3% Is the New 2%: What Higher Inflation Means for You

John Queen, Fixed Income Portfolio Manager at Capital Group, offers insights into a higher for longer inflationary environment and what it means for investors and portfolios with ETF.com's Dave Nadig at Schwab IMPACT 2025 last month. The two also discussed the similarities in current markets to the '90s, as well as digging into private credit and access via interval funds.

Transcript

Nadig: John Queen, Capital Group, thank you for joining us. I've been dying to talk to you.

Queen: My pleasure. Thank you.

Nadig: So, look, obviously, the fixed income market and the Fed is driving an enormous amount of anxiety in investors and the advisors. You guys have been writing about sort of the Fed's dual mandate shifting here a little bit. What's the thesis there? How do you think we should be thinking about the next couple meetings at this point?

Queen: Well, I mean, it's – first it's great to be here and thank you. It's really interesting to think about the Fed's dual mandates because for a lot of, well, most investors' careers at this point, the Fed effectively only had one mandate, and that was jobs. We've had such a long stretch where not only inflation wasn't a worry, if it was a worry, they had to think about how to get it up high enough to meet their 2% target, rather than keep it suppressed. So, there was this sense of, “Don't worry if there's even a bobble in equities or in the economy, the Fed's going to step in because of labor market concerns.”

Nadig: Right, the infamous Fed put.

Queen: Exactly. Right. Started with as the Greenspan put, became the Fed put, right? And so, that's been the kind of the story. Clearly that changed in ‘22, where all of a sudden, oh, yeah, there's that other pesky mandate, inflation, that they've got to worry about. And so, you know, now we're off of inflation being the huge concern and back to a little bit of a balance. So, we're watching labor markets. They've been weakening.

At the same time, inflation's been probably sitting above their 2% mandate, higher than, at least in theory, they would like it to be. Our view for a while was, they're going to have to balance those. They're trying to look at both things. If labor weakens, they may go a little that way. If inflation keeps creeping up toward three, they may go a little that way. The fact is that labor's continued to weaken a bit, although it's not – we don't think collapsing. Inflation appears to continue to be picking up a little bit.

Most of the commentary though out of the Fed has been about labor, not inflation. And so, I think you could almost say that they have tacitly accepted 3% as the new 2%. And so that's a really interesting shift. Markets seem to be taking that with a, "Okay, great."

Why a Steeper Yield Curve Longer-Term Makes Sense

Nadig: But that's a huge shift for investors that are used to like the boring old math I remember from B-school where we worried about like stocks versus bonds and rates of return. That implies higher for longer is actually going to be here for longer.

Queen: I think that's exactly right. I think you can say, “Let's go back to looking at what's a reasonable real rate you should earn for risk premium on a 10-year Treasury.” Maybe 1 to 2% is not unreasonable in the long run. So, if they're accepting 3%, that's telling you a 5%, not a 3 to 4% Treasury.

I'm not saying that's where it's going, but if they in fact end up with that is sort of a tacitly accepted level, you have to start thinking about out the curve a little bit higher rates. At the same time, there's concerns about federal involvement in the Fed, what's known as Fed capture, a more activist Fed in terms of helping the economy along. So, even with inflation a bit higher, you might see short rates not go up and in fact come down a bit, and the long rates up a bit higher. A little bit of a steeper curve seems like a reasonable expectation in the long run.

And frankly, I go back to, you know, early ‘90s, we had a 300 basis point 2s30s curve. So, it is not unusual in the long run to have a steeper curve than we have now. It'll be interesting to see how they work those different mandates out, but as you say, the way we're thinking about it now is, they've got to worry about both. Let's listen to what they say, watch what they do, and see where they're spending their time and their focus.

Nadig: So, that makes it sound to me like you don't think we've got another long string of cuts here coming. That there’s one or two next quarter, maybe?

Queen: I think, yeah, you can take them at their word largely, and that's, yeah, one to two more cuts. Now, obviously, you know, have new voices in there and a broader set of voices about what they'll do. But I think if you look at Powell and you look at the sort of collective, maybe a couple more cuts coming. Not sure exactly when.

It'll depend on, well, it'll depend on what jobs numbers you can get since with the shutdown, many of those numbers aren't coming out. But even the numbers we're looking at, ADP and some of the other indicators, seem to most recently have said, “Yeah, it's a little weaker but not too bad.” So, those cuts may yet be pushed out a bit, not next quarter or two.

It "Looks a Lot Like the '90s In Some Ways"

Nadig: How do we mesh up what we're seeing in investor sentiment, which looks like concern to me? I mean, we just had a couple of some rough days in the market, right? So, maybe a little bit of action happening there. But on the bond side, it doesn't seem like anybody thinks there's any risk, like spreads seem incredibly tight. We haven't had a rash of defaults. I mean, a couple little hiccups in some of the, you know, corners of the market.

You're also involved in some of the private credit stuff that Cap Group and KKR are doing. Help me piece that together because how are we getting better yields out of private credit when the corporate bond market basically can't tell the difference between Citibank and the Fed?

Queen: Well, I mean, they're great questions. And interestingly, I think for me, if I were to step back a little bit and say, “Instead of just focusing on the now, what does this look like?” Looks a lot like the '90s in some ways to me. So, kind of mid-late ‘90s, obviously, with a very different fiscal situation than we had then, I mean.

But you had massive investment in a new technological infrastructure that was going on through very high valuation of companies that were involved in doing it. That valuation suggests additional volatility in equity markets. Not necessarily all bad, but you have very high valuations, they're built on expectations of significant ongoing profits, and in fairness, most of these companies are profitable. But even relatively modest change in those valuations mean some equity volatility.

At the same time, what you have is massive amounts of money being spent in the real economy by these hyperscalers and others associated with it that is frankly keeping the economy fundamentally more sound.

Nadig: That makes me concerned because if we look at where that spend is happening, and look, we've all seen the K-shaped corporate chart with all the AI spend. We all, I think, can understand that. We got Michael Burry calling for a bubble. I think we get the vibe of what the moment we're in right now. It's all been funded by either cash or equity. We haven't had a cycle here of massive corporate bond issuance to put fiber in the ground, which we did in '99. Right? Yes. So, this feels very different. If this is all coming out of cash balances and equity risk, to some extent, does that just insulate the economy from it being a bubble?

Queen: A little bit, right? I mean, I think the cash piece is interesting because we and others have been saying for years now, there's a lot of cash sitting on the sideline. Where's it going to go? And so, it's being put to work, right? And so, I think that's part of it. If that's going into the real economy, and yes, more some companies than others, but it's going into the real economy.

Nadig: It's getting spent somewhere.

Queen: Yes. And so, that means like again, ‘98, ‘99, before the bubble, you had fundamentally, actually call it ‘95 to ‘99, strong fundamental growth in the economy, remarkably compressed volatility in bond markets, tight spreads. I think you have something that's a real parallel here. Now, we have a fair visibility over the next few years of that spend ongoing. I don't know what it's going to look like in 10 years.

How Companies Are Financing in Today's Market

Nadig: But is that spend going to get financed through, you know, another piece of corporate debt that we get to see or is it going to happen in the private markets? It seems like, like when Intel needs to go build a new fab, they seem to be calling Apollo. They don't seem to be calling Citibank.

Queen: It's going to be both. There's no question about it. I mean, one of the, I just thought about it this morning, one of the fascinating things I think over the course of my career is in the early ‘90s, the talk about disintermediation was brand new. Mortgages suddenly were going off bank balance sheets into the mortgage market being sold to investors. Credit cards were starting to be invest securitized and financed through bond markets. And since then, you've had auto loans, subprime auto loans, rental cars.

Every kind of lending is coming off bank balance sheets. And what was left was lending and selling or keeping private, basically smaller loans to companies on bank balance sheets. Well, guess what? Regulations change. Over the last 10 years, that's shifted as well. So, there's an ongoing shift from banks lending to private lending. I think that's going to continue. It doesn't mean there's a problem.

It means that you're going from one group of lenders to a different group of lenders. I think there's some very, very good ones out there who are very focused on, “Who am I lending to?” They're doing underwriting like a bank would have. They're deciding, they're pricing risk accordingly. Clearly, you're going to have players with the money going in there that are newer and maybe not as experienced, and that's where you run into worries, but that's idiosyncratic. That's not a bubble across the whole the whole market.

So, if I look at where does somebody finance? Well, that's some really big bond deals the last couple of days. So, there's billions coming into financing that way and by companies that even after borrowing 5 or $10 billion, still have amazingly good balance sheets. So, you've got some of them being financed that way, and then you have big chunks in the private market as well.

And that's kind of the beauty of private markets is now if you're a borrower, if you're doing a big infrastructure deal, you get to look at all these different pieces and say, “What's best for us as a company and our shareholders? Let's do some here, some here, some here, or all public or whatever combination makes the most sense.”

So, yeah, you're right. They're going to go to the private market and finance part of it there. Now, a lot of that was then sold into the public market in some cases. They might go directly to the public market. So there's – they might continue to just take cash flow and invest some of it because they're getting massive cash flows for some of these companies.

Why Interval Funds Make Sense for Private Credit

Nadig: Let's talk a little bit about how the average investor can participate in some of that. Cap Group came out with interval funds with KKR to get some exposure to a piece of the private credit market. Obviously, not all of it. I was a fan of that launch because it addressed my biggest concern, which is the liquidity mismatch, right? Not just daily, but, you know, millisecond liquidity in an ETF is hard to match with an occasional mark on your bond. Talk about that process, the interval fund structure, and how that works. Like, what does fit in there and what wouldn't you put into something like a publicly available interval fund structure?

Queen: Great questions. I think it's been an interesting process for us to go through that same examination of how best to make this work. Our goal was, we have a great shareholder base, a great client base that largely don't have access to private investments. We think in the long run, it's a great category of investment. It tends to have an extra yield or return expectation. It tends to behave differently than public, so there's diversification benefits.

We want people to get that access. So, let's think really hard about how can we help provide that? We don't like doing it ourselves. We don't have the capacity to do it. We partnered up with true experts in the field in KKR, and working with them said, "Okay, what makes sense?" So, in our first foray, it was the fixed income and private credit side. We did a lot of work on how much liquidity do we need to be able to provide reasonable liquidity to our end investors?

As you say, ETFs were not in our view appropriate. A regular mutual fund with daily liquidity, okay, maybe, but you're starting to still run into some potential issues there if you have enough private in there to make sense. The interval fund structure, where you get daily ability to invest, but only quarterly opportunity to come out, made more sense to us.

Nadig: What does that let you invest in that you couldn't invest in?

Queen: 40% private. I mean, honestly, right? So, that's the answer is 40% private.

Nadig: And not all three-month duration, right? I mean, some of this stuff is actually reasonably long.

Queen: Yeah, well, and this is so we're going to be about 20% direct lending, 20% asset-based finance. The direct lending tend to be, call it 5-year loans, with an average life a bit shorter than that. The asset-based finance might be 3 to 7-year finals, but again, shorter average lives as they pay down. But you can't sell them. I mean, I think that's the main thing, right, is they provide pay down liquidity, they provide income liquidity, which matters over the longer term. But on a day-to-day basis, we can't commit and say, “Well, people want to take out money, we can sell this piece.” That's not something we can offer.

So, when we look at that interval fund structure, what it says is, “Okay, we can have 60% public, 40% private.” People get the benefits of a core plus mutual fund and the benefits of the diversification and yield enhancement of the private together. The liquidity that makes it feel a lot like a regular mutual fund. Quarterly isn't daily, but we're going to be able to double the normal quarterly 5% limit to 10% if people want to pull money out. 10% of the fund on a quarterly basis.

I think that's important. It's saying to our clients, “You know, we've really done the modeling, we've really done the work. We have a lot of liquidity built into this. So, you get access to private, you get the benefits of illiquidity without suffering the illiquidity as a whole.”

The other piece to the liquidity that I think's important and easily forgotten is within the portfolio. So, when you're investing in private, deals don't come, you know, on a regular cadence. You don't just go and say, “Well, I've got x amount of money, let's buy all the private I need.” It happens over months. The beauty in this case is, we've got the 60% public that can provide liquidity when there's a lot of deals coming that are really attractive from KKR.

We've got liquidity to invest in those a little more quickly, a little more aggressively. Or when the fund started and Liberation Day happened and public markets kind of blew up a little bit, and private didn't move a lot. Oh, wow, well, we can go a little slower into the private, take advantage of those marks in the public market on things we like, and then when that rallies back in, use that liquidity to go back into private.

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Nadig: You mentioned the marks and sort of the difference between the two markets and how they, at least on paper, respond. As a portfolio manager, I hate to say it, I know a lot of your job is looking at spreadsheets and tables of numbers. How do you think about that component of it because it isn't the same mark that you're getting out of, oh, this traded eight minutes ago, I know exactly what somebody's willing to pay for it around the clock.

Queen: Right. No, that's exactly right. And because of that, I worry less about levels and more about what my partners at KKR are seeing in terms of credit risks. Are they starting to see in the private market broadly and in the portfolio an increasing concern from their companies, the portfolio companies that they're lending to? Are we starting to see delinquencies in the asset-based finance fees? Are there credit issues popping up in that market that gives me information both on how I should think about this portfolio, but also it gives me information to think about the economy and what I'm doing broadly for portfolio?

Nadig: Especially in this lower information environment.

Queen: Absolutely. So, it's helping me, I think, manage these funds well. As a lead investor, I'm going to think about, “Well, maybe I need a little more duration, a little more risk off hedge in these portfolios.” But also, it's making me – I think – a better investor across these portfolios where I can find value because I have this new input into seeing the economy.

Nadig: Alright, I'd be remiss if I didn't ask you, in this market where we have a lot less information coming out of trusted sources than we used to, you're getting access to say some conversations with the KKR desk that the rest of us aren't. What else are you looking at that the rest of us are probably missing and where can we find it?

Queen: Well, some of what I'm looking for is – or looking at is – we have a tremendous team of analysts, both economic and political analysts within Capital, as well as our fundamental analysts on both the equity and fixed side. So, it's hard to make up for economic releases, but what you can do is combine. So, for the labor market, ADP releases, they've had a regular release that everybody's looked at and largely dismissed because, well, we just we just wait for the official non-farm.

Now, all of a sudden it's what we have, and we're all going back, or we always have, but people are going back and saying, “Okay, well, actually, what's been the correlation of their release and how it's done versus the broader release?” So we're using publicly available numbers certainly, but we also then have ability to talk to companies, both from the private side on KKR's sense, but also in our public side from our own analysts and portfolio managers when they're talking to companies, which is happening daily. What are they seeing? What are they doing? Are they looking at maybe headcount changes? Are they looking at investing? What are they doing in AI?

Nadig: Wait, it is like the ‘90s. Everybody's just making phone calls and talking to each other.

Queen: Exactly! Exactly.

Nadig: This has been absolutely great, John. Thanks so much for catching up with us.

Queen: My pleasure. Thank you.

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