Volatility seems to be the word of the day. Volatility in fuel prices. Volatility in the market. And of course, volatility in interest rates. David Czerniecki, the Chief Investment Officer of Nassau Financial Group joins our show today. He discusses current events and explains the difference in risk profiles between banks and insurance companies.

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Episode Transcript

The discussion is not meant to provide any legal, tax, or investment advice with respect to the purchase of an insurance product. A comprehensive evaluation of a consumer’s needs and financial situation should always occur in order to help determine if an insurance product may be appropriate for each unique situation.

paul_tyler:
Hi, this is Paul Tyler, and today I’d like to welcome David Zernicki, the Chief Investment Officer of NASA Financial Group to our show. Today is our quarterly review of the state of the economy. David, welcome.

david:
Thanks Paul, good to be here.

paul_tyler:
Yeah, thanks for making time. I know your time is precious these days. And the state of the economy is in quite a state.

david:
Mm-hmm. That’s indeed.

paul_tyler:
Now, the CPI, which we’ve been watching intensely, we’ve had a lot of conversations about over the last year or so. CPI finally looks like the inflation may be slowing. So do you think the Fed is finally winning the war or starting to win the war against inflation with all the rate hikes.

david:
We do, Paul. They are making progress, as we’ve stated in the past. It takes time for the rate-hiking mechanism to flow through to the real economy. The Fed’s tools are powerful but blunt, and so the rise in rates is having a dampening effect. I think there are a couple things going on. One is that, again, continued improvement in the supply chain, trade activity, and the you know, all the port jams are, you know, cleared. Things of that nature has helped, particularly on the good side. So we’ve seen progress there. Services costs are still up, and labor costs are still up, which is, we would expect, because labor tends to be more sticky. If I give you a raise, Paul, you’re not going to give it back when CPI comes down, which is why I didn’t give you a raise when you asked for one last week. But, no, seriously though, Paul. You know, so it does tend bit more sticky and the mechanism tends to be a little bit slower. The other thing is increases in rates will tend to slow economic activity and I’m sure we’re going to talk about that today, but slow down in economic activity will reduce demand for things and that too is disinflationary. So you are seeing traction. We don’t know when we’ll sort of get back to that 2% percent target but we are moving in that direction.

paul_tyler:
Yeah, well, this is good news.

david:
Thank you.

paul_tyler:
We’ve also had conversations in the past about how rising fuel prices works its way into almost every commodity we buy. Now, good news is that I’m driving past freeways on the Merit and 84, the numbers are going down. Now, how long does it take typically, or do you think it will take for those lower fuel prices to work its way through, you know, shipping cost of goods and things coming in from other countries.

david:
Sure. So, again, I think similar to the broader inflation context, it does take a while. One of the things that economists look at, in particular the Fed, is what they call core inflation, or core PCE, personal consumption expenditures. That’s their favorite number. And what that factors out is food and energy. Now, if, you know, for most working Americans, them so they haven’t the Fed tell you we’re factoring that out. You might as well factor out A or two, right? But the reason they do that is because the pricing mechanisms there are much quicker. So energy prices as we’ve all seen swing around week to week and pretty volatily at times. But what’s really happening? You’re starting to see inflation come down a bit. You are seeing some slowing in economic activity. And so less inflation. Reducing commodity prices, especially oil. And so therefore, you see that at the pump rapidly or more quickly, it’s transmitted. But also, slowing economic activity reduces demand for oil. And that’s what you’re starting to see pricing a little bit here, is people’s forward expectations of how much oil we’ll need for, not just to fill our cars, but to make plastics to build things, as we’ve talked about. somehow or other petrochemicals is everywhere and the less demand for goods and services, you know, the less demand there is for oil and so you’re starting to see that play through. I think you’ll continue to see volatility in oil. Geopolitical factors of course have been a big player there, independent of inflation and that’s not gone away, okay? But you are seeing slower economic forecasts both domestically abroad, particularly in China, which is a consumer of oil because they’re big manufacturing platform. So you are seeing it start to play through and I think that generally the trend will continue. Although I don’t think we’re going to see $10 oil anytime soon.

paul_tyler:
Yeah, let’s hope not.

david:
Right.

paul_tyler:
You use the word volatility a couple of times. Now, one thing that’s been exceptionally volatile over the last few months have been interest rates, short-term rates,

david:
Bye.

paul_tyler:
long-term rates. How do we make sense out of what’s happening with interest rates?

david:
A number of factors play into rates and we could spend a long time on all of these things, but let me just hit a few highlights. It’s clearly the level of rates, particularly in the short end, is set by institutions such as the Fed, the ECB, the Bank of China, etc., etc. So you’re seeing some of the volatility just coming from their actions. The longer term rate tends to be set by the market and the market will be putting into that. You’re factoring in. about where we’re headed from an inflation perspective. So to give a very simple example, if the market believes that the Fed is getting inflation under control, you would expect the longer end of the curve to come down because we’re not worried about the purchasing power of our paycheck 10 years down the line. And so you start to see rates come down. If we think the Fed doesn’t have it under control, you’ll see rates go up a lot. But other factors that play into rates are, outlook on GDP and economy. Well, the Fed is the, If that is raising rates right now to fight inflation, will they start cutting rates to fight a recession? So that’s a place. And now clearly from the past couple of weeks, a lot more economic uncertainty leads to a lot more volatility. If you take the view that we’re headed into recession and I take the view that we’re going to achieve self-lending, guess what? We have a market because you and I don’t agree on what the level of rates should be. And so we’re willing to trade around that. If your position is extreme, which it might be right now. are nervous and my position is you know adamant and firm you’re gonna have a lot more vol as we you and I try to trade so you’ll see that the other thing is and is is rates also reflect risk not just prices and so what you’re seeing is risk has dramatically repriced in the last couple of weeks that people have become more concerned about financial institutions about the general state of Again, if we go into a, let’s say a deep and prolonged recession, we’re not calling for that, but let’s just say that with a case. You wanna be compensated as an investor a lot higher to cover you for that. And so your expectation or our rates in return just changed dramatically.

paul_tyler:
You mentioned financial institutions, David, so you open the door here.

david:
Yeah.

paul_tyler:
It’s hard to have a conversation these days without talking about some of the bank’s in the news. Now, to what extent do you think bank failures reflect more in the state of the technology industry versus, say, a rise in interest rates?

david:
Um I, it is a little tough to parse, but, and usually there are some catalysts to some of these problems and challenges, and I think it’s easy to somewhat extrapolate and say, look, what happened in Silicon Valley Bank was unique to the tech space, it was an odd confluence of factors, it was an odd network, Paul, if I’m running a giant, giant, well-known venture capital fund, and I have lots of companies that I’m invested with, not to mention the network of folks that I’ve known in that industry for years because I’ve invested with the previous generation and the previous generation and the previous generation of tech companies. And I am worried about deposits at Silicon Valley Bank. I’m not just calling up the bank and saying, send me my money. I’m calling every one of my counterparts, constituents, my portfolio companies and saying, get your money out. So you can see how in that scenario, that network, that fabric of that space reacted very rapidly and very extremely to a concern. It’s a little bit of the thing of yelling fire in the movie theater. There we go. Okay. Okay. Okay. Okay. Okay. Okay. Okay. Okay. Okay. Okay. Okay. Okay. Okay. So there is an element of that, but I do think that is somewhat unique to Silicon Valley Bank. What that sparked is a general level of concern around mismatches of assets and liabilities in other smaller, I wouldn’t say poorly capitalized banks, but maybe not super well capitalized banks. The, you know, the Jagundo banks in our country, right, the big money center global banks are very living wills and they have significant restrictions on what they can and cannot do. They are monitored very, very closely, but we have thousands of banks in the country. It’s hard to monitor all of them very, very closely. And so Silicon Valley banks problems spook the market. Banking is a confidence game. People may forget, but we have what’s called fractional banking in this country. When you put $100 in the bank, They’re only keeping a few bucks around to give back to you on a given day because they’re putting that money to work in loans and Securities and things like that so that they can pay you an interest rate And so it’s not all there on any one day And I think what you’ve seen is a bit of a spooking of that It has largely been centered or focused on regional and smaller banks, but as you’re well aware we read the papers and Other issues of confidence have hit some of the bigger banks, not in the US, but international banks as well. Not just about fractional reserve banking and about mismatches of assets and liabilities, but other business issues have had an impact in the way folks have reacted in the sector.

paul_tyler:
Yeah, and I guess if you think about banks and insurance companies, some similarities, a lot of differences.

david:
future.

paul_tyler:
What is the difference in risk profile today of a bank and an insurance company? Maybe it’s a balance sheet comparison. I mean, what’s the best way to put these sectors in relative

david:
Yeah, no, that’s

paul_tyler:
comparison?

david:
a good question, Paul, because I think there’s a natural tendency to, you know, we are all in the financial services industry, you know, and we know that. And we do similar things, you know, a bank takes deposits and it makes loans, a traditional bank, an insurance company, you know, takes in premium and invests it in order to, you know, and we’re both doing the same thing. We’re providing a return to that investor, that depositor over time. So there’s that thematically. There’s that similarity. But, but insurance and banking is very different in other respects. You know, insurance companies generally speaking aren’t designed to be liquidity providers per se. Again, we go back to the example you put your $100 in the bank on Friday, on next Monday you decide you want to, you know, get lunch and you go take your $100 out and you expect them to give it to you. When you deposit, you know, when you purchase an insurance policy, an annuity or a life policy, you that you’ve signed up for a period of time before you can access that $100. It’s a little bit more like buying a CD, let’s say, right? And so we then turn around and invest that money along the lines of what we’ve promised to pay. So the asset and liability, so the liability is what we owe to you. Our assets are what we invest in in order to meet that obligation. The liability and the asset well matched with banking. Some of it is matched, but also there’s a lot of guesswork as to whether or not you’re going to show up on Monday because you need cash for your turkey sandwich. And so you get these disconnects, and so it can happen more rapidly in banking. Insurers have controls over that. We have surrender agreements, and we have contractual agreements with policyholders, And part of the way we’re able to do that is because we have more certainty around when we need to return that money. If I have to have your money there in the bank every day for you because I don’t know when you’re going to want your jerky sandwich, I can’t invest it the same way as we can as an insurance company. If you promise me I can have it for a year, we invest that $100 different.

paul_tyler:
Yeah. Well, listen, very interesting. Yeah, time, you know, time is valuable. And I think it sounds like the structure of the insurance policies in some way give us a little more buffer from those sudden runs that, you know, banks may be exposed to, which is should be reassuring for our policyholders. Well, David, listen, thank you so much for your time today. This is great. And listen, we’ll look forward to having you back again in another few months and hopefully we’ll have the Federal Reserve in our banking system will have navigated these rapids successfully. So thanks so much, David.

david:
You’re welcome, Paul. Thank you.