Branstad: Hi, everyone. Thanks for joining us. I'm Jeff Branstad, a portfolio manager here at Thrivent Asset Management. This is Steve Lowe, our chief investment strategist. Today, we're going to talk to you about our perspective on the capital markets.
But first, let's talk a little bit about 2022. It's been a pretty wild year so far. Could you give us a recap and bring us up to speed on where we're at today?
Lowe: It's been a very volatile year. Both sharp moves down and sharp moves up. There've been a number of bear market rallies. The largest was about 17% toward the beginning of the summer. So, it's been challenging for equities at bear market levels, down 20% – I think they bottomed at about 25%.
Bonds, too, have been hit very hard – it’s the worst return in decades. If you look at the benchmark ten-year Treasury, and if the year-to-date return holds, it’s the worst since the late 1700’s, which is pretty crazy – that’s the beginning of the republic.
Because both equities and bonds are down, the returns for mixed-asset portfolios are also the worst in decades. So, our expectation is that this volatility continues, which is typical when the Fed is raising, and particularly when inflation is very high.
Branstad: Speaking of inflation, is it safe to say that's still the primary driver of what's moving the markets today?
Lowe: Absolutely. It is everything right now. Inflation and the Fed's response to it are what continue to drive market and the economy, really. So, inflation remains high. Core inflation is very elevated. The concerns that wages in particular, rents, and what's called owners equivalent rent – which is an imputed cost of owning your home – and other core services, will remain persistent.
But, at the same time, there's a lot of signs that inflation is easing a bit. The most obvious is gas prices at the pump; those are down. Other commodities are down. You're seeing used car prices, which got really elevated; they've fallen off a lot. Freight rates have plummeted, and that's really a sign that there's less demand on the end user for moving goods around. It's also [a sign] that inventories are very high and retailers are discounting.
You've seen housing prices go down with very high mortgage rates. Our expectation is that this will continue and that inflation will end the year, toward 3–4% next year in 2023. But, it's going to be a lot harder to get down to the Fed's old target of 2%. But inflation easing; easing opens the door for a Fed pause.
Branstad: What are your expectations for how the Fed is going to react, not just for the rest of this year, but going into next year as well?
Lowe: We expect the Fed to continue to raise [rates]. We think they’ll stop at around 5%, probably in the first quarter of 2023. Why they want to stop is just to assess the data and see how it reacts to higher rates, because monetary policy acts with a lag, sometimes up to 12 months. They need to make sure that they're not being too restrictive – over tightening – because when the Fed raises, they often make mistakes and recessions often follow.
We would expect cuts probably around later 2023 or so. If you look at what metrics to watch for when the Fed cuts, the first is inflation, obviously; it needs to cool off. Historically, the unemployment [rate] has risen significantly for at least a few months. The unemployment rate has gone up. That's true both for times that we've gone into recession and for times where we've had soft landings. They're also watching credit spreads because they can indicate where financial conditions are. Those are up, but they tend to move up significantly ahead of the pausing or the Fed cutting rates because they get concerned about financial conditions then.
Branstad: Before we get to the pause and the eventual cut, are we going to be able to pull off this soft landing? Is the Fed going to tip us into a recession? What do you think?
Lowe: There's a very good chance they do. There's a narrow path to a soft landing. It's tricky. Most Fed cycles end in recessions. The economy is clearly slowing in response to higher rates and high inflation. You can look at consumer confidence; It's very low. That's a function of high inflation. People are having a hard time meeting their budgets. CEOs also have very low confidence right now.
Then you look at measures of economic activity, particularly the manufacturing and the service sectors. There are surveys in the U.S.; the most popular is ISM, but there are also PMIs that measure the level of activity. Those have clearly slowed for both the manufacturing and the service sector. Housing has cooled significantly because of higher mortgage rates. Private sector spending is slowing down.
That said, the tricky part is the jobs market, which is very, very tight, and the Fed needs that to loosen or to pause, particularly in order to cut rates.
So, if we had to handicap the odds of a recession, you can look at models – which may or may not be accurate – and those are anywhere from 100% to well below 50%. I think, most likely, the odds are north of 60%, probably around two thirds. There is a way to get a soft landing: inflation has to slow down quickly and the jobs market needs to loosen quickly in order to do that. If we do get a recession, I think [it would be] relatively moderate because the consumer's in very good shape and corporate balance sheets and companies are in very good shape heading into this.
Branstad: In light of that economic backdrop, what's your outlook for equities?
Lowe: We are modestly overweight equities, [but] not a lot, because there's still risks out there. But, valuations have improved significantly. They were very rich heading into the year and they've normalized to roughly average levels.
We've been tactical through this period. At this point, we're really looking with a long-term perspective in particular, because once you hit a bear market level, the odds of having a negative return – particularly over six months, but really 12 months – is relatively low, lower than 20% over a 12-month period.
The market is simply very volatile at the bottom, both up and down. And when it rallies, it can rally very quickly and very hard, as people who are short the market or below-weight equities scramble to cover their short. So, you don’t want to miss out on that because it tends to be very violent and very sharp.
Branstad: How about within equities? Are there some areas that are more attractive to you right now than others?
Lowe: Certainly. We are overweight domestic equities – we have been, and that continues. We’re overweight across market capitalization, meaning, we're overweight large, small and mid, but particularly overweight what we call SMID, which is small and mid.
When you look at small-cap valuations, they’re very attractive compared to history and they're attractive versus large caps. The time you want to buy small caps is when sentiment is very bad, when the market's near the bottom. The valuations are better, but they also tend to move quickly because they respond to a cyclical turn in the economy. We have added recently.
Branstad: How about international? What are your thoughts there?
Lowe: We're still underweight international. Europe in particular remains challenged right now. Inflation is extremely high there. Part that is a function of gas prices, and those have eased a bit. But, you still have the ECB hiking into a slowing economy and this is an area that had negative rates a year ago. There’s still a war in Ukraine, which is very hard to predict, and there's risk there. China, their largest trading partner, is slowing.
Earnings estimates remain too high right now. So, the valuation is actually relatively low compared to history. But, we need to see a firmer or a solid way toward earnings reviving and the economy turning up before we get more positive. And that's not there right now.
Branstad: What about within the emerging market space?
Lowe: We remain underweight emerging markets. There are a number of challenges there. You can look at inflation, which is very high. The U.S. dollar is extremely strong, and that is a headwind for emerging markets. They have imports priced in dollars and they have dollar denominated debt, which becomes more expensive. So, you have rates higher in emerging markets in response. Global trade is slowing.
But in particular, you can look at China, which is a huge part of emerging markets, and they continue to have shutdowns to control Covid. That's impacted the economy because often they're in key areas of China where there's manufacturing activity. The property sector is still extremely weak; it's about 25% of GDP or areas connected to it. Growth is just slowing. The other concern is that the government remains very involved in the economy and there are signs that they may be willing to trade off economic growth for other goals.
Branstad: What about on the fixed income side of the house? What are you seeing over there?
Lowe: First and foremost, the concern for most people is rates. We recently moved from being underweight duration to being about neutral overall duration. We're still short the short end of the curve, which means that we are looking for the Treasury curve to flatten, which typically happens in Fed hiking cycles. We think long-terms are likely capped or close to being capped at this point because the concerns for long rates is that they'll be driven more by concerns over slowing economy and lower inflation. The one area where you could get higher long rates is if inflation really surprises to the upside, and then that could shift long rates higher for a period. But, ultimately, they’ll be driven by growth concerns.
For yield oriented investors, the fixed-income market looks great. We've got the highest yields in years, if not decades. Investment-grade corporates, if you want high quality, look very attractive, but cheap compared to their history right now. High yield looks attractive from a yield perspective. Even with the short-term markets, you can get 4% in the Treasury bill; cash is a viable option now, for the first time in a long time.
If you look at credit spreads, they are right around long-term averages; we'd like an opportunity to buy if they get a little bit wider. We're watching that. We're at 600 basis points for high yield. We would probably jump in at around 800 basis points, would be much more aggressive.
As far as emerging market debt, we're still cautious on that. That said, there’s a lot priced in. If you're in a higher-income tax bracket, municipals on a tax-adjusted basis look very attractive.
Branstad: That's excellent. Thanks for all that great information, Steve. And thank you all for joining us today as well. We’ll hope to see you next time. Goodbye.