioned. So, whatever they do, inflation can keep running until those things start to take hold.

And over that period, that means if you're in a portfolio, one, you're dealing with this rising rate problem as they try and catch up, but two, you're earning a return, even at whatever level of rates are at. That's less than inflation in all likelihoods. So you're earning what we call negative real rates. And the challenge as an investor is one, how do you stop from losing money as rates go up in areas like fixed income and gross stocks, and the second one is how do I earn a positive, real return? How do I earn a return higher than the rate of inflation? And the answer to both of those is really alternative investments. That's always been the answer, and that will be the answer this time, and there's a number of ways you can do that. There's not one strategy or asset class. There's lots of things you can use to both protect yourself and earn a positive rate of return in an inflationary environment.

Michael Hainsworth:

But gold is usually the go to natural hedge against inflation. S&P Global is telling its clients though the price could lose momentum beyond the pandemic after, what, a 28 some odd percent rise this year, Fitch figures bullion falls is 1700 announced next year and sits at that level for the next several years.

John Wilson:

Yeah, I guess I'm wary of forecasts for whoever gives them and including myself, frankly. It's a very, very, very difficult game. Obviously, it's always difficult and in this environment where you have a global pandemic that's morphing and central banks doing incredibly unprecedented things and governments introducing fiscal stimulus at a level never seen before, all of those things create a number of possible outcomes. So I think it's difficult to know exactly how all of these things will react. I would agree that historically when people have felt like inflation was here and it was a problem and it wasn't going away quickly, in that environment gold has been one of the things people have rotated to, not everybody, but it certainly has done well in those environments as a store value. And if this inflation doesn't really take hold in a permanent sort of wage cycle and a permanent inflationary cycle, then maybe their forecasts are right.

Maybe gold people will realize, ah, this isn't really something I have to worry about over the long run. I don't really want to be in gold, but if it does, I would be shocked and surprised if gold didn't get a bid. So, that's one, and certainly most people, when we deal with mainstream asset allocators, whether that's institutional or advisors or family offices, what they'll do is take a percentage of their portfolio and allocate to that type of asset, 5%. They're not going to put 80% of their assets in something like that. But they will look for that to play a role in a portfolio approach to hedging the inflationary risk. There are other potential store values that are emerging. I think the last time you and I spoke, we talked about digital assets is something that certainly the younger generation sees as a longer term store value.

There's, frankly, just not enough history with it yet to really point to say, "Ah, see it does," because one, crypto's obviously not even 10 years old and two, we haven't really had an inflationary environment to measure it against, but if you canvas younger investors and ask them about protecting their wealth, they are 100% on crypto and almost 0% on gold. So I would argue, it'll be interesting to watch, but my guess is that there will be a store value component to what people do in the crypto space. And then of course there's other traditional real assets. Historically energy has always been a key component of the inflationary makeup and real assets generally have done really well in inflationary environments. So we would anticipate, especially in this setup where supply is constrained by ESG investment and all those sorts of things, in an inflationary demand cycle, energy's going to do really, really well. So that's another one.

Michael Hainsworth:

So then when it comes to alternative assets as an offset for the inflation risk, what kind of alternative assets are we talking about in the first place?

John Wilson:

Well, I'll go back to the one that gets hurt most by rising rates, fixed income. You don't have to just own a bond and sit there and get creamed by rates rising higher. Mark Wisniewski and Etienne Bordeleau, they run our fixed income team. They don't do plain fixed income. They'll use rate hedges in their diversified bond fund to protect against rising rates. And that's why they managed to sidestep pretty much all the damage that fixed income has gone through this year. And then they also run a leveraged alternative strategy, the alternative credit opportunities fund, which hedges out the rates and then owns credit with bit of leverage to boost the return. And that has generated a really attractive, positive real return this year. And so even in fixed income, you can look at things in an alternative way and say, "Well, if I have this issue with rates going up and inflation being a problem, how would I run investments in fixed income?"

And that's what, frankly, Ninepoint is here to do for people. Other areas that you could do, again, still on the income side, private debt, I think is not as well known by people, but most, if not all of those contracts are structured to rise as rates rise. So they're basically floating rate agreements. And as rates rise, you're protected. You're already earning a high nominal rate and as rates rise, your margin is protected. So that has been an attractive place for people to feel like they can be invested and ride out inflation and another big asset class, one of the biggest asset classes that traditionally has done well and you mentioned it earlier, is real estate.

Real estate and infrastructure, I mean, certainly I'm not going to, the components of what's going on with real estate, residential real estate for sure, in Canada has been more to do flow rates and people's ability to carry a much, much larger mortgage and therefore bid more for homes, but all types of real estate as real assets with a real income generating yield have traditionally done well in inflation environments, as long as inflation's not nine, 10, 12% percent. If it's something more reasonable in the middle digits, those assets can do very, very well. And we actually have a great real estate infrastructure fund with Jeff Sayer, which has done phenomenally well on a three year, one year, three year basis. If you think of infrastructure, I think people tend to think about highways and bridges and things like that, but it's also data centers. A data center's infrastructure in our economy.

It's probably one of the most important elements of infrastructure in our economy and the growth and the yields and the profit margins there have been exceptionally high. So there's lots of things you can do with infrastructure and real estate as well that can protect your portfolio.

Michael Hainsworth:

Not all real estate assets are created equal, and the same could be said of investing in corporate debt. If we choose the alternative asset class of corporate debt in that rising interest rate environment, where, as you point out, most of those arrangements are set up as a floating scenario, such that you're not going to get dinged as the rates continue to rise, but what though of the overall macroeconomic environment that is tied to that individual corporation and ultimately its debt?

John Wilson:

So you're talking about if rates went too high, and we tipped ourselves into recession kind of thing, is that where you were going?

Michael Hainsworth:

Or that we find ourselves in a scenario where investing in corporate debt of an organization that finds itself on the edge, on the thin edge, when it comes to the economic implications of inflation generally speaking. Some companies are going to be able to weather this economic environment better than others. How do we pick the good ones?

John Wilson:

Yeah, of course. Well, that is the job of the credit manager to look at the economic environment they're projecting, which I think pretty much everyone now assuming this omicron doesn't take us back into our caves like we were 18 months ago or 12 months ago. Everyone is predicting a continued reopening, continued really high economic growth. I mean, the US is running at about a 9% GDP for 2021. That's a big, big number. We were running two to 2.5% pre-COVID. So if you're thinking of that type of environment, then you have to look at all the fundamental things you look at as an investment manager. What kind of leverage does a firm have? Obviously, if you're a heavily levered corporate and rates are going up, your interest costs are going to be going up and that's going to be a problem.

If you've termed out your debt and refinanced, all this stuff and have like five and 10 year maturities, that's not necessarily a problem, but if you have a bunch to leverage that's got to roll and you need to refinance, and you're going to have to refinance 100, 150, 200 basis points higher, depending on how much leverage you have, that could be a real problem. So always the balance sheet's the first place that a credit manager starts and looks, but then to your broader point, an inflationary world with higher rates will impact demand in certain sectors of the economy more than others. And you obviously want to steer clear of businesses that may have more vulnerability there. Depending what happens with rates and mortgage rates, it would stand to reason that the home building sector may experience slower growth. And that's something you'd want to factor into, as one example, what you'd want to factor into your thought process.

But on the other hand, you may see sectors that look like they're more levered right now, and I'll give you the airline sector as an example, but if the reopening actually happens and everyone goes back to normal and people are in fact more eager to travel, because they've been locked up for two years and they go to new highs in terms of the business levels they run, then their leverage may actually not look that bad. That might be a really interesting opportunity for a credit manager. So that's just fundamental investment work. And you obviously want to be with a manager that's seen cycles, that ideally has seen a rising rate environment, which, by the way, in our industry there's not many people left. I mean, I'm old enough to remember lower rising rates. Mark Wisniewski's certainly old enough to remember rising rates. Sorry, Mark. But it's some crazy percentage.

Other than that little blip we had in 2016 to 2018 where they raised rates a quarter point five times and then immediately started cutting them before COVID, most investors in our industry haven't seen rising rates before. It's been, you'd have to go all the way back to 2005, really, to see a reasonable rate rising cycle.

Michael Hainsworth:

So how concerned ought an investor be about the liquidity of alternative asset classes?

John Wilson:

So there's a trade off always. If you want perfect liquidity and to be out of an investment immediately today, at any day, then you need to be in publicly traded fixed income, for instance, if you want to be in a sort of income oriented investment. The problem with that is the yields today in fixed income are below the rate of inflation. So you're earning a negative real return. You're also vulnerable as you hold that instrument to rates rising and losing money on that investment. The trade off with something like private debt that we talked about is you're protected from those things. But the price you pay is you don't have the same level of liquidity. You're giving a fund manager capital for them to lend to private companies and they'll have a series of investments and loans that are out there that mature at different times. So there's liquidity constantly being generated in the fund, but they can't obviously offer daily liquidity or oftentimes even monthly liquidity.

So, we talk to investors about that. It is a trade off, but I think most investors overestimate how much liquidity they need and they underestimate the price they're paying for that liquidity. People feel safer, I guess, if they feel like "I've got all my money. I can access it in 24 hours if I needed it." But you look at people and say, well, reasonably you have, often people have quite a bit of money to invest and it's like, "Do you really need to have all of that on 24 hours? Would you be able to have a third of that you could get on 30 days notice or 90 days notice?" And if they think about it reasonably they're like, "Yeah, I can't imagine what could happen, where I'd need all of that in one day." And if you point out what they're paying to have that flexibility, it increasingly doesn't look like that's worth it. So, you're right. We call it the price of liquidity. So it's not that there's not a trade off. It's just that there's a cost to having that flexibility.

Michael Hainsworth:

Proper investing is like good barbecuing. The key is to keep an eye on it. How frequently should we be reviewing the impact of inflation on our portfolios?

John Wilson:

Oh, it's a great question. It always comes back to barbecuing, doesn't it, Michael?

Michael Hainsworth:

Well, the weather's changing, but we're still going to be out there in our socks and slippers doing the barbecue routine right through to March.

John Wilson:

Yeah. So how do you keep your portfolio from getting charred by inflation? I think it's challenging for a couple reasons. One, investors, you'd have to be, again, quite old to remember real inflation, like damaging inflation and even me and I'm considering myself old now, I was not really an investor when inflation was really, I was still in high school when inflation peaked back in the early 80s. So the reality is people haven't been used to doing that. That's not a challenge they're used to thinking about. And it's an excellent question because most people won't have a process for thinking about that.

But given the threats I outlined both in terms of rising rates and negative real rates and given where inflation's actually running, which is not just a little bit above 2%, but well above 2%, and given that the Fed is now telling you that "Actually we don't think this is transitory anymore and we've really got to change our approach here because we're worried now it might be bleeding into the real economy and staying there," then, other than keeping one eye on what's happening with this pandemic, which obviously everybody is doing, by far the most significant challenge you need to keep focused on is inflation and what that's going to do to your portfolio, what's going to happen to rates, when rates go up and they're going to go up, what's going to happen to your portfolio, how much exposure do you have in equities, equities are historically high multiples, even generally in the index. And that's okay.

You can make the argument rates are really low, so what else are you going to do, there is no alternative kind of argument, but within that, there are, as I mentioned earlier, elements of the equity business, equity landscape that are extraordinarily highly valued because of low interest rates. And they're very vulnerable and just the equity multiple generally is vulnerable. And to your earlier point about every corporation is not going to be affected equally by interest rates, profits could be vulnerable. So, all of those things mean that it's a time. This is a very unusual and infrequent change in the fundamental assumptions that an investor has had, which for the last couple of decades has been rates are low and going lower. Inflation is not a problem. It's low. It's just profits, profits, profits, and growth.

And if we are moving into an environment where inflation is a problem and rates are not low and going lower and are in fact going to rise to try and put a pin in it, then that's a whole different set of assumptions you need to make. And I'm not saying that's definitively where we're going. Personally, by the way, I think rates are going higher, but they're not going back to in the early 80s we got to, whatever, the mid teens of-

Michael Hainsworth:

It was like 17, 18%.

John Wilson:

We're obviously not going anywhere near there. And the fundamental reason is there's way too much debt outstanding, both in the economy and with governments. So nobody can handle interest rates even back to 5%, but still it'll be painful to go from zero to one and a half or two. That's still a big relative move given where we've been.

Michael Hainsworth:

All right. So the holiday dinner party question that you're going to be getting the entire month of December, should I lock in my mortgage rate now or stick with variable?

John Wilson:

Well, everyone's situation is different. So, obviously people should do that math with an advisor and their mortgage banker and figure what the best solution for their personal situation is.

Michael Hainsworth:

Oh, come on, give me a quotable quote.

John Wilson:

I think that the safe bet is to lock in. That's certainly, I think that's what I would recommend people do. Then at least if you can afford it here and you can lock in here, then don't monkey around thinking, you might save a little bit of money if it goes a little bit lower. Just lock it in and be done with it. And that's the way I think of in my life, in our business. If that's something we can plan around and lock in and take away that uncertainty, then that's what we should do.

Michael Hainsworth:

John, it's always great getting your insight. Thank you so much for your time and all the best for the holidays to you.

John Wilson:

Yeah. You as well, Michael. Thank you.

Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.