"We Have an Inflation Problem:" AI CapEx, Yields Add to Fed's Rate Conundrum

SPEAKER_1 (0:00)

And David Busch, Co-Chief Investment Officer at Treasure and Wealth, and Jeff Klingelhofer is with me, Managing Director, Portfolio Manager at Aristotle Pacific. Jeff, I'll start with you.

You know, do you have more concern when it comes to either inflation or the labor market? What do you think the Fed is thinking? I know you can't speculate what the Fed is thinking, but your thoughts on how some of these prints that we've had could be interpreted.

Jeff Klingelhofer (0:26)

Look, I think there's no way to interpret the prints other than we have an inflation problem. If I go one level deeper, I would say what the Fed really needs to be focusing on is that inflation problem isn't just coming from energy, right? We've got CPI, we had PPI, and what we saw was goods inflation is too high, services inflation is too high, and both of those X energies. So we have an inflation challenge. I think we need to wake up and what the Fed needs to address is that we have a demand side shock. The big question that I think we'll all be watching next week is, how willing is this Fed in order to pair back demand, to create a little bit of demand destruction, how willing are they to tolerate a little bit of pain within the economy because that's ultimately what we need to get inflation back below 2%.

SPEAKER_1 (1:10)

So you're obviously a fan of a rate hike, how you're saying inflation problem. Is that right? Would I be wrong to assume that?

Jeff Klingelhofer (1:18)

No, I think that's exactly right. I think we have to see an inflate move in October. We're probably not going to, but it's a little bit tough when every single person coming out talking from the Fed talks about how vigilant they want to be on inflation, yet dismisses the actual inflation problem that we have. So I would put the probability below 50% we see when in October, but it's got to be above 17% on what the market is pricing, but possibly an outsized rate move in December, certainly on the table.

SPEAKER_1 (1:47)

Which is more at around 90% likelihood. And we know many on the Federal Open Market Committee echo your sentiments, they're worried about inflation. But I will say that we're not seeing CPI accelerating at this real fast trajectory. I mean, when you're talking about a tenth or the moves, granted, it's been five years we're above the 2% target here, David, but do we have an inflation problem if things are coming down or have been going in the right direction? I mean, oil isn't necessarily the inflation story. I mean, those are two different stories. What do you think, David?

David Busch (2:26)

Yeah, I agree that we have an inflation problem in the US economy. I also think that the Fed is in kind of a predicament because on one hand, inflation has come down from its post-pandemic highs, and at the same time, it's still above their 2% target. Meanwhile, we've started to see some softening in the labor market. So I think the Fed is going to be walking that fine line between demand destruction and anticipating any impacts in the labor market. But truly, the Fed can do, they really can't do anything about what's causing the inflation. It is higher oil and gas prices. It is higher diesel prices. All of that has been bleeding through to the economy really since the conflict in Iran started earlier this year.

I think the Fed is cognizant of that, but really all they can do is demand destruction, meaning they're going to force consumers and businesses to pull back their spending in order to bring that inflation rate down.

SPEAKER_1 (3:27)

So is there anything in the earnings story, because I know you wrote a lot in your notes about AI and meta and things like that. Could the earnings story be sufficient to see the fundamentals looking good there, David, and be enough to keep our economy afloat and things like that? I mean, where does that fit in, David?

David Busch (3:47)

Yeah, so the bears have a strong argument that higher interest rates lead to lower valuations, and I get that. But the bulls, on the other hand, are really focused in on corporate earnings, and specifically this AI technology and the adoption of AI technology and the efficiencies that can be gained.

But having said that, I think a lot of investors are going to be paying close attention to capex expenditures and the monetization of this AI technology. And any earnings misses or any reduction in forward guidance, I think we're going to see some volatility around those earnings announcements if they come out and either miss or lower their forward guidance, or if investors don't have the patience to wait for that capex and that AI monetization to play out.