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Powell has been very clear that he’s not going to react until the market slack is eliminated: Research Affiliates CIO

Chris Brightman, Research Affiliates CIO joins the Yahoo Finance Live panel to discuss Warren Buffett’s annual letter and the latest market action.

Video Transcript

ZACK GUZMAN: Chris Brightman, Research Affiliate CIO joins us right now. And Chris, you just heard us talking about the Oracle of Omaha. And far be it from us to really come at him. I mean, if you come at the king, you best not miss here. So what do you make of what you heard from Warren Buffett in that shareholder letter and kind of where we're at in this stage of the recovery?

CHRIS BRIGHTMAN: Well, reading the letter, what caught my eye was, as you've already noted, the importance of Apple to the performance of Berkshire. And also notably, he's been selling more recently. Also, the defense of buybacks. That kind of financial engineering works well to the benefit of investors in the company when you're buying the stock cheaply, as I'd argue Buffett was, buying Berkshire stock cheaply during much of 2020. Buying overpriced stock doesn't work out so well for investors.

And then what really reinforces my concerns is his reminder that, in his words, bonds are not the place to be. Just briefly, I'd observe that the rise in interest rates that we've seen from the low near 50 basis points a year ago to closer to 150 basis points, almost a tripling in the 10-year treasury note yield, has really been fabulous for the stock market. Because it was almost all, well, actually more than all, rising inflation expectations, inflation expectations as measured by the 10-year break even inflation rate, went from almost a 50 basis point, again, a year ago, to 2.2% today.

And that's terrific for the stock market when the Fed is having trouble getting to its inflation target. Now that the market thinks it's at the inflation target, again, BEI at 2.2% is right about the Fed's target. We're at this difficult inflection point where an overshoot of inflation, not so good for markets unlike a recovery from missing on the downside. So that's why we see the choppiness in the markets with the concern from rising inflation some days. Other days, we have a very strong reflationary trade where values performing growth, small outperforming large international outperforming domestic, et cetera.

AKIKO FUJITA: Chris, what do you think is contributing to the softening at least in the 10-year yield today? Is it a sign that potentially investors got their initial jitters out of the way in terms of inflation concerns? Or to your point, is this kind of the risk that continues to reemerge in the market?

CHRIS BRIGHTMAN: Yeah, bouncing around between 1.4 and 2.5 is just kind of noise, I think, in the context of a tripling of 10-year yields from 50 basis points to 150 basis points. Also of note, I think, is recently, there has been a considerable increase in real yields. If you break the 10 year down into inflation expectation plus its real yield, what you find is that we were pretty stable at about a 1% negative real yield throughout the second half of 2020 all the way into February. Now we're seeing that real yield lower, about negative 75 basis points. Still, notably negative. But as all of this fiscal stimulus comes in and then after the $1.9 trillion of stimulus, there's another $2 billion of buyback better infrastructure bill.

This is going to return real interest rates to a normal level. Whereas normal in the United States, I don't know, I would maybe pick somewhere between zero and 1%. It's going to be positive. Not the 2% kind of level we saw over the past few decades. But with interest rates rising, that really knocks out a support for very, very expensive equities. Many people rightly say if you look at where real bond yields are, it supports much higher equity prices. Well, that's all well and good so long as you have those low bond yields. But as bond yields rise and normalize, it's going to be difficult for equities.

ZACK GUZMAN: I'd be curious to get your take too, though, because we talk about this and this is something that Warren stressed in his letter. You can look at it and say, oh, 1.4%, we got there pretty quickly. But still, as he points out, a pretty steep fall from where we were back in the 80s-- 15.8%, that high point now down 94%, see kind of where we're at now. When you look at the update that we got in terms of ISM showing manufacturing expanding at the fastest pace in 3 years, how much does that maybe signal, I'll just give the numbers, 60.8 from 58.7 a month earlier, expectations for 58.9.

But when you look at that, how much does that maybe move forward the pace at which this recovery is really starting to accelerate now and maybe put pressure on the Fed to reel in some of those accommodative measures that they put in place?

CHRIS BRIGHTMAN: Well, I don't think the Fed's going to act. Jay Powell has been very, very, very clear that he's not going to react until we've eliminated all the slack in the market. Now that's difficult to measure. We know that the unemployment rate as calculated is not accurate. We're probably down 10 million jobs. There's a lot of people that are absent from the labor force participation. So until the output gap is eliminated, the Fed is not going to be raising interest rates any time soon.

And therein is a concern about inflation. And some days the market gets very upset and concerned about the risk of rising inflation. Again, inflation rising from below the Fed's target to the Fed's target, it's unambiguously good for the market. Inflation rising above Fed target, that's more difficult for the market to absorb. And then rises in real interest rates, while entirely a great signal for the economy. If the economy returns to normal, we're going to see real interest rates rise. But again, that takes a problem out from the stock market. If you want to know where to position inside the stock market,

I think the reflationary trade is the right response. But if you're worried about the market's valuation overall, I think you keep an eye on inflation expectations.

AKIKO FUJITA: Some good takeaways there. Chris, it's good to have you on on this Monday. Chris Brightman, Research Affiliates CIO, joining us there.