Chat with the CIO: Hindsight Is Not a Strategy


With the backdrop of her first year as CEO, Sonya Mughal, CFA chats with Chief Investment Officer, Eric P. Leve, CFA, about how geopolitics has overlayed on the look forward at the investment landscape.


December 31, 2021


Eric P. Leve, CFA: I’m sure you’ll recall when Peter [Hill] became Bailard’s CEO about 13 years ago, the GFC [Global Financial Crisis] landed in our laps almost immediately. And for you, when you took over the role in the Spring of 2021, we thought we were on the cusp of being able to speak of COVID in the past tense and that 2021 promised a return to normalcy. Instead, we’ve experienced the highest inflation in 39 years and are on the verge of COVID’s fifth wave. What did you learn from Peter’s trial by fire in the GFC and what you’re managing through thus far?


Sonya Mughal, CFA: Peter and I both had three elements that made these transitions easier: the presence of our predecessor to help guide us, a stable senior management team to work with, and a lot of personal leadership experiences to build upon. These once-in-several-generations events are, by definition, unusual, but the same thoughtful long-term management we employ every day in the organization and in our clients’ portfolios remains critical regardless of external events. That said, in both cases, I’m proud of how Bailard has found thoughtful ways to move forward in very positive ways.


Eric: You and I have been in the game a long time. One too-often-fair criticism is that professional investors tend to look back at recent events and predict how they will impact the economy and financial markets in the future. Alternatively, they are much less willing to “look over the horizon” to envision the events, and potential implications, that could be lurking in the future.

Sonya: Yes, you’re spot on. Our industry seems to live on giving context to history rather than working to peer around the next corner. We spent years interpreting the GFC, but didn’t see the wave of nationalism that was coming across the globe or the endemic low economic growth that accompanied it. It challenges me to consider what is it that we’re too focused on now and what might be missing, especially as we end two unprecedented years in modern history and look forward to COVID having less impact on the economy and markets.


Eric: In the first category of things that have received too much focus, I’d definitely put inflation, and I’m embarrassed to admit that I got it wrong. It isn’t “transient.” Inflation has reached levels that I underestimated and has lasted much longer than I forecasted. But at the same time, it is the most discussed and analyzed element of the investing landscape currently. In early December we got the CPI [Consumer Price Index, a measure of the weighted average of prices of a basket of consumer goods and services] for the year-over-year period ending in November 2021. The year’s change in CPI was 6.8%, the highest since March 1982. The broad market proceeded to rise by almost 1% on the day of the announcement, capping the strongest week for U.S. equities in ten months. Clearly, investors are now “pricing in” higher inflation for longer. There is no question that if inflation remains high, it increases the risk of the action that precedes virtually all recessions, a misstep by the Federal Reserve [the “Fed”].


Sonya: Agreed. This is a time when central bankers around the world need to navigate a minefield. The initial inflation from last fall resulted from huge demand by consumers whose coffers were filled with transfers from the government combined with a failure to get the right goods to them in a timely way because of manufacturing and shipping problems. But as inflation lingers, and employers continue to struggle to find people to fill vacant jobs, inflation could become entrenched in a more fundamental way.


We have the unemployment rate at 3.9% [as of year-end], lower than anytime between 2002 and 2017. At the same time, there are a near-record 11 million jobs that employers can’t fill. A tight labor market is a fertile environment for inflation. The only way I see us escaping this is something to reverse the “Great Resignation,” effectively drawing back into the workforce some of the more than 3 million people who have retired since the COVID outbreak. Barring that, even with consumer demand moderating and supply lines improving in 2022, I think we should expect higher baseline inflation.


Eric: And so, you’re implying that the Fed could be on the right track by reacting assertively to inflation fears. I suspect you’re right here, but 2021 served to humble a lot of macro thinkers. After years of striving to reach its 2% inflation goal, the Fed has more than it can handle now. As we know, a yield curve inversion [where short-term interest rates rise above longer-term ones] has generally led to recessions. The Fed’s newly aggressive stance, combined with what could be a weaker economic picture in 2022, could easily produce that unwanted outcome.


Sonya: OK, so there we have a “known unknown.” We know inflation is an issue and we’re watching it carefully, but it is hard to assess its impact. What really concerns me is that, as the world has focused on COVID, economics, and the financial markets, the “unknown unknowns” have continued to fester and grow. Here I’m thinking about geopolitics and that some hotspots could become a major focus for markets in 2022.


First off, is China. The nation’s usurpation of rights and autonomy in Hong Kong brought umbrage but little external action. That move was simply an acceleration of the timeline between the UK and China in the 1997 handover. Current saber-rattling over Taiwan is a completely different story. Chinese leader Xi Jinping seems intent on reintegrating the island nation, which, by no coincidence, is home to the world’s largest dedicated semiconductor company. And Taiwan is just one piece of the escalating risk emanating from China. The nation’s hypersonic missile program is a warning shot against the U.S.’s world-leading military power. China’s willingness to use military and economic force within the nation and globally is, for me, one of the defining issues of 2022. Vis-à-vis the U.S., the most hopeful outcome would be that both nations focus more on internal matters, relieving pressures that have been building between them.

Eric: In a similar vein, Russia is flexing its military and economic muscles across Europe. In an eerie echo of 2014, Russia is again massing troops at the Ukrainian border, seemingly intent on annexing further territory from the embattled nation. The U.S. and NATO are drawing a pretty strong line there, with their own eye-popping troop levels; this could easily become a larger and uglier coup than 2014. At the same time, Russia wants to increase its leverage over Western Europe by beginning deliveries of natural gas from its Nord Stream 2 pipeline. Europe’s need is dire, but pipeline approval won’t occur as long as Russia threatens the European Union’s eastern flank in Ukraine.

Sonya: And, as always, the Middle East is a confounding mélange. Quietly, multilateral and bilateral relationships have been forged by historic rivals, primarily prompted by the threat of Iran. In 2020, the Abraham Accords normalized relations between Bahrain, the UAE, and Israel. This led to further such agreements between Israel and Morocco, Jordan and, most recently, indications that Saudi Arabia is ready to lead the 57 nations in the Organization of Islamic Cooperation in the same direction. Here, “the enemy of my enemy is my friend” is quickly breaking down long-standing animosities. The downside is that Iran is increasingly isolated, along with its proxy militias in Lebanon and Yemen. Its missile program has evolved greatly and its nuclear enrichment program puts it perilously close to becoming the world’s newest nuclear power. Iran’s well-armed leadership is also more belligerent than it’s been in decades. Whether it is traditional or cyber warfare, the Middle East has the potential to flare up dramatically.

Eric: Wow, I’m almost breathless after picking through our communal anxiety closet! I’m sure you’ll agree that it is often hard to know how markets will react to geopolitical instabilities, but most of those we mentioned could easily lead the dollar higher, and others keep oil and gas prices at historic levels. As we look ahead this year, it seems prudent to be considering these undercurrents that could affect our normal calculus of earnings, interest rates, and valuations.

Sonya: Agreed. While they say in hindsight everything is much clearer, I think it behooves us all to remain vigilant about what could influence our future. When facing adversity, I’m a firm believer that you have two choices: you either fold, or you stand together. At Bailard, our spirit and strength and flexibility become—not only a shield against hardship—but a common bond. When we choose to stand together, we more readily see the silver linings and the paths towards perseverance and progress. Now, let’s get to work on 2022!