Branstad: Hi, everyone. Thanks for joining us today. And welcome to Thrivent Asset Management's Capital Markets Perspective on the third quarter. I'm Jeff Branstad, a portfolio manager. This is Steve Lowe, our chief investment strategist.
Steve, we're about halfway through 2023. How have you seen the year playing out?
Lowe: It's been a very resilient economy in many ways despite higher Federal Reserve (Fed) rates. And it's not where consensus expectations expected the market or the economy to be. We've had a very, very strong equity market narrowly led by mega caps, sparked in part by developments in artificial intelligence. Credit markets have also been solid – high yield bonds and investment-grade corporates have posted very good returns.
The market has pushed back expectations of Fed rate cuts this year into 2024. That's due to a strong economy and a very hawkish Fed [which is expected to hold rates] higher for longer. But, critically, inflation is decelerating pretty significantly and that's increased hopes of a soft landing.
The one potential hitch is a stronger economy – if it reaccelerates, that may increase the odds of inflation staying more persistent. If that happens, then you’d see the Fed raising rates again and an increased chance of a mistake or a recession.
Going forward, I think, as always, the Fed is going to be critical, but also the economy, inflation, and earnings, along with breadth of the market.
Branstad: So, the economy has generally held up better than expectations. Why do you think that is?
Lowe: I think a key part of it is the jobs market, which has been very strong, and it has been for several years now. And a part of that is that there's a shortage of workers. Also, companies are hoarding workers because they're concerned that, if they let them go, they won't be able to hire anybody back.
Also, consumption drives the U.S. economy. That's been very strong, especially in services. And you're seeing areas that were hurt by the pandemic still rebounding, such as travel. The consumer is in very good shape, overall. Debt levels are relatively low. Savings are still solid. I think the key point is that inflation is subsiding. People got hurt by high inflation. They fell behind on wages. They actually had negative wage growth after factoring in inflation. That has just flipped positive.
And I think there's also a debate over how rate sensitive the economy is right now. Is it less sensitive than it used to be? One example of that would be a period of very low rates when people locked in very low mortgages. And those can last for the average life in a home, which is about 13 or 15 years. Those are less sensitive to Fed rate increases.
I think it's also important to remember that turning points in the economy, from strong to weak, are always very muddy and often contradictory. Right now, we have forward indicators that look very negative and they're at levels where [historically] we've always had a recession, [like the leading economic index]. Yield curves are deeply inverted, and that can signal a slower economy or recession. Manufacturing is very, very weak, but services are strong and there's still solid spending. At the same time, bankruptcies are going up and delinquencies are going up. There’s a lot of savings, but it's being depleted very rapidly right now. The labor market, as I mentioned, is very strong, but you can see signs of easing. Jobless claims are going up; openings are starting to go down. And, typically, jobs hold up very well until you hit a recession and then they fall off very quickly. So, there's not a lot of lead time there.
Branstad: What are you expecting for the second half of 2023?
Lowe: I think the best way to put it is that I think the slowdown has been postponed, but not canceled. It just got pushed back. GDP, or the economy, in the first half of the year grew at about 2%. It’s forecasted to soften some going forward.
I think it's also important to remember that Fed rate hikes take time to impact the economy, anywhere from 12 months to up to a year and a half or two years.
Branstad: So, a recession is still on the table. We haven't hit a soft landing, at least yet.
Lowe: Well, as we've talked about, Fed cycles often end in a recession. I think the odds are lower than they were a few months ago, but they're still meaningful. But it's more likely to come maybe the first half of next year or very late this year. And it's not a given by any measure.
The chances of a soft landing have increased significantly over the last several months. [We could see a] so-called “immaculate disinflation” where inflation subsides and the Fed can cut – so, it could be different this time. Maybe the amount of money circulating still from the pandemic allow people to get through this. But I think it's just that the slowdown will take longer to play out. If there is a recession, we expect it to be mild. And if there isn’t, we’d still expect a slowdown.
In the long term, we're very positive on the economy. I think artificial intelligence could be a game changer. There's a really strong capital spending cycle going on related to manufacturing and companies reshoring, along with the investment in technology, too.
Branstad: Okay. With inflation having fallen pretty significantly, how is the Fed looking at rates and the economy overall?
Lowe: It's still very hawkish. They don't want to repeat the mistakes of the 1980s and cut inflation only to have it come back.
But, there are very positive signs that inflation is falling. Goods prices are down – used cars are a classic example of that. They ran up and they're falling pretty quickly now. Rent is falling. And supply chains have largely unraveled and pressures there have eased. And consumer price inflation, which people are most familiar with, has fallen from about 9% to 3%.
The issue is that core services is more persistent and too high, and it's higher than it was during the pandemic. And that's a lot more sensitive to wage pressure.
I think, looking forward, after the Fed hike in July, they’ll pause. There's a decent chance they hike in September, but then they’d hold rates high into next year while they assess the impact, at least that’s their expectation. I think there's a substantial risk that they will have to cut earlier than expected as the economy slows and inflation falls further from the impact of higher rates over time.
The risk of that view is that inflation does stay high longer and then they do have to raise rates again. And that's not good for the economy.
Branstad: So, what kind of impacts are we likely to see from tighter financial conditions?
Lowe: Yeah, it's not just the Fed. There are a number of other elements that impact it. The Fed obviously is in the most aggressive cycle in 40 years – it's a shock when rates shoot up from basically zero to relatively high levels. But, banks have been tightening credit standards and they're charging more for lending spreads. That has an impact.
Mortgage rates are higher and it takes time, though, for that to have an impact. Consumers and companies are locked into low-cost debt, but eventually they’ll have to refinance, and that's when it has an impact.
I think a good example is a broad bond index called the Bloomberg Global Aggregate Index, which is about $250 trillion. Yield was a bit below 1% and now it's about 4%. So, if they just had to pay the market rate instantly, that's $8 trillion more in spending, in interest costs for them. That's a lot. That's equal to the size of Japan and Germany combined.
So, we're already seeing signs of higher stress. I think the banking failures were partially related to that, like Silicon Valley Bank. Commercial real estate is challenged by higher rates – they have other issues like office vacancies with hybrid work. I think another area to watch is the private debt market. There's a lot of leverage there. It’s maybe a bit of a bubble. And the rates will hit as refinancing gets harder. So, I don't think we've seen the last of the impact of higher rates.
Branstad: Where do you think those rates will be? Or, where do you think they're going to go for the rest of the year?
Lowe: I think the Fed will stay high, but I think Treasury rates are going to fall, particularly longer-term rates up to the two-year rates.
We are positioned [towards] long duration, which means we're taking interest rate risk now because we expect rates to decline as the economy slows and inflation tails off. And that's what typically happens when the Fed stops hiking. If you look at Treasury curves, they have been deeply inverted and they should steepen going forward. That's what happens in front of a recession or slowdown as short rates come down [along with] expectations of Fed cuts.
Branstad: Let's shift gears a little bit. Let's talk about the equity markets. What do you see going on there?
Lowe: Equities have done very well as the Fed pause approaches, and that's typical as markets look toward a Fed pivot and a greater chance of a soft landing. But there've been a lot of other drivers. Earning expectations were too low. Company guidance has turned more positive. Positioning was light – a lot of people came into the year underweight, and they've had to buy equities to catch up.
But what really stands out is the narrow breadth of the market. A handful of mega caps have driven the market. The seven largest equities in the S&P 500® index – and they're mostly tech – have driven half of the first-half performance. They're sometimes called the “Magnificent Seven” – they’re household names: Meta, Apple, Amazon, Microsoft, Google, Nvidia and Tesla.
You've also seen equal-weighted indexes trail market-weighted indexes, particularly in the S&P 500. The S&P 500 is a market weight index, so it's driven by the mega caps. But equal-weight indexes have trailed substantially.
So, one of the sparks for this has been investors flocking to the potential of artificial intelligence. That's jumpstarted some of those names being boosted. The other thing is that there's safety in mega caps. So, if you expect growth to slow, these are solid companies – they have strong cash flow and solid balance sheets.
One of the issues, though, with narrow breadth is valuations, and they're rich compared to history. If you look at what's driven the market, it's been an increase in valuation this year because earnings have not grown this year. But it's not like the tech bubble. These companies actually have profits and ultimately earnings will drive the market.
The issue with earnings going forward, I think, is margin compression, particularly because [high inflation allows companies to raise prices]. It also boosts revenue. And when inflation is falling, revenue starts falling but costs fall less, and [companies] end up with margin compression, which hurts earnings.
Branstad: So, how is Thrivent Asset Management positioning portfolios for the rest of this year and heading into 2024?
Lowe: We've been moderately overweight to equities all year. Our long-term default is to be more significantly overweight [to equities because they] outperform over the long run. We intend to remain overweight, at least for the near term as the Fed cuts approach. But I expect we’ll turn more cautious as we get closer to 2024 [in anticipation of] a slower economy and earnings. And when there is a correction, we'll be looking for opportunities. I think the signs to watch for are the signs that the economy is also bottoming. Typically, things like manufacturing surveys turn in the middle of a recession – they start turning up – and also indications that earnings are troughing.
Branstad: What about on a style basis? Growth versus value?
Lowe: Growth has crushed value this year so far because all of the mega-cap names are growth names. You’ve seen signs of growth in cyclicals improving. But we expect quality companies to continue to outperform as earnings slow because they do have strong earnings and are supported by strong cash flows.
[The small-cap segment] have trailed year-to-date. It's done a little bit better more recently; the values look attractive. But I think it's a little early [to buy] because the time you want to buy small caps is into a cyclical turn or ahead of a cyclical turn, and we don't think we're there yet. So, that's maybe later this year or 2024.
International equities look very cheap, but they're going to be more cyclical and hit by a global slowdown, and there's secular headwinds in a number of markets.
Branstad: Alright. Lastly, before we go, could you touch on the credit markets and your outlook on those?
Lowe: I think, going forward, we favor higher quality and duration versus lower-tier credit risk – high yield would be in a lower-tier credit. So, that would leave us with investment-grade corporates – they’re much more stable and higher quality. [The high yield segment] is certainly not priced for a downturn. It looks very rich. Defaults could rise meaningfully in a downturn. We've already seen leveraged loan default rates tick up pretty significantly. So, we're trying to be patient. We would add at more attractive levels in credit, particularly high yield.
If you’re a yield-based investor, yields look very attractive. If you can deal with the market-to-market volatility, I think it's a good time to look for yield in the market.
Branstad: Excellent. Thank you so much, Steve. That's an excellent overview of what Thrivent Asset Management is seeing.
And thank you all for joining us. Please visit us at thriventfunds.com for more insights and we'll see you soon. Bye.