Greater possibilities

Brian Levitt:

Welcome to the Greater Possibilities podcast from Invesco, where we put concerns into context and the opportunities into focus. Hi, I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. And we're talking about the mid-year outlook today with Chief Global Market Strategist, Kristina Hooper.

Brian Levitt:

Mid-year already. Quick.

Jodi Phillips:

It always is.

Brian Levitt:

Time's going way too fast.

Jodi Phillips:

It always does. And to be honest with you Brian, I'm trying to remember what happened in the first half. I scrolled through our market insights for the last six months to try to refresh my memory and it appears the big theme was waiting. We did a lot of waiting in the first half, waiting for rate cuts to begin waiting for elections to take place. But what am I missing, Brian? The first half wasn't all just sitting around waiting, was it? Does

Brian Levitt:

That make us Didi and Gogo from Waiting for Godot? We're just sitting under a tree.

Jodi Phillips:

Oh, nice reference. Nice reference. All right, so which one are you?

Brian Levitt:

You think I remember my eighth grade English? You're giving me way too much credit. The only thing I remember about the play is that Godot never shows, but I suppose that's a decent way to be thinking about the first half is that, you're right, the Fed never showed with rate cuts and that's from a start of the year where many people had been expecting six rate cuts. And so there's a bit of irony to it. We spent a lot of the first half of the year, 'we' being the royal we, talking about will they or won't they and when and by how much. And the reality is the market has just enjoyed good growth and no rate cuts, which is actually preferable, I would argue, to weak growth and plenty of rate cuts.

Jodi Phillips:

Well, good point. Good point. So, so far it's been fine for us to stand by the tree and wait for Jerome Powell. Unlike Godot I trust he will show at some point, but we haven't needed him just yet. But what about the second half? So now it's time to look ahead and Kristina is here to help us do just that. Welcome, Kristina.

Kristina Hooper:

Thanks so much for having me. If you don't mind my adding to the themes for the first half, I wouldn't say it's just waiting, it's reacting and overreacting. Because we got market reactions to almost every data point and reaction to a lot of “Fedspeak,” and I would argue some real overreaction as well. And so that took us on a bit of a roller coaster ride in the first half.

Brian Levitt:

I've been saying that too. It's like we go from, it's going to be hyperinflation to it's going to be an economic hurricane to things are okay to it's too strong, it's too weak.

Jodi Phillips:

Stagflation. That's what I'm hearing now, right?

Brian Levitt:

Yeah, stagflation and Kristina, I'm sure you remember Saturday Night Live from the '90s with Linda Richmond when she would say the Holy Roman Empire is neither holy nor Roman nor an empire or things like that.

Kristina Hooper:

Brian, I'm getting verklempt just listening to you say that.

Brian Levitt:

You're getting verklempt. Good use of Yiddish. My grandmother would be happy, but yeah, stagflation, it's neither stag nor flation. Discuss.

Kristina Hooper:

Discuss amongst yourselves I think was the exact... Yeah, I think that's absolutely right. We've seen quite good growth in the United States, certainly relative to expectations and we've seen continued disinflation. Yes, there was a stalling in the first quarter, but we seem to be making some progress again and we made a heck of a lot of progress last year, which Jay Powell has noted.

Jodi Phillips:

Kristina, you've been emphasizing this all year though and beyond, that the path of disinflation is going to be bumpy, it's going to be imperfect. So does inflation have to hit central bank targets exactly before cuts start or is it enough to just get some more confidence that we're going in the right direction?

Kristina Hooper:

Yeah, it does not need to hit. In fact, if central banks wait until the target is hit, they've made a huge policy error. I think of it as not different from that old Wayne Gretzky saying, I think I'm attributing, I'm no sports aficionado, but, "You want to skate to where the puck is going."

Brian Levitt:

That's right.

Kristina Hooper:

And similarly, the Fed is doing what it's doing in anticipation of what will happen. And so I think the reason it stopped hiking rates almost a year ago was because it recognized it had done enough. Now it hadn't shown up yet in the data, but we were certainly on that journey. And similarly, I believe the Fed will start cutting before we get near that 2% inflation target.

Brian Levitt:

So when you say they should do so, how worried are you if they don't? It seems like the concern is that the inflation numbers just stay a little bit stickier, prevents them from doing what they want to do, which is normalize the yield curve presumably. Do you worry that what does the policy mistake look like?

Kristina Hooper:

Well, that's the $64,000 question. We don't exactly know, but we do know that there can be very long and variable lags to monetary policy. Now this economic cycle has been altered. There have been, I would argue, artificial forces at play that have made it an unpredictable economic cycle, not conforming to tradition. So it's hard to guess, but we do know that the longer we sit with rates as high as they are, the more damage is likely to be occurring to the economy, which won't show up for a while. And so I don't think anyone thinks we've seen everything, the full impact to the economy of the Fed's aggressive tightening. And I think the longer we stay where we are, we just increase the risks of having a financial accident, of having an economy sent into recession. I don't think it is a coincidence that we saw an inverted yield curve. I think that was foreshadowing what could come and certainly is still a possibility if the Fed doesn't, in my opinion, start to cut.

Brian Levitt:

Do you think Jay Powell can be Wayne Gretzky if he's data dependent? That's the thing, it's like why be data dependent when you hire a whole bunch of economists? You should be modeling the future.

Kristina Hooper:

So I think it's very easy for them to just use that term 'data dependent', but the reality is they need to be thinking about where the economy's going to be and trying to at least do some modeling. And I think they're doing that and that is what made them comfortable with stopping hikes in July of 2023. And I'm hopeful that then leads them to start cutting soon. Now that doesn't mean I think they should be cutting dramatically, but I do think the start of rate cuts of a very gentle easing cycle is called for soon just because I think we run the risks after a very aggressive tightening cycle. Brian, you've often talked about the '94 and '95 Fed and what it did.

Brian Levitt:

Mid-cycle slowdown. Yeah.

Kristina Hooper:

Exactly. And how we'd love to see a similar scenario now because we would avoid that alternative of going into a recession. But in that case, the Fed only hiked 300 basis points and it kept rates at that peak for just five months before starting to cut. We are already at almost a year and it was 500 basis points of tightening. So I recognize that this problem arguably was bigger inflation was more significant, but that doesn't mean that the Fed can hold rates at these levels indefinitely. I think the longer they do that, the more risks arise. And I just think that there are, at a certain point, the balance changes and the greater risks occur from keeping rates this high recognizing that there are some sticky components of inflation. But that's part of an imperfect disinflationary journey.

Brian Levitt:

I just want it to be '94, '95, so I could be a senior in high school, freshman in college again, but I don't think that's happening.

Jodi Phillips:

So Kristina, obviously a lot of focus on the Fed, but not only on the Fed, wanted to just run through quickly some of your views and expectations for global central banks. Maybe we can start with the ECB, the European Central Bank, and what you're expecting to see from them in the second half.

Kristina Hooper:

I think that what we're likely to see though is a central bank that, like the others, is going to be very gentle in its easing cycle. So once one rate cut is done, the ECB, like other central banks, is unlikely to rush into another rate cut. I think it's going to assess the data. I think just letting a little air out of the tires is going to be enough and is going to provide some level of comfort and I think will be a boost to markets. So my expectation is maybe we'll see one or two more rate cuts after June, but I don't think it's going to be an aggressive easing cycle, at least not this year.

Jodi Phillips:

Okay. How about the Bank of England? Much different place for them.

Kristina Hooper:

Much different place. And while in inflation, the most recent inflation print showed progress, not as much progress as had been expected. And so I think the Bank of England is more likely to err on the side of caution and wait until August to begin rate cuts. That's not a sure thing, but I think it's a pretty sure thing. Again, I think it's going to be a gentle easing process, very gentle because it still is seeing some pretty sticky inflation on the services side and it wants to manage that carefully. I think Bank of Canada, we've seen some real progress on disinflation there. It's going to be hard to get timing exactly right, but the way I look at it is they're all moving in the same direction. It's all going to be about a rate cut starting the first-rate cut will start in 2024 and we'll have a gentle easing cycle for all those. With the exception of the Bank of Japan, that major central bank that's moving in the other direction, we're getting more hawkish comments from the Bank of Japan. The data is-

Brian Levitt:

Ironic.

Kristina Hooper:

Yes, and the data is indicating that the BOJ has achieved some of its goals and I think that it's eager given the situation with the yen to start hiking, and now it looks as though it's a good possibility that we see two more rate hikes this year, which I think was unheard of a few months ago.

Brian Levitt:

What a world.

Kristina Hooper:

Yeah, for the first time in 11 years, we saw the ten-year JGB yield go above 1%. So the times they are changing.

Brian Levitt:

Yeah, we're going to start seeing dogs and cats getting along.

Kristina Hooper:

Exactly. And so all these central banks are poised to begin new regimes in some sense of the word. And Bank of Japan is just one of them. It's just moving in the other direction from the rest.

Brian Levitt:

I like how you used the word “gentle” throughout the conversation because it's like investors have a recent idea of what rate cuts look like, and that's predominantly what we saw in 2020 and '08. And so I've gotten a lot of questions, "Well, why would they cut rates? Wouldn't something disastrous have to happen?" And the answer is, "No. There's been plenty of moments." You brought up '94, '95 and even 2019, which I think a lot of people forget where the Federal Reserve will try and fine tune this or the central banks will try and fine tune it, lower rates, but you don't have to bring it to zero. Those were two very distinct environments.

Kristina Hooper:

Oh, absolutely. And I think investors also need to recognize that we are in very restrictive territory for monetary policy, so we don't need to have any kind of significant weakening of the economy for the Fed to start easing. In fact, if we were to look at the San Francisco Fed gauge of the real feel on the Fed funds rate, which factors in other monetary policy tools like quantitative tightening that has the real feel of the Fed funds rate at about 620 or so basis points. And so that tells me, "Gosh, there's an awful lot of pressure on this economy." And again, we don't need to see economic weakness for the Fed to start that gentle easing.

Brian Levitt:

Are you sure to wear flowers in your hair when you look at the San Francisco Fed data?

Kristina Hooper:

Not at all, but that's certainly a good question to ask. I think if I did wear flowers in my hair, it would be primarily daisies and sunflowers.

Jodi Phillips:

Hitting the important points. Perfect for spring and summertime. So let's talk about the growth picture for a little bit. How is that picture developing? I know we've talked before about divergence really emerging is a second half theme. What is driving that divergence and what are you expecting to see?

Kristina Hooper:

Well, it's interesting. We've seen different types of divergence. For a while now the US economy has been performing better than other major economies and we've heard terms like, "US exceptionalism" And we could point to a few key factors, the very significant policy stimulus that the US received, especially direct stimulus like PPP, but also of course all those other forms of stimulus including monetary policy support. Also, beyond that, Americans are very good at spending. And so we saw Americans spending down their savings at a higher level than other countries like Germany. The savings rate is significantly higher there. And then finally, there's one other thing that's made the US unique, and that is that grand privilege of having long-term fixed-rate mortgages. The US learned from the 2008 global financial crisis, the epicenter of which in the US was housing to Americans have learned to have long-term fixed-rate mortgages. And so if we were to look at the data today on outstanding mortgages, more than 90% of them are long-term fixed-rate, either 15, 20 or thirty-year mortgages.

So you don't have to worry about variable rates for most of American households with mortgages. And of course the average mortgage rate on those outstanding mortgages. So it's nowhere near where it is today, it's at about 3.6%. So that has created a lot of breathing room that other households in other countries haven't been able to have. They felt more of the pressure, more of the crunch from rising rates. So that's why I think the US economy has done as well as it has. But of course, if we look at the Citi Economic Surprise indices, what we now see is that the eurozone economy is doing better and we're seeing emerging markets doing better, we're seeing China doing better. And that's all because the US, I think has already done a lot of its spending. It's gone through a lot of its savings and also it's feeling more of that pressure of high rates. At some point, I think we'll see convergence, they'll all be reaccelerating if we get central bank rate cuts sooner rather than later.

Brian Levitt:

So in aggregate, it's been a pretty stable global growth environment. The US perhaps looking to slow a bit and the other countries in the world picking up, that still seems like a pretty good backdrop for growth.

Kristina Hooper:

Absolutely, yes. Certainly on a relative basis, I think that's what's happening and I think we'll see a re-acceleration probably by the end of the year. I think improvement in real wages will be a positive for US households and will or help to cause a re-acceleration as well as the start of rate cuts. So I think the global growth picture is going to be a good one for 2025. So long as, and I have to give this caveat, we get rate cuts starting soon enough because that is the big risk that those long and variable lags of monetary policy.

Brian Levitt:

If we bring that all together, Kristina, it sounds like a good backdrop for risk assets. Again, assuming that the Federal Reserve doesn't commit the proverbial policy mistake, is there anything else beyond the Fed that has you worried? Any other risks to the outlook?

Kristina Hooper:

Well, it's interesting to see the kind of performance we've gotten from risk assets despite all the storm clouds around us. So we look at the geopolitical situation and there are a number of crises around the world, the Israel-Hamas war, Russia-Ukraine, and yet markets keep chugging along, they're more reacting to the expectations around the Fed than things like this. So I don't think we're going to see any kind of significant impact from geopolitics. We certainly have a lot of question marks around elections this year, but I think unless we see some kind of an outcome where policies directly impact markets, I suspect they'll have very little effect. And of course, Brian, you've done great work on why elections in the US just don't matter for markets. And I think that's really important for investors to keep in mind.

Brian Levitt:

I've been trying to push that boulder up a hill for years, but the questions keep coming back. Even geopolitics, I always try and think of markets from the perception of what's the economy doing? What's the Fed doing? And then if there's a geopolitical conflict, does that change the answer to either of those questions? And typically the answer is no, so long as it remains contained or regional. But I think investors generally assume the answer is yes. And maybe we'll use this as an example in the future as well to remind, you and I had spoken about the MSCI Poland index, and I know Jodi's going to want a source at some point, but the MSCI Poland index is one of the world's best indices since Russia went into Ukraine. It's just these things that people think are going to happen, tend to not, they think that something disastrous is going to happen to these markets. Tends to be the opposite in a lot of instances.

Kristina Hooper:

Absolutely. And we see investors react in different ways that I think can be healthy. So for example, you see a terrible event like the Hamas terrorist attack on Israel, and the response in markets is investors don't run out of risk assets. Instead, you see a number of investors adding to alternatives like gold, as I would say, a geopolitical risk catch. So I think there are important ways investors can separate out geopolitical crises and just terrible tragedies from portfolios and long-term investment goals. And I think that's important, especially in a year when we have so many major elections occurring as well as several wars.

Jodi Phillips:

Kristina, is there anything that we didn't ask you at this point that you think is important to highlight for investors looking ahead to the second half of the year?

Kristina Hooper:

So the one thing I didn't mention when you asked about risks was financial accidents. And I think that's part and parcel of the risks of any tightening cycle and certainly the risks of maintaining rates at a high level. The most positive thing I can say, and it's a significant comfort to me, is knowing that policymakers are very, very sensitive to the potential for financial accidents happening. We saw really rapid responses and impactful responses to things like the regional banking crisis in the United States, or I should say mini crisis. Similarly, we saw a very swift reaction and response to the guilt yield crisis in the UK. So I think policymakers recognize that that accidents can happen in an aggressive tightening cycle, and they're very, very laser focused on recognizing them quickly and then of course reacting to them in an appropriate fashion. So while that remains a risk, I think it's less of a concern for investors' portfolios.

Brian Levitt:

Good growth, moderating inflation, central banks perhaps shifting.

Kristina Hooper:

Policymakers doing their jobs well. All good.

Brian Levitt:

All good. Good backdrop for risk assets.

Jodi Phillips:

So you're feeling good about the second half, Brian?

Brian Levitt:

Yeah, I've been feeling good since inflation peaked, call it June 2022. So a little bit early with regards to markets. The market bottomed in October, but that was always one of my north stars when inflation peaks and finds its way back to a more reasonable level, historically, that's tended to be a good backdrop for risk assets.

Jodi Phillips:

All right, very good. Well then let's call it here with everyone feeling good about the second half. Thank you so much, Kristina for joining us.

Brian Levitt:

Thank you, Kristina.

Jodi Phillips:

Listeners who want to hear more from Kristina can follow you on LinkedIn and on X. They can find your latest commentaries at invesco.com/kristinahooper and Brian, where can listeners follow your thoughts in the second half and beyond?

Brian Levitt:

Yeah, this is going to sound similar to what you just said, Jodi. Visit invesco.com/brianlevitt to read my latest commentaries. Please follow me on LinkedIn and on X @BrianLevitt.

Jodi Phillips:

We like to make it easy for everyone. All right, thank you so much.

Brian Levitt:

Thank you.

Kristina Hooper:

Thank you.

 

Important information

You've been listening to Invesco's Greater Possibilities Podcast.

The opinions expressed are those of the speakers, are based on current market conditions as of May 31, 2024, 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.

Past performance is not a guarantee of future results.

In general, equity 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, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

All data provided by Invesco unless otherwise noted.

Historical data about past Federal Reserve rate cuts sourced from the Federal Reserve as of May 31, 2024.

Data about Japanese government bond yields sourced from Bloomberg as of May 31, 2024.

References to the “real feel” of the federal funds rate given other monetary policy tools sourced from the Federal Reserve Bank of San Francisco as of May 31, 2024.

Data on the amount ot fixed-rate mortgages in the US sourced from the Federal Reserve as of April 30, 2024.

Data about the level of mortgage rates sourced from the Federal Housing Finance Agency as of April 30, 2024.

The MSCI Poland Index (US dollars) climbed 54.15% from the day Russia invaded Ukraine (Feb. 24, 2022) through the end of May, outpacing the S&P 500 Index over that period. Source: Bloomberg L.P., as of May 31, 2024. Indexes cannot be purchased directly by investors.

The Citi Economic Surprise indexes are quantitative measures of economic news, defined as weighted historical standard deviations of data surprise.

Stagflation is an economic condition marked by a combination of slow economic growth and rising prices.

Disinflation is a slowing in the rate of inflation.

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

Monetary policy easing refers to the lowering of interest rates and deposit ratios by central banks.

A basis point is one-hundredth of a percentage point.

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. In a normal yield curve, longer-term bonds have a higher yield.

JGB stands for Japanese Government Bonds.

PPP stands for Paycheck Protection Program, which was a loan program designed to help businesses keep their workforce employed during the COVID-19 crisis.

The eurozone (also known as the euro area) is an economic and monetary union of European Union member states that have adopted the euro as their common currency.

The Greater Possibilities podcast is brought to you by Invesco Distributors, Inc.

Brian Levitt:

Welcome to the Greater Possibilities Podcast from Invesco, where we put concerns into context and the opportunities into focus. I’m Brian Levitt.

Jodi Phillips:

And I’m Jodi Phillips. And on the show today are Ashley Oerth from Invesco’s Global Market Strategy Office, and Ken Blay, Head of Research for the Global Thought Leadership team. And Brian, we’ve brought them on today to talk about bitcoin.

Brian Levitt:

Good. I get a lot of questions about bitcoin, certainly with the moves that we’ve had again more recently.

Jodi Phillips:

All right. You get a lot of questions. Do you have any answers when you get those questions?

Brian Levitt:

Well, maybe some. I’m not sure people actually should be listening to me about bitcoin. Sadly I’ve missed out on all of this, so I don’t know if you want to ask me any questions about it.

Jodi Phillips:

That’s why we have guests, but-

Brian Levitt:

That’s right. We have guests-

Jodi Phillips:

But it sounds like you have a little FOMO.

Brian Levitt:

Yeah. Who wouldn’t have FOMO over this, right? What a move in price.

Jodi Phillips:

Well, so you say you’ve missed out, but why? Why have you missed out? What’s behind that?

Brian Levitt:

Well, I guess I’m just still learning, waiting to learn more, and maybe I’ve waited too long, but to learn more about its purpose, how it fits into a portfolio. And Jodi, you co-host this with me. So, we once had a wise man on this podcast tell us, sometimes things just have to go up without you.

Jodi Phillips:

I remember that. Well, look, we need to learn, and we’ve got the right guests to help us learn. I would also like to hear more about just sort how to think about bitcoin. It’s the same questions. Is it a currency? Is it a commodity?

Brian Levitt:

Yeah. And what about the initial rationale for it, whether think back to ‘08, whether that was failing banks or concerns about unsustainable government debt, rampant inflation. Either those things haven’t come to pass or the market sort of ignored them otherwise. So, has the rationale for bitcoin evolved and to what?

Jodi Phillips:

Right. And for investors who own it or want to own it, how should they think about allocating it in their portfolio? How does it fit alongside the stocks and the bonds that they already have, and how can that all potentially fit together for them? So fortunately, Ashley and Ken are on the podcast today to answer those questions and more.

Brian Levitt:

Yeah. And they’ve both written extensively on the topic, so I couldn’t think of two better people to bring on to speak to.

Jodi Phillips:

Well now’s the time to bring them on. Welcome, Ashley and Ken.

Ken Blay:

Hey, thank you for having us.

Ashley Oerth:

Thanks so much, Brian and Jodi. Great to be here.

Brian Levitt:

Yeah, great to have you. Ashley, I’ll start with you. What’s the purpose of bitcoin? What’s it for?

Ashley Oerth:

Yeah, I think that’s a great place to start. I think also this is probably the question that has most frustrated people over the last decade plus because there’s a lot of questions still over what exactly it’s supposed to be. But it seems like that hasn’t really mattered. So, let’s go back to the start.

So really bitcoin, it was intended to be a sort of digital means of transacting value really without the need for intermediaries. You referenced before the global financial crisis. This is when bitcoin was really born, and the idea was to be able to sort of evade the traditional financial system, to not really have to use banks or other institutions, but instead to be able to transact value in a way that was secure, but without the need for any kind of intermediaries.

That said, most would really say it’s failed as a digital currency. Instead, it’s really evolved to be a sort of digital store of value, similar in many ways to gold, which is drawing these sorts of comparisons of bitcoin being “digital gold.”

The problem with bitcoin really is that it doesn’t enjoy the same history that gold does. So, I think that this sort of comparison, it’s pretty difficult, at least at this stage. For the time being, bitcoin, it’s attracting a lot of eyeballs and investor dollars really because it’s both supply-limited and highly secure. And it has these really tempting price cycles, which we’ll get into, I’m sure. It’s in this sort of self-fulfilling cycle for the time being.

Brian Levitt:

If it has tempting price cycles, can it be a store of value?

Ashley Oerth:

That’s exactly the point I love to come back to, which is that if it is supposed to be the store of value, a store of value should be relatively stable. But it’s the opposite of that. We have seen volatility come down. Sure. And the sort of history of bitcoin shows it to be something that can go as low as 80% to 90% below its previous highs, but we still see this narrative be pervasive. So, I think that if the narrative lasts that it sort of becomes self-fulfilling in some ways. So, I guess it’s just a matter of time until we get there. But for the time being, there’s plenty of reason to be skeptical. Right?

Ken Blay:

Well, and when you say about volatility coming down, that’s a relative comment. So, the volatility was at 150% annually. Now it’s somewhere between 60% and 80% annually, which is still huge. And if I’m going to go buy eggs with my bitcoin, I need to know how much bitcoin I need to take. That’s part of the problem.

Brian Levitt:

It’s like being in one of those inflationary countries in the 1930s where you didn’t know what the price of a beer was going to be the next time it came around.

Ken Blay:

Yup.

Jodi Phillips:

So Ashley, we’re talking specifically about bitcoin here and we’re going to continue to do that, but I do want to ask just at the outset, obviously, the name recognition of bitcoin, but how else should we differentiate bitcoin versus so many of those other crypto coins that are out there?

Ashley Oerth:

Sure. So, I would say the sort of critical differentiator for bitcoin is the fact that it’s got this sort of supply limitation built into it. And as we’re discussing already, we’re focusing on bitcoin, but we could be discussing other cryptocurrencies as well. But bitcoin has got this incredible brand recognition, and I think that’s helped it stay at the top of the crypto charts.

Bitcoin, it was really the first cryptocurrency, and it sort of stands as representative of the entirety of the crypto space. Pretty much everyone, I would argue, has at least heard of bitcoin, and media coverage tends to really paint bitcoin as sort of representative of this space. I also think that it’s relatively simple compared to other cryptos — its design, its language around it. Sure, it has a hurdle to it to really wrap your head around how it works. But compared to other cryptocurrencies, I would actually argue it’s quite simple and straightforward.

And I think that it also requires less knowledge of the crypto ecosystem in general to really appreciate what it’s about. It’s a much more refined idea, I think, than a lot of other cryptos out there. So, in a space that’s very young, I think bitcoin is this sort of style work crypto. And this mixed with the fact again that there’s this limited supply that can only ever be 21 million bitcoins, I think it’s set up bitcoin for this relative success we’ve seen.

Brian Levitt:

Jodi, I had a friend of mine who was telling me that they were trading 82 cryptos or something, and I was trying to figure out how many I could name. I think I got to Ethereum, Dogecoin and I got stuck.

Jodi Phillips:

You got me beat already.

Brian Levitt:

I beat you already.

Jodi Phillips:

Oh yeah, for sure.

Brian Levitt:

Yeah, yeah. So, you’re not a big Dogecoin trader, Jodi?

Jodi Phillips:

No, no. I have to admit that I am not. I am not. At least not yet. We’ll see where I’m at the end of this podcast though.

Brian Levitt:

Ken, I love the research that you’ve done around how it fits into a portfolio. And what I wondered when you were thinking about that, did it even matter to you, these conversations around purpose, or were you just thinking about risk-return profile and how an investor may want to think about it in a portfolio?

Ken Blay:

Yeah, great. That’s a great question, Brian. We authored a piece and two of my other co-authors are these bitcoin fanatics. They love bitcoin. Everybody should own bitcoin. I tend to be the bitcoin skeptic. And so, it was a really nice balance because they pushed on one way and I pushed on the other way in terms of being skeptical about things. And really what it led us is to be very objective about how you look at this thing.

And it’s interesting, we’ve submitted the paper for publication. We’ve got some comments back from the referee and one of the things that came back, was you guys didn’t mention whether it was a commodity, was a currency or it was a collectible or anything like that.

Brian Levitt:

Wait. Was I that referee?

Ken Blay:

No. I don’t know who it was. But it’s funny that I went back, and I said, “Let me look at this.” And so there’s this guy named Aswath Damodaran from New York University. In 2017, he said, “Well, you might consider one of the paths that bitcoin can take is that it can be viewed as gold for millennials.” More recently, he basically expressed that bitcoin is a currency that nobody uses and a collectible that doesn’t behave like a collectible. Alright, so we’ve got all the three words that we need to get in there, but we’ve got no more clarity as to what bitcoin actually is. And so, my point to the referee and my point in terms of how we approach the research was in fact to say, “Look, let’s not get into those things. Let’s look at the things that we can understand or what we do know about bitcoin, and that’s where we are.”

The first part of our research was to really understand bitcoin prices. How has it moved historically? What’s changed? And in doing that research, what we found is that, say the period prior to 2014, was this real crazy period went from bitcoin inception to 2014. There was some just really weird returns, really high returns, but really weird risky returns. The period afterwards tends to be a lot more normal. So, from 2014 to 2023 where we did our research, that tends to be a lot more normal. And while it is normal, there were some huge price swings. So, when we look at the returns, we looked at rolling one-year periods, so how much money you would’ve made in one year. And we see several instances of returns of greater than a thousand percent and a non-trivial amount of one-year periods that exceeded a hundred percent return. This is amazing stuff for anybody that’s looking at this. But then we also saw -

Jodi Phillips:

It’s the beginning of Brian’s FOMO. That’s where Brian’s FOMO started for sure — a thousand percent.

Brian Levitt:

To be clear, my FOMO started in middle school.

Jodi Phillips:

Okay. Alright. Well beyond the scope of our experts here today. Sorry.

Ken Blay:

So when we look at the returns, there’s also four instances where returns like one-year periods fell before 30%. And then there’s three instances where you have one-year year returns below negative 70% or greater. And those things, the most recent one started in early 2021 and lasted to about the middle of 2022.

Jodi Phillips:

So Ken, I’m curious then when you think, I mean just all of those different numbers and price swings that you’re talking about, how do you even begin to think about allocating to bitcoin? Where do you start when you try to think about how could this potentially fit with my stock allocation, my bond allocation, and then, how do I even think about rebalancing to make sure all of these swings aren’t just throwing everything out proportion all the time?

Ken Blay:

Well, my starting point was to treat bitcoin as a speculative asset. And if for no other reason is that a lot of things that we just discussed, that the characteristics of bitcoin are indeterminate. What that means is that people have a hard time explaining it. Correlations are incredibly weird over the time. So, there’s a very limited timeframe for us to analyze bitcoin. The problem with that timeframe is that there was a global pandemic, there was massive government fiscal and policy intervention across the globe.

We saw the greatest increase in interest rates in over 20 years here in the US. The most significant increase in inflation in over 40 years. And we also had instances of stock bond correlations that were among the highest and the lowest, historically. So, you have this period, yeah, I’ve got 10 years of data, a lot of stuff is going on, so there’s a lot of noise.

But then you couple this with the fact that bitcoin was maturing at that time and all the infrastructure behind bitcoin and that allowed the trading of bitcoin, that was all brand new as well. So, you have this thing that’s evolving around all of this noise. And so, it’s really hard to make any inferences about how bitcoin is going to act relative to stocks or to bonds or all of that, for me, has to go out the door.

So, you have to really think about this as a speculative asset. And the two key things that you need to think about when you do that is first your initial allocation. That’s the first step in mitigating risk is, how much would I be willing to risk without impairing my ability to meet my financial objectives? That’s for the individual investor to determine.

And then how do I manage risk on an ongoing basis? And that’s where your point about rebalancing is actually a prescient one because it’s really important to rebalance, especially for something that bitcoin that can go up a thousand percent or whatever. It could become a huge part of your portfolio. And so you need to mitigate that. You need to manage that part of the risk.

So those are the starting points there. You treat it as a speculative asset, and you figure out your allocation size. And then you start looking at, alright, what are the benefits, and what are the risk implications? And our research is essentially that. We looked at what are the benefits from adding bitcoin to my portfolio. And we assume that you start off like any investor, like I’m a moderate investor, you have risk preferences as a moderate investor. As I add bitcoin, one of the things that happens, bitcoin, it doesn’t take a lot of bitcoin to add a lot of risk.

That said, it doesn’t take a lot of bitcoin to add a lot of return either.

Brian Levitt:

It goes a long way.

Ken Blay:

And so, you have to, all right, well I know that there’s a good part of this, but there’s also the bad part, the risk part. And so, all we did with the research is just say, as I extend myself in terms of accepting more risk, at what point should I stop? At what point do I stop getting incremental good stuff? And that’s essentially what we did. We called it a benefit-to-risk metric. And we said, alright, at the point that I stop, that the incremental risks exceed the incremental benefits so at the point that I get more risk than I get good stuff, that’s where I should stop. That’s the maximum. I’m not saying that that’s the optimal point. That’s the maximum point because you still have risk all the way before that point.

Brian Levitt:

And I love that approach and I do want to hear more about, a little bit more on detail in terms of what your allocations were with regards to that. But I want to bring Ashley back into the conversation for a moment. Ashley, when you think about the moves in bitcoin over the last period that Ken was talking about that had a lot of tumult, a lot of strange things, we saw it go to $65,000 a coin, back down to $16,000 a coin, sat there for a while. Now it looks like it is getting close to $90,000 a coin. Is there anything that you could take away from those movements and identify this is why that happened? Is it about easy monetary policy? Is it about inflation? Is there anything that you could latch onto in looking at those price moves over the last few years?

Ashley Oerth:

I think the answer to that is yes. I think that there’s quite a lot to unpack for exactly what drives bitcoin prices. Since bitcoin has been around, there’s been this desire to try to model it or explain exactly what’s going on with its price and what it should be responding to. And the truth of it is that valuing bitcoin, it’s immensely difficult. It’s essentially this sort of commodity currency that benefits from network effects.

So, for example, in some early models, this is when bitcoin was really first having its run back in 2014, people sought to really model it as something that would respond to network effects. And then we try to measure network growth and use that as a proxy for what should drive price momentum. But of course, as the ecosystem around bitcoin has grown, this approach, it really broke down. It doesn’t work anymore.

And I think the critical takeaway here is that you cannot really value bitcoin. You can try to price it, you could try to build a framework around its likely drivers. And so, we do have some ideas, and you highlighted a few of them, of what can be a driver here. But I think what it comes back to is what are the supply and demand factors underlying bitcoin itself, and then broadening away from that, what is the sort of financial backdrop? What are financial conditions telling us, and how does that affect the opportunity cost that’s wrapped up in holding bitcoin?

Brian Levitt:

Can I take a quick stab at what I think we just said and how the markets performed? It seemed to me that a lot of the run-up was ahead of the inflationary environment that we had. Then a lot of the rundown was ahead of the policy tightening that we had. And then more recently, expectations for easing again. I think of gold, I look at it from a real yield perspective. What real yield can I get in treasuries? Is gold enticing or not? And as that widens and narrows, it tends to have some impact on whether gold is attractive or not. Is it similar with bitcoin?

Ashley Oerth:

It is a similar kind of idea. I think that what’s interesting about bitcoin is that it’s sort of framed as this, as I’ve heard it described, marginal user of excess liquidity. Or in other words, when you have, for example, large scale money supply growth, that bitcoin is something that can benefit from that. And so we saw that dynamic play out in the post-pandemic environment where bitcoin really surged several times over. And we’ve seen the reverse of that as well, that as money supply has come in, or money supply growth I should say has come in, that that’s sort of pulled down bitcoin prices. And as you mentioned, there’s this sort of opportunity cost angle as well that if real yields are climbing, if the Fed is hiking rates, if long rates are rising, that this should penalize bitcoin because it’s a zero-yielding asset. And we’ve seen that play out as well. Similar again to what you just described, this kind of gold equivalency.

So there are those sorts of factors that we can point to as being, again, a framework for how bitcoin can be priced. But in terms of a long-term valuation, it’s quite difficult to really ascribe what is that long-term driver. That’s where I come back to demand. The price action we’ve seen since, I would argue, the fall of last year has been all about this spot bitcoin ETF news from the SEC. And we saw the ETFs launched in early January, and this has really been a very positive demand shock that’s helped send bitcoin prices to new highs, and we continue to see that play out. It’s, I would argue, not done yet.

Jodi Phillips:

It seems a little ironic, right? I mean, is there a certain amount of irony there that people said crypto was going to dis-intermediate the financial sector, but now we’ve got ETFs allowing you to track spot bitcoin prices. So, just that evolution and how people are thinking about it and how they’re able to access it. Definitely adds another dimension, doesn’t it?

Ashley Oerth:

It does, and I don’t think this irony is really lost on the crypto community. But I think that for the average investor, this sort of packaging, it’s important. Cryptos, otherwise, they’re quite challenging to access in a way that is secure, reliable, compliant, and to do this in a way that’s cost-effective. So, cryptos wrapped in an ETF, they really offer a meaningfully easier way for the average investor, the average client, who wants bitcoin exposure to be able to access this space. Whereas those sorts of previous offerings, they required more paperwork and oftentimes partnering with crypto-specialized firms and services that really offered a host of complications and added costs. So, I think that this wrapper, this packaging, of the ETF is attractive because it’s more familiar and it’s easier to work with at the end of the day.

Jodi Phillips:

Right. Brian has fear of missing out. I would have fear of misplacing my wallet password or whatever I need to even access it. Right? One more thing to remember.

Brian Levitt:

Fear of misplacing my wallet-

Jodi Phillips:

Yeah, it’s not-

Brian Levitt:

I’m going to try it.

Jodi Phillips:

No, don’t.

Brian Levitt:

Ken, you wanted to jump in?

Ken Blay:

Oh yeah, I was going to say with regard to bitcoin prices, I think the one thing that we do know about bitcoin prices is that the price of bitcoin is ultimately what somebody else is willing to pay for that. Now, ultimately, that’s going to depend on what’s happening to bitcoin and what people believe. And that’s where I think the speculative nature of bitcoin comes in because right now everybody believes that it should go up. There is demand driven by all of these ETFs.

The other thing that I’ll add there is that there’s two ways of viewing the financial system or these asset managers getting involved with bitcoin. One is a fairly cynical view, and another one aligns much more closely with what Ashley was saying. The cynical view is that the asset managers weren’t getting paid when bitcoin was being traded outside of conventional pathways.

Okay. That’s a very cynical view. But to Ashley’s point, one of the things that asset managers have done throughout history is provided access to difficult-to-access assets. So, the whole notion of pooling investments, that was asset managers actually started those things and it made life a lot easier for investors to get access to diversified pools of assets. Now, bitcoin ETF is not that, but it does simplify access to getting the bitcoin, getting access to bitcoin.

Brian Levitt:

Absolutely. And Ken, as we come to the end of this, I’d love to hear some numbers around allocations, like what percentages you put around this. You had talked about that benefit to risk and it just... You got to a point where you kind of maxed out. What did those numbers look like? Give it to me if I’m a hundred percent in equities versus if I’m more of a moderate fifty-fifty portfolio investor.

Ken Blay:

Well, I’ll give you two sets of numbers. So, when the research that we’ve done, we looked at historical returns of bitcoin. So, one of the things that you do is [you say] bitcoin does what it did in the past. Because that’s the one side of it is the return benefit. Okay, what did it do? Generally, what you’re looking at, in more conservative portfolios, you’re looking at about 1% to 3% allocation, or actually 1% to 2% allocation. That’s for conservative portfolios.

For more aggressive portfolios, you’re looking at somewhere from 3% to 6% allocation. So, that’s assuming that bitcoin does what it did in the past. If you look at and say, “Well, bitcoin isn’t going to do that. Maybe let’s just say that it does half of what it did in the past.” That’s just a rough... I mean, like I said, there’s no way of knowing what bitcoin is going to do, but let’s just say it did half just, still a pretty big number.

There, you’re looking at about 1% allocations for conservative portfolios and somewhere between two and five. These higher numbers are obviously the 100% stock portfolios. Anytime you start adding the bonds, you tend to come down pretty quickly. So, those are kind of rough estimates of what the research has pointed to.

That said, we pointed out what we’re saying here is the maximum. The maximum exposure is… after this point, you’re taking on more risk than the benefit you’re getting. I say that on the more aggressive points, you can go up to... The research points to 5% allocations. That’s all going to depend on the investor. The investor has to decide, am I willing to take on the additional risk of having that bitcoin in the portfolio? If you’re not, well bring it back a little bit. But if you are, okay, maybe 5% should be a maximum for the hundred percent stock portfolio. And so we are not suggesting that these are optimal allocations. We’re just saying this is the point where you take on more risk than benefit.

Brian Levitt:

So are we doing two or five, Jodi?

Jodi Phillips:

I don’t know. Are you more conservative or aggressive?

Brian Levitt:

I’m usually more aggressive. I’ve got time. Ashley, any final comments from you?

Ashley Oerth:

Look, I think that the bitcoin outlook from here, I think that we’re at this moment right now where everybody’s talking about this thing. That prices are high. And we’re doing this all in an environment in which rates are still elevated, that we’re supposed to be living through this period that I think that, from the financial backdrop, should be penalizing bitcoin prices, but we’re actually seeing quite the opposite.

So, I think that the sort of peak in sentiment is something to watch. And I feel like what I’m left wondering going forward is what is the next big thing. What is the next big driver for crypto prices? Now that we’ve reached this point where we have spot bitcoin ETFs, what is the sort of next moment that we’re looking to on the horizon to really help send bitcoin on another one of these price cycles? So that’s really where I think it’s sort of a thoughtful note to leave this conversation because I think that there’s so much to unpack for what is happening in the crypto world, and I think that we’re sort of in the big leagues today. That crypto prices are elevated, that we’re talking about putting it in a portfolio.

I think it’s an exciting time to be considering this space. So, I’m sort of thinking what comes next?

Jodi Phillips:

What comes next? Let’s leave it there. Right, Brian?

Brian Levitt:

Let’s leave it there.

Jodi Phillips:

Leave it on a cliffhanger.

Brian Levitt:

Well, thank you both so much for joining.

Jodi Phillips:

Yes.

Ken Blay:

You’re very welcome. Thank you for having us.

Ashley Oerth:

Thank you so much. It was great.

Jodi Phillips:

It was great to have you. And Brian, where can listeners find more commentary from you?

Brian Levitt:

Well, thanks Jodi. Visit Invesco.com/BrianLevitt to read my latest commentaries. And of course you could follow me on LinkedIn and on X @BrianLevitt. Thanks, Jodi. This was fun.

Jodi Phillips:

Thanks for listening.

 

Important information

You've been listening to Invesco's Greater Possibilities Podcast.

The opinions expressed are those of the speakers, are based on current market conditions as of April 11, 2024, 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.

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.

Past performance is not a guarantee of future results.

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

An investment cannot be made directly in an index.

All data provided by Invesco unless otherwise noted.

Bitcoins are considered a highly speculative investment due to their lack of guaranteed value and limited track record.  Because of their digital nature, they pose risk from hackers, malware, fraud, and operational glitches.  Bitcoins are not legal tender and are operated by a decentralized authority, unlike government-issued currencies.  Bitcoin exchanges and Bitcoin accounts are not backed or insured by any type of federal or government program or bank.

References to the historical performance and volatility of bitcoin sourced from Bloomberg as of March 31, 2024.

Discussions about Ken Blay’s research and conclusions based on Invesco analysis of bitcoin prices from Dec. 31, 2014, to Dec. 31, 2023.

The limitation of the supply of bitcoin to 21 million bitcoins was expressed in the 2008 paper written by Satoshi Nakamoto titled Bitcoin: A Peer to Peer Electronic Payment System.

References to the greatest increase in interest rates in over 20 years sourced from Bloomberg, based on the 10-year US Treasury rate.

The most significant increase in inflation in over 40 years sourced from the US Bureau of Labor Statistics, based on the US Consumer Price Index, which measures changes in consumer prices, as of March 31, 2024.

References to stock/bond correlations sourced from Bloomberg based on the correlations of the S&P 500 Index and the Bloomberg US Aggregate Bond Index.

The S&P 500® Index is an unmanaged index considered representative of the US stock market.

The Bloomberg US Aggregate Bond Index is an unmanaged index considered representative of the US investment-grade, fixed-rate bond market.

Fluctuations in the price of gold and precious metals may affect the profitability of companies in the gold and precious metals sector. Changes in the political or economic conditions of countries where companies in the gold and precious metals sector are located may have a direct effect on the price of gold and precious metals.

The Greater Possibilities podcast is brought to you by Invesco Distributors, Inc.

Brian Levitt:      

Welcome to the Greater Possibilities Podcast from Invesco, where we put concerns into context and opportunities into focus. I’m Brian Levitt.

Jodi Phillips:     

And I’m Jodi Phillips. This is the second in a two-part series with Justin Livengood, a senior portfolio manager for the Invesco Midcap Growth Strategy, and a senior research analyst for our discovery and capital appreciation strategies. Justin’s focus is on financials, real estate, and healthcare. If you missed the first part of our conversation, we focused on the state of the US banking system. Now, we’re going to talk about market concentration, artificial intelligence, and more.

Jodi Phillips:     

So, Brian, where do you want to start? Should we want to start with market concentration? I know that's been a huge topic of discussion and talk to Justin about what it might take for that to broaden at some point.

Brian Levitt:      

I do, and Justin had talked about how smaller and mid-cap businesses have been participating more. It felt to me like we saw a lot of performance in November and December in small and mid-cap, and maybe it's become a little bit more concentrated again as we sit here at the end of February. And so why is that the case and how long can this persist?

Justin Livengood:            

Yeah, so the rally you saw in small caps, particularly in November, December, was all about interest rates. That was when (Federal Reserve Chair Jay) Powell was-

Brian Levitt:      

Yeah, fixed cuts.

Justin Livengood:            

Right. Rates were peaking. He said, "We're done raising rates." Effectively. And there was this perhaps understandable swing in the pendulum to, "Oh gosh, the Fed's on the verge now of cutting." And that's going to be great because undeniably small cap companies are...

Brian Levitt:      

Can I let you in on a little secret?

Justin Livengood:            

Okay.

Brian Levitt:      

When you do what I do for a living, you write outlooks in September and October and they come out in December, and we wrote Fed's going to lower interest rates this many times. That sets the stage for a really nice backdrop for small and midcap, and then it all happens in eight weeks.

Justin Livengood:            

That's right. Then you're like-

Brian Levitt:      

Do you feel bad for a guy like me or it's just part of my job?

Justin Livengood:            

I hear you. Well listen, I feel your pain. Well, I don't. I sort of do because that was a tough relative time for us. I'm totally going off script, I don't even know if we're still rolling here, but when November and December happened, you had not just a small cap rally, but it was a pronounced rally by the weakest companies, the companies that were the most poorly financed, that looked like, "Okay, wow, they managed to survive. Now they're probably going to get bailed out by an accommodative Fed." And so lower quality businesses outperformed dramatically, and that's not helpful to the kind of investment process that we run. Having said that, the euphoria around the Fed pause and cut, hoped for cut, is what sparked that Q4 rally.

So what's happened in 2024 so far is first an awareness, a correct awareness that, "Hey, the Fed isn't about to cut. They are done raising rates in all likelihood, but they aren't about to cut any anytime soon." And then the second thing is you've had really good earnings from large cap companies. So we've largely finished Q4 earnings season and the high level statistics are telling. Small cap earnings, Russell 2000 earnings in the fourth quarter were negative, slightly negative as a overall group. Midcap earnings were slightly positive. Large cap S&P 500 earnings are tracking almost up 10%. So large cap again, and this is a trend that was persistent through much of last year, is winning in terms of earnings growth. And at the end of the day, earnings often, if not always move stocks and move valuations.

Now within that large cap earnings growth number, a lot of it was the largest companies. So one of the other questions that I know we're going to address is market breadth, and I'll just continue my prior illustration. Roughly a third of the S&P 500's market cap is in the top 10 companies. 50% of that earnings growth in Q4 was from the top 10 companies. So the big guys, the NVIDIAs and the Microsofts, they came through with excellent results and powered that outperformance and the stocks followed. And that's why we're looking at a lot of, and it's not just by the way, tech companies, Eli Lilly is up 25% year to date, Visa and MasterCard are up a ton, had great quarters. The other companies in the top 10 are doing well. It's not just the tech companies.

Brian Levitt:      

So it's an AI market and a weight loss market?

Justin Livengood:            

Those are two of the big things. Those seem like huge things that could materially change the U.S. economy.

Brian Levitt:      

You're laughing? They're huge.

Justin Livengood:            

Now in technology, there's a lot going on in addition to AI. AI's, I think, taking a lot of attention and somewhat deserved, but Microsoft and Amazon's cloud businesses are doing well for a lot of reasons, not just artificial intelligence. The semiconductor industry is doing well in part because of all the activity around NVIDIA and investments in AI, but in part for a lot of other reasons. And so it is a little more, I think, diversified on the technology side than perhaps the headline suggests. But away from that, the healthcare sector right now is absolutely being affected by this emergence of the GLP-1 obesity drug class and its benefits for Novo Nordisk and Lilly, but it's got a lot of implications on the rest of the sector.

Brian Levitt:      

Even consumer staples.

Justin Livengood:            

Absolutely.

Brian Levitt:      

If you're not going to snack as much.

Justin Livengood:            

Food companies, restaurant companies for sure, for sure.

Brian Levitt:      

Yeah.

Justin Livengood:            

So there's a lot of investing implications as it relates to that, but then there's just good solid things going on. I mentioned Visa, MasterCard, people are traveling again. People are, even though they're maybe not spending quite as much as they used to, consumer behavior's still pretty good. The best part of the market year to date though, isn't tech, it's industrials, especially in the small, midcap sections of the market. Industrials are thriving. There are some great, great, great industrial businesses. There's this whole trend of reshoring, we're having a lot of jobs and a lot of companies bring back projects and bring back work to the United States from the Middle East, and from Asia, and China. There's a lot of infrastructure investing going on partly because of AI and the cloud, but even partly just more basic and traditional infrastructure. So there's a lot of the industrial ecosystem that is thriving right now.

Orders are great. Some of our favorite companies in our funds, small, mid and large cap are industrials. They're not tech, they're not health care. And so it's fairly broad. So I'm happy to see that, but it's still tilted back to your original question, a little bit up cap right now. I do think though, as soon as we get a little further through this Fed pause, you're going to see that small cap and to some degree, midcap, performance perk back up. Perhaps not as much as we saw in the fourth quarter last year, but I think you'll see the rest of the market close the gap with those biggest companies

Jodi Phillips:     

Justin, you did touch on this, but I did want to ask a little bit about AI in the longer term, but in terms of companies that are using it, not the tech companies that are enabling it, but the companies that are using it in the longer term. You did talk a little bit about health care, but what about the intersection of, for example, AI in health care, or is that too much of a regulatory question, privacy questions? What are you looking at in terms of keeping an eye on the longer term ways that AI can fuel the other industries that you cover?

Justin Livengood:            

Absolutely. So I got several comments on that. I'll start with health care. It's a little unclear how much AI is going to impact drug development in the near term for some of the reasons you just listed, Jodi. The big pharma companies and the biotech companies are dabbling in it, they're using it, but it's going to be more, I think in early research and helping identify targets and benchtop science. It's not going to be useful as much in actually running in-person clinical trials, which still have to be done, I think in a more hands-on traditional way. So I think there will be applications, I think it will be helpful, but I'm not sure that's the use case that's going to be most visible to us, at least in the very near term.

I do think though, there are some emerging use cases that are really interesting. So I'll give you a couple of examples. The first is IBM on their earnings call, or maybe it was at a recent conference, but in the last six to eight weeks said that they were, through the investments they've made in artificial intelligence, able to reduce the headcount in their HR department from 700 to 70 people.

Brian Levitt:      

Wow.

Justin Livengood:            

So now they're further along than probably a lot of people, and I don't want to suggest everyone's going to be able to do that day one or year one, but that is a flex.

Brian Levitt:      

I'm going to keep my job.

Justin Livengood:            

I know. That's my first thought too. I'm like, "Wow."

Brian Levitt:      

I got two kids getting ready for college.

Justin Livengood:            

Just hang in there.

Brian Levitt:      

Just two more years.

Justin Livengood:            

Just a few more years. That's all you need, Brian. So don't go work for IBM is my point. Yes. Stay here. So there's an example though of a very real use case that is clearly helping IBM's bottom line. However, they had to make investments upfront to get there. And I think the other thing that needs to be considered is a lot of other companies are earlier in their AI journey and trying to figure out where to make those investments. And one such example is Moody's, a company that I know well that's actually headquartered right across the street from us here in Lower Manhattan. Well, they reported earnings last week that were excellent. However, they guided 2024 expenses well above all of our expectations entirely because of investments they feel they now need to make in that analytics business targeted on artificial intelligence.

They see a lot of things, use cases that they think their clients are going to want, but to get there, they're going to have to spend a lot and they're pulling forward a lot of different projects into 2024 because they feel some urgency. So there is a bit of a back and forth. Whenever AI comes up in an investment discussion, everyone wants to look at the semiconductor companies and NVIDIA and, "Oh, this is all great." Well, on the other side, somebody's got to be actually writing the checks and spending the money. And not everybody's IBM, not everybody's already gotten to the point where they're seeing the rewards of those investments. We're actually in a lot of cases still early in the process of figuring out, "Okay, I know I need to be doing something, what do I do?" And so there's going to be more of the Moody's like updates I think, over the course of this year, which is fine. I think investors just need to be prepared for this to be a pretty big theme, an investment consideration as the year plays out.

Brian Levitt:      

I get excited just hearing you talk about it. And so as we come to the end of this podcast, just talk a little bit about the opportunity cost of not being involved in markets, not being involved in the growth companies that you look at over the next couple of years or even beyond.

Justin Livengood:            

Yeah, and I'd start by saying there's been disruption in the markets for a while.

Brian Levitt:      

Forever.

Justin Livengood:            

Forever.

Brian Levitt:      

I'd hope so.

Justin Livengood:            

But even we were talking before the podcast, Brian, about how growth has done really well as a category for over a decade. Well, a lot of that is explained by companies disrupting various industries, many of them technology, but also health care and industrials and the like. So there's been disruptive opportunity to capture and invest in for a long time. It just happens that right now, two of the more prominent things happening are artificial intelligence, and then in health care I would agree, this whole obesity dynamic and they're getting more attention and they're arguably driving a little bit more value creation than some other types of disruption in the last 10 to 15 years.

But there's always really interesting secular growth opportunity to participate in, and I think I've mentioned this with you in the past, and I referenced it a second ago when I was talking about industrials. It's not just the stuff on the headline. So when I come to work, whether it's in the office or at home, I'm not thinking about NVIDIA and AI and a lot of the big cap stocks very much. I'm spending a lot more time thinking about companies that most people listening to this podcast will have never heard of that are either benefiting from some of these themes or that are just in their own unique little opportunities and disruptive situations, but that are thriving. I can think of dozens and dozens of companies in the last few years that have gone from 2, 3, 4 billion in market cap to 15 or $15 billion companies that have gone to 30. And the speed with which this is happening is increasing a little bit the Moore's law kind of concept.

Ron Zibelli, my boss and longtime colleague, loves to talk about this. He's like, "The pace of disruption is only increasing." And so you're seeing more and more companies taking advantage of that, that are not on the main playing field. They're off on one of the side fields, but they're still really, really exciting companies. So you go through the last two, three year period where the macro environment was extra volatile and sometimes that gets in the way of the stock performance of some of these really interesting secular stories because you've got to worry about what the Fed's doing and pandemics, and that's all understandable. But now that we've seen hopefully, the world calm down a little bit-

Brian Levitt:      

Back to basics.

Justin Livengood:            

Right. The Fed has gotten inflation somewhat under control. We seem to be in a little bit more of an equilibrium long-term macro wise. I think it's going to allow those really interesting disruptors, those really interesting secular companies to again, shine. And that's partly why you're seeing growth continue to outperform. That's why sitting here today at the end of February, the NASDAQ and the S&P are up almost 7% already this year, and you tear that apart, that's mostly these higher growth disruptive companies that have just continued what they were already doing for much of 2023. It’s been a really interesting group to invest in, and I think there's definitely going to be opportunities going forward. So I would strongly encourage people not to try and time the market, especially in this part of the market where there's so much long-term opportunity.

Brian Levitt:      

Jodi, as you know, I've been taking copious notes, so when we come back six months or a year from now with Justin, I will read that back to him and once again, hopefully he will tell us, "I feel very good about what I said."

Jodi Phillips:     

That's right, that's right. We'll definitely have him on again, and hopefully there doesn't need to be a bank concern or bank issues to do it.

Brian Levitt:      

Yeah. No crises.

Justin Livengood:            

Yeah. Hopefully, it won't be a crisis that is required for me to be here.

Jodi Phillips:     

No, not at all.

Brian Levitt:      

Thanks so much for being here.

Justin Livengood:            

Thank you.

Jodi Phillips:     

So Brian, where can our listeners find more market commentary from you?

Brian Levitt:      

Well, Jodi, as always, visit invesco.com/brianlevitt to read my latest commentaries, and of course you can follow me on LinkedIn and on X at Brian Levitt.

 

 

Important information

You've been listening to Invesco's Greater Possibilities Podcast.

The opinions expressed are those of the speakers, are based on current market conditions as of February 27, 2024, 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.

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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.

Investments in financial institutions may be subject to certain risks, including the risk of regulatory actions, changes in interest rates and concentration of loan portfolios in an industry or sector.

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.

Growth stocks tend to be more sensitive to changes in their earnings and can be more volatile.

The health care industry is subject to risks relating to government regulation, obsolescence caused by scientific advances and technological innovations.

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References to small and mid-cap performance sourced from Bloomberg. Based on performance of the Russell 2000 and Russell Mid Cap indexes in November and December 2023.

References to lower quality businesses outperforming in the fourth quarter sourced from Bloomberg, based on quality metrics as defined by FTSE Russell.

References to the earnings growth of the Russell 2000 Index, the Russell Mid Cap Index and the S&P 500 Index sourced from Bloomberg.

The percent of the S&P 500’s market cap in the top 10 companies sourced from Bloomberg.

Performance of Eli Lilly, Visa and Mastercard sourced from Bloomberg as of February 27, 2024.

Comments about the performance of the industrials sector sourced from Bloomberg, based on the sector’s performance of the Russell Mid Cap Index and Russell 2000 Index.

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Brian Levitt:

Welcome to the Greater Possibilities Podcast from Invesco, where we put concerns into context and opportunities into focus. I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. And this is the first part of a two-part conversation we’re having with Justin Livengood. Justin is a senior portfolio manager for the Invesco Midcap Growth Strategy, and he's a senior research analyst for our discovery and capital appreciation strategies. His focus is on financials, real estate, and health care. So we last talked to Justin almost a year ago. Brian, did you know that episode was our most downloaded episode for 2023?

Brian Levitt:      

Oh, is that right?

Jodi Phillips:     

It is. I checked the numbers.

Brian Levitt:      

I don't think I knew that. So I guess I'm glad that we're having him back on then. Jodi, as you know, I am paid by the downloads, so.

Jodi Phillips:     

Oh, really? Okay.

Brian Levitt:      

Yeah.

Jodi Phillips:     

You'll have to tell me later, how you got that deal.

Brian Levitt:      

Oh, you didn't get that deal?

Jodi Phillips:     

No, no, but we'll worry about that later. As you will remember, Justin came on the week that Silicon Valley Bank failed, and so we brought him on then to give his perspectives and to help ease concerns at that time.

Brian Levitt:      

Oh, okay. I see. So are you saying it wasn't about Justin, it was just about a crisis? So maybe we just need to manufacture some crises in order to get downloads here?

Jodi Phillips:     

That is not at all what I'm saying. Those things do tend to go hand in hand, but I would be more than happy to give up a few downloads if it meant fewer crises to deal with.

Brian Levitt:      

Oh, I would 100% take that trade off also.

Jodi Phillips:     

All right, look, so do you remember what Justin said on that March 2023 podcast?

Brian Levitt:      

I do, and I've been rereading it this week. I always write down my key takeaways. So here are the two things that I wrote that Justin had said that month.

Jodi Phillips:     

All right.

Brian Levitt:      

Number one, it's not a systemic crisis, and he said that the credit picture in the banking system is clean. And number two, he said, we're returning to a proper equilibrium in monetary policy that may help provide a stronger base for the economy and the stock market from which to operate in the next two to three years.

Jodi Phillips:     

That's some very thorough note-taking, Brian. That's great. And it feels like he was two for two.

Brian Levitt:      

It does. Credit to Justin, which is why we're having him back.

Jodi Phillips:     

Yeah, because despite that, the questions about the health of the US banking system keep emerging, don't they?

Brian Levitt:      

They do. And I get the sense that investors just feel like something has to break. We can't have the type of interest rate hikes that we've had over the last year without anything meaningfully breaking or impacting the banking system.

Jodi Phillips:     

So potentially concerns about office space, commercial real estate?

Brian Levitt:      

Yeah, I think that's the first candidate being put forward by investors.

Jodi Phillips:     

All right. So these are the questions we'll talk about in the first part of our conversation, and then we've got a lot of other questions we can focus on for the second part. We have a growth manager here, let's take advantage of it. So market concentration, the excitement about the Magnificent 7? Things like artificial intelligence. Is that excitement warranted or are we getting ahead of ourselves?

Brian Levitt:      

Right. And what would have to happen for markets to broaden out or do we just own growth stocks for the rest of our lives?

Jodi Phillips:     

All right. Well, let's bring on Justin to discuss. Hi, Justin.

Brian Levitt:      

Hey, Justin.

Justin Livengood:            

Hi, Jodi. Hi, Brian. Thanks for having me.

Brian Levitt:      

Absolutely. Thanks for coming back. So you probably felt pretty good when I was reading verbatim, what you said on the last podcast. So did it feel good what you said and has anything materially changed in your mind?

Justin Livengood:            

Well, I'm glad the economy has hung in there. I'm frankly shocked the economy has hung in there to the degree it has in the last year. I think the Fed would say the same thing. I think everyone was expecting more of a slowdown than we've seen. I'm also pleased the banking system has hung in. You're right. At the time of the failures of First Republic, Silicon Valley and Signature, there were some very anxious days and weeks, and we got through that relative well. So yeah, I'm happy that all that played out. And as you pointed out in your earlier comments, there's definitely some incremental concerns now to consider, but I don't feel it's nearly as much of a dangerous situation as it was last March.

Brian Levitt:      

And one of the critical points that you had made last March was that it was not a credit event, it was a mismanagement of the interest rate sensitivity of the bank.

Justin Livengood:            

Exactly. It was a liquidity event. Those three banks in particular were somewhat unique in how they were built, and they had concentrations in terms of clients and deposits. And especially at Silicon Valley and First Republic, when those depositors got spooked and a meaningful portion of those ran for the exits, it just started a downward spiral in terms of liquidity. And that's what forced the hands of those two. And that's why they were not anticipated properly by the regulators. The regulators don't historically look at much asset liability issues and liquidity. They spend more time looking at credit. So what we're going through right now is actually right in the sweet spot of what the regulators have all been trained to do, dealing with bad loans. That's Banking 101 for a regulator. So this next phase of, we'll call it the slow moving banking – not crisis, but banking challenge – is at least something that the regulators are more adept at handling and we can talk about that.

Jodi Phillips:     

Yeah, great. Let's do. I think, what was it, late January, Justin, where we saw the concerns flare up a bit around New York Community Bank?

Justin Livengood:            

That's right.

Jodi Phillips:     

When it declared its earnings had been well below expectations. And so some concerns may have been lingering in the background, but that really brought it to the fore pretty suddenly for some investors, it may seem. So what are maybe some of the similarities or differences between what happened then versus maybe where we were a year ago?

Justin Livengood:            

So let's step back a second and think about the banking industry and particularly the regional banking industry. So put aside maybe the top five or six banks, the Chases and the Wells Fargos. Going back three years or so when the pandemic began, you began to see a little bit of concern and emerging pressure on certain types of loans tied to commercial real estate and specifically office. And those have been building for a while. So that didn't just appear in January of this year for the first time. That's been an ongoing issue. Most loans in those categories made by regional banks are five- to seven-year duration loans or term loans. And so those loans are starting to get late in their life at a point when they would typically get refinanced and replaced with new loans.

And of course, as the values of those underlying buildings have come down, the owners of the buildings are having to face the difficult choice of either accepting less equity, writing off a lot of their investment in the property as they take on the new loan, or putting in new equity and trying to take on new debt, but at higher rates. And that puts more pressure on cashflow. So it's a difficult but somewhat predictable and slow process as it plays out over time. It's not a flash like again, we had last March. Last March, again, was not a credit event. It was a reaction by depositors to a — turned out to be a false concern that forced these banks into effectively the regulators' hands. Here, the regulators have had several years to watch and work with a lot of these regional banks as they've been starting to cull their loan portfolios and sift through some of these commercial real estate loans.

And so the good news is what happened in January with New York Community Bank was actually somewhat precipitated by the regulators. It was during the year-end audit of 2023 that the regulators sat down with those bankers, New York Community, and said, "Hey guys, look, you've got a handful of loans that are just not performing and it's time that you accept this and we reclassify them as non-performers. And in doing so, you're going to have to now make some adjustments to your capital ratios. You're going to have to move some things around your balance sheet. You're probably going to need to cut back your dividend."

And this was also happening as New York Community Bank was absorbing, ironically, the legacy assets of Signature Bank. And in doing so, they became bigger in terms of assets, deposits, et cetera. And so that put them under even more and greater requirements, capital ratios and things were changing. So they were under more scrutiny by the regulators just because of that transaction. And as part of that review with the regulators end of the year, said, "Hold on, you've got to come clean on a few of these loans." And that's what was confessed during the Q4 earnings call by New York Community.

Brian Levitt:      

So should you never come to the rescue, if you're a New York Community Bank or there are spots where if you step in and take over a Signature Bank where it actually works out over time?

Justin Livengood:            

Oh, it does and I'll show you another example. JPMorgan has absolutely come out like a hero with First Republic. They took over First Republic last March, and it has been a huge home run, both financially I think, as well as just building capital for JPMorgan with the regulators and in the eyes of Washington. So I don't want to suggest that coming to the rescue of a bank isn't a good thing. In this case though, New York Community, by helping take some of those signature assets, got bigger than perhaps they should have in hindsight and it forced them into this new bucket of regulatory scrutiny. As the regulators applied those new rules, they realized, "Wait a minute, you guys aren't completely onsides with at least some of these loans," and that reset is now happening.

It's probably also worth noting. New York Community is a pretty unusual bank. As the name suggests, they're geographically focused in New York and really the Long Island area. They have a very high proportion of their loans in multifamily and office. Although when they say office, they're not talking about buildings in Midtown, they're talking about five- to seven-story buildings in some of the outerlying boroughs and so forth. So it's a much more concentrated loan portfolio in terms of commercial real estate and office than the typical bank. A typical bank has a single-digit percent of its loans in these types of categories, whereas New York Community, it's 30%, 40%. So it exaggerates the optics, the risks, the issues that are very much under scrutiny here.

Brian Levitt:      

So let's talk about office. You and I are sitting here right now in downtown New York City. We're back in our high rise. I'm here half the time maybe.

Justin Livengood:            

Right.

Brian Levitt:      

Same, right? Flexible program. Jodi, you're in the office today or you're-

Jodi Phillips:     

Not today, not today, but yeah, we definitely have this office in Houston.

Brian Levitt:      

Well, right now you're in the Phillips office in Houston, Correct?

Jodi Phillips:     

That's right, that's right. Correct.

Brian Levitt:      

Yeah. And so how concerned are you about office space? To me, it seems like businesses were needing less office space even before the pandemic happened. You no longer needed rooms for file cabinets or you no longer needed rooms for servers. All of that was moving. Now, I think the last I saw in terms of the number of people swiping in at offices is around 50%, New York City might be a little bit less than that, although my commute would suggest otherwise. And the line downstairs for the salad might suggest otherwise.

Justin Livengood:            

Exactly.

Brian Levitt:      

How worried are you when you talk about a slow moving, did you call it a train wreck? A crisis?

Justin Livengood:            

Yeah, yeah, yeah. It's maybe not quite a train wreck, but it's a slow moving-

Brian Levitt:      

Derailment?

Justin Livengood:            

Process.

Brian Levitt:      

A derailment?

Justin Livengood:            

Right.

Brian Levitt:      

And so how worried are you that there's something lurking within that, that's unforeseen? it's comforting to me to hear you talk about the regulators being in front of it with New York Community Bank. Are you concerned that there's something lurking out there?

Justin Livengood:            

I don't think there's something lurking again, because I think it's fairly well known what everyone in the regional banking industry particularly owns at this point, where their exposures are. And I think there's stress testing that goes on that forces banks to consider what is going to happen to their loans and their assets in different economic scenarios. And there's some pretty punitive scenarios that the regulators make you consider. And then based on how you do in those tests, you have to adjust your dividend policies and perhaps your capital. So the industry right now is really well-capitalized in general, and that even goes down to a lot of the smaller banks. Even New York Community by the way, despite having to disclose those and write down some of those big loans last month, they're still above what is defined as well-capitalized. It removed a cushion, but it wasn't like they had to go out and do a dilutive financing overnight to suddenly get back onsides.

Here are a couple more interesting statistics that I recently read to help maybe frame this. So there are about $40 billion of reserves right now in the banking industry set aside specifically for office and commercial real estate loans. And that represents about a one and a half... Let me put it this way. Right now, one and a half percent of all office loans made by banks are considered delinquent.

Brian Levitt:      

Okay.

Justin Livengood:            

If things get as bad as they did in the global financial crisis (GFC) in 2008 and 2009, that delinquency rate would go to 6%. That's where we topped out at in the worst situation that these banks have probably ever faced. And that's the kind of stress test scenario that the banks have been getting put through in recent years. So in other words, you've got room for delinquencies and losses on this category of loans to quadruple, and you're only back to where we were in the GFC on losses.

Brian Levitt:      

Well, we don't want to be in-

Justin Livengood:            

We don't want to be there. But if we were hypothetically, you know what the dollar value of losses would be, round numbers? $40 billion.

Brian Levitt:      

$40 billion.

Justin Livengood:            

Which happens to be where the industry is roughly reserved. So again, it's not a scenario I want, but if it happened, it wouldn't happen overnight like back in March of '23, it wouldn't be like all of a sudden on a weekend, we're worrying about six banks going under because they suddenly realized they had two bad office loans. Furthermore, as they were taking writedowns on loans, they would presumably just be drawing on reserves already set aside. So the only thing that really concerns me, and I've heard bank CEOs say this, so this isn't really just my opinion, is if the economy were to take a left turn and get worse and other property classes started to struggle, other types of loans-

Brian Levitt:      

Like multifamily or?

Justin Livengood:            

Right, or even just residential mortgages.

Brian Levitt:      

Oh, don't say residential mortgages.

Justin Livengood:            

Traditional commercial loans. Exactly. If other pockets of a bank's balance sheet started to also see growing losses, which right now isn't happening, then you'd have other things eating away at bank reserves and capital, and then this office/commercial real estate situation would perhaps become more of a concern. But I think at the end of the day, as long as the economy cooperates, and I don't think it needs to do much more than it currently is, it is remarkably resilient at the moment. I think banks are going to have enough time, as will the regulators, to over a two-to-three year period, get the worst of these loans around office buildings and commercial real estate to where they need to be in terms of refinanced, re-equitized, and the industry will be on more solid footing. Now, having said that, there's a second reality that these banks are facing as this process slowly flipped out.

Brian Levitt:      

Jodi, were you feeling better?

Jodi Phillips:     

I was.

Brian Levitt:      

I was feeling so-

Jodi Phillips:     

I wasn't until we're entering the alternate reality.

Brian Levitt:      

I'm not good with second reality. My brain only works on one reality.

Jodi Phillips:     

One reality at a time.

Justin Livengood:            

It's not all bad. It's not all bad.

Jodi Phillips:     

Okay, okay.

Brian Levitt:      

Okay.

Jodi Phillips:     

If you say so.

Justin Livengood:            

But banks aren't making as many loans as they used to because of this.

Brian Levitt:      

Okay. Right.

Justin Livengood:            

So this isn't just back to business as usual at banks. So this is one of the things we talked about a year ago that I suspected like, "Hey, it's going to take a long time for underwriters and staff at banks to be told and allowed to go back to writing as many loans." And those loans they are writing, they're of course, and I'm not just talking about office, I'm talking about again, loans to individual companies and individuals.

Brian Levitt:      

If you have 3% inflation, isn't that a good thing? Maybe not 3%, but we were at 4% or 5% inflation. Isn't that a good thing? We were trying to slow down this economy, right?

Justin Livengood:            

Right.

Brian Levitt:      

But the problem is you get to 2% inflation and then things continue to slow and then the Fed's got to ease and try and reinvigorate credit creation and economic activity again?

Justin Livengood:            

Right. Some of this. Okay, there's two issues. One issue which I was driving at is just because banks are still trying to get properly capitalized and reserved for some of these lingering credit issues, they can't make new loans and grow as much as they used to. In fact, the industry basically did not grow in the fourth quarter. New loans were flat in the fourth quarter of 2023, and the outlook that banks gave for '24 is pretty flattish. It varies by type of loan, it varies a little bit by geography, but basically, there isn't credit formation from the banks. Now, there is credit formation happening outside of the banking system.

Brian Levitt:      

The shadow banking system.

Justin Livengood:            

This whole private credit phenomenon is real. It's going to have legs and we can come back and talk about this because I'm very close to a lot of the firms that are involved in that space, and I think that is a big durable trend. So what's happening is a mix shift away from the regional banks to other providers. We can call it shadow banking, but that has a little bit of a negative connotation that I'm not sure is fair. I think actually, it's somewhat healthy to have some incremental growth in the private side of the lending market. Now the second thing that you were referring to is what do we want to do in terms of interest rate policy and the Fed?

So the other thing the banks are having to deal with right now is the curve's still inverted and the front end of that curve is still five and a quarter, five and a half percent. That's not good.

Brian Levitt:      

But they're not paying that, right?

Justin Livengood:            

Oh, on incremental deposits and borrowings to the Fed window, they are.

Brian Levitt:      

Okay. But if I go to the bank, I'm getting 0.1%, right?

Justin Livengood:            

Well, if you're at one of the big banks who don't want your deposits. You're right, chase and BofA aren't going to pay anything. But if you're a smaller bank, a lot of regional banks are still dependent on time deposits like CDs and some money market checking type products, which are, if they're not at the Fed funds rate, they're still elevated. It's three, four and a half percent type things. Bank funding costs over the last 12 to 18 months have gone up faster than anyone expected, notably the banks. And that has squeezed their margins because their loans are priced quickly to rates, but only up to where usually the five or 10 year is because most loans are priced longer term. Deposits and funding are priced short term. So this inverted yield curve that has stubbornly stuck around is slowly squeezing margin on the banks on the industry.

So yeah, the Fed is watching this and having to, of course, juggle lots of different things when they're thinking about setting monetary policy. And one of their concerns is, "Boy, the longer we leave the Fed funds rate where it is in our attempt to fight inflation," which I think is the right move, "We're pressuring those banks who at the very same time we're telling to get their houses in order on some of these loans and get your credit ratio, your capital ratios up." So it is a little bit of a moving game that the banks are having to deal with.

Brian Levitt:      

Jodi, I got two things for you. One, it sounds like I might have my deposits in the wrong place. I might've been sleeping for the last year and a half.

Jodi Phillips:     

Perhaps you were.

Brian Levitt:      

And two, did you notice Justin doing the shape of his yield curve on his elbow?

Jodi Phillips:     

Yeah, no, that was really impressive.

Brian Levitt:      

In a podcast. It's going to be good for the podcast.

Justin Livengood:            

Exactly, right?

Jodi Phillips:     

We have to add a video component for this one.

Justin Livengood:            

It was not ideal for an audio only.

Brian Levitt:      

He's a New Yorker. He speaks with his hands.

Justin Livengood:            

Gestures. That's right. That's right.

Jodi Phillips:     

For sure. So Justin, what about any ripple effects in the broader markets? It doesn't really feel like we're feeling anything at this point in time, but in terms of banking concerns, what would you be watching out for just in terms of any broader market impact?

Justin Livengood:            

I think that as it relates to the economy, we're largely okay in terms of what the banks are doing. And I don't think the banks pose a major risk. Again, there has been now a multi-year period where the majority of banks have been able to get their houses in order, and it's only going to be outliers like New York Community that are going to be in the headlines and running into issues with regulators. The system, by and large, is in great shape.

Jamie Dimon just said that yesterday at a conference. I've heard that song and verse from other large bank CEOs in the last few months. And you listen to the larger banks, the top 25 banks, they just came through Q4 earnings with mostly flat loan loss provisions and non-performing assets were flat to down. So the big diversified banks are if anything, having a great stretch of performance, they're not posing a risk to the economy, they're not posing a risk to the markets. They're very healthy and happy. And smaller banks, again, have had time for the most part, to get into the position they need to be in to manage these credit risks.

So I think they'll continue to be outliers like New York Community. I think there'll be some headlines and some moments of concern, but as long as the economy continues to chug along at an okay rate, and as long as the Fed has at least done tightening and tilting towards making rate cuts as we move into next year, I think the banking industry in general is going to be fine and it's not going to be an impediment to growth.

Brian Levitt:      

We talked about private and credit as a durable theme. I get a lot of questions, "What are your thoughts on private markets." It's like the new, everybody's focused on it. So somebody says to you, what are your thoughts on the private credit market when you think of it as a durable theme? Should investors be looking in that space? I know you're focusing on it from the financial players in that space, but investors looking for incremental yield or opportunities they may not otherwise have, private credit, makes sense to you it sounds like?

Justin Livengood:            

Absolutely. So I'll back up. I think credit makes a lot of sense right now. So I also think that public credit is really interesting.

Brian Levitt:      

Investment grade corporates, 5% yield?

Justin Livengood:            

Or high yield corporates, even.

Brian Levitt:      

8%, 9% yield.

Justin Livengood:            

Yeah. Going back to where we started a minute ago, Brian, I am stunned at the resiliency of the economy and its ability to absorb what the Fed has done. As we sit here today, unemployment, Q1 expected GDP (gross domestic product), and inflation are all between three and a half and 4%.

Brian Levitt:      

And people are miserable.

Justin Livengood:            

Well, okay, people are miserable.

Brian Levitt:      

And that's cost of living.

Justin Livengood:            

But the stock market is making new highs.

Brian Levitt:      

New highs, right.

Justin Livengood:            

But my point is it's stunning that you would have at a moment when the Fed has pushed rates to their highest in over a decade, those three numbers I quoted a moment ago, and as long as those three numbers stay there, I don't think the Fed's going to be in any rush to go anywhere in terms of cutting rates. So I think that's really bullish for credit in general because I think a lot of loans... Now I'm going to segue a little bit to your private credit comment. I think there's a lot of value in, again, high grade and high yield public credit, but even on the private side, they're getting to underwrite new loans to businesses, whether it's tied to real estate or it's just straight up corporate-type lending as though you're going to have a normalized credit experience. And that's not what's happening.

I'm hearing all the time from the Blackstones and the KKRs that I get to talk to, that this is a once in a decade, maybe once in a 20-year career opportunity. You're getting interest rates on new loans that's low double digits with terms that are typically only seen in the best of times from a lender standpoint. And it's because borrowers don't have those regional banks. Those companies that are on the line from a credit standpoint that can't tap the public markets that would normally go to a regional bank or some bank to get that next piece of financing. The banks are saying, "Hold on, I'm in this shutdown mode. I got to finish getting my house in order. I can't give you a competitive loan." So they turn to a lot of these private pools of money. So yeah, I'm actually quite bullish on credit.

It's also a good thing for someone like me that sits in the small-midcap equity world because a lot of my small-midcap companies are in fact those same companies tapping private credit or at least the high yield kinds of public credit markets, and this is fine for them. They're able to get decent funding and execute their business plans and do well. And that's partly why now you're seeing the stock market, both the large cap and smaller cap parts of the market do well. People are comfortable that we've threaded the needle on a soft landing and they're able to get financing where they see growth opportunities. So even though loan growth in the banks I said earlier, has stalled out as an industry, this private capital opportunity, particularly on the private credit side, is adequately filling the hole. And I don't think it's reckless. I don't think it's for the most part-

Brian Levitt:      

Shadow.

Justin Livengood:            

Shadow type institutions.

Brian Levitt:      

It does sound very concerning.

Justin Livengood:            

I think it's good money and frankly, it's good money or it's a good trend in some ways because it's removing some of the risk from the regulated banking industry. If sophisticated institutional investors at a private credit fund take a loss on a loan, that's probably not a systemic risk. But if a bank goes down because they made a bad loan, well now we've got to tap the FDIC trust fund to repay the depositors and we've got to go deal with the broader systemic risk that could pose to the banking industry. Well, if we're moving some of those risks off to, at the moment, what seems to be a relatively thoughtful and sophisticated private credit industry, that's not a bad thing.

Brian Levitt:      

Jodi, should we pivot to part two?

Jodi Phillips:     

Well, I think we should, unless there's a third reality he's about to spring on us, which I hope not because I’m feeling pretty good with where we are. … And that’s the end of the first part of our conversation. In the second part, we’re going to talk to Justin about market concentration and what it might take for market participation to broaden. And we’ll spend some time on the potential impact of artificial intelligence – not only on tech companies, but on other sectors that are using this technology in interesting ways. Thanks for listening.

 

Important information

You've been listening to Invesco's Greater Possibilities Podcast.

The opinions expressed are those of the speakers, are based on current market conditions as of February 27, 2024, 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.

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All investing involves risk, including the risk of loss.

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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.

Investments in financial institutions may be subject to certain risks, including the risk of regulatory actions, changes in interest rates and concentration of loan portfolios in an industry or sector.

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.

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Statistics about the loan portfolio of New York Community Bank sourced from the US Federal Reserve.

The Magnificent 7 refers to Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla.

Statistics about the number of people swiping into offices sourced from Kastle Systems.

Reference to $40 billion in reserves set aside for office and commercial real estate loans and references to delinquency rates sourced from the US Federal Reserve.

The hypothetical estimate of the value of losses if the delinquency rate were 6% sourced from Invesco analysis.

References to the rates on the yield curve sourced from Bloomberg as of February 2024.

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. In a normal yield curve, longer-term bonds have a higher yield.

References to interest rates paid on bank deposits sourced from Bankrate.com.

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

References to investment grade yields sourced from Bloomberg, based on the yield to worst of the Bloomberg US Corporate Bond Index, which measures the investment grade, fixed-rate, taxable 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 high yield bond yields sourced from Bloomberg, based on the yield to worst of the Bloomberg US High Yield Corporate Bond Index, which measures the US dollar-denominated, high yield, fixed-rate corporate bond market.

References to unemployment data, gross domestic product (or GDP) and inflation sourced from the US Bureau of Labor Statistics.

References to small and mid-cap performance sourced from Bloomberg. Based on performance of the Russell 2000 and Russell Mid Cap indexes in November and December 2023.

The Russell 2000® Index, a trademark/service mark of the Frank Russell Co.®, is an unmanaged index considered representative of small-cap stocks.

The Russell Midcap® Index is an unmanaged index considered representative of mid-cap stocks.

All Russell indexes mentioned are trademarks of the Frank Russell Co.

FDIC stands for the Federal Deposit Insurance Corporation.

The Greater Possibilities podcast is brought to you by Invesco Distributors, Inc.

Brian Levitt:

Welcome to the Greater Possibilities podcast from Invesco, where we put concerns into context and opportunities into focus. I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. And on the show today is Jen Flitton, Head of US Government Affairs at Invesco.

Brian Levitt:

Must be general election season already, Jodi.

Jodi Phillips:

Yeah, it feels like it, doesn’t it?

Brian Levitt:

It sort of came early.

Jodi Phillips:

Yeah, it sounds like we skipped over the primaries a little bit. Just went straight to the main storyline, right?

Brian Levitt:

Yeah. It's too early. So now we get to do this for 10 months.

Jodi Phillips:

We've drained all the suspense out of the whole process, absolutely. But look, to your point, it's early February. What about investors' radar screens? Is this something investors are already focusing on?

Brian Levitt:

Yeah, I'm not sure they ever stopped focusing on politics and news flow in terms of what the implications are for their portfolio.

Jodi Phillips:

Despite your best efforts, despite your best efforts. I thought it was your life's work to tell people not to worry about the election, or at least in terms of market impact, right?

Brian Levitt:

Well, clearly I am not doing a good job.

Jodi Phillips:

I don't know. We're getting there, maybe.

Brian Levitt:

Slowly, one blog at a time.

Jodi Phillips:

One podcast at a time.

Brian Levitt:

Yeah, I don't know. I think there's some people who just maybe they hear it, but they don't want to change their mind. I remember my mom used to say, it reminds me of this, she said, "If you never change your mind, then why have one?"

Jodi Phillips:

I love that you're quoting your mom. I hope my boys one day find some wisdom for me to quote from. We'll see. But okay, so then what is something that could help investors change their mind about elections?

Brian Levitt:

Okay, so here's one that I've been using that I love. This has worked out so nicely for my message. So I was looking at when Biden was elected on November 3rd, 2020, and he was elected 820 or so market days ago, and the performance of the S&P 500's in the high 40%s since the day he was elected. And so then you go back and you look, when Trump was elected over this, what the performance of the market was over the same time period since Trump was like, any guesses?

Jodi Phillips:

I don't know. About the same, I would guess.

Brian Levitt:

Yeah. What gave it away?

Jodi Phillips:

I know your message, Brian. I know your message.

Brian Levitt:

So it's actually mid-50s. So if you're a Trump fan, you could say, "Great, we're slightly ahead." But the reality is, high 40s, mid-50s, this whole thing is really much ado about nothing.

Jodi Phillips:

Yeah. Much less stark than what the campaign rhetoric would have you believe.

Brian Levitt:

Exactly. Remember that whole, "Your 401k is going to zero if I don't win,” or “the US is going to go bankrupt if I don't win?"

Jodi Phillips:

Mm-hmm. All or nothing.

Brian Levitt:

Yeah, it's just not how things work out. Fortunately.

Jodi Phillips:

Fortunately. So that's S&P 500, that's the broad market, which is certainly important, but there are a lot of other issues and nuances that investors will want to have greater insight on, and so that's why Jen is here.

Brian Levitt:

Yeah. I just try to keep people calm. Jen actually knows stuff, so it's good to have her.

Jodi Phillips:

Oh, great! We like guests who know stuff, so let's not waste any more time and bring on Jen to discuss everything she knows about DC. Hi, Jen. Where do you want to start, Brian? Should we start with some of the major legislation that Jen's keeping an eye on right now?

Brian Levitt:

Yeah, I would love to hear it. We've been all focusing on this will we have a deal to fund overseas allies militarily and also have some money for the border, and it seems to be up in the air, and curious Jen's thoughts on it?

Jodi Phillips:

That's right. $118 billion package, bipartisan package in the Senate, to provide aid to Ukraine and Israel and some border security. So what do you think the fate of that's going to be, Jen?

Jennifer Flitton:

Okay, so we just had a vote. Today is February 8th just for context.

Jodi Phillips:

Yes, for sure. Let's timestamp that.

Jennifer Flitton:

So we just had a vote in the Senate. It's no longer a $118 billion package. It's now a $95 billion package. They are moving on Ukraine, Taiwan money, Israel money, some humanitarian assistance into Gaza money, but they've taken the immigration language out. So this was a negotiated language that Langford and Chris Murphy and Kyrsten Sinema have been working on for the last two months of negotiations, but it fell very flat in the Senate when they finally unveiled the legislation and the language in order to secure the border. They went through a number of really strong restrictions, I mean some of the strongest immigration restrictions, especially in a negotiated package that we have seen in recent memory. But it wasn't enough for especially very conservative members of the Senate.

Brian Levitt:

Was it not enough or was it viewed as perhaps a political challenge for Donald Trump running for election that if Biden had a win on the border, that would take away one of the key messages?

Jennifer Flitton:

So that is the argument from the Democrats. That's exactly what they're saying, that this is a cynical move by the Republicans in order to keep a live issue live going into the election.

Brian Levitt:

Well, I don't want to be cynical.

Jennifer Flitton:

Right. Not in politics, no. But yeah, so that's exactly what the argument is that they want to keep this a live issue, and it will stay a live issue if they can't reach any sort of agreement on even a few amendments to this national security bill. And it looks pretty unlikely they have 17 Republicans who are voting cloture to move forward. The Senate is about to recess for two weeks, so they'll probably get this bill done over the weekend, and it will be sent over to the House, where there are giant question marks how it will be processed.

Jodi Phillips:

Always question marks, no shortage of question marks, for sure. You mentioned that the immigration language was taken completely out of this, right? So what about that issue? I think that was it December marked a record monthly high of migrants crossing over the US southern border. It's certainly an issue that is top of mind for a lot of people. How can it be addressed?

Jennifer Flitton:

Yeah. Seeing what happened over the last 48, 72 hours in the Senate, I think it's highly unlikely that you're going to see some sort of solution coming out of Congress. So then you're looking to the executive branch. The complaint from the Republican standpoint, going into the Biden administration, the first several months of the Biden administration was that he repealed through about 64 executive orders, the actions of the previous administration on the border, and their argument is that that has led us to this point right now. And their argument is, "So you can undo by going back." It's not quite that simple, right? And one of the biggest restrictions was the "Remain in Mexico" policy. That can't be renegotiated with a snap of the finger. So the question really is what is the Biden administration willing to do? What is the Department of Homeland Security willing to do over the next several months, to your point, to try to bring those numbers into a more controllable sort of situation at the border.

Brian Levitt:

So as we move forward through this year, we know we have an election in 9, 10 months. Is there anything that investors need to be worried about in terms of the state of our politics or how things will operate between now and the election, or do we have to be worried about a shutdown or something else that perhaps is done to make one side or the other not look good ahead of an election?

Jennifer Flitton:

Yeah, we're always worried about a shutdown, right? Because Congress has not been willing or ready or able to get appropriations bills done on time. And so this constant kicking of the can with continuing resolutions brings into question whether they can do the business, the most important business of Congress, which is the power of the purse. But we are getting to a point where you finally have the negotiations happening between the House and Senate. They have their top line numbers, which are known as the 302(b) numbers. The subcommittees are negotiating as we speak, and signs are positive in my conversations with staff on The Hill they seem to be getting there.

Brian Levitt:

Oh, good. Yeah, that seems to be how we do this, right, Jen?

Jennifer Flitton:

Yeah.

Brian Levitt:

We seem to get to the 11th hours, and either we cross it, we cross some breach, and we have to deem everybody's necessary so people all work anyway, or we pass it.

Jennifer Flitton:

Yeah, you're right.

Brian Levitt:

Essential, not necessary. Essential. My apologies.

Jennifer Flitton:

Essential employees, yeah.

Brian Levitt:

Essentials, yeah.

Jennifer Flitton:

It's always darkest before dawn, I think, with the appropriations process, and as we approach these March deadlines, I think we're probably going to see two packages hitting right at those threshold dates. And that is also a big week, that first week of March, because not only is it Super Tuesday where we will then see almost 50% of the Republican primary vote in, we also have the President addressing Congress for the State of the Union on March 7th. Shortly after that, the President will release his 2025 budget, which will really set the parameters for his priorities both on spending and tax, and it will also sort of telegraph where he's going as far as his campaign message and his agenda going into this general election season.

Brian Levitt:

Jodi, have you ever actually played kick the can?

Jodi Phillips:

No, I sure haven't.

Brian Levitt:

Jen, have you?

Jennifer Flitton:

Yeah.

Brian Levitt:

You have?

Jennifer Flitton:

I'm from Ohio. Where are you from, Jodi?

Jodi Phillips:

Texas.

Jodi Phillips:

Jen, primary season, you mentioned primary season. So I don't feel like I understand primary season this go around. I know Nevada had both the Republican caucus and a Republican primary, and “none of these candidates” won the primary. I don't know. I don't know what's going on. It just feels like it's quick and chaotic, and can you maybe help explain what's going on and what you're looking at?

Jennifer Flitton:

Nevada is a funny story, and it's really just this year that they're trying to get two caucuses in on both the Republican and Democratic side, and now the primary's sort of leftover, but if you filed to be in the primary, you can't file to be in the caucus. And so Haley filed to be in the primary, but then the Trump campaign put a campaign against her telling his supporters to vote, "None of the above," or "None of the …"

Jodi Phillips:

Sure. I don't know why I'm having trouble keeping up. This totally makes sense.

Jennifer Flitton:

Yeah, exactly. And then they managed to beat her by like 60-plus percent to her 33%. So it was a little humiliating. I think that was their intention. And now Trump runs in the caucus today, so we'll see what that number is. It should be strong. And then we go into the end of February here with the South Carolina primary, which will be the primary to probably define whether Haley stays in this election or not.

Brian Levitt:

None of the above. Sounds like a good theme for the 2024. So Trump versus Biden, probably a foregone conclusion. And is there anything that's going on right now with the Supreme Court or the Colorado case that changes that?

Jennifer Flitton:

Yeah, I was just watching the oral arguments. So the constitutional question as to whether Colorado and Maine, also relying on the Colorado decision to take Trump off the ballot in Colorado, that is being decided right now by the Supreme Court. Listening to oral arguments pretty much indicates that by the questioning of both sides of those who were put onto the court by Democrats and those put on the court by Republicans seems to indicate that this will be overturned, and Trump will be back on the ballot in Colorado and Maine.

Brian Levitt:

So this will be determined by the voters, not the Justice Department.

Jennifer Flitton:

I think that is very likely the decision that comes out of the Supreme Court.

Jodi Phillips:

So given how crazy the primaries have been this time around, does that change the landscape or the complexion of the general election at all? I know my impression has been, and maybe this is true or false, but that primaries were sort of auditions for folks who wanted to be the VP candidate, right? So what do you think in terms of a running mate for Trump?

Jennifer Flitton:

Yeah, I'll first answer that first question. This is going to be a strange election in the sense of the court system being as involved as it'll be, and not just in the indictments of Trump and him having to maneuver his way through different courts in different states in America, but also these questions of taking him off the ballot and his own question of immunity. The Supreme Court is clearly going to have to get involved in some of these issues, most likely on the immunity case. We'll see if he files appeal.

But to the question of the vice president, right now, as we've been told, it's been reported, and some of us have been in contact with the different campaigns, and it's clear that Trump and his team are vetting potential vice president nominees right now. And so I think it's very likely he will announce come late spring, early summer who his running mate is.

Brian Levitt:

What are the big issues that investors should be focusing on, Jen? What are the big issues that you're focusing on?

Jennifer Flitton:

Well, I'm trying to get through the noise, right? There's so much around this election that is going to be incredibly hyperbolic. There's going to be manufactured crises, and what we're trying to do is keep our investors' eye on the ball. This is where it is actually going to come down to Joe Biden policies versus Donald Trump policies on taxes and immigration and the economy and spending priorities. And I think the more we can cut through the hyperbolic rhetoric and the more we can focus on what is actually at stake, the better, and I think that just keeps our investors better informed.

Brian Levitt:

Good luck.

Jodi Phillips:

Absolutely.

Brian Levitt:

I've been trying to do this for years, Jen.

Jodi Phillips:

And at the risk of injecting any hyperbolic rhetoric, I see people mentioning that the next president is going to face a tax cliff, so to speak, because of certain provisions of the Tax Cuts and Jobs Act (TCJA) that are set to expire at the end of '25. Obviously, tax is an extremely important issue. How would you describe what the different issues are in terms of what the next president will face?

Jennifer Flitton:

Yeah, this is going to be a major point of contention in the general election, and if we do see debates out of these two men come fall, I think this is going to be a major focus, because in 2017, Donald Trump was able to get through his TCJA, which is the tax reform restructuring of our code, but a number of those provisions do expire, as you indicated, Jodi, in late 2025. We also have a tax bill. In all of this mess in Congress, they were able to negotiate a bipartisan tax bill that not only extends the child tax credit, but also does important work on research and development, expanding that and extending that along with accelerated depreciation. These things mean a lot to farmers and small businesses along with big corporations here in America. And so that would also, though, the way that they've structured it, would expire at the end of 2025. So there's going to be momentum going into 2025 to do something about this. There's other expiring provisions that have to be taken care of, the SALT issue, which is the state and local income tax.

Brian Levitt:

Yeah, I'm in New Jersey. Tell me about the SALT issue.

Jennifer Flitton:

Yeah. So unfortunately for those New York and New Jersey delegation members, they were not able to include some SALT changes to this latest tax bill. They're trying to get a standalone vote. I think it's going to be hard to get it out of rules committee. I don't think it has a good future, but it does expire along with the others at the end of 2025, and that would mean a huge revenue decline for the IRS. So they have to deal with all of this, and it's going to look very different between a President Biden or a President Trump. That's probably one of the issues that swings strongly one way or another come 2025.

Brian Levitt:

Well, Jen, I was getting a little bit of deja vu when Jodi said tax cliff. So I was thinking back, what I remember now is the fiscal cliff, which was maybe a decade ago, and I think that was the end of the Bush era tax cuts, to which ultimately I think all the concern investors had about the fiscal cliff, I think Obama ended up extending many elements of them, some of the elements of the Bush era. So is that a blueprint that we could draw in that if investors do have concerns that Biden will win the election and these things will potentially expire, can we draw on the 2014 or 2008 example? I'm trying to remember the date.

Jennifer Flitton:

I do think you're right. It is much more a mixed outcome if Biden is reelected, because in the run-up to his first election in 2020, he made clear that, as it relates to tax or tax increases, that he won't raise taxes on any families below $400,000. And so as we look at the tax framework, the individual tax framework, the tax brackets that currently exist under this, will expire at the end of 2025. I'm curious to see if some of his messaging comes out as we get into the general campaign season as not increasing below $400,000, but then looking at those tax brackets above $400,000.

Brian Levitt:

I also vaguely remember when he was running in 2020, a lot of concern from investors of where the capital gains tax rate would be. Wasn't it a very large number that had people very concerned that actually did not come to pass?

Jennifer Flitton:

Yeah, right. And that withered on the vine pretty quickly. But there's also members of his own party, and important members like the chairman of the finance committee, Chair Wyden, who has his own legislation. It's kind of a wealth tax. It's basically taxing on income that isn't income yet. And so how some of those questions are going to be answered, how he's going to put together his own tax plan, we're going to see that here very shortly. And I think some of this, like I said, is going to be telegraphed in his budget, and we're going to get an idea of what his economic plan is partly through his budget that he's going to release at the beginning of March.

Jodi Phillips:

So Jen, as someone who has aspirations to retire one day, someday, should I be concerned at all about the SECURE 2.0 implementation, the bipartisan act, lots of implications for retirement savers? Obviously, with a multi-year rollout of these provisions in the middle of an election, is there anything you're watching with that?

Jennifer Flitton:

So we're basically in implementation mode now, and members of Congress are watching very closely what sort of effects this legislation is having on the retirement community in getting more people to save for retirement because that's the whole point of it. It's not just those currently saving for retirement, but those who are sort of underserved in the retirement industry. And so that's really what the focus is for members of Congress in watching this implementation.

But you're right, the Department of Labor and Treasury, they still have to write guidance, they still have to write regulation. There's a technical corrections bill that's going to have to move through the Senate, but because of other priorities, they're going to have to get to the more controversial first, because there's a reason it has to do with the Congressional Review Act and we'll get into that, but you're right, the first half of the year is going to have to be spent on the President's agenda and his priorities and what he needs to get promulgated and finalized within the first half of the year. So that's going to push some of these less controversial issues towards the second half of the year.

Brian Levitt:

Is there anything else that the asset management industry needs to be particularly focused on or the advisory business needs to be focused on?

Jennifer Flitton:

Yeah. Like I said, there are a number of regulations that are going to be finalized in the first half of the year. I'm talking to advisors a lot about the DOL's (Department of Labor) new fiduciary rule, which we do expect to come out at the first half of this year. It will have a CRA attempt at it, which is Congress's Review Act, which tries to get regulation eliminated because they deem it not at the discretion of the regulatory agency, and it should be at the statutory authority of Congress. And so that's going to be a fight. But also, the SEC is putting out a lot of proposals. Those are going to be finalized, and what is the aggregated effect on the capital markets? I think that is one of the questions that's out there that we're watching very closely.

Jodi Phillips:

Is there anything we should be watching with artificial intelligence, crypto, any of those issues?

Jennifer Flitton:

Now, that's a favorite issue, artificial intelligence (AI) first, on The Hill, and that's a bipartisan favorite, and there's been a lot of time and effort spent. Especially, it started this last half of last year in 2023. Chuck Schumer, the majority leader, put together a number of briefings with corporate America, tech America to come in and really sit down and help members of Congress, senators really understand artificial intelligence and how it could be regulated and what needs to be done on a governmental level. And so that question is going to continue into 2024.

If you sit down with some of these senators who are really focused on it, it's all they want to talk about. It's hard to get them off the topic, in fact. And so I think you're going to see some of them, who are most challenged and want to be champions on the issue, really trying to come together on some bipartisanship. We'll see if they're able to get there this year. But those talks, that's the sausage being made, that's the side of it where it takes time for these things to come to fruition.

Brian Levitt:

Do you think they're able to get their heads around a topic that's so potentially complex?

Jennifer Flitton:

I know. Can the world get their heads around AI and all the good and bad that can come from it? Yeah, you're right. It's a hard one to answer.

Brian Levitt:

And what about crypto, to Jodi's point, about crypto regulation?

Jennifer Flitton:

Yeah. So there's a market structure proposal at the SEC (Securities and Exchange Commission). There is also a big attempt by the chairman of the Financial Services Committee, Chairman McHenry, to try to get some stablecoin legislation through, to get some digital asset market structure legislation through. They're going back to the drawing board on stablecoins with his Democratic counterpart, Maxine Waters, really trying to work through some of that illicit financing angle that still is really concerning a lot of members on both sides of the aisle.

And then we saw Secretary Yellen. Secretary of the Treasury make clear at a hearing this week that the Treasury generally supports legislation on stablecoin digital asset market structure. But it's really the devil's in the details, and getting there has to come out of the House, because those conversations just aren't really happening in the Senate.

Brian Levitt:

So how's this going to play out, Jen? Do you have a horse in the race for the election?

Jennifer Flitton:

Yeah. I know that Wall Street investors love a theory of the case, but with the polls where they are right now, it is a virtual 50/50 race, and it is all within the margin of error that it could be either candidate, I'd say incumbent, but they both are sort of ... One's definitely an incumbent, one's sort of a quasi-incumbent. And you're talking about a second term for either one, which would mean a lame duck sort of term. This is going to a very interesting race.

Brian Levitt:

Unprecedented since Grover Cleveland? Is it Grover Cleveland?

Jennifer Flitton:

Is it?

Brian Levitt:

Born in my hometown, by the way, Grover Cleveland.

Jennifer Flitton:

Oh, congratulations.

Brian Levitt:

Yeah, thank you. So when we talk about that 50/50 so tight, one of the things that I've asked you before, but not on the podcast is, is there concern that we don't know who won for a long while, and should investors have any concern about potentially two men showing up on January 20th, 2025, to take the oath of office?

Jennifer Flitton:

I don't think it'll take that long. We may not know the night of, but it's really going to come down to six states. So it's going to be Arizona, Nevada, Wisconsin, Michigan, Pennsylvania, and Georgia.

Brian Levitt:

Georgia. So Jodi and I'll sit these out, Texas and New Jersey?

Jodi Phillips:

Yeah.

Jennifer Flitton:

We all know where you're going. But those six states are really the swing states, those are the presidential makers. And so going into election night, you're probably talking about 100,000 votes total that are really going to decide where this race goes.

Brian Levitt:

So these guys better go start knocking on doors, huh?

Jennifer Flitton:

Oh, yes. I think those states are going to have a lot of commercials coming their way, lit drops and phone calls, and I'm sure it will be very annoying.

Jodi Phillips:

It's going to be a long nine months. All right. Any more questions, Brian? I think we've covered everything.

Brian Levitt:

Well, we're going to have Jen back on many times over the next nine, 10 months, correct?

Jodi Phillips:

Absolutely, and I'm going to take the lesson that I've learned from whenever we have Jen on the podcast, which is to check X, Twitter, right before she comes on. I think last time, we had someone drop out of the Speaker's race about five minutes before we talked to Jen, and now they took all the immigration language out of the immigration bill. So always late-breaking news that Jen's here to put into context for us.

Brian Levitt:

Because Jodi, you and I are working too hard. We're not keeping up to it.

Jodi Phillips:

That's right. Next time.

Brian Levitt:

Well, Jen, thank you so much for joining us.

Jodi Phillips:

Thanks again for joining us, Jen.

Jennifer Flitton:

Thanks for having me.

Jodi Phillips:

Okay, Brian, where can listeners find more information from you throughout election season and beyond?

Brian Levitt:

Well, thanks, Jodi. Visit invesco.com/brianlevitt to read my latest commentaries, and of course, you can follow me on LinkedIn and on X, formally Twitter, that's @BrianLevitt.

 

Important information

 

You've been listening to Invesco's Greater Possibilities Podcast.

 

The opinions expressed are those of the speakers, are based on current market conditions as of February 8, 2024, 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.

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.

 

In the 815 days following Joe Biden’s election as president (Nov. 3, 2020, to Feb. 2, 2024) the S&P 500 Index was up 47%. In the 815 days following Donald Trump’s election as president (Nov. 8, 2016, to Feb. 7, 2020), the S&P 500 Index was up 55%. Data sourced from Bloomberg.

 

Past performance is not a guarantee of future results.

 

An investment cannot be made directly in an index.

 

Based on US Border Patrol figures reported by multiple news outlets, migrant crossings at the US southern border reached a record monthly high in December 2023.

 

All data provided by Invesco unless otherwise noted.

 

Stablecoins are cryptocurrencies that seek to peg their market value to an external reference such as a currency like the US dollar or a commodity like gold.

 

The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.

Brian Levitt

Welcome to the Greater Possibilities podcast from Invesco, where we put your concerns into context and the opportunities into focus. I'm Brian Levitt.

Jodi Phillips

And I'm Jodi Phillips. Welcome to our first podcast of 2024, Brian.

Brian Levitt

Yeah, it's good to be here. We made it.

Jodi Phillips

We made it. We'll see if you still think it's good to be here — you're on the hot seat today, so this is all resting on your shoulders today. But look, I know you closed out '23 with a lot of traveling across the US, speaking to investors. So I thought today we'd cover the top 10 questions you've been getting. And just to up the level of difficulty a little bit, let's give you three points or fewer to answer each of those questions. What do you think? Can you do it?

Brian Levitt

I'm a kid from New Jersey I can't really say my name in three points, but we'll give it a try.

Jodi Phillips

All right. Well we won't count too formally, but you get the gist.

Brian Levitt

No buzzer?

Jodi Phillips

No buzzer, no. We don't have sound effects.

Brian Levitt

No buzzer. No shocks. Okay, good.

Jodi Phillips

All right. You want to dive in?

Brian Levitt

Yeah, let's do it.

Jodi Phillips

Question one. All right. Brian, why wasn't there a US recession in 2023 despite all of the predictions to the contrary?

Brian Levitt

I'd say first the consumer in good shape, the job unemployment rate is low. So that would be one, the consumer's feeling good. Two, there's not a lot of leverage in the economy. Typically, when you see the Fed raise rates that impacts people. A lot of people have loans that they have to come back to market to fund, just not a lot this time. And three, we never really got a chance to build up cyclical excess meaning... Remember the challenge was businesses didn't even have inventory. There weren't a lot of homes for sale. We couldn't find cars. So we never built up the cyclical excesses that typically lead to a recession. How's that? Three bullets.

Jodi Phillips

Three bullets. You did it.

Brian Levitt

Was that too much? Or three bullets, that's good?

Jodi Phillips

Three bullets. That's good. All right. That's only question one, too. So …

Brian Levitt

Nine more to go. Let's see this.

Jodi Phillips

Question two. All right. Let's focus in on US stocks, specifically the S&P 500 last year, largely driven by a handful of stocks. I think some call them, what? The Magnificent Seven?

Brian Levitt

Yeah, the concentrated market.

Jodi Phillips

That's right. So where are we with that? Is that trend going to continue? Is this going to broaden? What are you expecting to see this year?

Brian Levitt

Well, the first thing is I like to remind people that it wasn't always a concentrated trade. People make it out as if the whole year was very concentrated. When the market bottomed in the middle of October 2022 and it rallied through February of '23, that wasn't concentrated. That was a soft landing trade, rising tide lifted a lot of boats. Then Silicon Valley Bank failed. So there was concern about the banking system and the economy. And then we actually got concerns that the economy was too hot and so the Fed was going to have to really, really raise rates. So that was really post February, and then into the spring and summer, that was the concentrated market. Not November, December. The market was not concentrated at all in November, December. That's when the soft landing trade reemerged, that's where we've been. We'll see if things get a little bit more concentrated as things slow down here in the economy.

Jodi Phillips

My memory fails me. It seems like just yesterday and a million years ago at the same time. I don't know how that works, but that's the phenomenon.

Brian Levitt

I know, right? I know.

Jodi Phillips

Question three. We're going to stick with the S&P 500. So the index, it gained what? Nine something percent, 9.1% in November, about 4.5% in December. So I heard you say the other day that you wished those gains hadn't been quite so sharp over those past two months. And that seems a little counterintuitive to me, Brian. So what's driving that? Why do you think, was it too much too soon?

Brian Levitt

Yeah, and it wasn't even just the S&P 500. If you look at the Russell 2000, which is the small cap index, that was up 21%. Mid-caps were up 18%. So we had a market call of a soft landing trade, and the soft landing trade was going to be beneficial to multiple capitalization or the capitalization range, smaller cap. So one my point would be I just wish it played out over a longer period, giving investors more time to get involved if they weren't in favor of small or mid-cap or value, you had these really big moves over a very short period of time.

 

Two, it's unlikely we see those outsized schemes again in the near term. And that's not a negative call on equities, it's just to say that was a tremendous move and it was broad. And so unlikely we'll see those broad market moves that favor all stocks.

Jodi Phillips

Is that the “everything bull market” you like to say?

Brian Levitt

Yeah. It felt a lot like an everything bull market, whether you were in bonds or whatever type of equities. And then three, look, the environment still favors equities over the next few years, peak inflation, peak tightening. It's just to say that we got a lot quick and I would've rathered investors had more time to enjoy it.

Jodi Phillips

Okay. Four, so you said it's unlikely we'll see those same types of gains in the near term. Why not?

Brian Levitt

Yeah, and I think it makes sense to say near term, call it the next three to six months. Well, the market priced in six interest rate hikes very quickly.

Jodi Phillips

Yeah, that's a little bit to absorb. Sure.

Brian Levitt

It was like rates are going to go from 5.25%, to the big CEOs of the bank saying going 7%, now all of a sudden it's 3.50% by the end of next year. So that was a lot quickly. I understand what the market is thinking, but the Fed could still very well underwhelm that and they probably will underwhelm the market.

Two, US growth is back below trend again. So you and I and the consumers, we did a good job of moving this thing along and we were actually above trend growth latter part of '23, we're back call it below trend again. That doesn't mean that we're heading into a recession, it just means that we're slower than what we typically are. So you take those two. I would say number three, we could just be left waiting for a catalyst, like a sign that the Fed is really going to ease or a sign that the economy's not going into a recession. We probably just need some type of catalyst, but that may not come over the next few months.

Jodi Phillips

Understood. What might a catalyst look like?

Brian Levitt

I mean, the catalyst typically would come from the view that we're going to really renormalize the yield curve, normalize the yield curve. So inflation, passe, it's over, which I think we're getting there, growth hanging in and that soft landing trade can reemerge. In the next weeks it might be, well, we just might not get as much from the Fed, inflation's too sticky or well this economy. So you just need more clarity now on the soft landing trade and it may take a little time to get there.

Jodi Phillips

Okay. Well that was a follow-up, so we're not counting that against your three points-

Brian Levitt

That's not fair.

Jodi Phillips

So your streak continues.

Brian Levitt

That is fair then. I thought that-

Jodi Phillips

It is fair. It is fair.

Brian Levitt

No. Okay, good. I thought you were going to say you're not counting that as a question. So are we doing 11 now?

Jodi Phillips

I wasn't counting that as an extra point. No, no. Still good. Still good. All right. So question five, S&P 500 hit a new record close in January, is that something to worry about?

Brian Levitt

No. And the first thing I would say, I quote Sir Arthur Clark, I've done this for years in meetings, which is to say that only small minds are impressed by large numbers. Now-

Jodi Phillips

I feel called out now.

Brian Levitt

Well, yeah, no, not you. I know it's bad. So I'm telling an audience that they have small minds. No, I'm just reminding them not to be impressed. Nobody has small minds, just reminding them not to be impressed by large numbers.

Jodi Phillips

Fair enough. Fair enough.

Brian Levitt

So when we hit the new high, was it Friday, January-

Jodi Phillips

19th.

Brian Levitt

19th. That was the 1158th new high of the... Yeah, I counted them. Thank God for Excel. Of the S&P 500 since 1957. So that's once every fortnight. That's once every couple of weeks. So you shouldn't be all that impressed by a new high when they on average happen once every couple of weeks.

And three, I think the biggest thing is that the market averages are not mean reverting. So they're not going to come back to some mean. If you think that the world is going to get better for us, for people, for economies, and I guess most importantly the 500 biggest companies in the United States, then markets should see many new record highs over the course of our lives.

Jodi Phillips

All right. All right. Question six, so January is a notorious month for those investors who'd like to see patterns in the calendar, the January effect, the belief that in any given year, January tends to be the strongest month for US equity returns. So do you believe there's some kind of predictive power to what happens in January? Is this going to set the stage for the rest of the year?

Brian Levitt

Yeah, well you started talking about January and perhaps some challenges that we had in the beginning of the month, I thought you were going to mention the NFC East. I can't point out your Houston Texans…

Jodi Phillips

Don't do it. Don't go to the AFC South, please.

Brian Levitt

No, no. That was impressive. They're ahead of schedule.

So yeah, I mean January started off challenging and I think that's why this question has come up, the first couple of weeks weren't great, so I think people got a little concerned about that. No, the reality is that when January is positive, so this is where this comes from, the market is positive in 80% of the years that are looked at, that sounds very impressive. But when you consider that markets go up 75% of the time or every three and four years, it's probably not that statistically significant.

Also, its predictive power is significantly less when January is negative. So the probability of having a negative year when January is negative is really no better than a coin toss. And so as always, don't try and time these things. A buy and hold approach-

Jodi Phillips

Buy and hold.

Brian Levitt

... is much better than trying to time things based on whether January is good.

Jodi Phillips

All right. Question seven, market leadership, how do you think that's going to play out over the next, say, year or two?

Brian Levitt

Yeah, so that gets back to what we were talking about with the everything bull market and what did we wish took longer. We talked about it, small caps, mid caps, value, all did well. I would say one, you may see more quality leadership in the near term that goes back to that catalyst. We need to reaffirm that soft landing trade.

Two, ultimately if you're an investor and you're not just looking very near term, I would view all of this from the perspective of getting out of this bizarre COVID environment finally once and for all. And so the clock has started on the Fed cutting interest rates. The next few months are going to be will they, won't they, should they, can they? But then over time it's pretty clear to us that the Fed will normalize the yield curve. And as that happens, you tend to get the broader market participation and that's when you'll get the shift away from what we think will be in the near term a quality trade back towards more small cap value and international.

Jodi Phillips

International, okay, so let's talk about that a little more. What's the story there? What are some of the reasons in your opinion that investors might want to consider international?

Brian Levitt

Yeah, so Jodi, that's question eight for you.

Jodi Phillips

It is.

Brian Levitt

I think that's question one that I typically get... Well one might be about elections, but we're going to cover that in other podcasts. But this idea about international after multiple years of under-performance, let's do the one, two, three.

One, the post global financial crisis environment was very slow. All these years of under-performance, that was a slow growth world. You could pretty much set your watch to 2% GDP growth in the US, very slow growth. And so international markets, value markets, they tend to need better macro environments. They tend to need growth picking up, nominal activity, picking up. And we didn't get that.

Now two, each time it appeared to be coming like some synchronization, some pick up in global growth, the US tightened policy. And in hindsight, and I was saying it at the time, inexplicably tightened policy. So 2015, the Fed raised rates attempting to be the first central bank in the history of the world to raise rates during a slow growth deflationary environment. Then they backed off and said, okay, just kidding. And 2016 and 2017 were great years for international markets, particularly the emerging markets. It's really good times, the Fed had backed off. Well what did we get in '18? The trade war, more interest rate hikes. And then the Trump administration gave us more clarity on trade. The Fed said, okay, just kidding again. And then 2019 we got started to get more broader regional participation — then COVID hit and we shut down.

So you'd never really got a chance. And so investors think of it as, well, never happened for 10, 15 years, can't ever happen again. That was a very unique post-GFC, global financial crisis, environment. So what may be happening now is, if you think about it from that perspective of tightening policy at inopportune times, we haven't even started easing yet.

Jodi Phillips

Right. That's right.

Brian Levitt

So maybe a long time before we're tightening policy. That tends to suggest the dollar peaks and may have already peaked just because of interest rate differential between the US and the rest of the world. And valuations are more attractive. So if money's going to be looking for a different home than the US dollar and the economy's good, money may start to flow to other parts of the world where valuations are more attractive.

Jodi Phillips

Okay. All right. Question nine, yeah. So we've already established that I'm not supposed to be impressed by large numbers, but US debt, it's over $34 trillion. Come on. That's an impressive number.

Brian Levitt

That does impress you? 34 Trillion?

Jodi Phillips

Yeah, 34 trillion - with a T - for sure.

Brian Levitt

But that scares people.

Jodi Phillips

Sure. Sure, it does.

Brian Levitt

So what do we say about this?

One, very happy to live in a country that was able to respond to the last two crises. So the reason that we've seen significant rise in debt over the last decade plus is we had to respond to the global financial crisis. We had to respond to COVID. And COVID was, call it, 4 to 6 trillion of additional spending. Now maybe we overdid it. But I'm happy that we got beyond each of those environments without depressions. Really, really critical and really, really impressive that we were able to do that. So that's one, before we get nervous, let's be happy we can fund this debt.

Two, I think people underestimate how wealthy a country the United States is. So Jodi, you want me to impress you with some large numbers again.

Jodi Phillips

Please. Please do.

Brian Levitt

The debt is $34 trillion. US household net worth is $150 trillion, five times the size of the debt. So think about it. I mean, are we a good credit? The net worth of our household is 5X-

Jodi Phillips

Sure sounds like it. Yes.

Brian Levitt

I wish my household net worth was 5X the size of mortgage, right? I mean, think about it.

Jodi Phillips

Yeah, it's all relative.

Brian Levitt

And then there's a captive audience for US bonds. The government buys, the Fed by some of it, the Social Security Trust Fund, so government entities, US savers like my dad and US financial institutions, US mutual funds, US endowments, US pensions, US insurance companies, and then foreign investors like the Germans, the Japanese, and the Brits who can't get higher yields in their home countries. So there's a pretty captive audience. So no, I'm not worried about the US debt.

Jodi Phillips

Good. And now neither am I. Thank you.

Brian Levitt

But impressed. You're not worried, but you're impressed. Still impressed.

Jodi Phillips

Still impressed. It's still a big number.

Brian Levitt

It is impressive.

Jodi Phillips

All right. Question 10, how concerned should investors be about geopolitical events? We look at what's going on, particularly in the Red Sea. We've got shipping companies that have been diverting their routes like an extra 4,000 miles in order to avoid attacks in that area. And so are those shipping disruptions going to lead to the type of inflation we saw a few years ago when ships were backed up at the Port of Los Angeles, for example?

Brian Levitt

Right, that is one of the iconic images of COVID. There's actually too many iconic images of COVID, but that was one of them.

Okay. One regional events have tended to not disrupt markets. I say regional, I think that's the critical word. If this gets significantly broader and the powers that be don't seem to want it to, even with the tit-for-tat that's going on, regional events have tended to not disrupt for markets. And since October 7th when Hamas went into Israel, this time has been no different. The markets have looked beyond it.

So point two, I always tell people ask yourself is what's going on going to change the direction of the US economy or what the Fed will be doing? Usually the answer to that, particularly after Hamas went into Israel and then Israel went into Gaza, the answer to that was, no, not really. It's not going to change the direction of the US economy or what the Fed will be doing.

But then your point about trade. So point three, it's not insignificant, so I don't want to sugarcoat it. But, let's at least put it into perspective. So the ships going through the Red Sea, that amounts for about 15% of global trade. So 85% is not going to necessarily be impacted by this. And going around the Cape of Good Hope, to your point, at Southern Africa does add costs. And so some of that may be inflationary. It's not ideal, particularly when your market outlook is based on inflation being tamed.

But I'd argue that if we really think about where inflation came from, it really came from businesses slashing inventories and slashing workers when COVID hit. And in hindsight, they did it at a really inopportune time and then struggled for a couple of years to rebuild inventory and get workers back. That's not the case now. We're looking at record levels of inventory, not from an inventory to sales ratio, but in nominal terms, record levels of inventory and record number of workers and near record low unemployment rates. So it's just, yeah, we watch geopolitical, but it doesn't drive the base case of our views.

Jodi Phillips

You made it.

Brian Levitt

10.

Jodi Phillips

10 questions. Three points each.

Brian Levitt

So did I speak more or less than you expected?

Jodi Phillips

I don't know. I'll gauge when I get the transcript, I'll do the word count.

Brian Levitt

You can edit me.

Jodi Phillips

We always have that power, so yes. But, seriously, thank you. Thank you for doing this little exercise and rest assured you will not be on the hot seat for the next episode. We've got some great episodes that are coming up. Planning one to talk about the presidential election, of course. Definitely a hot topic of conversation. We're going to talk about Bitcoin in a future episode, so looking forward to that. Be sure to subscribe to get the latest episodes, if you haven't already. You'll get them as soon as they release. And Brian, where can listeners get more from you?

Brian Levitt

Oh, thanks for asking. So visit Invesco.com/BrianLevitt to read my latest commentaries. And of course you can always follow me on LinkedIn and on X, I think I'm supposed to say formerly known as Twitter @BrianLevitt.

Jodi Phillips

All right, thanks for listening.

Brian Levitt

Thanks Jodi.

 

Important information

You've been listening to Invesco's Greater Possibilities Podcast.

 

The opinions expressed are those of the speakers, are based on current market conditions as of January 23, 2024, 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.

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.

 

Past performance is not a guarantee of future results.

 

An investment cannot be made directly in an index.

 

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, including emerging market 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.

 

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.

All index returns sourced from Bloomberg, L.P., as of Dec. 31, 2023.

Russell 2000® Index is an unmanaged index considered representative of small-cap stocks, and returned 21% over November and December 2023.

References to mid-cap stocks refer to the Russell Midcap® Index. The Russell Midcap Index is an unmanaged index considered representative of mid-cap stocks, and returned 18% over those two months.

The Russell 1000 Value Index is an unmanaged index considered representative of large-cap value stocks and returned 13% over those two months.

Russell indexes are trademarks/service marks of the Frank Russell Co.®

The S&P 500® Index is an unmanaged index considered representative of the US stock market.

An investment cannot be made directly in an index.

Statements about the market pricing in interest rates cuts are based on Fed Funds Futures, sourced from Bloomberg as of January 24, 2024. Fed funds futures are financial contracts that represent the market’s opinion of where the federal funds rate will be at a specified point in the future. The federal funds rate is the rate at which banks lend balances to each other overnight.

The number of new market highs sourced from Bloomberg, as of January 24, 2024. Based on the S&P 500 Index from 1957 to current.

Discussions about historical market performance in January are based on yearly S&P 500 Price Index data from 1928 through 2023, sourced from Bloomberg as of December 31, 2023.

Comments about the 2016 and 2017 performance of international and emerging market stocks based on the returns of the MSCI ACWI-ex USA and MSCI Emerging Markets Indexes sourced from Bloomberg. The MSCI ACWI ex-USA Index returned 4.50% in 2016 and 27.19% in 2017. The MSCI Emerging Markets Index returned 11.19% in 2016 and 37.28% in 2017.

The MSCI ACWI ex USA Index is an unmanaged index considered representative of large- and mid-cap stocks across developed and emerging markets, excluding the US.

The MSCI Emerging Markets Index captures large- and mid-cap representation across 26 Emerging Markets countries.

Data on the size of the US debt, COVID spending, and US household net worth all from the US Treasury Department as of January 24, 2024.

Information on the amount of global trade passing through the Red Sea is from S&P Global Market Intelligence.

Tightening monetary policy includes actions by a central bank to curb inflation.

The Magnificent 7 refers to Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla.

The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates.

Gross domestic product, or GDP, 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 Greater Possibilities podcast is brought to you by Invesco Distributors, Inc. 

Brian Levitt:

Welcome to the Greater Possibilities podcast from Invesco, where we put concerns into context and opportunities into focus. I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. It's December and we've decided to use our last podcast of the year to answer the most frequently asked questions that we've heard throughout 2023. And we've asked Turgut Kisinbay, Chief US Economist for Invesco Fixed Income, to join us in answering those questions.

Brian Levitt:

Last one of the year, Jodi?

Jodi Phillips:

It is.

Brian Levitt:

Oh, good. So, I guess a little hiatus for a couple of ... I feel like one of those late night talk show hosts like a Jimmy Kimmel or something, we get to do a little hiatus here.

Jodi Phillips:

All right, well, don't get too excited because we're going to be back before you know it at the start of the year.

Brian Levitt:

Yeah, I figured but we'll enjoy it while it's here. So, I guess I'll ask you, what are some of those questions you think you want to ask Turgut?

Jodi Phillips:

Well, first and foremost, does he think the US is going to have a recession in 2024?

Brian Levitt:

Yeah, that one seems to be pretty popular and why didn't we have one in '23? Can we have a soft landing? These are the most frequently asked.

Jodi Phillips:

Yeah, most popular questions.

Brian Levitt:

Most popular. Yeah, it's like a high school superlative. Instead of smartest student, prettiest eyes, we'll go with most asked questions here.

Jodi Phillips:

Something like that. Well, okay Brian, so did you win any superlatives in high school?

Brian Levitt:

No. I peaked in middle school. In middle school, I won most energetic, although I'm not sure in hindsight if that's good or bad.

Jodi Phillips:

Yeah, no, that's a nice way of saying you drove the teachers crazy.

Brian Levitt:

Yeah, I think I did. Anyway, you? You win any?

Jodi Phillips:

I did. I was actually named most likely to succeed in high school.

Brian Levitt:

Wow.

Jodi Phillips:

Yeah.

Brian Levitt:

Wow.

Jodi Phillips:

So, fun fact though, I mean, the first thing I noticed when I got the award was that succeed was misspelled.

Brian Levitt:

Ooh, irony. Interesting.

Jodi Phillips:

I suppose no big surprise I became an editor, but there you go, there you go.

Brian Levitt:

And now you get to host the Greater Possibilities podcast.

Jodi Phillips:

I do.

Brian Levitt:

So, I would say your classmates could not have been more spot on.

Jodi Phillips:

They nailed it, but I digress.

Brian Levitt:

But we digress. Yeah, we both digress. We like digressing here.

Jodi Phillips:

We do. So, question two after the recession question. Question two, what's the Fed going to do? And question three, have interest rates peaked? And if so, where are they heading?

Brian Levitt:

Right, and how long does it take to normalize the curve? How should we be invested for it? Those all seem to be, should we say, the superlative questions?

Jodi Phillips:

The superlatives, most popular.

Brian Levitt:

Most popular. What about the dollar? Has it peaked? Can we expect a new dollar environment? What does that mean for international investments, et cetera, et cetera, et cetera?

Jodi Phillips:

That's it, those are the questions so let's bring on Turgut. I don't know which superlative he might've received in high school but I know he has a PhD in Economics, so we're just going to leave it at that. Welcome, Turgut.

Brian Levitt:

I would've thought PhD in Economics means that he won the life of the party.

Jodi Phillips:

I don't know, we'll have to ask him. We can add that to our list.

Turgut Kisinbay:

Yeah. Hi, Jodi and Brian.

Brian Levitt:

Turgut, welcome.

Turgut Kisinbay:

Thank you, thank you.

Brian Levitt:

It's good to have the life of the party here.

Turgut Kisinbay:

I don't know if I'm the life of the party. I was maybe earlier. Brian, I think I peaked earlier than you in primary school and I was really energetic at the time and then adolescence happened and I got introverted and shy. And I'm trying to recover from that all my life.

Brian Levitt:

Well, not shy enough to be a podcast guest, which is great.

Turgut Kisinbay:

I've been told this is the place to be, this is maybe where I'm going to do my takeoff.

Brian Levitt:

The coming out party. So Turgut, why not a recession in '23 and how surprised were you by it?

Turgut Kisinbay:

So, we were not surprised, our baseline was no recession and some sort of the soft landing, which we can discuss what that is. But we didn't expect a recession in Invesco Fixed Income, IFI because this is actually not a typical cycle, this is not a typical economic cycle. In most cycles, obviously there are differences and not all of them are the same, but in most cycles there is a leverage component. Households, corporates borrow quite a bit during an expansion and the economy overheats, we get inflation, at that point central banks in the US Fed hikes interest rates. And then, all of this is reversed with high levels of debt and difficulty to basically handle debt at high interest rates. That creates a downward spiral, defaults, delinquencies and all that.

This is the household and corporate side. Of course, there's the financial side. Usually, banks are exposed to that cycle so then that makes the cycle even worse, right? This downward spiral is challenging. This cycle was different, we didn't have that. Unusual for a cycle, we actually have incomes increasing during the cycle and debt levels not increasing or actually decreasing, credit card and others. We didn't have a leverage cycle even in the previous expansion before the pandemic because we had the GFC, global financial crisis, a big housing bubble and a big mess. But after that, households didn't borrow that much relative to their incomes.

Brian Levitt:

We learned our lessons, huh?

Turgut Kisinbay:

We learned our lessons, banks were prudent and tightly regulated so high capital ratios. So, the debt to income ratios are not high. In housing actually, usually housing is a problem in cycles, housing versus the bank nexus. This time around we have actually a shortage of housing because maybe we learned our lesson too much and there is not enough building in the US relative to the demographic trends. So, inventory was very low and so none of that is there. Of course, there are pockets of leverage here and there, but usually most of the debts of the household sector is mortgages and we have no problems there. So, I think that was the main reason basically, there are others, but the vulnerability coming from leverage was not there.

Brian Levitt:

Jodi and I both levered up to buy Taylor Swift tickets this summer so that doesn't count?

Turgut Kisinbay:

That's less than your mortgage, I assume.

Jodi Phillips:

Yeah, good decision though, good decision.

Brian Levitt:

I don't regret it at all.

Jodi Phillips:

Turgut, you mentioned soft landing, which is a phrase that sounds awfully reassuring, but can you dig into the details about that a little bit and what that could potentially look like?

Turgut Kisinbay:

Yeah. So, it's not well-defined admittedly so we can kind of narrow it down. I mean, it's definitely not a recession. It's definitely, I think on the upside. It's not an economy that is growing above potentially, let's say, high 2% for a sustained period of time. And it's not an economy where inflation doesn't come down, it's sticky. But within that range, between a recession and no landing, there are I think a range of outcomes that can be considered as soft landing. In our case, I think maybe I can go to that. Again, in Invesco Fixed Income we have our monthly process so we have specific GDP inflation and policy forecasts, Fed policy forecasts. So, that's our baseline, rather than trying to define what soft landing is, we go with our numbers.

But I think maybe I'll also tilt a little bit towards that is we expect the economy to slow down a little from 2% plus to below 2%, which is the potential, close to the potential. So, a bit of a slowdown for a couple of quarters but no recession because of the reasons we just discussed. And on the inflation side, we expect inflation to continue to come down. And so, that is our definition basically. A couple of quarters of one, one and a half percent GDP growth. And then, slowly growth goes back up to its potential and inflation continues to come down through 2024.

Brian Levitt:

What drives inflation down now, is it the lagged shelter impact on the Consumer Price Index? And if so, why does that happen and why does the Bureau of Labor Statistics calculate it the way they do or is it something else?

Turgut Kisinbay:

That shelter component is by design because they want to consider all the contracts, not just the latest contracts. So, you have new contracts throughout the year and the current trend is not necessarily what accrues to everybody but in a year you have that convergence towards market trends. But there are a couple of things, shelter is definitely a big one. We also try to model using macro variables, what drives shelter inflation. So, that's one inputs to our process. The other one is basically the market trends and the lag between market trends and the measured CPI and other indices. So, I think that's on track because market trends are back to pre-pandemic norms, by some measures it's actually even lower by some measures. It's right there.

Brian Levitt:

What do you mean by market trends, market trends for prices?

Turgut Kisinbay:

So, current market trends are running close to let's say 4% year-on-year, new rents, whereas the CPI measure will be seven, six, seven, I don't know what it is.

Brian Levitt:

Got it. Right.

Turgut Kisinbay:

So eventually, if the current trends, new rents are back to pre-pandemic levels a year from now or something like that, the measured inflation will also converge to pre-pandemic levels, which was three and a half to four. If you want to be on the conservative side, you can say 4% but it could be lower given that market trends are back to where they were. That's one component. The other one is we have goods deflation now and we expect that to continue. That was the norm in the last 10, 15 years. Goods prices come down because of improvements in technology, because of globalization. So, we don't expect the same outcome because globalization may have peaked and these low cost producers are not necessarily as low cost as they were before.

But we also had very inflated prices. For example, car prices and used car prices, those are really, really high. So, I think they will come down for two reasons. First, the prices are high. Second, global supply is improving substantially so that is the other reason, supply improving. 

It's expensive to buy a new or used car now because of financing costs. So, if you look at car sales, we had two years of shortages of cars. So, car sales came down from 17 million to 15 million for a long time. So, that means that there's pent-up demand probably. But despite that and despite improving supply, we don't see an increasing car sales, it's going sideways. I think the reason is because A, cars are very expensive and B, relative to incomes so you can't just go and buy with the cash.

And if you want to borrow, it's very costly to borrow so we expect deflation in cars — and that's new and used cars. That is another driver. And I just want to generalize a little bit to the rest of the goods side. During the pandemic, there were demand and supply imbalances. So, we consumed a lot of home exercise equipment and new electronics because kids were at home and studying from home. We were working from home. We were at home all the time and you have money 'cause we didn't lose incomes and then you look at the furniture that you're sitting all day and I'm like, "You know what? I'm going to buy a new one." So, there was a very high level of consumption on home goods and furniture and that kind of goods relative to services. So, that's also normalizing. So, there are two components of that. First, the demand we consumed so much, so now we do a little bit less. Yeah.

Brian Levitt:

Yeah, we bought too much. What else is there to buy?

Turgut Kisinbay:

How many computers do you need?

Brian Levitt:

Here's my holiday gift, 32-inch $75 television smart TVs, I'm like wallpapering the house with them.

Turgut Kisinbay:

So, there's still demand of course, but ...

Brian Levitt:

Just me, just me. I don't even watch television.

Turgut Kisinbay:

Well, on the aggregate, so that kind of goods consumption has been going sideways so the demand has been satiated to some extent. It's not collapsing, it's just not growing as it used to. And supply improved substantially so that imbalance that was created, that was a pandemic problem, that's also improving. And finally on inflation, we also look at the labor market is slowing down. We have trackers for wage growth, that's slowing down. It's not where the Fed wants wage growth to be, that's not the ideal level, but it's still, we are talking about inflation at the levels five, 6% levels coming down to below four and eventually below three. So, current wage growth is consistent with that.

Brian Levitt:

Jodi, that's a bummer for us.

Jodi Phillips:

Well, what's a bummer for me is I bought a used car this year, so of course the prices were destined to go down -

Brian Levitt:

And your wages are slowing.

Jodi Phillips:

I saved up that demand as long as I could, but at some point you have to get from point A to point B. You just have to do it.

Brian Levitt:

Yeah, you're not walking, right?

Jodi Phillips:

So Turgut, what does all this add up to in terms of the Fed and what they're going to do next? Are they done hiking rates and when could we potentially see cuts?

Turgut Kisinbay:

Yes, they're done hiking rates, I think — this is now becoming market consensus too because again, just going back to our baseline, which is economy slows down a little bit for a variety of reasons but including because of tight policy and a slowing labor market. So, a couple of quarters of slow growth and inflation is coming down for the reasons we discussed. So, Fed is now in a position to cut rates. When? So again, one or two quarters, couple of more or maybe more inflation prints we penciled in May not March, which is being debated now. But May because I think there will be enough macro evidence on this inflation and also on the slowing economy. At that point, if the economy is growing, let's say 1.5 and inflation is 3%, that's 4.5% nominal growth. Whereas the risk-free rate in the economy will be 5.3, that's very high to sustain. So, I think at that point the Fed will be in a position to slowly cut interest rates, not aggressively.

Brian Levitt:

That is such a critical point. I really love the way you explain that with regards to where the risk-free rate is versus the nominal growth. Because what I hear from people when they hear rate cuts by March or May or June or whenever next year, their minds immediately go to 2020 or 2008 where you had to immediately bring interest rates to zero. And so, it seems like investors, even though you had one in 2019, you had a 94, 95 rate cut, investors seem to have forgotten that the Fed will try to fine-tune this, they won't necessarily wait for a disaster to cut interest rates. I would say if we're talking about frequently asked questions I'm getting all the time now, "Well, what happens between now and May that they have to cut interest rates?"

Turgut Kisinbay:

Yes. If our baseline is correct, if we get a soft landing, then the current policy will be too tight. And if we don't get a recession, but there is still a case for gradually removing monetary accommodation, that's our story.

Brian Levitt:

And they stick that landing. No recession.

Turgut Kisinbay:

Sorry?

Brian Levitt:

They stick that landing, no recession '24, maybe even '25?

Turgut Kisinbay:

No, because well, I mean assuming that they will gradually cut rates as we expect. We also don't expect them to cut very aggressively. Currently, market is pricing in five cuts, which I think is not a soft landing, consistent with soft landing. I mean, we need to remember that there's still segments of the market that expect the recession so that's their pricing. Obviously, the market pricing is the weighted average of different opinions. But I think 5, 4, 5 is a bit too much and here is the reason. If our baseline is correct, if the economy manages to slowly, gradually slow down with also this inflation, markets will see that and the financial conditions will change substantially. For example, bank lending. The surveys are telling us that banks are still tightening lending conditions. Credit is more difficult to get. So, those will start to change. Equity market may react to that, risk assets may like that. 

And maybe that may be too much by, we are talking about May and June here, inflation is still higher than Fed's target. They have to be cautious. So, they will talk hawkish but I don't think they will be hawkish. But they just need to basically lean against the markets a little bit. That's why we don't expect a lot of cuts but measured amount of cuts. Basically, Fed will follow the market here, but it's good for risk assets.

Jodi Phillips:

So, Turgut we mentioned obviously at the top of the show that you're positioned within Invesco Fixed Income. So, for income-seeking investors in particular, I mean, this is a lot going on and a lot to think about for the year. So, in your opinion, trying to position a portfolio in times like these and changing conditions, how might income-seeking investors think about all this?

Turgut Kisinbay:

So, this is peak interest rates for us. You have volatility around whatever the long-term rate is, but basically inflation has peaked and coming down and Fed rates will also come down. So, macro drivers will, I think mean that interest rates will be peak-ish around here. And I mean, the speed of decline and even if it's stable, even if interest rates are stable, you earn your income, so it's pretty attractive I think.

Brian Levitt:

Lock them in.

Turgut Kisinbay:

Lock them in, exactly. And it's true globally too by the way. Europe is in stagnation, it will be a while for them to I think catch up with the potential. So, I think the inflation has peaked in almost everywhere that I can think of now. So, that also means lower interest rates, global factors for those I think support stable or lower interest rates.

Brian Levitt:

You mentioned international, so it's been a while where investors have preferred US dollar assets. So, implicit in your point would have to be perhaps the end of a dollar cycle, the time to look around to see where other opportunities may exist?

Turgut Kisinbay:

Yeah, I mean, I think global assets do well when global growth improves and when there is a recession or a risk factor, dollar is the safe asset and people come back to dollar assets. So, if our outlook is correct and that's also broad Invesco outlook that we expect the recovery next year in 2024 globally, maybe more in the second half, but markets anticipate developments. So, if global growth picks up, that's generally good for global assets, emerging market assets are kind of high beta to global growth. There are also a couple of other things that support emerging markets, local assets, local and dollar base too. But emerging markets were the first or early to hike interest rates because given their inflation histories, they're more sensitive to inflation developments.

And inflation is now coming down in these countries and they are also in a position to cut interest rates, which is just kind of attractive for local bonds. And finally, during this pandemic and then war, global assets were not the most favored. We had seen years of or a prolonged period of outflows from emerging market assets. And now I think it's basically positioning is not there. Most people are underweight or at least they don't have enough global and emerging market assets. If the environment changes, I think there's also room for growth there.

Brian Levitt:

That's great. Anything you worry about as we head into the year? I mean, anything that could potentially go wrong or are you feeling pretty sanguine about these views?

Turgut Kisinbay:

So, I mean as an economist, I guess part of our job is to worry about things. Yeah, we worry. On economics one risk, I mean not these days, but one risk is of course inflation remains or it is, inflation is sticky, doesn't come down so we have another round of hikes. That was maybe a risk like six months ago. But now I think generally inflation developments are going in the right direction. We have energy prices coming down, food prices coming down, supply sites improving. So, those look good to me. Another risk is of course, central banks do not ease policy when it's warranted and they remain too hawkish too long. I'm not worried about that but the risk is there. So, that's another risk. Let me underline that. They have to remain a little bit, at least in rhetoric, they have to be a little hawkish because of the past mistakes. I mean, they said this is transitory and all that and we had 10% inflation in Europe, in the US. So, they cannot-

Brian Levitt:

Credibility matters.

Turgut Kisinbay:

Credibility matters so they will be cautious and that's bit of a risk.

Brian Levitt:

Jodi, I don't know, it sounds to me like a happy and healthy new year. I think I'm going to stop at yes on this one.

Jodi Phillips:

Yeah, a great way to end the year. I was going to ask you in that bucket of et cetera, et cetera, did we get to all of your et cetera questions?

Brian Levitt:

I think we did. Maybe even a couple of et ceteras I didn't expect to get to.

Jodi Phillips:

There we go. All right, well thank you very much Turgut, we really appreciate your time.

Brian Levitt:

It's been a pleasure.

Turgut Kisinbay:

Thanks for having me. That was fun.

Jodi Phillips:

All right, so Brian, where can our listeners follow you for more?

Brian Levitt:

Well, first Jodi, happy and healthy to you and your family.

Jodi Phillips:

And yours as well.

Brian Levitt:

Thank you. And visit Invesco.com/BrianLevitt to read my latest commentaries. And of course, you can follow me on LinkedIn and on X @BrianLevitt. Thank you.

Jodi Phillips:

Thanks for listening.

 

Important information

You've been listening to Invesco's Greater Possibilities Podcast. 

The opinions expressed are those of the speakers, are based on current market conditions as of December 8, 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. 

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.

Past performance is not a guarantee of future results.

An investment cannot be made directly in an index.

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 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.

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

Market trends for rents represented by US apartment real estate effective rates from Moody’s Analytics CRE, as of September 30, 2023. References to the CPI measure and rent inflation refers to the yearly percent change in CPI shelter prices from the Bureau of Labor Statistics, as of October 31, 2023. 

Car sales from the US Bureau of Economic Analysis as of November 30, 2023.

Wage growth from the US Bureau of Labor Statistics as of October 31, 2023. Based on yearly percent change in average hourly earnings.

The risk free rate is based on the federal funds rate, from the US Federal Reserve as of November 30, 2023.

Information on how many interest rate cuts the market is pricing in is from Bloomberg, based on fed funds futures as of November 30, 2023.

US inflation sourced from the Bureau of Labor Statistics as of November 30, 2023. The peak rate of the US Consumer Price Index was in June 2022.

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. In a normal yield curve, longer-term bonds have a higher yield.

Bank capital ratios are their capital divided by assets.

Gross domestic product (or GDP) 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.

Nominal economic growth is inclusive of inflation, while real economic growth is not. 

Fed funds futures are financial contracts that represent the market’s opinion of where the federal funds rate will be at a specified point in the future. The federal funds rate is the rate at which banks lend balances to each other overnight.

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

Beta is a measure of risk representing how a security is expected to respond to general market movements. 

The US 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.

The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.

Brian Levitt:

Welcome to Greater Possibilities podcast from Invesco, where we put concerns into context and opportunities into focus. I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. And today we'll be discussing our 2024 annual outlook with Kristina Hooper, Chief Global Market Strategist, and Alessio de Longis, Head of Investments for Invesco Investment Solutions.

Brian Levitt:

2023, that was fun.

Jodi Phillips:

2024! 2024! That's what's blowing my mind. Are you ready?

Brian Levitt:

That was a fast year.

Jodi Phillips:

It was. And look, my normal answer to that observation would be something like, "Time flies when you're having fun," but I don't know, from a market perspective, is that anywhere close to reality?

Brian Levitt:

Yeah, it was definitely... It has been more fun than last year. I mean, we're not through it yet, but it's certainly been more fun than last year, at least for the market.

Jodi Phillips:

Well, it's all relative, I guess. Yeah. I mean, look, there's certainly no shortage of challenges and conflict in the world. Speaking from the market perspective, I guess it's been a better year than 2022.

Brian Levitt:

Yeah, I mean the difference is 2022 is one of those rare years in which things just got worse relative to expectations.

Jodi Phillips:

All right. So 2023 was a year in which conditions were generally better than expected?

Brian Levitt:

Yeah, I would say the economy has been more resilient than many had expected. Good news.

Jodi Phillips:

Well, good. Yeah. We definitely had so many predictions for a recession that didn't seem to come to pass this year. And along with that, so many mea culpas from the economists who made those predictions.

Brian Levitt:

Yeah, it's funny. Apologies always sound better in Latin.

Jodi Phillips:

They really do.

Brian Levitt:

But not only the economy being more resilient, inflation came down faster than many had expected. So, that also has been treated as good news this year.

Jodi Phillips:

So I know that's true, but Americans don't seem to be feeling all that good. You've been showing me some of the polls, Brian, what's 78% say that the US is heading in the wrong direction and about 80% say the economy is only fair or poor and getting worse. So why isn't this matching up?

Brian Levitt:

That's a very good question. I guess I'll go back to a Clinton-era line, “It's the prices, stupid." Even though inflation rate has come down. If you were up 9% year over year last June, and you're up 3% year over year now, it's a lot better for the market, but prices are still higher for people. So it's like you think about even Thanksgiving, right? Or think about cooking. People have been looking at the price of eggs. Yeah, they're down to $2 now from a high of over $4, but they were $1 before the pandemic, so it still feels not great for investors.

Jodi Phillips:

Again, it's all relative. So look, okay, so what you're telling me is consumers aren't happy, but if you're an eggheaded market strategist, things maybe look okay.

Brian Levitt:

Yeah, I like what you did there. Yeah, we actually have a misery index, unemployment plus inflation, and it's falling, and it's below the long-term average. So it's a bit different than how people are feeling.

Jodi Phillips:

There's an index for literally everything isn't there? Misery index. So maybe the economy isn't as miserable as it seems, as people might think.

Brian Levitt:

Yeah, I would say, but far be it for me to tell people how to feel. And look, we're not here to tell people how to feel, we're here to assess opportunities and markets. And yeah, we're feeling pretty optimistic as we head into 2024.

Jodi Phillips:

Well, good. Well, on that note, then, let's bring on Kristina and Alessio to discuss that level of optimism and where they see opportunities for 2024. Welcome.

Brian Levitt:

Yeah, thank you both for being here.

Alessio de Longis:

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

Kristina Hooper:

Yes. Thank you, Jodi. Thank you, Brian. Really excited to be on.

Jodi Phillips:

So Kristina, let's start with you. I think what I got from Brian's analysis about egg prices is that as far as markets are concerned, it's not necessarily about labeling things as good or bad, but about are things getting better or are things getting worse? So I'm curious what you might say to the 80-some-odd percent of people who are telling pollsters that the US economy is getting worse.

Kristina Hooper:

So it's about the lagged effects of monetary policy at the end of the day. It's that we are still seeing, and there's much more to be seen in terms of the impact that rate hikes have had, both good and bad. So we're likely, very likely to continue to see significant disinflation, but it comes at a cost. So as we look ahead to 2024, we think of this as a balancing act, right? It's will inflation get under control faster than the economy deteriorates? And that is the very significant balancing act. So hopefully, in a few months in a poll, consumers will feel better, because we'll have made more progress on disinflation, but we won't have had a very significant impact in terms of depressing economic growth.

Brian Levitt:

Alessio, what happened to this recession? I thought it was the most anticipated recession ever, destined to come. What happened this year and does it ever come?

Alessio de Longis:

Well, I think what happened is exactly the super important element that Kristina just highlighted, the balancing act between inflation and unemployment, right? Unemployment is at all time lows. You don't have a recession. Obviously, unemployment is a lagging indicator, but even the leading indicator of unemployment are suggesting, if anything, a moderate rise in unemployment that would be perfectly consistent with that Goldilocks scenario that Kristina has outlined. Where inflation comes down faster than the unemployment rate rises, growth remains good enough, not too hot, which is exactly the perfect development for monetary policy.

And Brian, we have multiple times over the last two years flagged the rising probabilities of a recession. I think we have never had an official recession call, but we have rightly multiple times in 2022 and 2023 highlighted when we felt that the risks of a recession were rising and offered the template on how to think about that. I think what we are seeing in my mind is a scenario that is very reminiscent of what we saw in 2011 or in 2014, 2015. If you recall, the US economy and the world economy went through a meaningful deterioration in growth. In some instances, even a couple of negative GDP (gross domestic product) prints struggle in credit markets, but eventually both all those instances turned out to be meaningful soft patches that did not really translate into a recession and the cycle extended on for a few more years. That's the closest analogy that I find today with respect to historical standards in our lifetime.

Brian Levitt:

And I remember those well. And of course, in 2011, and correct me if I'm wrong, but it took some type of a policy shift or a policy response to get us there. So 2011, or what was the exact year where Mario Draghi said, "I'll do whatever it takes to maintain the stability of the euro and keep the eurozone together"? And 2015 into 2016, was it at the Federal Reserve who said, "Okay, we were just kidding about raising interest rates"? So it likely warrants some type of response by policymakers, and are you seeing the expectations of that type of response?

Alessio de Longis:

I think you are highlighting exactly what the issues were. There was an economic shock or a geopolitical shock, whether it was the European debt crisis, the US sovereign debt downgrade, the energy crisis in the States, the policy response, either fiscal or monetary or both, helped set the economy on track. In other words, the fate of the economy is not written, right? There is policy mistakes and there is policy responses that affect that path. If we draw an analogy today, if inflation, as Kristina highlighted, if inflation declines, or was starting in a credible way, and it's nice to see oil prices are not contributing to that problem despite the terrible escalation of conflicts in the Middle East. We are seeing a rising probability of an actual soft landing on monetary policy where rates may stay high for longer, but markets are correctly pricing, as of today, lower policy rates by about a hundred basis points into the end of 2024. If that pans out and the unemployment rate remains fairly stable as Kristina suggested, I think that is a scenario that would be consistent with us postponing the recession risk by a few years.

Jodi Phillips:

Okay. So Kristina, just kind of boiling this down into a nutshell in terms of the Fed, and we definitely want to talk a little more globally later on, but expectations and predictions that the Fed will start to ease in 2024. What is the base case that’s laid out in the outlook for how you're thinking about the timing of when that might happen and what that would suggest for what the economy's doing?

Kristina Hooper:

So, Jodi, great question. And we anticipate that rate cuts would begin by the end of the first half of '24. Now, this will be dictated very much by the data we see going forward, but from where we sit today, we think that's very likely. Now, you may recall, if we just go back to September, there was a huge market reaction and the start of yields skyrocketing, especially on the long end, when we got the Fed's September dot plot. The June dot plot had implied four rate cuts in '24, and then the September one implied only two rate cuts in '24. And that was sort of the “dot plot heard around the world” as opposed to the shot heard around the world that triggered this big rise in yield. And I think markets have finally come to the realization that the Fed can be incredibly wrong, especially the further out they look.

I mean, all we have to do is look at the December ‘21 dot plot and the expectations for the Fed funds rate at the end of '22 to know that. And so, clearly, markets have been going through this repricing process. I think, in particular, what we've seen is that recently with the CPI (Consumer Price Index) print for October, there is this great realization that, in fact, the July rate hike was the last one. And that if we use that rule of thumb that it's about eight, eight and a half months to the first rate cut, that'll take us to the second quarter of '24, and that we'll probably see around a hundred basis points in cuts. But again, we just don't know about the lagged effects of monetary policy. Maybe it's even more than that in '24.

Brian Levitt:

Alessio, let's create some conflict here, a little debate. Would you push that back a little bit? Would you suggest that the rate cuts may become a little bit later than what Kristina's saying?

Alessio de Longis:

My baseline aligns with Kristina, but since you want a little bit of a match, I have to find a narrative and a scenario that would be perfectly consistent with that higher rates for longer. And again, I think we shouldn't discount the risk at this stage in the cycle where there's tight labor markets. If commodity prices, be it food or energy prices were to increase, it takes very little, six months of rising commodity prices, which it's somewhat exogenous, geopolitical risk. It's not only demand-driven, it's also supply-driven. There is a non-negligible probability of a scenario where the inflation picture changes on a dime. And this, I'm fairly convinced of, central banks around the world have been so shocked by how wrong they were on inflation that they will be very reluctant to deliver any rate cuts when the optics of inflation are not supporting that decision. So not my base case, but I would say that's more than a 20%-30% probability, which is not negligible. Right?

Brian Levitt:

Okay. So the base cases are aligned, Jodi.

Jodi Phillips:

Good. Well, good. I know you were trying to prompt something there, but we've got some consensus.

Alessio de Longis:

We're shaking hands instead of using boxing gloves.

Kristina Hooper:

Listen, Alessio is absolutely right. There is that significant alternate scenario, significant probability of an alternate scenario, in which we get more of a hard landing because rates are higher for longer, because of persistently high inflation. The other sub-scenario within a hard landing is that so much damage has been done to the economy, that it is sent into recession by the restrictive level of rates as they are now, which I think is a lower probability than that first scenario about a higher for longer. But again, I think our base cases are aligned in that it's certainly not the highest probability scenario. The highest probability scenario is that that D-train, that disinflation train, continues and it's significant.

Jodi Phillips:

Pulling back a little bit from that US perspective and maybe getting a little more detailed about what you're seeing in Europe, the UK or Canada, what kind of timeline would you see in 2024 for that type of policy to see a shift?

Kristina Hooper:

I think a lot of the central banks are going to be quite aligned in terms of when they act, but it might be for different reasons, right? For some, you could argue they've seen more progress with taking down inflation while for others it's more about the economy deteriorating enough to necessitate cuts. I certainly think that we're likely to see the Bank of England move sooner rather than later there. But I suspect that the second quarter is going to be something of a sweet spot and that we'll see more than just the Fed acting.

Brian Levitt:

Alessio, let's get down to “brass tactics” here. Let's talk about your regime analysis. Let's talk about how your positioning as we move through the end of this year into the beginning of next year. And so I love that you talk about things from the perspective of whether we're in a recovery, an expansion, a slowdown, a contraction. What are you seeing right now? What are your indicators telling you and what are the implications for markets early on in the year and how that may play out throughout the year?

Alessio de Longis:

So from a market implied growth expectations standpoint, which we monitor through our more asset price-based indicators, we have seen improving sentiment and improving growth expectations since late June, early July. And so we have positioned for that recovery in the global cycle already in the middle of the summer, and we continue to be positioned with that view. We see a consistent improvement in growth optimism as implied in the market, in market prices into year-end. Interestingly, in the last couple of months, we have also seen validation of this forward-looking market view in the economic data, where consumer sentiment surveys continue to improve globally. Manufacturing business surveys are frothing. They're stabilizing at cyclical lows. And even housing indicators, which as we know, housing because of the rising mortgage costs, you should expect to see an ongoing deterioration there. Instead, we've seen some stabilization in building permits, housing starts, and so on and so forth.

Brian Levitt:

And what's that about? There's just not enough supply and there's still going to be demand given the demographics of this country?

Alessio de Longis:

There is certainly an element of that, but also going back to the important point from Kristina about the lagged effects of monetary policy. We have spent, post-GFC (global financial crisis), 15 years where the private sector has extended duration, has locked in very low interest rates, so the effective cost on consumers from interest rates has not fully passed through yet. So to your point, that limited supply is not due to the fact that we're not building new homes, but there's not enough turnover. There's not enough mobility in the housing market because a large portion of consumers have locked in interest rates that make them perfectly capable of sustaining their life expenses.

Brian Levitt:

I'm so happy for my two and a half percent mortgage rate. I refinanced the day COVID hit, and the big debate in the house was whether we let the appraiser in because we didn't know whether we were all going to get COVID from the appraiser, but best decision I ever made.

Alessio de Longis:

I had the exact same thing, yes.

Kristina Hooper:

And that creates golden handcuffs, right? No one wants to leave their house because that's a more important consideration sometimes than if you have four bedrooms or a pool or whatever.

Brian Levitt:

Right. Alessio, you must've been feeling good at least the day that the Consumer Price Index report came out and it was weaker than expectations, and you just had one of those days where value stocks, small cap, international, did very well. It's one day, but it was aligned with your expectation of how these things were going to play out between now and the end of the year and into 2024.

Alessio de Longis:

Yes, because, as I said, from July onward, have markets necessarily validated in the different aspects of capital markets, whether it's asset allocation, style factor allocation, and regional performance. The evidence of this recovery in the cycle has not been really, really clear. The day that you're referring to, which is it's one day, but it's very indicative of what the market cares about, and the market cares about the nexus that Kristina described. Inflation trends compared to labor market trends is really where the balancing act is today. And on that day, which I believe is significant, we saw that perfect cyclical, favorable cyclical reaction. To your point, sizes like small caps, mid caps, value stocks, meaningfully outperformed quality, meaningfully outperformed tech and large caps. We saw emerging markets perform well, credit spreads compressed. So it's saying that the market is ready to react to good news. The good news are not fully priced in. So the question is, will we be right about the cycle? And if we are, the potential for outperformance is there.

Brian Levitt:

Jodi, I know what you're thinking. That's a lot of footnotes that we have to put in. But I was in New York City that day, I presented with Alessio that day, and let me just say he was smirking. He was grinning. He wasn't a full smile, but he was grinning a little bit.

Jodi Phillips:

Always glad to see that for sure. And Brian, look, I've heard you quote, what is it? Investors have more than $22 trillion, is that right? Sitting in bank deposits and money market strategies. So when investors are feeling good and they start to smile and want someplace to put that money, what type of risk is that going to cause? I mean, whether it's reinvestment risk or just the force of all that money potentially coming into markets at once. What is on the lookout for when that money goes in motion?

Brian Levitt:

Yeah. I mean, I would pose that to Kristina. I mean, when she's talking about rate cuts potentially in the future, for these investors that seem to love five, five and a half percent in short yields, what does that mean for them? At some point, those rates have to come down, right?

Kristina Hooper:

Oh, absolutely. Those rates will come down and investors will move their money. What we have seen is very mobile money over the last few years. They might as well have sneakers on them because they've moved. They've moved out of traditional bank accounts into high yielding accounts, and they are poised to move, in my opinion, in a significant way. And they're likely to follow the path of historical recovery traits. So that ultimately means a broadening of the market because it won't just be the defensive, the large caps, the traditional areas where investors have focused recently, it's going to be about the small caps, it's going to be about the international, especially emerging markets.

Brian Levitt:

And Alessio, that would suggest to me, that's how we normalize the yield curve, right? But I would expect, given this conversation, you would think that perhaps you would see... Would we be in a slowdown regime at some point in 2024? And then how does the yield curve respond within that? Where do we think rates settle? And will you make sure to tell all of us how we want to be positioning for that type of an environment when it happens?

Alessio de Longis:

To start from the last question, yes, we'll continue to provide our market pulse on a monthly basis. I think what you outlined, I think is certainly possible-

Brian Levitt:

Hold on, one sec. Invesco.com/PortfolioPlaybook, right?

Jodi Phillips:

Oh, very good, Brian. Nice.

Brian Levitt:

Sorry to interrupt. Go ahead, pardon me.

Alessio de Longis:

Perfect. No, thank you. Thank you. So we could have a situation where, yes, actually in the US we find that growth is leading. We believe the US is already reemerged to growing above its long-term trend while Europe and emerging markets are lagging somewhat behind. So let's fast forward by a couple of quarters and assume that we are correct on our cyclical rebound. Now, a slowing and eventual normalization or re-slowing of the economy in the second half of the year, which would then justify and amplify the rate cuts that Kristina is talking about.

The yield curve has been inverted or flat now for a prolonged period of time. The natural shape of the yield curve is upward sloping. And the direction of the yield curve is, I don't want to say easy, but easier to predict than the level of rates. The yield curve is more stable and tends to have mean reverting properties. So an upward sloping yield curve driven by lower interest rates in the front end of the curve would be cyclically a very natural outcome for markets.

Jodi Phillips:

Brian, we're very much in the details of yield curves and monetary policy. I do have a question though. I'm just wondering when you're faced with a task of creating an outlook for the next year and just thinking about all of the other things that are going on in the world at the same time, whether it's geopolitics or whether it's an election coming up in 2024, just curious how much these types of factors weigh in on how you're creating your base case or thinking about your alternate scenarios.

Brian Levitt:

I mean, I try to look beyond. I mean, I'll pose that to our guests. From the geopolitical, I always try and contemplate whether it's going to remain regional, in which case you can largely look beyond. Everyone knows my opinion on elections, so we could ask-

Jodi Phillips:

They don't matter to markets. They don't matter to markets.

Brian Levitt:

Jodi came up with the title for my election paper this year, which is "People care about elections, and markets don't." So you know my opinion, but let's see if our friends on the podcast have any opinions.

Jodi Phillips:

Yeah, Kristina, let's start with you, if you don't mind.

Kristina Hooper:

Yeah. I don't think elections matter. Certainly, not in a material way over more than the very short term. Certainly, we can see short-term gyrations as a result, but I don't think it really matters in the medium or longer term. Now, geopolitical issues, they can have a bigger impact, although again, very much in the shorter term, in my opinion. We always have to ask ourselves, is it contained or is it contagious? And I think that's a question you ask about any kind of crisis, whether it's a financial crisis or a geopolitical crisis. But I tend to not let myself get concerned about geopolitical crises because we know the history, and what the history has told us is that it doesn't matter to markets in any material way over the longer term.

Brian Levitt:

And so far, we would categorize Russia, Ukraine, and what's going on in the Middle East as contained?

Kristina Hooper:

I would say so. I mean, certainly there is that risk that it becomes contagious in the Middle East, but we can certainly hope that it's contained and that it ends soon.

Alessio de Longis:

I agree with Kristina. We mentioned earlier, oil prices as being a real time barometer to determine when a regional problem becomes a global systemic problem. Oil prices is a very simple way to think about that transmission mechanism that affects everyone. But Kristina said something important earlier on monetary policy and recessions, which applies also here with geopolitics. You don't position a portfolio ahead of geopolitical risk, which is kind of like a lottery ticket in terms of probabilities, in terms of how rare and difficult to understand they are. But once a geopolitical risk hits, there is also often the right or wrong policy response. So again, we're back to that template that Kristina described. Watch for that policy response. Watch for what policymakers will do to exacerbate or remedy to the problem. And yes, agreed, elections. We need to make a distinction. Politics don't drive markets. Economic policies drive markets.

So once an election outcome is clear, going back to the drawing board and understanding what are the economic policies that come with that election outcome, now you can go back to a sound investment process and determine what the impact on market is. So you don't position ahead of an election. But as investors, we need to understand once the election outcome is certain, what are the economic policy implications, if any, and have they changed? And historically, what we find is that economic policies tend to impact more the relative performance between sectors because taxation and fiscal policies are often redistribution policies, say between industrials and materials or financials and energy. But economic policies rarely go and affect the predetermined direction of bond markets, equity markets, and around the growth cycle, as you, Brian, have always described with analyzing the historical analogies between different administrations,

Brian Levitt:

You just say it so much more eloquently than I do.

Alessio de Longis:

I'm learning from you. I'm listening to you all the time. It's the accent, Brian, it's the accent.

Brian Levitt:

We're coming up on the end, Jodi, I think we've exhausted our time, but I want to make sure we get parting shots from both guests. I want to make sure that they've been able to articulate precisely what they want to say before we end the podcast. So Kristina, maybe we'll start with you.

Kristina Hooper:

Sure. What I would say is that this is an environment that is changing as we speak. Markets are processing the reality that the Fed has almost certainly stopped hiking rates. And that means there is a change in markets because they start to discount an economic recovery. So we're already starting to see that. Of course, in the early stages, there will be a lot of volatility because there is still some level of policy uncertainty. The Fed has not come out and said they've ended rate hikes, and in fact, we might get some hawkish language from the Fed trying to tamp down financial conditions. But in my opinion, this is the beginning of a recovery trade. And I think that's important for investors to understand. I'm very excited about the coming months for markets and investors.

Brian Levitt:

Alessio?

Alessio de Longis:

Yes, I think, from an investment standpoint, this is an environment where we believe investors are still compensated for adding cyclical risk in the portfolios, maintaining overweight exposures to things like credit or equities. This is an environment where compensation for risk-taking should still play out. We are in a cycle that is already somewhat extended and accelerated because of the policy response to COVID. And so this is not a close your eyes and forget your investment strategy. You need to reassess and evaluate how monetary policy is impacting the economy. We have a long way to go on that. And given the geopolitical risks that are real and alive, maintaining basically a fluid approach to analyzing the situation. And if the facts change, being prepared to change your investment posture.

Kristina Hooper:

Yeah, I can't agree more with Alessio's last statement. If the facts change, right? Because of the lagged effects of monetary policy, we can guesstimate, but we don't know for sure until we see the data.

Brian Levitt:

So Jodi, you ready to join Kristina and Alessio in the 20% of Americans feeling good about the economy?

Jodi Phillips:

Sure. As of today, unless the facts change.

Brian Levitt:

Unless the facts change. So Kristina, Alessio, thank you so much. As always, we look forward to speaking with you again soon.

Alessio de Longis:

Thank you, Jodi. Thank you, Brian.

Kristina Hooper:

Thank you. Bye.

Brian Levitt:

This has been the Greater Possibilities podcast. Visit invesco.com/BrianLevitt to read my latest commentaries. And of course you could follow me on LinkedIn and on X, formerly known as Twitter, @BrianLevitt, the real Brian Levitt. Jodi, great chatting with you.

Jodi Phillips:

You too. Thank you so much.

 

Important information

You've been listening to Invesco's Greater Possibilities Podcast.

The opinions expressed are those of the speakers, are based on current market conditions as of November 17, 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.

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.

Past performance is not a guarantee of future results.

An investment cannot be made directly in an index.

Polls on the direction of the US economy are from the Associated Press-NORC Research Center and Gallup as of  October 2023.

The United States Misery Index tracks the mood of the country by adding the unemployment rate to the inflation rate. The index was at 7.1% in November 2023, compared to the long-term average of 9.22% from January 1947 to November 2023. Data from Bloomberg.

Discussions about the US inflation rate are from the: US Bureau of Labor Statistics as of October 31, 2023. Based on the yearly percent change in the US Consumer Price Index, which tracks changes in consumer prices. In June 2022 inflation rose 9.1%. In October 2023 inflation rose 3.2%.

Data on the price of a dozen eggs is from the US Department of Agriculture as of November 14, 2023.

Statements about US unemployment are based on the U-3 Unemployment Rate, Total in Labor Force, Seasonally Adjusted, from the US Bureau of Labor Statistics as of October 31, 2023.

Statements about the markets pricing in lower policy rates are based on Fed Fund Futures data as of November 20, 2023, sourced from Bloomberg.

Fed funds futures are financial contracts that represent the market’s opinion of where the federal funds rate will be at a specified point in the future. The federal funds rate is the rate at which banks lend balances to each other overnight.

Statements about the dot plot based on data from the Federal Reserve.

The dot plot is a chart that the Federal Reserve uses to illustrate its outlook for the path of interest rates.

The discussion about the release of the Consumer Price Index and the one-day reaction of various asset classes is based on data from Bloomberg on November 14, 2023. On that day, the Russell 1000 Value Index returned 2.24%, the Russell 1000 Growth Index returned 1.95%, the S&P 500 Information Technology Index returned 1.92%, the S&P 500 Quality Index, returned 1.48%, the Russell 2000 Index returned 5.47%, the Russell Midcap Index returned 3.33%,  the Russell 1000 Index returned 2.08%, the MSCI All Country World Index ex-US returned 1.74%, and the MSCI Emerging Markets Index returned 0.72%. Credit spreads fell from 125 basis points at the beginning of the week prior to the Consumer Price Index report to 114 at the end of the week that the Consumer Price Index was reported. Credit spreads represented by the Bloomberg US Corporate Bond Index option-adjusted spread.

The Consumer Price Index (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.

The Russell 1000® Growth Index is an unmanaged index considered representative of large-cap growth stocks.

The Russell 1000® Value Index is an unmanaged index considered representative of large-cap value stocks.

The Russell 2000® Index is an unmanaged index considered representative of small-cap stocks.

The Russell Midcap® Index  is an unmanaged index considered representative of mid-cap stocks.

The Russell 1000® Index is an unmanaged index considered representative of large-cap stocks.

These Russell indexes are trademarks/service marks of the Frank Russell Co.

The S&P 500 Information Technology Index includes stocks in the S&P 500 Index classified as information technology companies based on the Global Industry Classification Standard methodology.

The S&P 500® Quality Index screens holdings based on three fundamental measures of quality – profitability, earnings quality and financial robustness.

The MSCI All Country World ex USA Index is an unmanaged index considered representative of large- and mid-cap stocks across developed and emerging markets, excluding the US.

The MSCI Emerging Markets Index captures large- and mid-cap representation across 26 emerging markets countries.

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

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.

Statements about the amount of money investors have in cash are sourced from the US Federal Reserve and Investment Company Institute as of October 31, 2023. Based on total amount in US bank deposits and money market strategies.

Statements about the level of short yields sources from Bloomberg as of November 20, 2023, based on the 3-month US Treasury rate.

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.

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

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 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.

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

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.

A basis point is one hundredth of a percentage point.

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 front 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. In a normal yield curve, longer-term bonds have a higher yield. A steepening yield curve means that the difference between short term and long term is increasing.

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

GFC stands for global financial crisis.

The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.

Brian Levitt:

Welcome to the Greater Possibilities Podcast from Invesco, where we put concerns into context and opportunities into focus. I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. And on the show today is Jen Flitton. Jen is the head of US Government Affairs at Invesco.

Brian Levitt:

So Jodi, we're talking politics again.

Jodi Phillips:

Well, it's kind of hard not to at the moment. We won't discuss it at cocktail parties or family dinners, but we can't help ourselves when it comes to this podcast.

Brian Levitt:

Yeah. And I don't think we should. I've been out seeing clients, seeing investors. It is top of mind. It's among the one or two top questions that I'm receiving right now.

Jodi Phillips:

Well, sure. I mean, there hasn't been a Speaker of the House since when? Early October.

Brian Levitt:

I don't mean to laugh.

Jodi Phillips:

That's something to talk about.

Brian Levitt:

Yeah. Is that a problem? I mean, it's not even clear there's a path to getting one, although there's some options I think that are starting to emerge.

Jodi Phillips:

Yeah. Yep, definitely. And so Jen will give us a scoop on all of that, but it's certainly unprecedented. I mean, as much as you like to make historical comparisons, Brian, when big events happen, ousting a Speaker like this hasn't happened before. So an unprecedented territory here. And it happened just a few days after we were able to avert a government shutdown.

Brian Levitt:

Yeah. So you and I were happy about that. We had talked about that on the last podcast, and I've got a friend at the federal prosecutor's office, so we weren't sure if he was essential or non-essential, but he's still getting paid, so he's happy right now.

Jodi Phillips:

Well good. Well good. And importantly, the animals at the National Zoo are being fed. I know you,

Brian Levitt:

Yeah. Good.

Jodi Phillips:

Always like to ask that question, but.

Brian Levitt:

We were happy about that.

Jodi Phillips:

But look, the next shutdown deadline isn't that far away, November 17th. So the question is how is all of this uncertainty going to impact what happens between now and then? Can we avoid the next one without a speaker?

Brian Levitt:

Right. And we had said that even if you have them, they don't last that long. So I don't know how you do this without good leadership in the House of Representatives. So I think it's a good question.

Jodi Phillips:

Yeah, I mean, I think you've said something about seven or eight days on average is usually about how long shutdowns have lasted in the past, but what would that look like if this Speaker thing isn't settled?

Brian Levitt:

Right. And right now, and I'm not sure it's front and center in the markets, I mean, it seems like Americans have gotten used to these things working out, but there's no shortage of challenges for the US government to contend with right now.

Jodi Phillips:

Nope. There's funding for Ukraine for one, and of course significant concerns with the Israel-Hamas war.

Brian Levitt:

Right. And all happening on the eve of an election year.

Jodi Phillips:

It's always the eve of an election year, right? I mean, that's what it feels like. There's always one upon us. So,

Brian Levitt:

Do we really have to do this again?

Jodi Phillips:

The calendar says so and the Constitution. So yeah.

Brian Levitt:

I guess we'll start dusting off those presidential elections don't matter as much for markets as you think they do content. At least that tends to be popular with our friends.

Jodi Phillips:

Yeah, maybe you can talk about it at cocktail parties too. It's always a crowd pleaser. So in any case, look, let's bring Jen on to discuss each of these issues and more. So welcome, Jen.

Jen Flitton:

Hi. Thanks for having me.

Jodi Phillips:

Sure. Well, thanks for joining us, especially when there's so much uncertainty going on to help us figure this out as much as possible. As we're recording this, still a lot of questions about the speaker. Jim Jordan failed to get the gavel after two rounds of voting, and I'm starting to see headlines that he may not go for a third vote and instead could support a plan to give additional powers to Representative Patrick McHenry who's now serving as temporary speaker. So I definitely want to get your views on all of that. But first I'm hoping you can kind of set the stage and explain to us what can and can't the House do without a Speaker right now?

Jen Flitton:

Well, first I'll say, so we're a bit whipsawed. Right. So that was the news this morning and now it's two hours later post conference. And the members erupted over that idea.

Jodi Phillips:

Oh, goodness.

Jen Flitton:

And so there were a lot of tweets and a lot of talk with press as they left the conference meeting. And they right now are not at all interested in empowering the current Speaker Pro Temp, Mr. McHenry.

Brian Levitt:

Why?

Jen Flitton:

So there is a lot of frustration over the idea that they would require Democrat votes,

Brian Levitt:

Okay.

Jen Flitton:

For this. And there's not a majority of the majority currently that's backing this type of empowerment that would essentially take us over the next two months into January. So past some of the biggest legislating, right, over the next two months. And so you saw the hardliners, the conservatives really rally against that. So the expectation is that potentially we will see a third round,

Jodi Phillips:

Okay.

Jen Flitton:

With Jordan as of 2:30 right now.

Brian Levitt:

2:30 on Thursday on the East Coast.

Jen Flitton:

Right.

Jodi Phillips:

Okay. Well, Brian, that's a note to self. I should always check X right before we start recording a podcast.

Brian Levitt:

I mean, we have other jobs to do also, but you're not refreshing the internet every couple minutes for your latest news.

Jodi Phillips:

No, that was my mistake.

Brian Levitt:

Hey Jen, I have a question. I've been getting this from people. When we used to do these things in the past, was it always only one party voting for the Speaker or did you used to see crossover votes from other parties? For example, in the ’80s we used to hear about how these guys and gals would get together and hang out and drink. Was Tip O'Neill getting votes from the other party?

Jen Flitton:

No, this has always been a partisan exercise. I mean, there are occasionally you have independents who aren't members of either Republican or Democratic Party, but then they caucus or conference with those parties. And you see that happen in the Senate. Right. We have three independent senators right now. They all caucus or have some sort of negotiating agreement with the Democrats. But in the House, because majority rule is so strong, the minority, it's easy to stay together because you're in the minority, right, you're the opposition party. What we're seeing over the past two Congresses, the last one in which Pelosi was the Speaker, she had a similar margin, right, a similar margin of votes, four to five votes,

Brian Levitt:

Right.

Jen Flitton:

But she had changed the rules. So there would not be a motion to vacate unless there were a certain number of members who put it forward. They changed the rules back to only one person being able to issue this motion to vacate.

Brian Levitt:

Regrettably. Well, that was,

Jen Flitton:

Regrettably.

Brian Levitt:

That was because Kevin McCarthy had to go 15 rounds, right? And this all stems,

Jen Flitton:

That's right.

Brian Levitt:

Back to the expectation you would have a wave Republican election perhaps in the midterms that just didn't play out.

Jen Flitton:

That's right. It did not materialize. And so what they were left with was a four to five vote, depending on a good day, right, margin. And so because McCarthy had become somewhat of a polarizing figure within the House Republican membership with such a small margin, it took him so long and then he had to start making deals to get to the speakership.

Jodi Phillips:

So Jen, on the second ballot, Jordan got even one fewer vote than he did on the first ballot. So going into this third vote, and maybe votes 14 through 15, who knows? I mean, what would you think might we be looking at next?

Jen Flitton:

You're right. So if he does not gain in numbers, right, it's going to continue to sort of unravel within the conference and the temperature is incredibly heated. I mean, these are very tense moments. Typically, conference meetings stay very private. They're not, they're literally playing out on X right now. And so you see these members just throwing out the family meeting and putting all of their dirty laundry on the floor and in front of the press and all over the Twittersphere. So it needs some time to calm down. That was the whole intention of empowering the Speaker Pro Temp for two months is to allow some calm to come over the conference.

There may be a way in which the Speaker Pro Temp can bring legislation to the floor with without further authority, assuming that they make the argument that the authority is currently within statute. And that is a debate that's happening within Washington right now. And what we could see is the Biden administration bringing the supplemental draft to the Senate next week, the Senate passing it, and that essentially triggering the House to do something. Right. Now they have something, a forcing mechanism, and that we could see potentially next week.

Brian Levitt:

Speaker Pro Temp, I don't remember learning about this in high school. Is this a post 9-11 type of thing? Is this to make sure, what was the show with Kiefer Sutherland the last survivor? Is it that type of thing?

Jen Flitton:

Well, yeah, it's sort of, right, because that would be in an emergency, right, the one cabinet member who doesn't come to the State of the Union, that was sort of that reference, but this was also devised after 9-11 in case of an emergency where potentially there's devastation within the chamber. And so this would allow for, the Speaker has to provide a whole list of members who could then fulfill that position. And it's written in such a way that he would have the necessary and appropriate, he or she would have the necessary or appropriate and appropriate authorities deemed by the speaker. Right. But his main goal is to allow for the election of a new Speaker.

Brian Levitt:

Why should Americans care? What should we worry about if this persists?

Jen Flitton:

Well, right now we have a lot of volatility, right, around the world in the Middle East. What the Biden administration is proposing is to bring a supplemental that funds Ukraine, Israel, Taiwan, potentially and includes some border money. And so these are all threats within the world and at our own border. So this is a real exercise and I think that there will be a lot of pressure. Right now, there isn't really that forcing mechanism. There isn't legislation that has to get done this week. Right. And the House was already scheduled to be out in recess for the last two weeks. So while we're approaching the supplemental draft coming to the House floor and we have the appropriations process, we're running into that November 17th deadline where the continuing resolution, the stop gap funding runs out. It's really over the next week, two weeks, three weeks, where there's going to be a need to get legislation passed. We're not quite there yet. And we all know Congress doesn't work without forcing mechanisms, so we're going to have to see what happens.

Jodi Phillips:

So Brian, a lot of issues definitely on the table. I don't know if we want to break this down kind of one by one, maybe looking at the shutdown first. Definitely hopeful for another solution to this, but Jen have to ask, what does a worst case scenario look like in terms of if we can't get things together before November 17th and the shutdown happens?

Jen Flitton:

Right. This is pretty embarrassing for House Republicans right now, but embarrassment will turn to humiliation if by next week the House and Senate pass a supplemental funding, they're able to bring forward a bipartisan supplemental bill that will aid in the crisis that we're seeing play out in real time in the Middle East, and then the House can't bring it to the floor. That would be an emergency. Right. And so that's why it's a big question whether that may be the moment that the conference decides, okay, we just need to figure out what we're going to do till the end of the year. And maybe that is a way to get more empowerment into the Speaker Pro Temp.

Brian Levitt:

Are there are all options open on this? I mean, you say that typically you don't see the two sides come together and think of an option. I mean, are there Democrats willing to put their votes behind a Republican candidate in exchange for some of the concessions that they want to? I mean, clearly they weren't with Kevin McCarthy. Do you think they're regretting that or is it possible that something may happen in the future?

Jen Flitton:

Well, there's been a lot of chatter about that in Washington, whether they regret. I mean, Jim Jordan could still become Speaker by next year. Right. And so the idea that some of the Republican rhetoric that came out after McCarthy was removed and deposed was that Democrats joined with Matt Gaetz and friends to kick out Kevin McCarthy. Right. And at the time I thought that was – okay, wow, that's quite a reach. But apparently some of that's resonating.

I don't think there's a real understanding over the process and procedure of the House in most American kitchen tables, that's not what they're discussing. But when you try to present yourself as the pragmatic party, the party who's serious about getting things done and making government function, and then you vote to remove the speaker, apparently there is in some circles that's resonating in the sort of independent, those who can kind of go both sides depending on the election. And so they're starting to feel some of that in certain districts. And so I think they want to be part of the solution. But of course that is then getting the hardliners, the Gaetz and extended into the rest of the Freedom Caucus, really frustrated over the idea of an electing a Speaker with Democratic votes.

Brian Levitt:

As always, where you stand depends on where you sit.

Jen Flitton:

Right.

Brian Levitt:

Right.

Jen Flitton:

Right.

Brian Levitt:

You hear what you want to hear. I've got to imagine that Benjamin Netanyahu and Volodymyr Zelenskyy are watching this pretty closely.

Jen Flitton:

I would imagine that the need to replenish the Iron Dome and the need for Ukraine to have further support, which quite frankly right now, of the $100 billion that the administration is drafting, the talk is that $60 billion of that is for Ukraine. Now, that's a lot over the $24 billion that the White House had originally asked for earlier this fall. So I would imagine that is not going to be well received by House Republicans, many House Republicans. And so that number is going to be really difficult to get to. The House Republicans if they want to play here, they have got to come together if they want to negotiate around this package, because it's not just money. They'll have to be accountability. They'll have to be policy and direction for exactly where that money goes. And the House Republicans are going to want to be part of that conversation, but they can't. They have no leverage if they don't get a Speaker or empower a Speaker Pro Temp.

Jodi Phillips:

So speaking a little more specifically about the crisis in Israel and Gaza, I mean, does all this dysfunction and distraction in the US have potential implications about this expanding into a broader regional conflict while we're busy infighting? What's the broader perspective globally?

Jen Flitton:

Well, that's the ultimate fear. And so you've seen the administration today, or maybe it was last night, provided a briefing to members, the leadership of the House and Senate, bipartisan to really bring them up to speed as to what they're seeing. And of course, the fear is that this could spread, that Hezbollah could become involved, that Lebanon could become involved, and what does that mean for the spread of this in the region? And so that is definitely a concern that is shared by both sides. That's a bipartisan concern.

Jodi Phillips:

Absolutely.

Jen Flitton:

I mean, that's the consensus of Washington right now. And then you saw the State Department just a few hours ago issue a concern to American travelers around the world, that they need to be vigilant because of the protests and potential terrorism.

Brian Levitt:

I guess I was very naive six months ago, walking around the Holy Land without much of a care in the world. It's amazing how quickly things change. Did you get a sense based on President Biden's trip to Israel, did you get a sense of everybody's talking about the morning after, the morning after, or how does this end? Do you have a sense of whether we're stepping into a prolonged conflict similar to perhaps what we saw after 9-11 with what the US was seeking to accomplish in Afghanistan? Or does this seem to be a more limited mission with a potential reasonable outcome?

Jen Flitton:

Well, I think the key question right now as things stand today is the Israeli entrance into Gaza and what they will need to do to extract Hamas from Gaza, what is left in Gaza after that?

Brian Levitt:

Right.

Jen Flitton:

Right. And so as much as the US and Biden's rhetoric has been, we don't want Israel to have to occupy Gaza. Israel doesn't want to have to occupy Gaza. But there's a famous saying, right, in defense and going into and occupying, “if you break it, you bought it,” right, you have the responsibility of those people. There is discussion and you saw that as President Biden left Israel, he apparently immediately had phone calls with president of Egypt and the president of the Palestinian Authority because they're trying to get a handle on what happens after they remove Hamas, which was essentially the governing force there in Gaza after 2007 when they rather viciously took over the strip.

Jodi Phillips:

So Brian, I know on our list of questions that we wanted to ask Jen, we definitely wanted to ask her about 2024 election. Is there anything else before we pivot, anything else you wanted to ask about the shutdown or should we just jump straight into the election picture?

Brian Levitt:

I guess before we get to that, I mean, I think investors want to know what they should be concerned about most or what they should fear most. And one of the things that I've been hearing lately is inflation is still a challenge. We can debate how much of a challenge in the US. We've seen interest rates go up a lot, and obviously there's rates kind of settle based on where supply and demand are. And the concern that I'm hearing is more supply, the more need for money, not only at the US border, but also Israel, Ukraine, and whether there, I don't know necessarily if this is a question for you, Jen, but whether there's demand for all that supply coming to market and is now the right time for more spending. Not that the United States largely has a choice in this instance, but is there really the reasonable ability to sop up this supply that's going to come to market?

Jen Flitton:

Yeah, I think the appetite for additional spending is incredibly low. And you saw out of this debt ceiling deal, the parameters that were set were to bring that fiscal spending down considerably. And I think no matter what comes out of this, we will not be growing spending here in the government. And there will be a restraint. How they do it on discretionary spending specifically, right, which we know isn't the main growth of spending. It's really entitlements, it's Social Security and Medicare.

Brian Levitt:

Sure.

Jen Flitton:

But within that discretionary spending and the non-military discretionary spending, they will start to contract that, whether it's at the House level of really restraining it, or it's the Senate level, which is a compromised restraint, it will be restrained.

Brian Levitt:

I think a lot of investors will be happy to hear that.

Jen Flitton:

Yeah.

Brian Levitt:

So to Jodi's point, do you think that what is going on in the House of Representatives right now is being closely followed by the American public, and do you believe that by the time we get to the conventions next summer or the debates in the early fall that anyone's even going to remember this?

Jen Flitton:

Right. Exactly. And I was with a few members this week who were saying the same thing, right? I mean, they're hearing from their base, right, the base voters who of course are political junkies or they pay attention and they're sent little messages, email or text otherwise. And so they're engaging in calling up their office, their congressional office, and having their own opinion about Jim Jordan or a Scalise or what have you. But the vast majority of people don't know who the Speaker of the House is, don't care who the Speaker of the House is. And quite frankly, once we get into the general election season, the presidential will be the main stage and everything will just be sideshows. It's going to be two main characters. And we can in a point in time right now, it looks like it's going to be President Biden and former President Trump, a sort of redo of 2022, two very well-known figures who also have their own polarizing forces. And so that will be the vast majority of the focus come 2024.

Brian Levitt:

Yeah, this will seem like a distant memory.

Jen Flitton:

Yeah.

Jodi Phillips:

So do you have any, I don't know if predictions is maybe too strong of a word or just thoughts in terms of what the most likely outcome might be in ’24?

Jen Flitton:

Well, I think the consensus right now, if you're looking at the polling, the aggregated polling is that Donald Trump is quite a force and he is only growing in that and short of being sent to prison, which by the way, you can run for president and you can be president if you are in prison, short of experiencing some sort of issue along those lines, it does look very likely that he will be the Republican nominee. And we have the caucuses meeting here in Iowa in January, and then that will follow for the first primary in the country in New Hampshire in February, and then it'll go to South Carolina and all of a sudden you're at Super Tuesday. The momentum if he takes Iowa and New Hampshire and then South Carolina is just going to be unstoppable. So really that's why you see sort of the next rung of characters, DeSantis, Haley, Tim Scott, they're focusing all of what they have on Iowa and New Hampshire.

Brian Levitt:

What about 2028? No, I'm just kidding.

Jodi Phillips:

So Brian, is this the part where you pull out your presentation about how 2024 isn't going to matter much to markets and make us all feel a little bit better about that at least?

Brian Levitt:

I mean, at least what I've been able to tell people, people get so worried around the elections on what it's going to mean for markets. If you look at the market performance under Trump from the day he got elected in 2016, so I think that was November 8th, 2016, for the first 720 or 740 days in office, which is what Biden has now done. And you look at Biden's performance, the S&P 500 from November 3rd, they're pretty close. Trump's got a slight advantage, but they're pretty close. Nowhere near what the amount of concern that we heard from investors. So Jodi, Jen, I will keep going back to those points. I know these things mean a lot with regards to policy and direction of the United States and what type of country we're going to be and how we're going to form a more perfect union. But ultimately, markets seem to be focused far more on what the Federal Reserve is going to do.

Jodi Phillips:

We promise not to ask you any Federal Reserve questions Jen. We'll save that and put Brian on the hot seat there.

Brian Levitt:

Jen, is there any parting shots, anything we missed, anything that you can tell us to maybe calm the concerns of people that are watching this too closely?

Jen Flitton:

Well, I think we will have a resolution here. It's going to be, it's already dragging out, but it's going to drag out further. And if you watch too much news, and right now people are because of all the volatility in the world, so they're seeing all of this playing out in real time. But I do think that by the end of this year, there will be some sort of resolution to the government funding, to the continuation of the NDAA, the reauthorization of the Defense Act, which is how we fund our military and some sort of resolution on supplemental funding for the Middle East and the war in Ukraine. And so I think by the end of this year, we will find ourselves resolved around Christmas.

Brian Levitt:

All right, my blood pressure just went down quite a bit.

Jen Flitton:

Merry Christmas.

Jodi Phillips:

Merry Christmas.

Brian Levitt:

Happy Holidays.

Jodi Phillips:

And Happy New Year. Thank you so much, Jen. We appreciate you joining us.

Jen Flitton:

Thanks so much.

Jodi Phillips:

So Brian, as we track these issues through the next couple months, where can people find your market views?

Brian Levitt:

Yeah, it's not going to be hard for us to come up with topics, right, Jodi?

Jodi Phillips:

Not at all.

Brian Levitt:

Visit invesco.com/brianlevitt to read my latest commentaries. And of course, you can follow me on LinkedIn. And on X. Do we have to say formerly known as Twitter?

Jodi Phillips:

Why not? Formerly known as Twitter.

Brian Levitt:

At Brian Levitt, the real Brian Levitt.

 

Important information

You've been listening to Invesco's Greater Possibilities Podcast.

The opinions expressed are those of the speakers, are based on current market conditions as of October 16, 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.

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.

Past performance is not a guarantee of future results.

Information on the frequency and duration of US government shutdowns is from the US Department of the Treasury.

All data provided by Invesco unless otherwise noted.

NDAA stands for the National Defense Authorization Act.

The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.

Brian Levitt:

Welcome to the Greater Possibilities Podcast from Invesco, where we put concerns into context and the opportunities into focus. I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. Brian, I have questions about a lot of different topics today, so I didn't bother booking a guest. I didn't want to subject them to my stream of consciousness, so you're in the hot seat.

Brian Levitt:

I am in the hot seat.

Jodi Phillips:

Congratulations. Yeah.

Brian Levitt:

I like being in the hot seat. I just want to know where you want to start. I have some sense of the things you want to ask, but I'm wondering where you want to start with all of this?

Jodi Phillips:

Okay, short list: interest rates.

Brian Levitt:

Okay.

Jodi Phillips:

Central bank policy.

Brian Levitt:

Makes sense.

Jodi Phillips:

Government shutdown fears.

Brian Levitt:

Sure.

Jodi Phillips:

Worker strikes.

Brian Levitt:

Yeah, that's all?

Jodi Phillips:

Do you want more?

Brian Levitt:

Well, we'll see. Let's see the runtime. It seems like a good list, so let's see how long this goes.

Jodi Phillips:

That's enough to start with. Okay, then without further ado, let's start with interest rates. Have you been surprised by the rise in interest rates in August and September?

Brian Levitt:

Yeah, I've always promised to be honest with the listeners, so yeah, I have been, and why have I been so surprised? Mostly because, Jodi, as we know, inflation peaked over a year ago. We see inflation peak in June 2022 at 9% with rates at — 10-year rate at four and a quarter, I would've thought that that was the move.

Interestingly though, the move in rates has not been driven by inflation expectations. Inflation expectations are very well anchored. It's been a sharp move higher in what we call real yields, and that is the result of US economic strength. Now, I just simply underestimated how strong the economy would be by the second half of 2023. I mean, we figured that things would not be as robust as they are right now, and yet people continue to shop.

Jodi Phillips:

Okay, so it's not about the political turmoil. The high rates have been about the strong growth?

Brian Levitt:

Yeah, I don't think it's about the political turmoil. I mean, we could talk about that in a bit, but that doesn't seem to be what's caused rates to jump. We've had political turmoil before. This has just been a strong economy.

Jodi Phillips:

Sure, and look, you're far from the only one who underestimated the strength of the US economy, so lots of economists are all offering their mea culpas on their recession calls.

Brian Levitt:

Yeah, a lot of mea culpas.

Jodi Phillips:

Yes, for sure. Why? What do you think folks got wrong?

Brian Levitt:

Well, it might just be timing.

Jodi Phillips:

Timing.

Brian Levitt:

Yeah, the expectation was that we got a lot of tightening and we would've had a recession by now, but maybe it's just more timing than anything else.

Jodi Phillips:

All right. The lagged effects that I keep hearing so much about. I mean, 550 basis points in a short period of time. Yeah, that's a lot to digest.

Brian Levitt:

Yeah, it is. And maybe it's just taking longer to work its way through the system than it usually does.

Jodi Phillips:

For sure. Well, whatever the case, I'm definitely glad I have a fixed rate mortgage.

Brian Levitt:

Right, that's exactly what I'm talking about. It's been negligible to a lot of people, at least to this point. I mean, why does it matter if rates went from zero to 550 basis points if 80% of us have fixed rate mortgages? Whether that's most of us, 30, some 15-year mortgages, but fixed, and you think about it from the chief financial officers of businesses, they were also paying attention. I mean, they locked in low rates when they could. It's just not hitting, all these rate hikes are just not hitting the economy as soon as we would've expected.

Jodi Phillips:

Okay. Well, I mean, that's all well and good, but ultimately it's going to start to weigh on the economy, right?

Brian Levitt:

Well, that's the idea. I mean, the Federal Reserve wants things to slow down. They don't want to see the job market remain so strong. There'd be a dearth of workers' wages to go up. That's the idea here. And you can look back at other cycles, which always does provide us some comfort. I looked at 1988 before the early nineties recession, '94, '99. Rates rose either before a recession emerged or the Federal Reserve had to back off its tightening stance. This feels pretty similar to that. The last leg up in growth, the last leg up in rates, and then people extrapolate that to be forever, but unlikely to be the case. Rates will ultimately start to moderate, in my opinion, as the economy moderates.

Jodi Phillips:

Okay, so you're not in the “high for long” camp?

Brian Levitt:

“High for long.” No. I've been joking that that sounds like it should be a Grateful Dead song. No, I am not in the high for long camp. Rates will be higher than they were in the last cycle. Let's be honest. I think sometimes when I say I'm not in the high for long camp, people think I mean they're going back to zero or 2%. No, that's not what I'm saying.

Jodi Phillips:

Okay. Okay. Not likely to go back to a negative real yield after inflation then?

Brian Levitt:

No, and I think that that's probably a good thing, but importantly, I expect rates to be at or nearing a peak as the economy's likely to moderate going forward. Now, some might hear that and say, "Oh, he is calling for slow growth, or maybe even a recession," but I'm in the camp that peak rates, peak tightening, all tends to be quite good for markets over the subsequent years.

Jodi Phillips:

Okay. All right then that brings us to the next topic, Federal Reserve. Will they, won't they, and Brian, do we care anymore?

Brian Levitt:

Yeah, unfortunately Jodi, I think we care.

Jodi Phillips:

Okay. All right, fine. We care.

Brian Levitt:

You know you care.

Jodi Phillips:

I care very much. Yes. Tell me, what do you expect?

Brian Levitt:

People have been asking me why this year was so much better than last year. Now, it hasn't felt like that over the last couple of months, but why has this year been better? And it's mostly because we've been moving towards more policy clarity. Markets don't like uncertainty, and last year we had so much policy uncertainty because inflation was so high, just how many times were they going to have to raise interest rates? And now we're still debating it, obviously, you just asked. We're still debating it, but we've got to think we're getting closer.

Jodi Phillips:

Okay. But the past few weeks, I mean, that's been the opposite of clarity, right? You're saying we're closer than we were last year?

Brian Levitt:

Yeah, it's like those kids in the Station Wagon. You ever go on that road... I know you go on the road trip, you take out the Winnebago, you go across the great divide.

Jodi Phillips:

Yeah, I've done that a couple of times. Yes.

Brian Levitt:

You have, and the kids are always, "Are we there yet? Are we there yet?" "No," and then I don't know about yours, but mine say, "Are we getting closer?" And we're raising geniuses. Yeah, I mean, we think we're getting closer.

Jodi Phillips:

Well, we're driving an awful long time, so we're closer – unless we make a wrong turn. Okay, let's just hope the Fed isn't navigating by a crumpled up map in the glove compartment.

Brian Levitt:

Yeah, they're using their GPS. As I say, Jodi, inflation expectations are generally contained, and so they have restored credibility, which is great, but at the same time, I do worry about them overtightening. I mean, I look at inflation expectations and say, "Well, why keep going? We're pretty contained here. Why don't we see what this all will ultimately do?" I do worry about them overtightening, but the reality is they don't answer my phone calls.

Jodi Phillips:

They don't?

Brian Levitt:

No, they don't answer. I mean, most people don't.

Jodi Phillips:

Well, I do. I answer your phone calls.

Brian Levitt:

You do, but be honest. You have to because of your job description, right?

Jodi Phillips:

Yeah, I couldn't negotiate that out. All right, so why? Why are you worried about overtightening?

Brian Levitt:

Well, think about it this way. The Fed famously tells us that they're data dependent, so they're looking each month at the data, but we know that policy operates with a lag.

Jodi Phillips:

Mm-hmm. All right. That by definition leads to overtightening.

Brian Levitt:

Right. I mean, if the challenges don't hit a few months out, data dependent's not really going to have you recognizing that. And so yeah, most of these things and most of the Fed tightening cycles end in recession or some type of challenge. I do fear that they're overtightening, which is largely takes us back to our first conversation, which was asking have rates peaked. I mean, at some point they tighten too much, growth slows and rates start to come down.

Jodi Phillips:

Okay, after overtightening comes easing, right?

Brian Levitt:

Usually.

Jodi Phillips:

The futures market, I mean, what's that telling us? The Fed funds rate will be about five and half percent — four and a half percent a year from now. Yeah, let's get that right. Four and a half percent a year from now. That suggests we'll get a few cuts between now and then, right?

Brian Levitt:

Yeah, I mean, although after that September jobs report, five and a half percent might have felt...

Jodi Phillips:

Right, right. No, that's...

Brian Levitt:

And that's what scared the market initially after that jobs report. Yeah, I mean, Jodi, the futures market had suggested rates as low as 4% at one point a year from now. The market's had to reassess recently. If the market's pricing 4% at one point and now things have still been strong and okay, a year from now we're pricing four and a half, well equity markets, risk assets adjust. Now, this is all very nuanced and very short term. To me, the most important point, I'll say it again, is that we're getting close to peak rates. And again, historically that's a good backdrop for risk assets.

Jodi Phillips:

A good backdrop. Okay, that's good to hear. Let's stop there with the good backdrop and jump from the Fed to Congress. Have you tried putting in any calls to those folks lately? Maybe they should be answering your calls?

Brian Levitt:

Talk about people who really don't answer my phone calls.

Jodi Phillips:

We avoided a government shutdown, okay, but it cost the Speaker of the House's job. Would you call that a good trade-off?

Brian Levitt:

Oh, I don't know.

Jodi Phillips:

It's a hot seat, Brian. It's a hot seat.

Brian Levitt:

My mom told me not to discuss politics in mixed company.

Jodi Phillips:

All right, fair enough. We don't want to make her mad.

Brian Levitt:

I'm not sure if I'm the right person to answer that, but look, I guess if you're a non-essential worker, you're probably pretty happy to be getting a paycheck this week.

Jodi Phillips:

Oh, sure, right? I mean, the park rangers, the NASA experts, the zookeepers at the National Zoo, they're all happy, at least for now. We'll see-

Brian Levitt:

Yeah, you're down in Houston, you probably know some NASA rocket scientists.

Jodi Phillips:

Oh, sure. Yeah, we all hang out.

Brian Levitt:

You all hang out, right? Yeah.

Jodi Phillips:

We'll see if we can avoid another shutdown scare in November.

Brian Levitt:

Yeah, round and round we go. I guess at some point we just get used to this.

Jodi Phillips:

Yeah. There's the view from being a constituent and then there's a view as an investor. As an investor, how caught up do you get in these things?

Brian Levitt:

Well, you framed that correctly. I mean, I watch as a concerned spectator, and maybe occasionally get out the popcorn, but I don't change my investment approach. As I said, I'm getting used to it at this point. There's been enough of these things.

Jodi Phillips:

21. 21 shutdowns since the 1970s.

Brian Levitt:

21 times. Ferris Bueller reference? Nine times. No, that's a lot. And I mean, the good news is, you've had them. The good news is they tend to not last very long. On average, if the government does shut down, it lasts seven to eight days and then we move on. Now, there may be some hit to the credibility of the US government or the ability to run the US government, but for the most part, markets look past it.

Jodi Phillips:

Great. And the zookeepers get paid.

Brian Levitt:

Yeah, they get their back pay as they should. I mean, hopefully the animals were being fed the whole time.

Jodi Phillips:

Yes, I have no doubt. You mentioned earlier that you don't believe that the move in the treasury rates is related to this political turmoil. Why is that?

Brian Levitt:

Yeah, I don't believe it is. I mean, if you think about it, government spending is an input to GDP and the 10-year rate is going to be a reflection of what growth is likely to look like. And so if you don't get a spending bill, you don't get spending, then the G in the old GDP equation, C plus I plus G plus NX, the government spending slows. And so in actuality it may be paradoxical, but I would actually think rates would've rallied if investors were so concerned about it. And if investors were concerned about a component of US GDP not being an input to growth, I would've thought rates may have rallied. This move, again, seems far more attributable to stronger than expected economic activity than political concerns.

Jodi Phillips:

Okay. If I asked you about the recent stock market volatility, a similar answer?

Brian Levitt:

Yeah, I think so. Political uncertainty doesn't help, but it's part and parcel of the same thing you were just asking. I mean, if equities are going to adjust as rates go higher, then it goes back to why did rates go higher? And historically, markets have looked past shutdowns. What would you guess the average return during shutdowns is the last 21 times we've done this?

Jodi Phillips:

I couldn't guess. I would guess it's not great though.

Brian Levitt:

Yeah, no, it's 0.1%. You've had a few up, you've had a few down, a couple that were maybe down 3% or so, but essentially flat.

Jodi Phillips:

Essentially flat. Okay. Well, markets must've heard the quote, "Americans always do the right thing, but only after exhausting all of their other options."

Brian Levitt:

Yeah, I guess you're my co-host on this. I think you've probably heard me say that a few times as well.

Jodi Phillips:

Once or twice.

Brian Levitt:

Once or twice, right. Well look, I mean, what number episode is this? Like our 50th episode? Something like that.

Jodi Phillips:

I think it's close to that. It sure feels like it.

Brian Levitt:

I mean, you think I'm still going to have fresh material after all of these? I have to go back to the tried and true.

Jodi Phillips:

Go back to the classics. All right. Well, the last topic we promised to cover are strikes.

Brian Levitt:

Strikes, yeah. Well, at least the writer's strike is over. Are you happy to see the late night hosts back on the air again?

Jodi Phillips:

Yeah. At least they have new material.

Brian Levitt:

Right. Right, because none of them are... You just hit the problem. I don't need writers.

Jodi Phillips:

All right. All right. The writers have a deal, but the auto workers don't. That strike continues. And what is it, 75,000 healthcare workers have just walked off the job at Kaiser Permanente? I mean, that's one of the United States's largest not-for-profit healthcare providers. That's definitely a big deal. Again, how should investors put this into perspective?

Brian Levitt:

Well, look, I'll focus on the auto sector. The automobile sector is very cyclical. I mean, the first thing you want to think about is growth. And obviously, there'll be a hit to economic growth at a time when I'm already telling you that the economy is poised to slow. Now, ironically, I think markets are hoping that the economy slows here so we don't see additional moves in rates, but it's estimated that the drop in motor vehicle production would be a tenth to two-tenths percent drag on gross domestic product per week. Over an entire quarter, you could see one and a half to 2% drag on growth, which could result in a flat quarter. It's not tiny, but it obviously depends on how long it goes on and is unexpected to be the catalyst to really create a recessionary environment or something far more damaging to the economy.

Jodi Phillips:

Okay, then are car prices going to drive up inflation at just the wrong time?

Brian Levitt:

Yeah, I mean, that's an excellent question because new and used vehicles have been a source of deflation in recent months. In fact, used car prices are negative on a year-over-year basis. Now, the percent change, I think the rental car companies have done a pretty good job rebuilding their fleets. Now, whenever I go to an airport, I'm on the one that has the long line. There's 10 rental car companies. I don't get that. But anyway, I digress. Now, if you do have a long-term hit to new production, you could, again, put upward pressure on vehicles. New cars haven't come down a lot. They've been slowly grinding lower. That wouldn't be ideal, again, as the market tries to look forward to the end of Fed policy tightening. There's some risks here. I don't want to overstate them, but there's some challenges we'll have to grapple with.

Jodi Phillips:

Okay. Well, I guess the good news then is that much like government shutdowns, strikes have not typically lasted for too long.

Brian Levitt:

Yeah, I mean, that's generally been the case. I mean, the United Auto Workers Union does have a finite strike fund. I think I had read that the strike fund, which is there to pay workers, provided they strike, I think I've read that it could last 11, 12 weeks. That's that flat quarter that we warn against. But again, it goes more back to that inflation story. And again, most domestic car manufacturers have rebuilt supply, used car companies have rebuilt their fleets. Supplies increasing at a time when consumer demand's supposed to be slowing, we'll see. But I would expect any upside move on inflation to be relatively limited.

Jodi Phillips:

All right, I'm out of questions. I mean, we've covered an awful lot here, Brian.

Brian Levitt:

Did I answer all of them?

Jodi Phillips:

You did.

Brian Levitt:

We did?

Jodi Phillips:

You did.

Brian Levitt:

I mean, I'm trying not to be too Pollyanna, but I'm looking ahead to what I think will be a better environment. We're like 1010 WINS here for those New York radio listeners, you give us 22 minutes, we'll give you the world. I mean, that's what we just did. I don't know if this was 22 minutes, but it felt about that.

Jodi Phillips:

And I don't think it was the world either. At least the United States, but maybe we'll tackle the world in the next one.

Brian Levitt:

You give us 20 something minutes, we'll give you the US.

Jodi Phillips:

Yeah, that's a tagline that writes itself... Thank goodness those writers are back so we can come up with something a little better than that. All right, that wraps up this episode of Greater Possibilities. Brian, where else can listeners find your views on the markets?

Brian Levitt:

Yeah, thanks Jodi. Visit invesco.com/brianlevitt to read my latest commentaries. And of course, you can follow me on LinkedIn and on X.

Jodi Phillips:

X.

Brian Levitt:

X, at Brian Levitt. That's two T's.

Jodi Phillips:

At Brian Levitt. All right.

Brian Levitt:

Thanks Jodi.

Jodi Phillips:

Thanks for listening.  
 

Important Information 

You've been listening to Invesco's Greater Possibilities Podcast. 

The opinions expressed are those of the speakers, are based on current market conditions as of October 6, 2023, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. 

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. 

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. 

Not a Deposit; Not FDIC Insured; Not Guaranteed by the Bank; May Lose Value; Not Insured by any Federal Government Agency 

Data on the June 2022 inflation peak and 10-year rates comes from the US Bureau of Labor Statistics as of August 31, 2023. 

Information on moves in real yields comes from Bloomberg as of October 6, 2023. Real yields are calculated by subtracting the 10-year inflation breakeven from the 10-year US Treasury rate. Breakeven inflation is the difference in yield between a nominal Treasury security and a Treasury Inflation-Protected Security of the same maturity. 

The 550 basis point rise is from the US Federal Reserve as of September 30, 2023, and is based on the federal funds rate. The federal funds rate is the rate at which banks lend balances to each other overnight. A basis point is one hundredth of a percentage point. 

Statistics about the percentage of Americans with fixed rate mortgages come from Bankrate.com as of September 20, 2023. 

Information about rate increases and recessions in 1988, 1994 and 1999 are from Bloomberg, based on the 10-year US Treasury rate. 

Projections about the federal funds rate are from Bloomberg as of August 31, 2023, based on fed funds futures. Fed funds futures are financial contracts that represent the market’s opinion of where the federal funds rate will be at a specified point in the future. 

Information on the frequency and duration of US government shutdowns is from the US Department of the Treasury. 

Stock market returns during government shutdowns comes from Bloomberg, based on the average return of the S&P 500 Index during each shutdown. 

Past performance does not guarantee future results. An investment cannot be made into an index. 

Information on used car prices comes from the US Bureau of Labor Statistics as of September 30, 2023. 

Information on the strike fund for auto workers comes from the United Auto Workers union. 

Estimates about the potential impact of the auto workers strike on gross domestic product comes from Bank of America. 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 GDP formula is Consumption + Investment + Government Spending + Net Exports. In other words, C + I + G + NX. 

Tightening monetary policy includes actions by a central bank to curb inflation, such as raising rates. Overtightening is the risk that a central bank harms the economy by raising rates too much. 

The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.

Brian Levitt:

Welcome to Greater Possibilities from Invesco, where we put concerns into context and opportunities into focus. I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. And today in studio, we have David Nadel. David is a senior portfolio manager for the global equities team at Invesco, focusing on small and mid-cap international companies. Okay, Brian, so is now the time for international investing?

Brian Levitt:

Well, I guess if I had a dollar for every time somebody asked me that question, Jodi.

Jodi Phillips:

Yes. What would you have?

Brian Levitt:

Oh, I'd have a few dollars.

Jodi Phillips:

Okay. So you get this question quite a bit then, I'm assuming. So where does this question rank. Is it right up there with: Should I own bitcoin, and what's the US going to do about its debt?

Brian Levitt:

Yeah, those are the big ones. Those are the Mount Rushmore, they're on the Mount Rushmore of questions. I guess we have to come up with a fourth one. But yeah, those are the questions.

Jodi Phillips:

Something about artificial intelligence, I'm sure.

Brian Levitt:

Okay, we'll add that.

Jodi Phillips:

Yeah. Look, it's understandable.

Brian Levitt:

That'll go in the Teddy Roosevelt spot.

Jodi Phillips:

It's understandable though, that's a really popular question for you. Right? The so-called lost decade of US equity performance, 2000, 2009, had investors looking elsewhere trying to figure out what to do next. But then the decade after that favored US stocks. So yeah, investors are wondering about what comes next and if it's the time to do something differently.

Brian Levitt:

Well, I do have a theory about this and I'm sure that David will as well.

Jodi Phillips:

All right. What's your theory?

Brian Levitt:

Well, at first, these things tend to go in cycles. So I think what's critical to note is that the past decade wasn't lost in international the way 2000 through 2009 was lost in the US. It did generate positive returns. But the under-performance was similar to what the US experienced versus international in the so-called aughts. Is that what we call it, the aughts, the 2000s?

Jodi Phillips:

Sure. We still haven't figured that out. Have we? But yeah, I guess to your point, to everything there is a season.

Brian Levitt:

Yeah, turn, turn, turn. It's a very strong dollar environment, and each time it looked like non-US assets would participate, a US policy decision or something unexpected would disrupt it.

Jodi Phillips:

Unexpected, like a trade war and a pandemic, that kind of unexpected?

Brian Levitt:

Yeah.

Jodi Phillips:

Yeah.

Brian Levitt:

Exactly, and the Fed raising rates a few times in a slow growth environment.

Jodi Phillips:

So you mentioned strong dollar environment, Brian. So as we all know, a strong dollar environment means that returns generated overseas by US investors translates into fewer dollars when that money is brought home. So I guess to put a little bit of a finer point on the original question, is the strong dollar environment finally over?

Brian Levitt:

Well, let's see what David says. But it does tend to happen when policy cycles, policy tightening cycles end, money can then start to look for other opportunities where valuations are more attractive.

Jodi Phillips:

And we may finally be at the point where the Fed stops raising rates and we can all start anticipating an easing cycle.

Brian Levitt:

Oh, that's the fourth question.

Jodi Phillips:

There you go. That's the Mount Rushmore question. We got it.

Brian Levitt:

When's the Fed going to be done? All right, so we got the four, bitcoin, US debt, international investing. And when's the Fed going to be done?

Jodi Phillips:

Perfect, there it is.

Brian Levitt:

There it is.

Jodi Phillips:

All right. So now we've got that settled. Let's bring David on to discuss the opportunities that he sees in international stocks, especially in that small and mid-cap space and where money might flow as investors look for opportunities in a potentially new dollar regime.

Brian Levitt:

David, welcome.

David Nadel:

Good to be here.

Brian Levitt:

So you have the answer to all four of the questions on Mount Rushmore.

David Nadel:

Possibly.

Brian Levitt:

Possibly.

David Nadel:

We can handle them one at a time.

Brian Levitt:

We can go one at a time. Well, let's start with your wheelhouse, then we'll see your thoughts on crypto. No, we're not doing crypto today, Jodi.

Jodi Phillips:

No, okay, good. I'll refrain.

Brian Levitt:

Thank goodness. So when you look at investors' portfolios, I have to imagine they're pretty overweight, the United States, whether that's by design or just performance that we've seen in recent quarters or years. Correct?

David Nadel:

Yeah. I mean, I think you're exactly right. It's a combination of design, which probably put those investor portfolios overweight the US in the first place. And then the relative performance of the US, out-performance of the US over international during the past decade has stretched that to kind of garish levels of imbalance. And therefore, it's elevated the risks at multiple levels. So if you think about, for example, our benchmarks or the benchmark for global SMID companies, in the last 10 years, that's moved from about a 45% US weight to a 60% US weight. All 10 of the top 10 positions, companies in that benchmark are US stocks.

Brian Levitt:

And that's because it's a market cap weight. It doesn't rebalance.

David Nadel:

Exactly, exactly. And so dynamics like that I think create kind of overlapping risks for investors, where if one of those risks doesn't hurt them, another one is very likely to hurt them. You have valuation risk because these companies are much more expensive, the US companies, than the international ones. And you have the risk of these being very crowded trades, so that the companies that make up the benchmark are very heavily invested in, and when people exit, it may not be pretty. And the dollar and US outperformance are all basically cyclical. To your point, Brian, that you mentioned earlier, they trade leadership. And it's looked like for the last 20 years, it's looked like roughly sort of a 10-year cycle. But there's no magic to that.

Brian Levitt:

Nothing magic, right. And when you think about that underperformance, I mean, in the conversation I had with Jodi, I had categorized it as any time it looked like international was really going to get going, I remember years like 2016 into 2017, I remember 2019, something happened that disrupted it. Right? It was trade wars or pandemics. Is that an accurate way to think about it?

David Nadel:

Yeah, I think that's right. I mean, investors react, US investors at least I think suffer from significant home country bias, and so the devil that they know is more comforting than the devil they don't know. International equities is the devil that they don't know, which is understandable. But I mean, I will say, abroad, it would be unthinkable to have the level of home country bias that US investors have. If you're a UK manager, you're not going to be 60% in UK equities and 40% in everything else. But it is understandable because the US economy is so broad and the leading economy of the world. So yeah, let's leave it there.

Brian Levitt:

So Jodi, do you have your portfolio structured based on the Mississippi River, so half is, 70% of companies headquartered to the east and 30 the west, or anything like that?

Jodi Phillips:

Interesting. I'll have to check. I'm not really sure how that allocation works out. David, you mentioned the devil you know, the devil you don't know when it comes to US investors. And so do US investors tend to see international small and mid-cap in particular as a distinct asset class the way they do in the US? Right? What do allocations tell us about that viewpoint?

David Nadel:

So Jodi, I think US investors see international SMID cap in all the wrong ways. They not only do not see it as an asset class, as indicated by their allocations, which are less than 1% to international SMID, versus around 14% for US SMID, again, massive home country bias.

Brian Levitt:

Less than 1%.

David Nadel:

Less than 1%. But I think they also see international SMID as very high risk, high volatility. And international SMID is higher standard deviation, higher volatility than international large. But when you look at risk adjusted returns, because the returns historically have been so much better from international SMID versus international large, those risk adjusted returns are better. So when you look at things like Sortino ratios or Sharpe ratios, you're looking at an asset class which is producing very attractive risk adjusted returns. But again, investors are not really treating it even as an asset class in the first place, even though the opportunity set of international SMID is twice the size of US SMID. It's twice the number of companies in the benchmark, and so it really is an asset class. Right? But if you're thinking about asset classes from the vantage point of how US equity investors are allocating, it doesn't look like an asset class, less than 1%, which creates a tremendous opportunity.

Brian Levitt:

I think I have more Beanie Babies in my portfolio than people have. Right? Those things are going to make money. We're getting there.

Jodi Phillips:

Eventually. Keep holding, keep holding onto them, Brian.

Brian Levitt:

Keep holding. Define Sortino ratio real quick.

David Nadel:

So Sortino ratio is sort of a better version of the Sharpe. I mentioned the Sharpe as well.

Brian Levitt:

Which is return per unit of risk.

David Nadel:

Exactly. The Sharpe is return per unit of risk, where risk is defined as both upside and downside, whereas the Sortino ratio eliminates the upside risk, because people talk about risk and volatility, but they actually never complain about it when it's on the upside.

Brian Levitt:

I think they just assume volatility means downside.

David Nadel:

Yeah, the bad stuff, so that's what the Sortino ratio does, it's your kind of more specific and fine-tuned version of a Sharpe ratio, where it's eliminating... It's not punishing returns for upside. It's only punishing them for downside.

Brian Levitt:

So if I come up with one that's just upside, can I call it the Levitt ratio? Does that exist?

David Nadel:

Yeah, that'd be a great plan. I think a lot of people would be fighting you for the name rights on the upside only ratio.

Jodi Phillips:

So then with an asset class like that and a space like that, the way you described it, for an active manager, such as yourself, then that seems like it would be a particularly good space to find opportunities. How do you think of it in that way?

David Nadel:

Yeah, that's exactly right, Jodi. So it's a very large universe. It's really inefficient. I mean, we're looking at something like 13,000 companies that have market caps between $300 million and $10 billion outside the US. That's a lot of companies. And as I mentioned-

Brian Levitt:

That's small to mid.

David Nadel:

That's small to mid, yeah. As I mentioned, again, this is a much larger opportunity set than US. You have a very large portion of the companies that have no analyst coverage whatsoever, even among the private ... Among the more prominent companies within the asset class, it's common to have much less coverage than for example, a prominent company in US SMID. So it is a place where active managers have consistently added value, and that really distinguishes international SMID as an asset class versus other equity asset classes. So if you think about rolling returns, which we love to use because rolling returns really represent a true investor experience as opposed to, no one invests on January 1 and sells on December 31st, or ridiculous periods like that.

So if you look at rolling returns, three year returns, five year returns, 10 year returns, international SMID active management in growth has added on average about 330 basis points of out-performance per year for three year rolling periods over the benchmark. And if you look at five year periods, it's more like 250 basis points, 10 year periods, it's more like 180 basis points.

Brian Levitt:

That's a lot.

David Nadel:

And that's per year. So even on the 10-year basis, 180 basis points of outperformance per year for 10 years, that's going to make a huge difference in people's returns. And it's the reason that there really is not a viable benchmark strategy for international SMID. In other words, for asset allocators to get exposure to this asset class, they're almost certainly going to go with active. You look at the portion of assets of the asset class that are in passive strategies, it's tiny.

Brian Levitt:

David, you talk about looking at thousands and thousands of companies. What are you looking for? And what type of themes emerge in the portfolio that have you very excited?

David Nadel:

Yeah. So Brian, what we're looking for, I mean, our strategy is very much about high quality compounders. So we're looking for companies that can grow regardless of what the economy is doing. In other words, acyclical growth. And we're looking for companies that generate consistently high levels of profitability, particularly internal rates of return, so things like returns on capital, but those derived from let's say high profit margins, which in turn tends to derive from very strong pricing power. So what that essentially means is that we invest in a lot of industry leaders. We're often invested, about a third of our portfolio I like to describe as global number one businesses, meaning that they have the undisputed world leading market share in what they do. This is a little counterintuitive I would say for investors to hear about SMID cap companies.

Brian Levitt:

Small and mid, yeah.

David Nadel:

Because in the US, a SMID cap company is rarely a global leader. You can be a $4 billion company in the US and sell to a single state in the country, like California, or Massachusetts, or something. On the international stage, it's a much tougher and more demanding standard. So if you're coming from a small country, you don't have a large home market. You have to figure out how the whole world works. You have to adopt basically global standards. And so these are really battle tested businesses. And it's not surprising in that context that a lot of international SMID companies become global number ones.

Brian Levitt:

Can you give an example without necessarily mentioning the company? Just talk about what they do and how they've grown to that place.

David Nadel:

Sure. I mean, there are so many. I'll talk to you about a couple of our investments. So one company makes transducers. Transducers are devices that basically regulate the amount of electricity flow, so they would be used in something like an elevator, for example, to have a very consistent flow. This is a small market globally. It's something like a billion dollar market total in terms of sales. This is a tiny market. Right? We're talking about niche businesses here. But this company has about a 50% share of the global market, so that's one example. Another company literally invented the cochlear implant. I don't know if you're familiar with...

Brian Levitt:

I am very familiar. One of my best friend's sons wears the cochlear implants. It's unbelievable.

David Nadel:

Yeah. It is totally an unbelievable technology because it literally gives the gift of hearing. And you mentioned a son…

Brian Levitt:

And speech, right?

David Nadel:

And speech, right, because without the hearing, you're really at a disadvantage. And you mentioned it's a son, probably a young child, the typical, or maybe a growing child. But the typical beneficiary of a cochlear implant is a child.

Brian Levitt:

He was a baby.

David Nadel:

A baby, yep. And this is a technology that will last the life of the child. And it requires a lot of software updates, so there's about a third of this company's revenue and even more of their profit is coming from recurring revenue. That's another thing we really like to look for in our businesses, high portions of recurring revenue. We like these businesses to just compound. And you can literally with this company run a discounted cashflow per patient because you're going to get the lifespan of that patient 75 year lifespan of beneficiary of a cochlear implant.

But essentially what we're looking for, I mean, maybe those give you a couple of illustrations, but companies that are going to ... They're built to last. They have a capacity to suffer. They are going to do well in any sort of an economic environment. A lot of them tend to be quite kind of, I might say boring or almost hum drum type of B-to-B (business-to-business) companies that are below the radar. I mean, another one of our prominent holdings does steam systems. No one even thinks about steam systems. But two thirds of Nestle's expenditures on energy are for steam. It's a mission-critical service that the company is providing. And that's typical of our holdings, is mission-critical. So when things get tough, their customer, which is a corporation rather than an individual, is very unlikely to cut that service.

And so what you'll see in our strategy is kind of a de-emphasis on consumer discretionary because we find that consumers in the small and mid-cap space are quite fickle. We rather deal with a corporate buyer, much more reliable. Everything we're doing is we try to de-risk the portfolio at the level of each company, so we have extremely high conviction in each company we invest in to the level that we would be comfortable having the entire portfolio in any of our individual holdings.

Brian Levitt:

Wow, that's a bold statement. And you know management well, you visit them, you kick the tires.

David Nadel:

That's right, yeah. We certainly do all of that fundamental research that is pretty standard across our industry.

Brian Levitt:

But you have good status on your airline, I'm sure.

David Nadel:

Yeah. It's a perk of the job. That's right. But we do a lot more than that, we also do strategic research. We have a person fully dedicated on our team to do strategic research which is talking to former executives at companies, talking to customers, talking to suppliers, understanding the ecosystem of a business. That's work that a lot of other mutual fund managers or management teams don't really do. And so we're getting a really full picture of these companies. Yes, we do visit them on site. Next month, I'm going to Sweden to see companies. The month after that, in October, to the United Kingdom to see companies, hence, those frequent flyer miles. And two people on my team will be in Japan next month seeing companies where I was last September. So yes, we do that work, but I think supplemented by the strategic research, which really adds a nice edge to our process.

Brian Levitt:

Jodi, you willing to be a companion on some of these trips?

Jodi Phillips:

Oh, sure. I could collect some frequent flyer miles, for sure.

Brian Levitt:

I was getting the sense from David he wanted company.

David Nadel:

Definitely, definitely. They're a lot of fun and you learn so much. I mean, it really makes the job so engaging and gratifying to travel and see these companies.

Jodi Phillips:

Oh, sure.

David Nadel:

The idea of being paid to learn is really-

Brian Levitt:

That's not bad.

David Nadel:

It's really a gem of this profession.

Jodi Phillips:

Not at all.

Brian Levitt:

You spent a lot of your childhood paying to learn. Right?

David Nadel:

That's right.

Brian Levitt:

That's nice.

Jodi Phillips:

If I tell you I'm interested in steam systems, does that help? Does that get me a ticket on the plane?

Brian Levitt:

You're big into transducers, aren't you?

Jodi Phillips:

There you go.

David Nadel:

You would be the one out of a million who if you're able to convince someone you're genuinely interested in steam systems. But steam systems are not ... Just to clarify that in case people are picturing a steam engine or something and wondering why you'd invest in a 19th century technology, steam is used in so many processes that are literally day to day processes, so pharmaceutical production. It's a bacteria side, it's a sealant, it's used in beer production, which people can relate to.

Jodi Phillips:

Okay, there you go.

Brian Levitt:

Now we're talking.

David Nadel:

Petrochemicals. It's just got an incredibly broad level of applications, which is why Nestle again, two thirds of their energy outlays are for steam systems. But for us from an investor perspective, you know what's great about steam is it's corrosive. Right? So it means that all these parts need to be replaced, and so they can put in the initial traps and all of that, set up a factory floor with all of these items that look sort of like Charlie and the Chocolate Factory.

Jodi Phillips:

Sure, absolutely.

David Nadel:

Parts wear out, and so that gives them, in the case of this company it's something like 80% of their operating profit comes from recurring revenue. And for us, that's the secret sauce of what we do strategically is when you have this recurring revenue, you can build models that you can rely on for predictable cashflow for years to come. And that tends to result in favorable outcomes for investors over time.

Jodi Phillips:

You've described a pretty wide range of companies. Are there any themes, commonalities that are emerging lately from all those different types of businesses that you're interested? I mean, tech, innovation. Our last episode of this podcast focused on artificial intelligence (AI), which is on the Mount Rushmore now. So are there themes that are kind of gathering from all of these different types of companies that you're looking at?

David Nadel:

Yeah. So Jodi, I would say definitely there are themes that emerge. I mean, I guess the one caveat I'd give is the themes are the result of a bottoms up process, as opposed to being us as a PM (portfolio manager) group saying, "AI is hot. We've got to get exposure to as much AI as possible," that's not how we invest. We want to invest in companies that meet the financial characteristics that are going to result in compounding and more predictable, lower volatility returns for investors. But that having been said, we're happy to invest with companies that are closer to the action on some of these mega themes that are happening in the marketplace, like AI, for example. One way that we benefit from that is through IT consulting companies. So IT consulting companies are kind of an agnostic play on these mega themes. And you never know where an individual mega theme will go. I mean, we all remember disk drives. Do we? I don't know. Maybe not anymore.

Brian Levitt:

Vaguely.

David Nadel:

There have been so many mega trends in technology that people got extremely excited about and send valuations into the stratosphere, and then literally three years later, no one's talking about them. But IT consulting companies are going to be there to advise on those issues in a much more comprehensive way, and benefit regardless of whether the technology is long-lasting, medium cycle, or extremely short cycle and just dies a quick death. So I'm not making a prediction on AI that it's not going to disappear over the next couple months. That's not what I'm saying. I'm saying that we like to align ourselves with businesses that take a more agnostic approach.

And let's see, I mean, other themes I would say value-added distributors are a big part of our portfolio, so these are companies that are involved in the distribution of highly sophisticated products, where they have very close customer relationship with corporate customers, very technical products, so distributors that are not subject to, let's say an Amazon effect at all because this is stuff that requires a lot of consultation and a lot of implementation. So value-added distributors are a theme. Businesses, and those are businesses which have tremendous pricing power, great in an inflationary environment. They can immediately pass through inflationary increases to their cost structure onto the customers.

I'd say medical devices are a theme that we come back to repeatedly. I mentioned the company that created the cochlear implant. But there's many medical device companies that we own. In the SMID cap space, medical device companies are a natural fit because they will often have a very large portion of recurring revenue from some sort of backend service. And other areas of health care are less of a fit for us, like pharmaceuticals, because those are typically companies where they'll have one productive drug and then a pipeline. That's too risky for us. Right? We like more certainty. So medical device I'd say is another theme that is recurring in our portfolio.

Brian Levitt:

Okay, so I can listen to you talk all day about bottom up and themes and I'll eat it all up. But for the investors who are listening, who have now dealt with the decade of under-performance of international investing or concerns about geopolitical risks, or regional hot spots outside of the United States that are now sitting here looking at valuations more attractive, you talking about all these really interesting ideas. How do you get them over the hump to think about international? Are there certain catalysts that you would look for as an investor, where you would say this is the type of environment that starts to favor non US dollar assets?

David Nadel:

Yeah. It's hard to identify catalysts with certainty for sure. And we can almost say with some confidence that whatever it is will not be what people predicted. But I think an obvious area that people should be tracking and what will likely be a catalyst is just reversion to the mean with currency because the dollar ... Currency is always a mean reverting phenomenon. And the dollar has reached these points of incredible strength before, only to return to that mean. You saw this in the '80s with Paul Volcker's supercharging of interest rates and then they agreed we can't have a dollar that's strong, and suddenly, it's back to 80 on the DXY (US Dollar Index), the dollar benchmark …

Brian Levitt:

It usually is about the Fed.

David Nadel:

It is usually about the Fed. I think by many measures, we're about 15% to 20% overvalued where we are now on the DXY. And I think a lot of people will recognize that. It's just a question of when you look at long-term charts, that's certainly what's implied. And you're seeing rates higher from a lot of regimes around the world, a lot of other currency, so the US is not the only place where yield is possible in terms of the currency. So I think that's one catalyst.

I also think international SMID cap companies have historically been much more profitable than US SMID cap companies, much higher margins, higher internal rates of return, and by the way, stronger balance sheets too. But they haven't had the level of margin expansion since the global economic crisis that US stocks have had, so I think there is also, we see it in our holdings, the potential for incremental margin expansion. Again, these are already more profitable, but they have scope to get even more profitable with higher margins and higher returns, so that could be a catalyst.

I think on the geopolitical stage, seeing how some of these economies integrate and manage immigration is going to be an important catalyst. I am personally optimistic about Europe's absorption of immigrants and that tends to be a catalyst for growth and innovation. When countries like Sweden, which are a fraction of our size, are taking more immigrants on an absolute basis by a factor, by a multiple than the US is, from certain countries, you're going to get an impact. And in the short-term, that can be a little volatile or a little rough, and there's cultural chafing and sometimes things that are even worse than that. But over the long-term, you're getting a whole new base of more motivated workers and people that are going to innovate. And I think Europe's already been through a lot of the tougher period of the immigration boom. And I don't think that's going to end because global warming means more immigration. It's just going to continue. This is going to be a secular issue, and by that way, an important issue for the US to figure out as well. I'm not sure we're doing a great job with that yet.

But a lot of these countries in Europe, where we're heavily invested at least in terms of the headquarters for countries, a lot of them are in Europe, about 60% of the portfolio. I think they are going to benefit from that less expensive labor force and hungrier labor force.

Jodi Phillips:

All right. Well, Brian, it looks like our time is winding down. And since we promised we wouldn't ask any bitcoin questions, I guess we can't go there. So is there anything else, Brian, that you have on your list while we have David here?

Brian Levitt:

My last question would be, so you had talked about the exposure to Europe. Where else is the exposure in your portfolio? Do you ever think specifically about the country? It sounds like it's always from the bottom up. And do you have exposure to emerging markets?

David Nadel:

Yes. So the bottom line is we are companies, not countries, in terms of how we invest, so it is very much the bottom up. The way I'd like people to think about our approach and the way I think about it is really more in terms of revenue exposure than…

Brian Levitt:

Geographic.

David Nadel:

… than the exposure of the listing of the company, the stock exchange it's listed on, or where the headquarters are. Again, we're invested in so many of these world leading businesses, either global number ones, or let's say global number two, but they're multinational businesses. If you're providing a mission-critical service, everyone in the world wants to work with you, and that means emerging market companies want to be your customer as well, so that's how our companies interact with the world. So from a perspective of kind of cumulative revenue in the portfolio, we probably have about 30% exposure roughly to the emerging markets, so quite substantial, and that again is what matters.

If you look at the portfolio from the perspective of headquarter, we probably only have about 7% emerging markets. But this is very deliberate because we rather, all other things being equal, we rather get the world-class corporate governance that you're going to get investing in a European company, particularly north of the Alps in Europe, global number one, those types of corporate governance standards selling to China rather than investing in a local player in China where corporate governance on average is much lower. That's just an objective assessment, that's not a controversial statement. And so that's kind of how we go about it, we'd rather ...

For a market like Russia, for example, we much rather invest in a Finnish company that sells to Russia than invest in a Russian equity. Why? Because Finnish corporate governance standards are completely different. The Finns have been trading with the Russians for hundreds of years. They know them a lot better than we do. But I don't really want to get exposure to the Russian corporate governance and kind of the capricious approach to shareholders' rights, et cetera, et cetera. But we don't mind having exposure to the Russian consumer. So Finland, that's the answer.

Brian Levitt:

Right. Finland's the answer. Well, we could listen to you all day, but we'll let you get back to your regularly scheduled program.

David Nadel:

It's been a pleasure, Brian. Jodi, thank you.

Brian Levitt:

And thank you so much for joining us.

Jodi Phillips:

Thank you.

David Nadel:

Thank you.

Jodi Phillips:

So that brings us to the end of another Greater Possibilities Podcast, but the conversation doesn't stop here.

Brian Levitt:

It does not. Visit invesco.com/brianlevitt, to read my latest commentaries. And of course, you can follow me on LinkedIn and on Twitter at Brian Levitt.

Jodi Phillips:

And if you missed any of that, that information is on our podcast page. Thanks for listening.

 

 

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Transcript

Brian Levitt

Welcome to the Greater Possibilities podcast from Invesco, where we put concerns into context, the opportunities into focus. 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 to the Greater Possibilities audience.

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 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.

Jodi Phillips

So that brings us to the end of another Greater Possibilities podcast, but the conversation doesn't stop here.

Brian Levitt

Yeah. Visit invesco.com/brianlevitt to read my latest commentaries. You can follow me on LinkedIn and on Twitter @BrianLevitt.

Jodi Phillips

And if you missed any of that, that information is on our podcast page. Thanks for listening.

 

Important Information

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The opinions expressed are those of the speakers, are based on current market conditions as of July 25, 2023, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

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