Jenna Dagenhart:

Welcome to this Asset TV 2023 midyear outlook masterclass. We'll cover what the next recession might look like, some of the top macro themes heading into the second half of the year, where investors are finding opportunities, and why it could be the start of a secular bull market. Joining us now to share their perspectives, we have Kathryn Rooney Vera, Chief Market Strategist at StoneX Group, Jeff Schulze, Head of Economic and Market Strategy at ClearBridge Investments, and Tom Ognar, Senior Portfolio Manager and Growth Equity Team Manager at Allspring Global Investments. Well, everyone, thank you so much for being with us today. And Kathryn, kicking us off here. Why don't you give us a broad overview of the current environment and some of the most important themes to watch right now?

Kathryn Rooney Vera:

Well, we've seen risk on of late. The market seems to me not attached to the economic reality, which is one, although it's not recession, is certainly slowing with inflation sticky above that 2% target. Equities regardless, specifically the most vulnerable sectors to high interest rates continue to rally very aggressively led by artificial intelligence. I'm referring mainly to the tech space. NASDAQ has done remarkably well, their significant laggers such as small caps, energy, financials, all of these sectors have been hit by the inverted yield curve, which itself is forecasting a recession while the equity markets seem to really discount that as a possibility in the near term. One other thing that I think has caught my attention is that the markets seem to be discarding maybe the reality of the Fed's maybe not reality, but the Fed's intention to get to a 2% target.

Regardless of what Jay Powell says, we see equity markets continually moving higher. Even we've had recently congressional testimony, the hawkish pause accompanied by an increase in the dots plot indicating additional rate hikes in the offing. And what we've seen is treasury yields barely move. We've seen a further inversion of the yield curve and equity markets continue off to the races, specifically pushed by a narrow breath with technology, or specifically eight stocks leading that rally.

I think that the Fed does have further to go in terms of rate hikes. I do expect the Fed to hike an additional one or two times. It's out of consensus, Jenna, but here I'll finish. I think that the labor market does matter. A lot of economists seem to think it no longer does. I think that the current pressures on wages and the beverage curve, which indicates enormous job openings have to evaporate before we see an unemployment rate increase still matters. The Phillips curve still matters. What does that lead me to believe? I believe that a recession is in fact in the offing. Not a 2023 event, but it is the next stage of the economic cycle. Economic cycles are that cyclical. The no landing and soft landing view from my perspective is not the most likely scenario to come to fruition.

Jenna Dagenhart:

And what about you, Jeff? What are your views on the US economy and do you think we're headed for a recession, perhaps as many are calling it the most widely anticipated recession in history?

Jeffrey Schulze:

I think we are. I agree with Kathryn that the US economy will witness a recession in the back half of the year. Now, we've been in the recession camp for quite some time. The key reason for that is our proprietary recession risk dashboard, a group of 12 variables that have historically done a very good job of foreshadowing an upcoming recession. It's a stoplight analogy where green is expansion, yellow is caution, and red is recession. And our dashboard turned red at the end of August last year, but given the strength of the US economy, we felt that it would take about a year for that recession to materialize. We still think that it's going to happen, but it may be the fourth quarter instead of the third quarter when the rubber hits the road.

Looking at a lot of the data that's accelerated recently or has been buoyant, a lot of it has been lagging or coincident, which means it can tell us where we've been or where we are, not necessarily where we're going. When you look at the Conference Board's leading economic indicator index or LEIs for short, it's signaling that the US economy is going to witness a pretty big deceleration in the next six to 12 months. The LEIs have been down for 13 consecutive months in a row. The only two times where you've seen a greater number of declines was in 1970 threes recession and in 2008, so we're in rare territory right now.

Looking at this from a different vantage point, the largest drop in the LEIs ahead of US recession was negative 5.7% on a year-over-year basis ahead of 1980s downturn. We're to negative 8% today. I know a lot of airtime goes into whether or not the Fed's going to hike one or two more times, maybe three. I don't think it matters. I think that due to the long and variable lags of monetary policy that has not hit the US economy quite yet, that we're going to have an economic downturn and the die is cast.

Jenna Dagenhart:

And you put it well, we're in a very rare environment right now. Tom, anything you would add?

Tom Ognar:

I think you qualify that well. It's very uncertain times. We've been believers that the Fed historically breaks things. They put themselves in a bind with unprecedented, easy monetary policy and they've been, I call it bailing water out of the boat for the last year. However, just as I always like to look at the counterpoints, you've got a consumer that arguably has never been as healthy potentially going into a recession. Extremely high savings rates which have been coming down, but still above average today. Employment extremely good where we are. And also, even though they're interest rates they have to pay on purchasing items have gone up a lot, the counter to that is they're making more money on their savings with that.

And then I would ask, and one of the things I've been trying to figure out is yes, the equity markets, at least right now, don't seem to be worried about a recession, especially up the market cap and love to get into that further in the discussion. But also the credit markets. If you look at credit spreads in particular high yield, not predicting at least the way we look at it, not predicting a recession, which seems interesting from our point that it's not just the equity markets that seem benign to the fact that we may enter a recession.

Jenna Dagenhart:

And another sign of strength that we're seeing right now, a surprising sign of strength has been in real estate. US housing starts unexpectedly rose 21.7% in May. Kathryn, what are you reading into that?

Kathryn Rooney Vera:

Well, there's a lot of demand in the dearth of supply. I think this is a response to that dynamic. The issue with housing is, of course, that mortgage rates have surged, rendering affordability of buying a new house or even the possibility of selling your old one very unattractive. Some people call it deflationary. I think it has more to do with excess demand and a response to that, and I revert back to the labor market. While people have jobs, are seeing wage increases, the Atlanta Fed, which I think is the most accurate and the best measure of wage growth, puts wage growth at 6%. Even though we have such a strong labor market, we have housing demands. Yes, housing prices are falling off. That's good for inflation in the CPI basket, because 40% is shelter cost, there's still healthy demand. In my view, at the current juncture, the Fed cannot achieve a 2% target if it's serious about its 2% inflation target with the current trajectory.

Jenna Dagenhart:

Let's spend a little bit more time on the labor market because it is so critical to the economy and the future of what the Fed does. And Jeff, headline jobs numbers continue to defy expectations. How are the obscuring broader labor market weakness and why is that a concern?

Jeffrey Schulze:

Yeah, there are more cracks in the labor market foundation than appears on the surface. Now, on jobs day, there's usually two reports that are released. One is the establishment survey where the government contacts businesses and asks about changes in labor conditions, and this is where we get the headline jobs number, which came in at positive 339,000 last month. But there's a second survey, which is the household survey where the government contacts individuals and asks them about the changes of their employment, and that came in at negative 310,000 jobs, so that's a pretty stark contrast. And though you usually do see divergences between these two surveys, at inflection points, it's usually the household survey that's more correct. This is the dynamic that bears watching as we move into the second half of the year.

That's not the only crack that's out there though. Our economic canary in the coal mine is initial [inaudible] claims. It's the top three variable on our recession risk dashboard. Usually when it turns red, it coincides with the start of a US recession. It's yellow caution right now, but initial job claims have risen pretty dramatically over the last 12 months, and if it raises another 20 or 30,000 per week, we're going to be in recession territory. Obviously, that bears monitoring. One of the other indicators that we have on our dashboard is job sentiment. Now, you get this from the Conference Board's consumer confidence survey, and really what we're looking for is the number of respondents that say that jobs are plentiful minus those that are hard to get, and we're well off the highs that we saw last year, which suggests that you still have a strong labor market, but things are deteriorating if you're looking forward six or nine months.

And the last thing I'll mention is if you look at hours worked, they've been steadily falling since their peak in early 2021. And usually when hours decline, it's because that employers are cutting back hours because of weaker demand. Again, there's a number of areas in the labor market that are showing some signs of strain even though on the surface it appears that things are well,

Jenna Dagenhart:

You actually read my mind, Jeff. I was planning to ask about the US aggregate weekly hours index. Tom, what do you make of all these potential cracks in the labor market?

Tom Ognar:

Well, I would throw back at Jeff and I'm just curious, if that's the case and that data continues along that trend, doesn't that portend a Fed that should stop and continue this pause? And if that's the case, then, at least from my perspective, thinking about the markets and less about the absolute economy, what is the market's reaction to that? But I guess if you put on your Fed governor hat, you think it's time for us to stop raising rates.

Jeffrey Schulze:

If I'm a Fed governor right now, I do not want to go back and be looked at in the history books as the Fed that let inflation get out of control. They're going to air on the side of over tightening to make sure that they can get inflation back down to 2% in a sustainable fashion. Although the data is clearly showing that things are decelerating and they've probably done enough at this point, they're unfortunately going to have to go into overkill mode and hike a couple more times because you're not seeing it go down to trend levels quite yet. And you look at labor, you look at inflation, they tend to be lagging indicators, so they shouldn't necessarily be looking at this to inform policy, but unfortunately that's the environment that we're in right now.

Kathryn Rooney Vera:

Maybe I would add something, Jenna, which is yes, the labor market is starting to roll over, but we should put in order of magnitude what levels we're talking about to be commensurate with the 2% inflation target. Right now, the unemployment rate is at 3.7%. That's very close to record lows. Yes, we are seeing a tick up in initial job list and we are seeing JOLTS, which is the job openings, decline slightly. We're still at 10 million job openings. That's pretty enormous. But we need to get to you, and I open this also to the panelists if they have an estimate, but we need to get into a non-accelerated inflation rate of unemployment, which is the neighbor of approximately 5%. We're at 3.7. We need to see the unemployment rate jump to about 5% to be in line with the 2% inflation target. And just looking at my historical data, I cover the wage and the labor mark pretty closely. Wage growth, the 50-year average wage growth is about 3.8% and by my estimates, 3.5% is the level of wage growth that is net neutral for inflation.

We would need the unemployment rate to jump by that magnitude. We would need wage growth to virtually be cut in half. And JOLT, which is the, as I'm referenced earlier, the beverage curve, which is an inverse relationship between job openings and the unemployment rate needs to roll over in a more meaningful way, which is of course [inaudible] And Jay Powell in the last congressional testimony specifically highlighted this, which is that the labor market sluggishness that we've seen so far is primarily due to jobs being taken off the table, meaning if you have 10 jobs out there and you see a drop in demand in the future, you're going to take those 10 jobs that you're offering and drop them to five or maybe to zero. Well, eventually to zero before you start firing.

We have not seen that occur yet, and that's what I'm laser focused on. Taking those jobs off the table before corporations start firing. But when they do, it can be fast and furious and we can see an unemployment rates sky skyrocket and that I think is what the Fed actually needs to get back to its 2% target. Now, a lot of people, and I'll finish here, but a lot of analysts think that that 2% target is irrelevant and that the Fed is going to accept something somewhat higher. I don't agree. I think the Fed realizes it needs to regain credibility with regard to inflation targeting. It has lost a lot of it and is going to push the rate until we hire, until get to that 2% target. Will that mean that we need to get a recession? In my view, the answer is unfortunately yes.

Jeffrey Schulze:

Yeah, just to dovetail on some of Kathryn's comments. Yeah, they've spent 40 years trying to earn that credibility after defeating inflation with Volcker in the early eighties. They do not want to lose that. And although there are cracks in the Labor Foundation, to Tom's point in his question earlier, if you look at JOLTS and the number of job openings, poor the number of people that are unemployed, it's at 1.8. Prior to the pandemic at the peak, it was at 1.15. This is a hot labor market no matter how you look at it.

And over the course of this year, you've seen 314,000 jobs created on average. The last time you had sub 4% unemployment last cycle, we were seeing less than half of this job creation. This is way too hot for the Fed, obviously way too hot for 2% inflation. Kathryn had mentioned some of the wage statistics out there not consistent with 2% growth... Inflation, I should say. The Fed unfortunately has put themselves in a corner and they're left with just bad choices right now, which is hotter inflation or a layoff cycle to cool the economy and get back down to target. And they're clearly choosing the second option, which is a recession and higher unemployment.

Tom Ognar:

Hey, I'm curious, Kathryn, how far do you think we can get along that curve by more people entering the labor force?

Kathryn Rooney Vera:

Well, new entrants, I estimate about 170,000 per month. We need to get non-farm payrolls to be above that. I'm sure there's other estimates as well, that's mine. Non-farm payrolls significantly above in terms of new jobs created, significantly above 170, which is the natural demographic, new entrance. We're talking about people that are graduating from college, growing up, maybe leaving their parents' basement, who knows? But people that are entering the job force are about that amount. For us to seek kind of wage or labor market pressures come off, we would need to see non-farm payrolls drop meaningfully below or contract.

Jenna Dagenhart:

And not come in above expectations like we've been seeing.

Jeffrey Schulze:

Came in above expectations for 14 consecutive months. Longest streak in over 25 years. Yeah, still a hot labor market,

Jenna Dagenhart:

Very. And when you have more openings than workers who are unemployed, it's just really tough to deal with that. I mean, you said it well, the Fed is in a corner right now, Jeff, how does the Fed get out of that corner?

Jeffrey Schulze:

Well, unfortunately, again, the Fed needs to cool inflation. And although there's this idea that you could have this immaculate slackening, as I call it, this idea that job openings can come down meaningfully and you see lower wage growth, you've never seen that happen before in history. Usually when job openings come down, you see an increase of a layoff cycle. Now, to be clear, job openings are at 10 million. Prior to the pandemic, we're at seven million, so we're about three million above trend. That certainly is a possibility. But given the rise of the unemployment rate that we've seen by 0.3%, usually not a good omen. Usually when you see a rise of that magnitude, it jumps to 1.5% or greater of a rise of the unemployment rate.

The reason why you know the Fed is acting as hawkish as they are, even with some signs of deterioration and potentially a recession, the reason why they are doing this is they don't want to repeat the sins of the FOMC of the 1960s. Now, since 1955, the Fed's been able to have 13 primary tightening cycles, of which they've created three soft landings, 1966, 1984, and 1995. Now, in order to have those soft landings occur, the Fed needed to cut rates in each instance, but yet a very different inflation experience in 1966. In 84 and 95, core CPI actually dropped three years after the Fed pivoted or cut rates. In 1966, core CPI doubled going from three to 6%. And the key reason is that in 84 and 95, you actually had a lot of slack, a lot of excess in the labor market, so it took a long time for the labor market to tighten, wage growth to move up, higher demand higher inflation.

In 1966 when the Fed pivoted, you had an unemployment rate at 3.8%, and that really kicked off the high inflationary 1970s. From the Fed's vantage point, they understand that if they don't create more slack in the labor market, they don't create layoffs, a higher unemployment rate, they run the risk of seeing structurally higher inflation looking out three, five or 10 years from now. Again, they're in that corner. Unfortunately, they have nothing but bad choices, but given their mandate in their 40-year fight with inflation, they don't want to go back down the road at the FOMC of the 1960s.

Jenna Dagenhart:

Tom, do you think that we could see the Fed reverse course soon, and what would it take in order for that to happen?

Tom Ognar:

I do. I'm not one of these believers... It's been interesting, if you've watched the Fed futures curve and its predictions on what the Fed's going to do, it's been completely wrong for the last year. They've been predicting more or less a halt in reversal for six months out for the last 12 to 18 months, or at least for the last 12 months, and they keep pushing it out. And I think that's been right. At one point, if we were sitting here last year, I think the futures market was predicting that the Fed actually would start cutting rates by the end of 2022. And this year, I forget exactly where it is today, but I think now it's been pushed back into 2024, if not at the very, very end of 2023.

And we've been of the belief that no, the Fed's not going to... Because I do agree with Jeff that the Fed doesn't want to destroy its reputation, and who does want to go down in those history books as the one who created this inflation, this runaway inflation with that?

But also, I do think the Fed has to note that they've historically broken things. They didn't predict what was going to happen with Silicon Valley Bank. And you actually were testifying right before that, that all was well. And the other thing that I think is going to be interesting, and I know the Federal Reserve is supposed to be agnostic and independent, but you have to believe there is going to be a lot of pressure as we move into the 2024 elections to not have a weak economy going into those elections, because historically, the party in charge when we're in a recession does not do well in those elections.

And so, I think there's going to be a lot of psychological pressure coming down from politicians every day in the press on the Federal Reserve to take into account those Americans that are hurting from their policies or potential policies. And I'm not to saying that that would be the right thing for the Fed to do, but I think it's realistic for us to actually look at that and think about that the Federal Reserve is going to be under a lot of pressure trying to work its way out of this structural inflation that we've had.

Kathryn Rooney Vera:

And Jenna, and maybe there's one other thing I would add to what Tom is saying, and Jeff, both excellent analyses and commentaries, is something that's little discussed, which is the fiscal contribution to inflation. Discussed very little given. I mean, insignificant attention. But the fact is the fiscal deficit here in the US is 6% of GDP, and 6% of GDP with full employment. That in itself is inflationary. We see additional spending on pet projects out of Washington, as if we did not already have a massive debt burden and fiscal problems that even the Fed doesn't want to talk about, doesn't even want to touch. Jay Powell and his congressional testimony doesn't ever want to talk about the fiscal part of things, but the truth is that fiscal monetary policy, yes, they are separate, but they need to work together.

If there were some pressure from the market participants on the government to reign in deficits, maybe control spending rather than continuing profligate spending, adding onto COVID stimuli, which has, as I predicted back then, Jenna, has become massive social spending ingrained into society and never rolled back, we're just adding to it. I think that the inflationary impulse is here to stay for a continued period of time. The question that we need to ask ourselves, and I would love to hear what Jeff and Tom have to say about this, is what happens when the Fed... I mean, the Fed is already rolling off a balance sheet. We're talking about inordinate amounts of deficit financing that's coming into play here, and the Federal Reserve has been monetizing that deficit.

You have China that desperately wants to, from my perspective, given the terrific relation between the US and China and the lack of trust between them, China wants to diversify its $3 trillion of reserves away from US assets, where the vast majority of its reserves are already located into something else, perhaps gold, perhaps other markets. There's just not as many liquid markets in the world as US Treasury and US dollar. But there is this interest on the global scene to move away from the US reserve currency dollar, which is the international reserve currency of the world. This can come to a powerful implosion at some point, and I think that we could be seeing higher yields on treasuries as a structural phenomenon.

And I'll just finish with one thing that I've been thinking about quite a bit. Maybe this is a bit academic in nature, but when you think about the impact of government crowding out the private sector, what happens here is you have deficits that need to be financed. We need to issue debt to finance those deficits, because somehow the deficits have to be covered. And then you have in the secondary market banks having to buy that paper, so you have a dampened effect on private issuance and private capital markets because the government debt is so huge and onerous and is sucking up all the oxygen. What happens then? It has an impact on GDP, on growth. There is something that's going on here that I think is structural in nature that will affect the US growth rates over time, and there is nothing being done about it. We're not even really talking about it. And I refer mainly to the fiscal impulse, both on inflation, on our debt dynamics, and ultimately on our capacity to grow.

Jenna Dagenhart:

Well, Tom, Jeff, do either of you want to pick up on Kathryn's thoughts there?

Tom Ognar:

The fiscal stimulus should grow the economy, generating more tax revenue to help pay for that spending. I'm not necessarily in that camp, but I do think that argument is out there. And I do believe, I think the argument that you do have countries around the world who would like to move off the US reserve currency is completely accurate, I just don't think there's an alternative and I don't think it's coming soon. And I think the lip service that's been done to it, really, if you look at the underlying data, the underlying transactions, it's still using the US is that structural currency, and I just don't see that changing over the next decade or two.

Jeffrey Schulze:

Yeah, I would agree, Tom. Look, there's no alternative. If there was a viable alternative, you would see, obviously, changes in reserves holdings actually happening. China's been relatively flat with their holdings of treasuries over the last couple of years. That hasn't really been declining. I don't think there's necessarily a desire to add to the reserves, but the world has never been more dollarized. And a lot of people talk about the Yuan replacing the dollar with some of the deals that have been struck here recently. But we're talking about drops in a bucket, and the Yuan's not even freely traded like the US dollar, so you have a hard time being a reserve cu.

Rency, let alone the world's reserve currency unless you will let your currency freely trade. I think there's still demand for US assets, most liquid markets in the world. There will be a point where you're going to have a crowding out effect that Kathryn had mentioned, but I don't necessarily see that happening over the next four or five years. And let's not forget, although the deficits are pretty big right now, the markets can induce discipline on policy makers and started with higher interest rates and higher inflation, and those deficits may ultimately come down. But again, we're on a path that will likely lead to the rubber hitting the road, and hard decisions in Washington are going to have to be made at the back half of this decade.

Kathryn Rooney Vera:

Hard decisions won't be made until we get a crisis. The CBO put out a piece a couple years ago, which stated correctly that by year 2030, I believe it was, that the combination of social security, Medicare, Medicaid and interest payments will consume 100% of all revenues. And those are mandatory. Anything else that the US government wants to spend on will have to be deficit financed. We're almost there. I think it's something structural that one has to consider. And I think that yes, you guys are both right. There is no market as liquid, as deep as the US treasury market, and China is going to remain a net buyer of treasuries. But I would say that it's something to keep an eye on with regard to inflation and asset prices going forward, specifically with regard to maybe gold positioning. I think that gold has a leg up. I'm a buyer of gold, and I think structurally it makes sense as well if we are talking about some sort of diversification out of US dollar assets.

Jenna Dagenhart:

Tom, what kind of asset allocation do you think makes sense to you right now?

Tom Ognar:

Well, as a growth equity manager, it probably would be undisciplined for me to say 100% equities. But to be fair, I do think it's the first time in a long time you could actually get real income, real yield out there in the market, which I think is helpful. I have always been a believer, though, that equities are probably one of the best inflationary diversifiers that are out there. And I think if you look at the data, if we're not in periods of deflation or in hyperinflation or higher inflation, and I think the data I've seen is above 5%, then equities actually are a really good store of value. And I always use the example, and we've seen it. McDonald's can raise the price of a cheeseburger. Coca-Cola can raise the price of its Coke, and it's still the best fuel out there for consumers, and they go and buy those types of assets or those types of consumables.

And so, I do think equities have a really good place within that as an inflation hedge, and I also think it's a hedge for the potential for rates to come back down again. And I've been of the belief that yes, we can go into an earnings recession either this year or going into next year, yet equity markets go up from the standpoint that we've come down a lot. We came down a lot last year in the equity markets, especially on the growth side. And then two, multiples can expand as your discount rates change and your discount rates come down and that can lead to higher valuation.

And so, I do believe equities in particular, I'm biased towards growth. Equities have a really good place in that portfolio. And one of the things I think is very interesting on the growth equity side is if you look at the last 25 years or so, at least since the start of this century, you've seen, actually, the returns on equity on the growth sector move up almost three times, move from about 13% to over 30% today over that time period. Whereas on the value side of the market, they stay pretty flat in that 13, 14% range. And so, I always argue that yes, growth stocks look more expensive than they historically have relative to the rest of the market, but for good reason. They're doing a much, much better job than they historically have done at returning that capital or at least generating that capital for investors.

Jenna Dagenhart:

And spending a little bit more time on equities here, Jeff. What are some areas of opportunity that you're seeing in the markets right now?

Jeffrey Schulze:

Well, it really depends on one's timeframe. I think near term, I think growth over value. I think value has a little bit of relative performance. The call back here, and we've certainly seen that here over the month of June, but usually as you're going into a recession and out the other side, growth has outperformed value from a style perspective. As Tom alluded to, if we do indeed have a recession, 10-year treasury rates are going to drop, that usually helps multiples again, a tailwind to growth. Now, I don't think that the tenure treasury is going to drop as much as what we've seen over the last number of cycles. I think investors are going to demand an inflation premium this time around, but tenure charges may drop to 3%, maybe the high 2% range, which could be a tailwind.

I also like dividend growers. I'm expecting a lot of volatility in the markets over the course of the next 12 to 18 months. Dividend growers have all the attributes that you want in that environment. They're high quality companies. They have rock solid balance sheets. They can fund their own growth, so they don't need to access the capital markets in a choppy environment. They have a high degree of earnings visibility. That's a really key attribute that investors covet when earnings expectations are coming down. And then lastly, if the Fed has to do more rate heights, and I know a lot of people think that they don't and they won't, and I'm in the camp that they're only going to do two more heights, but they might have to, if inflation's a little stickier than anticipated, that higher income stream will help negate some of the effects of duration.

I like growth and dividend growers on a shorter term basis, but looking out on the horizon, I actually do see brighter prospects for value as we get through this recession, and I think they're going to be a key beneficiary of some of the AI productivity enhancement that you're going to see in the US economy.

Jenna Dagenhart:

And Kathryn, anything that you would add about equity markets right now?

Kathryn Rooney Vera:

I don't like equity markets. I think that they're overdone, I think they're overvalued, and the breadth of the appreciation or the rise is too narrow from my perspective. If we are entering into recession, which I think is the next phase of the economic cycle, it's not where we want to be. And I think I did an analysis on this. Those who are alive, all of us who are living in the markets right now, we have lived in the second quadrant of the economic cycle, Goldilocks, where you have low inflation, high growth. In that quadrant, large cap stocks performed phenomenally.

And if you look at this chart, it's pretty cool. Over the past 50 years, we've lived the majority of those years in that quadrant. If you move into the recession quadrant, it performs horrifically. So I would be wary. For those dedicated equity investors, what I'm telling them to do is to invest in those sectors that historically have outperformed both in stagflation where we are right now, and recession, which is where I think we're going. And that would be accumulating positions in sectors such as staples, healthcare and utilities. Some amount of energy, I think, makes sense. And Jeff had mentioned the time horizon. You're right, 12 to 18 months. This is my view.

If we're talking in the next few months with the momentum that's carrying us, you know, could do short-term tactical plays. For example, playing the divergence between the NASDAQ, which has skyrocketed versus laggards such as small cap, Russell, financials, energy. There's a massive divergence between these two. If you think that everything's going to go higher, not just tech, then you want to play the laggards. Those are the names that I just suggested. That would be a tactical position. I think I tend to look in emerging markets as well. Emerging markets, I'm also bearish on in terms of equities. I think there are opportunities in fixed income, but we have to get to the peak of the fed tightening cycle. And again, I agree with Jeff. I think we do get at 50 basis points more in fed tightening. That means that EM currencies have further to weaken. If I'm right on that, then we have better opportunity and entry points to get into some juicy yielding fixed income assets outside of the US.

I think that's going to be a very attractive play for portfolios that are looking for some alpha. And I think that would also be something that's longer term in nature, not over the course of the next three to six months.

Jeffrey Schulze:

And I just want to dove down some of Kathryn's comments. I think that you're going to see some market volatility over the next 12 to 18 months as this recession is priced. Now, a lot of people view that the October lows was the market pricing in a recession. But in the post-World War II history, you've never seen the market bottom prior to the start of recession. And if the October lows were the lows, that bottom would've happened about a year ahead of time. So we know that the market is forward-looking, but it's really not that forward-looking. It's a very interesting dynamic. I think multiples being at 19 times forward earnings for the S&P 500 is pretty optimistic. We got the trough multiples of 15 back in October. Ultimately, I think we probably get back there, but earnings expectations are way too optimistic for the environment that we're anticipating.

Right now, consensus expects an earnings acceleration in the back half of the year coupled with margin expansion. This is in stark contrast to economist forecast that expected decelerating economic activity backdrop. One of these cohorts are wrong. I think it's earnings. And if you look at the last three recessions, earnings expectations have moved down by about 26%. We're at mid-single digit levels. Again, we think this probably pressures the market, may retest the lows that we saw in October. But longer term, Jenna, I really do advocate that investors should take advantage of that volatility methodically buy into the market as it moves down, because I'm a firm believer that we are in the midst of a secular bull market, which is historically a 20-year period where US equities have outsized returns. This dynamic between secular bear and secular bull markets have been going on for almost 100 years, and the start of this secular bull was the bottom in March of '09.

We're right now in year 14, which we suggest we have another five or six years of upside. And I think the driver of this is right in front of our eyes, AI. A lot of the benefits have accrued to the handful of tech companies that are the obvious beneficiaries of this. But as the productivity gains nationwide, I think it's going to trickle down into the old economy. High labor firms and the high labor firms are going to benefit from AI because it's really going to close the gap between junior and senior workers. These are companies with low margins, low growth rates, low market caps, and I think that is a reason why I mentioned just a second ago, why value over a longer time horizon that I think those benefits are going to accrue to a lot more of the companies than what's initially meeting the eye right now. But unfortunately, these companies are going to have to invest in AI and they're going to be burning cash through a potentially challenging profitability backdrop. But short term, obviously think some choppiness, but longer term I think there's a lot of opportunities in US equities.

Tom Ognar:

Well, I would throw in that while eventually I think companies will benefit from that productivity, what we really see as an opportunity, and where we add a lot of value is investing in those companies that are creating those picks and shovels or as they say, the arms dealers into that. We're not trying to pick winners yet within who wins for a AI from the end markets or from the rest of the economy. There will be companies that do that, but that's going to be probably a narrower list. And so, if we can find companies that have that opportunity and then create those tools that companies need in order to really exploit AI, I think that's where, at least in the near term, near to medium term, there's a lot of opportunity.

Furthermore, there's no doubt that small and midcap stocks have lag. Even year to date, they've been lagging for a few years now. Year to date, within the growth universe you have the Russell 1000 growth up over 25%, yet you've got the mid-cap growth index up about 13%. You've got the small cap growth index and value index up about 7%, and those are big divergences. Now, I could have been on here a year ago and said, "This is historically widespread on valuation relative to history." Historically, small caps have only traded this cheap about five to 10% of the time, mid-caps somewhere between 10 and 20% of the time, but it's persisted. I think part of that is because earnings have been tougher to come by and the larger cap stocks have done a better job of protecting those earnings.

But from a macro standpoint, what we've historically seen and the data would tell you is the catalyst for those more market breadth and for mid and small cap stocks to really regain a leadership position is when the Fed eases, is when interest rates start to come down. And maybe that's what, again, will lead to more breadth with this market.

Jenna Dagenhart:

Yeah. Jeff, how are you looking into the market breadth right now?

Jeffrey Schulze:

Yeah, it's been extremely narrow up until June. Usually narrow market breadth is indicative of a bull market that's running out of steam rather than the start of a new bull market. The thing that I've been more optimistic about, though, is... Tom alluded to this, but you've actually seen participation broaden considerably over the course of this month. It's been into value, it's been into more cyclical areas of the marketplace. You've seen small cap participation. This is a really good sign, but still today only 56% of the S&P 500 is trading above its 200-day moving average, which is historically a pretty low number, if October was the lows a little over eight months ago. What I'm really looking for about the durability of this rally is can that participation continue to broaden when we get into July and August, which would be a really good sign for the staying power of this rally, or does it start to weaken and we get a more aggressive selloff? And this was just short covering when we look back in hindsight. But again, I think the direction of participation is really going to dictate the fate of this rally.

Jenna Dagenhart:

Going back to your comments about a recession, Jeff. How deep of a recession are you anticipating and why? And then how does that factor into your thoughts on the secular bull market?

Jeffrey Schulze:

Yeah. I would say on a scale of one to 10, I would say most people, if they anticipate a recession, they're thinking of one or two, short and shallow. I think it's probably going to be more of a moderate and longer recession, a four or a five. And it really comes back down to the change of the Fed's reaction function,. I talked about this a little bit earlier, the fact that the Fed doesn't want to make the same mistake twice. They don't want to loosen into a tight labor market environment and create structurally higher inflation looking out three, five or 10 years from now.

But also, when thinking about the Fed's reaction function, by just looking at their dot plots, it's changed. The Fed is expecting the unemployment rate to rise by 4.1%, by the end of the year from 3.7 today, and expecting it to rise to 4.5% at the end of next year. Now, historically, the Fed has no tolerance for job loss. They usually have their first rate cut as the economy goes from creating jobs to a standstill. But after that first rate cut, you see the snowball effect of layoffs occur, and a year afterwards, the US economy loses around 800,000 jobs. Now, I'm looking at the dot plots. The Fed is basically saying that they're going to accept almost a million job losses over the course of this year and another close to a million job losses next year, and they're not going to be cutting this year, they're going to be actively hiking into that environment, and next year they're only expecting themselves to cut four times, which would be relatively shallow for the magnitude of job loss that they're projecting.

Now, I will say that the Fed's dot plots are historically not accurate, but I think that really just goes to show you their reaction function and how concerned they are about getting inflation back down to target, and they view it as a really hard and tough battle. And if you look at Powell's presser from last week after the FOMC meeting, Powell went as far to say that he thinks rate cuts are a couple of years away. Again, I think it comes back to that Fed's reaction function changing given where we are from an inflation standpoint.

Jenna Dagenhart:

Kathryn, I saw you nodding your head a few times in there.

Kathryn Rooney Vera:

I agree, and I think that the Fed does have a very tough run, but it's of its own making. I mean, this is a Fed that has made many errors, unforced errors. We all remember infamously the transitory nature of inflation, but let's not forget that this is a Fed that also overextended by about a year its focus on supporting the labor market. What did we get from that? Remember, the Fed would insist that the labor market needed additional support, so they continued with quantitative easing well into when they should have subsequently stopped. We're talking at least I would say a year ago, a year previous, the Fed should have started hiking rates and at least should have started to stop the quantitative easing purchases.

A lot of it is of their own making. I do think that the Fed has realized their difficulty with regard to inflation forecasting. And I agree also with Jeff with regard to the dot plot. They can say whatever they want, but things can change very quickly. And unfortunately this is a Fed that I would love to understand what their vision of data dependency is, because really, it produces a lot of volatility in the markets and in risk assets when the Fed is so data dependent that a couple of data points or one data point can throw them off of their trajectory. That gives inherent volatility. Volatility is very poor for asset prices, especially in the equity market. To finish, I think the Fed needs to really get inflation of the 2% target. There's a lot of talk about moving that target. They're not going to do that. If they do, it's a grievous error. It's a massive error from my perspective. If they change the Fed target or cut rates before getting to 2%, I think it's a mortal blow to the credibility of the Fed as an inflation fighter.

Jenna Dagenhart:

Tom, anything you would add about how the growth equity team is thinking about rates and your longer term outlook for growth?

Tom Ognar:

Yeah, I'd add a few things there. As I mentioned, one of the things that's been perplexing is what the credit markets have been discounting. And one of the things we have been very disciplined about is looking at other asset classes, in particular credit to help us with our discount rates. We invest in robust growing companies, many that are in the news at the top of the page. But we're doing that with valuation discipline, and part of that valuation discipline is understanding what's going on with discount rates. We weren't surprised that parts of the markets sold off last year. You had interest rates going up, meaning your discount rates were going up, so valuations all else being equal should be coming down. And you could explain 80, 90 plus percent of what happened last year in the equity markets just by changes in discount rates.

And so, from our perspective, it's something we've spent a lot of time looking at in ingraining in our valuation discipline, in thinking about how we want to structure the portfolio. And so, I think that got lost within equity market and equity portfolio managers over the last 10 plus years in this extreme. And I think Kathryn hit on it. Unprecedented Federal Reserve policy, and not just in the US. Really, let's be fair, it was around the world. And from that perspective, valuations almost didn't matter. Portfolio construction almost didn't matter. Diversification almost didn't matter. And as I always tell our team, it doesn't matter until it does, and then you better be ready.

And it's amazing, and I've been doing this for close to 30 years now, and I think maybe Kathryn talked about it. This is the first time in my career where you've seen structural inflation. We've had many bouts of inflation, but the first time, you think about any analyst on your team who's only been doing this five or 10 years, they don't know. They've never seen anything like this. They don't remember the seventies. They don't remember Volcker or anything like that. And so, I think you have to be disciplined. You have to be ready for it all the time within your portfolios, and you have to think about construction, you have to think about valuation. And I think valuation almost became a dirty word among growth investors. And I'm really, really glad that it's back in our vocabulary and people are thinking about risk management.

And I think what's going on with not just the central bank, but what's going on with the capital markets, I think is indicative of that. There's a new approach to risk management, at least relative to the last three to five years. I think it's a very healthy approach. I think it's needed and I think it makes it a better time to be a portfolio manager, especially one that cares about risk management in this environment.

Jenna Dagenhart:

Well, before we wrap up this panel discussion, I want to go around the room and give everyone an opportunity to share their final thoughts. Jeff, anything you'd like to leave with our viewers?

Jeffrey Schulze:

Yeah. Although the economic data has held up so far, we are anticipating a recession on the horizon. We think equity markets are pricing in a lot of optimism at the moment. I think a lot of the decline that you saw last year, as Tom just mentioned, was a rising discount rate rather than fears of a recession. We're expecting that we may retest the lows that we saw back in October as this is fully priced, but again, we still believe we're in the midst of a secular bull market. We're advocating our investors to take advantage of those opportunities and put money into work for the next leg of the secular bull market.

Jenna Dagenhart:

Kathryn?

Kathryn Rooney Vera:

Yeah, I guess in addition to what Jeff has said, I think that we have to look outside of the US as well for opportunities. We're not just talking about developed markets but emerging. I think that should be part of a portfolio. Doesn't have to be in a huge amount, but certainly does add additional returns to a portfolio that may be overweight in US, Europe and Japan. Look into Asian markets, Latin American markets. I think those will present some attractive opportunities over the course of the next 12 to 18 months, if and when we are mired in some recession. Whether it be narrow, whether it be more serious, I do think that we need to look for other opportunities, and as Tom said, be positioned or be at least contemplating the next phase of the economic cycle. And that's the way I look at things. As a macro economist, a market economist, I like to look at things from where we are and where we're going in the economic cycle.

And I think we have to be very careful of discarding tried and true economic principles. This is one thing that I noticed five years ago. An analyst that I really respected, economists said, "Inflation is a phenomenon that's dead and buried." Well, dead and buried for the past 20 years. But we have to avoid anchor bias. What's happening today doesn't mean that this time is different. This time is usually not different. We need to look at the Phillips curve. We need to consider NAIRU. And I think that these fundamental principles should be paid attention to. Yes, artificial intelligence is important. Yes, it will help, maybe hinder productivity, that's up for debate. But resume back to basics. What are the portfolio goals and how can we help you reach your goals, minimizing risks?

Jenna Dagenhart:

And Tom, I'll close out the panel with you.

Tom Ognar:

Yeah, I think what's really the most interesting thing when I look at the markets right now, the equity markets, is that divergence between the large and especially the mega cap and down the small and mid-cap area. And I'm not one to say that investors shouldn't own. I do believe they should own large cap stocks. I believe they should own mega cap stock. I think there are some inherent advantages that some of those companies have, especially in this digital age where information is the core commodity and you think about how much information they can process, where they can point their businesses, the capital they have to invest going forward. But when you look at valuation and you look at that opportunity set, and you look at it relative to history where small caps historically trade about on par with large caps, yet today are about 80% of the forward valuation of large caps, or mid-caps are historically, again, about on par to 10% premium today trade at about 90% of that valuation of large caps.

Not sure when that reverses, but there is a potential snapback that I think is presenting opportunities where if you're a good portfolio manager, you're a good analyst, you should be doing a lot of work down the market cap and seeding your portfolios with those companies that really have that opportunity. And I've been telling people, this reminds me a bit of really the early part of my portfolio management career, which was that early 2000s, mid 2000s period. Coming off, if you recall, a mega cap driven market in the mid to late nineties going into an extreme almost bubble, if not bubble market in 2000, and then you really had this period where small caps outperformed from about 2000 through 2007. And so, that leadership can return. I think there's that opportunity in front of us. It's hard to judge when exactly that will happen, but I think you should be seeding your portfolio with opportunities or with investments that include small midcap stocks.

Jenna Dagenhart:

Well, Tom, Kathryn, Jeff, thank you all so much for joining us today.

Kathryn Rooney Vera:

Thank you.

Jeffrey Schulze:

Thanks for having us.

Tom Ognar:

Yeah. Thanks,