Rick Rieder: Explaining the ‘Polyurethane’ U.S. Economy

BlackRock’s longtime chief investment officer on his new ETF, whether we’ll get a soft landing, the fight against inflation, and more.

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Our guest this week is Rick Rieder. This is Rick’s second appearance on The Long View. We last interviewed him in May 2020, and we are happy to welcome him back. Rick is BlackRock’s chief investment officer of Global Fixed Income, head of the Fundamental Fixed Income Business, and head of the Global Allocation Investment Team. Rick also is a member of the firm’s Global Executive Committee, its Investment Subcommittee, and is chairman of the firmwide BlackRock Investment Council. In addition to these duties, Rick manages numerous multi-asset and fixed-income strategies, including BlackRock Global Allocation Fund and a new active exchange-traded fund that the firm recently launched called BlackRock Flexible Income ETF.

Bio

“Rick Rieder: Nobody Has Ever Seen Anything Like This,” The Long View podcast, Morningtar.com, May 20, 2020.

BlackRock Flexible Income ETF BINC

“Investors Rediscover the Importance of Getting Paid Back,” by Rick Rieder, blackrock.com, June 21, 2023.

“BlackRock’s Rieder: Grab High Yields on Super-Safe Bonds While You Can,” by Tom Lauricella, Morningstar.com, May 18, 2023.

“BlackRock Bond Chief Rieder Says U.S. Economy in ‘Much Better Shape’ Than Doomsayers Say,” by Hugh Son, cnbc.com, May 23, 2023.

“The Polyurethane Economy: Flexible and Adaptable,” by Rick Rieder, blackrock.com, Feb. 22, 2023.

“5 Reasons to Call an Investment ‘Time-Out,’” by Rick Rieder, blackrock.com, March 31, 2023.

“The New Inflation Regime,” blackrock.com.

“Fed Chair Powell May Lean Hawkish on Inflation, but Stocks Have ‘Tremendous’ Technical Backdrop, Says BlackRock’s Rick Rieder,” by Christine Idzelis, marketwatch.com, July 26, 2023.

“Investing in a Changing World: From Carburetors to Compilers,” by Rick Rieder, blackrock.com, Aug. 10, 2023.

“July Jobs Report Shows the Post-Pandemic Labor Market Is Over,” by Myles Udland, finance.yahoo.com, Aug. 4, 2023.

“Rotation to Duration: Seeking a More Resilient Portfolio,” by Rick Rieder, blackrock.com, Aug. 1, 2023.

BlackRock Global Allocation Fund MALOX

(Please stay tuned for important disclosure information at the conclusion of this episode.)

Jeff Ptak: Hi, and welcome to The Long View. I’m Jeff Ptak, chief ratings officer for Morningstar Research Services.

Amy Arnott: And I’m Amy Arnott, portfolio strategist for Morningstar Research Services.

Ptak: Our guest this week is Rick Rieder. This is Rick’s second appearance on The Long View. We last interviewed him in May 2020, and we are happy to welcome him back. Rick is BlackRock’s chief investment officer of Global Fixed Income, head of the Fundamental Fixed Income Business, and head of the Global Allocation Investment Team. Rick also is a member of the firm’s Global Executive Committee, its Investment Subcommittee, and is chairman of the firmwide BlackRock Investment Council. In addition to these duties, Rick manages numerous multi-asset and fixed-income strategies, including BlackRock Global Allocation Fund and a new active ETF that the firm recently launched called BlackRock Flexible Income ETF.

Rick, welcome back to The Long View.

Rick Rieder: Thanks for having me. Appreciate it.

Ptak: It’s our pleasure to have you. Thanks again for doing it. We wanted to start the conversation with the new ETF we mentioned in the intro. It’s called BlackRock Flexible Income ETF, and it’s your maiden voyage, so to speak, as an ETF manager. Can you talk about the ETF’s strategy and how it differs from the other mandates you run?

Rieder: Thank you. Yeah, we’re super excited about it. The beauty of ETFs is there is a distinct investor base that’s growing in size. I would say they’re distinct today, but becoming, I would say, in the normal mainstream going forward. They’re looking for things that can go into models, things that can give them a differentiated return. There’s been, obviously, the success rate of passive ETFs has been people are getting what they want to get in terms of index returns, but in fixed income, most managers outperform the index. The reason why is that there are 68,000 fixed-income securities. It’s pretty extraordinary. So, the series of tools you have at your disposal is pretty amazing. Your ability to tactically asset-allocate to where there is yield, where the opportunity set has grown in fixed income, and to do it through an ETF wrapper is something that a lot of people are excited about, a lot of people are looking for, and so why we’ve created this. So, the idea is to get people yield. Today we’re yielding at about 7%, and then try and manage your asset allocation, keep your volatility lower than a traditional index would be, but then just try and create what is a consistent return.

The one thing that I think is super powerful around the next few years is that you’re going to see more dispersion. You’re going to see more defaults. We went through this unbelievable period of very low interest rates, quantitative easing globally, and so you didn’t have much dispersion. If you look at, for example, the High-Yield Index today, half that index trades at wider than 800 and tighter than 300. And the other half is in the middle, meaning there’s extraordinary dispersion and there’s some credits that trade too tight—why own them—and then some of the ones that are distressed, like you need to really do your credit work to see if you want to own any of those. So, dispersion is growing. The opportunity to get yield, to tactically allocate to where the opportunity set is going to be, and then try and create a better mechanism to outperform is why you’re seeing that sort of excitement around it today.

Arnott: With that as a backdrop, when you’re thinking about liquidity, how does the liquidity profile of the ETF compare to that of the other strategies that you manage with other wrappers? And do you have to adapt your portfolio management style to the ETF structure, given the need for more liquid underlying securities?

Rieder: It’s a great question. A, in terms of people are looking for these to be as transparent, they understand how they’ll fit in a model, to understand the beta, how will this react under different scenarios? So, how is this different than we would run in a mutual fund? One, we would use less assets that are bespoke, private, and to create more. Areas like securitized emerging markets, which is a big place to get yield—we want to make sure we’re using more of what is mainstream assets within those areas. A little bit different from that regard, so that for somebody looking for it to understand the beta and can recreate it. You see a lot of players that try and recreate this, whether it’s sell-side or otherwise. This will be, yes, more liquid, and maybe not take advantage of, in a mutual fund, some of the things that can be more highly structured, and you can hold for a longer period of time, and that give you some yield.

But the beauty of this is, gosh, we can still use securitized, that market is huge. We can still use EM, same, but maybe use it a little bit differently. In this structure, we do a lot of hedging in our mutual funds. We’ll use options, and we use, whether it’s TBAs versus pools, and so on, we’ll do. Whereas here, less hedging and more of the organic asset you would own, so that people understand what it is and can manage to it. And we think there’s a load of people that want to look at, give me that, and then, gosh, I’ll go in a mutual fund where I could do more of bespoke, where the manager is doing a lot more hedging of the portfolio and a lot more managing the dispersion and the volatility around it.

Ptak: Very interesting. Thanks for sharing that about the ETF. I did want to jump and talk about the macro picture, the economy. This year has been, in many ways, especially confounding from a macro perspective. The Fed has continued tightening. The existing home market has, I suppose you could say, it’s stalled in various ways. Inflation is still above target. Why isn’t the economy doing worse than it seems to be in light of all that?

Rieder: I think the U.S. economy is one of the most extraordinary economies in the history of how people think about business structure and about how the world works from a commerce point of view. I did a presentation where I called the U.S. economy the polyurethane economy, meaning it’s so flexible, so adaptive. When you think about those Tempur-Pedic beds, when one side of the bed has volatility, the other doesn’t necessarily have that. And I quite frankly think that is the case here in the U.S. economy. It’s 70% services, 70% consumption. Services don’t really go in a recession. Think about how people spend on healthcare, education, and so on. It doesn’t really go in a recession. It’s so different than 20 or 30 years ago when you had a commodity-oriented economy that was spending an awful lot and manufacturing was driving the economy. You could have big cyclical evolution. The U.S. economy today is much more stable.

And then, you break it down and you think about it’s an economy that has energy independence, spends a tremendous amount on R&D and tech, and quite frankly, also has brought the debt down, which seems inconceivable when you say that because people look at the size of the government debt. But the way economies work is there are four parts of your debt structure. It’s your private, it’s your household, it’s your corporate, it’s your financial, and then it’s the government. You think about what’s happened over the last few years. Households have deleveraged financials, particularly big financials have deleveraged, and corporates have extended their maturity and have brought down some of their leverage. So, it’s just the government that holds the debt, meaning the stability of the economy, even when interest rates grow, is not that significant. Anyway, I think people will continue to question, is the economy going to go in a recession? And you just have this immense amount of growth. Nominal GDP in 2021 was 12.3%, in 2022 was 7.3%. If we went into two quarters of negative one, the economy is still operating at an incredible level. So, I think the economy will continue to confound people for a long time.

Arnott: With that said, what is your opinion? Are we going to get a soft landing? And what kind of indicators are you paying attention to when you’re looking at the economy and trying to gauge the trajectory?

Rieder: A lot of the traditional indicators—people talk about the inversion of the yield curve. I think of the inversion of the yield curve is predicted now in the last three recessions. I don’t think that is a terribly good, particularly when the economy is not that interest-rate sensitive anymore. I think the economy is moderating. And I think you have to assume that a 3.5% unemployment rate is not going to be the go-forward. We’ve gone through this incredible structural lack of labor in the system that in places like healthcare, education, leisure, hospitality, restaurants, hotels, airlines, you have to believe that 3.5% is not going to be the steady state going forward.

So, big focus on employment and to see that you get some softening there. Quite frankly, I also think the global economy, it can and is slowing. And you look at China and then the impact that’s having in Europe, that the global economy can certainly have a negative influence. So, we watch what’s happening extra to the U.S., which I think will give you a pretty good indicator.

And then, beyond that, we’re watching technology really closely. And if you break down—consumer is in good shape, savings are at a good level, slowing a bit in terms of what their savings are, employment should slow a bit, and it’s just corporate sector willing to continue to spend. And the capital expenditures in this cycle is so different because it’s largely technology. So, we’re watching really closely all the big tech businesses or the investments around tech, which now is AI, software, and so on. We’re keeping an eye on that closely to see the companies start pulling back. My sense is that they were going through a step change around companies’ investments to make their business more efficient and increase the level of productivity. So, I think corporate spend will continue to be robust. But keeping an eye on those things, I think, is going to be pretty significant from here.

Ptak: Do you think the odds of a recession, albeit lower than they were maybe entering the year, are being properly priced into risk assets? Or do you think markets have gotten a bit blasé?

Rieder: I think when you break it down—I find that some of the credit markets are tighter than I think they should be. When you think about what is credit, you get paid yield, you get paid income, or you don’t. I think that when you go through periods like this, people forget you can have an increase in defaults, you can have parts of the credit markets that can come under pressure. So, do I think spreads are going to widen out a lot? Probably not, because I think the economy is in good shape, and I don’t think we’re going to see a deep recession. Companies have termed their debt out. But I would say the parts of the high-yield market where spreads are pretty tight, if you ask me, given upside downside, and by the way, how you can get yield in other places that, with the risk-free rate so high, you can get a lot of yield and particularly, with the curve inverted, you can get it in the front of the yield curve.

So, I think parts of credit are a bit, to your words, blasé. But I think the equity market is … You think of the companies that are cyclical or more traditional and whether it’s airlines or autos or homebuilders, energy and the multiples on those equities are not very high. So, I think they’ve built in that this economy may slow, your top-line of revenue could slow alongside of it. And quite frankly, I think those valuations are OK. Because I do think that part of the market has priced it in. The other one is, the interest-rate market is moved to a level that is—I do think what’s going to happen is, you’ll see rates start to come down as the economy slows. And I think the Fed will have to cut rates in later part of 2024. We’re moving some of our assets to taking just more interest-rate risk given these yield levels today.

Arnott: Speaking of interest rates, obviously, we’ve had a huge jump in rates over the past year or so. And as we’re taping this in mid-August, you’ve got the average 30-year fixed-rate mortgage at about 7.5%. Is that a concern for you? Are you worried that with higher mortgage rates, is housing affordability going to imperil the economy, or throw things more toward the negative side?

Rieder: I think people underestimate how important housing is. If you go back and you think about deep recessions or crises—even in 2008, it was obviously the pressure from subprime and the broader housing dynamic. You go back to the early ‘90s, the savings and loan crisis. Housing is the bedrock of the U.S. economy, and it is roughly 75% of the asset value of people in the country by individual as opposed to total aggregate. So, it is hugely important. So, keeping an eye on housing is such a big deal. But today, why this situation is so unique is we had this period of extremely low interest rates where people locked in their mortgage. And when you spike rates higher, the reason why you don’t see much volume in terms of the housing market is people are sitting in those mortgages now and don’t want to give up those low-rate mortgages.

So, A, I think they’re in pretty good shape in terms of what their current interest rate is on those mortgages. B, there’s been a tremendous amount of value built up in the home or equity built up in the home. So, that’s in pretty good shape today. Two things that are hugely important. One is, the consumer, the households have deleveraged. They’re not sitting in the same amount of credit card debt and mortgage debt, and so on, than they used to, and then the unemployment rate at 3.5%. If unemployment starts to move significantly higher, then you could start to see some pressure on housing. And this is one of the reasons why I think the Fed needs to be a bit careful about how much they continue to move interest rate higher, because if unemployment started to move higher and then you start to infect housing, then that would create a tricky dynamic for the economy. And that, to me, is, again, a barometer for where stress in the system could be, where stress could be in the banking system, and so on. So, I think you’re dead right to focus on housing. And we spend an awful lot of time. It’s just organically in a better place than it’s been over prior cycles.

Ptak: We’re going to shift and talk a bit about inflation, ask you whether you think the Fed has gotten the upper hand in its battle against rising prices, or do you think maybe we’ve gotten a little bit complacent and there are still embers, so to speak, that could reignite inflationary pressures? What’s your take?

Rieder: I think you have to build into your model that there is—and I think there’s roughly a 15% or 20% chance that inflation reaccelerates. What would cause that? Wages, per the point I was making before about there’s a structural need for people in this country, and by the way, not just this country, in Europe, U.K. So, wages are going to stay high. And then, the service sector inflation can stay higher than it has and potentially reaccelerate. But again, I don’t think that’s the base case. My base case is inflation is on the way down. We’ve certainly achieved on the goods side of the ledger—the last three-month goods inflation, if you take out used cars, which, by the way, are coming down significantly. But if you take that out, you’re talking about negative inflation. I think it’s negative 0.7% over a three-month moving average. So, goods inflation is coming down. And I think that is persistent, that you’ll see that. Again, we talk about used cars. And then, the other one that’s been sticky has been shelter. But shelter, you can do a pretty good job of predicting because you can see the availability of rental that’s coming on the market. So, my sense is that shelter is coming down as well.

So, my base case is that inflation is moving lower, more to a normalized 2.5% to 3%, and I’m pretty confident in a moderating economy that that will continue to be the place in case there is some exogenous shock in the world. By the way, you think about why we had this sort of inflation: supply chain shock post-COVID, a war that infected food and energy prices. My sense is if we’re in a more normalized world in a moderating economy and the increase of things like AI coming in and productivity enhancement, I think the base case has to be that we’ll be at a lower rate of inflation than we’ve been at over certainly the last few months, and you’re seeing that play through today.

Arnott: When you’re thinking about inflation, it’s obviously caught a lot of people by surprise, both on the upside and the downside. So, what’s the simplest way to explain why inflation spiked so high and why it’s now coming down? And do you attribute that to the fiscal stimulus? Do you worry at all that the unprecedented levels of fiscal stimulus will have an inflationary effect over longer periods?

Rieder: If you break it down and say, gosh, we had the combination of fiscal and monetary, immense amounts of fiscal and monetary stimulus, coming in all together buoying huge amount of growth in the money supply, over $2 trillion of savings in the system, this de-levering of consumer debt we talked about—pretty incredible. And like I say, I think we’re on the backside of much of that today. So, that gives you some confidence in the persistence of lower levels of inflation. There was this monstrous undersupply of labor. You’re seeing all the jobs that are being created, literally all the jobs that are being fulfilled today are coming from immigration, from international. So, to the extent that you see more and more of this, then that should dull some of the wage impact. And then, we talked about the post-COVID—the supply chain shock, the war and the shock that it’s had on food and energy.

So, my sense is, all these things are starting to become more normalized. So, I wouldn’t say we’re in the rearview mirror of higher levels of inflation, because you still are getting a deglobalization effect, you’re still getting what will be a significant spend on things like climate, clean energy initiatives, infrastructure initiatives. So, my sense is, inflation will stay higher than we’ve been used to in the pre-COVID period. But a lot of those exogenous shocks that nobody in our industry has ever seen anything like before, that was creating things like 12% rates of inflation in goods—when people were locked in their homes and all of a sudden had to buy cars all at once or furniture or electronics or what have you. So, my sense is, this will be more normal, save some exogenous shock. But, boy, you talk about the perfect storm of things happening all at once to create excessive levels of inflation, my sense is, we’re past some of that.

By the way, I want to add that one last thing: I’ve seen some studies on AI’s impact on the job function and about the efficiency of running your business. And you’re seeing this incredible amount of capital investment in that space. I’ve always felt like you can interpret what inflation will be for the next few months, maybe a year out. But I think we’re going to enter a period where it’s going to be hard to … It’s hard today to estimate how much of an impact that’s going to have. My sense is, though, it’s going to be a pretty significant amount.

Ptak: As you reflect on COVID and the policy response to the coronavirus, how would you appraise it and what lessons do you think can be drawn, do’s and don’ts, if you will, to the way fiscal and monetary policymakers responded to COVID? Certainly, we’ve talked about some of the aftermath insofar as inflation. But as we look back on it, did they do a good job of responding?

Rieder: I think you’d have to give an A to an A+ rating for how quickly, particularly the Fed, came in and was flexible in their approach and was willing to go at different types of investments and took out the “bazooka” to make sure people realized they were serious, whether that’s dropping rates, doing QE, willing to buy assets that are not normally within the Fed’s purview. That was incredible. And then, the amount of fiscal spend in conjunction with that was also incredible. So, what would I give a lower grade for? I would say, staying in the policy too long. And I think the do’s and don’ts will be: be aggressive early on, show what you’re willing to do, but then back off. And you think about how long the Fed stayed in this easy policy, which seemed inconceivable that we needed to stay there for that long and do QE almost at the same point in time that we started raising rates aggressively, my sense is that that going forward won’t be repeated, I hope.

And, the one thing I will say about policy, policy at the extreme I think, can be more debilitating than it can be accretive. Things like negative interest rates, which I think make no sense. We had negative interest rates for a long period of time. It dulls velocity, hurts the banking system, hurts the pension system, hurts investment. People don’t want to make dead investments, so they put all their money in equity investments, which raises cost of capital for companies, despite the fact you brought interest rates down. I think policy at the extreme needs to be rethought. Use it aggressively when you have a pandemic, when you have a financial crisis, when you have an exogenous shock, use it aggressively. And then, once you’ve stabilized the system, get out of the way and let the system, particularly in places like the U.S., where the system has this extraordinary ability to adapt to what those conditions are.

Arnott: We’ve had a period of time when the Fed was relatively open and clear about their view on interest rates and potential future directions. You’ve expressed the view that you don’t think that the Fed will be quite as open and forward-looking as perhaps they were in earlier phases of the tightening campaign. So, why is that and what are the implications for investors?

Rieder: I don’t think central banks need to prescribe every single move or every single tool in their arsenal and how they will employ it. I actually think there’s a tremendous benefit for central banks to say, these are the broad environmental conditions we are reacting to. These are the metrics we’re looking at. And then, quite frankly, using some flexibility and adjustment without telling the world in advance, we’re going to do exactly this. It’s interesting watching the Bank of Japan now. They’re laying out this—they’ll buy securities, they’re watching it. I think that’s great. I think the markets require a vast, places like the Fed or the ECB or the Bank of England, lay everything out to us so we know what to watch for. And I just don’t think it needs to be that detailed, particularly in periods of greater stability when you’re closer to your goals. We have an incredibly complex economy. I think one of the things in the Fed—remember, go back in time and the Fed would lay out how many months or what the period of time before they would move, or they’d lay out specific metrics. I just don’t think they need to be that prescriptive. I think you let the economy adapt and adjust and then react accordingly. Where you have an impact on the economy and markets tangentially is, quite frankly, a bit of surprise, and I think that’s a tool that the central banks can use more effectively going forward versus prescribing every single word of what we’re looking for. I think it’s been a bit overused, and quite frankly, I’m really looking forward to less communication going forward.

Ptak: Wanted to turn to the consumer. If I’m not mistaken, I think that wages rose faster than inflation for the first time in a while, relatively recently, which is good, but it’s also, I suppose, depending on how you look at it, potentially bad or unwelcome. How do you think about that, that equilibrium between wages keeping up but not running so hard that they create their own sorts of pressures and unintended consequences?

Rieder: I have a slightly different take, but I think it’s great. Particularly, the fabric of that increase in wages—it’s low-income wages. It’s the low-wage jobs that have grown precipitously. And by the way, grown in terms of demand, but also grown in terms of those wage levels. For the first time in decades, we’re closing the income gap in this country. We’re reducing the unemployment rate in the lower-income strata. You’re seeing this in some of the recent wage agreements from big companies and you’re moving money from capital to labor. For years, capital was experiencing the benefit much more than labor was. I think it’s great. In fact, if you look at—and part of why I think the Fed doesn’t need to keep raising rates, and I would argue, in my view, they didn’t have to go as far as they did—is if inflation temporarily elevated, in places like energy, shelter, food are elevated, that’s what hurts lower-income people. To me, it’s counterproductive to reduce jobs because it’s lower-income jobs that get reduced, but it’s counterproductive to do that when the people getting hurt from the inflation are the people that actually need those jobs. I think having wages higher at this point in time, for the lower-income wages being higher, I think is quite frankly a very good thing.

Going forward, we still have this demographic challenge. As you have aging populations and people that have retired and left the workforce, you have this real need for labor. I think in most economies around the world, you need immigration. It’s part of why Japan was so tough for so long. They had very rigid immigration guidelines. Immigration helps. AI is going to have a big influence in terms of the number of the jobs that are required going forward. But in the interim, to have higher wages in these lower-income jobs, and quite frankly, to reprice a lot of these lower-income job functions to higher levels, I actually think it’s a great thing for the economy, and I think it’s really healthy today. I don’t think the central banks should try and negatively impact that today.

Arnott: When you think about consumer spending and household balance sheets, there’s been lots of worry and hand-wringing about the levels of credit card debt outstanding. But it seems like, in some ways, that’s more of a function of income growth. Would you agree with that assessment, and are you worried about credit card debt?

Rieder: Yeah. Interesting—and part of it gets to the last thing we just talked about. There’s an incredible bifurcation of the economy today. And even with this higher level of lower-income jobs, it is still that the bottom 10% that is struggling. And you see that—you’re now starting to see higher credit card balances, you’re seeing charge-offs that are increasing, and it’s that bottom 10% that is still being pressured. One of the things about part of why I don’t think interest rates need to move much higher is you think about when you move interest rates higher, who do you help and who do you hurt? You help the wealthy in that those are the savers, those are the people that obviously garner a lot of income from investment. But what you do is you hurt the bottom end, and you’re seeing that play out today in the bottom 10%. And that’s exactly where the credit card balances are growing, and you’re starting to see some consumer loan pressures.

So, it’s something to keep an eye on. It’s part of why I really believe in the thesis that the Fed should cultivate more jobs, higher nominal GDP in the economy, and the lift all boats. And like you say, you’re starting to see some pressure alongside of our interest rates. But it’s the same thing that when you move interest rates to these higher levels in a modern economy, different than years ago when companies used to borrow at the front of the yield curve, when it was big capex spend that was away from things like technology companies that don’t really borrow a lot. Now when you move interest rates higher, you really hammer places like commercial real estate, small banks, the bottom 10%, and it doesn’t really affect a lot of the other parts of the economy. So, I think you have to be really thoughtful about using that interest-rate tool in a modern economy, because that is where you’re starting to see the pressure today.

Ptak: I think you previously said that some industry segments remain, in your words, structurally understaffed. What do you mean by that? And to what extent does that put a floor under the job market?

Rieder: So, if you take the trend, the pre-COVID to the trend rate today of where we are in places like healthcare, education, hotels, restaurants, airlines, we are so far below what would be the trend rate of hiring. And you see this from a load of companies. I think United Airlines said they have 91,000 employees. They have to hire 50,000 in the next three years. So, think about these companies, hotels, airlines. You can’t operate at full capacity. You see this with all the flight cancellations today that you can’t operate at full capacity because you just can’t find the labor certainly at a reasonable price, but you just can’t find enough labor. It’s so hard to fix that. And with an aging population and like I say, without immigration, it’s really, really hard to fix that. We had a historic number of people leave the workforce that hit an age level, but also built wealth because of the appreciation of financial assets. And quite frankly, if wages continue to elevate, you’ll bring some of those people back into the workforce. But today, we’re so far below the trendline. And you see in the last employment report was that 55% to 60% of the total jobs were in healthcare and education. It’s not interest-rate sensitive. It’s not cyclical. It’s just this understaffing that’s still got some room to go. My sense is, you’ve hired a lot of people in the last two or three years. So, that impact will come off a bit, but it’s still there across a whole series of industries and particularly industries that aren’t cyclical.

Arnott: So, we’d like to shift gears and talk a bit about the bond market and interest rates. We’ve seen this strange situation where long-term interest rates really haven’t moved that much, despite the repeated hikes in short-term rates. Why is that? And do you think it’s just a matter of time before the long end of the yield curve moves higher and you get back to more of a normal yield curve as opposed to the inverted yield curve?

Rieder: I think there is a couple of things. One, we are at this incredible point in time where life insurance companies, pension funds have tremendous amounts of money to put in the system and they tend to buy longer-dated assets. And while you’ve hit yield levels that work against your liability stream, you’ve got a tremendous amount of buying that’s taken place. It’s interesting in the last few weeks, as you’re getting now the Treasury is willing to issue more longer out the curve, Japan changed their yield-curve control, such a bit more flexibility, letting their 10-year rates move higher, that all of a sudden, you’re starting to see those long rates move up. I think my sense is the curve is going to steepen over the next year or so. Economy slows, the Fed can start cutting rates. I think they’re going to wait until the middle of next year but with some variability around that, and then I think the curve will steepen out again. But when you think about asset allocation, you say, gosh, you got a very inverted curve. I can capture a ton of yield in the front end of the curve and get 6%, 7% without taking a lot of interest-rate risk. If you’re not an insurance company or a pension fund, you have to wonder, why do I own that asset? When you think about your portfolio, you think about volatility. I can get my volatility in equities that have had incredible returns, or I can take it buying the long-end interest rates, which have negative return this year. And I think you’re seeing this big shift of people that don’t have to match a liability that have said, gosh, I’d rather get equity upside for my long duration bucket versus owning the long end when you’re not getting a lot of carry. And it’s questionable whether it’s a great hedge today if rates aren’t coming down significantly anytime soon.

Ptak: I think you touched on corporate credit spreads earlier, so I might ask you a slightly different question that it’s related. Corporate debt service does appear to be falling as a share of income despite rising rates. To what extent does that reflect firms paying down costlier sources of financing, leaving smaller balances of lower rate debt, or does it reflect other factors, in your opinion? What explains that phenomenon, especially against the backdrop of rising interest rates?

Rieder: Companies were incredibly thoughtful about terming their debt out when rates were incredibly low. If you were running a company that has any level of debt, and if you didn’t term your debt out, what were you doing? And companies did it in size, even companies that didn’t really need the debt but put on significant amounts of long-dated liabilities, debt on their balance sheet, because you can hear your return on equity to create what is a normal, and a lot of tech companies that were becoming mature businesses and now building mature balance sheets. So, a huge amount of that was just term it out, term it out at very low interest rates. And like you say, now, if you’re running a company, you think about your margins. Interest rate has been well taken care of. And now, you have pressures coming in from your input costs, commodities, labor, which we talked about, but interest rates have been—the ability for them to term it out has been incredible.

The interesting thing as well today, a lot of companies use the front end of the curve for working capital and commercial paper is at 6%. And we bought a lot of commercial paper cheaper than 6%. Thankfully, companies don’t have to use a lot of that because they’ve termed so much of their debt out. And by the way, not just investment-grade companies, high-yield companies. So, the interest rate, A, your term structure of your debt is in better shape and B, your cost structure is much better. Pretty historic that you saw rates that low for that long and to let companies do an incredible amount of refinancing.

Arnott: In terms of corporate earnings, it looks like company profit margins are back on the higher side of average after having dipped for a while. How much of that margin improvement comes from pushing through price increases versus cost-cutting, or are there other factors at play?

Rieder: I think the big one is top line revenue. Companies have had what has been an inelastic pricing function for a long period of time, particularly in some of the services areas, that you can just keep increasing price with almost no pushback from your client base. It’s pretty incredible. You see this in restaurants. You’ve seen this certainly recently in airline fares. It’s been an amazing thing. So, I think you have to start with the big one being you’ve been able to increase your price in a pretty extraordinary way. You think about in some areas as well that there were shortages. You think about food and other places where you could just keep raising your price. Anyway, that was the big part of margin was, gosh, you can grow your top line revenue faster than your cost structure. But I say, now it’s evolving. I quite frankly think that consumer corporate is now becoming much more sensitive to these high prices and the economy is moderating. So, I think the pricing is becoming much more elastic today.

But then, I think there’s also something now that’s building into it. People underestimate things like just-in-time inventory, your ability to use software to manage your inventory, manage your people infrastructure has been pretty incredible. I did something where I showed how sophisticated now versus classified ads 20, 30 years ago, how sophisticated the hiring is regionally, by sector, and so on. So, I think a lot of those things have allowed companies to be more effective at managing their cost base. Even with rising costs they’ve been much more effective around that.

And then, I’d say the last thing that is, as we move to a more service-oriented economy versus a goods-oriented economy, you become much less sensitive to spikes in commodity prices. So, your ability to keep your margins more stable is much more readily apparent. You go back to the 70s and 80s, when you had a more manufacturing, more commodity-oriented economy, and boy, if oil prices spiked, the system had a problem, companies had a problem. Today, the impact, I won’t say it’s insignificant, but boy, you have a really different dynamic when you have an asset-light economy than when you’re asset-heavy and have to be financed as such.

Ptak: Wanted to talk a little bit about allocation. I believe you mentioned in a recent commentary that you expect stock-bond correlations to be less stable as long as inflation remains above target. Can you update us on your views, particularly given the fact that the Fed seems to be having some success in subduing inflation? And is that previous view, is it informing the way you run money, allocate assets at this point, or not so much?

Rieder: The first thing I’ll say, with the utmost respect for the Federal Reserve, I actually think the reduction in inflation is less because of interest rates moving higher as it is an organic normalization of pricing that you’re seeing playing out. But I think that’s a critical factor for thinking through asset allocation today. I think the Fed has come to the realization that, gosh, if we keep raising interest rates, the pressure we put on the banking system, commercial real estate, and it becomes incredibly bifurcated because after 500 basis points of interest-rate increase, we’re still at a 3.5% unemployment rate. Meaning, I think we’re at a very different point in time today that interest rates, A, I don’t think they’re a great hedge in your portfolio because if inflation does reaccelerate, they will have to go further. But I think your base case is they don’t go further. So, now, build a lot of income in your portfolio. Gosh, you can use the front end of the yield curve, maybe go a little bit further than we were willing to a few months ago, and now we can go out to the two-year, to the three-year, to the five-year part of the curve. Get a lot of carry into the portfolio, build a lot of income, and then take your upside convexity using the equity market, and then parts of the spread markets, things like securitized assets, parts of EM. It’s a very different phenomenon.

We talked about it earlier. Gosh, what am I going to do with my long interest-rate exposure? Quite frankly, today, I don’t need it. It’s not a hedge. It’s not giving me enough income. I want to build a lot of income in the portfolio, use the front end, use things like securitized parts of EM, get some yield in, where I can use the different portfolios—whether we’re on fixed income or multi-asset—then use some equity for the upside. And the beautiful thing about equities today is the volatility is really low. So, where interest-rate volatility is super high, we like selling that and then buying equity volatility, which is super cheap today. So, you think about normally, when volatility is high, your hedge is really difficult, particularly if you’re running equity assets or high beta assets. But when volatility is really low, it allows you to build convexity in the portfolio. Don’t have to hedge it using long-term interest rates. And you can build a really convex portfolio with upside and with a lot of income in it.

For a fixed income, generally fixed income, we do a decent amount in equities as well. But boy, when you can buy interest-rate exposure and don’t have to take much yield-curve risk, much credit risk, that becomes really, really interesting in your portfolio. Because then I could use my risk buckets for places where I can get some real upside, particularly if I could use low-priced options to manage the downside.

Arnott: You mentioned bonds not being a great hedge. How does that viewpoint inform your opinion on the traditional 60/40 portfolio? It sounds like you would be in the camp of not necessarily using that as a template at the moment and trying to venture out into other asset classes?

Rieder: By the way, if you look at year to date, depending on what people listen to this, 60/40, your equities have done almost 20% return, depending on where you are in equities, and the ag is not that far away from zero. So, your 60/40 has done really well. It’s only because your 60 has killed it and your 40 has done nothing for you. If you said today, going forward, gosh, maybe I still like the equity upside, how you manage it. We talked earlier about doing … Tech has carried the day, maybe some of these cyclicals that trade at low multiples. And then, what is my 40? Well, maybe your 40 can be—let’s say, you took 30 fixed income and then you said 10 was in things that are less liquid today, depending on the type of portfolio, things like private credit, things like securitized assets, finance, real estate or other forms of financing at 10%, 11%, 12%, boy, in a world where income can be really helpful, that becomes really interesting. So, now, if I have 60 in equity and I have 10 in these assets, it gets you a 10% to 12% return, what do I do with my 30?

My 30 can be—we talked about short-end investment-grade credit. Investment-grade credit in places like Europe swapped back to dollars, you can get 6% to 6.5% yield for buying two- and three-year investment-grade in Europe. Wow. I haven’t done this in a long time. That’s pretty sexy. So, you get a lot of income and yield using the front end of the curve maybe out to the belly, use some of the spread assets, high-quality assets. Agency mortgages today are giving with incredible liquidity and an awful lot of yield today and will benefit from interest-rate volatility coming down. To buying quality income with your 30% without taking a tremendous amount of interest-rate risk, I think is really attractive. As time goes on in the next three months, six months, taking more interest-rate exposure—like I said, I don’t think you have to go all the way out to the long end—but I think, as the economy slows and we get closer to the Fed maybe cutting rates, then maybe involve the portfolio. But today, boy, this is a great environment to keep your beta down in fixed income and capture an awful lot of income.

Ptak: Maybe it’s logical with our closing question to ask you about one of the funds that you run, which is BlackRock Global Allocation Fund. You just mentioned the fundamental case for venturing beyond the 60/40 into some of the areas that you mentioned. Are we safe to assume that a number of those ideas are being expressed in BlackRock Global Allocation Fund at the moment? Maybe you can talk briefly about that.

Rieder: Yeah. That’s the whole gig of what we’re trying to do: Keep your income at really high levels. I think we’re running the highest level of income in that portfolio that we’ve ever run. And so, the idea of being buy a lot of short-term assets—I could buy a commercial paper at 6%, I still can’t believe that. And there were some I bought a big piece at 6.5% the other day. Use that, then do some bespoke financing in parts of—there are parts of commercial real estate that are not office that are actually doing really well, places like leisure, et cetera. Asset-based finance in terms of private credit. We’re doing more and more of that keeping our liquidity at a reasonable level.

And then, we’ve shifted some of our equities to the places where the multiples are not that high anymore. We still are always, in Global Allocation, I still think tech and healthcare have to be the ballast of your portfolio. And I think the world, because of the aging demographic and the extraordinary growth of technology spend and productivity, those are going to be a bunch of where we’re going to hold the equity from today. But the ability to build a portfolio that has got a real upside but being a lot less volatile than a traditional equity portfolio is really in front of us today. So, yeah, we’re doing a lot of it.

And the point we talked about earlier, we use a lot of optionality in two ways. One, you can buy index volatility super cheaply. And we literally can buy options on the index at 10, 11 volatility. It’s incredibly low. And then, writing some call options against some of your current holdings where single-name volatility is reasonable—particularly in tech—to overwrite some of your portfolio, again, to buoy your income, but create real convexity in a portfolio. So, it’s a fun time for investing in these portfolios because you have so many more tools. You think about last year—last year, you couldn’t hedge. All you had to do was just get your wrist down, get your interest-rate exposure down. Now the world has opened up to you in so many ways, and the Fed is not cutting rates for a while. So, your ability to get income and then build convexity, it’s a fun time. And we talked about earlier, dispersion. There are a ton of companies that trade at low equity multiples now, not just U.S.—Europe, Asia, parts of the emerging markets. Anyway, it’s a fun time to be investing in portfolios like this.

Ptak: Well, Rick, it’s also been a fun conversation. Thanks so much for sharing your time and insights with us. We really appreciate it.

Rieder: Thanks for having me. I loved it. Thank you for doing it.

Arnott: Thank you so much. This has been a great conversation.

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