May 17—On Thursday, May 12, Chief Investment Officer Tony Roth hosted a webinar, Growth Scare or Recession? with Chief Economist Luke Tilley and Head of Investment Strategy Meghan Shue. The discussion, which focused on the extraordinary volatility in the markets and the likelihood of a recession, also analyzed the current economic and market forces at play including Federal Reserve rate hikes, inflation expectations, and a dicey geopolitical backdrop, as well as the continuing Ukraine conflict and COVID outbreaks anew in China.

Please listen to important disclosures at the end of the podcast.

 

Growth Scare or Recession?

Tony Roth, Chief Investment Officer, Wilmington Trust Investment Advisors

Luke Tilley, Chief Economist, Wilmington Trust Investment Advisors

Meghan Shue, Head of Investment Strategy, Wilmington Trust Investment Advisors

TONY ROTH:  Welcome to Capital Considerations, the market and economic podcast that’s fully invested in your success. I’m your host, Tony Roth, chief investment officer of Wilmington Trust.

Last week, I hosted a webinar, Growth Scare or Recession, with Wilmington Trust’s Chief Economist, Luke Tilley and Head of Investment Strategy, Meghan Shue to discuss the increased market volatility we are experiencing.  Are we headed towards a recession or is investor pull-back just a growth scare?

 Luke, Meghan and I discussed the forces currently at play in the economy including inflation, consumer sentiment, and Federal Reserve rate hikes, as well as economic pressures from the dicey geopolitical backdrop with the continuing Ukraine conflict and new COVID outbreaks in China and zero COVID policy.

 I think you’ll find this conversation insightful and useful. Remember to follow Capital Considerations so you don’t miss future episodes and updates.

TONY ROTH:  Good morning, everybody, and thank you for joining today.  And I want to welcome all of you to our conversation and, of course, I want to have a special welcome to my colleagues, Luke Tilley, our Chief Economist, and Meghan Shue, our head of Investment Strategy.  So, thank you, thank you all for being here today.

We decided to hold this conversation because, obviously, there’s a lot of stress in markets and it’s resulting in destruction of value for investors and people are seeing portfolio values decline fairly quickly.  And so, we wanted to take a moment to talk and take a step back and try to understand what’s going on, why we’re seeing such extreme volatility, and what our outlook is and what we think is going to happen going forward.  And I think that the title of the conversation, Growth Scare or Recession, frames it really well and it was actually an idea and based on an analysis that Meghan articulated in a blog post very effectively earlier this week that we had been discussing last week, which is very prescient actually relative to what the market has done.

I want to start the conversation by going back to the Fed meeting last week.  So, last week, Chairman Powell held a press conference as he always does after the meeting, the Fed, Federal Reserve meeting last Wednesday.  And he said a couple things in the press conference that were very consequential.  The first thing he said, which resulted in a sort of a missed signal if you will in the market where the market took off on Wednesday for a day, was he said that the Fed was not going to raise more than 50 basis points in any of their meetings moving forward in this cycle.  And so, the market took that as a very relatively dovish signal that the Fed wasn’t going to be raising quite as much and perhaps inflation wasn’t as serious and the market took off.

But Chairman Powell said something else that was more important the market realized as commentators started to digest the information and started to speak publicly the next morning, which was Chairman Powell said that it was going to be very difficult, it would be possible but very difficult to engineer a soft landing for the economy, which is to say that to be able to manage inflation down without as a result of the higher interest rate environment and the tighter monetary conditions to prevent a recession from occurring.  And as a result of that statement, we’ve now experienced what we would call a growth scare in the market. 

Investor sentiment is pretty much as low as we’ve ever seen it.  And we’re seeing that we’ve only had two other times in the last 50 years where investor sentiment has been as poor as it is today.  And this is as of May 4th.  If we were to actually poll investor sentiment today, it’d probably be even lower.

And what we see typically when investor sentiment is this low is we see people fleeing the market and that’s why asset values are dropping as quickly as they are.  And when investor sentiment drops in this way, it typically suggests that either there’s a recession coming or there’s concern about a recession, which we would call a growth scare, that doesn’t actually materialize into a recession.

Over the course of the past four to five months we’ve seen a very steep increase in nominal interest rates, and that is essentially the outgrowth of the realization that there’s all this inflation in the economy and interest rates will have to move up. 

We just released a podcast last week on the significance of real interest rates.  And you also see that back to positive territory where it hasn’t been in some 2.5 years.  So, what is the real return on capital, the after inflation return on capital for an investor in these kinds of bonds?  Now, what it’s telling us is that after inflation if you buy a ten-year bond, you’re actually going to make money, which hasn’t been the case over the last couple years when interest rates have been so incredibly low.  And that’s very consequential, because it means that rather than investing in stocks, we can actually buy a bond, which is relatively safe despite the fact that we’ve lost a lot of value in the bond market because rates have spiked up so much.  But certainly if we’re buying lower maturity, lower duration bonds, high credit quality bonds, we can have a return that is going to provide a positive return after inflation and it provides a real alternative to stocks as opposed to the last decade going back to the great financial crisis where we’ve had such a low interest rate environment, negative real rates over most of that period of time where we’ve used the phrase TINA, there is no alternative to stocks.  Now there’s an alternative to stocks.

In the last two or three days we’ve seen interest rates, ten year interest rates drop by around 40 basis points, so in other words move down from around 3.25% to 2.85%.  And in the 25 years that I’ve been doing this, I can’t remember a time where I’ve seen on a proportional basis interest rates drop that quickly. 

So, the question is what does that signify?  Well, when you look at the collapse in investor sentiment along with the fact that people are now jumping back into high credit bonds in the last couple days since Chairman Powell spoke, we’re seeing what we would describe as a growth scare.  Folks are very concerned around the economy.  They’re very concerned around whether we’re going into a recession.  And so, there’s they are selling their equities and they’re buying bonds.  And so, for the first time this year we’re seeing a divergence in the trading for the values of stocks and bonds where we’re seeing stocks continue to drop, but bonds are actually picking up some ground and increasing in value because in the face of this concern around growth, folks are concerned around continuing to own stocks because if we do have, in fact, a recession, then stocks would decline even further.

So, what’s our read on all of this?  So, we’re going to get into some detail in our conversation with Luke and Meghan.  But let me just give you the overall framing of our assessment, which is that we do not believe right now that we are due for a recession in the next 12 to call it 16 months.  We believe that what we are experiencing, in fact, is a growth scare.  But when we look at the strength of the economy, when we look at the strength of the consumer, when we look at the strength of businesses and their ability to spend and their actual spending on things like infrastructure, research and development, etcetera, those metrics around the economy are quite strong.  And then when we also bring in the concern around inflation, what we’re seeing is that while inflation is still high, we believe that we’re now either at or even past peak inflation.  And so, if inflation, and it’s an if, if inflation comes down to around maybe 3.5 to 4% by the end of the year, then we think that the Fed will be able to manage the continued trajectory of inflation in a way that does not send the economy into a recession.

So, the one caveat to that, which is why I think that there’s so much uncertainty in the market, is that as it relates to inflation there are two key risk factors that we don’t know what the outcome will be.  One is China and the zero COVID policy and the impact that’s having on supply chains.  And the second is the war in Russia and the potential, if not the likelihood frankly, for forthcoming additional sanctions on Russian hydrocarbons.  Oil eventually seems to be in the crosshairs to be sanctioned so that Russian oil stops flowing to Western Europe and then ultimately natural gas and what impact does that have on, potentially on inflation?  And that’s the reason that I think there’s so much uncertainty in the market as between is this a growth scare or is this a recession.

When we have growth scares, so these are by definition situations where the market became concerned around a possible recession given the rate of growth, but a recession did not actually occur.  In those scenarios the average drawdown in the S&P is around 15 or 16%.  We’re just past that level right now.  And the maximum drawdowns that we’ve seen in the S&P is around 20%, just a hair less than 20%.

So, as we move forward and we assess is this in fact a, merely a growth scare in the market that will not actually transpire into a recession or is this in fact a positioning in advance of a recession, there are two things that will help us answer that question.  One, going forward, we’ll have to look at the markets themselves.  And if we see a drawdown in the market significantly greater than 20%, it would suggest to us that this is more likely just from that market indicator to be a recession that’s coming and not just a growth scare, because we have not seen historically a drawdown in markets greater than 20% that did not actually foretell a recession.

The second thing is our own organic economic analysis that tells us whether or not we think a recession’s coming.  And so, with that, Luke, let’s pivot to you.  And I think the place to start is that as I’ve articulated, we’ve looked at consumer spending, the durability of the consumer and companies and company spending as they try to continue to increase their productivity and so forth and those numbers look very strong to us.  We had a good earnings season.  Corporate profit margins have actually been surprisingly strong, continue to be at record highs, so on and so forth. 

But when we looked at first quarter GDP, we actually saw a significant contraction in the economy.  So, that would suggest that if we have a sequential second quarter with negative growth that we’d actually already be in a recession.  So, let’s just start by explaining why we think potentially that first quarter was an anomaly and should not be taken as a, an indicator of what’s really happening.

LUKE TILLEY:  Yeah, Tony.  So, I agree with you.  This -1.4% annualized in the first quarter is a little unsettling, because not just as a negative, it’s pretty deeply negative, going down below the 1%.  Domestic consumers and domestic businesses are spending and demand is strong, putting through orders, and that is encouraging.  That’s businesses spending on new equipment and software and whatnot.  And then, consumers are still adding to growth. 

Where it came in negative was principally inventories. We were actually adding to inventories, just not as much as the previous quarter, so there was a little bit of drag there.  But the big contributor is net exports in goods and services.  So, we imported and accelerated our imports in the first quarter because domestic demand was so strong.  But that’s actually a subtraction from GDP, because we’re bringing in somebody else’s production.  What was really weak were the exports, exports because of a little bit of a weaker demand across the globe relative to our imports.  And the result of that is about three percentage points pulled off of GDP just by our international trade.  And I think that this cuts both ways. 

So, the first statements about our domestic consumers and businesses having strong demand is really encouraging and we cannot write it off but say, okay, you know, a lot of this is from a little bit of weakness overseas.  But we don’t want to write it off entirely, because our exports are important.  We have domestic producers who have overseas customers and if they continue to see weaker demand, that could be a source of weakness going forward.  I think the main point here when we talk about growth scare or recession is when we see a recession coming on, it’s usually our own consumers and businesses pulling back, and we haven’t seen signs of that yet.

So, we’re still maintaining the outlook that we’ll have economic growth going forward.  We have that projection of 2.4% for this year.  We have brought that down a little bit iteratively over the year as different things have come.  And there’s probably downside risk to this, especially if global growth continues to get hurt.  But we still think that it is an environment for growth.  We don’t think that we are going to have a situation for the, where the unemployment rate is moving up really sharply.  We don’t think that it’s a situation where consumers are going to pull back in a way that they’re actually cutting their spending and neither for businesses.  And those are going to be really important as we talk about inflation and as we talk about the Fed, Tony.

TONY ROTH:  So then, Luke, if we get into the conversation around inflation, take us through why you believe that not only has inflation peaked, but why you have some optimism that inflation is going to drop at a quick enough rate that the Fed will be able to manage financial conditions in a way that’s consistent with a soft, you know, what we call a soft landing, which is slower growth, as you’ve demonstrated already, but without putting us into a recession.

LUKE TILLEY:  Yeah.  So, this is the most important thing.  Inflation has peaked in the sense that that very last little tick of the solid orange line came down.  That’s with earlier this week the report.  And we know that the next couple of readings will probably pull that down further.  That’s not really much of a debate.  It has to do with base effects. 

But really the forecast going forward is how quickly does it slow down, because it could slow down from here.  But obviously, if we’re stuck at 5% inflation that’s much higher than the Fed wants.  But if it slows down as we’re showing here, where it’s still coming down, this is showing 4.5% by the end of this calendar year on its way down to lower, that is where we think and most importantly the Fed will be able to slow down later this year. 

And it really has a lot, it has mostly to do with consumers.  We know that there are cost pressures.  We’ll talk about a couple of those risks here.  But ultimately consumer prices can only move up and consumers will only accept them, so to speak.  They, the market will only bear them if consumers are willing and able to pay for them.  And the crux of the matter is that last year consumers were able to take on price increases across all goods and services.  We had two big rounds of stimulus last year.  There were a lot of savings piled up and we see those as much lower now and consumers in less of a place.

So, we know that aggregate savings across the entire economy are still very high.  But when we look at the detailed data and go to the median consumer and lower income consumers, we know that more than half of households in this country have depleted their savings and they are less willing to take on those big price increases.  So, you know, we’ll talk about energy and food in a moment, but as those prices start to go up, last year consumers would accept those price increases and spend on other things.  Whereas, now with this environment, we see consumers as being more discretionary, making those choices, and we’re already seeing them cut back on a lot of the things that moved up last year like household goods and furniture.

We also see the movement in interest rates has not hit home prices yet, but it has hit housing activity.  Foot traffic for homes, permits for new homes, pending home sales, mortgage applications have all come down and we expect those to come down.  But, again, the real thing here is the consumer.  And consumer sentiment is lower than it was even during the pandemic, and this is because of inflation.  It’s actually only been this low four times in the past.  Two of them we’re showing here, global financial crisis and then a quick dip in 2011 during the debt ceiling crisis.  The only other times were back in the ‘70s. 

And we can talk about this more, but if it comes up, but we see the labor market as a key thing here.  Wages were really rocketing higher last year. On a three-month basis wages have slowed down to 3.7%.  And that’s getting pretty close to normal, Tony. 

TONY ROTH:  So, Luke, can you explain? We talk a lot about demand destruction and the idea is that not that the Fed is causing demand destruction, but that because certain elements of the economic basket of goods and services are becoming so expensive.  So for, the classic example would be gasoline, right.  It prevents folks from being able to go out and spend money on other things.  It might even actually cause people to cut back on gasoline, which is something that we saw, you know, a bit this year already. 

So, can you talk more about demand destruction and how that works?  And also, I discussed earlier in the conversation that real interest rates were actually positive.  That is looking over a ten-year horizon.  But when you look at wages, even though people have experienced wage growth, because inflation today is so high real wages are actually quite weak and are negative and that has a big impact as well on consumer sentiment and demand destruction.  So, could you just talk a bit more about how this all plays into ultimately helping to slow inflation down just through the, you know, if you will, the strains that exist on the consumer?

LUKE TILLEY:  Yeah, absolutely. it’s astounding to me that when people were locked in their homes in early 2020 and we don’t know when you’re going to come out, go to work, we don’t know if there are going to be vaccines, that even sentiment at that time was not as low as it is nowAnd it’s about inflation.  It’s about consumers uncertain and pessimistic about their future ability to spend and that brings it back to wages.

And, Tony, it really comes back to how much money is in the system and whether consumers are willing and able to spend on everything everywhere.  When there was initial bursts in inflation last year, the Fed did not react and that was because it was isolated to just a few categories, airlines, hotels, that sort of thing.  The Fed reacted at the back half of the year when inflation really started to pick up and it was broad-based across all categories.  That was the signal to them that, oh, that’s very concerning.  There’s too much money in the system.  It’s just going back-and-forth from high wages to higher prices, higher wages to higher prices and that feels like the 1970s and the labor market was tightening, and we had these high wages.

If wages are slowing down and if supply chains are improving, which broadly they were before China lockdowns, and we start to see the slowdown in those other goods, we get that signal that the inflation is not going to continue to cross all these other goods.  We see used car prices coming down.  We see much lower inflation in education and medical.  We see it slowing down for so many of the things that went up last year and it’s because the consumer is slowing down, Tony.

TONY ROTH:  Yeah.  And again, one of the reasons the consumer is slowing down is because inflation is so high.  So, while you see this wage growth may look positive, it’s actually negative.  On an after-inflation basis, the purchasing power that people have is less than it was the month before or the year before and we’re all experiencing that in our own lives.

So, to summarize here at this stage of our conversation, we think that these organic forces within the economy are going to help tame inflation very significantly because of demand destruction on the part of consumers.  So, before we look at some of these so-called exogenous factors that could change the story, I want to go to Meghan to talk about sort of the reality of the markets.  So, what we’ve talked about so far is the theory of the economy.  But let’s go back and actually talk about, you know, real-world reality. 

So, Meghan, it’s been a very volatile year.  Unlike, you know, past times of volatility, it seems like everything has gone down at the same time.  What do you see in the market?  What is the market telling us?  As I mentioned at the outset, there are two things that are going to tell us whether this is a recession or a growth scare.  One is going to be ultimately the intellectual analysis around what’s happening in the economy that Luke provides.  But the other thing is going to be the market itself.  So, what do you see happening in the market, Meghan?

MEGHAN SHUE:  Yeah, Tony. So, S&P 500 down 19% year-to-date.  The NASDAQ down 28% year-to-date, 30% from its all-time high.  Small cap, a similar figure.  And individual companies, as I’m sure you’ve seen from the headlines, are down even more in some cases.  Netflix shaving 75% off of its stock price.  Meta or Facebook down more than 50%.  Starbucks, these are just a few well-known brands that have really taken a dramatic hit.

And we often talk about equity volatility and equity volatility is normal.  We are trained to expect drawdowns of this magnitude in fact on a regular basis.  But what’s more jarring is the volatility that we have seen in the bond market. We’ve seen some very large drawdowns historically speaking for parts of the bond market.  And this increased correlation, if you will, at least on a quarterly basis, between stocks and bonds means that most investors who are diversified and have a combination of stocks and bonds and some commodities and other assets, they’re really hurting on a year-to-date basis. 

So, you asked me what the market is saying. The market is fearing stagflation where stocks and bonds are selling off, commodities are really the only place to hide.  Where do we go from here?  One of the things that we do like to do, and investors and strategists tend to be rightly or wrongly a little bit more trusting of the bond market, so we look to credit spreads as a signal for whether this is a growth scare or a recession.

And so, what you see here is the high yield bond option adjusted spread, which basically just means the spread between a high yield bond interest rate and a treasury bond of similar duration adjusted for option activity, such as the callability of a bond.  And typically, this spread spikes during times of stress.  And what we’ve seen is definitely a pickup in credit spreads and a pickup in angst in the bond market, but nothing like what we’ve seen in recessions where you might see that number spike to 10 or even 20% and not even on par with the peak panic if you will during those prior growth scares.

So, to me so far this says that the market is expecting this to be a slowdown but not predicting recession in the near-term.  And it really is important to distinguish between growth scare and recession, because we tend to see a very different profile in terms of the S&P 500 drawdown, as well as importantly for long-term investors, the time it takes to recover.

So, on average during a growth scare it takes about call it three or four months to recover back to where the market was.  In recessions, not only is that drawdown much more significant, on the order to 30, 40, or even 50%, but the time it takes to recover is much longer, as you might expect.  And that is really why we are so focused on whether this is going to be a slowdown and a bit of a readjustment in terms of what investors will pay for companies and the earnings they’re expecting or if this is a recession and we’re in for a much longer slog here.

TONY ROTH:  So, again, just to point out for everybody – thanks so much, Meghan – whether or not the market itself, and we look at the S&P 500 or the Russell 1,000, but they’re both down around maybe 17.5 or 18%.  If they break through 20% and go down much more, it would suggest by historic standards the market is telling us that this is a recession coming.  Now, we would look at not just the equity side of things.  We would look at the bond market, as Meghan has just taken us through credit spreads, and see if they are confirming and corroborating that this is a recession coming.

So, that is the complementary angle we have to Luke’s analysis and the Economic team’s analysis on what’s happening in the economy.  So, along with Meghan’s conclusion that this not a prelude to a recession given what the bond market’s telling us and that we haven’t broken through that 20% yet on the equity market, Luke has concluded that this is not a recession.  The economy continues to be strong, and inflation has peaked and is coming down. 

Now, Luke, there are a couple of factors that could change that scenario.  We call them sort of exogenous factors.  They’re both on the supply side of things.  One is Russia and one is China.  Could you take us through how it is that the scenario in Russia could potentially impact commodities and either push inflation back up or cause it not to come down fast enough to be consistent with a soft landing?  And then we’ll turn to China and talk a bit about how the COVID situation in China is also quite concerning.

LUKE TILLEY:  we know that the war in Ukraine and Russia, and I’m sure that everybody has read some of the statistics And it’s a heavy reliance of Europe on those hydrocarbons and we know that Europe is a big trading partner for the US.  You can go back to my statement about exports.  We also know that more broadly in a global context Russia and Ukraine providing a lot of the industrial metals and a lot of agricultural products. 

And what we’ve seen so far in the chart on the right-hand side, and these are the sub-indexes of the overall Bloomberg Commodity Index, after the date of the invasion we did have a large spike in those commodities as fear set in.  And we’ve had basically differentiated experience for these three categories and these are not all three categories of the index.  But energy continues to push higher and this is clearly one of the risks and we talked about this in a webinar that we had just a couple days after the start of the invasion and we talked about at that time our, you know, our equity analyst, Mark Horst, talked at the time about how even without the war and the invasion the global petroleum market was likely to be undersupplied anyway on a going forward basis and it was going to push prices higher.  And, indeed, they were moving up higher before the war spiked, come down, but they’re still moving higher and that is a risk.  It’s a risk because it makes items more expensive for consumers.  As I said, I think that will shift them to other, shift away from other goods and not push overall inflation higher, but it’s also a threat to spending and it makes things more expensive for businesses.

Agricultural commodities also pushing higher.  I think that food prices are going to be a major challenge as we go forward and it could get even worse when we see how, you know, the so-called breadbasket of Europe, Ukraine, how the planting season goes and what their harvest is going to look like and how much that’s going to exacerbate price pressures. 

And then, I think industrial metals are really interesting here, because they highlight both the importance of this particular conflict, but they’re also now showing as they’ve taken a dip over the past month or so, showing that global growth scare, because we know that things like copper and some of these other metals that are included in the index will take a dive when there are these growth scares and when there are recessions.  So, that’s actually pulled a little bit down.

But on balance, when we look across all of these commodities, they’re obviously an important input.  They’re, they are a challenge for inflation, and they are an upside risk to that baseline inflation story that I laid out. 

And in terms of China, of course, we’ve been watching this very closely.  A lot of discussions about they are shutting down and that hampers their production.  They have the whitelist of companies that I know you’ve talked about a lot, Tony, in letting those companies operate with some special circumstances. 

We’re just as reliant on China as we were before.  Our total imports from there, incredibly important to our overall economy and it’s not just imported finished goods.  It is also components.  It is cell phones.  It is all of those important components of the supply chain that enable our companies to keep operating.  And this is just an incredibly important factor when we think about inflation.  And if China struggles with COVID for the entire year, then it’s really going to be a challenge, Tony.

TONY ROTH:  Yeah.  And I think this is a little bit ironic, right, because, you know, as an economist, Luke, we look at the amount we import from China, and we think about the strong dollar.  The strong dollar is disinflationary.  It makes things, it makes us cheaper for us to buy all this stuff from China that we’re importing and from other places around the world.  But even that disinflationary effect today is not enough to overcome all the other inflationary forces it seems.

LUKE TILLEY:  Yeah.  Certainly not with such strong domestic demand.  That’s right.

TONY ROTH:  So, let me just provide our views on these two issues in terms of what, where they may be going.  So, as it relates to Russia, we do think that a, some type of meaningful boycott of Russian oil is coming from Europe.  We are a little bit less concerned about that than we are natural gas.  In fact, we’re significantly less concerned about that for a couple reasons.  One is that the energy density and the transportability of oil makes it less concerning because the oil that is now going from Russia to Europe can be diverted to Asia and all the oil that’s going from the Middle East and the Emirates specifically to Asia could be diverted to Europe.  And so, there’s a bit more of a fungibility, if you will, around how oil moves around the world that would allow the market to self-correct for the potential boycott of oil from Europe to, excuse me, from Russia to Europe. 

Natural gas, on the other hand, does not have that advantage.  The ability to take natural gas and transport it in a liquid format is far more expensive and the global capacity to do that is very restricted relative to the capacity to transport oil around the world.  And so, as you – as we calibrate how this particular factor is likely to impact inflation, we believe that the market is pretty much pricing in a boycott of oil from Russia to Europe, but certainly not a significant disruption in natural gas.  If that latter were to happen, we think it would really change the game around inflation and whether or not we are in a growth scare or ready for a recession.  So that’s the first one.

As it relates to China, there’s no question that the Chinese are very aware of the impact that their zero COVID policy is having on their economy and they’re working very hard to keep manufacturing areas up and running.  Just to set the background, China is essentially – their society is essentially what I would describe as in sort of a virgin territory in terms of immunity to COVID.  They had essentially 62% of their population immunized.  That was on average over a year ago.  It was a single shot, and it was with a relatively poor-quality vaccine.  So, when you put all that together, and it was focused in younger cohorts rather than older cohorts.  So, when you put all that together, there’s a tremendous amount of vulnerability within China to extreme levels of death as a result of the new variants that are circulating in China.  That’s why the Chinese need to be so serious about the zero COVID situation. 

So given that, we think that they’re going to continue to be pretty tough on variants floating around the country and putting people into isolation in large numbers.  But we also see these so-called whitelists, where there’s over 1,000 companies now on these whitelists that are cleared to operate and continue manufacturing and exporting with the right type of constraints around the ability for individuals to come in and out.  So, essentially, they’re creating bubbles where people are working for long periods of time within the context of the manufacturing area and, you know, food is brought in.  People are not coming in and out of those areas. 

So, we’re somewhat optimistic that the China situation, while it’s going to be a drag on inflation because it is going to constrain supplies and push up prices or be a, you know, a negative force on prices pushing them up rather than down, we think that it’s going to hopefully be managed in a way where it’s not going to be a decisive factor.

Luke, just tell us quickly about the Fed.  I think ten rate hikes.  We’ve got three under our belt in terms of quarter point movements, one quarter point and one-half point.  You view, I know, is that you think the Fed might actually move less times than is baked into the market given your outlook for inflation.  Tell us about that and what you expect from the Fed.

LUKE TILLEY:  And that’s sort of the natural outgrowth of the inflation outlook.  We’re expecting inflation to slow more than consensus is, albeit with those risk factors of Russia/Ukraine and China.  But we do expect inflation to slow.  We think even though yesterday’s report showed the peak in inflation.  There were some positive, some negatives in there.  But our outlook leads us to think that the Fed will be hiking less than what’s priced into markets right now.

We’re showing 2%, 2.25% by the end of this calendar year, which is a lot lower than the over the past couple days 2.75 or so that is priced in the markets.  And really, that comes from that, you know, the idea that inflation is going to be slowing, that they’re going to see some weakness, a little bit, from consumers, some pullback there.  And also, the housing market that I mentioned is going to start to feel a little bit of the pain of the higher interest rates and the Fed will have every reason to sort of slow it down. 

That’s one of the reasons Powell mentioned that he doesn’t think 75 basis point hikes are on the table for the next couple of meetings.  Clearly, they are going to be reacting to the data. So, we do expect them to be hiking rates, but expect that slowdown later this year, Tony.

TONY ROTH:  Okay, thanks. Meghan, so I’m going to really put you on the spot as our head of Strategy.  Given our conclusions today that this is a growth scare, not a recession, we’re close to the line.  It’s sort of on the knife’s edge.  But right now, we’re on the side of growth scare and not recession.  We have currently an excess of cash in our portfolios, a significant overweight to cash.  Why don’t we put that to work in equities today?

MEGHAN SHUE:  Yeah.  Tony, we’re definitely looking at it and the market, having pulled back almost 20% is starting to look definitely more attractive.  It’s always a combination when making these decisions of our economic view combined with what the market is pricing and our assessment of what is priced in there.  And based on our view that we’re going to have a slowdown from last year but no recession, inflation is going to come down, and the market correction that we’ve seen, as I said, that sets up for a much better second half of the year than what we’ve seen so far this year.

But I don’t think it’s an obvious decision.  You highlighted one measure of investor sentiment.  But there’s other measures of sentiment and positioning and technicals that suggest maybe we have further to go before we’re totally flushed out and ready to find a bottom.  The VIX, for example, a measure of equity volatility in the S&P 500 based on the options market, it’s around 33 today and in prior bottoming periods we’ve seen it spike even higher than that.

So, and then I think importantly the risks are higher. And I think inflation, Luke made a very convincing case for inflation peaking.  It really does, as he said, matter how quickly that comes down.  It’s not quite enough in my view to have inflation peaking.  We really do need it to start to decline quite rapidly. 

But we are looking at a variety of these measures and over the next 12 months I would say equities are starting to look more attractive.  Fixed income as well may be a little bit less attractive than it was a few weeks ago when you pointed out that we got up to about 3.2% on the ten-year treasury yield.  But real yields on bonds as measured by the TIPS breakeven and equities trading at more attractive valuations definitely sets up for potential to deploy some of that cash.

TONY ROTH:  So then, Meghan, for folks that have an excess of cash for whatever reason.  They’ve been lucky enough to be in cash.  They’ve sold a business, haven’t deployed it, inherited some assets, whatever it may be.  What do you recommend they do today?  Typically we say deploy over 90 days on a fairly consistent basis.  Do they accelerate that?  Do they?  What do you think?

MEGHAN SHUE:  Yeah.  I think we stick with the plan.  We have done a variety of research into different time periods over which to deploy capital and that, you know, one to three month time period, while it can be difficult when the market’s falling like it is, historically speaking if your time horizon is longer than about a year or two, you’re very likely to do quite well getting that money invested. 

I think we might get some, perhaps some larger down days that might give clients an opportunity to accelerate that slightly.  But I’d say by and large stick with the plan that you devised to get that money invested over a relatively short timeframe.

TONY ROTH:  Okay.  Thanks very much.  So, I want to thank everybody for joining today.  Special thanks to Meghan and to Luke. 

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