MASTERCLASS: 2022 Outlook

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  • 57 mins 18 secs
With inflation hitting its highest level since the 1980s, the Fed will be tasked with preventing it from becoming 1970s style inflation. Two panelists discuss where to find opportunities and yield in this kind of environment, given the rate hikes on the horizon, a new COVID variant, and a host of other risks.
  • Brian Smedley, Chief Economist and Head of Macroeconomic and Investment Research, Guggenheim Partners
  • Jake Weinstein, CFA® Research Analyst, Vice President of Asset Allocation Research, Fidelity Investments

Jenna Dagenhart:  Hello, and welcome to this asset TV 2022 outlook masterclass. With inflation hitting its highest level since the 1980s, the FED will be tasked with preventing it from becoming a 1970s style inflation. Now with great hikes on their horizon, a new COVID variant and other risks, we look at where to find opportunities and yield in this environment. Joining us today, it's an honor to introduce of Brian Smedley, chief economist and head of macroeconomic and investment research at Guggenheim Partners and Jake Weinstein, research analyst and vice president of asset allocation research at Fidelity Investments. It's great to have you both back with us and kicking us off, Brian, where are we in the COVID recovery?

Brian Smedley: Yeah, thanks Jenna. Appreciate the question and thanks for having us on this webcast. We saw an extraordinarily deep downturn, of course in early 2020, and the recovery has been just as exceptional. In fact, I would say at this point, we're no longer in the recovery phase in terms of the macro economy, we are moving well into overheated territory. So, in the third quarter of last year, the CBO estimated that GDP, real GDP in the United States moved beyond its supply side capacity, which is to say, we now have a positive output gap. Meaning that the demand side and what we measure in GDP, now exceeds the supply side capacity of the economy. The economy is very strong. Third quarter growth was around 2%. We think fourth quarter growth, when it comes in, will be closer to 6%, thanks in part to a big boost from inventory restocking in the quarter.

Brian Smedley:  Looking ahead, we see the economy growing well above potential through 2022, so probably around three and a half percent for the full year, which would be a phenomenal year in normal times, even more so considering the fact that the unemployment rate is starting the year at 3.9%, quite low from a historical perspective. The economy's booming. That is attributable to of course the advent of several highly effective COVID-19 vaccines, which play a critical role, but also we've had extraordinary monetary and fiscal stimulus. I would say at this point, we're starting to see signs that, that was overdone. We got a big dose of fiscal stimulus in the initial downturn, which was very important to help stabilize the economy and stabilize confidence and financial markets. But then, politicians went back to the well in December of 2020, and then again a few months later, under the new administration.

Brian Smedley:  I think at this point, we're dealing with the consequences of a very strong recovery that's been aided and accelerated by, you could call it a proverbial helicopter drop of money. The FED has been expanding it balance sheet very aggressively, much more so than they did after the financial crisis, especially considering the duration of their asset purchases. It continues to hold interest rates at zero and I know we'll talk more about the FED. But there is, I do want to say one more granular take on the growth outlook, which is that in the last, roughly two years, we've seen a big bump in goods consumption and the services side is still depressed relative to the pre-COVID trend. It's not the case that everything is recovering equally by any means and that's also true if you look around the world. There's a great deal of dislocation and disparity in terms of different sectors and different economies around the world and how they've dealt with the pandemic. But for the U.S. economy overall, we're in a very strong place and the economy is set to strengthen even further.

Jenna Dagenhart: And Jake, building off of Brian's comments, do you think this time is different with the pandemic and where do you think the economy is headed from here?

Jake Weinstein:  Yeah, thanks Jennifer having me. I appreciate your comments, Brian. It's always nice to follow somebody who lays everything out perfectly, because then I can pick and choose the things that I want to follow up on and maybe disagree with a bit. Overall, I think what you said was pretty spot on. I'd say one thing to highlight is the comment about overheating. Now, I completely agree that it feels like we're overheating. I would agree that we've probably hit peak levels of growth already, and this year we're not going to grow nearly as much as years passed. I mean, that's pretty much an obvious and trend that we see. But probably also had peak inflation, but inflation might also stay high and growth might also stay high. I think to your point, you're right that we're going to have a nice, a strong economy to continue throughout the year.

Jake Weinstein:  However, a, lot of risks to that outlook. I mean, if you think about asset markets, they've done phenomenal over the past year, 18 months ever since they've bottomed in late March and you saw the federal reserve and fiscal authorities come in and basically save the economy, and to your point put way too much money into the system that is now you're seeing is having this overheating type of feel to it. However, it doesn't mean that we should be completely concerned about things getting so bad and overheating that it's going to cause any type of corporations to be able to completely have to change and back off things that they're doing. Overall, I would summarize everything by saying, we think from a business cycle point of view, which is looking at the direction inflection of the economy, likely have those peak levels of growth of inflation, but still likely to maintain and stay in a mid-cycle type of environment, even with the federal reserve normalizing policy.

Jenna Dagenhart: Yeah, going back to your points on signs that stimulus has been overdone, perhaps the most blatant would be inflation coming in around 7%. Brian, what's the outlook for inflation from here?

Brian Smedley:  Yeah. It's been an extraordinary year for the inflation story. This time last year, most economists were expecting inflation to come in below 3%. And here we are sitting at 7% year over year. The inflation uncertainty and inflation volatility is very high relative to anytime in the last 40 years. Part of what's driving that of course is a big gain in durable goods consumption, at a time when durable goods supply globally has been disrupted by the pandemic and other issues related to supply chain shortages, chip manufacturing, et cetera. The impetus for inflation for much of the last 12 months has been this durable goods inflation. But, as we look into 2022, we think there's a handoff underway. We think durable goods inflation is going to recede. Durable goods prices will probably begin to fall as supply chain issues globally, get ironed out and we see better chip production and auto manufacturing deliveries, et cetera.

Brian Smedley:  That decline in durable goods prices on the margin is going to bring down headline inflation and core inflation on a year over year basis, we think fairly meaningfully. But speaking to this handoff, some of the larger and more durable categories that drive core inflation in particular, things like housing and things that are affected by rapid wage gains, those things we think are going to be more persistent. And in fact, we're seeing acceleration in the inflation data from contributions of that nature.

Brian Smedley: As we look into 2022, we see a rapidly tightening labor market continue to put upward pressure on wages, and gains and wages continue to put upward pressure on core inflation. So, adding the two sides together, we think what you'll see is a decline over the course of the year, in year over year numbers for core and headline inflation. But, we think the landing point a year from now is going to be still meaningfully above the FED's 2% target. We think we'll see at least two and a half percent core PCE on a year over year basis, which given the labor market and how tight it is, is still going to be causing the FED some concern.

Jake Weinstein: Yeah, Brian, I would follow up by I completely agree with the direction of what you're saying. 7% CPI is to start the year, I mean, we could easily as economists say, that's not going to be that high, going to be lower throughout the year. The question to your point is how low does it go? I think a lot of market participants, including all economists models we see in FED models, do suggest that the inflation's going to ultimately head and trickle down lower to about this two, two and a half percent range. But I would agree with you, that it's probably going to settle above where it was pre-pandemic due to all the differences, the supply changes, the massive policy that we've talked about. A lot of those factors that basically the pandemic has turbocharged this inflationary environment that's going to take a lot longer for inflation to come down, especially on that shelter and housing side, to your point. Because low rates have basically, and the pandemic induced money coming into people's hands has basically induced all this house buying and push up on the housing component of CPI.

Jake Weinstein:  So, to put a number to it, it's always tricky. It's always careful. It's always hard to do that, because someone could always point to you for it. But, I always say by the end of the year, we would say that inflation while coming down from 7%, might actually stay above three for most of the year, maybe average about three and a half on a year over year basis because of those persistent factors that you mentioned.

Jenna Dagenhart:   Yeah and going back to your point about employment, Brian, we did start the year at 3.9% unemployment. But the labor force participation rate is still not as high as where it was before the pandemic. Does that keep you up at night at all?

Brian Smedley:  It does Jenna and a key reason for that is because without those people returning to the labor market, a given path for total demand is going to drive a faster drop in the unemployment rate, than would otherwise be the case. If we had the supply side rebound to match the demand recovery, we could see a more steady, more stable drop in the unemployment rate, which is what we saw after the great financial crisis, a long period of labor market healing. I think what we've seen in the data so far has been something very different, where the pace of decline in the unemployment rate is running at three to four times as fast as what we saw at a comparable period in the cycle, let's say three, four years ago, when the unemployment rate was coming down to around 4%. That's a big concern.

Brian Smedley: The FED's objective, and you see it embedded in their summary of economic projections, the infamous dot plot that they update every quarter, they have an estimate of the longer run neutral rate or the natural rate of unemployment, which is their notion and nobody knows the true number, of what kind of unemployment rate the economy can sustain in equilibrium. All right, so we think first of all, real economic growth, potential supply side growth, which is to say a number, a pace of growth that we can sustain over time fully utilizing our supply side resources is only about one and a half percent. All right. That would be consistent with maintaining a steady unemployment rate and steady inflation dynamics.

Brian Smedley:  Because the economy is growing dramatically faster than that, we're seeing a very rapid drop in the unemployment rate. And even if you look beyond the unemployment rate itself at a broader measure of labor market health, things like the job openings and job quits, which are very high. Survey data from small businesses on how hard it is to hire new workers for open positions and data from consumers themselves on how easy it is to find a job if they're looking. Aggregating those types of statistics and comparing them to the unemployment rate, we find that those survey measures point to an even tighter labor market than our 3.9% unemployment rate indicates. Given that, and that's been the case for much of the past year.

Brian Smedley:   That's really, I think, pointing to a continued drop in the unemployment rate, which isn't a problem in and of itself. The FED in its new framework that was unveiled in 2020, actually states now that going forward, they don't intend to aim to slow down the labor market just for its own sake. In the past, they have done that. They have preemptively tightened policy because they don't want the labor market to get too tight. The problem we have now is that because of these dislocations that have created a lot of inflation and ratcheted up inflation expectations, when you have a really tight labor market, we are seeing in the data that it's putting upward pressure on wages. And in fact, we're seeing more sure on wages at a 4% unemployment rate than we did last time we had a 4% unemployment rate just a few years ago. It's a very different story.

Brian Smedley: That means that as the labor market tightens, it's likely to feed back into the price and wage setting situation, where as the labor market gets tighter and tighter, it's harder and harder for employers to find workers to fill open positions. They're seeing actually a record number of people quit their jobs, so that they can take generally what's happening is people are quitting their jobs to take another job where they can get a sign on bonus and, or they can get higher wages. That has an effect of ratcheting up wages for the economy overall month by month, because the labor market is so tight and demand for labor is so strong. That is going to feed back into personal income. People will have more money in their pockets to spend. The concern is that can feed back into inflation as demand for goods and services remains hot, thanks to the strong labor market.

Jake Weinstein: Yeah. One thing to follow up on that, Brian, is from the labor market perspective that you laid out very nicely, is with such a tight labor market and I agree, and I agree the unemployment rate can go even lower this year and continue and not go down as fast as the pace that you mentioned, but continue to go lower. The reason for that is twofold. One, there's still about two and a half million people that have not re-entered the labor force, compared to pre-pandemic. Now, a lot of those are guys, people aren't coming back for various reasons. A lot of the people are above age 55, the data shows. A lot of people maybe aren't going back into the service, that base type of industries that they're in. But they still are coming back and they have to come back because they've been spending their money and don't have as much from the extended unemployment benefits that were provided, very generously by the government over the past year plus.

Jake Weinstein:   The other interesting thing here, when you think about what the impact will be over maybe the more intermediate longer term is because there's fewer workers as a result of this and because wages growth, you're actually seeing it, which we haven't seen really significantly over many, many years is that companies have realized this. They may actually engage in capital expenditures to try to automate things in order to account for these types of things. To your point, the cycle will fix itself in the intermediate term, or near term, I should say, that is still higher wage gains and there's still inflation. It still could hinder profit margins. But the good news about all this is that we've got a free market, vibrant economy, and that could adjust to these changes that we're starting to see. I see it as a positive from intermediate term or structural standpoint.

Brian Smedley:   Yeah, if I can add on to that, Jake, I think you make an excellent point about capital expenditures. I think that's one way that we're going to have to try to cope with this ongoing labor shortage. It's true, not only in the United States, but in other countries around the world where labor force growth rates are negative or slower than they've been in the past. In the case of the United States, that's one key reason why our potential growth rate over the last 20 years has fallen fairly substantially, is because the contribution to our potential growth rate from a faster labor force expansion, has really diminished. That's happened both on the immigration side, but also with just the natural demographic trends of our American population, as the baby boomers make their way through the labor force and the cohorts that are coming up behind them are not sufficient to maintain the same growth rate and labor force that we've been accustomed to in prior decades.

Brian Smedley:  What that means, I think Jake's exactly right, that we will have to, businesses will have to get creative and find ways to automate and find ways to use technology and other processes, retool their operations to gain efficiencies. We call that productivity gains, to make due with smaller growth of labor inputs. I do think, I agree. I think that's a good thing. I think actually, if you go back four or five years, we all probably remember there was a lot of discussion about the potential perils of automation and self-driving cars and machine learning. These things were going to displace a lot of workers.

Brian Smedley:  I don't want to make light of that because as these technologies are rolled out, there still will be some dislocations and people that may be displaced. But in the aggregate, the U.S. economy needs a lot more labor supply, and to the extent that that's not forthcoming. There's not a lot that we can do to change that reality in the short run. Having more automation, more technological advancement, better processes to help us do more with fewer labor inputs would do a lot to helping easing some of these inflation concerns.

Jenna Dagenhart: Yeah and in this inflationary environment, Jake, would you say that the 60-40 portfolio is still inappropriate investment, or would you say it's broken, like many are arguing?

Jake Weinstein:             18:54                Yeah, we've talked a lot about the economy and all the economics and the background behind it. But, what really matters is for asset TV, the investments themselves. If you were in a 60-40 portfolio over the past three decades, you were probably very happy. You probably didn't have to call your advisor too much. Bonds went up, stocks went up. It was just a great period, because you've got the benefit of both appreciation from your stocks side of your portfolio, the bonds side of your portfolio, and a negative correlation between stocks and bonds, the Goldilocks type of portfolio construction environment. Yields are really, really low right now and stock valuations have crept up a bit. That may not necessarily be conducive over the next 10 to 20 years. The important thing to think about with portfolio construction is what's going to be different going forward that's not going to have your portfolio be able to replicate hate the way it behaved over more recent periods.

Jake Weinstein:             19:54                The one theme that we heard about, that Brian and I have been talking about, has been inflation. If you get inflation that's a little bit more elevated, it could potentially reduce some of that diversification benefits, that fixed income provide a portfolio. I don't think it's going to get to a point where inflation gets so high, that bonds don't provide a good balance to a portfolio. But, I do think that they could provide maybe a little bit less protection or there's other types of assets you might need in order to think about how to diversify these types of adverse outcomes. For example, having exposure to something that has more of a hedge against higher inflation, whether it's commodities, treasury inflation protective securities, real estate, real assets. These are types of things to think about and consider because even though I think 60-40 will still work fine.

Jenna Dagenhart: Looking at the push and pull between inflation and the FED, Jay Powell certainly has his hands full in 2022. Brian, how do you think the FED is going to respond in light of all the things that we've been discussing?

Brian Smedley:  Yeah, well we've talked in the past about the Powell pivot in the fourth quarter of 2018. This is, you could almost call this a Powell U-turn. I mean, over the course of 2021, there was a significant shift, 180 degree shift, really in the way the FED was thinking about the appropriate path for monetary policy. Now, I think in fairness, this is an unusually uncertain environment. This is an extraordinary situation we find ourselves in with a high degree of uncertainty. It's difficult to forecast. But the policy prescription for much of 2021 was really based on the FED's experience over the last 20 years, where they struggled to get inflation up to target, even in a really strong economy. They were aiming to tighten the labor market and get back to full employment, when a lot of individuals, particularly those groups most affected by the pandemic were out of work and really struggling.

Brian Smedley:  Now we find ourselves with a very different situation where inflation has been persistently above target, not just a little above target, but considerably above the FED's target. And we have the labor market tightening very rapidly, as we talked about, and showing signs that we've already come down to, if not beyond full employment and the direction is clear that we're going to continue to overshoot what the FED deems to be a sustainable level of employment. They've really changed their tune in the last few months. The balance sheet is due to finish, the FED is due to conclude QE in mid-March. At that point, we think they're going to start hiking rates. We think they'll hike, right now we've penciled in a hike in March, and then another 25 basis points, every other meeting, which would be once per quarter.

Brian Smedley: We have them getting back up to a FED funds target rate of around two and a quarter at the end of 2023. I think the odds lie in favor of them accelerating that timeline, because again, they might need to get to a neutral policy setting, which according to their own projections is more like at a two and a half percent FED funds rate. They might need to get back to a neutral policy setting a lot sooner, and that's going to be guided of course, by the data. Now, the other thing that we've heard from the FED is a change in the way they're thinking about the balance sheet.

Brian Smedley: It sounds like there's going to be a really rapid handoff from QE, which is expanding the balance sheet through their purchases in the open market of U.S. treasuries and agency mortgage back securities. They're going to have a quick handoff from QE to QT, or quantitative tightening, which is to say probably later this year, we think most likely in July, the FED is going to announce that they aim to start to let the balance sheet shrink by letting some of these securities mature and roll off the balance sheet, which means that if the treasury security that's held by the FED doesn't get reinvested at the auction, that means that somebody in private market maybe it's fidelity or Guggenheim or somebody else, is going to need to purchase those treasuries or purchase those mortgages because the feds holdings are being redeemed.

Brian Smedley:  The goal there is to gradually tighten financial conditions overall, to bring long-term interest rates somewhat higher in a way that would allow the FED to, again, slow the economy down ever so carefully, in such a way that we can hopefully have a smooth landing and bring growth to a more sustainable place. Zero in on a full employment measure for the labor market, but not go considerably beyond that. Hopefully anchor or inflation expectations around the appropriate levels and bring actual inflation, hopefully see that come down to a level that's more consistent with their 2% target. It's going to, I think the one thing that we can say is that the FED's going to have to adapt on the fly.

Brian Smedley:  I think they've been pretty good at doing that. Really, if you look at the changes in the outlook for monetary policy and their communications in the last six months, I think they've been reasonably adept at preparing the market and preparing the public for a very different policy outlook than they had previously communicated. I think, as you mentioned, Chair Powell, who's just been renominated by President Biden to lead the FED for another four years, seems like he's easily going to be confirmed. He's going to have his hands full, to not only execute on a policy path in the context of very high uncertainty, but number two, communicate effectively, not just to the markets, but to the broader public that is increasingly concerned about the direction of the economy, principally the elevated level of inflation.

Jake Weinstein:  Yeah, I think Brian, that's a great summary of how the FED is basically what they've done and what they've communicated. The question I think is will they actually really be able to do it and to your point, have to be on the fly. They made this U-turn obviously, because they're finally concerned about inflation, like what took them so long? Everyone realizes there is inflation and they're going to tighten accordingly. But can they actually raise rates three times, maybe four times, stop quantitative easing and reduce the size of their balance sheet all within this period that they're talking about and expect that to have no impact on financial conditions? That's a big question. Can it happen? Sure. Have they been able to do it? Maybe. I mean, it's really hard to know. There is risk of that not working very smoothly and it working in fits and starks, maybe a little Mississippi half step, if you want. You just don't know how it's going to transpire over the course of the year.

Jake Weinstein: That being said, the approach you should think about when it comes to that is, is your portfolio prepared for the opportunity for the chance of them not being able to do it smoothly. But then acknowledge the fact that they might come back and basically be a little bit more dovish, which can help financial conditions ease a bit. The question really is, is are they going to do what they say, as they say it, or are they going to be nimble enough as financial conditions start to ease and tighten and bond yields get higher or lower? I mean, one of the major things to think about in terms of 2018, when they were doing a similar exercise by raising rates and reducing the size of their balance sheet, is they were successfully able to move up long term bond yields.

Jake Weinstein:   But what that did was make the 30 year mortgage rate get close to 5%. I think it peaked at about four and three quarters percent. That actually caused the housing market to slow down, which you could argue maybe they want to do and maybe they should be doing, considering how hot it is,, considering what we talked about. But if it does do that, that does have a negative impact on real growth. I mean, how much more can interest rates go higher before you get there? It's always a moving target. You don't really necessarily know. But I think the mortgage rate, financial conditions are things to monitor to see if the FED can actually do what it claims it's on its path to do.

Jenna Dagenhart:  And even if we do get three or four hikes this year, interest rates will still be very low, historically speaking. Jake as the search for yield continues, especially real yield, where are you finding it?

Jake Weinstein:  Yeah. I mean, one thing I do want to say is yes, to your point, interest rates are going to stay low, lower than they were maybe historically relative to their averages, just because there's lower growth. As Brian and I have laid out, probably less inflation and more desire for the FED to get involved and keep rates lower, just because there's so much debt. This market has become very hooked on financial repression and federal reserve intervention. Near term, that's the case. In that environment, where's the search for yield come from? Well, in financial repression periods, we did a big study deep into the 1930s, 1940s, other periods of financial repression and found that during these periods, when the Federal Reserve was indeed in doing financial repression as it did historically, stocks were still the best bet you wanted to invest in. They would outperform bonds.

Jake Weinstein: The question that comes down to is, in this environment, there is not that much yield. Maybe you could look at other type of yield year type of securities like emerging market debt, real estate debt, or high yield bonds. But I mean, they're not going to get you nearly as much yield, because those yields are much lower compared to history. So, to answer your question, there's really not that many yield securities out there. I mean, I feel like this has been the environment for the past 10 plus years. However, given that there is such a need for yield from investors, that's basically going to keep a lid on how high interest rates can go. That basically warrants that fixed income is still not a bad place to be, given the ceiling on on interest rates.

Jenna Dagenhart: Brian, would you like to respond to that?

Brian Smedley: Absolutely. Yeah, I would agree that equities will outperform bonds over the next one to two years, but I think they will also deliver much higher volatility. I think the question for investors is what's your risk preference? What's your risk budget? Some of that, presumably will be allocated to equities. I think that is a good place to be for investors aiming to maximize their total return. We could talk about opportunities in the equity market, but your question about where do you find yield? I do think there are still attractive opportunities within fixed income. I do agree that duration, interest rate risks still will be important to hold in a portfolio as a ballast against big risk off moves. There's always the risk of some unknown, unknown, some exogenous shock like the pandemic, that could push down treasury yields, that could push also down risk asset evaluations.

Brian Smedley: You'd be glad you had some allocation to higher grade, longer duration securities if that were to transpire. What we like best right now, based on our baseline outlook for the economy and for the markets where the FED raises rates probably four times this year, gradually starts to shrink the balance sheet. We think long term rates will rise. We see the 10 year treasury yield moving up to probably around two and a quarter by the end of the year. In that environment, we like having floating rate exposure. Several places that you can get that. We've been increasing our allocation to senior loans. These are typically below investment grade credits, as opposed to a high yield bond that has a fixed interest rate, fixed coupon. These have floating rate coupons that will typically rise with the short term interest rate and therefore deliver you higher coupons as the year goes, if the FED does indeed raise short term rates.

Brian Smedley:  We also see relative value, if you look at credit spreads in the loan market, we think that there's some room for those credit spreads to tighten on the basis of a strong economy and good corporate profit growth. Within the high yield space, we like higher rated high yield bonds. Something like in the double B category, where you've got a little bit more protection from a sell off that might affect lower rated [inaudible 00:32:33]. We also like structure credit. So, asset backed securities, I think provide a really interesting play in this environment. You also get typically a lot of floating rate opportunities in that space. Decent spreads and a nice amortization feature in a lot of those structures where you're getting cash coming back to the investor that can then be redeployed at higher rates, if indeed interest rate its go up over time and that's a nice feature to have. We think there are still great opportunities. It's just a question of picking your spots and I think being selective. But we do have a long credit bias. I think it makes sense to again, focus on floating rate opportunities here.

Jenna Dagenhart:   Jake, are there any areas where you're particularly bullish in the new year?

Jake Weinstein: Yeah. I mean it's again, to our point, you see it. The economy's doing fine. Having exposure and overweight to risk assets, equities over bonds makes sense. But I'd agree with Brian that it's going to be volatile. Will the FED be able to do what it says and that could cause interest rates to even fall. Having type of a high quality interest rate exposure and a portfolio could help provide a little bit of that ballast. Is there a pound the table bullish investment out there that ... One thing's interesting, we just talked about, so far has talked about just more stocks and bonds in big picture categories.

Jake Weinstein:   On the equity side, emerging markets actually had a negative return last year. China was in a growth recession, had an extremely difficult time, given its housing market and everything going on there. Emerging markets, maybe there's an opportunity there. They underperform large cap stocks by 30%, as far as the Chinese economy, we could talk a little bit more about that later. But it may have been maybe bottoming right now and if China's the most important country in terms of its economic growth to the emerging market complex, emerging markets might be a place to think about allocating, which provides more of a relative value opportunity.

Jenna Dagenhart:          34:36                Given everything we've been talking about, Brian, what are the implications for markets in 2022?

Brian Smedley:              34:43                Yeah, well, I certainly see higher volatility and that's partly because number one, valuations have recovered post the pandemic, to elevated levels. The FED is now in the process of withdrawing liquidity, withdrawing accommodation, and trying to slow the economy down by gradually tightening financial conditions. That is going to introduce more bouts of volatility, potential for pullbacks. We also have the midterm elections coming up in November in the United States and the historical data suggests that it's common to see bigger pullbacks in the years where we're anticipating a midterm election. There's a possibility that we'd have a more bumpy ride. We're still positive, start to finish, on 2022. We think you'll see decent gains for stocks, as well as for credit. But, that will benefit from a strong economy.

Brian Smedley: But, one way to play that is to pick certain sectors that may be more prime to benefit from a rising rate environment. Financials have been strong relative to the market. Financials should continue to benefit from rising interest rates. More broadly, we would say cyclicals, energy financials, industrials, other parts of the market that are more cyclically oriented should do better than other sectors, such as technology, which has come to take a very large share of the S&PP 500, for example. If our view is correct that the market is under pricing, what we call the terminal FED funds rate, which is to say the peak in the hiking cycle and that the market's pricing and only about a one and three quarters percent FED funds rate when the FED is all done hiking rates, we think that's too low. If our view is correct, then you should, based on historical correlations, you should see cyclicals outperforming sectors like technology, so that can help insulate investors from some of the pitfalls of a regime where the FED is withdrawing with liquidity.

Brian Smedley: The other thing I would say in the equity space that could be attractive in this environment is call overwrites, or covered call strategy. If you've got longs inequities, whether it be individual stocks or ETFs, et cetera. It could be an attractive environment to sell calls against that exposure, because you're bringing in premium today and that is going to reduce your beta to the market and partially hedge you from the day to day volatility. But, you're also going to see some accretion of that premium as you get time decay, between now and the expiration of that option. That can be a really attractive way to boost risk adjusted returns. Because again, it's going to smooth out some of the bumps in your portfolio as the market moves up and down. It's also going to provide you a form of carry, which is to say the time decay, or the decline in the value of that option as you move forward toward expiration.

Jenna Dagenhart: We've talked a lot about the things that could go right in 2022, but let's spend a little bit more time on the things that could go wrong. Jake, what are the top risks that you're monitoring in 2022?

Jake Weinstein:  Yeah. Keep your eye on the FED, mentioned that several times. I mean, to think that they could just, the expectation that they'll be able to just do everything smoothly, I think is a little bit high. So, keep an eye on there. The other interesting one is, so the Chinese economy is in a growth recession right now. Even though they may have bottomed and aren't getting any worse, the issue, structural issues they have and the reliance that they basically have had on credit and the credit channel basically fueling its real estate market. Structurally, they are trying to back off that because it's basically created this level of inequality, which for a country like China, Xi Jinping is trying to back away from. You're not going to get that massive re-acceleration after a Chinese growth recession, similar to how you got it in 2009, in 2012 and in 2015.

Jake Weinstein: The other thing to think about is since China was so weak last year, the rest of the world tends to have about a six month to nine month lag in terms of the Chinese economy. So, especially countries like Europe and Japan that are reliant on Chinese demand, we haven't yet seen that weakness out of Europe. Could be because of the virus, could be because we haven't seen the lag yet. But that basically suggests that there is a risk to the overall global growth like XUS, XChina being a drag on the overall growth picture, which could have some of an impact as well. There are risks out there. The virus is another one. There's a lot of things always to think about. We're paid to think about risks and how they can impact a portfolio. But I think the impact of China not being able to re-accelerate as fast as prior cycles and the rest of world growth, is probably one that many people aren't really paying attention to because they're so focused, U.S. centrically, on the Federal Reserve and quantitative easing and quantitative tightening.

Jenna Dagenhart: Jake, to quickly elaborate on that, how much of a risk, how much of a threat do you think that China's real estate market is to the global economy?

Jake Weinstein:  Yeah, I mean it's a big, what was it, 25% of China GDP China's the second largest country in the world. So, if you do the math, it's a pretty significant fraction and share. Countries that rely on China, commodity producers, Australia, other types of countries that rely on the whole supply chain that they've embedded themselves and relied on China, they can get in trouble as well if that occurs. At the end of the day though, I mean, they've got pretty smart policy makers over there. I'm not saying they're going to be perfect in all their decisions, but they do have the ability to shift. When they realize something isn't working, they've got a longer term plan, the ability to make that and have the time in order to engage in other strategies. So near term, it's a big risk.

Jake Weinstein:  I don't think it's going to be a major concern over the very long run. If you just look at the growth over the past 10 years in the real estate market in China, you probably have had too much development and that's been nice for people. It's created a lot of jobs and the Chinese economy's going to have to figure out how to reallocate those jobs to other sectors. Will it be to a low cost manufacturing jobs? Will it be a service based labor? We don't know, but they can do it.

Jake Weinstein:  Basically what I'm trying to say is that near term it's a risk, but I don't think it's going to completely break apart anything over the long run. However, you should be very concerned because that transformation from what the economy's like now to what it's going to look like in five years, there could be a lot of ups and downs and bumps and bruises. I know I'm talking out of both sides of my mouth here, because I am concerned, but I just don't think it's something that you should basically just try to think that, "Oh my God, it's going to be so bad I got to just stop investing in risk based assets because it is going to cause a global recession." I don't think that's the base case.

Jenna Dagenhart:   Brian, what are the risks to your outlook and is China on there?

Brian Smedley:  Yeah, China is definitely at the top of our risk list. The real estate sector in addition to delivering a significant share of GDP growth, the stock of real estate assets has also grown into such an enormous degree that the valuation of Chinese real estate is really enormous relative to Chinese GDP and global GDP. Chinese housing activity also propels a lot of other parts of the economy that we may not necessarily see. For example, state and local governments, or local governments I should say, that benefit from land sales and use that money as part of the real estate development process to go out and spend on other things and hire people. Chinese real estate is very important to watch. I think we need to get used to China growing much more slowly than we've seen in the last one to two decades.

Brian Smedley:  As Jake mentioned and described very well, growth already slowed a lot in 2021. We think the party is very focused on stabilizing growth and maybe trying to build a little bit stronger GDP outlook for 2022. But there are limits to how much they can do that, because they know that they don't want to create an even bigger leverage problem for the economy to deal with later. Beyond China, I think the FED is going to have their hands full. We already talked about that. In terms of knowing whether the FED has gone too far too fast, and whether we should start to prepare portfolios for a potential recession, let's say. I think the thing to watch is the three month, 10 year treasury yield curve. The spread between three month T-bills and 10 year treasury notes is a very important one to watch.

Brian Smedley:  Right now that curve is relatively steep. It's probably going to flatten as we go through the year. If we get to the point and I don't think it's going to happen in 2022, but if we get to the point where the FED hikes rates to such an extent that we see that curve flatten or invert, that will be a warning sign that it's time to take that signal very seriously and take a more defensive posture and portfolios. There's always the unknown unknowns, the exogenous shocks that sometimes happen. It may be a geopolitical crisis. It may be something related to the midterm elections. We had after all, after the 2020 presidential race, we had some political violence in this country at the capital, sadly. That's something that we're going to have to watch and see how things play out in the midterms.

Brian Smedley: But I think in terms of the virus, we've made great progress. Not only do we have several highly effective vaccines, but we also have important therapeutics that can help reduce mortality and reduce the severity of the disease for people with greater sensitivity, greater preexisting conditions. But I think we do need to be prepared for more variants. They will show up and there still is a large portion of the world's population that's not yet vaccinated and that's prime opportunity for the virus to replicate and to mutate into new variants. If you think about the beginning of 2021, we weren't dealing with nearly as many variants of this virus and we've had to adapt to Beta and Delta and Omicron and other really important variants that propagated around the world. That is something that I think we should expect. But again, there is a tail risk associated with that. But our base case is that as we move through the year over time, we start to put this pandemic behind us.

Jenna Dagenhart: Yeah. Hopefully, before we run out of Greek alphabet letters to use to name them. Now, stocks don't seem to be too concerned about some of these risks that we've discussed. In fact, we saw total returns for equities double in just the past three years. Jake, do you think we're due for a correction in 2022 and are you at all concerned about another recession?

Jake Weinstein:   Well, I'll answer the second one first. Another recession, no. The FED can cause a recession if it wants. I mean, to Brian's point, the yield curve. So if the FED raises three times and the bond market's like, "Whoa, FED don't do that." And the 10 year treasury drops below 80 basis points and FED keeps going, they can cause a recession if they want. Very highly unlikely they're going to do that, even in light of inflation. They have a dual mandate and causing a recession is not the case. The stock market to your point though, it just seems to just be very, very happy and not wanting to have any type of movement. I think for the reason for that's what Brian said before. There's just been so much liquidity in the system over the past two years, with all the stimulus, that there's just been nowhere for money to go. Money has had to go into stocks. The economy's doing fine. You had an accommodative FED.

Jake Weinstein:  Now this year, volatility, much higher prospects. Brian said that, and we completely agree. Can you get a correction? Yes. But the difference here, the very, very important part is you're very likely to get a correction defined by anywhere between 10, 15%, less than 20%. If it happens during a period, say it's a mid-cycle period, like we're in and the fed doesn't continue to double down and backs off, it'll likely most likely based on historical standards, maintain a correction. However, if the Federal Reserve's raising rates and the yield curve starts to flatten and you have an economic environment that's just having slower growth and you have that occur, then you're more likely to have a correction turn into a bare market, which is more conducive, which is more consistent with recessionary period.

Jake Weinstein:  Do I expect a correction? I do. I'm not going to predict one, but I completely expect one to happen because of this fading liquidity. But am I going to try to time it and buy in and buy out of the equity markets? No, because historically these corrections that occur during the mid-cycle, they occur very quickly. The one year return on average after these corrections tends to be over 20%, even as high as 30%. Very hard to time the market perfectly. If you're concerned about a recession, because the economic backdrop is weakening, which neither Brian and I are saying, But, the volatility that I expect, I think having equity exposure through that and plenty of it, is going to be fine because any type of correction will likely be short-lived.

Jenna Dagenhart: And corrections are healthy. They're normal. We forget that sometimes.

Jake Weinstein:  Yeah, it's cleaning the blood. You just want to just make sure everyone doesn't think stocks can go up every single day, all the time. They are risk assets. There should be risks there.

Jenna Dagenhart:   Yeah, I cannot succumb to recency bias there. Well, Brian, what about your thoughts on recession risks?

Brian Smedley: Yeah. Look, I think recession risks in 2022 are very remote. I think as you move forward through 2023, the risk rises a little bit. My guess is the FED is going to have to do a lot of work between now and the middle of 2023 to tighten policy. There is a risk in that context, that we get to this point, we get to middle of 2023 or second half of 2023 and policy is tighter. We're looking at a yield curve that's flat or possibly inverted, similar to what we saw in the first quarter of 2019. I think there's a potential there that, that could be a signal that 2024, let's say might be a time to expect a recession. Again, I think the odds are pretty remote for the next 12 months.

Brian Smedley:   We're just going to have to be watching. We're going to have to watch to the data and see how the FED responds to that. See how the fiscal policy situation evolves. But I think, at this point, my best guess would be that 2024 would be a rising risk of a downturn. And in the meantime, I would agree with Jake. If you get a correction in the stock market, something in the order of 10 or 20%, I think that'd be a great opportunity to buy more risk. I think it's smart for investors to have a game plan in mind, so that if you see a meaningful pullback of that magnitude, you could make a tactical decision to increase risk allocation. We saw that in late 2015 and early 2016, where we had a mid-cycle correction and concerns about the economy, concerns about commodities that ultimately proved to be a great buying opportunity.

Brian Smedley:   The same was true in the fourth quarter of 2018. If you see something like that, and again, I agree with Jake. It wouldn't surprise me if we see something on order of 15, 20% pullback, I would see that as a great opportunity to add a bit more risk to the portfolio. Try to have a game plan in mind. Try to prepare for a bit more volatility. And again, the key is try not to lose your nerve. Look at the long term perspective. This is what markets do. If we get an event like that, I would say at least for 2022, and that's probably a good opportunity for you to rotate and rebalance your portfolio in a way that takes up the risk a notch, to take advantage of what would likely be a recovery and a rebound in the market on the other side of that.

Jenna Dagenhart: What about alternatives? I know we discussed real estate earlier, but many investors are also piling into cryptocurrencies. Jake, how are you thinking about the role of alts?

Jake Weinstein: Yeah, so alts in general, I think is an important asset class to investigate, from multi asset standpoint. Again, your question before about a 60-40 portfolio, maybe alts are something that could provide a little bit more diversification the important thing there is, know what you own and why you own it, and what exposure you actually have. Sometimes if you don't understand it and it doesn't do well, you're not going to be happy. So at least understand why you own it and it could do poorly, it's fine. But, get it, you should understand why. Crypto is another one of those that people are looking to. Look, I mean, I'm no crypto expert by any means. I've watched a lot about this, try to think about it. It's something, I think, that is extremely interesting.

Jake Weinstein:  What I could say with most definitive aspect, I'm not going to tell you which way any of those are going up or down this year. But they do offer diversification against a typical multi-asset portfolio. If it's something you're trying to do from a mathematical standpoint, in terms of diversification, that will probably work for you. When it's going to work and how it's going to work, high inflation periods, low inflation periods, high growth, low growth, a geopolitical uncertainty, I'm not positive on that. Regulatory aspects are extremely risky there. There's probably a "theoretical" risk premium embedded in there, knowing which one to own and understanding which one you own. So, worth the investigation, worth looking into for sure. Quantitatively, how to apply it in a portfolio, there's just not enough data to actually get a right answer for that. But, I do think it's an interesting place to spend some time doing some research.

Jenna Dagenhart: Yeah, definitely do your research before you invest in a coin named after a dog.

Jake Weinstein:  Yes.

Jenna Dagenhart:  No, Brian turning to you, any final thoughts that you'd like to leave with our viewers?

Brian Smedley: Yeah, sure. I mean, I would say to wrap up, challenging time for investors, but there are still some great opportunities out there. I think the key is to focus on diversification as part of that. I think you should maintain an allocation to fixed income. I think there's been a trend over recent years to move toward passive vehicles. That's all fine and good and there's certainly a role for that in portfolios. But, I think this is a market where having an active, an allocation to an active manager that has the combination of a top down and a bottoms up process, to identify the best opportunities and to avoid the biggest risks. I think that's more important than ever in this environment.

Brian Smedley: Where the FEDs raising rates, but the economy's very strong, we think credit is a great place to be. We think you should, to reiterate, you focus on floating rate credit and take advantage of a little bit better coupons and potential for spread tightening in a range of credit assets. We think that'll provide a nice balance and a steadier return profile in a year that may be a little bit more bumpy for the equity markets.

Jenna Dagenhart:   Jake, I will give you the final word here.

Jake Weinstein:  All right, the final word. I would say, keep in mind that Brian and I, this is the 2022 outlook and we're going to provide you our views that we think is going to happen over the next year. It's very challenging for us to predict that perfectly, which way stocks are going, bonds, interest rates, et cetera. Keep in mind, the most important thing to think about is your strategic mix and asset allocation, because the last several decades, what has worked may not necessarily be the case over the next several decades. Things are very different. The macroeconomic trends, the political landscape, the geopolitical landscape, demographics, factors are indeed different. It's very important to keep an open conversation. If you have an advisor, speak with them. But just have an understanding that it's an environment when you invest, it's going to be very different looking forward compared to historical periods. Strategic asset allocation long term thinking is probably the most important thing I think you can do.

Jenna Dagenhart:Well, Brian, Jake, great to have you both back on asset TV.

Jake Weinstein: Thank you.

Brian Smedley: Thanks Jenna. Thank you, Jake.

Jake Weinstein:   Thank you, Brian.

Jenna Dagenhart:  And thank you to everyone watching this 2022 outlook masterclass. Once again, I was joined by Brian Smedley, chief economist and head of macroeconomic and investment research at Guggenheim Partners. And Jake Weinstein, research analyst and vice president of asset allocation research at Fidelity Investments. And I'm Jenna Dagenhart with asset TV.


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