Chris Hyzy: This is Chris Hyzy, Chief Investment Officer, for the January 30th Market Update. We start off by asking one question on this update, “Why is everyone downplaying the latest rally in the equity markets?” We point to a few things. First and foremost, liquidity. There’s still concerns out there that the bond market’s liquidity isn’t at its level that it normally is as it relates to an overall vacuum that some are discussing in the marketplace. This could be due to continued concerns about the raising of the debt ceiling. It could also be to the fact that the two largest traditional buyers at least recently in the market - the Federal Reserve and China - have backed away. Nonetheless, the massive inversion of the yield curve, particularly between the front end and the back end, as it relates to the two to 10-year spread and the drying up of some liquidity in the market is still a big concern on the part of investors. Number two, investors also point to the concern over money supply, which has some elements of liquidity to it, but the money supply, overall money in circulation in checking and deposit and savings accounts and money market funds overall collectively is contracting first time since the data has been collected in over seven decades. So, when we take a look at those two - big concerns. Another reason why everyone is downplaying the latest rally to start the year is earnings deterioration has yet to be reflected. In fact, investors rallying this market right now are starting to possibly look through that. We know that earnings overall bottom after the market bottoms, but still it remains to be seen coming out of these earnings announcements exactly what is the path forward, so that’s another concern in the marketplace. Valuation is another one. Most people say it’s still not low enough. They point to below 15 times earnings and they’re also pointing to where we are right now, which is about 17 - 18 times earnings on a go forward basis. If you get earnings deterioration more than expected, they point to the fact that valuation could actually go up before it starts to ultimately bottom out. Last but not least, two more that are out there - should three more. China, the reopening is great but lumpy and then geopolitics still a major concern. Finally, they point to two other ones I guess on a secondary basis - that wage growth is still sticky and even though inflation is coming down, the worries are still there that wage growth would remain at an attractive level, keeping the Fed pumping on the brakes. The tech rally that we’ve seen recently, they’re pushing that off to the side. Overall believing that tech earnings deterioration has yet to happen and if that happens, that could overhang on the market but we simply ask another question, “What if the market started to factor most of this in last year when we hit the lows three or four times throughout the year, somewhere around 3,500 or so on the S&P 500?” We sit about over 4,000 right now or just at the 4,000 level coming off of the high which was over 4,700. We had a peak to troth move of 25% from the high to the low and now we’re just grinding it out, which is what we expect for most of this year, is a grind it out type of marketplace trying to figure out the final reset but when we think about last year when we hit those lows, obviously a lot of hard work to do but that’s when most of the economic data, at least in our opinion, and the data that the Fed was watching was at its most concerning time and most concerning levels. Inflation at its highest level. Valuations in the 20s, not around 17 or 18. War still overall affecting at its highest impact point. Supply chain - most of it still being very much distorted. So, what if things are generally simply better right now? Even in the face of this final reset, what if investors are actually looking through this and out to the other side? It still seems a little bit early to do that but we still ask the question because oil and gas prices are significantly down, particularly in Europe; one of the reasons why Europe equity markets are significantly outperforming. Inflation - sharply lower and heading lower in the right direction. The Fed close to its ending of its tightening campaign. Valuation some 20% lower. Curve inversion still very, very major but suggesting that the front end could come down by the end of the year. We will see on that. Europe, as we already said, much better off. China reopening - yes, lumpy but still reopening. We didn’t have that last year. So maybe, just maybe, investors are looking through the final point of this reset and the final point of the storm on to much brighter skies or at least subtly brighter skies. We will find out this week a lot more to major answers - obviously, earnings, big earnings week this week and then the Federal Reserve Open Market Committee meeting final meeting and communication coming out on Wednesday. We expected 25 basis point hike, but that’s yesterday’s story. Tomorrow’s story will be more about, “What is the path forward?” That’ll do it for today. Thanks for listening.
Operator: Please see important disclosures provided on this page.
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Chris Hyzy: Hey. Thanks, everyone, for joining this week’s Street Talk Call which is actually in between our two Viewpoints, the one that we already released for January and then the upcoming February one. So much of the discussion upfront today is a general mixed bag about what’s going on in the economy, what’s going on in the capital markets, our reasoning for the rally to start the year, what we believe is coming down around the corner. One of the clues to all of this is the general mixed tone that's happening in terms of what is leading in the markets to start the year and what is lagging. So, we want to talk about the rally, we want to talk about this concept called the mixer, and then ultimately how that segues into what we believe is in the oven. So, all of these things we'll talk about in the context of where we see capital markets going and how to deal with it as it relates to portfolio strategy and enveloping all of this, at least in our opinion, is it's different this time. It's not necessarily all historical references given the fact that we're in late cycle. It's not about what credit spreads are telling us. It's not about what the fed’s communication is about to say. It's not necessarily about the differences between Europe, Asia, and the United States. It’s not generally about what the employment markets are telling us. It's about everything. This time around we have mixed signals that are much more expanded in our opinion because the pandemic cycle was very different. The response to the pandemic cycle was very, very different. We've long discussed this concept of the last time that collectively we had a response to fund something this heavy and that was World War II. So, most of what we are trying to ascertain and look for coming out of this late cycle cyclical bear market into the bridge period of recession and then out of it is not just earnings deterioration of the yield curve or the fed as we said before. It’s about various components that are more akin to this cycle, more akin to this economy both US and globally, more akin to how the yield curve works nowadays versus prior periods. It is our belief that we will be in a longer, confusing, more complex workout in the markets as it relates to what they're telling us. Therefore, it's important to digest this rally, “Why did it happen? How long it can continue? What's driving it? Ultimately, what can reverse it?” - number one. Number two, we talked about this concept of the mixer. You can have a ton of ingredients out there that you can examine one by one. That's great. That's interesting but the mixer can aggregate that all together and tell you a very different picture and that's generally speaking what the markets are telling us right now. Then finally, if you are going to create some batter, “How long is it in the oven? How does it come out? What temperature is the oven set at? How long can we deal with that?”
So, let's start with the rally. Financial conditions have clearly eased since October. Noticeably. Namely when you take a look at the long rates, overall fed’s communications, inflation, the dollar, reopening in China. All of this started to occur, for the most part collectively give or take, since October, but really gathered momentum at the tail end of December into this year. The direction and magnitude of things like inflation, the global economy, the labor market, central banks, and obviously external concerns have all been in the favor of a relief rally to the upside that has been driven primarily by again, financial conditions easing at least right now but really, we see it as liquidity. So first and foremost, the biggest wedge last year in the markets for most of the year was inflation. There was references to 40 year highs, references to, “Here we go, the 1970s are all over again,”, “the supply chain will never get fixed,” Wage price spirals continue, the labor pool is very low, the demand for labor is very high, we have goods spending switching to services spending, we have pricing power that's going to last, and most of that is unwinding. There's this also realization now that money, money growth in particular or money supply, is the catalyst to inflation. Most still don't believe that. In fact, some policymakers are still pointing to wage growth as the underlying basis of inflation primarily. It's a component thereof, but not necessarily the underlying driver, at least not in our opinion. If there is more money to do things with, particularly if it's over and above the level of inflation, it can continue to drive inflation both in the short and long run. How that filters into the broader economy is a whole other question and how that leads to sticky inflation is a whole other question, but simple thought process here - if you expand the money supply greatly to the level that we have, both in the United States and globally, inflation becomes an issue and then when you start to contract that money supply - right now inflation is coming down not necessarily because wage growth has stopped going up at the level it did last year, but it's coming down across the board because there's less money to do things with and there's less confidence in the growth of the general level of the economy and that creates a more conservative tone overall in things like spending, the ability to take risk, to raise wages overall even though the supply of labor still low and demand for it is still high. All of this leads us to say the single most important aspect to the direction of inflation and its magnitude is still the money supply. The money supply is now contracting and that leads us to believe that one of the greatest surprises in the next 18 months could be how far inflation falls. We’ve said that before, but it is now the story that is being picked up in the marketplace. It's one of the reasons why long rates are coming down and have come down to a level that most expected to happen later in the year and we haven't even hit the recessionary tones yet. So first and foremost, direction and magnitude matters. The rally is pointing to the wedge. First wedge - inflation - is gone. The inflation wedge is out of the markets. There's a new wedge. We'll talk about that in a second. The second level to look at is rates. We've talked about it. Short rates are high. Short rates are providing yield at the front end of the curve. The fed is not done hiking. B of A Global Research still expects 25 - or now expects 25 for February from the original forecast of 50 - bump up to short rates. Another 25 in March and now a 25 in May because it is their belief that overall, the US economy, which was originally expected to enter some level of recession early this year, has now been pushed out to the second quarter. Again, it's different this time.
Now, let's switch over to what's going on outside the United States. China reopening is providing a tailwind. It could also be one of the reasons why the global economy and the US economy is stalled out on moving into a recession, but it's certainly a major reason why the European economy/European stock markets are outperforming the developed stock markets including the US and have been since the reopening has occurred and that also is combined with a major tailwind as it relates to expectations of where we are in oil and gas prices relative to where we were with the biggest fears being a major move higher into a very tough winter for Europe. That has not materialized. Those are the two big tailwinds to the European economy/the European markets which are inherently more value and also more exposed to things like metals and mining and areas that have been generally leading the markets. So overall, you can check the box direction and magnitude of inflation’s going in favor right now of easier financial conditions, less need for the fed to tighten further. Nonetheless, money supply is contracting and that is very pressurized to the level of inflation. We could be talking about negative inflation within 18 months or sooner if they continue to tighten conditions aggressively both at the balance sheet level reserves and overall, the cost of capital.
Let’s shift over to labor market. That's the new wedge. We've talked about this before. Why is that a wedge? Well because that's providing the hands to open the window that the fed still sees as a reason to hike. So, if the labor markets provide us a reason to get more worried, central banks will get more worried and potentially pause before that last hike in May. Right now, the signs that are showing cracking is mostly in the technology space, but we rolled up all of the layoffs in technology, at least in the big mega technology names, and we don't even get above 400,000 at least it was announced. Four hundred thousand layoffs is tough for those individuals but overall where we are in the grand scheme of things in the labor market, it's small. So, we haven't seen this happen across. Slightly in the financial sector, some parts of consumer discretionary, but overall, the labor market is a wedge for this reason. It provides the opportunity for the Federal Reserve in particular to still put their foot on the brakes thinking that wage growth will continue to be high and overall or potentially reignite later in the year. We don't believe that the labor market is showing signs of a re-acceleration. We believe that the labor market is beginning its trend to the negative side of the equation, adding to our belief across the firm, particularly from global research, that a recession - at least if not already started - is about to start in the second quarter. Central banks - another thing to watch. ECB, European Central Bank, likely to be more hawkish, believe it or not, than the Federal Reserve. Part timing, part reasons around in how inflation feeds through into Europe, but overall, that should widen or at least narrow interest rate differentials between the US and Europe. Ultimately, that has a counterintuitive effect on the euro versus the dollar across. So, the euro should strengthen, and the dollar could weaken further versus that area, underpinning the support for the European equity markets further. It is our belief that that should slow down before it picks up again, but it is still a trend that we think is gathering momentum. The Bank of Japan backed off on full yield curve control at least for now in terms of allowing significant increases in their yield ranges. We think that that's just a stalled-out method right now. Part of it has to do with the handoff from one official to the next, but what we think that that's going to continue. Bank of China - easing conditions in conjunction with its reopening as well. So, all of this is lending itself generally speaking to a mixed bag from central banks, but still on the hawkish tone overall except for the Bank of China.
External concerns. The debt ceiling is now creeping in and a lot of talk around that. Watch the narrow House majority here. It's very different than 2011 when there was a much wider, stronger, higher majority. There's also a very different makeup in congress right now. Most political strategists believe that it would be very difficult ultimately to not do the right thing, which is to raise the debt ceiling and it could potentially obviously go to the last minute here. We're used to that. It's a very big concern. It is something to watch but overall, we believe that ultimately that gets fixed. Last but not least, tech regulation is out there and the extended war in Ukraine continues. Tech regulation, we've seen this before. It comes and goes. The drumbeat is getting louder there therefore we don't think this rally in technology land has much legs further than this quarter.
So put all of this in the mixer and what do you get? It is our view that we get pretty good batter. We get a delayed recession, we get easier financial conditions, we get narrowing of interest rate differentials, we get credit spreads that are still tame. You’ve looked at the individual ingredients and you could poke a story there any way you want. You could look at negative ingredients and you can look at subtle positive ingredients and when you put it all together, again, a pretty good batter for now. So, risk assets are up. The S&P's up 5% or so to start the year, NASDAQ is up 9%, the Dow much less than that because of the price weighted components there of some individual names - Dows up 2%, the S&P we already mentioned, Europe up 11% in dollar terms, China - depending on the index - up 8% to 14% leading the world, Hong Kong up 13%, Japan up 5% give or take to start the year. Credit spreads generally tame and narrow mostly because investors look at corporate health and they don't see a very difficult recession coming. They also see most of the pain in technology land which happens to have clean balance sheets, less debt load, and more cash. That's one of the reasons, at least in our opinion, why credit spreads are where they're at. So put it all again in worries over the major turndown in the employment market - not there yet. Major turn down in commercial real estate - not there. Economic growth slowing - yes, but still the waiting game on the most telegraphed recession, at least we believe, ever that we've seen in our time - not there yet. Earnings deterioration - yes, happening, but it's targeted right now. It seems to be in some parts of discretionary. Obviously in tech land, but it's not across the board yet. We are seeing signs that revenues are slowing down. Pricing power is going away. The next shoe to drop is going to be how much do unit volumes drop? If you get less pricing power, lower prices, lower volumes, that feeds into more earnings deterioration. Again, down 9%, down 10% is the forecast from B of A Global Research at this point.
So, what's in the oven? Again, recession timeline is delayed. It's pushed out. How big or small is the recession? Still feel a mild one. Is it an earnings recession? Yes. What does that mean? That means a downdraft in earnings. Again, the magnitude is going to be the key here. At this point, down 10%. Not your classic recession, which is down double that or more. If we go down double that or more, then it is our belief that the fed stays higher for longer, continues to contract the balance sheet, and adds a major turn down in pricing power mixed with unit volume growth that could lead into a tougher earnings season than we currently expect. Equity markets are viewing right now. Overall, the batter as a soft landing. Bond markets are viewing the batter that a recession is coming.
So, what do we look at? We’re looking at gold here. Gold is up 10% year to date largely with the tailwind being the weaker dollar, but also as a hedge on what's going on around the world and the confusing signals coming from liquidity. Liquidity in the market - let's talk about that. Liquidity in the markets - there's a way to express liquidity and then there's another way to think about expressing liquidity. From our perspective, the best way to look at liquidity is what's happening in the bond markets, what's happening in what the Treasury is issuing, what's happening in what they call the Treasury General Account, and what's happening in reserves. That, at least our belief, is one of the better ways to look at liquidity that's available for the markets whether to invest, whether to hedge, or whether to simply smooth out volatility. Right now, the liquidity, as far as we can see in the Treasury General Account, typically $900 billion has been drawn down to about $300 billion. That's $600 billion out there extra to provide liquidity into the capital markets. That is generally of the worries that are out there over the debt ceiling and how to pay for it overall in terms of bill payments. As we move closer and closer to the drop-dead date - at least many people believe that is post spring, maybe perhaps early June - when your back is against the wall, you need to start to raise the debt ceiling once and for all. It could be that the debt ceiling gets raised. We move on. There's a positive viewpoint in the marketplace, but then what the Treasury General Account would have to do would have to be re-liquefied. It'd have to be going back up from $300 billion to a more normal level and if that occurs, it’s likely that liquidity comes down. So, it's actually a counterintuitive way to think about a positive event in terms of getting a concern out of the markets but ultimately its effect on the reserve base could be tighter financial conditions precisely at a time when earnings deterioration begins to happen more visibly. So we're watching that very, very closely and that could be the next time in which the markets exhale and that could also be a large opportunity to rebalance portfolios back into the areas of upward drifting risk like equities. We'll be watching that closely. So, rebalancing could happen in a larger way closer to the middle part of the year for long term investors.
Finally, what's in the oven and what's baking? Well, the dollar has peaked. Two-year yields have peaked. The employment slowdown overall is starting to show some signs of filtering into other non-tech areas but not in large mass. Liquidity we already talked about that. Finally, technicals. When you start the year with a rally of 5%, you're almost closing out the month of January and your first five days are also positive, you generally have a positive historical effect on the full year. We have long said that it's potentially different this time but we're looking at technicals right now in favor of the equity investor, particularly when you come off of a negative year and a negative year that was in the double digits. When you look at negative years, you shift to positive for the first five days, you shift to positive for the month of January, you generally have had a sizably solid year that next year. So technicals - in favor. Liquidity – right now in favor but liquidity’s about to shift. The batter looks overall pretty decent right now. The oven is baking. Here’s one caution overall which is why we need to watch this temperature very, very closely. The leaders in the latest move up in the market and the laggards are telling us very mixed results. Tech is going through a relief rally. Semis have powered this. Most of it’s because of an exhale from tax loss harvesting selling last year but it’s also generally speaking because earnings were not as bad but also the layoffs have been announced in technology are what investors were looking for, that their seriousness as it relates to holding margins in there, but we still believe that there’s more of a relief rally than actual the technology sector has turned completely for the better. Healthcare is up. More of a defensive tone. Generally higher quality in some areas providing yield and a little bit of growth. Makes sense. Thrifts and mortgages are down. Although mortgage rates are down, the belief there, at least in our opinion, is the inverted yield curve. Rails. Rails have rolled over – traditional, very cyclical. Late cycle relief rallies tend to not include the rails going down. Usually, they start to hold the line and then start to turn more positive. This time around the rails are obviously pointing to the fed, which is not showing any signs that they're going to cut any time soon. Emerging markets up - that’s a dollar play but also a commodity relief exposure overall and obviously, China's reopening which is a heavy part of the index. Steel also up. Very interesting there given the housing situation, but likely because of China's reopening. Then ultimately discretionary sector is far outpacing the staples sector which tends to be a little bit higher quality, less cyclical.
So mixed bag overall, which is why all of this leads us to stay neutral. We started out the year neutral across the board in fixed income and equity, expecting a mixed bag to continue. We're going to continue to wait for concrete signs that the oven is baking the batter to a better temperature and we’re going to point to things like again, liquidity, the leading economic indicators driven by the Institute for Supply Management and purchasing managers indices. Those are the ones that we'll look to first. The yield curve is most important and spreads. Secondary is earnings and estimate revisions because ultimately that bottoms after the market finally bottoms. We expect another rebalancing opportunity in the next few months and a long-term bull market to begin some time around the turn of the year into 2024 pointing to better earnings outlook from the trough that we expect in 2023. We'll use the short end of the curve for cash flow, the long end of the curve for total return. We'll use equities for long term growth and we're going to continue to emphasize value and higher quality. We want to be diversified across sectors, namely industrials, healthcare, and energy; areas that are still generally exhibiting better estimate revisions and then finally, we want to keep emerging markets, non-US equities overall in small caps on our upgrade watch list once we feel the turn has stronger legs. We're not there yet, but we're getting closer. With that, that’ll do it for upfront comments for today.
Operator: Please see important disclosures provided on this page.
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Chris Hyzy: This is Chris Hyzy, Chief Investment Officer, for the market update for January 23rd. I thought what we would do for today's upfront was discuss the overhangs on the market as well as what is balancing out some of those overhangs and then ultimately end on what we expect in terms of a market environment type of overall action at least for the first few months of the year. First and foremost, the largest overhang right now has been widely discussed in the last few days. Unfortunately, no real resolution is in sight, and that is the debt ceiling negotiations that we expect to drag on well into what we call the pay the bill end date which is likely to be sometime in early June, so unfortunately no resolution there. A light gray cloud at this point likely to get darker as we get into the spring months and the actual negotiations do unfold in a much more assertive way. Secondarily is Fed hikes, which is widely expected. Two to three more Fed hikes, but this time around moving down to a 25-basis point hike versus 50 basis or 75 basis points, which is what we have become accustomed to. So, two to three more is what the market is expecting and the forecast out of B of A Global Research Economics Team is three - at this point - 25 basis point hikes at the February meeting, March meeting, and May meeting with some risk that the Fed pauses earlier than expected. Number three, it's the attractiveness of yields at the front end of the curve. Shorter dated fixed income roughly 4% - 4.5%, in some cases slightly higher than that, is what is keeping investment in dollars still at the front end and in fixed income and the attractiveness in that particular asset class relative to equities given the volatility in equities is still very high in that part of the fixed income curve. So overall, investor sentiment continues to be somewhat on the defensive despite the rally to start the year. Number four, earnings deterioration. We're starting to see some of that, but actually to a lesser than expected degree at least as it relates to the fourth quarter announcements to start this year here early in earnings season. The margins are narrowing and there are some wage cost pressures in certain industries particularly those that are in the manufacturing arena. That is likely to shift over to the service sector as that is much more labor intensive. However, the service sector is not experiencing layoffs en mass at this time. Subtle increase, but not a large one right now. Technology land is the area where most of the layoffs have been and that is a small portion of the overall labor force. So that is also still right now earnings deterioration beginning to become an overhang, but slightly better than expected at least early in this earnings season. Last but not least, manufacturing and industrial production numbers were adjusted lower. It was expected, but the adjustment that did occur was more than expected and we're starting to see some more deceleration in that part of the economy. Ultimately, this is the area that does feed in first and then it likely switches over to the service sector. Distortions from the pandemic are making this a much more delayed expected type of recession, potentially pushing the recession to begin now in the second quarter versus the first quarter. We'll see how that unfolds. What's balancing out all of these overhangs? Well, number one is consumer spending. Consumer spending continues to remain healthy at this point in time in the cycle where we are late in this economic cycle and that is because the employment data is holding up at least at this point. The service sector is where the strength is widely discussed. That is also balancing out and giving some fuel a little bit to the consumer spending largely because of jobs which is the third balancing out. For now, jobs and employment health are still there, most notably outside of the technology sector. Number four, what’s balancing this out is liquidity facilities. There are a couple of liquidity facilities that have been put in place by officials to help provide capital smooth out the volatility in the treasury markets - number one and the funding markets even more in particular. So those two areas are feeding a little bit more liquidity into the markets; one of the reasons for the rise in risk assets to start the year. Number five, China's reopening continues apace despite worries over rising Covid infections in China, but China's reopening and their economy’s providing a tailwind at least to that part of the world for now. Lower oil and gas prices, the biggest tailwind in Europe, is also one of the bigger reasons why European equity markets are outperforming the rest of the world. Finally, India's capital expenditures budget is widely expected to be about 20% of their overall budget. That is higher. That's one of the highest in 10 years and that also could support what we call this adjustment to supply chains going forward for most of it being core production in China to other parts like India. Last but not least, let's take a look behind the scenes. What's doing well? Value is outperforming growth. Handily, that's coming off of a very big outperformance at least in the US overall value outperforming growth last year. Non-US markets including emerging markets have a tailwind to them relative to the US again to start the year and that's where they left off in 2022. Gold is significantly outperforming the utility equity sector, which is very defensive and has yield. Gold doesn't have yield, but it is deemed to be a geopolitical risk hedge as well as a weak dollar hedge and some central bank investment flows are moving towards that and it is now at the highest level versus where it's been since April of last year. Equal weighted S&P takes out the market cap weighted S&P 500. It’s outperforming the market cap weighted. That just simply means that the average stock within the S&P is outperforming the broader index. We expect this to continue at least for majority of this year. Finally, overall, we expect a grinded out type of marketplace to put an end point on this cyclical bear market through the first half of this year. We've got new worries obviously. One that was expected which is the debt ceiling negotiations. The others continue to be a delay to the overall well forecasted, well discussed, well debated recession. Nonetheless, an expected grinded out marketplace to continue in our view. We stay neutral equities and fixed income. We see equal risk adjusted returns overall all things considered for the balance of this year and into early next. We expect a new long term bull market to start next year largely speaking as earnings climbs the wall of worry after earnings deterioration in ‘23. That'll do it for today. Thanks for listening.
Operator: Please see important disclosures provided on this page.
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