Branstad: Hi, everyone. Thank you for joining us today. I'm Jeff Branstad, a portfolio manager here at Thrivent Asset Management. This is Steve Lowe, our chief investment strategist.
Steve, 2022 was an awfully tough year. What stands out so far about 2023?
Lowe: Yeah, 2022 was definitely tough. We're off to a very solid start so far in 2023 across both fixed income and equities, something that didn't happen last year. Equities were up in the first quarter. Rates declined and credit, such as high yield bonds, held in really well. In particular, fixed income this year is playing a diversifying role, which it has historically done and which is something that we expected for this year.
And another interesting thing is we're starting to transition from “bad news is good news” – in other words, bad economic news allows the Fed [or Federal Reserve] to back off and maybe that's the route to a soft landing – to “bad news is bad news.” I think that what the market is saying or thinking is that they're shifting from focusing on a soft landing to worrying about recession risk going forward.
Branstad: So, the big key issues are the Fed, the economy, and earnings. So, let's start first with the economy. What's working well right now? What's not working so well?
Lowe: The economy has actually held up pretty well. The jobs market remains very strong, but there are still labor shortages out there. If you look at GDP [or gross domestic product] – the normal measure of economic activity – that's running at about 2%. The Atlanta Fed – which is sort of an outcast and does real-time forecasting – measures about 2.5% for the first quarter. The consumer is holding up okay; they're still in a relatively strong position.
Across the board, you can look at key forward indicators, and those are softening. The leading economic index is negative and it's at a level where historically there’s always been a recession. Yield curves are inverted. That's a sign that a recession may come – they've inverted before a recession. Sometimes there are false positives, though, where they invert and there is no recession. But the interesting thing is that curves have started to steepen and that is what happens just before a recession as the market begins to [anticipate] the Fed cutting rates.
You can look at surveys of manufacturers, in particular – those have generally been pretty weak. Another leading indicator is temporary employment; that tends to get cut first, and that's going down. Bankruptcies are climbing up. You can see higher delinquencies in credit cards and other areas. Banks like Bank of America or Citi – they publish real-time card data, and there's some signs that that’s softening.
Job claims are very low; they're rising, but the job market has still held up very, very well. But, that isn't necessarily a sign that there could be a recession because, historically, jobs hold up until they don't. It's usually the start of recession, then they fall very quickly.
I think the most important point is that credit standards are weakening. In other words, banks are tightening credit and there will be probably further knock-on effects after the banking issues.
Branstad: So, it definitely sounds like the likelihood of a recession is increasing. Is there any hope left for a soft landing?
Lowe: Well, there's still hope. Jobs are strong. There's still savings. The consumer is very good. So, it’s far from a foregone conclusion. I think the odds of a recession have gone up materially for either toward the end of 2023 or early 2024.
If you think there's going to be no recession, you have to point to all those indicators we talk about and say “that doesn't matter here;” the history is going to be different because several of them are at levels we've always had a recession. You can say history is different. We've never had a pandemic, shut down the economy, and then throw trillions of dollars into the economy.
I also think that another important point is that if there is a recession, it's likely to be mild.
Branstad: Monetary policy has been such a prominent focus the last several quarters. So, what's the Fed's thinking now?
Lowe: They’re thinking about when to stop. They're very near the end of the hiking cycle. There's maybe one or possibly two more hikes. Right now, I think they’re going to end in a range – because the Fed funds rate is a range – from 5–5.25%. Then, they’ll pause to assess the impact because monetary policy acts with a lag, sometimes up to a year or even more.
Rates already are in restrictive territory. When you throw in banks tightening credit, which they are right now, that's doing some work for the Fed. So, I think they want to pause and see how all this impacts the economy.
Branstad: How long would it be before they do start cutting again?
Lowe: Yeah, good question. They don't expect to cut at all this year and into 2024. I think they will cut before what’s been forecasted. The market is pricing in a very good probability that they will end up cutting this year. And the reason is that the economy is going to slow significantly later in the year and inflation will continue to come down most likely.
Branstad: So, how does this end? When is the end and how does it end? What is it going to look like?
Well, historically most hiking cycles end in recessions. And this is a very aggressive hiking cycle; it’s been a really rapid pace. When the Fed raises rates, historically, something breaks. We’ve had a few little things, some banking issues. If you look in the past, it’s been the mortgage and leveraged loan markets, or the tech bubble contributed to that. Go back further, there were the rolling debt crises in Mexico, and in Asia. You had bank failures like Continental Illinois, which was a high profile one in 1984.
And the issue is that money was essentially free. Rates were set at 0% and that encouraged risk taking. It's a shock when rates shoot up, then, because the cost of funding increases and liquidity starts draining from the economy. That's really what causes things to get stressed.
Branstad: What's the risk to this view then?
Lowe: Yeah, the risk to the view is persistent inflation. Certainly, the Fed will not cut at all this year because core inflation will stay high. Inflation is already easing. CPI, or the Consumer Price Index, has fallen from about 9% to about 5%. Good prices led the way. You're starting to see signs that supply constraints have eased; largely, freight rates are significantly down and there’s been some easing in services inflation.
But core inflation is still high, higher than the Fed wants, particularly with services inflation. But yeah, I think inflation will ease. If it doesn't, the scenario is the Fed is going to raise more than people expected and maybe they’ll have to come back, and that actually increases the risk of a recession if they have to come back again.
Branstad: With the hike, the pause, and all the timing around that, what's the impact going to be on interest rates?
Lowe: I think rates will head down. We already shifted from especially short duration or less interest rate risk last year toward neutral. We expect longer term rates to fall, and we think there will be opportunities to add duration. That's the way you want to be positioned, because we think the economy will slow from the impact of higher rates.
If you look at what happens when the Fed pauses: rates typically fall. It's choppy, but they typically fall after the Fed pause. If you look at curves, which have been deeply inverted, they should start to steepen, which typically happens after a pause and as the market starts to price in Fed rate cuts – there’s a chance of that on the front end.
Branstad: How about equities? How do you think those are going to be impacted?
Lowe: Yeah, I think equities will be challenged later in the year. Right now, we're underweight on our long-term strategy, which is to be overweight in equities, because equities outperform in the long run. So, where does that leave us? It leaves us roughly neutral. But we're looking for opportunities going forward through the year to reduce risk. In the near term, I think there is a positive dynamic with the Fed pausing potentially because, historically, equities have rallied after the Fed pauses as they look at the chance of a soft landing.
A soft landing is not our base case as we expect a recession or at least a significant slowdown going forward. So, our expectation is that equities retest the lows, which was down 25% in October, or get close to that before they sustainably rally.
Branstad: So, what kind of impacts are we going to see in earnings?
Lowe: Yeah, good question, because earnings ultimately drive equities over the long run. You've seen earnings estimates come down. I think they have farther to fall, and that's largely a factor of our expectation that the economy will slow. But, in particular, we expect margin compression or negative operating leverage because revenues have been pretty high. A part of that is just because of inflation. It’s boosted [the absolute number of dollars in sales that come in] and costs have gone up. But as that comes down, costs don't follow, and you get margin compression.
Branstad: So in a challenging environment like this, are there opportunities out there?
Lowe: Yeah, we think there will be opportunities later this year again. Equities may retest their lows, but we think there will be an ability to buy them at a more attractive valuation later in the year. Equities sustainably rally about the time there are signs the economy is bottoming, which is typically about halfway through a recession because the market is forward looking.
You can also look at indicators of whether earnings are bottoming, too. The momentum there is also a positive time to buy.
Branstad: Okay. So, really quickly, let's talk positioning. How would you be positioned in the equity side from a style in a market cap and region perspective?
Lowe: Yeah, I think growth last year underperformed by a wide margin to value. That has changed so far this year, and I think that will continue to hold. Lower rates have helped growth, but we expect quality companies – especially quality growth – to do well, and in particular companies with strong cash flows and balance sheets. That's typical in an environment where the economy is slowing significantly.
You know, small caps look attractive from a valuation viewpoint, but they'll probably lag in a recession. They tend to be more cyclical. So, I think the time to buy that isn't here and you want to buy it [further into] the recession as the market looks forward and small caps start to outperform. International valuations look attractive, but both the main markets – the European market and emerging markets – are also very cyclical and will probably be challenged a global slowdown.
Branstad: Let's close it out with a quick discussion on credit markets.
Lowe: Yeah, we have a bias for high quality and would favor duration over credit risk at this point because we do expect the economy to slow, and that's certainly not priced into the market – or at least a recession is not priced into credit markets like high yield because defaults will increase. So, we're looking for an opportunity to add there. You know, for an investor who wants yield, yields are attractive, but we think there will be a better opportunity later in the year to buy into credit markets.
Branstad: Excellent. Thank you for all that great information, Steve, and thank you all for joining us today. Goodbye.