Market Conversations

Brian Levitt

I'm Brian Levitt.

Jodi Phillips

And I'm Jodi Phillips. And we're talking artificial intelligence today. Ashley Oerth is here. She's a senior investment strategy analyst at Invesco. So Ashley will be here to make sense of the optimism and the fear surrounding AI. So Brian, which side are you on - excitement or fright with AI?

Brian Levitt

Yes. Is that okay?

Jodi Phillips

Yeah, sure. Great answer. Probably most people would echo that, but yeah, no, I think that's pretty common.

Brian Levitt

Yeah. I'm not sure if I even know enough yet to be excited or frightened, but yeah, I'm still trying to get my head around it. I think everybody else is as well. I can look to certain things, like if you were to ask me, am I excited about autonomous cars that get safer and safer over time, then yeah, sure, of course I'm excited about that.

Jodi Phillips

You sound like the father of teenage girls.

Brian Levitt

Yes, no doubt. No doubt. And my oldest one will be 16 next year, so that'll be really front and center in our minds. Very real.

Jodi Phillips

Yes. Well, as the mother of teenage boys, including a 17-year-old, I 100% agree with you that safer cars would be an amazing, amazing development. And look, beyond that, really exciting possibilities. You think about the medical field, robotics and hospitals, predictive software that can diagnose diseases earlier. That's just amazing.

Brian Levitt

Yeah, exactly. And look, so the possibilities can boggle the mind. And I know deep in my soul, everything about history tells me that I shouldn't fear technology. And so I'm very much, Jodi, pushing back against any instinct to be frightened. You look at history, it's always hyperbole. It's always overblown.

Jodi Phillips

Yeah. Well, it's like the quote I read the other day, right? "Once a technology rolls over you, if you don't get on a steamroller, then you're part of the road."

Brian Levitt

Yeah, it's so true. It's so true. So you want to lean into it. Although I will tell you, I'm not going to watch the Terminator again anytime soon.

Jodi Phillips

Oh, yeah. We were warned about this back in 1984, and we didn’t listen.

Brian Levitt

We were. But look, as we're saying, almost all technologies are initially feared until they are embraced. And typically what you see, standards of living generally climb as a result of it. Concerns of mass unemployment have historically not materialized and of course-

Jodi Phillips

No, in the US what is it, 3.6% unemployment?

Brian Levitt

Yeah. So technology's not killing all the jobs and the human race persists. But I think what investors want to know beyond-

Jodi Phillips

Thank goodness.

Brian Levitt

... all of this is how do they prosper from AI? How do they identify the types of businesses that will benefit from this?

Jodi Phillips

Absolutely. And that's why we're so happy that Ashley's here. She's going to put this all into the proper perspective for us and help us to think about the investible opportunities. Ashley's got a framework to help us categorize companies that are directly and indirectly involved with AI. And I think that's going to be really helpful to wrap our arms around all of this.

Brian Levitt

Ashley, welcome to the show.

Ashley Oerth

Thank you so much for having me.

Brian Levitt

Yeah, I promise you that I'm not a cyborg from the year 2029 sent to hear your best investment ideas.

Jodi Phillips

Well, that's a movie pitch right there. I'd watch that.

Brian Levitt

How far away did 2029 seem when we first watched The Terminator?

Jodi Phillips

All too fast.

Brian Levitt

All too fast. So Ashley, why don't we start, what is all this? What is artificial intelligence? What does it mean to you?

Ashley Oerth

Sure. So artificial intelligence, I think it's one of those words similar to so many we've heard in the not too distant past of metaverse and cryptocurrencies and all this, that it carries a lot of meaning, but we don't really know exactly what that is. So artificial intelligence, it's a pretty nebulous concept, but in its most basic form, it's really about mimicking some kind of human intelligence or decision making. It's really about helping us process and categorize data, make decisions based on available data, or even create new data, as we're seeing today, based on some kind of prompt. So really what we have today, it's not the Terminator, it's not HAL from a Space Odyssey, it's really what we call narrow AI. It's task specific, it's designed to accomplish something in particular.

Brian Levitt

How did we forget a Space Odyssey?

Jodi Phillips

Yeah, that's a classic reference for sure. But Ashley, so what's driving all the excitement now? We're making all these old school references and we've been talking about AI since, I don't know, what, the '50s or so? So what is it about today? Why is it all of a sudden, or at least it feels like all of a sudden, everywhere you look?

Ashley Oerth

So we're excited today because of generative AI. It's really this topic that has taken us by storm since the release of ChatGPT late last year. Really, this tech has been around for a while, but really through this combination of incremental gains and computing power, greater data availability, better models over time that have really just been incremental improvements, we're now able to have these generative AI systems that are able to match human capabilities in natural language and a whole host of other possibilities.

So what we have today are these systems that are able to, for example, pass the bar exam or score well on the LSAT or the GRE. And we have similar systems as well, not just for text, but also for images, for audio and video, all sorts of capabilities that are cropping up and the capabilities are impressive. So I think that's why people are excited is because suddenly we have these tools that they're not the stuff of science fiction, they're the stuff that we can go online and play with at any given moment. And I think that the possibilities are boundless, but also I think there's a great deal of fear that comes with that. So possibilities plus fear, I think is excitement, right?

Brian Levitt

Yeah, exactly. And is this different than Deep Blue beating a chess master in the 1990s? Or Jodi, do you remember when IBM Watson was on Jeopardy and-

Jodi Phillips

Yes.

Brian Levitt

... and was doing quite well? Is this all that different? Have we made huge leaps and bounds since then?

Ashley Oerth

So in those cases, I would say AI was really purpose built. So you mentioned the examples of Deep Blue and of Watson. So these tools were really designed for that task at hand. They were within that context of narrow AI that I mentioned, they were even more narrow than what we have today. So things like these large language models that we've been hearing about and have been able to play with since late November, these are exciting because they are quite flexible. They're able to understand and respond in natural human language. And it is something that I think seeing is believing. You're able to play with these things and they're able to write you a poem or write you a paper or summarize a document or all sorts of everything from menial tasks to things that are more, I think, intellectually demanding.

Jodi Phillips

That's right.

Brian Levitt

It's pretty remarkable.

Ashley Oerth

It's amazing.

Brian Levitt

A friend of mine was having a religious service for his daughters, and we asked for a speech and it spit out a beautiful speech for him. I don't know if he used all of it, but it was almost too lovely to use all of it. But Jodi, you're a writer. Are you using the shortcuts now? Is the great American novel by Jodi Phillips coming from ChatGPT?

Jodi Phillips

No. No, not at all, although I am mindful that the more I write, apparently that helps ChatGPT get smarter. And Brian, you have a monthly column, Above the Noise, and you occasionally do a segment in there that I really like where you ask ChatGPT a question and kind of critique its answer compared to how you would answer it. And I think in most cases it was maybe a little off base, not quite the full story, so it's got a lot of room to improve. So Ashley, when does that happen? When can ChatGPT just write the whole column or write my whole book?

Ashley Oerth

So you know what they say, Brian, right? Prediction is very difficult, especially if it's about the future. And really to me, it's not clear if it ever will be able to do our jobs. I think we can create increasingly convincing facsimiles of our jobs with AI that can sort of give the impression that it's able to think and learn, but ultimately there's not a whole lot of deep thought that's going on here. In other words, AI can learn, but it can't think, it doesn't have ideas. It can't really critically analyze a problem. It can really, at best, give the impression of ideas by recognizing interconnected topics based on the training data it was initially trained on.

So that said, data science, it's really a field that's been developing at a breakneck pace for quite a while now, and predictions about future capabilities are often exceeded, and the timeline of them is something that maybe will say, oh, this will happen in five years, but it ends up happening in two, or maybe nothing happens for a decade, but then suddenly everything happens in two years. So I think that the most likely outcome right here, is that AI, I think, will be used as a tool paired alongside knowledge workers as part of our regular workflows, rather than something that really just takes our jobs. That's my prediction, but of course, we could all be very wrong about what the timeline is here and what its ultimate capability is.

Brian Levitt

I love that Ashley assumes that there's deep thought going on here or in the rest of the US workforce.

Jodi Phillips

Very optimistic point of view.

Ashley Oerth

I have aspirations for our lives.

Brian Levitt

Do I need to know how it works or am I just going to be harnessing the... I don't really know how the World Wide Web works. I'm not really sure I know how my telephone works, so do I need to know how it works or it's just that these are going to be tools that I'm going to harness?

Ashley Oerth

So it's similar to what you just described with the phone. It's something that you can appreciate how it works, but it doesn't necessarily change how you interact with it. So I think that when we're talking AI, everything that we're talking about today is really centered on this generative AI topic, and I think there's a lot that's exciting here. So when we think about exactly how it's working, it's essentially a prediction model. If we're using the example of text, if we ask one of these chat bots a question that it's able to predict the series of words that flow from that. So if you ask it, how are you? It's going to, based on the training data it's seen before, sort of throw at you what the next most likely words are from that. So I think what's exciting about what's going on here is that these models, they're not just giving you the same response every time, in the parlance of the space, they're not deterministic, they're not always arriving at the same output given some kind of prompt or input.

So in other words, they're probabilistic. There's a sort of dice roll that's happening every time there's a new word that we're getting new content that flows from that. It gives us the impression almost of creativity. So if we take this idea and apply it to a model that has been trained on a mindbogglingly huge amount of data, we get this sort of large language model that's able to understand natural language, understand topics, and provide intelligent sounding replies with variety. So if we can ask it to write a screenplay or write an academic paper or whatever, each time that we do that, we'll get a different output because it is probabilistic, which I think is one of the really cool things about this generative AI craze, is that there's so many things that can come from it that, again, it can feel like creativity and we can make use of that.

Brian Levitt

Now, I've heard that ChatGPT may have been getting dumber. Is that true?

Ashley Oerth

Well, I think that there's a lot of fervor to question what's going on here to try to cast doubt on the capabilities, so maybe look at that with a grain of salt. But so far there have been some studies that have suggested that because some of these models are live models, in other words, they're learning over time, given how people interact with them, that then maybe that's a commentary on society.

Brian Levitt :

Yeah. It's idiocrasy.

Ashley Oerth

… that it’s gotten dumber over time, which go figure on that. But it has been documented that on certain tasks that performance has degraded in certain categories, but in others it's actually improved. So maybe this is a challenge for engineers to figure out how exactly to wrangle how exactly these models we're learning.

Jodi Phillips

Putting it in that context, it's a tool, it's a predictive model, what it actually is versus what people either hope or fear it could be, understanding that, do you feel like the market's become too excited about it in that context? Is the excitement that the market is showing, do you feel like that's appropriate for the potential or how do you view that aspect?

Ashley Oerth

So that's a tricky question for sure. I think that from what I've seen year to date, I'm feeling like the euphoria is there. I try to look at any sort of tech trend or anything that's driving the markets from two perspectives. So on the one hand, how reasonable is the growth that we're pricing in? So what are the earnings estimates of the companies that are pushing up the markets? And then two, what price am I willing to pay for that? So we've got earnings on the one hand and the valuation we're paying for it on the other.

And so from the earnings growth side of things, we have seen companies that are involved in this AI craze be marked up about five percentage points. If we look at some of the mega cap tech names since the release of ChatGPT, which that's not too crazy. So that's five percentage points over the next three years. That's a compound annual growth rate there. So again, seems reasonable. And then on the valuation side of things, if we think of it from the price to earnings perspective, we've really moved up from about 36 times earnings earlier this year to 51 times earnings on a trailing valuation perspective. And then on forward PEs, we've also moved up from around 32 times earnings to 37, which-

Brian Levitt

And that's on the mega cap growth names?

Ashley Oerth

These are the mega cap tech names.

Brian Levitt

The mega cap tech names.

Ashley Oerth

The typical FAANG names that we like to pick on. And so you have to ask yourself, do you believe that earnings growth, and again, if so, are you willing to pay for that? And I think the earnings growth has been marked up, but so is the valuation. So I think that from the sort of perspective, yes, it has moved up in price and I think that it's gotten quite expensive, especially if you look at these names, but it doesn't seem too outlandish.

However, in the context of all of this, we've got rising interest rates, we've got a backdrop that's macroeconomically speaking fairly weak. So at this stage I'm sort of thinking, okay, maybe that's a bit expensive to get it on this trend, but maybe you could say that it's just been priced in.

Brian Levitt

Now I'm old enough to remember the craze around the dot coms and the original launch of the internet. And of course some of those businesses were famously overvalued, and some of them of course did disappear. But yet there was a lot of way to profit and a lot of ways to take advantage from this new platform that was going to connect billions of people around the world and change really how we do everything. So regardless of cyclically whether it's expensive, how do you think about the structural investment opportunities and what type of businesses should investors be watching?

Ashley Oerth

Yeah, so I think that this is always tricky to think of who's going to win, who's going to lose, and over what timeframe. If you go back to the tech bubble days, a lot of the ideas that were at play there eventually did play out. It's just it was a bit ahead of its time, that the rest of …

Brian Levitt

Right. You had to own Amazon eventually, not pets.com.

Ashley Oerth

Yeah, exactly.

Brian Levitt

But I've heard you categorize the types of businesses in this space. I'd love to hear you talk through that.

Ashley Oerth

So the sort of buckets that I put all of these investment implications, if you will, there are sort of three categories of business that I think broadly speaking would benefit from this AI craze. So on the one hand, and I think we've already seen a lot of this, are the enablers. So this is everybody from, if we go to hardware, so the hardware that's used to train these AI models, so if you think semiconductors, those are in the sorts of enablers or picks and shovels approach, if you will. And then we also have those companies that are building the models themselves. These are often, again, the mega cap tech names that really have the development capabilities to make this happen. And also companies that have large treasure troves of data. If data is the new oil in our information economy, then you're well positioned for being somebody who can develop a differentiated AI model.

So those are the enablers that I see behind this whole AI craze. The second bucket would be sort of the adopters. So those are the companies that are able to use these AI models that have been built and integrate them into some kind of part of their business, whether that's their product or how they actually run themselves. Maybe it's internal efficiencies that they can gain. There's a long list of possibilities of how exactly this can be applied and in different sectors. And then on the third bucket, I sort of view this as responders. So AI brings all sorts of new threats that society must address, and we have companies that can also use AI themselves to respond to that. So I think that's a third bucket that can perhaps benefit from this AI trend. So there you have it, you have the enablers, you have your adopters, and then you have your responders.

Jodi Phillips

When you're thinking about those buckets, are there any that you think are, I don't want to say better than others, or just a better position to be in than others? Or are there buckets that you're watching particularly closely to see how either the adoption plays out or the enablement plays out? What are your thoughts in terms of that?

Ashley Oerth

Yeah, so I think that from what I just laid out there, you can sort of view it almost like a timeline. So in this theory I've laid out, the enablers would benefit first, and I think we've already seen a lot of that in the price action so far. Then the adopters would be those companies that are able to actually make use of AI. And I think that we're seeing the beginnings of that, although it's still early stages.

Brian Levitt

And that could be pretty much anyone in any sector or industry. We started this talking about autonomous vehicles or robotics and hospitals, that could go to even some people like us analyzing markets, writing emails.

Ashley Oerth

Absolutely.

Brian Levitt

Yeah. So that's a broad bucket.

Ashley Oerth

That's right. And I think the broad bucket, broadly defined like that, it's done that way for a reason. We have so much that AI can impact that it'd be a mistake, I think, to just focus on one particular sector. I would say though, from studies I've seen on automation and in general, they tend to focus more on the information economy and less on more manual tasks. So perhaps those adopters are those that are less manual labor and more information economy, which is, in the US at least, some a hundred million jobs. So it's a pretty large chunk to sift through.

Brian Levitt

Now, let's go with an FDR (Franklin Delano Roosevelt) quote here, "The only thing we have to fear is fear itself." Is the only thing we have to fear, fear itself? How fearful should we be when... You hear some of these people who have worked in AI over the course of their lives say, look, we got to slow this down. There's big challenges that face humanity here, and you already have the Biden administration speaking with some of the leaders of those mega cap growth companies that you had mentioned to try and put some parameters around this. Do you have concerns?

Ashley Oerth

So I do have concerns, and I think that my concerns are less focused on what people normally talk about, which is this going to replace me? And it's more about what its implications are for society at large. So my biggest fear is really about how AI can be used for malicious purposes. So you've probably heard of things like deep fakes, voice mimicking, image manipulation, automated code generation, and all sorts of threats that are brought on by generative AI.

And there's already been examples of this. We had last year, deep fakes of Ukraine's President Zelenskyy. This year just in May, we had a faked image of an attack on the Pentagon that briefly moved markets on a morning late in May. And these threats are real. I don't think as well that our tools as a society are really evolving fast enough to appreciate and tackle those problems. We're already struggling with how to handle the internet, cryptocurrencies, misinformation, and all sorts of other challenges. And I think these problems will only add to that pressure.

Brian Levitt

And this whole idea that the machines will rise up, is that just science fiction nonsense I joke that I'm not a cyborg from 2029, but I do get questions from investors about the fate of humanity. Are you unwilling to even go there in your mind?

Ashley Oerth

I'm not worried about the fate of humanity. Maybe we could all live in a WALL-E world, maybe the good parts of the WALL-E world, maybe not so much the other side of things, but I think that the risks to what this means for humanity, it's not like we're going to have something that's in control of the nuclear codes or something like that, that we have some kind of tool like HAL that's able to go rogue and cause all kinds of mayhem, rather these tools are really built for a particular purpose. Their abilities are limited to a specific set of functions. It's not like we can just give them free rein over whatever they want to do, right?

Brian Levitt

Right.

Jodi Phillips

So Ashley, tell me, we've talked a lot about the capabilities and what AI is and isn't, but what excites you the most? What are you most looking forward to watching develop as time goes by?

Ashley Oerth

Yeah, I think like we've been talking about, there's a lot that people I think are nervous about, but there's a lot I think to be really excited about. So for example, if we're thinking of generative AI involved in our day-to-day work, this could mean faster summarization of content that we're looking to read but don't have time to get to. It could mean helping us with task prioritization. In essence, we're kind of getting this personal assistant that could be embedded into our work streams that really helps alleviate distractions and enable the kind of knowledge work that our livelihood center around.

There's this author Cal Newport who's really written at length about this idea that he calls deep work. And his argument really is about how in today's knowledge economy focus is a sort of precious commodity, but really what we see happening is evermore notifications and things that are distracting us that pull away from our ability to do real quality knowledge work. So in other words, every interruption costs us, whether it's our phones or an Outlook email or other distraction. And if AI can be integrated into our work streams to help minimize those sorts of distractions and alleviate menial work, take care of those rote tasks and allow us to focus, I think we can all be more productive. So that's what I'm excited about with AI, that it can really make us more productive in our day-to-day jobs and help us grow the economy and ideally our livelihoods.

Jodi Phillips

So Brian, how are you feeling on your own personal fear/excitement scale? This helps?

Brian Levitt

Yeah, of course it helps, and I love listening to Ashley, and like I said in the intro, I'm pushing against my instincts for fear because I really liked your quote. I can't get it exactly right, but I'm either going to be steamrolled into the road on this, or I'm going to get on board and I'm going to get on board, right? I'm going to look for opportunities to best take advantage to make my life and my career more efficient, and I'm going to look for opportunities on how to invest and take advantage of what I think is a strong long-term structural theme.

Jodi Phillips

Yeah. And I might try to write my book a little faster just in case. Ashley, thank you so much for joining us and help putting all this in perspective.

Brian Levitt

Ashley, thank you.

Ashley Oerth

Absolutely. So great to be here. Thanks so much for having me.

 

Important Information

NA3070198

Recorded date: July 26, 2023

Image: d3sign / Getty

Some references are US centric and may not apply to Canada.

The opinions expressed are those of the speakers, are based on current market conditions as of July 26, 2023, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

Should this contain any forward looking statements, understand they are not guarantees of future results. They involve risks, uncertainties, and assumptions. There can be no assurance that actual results will not differ materially from expectations.

All investing involves risk, including the risk of loss.

Discussions of specific companies are for illustrative purposes only and should not be considered buy/sell recommendations.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

Many products and services offered in technology-related industries are subject to rapid obsolescence, which may lower the value of the issuers.

All data sourced to Invesco unless otherwise noted.

Commissions, trailing commissions, management fees and expenses may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the simplified prospectus before investing. Copies are available from Invesco Canada Ltd. The opinions expressed are those of the presenter, are based on current market conditions and are subject to change without notice. 

These opinions may differ from those of other Invesco investment professionals. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although we make such statements based on assumptions that we believe to be reasonable, there can be no assurance that actual results will not differ materially from our expectations.

Invesco is a registered business name of Invesco Canada Ltd.

Invesco® and all associated trademarks are trademarks of Invesco Holding Company Limited, used under license.

© Invesco Canada Ltd., 2023

FDR (Franklin Delano Roosevelt) was an American statesman and politician who served as the 32nd president of the United States from 1933 until his death in 1945.

The US unemployment rate was 3.6% in June 2023 according to the US Bureau of Labor Statistics.

LSAT stands for Law School Admission Test.

GRE stands for Graduate Record Examinations.

Information on tech company earnings and valuations is from Bloomberg, L.P., as of July 25, 2023

P/E stands for price-to-earnings ratio, which measures a stock’s valuation by dividing its share price by its earnings per share. Forward price-to-earnings ratio is calculated by dividing the company’s current share price by its expected earnings, usually for the next 12 months or next full fiscal year.

FAANG is an acronym that stands for Meta (formerly known as Facebook), Amazon, Apple, Netflix, and Alphabet (formerly known as Google).

Brian Levitt:

Hi, I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. And we're talking about the midyear outlook today which means Alessio and Kristina are back. That would be Kristina Hooper, Invesco's Chief Global Market Strategist, and Alessio de Longis, Head of Investments for the Invesco Investment Solutions team. So Brian, welcome to the middle of the year.

Brian Levitt:

That was quick, wasn't it?

Jodi Phillips:

Yeah, all too quick.

Brian Levitt:

I mean the kids are already just about done with school. We've got to slog through the summer, keep working, but the kids seem pretty happy. But I mean fortunately, it wasn't too bad of a winter up here in the northeast. We got through it.

Jodi Phillips:

Yeah. I can't say we had much of a winter on the Gulf Coast either.

Brian Levitt:

Yeah, exactly. Maybe one day I get to live in the south too.

Jodi Phillips:

Well keep in mind, it's supposed to hit 99 degrees here this week, so there's a definite trade-off for that benefit. But what's important here is the temperature of the markets, and I think the first half was a lot like your winter, Brian, milder than most expected, would you say?

Brian Levitt:

Yeah, I think that's true. I mean the way I would categorize it, I've been talking to investors a lot trying to put last year into perspective versus this year. I mean last year was one of those years where things largely got worse relative to expectations, inflation, the amount of policy tightening, you remember all this? Russia going into Ukraine.

Jodi Phillips:

It's ringing some bells, yes.

Brian Levitt:

Yeah. I mean this seems like a year in which things are generally getting a bit better. Inflation's coming down, Fed is likely at or near the end of its tightening cycle, the economy's been resilient and so the market has taken some comfort in that.

Jodi Phillips:

Yeah. And let's not forget that despite all of the last minute drama, the debt ceiling was raised without incident.

Brian Levitt:

That's right.

Jodi Phillips:

So that was a nice way to mark the middle of the year. And before the debt ceiling became such a focus, I mean we were all focused on bank failures over the spring. But here at the midpoint, it feels like policymakers have been able to manage all of this and avoid the types of financial accidents that tend to happen at the end of policy tightening, would you say?

Brian Levitt:

Yeah, at least to this point. And it's funny, it's like how can I forget the things that you just mentioned? It's a reminder that I think investors and we all collectively jump from one issue to the next and we almost forget when that issue is overcome or moves to the background. It's like, "Okay, yeah, we knew that that was going to be fine," but did we? Yeah.

Jodi Phillips:

Been there, done that, on to the next thing.

Brian Levitt:

Right, exactly.

Jodi Phillips:

So how did market leadership change during all of this?

Brian Levitt:

Yeah, I would say the beginning of the year, and I know Alessio will talk to this, had a soft landing feel. It was broad participation in the markets, types of things you would think would do well if the economy was doing well. Lately the market's been driven by a handful of names, which also has some information as well. That's what we call “bad breadth.” So I guess improving economic activity would be the mouthwash to that bad breadth.

Jodi Phillips:

Bad breadth... I don't even know what to do with that. Is that technical humor? What is that?

Brian Levitt:

I think it's dork humor, maybe dork and dad humor combined.

Jodi Phillips:

Oh, that's the best kind of humor. Yeah, for sure. For the sake of our audience, Brian, I'm going to brush past that though.

Brian Levitt:

Oh, I like that. We'll paste over it.

Jodi Phillips:

Yeah. Mom humor is almost as bad as dad humor. But look, all right, we're done, we're done with this. We don't have time.

Brian Levitt:

We don't have time for this.

Jodi Phillips:

Too much to talk about. Let's get to Kristina and Alessio. Welcome.

Kristina Hooper:

Thanks for having us.

Alessio de Longis:

Thanks for having us, Jodi, Brian, always a pleasure being with you.

Brian Levitt:

Do you have any puns about bad breath or should we just get into the questions?

Kristina Hooper:

I've been racking my brain, I've been panicking thinking about what I could come up with that's dental related.

Jodi Phillips:

Don't put them on the spot.

Brian Levitt:

You'll pick your spots.

Jodi Phillips:

So yeah, we all heard us hitting a couple of the highlights and some lowlights of the first half. So Kristina, can you offer us a quick post-mortem from your perspective?

Kristina Hooper:

Sure. It was a very different environment from 2022, which I dubbed the annus horribilis, channeling my inner Queen Elizabeth. What we saw was equity markets around the world, with the exception of one major market, China, making gains. And so this was a fairly positive environment, although of course, bad breadth noted in the US market. One highlight that I don't think has gotten a lot of attention is the Japanese stock market. Japanese stocks have been on a tear. The Nikkei 225 Index closed at its highest level since 1990. It's up well over 20% this year. So a lot is happening and I think some of that certainly is being driven by monetary policy. The BOJ (Bank of Japan) is of course unusual in that it has held out and remained incredibly accommodative.

Brian Levitt:

Also, a reminder that a little bit of inflation in a place like Japan can go a long way, be supportive of nominal growth -

Kristina Hooper:

It's not a bad thing.

Brian Levitt:

- be supportive of profitability. Alessio, have you been surprised by what we would categorize, or I think the media has categorized, as the sustainability of this economy?

Alessio de Longis:

It's been really remarkable. If you think about what we have had in the backdrop, the sharpest most rapid tightening cycle we've ever experienced, and hints of bank failures left, and the resulting tightening credit conditions, the flattest or most inverted yield curve since the 1970s. I mean you go down the checklist of all the red flags ahead of recessions, it's absolutely remarkable how we sit here today with the unemployment rate at all-time lows, not just in the US, also in the eurozone. In the UK, the economy globally has remained remarkably resilient. So it really speaks to how much pent-up demand there was in the system and how tight labor markets were.

So it is certainly a confirmation that the inflation spike that we saw last year was fundamentally justified. It was not just a one-off due to supply chains and inventory cycles, right? The strength of the labor market to this day is a confirmation of how tight the inflationary picture was in 2022. And we're seeing how slowly that inflation is rolling over today because we still have very resilient labor markets. So yes, I do think if you had asked me where we would be today a year ago, I find today's results for the economy much more positive than we would've expected.

Jodi Phillips:

What about the question of recession in the US? And I know Kristina, you've called it the “recession obsession” in a recent column. And look, while you were joking about needing to come up with a dental-related analogy, I do recall one you made about zombie bites, the fact that central bank policy and Fed tightening bit the economy, and everyone was anxiously waiting to see what was going to happen and what the result was going to be of that and if it was going to turn to recession. So what do you think of this situation and what do you expect to see?

Kristina Hooper:

Well it is clearly a very unusual economic environment, a tight labor market. It is both a blessing and a curse because certainly, it has, as Alessio aptly pointed out, created an environment in which inflation is high. I mean that has been a big contributor. But at the same time, it's also the reason why the economy has been so resilient. I think about something that the United Airlines CEO said last week, leisure demand is really, really strong. Business demand hasn't fully recovered yet. We're probably in either a mild recession or moderate economy. I think actually in the US, we're in a business recession and the consumer is just fine, the consumer is strong.

And I think that that quote encapsulates or is emblematic of the unique economic environment that we're in where we have areas of real strength, including the consumer, which is of course a very large part of the economy, but also areas of weakness. And we are still waiting to see all the effects of monetary policy because there is that lag, just like there's a lag between when someone is bitten by a zombie and they turn, there is that significant policy lag between when it is implemented and when it has an effect on the real economy.

Brian Levitt:

That was exactly what I was going to ask. Alessio, you talk about that a lot, the lag, the effects of policy tightening. And one year ago, so 12 months ago, the Fed funds rate I think was 1.00%, right? And so we've had an awful lot of tightening from where we were a year ago, some 425 basis points. So when you talk about the checklists on the path towards recession, I mean doesn't that still give you some cause for concern the amount of tightening that we've had? And should we still expect economic moderation or dare we even say a recession from here in the United States?

Alessio de Longis:

I think when you look historically at the evidence, the lead and lags of monetary policy, of course, we try to simplify them, but they are uncertain and there is a large degree of variation, right? And when you look at historical episodes, anywhere between 12 to 24 months, it's a safe assumption in terms of the lag defect of monetary policy and the impact on the economy. So that meaning we are just entering now the hot zone so to speak.

Brian Levitt:

Right.

Alessio de Longis:

But with that being said, I think our generation has a little bit of an obsession with the recession word because, well, the last two recessions that we had were literally implosions. They were not just recessions, they were financial crises. It was the end of the world, right? 2008, 2020, everything required the bazooka to come in with zero rates, negative rates, quantitative easing and so on and so forth. I think that's what really caused the obsession with the recession. But to Kristina's point, we have done a lot of de-leveraging on the consumer side, which is still 70% of the economy, let's not forget that. A lot of the regulation also on the business side has prevented some of the leverage reverberation through the system that has created those atomic bomb type recessions that we've seen, right?

So is it reasonable to still expect a recession? Yes, absolutely. Does it have to be an obsession that paralyzes us from making investment decisions or remaining fully invested with capital deployed? Absolutely not. I think several asset classes are already priced for those recessions risk to be manageable, so to speak. I don't know if, Brian, that answers your question, but I would say the answer is yes, we are still waiting for a recession, and no, that recession does not have to be an obsession that prevents us from making sound investment decisions.

Brian Levitt:

Not only does it answer my question, it exceeded my expectations in terms of how you were going to answer that question. And as you were talking about it, I was thinking about 1991, which of course we all lived through. I mean I was only in high school, but I remember a recession that in hindsight had some challenges, a bunch of banks failed, but we still got through without significant incident to the broad equity market. So it's an interesting parallel. But what I was also thinking as you were talking, and either one of you can chime in on this, why is the Fed still talking about raising interest rates? I mean we've had so much tightening in such a short period of time, I've been calling them day after day, they don't answer my phone calls. Can we please stop raising interest rates?

Kristina Hooper:

The ghost of Paul Volcker, that incredible fear that this turns into a situation in which inflation becomes very entrenched. I think that is the concern just given that we haven't seen inflation prints like this in so long. Now, logically, we can understand how we got where we are, but I think the Fed is just so concerned that it may repeat the mistakes made many years ago that it would prefer to go full Volcker to a certain extent on this economy.

Jodi Phillips:

So let's timestamp this conversation just a little bit, right? We're recording this right before the June Fed meeting and chances are pretty good, most listeners will end up hearing this maybe after that meeting happens. So when you think about going into the June meeting and then especially into the second half of the year, right? I mean what are you expecting to see? And I know that more recently we've seen maybe some surprises from Bank of Canada and Australia. So what do you think this all adds up to for the second half?

Kristina Hooper:

So if you don't mind, I'll start. Well Jodi, luckily we did a poll on LinkedIn last week. So what our readers are saying is what I agree with, that we will see a pause this week. I believe though that it will be a hawkish pause, that it will come with lot of language that is somewhat scary, the proverbial sword of Damocles will be hanging over markets so that the Fed can try to keep a lid on an easing of financial conditions.

I think what's more important is going to be the Summary of Economic Projections. I want to see what expectations are with the dot plot, not just about the terminal rate, but also when a rate cut or cuts are anticipated because that to me is actually the bigger question facing markets right now.

Brian Levitt:

A skip and a pause. Wasn't that all the rage at the sock hops in the 1950s, wasn't that the dance, a skip and a pause?

Kristina Hooper:

I'll have to watch some more Happy Days episodes and get back to you on that.

Brian Levitt:

Alessio, when you think about these markets, you had talked a lot — and I stole a little bit of your thunder in the intro — about the soft landing market early in the year, and then the bad breadth market that we're dealing with now. What is that telling you about the expectation for the near-term direction of the economy? Thinking tactically, what does that all suggest to you?

Alessio de Longis:

Well I think the market price action always needs to be respected, right? I think in the interpretation of that price action, it does raise a question when the entire year-to-date performance of the market, primarily in the US, this is not true elsewhere, primarily in the US is really driven by 10 names. And these are your typical tech sector, mega-cap, quality names. So everything else being equal, a rally led by these types of “defensive” names, let's call them quality names, does feel a little bit more of a defensive rally than a rally led by the risky cyclical sectors of the economy or names, which much more of a value bent. We can see the laggards are cyclicals everywhere. Emerging markets that have more operating leverage to the global cycle are lagging, small and mid caps are lagging. So I think that begs the question-

Brian Levitt:

Financials.

Alessio de Longis:

Financials, exactly, financials are lagging. With this yield curve inversion, you can understand why, right? How much more risk banks need to take farther out in the curve in order to try to make a positive spread, right? So I think that speaks to, in my mind, a rally that is not indicative of a new cycle, right? Usually the beginning of the cycle is led by cyclicals, is led by value, is led by small caps, but it's a rally nonetheless. My interpretation, I think the risks into the second half of the year are actually tilted towards a bit of a repeat of what we saw in November last year where we wait, we wait, we wait for that something to break, it doesn't break, policy or global monetary policy takes a pause, the markets welcome that, basically inflation slows or inflation decelerates more evidently than the growth is actually breaking, right? So it could give us another round of, call it those three to six months where actually the market does fairly well because market participants simply get tired of waiting for that dreaded recession, right?

So it could be an environment where 2023 goes down as a year where we waited for Godot, it never arrived, and markets delivered healthy high single-digits or low double-digit returns across equities and fixed income. You were mentioning should we be overly tactical in this or are there things that we can do to navigate these type of market conditions? We said it many times in the past, these type of market conditions, if you for example focus on investment grade and collect your five and a half, 6% yields with very low volatility or even high yield, right? With eight, 9% yields, at the moment with very, very low volatility, those are equity-like attractive returns, but with a much better risk profile. And these type of exposures allow you to really wait for the cycle to take a direction.

Jodi Phillips:

So Alessio, of course one of the things that we're seeing right now is investors are doing a lot of their waiting in money markets, right? Money market balances have hit historic highs. And so what are your thoughts on that in terms of people who are maybe waiting with a lot of their cash in money markets and trying to figure out maybe what to do next with that and are just sitting and waiting and trying to figure it out? What would you say to folks who are there right now?

Alessio de Longis:

Well obviously, we haven't seen this type of short-dated yields in 20 years, so the temptation is incredible, right? But at the same time we look at these annualized yields and don't realize that unless they persist for multiple years, you don't really get to collect them. So what I'm saying is there is reinvestment risk, right? So I would say that extending a little bit of duration and increasing a little bit of the credit spread can allow you to actually achieve much higher yields and avoid a little bit of that reinvestment risk. I think it's always a function of the investment horizon. It's a strategy that has worked well for the last six months of course, but at some point that reinvestment risk question comes in.

Brian Levitt:

Should we turn to a conversation on equities?

Kristina Hooper:

Sure.

Alessio de Longis:

Sure.

Brian Levitt:

Kristina, let's start. Last year was a valuation adjustment largely, we've seen earnings moderate, but I don't think they've been as bad similar to the economy as many people thought. Do we still need to go through an environment in which there will be an earnings adjustment and evaluations adjusted enough to warrant what type of earnings decline we may see?

Kristina Hooper:

Well certainly we are going to see deterioration and earnings, but I think it's important to recognize that typically what we see is that at the same time that happens, we're seeing yields go down, and that tends to lead to multiple expansions. So they can be countervailing forces. So if your question is really are we going to retest lows from last year? I think that's very unlikely in this environment. Certainly we could see the stock market at periods of time this year come under pressure, but I do believe that a drop in yields is likely to lead to multiple expansion and that will be a fairly potent force.

Jodi Phillips:

So Alessio, can you give us some of your thoughts too looking at equities in terms of size and style and region too? I mean US versus international or even emerging markets. Where are you paying attention very closely right now and seeing potential opportunity?

Alessio de Longis:

I think in analyzing basically the cyclical risks, which may still be tilted to the downside for what we just discussed versus the what is really at risk more from a structural standpoint, I think there is a compelling case to begin to rotate more and more into international equities. We have discussed the dollar side, dollar valuations, but it's important to remember they don't affect just the currency of the denomination of your investments, expensive dollar valuations will mirror also cheap currency valuations in Japan, in the eurozone and how those cheap currency valuations really boosted the local equity returns. You had mentioned, we know how in the last six to 12 months, Europe surprised to the upside in terms of performance and now we are seeing Japan delivering good outperformance. All these equity markets are very attractive both from a local valuation standpoint and currency valuation.

So I think there is really a case too, after 15 years of US excellence, we know that these regional cycles tend to last about 10 to 15 years. I think that is one important theme that investors can begin to deploy systematically and rebuilding a way for US-based investors, right? Building an exposure that reduces that home country bias towards international markets. And that strategy does not need to be overly focused and obsessed with the next Fed hike, the next inflation print. But it's a strategy that you can begin to deploy methodically and it allows you, by the way, to also diversify not only away from a regional exposure, but diversifies away from that mega cap quality bias that we talked about that is inherent in almost any US equity exposure today.

Brian Levitt:

So should we get to the circadian rhythms portion of the conversation? Kristina, relatively optimistic tone to this conversation, although acknowledging some of the potential risks to the economy, is there anything that you would identify as keeping you up at night?

Kristina Hooper:

So I can't say that anything keeps me up at night because I do believe that if you have a long enough time horizon, you can weather any volatility you experience.

Brian Levitt:

Clearly, I mean look how well we've done since we first learned the words COVID or Coronavirus 19.

Kristina Hooper:

Exactly. What does worry me though, I will say, and this is something I learned living through the global financial crisis, was that there are some who get spooked from the market environment, lock in losses, leave when the stock market is down, sit on the sidelines and don't know exactly when to get back in, miss out on a lot of strong performance. And that certainly happened last fall. I think many were spooked, they got out, they sat on the sidelines, certainly they're getting paid a little more in yield, but I do worry about being able to reenter the market missing out on what has been very strong performance since then. So that's probably my biggest concern for investors. In terms of the macro environment and the pitfalls we might see, of course some are worrying about commercial real estate and I think there are valid concerns there.

But when I look at the space, I think that there are certainly some tailwinds in addition to the headwinds. Return to office policies mean to me that we've already seen the trough in terms of office occupancy. I think it only gets better from here. And of course, commercial real estate is not just office space. There are many other parts of commercial real estate that are doing quite well. So certainly there are concerns also when it comes to commercial real estate loans and when they mature and need to be refinanced, but actually the vast majority of them are coming due later in 2024, '25, '26. We could be in a very different interest rate environment as well as a different environment in terms of credit conditions. So I think that it's premature to become obsessively worried about what could happen in coming years.

Brian Levitt:

Alessio, a similar question for you and I would add onto that. Based on Kristina's comments, do you worry that commercial real estate is a next shoe to drop and do you have concerns about the implications for the regional banks?

Alessio de Longis:

I think the valuations, as always, markets reflect these things well in advance and valuations have adjusted and reflected that. I don't think this is a stage in the cycle where you look at all the office empty buildings and derive now a conclusion that commercial real estate may be in trouble, right? Valuations have been there, have gotten there. I think Kristina raises with her examples of our return to office policies, it brings back the eternal phrase which is “what matters is, are things getting better?”

Brian Levitt:

Better, yeah.

Alessio de Longis:

Is the rate of change improving no matter how poor the starting level of conditions is? So I'm not concerned about commercial real estate at this stage. I think that adjustment has largely taken place. I think where the balance of risks may still be, as we discussed earlier with learning from our mistakes on inflation over the last 18 months or so, where I look at position still being extended from a secular standpoint after 15 years of a bull market is in long duration US equities, right? There's quality names, there's the dominance of growth styles. I think there is still an overhang of exposures there. And if we are still underestimating what the real drivers are of inflation from both a cyclical and a secular standpoint, and if this tightening cycle were to indeed be higher for longer, I think that's where in my mind the positioning could still see some downside, hence diversification into more value, into smaller capitalizations, into other regions.

I think where there's been concentration risk is in the equity markets, in the public equity markets with a growth bias. And I think diversifying those exposures is probably still where the balance of the risks may pay some dividends and some better sleep at night.

Brian Levitt:

So when Jodi and I first came up with the idea for this podcast, we said it should sound like a group of us having a cup of coffee together. And now that we're all going to be back in the office, I hope that we can actually have those cups of coffee together.

Kristina Hooper:

Absolutely.

Jodi Phillips:

Sounds like a plan.

Alessio de Longis:

That's a promise.

Brian Levitt:

Well thank you both so much.

Jodi Phillips:

Thank you so much. Appreciate your time.

 

NA2960999

Important information

Recorded date: June 12, 2022

Some references are U.S. centric and may not apply to Canada.

The opinions expressed are those of the speakers, are based on current market conditions as of June 12, 2023, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

Should this contain any forward looking statements, understand they are not guarantees of future results. They involve risks, uncertainties, and assumptions. There can be no assurance that actual results will not differ materially from expectations.

All investing involves risk, including the risk of loss.

An investment cannot be made directly in an index.

Past performance is not a guarantee of future results.

Diversification and asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns and does not assure a profit or protect against loss.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.

Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.

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© Invesco Canada Ltd., 2023

Data on Nikkei 225 Index performance is from Bloomberg, L.P., as of June 9, 2023. The Nikkei 225 Index is a price-weighted average of 225 top-rated Japanese companies listed in the first section of the Tokyo Stock Exchange.

Information on the federal funds rate is from the Federal Reserve comparing June 2022 versus June 2023. The federal funds rate is the rate at which banks lend balances to each other overnight.

Data on bond yields from Bloomberg L.P. as of May 31, 2023. Investment grade bonds represented by the Bloomberg US Corporate Bond Index, which measures the investment grade, fixed-rate, taxable corporate bond market. High yield bonds represented by the Bloomberg US Corporate High Yield Bond Index, which tracks the performance of below-investment-grade, US-dollar-denominated  corporate bonds publicly issued in the US domestic market. .

The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity.

An inverted yield curve is one in which shorter-term bonds have a higher yield than longer-term bonds of the same credit quality.

A basis point is one hundredth of a percentage point.

Tightening is a monetary policy used by central banks to curb inflation.

Quantitative easing is a monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective.

Duration measures a bond's or fixed income portfolio's price sensitivity to interest rate changes.

Data measuring the impact of consumer spending on the economy is from the US Bureau of Economic Analysis

The US Federal Reserve’s “dot plot” is a chart that the central bank uses to illustrate its outlook for the path of interest rates.

The Summary of Commentary on Current Economic Conditions is a summary of anecdotal information on current economic conditions each Federal Reserve Bank gathers.

A multiple is any ratio that uses the share price of a company along with some specific per-share financial metric to measure value. Generally speaking, the higher the multiple, the more expensive the stock.

Credit spread is the difference in yield between bonds of similar maturity but with different credit quality.

Brian Levitt:

Welcome. I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. We're talking about the debt ceiling today. Jen Flitton is here. Yes, I know. Favourite topic, right? So Jen is Invesco's Head of U.S. Government Affairs, and she's going to shed some light on the negotiations happening in DC and let us know where she thinks this is all heading. And since she's here, we'll also ask for her thoughts on the national political mood and how things might be shaping up for 2024. I know you always like to get a sneak peek into that, Brian.

Brian Levitt:

Feels too soon.

Jodi Phillips:

It feels a little too soon. But in any case, are you ready for another debt ceiling crisis?

Brian Levitt:

I'm ready for it. I feel like I may already be living it, although hopefully we're getting some slightly positive news here. Jodi, life is strange when you're constantly refreshing your screen to see how high the one-month U.S. Treasury yield is going. That's where I am in life right now.

Jodi Phillips:

No, I hear you. If you don't know if you'll be paid the income on it, makes sense to keep an eye on it. So, look, with that question Brian, what are you saying to investors who have that same question?

Brian Levitt:

I'm trying to be optimistic. Look, we've done this 86 times since John Kennedy was president. We usually do it without incident, usually a mere formality. And so I think we'll raise the debt ceiling. I keep coming back to that line about what Churchill was said to have said about Americans.

Jodi Phillips:

We always do the right thing, but only after exhausting all other options. I think I've heard you say that in a podcast or 10.

Brian Levitt:

Exactly. I probably need some new material here, but we keep-

Jodi Phillips:

No, stick with the classics.

Brian Levitt:

We keep repeating over and over, so I keep coming back to it. But another favourite of mine is that market volatility doesn't emerge out of nowhere, it's always the result of policy uncertainty. And so that's what we're looking at here, perhaps.

Jodi Phillips:

Well, we are, but it's a little ironic. Just when we get maybe some clarity or close to clarity on monetary policy, now we get uncertainty about fiscal policy.

Brian Levitt:

And hopefully short-lived. And the good news is we do have a historical parallel to consider. If you remember 2011, you had a very short-lived risk-off trade. And I still think it's ironic — Treasuries rallied. Something's going to potentially default, let's buy the thing that's going to potentially default. So Treasuries rallied and ultimately, it created a buying opportunity for investors in the early stages of a new cycle.

Jodi Phillips:

Very good. Well, on that note, let's bring in Jen to help explain what's going on in the here and now. Welcome, Jen.

Brian Levitt:

Hey, Jen.

Jennifer Flitton:

Hi guys.

Brian Levitt:

Hey Jen, why do we still do this when this is happening?

Jennifer Flitton:

Well, it depends if you're a Republican or a Democrat, what your answer would be to that.

Brian Levitt:

Well, I'm not allowed to answer that question. I'm everything to everyone.

Jodi Phillips:

What about both sides? Let's get both sides.

Jennifer Flitton:

You're right. From the Democratic perspective, they would love to push this off. In fact, some say if they had their way, if they were able to get rid of the filibuster or had the reconciliation process back, they would extend debt ceiling forever, get rid of this congressional authorization of debt ceiling raising. From the Republican perspective, we have a $31.4 trillion debt. So we're looking at austerity arguments from the right for a while now, and I think that this will be used consistently as leverage going forward.

Brian Levitt:

Jodi, I had read that if you take 31.4 trillion dollar bills and stack them, you would get to the planet Uranus.

Jodi Phillips:

Well, that's some trivia that you're not going to find on any other podcast. So Jen, let's talk about the calendar a little bit. Personally, I was surprised when Janet Yellen came out and said June 1st was looking like the X date. I thought with incoming tax receipts, the Treasury had extraordinary measures, I was under the impression that they could buy some time until the fall. So what's behind June 1st, and can we still extend that a little bit?

Jennifer Flitton:

Well, yes, and she did give a caveat when she said June 1st is the X date. She did hedge herself a bit stating that it could be a few weeks, a few days from June 1st. So the real magic number would be June 15th, because if they could get to June 15th, the quarterly tax receipts, then you could extend it probably till the end of July. But it's just not clear. She's going to make another announcement next week.

Brian Levitt:

But we were originally saying September, October, November, right?

Jennifer Flitton:

Well, we always said it could be as early as June. Treasury did warn us.

Brian Levitt:

Maybe I was saying September, October, November.

Jodi Phillips:

Maybe that's why I was so surprised, Brian. I know where I got that from.

Brian Levitt:

I just make it up and sound confident.

Jennifer Flitton:

And we saw on the horizon from some of the analysts, whether it was Goldman or JP, I can't remember, but they were saying some of the tax receipts coming in after April were looking like maybe cap gains were a little too low and that that could affect this X date, and it may have.

Brian Levitt:

What is an extraordinary measure?

Jennifer Flitton:

Basically, once the Treasury Secretary gets to a certain point, she has to extend into extraordinary measures. And because we spend a lot more than we bring in, that usually is in the first quarter of the year where we start to acknowledge the fact that tax receipts and payments aren't going to match up.

Brian Levitt:

And so what does that mean? We're not going to invest money in government pension funds? Are there things that we do that let us push this out a little bit?

Jennifer Flitton:

It's a little gimmickry in the way that Treasury accounts for things, without getting too technical, that allows for them to extend their budget.

Brian Levitt:

And so what do the Republicans want? I obviously used the word austerity, and I remember in 2011 when we went to the brink, correct me if I'm wrong, the Obama administration ultimately conceded to $2- to $3 trillion in spending cuts over a decade. Seemed like some pretty large numbers. Are we talking something similar here?

Jennifer Flitton:

Well, where the Republican stand is on the bill that they were able to pass last month, which was April. And now Democrats are coming to the table and coming up with a different negotiating position. That's what we're seeing. But included in that original House bill, I think it was a cap to 2022 spending and it extended only a 1% increase in discretionary spending until 2033. So that's a 10-year move. That's not going to be acceptable to the White House. So reports are they're coming back with a 2023 cap, but only for two years. I think they'll probably land somewhere in the middle, but closer to the White House's position. But you're right, this is very similar to 2011, and that's what brought on the sequester. And that really comes out through the appropriations process. Because it's a promise into appropriations, how they're going to spend the framework.

Jodi Phillips:

Sequester. That word takes me back a little bit.

Brian Levitt:

Remind me of the sequester. What did that mean?

Jennifer Flitton:

It was a little bit of budget gimmickry, because what ended up happening was a promise of decreased spending, and then the constituencies of federal government spending came in around the appropriations process and they were able to kick some of that sequestration down and basically out of actually happening through the appropriations process. So this is the easy part. You're just setting a framework with these budget caps. Actually doing that comes later, during the appropriations process.

Brian Levitt:

I have a really dumb question, Jodi.

Jodi Phillips:

Go for it.

Brian Levitt:

So let a little bit more than 10 years ago, so this was Obama in 2011, they agreed to the spending cuts over a decade, and yet we just saw $6 trillion of spending in 2020 and 2022 for COVID. So most of that's within the 10-year period. So did we accomplish anything the last time we did this?

Jennifer Flitton:

Well some of the sequestration happened, but a lot of it that was difficult to do didn't happen because there were... Especially when it came to some physician payments, and I was on the Hill at the time, I remember just the health care community coming down and being really concerned with some of the cuts and how that would affect patients and hospitals, et cetera. So some of it happened, some of it didn't. I think what you're looking at with the COVID payments, that was outside of the ordinary budget. It was emergency appropriation money. And so a lot of that is still sitting at Treasury. It's sitting in the coffers of the states. But a lot of it's still sitting at Treasury and that's why it's on the table for this negotiation.

Jodi Phillips:

So looking at the math and the makeup of Congress right now, how many Republicans would need to break party line to raise the debt ceiling? What does that look like? How does that shake out for getting this done?

Jennifer Flitton:

So McCarthy needs a majority of the majority. So he needs at least 120 members, somewhere around there, to vote for whatever he negotiates with the White House. So keep in mind, this last meeting that was announced on Wednesday, or was it Tuesday when they met. They decided that it would just be McCarthy and his team. So Garrett Graves, who is McCarthy's right hand man. McCarthy's team and the Biden team. So Steve Richetti, who has been a longtime advisor, and Shalanda Young, who is the OMB Director, the Office of Management and Budget, and she used to be the staff director of appropriations. She's well liked, she's well respected on both sides of the aisle. So now with these brains in at the table and only them... Because before it was too big, there were too many people at the table. They've really narrowed it down. And so they're negotiating right now and McCarthy is socializing it with a few folks and getting his top people, his top members of Congress, together. They had a table session yesterday to get ready to socialize to a larger segment of the conference.

Brian Levitt:

Jen, what I think in some ways Jodi was getting at there is the last time we did this in 2011, the Democrats had just gotten shellacked in the midterms and I purposely use the word shellac. That was Barack Obama's word, that was not my personal word. Now this time, there was an expectation of a red wave that didn't materialize to the extent that some expected it to. So can I have any confidence in the fact that the Democrats had to figure out how to get 50 or 60 Republicans on board for this in 2011, versus today they need to get five or six. Can that make me more hopeful or is that just being too Pollyanna?

Jennifer Flitton:

Well, I think Democrats, you mean in the House?

Brian Levitt:

Yeah.

Jennifer Flitton:

Hakeem Jeffries, who is the minority leader, the leader of the Democratic Party, he's going to have to bring a number of folks to the table, for the voting actually.

Brian Levitt:

So it's going to be hard to get all of his because of the cuts that are being made. So if Biden plays hardball and they can get all of the Dems, are there five Republicans or no?

Jennifer Flitton:

Oh no, you mean in a discharge petition. Because they have a discharge petition that they put out. But you don't have five or six Republicans who are going to undercut…

Brian Levitt:

They're not going to do it.

Jennifer Flitton:

... right now. No, that's not going to happen.

Brian Levitt:

So even though you needed 50 in 2011 and today you need five or six, it still doesn't matter.

Jennifer Flitton:

Yeah, no. It would be like voting for Hakeem Jeffries as speaker. You're just never going to get this vibe.

Brian Levitt:

It's the end of your political career if you do that.

Jennifer Flitton:

What's going to happen is McCarthy and Biden are going to come to some sort of agreement, and then McCarthy has to go back and sell it to his people. His very right are not going to vote for it. But can you shave off a few of them? Can you get a few of those Freedom Caucus members? And to give cover for others who are going to get hit from their right, that it's not enough. And then you have Jeffries who is going to have to make sure that his moderates and his establishment Democrats are voting for it as well, even though the progressives are going to rail against maybe some of the work requirements that might be included in it. And so they have to be concerned about each of their right and left for length.

Brian Levitt:

I'm singing Schoolhouse Rock in my head right now.

Jodi Phillips:

Just a bill.

Brian Levitt:

Just a bill.

Jodi Phillips:

So what about other methods of getting around this? There's a lot of talk about the 14th amendment, the validity of the public debt shall not be questioned. Does that give cover to just forget about the debt ceiling?

Jennifer Flitton:

Yeah, it would be a constitutional crisis. And so you've seen Secretary Treasury Yellen, pretty much outright rejected. Now, I think there are others within the White House who may be a little more open minded to that or to minting a trillion dollar coin or something. But ultimately that would go into the court system, it would be litigated, and it could really be devastating as far as the process.

Jodi Phillips:

Brian, the trillion dollar coin, I know that was your preferred method of fixing this, right?

Brian Levitt:

Yeah, I was very excited about that. We mint a coin and we make it available to ourselves. Oh yeah. Well, it doesn't sound like we're going to be minting that trillion dollar coin. So Jen, we don't mint the coin, unfortunately. What would it look like if we breach it? I know Jodi and I had joked up front about the one-month T-Bill. People don't want to invest there because they don't know if they're going to be generating any income in that particular month. Is it just the thing, if you own it, you're going to get paid back at some point, you just may have lost income? What does it mean to default on this?

Jennifer Flitton:

And what is a technical default and how can Treasury prioritize payments in order to pay the debt first? And I think that's really the larger question.

Brian Levitt:

Can we do that? Shut down a national park and keep paying the debt?

Jennifer Flitton:

I don't think we're going to save too much there, but we could potentially.

Brian Levitt:

Don't pay the prosecutors? What are we doing?

Jennifer Flitton:

Think of infrastructure or military infrastructure where 13% of our budget goes. Defense projects, et cetera.

Brian Levitt:

So it's not rangers at the park.

Jennifer Flitton:

That's not really our money maker. That could happen in some sort of prioritization. So you get the Social Security checks, you get the veterans checks, and you get the debt paid for. And really think about it this way, say June 1st is the true X date. You have two weeks you really need to account for in the prioritization. Now, what would actually happen to the credit rating in the United States if we get past the X date? That's a much larger question. What do the markets do? But technically, we know the New York Fed's been running tabletop exercises on this sort of thing happening for the last decade. So there is a way to buy time, at least it's been suggested in reports, that there is a way to write buy time through prioritization.

Brian Levitt:

And thus far, the markets have been pretty sanguine about this, at least it seems

Jennifer Flitton:

It seems, right?

Brian Levitt:

It seems. We haven't had a big drawdown, little range bound on broader markets, S&P 500 type of thing, but nothing extreme. So the most likely outcome, Jen, you still believe that we get past this without significant incident?

Jennifer Flitton:

I think we either go right up to the X date with some deal, or maybe just go a little bit past it. And I think the framework of the deal is going to be budget caps of some sort. It's going to be COVID funding rescissions, it's going to be energy permitting reform, and some degree of work requirements around TANF, definitely not Medicaid, possibly around food stamps, the SNAP program.

Jodi Phillips:

So Jen, while we have you here, let's talk about legislation. Are there any big topics that investors in particular need to be focused on?

Jennifer Flitton:

Well, again, going back to this legislation, this is probably one of the biggest that we're going to see happen. And then the next big move will have to be appropriations. Then we can get back on this podcast and talk about a potential government shutdown.

Brian Levitt:

Wait, will the national parks be open?

Jennifer Flitton:

Now that actually might close the national parks. But so that you give some runway then to the appropriations process can really begin, because they've had a hard time doing budget resolutions on either side of either chamber because this looming debt ceiling is so large and it's just sucked all the oxygen out of the room and taken a lot of the folks who are needing to draft on appropriations into this negotiation.

Brian Levitt:

So Jen, we're going to ask about 2024. I'm not even ready to start thinking or talking about 2024, but the people want to know what you're thinking. Are we running it back again? The fans want to know, are we running it back again? Is it Biden v. Trump? Who's going to win?

Jennifer Flitton:

Right now, Biden has said he is running and he's the president of the United States, and Bobby Kennedy Jr. is what? Running at 20%. Although that is rather high in some-

Brian Levitt:

Is he at 20%?

Jennifer Flitton:

He's 19%, 20% on some polls.

Brian Levitt:

Wow. Talk about name recognition, huh?

Jennifer Flitton:

Well look, President Biden obviously has some issues in his favourability, and the fact that Kennedy is running against him, and I think Marianne Williamson threw her hat back in the ring too, although I don't think she's polling. That's going to cause a bit of a headache for the Democrats, because that's a little too high in the polling. And we'll see if that's adjusted as we get closer to the general. But in the primary for Republicans, you have a lot of folks throwing in their ring.

There are going to be a number of people around the Memorial Day period that are going to formalize their run, like Tim Scott's expected to announce, for example, on the 22nd on Monday in Charleston. He just launched his exploratory committee. Some of these guys have just launched exploratory committees and are now going to officially get in the race. But of those currently in the race, you have Nikki Haley and Asa Hutchinson, and DeSantis has not announced yet, but he will. And it's going to be a very wide field. You're going to start to see the debates then around the August, September period for Republicans, and that's really going to feel like the kickoff for the American people who aren't paying attention quite yet.

Brian Levitt:

The big stage with a lot of podiums again.

Jennifer Flitton:

Exactly.

Brian Levitt:

And that probably favours the former president?

Jennifer Flitton:

I think the more Republicans in the primary, the better for former President Trump. How many stay in, I think is the larger question.

Brian Levitt:

And does it feel like a change election, 2024, or too soon to say?

Jennifer Flitton:

Too soon to say. I think we have to allow the process to play out a little bit to see where these numbers start to fall.

Brian Levitt:

And you had made an interesting point about where Hillary Clinton was polling in the 2008 primary before, just to put a finer point on how early it is.

Jennifer Flitton:

That young first-term-

Brian Levitt:

Junior senator.

Jennifer Flitton:

... Democratic junior senator from Illinois, Barack Obama, had the gall to go up against Senator Hillary Clinton. And she was polling much higher than he was. And I think that's why you have to take some of this and step back and realize that we're going to have... Americans really just aren't paying attention yet.

Jodi Phillips:

All right. Well, what I'm getting, the is let the process run its course, whether it's the debt ceiling or elections. So Brian, are you feeling any better than you were at the top of the show about that process?

Brian Levitt:

Yeah, I feel good. Yes, I'm one of those people who believes in the Churchill line. Ultimately, we will do the right thing, we will get past this, and we'll be back to focusing on what's most important for investors, which is where are we with regards to monetary policy? Is a new cycle starting to play out? And I'm looking forward to getting back to that focus, but I'm thrilled that we were able to have Jen here as we're dealing with these current challenges.

Jodi Phillips:

Yes, thank you for joining us, and hopefully we won't have to have you back to talk about a shutdown, but would love to talk about anything else that's going on. So thank you.

Jennifer Flitton:

Thanks.

Brian Levitt:

Bye Jen. Thank you.

 

NA2914219

Important information

Recorded date: May 18, 2022

Some references are U.S. centric and may not apply to Canada.

All figures are in U.S. dollars.

The opinions expressed are those of the speakers, are based on current market conditions as of May 18, 2023, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. Invesco is not affiliated with any of the companies or individuals mentioned herein.

Past performance is not a guarantee of future results.

Diversification does not guarantee a profit or eliminate the risk of loss.

All investing involves risk including risk of loss.

Commissions, trailing commissions, management fees and expenses may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the simplified prospectus before investing. Copies are available from Invesco Canada Ltd. The opinions expressed are those of the presenter, are based on current market conditions and are subject to change without notice. 

These opinions may differ from those of other Invesco investment professionals.

Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although we make such statements based on assumptions that we believe to be reasonable, there can be no assurance that actual results will not differ materially from our expectations.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions. The information and opinions expressed do not constitute investment advice or recommendation, or an offer to buy or sell any individual security

Invesco is a registered business name of Invesco Canada Ltd.

Invesco® and all associated trademarks are trademarks of Invesco Holding Company Limited, used under license.

© Invesco Canada Ltd., 2023

Number of debt ceiling increases from the U.S. Treasury as of December 31, 2022.

Information about Treasuries rallying in 2011 is from Bloomberg. U.S. Treasuries rose 6.7% from July 2011 to September 2011.

All data provided by Invesco unless otherwise noted.

TANF stands for Temporary Assistance for Needy Families.

SNAP stands for Supplemental Nutrition Assistance Program.

 

 

 

Brian Levitt:

I’m Brian Levitt. Before we launch into our latest conversation about commercial real estate, I wanted to note that this conversation took place shortly before the failure of First Republic Bank, as well as before some of the other challenges that have emerged within the regional banking system. So as we talk about the lending landscape, you’re not going to hear their name mentioned. But that’s OK. What’s most important about this conversation are the long-term opportunities that our real estate experts see ahead. And that’s just as true today as it was when we first recorded this in mid-April.

INTRO MUSIC

Brian Levitt:

I'm your host, Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. Bert Crouch is on the show today. Bert is head of North America and a portfolio manager with Invesco Real Estate. We're getting a lot of questions, Brian, about commercial real estate. So Bert will be addressing those and discussing why he believes some of these concerns may create opportunities.

Brian Levitt:

Ooh, very on par with the branding of the podcast, right?

Jodi Phillips:

I listen. Yeah.

Brian Levitt:

Would you say that we're going to put concerns into context and opportunities into focus?

Jodi Phillips:

I would. I would say that for sure. But hey, before we get to Bert, I do want to add that I did enjoy your conversation last time about Silicon Valley Bank with Justin Livengood. I got to experience that as a listener instead of a host this time. Terrible timing for my kids' spring break to coincide with such big news.

Brian Levitt:

It's funny you said that. I was talking to Bert a few minutes before starting this and he said the exact same thing. It's got to be Murphy's Law for both of you. You finally get away a little bit, and we get this little financial crisis that we have to deal with.

Jodi Phillips:

A “little crisis.”

Brian Levitt:

A little crisis.

Jodi Phillips:

Yeah. That sounds like an oxymoron, Brian, like “organized chaos.”

Brian Levitt:

What's your favorite oxymoron? I'm going to go with, maybe I'm going to go with “accurate estimate.”

Jodi Phillips:

I like that one. I mean, look, “jumbo shrimp” is a classic menu-oriented oxymoron.

Brian Levitt:

“Awfully good.”

Jodi Phillips:

Awfully good. I like that one, too.

Brian Levitt:

Awfully good.

Jodi Phillips:

All right. But little crisis is where we're at.

Brian Levitt:

Little crisis. Yeah. I mean, it might sound like an oxymoron, but it's accurate and it could have become a bigger crisis had we not seen policymakers respond quickly. So, we learned in fairly short order that depositors will be protected, the Fed opened the discount window widely to any bank that needed emergency liquidity. And I would say it also hasn't hurt that the bond market at least primarily has rallied recently.

Jodi Phillips:

Yeah, not at all. No. It does feel like things have calmed down. And as you were telling me before, the deposit flight from the small banks seems to have ended.

Brian Levitt:

Yeah, it looks like deposits have bottomed, they're climbing again. So that's a good sign. Maybe it's a little bit of confirmation bias on my part, but that feels like a good sign. And I don't know. I mean, probably a lot of that's just from you, Jodi, right? You got your bonus in February and you put it in a small bank, and that's why deposits are up so much?

Jodi Phillips:

“Podcast bonus.” Yeah. Is that one for the oxymoron list? Oh, nevermind. Nevermind.

Brian Levitt:

We need a few million more listeners.

Jodi Phillips:

So look, now everyone is focused on what's next and how does commercial real estate fit in. So we've all seen the headlines. Some say commercial real estate may be the next shoe to drop from this little crisis.

Brian Levitt:

And I don't think we can disentangle the interest rate environment, the challenges at regional banks, the challenges for the economy from the real estate market. Obviously, it's all connected.

Jodi Phillips:

And that's why Bert's here. So let's bring him on to address the current environment and how he's navigating it. Plus we'll ask about the structural themes that he believes are intact and likely to offer opportunities to investors.

Brian Levitt:

Bert, welcome to the show.

Bert Crouch:

Yeah, thanks for having me, guys. Appreciate it. And I've got to go with “cautiously optimistic.”

Brian Levitt:

Ooh, I like that one.

Jodi Phillips:

Ooh, nice, nice.

Bert Crouch:

That's a real estate oxymoron, if you'll work with me there.

Brian Levitt:

And you hear it a lot, right?

Bert Crouch:

All the time.

Brian Levitt:

Cautiously optimistic. Just me, that's like Harry Truman's one-handed economist, right?

Bert Crouch:

Well played. Yes, exactly.

Brian Levitt:

So, first condolences on Spring break. My apologies that you didn't get as much time off as you probably deserved.

Bert Crouch:

It's all good. I think my kids were thrilled.

Brian Levitt:

Your kids were thrilled that you were working and they were-

Bert Crouch:

Correct.

Brian Levitt:

... were enjoying some leisure time?

Bert Crouch:

That's right. That's right.

Brian Levitt:

Good, good. It's hard to open a newspaper, I don't know, do people still open newspapers? Or maybe swipe on the phone now without finding warnings about commercial real estate, which is probably why you were working on spring break. So I'm just going to tick off a couple of these things that I think investors are hearing, and maybe we can take them one by one. So, just a couple of problems I'm hearing: the challenges in the regional banks, this whole work from home phenomenon, retail at a crossroads, higher rates, a wall of maturity on commercial real estate loans.

So let's start with the regional banks. Why was Silicon Valley banks such an issue and why did you have to work on Spring Break as a result of it?

Bert Crouch:

Yeah, it is a good question, and that was a tough intro. I think I need a cocktail for this morning.

Brian Levitt:

There'll be cocktails. There'll be cocktails.

Bert Crouch:

For the morning podcast.

Brian Levitt:

It's coming.

Bert Crouch:

But joking aside, I do get a lot of questions on SVB, Silicon Valley Bank, and why was it so relevant to commercial real estate? When you look at their balance sheet, it was irrelevant. I mean, it was of their total loan books sub 4%, total assets sub 2%. So why did it matter? And it mattered for a couple of reasons. I think most importantly, liquidity was already at a premium in commercial real estate. When you think about just year over year, it's Tale of Two Cities, and you touched on a lot of the aspects out of the gate. But I mean, a year ago, Fed funds was essentially zero.

Brian Levitt:

Zero, yeah.

Bert Crouch:

SOFR, Secured Overnight Funding Rate was essentially zero. So you could borrow in commercial real estate at 2%. You had capital markets were humming, Commercial Mortgage Backed Securities, CMBS, CLOs, Collateralized Loan Obligations, wide open.

So you had capital flowing excess M2 coming off the stimulus out of COVID, and the regional banks were playing a huge role in that. So when you think about banks, generally, I like to break it up a little bit simpler because we debate regional and super-regional, money center, bulge bracket. Think about it this way, just on assets, zero to $10 billion, small. $10 billion to $250 billion, the mid-size. And then $250 billion up, whatever you want to call it, bulge bracket. And then you've got the G-SIBs, the systemically important banks at the top tier.

When you think about the regional, let's call it the mid-size, so $10 billion to $250 billion. Why SVB mattered is because Signature failed right after. And Signature failed on a Sunday and Signature was very much overweight commercial real estate, especially here in the New York City metro area. And it created a couple of things. It changed the mindset of bankers generally, which was one of the last bastions of liquidity. If you look at CMBS already being down really to a two-decade low in the first quarter.

Brian Levitt:

And that's because of the interest rate move?

Bert Crouch:

Interest rate move, but also just broader capital markets dislocation. I mean it's down over 80%. Basically nothing got securitized. And we can hit on that again later to the extent of interest. But going back to the regional banks, last year, so 2022, they were over 40% of market share. They've grown — their total loan book has grown over the last decade from just under 20% to just under 30%. They did, I think it was $1.3 trillion of origination last year. So, they have been loading up on commercial real estate because they've had excess deposits and the excess deposits, excess liquidity coming out of the Fed stimulus, M2's gone through the roof, where to house it? Back to SVB. Why is that relevant? Social media and technology. We saw a bank run in 24 hours. $42 billion on Thursday, a hundred billion teed up for Friday, and then Signature is failing on a Sunday?

Brian Levitt:

And nobody even had to line up.

Bert Crouch:

No one. I mean, it happened so quickly. It has forced "bankers", their credit teams, to reassess how sticky really are deposits. And you mentioned, they've stabilized a little bit, but some headlines this morning, whether it was M&T or State Street, I mean just everyone is focused on deposits and are they sticky? The better question is, will you now lend them out at the same velocity that you would before if they can be pulled back so quickly?

Now go to your interest rate comment. What was SVB's issue? They had hold-to-maturity assets in fixed income, and when they had to liquidate those to stem the deposit withdrawal, you realize they weren't worth what they showed. Why? Because of simple convexity, right? It's Finance 101.

Brian Levitt:

Convexity?

Bert Crouch:

Right? This is me-

Brian Levitt:

That's like Finance 401, isn't it?

Bert Crouch:

This is me trying to act intelligent. I'm just a dumb real estate guy at the end of the day, you and I both know it. Let's just be honest. But when you look at that, it exposed it. So it changed, it furthered... If you think about inflation and what happened in the wildly unfortunate situation with Ukraine, it really just exaggerated a trend that was already moving forward. And I'd argue somewhat similarly here, an exogenous circumstance like SVB and then ultimately Signature took a dislocation just to the next level.

Brian Levitt:

So Jodi, are we going to need a “It's a Wonderful Life” for the new digital environment that we went through? I could already start casting it in my mind.

Jodi Phillips:

Well, while you do that, I'm going to ask Bert, as we mentioned in the intro, of course, some say commercial real estate's the next shoe to drop from all of this banking turmoil and banking crisis. So how would you respond to that statement?

Bert Crouch:

Yeah, again, Brian kind of hit on it out of the gate. A lot of sensationalist headlines right now we've got to be careful about. So the next shoe to drop, euphemisms aside, I mean there's clearly some headwinds there. You read about the wall of maturities, $900 billion maturing over the next two years. Good news is relative to the global financial crisis, leverage is lower. It was more prudently done. So if you look at the fixed rate universe and CMBS, Commercial Mortgage Backed Securities, loan-to-values — global financial crisis started in the mid to high sixties. Now they're sub 60, at least going in. Debt service coverage ratios were higher. Now, base rates were lower, and that's changing now, but your starting point is better. Leverage was less utilized, it was more prudent, and CMBS is a smaller part of it. So, I think that's the positive news.

The negative news is all the things, again, Brian, you just touched on, and Jodi you as well, you got SOFR at almost 5%. You got spreads up. So if you financed an apartment asset a year ago that was going to be done at low 2%, that's now somewhere high sixes to maybe as high as 8%. So you've seen that fly up. And what does that mean? Even for good assets, there could be challenges on the refinance front. Does that mean widespread distress post-Lehman? I'd argue no. But does it mean that we're facing some real headwinds from a, if you go back to the comments we were just making, regional banks are going to want to decrease exposure to commercial real estate.

The regulators are all over them. You read about it over the last week and a half, Dodd-Frank rollbacks, they want to refocus on the sub $250 billion asset banks. Uncertainty around is there a recession coming or not? I don't know. But a chief credit officer is worried about that. They're pulling back, CMBS nonexistent, rates up. It just creates a tricky picture that candidly, Jodi, we feel like is going to create some real opportunity.

Brian Levitt:

Bert, let's take a giant step back for a second and talk about the mechanics of this. So the regional banks are lending money over a set period of time at a certain interest rate to who? And what's coming due for them and at what rate versus where they were not so long ago?

Bert Crouch:

Yeah, good question. So when you think about regional banks, usually they're floating rate. So your life insurance and commercial mortgage-backed securities are going to be your five- to 10-year fixed rate.  Your regional, and really all banks mid-size, large to small are going to be usually three-year initial term, two-year, one-year extension options, all floating rate. Why that matters is most of them required you to buy some sort of interest rate hedge. Layperson's terms, what does that mean? It means the interest rate could only go up so high before your hedge kicked into place. In large part, that's the case now. Think about what the Fed's done. They've taken rates up almost 500 basis points in around 12 months. That is twice the average on a monthly basis. So the last nine rate hike cycles, it's been sub 20 basis points a month. This is 40. People have to put that in context. It's not just the absolute amount, it's the time in which they've done it.

Punchline for real estate and your question, when those hedges expire, suddenly they're exposed to significantly higher debt service costs. And that creates that decision point. Do I continue to feed this asset? What does it look like on a refinance? How much capital do I have to inject to right size that loan? And that's going to create that stress in the system. And again, as I just alluded to Jodi, we think some real opportunity here.

Jodi Phillips:

All right, Brian, so do we pivot to the putting opportunities into focus section of the podcast?

Brian Levitt:

Yeah, I mean, why do we want to focus on the negative for so long? I mean we've laid it out. Bert understands it. He's got his hand on the tiller of this portfolio, and let's think about how we take advantage-

Jodi Phillips:

All right. Yes.

Brian Levitt:

... of all this negative sentiment in the asset class.

Jodi Phillips:

All right, let's go then. So, Bert, are there any dislocations emerging that you're viewing as opportunities at the moment?

Bert Crouch:

Yeah, of course. So, in the old Winston Churchill, “you never want to waste a good crisis.” And that's kind of how we're viewing this. You don't want to exploit the market. You want to take advantage of it. And so our job as a global real estate investment manager, people ask us all about what differentiates Invesco Real Estate and how does that translate to opportunity today? 21 offices, 16 countries, truly global. We play across a risk-return spectrum: core equity to high-returning equity, and then across the capital structure, equity to credit, and then also listed real assets to private. And so today you've got to play all aspects of that, and that's the key.

So you asked me about the banks earlier? I referenced the wall of maturities that you read a lot about, banks, specifically $550 billion over the next two years-ish. There's going to need to be gap financing that's going to need to be injected there.

So we've been pivoting a lot of our strategies where historically we'd say, why wouldn't we buy that asset? Today, the question is why wouldn't we lend on it? It's just a better inherent opportunity. So if you're a seller and you don't like today's pricing, so the cap rate on an industrial asset, well leased, you like, has gone up a hundred plus basis points. So values down 15% to 20%. You say, "I'm not a seller, but I've got to pay down my loan to extend or refinance." We're a great preferred equity investor there.

And you answer the question that everybody wants to ask, where are values today? You say, "I don't care because I've got a significant cushion to the last dollar value here and my return is more current than upside." The other way to play that is just be a lender. That's what we've done. We've originated over $4 billion annually the last two years, just filling the void, whether it's CMBS or now going to be the regional banks.

So what we're really leaning into today in the private side is some aspect of credit. We expect there to be consolidation in the banking industry. You're already starting to see that on the regional banks. We expect to see more of it, and/or they're going to start to move some of these scratch-and-dent legacy portfolios to take — if the regional bank has, whatever, 20% to 30% of their asset base, and they probably want to take that down, whether it's five points or cut it in half, they're going to want to move some of the best product. We can be a great buyer of that on a moderately levered basis. So, you can kind of play the credit dislocation three or four different ways.

Brian Levitt:

Now, are there parts of the market that you're looking to avoid versus parts of the market that you're diving into when you hear about things like work from home, or retail at a crossroads, or demographics, people are going to need different types of living facilities. Are you leaning into and out of some of those different structural stories that are taking place?

Bert Crouch:

Yeah, absolutely. So, when you think about commercial real estate at UC, it was kind of the big four. Think about the old accounting. It was office, industrial, multi and retail, and now it’s not. We’ve redefined our index to really have nine different sectors.

Brian Levitt:

Nine? Nine times.

Bert Crouch:

So, if you think about it-

Nine times, I’d say it’s a great... Oh, we named our dog. We got a dog in the middle of Covid, named him Ferris.

Brian Levitt:

Love it.

Bert Crouch:

But back on point. So when we think about the different sectors, instead of looking at it as apartments, we call it residential. Single family rental is an area that we’re leaning into hard. If you think about today, affordability prices are still high, but mortgage rates are an all-time high. We’ve seen new supply pull back and the regional mom and pop investor that needed that accretive leverage to invest is gone. So competition, down; market opportunity, better; and pricing more attractive. So we’re seeing some entry points like that where we’re leaning in more.

I’d say there’s also an inelastic story, so take medical office, some of your questions. Life science, the 75 and over demographic is expected to increase almost 50% in the next 10 years. That’s huge. We want to take advantage of that. That demand driver, again, whether it’s life science on the R&D (research and development) side, or whether it’s MOB (medical office buildings) around a hospital, that has been shockingly resilient, very attractive, and very financeable. Flip it on the other side, to answer your question. Retail is misunderstood. Neighborhood and community retail today, vacancy is sub 7%.

Brian Levitt:

It is?

Bert Crouch:

Yeah. It’s better than it was pre-COVID.

Brian Levitt:

Is that right?

Bert Crouch:

Yeah. Why? Because new supply didn’t hit. It’s been pulled back. Footprints have been right-sized. Now there’s still some struggles in power centers at times, but on the whole, it’s better than it was. Regional malls, a little bit of a different story. But if you look at, just take apartments and regional malls in the public universe, multi-family’s down, call it 30% just because it got so highly valued where regional malls had already gotten hammered. So it’s only down 9% year over year. So there’s been some anomalies there. Office is the tough one.

Brian Levitt:

Before we get to office, I want to talk a little bit about the retail. You’ve seen sort of a changing face of it, where it’s more experiences rather than necessarily going to buy a shirt that you could just get on the internet. I mean, I’m seeing it’s a Starbucks, it’s a Pliable, it’s a Dave and Busters, it’s these types of places, right?

Bert Crouch:

Yeah. Look, it’s the omnichannel experience. You know, want to have enough in the store to attract. I mean, in the experiential mindset, you got to get people open air, foot traffic where they can do more than just shop. And that’s what people want to do. Whether it’s safety, whether it’s fun, whether it’s actually shopping, usually it’s a combination of those things. It’s gotten much more creative. But at the end of the day, those that are most successful have the online presence, but have the brick and mortar presence.

Brian Levitt:

Jodi, you got one of those strip malls by your house that you dropped the kids off and you don’t see them for hours?

Jodi Phillips:

Yeah, no, I was about to say I have two teenage boys. And somehow they manage to spend so much money at the mall and never come home with a shopping bag. What did you do with that money, right? They’re eating, they’re playing. It’s a virtual reality center and shooting zombies. They don’t bring home anything.

Brian Levitt:

And those pretzels are usually pretty good.

Jodi Phillips:

They’re not bad.

Brian Levitt:

Yeah, those pretzels with the cheese sauce? That’s really good.

Jodi Phillips:

Good stuff. Well worth the money.

Brian Levitt:

I want to hear about the work from home. I mean, I’m enjoying the flexibility, but I want to know, two of us are sitting here in the office. Actually, our whole multimedia team is here as well. And Jodi, you're home today. So, how's that working? Are you productive? Are you making it work through the phone?

Jodi Phillips:

You can hear me. I can hear you.

Brian Levitt:

Oh yeah.

Jodi Phillips:

We're making a podcast, it's seamless.

Brian Levitt:

Yeah. So where are we going with this, Bert?

Bert Crouch:

Everyone starts with the Kastle data. So Kastle with a K, does card swipes. We come in and out of the office and they have a very statistically significant sample set of who's returning to the office and when. Two or three trends I'd highlight, one, we've all been kind of waiting for some sort of normalization. We're starting to see it. Nationwide, we're around 50% that are actually coming into the office and it's stabilizing like that, which is well below pre-pandemic. And we're seeing that, Brian, very coastally focused, meaning it's very different. San Jose, California, generally in the mid-thirties, Texas up to mid-sixties, New York, somewhere in between. But very challenged.

Now, it always takes a good recession, a good scare, market dislocation volatility, and people want to come back to the office. Not to mention a lot of our younger cohort on the investment professional fund have not seen a downturn in their careers. So we're feeling that's driving people back. We saw Jamie Dimon put out MDs (managing directors) have to be in five days a week to show certainty, to tutor, to mentor their younger people. So we are seeing a positive trend there. But where they're going - very bifurcated. If you look at office space built between 2017 and 2020, that's 200,000 square feet or more, so large institutional space, that's new. New means it's well-amenitized, it's got great light, it's got everything -

Brian Levitt:

Ping pong tables?

Bert Crouch:

Ping pong tables, got your beer tap. Nothing that any Invesco offices have anyway.

Brian Levitt:

Maybe a coffee, a coffee cold brew. Not the cold brew you may want.

Bert Crouch:

Yeah, we got one of those new flavored water dispensers.

Brian Levitt:

I like that.

Bert Crouch:

That's the new, right, folks?

Brian Levitt:

Right. You save the bottles.

Bert Crouch:

But the punchline there is occupancy is way up or said the inverse, may be vacancy is sub 10%. If you go to that 2016 older cohort, it's over 20%. So that obsolescence is a huge debate. And right now capital flows, whether it's equity or credit, it's just not there. So, it's really pushed values down. If you look at the public REIT (real estate investment trust) space down over 50%, trading at an almost 60% discount to the net asset value, historically high cap rates approaching 10%. So, you look at the fundamentals, very “Tale of Two Cities.” And from a valuation standpoint, at least what the public market's telling you, pretty tough.

Brian Levitt:

Are you trying to avoid that part of the market?

Bert Crouch:

You know, you are. With the outlook there, you just want to be careful. Now again, we have office holdings that we fundamentally believe in. You just have to position yourself to get through this. And I go back to your question on retail. Retail went through a similar period. You had winners and losers. We very much believe the same to be true here. But in this broader capital markets environment, what you truly believe in, you need to hold and live to fight another day.

Brian Levitt:

Okay, so we talked about experiential retail, we talked about life science, we talked about being very specific with regards to office space. We talked about tech centers, apartment rentals. What else? Anything else that we missed that gets you excited?

Bert Crouch:

Well, industrial.

Brian Levitt:

Industrial?

Bert Crouch:

Yeah, industrial. Yeah, a hundred percent. The e-commerce trend continues. The biggest change over the last 6, 9, 12 months is Amazon. Amazon drove the market and they've really pulled back. Pulled back on capital investment, pulled back on new leasing, net absorption. So that's something that needless to say, everyone in the market is very aware of. That said, demand continues to be strong. Now the second derivative, it's tailing off the rental demand, the net absorption is starting to slow, which you would expect to see. But overall, the sector's one that we believe in long term.

Brian Levitt:

Second derivative and convexity in the same podcast.

Jodi Phillips:

Yes. Yeah.

Bert Crouch:

Hey, I named my dog Ferris man, come on. I'm just trying to provide some balance here.

Jodi Phillips:

Balance. You balance it out.

Brian Levitt:

You remember that book?

Bert Crouch:

Yeah, “You Can't Fix Stupid.”

Brian Levitt:

You remember that book? Clearly not fixing stupid here. You remember that book, “All I Needed To Know in Life, I Learned In Kindergarten?” I think we're going to change it to All I Needed To Know in Life, I Learned in Calculus Class. Now the second derivative, the change in the rate of change.

Bert Crouch:

I have no idea what that means.

Brian Levitt:

Amazon, why is Amazon pulling back? Is that just, they overbuilt?

Bert Crouch:

Yeah, I mean they were the largest and when they say built, majority of that was done third-party. So someone built it for them and then they leased it. But yes, extremely aggressive over the last three years as they should have been coming out of COVID. And a lot of COVID stories, they pulled demand forward five years. So, what they would've done in a five, maybe even a 10-year period, they did in a three-year period. So, I look at it, they’re just being smart, hitting the pause button a little bit, reassessing the efficiencies where they want to focus their capital allocation. And I would expect them to expand again at some point in the near future.

Brian Levitt:

I wish they would stop sending one box at a time. Can we just group these things together and be a little bit more efficient, A little bit greener?

Bert Crouch:

My 15-year-old daughter would beg to differ with that statement.

Brian Levitt:

Yeah, I’m sure she would. I’m sure she would. So Jodi, now do you want to ask your famous question?

Jodi Phillips:

Yeah. Well, I don't know how famous it is, but I think it's important. What did we miss, Bert? What should we have asked you that we didn't?

Bert Crouch:

I think we covered the bases fairly well. The environment right now is challenging in a good way. The dislocation, it breeds opportunity here. We're really leaning in, as I said to start, and I'll say again to finish. From a private credit standpoint, just seeing a lot of opportunity in the three areas that I touched on, whether that's non-bank origination, gap financing or what we're expecting to see in some secondary scratch and dent, maybe even some distress in the second half of the year. But if you can be convicted today and reallocate dollars, it's something that we think from a current income and portfolio fit, too.

Jodi, correlations have really gotten uncorrelated, meaning, and I'm kind of saying that in a double negative, stocks, bonds, gold, crypto, it's moving very similarly in a correlation that has defied historical norms. And one of the things that we've really liked as we talked to clients about portfolio fit, efficient frontier, how does private credit, how does real estate credit fit into that? Whether it's Sharpe ratio, looking at risk relative to return, whether it's correlation, how does it play into my real estate equity? How does it play into my stock positions? Historically, it's fared incredibly well as a complement to a broader portfolio. So maybe that's a good tag along. It's not just the opportunity set, it's not just the total return. It's not just the relative return, but it's also portfolio fit.

Brian Levitt:

So Jodi, we've got jumbo shrimp, we got challenging in a good way. We got correlated in an uncorrelated way.

Bert Crouch:

I'm just trying to stay on theme, on point.

Jodi Phillips:

We've got jumbo shrimp to convexity. I don't know how we covered so much ground in this short amount of time.

Brian Levitt:

My new favorite one is correlated in an uncorrelated way.

Bert Crouch:

We are fishtailing beautifully. I love it.

Brian Levitt:

I love it. Bert, thank you so much, very informative. Great having you on the show, we'd love to have you back again soon.

Bert Crouch:

Appreciate the invite guys.

Brian Levitt:

Absolutely.

Bert Crouch:

Thanks so much.

 

Disclosures:

NA2933011

Important information

Recorded date: April 18, 2022

Some references are U.S. centric and may not apply to Canada.

All figures are in U.S. dollars.

The opinions expressed are those of the speakers, are based on current market conditions as of April 18, 2023, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. Invesco is not affiliated with any of the companies or individuals mentioned herein.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions. The information and opinions expressed do not constitute investment advice or recommendation, or an offer to buy or sell any individual security.

Past performance is not a guarantee of future results.

Diversification does not guarantee a profit or eliminate the risk of loss.

All investing involves risk including risk of loss.

Commissions, trailing commissions, management fees and expenses may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the simplified prospectus before investing. Copies are available from Invesco Canada Ltd. The opinions expressed are those of the presenter, are based on current market conditions and are subject to change without notice. 

These opinions may differ from those of other Invesco investment professionals. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although we make such statements based on assumptions that we believe to be reasonable, there can be no assurance that actual results will not differ materially from our expectations.

Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.

Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

Mortgage- and asset-backed securities are subject to prepayment or call risk, which is the risk that the borrower’s payments may be received earlier or later than expected due to changes in prepayment rates on underlying loans. Securities may be prepaid at a price less than the original purchase value.

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© Invesco Canada Ltd., 2023

Information on the size of commercial real estate on the loan books of Silicon Valley bank is from the Federal Deposit Insurance Corporation as of February 28, 2023.

Information on the level of the federal funds rate and the amount of rate hikes from the US Federal Reserve as of March 31, 2023. The federal funds rate is the rate at which banks lend balances to each other overnight.

Information on the level of the Secured Overnight Funding Rate from Bloomberg as of March 31, 2023. The Secured Overnight Financing Rate is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.

Information on the market share, total loan book size, and level of origination of regional banks from the US Federal Reserve as of March 31, 2023. Based on regional bank commercial real estate assets compared to the total amount of commercial real estate assets on all US banks.

Information on the size of the bank run in March from the US Federal Reserve as of March 31, 2023. Based on the daily change in small domestic chartered commercial bank deposits.

Information on the size of the wall of maturities from Bloomberg and Morgan Stanley as of March 31, 2023.

Information on the loan to values of Commercial Mortgage-Backed Securities from Bloomberg as of March 31, 2023, based on the Bloomberg US Aggregate CMBS Index, which is a benchmark of the US CMBS market.

Information on the size and scope of Invesco Real Estate is from Invesco as of April 18, 2023.

Information on US industrial cap rates and property values is from Green Street as of March 9, 2023, the most recent data available for metro-level data.

Information about the growth of the 75-and-over demographic from the US Census Bureau as of December 31, 2022.

Information on vacancy rates in neighborhood and community retail from the Association for Neighborhood & Housing Development, as of March 31, 2023.

According to Green Street’s Commercial Property Price Index, apartment prices declined by 21% year-over-year ending March 2023, whereas mall prices declined by 15% for the same period.

Office card swipe data from Kastle Systems as of February 28, 2023

According to Green Street on April 14, 2023, public office REITs on average were trading at 50.2% of net asset value, with some individual office REITs discounted in even deeper negative territory. Cap rates implied from office REIT valuations averaged 9.8% on that date.

M2 is a measure of the money supply that includes cash and checking deposits as well as savings deposits, money market securities, mutual funds and other time deposits.

A systemically important bank is a financial institution that US federal regulators say would pose a serious risk to the economy if it collapsed.

Convexity is a measure of the curvature in the relationship between bond prices and interest rates.

The loan-to-value ratio is used by lenders to compare the amount of a loan to the value of the asset purchased.

The debt-service coverage ratio measures a firm's available cash flow to pay current debt obligations.

The efficient frontier is a set of investment portfolios that are expected to provide the highest returns at a given level of risk.

The Sharpe ratio is a measure of risk-adjusted performance

Correlation is the degree to which two investments have historically moved in relation to each other.

A basis point is one hundredth of a percentage point.

Cap rate is the rate of return on a property based on the income that it is expected to generate.

Transcript for Justin Livengood episode

Brian Levitt (00:08):

Welcome. I'm Brian Levitt.

Jodi Phillips (00:16):

And I'm Jodi Phillips. Today we have Matt Brill, Head of North American Investment Grade Credit. So, we're talking bonds today, Brian.

Brian Levitt (00:25):

Are you already hearing it, Jodi? After last year, we're already hearing people call this a golden age for bonds?

Jodi Phillips (00:31):

I have. I have heard that. It's quite a welcome perspective after last year and the rough go that both stocks and bonds experienced together.

Brian Levitt (00:41):

Yeah, I'm sure investors could have done without that selloff last year, and then they're even calling that now the “death of the 60/40,” right? Such hyperbole in our industry.

Jodi Phillips (01:01):

Oh yeah, that was the refrain: “Diversification isn't working.” But that's quieted down so far this year though, right?

Brian Levitt (01:07):

Yeah, I would say the reports of the death are greatly exaggerated of the 60/40 portfolio.

Jodi Phillips (01:13):

A Mark Twain [PJL1] reference, Brian, that's definitely-

Brian Levitt (01:15):

Yeah, we're going literary.

Jodi Phillips (01:16):

-not your usual '80s lyrics. Putting that aside for a minute, all right. I will say though, fun fact, that quote was reportedly a little exaggerated itself.

Brian Levitt (01:27):

No.

Jodi Phillips (01:27):

Yeah. No, no, he actually said “the report of my death was an exaggeration.”

Brian Levitt (01:32):

Oh, so they embellished it?

Jodi Phillips (01:34):

Little bit, little bit.

Brian Levitt (01:35):

Oh, and I fell for it.

Jodi Phillips (01:37):

You did, but that's all right. That's what I'm here for.

Brian Levitt (01:39):

I guess a sucker is born every minute, huh?

Jodi Phillips (01:42):

Okay, so P. T. Barnum[PJL2] , another fun fact, there's no evidence he said that either, Brian.

Brian Levitt (01:47):

Oh God. Jodi, I give up and this is what I get for having an editor as a co-host.

Jodi Phillips (01:53):

That's right, that's right. You're in charge of the numbers, I'm in charge of the words. That's how we split up the two things around here.

Brian Levitt (02:00):

Every quote I say was never said.

Jodi Phillips (02:03):

Nope. Nope, not at all. But all right, all right, back to our topic though. I could do this all day, but tell me why could this be a golden age for bonds, Brian?

Brian Levitt (02:11):

We'll have Matt talk to us about it, but yield for the first time in a long time certainly feels nice. I know my father appreciates it. Maybe even return opportunities, right? Total return opportunities if and when. I'm going to say when interest rates go down, not if and when, but again, we'll ask Matt his opinion on that.

Jodi Phillips (02:31):

Yeah, I mean, it feels like that's already started to happen, right?

Brian Levitt (02:34):

Yeah, well, certainly a bit. I mean, just think of 10-year Treasuries, I know people use that as the benchmark, certainly off their highs, but borrowing costs for corporations are significantly higher than where they were a year ago. I guess that's what happens when you get a lot of policy tightening in a very short period of time, it creates concerns that the economy could roll over.

Jodi Phillips (02:56):

That's right. But as you always like to remind us, Brian, the market leads the economy. So, has the corporate bond market already priced the worst of it?

Brian Levitt (03:04):

Yeah, perhaps. Although, again, well, I keep saying it, this is why Matt's here. I love having him on, because we'll talk to him about so many things. We're going to talk about the Fed, we're going to talk about the path of rates, recession concerns, opportunities in corporate bonds or other parts of the bond market and how to structure a fixed income portfolio. If 60/40's not dead, well, then what does the 40 look like?

Jodi Phillips (03:29):

Excellent question. Yes, that's a ton to go over, so let's not delay anymore. Welcome, Matt. Appreciate you joining us today.

Matt Brill (03:37):

Thanks Jodi, thanks Brian. Good to be here.

Brian Levitt (03:38):

It's good to have you here. What's the bond market telling you? I mean, we've now heard from the Fed we're probably past peak hawkishness. What's the bond market telling you?

Matt Brill (03:55):

Yeah, so I think the first thing the bond market's telling you is that the Fed is going to win this battle versus inflation.

Brian Levitt (04:01):

Yeah, can we stop and celebrate?

Matt Brill (04:06):

It's not done yet, that's the thing, but they're going to win, the Fed is going to win. With that, eventually rates are going to go lower. Whether we go back to the really low rate era that we had for so long is debatable, but this persistent inflation will get stomped out of the economy and the Fed's going to win, and that's what the bond market's telling you.

Brian Levitt (04:30):

Can we call it transitory? Is that back now? Was it always transitory or the Fed having to stomp it out means it wasn't transitory?

Matt Brill (04:37):

I think we don't want to use that word-

Brian Levitt (04:39):

Okay, we're done.

Matt Brill (04:40):

It has a really bad connotation to it. It could be a three-year transitory thing, I don't know, but at the end of the day, the Fed had to act. So, this would not have occurred without the Fed's actions. So if that's the definition of transitory, then it certainly was not transitory, because the Fed had to do something, the fire wasn't going to put itself out, essentially.

(05:02):

They've raised about 450 basis points at this point, and they did that in basically pretty much a year, so one of the fastest hiking cycles that we've seen in recent times. That was needed. I think the Fed got on board a little late, but once they started to really through last summer continue to tell you that they were going higher and higher, we all of a sudden realized, hey, they're not going to stop till they win this.

(05:30):

Even in the comments that you're going to hear from all the Fed members, they're going to tell you they still have more work to do, but that's only because they don't want to declare victory too soon. So we're not saying it's over, but we are going to say that they're going to win.

Brian Levitt (05:43):

So Jodi, Jay Powell's now singing “All I do is win, win, win no matter what.”[PJL3]

Jodi Phillips (05:49):

I would love to see the video feed of that, if that's indeed what's going on. But Matt, are there concerns then that the Fed's going to over-tighten and take it a little bit too far?

Matt Brill (05:59):

Well, that's the new shift or the new focus, in our opinion, is stop looking backwards at the inflation, because that will be solved, now you need to start focusing on whether or not the Fed is going to take it too far and drive us straight into a recession.

(06:26):

But our general view is that the Fed can engineer this soft landing. The runway for the soft landing keeps getting wider and wider, because the labour market is still good. Maybe not as good as it once was before, because you're seeing some layoffs in the financial sector, you're seeing layoffs in the technology world, but the general what I would call the mainstream America economy is still yet to see those layoffs.

(06:49):

So just in general, it feels like the labour market is loosening up a little bit at the same time that inflation is coming down, which gives us the chance that they're not going to put us straight into recession. But if the Fed stays at a high level for too long, then that's the bigger concern. I think if you're just looking at inflation, you're missing the story here, you need to start focusing on the slowing of the overall economy.

Brian Levitt (07:10):

I'll mix the metaphor here and say that the porridge is tasting just about right about now. Maybe I'll go on and say I guess we make hay when the sun shines, right? So, I'm mixing a whole bunch of metaphors here.

(07:25):

So Matt, I'll tell you the biggest question I'm getting from people is, or among the biggest questions is when I look at the yield curve, does it make any sense to move out beyond short rates, or just take the bird in the hand? You're getting four, four and a quarter at the short end of the curve. Why even think about going longer?

Matt Brill (07:48):

Yeah, so we get that question a lot and a lot of people are just in T-Bills rolling them along, and they're saying, "Look, I'm not going to get fired by my client for getting them 4.5%." But I'd argue that you're not really looking forward to their future either, you're not protecting for what we describe as reinvestment risk. That's the term we keep throwing out in 2023 over and over and over is reinvestment risk.

(08:08):

That tells you that yes, you might have a three-month T-Bill or possibly a year-long Treasury, but what is that going to be yielding by the time that comes due? What are you going to be rolling that into at that time? A lot of people say, "Well, I'll take my chances when I get there," but that's not really the way that you're supposed to be thinking about your finances, right? You're supposed to be locking in these yields at these elevated levels for longer and planning ahead.

(08:31):

You mentioned your dad earlier, that your dad's excited to get fixed income. I go back to the '80s and I look at the charts. I was born in the '70s for the record, but I look at the charts-

Brian Levitt (08:41):

Me too.

Matt Brill (08:43):

I look at the charts and you can see that in 1980, Fed Funds, I think it was around 18% and the 30-year Treasury was around 12%. So at that time, you could have bought a front-end T-Bill for 18%, or you could have bought a 30-year Treasury at a very inverted curve. I hear stories all the time of the grandparents back at that time that bought 30-year Treasuries for their kids, or the grandkids, and they locked it in for a long time and they were the geniuses.

(09:09):

I have never heard ever of a grandmother buying a three-month T-Bill at 18% and how smart that grandmother was, 'cause guess what happened? In three months or six months, whenever that T-Bill came due, they had to roll it into something else that yielded a lot less by that time, because Volcker had gotten inflation under control.

(09:26):

So while we're not at those extremes, I certainly point out to people that when you think rates are attractive, if you think 4.5% is attractive, why are you not willing to take it for five years? Why do you only want to get it for three months? As we're seeing already as rates are coming down lower, in a year or six months, we do think yields will be lower than they are today.

Brian Levitt (09:50):

I'm just trying to picture you at three years old trading bonds, but you tell us you're looking at the charts now, you weren't doing it back then?

Matt Brill (09:57):

I had a solid about 40 days actually, that's it, Brian, but it was a very short period of time in the '70s.

Jodi Phillips (10:05):

So Matt, you heard at the top of the show that we don't always have the best of luck accurately remembering famous quotes or being able to quote people word for word, but one thing Brian always likes to reference, and we'll see if I get it right, “get the credit cycle right and all else will take care of itself.” Is that right, Brian? Did I get that-

Brian Levitt (10:25):

Yeah, that sounds right. See, I'm not going to pick nits the way you do and tell you that you got the quote wrong.

Jodi Phillips (10:32):

Well, I appreciate that. So then Matt, given that, where are we in the credit cycle?

Matt Brill (10:38):

So, we're sort of in the early stages of the credit cycle, actually. So, when we think about what happens at the late stages of the credit cycle are that companies do silly things, like they over-lever their balance sheet, they buy back a lot of stock, they might even make a large acquisition that's debt-funded.

(10:55):

Then when you get the fixing or the reset of the economy and you get through the really good times, then you start to have the negative times, they start to say, "Oh, I probably shouldn't have spent my money on that, probably shouldn't have done that," and they really tighten their belts, and that sometimes creates an additional feedback loop of the economy going into recession.

(11:17):

What we're seeing now is that you're at this point where corporations have said, "We just went through this really strange pandemic, we survived it. We do think that the Fed is going to make this economy worse." So, they're simply saying, "We're just going to preserve our balance sheet. We're going to actually do everything possible to prepare for this really bad period of time coming," and they're ready for it.

(11:42):

So, I kind of feel like they can survive this fairly well. If and when we get through this shallow-ish recession or soft landing, then we're going to really start the new era of the credit cycle. So, I sort of feel like we're kind of at the end of the belt tightening, the end of the really bad period of time for earnings. You're going to see earnings fall off here for sure, but I would just say that I don't see corporations doing silly things that they're notorious for doing at the end of the credit cycle.

(12:11):

So it's a weird time for us right now, but the biggest point I'd like to make is that companies are not going to be surprised by a slowing economy, so they're prepared for it. This isn't like the pandemic that came out of nowhere that really could not have been forecasted. Corporations are all hearing that there's going to be a recession coming, and I would say this is the most forecasted recession that we've ever had, so if you're not ready for it as a corporation, you're not doing your job.

Brian Levitt (12:34):

So let's say we go into the shallow, as Lady Gaga [PJL4] might say, right? You said a shallow-ish recession. Has the credit market priced for that? If you're looking at a 5%, 6% in investment grade corporate, 8%, 9% in riskier credit, is that priced for a recession already?

Matt Brill (12:56):

So, we just look at yields it is. So if you look at yields, you're saying that these are elevated yields that are punitive to corporations and you're getting paid to take on risk. Now that being said, Treasuries are also elevated, and so the credit spreads or the premium you have to get paid to buy something other than Treasury are actually not really pricing in a recession, so they're really just kind of in the middle of the pack.

(13:18):

So, you can possibly buy just Treasuries or you can buy corporate bonds that get that additional spread. So we look at credit spreads and they're kind of around 110 to 125 (basis points) depending on which metric you look at, and a recession's more like 150 to 200. So, we're not-

Brian Levitt (13:33):

And that's investment grade?

Matt Brill (13:34):

That's investment grade. If you look at high yield, they're around low 400s, a recession might be 600 or 700. They don't tend to stay there very long, 'cause if you're yielding 700 basis points over Treasuries, you're probably not going to either be in business very long or you're going to need to have the economy rebound quite quickly, and people realize that there's value and they're not going to stay at those levels.

(13:55):

So at the 400 and the 125-ish range that you're at on credit spreads, you're in the middle of the pack, but what it's telling you is that corporations can weather this. I think that's kind of the key point here is that the yields are attractive, technicals are going to continue to be very good, because we feel like there's going to be a lot of money flowing into the asset class.

(14:17):

And fundamentals should not be that poor, because even though they're borrowing at higher rates, most companies aren't borrowing really at all. If they have to borrow, then they're borrowing at higher rates, but they have fixed debt that they have, they borrowed a fixed term. A lot of them borrowed back in 2020 and 2021 at kind of 2%, 3%, and now that rates are 4%, 5%, 6%, they're just saying, pass, no reason to borrow. We'll use our excess cash. We'll maybe slow our dividend payments, things like that in order to not have to borrow at a higher debt level.

Jodi Phillips (14:49):

All right, so Matt, you had mentioned high yield spreads for a little bit, and obviously you're the head of investment grade. Are you willing or able to reach into the high yield bond market?

Matt Brill (14:59):

Yeah, so we do like pockets of the high yield market. I think if you're buying the lower portion of the triple-Cs of the world, you really have to believe that you are going to get a soft landing. If you think anything other than a soft landing, triple-Cs will get hurt. But the double-B portion or the higher portion of the high-yield market still looks pretty attractive, and all the yields there are somewhere between 7% and 8%, which historically looks really good.

(15:23):

I would also point out that despite the slowing economy, we're forecasting that you're going to see at least $50 billion of upgrades out of high-yield into investment grade in the first half of the year, and you might even see a $100 billion total for the full year. So despite the fact that the economy is slowing, there's still going to be more upgrades than downgrades in 2023.

Brian Levitt (15:44):

How does that happen?

Matt Brill (15:44):

Well, the ratings are just sort of behind the curve. So if you look back in COVID, there's a lot of downgrades that hit then, a lot of these companies then really repaired themselves quite quickly, and the rating agencies have said, "Well, we'll wait till COVID's over." All right, well, COVID's pretty much over. They said, "Well, we'll wait till we see what the recession is, really how bad it's going to be." They keep kind of delaying that. At some point they're saying, "Well, the metrics are really, really strong on these companies. We've been waiting for the other shoe to drop and it just hasn't happened, so I guess we're going to have to go ahead and upgrade now."

(16:12):

So, they've been very hesitant and the pendulum swung really far to the downgrade side in 2020, we think it'll come back to the upgrade side this year. So I mentioned $100 billion of upgrades potentially for the year, there's only probably going to be about $15 billion of downgrades out of investment grade to high-yield.

Brian Levitt (16:28):

Wow.

Matt Brill (16:28):

So the ratio is still almost 10 to one despite a slowing economy, and that's because balance sheets are in such good shape. Again, it's all about these companies having predicted the worst. The worst hasn't happened yet, and they're in really good shape in just preparing for this proverbial winter is coming that just isn't really happening.

Brian Levitt (16:47):

Yeah, Game of Thrones, winter is coming[PJL5] , right? It's the most forecasted (recession), as you said. I got to imagine a lot of those chief financial officers were banging their heads against the wall waiting for these upgrades, huh?

Matt Brill (16:59):

Yeah, it's costing them money to not have been upgraded yet anytime they still have to continue to borrow. The area that we found has really been the least recognized by the rate agencies has been the energy space. There's a lot of energy companies that have really completely repaired their balance sheets. If you look at where price of oil is, even though it's off the highs, the energy sector's really just printing money.

(17:24):

Back in 2020, we had WTI go negative for futures for things like that, but even in a more normalized curve, it was still $40 a barrel versus now 70, 80 bucks. Even the service industry, you've got drilling coming back. There's a lot of areas within the energy space that are making a fair amount of money, and they've just continued to pay down debt this whole time too.

(17:48):

So the focus on shareholders has not been there, and I think that's one of the key things is debt holders that we like. We don't like to just make money and pay it all out to the equity market. The equity market has said, "Let's get our balance sheets fixed, particularly in the energy space. Let's get our balance sheets fixed first, and then you can start paying us back after that, because we just don't want to take any chances that you're going to be on the verge of bankruptcy like you were in 2020." So, the focus on cash flow has been to pay down debt and the rating agencies are soon to follow with their upgrades, we believe.

Jodi Phillips (18:20):

Well, let's talk about upgrades. I was planning to ask you about potential default cycle and what that might look like, but I mean, is there anything you're keeping your eye on in regards to that?

Matt Brill (18:30):

Yeah, so the consumer cyclicals are still a challenge. Yeah, you've seen that there's certain portions of the retail spectrum that we would be concerned around. One of the things is that the high-yield market had a issuance down about 80% in 2022 over 2021. The issuance of high-yield market is picking back up this year, meaning that companies are able to borrow. Although it's expensive, they are able to borrow.

(18:54):

With that, we've seen kind of the lower quality names really starting to rally, because investors are saying, "It looks like these companies can actually get access to capital." Versus in 2022, they would've never been able to borrow at all at any price, and now they're able to borrow, and that'll enable them to kick the can down the road a little bit.

(19:14):

So you can borrow to extend out your lifeline, if you will, for another year or two, and the economy turns out to either not have a hard recession, or if it just starts to have a recovery in back half of 2024, you've made it that far. So, we're predicting around 3% in defaults for high-yield this year.

(19:32):

Certainly I would say just in general, there's always a greater risk that it's higher than that, I think that's kind of the way the bond market is. But 3%'s kind of our target for the year, but it could actually be even less if this high-yield market stays open the way that it is now, because it's enabling these companies to kick the can down the road and fight another day.

Brian Levitt (19:50):

When you say consumer cyclicals, is that a lot of the names that we expected to have problems even prior to ever hearing the word COVID? Are these the names that were being disrupted by eCommerce anyway?

Matt Brill (20:04):

Yeah. Yeah, and I think COVID sometimes gave them a lifeline in some instances, whether it was through the government funding or just behavioral patterns that have changed for a brief period of time. But the longer long-term trends for a lot of the retailers, you saw Party City recently, they defaulted, but there's areas like that that just weren't going to make it probably no matter what. They tried to fight it as long as they could and eventually they had to throw in the towel.

Jodi Phillips (20:47):

So, let's look globally for a minute, Matt, if you don't mind. What about the emerging world, how do yields look there? Are they more attractive in those markets?

Matt Brill (20:55):

Yeah, so EM in 2022 got hammered just as hard as the rest of us, if not more, anything China-focused. So, China was specifically the problem child. You saw Evergrande, the real estate company there in China, that was really the first domino to fall, that there was some problems within the property development space within China specifically. Then you also had anything industrial-wise that was impacted by supply chain out of China and through a lot of the emerging markets. Some of them benefited, but a lot of them just were very correlated to China from a risk standpoint.

(21:35):

So, we saw massive outflows of EM in 2022, we saw property developers in China go from par to 15 that were investment grade rated names. Not household names, but very large corporations within China. Some of those have come back and come back 60, 70 points within the last eight weeks, which is just pretty phenomenal.

(21:57):

I would say those are not really things we generally would be investing in, but it's just pretty interesting to watch. But the typical EM bond that often at times is going to benefit from oil prices being higher has still gone materially lower versus where it was a year ago, so we think there's some opportunities there. We prefer to stay with companies in countries that are commodity-rich. I think if you're on the flip side of that, or if you're a commodity buyer rather than a commodity seller, you may have more issues. Then just overall, the rising tide of China does lift all EM boats.

(22:38):

So we buy hard currency, not local currency. EM, generally we're not taking the currency risk, but we just look at the champions in these emerging market countries, and a lot of them were just severely punished last year, and now we're seeing some pretty good opportunities. Again, I'd rather have the commodity aspect of things. Middle East is a great opportunity for us, and then we'd kind of be more some Latin America, that'll benefit from that as well.

Brian Levitt (23:05):

Where else do you look for yield beyond what we've asked you?

Matt Brill (23:08):

So, the housing market in general with non-agency mortgages is a really interesting opportunity. You saw the fear that higher rates were going to ca use just a massive housing market correction, it really hit the non-agency mortgage market. So, the agency mortgage market is guaranteed by Fannie Mae,  the US government essentially at the end of the day, but the non-agency mortgage market, even if you're buying the top of the stack or the highest rated, it's going to be fine from a principal standpoint, but people start questioning how bad is it going to get for the economy? How bad is it going to get for the housing market?

(23:49):

You see the home builders really started getting sold off within the equity market, as well as the debt market. We look at the non-agency mortgage market and we say, well, there's still a housing shortage. It's probably going to have to have some sort of correction just given where mortgage rates are. But all of a sudden you look up and mortgage rates are probably 100 to 150 basis points lower than their peak, and maybe the cost of the housing market isn't as punitive as people might've originally thought.

(24:12):

So, that's one area that we're looking at. It's not as clean, it's not as obvious that it'll be able to rebound here, but I'd say overall, that's one area that tends to lag and still have significant amount of yield. If you believe that rates keep going lower from here, it's going to be nothing but the wind at the back of the housing market.

Jodi Phillips (24:30):

So Matt, kind of at the top of this episode too, we talked about the talk of the 60/40 portfolio, 60/40's dead, that that refrain has clearly eased off a little bit compared to last year. But in your mind, looking at that 40% and looking at how investors might want to think about it, the role of bonds in their portfolio, what's your view of that bond allocation, and what do you think investors ought to be thinking about at this moment?

Matt Brill (25:00):

Well, I think you need to think about, one main thing is why do you want to own fixed income in the first place? I think a lot of people wanted reasonable steady yield and they weren't getting it for the last decade, and so they came up with new ways to buy their ultra conservative funds, or they bought preferreds, or they bought a lot of dividend-producing stocks in order to replicate that.

(25:24):

But more than anything, if you bought fixed income, you probably bought it because you had to, not because you wanted to. Maybe your company forced it upon you and said, "You have to own 40%, figure out the way how," and you got to try to make that puzzle work. Now, what we're finding is that investors are saying, "I don't have to own it, or if I do, I still want to own it anyway, and how do I own more of it?"

(25:48):

The pain last year was really tough, and so why did you buy it? You bought it for yield. Well, yield's got more and then everybody sold. So, then now that things have stabilized and people just have a little bit more time to think with a cooler head, they're looking at yields and they're saying, "I haven't been able to buy bonds with these yields since, call it 2007, maybe for the peak of 2008 when everything really, really kind of fell apart."

(26:16):

So you have to have some credit spreads, but for the most part, you haven't been able to buy it in a normal market since around 2007. This looks pretty attractive, and so they're buying more. The technicals look really good, and we feel like at the end of the day, you should like bonds of this 4% to 5%.

(26:31):

Now, are you going to be able to get back to that 6% that we saw in investment grade bonds very briefly in October? Probably not, but everybody says they want to buy more if they get there, which means you probably don't get a chance. But at the end of the day, we feel like you're getting in stable cash flow, you're going to not have to go through what you went through in 2022, which was really, in our opinion, once in a lifetime correction, which is really, really painful, but the adjustment that happened from it provided a lot of attractive yields.

Brian Levitt (26:56):

It's just a unique pandemic cycle and we're finding our way out of it back to maybe some normal equilibrium. Is that how you're thinking about it?

Matt Brill (27:04):

That's right. You're still arguably being distorted by the Federal Reserve, but in the opposite way. Meaning that the Fed is doing quantitative tightening, they're selling bonds. A normal market where the Fed is not intervening in any capacity, yeah, I think looking at yields at 4.5%, 5% would look attractive. So when we get to that point, we think that people have been really kind of fed up with the Fed-

Brian Levitt (27:31):

Distorting their bond portfolio.

Matt Brill (27:33):

They like that the Fed makes stocks go higher, they don't like it makes their bond yields go lower. But the reason why stocks go higher is because there was no yield in bonds. The whole TINA Market, right?

Brian Levitt (27:41):

Right.

Matt Brill (27:42):

So you had TINA for a number of years: “There Is No Alternative.” But now we're talking about TINA's sister, TARA, which “There Are Reasonable Alternatives.”

Brian Levitt (27:53):

Ooh.

Matt Brill (27:54):

So TINA is no longer around, her sister TARA, her alternate personality, I guess, is back.

Brian Levitt (28:00):

Did you just coin that or you're borrowing that from someone?

Matt Brill (28:02):

I've heard TARA out there.

Brian Levitt (28:04):

Oh.

Matt Brill (28:04):

I've also heard BAAA, three A’s: “Bonds Are An Alternative.” So BAAA or TARA, but I kind of like TARA.

Brian Levitt (28:12):

I like TARA, because-

Jodi Phillips (28:13):

TARA works better.

Matt Brill (28:13):

Yeah.

Brian Levitt (28:15):

I might have to start using that and say it's mine. We all steal from each other anyway, right?

Matt Brill (28:21):

I don't have a patent on it or any kind trademark.

Brian Levitt (28:24):

So Jodi, doesn't having Matt on make you feel so much better?

Jodi Phillips (28:27):

It does.

Brian Levitt (28:27):

Such clarity?

Jodi Phillips (28:29):

It does. I mean, we've run through such a long list pretty quickly, right? Investment grade and high-yield and emerging markets and mortgages. Is there anything that we didn't ask Matt that we should?

Brian Levitt (28:40):

Oh, I've got one.

Jodi Phillips (28:40):

Oh, okay, good.

Brian Levitt (28:40):

I've got, Matt.

Matt Brill (28:40):

Okay.

Brian Levitt (28:43):

Okay, so this debt ceiling thing we're going to have to grapple with at some point-

Matt Brill (28:47):

Yep.

Brian Levitt (28:48):

A little bit different than 2011, because in 2011 the Democrats needed a lot of Republicans to come on board, this time they only need a handful, so maybe we don't go to the 11th hour like we did in 2011. But in 2011, Treasuries rallied as it was happening. It was still viewed as the safe haven asset. Is there anything that could happen or do you have any concern where that would look different? Or would you still envision Treasuries to be the safe haven asset should we have to go to the brink on this?

Matt Brill (29:21):

Yeah, we certainly hope we don't get that far, but if we do, our view is that it would be a positive for Treasuries. Not for credit risk, but for Treasuries. The government can't issue debt during that period of time if there's a supply shortage, there's a flight to quality.

(29:37):

I think a lot of people often say, why are you selling all your Treasuries if the government's going to have a shutdown? You're like, "No, actually, we think you want to do the opposite."

Brian Levitt (29:46):

Right.

Matt Brill (29:46):

So it's completely counterintuitive, but at the end of the day, I think 2011 is kind of the playbook for it, and that's the way we would see it playing out again this time.

Brian Levitt (29:53):

Can we say what if, God forbid, or however you want to put it, they don't do what they need to, do we even let our minds go there? I mean-

Jodi Phillips (30:04):

You don't want to say it out loud, do you, Brian?

Matt Brill (30:07):

Yeah.

Brian Levitt (30:08):

Well, yeah, I mean-

Matt Brill (30:08):

We just hope both sides will have enough sense to not allow that to occur.

Brian Levitt (30:11):

Yeah, yeah, yeah. Yeah, agree.

Matt Brill (30:16):

Too many good things are happening in the economy that we're kind of fighting our way through this inflation problem that we had post-pandemic, and then just to have it disrupted by that would be really unfortunate. So, it's-

Brian Levitt (30:27):

Yeah, let's not shoot ourselves in the foot again. Yeah.

Matt Brill (30:30):

Exactly.

Brian Levitt (30:30):

Agree. Well, Matt, thank you so much for joining us.

Matt Brill (30:33):

Great to be back.

Brian Levitt (30:34):

Incredibly informative, great clarity. Feeling better about the world, Jodi seems to be too.

Jodi Phillips (30:41):

Absolutely, I do. Thank you so much for joining us.

Matt Brill (30:44):

I'm glad we weren't banned after the 2022 performance of bonds, so it's good to be back.

Jodi Phillips (30:50):

No one's ever banned, it always comes back.

Matt Brill (30:53):

We look forward not backwards over here, so thank you all so much.

Brian Levitt (30:57):

Thanks, Matt. Thanks, Matt.

Jodi Phillips (30:57):

Thank you.

 

NA2763011

 

Important Information

 

Some references are U.S. centric and may not apply to Canada.

 

All figures are in U.S. dollars.

 

The opinions expressed are those of the speakers, are based on current market conditions as of February 1, 2023, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

 

Past performance is not a guarantee of future results.

 

Diversification does not guarantee a profit or eliminate the risk of loss.

 

All investing involves risk including risk of loss.

 

Commissions, trailing commissions, management fees and expenses may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the simplified prospectus before investing. Copies are available from Invesco Canada Ltd. The opinions expressed are those of the presenter, are based on current market conditions and are subject to change without notice. 

 

These opinions may differ from those of other Invesco investment professionals.

Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although we make such statements based on assumptions that we believe to be reasonable, there can be no assurance that actual results will not differ materially from our expectations.

 

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions. The information and opinions expressed do not constitute investment advice or recommendation, or an offer to buy or sell any individual security

 

Invesco is a registered business name of Invesco Canada Ltd.

 

Invesco® and all associated trademarks are trademarks of Invesco Holding Company Limited, used under license.

© Invesco Canada Ltd., 2022

 

 

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

High yield bonds, also known as junk bonds, involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Investments in companies located or operating in Greater China are subject to the following risks: nationalization, expropriation, or confiscation of property, difficulty in obtaining and/or enforcing judgments, alteration or discontinuation of economic reforms, military conflicts, and China’s dependency on the economies of other Asian countries, many of which are developing countries.

Businesses in the energy sector may be adversely affected by foreign, federal or state regulations governing energy production, distribution and sale as well as supply-and-demand for energy resources. Short-term volatility in energy prices may cause share price fluctuations.

The 60/40 portfolio referenced throughout the episode refers to the traditional asset allocation of 60% stocks and 40% bonds.

Data on the level of Federal Reserve interest rate increases is from the Federal Reserve as of Dec. 31, 2022.

The references to yields between 4% and 4.25% are based on the 2-year US Treasury rate as of Jan. 31, 2023, sourced from Bloomberg.

Data on the level of the federal funds rate and 30-year Treasury yield in the 1980s sourced from Bloomberg.

The federal funds rate is the rate at which banks lend balances to each other overnight.

References to investment grade corporate yields between 5% and 6% and riskier credit yields between 8% and 9% refer to the yield to worst of the Bloomberg US Corporate Bond Index and Bloomberg US High Yield Corporate Bond Index, respectively. Sourced from Bloomberg as of Jan. 31, 2023.

The Bloomberg US Corporate Bond Index measures the US dollar-denominated, investment grade, fixed-rate, taxable corporate bond market.

The Bloomberg US High Yield Corporate Bond Index measures the US dollar-denominated, high yield, fixed-rate corporate bond market.

Yield to worst is the lowest potential yield an investor can receive on a bond without the issuer actually defaulting.

References to credit spreads for corporate bonds and high yield bonds sourced from Bloomberg as of Jan. 31, 2023.  Based on the option-adjusted spread of the Bloomberg US Corporate Bond Index and the Bloomberg US High Yield Corporate Bond Index, respectively.

Option-adjusted spread is the yield spread which must be added to a benchmark yield curve to discount a security’s payments to match its market price, using a dynamic pricing model that accounts for embedded options.

References to the borrowing costs of corporations are based on interest rates set by the Federal Reserve.

References to forecasts of upgrades and downgrades based on Invesco estimates.

References to the decline in high yield issuance in 2022 from 2021 sourced from Bloomberg. 

References to price movements of Chinese bonds sources from Bloomberg as of Feb. 2, 2023.

References to the level of mortgage rates sourced from Bankrate.com as of Jan. 31, 2023.

A basis point is one hundredth of a percentage point.

WTI stands for West Texas Intermediate. WTI oil prices sourced from Bloomberg as of Jan. 31, 2023.

The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity. The short end of the yield curve refers to bonds with shorter maturity dates. An inverted yield curve is one in which shorter-term bonds have a higher yield than longer-term bonds of the same credit quality.

Credit spread is the difference in yield between bonds of similar maturity but with different credit quality.

Quantitative tightening is a monetary policy used by central banks to normalize balance sheets.

Safe havens are investments that are expected to hold or increase their value in volatile markets.

A credit rating is an assessment provided by a nationally recognized statistical rating organization (NRSRO) of the creditworthiness of an issuer with respect to debt obligations, including specific securities, money market instruments or other debts. Ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest); ratings are subject to change without notice. NR indicates the debtor was not rated, and should not be interpreted as indicating low quality. If securities are rated differently by the rating agencies, the higher rating is applied. Credit ratings are based largely on the rating agency's investment analysis at the time of rating and the rating assigned to any particular security is not necessarily a reflection of the issuer's current financial condition. The rating assigned to a security by a rating agency does not necessarily reflect its assessment of the volatility of a security's market value or of the liquidity of an investment in the security. For more information on the rating methodology, please visit the following NRSRO websites: www.standardandpoors.com and select 'Understanding Ratings' under Rating Resources on the homepage; www.moodys.com and select 'Rating Methodologies' under Research and Ratings on the homepage; www.fitchratings.com and select 'Ratings Definitions' on the homepage.

Brian Levitt:

Hi, I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips.  it's time to talk about our 2023 outlook. Joining us are Kristina Hooper, Chief Global Market Strategist, and Alessio de Longis, Global Head of Tactical Asset Allocation.

Brian Levitt:

Jodi, welcome to 2023.

Jodi Phillips:

Happy New Year.

Brian Levitt:

Happy New Year.

Jodi Phillips:

And good riddance to 2022. I wasn't really that upset to turn the calendar page this time around.

Brian Levitt:

Yeah, I think most investors probably felt that way. It's amazing how there's just something therapeutic about turning a calendar after a difficult year in the market.

Jodi Phillips:

No, you're right. There really is. But does it really mean anything? I mean, it may be a new year, but is anything really different, or has nothing changed?

Brian Levitt:

That actually sounds like a U2 lyric.

Jodi Phillips:

Does it?

Brian Levitt:

Do you remember that song about whether anything changes on New Year's Day?

Jodi Phillips:

Oh yeah, it sounds a little familiar.

Brian Levitt:

I mean, I think you could find strategists, pundits, the so-called experts on both sides of this debate. It's very bifurcated whether anything has changed as we move into this year, or if we're still grappling with all of the same challenges that we were dealing with last year.

Jodi Phillips:

Okay, so then what's your take?

Brian Levitt:

I actually think things have changed. The good news is, and we'll talk to Kristina and Alessio about this, the markets had already priced in a fairly bad outcome. We're seeing, from the Bureau of Labor Statistics, inflation coming down, perhaps the Fed's getting closer to the yen, seems like it's becoming a better backdrop for risk assets. So it's hard to say that nothing has changed. I think quite a bit has changed.

Jodi Phillips:

Well, that's good. There's still some negativity out there though. But I've heard you say before that market cycles seem to be born in pessimism. So I don't know, is that true here?

Brian Levitt:

Yeah, I think that's exactly right. Now, I'm not saying it's going to be easy. We obviously have some issues to deal with, but history suggests by the time inflation has peaked, or by the time whatever challenge you're facing is starting to get better, you tend to see a better environment for markets, albeit if it's not a straight line. But we're certainly getting to a better backdrop.

Jodi Phillips:

Well, good. I'm feeling hopeful. So let's continue this conversation with our guests. We're going to set the stage with Kristina, and then follow up with Alessio to talk about the asset allocation implication. That's hard to say, Brian. Asset allocation implication.

Brian Levitt:

That is hard to say.

Jodi Phillips:

Hopefully, Alessio will do a better job with it than I did.

Brian Levitt:

How now brown cow.

Jodi Phillips:

All right, got little rusty for the new year. In any case, welcome, Kristina.

Kristina Hooper:

Oh, thank you so much for having me. It's great to be here.

Jodi Phillips:

So let's start with a quick postmortem on 2022, if we could. I mean, it's hard to remember, but at that time, no one really expected that the Fed would tighten as much as they did over the course of last year. I mean, I don't think the FOMC really expected it themselves. So how would you characterize what we've been through?

Kristina Hooper:

Well, I know Brian referenced U2, but I'm thinking Talking Heads, how did we get here, right?

Brian Levitt:

Same as it ever was?

Jodi Phillips:

Great question, great question.

Kristina Hooper:

So you're absolutely right, Jodi. No one expected 2022 to play out the way it did, and that includes the Fed, right? If we think about December of 2021, when they released the “dot plot,” they anticipated that by the end of 2022, we'd be at 90 basis points for the fed funds rate. And then fast forward to the end of 2022, and we ended up in a far different, a far tighter place. So I like to think of 2022 as the year of monetary policy whiplash, which then turned into, in my opinion, when we looked at asset class returns, annus horribilus. But it doesn't sound as good as when Queen Elizabeth said it with that great British accent.

Brian Levitt:

Hey, 90 basis points to 450 basis points. What's the difference for markets?

Kristina Hooper:

Exactly.

Brian Levitt:

It's like a rounding error. So when you think about all of that tightening, and the economy's still generally resilient, how concerned are you about the lagged effects of that policy tightening?

Kristina Hooper:

Well, what we lived through in 2022 was a great experiment. We don't know exactly how much of an impact that fast and furious tightening has had. I mean, let's face it, the Fed did not allow for enough time to see the impact, and they certainly tightened in much larger chunks than normal. So you always, I think, in this kind of situation, would worry about the potential impact on the economy, how much damage was done. But from everything that I can see thus far, it looks like the US economy has been very resilient. In fact, many economies around the world have been quite resilient, despite what has been really, really intense tightening.

Brian Levitt:

The Hooper family is still going out to restaurants, still traveling occasionally? We're still spending some money like the rest of the Americans?

Kristina Hooper:

A little bit, but I have imposed new budget constraints.

Brian Levitt:

Yeah. Well, and that's part of it, right? I mean the idea was to make us all feel a little bit less wealthy. I think the Fed did a pretty good job of that. As we feel less wealthy and as we put some of those constraints on, do you start to think that that inflation story becomes a bit passé, or it's starting to move a little bit behind us?

Kristina Hooper:

I think so, and that's what we're seeing from the inflation data we're looking at, right? I mean, the most recent CPI print suggested that inflation is moderating nicely. Now, we're nowhere near the Fed's target. We're moving in the right direction. And I think we have to anticipate, as we look out on 2023, that this is going to be a period in which inflation is likely to continue to moderate. But we have to think of it in terms of the three buckets that Jay Powell laid out recently when he talked about inflation.

There is the goods bucket, there is the housing bucket, and then there is the services ex-housing bucket. And so clearly, goods inflation has come down very significantly, and housing, despite the most recent CPI print, appears poised to roll over. I mean, clearly, there's been a lot of pressure on the housing sector with mortgage rates going up so much, and I think that that will have an impact on housing inflation and help moderate it. But the real stubborn area is going to be services inflation, especially because so much of that is driven by wage growth. So we are going to see inflation moderate, in my opinion, this year. It's just unlikely that we get to the Fed's inflation target by the end of this year. I think that's going to take more time.

Brian Levitt:

Jodi, you heard Kristina say it, my wage growth is going to be just fine this year.

Jodi Phillips:

Oh yeah, we have that recorded. Absolutely. We all have witnesses. Obviously, looking past the US, we've seen the eurozone has also had to deal with pretty aggressive tightening. How is the eurozone economy holding up?

Kristina Hooper:

Well, it's actually held up relatively well, given all the headwinds that it has faced in the last year. Not only has there been significant tightening, but of course they have been subject to very high inflation, especially coming from energy. I mean, there's just been a lot of hits to the Eurozone economy, and yet what we saw in the most recent PMIs is that while they remain in contraction territory, they've actually improved. And so that suggests to me a Eurozone economy that is quite resilient.

Jodi Phillips:

What about China? I know the big headline there has been rolling back so many of those COVID measures that were in place for so long. How is that adding up in terms of your growth outlook for China?

Kristina Hooper:

Well, when we first sat down to talk about the outlook back in October, when we took a look at China and thought about what could be possible for 2023, we felt the economic outlook hinged on two factors: property and COVID. And what we saw was that Chinese policymakers have addressed the issues in the property sector. They released this 16-point plan this fall. That seems likely to have a material positive impact on the property sector.

So then the other issue is COVID. I mean, we've seen pretty significant COVID stringency in China, and rolling that back is going to create some headwinds initially, because of course there is a significant increase in COVID infections. But I think that opens the door for significant economic growth as the year progresses. I think we just have to anticipate some headwinds in the near term, but this could be a very positive year for China growth.

Brian Levitt:

Alessio, let's bring you into the conversation. Thank you so much for joining us.

Alessio de Longis:

Thank you, Jodi. Thank you, Brian. Always a pleasure being with you.

Brian Levitt:

So I know that you always like to think about it from the perspective of what phase we're in, or what regime we're in within the cycle. How would you categorize this current environment, where it seems like risk appetite may be picking up a bit from where we were, call it September, or maybe even a little bit in December?

Alessio de Longis:

Yeah, the market has certainly, since late November, early December, has certainly started picking up a much, much stronger tone. The way I would like to characterize it is that we have basically been waiting for that recession for six to nine months now, the most well-telegraphed recession that, of course, didn't happen. So since early December, what is happening is that inflation, and therefore speculation on the end of the tightening cycle, inflation is rolling over more quickly than growth is rolling over. So the market is feeling optimistic, because it's finding that sweet spot now where inflation may be coming down, monetary policy tightening is coming to an end, while growth, as of today, is still holding up.

Brian Levitt:

So that sounds like a soft landing. Is it a soft landing? And for investors, does it have to be a soft landing, or have we already priced in a mild recession?

Alessio de Longis:

I think right now a soft landing is really the best way to characterize it. Basically, we have knowledge that growth has been close to zero, but now we can see light at the end of the tunnel and expect it to actually rebound, rather than going into negative. So we will characterize that market reaction more consistent with the market pricing and recovery regime, right? Growth still being low, but actually improving.

How long will that last? Well, this goes back to the eternal debate about the long and variable lags of monetary policy. I agree with Kristina. At some point, it will be more obvious what the damage has been or will be from past monetary policy tightening, but it's not here, and it doesn't have to be that severe. The unemployment rate is still globally near all-time lows. So without a doubt, this is not the beginning of a new economic cycle, precisely because the unemployment rate is at all-time lows, but we are dealing with a soft lending, similar to...

Brian, I like to draw analogies. Obviously, the circumstances were very different, but remember how many fake recessions we had, such as in 2011, in 2015? To me, the relationship between the economic situation and the market reaction is analogous to those. Those were very difficult years from a trading perspective, and there were large negative returns, but the economy ended up holding up and eventually the market recovered. So that's how I think the market is pricing in, basically, reduced risks of a recession in timing, in duration of that recession, and potentially the magnitude of that recession.

Brian Levitt:

That's interesting you bring up '15 and '18, I mean, '15 was, what, one rate hike, a Chinese currency devaluation? '18 was a US-China trade war. In hindsight, do those pale in comparison to what we've just seen, a 450 basis point rate hike in nine months? So I'm trying to get what you're saying. You're saying that it feels like a soft landing. We may still need to bump on the bottom a little bit. Is that what you're suggesting? But we're not there yet?

Alessio de Longis:

What I'm suggesting is that the market is... It's ill-advised to position with bearish traits, to position for a recession for too long. As we all know, positioning for a recession, be it in credit, in fixed income, in equities, it's an expensive proposition, right? Waiting for that recession to happen is difficult. So unless you have the evidence staring at you that that recession is rising in probability, no news is good news. And in front of no news, or improving news such as falling inflation and a toning down of hawkish rhetoric by central banks, those are catalysts for a better market environment that should not be ignored.

I guess my point is to say, yeah, the market is recovering, but wait because a recession will eventually come? No. Actually, thank you for asking that question. What I want to be clear on is that you need to acknowledge what the market is doing, and when the economy begins to deteriorate, when you begin to see those cracks, be it the unemployment rate, be it credit spreads, we have another chance at being more cautious and defensive. But right now, we are seeing some pretty convincing signs across all capital markets that we should take seriously a potential rebound in economic activity, especially, as Kristina mentioned, in the weakest zip code, which is Europe.

Jodi Phillips:

So Alessio, help me figure out what this means for portfolios and investors and asset allocation. You talked about seeing some convincing signs. For those who are tactically minded, they're trying to figure out what they should be doing at this moment as we're looking for signs and looking for evidence, what types of assets are you favoring?

Alessio de Longis:

So for the last couple of months, where we've begun to see this improving risk sentiment and falling inflation statistics, we have gone back to overweight equities. In other words, we believe that it's appropriate to run above-average risk again after being very defensive in the second half of 2022, above-average risk being expressed through both equities, but primarily, risky credit. Credit spreads are still wide above their long-term average, have started to come in, but they're still wide. You are still getting compensated.

As investors, we're now having the opportunity for 5% to 9% yields that we haven't seen in the last 15 years, so it's a golden opportunity to rebuild income in the portfolio to harvest some credit risk. In this particular market context, risky credit such as high-yield emerging market debt or bank loans offer equity-like returns, but with lower volatility. So that's important. In the equity space, I think it's appropriate to run some slight equity overweight, but primarily within that equity composition, favor value over quality, favor small and mid caps over large caps. In other words, favor the more cyclical sectors and more cyclical styles of the market.

Brian Levitt:

Let's go back to fixed income. You talk about, when you say 5 to 9%, 9% is pushing out in credit risk, so call it, what, a high-yield bond index around 9%. Is that enough in your mind to compensate for any type of default cycle that we may have?

Alessio de Longis:

That's a good question. So harvesting that yield in a very diversified way, it's always the best strategy. I think defaults, if they occur, are... Given how de-levered these sectors have been, how... We have gone already through a large cleansing of the debt situation, both on the consumer side and on the corporate side. Default rates, which will inevitably rise in the worst-case scenario, should not be large, systemic to lead to underperformance on a two, three year rolling basis on risky credit, in my opinion, and also, especially for the risky credit cores that also have duration. So in that sense, emerging markets debt and high yield offer more duration than bank loans, and that duration always offers a little bit more of a ballast than the purest credit exposure. So yes, I think on a two, three-year rolling basis, these level of yields are quite attractive, in my mind.

Brian Levitt:

Now, Kristina's always asking me what's the top question I'm getting from clients, so I will pose the top question I'm getting from clients to you, Alessio. When you're thinking about-

Alessio de Longis:

Bring it on.

Brian Levitt:

When you're thinking about generating income and you want to do so, perhaps call it in the Treasury market, are you taking advantage of two-year yields at four and a quarter (percent), or are you moving out in the yield curve where you're only getting on a 10-year, say 350 (basis points), but does longer duration make more sense if the economy slows in here?

Alessio de Longis:

That's a great question, and one that is really, really topical at the moment. For the first time in three years, we are moving away from flattening yield curve exposures. In other words, the yield curve is now inverted by a full hundred basis points, when you look from T-bills to 10-year Treasuries. That, for our generation, is as flat as it has ever been. The only times the yield curve has been more inverted than that was in the 1970s, in the 1980s where it got to negative 150. Obviously, the inflation situation today is comparable to that one, but it gives you an idea of the risk-reward.

So to answer your question, we are now starting to move out of the long end in terms of where do we choose to have our duration exposure. We're starting to come back up towards the two-years and five-years, where you now can harvest 4%, 4.5% yields. It takes basically a doubling of those yields for you to lose money on those bonds, right? So especially on the two-year, this is now becoming really, really attractive.

The two-year, obviously, because we're going, we believe that the Fed will eventually pause, and the market will begin to price in some easing. Whether the Fed delivers that soon or not, that's a different question, but the market always starts pricing in the beginning of the next cycle. Being in two-year bonds, in three-year bonds might give us also an extra juice in terms of declining yields, rather than being in cash at three months. So yes, I think the front end of the curve is now starting to look quite attractive.

Jodi Phillips:

All right. Well, Brian covered what the top question is from clients that we're hearing, so I'll ask my personal favorite question, and I want to ask you and Kristina as well. What are people not asking you? What are you not hearing about that you think people should maybe be paying more attention to at the moment? Alessio, do you want to go ahead and start? And I'd like to hear from Kristina as well.

Alessio de Longis:

Well, Kristina, I'm very curious about your opinion, but I am quite amazed by the lack of interest and inquiries on non-US assets, on emerging markets, on China, on Europe, despite the fact that a cycle has clearly ended, the growth versus value cycle. The unconventional monetary policy cycle has clearly ended. These were major factors that contributed to the US dominance, the US excellence. All of these catalysts are, one by one, unwinding, and yet there is so much skepticism around investing money in international markets. The euro went from 95 cents to 1.10, almost, and nobody's asking. So what I think this is, we always focus on tactical, tactical, tactical, but I think these tactical rotations are probably signaling the beginning of a new long-term cycle of rotation and diversification out of the home buyers in US assets into foreign assets.

Brian Levitt:

Before we hear Kristina's opinion, Alessio, I just want... Obviously, Bitcoin went from 16,000 to 18,000, so that's why nobody's paying attention in the euro, but talk about Europe, because it's just been so negative, right? You have the conflict that's existing in Eastern Europe, you have concerns that Germany might not even be able to keep the plants operating because they don't have access to the commodities that run it. How do you get investors to think optimistically about Europe in that type of a backdrop?

Alessio de Longis:

Generally speaking, what you just outlined reminds me of a lesson that I learned over the years, which is we always need to find comfort in a narrative, and a narrative always obviously makes sense. The problem with narrative-driven investing is that you also need to mark the market, and when the pricing changes, the narrative is still in place, but the pricing is changing. What does that mean today?

Europe remains the most geopolitically vulnerable and economically vulnerable region through the current situation, but we have been pricing that for 12 months. In other words, as Kristina mentioned, the PMIs are in recessionary territory, but they're starting to bounce back up. Consumer confidence has been at all-time depressed levels, well past even 2008 levels, and they're bouncing back up. The winter freeze that we were fearing, because of what the implications will be for natural gas prices and energy provision, the winter is turning to be much milder than expected.

So there is so many catalysts, one by one, that again, the narrative has not changed, but the risk and the pricing around those catalysts is now improving meaningfully, which is why European equities are reacting so positive. I think that's really what the key question here is. And one more point: let's not forget that Europe is the most cyclical region in the globe, and with China reopening trade in the horizon, that remains one of the regions that is likely to benefit the most from a global trade perspective.

Jodi Phillips:

All right. So Kristina, question comes to you then. What topics are flying under the radar that you think people should be paying more attention to right now?

Kristina Hooper:

Well, I absolutely agree with Alessio that one topic that we don't hear anything about, we don't see really very much interest at all in, is investing internationally. Europe, emerging markets, it's just not a focus for investors right now, and Europe, it's all about beating expectations, and that's what we're seeing right now. I couldn't agree more with Alessio. The other topic that I think I'm not hearing enough about is what Alessio called, and I love this term, the golden opportunity to rebuild income, and it really is. I think some have not realized just how robust yields are on investment-grade corporates, on a number of different areas within fixed income, and I just think there's not enough interest and focus there right now.

Jodi Phillips:

All right. Brian, do you think we've covered it? Anything else you want to ask?

Brian Levitt:

I'm just still happy that we turned that calendar page, Jodi. I mean, isn't this such a better vibe than what we were talking about, call it mid-summer?

Jodi Phillips:

It does. It feels a lot better, so let's just watch how it all turns out and shapes up. We've got a long way to go, but feeling a lot better after this conversation, that's for sure.

Brian Levitt:

We're feeling a lot better, and we know that Alessio and Kristina are going to be with us along the way to keep providing their insights as events unfold throughout the year.

Jodi Phillips:

Thank you so much for joining us.

Brian Levitt:

Yeah, we thank you so much.

Alessio de Longis:

Thank you for having us.

Jodi Phillips:

Happy New Year.

Kristina Hooper:

Happy New Year.

 

 

NA2741262

 

Important information

 

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The opinions expressed are those of the speakers, are based on current market conditions as of January 13, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

 

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In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

 

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

 

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The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

 

A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.

 

Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

 

The Federal Open Market Committee (FOMC) is a 12-member committee of the Federal Reserve Board that meets regularly to set monetary policy, including the interest rates that are charged to banks.

The Federal Reserve’s “dot plot” is a chart that the central bank uses to illustrate its outlook for the path of interest rates.

 

According to Bloomberg, the federal funds rate was 90 basis points as of December 31, 2021, and 450 basis points as of December 31, 2022.

 

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Information on US economic growth from the US Bureau of Economic Analysis.

 

Information on the US unemployment rate from the US Bureau of Labor Statistics as of December 31, 2022.

 

Information on credit spreads from Bloomberg, as of December 31, 2022. Based on the Bloomberg US Corporate Bond Index Option Adjusted Spread. 

 

The Bloomberg US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market.

 

The option-adjusted spread is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to account for an embedded option, such as calling back or redeeming the issue early.

 

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The Bloomberg US High Yield Corporate Bond Index tracks  the performance of below-investment-grade, US-dollar-denominated  corporate bonds publicly issued in the US domestic market. 

 

Yield to worst is the lowest potential yield an investor can receive on a bond without the issuer actually defaulting.

 

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates. Duration is expressed as a number of years.

 

Information on 2-year, 5-year and 10-year Treasury yields from Bloomberg as of December 31, 2022.

 

Information on current and historical inverted yield curves is from Bloomberg, as of December 31, 2022.  Based on the spread between the 3-month and 10-year US Treasury rates.

 

The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity.

An inverted yield curve is one in which shorter-term bonds have a higher yield than longer-term bonds of the same credit quality.

 

Information on the level of the euro from Bloomberg. Based on the move in the exchange rate between the euro and the US dollar from October 2022 to January 12, 2023.

 

Information on the price of Bitcoin from Bloomberg. Based on the price change of one Bitcoin from the beginning of 2023 to January 12, 2023.

Brian Levitt:

I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. And today we have Talley Leger. Talley's an equity strategist at Invesco, and he's here to provide his views on whether or not the U.S. equity market has hit bottom and what might come next.

Brian Levitt:

Jodi, I hope he's going to tell us that the market has hit bottom or near bottom. I mean, I think my 401(k) would appreciate that.

Jodi Phillips:

Oh yeah, mine too. My college savings. My blood pressure would like that a lot as well. Look, I've heard you and Talley both call this an “everything” bear market. So how did you manage your emotions during this time, Brian?

Brian Levitt:

Well, you're assuming I managed my emotions.

Jodi Phillips:

Yeah, big assumption there.

Brian Levitt:

But maybe the fact that it was an “everything” bear made it a little bit more palatable. I mean, there just weren't too many places to hide this year, so you didn't end up kicking yourself for not being in other spots. I mean, I guess cash, I suppose, although it's not the greatest proposition when you're losing 8%, 9% after inflation in your cash.

Jodi Phillips:

Brian, the one thing I felt good about was I had that emergency cash stash, so thanks for that perspective. But look, I know how much you love your historical comparisons, so it has to help to know we've seen this before and that we've come out the other side, right?

Brian Levitt:

Yeah. I mean, we've seen this a couple of times in the last two years now. I'm trying to remember who said it. I don't know, it was one of those quotable investment gurus when they were asked how it felt to lose 25% of their net worth, and their response was, "Well, it felt the same as it did the last four times it happened."

Jodi Phillips:

Oh, ouch. Yeah, not great. That's how it feels, it feels not great. But it also feels not great to miss the upturn. And I know that there have to be some market timers who weren't happy being on the sidelines in October and that big day the market had around mid-November.

Brian Levitt:

Yeah, of course. And we've said it so many times that the great months, the great days always seem to occur during challenging times. And so trying to miss the worst days, oftentimes you end up missing a lot of the best days. And of course, as you point out, October was like the 11th best month. November 10th was like the 15th best one-day. And of course, that happened right after investors pulled, according to the Investment Company Institute, $27 billion from equity strategies. So we can't help ourselves.

Jodi Phillips:

Got to keep perspective. It's about staying above the noise. And that's why we have Talley here. So Talley has a list of market bottom indicators to help keep us focused on what really matters. And Brian, I've just got one question for him: Are we there yet?

Brian Levitt:

I mean, you sound like the kids in the backseat of the car. "Are we there yet? Are we there yet?" It's funny. I always answer them, "No, I wouldn't still be driving." But then someone says, "Are we getting closer?" Yeah, I certainly hope so, unless we made a wrong turn. And so I guess Talley will be our global positioning system here to tell us if we're on the right path.

Jodi Phillips:

Excellent. How did we ever survive road trips before GPS? I don't know. But I guess I'll add a few more questions to my list then. If we’re bottoming, what comes next? What does a stock market recovery typically look like? What are you seeing now, and what kind of leadership do you expect in a time like this? So let's bring him on, Brian, to answer.

Brian Levitt:

You know I love these conversations. Talley, welcome to the show.

Talley Leger:

Great to be back, as always. Lots of questions.

Jodi Phillips:

Absolutely. Lots to ask and lots to answer so thank you for helping. Look, can we just start at the beginning and give us a little bit of context about what happened this year with this “everything” bear?

Talley Leger:

Absolutely. So I think first and foremost, and this is broadly recognized, we had some of the frothiest paces of inflation seen in four decades. So a very different operating environment for most professional investors, and of course individual investors included in that. And in response to hot inflation prints, the Federal Reserve, our central bank, has been tightening financial conditions to cool down this overheating U.S. economy. And I would point out that we've been in this environment of tightening conditions and slowing activity since the first quarter of last year, so bordering on a year and a half to two years. So we've been, I think until recently, in this kind of broad, general de-risking phase of the market cycle.

Brian Levitt:

Basically, Jodi, what Talley is saying there is the U.S. Federal Reserve wanted us to feel less wealthy. And as you and I both said at the start, they have succeeded in making us both feel-

Jodi Phillips:

Mission accomplished.

Brian Levitt:

I'm not sure I ever felt wealthy, but I certainly feel less wealthy now.

Talley Leger:

Well, you know what they say, don't fight the Fed. And I think this was a healthy reminder of that. And my point when I say financial conditions, together we're talking about a dollar that was too strong, bond yields that soared in response to the Federal Reserve's efforts in raising interest rates, the spread between corporate bond yields and their Treasury counterparts widened. And of course, as we're discussing, we had sharp drawdowns in stocks. So you put it all together, the Fed did its job and tightened these financial conditions, and that's the transmission mechanism for monetary policy. It's the channel through which the Fed really engineers these desired economic slowdowns.

Brian Levitt:

Don't fight the Fed. Very good advice. Talley, when did you first get concerned? I remember talking to you at the beginning of the year and I think we even wrote a blog, what is the nightmare scenario? So when did you first start getting concerned?

Talley Leger:

Yeah, so I would say that I started getting concerned at the tail end of the first quarter of this year. Now technically, hindsight, as we know, is 20/20, so I wish I nailed it in January. But at least I had a change of tone and heart as we had this kind of counter trend. I think it was an 11% rally in the stock market in the context of what we would eventually recognize as a downtrend in the market. And we've had several of these sharp bear market rallies. We had another one in June into July over the summer. But yeah, that would be my long answer. I started getting concerned around the end of the first quarter of this year.

Jodi Phillips:

So Talley, as we mentioned in the intro, you have a list, a dashboard of market bottom indicators that you look at, that you update to keep us focused, to keep perspective. Can we walk through a couple of those? Can you point out a few that you rely on and what they're telling you?

Talley Leger:

Yeah, so that's the problem with putting out these frameworks. You're married to them, especially when they get popular and everybody asks you. And as a paranoid analyst, I'm always second guessing myself and questioning myself, hey, was this the right mix of indicators to serve up to folks? And I mean, look, it worked well in 2020 and I thought it has done a pretty decent job of taking the pulse of the downdraft in stocks so far.

Brian Levitt:

Talley just defined marriage. I'm always second guessing myself and questioning myself as well.

Talley Leger:

That's right. A lot of lessons are healthy reminders here to be taken away. But the point is, I think the answer is the market bottom really depends if you're a glass half full or glass half empty kind of person. And I tend by nature to be an optimist. And over time, I think, Brian, I don't want to put words in his mouth, but would agree that that has been over time a proven successful investment strategy.

Brian Levitt:

It has. And so walk us through some of these market bottom indicators and which are your favorites and what are they telling you right now?

Talley Leger:

We've made a lot of progress, Brian. At the beginning of the year, we only had one of the eight. The first one was the bull-bear spread, talking about the investor sentiment survey. That sentiment survey has been deeply bearish, very negative all year. It was the only one that we had back in January, and it actually helped keep me disciplined in saying, nope, we're not there yet, all year, until some of the others started to kick in. So this is important on the checklist of market bottom indicators.

Another one, while sentiment is important, I think it's also good to have positioning on side as well. And that would be what we call the equity put-to-call ratio. “Put” meaning sellers, “call” meaning buyers. So when the put-to-call reaches a trigger of one or higher, that means you've got technically more sellers than buyers. In the past that's proven to be a very useful contrarian indicator and helps us zig when others are zagging. We now have investors putting their money where their mouths were earlier in the year. So this is a sign of a capitulative wash out low in stocks when you have more sellers technically than buyers. So I thought that was an encouraging one.

Jodi Phillips:

You had mentioned that there are eight indicators. Are there any other ones that you would want to highlight?

Talley Leger:

Yeah, so sticking on the positive side of the checklist for now until we pivot, Brian, I think you'd be happy to hear this one. The Economic Policy Uncertainty Index actually peaked earlier this year and has come down. And I think getting through or past the midterm elections has helped us, at least in terms of removing, if we do have gridlock in Washington, some of that political discord and allowing fundamentals and interest rates and inflation and monetary policy to work their magic for markets.

Brian Levitt:

I'm comforted that we're making progress. I'd like to hear more about the indicators that aren't yet flashing and what are those telling you right now?

Talley Leger:

Yeah, so the two... And I'll say this honestly in my heart of hearts, that while I am an optimist, I'm being positive here, looking for reasons to be bullish, there are two indicators that served me well in 2020 that I quite frankly have not seen this time around yet that would give me a lot more, shall we say...

Brian Levitt:

You'd scream it from the hilltops rather than blog it on our website.

Talley Leger:

That's right. So the point is the VIX, so that would be the fear index, the volatility index, while it has been on the rise and in motion, it didn't give me a reading above 40 that I would prefer to see, meaning more blood in the streets and fear in the marketplace that would be indicative or supportive of this notion of a significant damage in the market that would get me excited as a contrarian.

Brian Levitt:

Some big blowout volatility event that happens.

Talley Leger:

That's right. And we've seen this, and you talk about every generation facing its set of challenges and the Time cover magazines. That's what we like to see, the market kind of climbing the wall of worry and moving from the lower left hand corner of our screens to the upper right hand corner.

Brian Levitt:

Ironically.

Talley Leger:

Yeah.

Brian Levitt:

Talley, the VIX hasn't gotten to 40. What's the second indicator that hasn't flashed yet to give you more comfort?

Talley Leger:

So Brian, it's very similar to the VIX. It's high yield corporate bond spreads above their Treasury counterparts. So again, very similar dynamics. Spreads had been widening as a reflection of this general risk off tone, but we didn't quite get the signs of fear or risk aversion that I would've preferred to see. And this might be a little bit wonky, but I was looking for that spread to reach at least 700 basis points above Treasuries. And it's a low bar, I'm not asking for much, but we never quite got there. And I had been waiting for the major credit event of the cycle. As I've said, when the Fed starts tightening, we were discussing tightening financial conditions, things start to break. And perhaps the crypto debacle, that major news, was the ultimate credit event for the current cycle. And so maybe I got that, at least conceptually.

Brian Levitt:

So it's the crypto exchanges which probably are not sitting in the high yield bond indices. And maybe otherwise it's a testament to the fundamental strength of some of those businesses and those high yield bond indices.

Talley Leger:

That's right.

Jodi Phillips:

So Talley, you divided us into the glass half full contingent … the glass half empty folks. All right, I'll ask you the glass half empty question then. So what's the worst case scenario?

Talley Leger:

I think the worst case scenario, and I was deeply involved in this year's outlook, drafting the scenarios, and I had to give a really good nod to the worst case dark outcome that I think most investors are aware of, that the Fed in response to hot inflation overdoes it in a kind of 1970s Burns or 1980s Volcker style, raises interest rates too much and really breaks the back of the economy.

I think personally, with many of my colleagues at InvescoI'm coming in the middle of the road with kind of a shorter, shallower economic recession. And that gets to the point where we actually have seen some really good moves in stocks. And I don't want to steal our own thunder here, but the kinds of rotation in leadership that would, I think, underscore where we're coming out as a team and as a group on the more positive side of the ledger.

Brian Levitt:

It's interesting you bring up Volcker, because when I think of Volcker, Paul Volcker, of course, the Fed chair in the late '70s, early 1980s, what I think about is inflation peaking in 1980, early 1980, Volcker raising rates through the year. So similar parallels to what we're dealing with right now. Inflation seems to have peaked in the spring. Right now, Jay Powell raising rates through the year. You did have a recession in '81, but if you invested when inflation had peaked, you were pretty happy over the next few years. And so do you think that that is an interesting parallel? Is that one that we can hang our hats on? And how would you start to think about positioning if so?

Talley Leger:

I think that's a really good point. Crazy markets, huh? Did inflation peak before bond yields? And did the economy bottom before stocks? Usually you'd think it'd be the opposite way. But yeah, I mean, look, on that score, and I've got a whole host of different tools in my toolbox to help guide the outlook here. I developed this proprietary supply chain disruption index, which has kind of helped confirm this more strategic... Moving away from the popular technical checklist to the strategic or cyclical bottoming process for stocks. And I think that's really where it starts. And inflation is kind of public enemy number one here, and it has been coming down with an improving supply chain outlook.

Jodi Phillips:

So Talley, thinking about what a recovery could potentially look like, I mean, are we going to go back to the same big names that drove performance last time around, or would we expect to see some broader leadership?

Talley Leger:

I mean, look, I think no two cycles are identical, and we've got our frameworks and our indicators to help investors get their arms and minds around these processes. But look, through it all, I don't think that the business cycle disappears. I don't think that the central bank and all its wherewithal disappears. And these are two really important forces or concepts that help shape our decisions and choices when it comes to broad asset allocation. So yeah, directionally, generally, the things that I would expect in a recovery type of scenario seem to be playing out.

And that really started, I would argue, back in October. So bonds starting to fall at the wayside relative to stocks, meaning stocks have begun to improve and lead the charge generally. Within stocks, the cyclical or pro-economy sensitive sectors of the market have been breaking out here. And even the riskier, smaller-cap value stocks have been perking up and responding to this general improving risk on tone that we're starting to see in the markets.

Brian Levitt:

Now, if the Fed stops raising interest rates, or we get the pause, I don't think any of us are thinking about an easing cycle, but if we get the pause, does that change the environment for the U.S. dollar, and what does that mean for international investing?

Talley Leger:

Well, that's another really interesting point, Brian, that the dollar actually so far, tentatively, is looking like it peaked in October as well, which would confirm exactly what we're discussing about this... And I know it's early, but we want to be forward looking, this general kind of about face in positioning and firming in investor risk appetite. So if the dollar continues to come down, and these are markets, right? They're forward looking, they're real time market variables, they tend to get ahead of the Fed. And perhaps they are discounting, at least a downshifting pace of interest rate hikes from the Fed. And remember, this has been the most intense rate hike cycle that we've seen in decades. So to me it's less about a pause or even rate cuts and really more about a downshifting pace of those interest rate hikes.

Brian Levitt:

Do you know what the biggest challenge, Jodi, with recoveries is?

Jodi Phillps:

What's that?

Brian Levitt:

Everybody misses them. And you know why people miss them is because they're still looking in the rear view mirror, believing that the world isn't good. And by the time things are good, a lot of the market recovery has already happened. It's really, and what Talley seems to be saying, it's really about things getting a bit better relative to expectations, inflation better to expectations, the Fed tightening starting to slow a bit. And that's how recoveries begin. I guess they say it's always darkest before dawn, which isn't necessarily true, but that's what they say.

Jodi Phillips:

More philosophical than I was expecting to get, Brian, I have to say.

Talley Leger:

Well, Brian, maybe this is sharing too much or oversharing, TMI as they say, but in our personal investing conversations, as you know, I have stuck to the plan, I stayed buckled in. You reminded me of that in your Compelling Wealth Conversations program and Financial Literacy program. And with my existing holdings, I own a lot of equities, especially US midcaps. So I did benefit from one of the, if not the best, Octobers that we have seen in a long time, I think, months to be invested in stocks at all. So I benefited there, but I'm still, as I've said to you, I'm still kicking myself, this is the greed factor coming in here, for having not put new money to work sooner to reap the rewards of that fantastic October.

Brian Levitt:

Well, and if we do see a recovery and the beginning of a new cycle, then I would assume you'd have ample opportunity to take advantage.

Talley Leger:

That's right.

Jodi Phillips:

So Talley, before we wrap up, I always like to ask our guests, what didn't we ask you that we should have? What else didn't we cover that you think is important to point out?

Talley Leger:

Thank you. And I wanted to bring us back because there was something I was playing around with, being a fan of building indices. And this goes back to my point about being a paranoid analyst. So this time around, second guessing the personal kind of human judgment and intuition, the assessment of the indicators on the tactical side, the checklist, what if I got it wrong? What if my lens is distorted or cracked? So I tried in that spirit to remove myself from the decision making process by trying to coax out or introduce a sense of statistical significance to the eight indicators. And the way I did that, not to get too wonky here, but I used a Z score transformation to try and express each one of these indicators in common units of standard deviation away from their respective means.

Brian Levitt:

That's what I was going to do.

Talley Leger:

Yeah.

Jodi Phillips:

Beat you to it.

Talley Leger:

That's a dorky way of saying I just took myself out and I just let the data and the statistics... We all remember our statistics from high school math and first year…

Brian Levitt:

And what did it tell you?

Talley Leger:

Well, I'm happy to say that it told me that after having expressed this thing in common units that we can all understand, standard deviations, it's a variability concept, we actually had a north of 2-Sigma event in late September, which now, again, in hindsight, as I said, is 20/20, looking back perfectly explains from a contrarian perspective, we had so far peak risk aversion, and that was the setup for a fantastic month of October.

Now, having said that, it wasn't the level of significance that we saw, say, back in early 2020 or 2008 or 2009. Those were 4+ Sigma events, really massive dislocations in markets. But again, I think the story here at the end of the day, is this market draw down is probably shaping up to be something along the lines of a shorter, shallower contraction.

Jodi Phillips:

Well, as a paranoid investor, I'm glad to know that paranoid analysts are crunching the numbers the way that you are. Thank you for that.

Brian Levitt:

And we may not be there yet, Jodi, but it sounds like we're certainly getting closer.

Jodi Phillips:

Yeah, that was my one question. We're not there yet, or we wouldn't still be driving, but we're getting closer.

Brian Levitt:

Well, Talley, thank you so much for joining us. This was very informative. I hope you can enjoy some time over the holiday season where you can step away from your advanced statistics and maybe enjoy some time with friends and family.

Jodi Phillips:

Have some half full glasses.

Talley Leger:

That's right. Thanks, guys. It was great to be on. Good talking.

Jodi Phillips:

Thank you.

 

NA2639966

 

Important Information

 

Some references are U.S. centric and may not apply to Canada.

All figures are in U.S. dollars.

The opinions expressed are those of the speakers, are based on current market conditions as of November 22, 2022, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Past performance is not a guarantee of future results.

Diversification does not guarantee a profit or eliminate the risk of loss.

All investing involves risk including risk of loss.

Commissions, trailing commissions, management fees and expenses may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the simplified prospectus before investing. Copies are available from Invesco Canada Ltd. The opinions expressed are those of the presenter, are based on current market conditions and are subject to change without notice. 

These opinions may differ from those of other Invesco investment professionals.

Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although we make such statements based on assumptions that we believe to be reasonable, there can be no assurance that actual results will not differ materially from our expectations.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions. The information and opinions expressed do not constitute investment advice or recommendation, or an offer to buy or sell any individual security

Invesco is a registered business name of Invesco Canada Ltd.

Invesco® and all associated trademarks are trademarks of Invesco Holding Company Limited, used under license.

© Invesco Canada Ltd., 2022

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.

Inflation prints refer to Consumer Price Index reports issued by the U.S. Bureau of Labor Statistics. In June 2022, U.S. inflation reached a 40-year high of 9.1%.

According to the Investment Company Institute, investors pulled $27 billion USD out of equity mutual funds and exchange-traded funds in September 2022.

According to Bloomberg, October 2022 was the 11th best month for the S&P 500 Index in 35 years, rising 8.1%. Nov. 10 was the 15th best day for the index since 1957, rising 5.5%. The index experienced an 11% rally from March 8, 2022, to March 29, 2022.

The American Association of Individual Investors Bull-Bear Spread is the net percentage of positive minus negative respondents to the association’s sentiment survey.

The Chicago Board Options Exchange Equity Put/Call Ratio is a measure of seller relative to buyer positioning derived from the options market.

The Economic Policy Uncertainty Index utilizes U.S. newspaper archives to gauge the level of policy-related economic uncertainty.

The Chicago Board Options Exchange Volatility Index®, or VIX, is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.

The Bloomberg U.S. Corporate High Yield Average option-adjusted spread measures the spread of US dollar-denominated, below investment-grade, fixed-rate corporate bonds above their Treasury counterparts. When the spread is wide, investors demand high compensation for taking risk.

The Supply Chain Disruption Index includes the Institute for Supply Management manufacturing and services supplier deliveries, backlog of orders, and inventories; the Baltic Exchange Baltic Dry Index, which is a composite of the bulk time-charter averages; spot prices for dynamic RAM chips measured by inSpectrum; and the Drewry Hong Kong-Los Angeles container rate per 40-foot box.

A basis point is one hundredth of a percentage point.

A Z-score is a numerical measurement that describes a value's relationship to the mean of a group of values. Z-score is measured in terms of standard deviations from the mean.

Standard deviation, or Sigma, measures a range of total returns in comparison to the mean. A 2-Sigma event, for example, refers to returns that are two standard deviations away from the mean.

Risk aversion is the tendency of an investor to avoid risk.

Brian Levitt:

Hi, I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. Today we're talking with Andy Blocker, Global Head of Public Policy, and our resident expert on all things happening in DC. And nothing's bigger right now than the upcoming midterm elections on November 8th.

Brian Levitt:

That's right, Jodi, the midterm elections. You know what David Letterman said about the midterm elections?

Jodi Phillips:

What did he say?

Brian Levitt:

He says, "It's the day that Americans leave work early and pretend to vote."

Jodi Phillips:

Okay. All right, well far be it for me to argue with Letterman, but there's a lot of speculation that we could break the modern day record for midterm turnout this year, last set in 2018 actually.

Brian Levitt:

What was that, like half the country? 50.1% or something I think voted in 2018.

Jodi Phillips:

Yeah, I didn't say it was an impressive record, but it's a record nonetheless. And for Democrats, there's an expectation that those high profile issues, the overturning of Roe v Wade, the January 6th committee hearings, could bring more Democrats to the polls this time.

Brian Levitt:

Yeah, that would be a bit of a push against what we've seen historically if the Democrats were to maintain. I think historically the midterms haven't been very good for the president's party, and we'll see. I mean, we'll see. Biden's approval rating had fallen pretty low but maybe coming back up a bit, so we'll see if this time is going to be different than what Obama experienced, what Clinton experienced, what Trump experienced.

Jodi Phillips:

We'll see. But Brian, before we get into that and before we bring Andy on, I do want to ask you a question about the historical trend for markets in the midterms. Is there a particular outcome that markets would clearly prefer?

Brian Levitt:

Yeah, it's a good question, Jodi. I mean if you look at the performance over the last 121 years, and that's as far back as we can go on the Dow, it shows a preference for divided government over single-party rule. That's a comment that I think is well-known in the industry. I've always heard that for as long as I've been in this industry that markets like divided government. It's kind of hard to even discern if that's a statistically significant statement. I'll give you an example. One of the potential outcomes from this election would be obviously a Democrat in the White House, a Democrat Senate, and a Republican House. Now, that's not a foregone conclusion, but it's a possibility. That has actually been the best for markets over the last 121 years. But you know what's funny about that, Jodi?

Jodi Phillips:

What's that?

Brian Levitt:

It's only happened in four years, so it only happened from 2011 through 2015.

Jodi Phillips:

Four out of 121, that's it?

Brian Levitt:

At least as I can tell. Maybe Andy will tell me I'm wrong on that, but I tried to go through the Wikipedia page and look at it.

Jodi Phillips:

Well, there you go.

Brian Levitt:

Yeah, so it doesn't seem that statistically significant, but maybe it's a similar environment where maybe we'll be coming out of a little recession like we were 2009, '10, into '11, and maybe it will be a good time for markets.

Jodi Phillips:

Well, let's hope, let's hope. So on that note, let's bring on Andy to get the scoop on which particular combination of government rule we might see after these midterms. And I also want to talk about some of the legislation that our current Congress has passed over the summer, the past few months, and what that could mean for investors and for taxpayers.

Brian Levitt:

Andy Blocker is back. Welcome.

Andy Blocker:

It's good to be with y'all. Thanks for inviting me back.

Brian Levitt:

And so Andy, let's just start with the bigger picture. What are you expecting to see in November?

Andy Blocker:

So, that's a great question because expectations are changing day by day. This is a different year than I think we've ever seen. I mean, conventional wisdom is, look, we are a rebellious lot. What I mean by that, our country, we started by rebelling against the Brits, and we really don't like any one group of people or party holding the levers of power for too long. So historically, we just throw the bums out or we recreate or at least put some other people in to hold it back.

Andy Blocker:

So whenever one party has all levels of power vis-a-vis the Presidency, the House, the Senate, we like to at least take one or both the House and Senate away from that power that holds the Presidency. And the numbers are pretty stark. So I think in the last 30 years, which is a tight window, but I think the average is like 47 seats in the House are lost by the party in power and four to five seats are lost in the Senate. So that's history, and I think a lot of that is true for this election cycle.

Brian Levitt:

That's what Obama called the shellacking, right? I think Obama in, was it 2010, had the worst outcome of any of those presidents over the last 30 years?

Andy Blocker:

That's right, and it was a shellacking partly, and look, I think each party in power has a little bit to blame because usually when they come in the office, they overreach. They focus on their agenda and aren't as bipartisan as they should be, but I think it's just our natural reflection and natural inclination to be like, "Okay, you had a couple years with all of it. I'm not certain I want to give you any more time." And all the facts is that the party out of power is more energized, much more energized because they're the ones feeling aggrieved.

Jodi Phillips:

So Andy, what do you think is energizing voters this time around? What is the latest polling telling us about what issues are most important to voters right now? And in particular, where would economic issues land on that list?

Andy Blocker:

Yeah, so that's the key question. What's going to motivate people to get out the polls? So I just gave you one, just the inclination to "Hey, get those guys out before they destroy our country." The second is, yeah, economic issues. My former colleague James Carville, he said, "It's the economy, stupid." And it holds true today. It's basically this is a tough time for both, if you look historically for Democrats in the midterm and if you look at the economic numbers. So inflation is much higher than you would want going into the election. It looked like it was waning, and then the last month's numbers didn't do that. And the question is, where is it coming into November? But the practical ones are like, "Forget the top line number, gas prices." I mean that's what impacts people's lives every day.

Andy Blocker:

There's a almost directly inversely proportional correlation between gas prices and Biden's approval rating. It's like as gas prices go up, these numbers go down. So that's a very motivating factor. It's like, "Hey, these guys are in office and look what's happened," whether it's totally their fault or not. We got Ukraine/Russia. You've got coming out of the pandemic. You've got all these factors, but it doesn't matter, you're in charge and my life isn't as good so I want somebody else.

Andy Blocker:

But I do think there's some interesting counter-veiling forces this cycle, which we haven't necessarily seen. We've seen one of them. So the first one is Donald J. Trump. The more that Donald J. Trump is in the news, the more it motivates the people who don't like him, and so that's something good for the Democrats. You name your investigation or whatever he's saying, it doesn't matter. He's front and centre in the news. I think net-net is going to motivate Democrats to get out more than it's going to motivate Republicans because he's not on the ballot. When he's on the ballot, he has record turnout. He did it in 2020. He helped Republicans actually gain seats in the House in a year when Biden won the presidency. But in 2018, he did a lot more damage to the Republican party. Not a record number, but a large number of seats taken away from the Republicans. They lost majority in the House. And so, I think that's a real element, but I think the one that's even bigger this year is abortion and Roe v Wade.

Brian Levitt:

Right, right. Well, I was just going to say Carville also said that he wants to come back in life as the bond market so he can intimidate everyone, and that was kind of to your point about inflation. I don't know, Jodi, if you ever heard that one. He's like, I don't want to be a rockstar. I don't want to be a-

Jodi Phillips:

No, that one's new to me.

Brian Levitt:

I don't want to be an All-Star baseball player. I want to come back as the bond market so I can intimidate everyone. And that's clearly been what's happening this year. The rate's up significantly, equity valuation's down, and that's all part of this inflation story Andy's talking about. So yeah, I do want to hear about Roe v Wade and abortion and what that's going to mean for the getting out of the vote.

Brian Levitt:

But I'm also curious, before we even get to that Andy, you were talking about gasoline prices and Biden's approval rating. Is there a cutoff point on approval rating that matters? Biden was in the low forties, I think. Has he come up from there as gas prices have come down a bit, and do you expect that to roll over in the next few weeks, given what OPEC has just done to cut oil production?

Andy Blocker:

No, I think that's right. So he has come up as it's continued to... He's in the what, mid-forties now? I think depending on what you use, if you use RealClearPolitics or if you use a particular poll. But no, it's still been in his favour and that's why this OPEC announcement is, I think, that's why the administration was not very happy with that because they know what it means. There's reports that, I think, Ron Klain admitted the first thing he looks at, the Chief of Staff for Biden, he looks at gas prices because he knows that's how it impacts people's lives. And for those who are more well off, it doesn't impact their lives as much. They might get annoyed, but for people who are on the lower end of the income spectrum and people who have to travel greater distances... In a lot of these metropolitan areas, you might not have to travel. You might have to travel 5, 10, 20 miles, but in the rural areas, you're traveling 40, 50 more miles.

Andy Blocker:

And so I do think it has a huge impact, and we'll see what the impact is. They say they're not going to reduce production until November, but I think it's already hit the markets. I mean I think the futures markets, it's already hit. And so, the question is how fast does it get down to the pump?

Jodi Phillips:

So to the point that you were making a little bit earlier about the Roe v Wade issue energizing voters potentially, are we seeing any signals to help support that idea? I mean when it comes to either voter registrations or anything else that might give us insight into what the turnout could look like.

Andy Blocker:

So we were very cautious on that. We knew it would have an impact, but we were kind of like well, seeing is believing, right?

Jodi Phillips:

Right.

Andy Blocker:

So we see a lot of news reports, we see a lot of things going out there. So the first signal that this was real, the first real signal, was the Kansas referendum on abortion. Kansas is a Republican state, a majority very conservative state. And so, when it came back 59% to 41% for the right to have an abortion, that was a pretty clear signal that this was going to be a big deal because it wasn't just Democrats coming out, but you needed Republicans and Independents and you saw that in Kansas.

Andy Blocker:

Then the next question was, okay, okay fine, it's going to be a big issue, but it can't have a one-to-one translation to, “If I'm anti-abortion, that means I'm going to all of a sudden vote for a Democrat.” And I don't think it does. But we did see another data point in the New York special election for congressional seat where the Democrat ran solely on this issue, ran solely on the issue of abortion rights and won the race. I think it was 51/49. It wasn't a big win, but it showed that this is a winning argument.

Andy Blocker:

But the bigger data point for me is that Republicans who have, up until this point, had (said) “I'm totally pro-life, no exceptions for the life of the mother, rape or incest.” All of a sudden their websites have been scrubbed, and they are no longer purporting that or at least advertising that loudly. And so, that's a sign to me that when you are moving how you're positioning yourself, that you recognize this is a threat to your candidacy.

Jodi Phillips:

So Andy, I want to talk a little bit too about the Congress that we already have and the summer that they had the past couple of months. I saw in your LinkedIn article recently, you called it an “outbreak of bipartisanship,” and it seemed like they were checking a lot of things off the list in terms of infrastructure and energy and veteran health care, manufacturing. What happened? What's behind all that?

Brian Levitt:

We finally had a good outbreak, Jodi.

Jodi Phillips:

Oh my goodness. Yeah, seriously. So what prompted that?

Andy Blocker:

My theme for the year has been this concept of politics, Trump's policy, and I think this goes right underneath that. So under that rubric, some people get upset when I say that. They're like, "No, that's not the way it should be. The best policy should win." Well no, I agree with you the best policies you should win, but since we're in a democratic republic, the voters have a say. And so, if you want your good policy to become real, you make a good politics. So that's the job there.

Andy Blocker:

So I think a lot of the things that you mentioned, a lot of the different areas that passed, look, voters wanted safer communities, they wanted better roads, they wanted modern manufacturing, they wanted U.S. competitiveness globally. So I think that allowed a lot of these things to come just as a baseline. They're generally popular. And then also, there are certain constituencies that were pushing for it. You need the right constituencies pushing for it, and you need the, how should I say, not just the macro polling to go your way, but you need the micro polling. You needed the key members in the different chambers, the House and Senate, who are going to be in favour of it. And a lot of these things, Senator Schumer, the majority leader and Senator Mitch McConnell, the minority leader, supported. And once you got that, that kind of paved the way, but they weren't just doing that in a vacuum. They were looking at the polls, and a lot of it was the pushback or the consequence of inactions in some of these areas outweighed the potential pushback against any action.

Brian Levitt:

If we get to the beginning of next year and the composition of the government is what many people believe it to be, which would be divided, let's just say for example, are there other things to tick off here where we're going to see more outbreaks of different strains of bipartisanship, Jodi? Or should we expect it to be more of a lame duck couple of years?

Andy Blocker:

Yeah, I think between those choices, I'll use the word lame duck, I think is the most likely scenario. And I say that because I think 2018 is more the model here. I mean in 2018 after their Democrats won back the House, they spent the next couple years the way they do. They impeached President Trump twice. I think this Republican House is going to definitely, if they're not successful, they're going to try to impeach President Biden. And you also saw the government shut down because there was divided government. It was Trump and the Democrats going at it last time. This time it would be Biden going at it with the new House Republicans, who are going to probably want to extract a lot of things from him, holding that over his head. And then you've also got late next year, you're going to have to deal with the debt ceiling. So I think it's going to be very, very, very contentious, I think, between impeachment, all the different investigations. They'll have subpoena power. So it's going to be pretty raucous.

Brian Levitt:

Is this the country now? We're just going to do rolling impeachments? I remember that chapter we learned in, what was it, 11th grade where I think we were going through the, I'll give up my age, the Clinton impeachment at the time. And then you had to learn about Nixon's resignation. I think before that you had to go all the way back to, I don't know, maybe Andrew Johnson or maybe I'm missing a couple. Is this just how it is now?

Andy Blocker:

I think at least coming up in this next year, it's going to be tit for tat. It's like, "You got my guy, I'm going to get your guy."

Brian Levitt:

As my grandmother would say, "Oy."

Andy Blocker:

You know what? It's not even about “I disagree with you.” It's “I don't like you” and “I don't like, you know ...”

Brian Levitt:

It's a shame. It's a shame.

Andy Blocker:

So it's not about we have a difference. No, you are the enemy within. And so look, that's why I think things like the Cold War, we had a common external enemy, and that mitigated a lot. Didn't mean we didn't have differences inside the country, but most of our energy and our ire was focused outside and we didn't have as much time inside. Now that we don't have as much time outside and who knows, I mean there's been some unity, vis-a-vis anti-Russia with Ukraine. There's growing unanimity vis-a-vis China. I think that's the one bipartisan thing we're going to see. I mean the CHIPS and Science Act doesn't come to pass unless 82% of the American people have an antagonist view of China. It just doesn't happen. And so, that was seen as a move to be more competitive with China, and I think there will may be opportunities even in the next Congress to do some things there. But that's the one area where there's kind of unanimity by pushing your animosity outside, but yeah, it's going to be a rough couple years.

Jodi Phillips:

So Andy, you mentioned that the CHIPS and Science Act to boost U.S. semiconductor competitiveness, production. What could that mean for manufacturing jobs here?

Andy Blocker:

Well, I mean we've already seen it. Intel was the first. They got out of the box quickly. They announced $20 billion investment for a couple factories in Ohio. You saw more recently Micron announcing a $100 billion investment in upstate New York, and IBM came in with another $20 billion investment announcement in upstate New York. So you've already seen it, and I think you're going to see a lot more of that because the incentives are really good. That's what the bill was meant to do was incentivize, bringing a lot of that manufacturing back to the U.S. because we saw during COVID that that put us at risk. It's the fact that some of the challenges of having global supply chains, they're fragile, and then on top of that, the fact that China's relationship with Taiwan and the threat of that semiconductor production not being able to get back to the U.S. when we're still relying on it. So I think you're going to continue to see more and more announcements out of that.

Brian Levitt:

And then the other big piece of legislation I think to talk about briefly is the Inflation Reduction Act. I love how they name these things. How much of this was really meant about reducing inflation in the near term? But that's certainly a catchy name for what's going on. So give us a sense of what that means for businesses, for taxpayers. What does it mean? Is it really a panacea with regards to the environment, and what perhaps may be flying under the radar with that bill?

Andy Blocker:

Yeah, no. Well first of all, so the three major parts are taxes, health-related provisions, and then the energy and environment that you just mentioned. I think politically the prescription drug part is really, really important. The question is whether or not people see that or pay attention to that before this election. But the fact that Medicare can negotiate on a lot of these prescription drugs and they've capped some of the payments for your prescription drugs going forward is a huge deal. But going back to the energy and environment, I think look, there's a bunch of tax credits and rebates to help lower energy costs, to strengthen supply chains of critical minerals, and to increase domestic production of clean energy. And I think this is the largest investment we've seen in those areas.

Andy Blocker:

And the one thing going forward, the supply chains for critical minerals and the increasing domestic production of clean energy, those are obviously important, but in the short term, it's interesting that to lower energy costs coming into this winter, that's a big deal. So no, I don't think anything's "under the radar." I think these are real things. This is bipartisan. Everyone's going to try to take credit for it, and I think they did a lot of good. I think the one thing, if I were going to say under the radar, is the long-term science investment because you don't see it right away. But we really need that as a country to be competitive long term because it's not just about having the best technology now. It's having the leading edge science now that can lead to the continuing of our supremacy in that technology arena, which I think is important.

Brian Levitt:

I keep hearing you use the word investment, and that's after the federal government spends $6 trillion to support the economy through the pandemic. And a lot of investors, a lot of people I speak with are very concerned about the type of money being spent. The national debt now over $31 trillion. What I've tried to talk about is these investments in the future don't all hit at once. This is not $4 trillion from the Trump administration, $2 trillion from the Biden administration. This is money over a longer period of time. So can you put that into some perspective?

Andy Blocker:

No, I think you hit right on it. I think first of all, it's the investment versus spending. So I think we were propping up the economy by giving people money, and the money was flowing out fast to keep the economy going. So even the $1.9, $2 trillion you talked about from the Biden administration early in their tenure, I mean a trillion dollars went out in six months. So that is inflationary. Sorry, we're seeing the effects of that now, but that's a lot of money to go out really, really fast.

Brian Levitt:

You forgot to tell Jay Powell.

Andy Blocker:

Exactly. Well he was in the middle of... Well, we're not going to go down there. I have so many … But yes, investment doesn't hit the economy right away. You see it on the back end, and these bills weren't as big. I mean, Inflation Reduction Act... Even saying it, it's funny. But it's actually, and most economists agree with this, it's not as inflationary as the other things. That's the whole point. It's really about investment. And so, it's got a longer-term spend. Even in the infrastructure bill, that was a longer-term spend. We talked about that, how it's over a 10-year period. I think these are investments we need to make now. I don't think there's inflationary, but they're going to be immense benefits down the road.

Brian Levitt:

Jodi, it reminds me of when the American Tax Payer Relief Act increased my taxes.

Andy Blocker:

Don't even talk to me about that.

Jodi Phillips:

Good times.

Andy Blocker:

I don't want to know. I'm in one of those states where they got rid of the SALT and that's just been very, very painful.

Brian Levitt:

Exactly, exactly.

Jodi Phillips:

So Brian, is it time to ask Andy what I'm sure his favourite question is?

Andy Blocker:

Don't do it.

Brian Levitt:

Let's do it.

Jodi Phillips:

2024, what's going on? Who's running?

Andy Blocker:

We're not even past 2022. Why are you... Come on. All right …

Jodi Phillips:

I have you here. I'm taking advantage. I want to be the first to know.

Brian Levitt:

We don't ask what you want to answer, we ask what we want to know.

Andy Blocker:

My problem is I actually answer this question. So I want to give you what I've been saying for a year, and no one likes what I say but that's okay. Just got to give it to you straight.

Jodi Phillips:

At least you're consistent, that's good.

Andy Blocker:

So here we go. I'm going to start with the answer, which is going to have a bunch of moans and groans, and I'll explain why. Trump versus Biden. Okay, here's why.

Brian Levitt:

Are you groaning? I didn't groan.

Andy Blocker:

You didn't groan. I think they're the default case. I'm not saying that's what's going to happen, but if you had to put money and bet today, those are the two candidates. Why? Because each of them is in control of whether that happens. So if Trump decides to run for the nomination, the Republican party, he will win it. If Biden runs for the nomination of Democratic party, he will win it, and that's where I start with.

Andy Blocker:

So are there counter-veiling pressures on each of them? Yeah, sure, and there's a lot that can happen between now and then. I will say for the record, despite all of the investigations of former President Trump, being indicted is not a disqualifier to run for president or be president. Now being convicted is. Even if he's indicted, I'm not sure how fast the court system works where that could even happen. So that's why I'm saying if he wants it, he gets it, and I'm not sure all these investigations do anything for it.

Andy Blocker:

On Biden, I think Biden is equivocating. I mean he's gone back and forth between keeping it open and then also saying, "No, I'm definitely running," in the last few weeks. So I think that's going to see what it looks like coming into the year 2024. We will not hear from him until that time, but if he runs, he's a leader of the Democratic party, and you're going to have multiple candidates against him. And he'll have his solid 30% to 40% just like Trump would have on his side, and the math will work out that way where they get there. So there you go.

Jodi Phillips:

All right.

Brian Levitt:

My last question on that, Andy, is okay, so it's January, 2025, it's Inauguration Day. We've had a contested election. Is there any risk that we don't know who the president is on that day? Is there any risk? Bill Maher talked about this a lot on his show of two candidates showing up to take the Oath of Office.

Andy Blocker:

So I think that's why the Senate's working on this Electoral Count Act to prevent that. And so, they're being bipartisan about it, trying to make sure that the Vice President's role is ceremonial and that there's different guardrails against that.

Jodi Phillips:

Well, the next question on my list is about 2028. So we better cut this off now. We'd better cut it off now. Andy, thank you so much for joining us once again and entertaining all of our questions, and we'll see how this all turns out quickly enough.

Brian Levitt:

Thanks, Andy.

Andy Blocker:

All right, thanks, guys.

Jodi Phillips:

Thank you.

Brian Levitt

I'm Brian Levitt.

Jodi Phillips

And I'm Jodi Phillips. And today we have Rob Waldner. Rob is Chief Strategist and Head of Macro Research for Invesco Fixed Income. Fixed income. Not a lot going on there, right, Brian?

Brian Levitt

Yeah, we seem to get the timing right, coincidentally, or maybe not coincidentally with these guests. There's a lot going on in every market, Jodi, but for fixed income it had been particularly rough. I think equity investors have probably become somewhat conditioned for bad environments. We've seen this a lot over the years, even in my career, just 2000, 2008 … I mean we've seen this, but for the bond investors to be down, I think at one point, 14.5%, if you look at the aggregate bond index, in the same year that equities are down 25%, I mean that's a tough pill to swallow.

Jodi Phillips

Well it has and you can see that in the numbers, right? You look at the Investment Company Institute, look at their flow numbers. And there's been about $260 billion in outflows from fixed income mutual funds and ETFs this year. And around $30 billion or so of that has been in the past five weeks.

Brian Levitt

Yeah, I mean investors tend to bail at inopportune times. But remarkably, equity flows have actually been positive over the year.

Jodi Phillips

That's a little surprising to me, honestly.

Brian Levitt

Yeah, I mean maybe, and maybe we're learning, maybe equity investors are realizing how badly they've been burned by selling at those inopportune times in the past. Well, we'll see.

Jodi Phillips

We learn but we learn the hard way, right? So we'll see how this works out. But you know what, it has been a remarkable year for interest rates and inflation, no doubt.

Brian Levitt

Oh, I mean remarkable is, I mean this is one for the history books, right? I don't even know is remarkable the strong enough word?

Jodi Phillips

No, probably not.

Brian Levitt

Probably. Even the two-year rates started below 1%. I mean that was like the market was expecting only a couple of interest rate hikes this year and surged above four. I mean the 10-year was what had climbed from a low of around 1.5% to what, 3.75% or so. So I mean it's been remarkable.

Jodi Phillips

Yeah. And those 10-years that were 1.5% at the start of the year just aren't that valuable when you're looking at three and three-quarters right now. So it is an interesting situation for sure. Not a lot of places to hide.

Brian Levitt

Yeah, there hasn't been. It's not only Treasuries. We've seen borrowing costs go up for corporations as well, but we start to think, look, perhaps a decent amount of the worst is behind us for rates — if we're certainly getting closer. And so at this point, it's really about the market getting more clarity on inflation, on the Fed. How tight does the Fed need to be?

Jodi Phillips

That's the question.

Brian Levitt

Yeah, that's probably the 200 trillion dollar question.

Jodi Phillips

200 trillion dollar question. No pressure there. So that is definitely Rob's cue. Yes?

Brian Levitt

Yeah, that's his cue. I want his view on rates, inflation, credit, how far he thinks the Fed is going to go. Are we finally generating income in fixed income? Is this what we've been waiting for? And now investors are bailing on it. So there's just so much to talk about. Let's bring Rob on.

Jodi Phillips

Great. Welcome, Rob.

Rob Waldner

Thank you, Jodi. Thank you, Brian. Thanks for having me on.

Brian Levitt

Yeah, it's our pleasure. Let's just characterize, Rob, what's going on. What's been driving markets here?

Rob Waldner

Well you've spoken about the poor total return performance we've had this year in fixed income. And I think it's helpful though to disaggregate it into what kind of really drove it. And I think there's a narrative out there that it's all about inflation and that inflation really picked up and therefore fixed income had such negative returns. That's partially true. But really what happened, I think if you're going to look at this, what really drove fixed income this year is that after years of being sort of excessively loose with monetary policy, the Fed took a total pivot and went all the way from the loose side — as loose as possible — to now being essentially as tight as possible.

Rob Waldner

But the reason I say that is if you look at what happened in real yield, so in fixed income we like to talk about real yields, which are the yields that you get by comparing inflation-adjusted securities, or TIPS (Treasury Inflation-Protected Securities), to Treasuries and what the implication is for inflation. That TIP gives you the real yield. Real yields have risen by almost 250 basis points. So we started out at negative in the 10-year sector, we started at negative yields at a year ago, about minus 1%. We're now at plus 1.5% percent. And that's really not inflation, because the inflation compensation component of that has moved kind of sideways. That's really driven by the Fed getting very aggressive. And so that's the story, is that the Fed is pivoted from being super easy with QE (quantitative easing) to being very tight with QT (quantitative tightening).

Jodi Phillips

So Rob, talking to you the other day, just to put a point on this, you mentioned that you hear so often from investors, "What do I do about inflation? What do I do about this?" And that that's really not necessarily the right question to be asking. So what should investors be asking right now?

Rob Waldner

Well, I think with what the Fed has done, what the Fed has told us is they are going to get inflation back down to 2% no matter what. So the question really isn't, “How do I protect my portfolio from inflation?” It's “How do I protect my portfolio from the Fed?” Because the Fed told you what they're going to do, which is they're not going to rest until they have clear signs that inflation is headed to 2%.

Rob Waldner

And by the way, that's what the market is implying. So market breakevens, again looking at TIPS versus nominal Treasuries, tell you that the market has confidence in the Fed. And so what we need to do is figure out exactly how far the Fed is going to go and to cut to the chase. We think that we're getting pretty close to the time when it's a good opportunity to buy fixed income and that the Fed has tightened policy quite a lot. We see signs that inflation has peaked. It may take a while to come back down, but we think that this narrative that is out there — “This is the 1970s, and we’ve just got to keep raising rates and raising rates” — is just not the right narrative.

Brian Levitt

I mean that's good from an investment perspective, but not from my wardrobe. I just went out and I bought a polyester leisure suit and Jodi's been crocheting sweaters.

Jodi Phillips

I'm so glad this is audio only.

Brian Levitt

But to that point, Rob, I mean when I think of ’73, ’74, ’75, I think of the idea at the time that the Fed had kind of lost the narrative, whether it was previous to Arthur Burns, William McChesney Martin doing the bidding of Lyndon Johnson or then Arthur Burns doing the bidding of Richard Nixon and long-term inflation expectations getting out of whack. The bond market is telling you that this is a very different situation. Is that what you're saying?

Rob Waldner

Exactly right.

Brian Levitt

And so when we think about them pushing so hard on this, even with inflation expectations pretty benign. What starts to happen with growth expectations? What starts to happen with financial conditions? I mean how worrisome is what's transpiring to you?

Rob Waldner

Okay, so let's break this down because I think that's a great question, Brian. So when we think about this, thinking about how the market's going to behave, we like to break it into three components, which is what's inflation going to do, what is growth going to do, and what is central bank essentially policy going to do? Right? And we already talked about inflation. We think inflation's peak is going to come down slowly, but will be maintained. This is not the 1970s. So then the question is, the Fed’s tightening policy, what is that going to do for growth? And so we have a bit of a horse race here between tightening policy and growth, and how much will the Fed slow growth, when will they pause to see how much tightening they’ve put into the system? And so the thing that worries us a little bit is that with longer-term inflation expectations remaining well-contained and the Fed just continuing to deliver for global central banks.

Rob Waldner

That's just like, global central banks continuing to deliver hawkish surprise after hawkish surprise after hawkish surprise. And really we've never seen, globally, central banks raise rates at this pace. There's really a real risk that we could see something break, or that they overtighten. And I think we could point to a couple of things that might point to that: tightening financial conditions, the dollar is on a tear, real yields are rising globally. So that's kind of what we're worried about.

Brian Levitt

Okay, Rob. So Jodi's Jay Powell, what do you say?

Jodi Phillips

Sorry.

Rob Waldner

Well, so the message for Jay Powell is you've set up this narrative where you are the new (Paul) Volcker and you are going to raise rates essentially until you see the whites of the inflation eyes. Right? And the problem with that is that we know that inflation is a lagging indicator, and we know that the inflation that we have today is about what we did two years ago in terms of fiscal policy and monetary policy, that really juiced the economy and gave people money to spend on cars, and houses, and they had low mortgage rates.

Rob Waldner

All of these things are what's driving inflation now. So that's gone, right? Those stimulus checks have been cashed, you can't get those back. Those mortgages at 2.5% or 2.75% — we never thought we'd see — people took them out. Those are all in place. You can't undo that. So that as well is one of the things that's really driving our inflation now. So those are trailing indicators, if you like, right? That's something that did happen. Meanwhile, the Fed has monetary policy and so I'd say Jodi, you're setting a forward-looking instrument which is monetary policy based on a backward-looking indicator. And I wouldn't recommend driving looking in the rear view mirror, just not a good strategy.

Rob Waldner

And so we would say, hey, maybe it's time to see, with all this tightening, to see what ... take a bit of a pause. We've been calling it pivot, and we've been hoping that they would pivot over the last several months. No signs of it yet. But they would take a bit of a pause.

Jodi Phillips

Absolutely. So do you have a sense, or I know everyone's looking, listening to every word that's spoken in every press conference, at every release, looking for signs of that pivot. What do you think it's going to take or what do you think they're looking for before they begin that process?

Rob Waldner

So I think it's either something breaks, right? And we have two recent examples of things that, well two minor, maybe, could start to chart the path. One, we had this whole episode in the UK last week where we basically had, for a variety of reasons, we had the gilt market come unhinged, the bond market there become unhinged, and put quite a lot of – that created quite a lot of collateral calls in the pension system there, due to the structure of the pensions, and really the Bank of England was forced to come in and stabilize things. So what they did is they bought bonds, they went back to essentially, it's not really QE, but they bought bonds the same thing basically as QE. And that is after they'd been planning on doing QT. So they really did a sort of pivot towards a more dovish stance, not a big pivot but that's that something was breaking. The liquidity in the market was deteriorating, causing a breakage in the market and they came in and stabilized it.

Brian Levitt

The market told us we shouldn't be lowering taxes on the wealthiest people in an inflationary environment or at least the British shouldn't be.

Rob Waldner

Yeah, well yes. That, and also it told us that with rates, when rates are moving this quickly and this aggressively, it doesn't take much for portfolios to get twisted, for these total returns to really become a problem. And so I think it said to the UK, you need to calm down, you need to take it a little bit slower, you can't move rates that aggressively. That was one. And the other is we've got the Reserve Bank of Australia recently and they delivered a dovish rate hike which is only 25 basis points. So I think the narrative there is that a little bit, maybe they are, we'll see whether the Fed might do something similar. We'd certainly love to see that.

Brian Levitt

Rob, how would you position, so many investors when they built the 60/40 (portfolio), the 40% was going to be longer-duration ballast in the portfolio, maybe not the highest yielding securities you could find in the fixed income market, but certainly protection or the perception of protection. When Jodi and I were talking about the flows data, it seems that that's probably where, or a good amount of it has come out of what was to be the ballast. If you're talking about excessive tightening, slowdown in the economy, dare we say a recession, is that a return back to longer-duration assets?

Rob Waldner

Well I think I agree with the way you kind of characterized it in the beginning, Brian, which is just when I can tell you there's some value in fixed income, for the first time in many years, the flows are still out. So I'm getting hoarse going out and talking to people about the value that fixed income can bring to your portfolio now. Because if you go back to the way I set this up a moment ago, we have tightening policy and we have growth. These are the two things we're worried about. Well if we game this out and let's say that the Fed does what we hope it will do, which is or that we think they should do, which is sort of take a pause, that would be a little bit dovish received by the market, overall level of rates would stabilize, might come down a bit, and you'd see probably credit spreads coming because that would be a better liquidity environment, less recession risk.

Rob Waldner

The bad scenario there would be the Fed continues to tighten and continues to tighten, and then we get a recession and we get a nasty recession. And the advantage in that environment though, I still can see fixed income performing a decent role in your portfolio relative to some of the other choices. I'm not saying investment grade bonds are going to give great total returns, but they're going to hold up relatively well to most of the other assets that you could put in your portfolio such as lower quality credit or equities. So I really do think bonds are back to being a great investment here for the first time in quite a few years. The investment grade index is yielding about 5.4%. So you can buy a basket of investment grade bonds, collect 5.4%, which by the way, everybody thought that a year ago people would've been falling all over themselves for 5.4%.

Brian Levitt

Absolutely.

Rob Waldner

Got 5.4% and you don't really have an investment grade index, you don't have the worries about near-term defaults, et cetera. And you have duration in that index. So if you do get the recession, the duration will help offset some of the spread widening, and if you get the dovish Fed pivot, that's going to be a great entry point.

Jodi Phillips

So Rob, you mentioned that you were going hoarse a little bit spreading that message out and I'm glad you regained your voice in time to join us today. But when you are talking about this story out there, what kind of questions are you getting, or what kind of concerns are you hearing that maybe you're having to work through, and really communicate to investors what they're looking at right now?

Rob Waldner

Well I think there's two things. One, the US Agg is down 12%, 13%. So your fixed income portfolio is really taking a beating. And so I think that makes one cautious. Two, while we think we've seen inflation peaking out, you haven't seen the decisive turndown that the Fed is looking for. And it's going to be messy. We know that there will be some persistence in inflation in housing, and so you're going to have to look through some noise really. So you have to look through the noise and ignore the negative total return so far this year, if you're going to buy into that story that I just gave you.

Brian Levitt

Are you surprised where credit spreads are today? And by that, I mean historically low relative to where they typically are in an environment where growth is slowing?

Rob Waldner

Yeah, I think the answer would be yes. I think we haven't really priced a recession in the credit markets or in probably some of the other markets as well. Even if I do a very simple look at, I think what we've largely priced into a lot of these markets is the rise in real yields and what the discount rate that that implies for companies and others. And so that means you got to take down your multiples in equity market and it means slightly wider spreads, but it doesn't seem to us that you've priced in a recession. Certainly, particularly in lower quality credit, you can see much wider spreads in a recession that we have now. And that's why I've been talking about investment grade, I was talking about investment grade and not high yield.

Brian Levitt

Yeah.

Rob Waldner

The other areas that, there are going to be areas in credit that could be challenging, or if you're a company, in a recession, if your funding costs are going up, let's say your floating rate debt and your top line is under pressure, your revenues are under pressure because of recession, we could get a default cycle there or at least a downgrade cycle picking up.

Rob Waldner

So that would bring you wider spread. So we're not positive on credit overall, but I think we like higher quality credit.

Brian Levitt

And to your point, you start to compound those attractive income level or that attractive income stream that we haven't been able to compound in a very long time.

Rob Waldner

Right. I think there's some benefit from that duration, buying fixed rate assets.

Brian Levitt

And in terms of the currency, it's all part and parcel of the same trade, is it a dollar trade until the Fed pivots?

Rob Waldner

Yes, I think that's what's driving it here is the Fed.

Jodi Phillips

So Rob, you had talked a little bit earlier about how it's not just the Fed, it's global central banks really almost working in tandem on this. Looking at this regionally, are there any spots that you would particularly highlight maybe in emerging markets or elsewhere?

Rob Waldner

Yeah, I think that that's one of the stories about this cycle that's interesting, is that while the Fed was quite late, not all central banks were late to the cycle. So particularly there's some central banks in emerging markets and in LatAm (Latin America) for instance, who really have been hiking rates for a while, increasing rates were out ahead of the Fed. And so there are some situations where the cycles are a little bit more divergent from the typical scenario. And we think that's quite positive. And actually some of these countries, like a Brazil for instance, has actually had relatively good performance in this year. I think partly because they got out in front of it, started raising rates sooner. So there is some divergence in the cycle. Another place is China, where China's kind of been in recession and the policymaking has been much more stable.

Rob Waldner

I.e., real rates never really went negative. They haven't really moved much, interest rates haven't really moved up with China for a number of years. So they're at a different point in the cycle. So I think we're really starting to see some real benefits of diversification globally. If you look outside of the western US/European bloc, you're starting to see some benefits from diversification. So I think that's a really interesting thing. Now it is clear though that the Fed is, it can really realize a lot of value here. From some of these markets, you probably do need to get the Fed to pivot or just to slow down the rate hikes.

Brian Levitt

Okay Rob, we're going to put you back in Fed Chair Jay Powell’s seat. We're not going to make it 2022 though, we'll make it Powell's retirement day, whenever that may be. And we're going to have you look back on how this all played out. How are you feeling? Did you emerge with the Powell name intact?

Rob Waldner

Well I'm going to feel a little bit uncertain about it, I got to say, because I know that kind of already, I made a policy mistake in sort of 2021, 2022 by keeping rates too low, too long. I bought into the lower employment forever kind of narrative that I made a mistake in 2022, 2023 by hiking rates too aggressively and keeping them too high. I bought into the “inflation is the big problem” narrative. And so hopefully the US economy will continue to power forward, so it will do great over this longer term period. But I think I won't feel that good about that period, this period here. And when I express that to my wife and say I feel kind of bad about that, she'll say, "Well, honey, you remember how much pressure you were under. Remember all the political pressure and the narrative of the time," and she'll try to make me feel better. And all that's true that tremendous amount of political pressure to get unemployment low, then to keep rates low, then now deal with inflation. But I do think that I will, with hindsight, I would have implemented a different policy.

Brian Levitt

Implement a different policy. But the key takeaway I'll take there is we'll get through it, and the US economy will continue to be a growing concern and an ongoing investible opportunity.

Rob Waldner

Absolutely.

Jodi Phillips

We'll get through it. It sounds like the perfect place to wrap up to me. Thank you so much, Rob, for joining us and for taking our questions and putting yourself in that hot seat, putting yourself there for a time. Not an easy question, Brian.

Brian Levitt

He needs a hug. Thanks, Rob.

Rob Waldner

Well, thank you all.

 

NA2517956

Important information

The opinions expressed are those of the speakers, are based on current market conditions as of October 4, 2022, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Some references are U.S. centric and may not apply to Canada.

All figures are in U.S. dollars.

Past performance is not a guarantee of future results.

Diversification does not guarantee a profit or eliminate the risk of loss.

All investing involves risk including risk of loss.

Commissions, trailing commissions, management fees and expenses may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the simplified prospectus before investing. Copies are available from Invesco Canada Ltd. The opinions expressed are those of the presenter, are based on current market conditions and are subject to change without notice. 

These opinions may differ from those of other Invesco investment professionals.

Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although we make such statements based on assumptions that we believe to be reasonable, there can be no assurance that actual results will not differ materially from our expectations.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions. The information and opinions expressed do not constitute investment advice or recommendation, or an offer to buy or sell any individual security

Invesco is a registered business name of Invesco Canada Ltd.

Invesco® and all associated trademarks are trademarks of Invesco Holding Company Limited, used under license.

© Invesco Canada Ltd., 2022

Data quoted for the aggregate bond index refers to the Bloomberg US Aggregate Bond Index, an unmanaged index considered representative of the US investment-grade, fixed-rate bond market.

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Data for US two-year and 10-year Treasury yields is from Bloomberg, L.P.

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Fund flow data from the Investment Company Institute.

All data as of October 4, 2022, unless otherwise specified.

Breakeven inflation is the difference in yield between a nominal Treasury security and a Treasury Inflation-Protected Security of the same maturity. Statistics on the 10-year, 5-year, and 2-year breakeven inflation levels are from Bloomberg and the US Treasury.

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

Municipal securities are subject to the risk that legislative or economic conditions could affect an issuer’s ability to make payments of principal and/ or interest.

 

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Investments in companies located or operating in Greater China are subject to the following risks: nationalization, expropriation, or confiscation of property, difficulty in obtaining and/or enforcing judgments, alteration or discontinuation of economic reforms, military conflicts, and China’s dependency on the economies of other Asian countries, many of which are developing countries.

Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.

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A basis point is one hundredth of a percentage point.

Real yields are the returns that a bond investor earns from interest payments after accounting for inflation.

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Floating rate debt are bonds with variable interest rates that are allowed to move up and down with the market.

Brian Levitt (00:00):

I'm Brian Levitt.

Jodi Phillips (00:09):

And I'm Jodi Phillips. And today, we have Alessio de Longis Global Head of Tactical Asset Allocation

Brian Levitt (00:34):

The tactical asset allocation model, the framework that we all support, that Alessio uses, that we all follow, moved into contraction territory.

Jodi Phillips (00:47):

Contraction territory. That doesn't sound very good, Brian.

Brian Levitt (00:51):

No, I guess it's not ideal. I mean, it's what we always say though. High and rising inflation leads to the type of policy tightening that can end cycles.

Jodi Phillips (01:03):

Yeah. I've heard you say that more than a few times this year. I mean, starting back in January, you wrote a piece. I think the headline was, ‘What keeps me up at night?’ Am I remembering that correctly?

Brian Levitt (01:15):

Yeah. I'm glad you remember that. That does sound familiar. I guess it's time to break out the warm milk then, if we're officially in contraction.

Jodi Phillips (01:23):

Or a white noise machine to block out the market rumblings, that might be helpful. But look, the question for investors is, does a contraction have to be a nightmare?

Brian Levitt (01:33):

Yeah, it's a good one. I mean, look. This has been a very, very unique cycle. We haven't really had time for big excesses to build in the economy, and perhaps maybe a contraction could even be mild by historical standards.

Jodi Phillips (01:49):

That would be great, right? So, all right. One question answered, the contraction is here. More questions, how long will it last? How damaging could it be for markets? And how might investors think about responding to it? So let's bring on Alessio to discuss all of that and more. Welcome, Alessio.

Alessio de Longis (02:07):

Jodi, Brian, always a pleasure to be with you.

Brian Levitt (02:11):

Alessio, thanks for joining. You talk about the different regimes that the economy goes through in a cycle, whether it's recovery, expansion, slowdown, contraction. What's so stunning about this is I feel like we're going through all of them at a very rapid pace. So I guess first, how rare is that? And then second, how do you define a contraction?

Alessio de Longis (02:35):

Yeah, Brian, certainly this has been a rollercoaster cycle that seems to have started only two years ago. And we are approaching its end when we look at the sequence, right? Just for our audience, we registered the last contraction between February and May of 2020. We entered the recovery June 2020, and here we are. Two years later, we have moved back into contraction. Really a two-year cycle, basically. What is a contraction? A contraction we define as, very simply, as growth expected to be below its long-term trend or its potential, and to continue to decelerate.

Alessio de Longis (03:14):

So to be clear, a contraction includes recessions, but is not limited to recessions, right? When we think about recessions, we think about negative economic growth across a wide spectrum and indicators. And so in other words, a contraction in our case includes also periods where the economy is still growing positively, slowly, and growing below its long-term trend. So it's a little bit more broad ranged.

Alessio de Longis (03:43):

So this goes into the other question that Jodi was asking. Does every contraction mean a nightmare? Does every contraction mean a financial crisis? Absolutely not. Just like, as we said, not every contraction that we register in our framework even means a recession, so to speak. Can mean a period of weakness, but not necessarily a recession. And certainly, not necessarily a global financial crisis.

Jodi Phillips (04:12):

So Alessio, were you surprised that your model is signaling a contraction right now? Or was this something that you would've been expecting at this point in time?

Alessio de Longis (04:22):

Not surprised because if anything, this is one of the few instances where I feel our model has lagged the actual perception on the street, right? And needless to say, of course, we haven't categorized the first two quarters of this year as a recession yet. But technically, we did have very soft growth, two negative quarters of GDP (gross domestic product) growth. Even though we can explain them statistically through some anomalies, they certainly don't feel like a recession, but they are clear evidence of weak economic growth.

Alessio de Longis (05:00):

So this contraction does feel a little bit pre-announced, so to speak. Not really a leading signal this time around. Doesn't mean it has to be a wrong signal, but I don't think anybody was shocked when we printed the blog this month, compared to other instances.

Brian Levitt (05:21):

Alessio, help me square it, though. So the market applauds a Consumer Price Index (CPI) showing that it looks like the pace of growth, or the rate of growth of inflation slowing a Wholesale Price Index, which was actually negative for the month.

Brian Levitt (05:40):

So the markets seem to be applauding this peak in inflation. Is the idea that the economy's in a contraction or the regime is contraction, does that tend to suggest that the market's not going to continue to applaud this?

Alessio de Longis (05:54):

Yeah. A great question. And to me, it's the biggest question mark right now. So what is the typical behaviour of a contraction, right? Brian, as you always say, every contraction or every recession is usually brought by the Fed, right? It's brought by inflation and the tightening cycle that the Fed needs to extend in order to slow the economy. It's exactly where we are today. Like, even if you read word for word what Chair Powell said in the last FOMC (Federal Open Market Committee) press conference. He said, we need to get the economy to grow below its long-term trend for a prolonged period of time in order to get the unemployment rate to rise and build slack in the economy.

Alessio de Longis (06:35):

Obviously, this is what we're trying to do. So what do you typically see in that environment, from a markets perspective? Which is the nature of your question. We tend to see during a contraction that inflation has peaked already, or is falling ...

Brian Levitt (06:56):

Do we want to stop there and applaud, all of us? Do we have streamers or the horns that you blow ... what are the horns, Alessio, they blow at the soccer games? The vuvuzelas?

Alessio de Longis (07:07):

Oh, yeah. The vuvuzelas, yes. I don't feel yet as excited to celebrate, I think ...

Brian Levitt (07:24):

A peak in inflation?

Alessio de Longis (07:24):

I'm going ... yes. Look, I think it's a good sign to see a peak in inflation. The part that is still not ... let's look at a glass half full. A glass half full would be one where we are in a contraction that doesn't turn into a recession. How does that happen? Inflation begins to roll over, which is probably what we're beginning to see. The economy actually holds up. The unemployment rate rises, just modestly. It turns out that the Fed, even though it hiked aggressively, the economy was more than able to handle it. We continue to grow below potential. The inflation comes down. In that environment, the markets are actually going to trade more like a recovery, right? Eventually the market is going to rally, substantially led by credit spreads, which is exactly the reaction that we saw after the CPI report. And we basically are able to say, yeah. We printed a contraction. It never turned out to be a recession. The cycle moves on.

Alessio de Longis (08:24):

There is another side. The glass half empty would be one where this rollover in inflation is still driven predominantly by rolling of supply factors. Rolling over in supply factors and the well-known supply chain issues. But that we haven't even begun to see the demand-induced slowdown by the Federal Reserve. Even though we know mortgage rates are at cyclical highs of 5.5% coming from 2.5%. Affordability in the housing sector is down to the all-time lows of 2006. And consumer sentiment is already very weak. But by-and-large, the unemployment rate is still at all-time lows. It hasn't even begun to move. So it's very hard to say that this rollover in inflation is due to the demand side of the equation.

Alessio de Longis (09:14):

Now, if the supply side of the equation for inflation rolls over very quickly, the Fed may actually be able to stop very soon. So that is the glass half full scenario. I think we are dancing a very, very difficult tango here, and it takes two to tango, right? It's the Fed, it's the economy. All right, let's say three. There is the market involved as well. I think monetary policy is a very powerful tool, but it's not a precision tool. And there is the lag by which the Fed will impact the economy and that the Fed will be able to see the response from the economy. I think that's the balance. That's the equilibrium. That's the tight rope that we're trying to walk at the moment.

Brian Levitt (09:58):

And Jodi, you and I have discussed this, the demand that exists out there. I mean, even just in our everyday lives. The restaurants being packed, the hotels being packed, the airlines being packed. And it does seem like the consumer's hanging in there.

Jodi Phillips (10:14):

Well, yeah. So Alessio, I'm curious, is this contraction signal unique to the U.S., or is this something that you're looking at globally?

Alessio de Longis (10:30):

So at the moment, this is a fairly broad-based observation. We find that basically all of the developed markets, UK, eurozone, the U.S., of course, China, emerging Asia in general, they are growing below trend. And our expectation from a market sentiment standpoint, as well as the rate of change in some of those leading economic indicators is that basically, we expect these regions to continue growing below trend and decelerate. So that's a contraction in our playbook. Where we see growth still holding up better is in Japan and the rest of emerging markets, Latin America. The smaller parts of emerging markets.

Alessio de Longis (11:14):

But let's say that on a forward-looking basis, by our metrics about 80% of world GDP can be considered to be growing below trend, and therefore being at risk of a contractionary or potentially recessionary regime. So it's broad-based. And what we typically see is the average duration of this state of the world is about seven months. Now, we're talking really just models and technicalities, right? Just sticking to the facts, right? So if we want to be overly precise, take it with a grain of salt. But on average, we see these type of regimes lasting seven months. The shortest instances have been about two months, which we would call basically a fake. A fake signal, right? A scare that didn't materialize.

Jodi Phillips (12:04):

Got it.

Alessio de Longis (12:05):

Which can certainly still be the case. But in some instances, we have seen contractionary regimes that have lasted for a year and a half. So look at instances in the double-dip recession of the ’70s or the double-dip recessions of the ’80s. So those have lasted a little bit longer. It's hard to say where we are going today, because frankly, I think that it's all dependent on this latent supply factor that Brian and Kristina (Hooper) have discussed at length recently. That if energy prices, if food prices, if some of the supply chain bottlenecks were to resolve themselves unexpectedly well, inflation may actually fall more rapidly than we think. And the adjustment, the growth adjustment, the growth sacrifice that the Fed has to induce might be shorter lift, or less severe in magnitude.

Brian Levitt (13:00):

And it actually does look like we're starting to see some signs. Actually, not some signs, pretty good signs that the supply chain challenges are starting to ease. Maybe we'll get that short one. I guess I can quote Green Day then and say, "Wake me up when September ends." And we'll get back into this recovery.

Brian Levitt (13:19):

But Alessio, I know you're a long watcher of the Fed. Is what they're doing ... I mean, they already seem to have made the policy mistake, right? That's the 9.1% inflation. Is what they're doing now doubling down or creating another policy mistake? And the reason I ask that, it almost seems like at some point, the medicine, i.e., tight policy, higher unemployment rate. May be worse than this disease, given that long-term inflation expectations still remain very well anchored in this country.

Alessio de Longis (13:55):

It's a great question. And it's the question that you could answer in many different ways. So at the cost of being a little bit dogmatic about it, what is the definition of a policy mistake? Especially for a central bank that has a dual mandate. And if you take the letter of the law, as of today, they're failing on both mandates. So I would say that I ...

Brian Levitt (14:21):

But why are they failing on full employment?

Alessio de Longis (14:24):

Because the idea is that they, at steady-state ... which is obviously a theoretical concept. But on average, they want the economy to grow at the NAIRU. They want the economy to grow where the unemployment rate is at the non-inflationary level. And we know it's a very difficult concept to estimate, but if you look at the CBO (Congressional Budget Office) or the Fed, these estimates for the natural rate of unemployment that does not generate excess inflation, is somewhere around 4.5%, maybe 5%. Take it with a grain of salt. It's an estimate, with error bands. But we are at 3.5% (unemployment rate), and so we are at all-time lows. And inflation, to your point, core inflation, core PCE (Personal Consumption Expenditures) is at 4.8%. Core CPI's at 5.9%. We're two to three times higher than what the desired target is.

Alessio de Longis (15:18):

So as a confirmation of why I would give slack to the Fed and say that maybe the policy mistake was certainly in the past, but they are remedying it now. And this is a point that you, Brian, has made very eloquently in the last few months. Inflation expectations read in the market are coming back in. Six months ago, 12 months ago, two year breakevens, five year breakevens were at 4%, at 5%. The 10 year was at north of three, three and a half. Now, the entire breakeven curve ... so the spread between nominal Treasuries and real Treasuries. Has come back in below three across the spectrum. So it's telling us that ... so if anything, there was a policy mistake when we were above three across the board. Both on a cyclical and on a long-term basis, right? And now all of those measures have come back in.

Alessio de Longis (16:13):

A further confirmation is the surveys on inflation expectations have peaked and are beginning to roll over. So even consumer surveys are responding to that. And another positive sign in my mind ... and this is a point that, Brian, you and I have discussed for the last 12 months. The consumer sentiment surveys were at recessionary levels when the economy was booming, and this rise in interest rates hadn't even begun. And we were scratching our heads and saying, wait a minute. The economy is booming. Consumer sentiment surveys are at the recessionary lows because they're complaining about things being too expensive. So there was a message from the consumer: “I don't like this. I am losing confidence on the price signal that I see in the economy.”

Alessio de Longis (16:58):

What happened today? We are seeing an uptick in consumer sentiment for the first time in three months. Which is ironic, when you think that rates have risen so much, and usually we associate it to a sign of trouble. So it's a very interesting message that we're getting from the market. So I prefer now to give some slack to the Fed and saying, they're doing what the letter of the law wants them to do. And if there will be a policy mistake, it will probably be later the time to evaluate that.

Jodi Phillips (17:32):

So Alessio, what do we do with all of this information? When you think about it from that asset allocation perspective, portfolio positioning, what should we be thinking about right now in a contraction?

Alessio de Longis (17:44):

So again, knowing that any macroeconomic analysis, any regime analysis does not carry 100% certainty, right? Over the long term, you're a very successful investor when you are right 60% of the time. But that still means you're going to be wrong 40% of the time.

Brian Levitt (18:04):

Wait, wait, wait. We're not guaranteeing future results here?

Alessio de Longis (18:09):

No, I didn't see the banner come through. But I think it's an interesting perspective, right? I tell everybody, especially people that enter this industry, the younger generations and say, look to be an investor, you need to be prepared. Even when you are a rockstar investor, you need to be prepared being wrong, let's say 40% of the time. And assuming you have a 30-year long career, that's many, many years to be wrong. And you have to be prepared to handle that.

Alessio de Longis (18:39):

So with that said, let's assume that ... it's not a silver bullet, but let's assume that we are more in that 60%. So if we think that we have better than a coin toss of being right in identifying this recessionary or growth scare regime, what is an investor supposed to do? Well, the first question, as Brian always says, the first question is, remind yourself of your template and your playbook. If you have a long-term horizon, maybe the best thing to do is do nothing. If you are sensitive, let's say to an outcome over the next 12 months, two years, and you want to do some adjustments to your portfolio, I think the first question to always ask oneself is, “if the market were to sell off today or over the next few quarters by 15%, would my portfolio be able to handle it? Would I be able to stomach it?”

Alessio de Longis (19:37):

I think that is, first of all, a behavioural question. The market gives us what it gives us, right? Are we prepared to handle a 15% drawdown in the market? Just to say a number – it can be 20%. If the answer is yes, maybe the answer is do nothing. Or maybe the answer is even, you look for the opportunities to keep adding to your portfolio. Now, if the answer is no, I would not be comfortable with that outcome over the next 12 or 24 months, now typically what we see in contractionary regime is that it is appropriate to reduce portfolio risk, typically by reducing marginally your exposure to equity and to risky credit. Increasing the allocation to quality credit and government bonds within your equity portfolio. But alternatively, together or alternatively, other wise decisions in the portfolio historically have been to increase the defensiveness within your equity portfolio.

Alessio de Longis (20:40):

For example, you may decide not to reduce your equity allocation, but you can increase the defensiveness in your portfolio by allocating to defensive sectors, away from cyclical sectors. So that suggests consumer staples, health care. In this environment, possibly even technology and communication services, because they have quality characteristics. And maybe reducing your exposure to cyclical sectors, such as financials, industrials, materials. Or you can act in the factor space, in what is the so-called beta space. And investors are very familiar with low volatility stocks being more defensive than value or quality stocks, being more defensive than small caps, right? So those are ways in which you can build defensiveness. You can reshape the risk of the portfolio, build defensiveness in your portfolio without necessarily selling equities outright.

Alessio de Longis (21:34):

Obviously, if you have a short-term horizon, or if you are concerned about the next 12 to 24 months, in a recessionary environment, you have to worry about defaults, right? So the ability of getting your principal back. So worrying about your exposure or the maturities in your high yield portfolio, in your EM (emerging market) credit portfolio. So the riskier parts of your credit markets, because if by definition, you don't have the period ... the time to wait. You may be subject to realizing losses that can be very short lived, but somewhat painful.

Brian Levitt (22:14):

I enjoyed that answer so much.

Alessio de Longis (22:17):

Thank you, Brian.

Brian Levitt (22:18):

I just love the way you went through that from a longer-term perspective, to why you may want to make adjustments in your portfolio if you can't stomach a 15% decline. That was really well done, Alessio. My ask of you, and I think Jodi's ask for you as well would be, will you come back on to tell us when the recovery's starting to form?

Alessio de Longis (22:39):

I'm available anytime to come, and to deliver good news, especially.

Jodi Phillips (22:48):

That would be wonderful. And hopefully, Brian won't have to write a sequel about what still keeps him up at night, right? I think this has definitely helped me a lot in that regard, for sure. So thank you, Alessio, for joining us once again, so soon after your last appearance. But it was really great to get this update from you and figure out what you're looking at and what you're seeing and what we should be thinking about too.

Alessio de Longis (23:09):

Thank you, Jodi. Thank you, Brian.

Brian Levitt (23:11):

Thank you.

Alessio de Longis (23:11):

And really looking forward to the next update and what the market will bring.

Brian Levitt (23:15):

As are we.

 

NA2395608

Important Information

The opinions expressed are those of the speakers, are based on current market conditions as of August 12, 2022, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

All investing involves risk including risk of loss.

Commissions, trailing commissions, management fees and expenses may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the simplified prospectus before investing. Copies are available from Invesco Canada Ltd. The opinions expressed are those of the presenter, are based on current market conditions and are subject to change without notice. 

These opinions may differ from those of other Invesco investment professionals.

Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although we make such statements based on assumptions that we believe to be reasonable, there can be no assurance that actual results will not differ materially from our expectations.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions. The information and opinions expressed do not constitute investment advice or recommendation, or an offer to buy or sell any individual security

Invesco is a registered business name of Invesco Canada Ltd.

Invesco® and all associated trademarks are trademarks of Invesco Holding Company Limited, used under license.

© Invesco Canada Ltd., 2022

The 30-year fixed-rate mortgage averaged 5.51% in the week ending July 14, up from the same time last year, when it was 2.88%, according to CNN.

According to the Wall Street Journal, the National Association of Realtors' housing-affordability index fell to 102.5 in May, the lowest level since July 2006.

The minimum, maximum and average length of contractions is based on Invesco analysis of proprietary leading economic indicators as of July 31, 2022.

Gross domestic product is a broad indicator of a region’s economic activity, measuring the monetary value of all the finished goods and services produced in that region over a specified period of time.

The Consumer Price Index, or CPI, measures change in consumer prices as determined by the US Bureau of Labor Statistics. Core CPI excludes food and energy prices while headline CPI includes them. Headline CPI rose 9.1% over the 12 months ended June 2022. Core CPI rose 5.9% over the 12 months ended July 2022.

The Wholesale Price Index measures changes in the price of goods before they are sold at retail.

The Federal Open Market Committee, or FOMC, is a committee of the Federal Reserve Board that meets regularly to set monetary policy, including the interest rates that are charged to banks.

NAIRU stands for non-accelerating inflation rate of unemployment. It is the lowest level of unemployment that can occur in the economy before inflation starts to inch higher.

The actual US unemployment rate hit 3.5% in July 2022, according to the US Bureau of Labor Statistics

CBO stands for Congressional Budget Office.

Personal consumption expenditures, or PCE, measures price changes in consumer goods and services. Expenditures included in the index are actual US household expenditures. The PCE rose 4.8 % in June 2022 according to the Bureau of Economic Analysis.

Breakeven inflation is the difference in yield between a nominal Treasury security and a Treasury Inflation-Protected Security of the same maturity. Statistics on the 10-year, 5-year, and 2-year breakeven inflation levels are from Bloomberg and the US Treasury.

A double-dip recession occurs when an economy sees two periods of contraction, separated by a brief period of expansion.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

Investments in companies located or operating in Greater China are subject to the following risks: nationalization, expropriation, or confiscation of property, difficulty in obtaining and/or enforcing judgments, alteration or discontinuation of economic reforms, military conflicts, and China’s dependency on the economies of other Asian countries, many of which are developing countries.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

Many products and services offered in technology-related industries are subject to rapid obsolescence, which may lower the value of the issuers.

The health care industry is subject to risks relating to government regulation, obsolescence caused by scientific advances and technological innovations.

The profitability of businesses in the financial services sector depends on the availability and cost of money and may fluctuate significantly in response to changes in government regulation, interest rates and general economic conditions. These businesses often operate with substantial financial leverage.

Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.

Factor investing is an investment strategy in which securities are chosen based on certain characteristics and attributes. Factor-based strategies make use of rewarded risk factors in an attempt to outperform market-cap-weighted indexes, reduce portfolio risk, or both.

Beta is a measure of risk representing how a security is expected to respond to general market movements.