Greater Possibilities

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 today we have Matt Brill joining the podcast. Matt's a senior portfolio manager for Invesco Fixed Income, so we'll be covering all things bonds, especially where Matt sees opportunities for investors.

Brian Levitt:

And bonds have become very exciting.

Jodi Phillips:

Very exciting. Do you think too exciting?

Brian Levitt:

I guess investors have seen their share of rate volatility. They would probably prefer it to not be as exciting, but such is the world that we live in, we'll see what Matt thinks about it.

Jodi Phillips:

Such is the world. What do you make of it?

Brian Levitt:

Yeah, it's a little bit of a market trying to figure out where growth is going to be and what the expectations for the Fed will be. So you get these periods where conditions look too hot and the ten-year rate moves up. And then for a bit over the summer, I think people thought it was too cold and we saw the ten-year rate go down to 3.5%. And I don't know, I guess now we're not too hot, we're not too cold, just right I guess and the ten-year is sitting around 4% or so.

Jodi Phillips:

Not too hot, not too cold. I do have to say, as an aside, it's pretty remarkable to me that a 200-year-old fairy tale about talking bears and lukewarm porridge has worked its way into our vocabulary to this extent when we're having these market conversations.

Brian Levitt:

Yeah, Goldilocks with the porridge, the sitting in the chair, the line. I've always-

Jodi Phillips:

4% yields.

Brian Levitt:

Yeah, everyone keeps talking about Goldilocks. I actually have no idea how that story ends. Is it a happy ending? Is it-

Jodi Phillips:

No.

Brian Levitt:

No. Everyone says Goldilocks. Shouldn't we know how the story ends?

Jodi Phillips:

Look, I mean, it's been a while. I think she escaped unscathed. I don't know. In my mind that's how it ends.

Brian Levitt:

Anyway, I don't even know what she was doing there in the first place. I mean, she's trying the porridge and beds of bears.

Jodi Phillips:

Okay. Okay. We're done. We're done. I'm stopping this no more. No more.

Brian Levitt:

I mean, shouldn't you be respectful of people's property? What's she doing there?

Jodi Phillips:

Well... All right, look, so you were talking about 4% yields if I recall correctly and those have not been a fairy tale for investors. There's been multiple opportunities to get yields at that level, right?

Brian Levitt:

Yeah. It seems like every time we think investors have the chance to "lock in" a 4% yield, we return, not that there's anything magical about 4%, but it seems like people want four.

Jodi Phillips:

And five years ago, everyone was wondering how they got there, how they could get four.

Brian Levitt:

Right. 2019, how can I get 4%? I mean, I was just hearing it over and over again, and that was just from my father, but I used to have to say to him, back then you would have to lend money to the Russian government. And I guess you don't have to do that anymore.

Jodi Phillips:

Well, on certain days you've been able to get it in US Treasuries. So a different time it sounds like.

Brian Levitt:

Yeah, and I'm trying to remember actually if that Russian government comment is mine or if I stole it from Matt Brill. So I steal a lot of my comments and I'm sitting here thinking, well, we're about to bring Matt on. And I might've actually stolen the Russian government comment from him.

Jodi Phillips:

All right. Didn't you just say you have to be respectful of people's property? You clearly didn't read Goldilocks, did you?

Brian Levitt:

Well, we share in this industry.

Jodi Phillips:

No, back to you. You need to do your homework. Look, here's your chance to return credit where credit is due. We're going to bring on Matt. Matt Brill, thank you for joining us. Did Brian just steal from you? Yes or no?

Matt Brill:

Brian's allowed to use anything that promotes fixed income. So wherever you got it from, I don't really care.

Brian Levitt:

Yeah.

Jodi Phillips:

All right. Good.

Brian Levitt:

What's yours is mine. What's mine is yours. Correct? Matt, have you been surprised by the resilience of the US economy?

Matt Brill:

Well, we have been. I mean, to be honest, we did expect a soft landing, but just the continued notion that there might be no landing at all has been a surprise. And what goes up must eventually come down. So we do believe that you will have a soft landing. In many ways we actually feel like you've already gotten it. To be honest, I feel like we've gotten a pretty good result so far and the economy is plugging along really, really well.

Brian Levitt:

So when you say we've already got it, you mean different parts of the economy have already slowed and maybe seem like they're picking up a little bit again?

Matt Brill:

Yeah, so there's really no end date, right? So it's always we never know when the end to any of these things are, but for now, if you look around, what's happened is inflation is materially less than it was. So whether it's completely in check is still debatable, but overall, we're not looking at 8%, 9% inflation like we saw back in 2022. You're around 2.5% to 3%, which isn't where the Fed wants it to be, but it's pretty darn close. Growth is pretty good. The Fed is not in a panic mode at all right now. So I'd say that you've gotten a lot of middle-of-the-fairway, middle-of-the-runway type activity, which is exactly what the Fed wanted.

Brian Levitt:

A golf analogy Jodi instead of a 200-year-old fairy tale analogy.

Jodi Phillips:

I'm on better territory with the fairy tales. I'm going to let golf go by, but I'm glad to hear the Fed's not in panic mode. We don't want anyone to be in panic mode. But what do you expect the Fed to do over the next year?

Matt Brill:

Yeah, so the way that we're describing the Fed is that they are cutting because they can — not because they have to. And so what we mean by that is they can because inflation has come down, they can because there are signs the economy is slowing, but they don't have to, meaning that they're not behind the curve and they're not in this panic mode that I just discussed. So overall, the economy is still good, they're ahead of the curve and they're cutting because they're very far from neutral.

And so we can debate all day what neutral is, but I don't think any of us think neutral is five and a quarter to five and a half, which is where they just were. So they needed to get away from a very restrictive policy closer to neutral. And in order to do that, our expectation is they'll cut in the November meeting, they'll cut again in December meeting just 25, though not in the big 50 that they did just last time. So 25, 25. And then next year they will do every other meeting 25 basis points. So that gets you about 150 basis points lower than you are today, which is in the low threes.

Brian Levitt:

And the low threes... Go ahead Jodi.

Jodi Phillips:

I was going to say, you said we could debate the neutral rate all day. We don't exactly have that kind of time, but I mean, what would be some of the points that would be underpinning that debate?

Matt Brill:

So go back pre-COVID back when Brian was trying to get 4% in any which way he could, or his dad was actually...

Brian Levitt:

Russian government.

Matt Brill:

And lending to whatever EM or high yield company or country that could get you that when Fed funds was low. And if you recall, the Fed was hiking rates all through 2018 and then actually started to pivot in 2019 before COVID and they got to 2.25% in late 2018. That was their high point of Fed funds rate. And 2.25% was too restrictive for the economy. World has changed since then, but just put in perspective that was 2.25% and that was greater than neutral. That was restrictive. So how much have things changed since 2018, 2019? Well, quite a bit in terms of some of the things around tariffs, some of the things around de-globalization. There are some other strengths in the labor market that weren't there before. But overall, I think that there is an argument that maybe it's 3% or less, but to be conservative we would call it 3.5%. So just as kind of a high level, conservative — meaning higher than it could be — would be 3.5%, which we're still very, very far from.

Brian Levitt:

I get the sense that each time the rates move up and we have seen some days where rates have moved up quite a bit, I feel like I hear from investors saying this is the return of inflation where when I'm looking at it seems to me a bond market that's responding to pretty good real economic activity whether it's a payrolls number or a US retail sales number. So when you see those types of moves, do you have concern that it's inflation or are you comforted by the fact that it's growth and how do you know?

Matt Brill:

Well, they are often intertwined, inflation and growth, but you can have growth without inflation and we did for a number of years, but if you get too much growth, then inflation often kicks in. So anything in growth, two to 3% real growth can be okay, but you start getting above that, you're going to drag inflation with it generally. But overall, we would encourage... the market in general is going to be much better if there's growth than if there's not at all. So the worst combination is no growth and inflation.

So I think people can live with growth and 3% inflation. Now again, that's higher than the Fed wants, but it's not a particular situation that people were fearful of back in 2022, which was stagflation, and they were thinking, "Oh God, we can't get inflation under control and there's actually going to be a recession. This is the worst combo." So for us as credit investors, we don't just buy treasuries, but credit investors, it's better for corporations if there's growth and they can actually inflate their way out of a lot of their debt. But overall, we think that the economy is slowing in both in terms of inflation, we're calling it a disinflationary environment, not a deflationary environment, but a disinflationary environment, which basically means inflation is still happening, but at a lesser extent and your growth is still positive. Atlanta GDP Now is still around 3%. So again, as you stated earlier, this economy continues to be way more resilient than anybody thought, but I am not seeing inflationary trends pick up. It's just not slowing as fast as the Fed wants it to.

Jodi Phillips:

Excellent. Well, I definitely want to talk about some of the particular opportunities that you're seeing. Brian, should we dive into that or is there anything else we want to establish higher level first?

Brian Levitt:

No, I want to dive in. I mean, investors want to know if growth is too strong and the Fed isn't going to lower rates. Should I just hide out in cash?

Matt Brill:

Well, cash has been a great place to be for a lot of this, but I think if you look at where we are now, I think the journal had an article recently just that money market funds are now... the 5% money market funds are no longer there. So you're in the high fours but still pretty attractive on a historical basis and still have generally an inverted yield curve of at least overnight rates versus out the curve. So cash looks better on an all-in yield basis, but the question is are you renting it and how long are you going to be able to get it for? So reinvestment risk we do think is real. I think what people will be surprised to know is that if you look back over the last year, fixed income returns are in the double digits. So everybody was waiting for the Fed to cut before they enter the market, but yet you've just had 10%+ type returns in the ag as well as corporate credit markets.

So a lot of it has already started to happen and it's kind of the market running ahead of expectations or running ahead of the actual reality of the Fed cutting. So I think the Fed is going to be on a path to cutting and whether or not they're going super fast or just kind of snail pace, the high point I'm pretty sure has already been hit. So the numbers that you got, 5%+ are gone. Are you going to stop at 2%, 3% or 4%? We don't know. But I think along the way you are served to start stepping out the curve, again, if you like this 4% for back all these years, we were looking to get 4% for so long, we've been saying if you like it for six weeks, you ought to like it for six years.

Brian Levitt:

I thought that was my line.

Brian Levitt:

I thought that... So I'm not sure which one. I probably stole that line from you. I've been using it all year as well.

Matt Brill:

Good lines are to be shared.

Brian Levitt:

Jodi, did you see how happy Matt looked when he was talking about double digit bond returns?

Jodi Phillips:

I did. Well, let's go around to some more specific sectors. Let's start with investment grade credit, kind of your opinion of the fundamentals there at the moment and any potential concerns you might see.

Matt Brill:

Yeah, so if you look at yields and investment grade credit, they still look very attractive. But if you look at what we call spreads or the additional compensation you get over treasuries or risk-free securities, they're on the lower end, which means that there is not a lot of fear out there right now. The market is believing that the fundamentals are good and the technicals are extremely strong. So you've got yields of corporate credit, investment grade credit above 5%, right around 5%, but going to call it slightly above 5%. Supply is light, so companies have not been issuing a lot of debt. We're not seeing a ton of M&A activity yet, and corporations are not levering up their balance sheets to take advantage of these lower rates that they have now versus a year ago because they're still relatively punitive and earnings are way better than expectations. So we've been seeing kind of a, I was going to say it, the Goldilocks environment for investment credit.

Brian Levitt:

Right down the fairway-

Matt Brill:

The supply is light and the demand is incredibly strong. So demand is coming domestically from institutional investors, it's coming internationally from Asian as well as European investors. And then the new entrant to the party is the retail investor. So the retail investor has generally sat it out in cash and we and others are finally convincing them maybe step out the curve and we're starting to see retail inflow, which is overall very supportive. And as long as you don't have fundamental issues, we continue to believe this will do very well.

Brian Levitt:

They're finally listening to you. Matt, is it-

Matt Brill:

We've tried.

Brian Levitt:

Is it possible? I mean when we think about spreads, there's two sides of that. Is it possible that just... it means the risk-free rate is too high?

Matt Brill:

Well, the risk-free rate of the US, you could argue that the US balance sheet is maybe not as good as something like Apple, but at the end of the day we don't make that argument. But the risk-free rate in the US is elevated on concerns of maybe not getting this inflation under control. It's also elevated because of budget deficits. And so corporations are issuing less debt. However, countries are issuing more debt. So the technicals are less positive in the risk-free rate or the government rates, treasuries basically rather than corporate. So that's why we prefer corporate credit and other asset classes, but we prefer high yield investment grade as well as emerging market corporate debt over sovereign treasury debt right now because the technicals are that much better and the overall fundamentals we think are better just because these corporations have done a better job with their balance sheets than the governments have.

Jodi Phillips:

Let's talk a little bit more about high yield you just mentioned. Your thoughts on that at the moment, in your opinion, is it worth the risk?

Matt Brill:

If you have an unlocking of potential growth in the US potentially through what Trump is describing his policy as, that would generally be good for high yield. However, we'll get to the politics later, but in any environment where growth is doing well, high yield is fine. High yield doesn't do well when you enter recession. So if you can eliminate the tail risk of a recession, which I think the Fed has done by telling you that they have your back and there's basically a Fed put there, I like high yield and actually you're seeing a significant amount of upgrades relative to downgrades in high yield.

It's been in the range of anywhere from two to four times depending on what you look at, two upgrades to every downgrade and in some instances it's been as high as four upgrades to every downgrade into high yield versus high investment grade going into high yield, so into investment grade. So the wind is at your back from a upgrade standpoint, yields in high yield, you can easily get 6%+ in high quality, the highest quality double B rated high yield, but you could get 7% quite easily as well in high yield. So overall the yields are positive. And our base case is a very low tail risk for the economy of entering a recession. So a no landing or a soft landing are good for high yield and that's how we're skewing the portfolio.

Brian Levitt:

Let's keep moving around the world. I want to talk about emerging markets. I know that we can add emerging markets to a core plus portfolio. I think the thesis that most had gone with was that the Federal Reserve was going to lower rates, bringing the rate differential between the US and the rest of the world to a narrower place, which should weaken the dollar, which would be supportive for investors to go overseas, own the bonds, take advantage of the currency exposure. Has that story changed?

Matt Brill:

Well, it's certainly been delayed just by the resilience of the US economy. So if the Fed cut because they are behind the curve, or even if the Fed just cuts because inflation just drops off a cliff and growth is okay, generally that would be bad for the US dollar. If the Fed's cutting like crazy whether they have to or because they can, that would be bad for the US dollar. If the Fed has to stay a little bit more elevated or a slower pace just because the resiliency of the US economy, that's generally strong dollar and that's not always good for EM local currency, it could be actually okay for EM corporations though, because at the end of the day, if the US economy is doing well, you would expect the derivative to be foreign economies doing well also. So it can be a difference of FX and things like that.

But in terms of really bad things happening to EM, not likely to happen if the US economy is doing well. Really bad things happen to the EM economy if the US is in a recession and people in the US are not buying goods. So overall I think there's little tail risk in EM. However, what are the opportunities? China is a very difficult one just given the volatility people have seen there. The Chinese property companies had a lot of losses for US investors. They didn't have them for local investors, which is kind of interesting, but overall you see a lot of stimulus coming out China. So if that's done appropriately and effectively, China could be a real opportunity from an emerging market debt standpoint. The other area, you have to talk about oil if you're going to talk about EM because it's such a large... any EM in general is very bifurcated.

You can't just paint it with a broad brush, but EM cannot be discussed without talking about oil. And just a few weeks ago, there was a lot of discussion of whether the Saudis would go for market share rather than price within the oil markets. And if they were to do that, basically they're saying they're going to flood the market with oil and drive the oil prices down. If they do that, that's not great for any commodity-rich EM country because the Saudis can win that game at the end of the day. That's probably the biggest risk out there is what do they do with oil prices and do they try to, I don't want to say manipulate it, but just drive it and basically break away from OPEC in that regard.

Jodi Phillips:

Matt, are there any areas, sectors, places of opportunity that you're watching that we neglected to ask you about?

Matt Brill:

Yeah, so the two hot spots have been commercial real estate and retail. And commercial real estate we've actually seen a huge turnaround and CMBS has done quite well. There've been opportunities and office reach that we've taken advantage of. And when I say that people just fall out of their chair and say, "Oh my God, I can't believe you're buying anything in there." This has been going back a year. And if you look at some of these REIT stocks, which we don't own, but this is representative of the activity, a lot of the office REITs have done incredible. You see things like Amazon telling people to go back to work, there's a huge push for this and the high quality or the highest... the best buildings basically are being leased and there is activity there.

Anything else? No. So you got to pick your spots there, but I would say the fear that we saw a year ago, for several years really, but really a year ago it was really getting a lot of people concerned that it could even spill over to the banks. We're not seeing that. And in fact the banks this week, you saw the bank earnings and Morgan Stanley actually said, "We're going to reserve less for our commercial real estate loans than we had before, reserve less for the losses because we don't think these losses are going to come." And that's the first time we've seen anybody do that since COVID in any material size. So basically no one's declaring victory there, but I do think at the end of the day, the worst is probably behind you in course real estate, which creates opportunities. Again, these are small opportunities, these are not major themes in the portfolio, but I just think it's good.

If you have eliminate one tail risk after another, generally it's good for the overall markets and course real estate has a lower tail risk of the day before. And then the other one is retail. And I think everybody was so concerned that we were going to hit this recession. We've called it the most anticipated recession and most forecasted recession in history. That never happened. And we had retail sales this week and they were fantastic. And you keep being amazed by people going out and spending, but guess what? If they have a job, they're going to spend and if you don't believe the US is going to go into recession, you don't believe that the job losses are going to be material. And in fact, we're still generating 150 to 200,000 jobs a month, people are going to spend. So I actually think that's an undervalued area of the market and mainly because of fear that's been there for so long, but the valuations are a lot better there than they are in other portions of the market. So I think retail could be an interesting play from here.

Brian Levitt:

And I am the living anecdote of all of that. The commute from New Jersey to New York City, as I always say now up to about 80 minutes and about 20 minutes to get a rice bowl at lunch. So I am the living anecdote of all of this. Matt, thank you so much, so informative, so great to have you on the show. You've always been such a great guest to bring on and a friend to the Greater Possibilities Podcast. So thank you.

Matt Brill:

Thank you guys.

Jodi Phillips:

Great. All right, Brian, that wraps it up once more. Tell our listeners where they can get more insights from you.

Brian Levitt:

Yeah, please visit invesco.com/brianlevitt to read my latest commentaries. And of course you can follow me on LinkedIn and on X at Brian Levitt.

Jodi Phillips:

All right. 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 18, 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 content contain any forward looking statements, understand that 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 risk of loss.

Past performance is no guarantee of future results.

An investment cannot be made directly in an index.

All data provided by Invesco unless otherwise noted.

Statements on the movements of the 10-year US Treasury rate in 2024 sourced from Bloomberg. The 10-year US Treasury yield was 4% as of October 18, 2024.

Statements on the current and historical US inflation rate sourced from the US Bureau of Labor Statistics as of September 30, 2024. Based on the core Consumer Price Index year-over-year percent change.

Statements about the level of the neutral rate sourced from the US Federal Reserve as of October 18, 2024. Based on the US Federal Funds Rate.

Statements on the level of the GDPNow model sourced from the Federal Reserve Bank of Atlanta as of October 18, 2024.

GDPNow is a nowcasting model created by the Federal Reserve Bank of Atlanta that forecasts real gross domestic product (or GDP) growth.

Gross domestic product (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.

Statements on the yield of money markets sourced from Bloomberg as of October 18, 2024. Based on the Bloomberg 1-3 Month US Treasury Bill Index.

Statements on the level of fixed income returns over the past year sourced from Bloomberg as of September 30, 2024. Based on the 1-year return of the Bloomberg US Aggregate Bond Index and Bloomberg US Corporate Bond Index.

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

The Bloomberg US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes US dollar-denominated securities publicly issued by US and non-US industrial, utility, and financial issuers.

Statements about the yields of investment grade corporate credit and investment grade credit slightly above 5% sourced from Bloomberg as of October 18, 2024. Based on the yield to maturity of the Bloomberg US Corporate Bond Index.

Yield to maturity is the rate of return anticipated on a bond if it is held until the end of its lifetime.

Statements on the level of upgrades versus downgrades in the high yield market sourced from S&P Global as of September 30, 2024.

Statements about the level of yields for high yield bonds sourced from Bloomberg as of September 30, 2024. Based on the yields of bonds in the Bloomberg US High Yield Corporate Bond Index.

Statements on the returns of REIT stocks sourced from Bloomberg as of September 30, 2024. Based on the returns of the FTSE NAREIT All Equity REITS Index. REIT stands for real estate investment trust.

Statements on the number of jobs created in the US sourced from the US Bureau of Labor Statistics as of September 30, 2024.

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.

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.

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

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.

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

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

The Consumer Price Index (CPI), which measures change in consumer prices, is a commonly cited measure of inflation.

The ”Fed put” refers to the belief that, when the economy falters, the Federal Reserve will jump in to support it through monetary policy.

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

The neutral rate is the theoretical federal funds rate at which the stance of Federal Reserve monetary policy is neither accommodative nor restrictive.

The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.

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. 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.

Inflation is the rate at which the general price level for goods and services is increasing.

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

Deflation is a decrease in the price level of goods and services.

Disinflation, a slowing in the rate of price inflation, describes instances when the inflation rate has reduced marginally over the short term.

Tail risk generally refers to events that have a very small probability of occurring. In finance, it is when the possibility of an investment moving more than three standard deviations from the mean is greater than what is shown by a normal distribution.

OPEC+ refers to the members of the Organization of Petroleum Exporting Countries (OPEC) and other oil-exporting non-OPEC members.

Spread represents the difference between two values or asset returns.

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

M&A stands for mergers and acquisitions.

EM stands for emerging markets.

FX stands for foreign exchange and refers to the conversion of one currency into another.

CMBS stands for commercial mortgage-backed securities.

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 today, our guest is Andy Blocker, Invesco's Global Head of Public Policy. Andy's had a long career at the intersection of politics and business.

Brian Levitt:

Andy is here and we are recording this 24 days out from the election.

Jodi Phillips:

24, that's very precise. How many hours, Brian?

Brian Levitt:

Too many. I think I actually looked it up, I had a feeling you were going to ask me that. It's something like 14 hours as we're presenting it right now. I can't, obviously it doesn't make sense to give you a minute, so they're rolling as we speak.

Jodi Phillips:

Well, that's right. So this is our recording day. Of course, by the time the audience hears it, we'll be that much closer to the election, but, Brian-

Brian Levitt:

Mercifully.

Jodi Phillips:

It was about a year ago that you developed your presentation, People Care About Elections, Markets Don't. So, how many times have you given that presentation to investors since you came up with that?

Brian Levitt:

Oh, a lot. It's like an out-of-body experience at this point, but it's popular. People want to hear it for obvious reasons.

Jodi Phillips:

That's right.

Brian Levitt:

That was a good presentation title actually, Jodi, I think you were the one who suggested that.

Jodi Phillips:

I did, you remember.

Brian Levitt:

I do, I do.

Jodi Phillips:

Yeah. Well, look, honestly, it was time to freshen up your old headline. Hating the government is not an investment strategy, but we needed to freshen it up a little bit.

Brian Levitt:

I actually liked that one. I actually still say it occasionally.

Jodi Phillips:

Do you? Old time's sake, I guess.

Brian Levitt:

Was there something not PC about that or you just ready to move on?

Jodi Phillips:

No, not at all. We're just moving away from hating, I guess. But look, here's the important thing though, is when you're giving this presentation in front of crowds of investors, what are you hearing from them?

Brian Levitt:

Yeah, I mean, I hear a lot of things. I think a lot of people do appreciate the presentation, us saying that markets aren't going to care as much as you believe and giving a historical perspective for that. But I'm hearing everything from, the US is becoming a banana republic, to World War III is near. There's just a lot of concerns out there and I try to help people get over those concerns.

Jodi Phillips:

How? It sounds like you're talking to some pretty pessimistic groups. I'm glad you're doing that, but what's your tactic?

Brian Levitt:

Well, I mean I mostly listen and then I do try to just use facts to steer the conversation back to the right direction. I mean, for example, it's pretty hard to call the US a banana republic when you've got GDP where it is. You've got the unemployment rate historically low. You've got oil production historically high. The stock market at all time high. So it's fortunately, I think a lot of the data's on our side when we try to push back against these concerns.

Jodi Phillips:

So you're just bring in the facts. I keep thinking, Brian, about one specific fact that you had mentioned in late August. You tweeted that it had been 957 market days since Joe Biden won in 2020, and on that day, the S&P 500 was up 66%. And then you looked at the 957 market days after Trump won in 2016, and the S&P 500 was up 65%, so.

Brian Levitt:

Amazing, right?

Jodi Phillips:

It was, yeah.

Brian Levitt:

Amazing.

Jodi Phillips:

Very precise.

Brian Levitt:

I do love that chart and it couldn't have worked out any better for the point that I'm always making. And yeah, it's not quite as good as it was at 957 days when they were exactly the same. Right now Biden's is 71, Trump's is mid-60s. Not that I'm trying to say one is better for the other, better than the other for markets. Just to say that people were so worried about it and they basically got to the exact same point.

Jodi Phillips:

Yeah, absolutely. So, so much for Trump's claim that the markets would go to zero if Biden won.

Brian Levitt:

Right, you remember that? Yeah.

Jodi Phillips:

I do.

Brian Levitt:

401k will go to 0, and not to make this too one-sided, I think Hillary Clinton said that we would all go bankrupt if Trump won. He would treat the economy like one of his casinos, so that didn't work out well either.

Jodi Phillips:

No, they were both equally wrong. But I guess hyperbole gets people to the polls, right?

Brian Levitt:

It does.

Jodi Phillips:

Or does it? I don't know. Maybe it drives them away, but that's why Andy's here to help explain all of this to us. So, let's bring Andy on to discuss the race and the issues that are on investors' minds. So welcome, Andy.

Brian Levitt:

Andy Blocker.

Andy Blocker:

How's it going guys?

Brian Levitt:

How are you?

Andy Blocker:

I'm great. I could just sit here and listen to you guys all day. I mean, I don't think-

Brian Levitt:

Well, that's nice of you.

Andy Blocker:

... I could add much to this conversation.

Jodi Phillips:

All you have to do is subscribe to the Greater Possibilities podcast and you can do just that.

Look, so Andy, we want to focus on the issues of course, but I have to ask the obligatory horse race question. So, is this race as close as it looks?

Andy Blocker:

Well, being in Washington, you know my answer. So the answer's clear, it's yes and no. I mean, so on one level it is.

Brian Levitt:

Yes and no, oh.

Andy Blocker:

Yes and no.

Jodi Phillips:

Settled it.

Andy Blocker:

I mean I have to hedge myself, I have to hedge myself.

Brian Levitt:

Crystal clear, crystal clear.

Andy Blocker:

So look, I think... Exactly. We're the government, we're here to help, right?

So look, I think it is, it's historically one of the closest races we've seen according to polling. I mean, usually at some point in the election, at least one candidate's up five percentage points or more, and that hasn't happened at all. And not only is it not widened out to five point lead, it's neck and neck, not just nationally, it's neck and neck in all these swing states. You do the RealClearPolitics average is like one point or less than one point, or it's tied. And I'm doing my map, which kind of changes, based on, I use RealClearPolitics as okay, if you look to seven states today and RealClearPolitics is right, where is it going to be? And two weeks ago, Kamala was winning because she won Pennsylvania. Last week, Trump was winning because he won Pennsylvania, and this week Pennsylvania's a tie, so.

Brian Levitt:

So then why do you say yes or no?

Andy Blocker:

Well, I say yeah, so it's both yes and no. So I think the no part is, that's if you trust the polls, right?

Brian Levitt:

Right, right.

Andy Blocker:

So they've under-counted Trump multiple times, '16 and '20, and polls recently have under-counted Democratic turnout after Roe v. Wade. So I think-

Brian Levitt:

Yeah, 2022.

Andy Blocker:

Yeah, and the question is, have they adjusted and accounted more for Trump or are they still under-counting him? And then what's this abortion effect going to be?

So, and the other thing is, look, I don't think there are really that many, if any, truly undecideds. I think there's some people who haven't decided but are leaning strongly and just waiting for something to happen or something that's going to give them something to move one way or the other. But I think, and a lot of people think, that this election in the last two weeks is going to turn one way or the other. It may not show in the state by state winning by 100,000 or 200,000 votes. It might still be by 10 or 20, that's all it takes. But I think these seven swing states, I think six of seven of them are going to turn one way or the other. And so while-

Brian Levitt:

Oh, wow.

Andy Blocker:

... it may be close, while it may be close, electorally, I think there's going to be a trend happening.

Brian Levitt:

Was that you who made that big bet on Polymarket that drove Trump's odds to like 58% from 46%? Were you the one that put the billion dollars into that market or that wasn't you?

Andy Blocker:

I am not a betting man.

Brian Levitt:

Okay, okay.

Andy Blocker:

And if I were, I would be a lot poorer.

Brian Levitt:

So Andy, if we think about the most likely outcomes, do you consider the House of Representatives a fait accompli for the Dems, and the Senate a fait accompli for the Republicans? And does that mean either way, whether it's Trump or Harris, we end up with a divided government?

Andy Blocker:

So I don't think it's a fait accompli, but I think that's the prevailing wisdom, is that based on the numbers that the House will go Democratic, mostly. There's a lot of different factors, a lot of redistricting, a lot of different things. But it basically comes down to, there's more seats that the Republicans are trying to hold onto that Biden won in 2020-

Brian Levitt:

Got it.

Andy Blocker:

... than there are seats that Democrats are defending that the Trump won in 2020. So, I think it all comes back to that there's redistricting in New York, California, and Alabama, all this, North Carolina. But, so that's the base case but I think in the House, the presidential election really, really impacts who wins the House. So if Trump wins the presidency, I think he could pull the House with him. And if Kamala-

Brian Levitt:

Oh, a clean sweep.

Andy Blocker:

Yeah, yeah. So the two scenarios. The two major scenarios are, Trump sweep or Kamala divided government with the House and not the Senate, because the Senate seemed really hard for the Democrats to keep right now.

Brian Levitt:

With Joe Manchin retiring, Jon Tester in Montana.

Andy Blocker:

Exactly. Now look, all these things, just like with this House, it could turn based on whether or not Trump wins and pulling the House with him. I mean, there's this slow moving feeling, or maybe it's hopeful feeling among Democrats that they can do something in Texas or Florida. So, but then on the other side, there's some of the latest polling show that maybe a few state seats you thought were safe, maybe Wisconsin or others, may not be as safe as you thought for the Democrats. So look, this can move either way here, but I think two weeks out, talk to me then and I'll actually tell you what I think will happen. But then when we're two weeks out, you're going to ask me, I'll say, "Well, give me another week."

Brian Levitt:

So we're still not putting our money on Polymarket?

Andy Blocker:

No, not at all.

Brian Levitt:

We'll leave that to Elon Musk or whoever else just drove that market.

Andy Blocker:

Exactly.

Jodi Phillips:

Well Andy, we'll bring you back in January so we can talk about 2028, because you know how we like to do this.

Brian Levitt:

Oh, God, oh my.

Jodi Phillips:

Get the early view.

Brian Levitt:

Please, no.

Jodi Phillips:

Andy, we established at the top that the investors Brian's been talking to lately seem to maybe have a little bit of a pessimistic view of things. What do you hear from clients? I know you do a ton of traveling across the US, across the world. What are you hearing as being the most important issue that people are really focused on?

Andy Blocker:

So it's a combination. So when I'm talking to clients, I'm usually talking to either institutional or retail clients, depends on where in the world they're from. So if I'm talking to retail US clients, I think it's the economy, it's... And what I mean by that, it's like taxes, tax policy, and who's going to be better for the economy. That's the number one thing people are... And they obviously want to know, yes, they do know, okay, they do listen to Brian and they're usually well schooled by the time I get to them that people may care about the elections but markets don't. so on the macro basis, yes, stay invested, but it's not about whether you're invested, it's about where you're invested. So they want to kind of know different industries, what's going on.

Internationally, they want to know geopolitics, and tariffs, and foreign policy. Realignment of allies, if it's Trump versus what Kamala might do, vis-a-vis, strengthening our current alliances. So those are it. And then just population generally, the top issues are economy, or should I say affordability, immigration, abortion, democracy. Those are the top four when you talk on the general population side.

Brian Levitt:

Andy, I remember, so you bring up taxes. I remember, I think it was around 2010, the big concern was the fiscal cliff that the Bush era tax cuts were not going to be extended, we were going to go over a fiscal cliff. There was a lot of fear about it. And if I remember correctly, the Obama Administration extended it and then extended the Bush era tax cuts, and then I believe in the American Taxpayer Relief Act, something like 82% ended up being extended. Do you think Kamala Harris, if she were to win the election, would be of a similar mind to what the Obama Administration was in the early 2010s? And does Congress have anything to do with it, or does the expiration just come down to what the President decides?

Andy Blocker:

So the baseline is just, I know you asked about Kamala, but for Trump, he's going to extend to all the tax cuts and he's going to try to get the corporate tax cut, which is permanent at 21% down to 15, so that's what he'll do. Kamala has already said that she wants to extend all the tax cuts for individuals if you make under $400,000, but she wants to let them snap back to the higher rates for those who make over $400,000. And for corporations, she wants it to go from 21% to 28%. So she's already said that.

Now, can she do that? I mean, I think reality shows, if I just go to the corporate tax cut, tax rate, most studies show that 25% is the actual optimal rate for actually bringing in income without hurting businesses. So I think if you actually, if she had all of Congress, which is not our base case, if she had House and Senate, there'd be some Democratic Senators who'd be like, "Okay, 25% is enough. Okay, we're not trying to go all the way back up to 28%." And I think they'll either do some, keep some of the tax cut for the wealthy or they'll do SALT (state and local tax deduction), bring SALT back, which is expensive. So there's all kinds of variations on that, but our base case is that she would have split government and that she'd have to negotiate with Republicans in the Senate.

So I think it's going to be closer, but somewhere between the $5 trillion of extending all of the tax cuts versus I think her is like $1 trillion. So somewhere between of the cost will be there, because she'd have to negotiate it out. She'll have a lot of leverage because if you do nothing, all tax cuts go up and so all the tax cuts revert. And so Republicans would want to deal with that, but then again, she won't have all the leverage because she doesn't want to raise taxes on those on the lower end, because she promised not to. So it'll be pretty brutal, hand-to-hand combat in those negotiations.

Jodi Phillips:

What about the cap gains tax, that unrealized cap gains tax on the ultra wealthy? I think it's like, what, over $100 million in assets? Is what Harris is talking about something that could happen, given hand-to-hand combat, or is it more of a political talking point?

Brian Levitt:

And let's be clear, that Jodi's asking specifically for the Phillips family because of their $100 million in assets.

Jodi Phillips:

I'm very concerned. Yes, yes, $100 million.

Brian Levitt:

You're asking for a friend, Jodi?

Jodi Phillips:

Yeah, well, once I got to 101, I started really caring about this.

Andy Blocker:

Well, no, I mean, look, this is important I think. Well, for all the tax cut proposals or tax increased proposals is important. So one of the themes I've had, just like Brian has this theme about people care about elections, markets don't. My big thing is, politics trumps policy. Right? And so you have to look at the politics of these things and from a standpoint of what's popular, what's not. Right? And so for that specifically, people, it's popular to raise taxes on the wealthy. Right? Because most people aren't wealthy. Now, they don't want you to kill them because everyone in America, good thing Americans, we all think, hey, we have a chance to be wealthy someday.

Brian Levitt:

It's coming, it's coming.

Andy Blocker:

So we don't want to really go after them, but.

Brian Levitt:

We will all be hanging out with the Phillips family soon.

Jodi Phillips:

Yes, yes.

Andy Blocker:

Yeah, yeah, and so I think on this specifically, this is a tough one. I think there's some issues with this. I think there's some constitutionality issues with it and there's some political issues with it. So, people are fine with everyone having to pay their fair share, but then how you do that may have issues. Because with this particular program you might have it where if it's unrealized cap gains, it's like, well, what if your cap gains are in the land you own and you not... How do you pay it? Right? There's lots of technicalities to deal with here, and so I don't really see that as something happening for a number of reasons. I don't think all the Democrats are behind that. And there's a practicality issue and there's a constitutionality issue, but it's out there and so it'll be discussed.

Brian Levitt:

Andy, I too get asked a lot of questions about tariffs. And I think back to my first day at university, and the professor in the class said every good economy needs to evolve. You shipped parts of things to other parts of the world, or you shipped other things that used to do at other parts of the world, countries that have comparative advantages, and that's how everybody gets wealthier. And so I've stuck to that theory or I've believed in that. And so when I answer questions about tariffs, it's really, if you're protecting industry or you're increasing the cost of bringing goods into the country, you're just going to get a less optimal economic outcome but it doesn't necessarily mean that you're derailing the economy or derailing the markets. I personally think clarity matters the most, right? Just let me know what the rules are. How do you like my answer and what have you been saying to people?

Andy Blocker:

No, I mean, I think that's as always, I mean, that's an intelligent answer. I think my big thing on tariffs is, yeah, these are choices, right? And so we may choose for national security reasons or for other reasons to say, "I want to protect XYZ industry," and you're saying, "I'm willing to have a higher cost in that industry because I want to be able to have it built at home or I want to save these jobs in this industry." Those are choices.

The interesting thing on tariffs and some of the proposals out there right now is, Trump did a... They actually tried to when they first, when they raised the tariffs on China, they were trying to raise tariffs on those that would have the least impact on the US. Right? But if you're coming and saying you're doing it across the board 60%, that's hard to do. Right? So the question is, do they say, "Okay, 60%, oh, but we're going to go in and try to parse it." It gets hard when you go to 60% and then you have the 10% across every country in the world, that gets hard too. So I think across the board tariffs, that's tough, but if you're targeted, you can actually get away with it.

Brian Levitt:

And do you think it will be targeted or you think that it'll be across the board?

Andy Blocker:

So, okay, I'll tell you how I think it will be targeted. It will be targeted vis-a-vis, country by country. So the countries that give Trump what he wants, they'll get a deal on the tariffs, right? Those who don't, they'll go in and I think with Lighthizer there, I think there will be some effort at targeting them, but it's kind of hard, right? So you have to... and that's going to, we'll see what Trump's thinking at that point, and that's the volatility moment.

Remember last time when he did it? Things kind of leveled off after about six months, once we figured out from the time of the proposal, but once a change he made, it created a lot of waves in the market as people were trying to figure things out. And I think that's what's going to happen here, except it's going to be whatever, every country in the world and those larger economies that impact us, right? Starting with China and then going to others. That's going to be the part, it's going to be the realignment and the rejiggering of our trade relations with other countries.

Jodi Phillips:

So Andy, when you were going through your list of topics that people ask you about earlier, I don't recall you mentioning specifically the Fed, the Federal Reserve, and maybe you did and I missed it, but I am definitely curious about whether the independence of the Fed is something to be concerned about or not.

Andy Blocker:

So I want to be careful with this one.

Brian Levitt:

No, it's the Greater Possibilities podcast. We're not careful here.

Andy Blocker:

You can have a lot of fun with this one, but look, I've met Jerome Powell and I think he's a credible person.

Brian Levitt:

Show off.

Andy Blocker:

No, I mean, no, no, I'm not showing off. I'm just saying, from what I've seen of him and having met him, I don't think he's ultimately totally swayed. Right?

So first of all, let's go to the Fed independence, the direct question. That would take an act of Congress to actually get rid of the current independence of the Fed. So that's number one. Number two, every president tries to influence the Fed. Doesn't matter how they do it, they'll just make statements like, "It'd be great if we had lower interest rates,” whatever. Trump is the most aggressive of that crew. Okay?

And so all I'll say is this, I believe that Powell has been data-driven, data-dependent, right? Whatever term you want to use, and I think it will continue to be that way. But as in baseball, we all know that tie goes to the runner. Going back to politics trumping policy, I don't think politics dictates Fed policy, but if you're telling me the data can go either way and you've got Trump breathing down your neck, you're not going to be influenced to go the direction Trump wants to go? So I mean, that's if it's truly a jump ball, as far as the data allowing you to go either way.

A lot of times the data's not there, the data supports going in one direction or the other, and I think the Fed will continue to make that case. But I think in that rare instance where there's flexibility and the Federal Reserve Board is split, I think those are instances where it could make an impact, but I think those are rare. I think most of the time there's usually consensus and because the data is saying one thing or the other and they go that direction. So I'm like, 1% of the time there won't be. It's still independence, it's that they're making an independent decision but if we're acting like they're not influenced by the world around them, I mean, I don't believe in that.

Brian Levitt:

And the key issue, of course, would be the bond market, right?

Andy Blocker:

Absolutely.

Brian Levitt:

Yeah, so as long as the bond market believes in the Fed independence, if it comes down to a jump ball or tie goes to the runner, whatever mixed metaphors we want to use here, as long as they're all sports related. Yeah, as long as the bond market feels comfortable with it.

So speaking of which, let's talk about the financial sector. What are you hearing as the most important issues or what are you focused on for asset management or the financial sector? Are there issues that are dependent on the outcome of this selection that could meaningfully impact the way we do business or the way our clients do business?

Andy Blocker:

That's a great question. So, how do I answer this? From a macro basis, I think Trump is much more deregulatory and there won't be this onslaught of new regulations from some of our primary regulators. So I think that would be true. Specific issues, I think, look, I mean, what are the areas that could impact our industry? I mean crypto, technology, all these impact how we may do business, how we have to adjust, what we have to offer our clients, what we have the ability to offer our clients. So in that respect, we're watching very closely.

The interesting thing is though, there isn't an intersection between the populist side of Trump-Vance, mostly Vance, and the potential Harris-Walz ticket, or at least some of the Democratic Party, about big being bad. Right? And so being anti-big corporations, being anti-merger, being all that stuff, so that's something to watch. I think every company's watching that. So, anyway.

Jodi Phillips:

So Andy, you mentioned geopolitics. I'll leave this kind of a broad question so we can address whatever geopolitical issue might be at the forefront your mind. But what are your thoughts when you get those kind of questions, how are you addressing them?

Andy Blocker:

So, we start off with politics trumping policy, right? And so let me go across the globe, let me start with China. Right? So what we've seen in China is that when Trump got into office in 2017, what, 47% of the American people had a negative view of China, when he left office, 76% had a negative view of China. Today it's 81% have a negative view of China.

Jodi Phillips:

Wow.

Andy Blocker:

So we knew going into 2020, no matter who's going to win that election, the politics would dictate you cannot be seen as soft on China. And what we've seen in the Biden Administration, I think even Trump mentioned in the debate against Harris said, "Look, you haven't even removed the tariffs I put in. You're complaining about them, but you haven't removed them." Yeah, there was no room to remove them. In fact, they've added targeted tariffs on specific industries, either to protect jobs or because they were national security issues.

So from that perspective, they may be different in their methods, like Trump being more volatile with Truth Social or tweeting something and being more bilateral, mano-a-mano taking on China, US, one-on-one. And where Biden or Harris would be more measured, predictable in their policies, and also being more multilateral working with allies. They're going in the same direction, and so there will be tension with China. The key is to keep the lines of communication open. Then there's the 60% tariff. You're going to have to deal with that. Day one, you're going to deal with that with Donald Trump. And that negotiation is going to be very important. A lot of Trump's folks have said the 60% is an opening bid. Okay, well, where do we end up on that? So that's China.

When you look, Russia, Ukraine, couple things there. Number one, NATO (North Atlantic Treaty Organization), we're not getting out of NATO. Okay? So you need a super majority of the Congress to get out of NATO, so that's not happening, so. However, and a lot of our allies and members of NATO, I think we started 2014, only three countries were meeting their 2% of GDP requirement for being members of NATO for defense spending. Now 23, this year. So they've made progress, and yeah, some of it's the rhetoric from Trump saying, "Hey, you're not paying your bills, you're delinquent. I'm not going to protect you." But some of it is Russia invading Ukraine, that nothing brings to mind like they're being a threat on your border. Okay?

So, and with respect to the main risks around Russia-Ukraine on the election, they're kind of in the same ballpark. I think we all agree at some point here, next year or the year after, we're going to have to work towards a negotiated settlement here. And the question is, is Ukraine negotiating from a position of strength with Kamala Harris fully backing them, or a position of weakness, where Trump has been pretty clear that he's not enthralled with this war? So that could impact. And there's also tail risk of, we can talk about that, but I don't want to spend time on that. What are the extreme options that could happen?

And then you go to the Middle East, how does that change? I mean, clearly Netanyahu prefers a Trump presidency. He feels like Trump would be much more behind him, being able to do the things he wants to do, whether it's with Hamas or Hezbollah or Iran. And then, but no policy has been articulated at all. All Trump has said is, "One, we need to fully support Israel, and if it were me, this wouldn't be a problem." So, what does that mean? We don't know. Right?

So there's a lot of different things geopolitically, from a trade perspective, from a foreign policy perspective. But I think the key is that with Trump, there will be volatility in the beginning, the normal change of administration. But then in addition to that, given all the different ways in which he would, not just with terrorists, but also with realigning our alliances across the globe, that realignment takes time and creates volatility.

Brian Levitt:

And yet Jodi, I come back to the point that economy is resilient and the Fed's lowering rates. So as long as, I mean, these geopolitical events are going to be with us. As long as those two things don't change, perhaps we still have a good backdrop for markets, even as investors worry themselves with those events.

Okay, so I just looked, we're 24 days, I think we're now 11 hours, 24 days, 11 hours away-

Jodi Phillips:

That's right, that's right.

Brian Levitt:

... from the election, so.

Jodi Phillips:

That's right. All right, Brian, I think we've asked everything we can at this point in time. It's just going to, we're all going to just see how this ends up.

Brian Levitt:

See what happens.

Jodi Phillips:

And get Andy back on as soon as possible afterwards to explain what to watch for when everything settles, so.

Brian Levitt:

And who's running in '28.

Jodi Phillips:

Oh yeah, that's the first question for sure.

Brian Levitt:

JD Vance vs. Tim Walz.

Jodi Phillips:

Yeah. Brian, while you were in economics class, I just took journalism classes, so all I know how to do is ask questions. So that's my role in all this, but Brian, where can our listeners find more commentary from you about the election or whatever else?

Brian Levitt:

Yeah, thanks for asking. Visit Invesco.com/BrianLevitt to read my latest commentaries. And of course you can always follow me on LinkedIn and on X at Brian Levitt.

Jodi Phillips:

Yes. And while you're on LinkedIn, be sure to follow Andy Blocker as well. And then you can get such resources as the new Investor's Guide to the Election that I saw featured on Andy's LinkedIn, as well as multiple, multiple media appearances where Andy gives the latest insights into what's going on in the world. So Andy, really appreciate you with everything you've got going on right now, making the time to come here and talk to us.

Andy Blocker:

Thanks, great to be with you.

Brian Levitt:

Thanks, Andy.

 

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 10, 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 content contain any forward looking statements, understand that 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.

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S&P 500 Index performance during Trump’s and Biden’s terms sourced from Bloomberg. Based on index performance over 957 and 989 trading days starting on Nov. 8, 2016, for Trump and Nov. 3, 2020, for Biden.

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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 is Justin Livengood. Justin is a Senior Portfolio Manager for the Mid Cap Growth strategy and a Senior Research Analyst for the Discovery and Capital Appreciation strategies with a focus on financials, real estate and health care.

Brian Levitt:

Yeah, thanks for the intro, Jodi. It's always good to have Justin on. I think our frequent listeners will remember, and I keep coming back to it, that Justin eased our concerns in 2023 during the week of Silicon Valley Bank failure, which I think was one of our more important episodes.

Jodi Phillips:

It was, absolutely. And earlier this year, Justin discussed his optimism about artificial intelligence (AI), which has obviously been a driver of market performance this year.

Brian Levitt:

I think you and I know the best people. I mean, I know the 45th president says it, but I think you and I know the best people.

Jodi Phillips:

Brian, no, we're not doing politics this week.

Brian Levitt:

Good, good. I think it's all anyone wants to talk about. So I am very good to take 20 to 30 minutes off from the political environment in the US.

Jodi Phillips:

For sure, and you may also be happy to know that we're also not talking about the unwind of the yen carry trade and a market correction on this podcast either.

Brian Levitt:

Yeah, we've come a long way since then. I know investors get upset every time these 5% to 10% downturns happen. They happen almost every year. People always seem to freak out. They're almost always the result of policy uncertainty, tend to abate when we get greater clarity, and this was the case as well this time.

Jodi Phillips:

Yes, they do. And this time it was the Bank of Japan that needed to clarify their policy stance instead of the Federal Reserve. But I did like the stat, I will mention this. I like the stat you included in your article when all of that was going on, your article about market corrections, just reminding investors that the US stock market has recovered within an average of three months after one of those 5% to 10% corrections.

Brian Levitt:

Yeah, maybe three months was too pessimistic, but these are averages, right? So we'll see what September looks like. September's not always a great month for stocks, but nonetheless, that three month number worked out pretty nicely.

Jodi Phillips:

Yes, it did. So yeah, great question, September, where do we go from here? So I revisited my notes of Justin's comments back in 2023, you mentioned that podcast. One comment I'd like to come back to today, I'll quote, "We are returning to a proper equilibrium in monetary policy that may help provide a stronger base for the economy and the stock market to operate from in the next two to three years." That what he said back in 2023.

Brian Levitt:

Yeah, great comment. And that was one and a half years ago, so does Justin still feel that way?

Jodi Phillips:

Absolutely. And what about this so-called great rotation. I mean, Justin is a small and mid cap manager after all, so he's a great person to ask about markets broadening out, including greater participation from small company stocks.

Brian Levitt:

He's also a growth manager across market capitalization. So where are we with the AI trade? How big can this be? And what other themes are exciting? I mean, I love talking to growth portfolio managers.

Jodi Phillips:

Yep. Well let's do it. Let's talk to him instead of about him. Let's bring him on right now. Hi, Justin.

Brian Levitt:

Hey, Justin.

Justin Livengood:

Hi, Jodi. Hi, Brian.

Brian Levitt:

So Justin, why don't we start with that quote that we brought up from 2023. Jodi and I take very good notes-

Jodi Phillips:

Thorough, very thorough.

Brian Levitt:

Copious notes.

Justin Livengood:

Do you?

Brian Levitt:

Yeah. So do we still have a strong base for the economy and the stock market to operate in the next, I don't know, can I still say two to three years or have we cut into that two to three year period?

Justin Livengood:

Yeah, no fair question. I think so. I feel a little better today, quite honestly than I did at the end of last year for two reasons.

First, we at least now are to the doorstep of the Fed easing regime. We'll see the exact magnitude, but a year ago, we still weren't sure if higher for longer was the reality, and now we can at least put that debate behind us.

The second thing that makes me a little more optimistic is that the economy has hung in better than I would've feared. There's definitely been some impact to the tighter monetary policy. We've seen some wobbly statistics. Clearly, the low end consumer, the middle income consumer even is feeling a little more strain, but it hasn't yet created a recession or pressure the economy even to get much below 2% GDP growth year to date. We overall have hung in a little better this year economically, both from the consumer, but particularly from the commercial industrial side than I might've predicted.

So I am optimistic going forward that maybe for the next couple of years, we'll go to the low end of that two to three year range, that the foundation for the stock market is pretty solid. To me, monetary policy is the most important thing. And so again, the fact the Fed is going to be cutting to some degree, my guess right now is at least 100 bps (basis points) over the next four meetings. Gives us a little bit of a tailwind.

The one thing that concerns me or that might change my answer the next time we're on this podcast would be inflation. So the fact inflation in the US has come down into the twos is a relief and it needs to stay there. If, for whatever reason, that starts to drift higher again, I do then worry the Fed slows or stops its easing campaign perhaps at some point next year and leaves the economy in a little bit more of a precarious position. I see no evidence of that right now, but I'm just saying, that would be the one scenario that I worry about and I'm hearing a lot of chatter about that from the buy side community. That is the one, if there is macro concern in stock market is, boy, it's great to see inflation get down to these levels, sure hope it stays here.

Brian Levitt:

Jodi, Justin mentioned that the economy was better than he would've feared. I feel like that's everything in my life. Everything ends up better than I would've feared.

Jodi Phillips:

You're taking the pessimistic approach, Brian.

Brian Levitt:

Well, I'm not-

Jodi Phillips:

You got to be more of an optimist.

Brian Levitt:

Well, that's the optimist's view, right? We worry about things, but things almost always end up better than we would've feared.

Jodi Phillips:

I suppose, I suppose. Well, in any case, we do have some good sound bites here that we can read back to Justin-

Brian Levitt:

A couple years from now.

Jodi Phillips:

... a year and a half from now.

Justin Livengood:

That's right.

Jodi Phillips:

But I'm curious, Justin, maybe what do you attribute that to? I mean, what perhaps were you expecting to see in the economy that didn't come to pass? What might be some of the driving forces behind that better-than-expected scenario?

Justin Livengood:

Yeah, I think that a handful of things have helped. First of all, even though as I said a minute ago, the low end consumer struggling, the broader consumer economy is doing pretty well. The stock market having held in there, the housing market having held in there, people actually have decent savings and that has propped up spending. Travel has been resilient. So some things like that have been pleasantly surprising.

On the commercial industrial side, there's been a lot of reshoring going on as companies have brought operations back from either China or perhaps parts of Europe. And so that's driven a little bit more of demand than maybe we would've expected to see a year ago. So again, I don't want to, by any means, give the sense that we're all clear, but the downside case that Brian correctly was referring to, and I take that glass half empty view as well on most things, fortunately hasn't played out yet. And I think with the Fed now ready to cut, the downside risk or that tail risk to the downside is smaller.

Brian Levitt:

When I think of the balance of risk though, it's interesting to hear you talk about inflation. I view inflation as something that we didn't have for decades and then a pandemic caused it, right? I think we all had too much money right at the exact moment businesses got rid of all their workers and all their stuff, right? I have a hard time envisioning that coming back. If I were to look at the balance of risk, it would be on the growth side. What would you need to see to have fear that there would be a recession coming? Is there anything that you're looking at that would give you that fear?

Justin Livengood:

Well, I think, yeah, on the demand side of the economy, if China's problems spilled a little bit more into the global economy and we had just less exports and a little bit more stress on the industrial side of the economy here domestically, that would concern me. That would cause some of the growth fears that you're referring to. I think if the problems the low end consumer is feeling as they are having to increasingly prioritize their spending, if that creeps up the economic spectrum a little bit more, it could get a little tricky. That's going to be very much dependent on employment. I think we need to see employment get a lot worse before that really becomes a major concern, but it could. So those are probably the two things that worry me the most, again, from the demand side. Assuming inflation stays behaved though, I think the Fed's going to pull this off. If I had to bet right now, I think China and the consumer are going to hang in there just long enough for them to get rates back down to a level that avoids these types of demand or growth issues.

Brian Levitt:

Are they lucky or are they good, this-

Justin Livengood:

I'm going to say a little both, right?

Brian Levitt:

All right, I like that answer.

Jodi Phillips:

It's a good combination.

Brian Levitt:

Just in case Jay Powell's listening.

Justin Livengood:

Yeah, I'm sure he will.

Jodi Phillips:

So Justin at the top, we mentioned the great rotation during our intro. Would love to get your views on that. What do smaller cap companies need in order to outperform and is that more dependent on the rate environment we've been talking about or the growth environment or, again, a combination of two things?

Justin Livengood:

Well, it's a combination, but in that order, so the rate cuts, the monetary policy is the most important thing. Small cap stocks are particularly sensitive to the yield curve given they're more dependent on financing than their large cap peers are. And just to put some numbers to that, in the last 13 periods where the Fed was cutting interest rates, going back over 50 some odd years, 10 of those 13 times, small caps outperformed large caps three and six months after the initial Fed cut. So if history's a guide, then what's about to happen here in September should, by the end of this year, demonstrate small cap outperformance as we move into 2025.

But that's not sufficient. It's a necessary first condition to have rates come down. But the second almost as important condition is you need to see earnings start to come through more for those small cap companies. And happily we've seen that here. In Q2, small cap earnings for the first time in over a year outperformed large cap earnings. Not dramatically, but that gap that had been present for a while where large caps were really doing better has finally started to turn a bit. So if that continues at least somewhat into the end of this year, beginning of next year, that earnings recovery should pick up the baton, if you will, from lower interest rates and help this broadening out that the market's seen for a while. I've been getting this question all summer and at first, the question was, "Can the markets broaden in small caps?" But now it's been like four or five months where small caps have at least maintained equal performance with large if not outperformed large caps. And so there's growing evidence that this has some legs to it.

The last thing I'll say on this rotation or this topic is 10, maybe even 15 years ago, small caps as a percent of the overall US stock market capitalization were about 10%. 10% of the market was the Russell 2000, 90-ish percent was everything above that. Today, small caps, the Russell 2000 represent only 4% of the market's capitalization, which means that when people want to go invest in small caps, the door's a lot smaller for everyone to jam through. And so you get a lot more volatility. And we saw that a little bit at periods this year where you would have, like earlier this summer, that big spike in small cap relative performance. It was in part just because there's not as much to buy.

So when traditional investors like me want to get more engaged, I'm always engaged. I'm not really the incremental buyer small caps, but when asset allocators, when quantitative trading strategies decide they want to move some money back to small cap, that has a much more pronounced impact on the market since it's a smaller slice. And so there's going to be more volatility. My point here is just be ready for it to be a little bumpier than normal.

Brian Levitt:

How did we get to 4%? Was that the result of just market moves or was that the result of more businesses staying private for longer?

Justin Livengood:

More the former. Mostly just the significant outperformance of the big, big stocks, the terra caps as Ron Zibelli likes to call them. That is-

Brian Levitt:

The terra caps.

Justin Livengood:

Yeah, yeah, that's his favorite word.

Brian Levitt:

I like it. Ron Zibelli being your co-portfolio manager on a number of strategies, yes.

Justin Livengood:

That's right. And he's right. I mean, the biggest companies have generated an enormous amount of incremental market caps since the pandemic ended, and that has moved mathematically a lot of that market cap shift that I referred to. A secondary reason is that the private economy is financing a lot of companies longer, and that's a durable trend. That's going to have an impact, I think, for a long time. I may have mentioned this on a prior podcast, but I'm pretty bullish on private credit, private equity for the longer term. I think those asset classes are going to continue to grow a lot, make a lot of sense. There's obviously a lot of money there for companies to tap, and often, it's the right thing to do. It's if it's not cheaper, it's least an easier form of capital for a lot of private companies to access.

And so I think that's going to be a durable trend. And you're right, that has an impact on the public markets. It definitely has had an impact on my opportunity set, but I think it will have a bit more pronounced one over the next four or five years if I'm right, and these private markets keep growing.

Brian Levitt:

So what would you do about that as a investor in more publicly traded names?

Justin Livengood:

So it probably will have, over time, a little bit of an impact on valuation. I think the public companies that are doing really well that stay public and choose not to go private will get a little bit more valuation. So I think it's important to not be too valuation sensitive. Remember, I'm a growth guy, so that's always my mantra, but I think perhaps a little bit more so going forward.

I think the other thing that is happening here is some of it is public companies today are perhaps going to go private because there's going to be great offers from private investors to take them private, but some of it's just trading among private equity funds, alternative asset managers where companies never get public and they stay private throughout their company's life. So it's incumbent on me and my team to be more aware of those kinds of companies while they're private and just better understand that ecosystem because there's competitive information that's relevant there for the companies that I do own and invest in.

I'm not necessarily going to get to see everything in an industry because some of the relevant competitors in a particular sector are going to stay private forever, but I still need to understand what they're doing. I still need to make sure that I have an opinion on them. And so that's something our team is increasingly doing. It's funny, when I go to investor conferences, the next two and a half days, I'm going to be at one of the biggest health care conferences of the year, they're increasingly are tracks for just private companies. It used to be you go to these conferences and it's just all the big public companies. Now there are dedicated tracks for private companies. And it's not just because those companies are looking to go public. It's this dynamic I described of folks on my side of the table wanting to learn more about that private universe.

Jodi Phillips:

So Justin, as you said just a minute ago, you're a growth guy, so we have to ask you about AI as we teed up in the intro a little bit. What are your thoughts on the AI trade right now? Is this just about NVIDIA, four or five big customers or is it bigger and broader than that? Just wanted to get your thoughts about how you're thinking about it.

Justin Livengood:

I definitely think it's bigger and broader than that. I think in our small and mid-cap portfolios, we've been able to find a lot of great companies that are providing pieces of the puzzle that are going to help the data center and electrical grid get big enough to support all of these artificial intelligence applications that hopefully are going to emerge over the next 5, 10, 15 years. So there are a lot of parts of the ecosystem that we can invest in. I don't think the trade is over.

I will, however, say that in the last few months, there definitely have been indications, particularly from some of the largest companies, hyperscalers in this space, that we're evolving from the first phase to maybe a second phase of this whole AI boom where the clients, the companies that are spending on AI need to start to develop more use cases to justify their investments. So I think in '23, '24, when chief technology officers were looking at their budgets, it was, "I'm going to invest anything that smells like AI. I don't want to miss out. I want to make sure my company is doing everything it can to keep up with our competitors." Now as we go into the '25 budgeting cycle, there's a little bit more of, "Okay, I did everything last year. Now I'm going to refine that a little bit. I want to be a little more specific in where I put my money. I want to see more ROI."

So we're hearing a little bit from the Amazons, the Facebooks of the world, that they're still planning to spend a lot on capex to build out their services for AI, but the incremental demand might be, on a scale of one to 10, it was an 11. Now maybe it's a nine and a half, which is still extremely healthy. But there's, again, that little bit of an element of prioritizing within spending by clients. That's healthy, that's understandable. And so we're evolving into this next phase of the AI trade. And so you're seeing a little bit of that in the reaction, the stocks that are involved in this theme. And that's good. I think it's healthy to have some of these companies and expectations around these companies get reset to a little bit more reasonable levels. That'll just add to the length that this opportunity, this trade plays out, which I still think will be several more years.

Brian Levitt:

I always like a Spinal Tap reference. We'll turn things up to 11. And it seems like just by saying that, you gave such a, without even mentioning, just a good explanation for the NVIDIA earnings report, which was so outsized, and yet the market took it a little rough. And that's, I think, just going from 11 to nine and a half is probably all you need to say about that.

Justin Livengood:

Yeah, yeah.

Brian Levitt:

Do you think that the market has even begun to contemplate, beyond just who's going to provide the hardware or the software, the services on AI, has the market even begun to contemplate the productivity gains to the economy or what that may mean downstream to other businesses?

Justin Livengood:

I don't think so. It's a great question. And that's the really strong bull case for what I was just describing as far as this trade has some years to go. We need to see more of that. It needs to be more than just, "Oh, we can, through AI, cut out a few headcount positions in companies where there were maybe some redundant operations and things that AI can now replace. It needs to be more revenue generating, more client-facing. I think that's what we're hearing companies try to find more of. I've heard a lot of companies in financial services, for example, where I spent a lot of time on the research side.

It's one thing to parse data and try to find the best customers and clients for a credit card or a bank account. AI can help with that, but it's not just managing claims and doing back office stuff. Again, it's helping be more efficient on the front end to make sure we find new clients more efficiently and that those clients end up spending more and doing more with that credit card company or that bank so that there's a really high growth case, not just an expense savings case. I don't think the broader stock market probably has factored in the revenue upside possibilities from AI. And so that's probably where we're going to see, over time, more excitement and upside if the markets ascribe value there. That would be my hope for what pushes this trade to the next level later this decade.

Jodi Phillips:

Great. So what other themes are we missing here, Justin? What else are you watching that has you excited about the future?

Justin Livengood:

Yeah. Well, there're always a bunch of different things going on, particularly in my parts of the market, the small and mid-cap universe, that excite me. I'll throw out two right now that I think are really interesting and timely. The first is commercial aerospace. And Brian, I don't know if you travel much, but-

Brian Levitt:

You know I do.

Justin Livengood:

The airlines are still pretty crowded. Those planes you're on are still pretty full, maybe not quite as much as last year, but demand remains really healthy and that demand is offset by the reality that the planes in this country and globally are getting older, not getting replaced as quickly as they used to. The issues with Boeing and now Airbus are material, they're going to last a long time, and what it's doing is putting more and more strain on the commercial fleet of airplanes. And so that is requiring a lot more repair, a lot more maintenance and upgrade than we've ever seen before.

And so there are a bunch of companies that do aftermarket support, not just for Delta and American and United, but for international airlines and for even the original equipment manufacturers like Boeing and Airbus. The last two to three years has been probably the best operating environment for that collection of companies in the aerospace supply market and repair market that I've ever seen. And the outlook going forward for the next year or two is just as good. I mean, Q2 earnings for a bunch of those companies were off the charts great. So we have a lot of exposure to aerospace companies in all our portfolios, but particularly our small cap and mid cap portfolios, and they are some of our largest holdings and some of our highest conviction ideas right now.

The other theme I'll quickly mention is real estate.

Brian Levitt:

Interesting.

Justin Livengood:

One of the best performing, quietly, parts of the stock market year to date has been REITs. REITs, particularly in the last four months, have been on fire. A lot of that's interest rates, people getting excited about the Fed cuts and the way the curve is starting to re-steep, and that's good for REITs, but it's also more than that, it's fundamentals. The office issues are well known and well documented, but even there you're starting to see transactions happen. Commercial real estate brokers are increasingly talking about even places like New York and San Francisco, buildings that for the last year or two have been troubled and no one's willing to go in and either refinance the mortgage or consider taking out some of the equity. Now stuff's starting to trade. We're starting to have price discovery and even in stronger markets away from the coasts, that's been happening more consistently for over a year. So the office markets are gradually perking up.

Other property classes though, like multifamily apartment, to some degree, warehouse, industrial, very strong. Even senior living, some of the health care senior living companies are doing exceptionally well. There's a ton of incremental demand there and not enough supply. So the REIT market and commercial real estate more broadly, really, really interesting. I think we're early stages in what is going to probably be a multi-year run for that part of the market. That's been a laggard group for three plus years, and it's just turning. Valuations are still not too extended. I really like senior living. I really like apartment and warehouse. I like the commercial real estate brokers that are not really exposed on the property value side. They're more just transaction exposed types of businesses. All of that is really compelling to me, and the stocks are starting to move, and so we're very much exposed in that area as well.

Brian Levitt:

As a guy who spends most of his life on airplanes and in office buildings, you are definitely speaking my language. Any parting shots from you, Justin? Anything before we go?

Justin Livengood:

No, I guess the only thing I would add is going into the end of the year here, I think we're relatively well set up for the markets. As you alluded to earlier, Brian, I think September will always be a little bit of a choppy month, but I think the backdrop is relatively constructive going into 2025. I'm not too concerned about the election-

Brian Levitt:

Me either.

Justin Livengood:

... in so far as I don't think it's going to derail the broader thesis around the stock market. It'll certainly create a little bit of headline noise here and there, but I don't think much is going to happen that changes the outlook for the next year or two. So like I said, compared to a year ago, I'm feeling okay right now.

Brian Levitt:

Good. So as Green Day's saying, we'll wake us all up when September ends and we'll be on our way. Justin, thank you so much.

Justin Livengood:

That's like your fourth reference to a band in this podcast. That's impressive.

Brian Levitt:

Yeah. Well, I need my pop culture references, otherwise I feel like I didn't give the audience what they wanted.

Jodi Phillips:

You have to listen to music when you're sitting on airplanes for as long as you do. It's just top of mind.

Brian Levitt:

That is so true, so true.

Jodi Phillips:

Well, thank you so much Justin, for joining us. And Brian, where can we find more commentary from you?

Brian Levitt:

Well, thanks for asking Jodi. Visit invesco.com/brianlevitt to read my latest commentaries, and of course you can follow me on LinkedIn and on X @BrianLevitt.

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 September 3, 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.

An investment cannot be made into an index.

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.

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.

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

REIT stands for real estate investment trust.

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

All data provided by Invesco unless otherwise specified.

The average length of time it has taken the US stock market to recover from downturns was sourced from Bloomberg, based on the performance of the S&P 500 Index since 1957.

The level of US gross domestic product, or GDP, was sourced from the US Bureau of Economic Analysis.

Year-over-year US inflation was 2.9% in July 2024, according to the US Bureau of Labor Statistics.

Statements about the performance of small caps versus mid caps during the last 13 periods of rate cutting by the Federal reserve sourced from Bloomberg. Based on the performance of the Russell 2000 Index versus the S&P 500 Index.

Statements about small cap earnings outperforming large cap earnings in the second quarter sourced from FactSet Research Systems, based on the earnings of the companies in the Russell 2000 Index and the S&P 500 Index.

From May to August, the S&P 500 Index was up 13.1% compared to 12.5% for the Russell 2000 Index, according to Bloomberg.

Comments on small caps as a percentage of the overall US stock market capitalization sourced from Bloomberg as of September 2024.

Comments on the performance of REITs year to date sourced from Bloomberg. Based on the performance of the FTSE NAREIT All Equity Total Return Index, which is an unmanaged index considered representative of US REITs. That index returned 10.7% year to date ended August 2024 and climbed over 21% from May 2024 to August 2024.

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

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

BPS, or “bips,” stands for basis point, which 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.

ROI stands for return on investment.

Capital expenditures, or capex. is the use of company funds to acquire or upgrade physical assets such as property, industrial buildings, or equipment.

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

Brian Levitt

Welcome. This is the Invesco's Greater Possibilities Podcast, and today we are going to be, as always putting concerns into perspective and opportunities into focus. I'm Brian Levitt.

Jodi Phillips

And I'm Jodi Phillips. And today we have Brian Watson on the podcast. Brian is the senior portfolio manager of Invesco's Master Limited Partnership strategy, investing in midstream energy infrastructure.

Brian Levitt

All right, Jodi, I am going to put you on the spot immediately with a tough question.

Jodi Phillips

Oh. All right, go for it.

Brian Levitt

Okay. Since the pandemic, March 2020, you and I are fetal positions sitting in our homes, trying to figure out what the heck is going on in the world-

Jodi Phillips

Accurate.

Brian Levitt

... whether we'll ever travel, whether we'll ever shop, whether we'll ever do anything again. Since then, which has had the better performance, the Alerian MLP Index or the S&P 500 Index?

Jodi Phillips

All right. I'm going to use my context clues here, Brian. We have an MLP manager as our guest, so I'm going to have to go with the Alerian MLP Index.

Brian Levitt

Yeah, well there's a method to this. It's like lawyers in court. I would never ask my co-host a question that they don't know the answer to.

Jodi Phillips

Thank you for that. I appreciate it. Look, naturally I knew coming in today that MLPs have had a strong four-year period, but the S&P 500 has rallied nearly a 100% since March 2020. It is somewhat surprising, at least to me, that the MLP Index has beaten that. I wouldn't have guessed it otherwise.

Brian Levitt

Yeah. And since we're being candid, I will say the same. I did not recognize. I knew MLPs had had a nice turn. I did not realize that they had outperformed the broad equity market. I did run another screen to see if they beat the Mag Five or Mag Seven. We'll have to tell Brian sadly, no, they haven't beat the Mag Five or Mag Seven, but they certainly have outperformed the broad market

Jodi Phillips

Absolutely. Look, you pretty accurately described the atmosphere four years ago, sheltering in our homes, staying put, not traveling. A lot has changed in four years.

Brian Levitt

Yeah. Now, we're producing a record 13 million barrels of oil per day or something like that. Presumably, it's being transferred in pipelines throughout the country.

Jodi Phillips

Yep. And in addition to that, I imagine there could be a little bit of AI, artificial intelligence helping to fuel some of this. I understand it requires quite a bit of energy.

Brian Levitt

Well, you said the magic two letters. Our producers have said to us, "Have a podcast. Say artificial intelligence. Say AI as many times as you can and that's how we get more people to tune into this podcast."

Jodi Phillips

That's the key. That's the key. Just mention AI and the rest takes care of itself, I guess.

Brian Levitt

Yeah, we get those high ratings.

Jodi Phillips

Well, let's digress. Let's bring Brian on to discuss three different letters, MLPs. We can discuss AI, we can discuss Brian's expectations for the future, whether AI will play a role in a structural bull case for the asset class. Let's go ahead and bring him on now. Welcome, Brian.

Brian Watson

Thank you for having me.

Brian Levitt

Brian Watson, welcome.

Brian Watson

Thank you.

Brian Levitt

Brian I want to start, you and I have worked together for a long time, and we've had a bunch of different conversations, and we've worked together through some different environments for the MLP market. I wanted you to just give us a little history lesson on that last decade or so. We've seen oil price collapse in 2014. We had a pandemic that we talked about. And yet, the MLP market has, like Jodi and I talked about, has responded in the last four years. It seems to be that these partnerships are in better fundamental strength than they were perhaps in past times. Can you talk about that?

Brian Watson

Yeah, so I guess a little bit of a history of the asset class I think helps explain why it's been doing so well lately and why we're pretty optimistic going forward. But if you go back to the mid/late '90s, this is when I'm beginning to invest in midstream and energy. Midstream was really servicing all of these basins that had no real growth potential. This is pre shale, so midstream companies with these boring entities just maintaining assets, some of them even in slight declines, offset by per barrel tariff increases. They were just very boring, spent, no capital. All that free cash they were generating were dividend to out to their holders and it was a nice boring life. Then shale comes around and suddenly, these parts of the world, parts of the country that hadn't produced much ever or much in decades, suddenly we're producing massive amounts and beginning to compete amongst the globe's greatest producers for their production capacity.

Brian Levitt

That was about the time that I was being invited to North Dakota for the first time in my career because there was money in the state.

Brian Watson

Yeah. Yeah. Barnett, West Texas.

Brian Levitt

West Texas.

Brian Watson

Dakotas. Marcellus, all this stuff that had always been trickles became gushes of oil and gas. And so the sleepy companies that weren't really designed to spend a lot of capital, they were designed to provide these big dividends, were being asked by their customers to build them hundreds of billions of dollars of new pipelines, and storage facilities, and processing facilities, and all this stuff that's required. And so they did. For about a decade, they attempted to build all these new things and keep paying their dividends. They did that by issuing new equity into a fairly receptive market. They could do this without diluting shareholders or at least, I mean there's always dilution, but providing growth still on a per share basis.

And then as you mentioned, '14 comes along, and we end over a decade of oil essentially trading 90 plus very reliably, and gas of seven, eight bucks. The energy markets go through, in my experience, the worst cyclical break in history. And really, there was several cyclical breaks in a row, and so the equities didn't trade great. And suddenly, all these midstream guys realized that they couldn't issue equity, they had to become self-funding.

We went through a period where midstream company after midstream company set their sights on becoming self-funding. Another way to say that is everyone's distribution coverage, or the amount of cash they made versus what they paid out, it was always about 1.0. The cash you made, you paid out 1.0 coverage. Everybody wanted to get closer to two so it's a massive shift in just a structural way that these guys are operating their finances. They go about doing that. Really, that is achieved, I'd say shortly before COVID hits in 2020 COVID upsets everything and puts everything back another six months, but that had essentially been done as this great three years you were just talking about began to emerge.

And what you really saw was I think a confluence of events where you had A, the worst fears of COVID and its impact on the energy markets become alleviated. The market comes and looks at midstream and they see now companies with hefty distribution coverages, so dividends that have been de-risked quite a lot. They see balance sheets that are repaired or quickly repairing, and they see companies actually that started this process of becoming self-funding, finding themselves with room to begin to grow dividends again. That's really what we saw the last three years I think, is the market coming to realize the asset class had really de-risked itself.

Jodi Phillips

All right, so then summarize it for me. We definitely have been through a journey here, but today, how do midstream companies as a whole look in terms of debt levels and free cash flow?

Brian Watson

Free cash is still healthy. We're high single digits. Leverage is on average now below four, which is for a midstream or pipeline company, pretty healthy. And obviously, a lot of names better than that. Coverages are right around two times. Now, I think since COVID, you've had about half of the group move to raise their dividend, and the average of those increases is about 15% We think over the next couple of years you'll get a good portion of that other half that's still concentrating on de-leveraging or in some cases, buyback shares with their free cashflow began to raise their dividends too. We look at it as we're back to the simpler days. Capital spending has really come in. We don't need thousands of miles of new pipelines. There's stuff being built, but it's not these huge, huge multi-year-

Brian Levitt

We like simple days.

Brian Watson

We do, yeah.

Brian Levitt

We do.

Jodi Phillips

It's refreshing. Yes.

Brian Levitt

It's nice to be back to simpler days. Brian, I want to talk. Jodi and I were thinking about some of the structural tailwinds that might exist for the master limited partnership energy infrastructure market, and so we want to talk about each of them. Before we even do that, when you say the infrastructure is built out, does that apply to a lot of the structural tailwinds that we're considering? You heard us mention AI in the intro and we want to dig deeper into that, but are we in a place now as a country where the infrastructure's in place and these companies don't have to commit additional capital for all of these structural tailwinds?

Brian Watson

Yeah, I don't want to say that on an absolute basis, but these thousands of miles, these huge, huge multi-state pipes are pretty much built. You'll continue to de-bottleneck. In West Texas, natural gas production continues to rise with crude oil production. And as most every field ages, crude oil field ages, the amount of gas coming out of the ground per barrel usually trickles up. Your gas growth is usually better than your crude growth in an oil field like that, so we'll continue to de-bottleneck, but you're talking about an interstate system, additions on interstate pipes that are much easier, cheaper to complete than something that stretches across six or seven states.

Now, Haynesville which I can probably get into it a little bit more, but is almost certainly going to be called on to grow significantly in the next five, six years. That'll need some more pipes. But again, these will be pipes taking something within the state of Louisiana or perhaps Texas to Louisiana. They're just very manageable projects.

Brian Levitt

Jodi, these are all the states you vacation in, you get in the RV with your husband and you drive across.

Jodi Phillips

Yep.

Brian Levitt

These are the states that I probably still have some touring left to do.

Jodi Phillips

Yeah, get in the RV, cross these really massive states like Texas. We're doing our part for energy consumption, I can tell you that much. Brian, you mentioned at the top of the show that mentioning AI gets ratings. Let's try to boost our AI mentions here.

Brian Watson

Let's do it, yeah.

Jodi Phillips

In terms of these structural forces Brian was talking about, let's just start there. What, in your mind, is the potential impact? I don't know how much energy companies are talking about this on their earnings call and whatnot, but what are you hearing?

Brian Watson

AI has become a hot topic amongst the energy companies as well. They try to say AI as many times as they can. Say AI one more time, data center-

Jodi Phillips

They all got the same memo.

Brian Watson

I don't know if the people want data center or AI, but yeah, so for midstream energy generally, AI is just additional tailwind. If you think about the drivers mostly for natural gas consumption going forward, first is LNG, which is just enormous. We export about 11/12 BCF per day of LNG today, and we're in the process between now and 2030 of doubling that. It's just a huge amount. We produce about 100 BCF That's in context.

AI, everybody's trying to wrap their hands around it, but obviously, these are massive users of energy power generation. We've looked at a bunch of different research reports. We've got a block coming out here shortly and we used some Goldman data because it seemed in the middle, and conservative, and thought out. Goldman is estimating 47 gigawatts of new power demand between now and 2030, taking the total power grid draw for data centers from three to eight percent, which is obviously a massive increase.

Then you're trying to wrap your head around what's that mean for natural gas demand? They've estimated somewhere in the three and a half to six BCF per day range. It's very significant, less than LNG, but still very significant. That takes the total increase between now and 2030 to somewhere in that 14 to 18 BCF per day increase in demand.

Brian Levitt

Is that enough-

Brian Watson

And it's...

Brian Levitt

Is that enough to fuel the DeLorean, the time machine?

Brian Watson

I think it's just shy.

Brian Levitt

Just shy.

Brian Watson

In a lightning bolt.

Brian Levitt

That was 1.21, I think?

Brian Watson

I think that's right.

Brian Levitt

88 miles an hour.

Brian Watson

Yeah. Yeah, I think that's correct.

Brian Levitt

AI, Jodi from now on, it stands to us, always incorporate into our conversation.

Jodi Phillips

Always incorporate. All right, understood.

Brian Levitt

These ideas, so AI is going to use as much energy as small countries that maybe is already doing. Brian, that probably concerns some people, right and you see it more as an opportunity? Is there a way to square that?

Brian Watson

Well, I guess obviously, on Goldman's analysis anyway, they assume 60%. For the three and a half they use 60% net gas and 40% other, which is potentially wind and solar. It would possibly be the non-retirement of coal, which is not probably what someone worried about that wants to hear.

The good news is natural gas is significantly less CO2 intensive than coal, something on the order of 60% less CO2 The molecule, the bolt is fungible. If you look at AI data centers, these must run 24/7. They don't really lend themselves directly to wind and solar because the intermittency. If you are running Bitcoin or something in West Texas, which is a fairly healthy draw of our power generation, when the price moves up and down with the wind blowing or the sun shining, and that's impact on inner day power pricing, they can throttle back and forth. They can make the most money they can. That's just not an option for AI data centers. I do think this demand growth is a little bit easier to meet with a fuel like natural gas.

Jodi Phillips

Brian, we got the other keyword in, Bitcoin.

Brian Watson

There you go, yeah.

Jodi Phillips

We just put that in there. But yeah, no, for sure. AI is obviously, not the only innovation. Electric vehicle, just the continued electrification of the economy. I don't think I got that word out, but you know what I mean. More things we’re plugging into the wall. Can you talk about that a little bit, just the impact of those trends as well?

Brian Watson

Yeah, they're all power hungry trends. There's not a lot of non-power hungry trends occurring currently. If you think about EVs, it's hard to guesstimate the penetration rate, just like it's hard to guesstimate AI's penetration. But again, most people are going to charge at night most likely, and that's what the data has shown. It's probably going to be a fuel works at night.

The flip side of this is that you can add wind and solar, and it can provide power during the day, and so offset that daily use. It's not all bad news for generation coming from wind and solar. It's just not going to be the same generative megawatt. It's going to be coming. You're not going to get it from both sources, which is something we've been saying for a while. I think you go back a couple of years ago, there was a lot of expectations that wind and solar plus batteries would allow the retirement of natural gas generation. I think more and more that's just proving not to be a very realistic option, just from the budgetary premise alone.

I don't know if we're supposed to say individual research providers, but we use a group that's very thoughtful on the topic and they recently looked at a scenario where a wind turbine field is backed up by a natural gas power plant. Over the first part of the year, I think there was several periods where the wind didn't blow enough for three to four days in a row where the natural gas power plant had to operate to provide battery backup that would've lasted that long, would've required a $12 billion install of batteries, which is just... A power plant that size would've been $500, $600 million. In this case, I think it was just a plant that was already there.

It just gives you a sense for how challenging really handling the intermittency of wind and solar is. Natural gas is just, again, a much better choice than coal from an emissions perspective, but really just the only logical choice in many cases.

Brian Levitt

Brian, let's go to conflict in the world. We'll talk about more things that seem to get ratings. When Russia initially went into Ukraine in February 2022, I think there was a perception that Europe would struggle mightily and that the world would really be challenged to diversify the energy mix away from Russia. It appears as if the world has largely come through that without significant incident. I'd love to hear a little bit of how that was possible and then what does that suggest going forward for US exports?

Brian Watson

Yeah, I think one thing that happened was that Russia and exports did not... Oil did not really get pulled back as much as originally thought, that they found ways around it. You look at, there's a lot of data providers for exports by country and their exports really didn't go down that much.

On the natural gas side, Europe used significantly less natural gas and benefited from a not so cold winter. And so initially, they were bidding away LNG from the rest of the world essentially, and skyrocketed LNG prices, which LNG is liquified natural gas. When natural gas is traded amongst countries, they have to freeze it, put it on a ships, and that's called LNG. They were able to fill up their storage pretty well. What happens if this winter is particularly cold or next summer is particularly hot? We'll have to wait and find out, but that's how they got through it.

Of course, we're talking about this 12 BCF per day of new US LNG exports that are coming due. There was a rash of new LNG contracts signed in the wake of the Russian invasion of Ukraine, as the world's natural gas consumers quickly realized that they needed to de-risk their supply. Some of that LNG we're talking about came through. It is coming about because of actions taken post the Russian invasion and we certainly might see more. As you know, the current administration paused new LNG licenses by the DOE. There was recently a court case that stayed that pause, but it's unlikely to make a big difference. What we do think is going to happen, is probably those new LNG licenses will begin to be issued again at some point.

We talked about 12 BCF. Most likely, that continues to grow after 2030. We talked about the three to six BCF related to AI data centers, AI data centers, AI data. That's probably going to keep growing. It's a decent place to be for midstream or US energy producers because there's just a very healthy tailwind. If you think about historically natural gas demand has come... It goes up and down with the weather. It's hard to predict. In this case, we have some demand drivers that are fairly easy to predict. They're going to complete LNG facilities and they're going to run.

Brian Levitt

Jodi, have you been adding that up on your calculator?

Jodi Phillips

Well, you know what, I've been trying to add it up in my head, which was my first mistake. But BCF here, BCF there, what is the total? At least for the US, what is the demand total that we're looking at right now, just to put all of these different pieces into context?

Brian Watson

Yeah, so it's 15 to 18, based on what we see between now and 2030, and likely keeps going relative to base of about 100 BCFs.

Jodi Phillips

Okay.

Brian Watson

Percentages are easy there, but it's good. If you think about a midstream operator, the most profitable thing that can happen to you, is have more volume flow through a pipe that's already been built. There's no capital spending. You got to use some fuels for increasing the flow or the pressure in the pipe, that kind of thing. But it's an incredibly profitable thing just to move more volume. When you have what seems to be lying in front of us as a very predictable and meaningful increase in natural gas demand, we suspect the beneficiaries would be manyfold. You'll have the pipes feeding the power generation directly and the pipes and the other facilities feeding the LNG facilities directly. Obviously, that's good for them, but that gas has to come through the whole system. If you're in the fields and West Texas and the Marcellus, as we talked about briefly earlier, the Haynesville, which is very near much of this LNG export capacity, likely really begins to grow in fairly short order.

Brian Levitt

I want to get to a little lightning round for investors, so I'm going to ask three questions one at a time. What type of yields are available now broadly on MLPs?

Brian Watson

Yeah, I think the average yield today is right around seven percent for the asset class, maybe a little bit above.¹

Brian Levitt

Yeah. Are you at all concerned about valuations given the run-up that we talked about in MLPs?

Brian Watson

No. We will look at our internal models, which are valuing the companies bottoms up. But even if you look at broader multiples our enterprise is right around eight and a half. It's almost two turns below the historical average. Which we have made this comment before, people in the recent past, and it seems confusing that we'll be trading relatively healthily despite this great run in the last couple of years. I think what's missed is how great the denominator has been doing. EBITDA's been growing high single digits, close to double digits for the last several years. Even though the sector's done pretty well price performance, the valuations have remained pretty reasonable. We think we're on deck for some more pretty healthy cashflow growth. And notably, this growth the asset class is benefiting from today is not being funded by accruing tons of new shares like it was in previous growth phases. On a per share basis, it's a great way to grow because there's not really dilution occurring. It's flowing through to the same number of shareholders.

Brian Levitt

And I said I had three of them, Jodi, so I'll go one more. Are you worried at all about an economic soft patch in here, or are you looking forward to a fed easing cycle, or anything on the macro horizon that you consider?

Brian Watson

Yeah, you always think about crude, and gas prices, and the impact on drilling. That's never going to go away. If you'd had a real sharp pullback, you'd have a slow-down in volume expectations, which would be a slow-down in EBITDA growth expectations. I will say that you've just seen a very significant change in producer behavior. Since that incredible period of energy market volatility that started in 2014, producers just aren't getting over their skis. If you look at the producer community, capital discipline is number one goal.

We've seen crude prices and gas prices go up pretty healthily and down pretty healthily over the last several years, and you just, we haven't seen in rig counts or activity changed that radically with these price moves, which in previous pre 14, they would have. When crude went above 100 and post Russian invasion of Ukraine, if that was pre 2014, we would've seen rig counts spike with it, and then we would've seen production expectations explode, and then we would've seen the price come down more radically and we would've seen rig counts come down more radically, and they're just not behaving that way anymore.

And so it's softened the impact of economy that's going great, or bad, or food prices are going skyrocketing, or coming in. We're just not seeing the volatility that we used to see, which is good for midstream. Not only does that remove some of that worry from investors' minds, that volatility, but it's from a very real perspective, midstream companies aren't being asked then to build this brand new pipe, or this new processing plant, or whatever during that high price environment where producers think they're going to be producing 10% more on exterior, only to have that expectation be disrupted by a pullback. The deployment of midstream is also being very steady and measured. That's good. That's good for midstream. It keeps their capital demands in check.

Jodi Phillips

All right, Brian, so at the risk of killing the ratings that we worked so hard to build up in the first part of this podcast, I'm going to ask you quickly about politics. Just curious-

Brian Levitt

Are we going to ask about religion after? Or just stick with politics?

Jodi Phillips

No, that's for the outtakes.

Brian Levitt

Okay.

Jodi Phillips

Politics, how much do you focus on the election? I think that the instinct of at least some investors is that a Republican Trump administration would be better for the energy patch, but we kept talking about the last four years and this growth, and clearly that's been under a Democratic administration. Does it matter?

Brian Watson

Yeah, I don't know that it matters as much as people think. Certainly, maybe from a sentiment perspective it's helpful. From the LNG perspective, I think it's assumed if the Trump administration would stop the pause on LNG export licensing, it probably, as I mentioned earlier, it probably goes away anyway eventually. Perhaps you could achieve... There's been some federal lease hold back from the current administration on providing the ability to operate on federal lands. That probably loosens up. It's not a game changer, but a producer might be able to then produce in a region with better economics. They have more freedom of choice there.

All in all, it's not bad. But you think about some of the biggest roadblocks to building midstream has really come from the state level and the local level, not so much the federal level. And as we talked about, we don't really need to build a whole bunch of new thousand mile pipelines that go across multiple states. There's just the opportunity for friction due to politics has decreased with the maturation of the infrastructure in the country.

Brian Levitt

You had me at it doesn't matter much.

Jodi Phillips

That's the theme for Brian, for sure.

Brian Levitt

You also complete me. Thank you so much for joining us. Really appreciate the opportunity to speak with you. We know that you sounded very similar messages when we talked to you in 2022, and it's nice to have seen them in hindsight play out in most of the ways that you suggested it would play out. Thank you for being with us.

Jodi Phillips

It was two years ago. Oh my gosh. I can't believe it.

Brian Watson

That's wild.

Jodi Phillips

Well, if you want to hear about the MLP industry more often than that, Brian does write a monthly commentary on MLPs that you can find on our website. Just head over to invesco.com/us. Click on that insights tab at the top and head over to Investment Insights to get monthly insights into the MLP industry and much more. And so, Brian Levitt, how about you? Where do we find more from you?

Brian Levitt

Yeah, if you want to follow the other Brian on this call, visit invesco.com/brianlevitt to read my latest commentaries and of course, you can always follow me on LinkedIn and on X at BrianLevitt.

Jodi Phillips

Sounds good. Thanks for listening.

Brian Watson

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 July 10, 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.

An investment cannot be made into an index.

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

Most MLPs operate in the energy sector and are subject to the risks generally applicable to companies in that sector, including commodity pricing risk, supply and demand risk, depletion risk and exploration risk. MLPs are also subject to the risk that regulatory or legislative changes could eliminate the tax benefits enjoyed by MLPs, which could have a negative impact on the after-tax income available for distribution by the MLPs and/or the value of the portfolio’s investments. Although the characteristics of MLPs closely resemble a traditional limited partnership, a major difference is that MLPs may trade on a public exchange or in the over-the-counter market. Although this provides a certain amount of liquidity, MLP interests may be less liquid and subject to more abrupt or erratic price movements than conventional publicly traded securities. The risks of investing in an MLP are similar to those of investing in a partnership and include more flexible governance structures, which could result in less protection for investors than investments in a corporation. MLPs are generally considered interest-rate-sensitive investments. During periods of interest rate volatility, these investments may not provide attractive returns.

Energy infrastructure MLPs are subject to a variety of industry-specific risk factors that may adversely affect their business or operations, including those due to commodity production, volumes, commodity prices, weather conditions, terrorist attacks, etc. They are also subject to significant federal, state and local government regulation.

All data provided by Invesco unless otherwise specified.

From March 2020 through June 2024, the S&P 500 Index returned 125.82% and the Alerian MLP Index returned 350.43%. Data from Bloomberg L.P. as of June 30, 2024.

The Alerian MLP Index is a float-adjusted, capitalization-weighted index measuring master limited partnerships, or MLPs, whose constituents represent approximately 85% of total float-adjusted market capitalization.

The S&P 500 Index is a stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States.

Data on production of oil and liquefied natural gas, or LNG, is from the US Energy Information Administration as of June 28, 2024.

Data on oil and natural gas prices from Bloomberg as of June 30, 2024.

Background on distribution coverage, free cash flow, leverage, and divided increases of midstream companies from Wells Fargo Securities as of June 30, 2024

Estimates of power demand growth to 2030 and its impact on natural gas demand are from Goldman Sachs as of April 28, 2024

Comparisons of the CO2 impact of natural gas compared to coal is from the US Energy Information Administration as of June 28, 2024.

Comparisons of the cost of battery backup for a wind turbine field versus the cost of a power plant are from Thunder Said Energy as of June 5, 2024

Discussion of yields on the Alerian MLP Index are from Bloomberg as of June 30, 2024.

Information on enterprise multiples and EBITDA are from Wells Fargo Securities as of June 30, 2024

An enterprise multiple is a company’s enterprise value divided by earnings before interest, taxes, depreciation and amortization, or EBITDA.

The Magnificent Seven stocks refer to Amazon, Apple, Alphabet, Meta, Microsoft, Nvidia, and Tesla. The Magnificent Five excludes Apple and Tesla.

BCF stands for billion cubic feet.

DOE stands for the Department of Energy.

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

Brian Levitt:

Welcome to the Greater Possibilities Podcast, where we put the concerns into context and the opportunities into focus. I am Brian Levitt. We are having an emergency conversation today after a bit of volatility in markets heading into the weekend and early this week. With us again, our friend Alessio de Longis, who is head of investments for Invesco Solutions. He's here to provide more commentary as we go through this journey together. Alessio, thank you for joining.

Alessio de Longis:

Thank you for having me, Brian.

Brian Levitt:

We posted a podcast of us having a conversation not that long ago, and in hindsight you seem pretty prophetic in that you were talking about weaker growth and concerns about markets in the short term, so I suppose I should say kudos. What's happened in the last few days in markets certainly is some validation of what you were seeing.

Alessio de Longis:

It certainly feels that way. I think we discussed at length the last time all the various indicators that were suggesting growth was slowing, and there was one data point missing, right, Brian? It was the resilience in employment, the resilience in the unemployment rate. What has changed? What has changed since we last spoke? I think the last payroll report put a few concerns into perspective and validated some of those concerns in the short term. Namely, we saw an unemployment rate that rose from 4.1 to 4.3%. That in and of itself is not a big problem, except that it validated a trend that started at 3.4%. Usually we have seen in the last year the unemployment rate having a weak data point and stabilizing, stabilizing, then another weak data point, and now we've had two monthly reports in a row that really showed a rising trend in unemployment.

Brian Levitt:

It's funny, I get a lot of message ... A lot of people say to me, "What was so bad about that report?" I mean, it was, the market I think was expecting 175,000. We got 114,000 jobs created. Of course, that'll be revised, and part of that pick up to 4.3% on the unemployment rate is some people just coming back into the labor force so they're being counted more. It didn't seem all that bad. Was this just a market that was really priced for perfection and looking for an excuse to come off some of the froth?

Alessio de Longis:

Certainly that is a big, big piece of it. The issue with the unemployment rate is that when you look at it compared to any other job indicator, when it moves, it doesn't have much volatility. Its trends tend to be quite persistent, and I think ... There is the famous Sahm Rule, the Fed economist that, and of course there's a lot of data feeding in history with this, but the idea is that when the unemployment rate rises by more than 50 basis points over a short period of time, it typically doesn't come back very quickly and that deterioration trend tends to then coincide with a recession. That's really what has changed.

Brian Levitt:

Yeah, I mean, so the Sahm Rule would say recession, and yet I think if we were to go through the typical guideposts that you would think about on the path to recession, most of them or many of them are not flashing, correct? But now that you have an inversion of the yield curve for 20 something months and the Sahm Rule flashing, does that start to give you more concern that maybe this isn't just a 10% correction or somewhere along that, let's call it a garden variety correction, and could it be something more ominous?

Alessio de Longis:

Are we seeing the rising probability of a recession when you look at all of the indicators? I think the answer is yes. However, the evidence in the data is also that this could be one of the many mild recessions that we've seen plenty of time. We don't have those large imbalances in the economy that turns this into another GFC (Global Financial Crisis) or a scary situation such as COVID. A mild recession could be happening.

The good news, and I really mean it as big, big capital letters, good news is that inflation is falling. Inflation is falling, wages are falling. The Fed has no obstacle. The Fed can react quite quickly to stabilize and provide comfort to the market. The market is already pricing in about 100, 125 basis points of cuts into the end of the year, which should be enough to calm market concerns. What we want is avoid discontinuities and panic in the market.

Brian Levitt:

Yeah. Why is the Fed waiting so long?

Alessio de Longis:

I think at this point they don't have to wait that long. September is definitely in the cards, and it didn't seem in the card back in July. I think it's in the cards now. It may feel like a long time from now, but there certainly isn't here justification for an emergency cut.

Brian Levitt:

You know I've had them on redial over and over calling. Just take them down a little, I mean, 5-1/4 to 5-1/2 in this economy. Just bring them down a little. Nobody. Nobody answers my phone calls over there.

Alessio de Longis:

Well, I think especially when they got so burned, and we all got burned by the inflation scare, I think there is a bit of a necessity here to let the chips fall a little bit. Look, to your point, Brian, the market has risen so much so strongly. It was priced for perfection. Let's watch ... We talked about this a week ago ... Watch credit spreads.

Brian Levitt:

Yeah.

Alessio de Longis:

If credit spreads continue to rise at a rapid clip, the Fed will intervene and will respond to your calls.

Brian Levitt:

They'll say, "Who's this guy that keeps calling us?" I'm looking at investment grade corporate bond spreads as of the end of last week, and they had risen. For anybody wondering what that is, it's just what are US companies borrowing, high-quality US companies, borrowing at relative to a risk-free rate? I think the average historically is high-quality businesses borrow at about 1.3% above a risk-free rate. We've been well below that. Seems like we're sort of heading towards it now, but still below average. Is the fact that it's moving in that direction, giving you pause or the fact that it's still below average comforting?

Alessio de Longis:

You're right. It's now at 110 versus that 130 average, and the same goes for high yield where the average tends to be 450, we're at 380 and so on and so forth. The direction of travel is going to that average. But that's the key difference, Brian. What you're highlighting is the Fed really starts getting concerned when you blow out above that average in a sustained way and a rapid way because that really creates that stop in the system where credit stops flowing and conditions get exacerbated. Liquidity concerns emerge. We are nowhere near those conditions, and I think the Fed delivering the cuts that the market is already pricing in should be sufficient here to stabilize the market.

Brian Levitt:

I'm going to give you a few stats, Alessio, and let's just see how they feel to you, how you respond to them. What I've seen historically ... Well first of all, we know there's five to 10% market corrections in the S&P almost every year, right? What I've seen is when it's of the five to 10% variety, the market's recovered in three months. When it's more of a 10 to 20%, the market's recovered in eight months on average. Again, all these are averages. When you were talking about a more mild recession, like a 1991, maybe like a 1981, the market's gone down somewhere around 20% and recovered within a year or two. Do those sound right to you? Well, don't argue with me, I looked them up. How does it feel as we're sitting here somewhere between five and 10%?

Alessio de Longis:

It feels somewhat the middle path that you outlined, therefore with the possibility of seeing the light at the end of the tunnel in the second half of 2025. I'm assuming an investor that basically got caught long right at the peak, as you mentioned, two months ago. We are moving down quite quickly, and I think to your point, there is still some extended positioning because of the strong market rally 2023 and early 2024. So an opportunity in the next six months to certainly add to those positions and actually be in the money much more quickly than that.

Brian Levitt:

Last question. As you think about a defensive posture right now in the portfolio, what does that primarily look like? It seems like you've had quite a good call on interest rates, but what do you think about the other side of this? If the Fed can move us through this, normalize the US Treasury yield curve, reinvigorate economic activity, what does that type of positioning look like?

Alessio de Longis:

That's a great question because you're referring to the view that we had on up to five-year maturities, five-year bonds, and that's played out quite nicely. You're seeing the yield curve is steepening. I think there's not much room for government bonds in the long end to come down. So bonds, long-dated duration bonds, not a great diversifier today. So extending some quality credit risk, so being invested.

This is not about going to cash. Brian, you and I keep saying this over and over again, when we talk about rotation this is not about divesting and going to cash. This is about rotating from a riskier asset class into a safer asset class that allows us to stomach that downturn and still harvest returns. So investing in high-quality credit, core plus type of bond exposures. You don't need to go all the way to cash. In equities, it's not about divesting from equities, it's about rotating into the more defensive sectors and styles such as low volatility, such as quality. These are styles in the market that we expect to do better than small caps, mid-caps and value. Again, it's not about selling stocks to buy cash. It's about shifting the composition of your equity portfolio from cyclical to defensive styles, factors and sectors, and the composition of your bond portfolio from risky credit into higher quality credit.

Brian Levitt:

Excellent. Alessio, as always, you've made me feel better. I'm going to sleep well tonight. I appreciate you coming in onto the podcast in such short notice, and we'll get through this, right? As you and I have been working together for a few decades, we've seen a lot of these. We will get through this.

Alessio de Longis:

This one too shall pass, Brian. Thank you for having me.

Brian Levitt:

Absolutely. Absolutely. Thank you. This has been an emergency edition of the Greater Possibilities Podcast. We hope we put some of your concerns into context as we promised. You can follow me on LinkedIn @BrianLevitt, as well as on Twitter or X, as they now call it @BrianLevitt. And please follow us on invesco.com/portfolioplaybook.

 

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 August 5, 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.

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.

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

All data provided by Invesco unless otherwise noted.

US employment data is from the US Labor Department as of August 2, 2024.

Discussions about the spread between high-quality corporate bonds and the risk-free rate sourced from Bloomberg as of August 5, 2024. Based on the Bloomberg US Corporate Bond Index option-adjusted spread.

Discussions about the spread between high-yield bonds and the risk-free rate sourced from Bloomberg as of August 5, 2024. Based on the Bloomberg US Corporate High Yield Index option-adjusted spread.

The Bloomberg US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes US dollar-denominated securities publicly issued by US and non-US industrial, utility, and financial issuers.

The Bloomberg US Corporate High Yield Index measures the US dollar-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.

Option-adjusted spread (OAS) is the yield spread that 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.

The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.

Discussions about the average amount of time it takes for the market to recover from a correction sourced from Bloomberg as of August 5, 2024. Based on the Dow Jones Industrial Average Index drawdowns and market cycles since 1945.

The Dow Jones Industrial Average is a price-weighted index of the 30 largest, most widely held stocks traded on the New York Stock Exchange.

The Sahm rule is a recession indicator that says that the early stages of a recession are signaled when the three-month moving average of the US unemployment rate is half a percentage point or more above the lowest three-month moving average unemployment rate over the previous 12 months.

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.

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

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

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 perspective and opportunities into focus. I'm Brian Levitt.

Jodi Phillips:      

And I'm Jodi Phillips. And today we have Alessio de Longis back on the podcast. Alessio is the head of investments for the Invesco Solutions team.

Brian Levitt:      

It's good timing, Jodi. I like the idea of having Alessio on right now, in particular.

Jodi Phillips:      

I do too. It gives us an opportunity to get away from the news flow a little bit and focus on what really matters to markets.

Brian Levitt:      

Yeah, I couldn't agree more. I mean, things are coming at us at a feverish pitch in the news right now, and maybe we all just need a little bit of a step back from breaking news and focus on the types of things that will likely matter most for investors over the short term and intermediate term.

Jodi Phillips:

So what types of things in your mind, Brian, what is that?

Brian Levitt:      

Yeah, I mean, it's the things we always talk to Alessio about. What's the state of the economy? What are the markets telling us? How are policymakers likely to respond? Things beyond who's going to win an election and who's a running mate and these other issues that tend to matter more.

Jodi Phillips:      

Absolutely. And what I really like about our conversations with Alessio is that he has a systematic approach to answering those questions. It's not just about pontificating, it's about reporting what his preferred indicators are telling him.

Brian Levitt:      

You're suggesting I pontificate too... That's what I heard in there, that I pontificate too much.

Jodi Phillips:      

That's what you got from all that?

Brian Levitt:      

That's what I got.

Jodi Phillips:      

Brian, it's not about you. No.

Brian Levitt:      

I hear that a lot in life. "It's not about you." Well, fair enough. Today it is about Alessio, so let's bring him on. I hear he's in Milan, probably visiting family, dialing into the Greater Possibilities podcast.

Jodi Phillips:      

Jealous. Well, thank you so much, especially for joining us today, Alessio.

Alessio de Longis:           

Jodi, Brian, always great being with you. And yes, I am calling from Milan. I just spent a week with the Invesco colleagues in the Milan office.

Brian Levitt:      

That sounds great, sounds great. And say hi to the de Longis family from all of us. So let's start broad. What are you seeing in the economy?

Alessio de Longis:           

So it's a very interesting moment for the economy because for the last two years we've seen an economy, both especially in the US but somewhat also globally, where growth has been very stable right around trend or just below trend levels. So let's say that in developed markets we've seen stable growth between 1% and 2% with a historically low unemployment rate, but generationally low, right? We're talking about the lowest unemployment rate in the entire developed world, going back decades and decades to World War II times, so to speak. At the same time, more recently we've begun to see some cracks. Not cracks in terms of alarmism, but some indication that some of the data points, some of the indicators that we were waiting for to prove, to deliver a cyclical rebound consistent with the solid outperformance of equity markets over the last 12 months.

Well, we are not really seeing that. We're seeing strong consumption, very strong job growth. But when you begin to look at the more forward-looking indicators such as the ISM surveys, both manufacturing and services, there we are at or below 50 and declining. We are seeing the new orders indicators, the inventory, the sales ratios rolling over, and as I mentioned, starting from already relatively below trend levels. And for the last two months, we have seen two consecutive retail sales reports printing substantially below expectations or even seeing downward revisions to previous months.

Brian Levitt:      

Although the recent retail sales report was a little bit better.

Alessio de Longis:           

Correct. Yes, that is true. That is true. So all in all, we are seeing some evidence in the data that certainly the economy is not going for escape velocity so to speak. It's not going for a major re-acceleration. If anything, we're staying at this below trend level and possibly decelerating somewhat. I wouldn't call it by any stretch of the imagination, anything like recession risks or anything like that, but an economy that is probably not going to deliver on the very, very aggressive optimism of markets over the past 12 months. What do I mean by that? We've seen double-digit outperformance in equity markets relative to fixed income. We've seen credit spreads touching new cycle lows across all sectors. High-yield loans, investment grade, emerging markets debt. Credit spreads are practically at cyclical lows. So markets have definitely priced out the recession risk of two years ago.

They have priced in the continuation of the cycle. Maybe they have priced in also a healthy rebound in the cycle and that's where we're drawing a little bit of a question mark today. I think the weakness in the data that we're beginning to see may be a reminder for the next few months that we still have a lot of tightening that is making its way into the system. The yield curve has been inverted for almost two years now. Real rates are very tight, inflation is rolling over, which is very good news. I'm sure Brian will later discuss the advantage of the policy implications of such scenario.

But overall, we are, to bring it all together in a nutshell, our systematic framework, as Jodi reminded us, our systematic framework has spent the last year flagging a recovery regime, flagging a rebounding in the economy. And just in the last couple of weeks, our systematic approach to modeling the business cycle is now flagging a rollover, a slowdown. In other words, actually technically we're calling it a contraction, meaning growth below trend but with a high probability of decelerating over the next few months and quarters.

Jodi Phillips:      

All right, so that's a lot to put together, Alessio. Calling this a contraction, technically speaking, a rollover, slowdown. What are some thoughts about positioning in portfolios in this type of environment?

Alessio de Longis:           

When we look at this picture, as I mentioned, we don't see at this stage large imbalances and stretched economic sectors that warrant — or even the behavior of labor markets certainly don't flag a recession risk anytime soon. I think despite this scenario, given that we spent the last 12 months in our portfolios being very procyclically tilted, I think if our framework proves correct, which is of course it's only a matter of probabilities. If our framework were to prove correct, we are basically repositioning our portfolios under the view of a necessary de-risking in exposures.

What do I mean by that? We have been overweight equities and credit for the last 12 months. We are bringing those exposures back to neutral or somewhat defensive. So we have recently moved our equity allocation to marginally underweight relative to fixed income. We have increased duration in the portfolio from neutral to slightly overweight, extending to maturities not beyond the seven to 10-year part of the curve given the inversion of the yield curve.

And we have also taken down credit risk, mainly taking it down via high yield where spreads are the most tight compared to historical standards. But the order of magnitude of these decisions is certainly not one arguing for a major risk off event. That's not what we expect. We expect somewhat of a consolidation in market performance, maybe a little bit of an increase in volatility. And we have also reduced the exposure from international equities and emerging market equities favoring again US equities now.

Brian Levitt:      

Alessio, talk to me a little bit about the market focus now that as the economy is slowing, the attention seems to be going towards what the Federal Reserve will do about it rather than a focus on the economy. Do you think that this is a short term phenomenon and the market will ultimately return back to fundamentals?

Alessio de Longis:           

Well, I think, Brian, you are absolutely right that at the moment the market is actually welcoming. When you look at the correlations of when interest rates drop in the anticipation of Fed cuts, you don't get that correlation of a risk off environment, but rather you get the reflationary trade, right? So meaning that at the moment, markets are not seeing or they're not concerned about a rollover in the economic data, but rather seeing and welcoming the rollover in inflation, therefore anticipation of rate cuts coupled with stable growth means extension of the cycle and reflationary trades. What are those? We see stocks rallying favorably, we have even seen a resuscitation in small caps and mid-caps more recently. So that is clearly the more procyclical trade, which is highlighting exactly what you have described. The market is now taking the view that growth is solid, growth is strong, it's on the low side, but likely to reaccelerate, and welcomes the fact that inflation is coming down and the Fed is able to support it.

So now the question is, how far and what kind of data do we need to see for the market to start trading differently? For the market to begin to react to the narrative that rate cuts are actually there, maybe to support an economy that is otherwise not able to deliver. I don't think we're there. So with that being said, why our positioning towards the defensive side, we see a bit of a stretched performance in risky assets and simply believing. Now, our tactical framework, our tactical horizons may not be appropriate for every investor listening to us. So I would say more we are positioning more for a consolidation in the price action over the next three to six months, nothing beyond that.

So that's how our defensive positioning posture should be interpreted as of today. And of course, as you know, we will always publish the real-time pulse of our indicators on a monthly basis. But I concur with you that otherwise as of today, any softening in the market should be seen as an opportunity to stay invested and potentially adding to exposures, bringing portfolio targets where one sees them as best appropriate. This is not an environment, a risk-off environment, what we're calling for.

Jodi Phillips:      

So Alessio, you made it very clear that you don't see signs of an imminent recession risk, but what would you be seeing if a recession was on the horizon?

Alessio de Longis:           

Well, as you know, the first thing on the asset prices side, the best leading indicator of the distinction between a soft patch versus something potentially more nefarious, in my mind it's always a high-yield spread.

Brian Levitt:      

A canary in the coal mine.

Alessio de Longis:           

That's right, that's right.

Brian Levitt:      

Have we talked about this in the past, Jodi, that they don't use canaries anymore? I've mentioned that before, right?

Jodi Phillips:

Yes we have. Yes we have. We did alleviate your concerns.

Brian Levitt:      

Yeah, they use detectors now just like the rest of us have in our homes. That seems like the smart way to do it.

Alessio de Longis:           

Okay, I was wondering if they had chosen a different bird. But yeah, on the asset prices side, definitely credit spreads and the more risky side of credit markets is definitely that canary or detector in the coal mine today. When we look at the economic data, my favorite indicators from a short-term perspective remain always indicators related to the inventory cycle, to the manufacturing cycle. So the ratio of orders to inventories in some of these.

PMI service and the ISM service are always good indicators for temporary three to six months adjustments in expectations as well as production. Now from a bigger picture perspective, I think we can all agree that there is really only one indicator that matters today next to inflation, and that's unemployment. And only if and when unemployment will begin to show steady deterioration, that's when we have to really begin to worry, right? Because from a distinction between a soft patch versus a recession. So that is the nexus in my mind, credit spreads and employment.

Brian Levitt:

It seems like it would be hard to have a recession when you came into this environment with so little excess. Not only was there so little excess, we didn't have enough inventory. We didn't have enough homes. The things that usually tend to get inflated relative to the broader economy, whether it's an inventory build or whether it's residential investment, it felt like even at the start of this, we had a long way to go just to get to a point where we had enough stuff to be able to sell rather than being worried about excess. Am I thinking about that correctly?

Alessio de Longis:

You are absolutely thinking about it correctly. As you have explained very well in the last few years, the entire cycle of production demand and inventory buildup and the consequences that we have seen to inflation, which were completely unexpected compared to the templates of the last three, four years. The disruptions that we've seen in supply chain management and demand management have led to a very difficult environment for us to really gauge where that inventory cycle is. So where that leaves us is really ultimately demand spending, consumption spending, retail sales are probably the most reliable indicator today of consumer demand.

You are absolutely right that there are no large imbalances to speak of, not on the housing side, not on the bulk of the corporate sector, especially the larger capitalization companies. We know that the industrial complex, the corporate complex in the US today is particularly skewed. There are concerns around the leverage and the thin profit margins of a large chunk of the industrial complex in the US, namely more representative of the small and mid-cap universe of the equity market, right? Where margins are smaller, interest costs have been certainly more demanding than in the past. So that's where there is, we bring it back to this question on credit. If there are any imbalances that warrant some real time analysis is in my mind the lower capitalization, the credit sectors in the lower capitalizations of the market. But so far, we have seen very resilient credit spreads. Exactly. Very, very resilient.

Jodi Phillips:      

Alessio, looking at market performance, narrow markets, market concentration is a theme that we've been discussing for a while. In your mind, what would it take for markets to broaden?

Alessio de Longis:           

That's the eternal question because the last 12 months have felt like eternity. Ever since the May 2023 earnings call from Nvidia that brought the theme of AI, we know markets have gone through an unprecedented narrow leadership in performance and we've never seen this level of market concentration. When we look at history back on the S&P 500 or the Russell 1000, what would it take? A continuation of the cycle led by a return of inflation back to 2% or even sub 2%.

We're not just talking about broadening to the things that have not worked over the last 12 months. The real, real next cycle in the equity market is really a broadening out to the themes both domestically and internationally that have taken a backseat. In that scenario, now that could be even more of a long-term cycle broadening rather than just a short-term dynamic. But to me that's the elephant in the room. The outperformance of smaller capitalizations, outperformance of value, dollar down, outperformance of international equities, outperformance of emerging markets. All of it versus what? We're talking versus the S&P 500, versus the blend. That is really the scenario that would lead to a much, much bigger broadening in market performance. Catalyst for that? Inflation sub 2% and rate cuts led by the Federal Reserve, right? Basically driving forces in the market that lead to really a shift also into international equities.

Brian Levitt:      

We haven't had a typical environment like that in a very long time. And you think about the ends of the last cycles, whether it was '08 or whether it was the pandemic, you didn't have an easing cycle. You just went to zero and responded. So perhaps investors aren't remembering what you just described could look like.

Alessio de Longis:           

That's a very good point. We have had a couple of instances of that. Remember the global synchronized reflation of late 2016 that then led to also very strong 2017 performance? That was led by international stocks.

Brian Levitt:      

I do. And then we had a trade war.

Alessio de Longis:           

Exactly.

Brian Levitt:      

We had a trade war and we had Fed rate hikes. We didn't let it go on.

Alessio de Longis:           

Correct. And then you are absolutely right. Following the trade wars that dominated 2018 and 2019, then towards the end of 2019, Q4 2019, we had a very similar dynamic. We had the beginning of a new globally synchronized reflation trade, and then COVID came and killed it.

Brian Levitt:      

Yeah, never gave it a chance.

Alessio de Longis:           

Never gave it a chance. So maybe those, you are absolutely right, Brian. Those are the most indicative data points of what that scenario could look like today without calling necessarily for the beginning of a new emerging market cycles that last 10, 15 years, right? Because we know some of those conditions may not be ready just yet given some of the dynamics in China, given some of the dynamics in other countries. So overall, still in this environment where I think we cannot see a recession on the horizon, we cannot see a major cyclical rebound on the horizon. And maybe the best policy is to simply stay the course and actually allow the Federal Reserve to deliver that very close recalibration of policy back to neutral. Those two or three rate cuts that simply unwind the insurance hikes of a year ago, and allow the economy to grow at potential. We are actually pretty much in that sweet spot. Full employment and inflation hopefully getting back to target in the next few quarters. That could be a very favorable scenario, favorable environment for markets.

Brian Levitt:      

Jodi, apologies for hogging this, but I'm going to ask a couple of questions for a friend here who may be me. When you think about how the market has responded in recent days to expectations of Fed rate cuts, the idea of small over large or some broadening of the market, is it possible that your indicator when you look at risk sentiment could potentially flip back to more of that recovery trade that we're talking about sooner rather than later? And I know that there's proprietary reasons and different compliance reasons why we can't discuss that specifically, but is it in the realm of possibility?

Alessio de Longis:           

What we see today, and again, as Jodi mentioned, I'm wearing now the purely systematic hat, interpreting what the models have done, are doing or are likely to do, and under what circumstances, right? Then I may agree or disagree with what the models are indicating, but then again, I'm not necessarily right more often than they are. What we see today, the most likely scenario is that we remain positioned defensively in this what we call contractual regime maybe for the next three months. At this stage, I don't see a scenario where we're likely to be positioned defensively for much longer than that as of today. And therefore, what it would take is simply markets and the economy not to get worse, not to deteriorate, but just trading sideways over the next three months to basically allow the models to then reengage in a more procyclical fashion.

I think there is a 50% or higher probability that that is the scenario that we're going to see. Now, interestingly enough though, over the next three, four months, we also have a major, major market event such as the US election, which again, Brian, you more than anybody, have always stressed how nobody should position ahead of an election in the anticipation of the election actually mattering at the end of the day for markets. And that is absolutely true.

Brian Levitt:      

Thanks for listening.

Alessio de Longis:           

And definitely we're not arguing for that, but it will certainly be an event in the calendar that will lead to some potential reaction in the market, exacerbate right or wrong, certain price dynamics before and right after that. So there are basically catalysts and pivotal points over the next three, four months to allow the markets to take a more constructive or a more defensive tone. But as of today, we are not overly worried and we see this as a natural adjustment in markets, a consolidation in markets after 12 months of simply outstanding performance. I mean, let's not forget the double-digit outperformance that equity markets have posted relative to fixed income and how credit spreads are at all-time lows practically, despite this being already a long in the tooth cycle. Now, Brian, you mentioned something though that if you ask me what has been keeping me up at night in the last few months.

Brian Levitt:

Jet lag.

Alessio de Longis:           

Besides the jet lag, good call, but also this changing correlations between bond yields, interest rates, and the performance of equity factors or equity styles. You alluded to it earlier, right?

Brian Levitt:      

Yeah.

Alessio de Longis:           

Historically, this is a very important, I think it's important to remind our listeners of how dynamic markets are and how certain dynamics can live in the short term, but we should not lose sight of the long term in how we construct portfolios. Typically, when we see interest rates decline, we see our performance of longer duration, higher sensitivity assets such as quality stocks, mega cap, technology, and we see underperformance in smaller capitalizations and value. Why? Because typically those interest rates go down, bond yields go down when they're associated to negative gross surprises. Today, those bond yields are going down because we're seeing negative inflation surprises, which are welcome, but we're not seeing meaningful negative growth surprises. Right? So actually let's quantify that.

When we go back and look at the relationship between bond yields and the equity factors or equity styles that we just described, that correlation is positive, right? Bond returns, higher bond returns mean higher returns for quality, for tech at the expense of value. That is true in 80%, 90% of the observations of the time covered between the 1980s and today. But today, and therefore just in that 10%, 15% of the observations that we've seen the exception to the rule, we have seen this type of dynamic today.

We have seen another couple of times in history. One of them was during the NASDAQ '99, 2000 rally, and another couple of instances in the mid-1990s where the correlation between bond yields and equity styles flipped. It was temporary. That is not the natural state of the world. So ultimately the question is, will growth hold up? What do we see today? The surprising indicators, we can mention the various surprise indicators that various dealers compile, which are very useful, are pointed to negative gross surprises in the US. We mentioned a few data points earlier. So that's where we need to see, that's what we need to watch, is that indeed the softness in the data that we've seen is not there to stay, and therefore we can hope for a reflationary easing cycle that allows markets to continue.

 

Jodi Phillips:      

So Brian, is this the escape from the daily headlines that you were hoping for?

Brian Levitt:      

It felt good.

Jodi Phillips:      

We ended on hope.

Brian Levitt:      

I mean, we mentioned the election briefly, but otherwise, I mean, the questions that I'm getting are so focused on the day-to-day news flow and simply not stepping back and focusing on a systematic approach or even thinking beyond the tactical, how the next few years play out. And I just love hearing Alessio put into context these concerns about an imminent recession. They don't seem there. Yeah, the model turned to be a little bit more defensive, but not necessarily something that's going to be a prolonged stance likely in the portfolio. So just a very well-thought-out conversation and it took me out of the news flow, which I certainly appreciated.

Jodi Phillips:      

Yes, and thank you for joining us from Milan, Alessio. Much appreciated taking time out of your day or night, I'm not really sure, to be here with us. So Brian, as you pontificate on the markets and the economy, where can people get the latest from you?

Brian Levitt:      

I think it is pontificating actually, guilty as charged. Visit Invesco.com/BrianLevitt to read my latest commentaries. And of course you can follow me on LinkedIn and on X @BrianLevitt. Alessio, great having you. Jodi, fun as always.

Jodi Phillips:      

Thanks so much. 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 July 17, 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.

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.

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

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.

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

All data provided by Invesco unless otherwise noted.

References to the historical economic growth of and unemployment in developed markets is from Bloomberg as of June 30, 2024.

Information about the Institute for Supply Management, or ISM, surveys is from ISM as of June 30, 2024. The ISM Manufacturing Index monitors employment, production, inventories, new orders, and supplier deliveries for manufacturers. The ISM Non-Manufacturing Index monitors business activity, new orders, employment, and supplier deliveries for non-manufacturing companies.

References to the double-digit outperformance of equity markets is from Bloomberg as of June 30, 2024. Based on the 12-month performance of the S&P 500 Index, which returned 24.5%, versus the Bloomberg US Aggregate Bond Index, which returned 2.6%.

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.

References to credit spread touching new cycle lows is from Bloomberg as of June 30, 2024. Based on the option-adjusted spread of the Bloomberg US Corporate Bond Index.

Option-adjusted spread is the yield spread that 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.

The Bloomberg US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes US dollar-denominated securities publicly issued by US and non-US industrial, utility, and financial issuers.

Discussion about the relationship between bond yields and equity styles sourced from Bloomberg as of June 30, 2024. Based on the historical correlation between the S&P 500 Index and the Bloomberg US Treasury Index.

The Bloomberg US Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury.

The Russell 1000® Index, a trademark/service mark of the Frank Russell Co.®, is an unmanaged index considered representative of large-cap stocks.

Purchasing Managers’ Indexes (PMI) are based on monthly surveys of companies worldwide and gauge business conditions within the manufacturing and services sectors.

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.

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

Spread represents the difference between two values or asset returns.

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

AI stands for artificial intelligence.

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. 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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All data provided by Invesco unless otherwise noted.

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.

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.

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.

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

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

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.

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