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Everyone Feared Recession. His Data Said Otherwise | US Bank CIO Eric Freedman on What It Says Now
00:59:15
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- [00:00]
A
A more, let's call it, elementary view of investing is, hey, we're looking for things to go from really good to excellent and that's where we're going to make a lot of money. The reality is that's not really how you drive returns in portfolios. It could be that things go from really bad to okay, or go from okay to marginally better. When we looked at different cohorts, could be by age, could be by income level, we just weren't seeing that deterioration that a lot of others who were more bearish were seeing. And sometimes if you play that association game with inverted yield curve or to your point, questions about the Taylor rule or the SOM rule or what have you concurrently, we have to understand what's happening in the moment and what is likely to happen out through 3, 6, 9, 12 months forward. The risk, we think in the bond market, which isn't showing up yet, but it certainly could show up, is twofold.
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B
Hi Eric, welcome to Excess Returns.
- [01:06]
A
It's great to be here. Thanks so much for having me on.
- [01:09]
B
You're very welcome. As Chief investment officer at U.S. bank, you and your team lead the firm's investment strategy across public and private markets and really work day in and day out to determine how to best position portfolios and allocations across the bank and, and for your clients, you know, doing some legwork and research for this, it became pretty clear that you've maintained a pretty consistently glasses half full outlook on the US Economy, which I think has been, you know, the right call. And so we want to work through sort of what's fueling that optimism, how you're looking at the markets, how you're thinking about things like rates, inflation, the labor market, and sort of how we might want to balance that with politics, possible risks that are also out there, but you know, just kind of working through where those risks and opportunities and getting your insight. So I think it's going to be a really good insightful discussion.
- [01:58]
A
I'm excited. Thanks again for having me. Great, great topics.
- [02:01]
B
Yeah. And if for people that want to US bank, like all big banks, I mean they're putting out tons of great research and content, you can go to U.S. bank, go into the wealth management section and then from there you can find the financial perspectives. And when you kind of double click into that, you'll see some of Eric's commentary along with other research that him and his team are putting out. So definitely encourage our audience to do that and learn more. You let's start with sort of something that you've described as part of your, I guess, investment philosophy. And that's around this idea of controlling the controllables and focusing in like on things like consumer behavior and business activity when assessing markets in the economy, rather than maybe some of the more unpredictable behavior and policy decisions that can be made. So I want to start with like, how does that framework idea of controlling the controllables kind of shape and influence the way that you design portfolios across, you know, a couple hundred billion dollars in assets at U.S. bank?
- [03:04]
A
Yeah, it's a great tee up, Justin. I think that really that the crux of our thought process is in the notion of controlling the controllables. We try to be very data driven. Everybody says that. I think that for me, as a cio, one of the things that's been very influential is actually ironically, a Journal of Science paper that came out in the late 80s. I don't want your, your audience to be bored by, by such a reference, but the crux of the, of the piece was evaluating the interaction between gut feel and actual data. And it found, and I think this relationship still holds, that the optimal outcomes across, whether it's medicine or finance or other disciplines is when you incorporate both intuition, feel, experience along with data. If we had to choose between the two, we would certainly emphasize data. And to your earlier observation, there have been so many opportunities this year to change one's view and how we were thinking about the world in April in light of what was coming out from the current administration. Again, zero politics and anything that I shared today. But what we're seeing with a potential set of outcomes that were potentially very policy driven relative to what we're seeing in economic data, they were saying two very different things. If anything, I think our process of being very data driven forces us to look at a large mosaic of information, but to also rely on that as opposed to being solely reactive function, if you will, based on gut feel or emotion that tends to drive better decisions for clients. That's the way we've had that approach as a team.
- [04:52]
B
Well, I think that's just an important overall framework or way to look at the markets because we're all being thrown 24, seven information and the media's fear and greed and is playing on our emotions a lot of times. So I think, you know, for individual investors and also the professionals listening to us and listening to you, that idea of, you know, being data driven and a lot of times you do hear it from people and it's like, well, what does that really mean? What are they really saying? And so that's a refreshing thing. And believe me, we're all into like, you know, old school 1980 academic papers and referencing that stuff. So that's great. Let's talk about your sort of, you know, how you've maintained this. The glass is more half full, not half half empty with regards to the economy. Walk us through the data points that you know, make you sort of have that conviction and what those, what those core sort of pillars would be.
- [05:51]
A
You know, one of the great parts of Working US bank is that we've got a really two pronged approach to looking at data. The first is a very top down macro driven approach. We look at again with a global perspective, everything from consumer business data, survey data, government releases, private data, source releases. And that forms a lot of, we think helpful variable assessments to just gauge what's signal and what's noise, if you will. We spend a lot of our time testing. We have a very deep capital markets research team led by a gentleman named Bill Murrz that really helps trying to tease out, if you will, what are some things that are more, let's call it insightful and perhaps leading not just about the economy, but also about asset prices. Because ultimately we're not investing in economies, we're investing in assets. And so understanding what is actually tied to hopefully some forward looking insights that, that's important to us. We also have a lot of bottoms up perspective that we learn from individual companies. We have a equity management team, Strategic Equity Group, we call it Run out of Minneapolis. And so that group sees a lot in terms of company management. They're going through Ks and Qs and understanding trends, everything from individual companies to sectors. And so that combination again, when you work at a big bank like ours, it's very easy to be siloed, but we intentionally get together with frequency. In fact, earlier today, every Monday we have a standing meeting where it is very consistent with our, with our approach, but the information is always changing. So that notion of glass half full comes from the combination of bottoms up corporate information, but then also top down data. And so where are some things we look at? So things like you wouldn't think this necessarily given how content is transformed these days, but things like box office receipts, things like TSA data, things like restaurant cancellations, not any one of these single data points is necessarily gonna drive our investment thesis. If you. I'll come back to that notion of thesis in a second. But we, you know, we aggregate these and we think about it on more, more of a mosaic basis because at some point the scales will tip in one direction or the other in terms of more favorable or less favorable. And I think as analyst, you know, it's interesting. My son, we only have one in the house anymore, and he's a really good math student. He's working through calculus. And so I've, I've, I've said to him, I said, connor, you're worth your marginal change across the rest of your life. And we spend so much of our time as analysts spotting marginal change. Oftentimes a more, let's call it, elementary view of investing is, hey, we're looking for things to go from really good to excellent, and that's where we're going to make a lot of money. The reality is that's not really how you drive returns in portfolios. It could be that things go from really bad to okay or go from okay to marginally better. And so those notions of spotting incremental improvement across both top down and bottoms up, that's what really drove us to have that class half full perspective. I mentioned the word thesis a second ago. We like to think that our job is to have a working hypothesis or a working thesis of what's going to happen next. And I say working because we have a tremendous amount of humility around what may happen next. The interplay right now across global macro of everything from geopolitical conflicts to disputes on tariffs to interest rates, all the things that we can, I'm sure we'll get into. But that interplay requires a, I think one, a mosaic approach, but also a flexible mindset because those subcategories can change and they're often difficult to forecast. I have no edge, no one has an edge on what may come out of the next set of negotiations between Washington and Beijing. But having a working thesis mentality versus a very dogmatic approach allows us to be flexible.
- [10:17]
B
Can you walk us through an example in which there was that thesis that you had and it was a sort of a, you know, a larger change, I would say, within an allocation, maybe like a new. And I'll just use this example. I'm not saying that this isn't in the notes or anything and I'm not getting this from your website, but let's say you guys wanted to allocate to gold or have a small position like to gold in. And I mean there's, there's probably thousands of different strategies at U.S. bank. And I'm just saying from like the CIO's office, when that idea is established and it's a new, whether it's A tactical or whether it's a long term sort of however you're thinking, how does that feel flow down and like triage down to the strategists and actually, I mean getting implemented at the portfolio level, okay, somebody makes the trade or puts a position on or whatever. But like how does that flow from like your office down to like the strategist or strategy level?
- [11:14]
A
Yeah, it's a great, great question. So I'll give you, I'll give you a couple of actual examples and some things that we've, we've had on and taken off or even, even evaluated but it never, never put on, so to speak. So really I'll talk about the process first. I'll give you an example. So the process is that for anything that we do on what I'm going to call a strategic basis, we go through a committee. And I don't mean to say like I'm not a huge committee person because sometimes committees can breed lots of indecision or what have you, but because again, we're a large regulated bank and we have a significant fiduciary obligation to clients, committees are important and making sure they're populated with the right people and action oriented is essential. And so anything that we may change strategically, if I were to say, Justin, let's say the Rodriguez family is in a balanced portfolio for us or a moderate risk allocation for us, any changes that we may want to make to the constructs of what's called the baseline of that allocation needs to be go through a committee vote. And, and that's a very ingrained process that we have. And again, let's say for example, we wanted to add crypto or we wanted to add non agency mortgages or reinsurance or what have you, that would be something that we want to do for the majority of clients or all clients in that category. And therefore it has to go through a committee. Anything that we do tactically is ultimately my final call. So if we wanted to tactically add to, let's say gold or midstream energy or have a differentiated view on technology or what have you, that ultimately is something that within established boundaries that we have through committees set up that ultimately goes through the CIO's office, that's ultimately my final call. So I'll give you a couple of examples. So things that we've thought about in the current context is this, for example, energy. So energy has not performed particularly well. There's this word association with energy and inflation hedge. But again, the sub, almost the microeconomics of energy are so vast that I think that in a way that's a very elementary and almost a parochial view of actually how it would play out over time. And so we've thought about, okay, what's the right way for us to express inflation protection in portfolios? And that could include things like treasury inflation protected securities or tips. It could include gold or silver, it could include crypto, it could include midstream energy. It could include energy either energy equities or actually a view on a specific hydrocarbon like oil or natural gas. And so those are all things that we think about both strategically and as well as tactically. And so ultimately our approach is to evaluate the structural considerations of an asset class or a category that would be something we want to add in strategically. So right now we actually don't have a strategic allocation to energy, for example, but we do have a strategic allocation to reinsurance within some of our client constructs, which is not necessarily a run of the mill strategy. So, you know, the way that we think about it is almost like the UN Security Council. There are members that we want to make permanent and there are members that we want to make temporary. And that's where that strategic and tactical bias goes. But again, the implementation is one that has to flow through ultimately from a client portfolio standpoint, or else it's just me and a bunch of talking heads, you know, discussing things in thin air versus actually being implemented in portfolios.
- [15:17]
C
Back to your point about data versus gut feel, I thought that was very interesting from the perspective of what we've gone through in the last few years, because you weren't one of the people doing this, but many people have been calling for a recession. And part of that I think is a lot of people just didn't feel great about the economy. But also I think part of that is maybe differentiating actual data that's happened versus more of you forward looking data like the yield curve inversion or the SOM rule or something like that. It would seem like it's also important to maybe, is that maybe how you avoided doing that is you thought about more. We're not seeing anything on the ground that indicates a recession versus maybe forward looking indicators that would say it might be coming.
- [15:49]
A
Yeah, Jack, that's a really thoughtful way to describe it. And you know, I think that to give you an example, one of the things that, that we think a lot about is how granular can we get with our forward view. And so one of the flashpoints right now, obviously, as it always should be, are questions around the consumer. And in A way the consumer is portrayed as this monolithic entity that acts in one lockstep fashion, if you will. And the reality is that by being very data driven, when we looked at different cohorts, could be by age, could be by income level, we just weren't seeing that deterioration that a lot of others who are more bearish were seeing. And sometimes if you play that association game with inverted yield curve or to your point, questions about the Taylor rule or the sum rule or what have you, these are important variables. And by no means do we want to avoid standing on the shoulders of economic giants and learning from past history. Without question, we embrace it concurrently. We have to understand what's happening in the moment and what is likely to happen out 3, 6, 9, 12 months forward. So I think by being very data focused, for example, we have a consumer scorecard and we look at the consumer, lots of different variables, but you know, we would get really concerned about the consumer. We scored from 0 being weakest, 10 being strongest. The weakest that we got in the most recent history was a 4 out of 10. That's not a great number, but it was a 4 out of 10 with some fairly explanatory variables driving that weakness. Had we gone to a two or a three and a real pickup on delinquencies or a real pickup on weakening borrowing conditions, for example, that would have been more concerning to us. But we kind of held that line, if you will, because we weren't seeing that deterioration. In fact, back to calculus. The marginal improvement has actually gone up in the past couple of months. And so those are things that help us in a way separate out some of the word associations or the old Wall street saws, if you will, that we think are convenient but aren't necessarily indicative of what's happening in the here and now that's helped us to at least make some good decisions by not flinching at a time when it would have been probably a little easier to do. So in a way it would have, it would have felt like going to safer ground was perhaps the right approach. But that, that, you know, we're not saying we get everything right by. There have been plenty of episodes, Justin and Jack, where we've, you know, we, we've made some, some decisions that, you know, if, you know, I'm a mediocre golfer, would have loved to have a Mulligan on, but, but this is one that we've gotten right. I think it's because of that data driven, team based approach.
- [18:56]
C
And I would think some of the real time Stuff you mentioned before, like TSA data box office data that probably helped in that regard. Right. Because you probably weren't seeing too much weakening in that.
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A
You know, it really did, you know, And I think if you look at, and I think it's a really important point, Jack, that you raised because you need a lot of conflicting data. And so take for example, company specific information we may get. So take a company like Breaker, which is a significant restaurateur that represents a number of different subcategories. They've got the Olive Garden, they've got Capital Grill, they've got lots of brands that can give us some level of insights into what's happening across different cohorts. Or maybe what was driving Lululemon. Like is Lululemon a great gauge on higher income consumer trends or is it more of a brand specific consideration set? Like those are things that you have to decipher, if you will. And again, we're fortunate to have a large team where we can help tease out some of these variables to understand. But by being data driven but also acknowledging that you can get conflicting signals, there have been plenty of companies that have said, hey, we're seeing a material shortfall in activity because of consumer behavior working against us. We're like, okay, let's do some homework, let's delve into that. What type of consumer, what type of product set, what are they actually we seeing from tariff pass through cost? Is that what's driving it? Or is there something that is more broad and universal in their observation? Those are the sorts of things that we want to make sure that we are trying to tease out as best we can. And so having that top down, bottom up approach really helps drive, we think, a clearer again, nothing is ever crystal clear but hopefully sharper focus into what may be happening in the future.
- [20:47]
C
You mentioned your consumer score. I'm just curious, where is that now?
- [20:50]
A
It's a five. It's a five. Yes. Yeah. So it's one that it's interesting. We're really focused on holiday season activity, but then also what does the consumer look like post holiday season? A lot of times you can see people stretch and especially in an environment like this where asset prices are higher. And so perhaps the zeitgeist is, well, I've got to get bigger Christmas or Hanukkah presents or I've got to throw a really large New Year's Eve party or what have you. We care a lot about what that first quarter will look like because we get again through the holiday season which can have all Sorts of conflicting variables. But that outlook in Q1 of 2026 will be, we think, really, really important to pay attention to.
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B
And I'm sorry, is that a five out of five?
- [21:44]
A
Five out of ten? So. Zero.
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B
Five out of ten. Okay.
- [21:46]
A
Yeah, ten strong.
- [21:47]
B
Gotcha. Right in the middle. Okay, gotcha.
- [21:49]
A
Yeah. So if we were, if this were, you know, calculus homework grades, that wouldn't be a great score. But you know, 8, 9, 10, like the highest it actually got post Covid was, I think it was Q3 or Q4 of 2021 where we had a lot of stimulus spending that was, that had not yet been spent, a lot of stimulus savings had not yet been spent and the labor market was, I mean there were help wanted signs everywhere. We're in a. Certainly we still think a decent labor market, but certainly a softer one. And a lot of that stimulus spending has not wound down, but it has certainly come down. And, and so that's, that's why we're still seeing again a, a decent level on that, that consumer score, but, but not necessarily strong as it, as it was, you know, a couple years ago when it seemed like there were a bunch of tailwinds behind it's behind consumer activity.
- [22:45]
C
How are you thinking about inflation? It seems to have settled maybe in that 3ish range. In some of the recent reports people have gotten a little worried about services inflation picking up. I mean, do you think it's going to just sort of sit where it is right now? Do you think that's concerning at all? That it's above the Fed's target?
- [22:57]
A
Yeah, it is something, Jack, that is concerning. And the notion of, I guess the word that I would use, which is probably thrown a lot these days, is that sticky inflation begets sticking inflation. And one of the things that is really interesting, at least on some of our data, is that if you look at economist forecasts out through, let's call it the second and third quarter of 2026, expectations are that headline CPI will still be at 3%, actually a little north of 3%. And that's very different than the rest of the world. Rest of the world is closer to just below 2. And so is there some level of American exceptionalism, if you will, in the inflation metrics here versus perhaps other places? And we think that in general, economists came into this year probably a little too concerned about inflation and a little less excited about growth and probably underselling growth that's starting to normalize a bit. We're seeing growth expectations come up, inflation expectations down a little bit. But to be clear, I do think that the Fed is in a tough spot right now. I think that is if there'd be a fly on the wall at the Fed meeting next week, I think would be very interesting. Just because not only do you have Dr. Muir and others that I think have a, have a more dovish view or trying to push forth a more dovish projection, but I am concerned about the notion of what economists and central banks will call that more embedded inflation expectation. And so I do think that the three of us use Excel a fair amount. There is a function in Excel called round down. If we wanted to round down to the next decimal pointer, integer if you will. Ideally the Fed is happy to see anything with a 2 in front of it. 272829. I'm not saying that's the new 2, but if we can see a economist forecast at 3% for CPI and if we can see the Fed, either their preferred PCE data or subcomponents come in with a two in front of it, that I think will be viewed as some level of progress. So I think that the, but the risk is that the exhaustion level at the Fed of this back and forth between labor market and inflation concerns that if they were an arm wrestling match, one will win out over time. But I also have to all keep in mind is that in May of 2026 there will be a new Fed chair. And so those dynamics of what may happen with labor markets versus what's happening with inflation, those may actually be subservient to the desire for just lower rates to begin with, which is certainly a topic that I'm sure you get a lot of questions about.
- [25:54]
C
Yeah, to your point, I think this is, I mean people love to criticize the Fed. This is one of the toughest positions the Fed's been in for much of my career. The dual mandate wasn't something you really had to worry about. They didn't have to worry about the inflation side of it and now they do. And you know, it's easy to criticize them in retrospect, but I mean, looking at what we're seeing in front of us on the ground right now, it's a hard decision as to what they should be doing.
- [26:12]
A
Yeah, I agree Jack. You know, it's interesting and you know, it's almost like there's the third mandate which has been largely forgotten, but ironically in the, in the aftermath of the Jackson Hole meeting, Chair Powell did bring up the third mandate, which is stable long term interest rates. And so I think that the way that we're thinking about the Fed right now is almost in two time continuums. Continuum one is now until May, where again, this arm wrestling match between a softening labor market and still steady inflation, eventually one will win. We do think that over time inflation will come down. We think it'll probably be again still north of that 2% mandate for some time. No one's going to hand me the Nobel Prize for saying that, but we do think that the opportunity for the economy to gradually recover and show this kind of late cycle type of behavior, we think inflation will normalize back down to probably mid 2% type of range. But will that be fast enough to get us to the second time continuum, which is May, when, if President Trump and others are really trying to reinforce that mandate of we need to have lower interest rates as a static component of our economy, that doesn't mean the rest of the bond world's going to buy into that. In fact, this may be too much of an aside, but we wrote a piece which your listeners can pick up, equating the bond market to a Brazilian steakhouse. And if you'll bear with me for a second, to kind of go through this visual, for those of you who've been to a Brazilian steakhouse, you know how it works. But for those who haven't, when you walk in, usually at these establishments on your left, there's a, you know, there's a potato bar and salad bar. You want to bypass those too. Those are just fillers. So you get to your table, you sit down, and you're given a card. The card has two sides. Side one is green, which means you want more, and the other side is red, meaning you're full or at least you want to pause. So I think about this as a bond market investor, like I'm at a Brazilian steakhouse. And so if we're actively buying bonds, which we are, and our placard is green, there are a lot of issuers who surround our table. They come across with all sorts of skewers. Could be a municipal bond, could be a corporate bond, could be a government bond, could be a reinsurance issue, could be, again, the list isn't endless, but there's a lot out there. And we have to decide, number one, what are the choice cuts that we want? And then number two, when's enough? And so the risk, we think, in the bond market, which isn't showing up yet, but it certainly could show up, is twofold. Number one, you, US debt, US Government debt has been the choice cut for forever if you like wagu, if you like prime filet, if you like whatever your fancy is, that has been the choice issuance that everyone has had want more of, that could shift, that could change. And we'll know through bond auction performance, we'll know through how the 10 year yield actually transcribes over time. Those would be some tells for us that the market is getting either full or the market no longer views US debt, US government debt specifically as that prime cut. So the Fed and Treasury, even though they are meant to be separate, they both face the same considerations. And I think what you're seeing, gold, to extend this analogy, hopefully your listeners aren't know, too distant from a meal. But to extend this analogy, you've had gold show up as a, a slice that people want a lot more of. You've had silver, you've had in some cases crypto. There have been some central banks that have been draw that have been buying global equities. There have been central banks that have been making a lot of property investments. And so that dynamic of the interplay between assets and inflation and government issuance policies, that's going to be very important. I think a topic that again we as large bond market investors are hyper focused on for clients.
- [30:47]
C
On that point you made about people pulling money from US Bonds, is that something you worry about? We had that small period of time where they talked about the US is an emerging market because the bond, stocks and currency were all going down simultaneously. Do you think that's a risk here? Do you think the US being this exceptional place where people want to put their money, do you think that's a long term risk?
- [31:06]
A
You know, it's a, it is something that we have to, we have to respect as a, as a possibility. It's not our base case. And I think that everybody uses this analogy and I feel like I'm torturing it. But again, as the father of a teenage boy, we still get away with being the cleanest dirty shirt in the pile, if you will. In terms of liquidity, in terms of, in terms of, let's call it military strength, in terms of, you know, let's call it the default option of both by currency as well as by liquidity. We get away with a lot. And so look, I think that from a geopolitical standpoint, what are we seeing right now that could threaten the US either as a dollar currency or having the ability to get away with a lot of what's called fiscal looseness, so to speak? You know, one of the things you're Seeing are, are a lot of partnerships that are very unnatural. So think about even things like Saudi Arabia and Pakistan having a security agreement between them. Think about who showed up when China had a significant ceremony in Tiananmen Square six weeks ago. You had five major heads of global state present alongside Xi Jinping. And so I think the risk to the US isn't necessarily that there is a binary replacement for the dollar or for Treasuries, but there's a lot more competition on a aggregated basis that countries team up more. China and India and Indonesia and other countries that maybe aren't as natural allies, if you will. And maybe it's too strong to call them default allies because that suggests you have to pick one versus the other. But there's a lot more cohesion with the rest of world, while the US attempts to be much more country by country, deal by deal. That has implications for assets, that has implications for how people view currencies. And so we as investors have to certainly respect that there can be some changing, moving dynamics that are just different, different than the trade blocks that we've had on for some time. Think about nafta. I grew up in the middle of central New York. I grew up in the middle of New York State, where in the 70s and the 80s when I was growing up, you had these huge conglomerates, US Conglomerates, General Electric and Carrier and Crucible Steel. And then NAFTA occurred and these trade. And then a lot of China's exports came up. And the region where I grew up had to pivot and change because heavy industry was no longer a homegrown thing. And so we've had plenty of evidence in the past of change and a dynamic, if you will, relationship across countries. And, and certainly there are accelerants to that happening now that we have to respect as investors.
- [34:20]
C
As someone who builds portfolios, how do you think about international diversification? It's something we've debated a lot on the podcast. We have some people who come on and say, listen, you've got these multinational US Companies, you've got everything you need here. You don't need international diversification. And other people who look at the math say you're getting a significant diversification benefit. Plus, we don't know if the US Is going to be dominant like it's been in the past couple decades. So how do you think about that?
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A
Yeah, so we are proponents of international diversification. We think that currencies over time are more of a wash. We don't look at, at, at. Let's call it like we don't have an outright allocation to, to currency X, currency Y, currency Z. Most of our customers are US domiciled and, and so you know, they, they, their goods that they're transacting in if you will, are dollar based. If certainly if we have concerns about the dollar and dollar debasement over time, we will take action in portfolios. But we do think that, and this is, I think part of it is just, I think the reality of local company, you know, let's call it exposure is very unique. And there are certainly some indices that have a bias. Like think about, like the UK where you have a lot of banks, you have a lot of pharma, you know, you're not necessarily, you have a lot of consumer products if you will. So are you going to get a ton of, of international diversification exposure to Sterling? Not necessarily. Relative to other, other indices that are really much more local market biased and based. We tend to have more of a US bias in our portfolios in terms of strategically we own more domestic equities and more domestic fixed income on purpose. That is by very purposeful design. I'd also say this one trend that we are encouraged by that does augur for potentially a reevaluation of our international exposure is that international companies are becoming more shareholder friendly. We've seen that in countries like Japan. You're starting to see that a little more in EM countries. I don't want to paint EM as one. EM is also not one monolithic entity. There's so many sub micro categories. I almost wish we, we didn't come up with that, that moniker because it is, it is a misnomer. But one of the things that we are seeing with things like easing labor laws and less of a conglomerate focus and more engagement with shareholders, that's a positive because you know, I could tell you that there's going to be massive growth in many sub Saharan African countries. But that doesn't mean you can extract value from a shareholder from that growth. And so we want to be very mindful of that potential wedge effect between what is happening from a growth standpoint, what is happening from a realization of that value, so to speak, from that growth. Those wedges can be perpetual. I have sat in meetings in Beijing and it sat next to companies that I was like, I am sure you're going to do what it is that you say you're going to do, but to get shareholder protections for our clients, irrespective of how fast you grow there isn't that cohesion, that alignment if you will. And so we walked away from those sorts of opportunities. So I just want to say that can happen in, in Chula Vista. It can also happen in Beijing. Those wedge effects happen everywhere.
- [38:07]
C
Another thing I want to ask you about in terms of portfolio construction is inflation, because that's another thing. We've debated a lot on the podcast. We've had some guests, maybe more of the Boglehead type guests, who said, you need your stocks and your bonds, that's all you need. You don't need anything else to protect from inflation. If you're a long term investor, you'll be fine. And then we have other people who come on and say, yeah, you want to have an allocation to gold, you want to have an allocation to something real estate or whatever it is, something that's going to protect you from inflation, because that's now here. And even though it hasn't been present in the last 30 years. How do you think about that?
- [38:33]
A
Yeah, we think you should have some discrete inflation protection portfolios. And I think that if you go through the consideration set in the past, and this predates my tenure, I've been at US bank for nine years as a cio. When I came in, we had an outright allocation to commodities. We actually don't have an outright allocation to what I'm going to call, you know, the GSCI or the Bloomberg Commodity Index. We actually don't like futures based, you know, we do have exposure to tips. We have exposure to, you know, to, to real assets as a, as a dedicated category. So the way we think about things from a taxonomy standpoint, we start with what we call tier one assets. Those are equities, both public and private, fixed income, both public and private equity, as well as real assets. And real assets. For us, what's available on our platform can include everything from gold and silver to crypto to things like global infrastructure to hydrocarbons of various sorts or what have you. But for us, strategically, what we think about, and I think that one of the categories that right now we're a big believer in is global infrastructure. And so I think that what do you get with global infrastructure? You certainly have some utilities exposure which have done well because of the big data center build out, which is certainly a very topical item. But you also have the transportation of, of hydrocarbons, which in and of itself offers a diversification as well as inflation hedge, so to speak. And so like, you know, we like those contracts because they, they have an inflation adjustment already in them. They also spit off some income. One of the things. One of the reasons why we haven't been as big in places like gold or silver is because we like to have some level of cash flow. But concurrently, that hasn't been. You haven't needed one to make money in gold or gold miners or silver or silver miners. But I do think back to your thoughtful question. We do think having a bespoke allocation in one's portfolio that is dedicated to inflation risk is important. And we are not believers that equities in and of themselves are sufficient to protect against inflation. And there are plenty of examples of where that has worked and plenty of examples where that hasn't worked. We have to think about what's next, and we do think the potential for inflation to remain sticky and structural, that will have an erosion effect on corporate earnings, which by definition, we don't think will help equities.
- [41:34]
C
You mentioned the data center build on. I want to ask you about AI because it's something I struggle with in my own life. I'm seeing massive, I think, productivity boosts with respect to AI, but then when I, like, carry it up to an overall economy and I think about economic growth and productivity, I have a hard time thinking about, like, how massive of a change it is. So I'm just wondering. I always like to ask people on the podcast for their take on that. So how are you thinking about AI in terms of how it might impact the economy?
- [41:55]
A
You know, we're big believers in frameworks. We, you know, we. We're privileged to speak with a lot of different clients. And so when we talk to AI, we talk about it in really three phases. Phase one was, you know, the marketplace asking companies, do you have an AI strategy? Yes or no? And if the answer was no, then you received a lower multiple than your peers, which. Which did. Phase two was, do you have an AI strategy? And how credible is it relative to the capital that shareholders in the street will allow you to spend? And I think that we're still in that phase two. Phase three, which we haven't quite fully gotten to yet, is what is your return on capital employed on your AI investment? And so I think that we're somewhere between 2 and 3 right now. And as someone who actually I used to be on the board of an AI firm, and so I've had a lot of insight into the inner workings, if you will. And so I think that there isn't this universal application of all things AI. There are some very thoughtful technologists and practitioners who say, you know what, the code that AI programming generates is actually flawed. And it's really good for some, let's call it applications where you can have a margin of error, but in some applications where you cannot have a margin of error. So things like in medicine or in sub, sub components of finance, or in sub subcomponents of consumer experience, like driving that if you have a failure, there is a very negative outcome like that that is still unproven and not yet scaled. And so I think that there are plenty of examples of companies we see where that margin of error exists and we think that the deployment, the diffusion of AI technology where it's okay to have a margin of error, we're still very early innings in that phenomenon. And markets probably haven't fully recognized the scale at which the deployment will help productivity and actually drive value. Now I'm not trying to be the two handed economist here because I'm not an economist, but also talking to both sides of my mouth. But there are plenty of examples where the market has over extrapolated the power of AI in industries and applications where there is no margin of error. We just haven't seen those errors pop up at scale. And so I think like anything Justin and Jack, it's going to boil down to can you separate out the winners from the pretenders? And I think that's the phase at which we are getting to across both public and private markets. And look to be sure it is a transformative technology. But we've all heard about transformative technologies before. 3D printing, in some cases a transformative technology, the Internet, I mean as someone who grew up in this business, worked in San Francisco in 99 and 2000, it was, was there for the big buildup. The Internet was certainly a transformative economic driver, if you will. There's just too much value assigned too early, if you will. And so I think that's where we are right now is trying to decipher where are their applications at scale where margin of error is okay. And there's a simpatico relationship between the AI deployed and the capital deployed to fund it. And then on the short side of things or the things where there's over extrapolation of where, where has the market over extrapolated the application? And I think that that will play itself out both in public and private markets. And just like we saw, I think during, I think people often ask me is this, is this the Internet 2.0? And again I don't see this as like some nostalgic look back at my career. But I do think that as someone who was in San Francisco Printing two to three tech deals a day that were going out to the public. It was like there was this massive transformation with anything.com net it's more contained right now but I want to be very clear. It's contained but it doesn't mean the market has it right. When I say that, I say that with a ton of humility. I say that with a ton of a working thesis mentality that look, we will likely over build data centers just like we overbuilt spectrum licenses and we overbuilt sea like capacity in Europe. Those things are likely to occur but we're not quite at that point of determining that we've gone too far. Within some companies I think that we have, but other companies we haven't quite scratched the surface.
- [47:08]
B
And I wonder, I want to ask you about the Mag 7 and the concentration of something like the S&P 500 in the top stocks which is very tech heavy. But I almost wonder to your point about this AI, I wonder if there's a recency bias because it's the biggest tech companies that are, you know, plowing all this money into the data centers and investing tens of billions in capex. And it's almost like those stocks have done so well in their core businesses that investors and obviously AI is exciting. It's new technology and we want to see what it can do and it has all these possible benefits. But it's like almost like investors are giving the Mag 7 maybe a pass because of like their core businesses and sort of just being biased to like the success that those stocks have had over the last 15 years. So there's kind of two embedded questions in there. One, I'm just wondering your thoughts on that if there's even a question. And then two, you know, does the level of market concentration in these top stocks concern you at all?
- [48:08]
A
Yeah, look, it's incredibly thoughtful just the way you frame that. And let me just start by, by saying this. I think that the concentration is certainly a concern and to kind of answer both questions simultaneously. One of the things that gives me some pause and gives us some pause is when people say yes, but these companies are generating their own free cash flow which are funding these projects, they're funding the expansion and the market's giving them free reign to do so. That's why I think we're in those in between those two phases I mentioned earlier, phase two and phase three. Phase two being do you have a credible AI strategy? And then phase three is what is your return on invested capital or capital employed of the AI portion of your strategy. And I think we're going to sit between those two areas for some time now. I think if you look at, for example, Nvidia's last earnings report where they detailed their customers, one of the things we pay a lot of attention to isn't so much the total addressable market. It's important, but it changes all the time. It's the diffusion of the technology and how readily available is it. So if I had a fictitious company, Acme Incorporated, and I had a credible AI strategy where the margin of error of my application was, was okay, such that it's not a life or death outcome if something goes wrong. But you know, but like, let's say that sounds like a very stylized example, but how quickly and how readily can I access the technology and can I get enough of it to scale up my business needs? And we still think that that diffusion, because you still only have a couple of chip producers and you still only have a couple of, I shouldn't say a couple, but you have a growing list of others in the ecosystem who are producing incredible off the shelf widgets or applications. That's like for us, the diffusion is a big constraint right now. That could change, that could change for lots of different reasons. But for us, the diffusion is still very gradual. And so I do think that if we saw nothing cures high prices like high prices. I'm a big believer in that statement. And so let's say we saw a bunch of chip makers able to produce competing products and we also saw a market that was separating out winners and losers from the application standpoint. I'll just make up an example. Let's say that it's determined that AI, despite its great powers, is unable to execute XYZ medical application. So then that comes off the board, if you will. From an investor standpoint, where we would have a lot of concern is that if we still see the Mag 7 perform really well as diffusion goes up and as credible business cases become more defined, that's where we get concerned. That says to us, all right, this is a market that is the beach ball underwater phenomenon and we haven't learned our lessons. And we have to learn a lesson again this time that for us would be a concern.
- [51:49]
B
How do you think about market valuations? On the one hand, the market might be looked at by some as being expensive. If you look at like something like the CAPE ratio or other indicators like the Buffett indicator and Tobin's Q and stuff like that, I mean, the market looks pretty lofty. But on the other hand, you know, these large companies that make up a lot of the market, they are performing and you know, you could maybe make the case that while some have said, you know, margin should maybe revert to their long term mean, you know, maybe they don't, maybe they stay elevated, maybe they even go higher with more productivity. So how do you think about just overall market valuations? And should like individual investors be paying a lot of attention to that? Like I like to think of valuations like in terms of like thinking out in the long term, 7 to 10 year like returns and what you might get, but at the same time that's even very hard to have any accuracy.
- [52:43]
A
Yeah, just I think that I, I would say that we, we follow your school of thought, if you will. Where I kind of think about it, we think about it in almost two, two time spaces. Space one would be the here and now and then time two would be. What do we think when we're building our capital market assumptions? Do we feel like, you know, we're just pulling forward future returns? And I think that right now our viewpoint is that with falling interest rates, at least at the front end of the curve, we're not convinced we're going to fall at the back end of the curve necessarily. But with more subdued front end rates, can we, and again some slight enhancements of productivity and still delivery on earnings. We don't think that next year is 12 to 13% is necessarily a, a massive ask for the S and P, so to speak. Can we justify current levels? We can, but we're certainly in the higher side of fair. And so that leaves us, in fact we've been a little more biased towards owning non US equities. We're overweight equities in our portfolios right now, but our expression is, is greater in non US versus domestic. And some of that is because of valuation. Valuation is never catalyst, but part of it is a combination of valuation plus some marginal improvement. Back to what we talked about earlier in the podcast is this notion of marginal improvement is actually still we think at the margin getting better, especially in places like Japan. So I think that right now we view this as a bit of a pull forward of future returns. I do think that the CAPE ratio is valuable tactically speaking. If I was from the CAPE ratio at any point, I mean you would always be underweight domestic equities. And so the tactical piece for us, our idea is that we have very tight stops around levels that we're focused on. That's the way that we approach tactical. We are not going to let a dogmatic approach dominate what the market gives us. And so back to the notion, maybe full circle on that working thesis mentality. One of the best things to be disciplined about when you invest is not to try to rationalize prices and not to try to almost reverse engineer what you're seeing. We have to be able to corroborate prices with earnings growth, with what we're seeing from sentiments, and at least for now, in price is truth. But we can't just back into a story which makes us feel better. It has to be corroborated with, with data. So that's the way that we, I think, coming full circle, approach the, the capital market process.
- [55:48]
B
Yeah, and that's, that's great. And that might be the way that you would respond to this. So we have two standard closing questions we like to ask all of our guests. The first one is based on your experience in the markets. If you could teach one thing to your average investor, what would that be?
- [56:02]
A
I think, number one would be to have a plan and stick to it. It sounds so pedestrian, commonplace. But being able to stick to your discipline on April 9th, 11th and 12th, when, you know, intraday, we had an 11, actually, we had a 15% intraday reversal. That's like two years of returns if you made a bad decision that day. And so being incredibly disciplined, whether it's your exercise routine, you're brushing your teeth, investing is the same way. If you have a plan and you stick to it, make sure that plan is interactive, you're engaging. We could be dead right on all aspects of the capital market spectrum, but if we're not executing within a plan, it's for not. And I think the second piece is to be as unemotional in the execution of that plan as, you know, as you possibly can be. That's again, easier said than done. And I think the last thing I'd say you asked me for one is to be an informed consumer and empower yourself. Read, read, listen to podcast. Obviously you're a student. Again, if you're listening to this podcast, I'm not saying it's the pander. These are two thoughtful people and it's a robust set of content. Not because I was on it, but skip me, but listen to others. It's like you're going to give good info, keep doing that. And recognize that empowerment also requires you to separate good advice from bad advice. If you go to Reddit, if you go to whatever. I'm not saying it's a bad. I use, I use Reddit for information. There are a lot of people who offer perspectives on Reddit and other mediums that would put you in a very bad position in an instant if you execute it. So I think that the empowerment piece also allows you to be more let's call it this is an SAT word parsimonious with whom you follow. And that that parsimony is very important because we are all drowning in information, but we're all thirsting for knowledge. And empowerment helps you separate those two variables which ultimately are going to be in your own self interest.
- [58:34]
B
That's a fantastic way to sort of wrap up this conversation. So really appreciate your time. Eric. Thank you very much. I've enjoyed it. I know Jack has too. So come back soon.
- [58:43]
A
We love it. Best wishes and thanks for what you all do. Thanks for contributing to the community in the positive way that you do.
- [58:48]
B
Thank you for tuning in to this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio platform or on YouTube. You can also follow all the podcasts in the Excess Returns network@excessreturnspod.com if you have any feedback or questions, you can contact us@excess returnspodmail.com no information on this.
- [59:08]
C
Podcast should be construed as investment advice.
- [59:11]
B
Securities discussed in the podcast may be holdings of the firms of the hosts or their clients.