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Inflation rising and acceleration 'across the board,' putting the Fed 'in a bind': Clearnomics CEO

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Clearnomics Founder & CEO James Liu joins Yahoo Finance Live to discuss the situation for the Federal Reserve ahead of the last policy announcement of 2021.

Video Transcript

KARINA CONTRERAS: But we are going to stay on the markets and bring in our guest James Liu, Clearnomics founder and CEO. James, thank you so much for your time today. Just want to get your reaction really quick. So PPI coming in hotter than anticipated. Is that what we're seeing reflected in the markets today, or is something else being priced in? And tied to that, then, is how hawkish can the Fed afford to be tomorrow?

JAMES LIU: Hi, Karina. Good to chat with you. Well, you're right. The PPI number that came in is red hot, and it is consistent with all the other data we've gotten recently from CPI to consumer inflation expectations. So across the board, we are seeing rising and accelerating inflation right now. I think the challenge, though, is how long will that last? We had the whole debate over the last year about the word "transitory" and what that means. And if the meaning of transitory that is still with us is that this was a one-time shock to the system, we don't know exactly when it will filter through the system, but it was a one-time shock, then that's probably still the case today.

And so to your point on the Fed, it puts the Fed in a bind, because they do need to react to rising inflation, the highest level in four decades. However, they also need to be cautious. And so what it looks like right now is that at tomorrow's announcement, most likely, they're going to accelerate the rate of tapering, meaning tapering will finish probably in March.

And then we're looking at probably the first rate hike at the beginning of-- in the first half of next year, most likely. You know, that's not something that most investors should be worried about. In fact, many investors have been calling for something like this. So we're seeing some short term volatility in the markets, but we think, longer-term, things do settle down here.

ALEXIS CHRISTOFOROUS: You know, James, this is going to be the first Fed meeting since Chair Powell said that the Fed needs to shift its focus toward higher inflation and away from fostering a rapid rebound of hiring during the pandemic. But do you believe that inflation will remain sustained at this level, into the first half of 2022? Because a lot of the strategists we've been talking to lately are saying, as those supply chain issues start to ease next year, it looks like inflation should have already peaked, and it's going to start to come down.

JAMES LIU: Yeah, well, that's a great point, Alexis. There are basically two drivers of what we're seeing in inflation right now. The first is just year-over-year comparisons being astronomically high, both CPI, PPI, and across other measures. And those numbers over time will come down, just by the very arithmetic of it. But the second fact, which is the thing that is really puzzling to not just the Fed, but everyone else watching this, is how long will those supply chain disruptions stay in place?

And by most estimates, those should start to dissipate hopefully by the second half of next year. And if that's the case, you'll see these numbers start to come down. And a lot of the fear and the push toward the Fed raising rates more quickly, some of that pressure will ease off as well. Now, overall inflation might still be a little bit higher than historical averages, especially over the last cycle, but we'll start to see that pressure ease.

And I think what that means for most investors is that we should not overreact to some of these numbers that we're seeing today. The fact that the Fed is raising rates, that's a very natural part of the cycle we're in today, with or without faster inflation. This is a normal part of this phase of the expansion. It's something that you would expect, even if inflation were around historic levels, not just because labor markets have improved, but because GDP growth rates are strong.

And so, again, this is very different from what we've seen in the '70s. It's a little bit different than what we saw the last cycle. But overall, staying invested, staying in equities, staying in those parts of the market that can fight inflation, that's probably still the best move going forward.

KARINA CONTRERAS: James, I really love that you said people shouldn't overreact, because there seems to be a lot of volatility and overreaction in the last couple of weeks in the market. But I want to turn your attention to the bond market. And it's confounding to many people, and I'm wondering, what does it tell us about what's going on with growth and inflation? And then how much of a worry is it to the Fed at this point in time?

JAMES LIU: Yeah, well, the tricky thing is that the Fed, even if it accelerates the tapering, they're still one of the biggest buyers of bonds in the market-- treasuries and mortgage-backed securities. And so that'll taper off the first few months of next year, but they're still buying billions of dollars of assets every single month until then. So you look at interest rates and where they are, and I think the confounding part is just how low some of the long-term yields are.

You know, if you look at the 10-year, which is around 144 right now, it was much higher earlier this year. And we still expect that it should creep up over time as interest rates rise, as growth continues, as some of those inflation pressures remain. And so we still think that interest rates rise, but it will happen relatively slowly and steadily. And so bonds, while still somewhat higher value than the historical averages, they are still an OK place to be if you need that income and if you need that protection against things like stock market volatility in order to balance out your portfolio.

ALEXIS CHRISTOFOROUS: What do you like, James, in terms of inflation hedges right now? Which receptors are going to be able to absorb those higher costs without squeezing margins too much?

JAMES LIU: Yeah, well, Alexis, usually, when we talk about inflation hedges, we're talking about things like commodities. You know, energy prices, of course, have risen based on demand and lack of supply. You also have real assets, notably real estate. Most investors have real estate naturally, just by either owning their home or having a focus on things like REITs.

But I think, for the average investor, the thing I would say is we don't need to get too overly focused on this issue. And the reason is because the biggest holding for most investors is large cap equities. And when you look at the history of large cap equities against inflation, what you see is that large cap companies can, in fact, pass on those costs to their customers. And that's generally what we've seen over this last period as well. So for the average investor, the thing to understand is that a large part of your portfolio, in general, is probably in a place that can already hedge inflation, and that tends to be large cap stocks and just equities in general.

KARINA CONTRERAS: And I want to ask you really quickly, if inflation has been the villain over the last few months, then growth and earnings has definitely been the big hero. But what happens to that going forward, particularly as we see rising inflation continue and as that sort of starts to cut into margins for companies? Who ends up as the winners?

JAMES LIU: Yeah, well, Karina, I think that's where it's important to take stock of where we are in the business cycle. You know, if we were late in the business cycle and we were seeing inflation rates of close to 7% or above, that would basically spell trouble, because it means the economy has overheated, and we're nearing the end of the cycle.

That's really not where we are today. If anything, we're quite early in the cycle. The economy is still robust, and that, of course, continues to drive earnings. So the remarkable thing is we'll probably hit above $200 on S&P 500 earnings per share this year, which is a remarkable increase from last year. And given what the economy is, we and also consensus estimates expect that earnings growth could continue around 10% each of the next two years.

Now, of course, there's some risks to that forecast. But the point is that earnings, over the long run, is what supports portfolios, and equities, and stocks. And so because those numbers are strong, we think it's an important time to continue to be invested and not focus too much on short-term data points, like we've seen over the last few months.

KARINA CONTRERAS: All right, sounds like you're saying the bulls still have a little bit of room to run. We will leave it there. James Lu, Clearnomics founder and CEO, thank you so much for your perspective today and being with us.