Market Conversations: The midyear market mood

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.

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Past performance is not a guarantee of future results.

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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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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.