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Host: Hello and welcome to Talking Markets with Franklin Templeton.
Ahead on this episode: how the largest Fed hike in nearly three decades, along with the possibility of subsequent significant hikes, could impact US markets and the economy. Plus, which developed and emerging markets face the most challenging economic and investing environments. And, why history shows investors worried about inflation should consider small cap companies.
Talking about it all is Gene Podkaminer, Head of Research at Franklin Templeton Investment Solutions; John Bellows, Portfolio Manager with Western Asset; and Frank Gannon, Co-Chief Investment Officer at Royce Investment Partners. They join Jeff Schulze, the architect of ClearBridge Investments’ Anatomy of a Recession program, for this conversation.
Jeff Schulze: The current macro environment is giving investors much to consider when making portfolio decisions: interest rates are surging, inflation is reaching new highs, corporate earnings may be slowing, and energy prices are spiking. Amid these developments, the path forward for investors seems uncertain at best.
However, when you go beyond the current headlines and look beneath the surface, the fundamentals appear to be positive. Pandemic-related supply chain issues are easing. Consumer demand is strong, and wages are rising. However, the Fed [US Federal Reserve] is getting more hawkish, which could challenge the path forward for the US economy.
You’ve seen a very strong tightening of financial conditions, and you’ve also seen a lot more rate hikes priced into fed fund futures. In fact, if you look at what’s being priced into the fed funds rate, in the first year of this tightening cycle, it’s 3.65%. That would be the second strongest tightening, to beginning of a Fed tightening cycle in a year since 1955.
Now, John, I want to turn to you first. How do you think that this is going to impact fixed income securities as we move forward?
John Bellows: Our view is that the risks around the Fed in the second half of the year are going to be much more balanced than they were in the first half of the year. The first half of the year was a string of successive, hawkish surprises. It was all one way, bond yields only moving up. And I think as we move into the second half of the year, the risks are going to be much more balanced, and I think there’s a risk for a dovish adjustment at some point.
The reasons for that would be as follows. You know, the foundations of a more moderate inflation going forward are actually falling into place. So, let me just give you a few examples. One would be wages. If you look at the last two employment reports, wage growth, month over month, has only been running at about a 3.5% annualized rate. There’s nothing particularly concerning about that, and over time, you would expect, kind of, moderate wages to feed into more moderate service prices. So that’s a really important consideration. And again, I think the foundation for moderation is already in place there. The other thing that I would point to would be in housing. The mortgage rates are 200 basis points higher. Every high frequency statistic, whether it’s new home sales or new home starts or number of days in the market or discounts relative to listing price, are all going in the same direction, and that’s lower. So, while we are currently reflecting on the CPI [Consumer Price Index] what happened three months ago, I think what’s likely to be in the CPI three or six months from now is something that’s going to be much different. And again, that’s very important as we think about what the direction of the surprises are going to be in the second half of the year.
And then the final thing that I just want to put out there is yields are a lot higher. We’re now pricing in a 3.5% funds rate by the end of the year. As yields go up, that affects growth, it affects sentiment, but it also means the risks are going to be a little bit more symmetric.
And I think the second half of the year in contrast to the first half of the year is going to have much more balanced Fed risks as we see a moderation in inflation, and I think those higher yields just kind of change the risk profile.
Jeff Schulze: Very interesting point, John. Yeah, if you look the three-month annualized rate of wage growth at the end of the year it was 6.1%. As you mentioned, the last two prints came in annualizing at 3.5%. So, obviously, that could be a reason for a more dovish pivot.
Gene, I want to turn over to you. And obviously when we think about interest rate increases impacting fixed income the most, but there are other assets that are impacted. So as someone who invests in multiple asset classes, how are you thinking about interest rates when it comes to equities and alternative investments? And do you see any examples of alts being used as an inflation hedge right now?
Gene Podkaminer: When we think about asset classes other than fixed income, we really need to understand what the macro factors that impact those asset classes are. And when I consider interest rates, it’s more of a reaction. It’s a reaction by central bankers to what is happening with growth and what is happening with inflation. So let’s take a moment to decompose what’s going on in the world of economic growth. We can talk really briefly about inflation because you laid the case out nicely. And then let’s think about how they fold together to influence interest rate policy and then what that means for the different asset classes
Growth is slowing, but it’s slowing to trend at this point. So not to zero, not to negative, but something like trend that we’ve experienced over the last couple of decades. We’ve had gangbusters growth in the US and really strong growth in developed and emerging markets over the last couple of years, as we went through the pandemic. And of course, now the situation’s changing. That’s one reason why the Fed and other central bankers are reacting the way that they are with interest rate increases. The other piece of course is inflation, which is tied in with growth. And as you mentioned, and John mentioned as well, inflation is high. It’s not necessarily predicted to stay high for a long time and central bankers want to do something about it. And we have several playbooks that are imperfect to look at. Of course, we can look at the seventies and we can look at some other inflationary episodes, but we’re really charting a new course here, given the confluence of where we are with growth and where we are with inflation. Why does this matter? Why does this matter for our asset classes?
The reason is that fixed income is mechanically impacted by changes in rates. And let me be clear, when I say rates, right now, I’m referring to nominal rates, which are a combination of real interest rates and inflation. Those two things come together to form nominal rates, but it is also pretty critical that we decompose those and think about what is driving some of that mechanical change in fixed income pricing. It’s real rates clearly, but it’s also the inflationary component. And this is important when we start talking about asset classes that aren’t fixed income. So, for instance, equities or other alternatives like real estate. With equities, there’s more emphasis on growth prospects than there are with just interest rates in terms of pricing. Clearly, when the price of money changes, so when interest rates change, that impacts how we think about the forward-looking earnings from stocks and stock markets around the world, and the same thing for, let’s say, rents from real estate. So, growth has a much bigger impact on some of these other asset classes that are not fixed income than we typically see in bonds, unless you’re talking about credit or high yield. The way that assets are pricing in the future direction of growth, of inflation, and from interest rates, is pretty different at this point. You’ve already seen the mechanical step down with fixed income, although that’s being somewhat offset by higher, forward-looking yields. You’ve seen equity markets stumble over the last couple of months as re-pricing in the inflection point becomes really clear. And with alternatives, you’ve seen the same, although because of the lag with appraisal-based reporting, it takes a bit longer to understand what’s going on with some of the pricing for alternatives.
When it comes to inflation hedges, and this is on many, many investors’ minds, how do I think about inflation exposure in my portfolio? Maybe, how do I protect my portfolio from shocks to inflation? There’s a lot of assets that do have mechanical characteristics that go along with inflation, like Treasury Inflation-Protected Securities (TIPS) or “linkers” elsewhere in the world. Those have very strong connection with inflation, but so do some alternatives, specifically real estate, infrastructure, and even commodities give you access to the real economy and to what’s going on with inflation. And we’ve seen investors shift their portfolios to take advantage of more of those asset classes that have true inflation exposure.
Jeff Schulze: And Frank, I want to stick on this idea of, of rising rates. How do you view the impact of rising rates on small caps and what should investors know about small cap performance in today’s environment?
Francis Gannon: Just building on the conversation about inflation, small caps have beaten inflation in every decade since the 1930s. So, if you’re looking for a great way to play inflation look to the small cap asset class. Small caps, as measured by the Russell 2000 [Index], have been in a bear market since January of this year and through its most recent low, or down around 30%. And to put that, kind of, into context, because I think it’s important and it’s good to remind ourselves, bear markets happen. While they are not fun, they do happen, and not only that, they do end. And I think that’s another important thing to remember in this environment. History has shown us in the Russell 2000, there have been 12 drawdowns of greater than 20% with the average decline being around 31% for small caps throughout history. And what we have found here, we’re close to that particular number today. We’re down around 30% from the highs of last November. Would also say just ironically, if you look at what happened during COVID when the economy effectively shut down, the correction in the small cap market was around 41.8%. So pretty dramatic. Here, we’re down about 30%. And as both Gene and John have pointed out the economy is slowing, but it is not shut down completely at all. So, I think there’s a lot of news priced into the market if you will. Using history as our guide, I think that’s always important in moments of stress like this, since 1945, and this is based on data from the Center for Research in Security Prices at the University of Chicago, small caps have posted positive annualized three year returns 88% of the time on a rolling monthly basis, with an average return in the low double digits.
Granted, each bear market is different. But history has showed us, time and time again, that at market extremes there’s always a lot of opportunity. So your forward returns are really on sale today. And that’s what we as a firm are trying to take advantage of.
Jeff Schulze: Let’s turn to probably the most important question for equity markets and financial markets over the next couple of years is, are we heading for a recession?
Now, John, I’m going to turn to you for your thoughts, but first I want to give you my thoughts to see if we sync up on what our view is on a recession likelihood over the next 12 to 18 months.
Now, obviously the Fed is going to be tightening quite a bit here over the course of the next six to nine months, certainly going to slow economic activity, but our proprietary [Recession Risk] dashboard is still showing a pretty strong expansion color, a green overall signal, but you are starting to see some weakness underneath the surface. In particular in our labor market indicators. So our job sentiment indicator, which looks at the Conference Board’s consumer confidence survey, we look at the labor differential, which looks at people that think that jobs are plentiful minus those that say that jobs are hard to get, has dropped pretty dramatically over the course of the last couple of months coming in at 39.3, which is the first time that it’s under 40 in over a year.
So, you’re starting to see some labor market weakness, which I think the Fed would actually probably applaud. Also, initial jobless claims have increased from 166,000 in late March, all the way up to 229,000. So you’ve seen this culling of the workforce, that’s again creating some labor market weakness. But with initial jobless claims, that’s one of the last indicators on our dashboard to turn red and when it does, it usually means that you’re on the precipice of a recession. But the good news is that we look at it on a year over year basis. And even though you’ve had this dramatic increase of claims, on a year over year basis it’s down on four week moving average, 51%. So still a healthy trend, but you are starting to see some labor market slack. So, my view is that you are starting to see a stressed consumer. The consumer is bending, but not breaking. They’re going into their savings. Savings rates are at the lowest levels that we’ve seen since 2008. They’re starting to see a pretty big increase of revolving credit. In fact, the increase that we’ve seen over the last year is the strongest is 1997, but I think that consumers are going to be able to weather the storm. But I ultimately think it comes down to whether or not the Fed does feel comfortable with the path of inflation and makes that dovish pivot that we’re all hoping for at the end of the year. Now that’s my views on recession risks. John, are you seeing it the same way?
John Bellows: I guess in order to respond to the question, I’m going to go back to something that Gene actually said earlier when he said we’re going to slow to trend. I think the risks are probably lower. I think the risks are that we slow and slow below trend and here’s why. The first observation is that 2022 was always going to be a year of deceleration in demand. We had an extraordinary demand in 2021 supported by very aggressive fiscal stimulus together with a reopening. As we move farther away from that demand’s going to decelerate, we’re not getting the same fiscal stimulus and you’re not getting the same reopening help.
One way to kind of think about this is disposable income. Real disposable income is set to decline in 2022 relative to 2021. Now, generally speaking, if real disposable income is declining, it’s kind of hard to post very good, real growth numbers with that as a backdrop. That’s where we started the year and I think that trend has only gotten worse. You know, we’ve only seen higher inflation, which means lower, real disposable income—that’s clearly showing up in sentiment. As you mentioned, there’s some signs of turning in the labor market, which means that kind of the wage component could actually be weaker going into the second half. And so, what started out is already an environment of deceleration, I think has gotten somewhat, somewhat more challenging. Just to kind of give you one more to kind of think about, I think having real growth in retail sales it’s negative, in the month of May, again, is consistent with that backdrop of deceleration.
So again, that’s kind of the first observation, risks to the downside, because this was already going to be a very tough year. Second observation is that I do think the Fed hikes are going to matter. I think the Fed hikes are going to matter, especially in housing. I mentioned that earlier where we are seeing a sharp change, both in sentiment and in housing activity. But housing’s not the only interest rate sensitive asset. It also impacts business investment. There are certain other durable goods that consumers are, kind of, thinking about that do have an interest rate component. Autos would be on the top of the list. We’ve seen recent weakness in autos. We need to pay attention to that. And then obviously financial conditions do affect sentiment. And that’s kind of, one of the big things that’s changed is the tighter financial conditions have affected sentiment and at some point that shows up in, in consumption as well.
So, point one was the backdrop was already one of deceleration. I think we’re definitely seeing that. Point two is that Fed hikes are going to impact especially housing, but I think more broad than that. And then point three is I think we’re in a very challenging global environment. When you think about the US, you know, you can kind of get your head around how much savings does the consumer have and how much that can support them. But boy, when you look around the world, there’s a lot more stress in other places. I think Europe in particular, very heavily impacted by the ongoing war in Ukraine, both in energy prices and supply chains. I think China has a very challenging situation trying to manage COVID and a de-leveraging of their housing sector, all in the environment of running relatively tight monetary policy, I think the risk to the downside Chinese growth. And so, we do have a global environment that’s really quite challenging. I think Gene’s right, we’re going to slow, but I think the risks are always slow to below trend growth rather than just kind of comfortable to trend growth.
Jeff Schulze: Sticking on this idea of potential recession. Frank, obviously the economy is slowing, the Fed is tightening. When you look at valuations, is the market pricing in a recession at this point?
Francis Gannon: I think the easy answer to that is yes. The average stock in the Russell 2000 is down somewhere around 45 or 50% from its 52-week high. So, there’s a lot of bad news I think, priced into the overall market. What’s interesting is the fact that, I think from our perspective and what we’re seeing and hearing from companies from a bottoms up perspective, is that demand remains quite strong. So, the earnings picture within the small cap space remains, I think, quite healthy at the moment, and it’s something we’re going to be watching very closely throughout the remainder of the year. But there have been many times on conference calls with management teams as they were reporting their first quarter earnings, we were hearing about this difference between headlines and what they’re experiencing from a bottoms up perspective. So, I think demand in many businesses remain strong from a small cap perspective, domestically. When you look at valuations in general, what we’re finding is forward EV to EBIT, which is one of our favorite metrics in terms of valuing a business, is selling below trend, that we’ve seen over the past 15 years. So significantly below those numbers, which I think is pretty significant. And then if you break down small caps, small caps are trading at a 20-year low versus large caps as measured by the Russell 2000. Even with the outperformance we’ve seen in the value side of the small cap market of late versus growth, small cap companies are also selling at a 54% discount, compared to its historical average valuation. So we’re seeing a lot of news priced into the market. And I think, again, it’s just creating a lot of long-term opportunity for those investors who have the ability to look out three to five years.
Jeff Schulze: We’ve been talking a lot about the US, I want to focus more globally at this point. Now, John, I’m going to turn back over to you and then talk about other central banks around the world. How are they reacting to this kind of slowing of global growth that we’re seeing in this higher inflationary environment?
John Bellows: I think growth is slowing around the world and I think kind of the growth risks to the downside, especially in Europe and especially in China. I think what’s interesting against that is that most central banks are doing with the Fed is doing, which is they are responding to inflation right now. The ECB has done a very dramatic pivot. They are winding down their asset purchases, and they’re set to hike more and they’re not alone. You look at, kind of, Bank of Canada, Royal Bank of Australia, everybody’s kind of on the inflation fighting right now. And again, what they’re doing is pretty transparent, which is the inflation numbers are too high and central banks are defending their credibility by responding to that.
I think for investors though, the real question is, where do we go next? We clearly understand the inflation’s too high today, which has generated the central bank response, but we suspect that an environment where global growth is risk for the downside—and again, I think that’s even more pronounced in Europe and potentially in China, that at some point that limits kind of the enthusiasm of fighting inflation and does so for two reasons.
The first reason is that central banks around the world have inflation forecasts, inflation models, that are largely dependent on growth. If you have growth below trend, very hard to sustain inflation above trend. And I think that’s where we’re headed here in the United States, I think it’s very clearly where you’re headed in Europe. I think the discussion in Europe is not whether you’re below trend or not, but are you in recession or not by the end of the year? And what I would say from a central bank perspective is if there is a European recession at the end of the year, it’s very unlikely that we would continue to have ECB forecasts for above trend inflation, kind of, as far as the eye can see.
So growth matters insofar as it’s an important component of the inflation forecast—that’s the first one. And the second, and perhaps is a little bit more relevant in some countries than others, but central banks also have an eye on growth as an outcome that they’re trying to manage. It’s probably tolerable in the US to have a little bit higher unemployment rate, but boy, that’s a slippery slope. And once the unemployment rate starts going up, it’s really hard to calibrate exactly where it stops. And I think that it’s very likely that once that starts happening, that central banks are going to start worry about the unemployment. You saw that very clearly in the UK, by the way. UK has a situation where inflation’s very high, but the economy is contracting. And so they’re in this very difficult position where they’re trying to balance those two considerations. So this is the second point, which is slowing growth and downside risks and growth matter in their own right, because it is a part of the central bank reaction function.
Jeff Schulze: Now, Gene, can you talk about the international situation and the divergence between developed and emerging markets right now? I’m also curious about your views on the implications of the new power configurations that we’re seeing, meaning China versus the US, Russia versus NATO. What should investors be paying attention to in the geopolitical landscape?
Gene Podkaminer: Jeff, those are big topics on everybody’s mind. As we pivot the conversation here, a bit more global, echoing some of what John was saying, I think it’s important to understand that we are certainly in a period of divergence. Divergence in terms of where policy is starting from, divergence in growth rates, divergence between emerging markets and developed markets. There was a time, not so long ago, where it seemed like most of the global macro economy was very well synchronized. That is clearly not the case today. And what’s interesting is, in the fragmentation that you see across developed markets and across emerging markets, there’s clear differences in starting positions. The US has started by tightening policy much earlier than say the ECB, which is talking about it now, but talking about it and doing are very different things. When we explore where China has been and China’s path over the past couple of quarters, they started tightening policy much earlier on, and now are actually at the point of considering loosening policy as well. So, you see big divergences across these major developed market blocks. So, the US versus Europe versus UK versus Japan, and also emerging markets, which are very different groups amongst themselves versus China. Broadly speaking, between developed markets and emerging markets, our thinking is that, big picture, developed markets can probably weather this storm better as a whole. Emerging markets have a couple of points of weakness that that need to be explored. The first is COVID. Yes, we still need to be talking about COVID, about what proportion of the population has been exposed to it, the efficacy of vaccines, what the lockdown situations and other containment measures look like. Those vary drastically between emerging markets and developed markets. We also need to be talking about the commodity situation. Emerging markets are both commodity importers and exporters, depending on which commodities we’re referring to, their economies may be more sensitive, more geared, to what’s happening in the commodity environment, and so, are also more geared to what’s happening with inflation. And then lastly, let’s not forget that, right now, we’re in a period of dollar strength, and currency matters for emerging markets. And that’s another headwind for emerging markets. So, for these few reasons, and there’s a lot more behind them as well, we see this divergence between the fate, at least in the short term, of emerging market economies and developed market economies.
That sets up the second part of your question, which is geopolitical configuration, US versus China. So developed market versus emerging market. Russia versus NATO, NATO being composed of developed markets and Russia an emerging market. The themes are not new, China versus US is something that strategists and economists have been talking about for quite some time, whether in the context of tariffs or trade and policy, and Russia versus NATO is also not new. This is a theme that’s been going on from before the 2014 invasion of Crimea, from before 2008, probably from the time when Putin first came to power. So the dynamics are not new, but you’re certainly seeing fault lines. And you are also seeing, I think, a renewed interest by the global community in understanding what does the future configuration of the geopolitical setup look like? When we come out of this, how will the US and China cooperate, or not? And what is going to happen with Russia versus NATO? It’s an interesting situation economically. And I think for investors as well, because what you’ve seen is a lot of the NATO countries, of course being hurt by the lack of energy coming out of Russia into those markets. And that has big ramifications for what the infrastructure of Europe looks like energy wise going forward. So that configuration, Russia versus NATO, is going to be predicated on trade. It’s going to be predicated on energy and alternative energy. And it’s also going to be predicated on really hardheaded policy that needs to be much more generational in nature versus what’s happening over the next one, three or five years.
Jeff Schulze: And, Frank, I’m going to ask about some of the other issues that we’ve been talking about, obviously ongoing supply chain issues, the war in Ukraine, the lingering effects of COVID, all have really hurt small cap performance relative to large caps. But looking in the international markets, are there any areas that are able to sidestep some of these challenges that we’re still experiencing?
Francis Gannon: So, I guess just building on what Gene said, the best way to approach small caps outside of the United States is quality. And obviously quality is a very large, probably overused word in our industry, but quality as you think about it, should be companies that have high return on invested capital and proven histories of long customer relationships. And as you go through the litany of things to worry about in today’s world, when we think about these small cap businesses outside of the United States, many of them happen to be in developed economies. And many of them happen to generate revenue from all parts of the globe outside of their respective headquarters. So when you think about inflation, many of these companies have pricing power. When you think about interest rate increases, many of them have the ability to generate significant amounts of cash and have very little debt. And then finally, from a supply chain standpoint, which is obviously very topical, many of these companies are asset-light businesses, and asset-light models that are effective way to play some of the supply chain fears that we’ve had to deal with over the past year or so. And then the customer obviously is slowing from what we’re hearing, but our structural preference is for B2B companies. Companies that have products that are embedded in other products from a small cap perspective, and they get great visibility and repeat revenue, which is a wonderful way to play this really dynamic, inefficient asset class outside of the United States.
Jeff Schulze: John, any areas that you’re finding interesting opportunities?
John Bellows: Well, I think one thing that’s really changed with all this volatility is the yields on offering fixed income. When you think about something like investment grade corporate bonds, the investment grade corporate index today has a yield right around 5%, materially higher than where we were earlier than the year. Obviously, there’s two components to that. Treasury yields are higher, but we’ve also seen a widening in corporate spreads, which is due to investors being reluctant to hold corporate bonds in a volatile environment. Now 5% yield on investment grade corporate bonds, in our view, is a real opportunity. That more than compensates you for default risk over the next four or five years. These are very high-quality companies. You’re very likely to be repaid on that principle and so the default risk is fairly small.
And I would also say kind of the Treasury component could have value if we do see, as I suggested at the beginning, a more balanced set of Fed risks. Obviously, when the Fed is increasingly hawkish and kind of yields are going up sharply, you’re not going to earn the yield on a corporate bond. And that’s what we saw in the first half of the year. But if we move to an environment where the risks are more balanced, then that yield starts to become more indicative of the total return. And I think that’s where we’re going. So, I think there’s a big change in the market. I think that yield and income is an important component of all investors’ portfolios, or it should be. That’s changed, it’s certainly higher now. And I think where we’re going in terms of the environment is one where you start earning that yield. And again, that would be a very powerful part of a portfolio construction.
Jeff Schulze: Thanks, John.
Gene, any thoughts?
Gene Podkaminer: Absolutely. So about a year ago, it was hard to find any alternatives to equities when building multi-asset portfolios in that equities were delivering pretty good value. The yields and interest rates on fixed income were, really low, very anemic. And so, it was hard to balance that out in favor of fixed income. Boy, have things changed over the last year. So with tightening regimes going on in most developed countries, with inflation, as we’ve already discussed, happening loudly everywhere, what we’ve seen is definitely a pivot. Where before it was TINA, right, there is no alternative, to equities and now it’s more fixed income actually looks appealing and compelling and will probably be even more so as we go through the next couple quarters as yields rise and they can actually provide more return to a portfolio and also act as a shock absorber to some of the volatility. So that’s been a big change in looking at that risk-return tradeoff and trying to understand where to position assets. And looking at economic growth, as its forecast to slow, thinking about investments that aren’t as tied to economic growth like sovereign bonds.
Jeff Schulze: John, Frank, Gene, thank you for your insights.
Panelists: Great. Thank you very much, Jeff. Thank you.
Jeff Schulze: And I want to thank everybody for joining us.
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