Jenna Dagenhart: Hello and welcome to this Asset TV 2023 Outlook Masterclass. 2022 has challenged investors across the board with double digit losses in both stocks and bonds and inflation hitting 40-year highs, leaving many wondering if there's any way to escape a recession in 2023 on the heels of historic rate hikes. Joining us now with our outlooks for the new year, we have Tom Wald, chief Investment Officer at Transamerica Asset Management, Malcolm Polley, president and Chief Investment Officer at Stewart Capital Advisors, and Jeff Schulze, director and investment strategist at ClearBridge Investments. Well everyone thank you so much for joining us today.

Malcolm E. Polley: Thanks for having me.

Tom Wald: Thank you. Yeah.

Jeff Schulze: Happy to be here.

Jenna Dagenhart: So Tom, kicking us off here, inflation and recession, obviously, clearly the two macroeconomic most top of mind for investors, say, enter the new year. How do you think they should be gauging those risks and are there any potential silver lining outcomes as these two risks play out?

Tom Wald: Yes, Jenna, the combination of inflation and recession, just using those two words in the same sentence, as we have so much, of late, certainly has an ominous ring to it. I think from a comparative perspective, I would still consider inflation investor enemy number one, so to speak. Since World War II, the US economy has weathered about a dozen recessions. None of them fun, of course, but persistently high inflation for prolonged periods of time can really debilitate an economy, and that's why the concept of sustained and elevated inflation tends to generate an extra degree of urgency from investors and from the Fed. I continue to view inflation as the first domino to fall in the chain of negative investor events that changes consumer habits and impacts market valuations, and of course, incense the Fed to raise rates which ultimately slows the economy and to potentially drive us into a recession. So for investors to gauge the overall risk, in this chain, I think they have to assess the persistency or, what I refer to, as the stubbornness of inflation. How long is it staying above a critical level?

                                    And I would say right now that critical level is about four to 5% on core PCE and core CPI. You also have to gauge the risk the Fed is reacting appropriately and in that regard I'll be watching whether they eclipse 5% of the Fed funds rate in 2023. And finally whether an inevitable economic slowing created by these higher rates escalates into more severe economic contraction. And there I'm watching if a pending recession looks like it will be closer to 1% overall GDP contraction, like the recession of 1990 and 2001, rather than much worse downturn of say three to 5% that we experienced in recessions the beginning of 1981, 2007. Finally, Jenna, I think the silver lining is if core inflation can subside into that 4% or lower range by about mid-year and stay there, then you get that chain of dominoes starting to fall, perhaps, the other way and potentially to the investors' favor. And if that becomes apparent, I think markets could react quickly and favorably.

Malcolm E. Polley: Yeah, I think I would agree that inflation is public enemy number one. In fact, the Fed has been pretty clear about the fact that we need to be cognizant of what happens if we don't pay attention to it. We learned lessons from the Volker era, where we let inflation get ahead of ourselves and we didn't address it until it was too late. And I think they're very leery of not doing that. So I think they will err on the side of tightening too much just to try and squeeze down inflation. Now, from the other side of that coin is that the expectation by the Fed is that they can get inflation back to that two to 2.5% target. And our belief is that they won't be able to. I think we're in a different environment for a lot of different reasons and I think it's going to be very, very difficult for the Fed to get inflation back below 2.5%.

Tom Wald: Yeah, I agree, Mal, and the way I look at it is I'm not even talking about 2% inflation right now. To me, it's where do you get to a point where you can even talk about 2% inflation? And to me that's four to 5% core inflation about mid-year of next year. And then you can start to have that discussion. But until then it's even hard to even have that conversation.

Malcolm E. Polley: Yeah, and I think our view has been that inflation's going to come down. It's not going to come down to where the Fed would like it to be, but it'll at least come down to somewhat more manageable level, and double digit inflation, high single digit inflation is clearly not acceptable.

Jenna Dagenhart: Yeah. 2% inflation feels like a unicorn right now rather than the norm that it used to be. But inflation is showing some positive signs of cooling, still of course, remaining stubbornly high. Jeff, what are your expectations for price levels in 2023?

Jeff Schulze: I think I'm going to split the middle with Tom and Mal. I think inflation's obviously peaked. It's moving down, and you've gotten some really good CPI prints in October and November, which is showing that maybe we can get to the other side of this inflation story. But in breaking down CPI into three components, two are actively going to help inflation move down in the next year, and I think one is going to keep it stubbornly high. So the reason why those two inflation prints were coming in below consensus expectations is they're seeing broad-based goods deflation. This is what the transitory story was always built on, and it's finally coming to fruition as supply chains are being rebuilt, and you're seeing a normalization of demands away from goods back over into services and used cars, for example. They were the fastest moving item on the way up, it appears that they're going to be one of the faster moving items on the way down as well.

                                    So this is something that's cooling inflation, and I think this is obviously going to be a story as we move into 2023. The second component is shelter, and shelter inflation is still going to be sticky to the upside, but I think you're seeing peak shelter inflation and it's going to move down, forward-looking measures of rent that usually lead shelter inflation are clearly seeing an inflection lower. And I think although it's going to be sticky, it's going to help the Fed feel more comfortable about the inflation backdrop. But the third component, which I'm a little bit more concerned with is core services ex shelter. This has the most correlation to wage growth. The hottest inflation you're seeing is in the service sector as people are looking to reengage with the economy in that capacity, but also that's the area that you are seeing the hottest wage growth as well.

                                    And I don't see a situation where that moves down meaningfully enough to bring inflation towards the Fed's 2% target by the end of next year. So my view is that core inflation's probably going to be three and a half at the end of next year, and depending on whether or not we have a recession, will really dictate whether or not we can eventually get down to that 2% target. But I think it's probably going to be uncomfortable for the Fed no matter what at those levels.

Jenna Dagenhart: Speaking of recessions, Jeff, some strategists think that a recession is all but unavoidable in 2023. However, your economic outlook for 2023 is called, "handicapping, the most anticipated recession ever." Looking at the resilience of a slowing economy and whether 2023..." I'm going to do that from the top. And speaking of a recession, Jeff, some strategists think that a recession is all but unavoidable in 2023. However, your economic outlook for 2023 is called a "handicapping, the most anticipated recession ever. Looking at the resilience of a slowing economy and weather 2023 can escape with a soft landing." Could you walk us through some of the findings?

Jeff Schulze: This is the most anticipated recession ever. One of the regional Feds look at professional handicappers that are out there and it's the highest probability of a recession over the next year that it's ever been. So this is very well anticipated, and there's an element of reflexivity there. If everybody believes that a recession is going to materialize, everybody incrementally may spend a little bit less and that recession becomes a self-fulfilling prophecy. But our core view is that although a [inaudible 00:08:54] understanding is certainly a possibility, our base case has been a recession since June of this year when the Fed really started to prioritize the price stability aspect of their dual mandate over full employment. And our recession risk dashboard is confirming that view. We moved to a recessionary red signal in August, and that red signal has gotten even more deep as we currently sit here. And I think it's going to become a very deep red signal given what the Fed has hiked already and what's anticipated as you look out on the horizon.

                                    Now, one of the reasons for a soft landing is a potential Fed pivot, and I don't think a pivot is a pause, I really think of it as rate cuts. But the Fed has learned their lessons from the mistakes of the past. So looking back to 1955, 13 primary Fed tightening cycles, three have been soft landings. That was 1966, 1984 and 1995. Today's environment is like 1966's, because when the Fed cut rates in those three instances, in 84 and 95, actually core inflation moved down three years after that pivot. It really didn't become a problem until later in that cycle. In 1966, it actually doubled, going from three to 6%. And the key difference was that you had a lot of labor market slack in 84 and 95, high unemployment rates. You didn't really see that creaking up of demand, that stoking of inflation until later in that cycle.

                                    In 1966, the unemployment rate was 3.8% at the time of pivot. Today we're lower than that. So I think this makes the Fed really uncomfortable. I think the Fed wants to create more slack in the labor market or else they risked repeating the sins of the 1970s. So we think the Fed will get to restrictive territory, they're going to keep it there for a while, and they're not going to cut until it's clear that the economy is in a recession. So that's our base case and it continues to be so.

Malcolm E. Polley: I think I would agree on the employment side. In many ways our economy today is very similar to what it was in the 1960s, where you had a lot of people coming into the labor market getting jobs and looking for stuff. And that's the forward end of the baby boom curve, if you will. Fast forward to today, we boomers, I'm the tail ender, all leaving the labor pool at a fairly high rate, and that's really causing a real barbell effect on the labor pool. If you look at existing labor growth, and you break it into cohorts, what you find is the 16 to 24-year-old cohort, which is your source of new labor, since 1975, has only grown by a little over 1%, and it's dramatically lower than any of the other cohorts.

                                    And if that's the group you're looking for new laborers, it really means that the supply of new labor is really quite low, which means that this disconnect you see between the unemployment rate and the job availability is probably going to continue, which, in our mind, probably caps the unemployment rate at a much lower level than would normally be the case in an economic downturn.

                                    And that probably keeps us from going into a full-blown recession like we had in the periods other than the ones that Jeff indicated. So the unemployment rate probably peaks at five plus percent, which, when I graduated from high school, when I graduated from college back in the old days, that was considered full employment. I think that dynamic is going to play out for a while, and it really creates a lot of interesting paradoxes within the economy itself as to how full-blown a recession gets.

Jeff Schulze: Yeah, I would agree with that, Mal. If you look at the labor force participation rate, it drops dramatically when you turn to the age of 70. It goes from about 25% down to less than 10%. And what the oldest boomers reaching 70 for every year for the next 10 to 15 years, that's going to shave off about 0.2% off of the labor force participation rate as we move through the next decade. So I think that obviously is one reason why structurally you're going to have a tighter labor market today than what you've experienced in decades past, and again, may negate some of the impact of a higher unemployment as we move through the next couple of years.

Malcolm E. Polley: Right.

Tom Wald: These are great points. I think a wild card in all this, it's really we don't know what it's like to adjust to a post pandemic labor market recovering to the extent that it has. Remember it was in March and April of 2020, where we lost 21 million jobs, and we're just recovering that full amount in August of last year. Whereas from an overall economic standpoint, we recovered much sooner from that in terms from a GDP perspective. So there's everything that you all said, plus there's just this anomalous environment as to how we're going to continue to adjust from that overall recovery of so many jobs lost, and so many jobs picked up again in a relatively short period of time.

Jenna Dagenhart: Yeah. Such a contrast to today, where there's still more jobs available than unemployed people to fill them now, as you mentioned. In fact, we have 1.7 job openings for every job seeker. Do you think that this trend will continue, Mal?

Malcolm E. Polley: I think so. We simply don't have enough people to fill the jobs that's available. If we do go into a recession, and our view is really that we probably look much like we did in 2015 where it really felt like a recession in many regards, but it didn't reach the NBER's definition of a recession. So it felt like a recession, it looked like a recession, but really wasn't officially called a recession. So I think what we could be seeing in 2023, for many people, it will feel like a recession. You get a lot of job losses. It will look like a recession to a lot of people, but again, it won't reach the level of a true recession. The unemployment rate, as I said earlier, is probably capped because there are so many more job openings available. You've got a lot of things caused by the pandemic that are creating the need for more jobs.

                                    Here in the United States you've got reshoring and onshoring happening. And how do you deal with that? Well, you have to deal with that through automation, through finding ways of increasing efficiencies in your workflows, to try and reduce the lowest skill level of your laborers so you can get your people assigned to the highest tasks available. It's interesting seeing these Facebook memes talking about how if I wanted to bag my own groceries at Walmart, I would have joined the Walmart staff. Well, the reality is they can't find enough people to do that. And people that are checking out, really, that's not where you want people. You want people stocking the shelves, so people have product to get. So we are really having to completely rethink and reorder how we do the basic job of business.

                                    To Jeff's earlier point in the services sector, it's interesting going into restaurants, I think more and more where you're going to see a pickup and change in how you do things, is that you may very well not see a wait staff take your order. You may place it at your table and just have somebody deliver the food to you. So we are really going to have to rethink how we do things in this economy, to try and elevate the highest value added tasks, and reduce as much of the lower value added tasks simply to ring as much efficiency as you can out of this market, so you can make the maximum use out of the employees you do have. But that's also probably going to mean that wage pressures remain quite high.

Jeff Schulze: Mal, to your point, number of job openings to unemployed. Yes, 1.7. At peak it got to two, but prior to the pandemic, the peak was 1.15, right? We're in uncharted territory still, even though we're off of those peaks. So still this insatiable thirst for labor demand remains out there, even with the Fed trying to cool things pretty dramatically.

Jenna Dagenhart: Yeah. And to your point earlier about the 1966 situation, Jeff, where unemployment is still lower than that point in time at 3.7% as of the November BLS report. What are some of the factors driving employment, and what are your expectations for next year, Jeff? Because the Fed is expecting an uptick in unemployment.

Jeff Schulze: Well, the Fed is. Based on recent dot plots, the Fed anticipates the unemployment rate to rise to 4.4% by the end of 2023. They're basically saying a shallow recession is coming. That would violate the SOM rule, where historically you've never seen an increase of a half a percent or more of the unemployment rate without causing a recession. So I think we're probably going to see a loosening up of the labor market. It's going to take some time, but what's really driving this? Again, is very strong economy. A lot of those post pandemic issues that you were seeing, and people leaving certain industries in favor of others. A lot of these job openings are in hospitality and leisure and retail, things of that nature, which are areas that are seeing beneficial growth as we renormalize. But looking at job openings, we've gone from 11.9 million job openings down to 10.3 million. Pretty big job, all things considered, but that's still 50% higher than what we had prior to the pandemic.

                                    But if you drill down just a little bit further, a lot of that demand is through small businesses. About 90% of the excess job openings that we're seeing today, compared to prior to the pandemic, is from small businesses. And it makes sense, right? They're still seeing almost record profitability right now. They're seeing pricing power. The economy hasn't rolled over, so they continue to try to hoard labor to be able to keep up with demand. But I do think that that's probably going to change next year as costs and wages are relatively sticky, and if you have lower inflation, lower revenues, that starts to come out in margins, and really kicks off that recessionary layoff cycle, which is what we're expecting next year. But looking at the numbers, it's really small businesses that are driving this demand for labor at the moment.

Jenna Dagenhart: Tom, I see you nodding your head.

Tom Wald: Yeah, that's right. And I think what's also really interesting here, as Jeff alluded to, is what this environment does for corporate margins. There's still this official expectation out there which no one really fully believes, which is that there's going to be positive earnings growth in 2023, at least where the official Wall Street estimates are right now, are about somewhere around 5% positive growth on S&P net operating income for 2023, off in 2022. And that is probably the most anticipated earnings miss that I've seen in my career. So that really plays into, I think, where expectations are. I think expectations are, a lot of people talk about in your garden variety recession, you'll see 10 to 20% decline in absolute levels of earnings going forward. And when that starts to develop in 2023, I think it's going to be important, because there starts to be a story that the earning miss is not going to be as bad as most anticipated, say, maybe around first quarter of next year.

                                    Then that starts to create, I think, also this notion of maybe things will not be as bad from an earnings perspective as most are anticipating, and that's also something that could possibly be another silver lining going forward. But I think that's really where the story is going to start to move a little more macro and a little more micro as we begin in 2023, versus what we expect in terms of inflation and economic growth to where is this really going to show up and when is this really going to start to show up in the bottom lines of companies?

Malcolm E. Polley: Right. And because the markets tend to be very forward-looking animals, the further you get into 23, the calendar's going to flip, and you'll no longer be looking at 23, but beginning to anticipate 2024 earnings growth, which should be a much better story.

Tom Wald: Right. That's a great point, Mal, because we've talked about 2023 earnings for so long now and still the numbers are still positive. If we start to look at that rollover in corporate earnings growth in the second half of 2023. But the expectation is you're going to get a pretty good recovery in 2024, given how much stocks have declined over the past year, market might just look through that entirely and start to value stock prices off 2024 growth.

Malcolm E. Polley: Right.

Jenna Dagenhart: And PE multiples are still rather high, Mal, even though stocks have had a rough year, do currently high PE ratios put a lid on equity returns or is there something else at work?

Malcolm E. Polley: I think there really is something else at work, and we came through a period where you've had a decade or more of growth outperforming value, and it's really a function of the fact that most of our benchmarks are market cap weighted. So the better you perform, the larger your component of the index. And you had the most extreme example last year where you had some of the 25 largest names in S&P 500 represented close to 50% of the market cap of the S&P 500. Most of those were very growth-oriented names with earnings that were probably out quite a ways into the future. And what you see in a rising rate environment is future and earnings get discounted more heavily and therefore their valuations get repriced downward. You're getting a reordering in the marketplace and a reordering in a lot of those benchmarks where value names start outperforming.

                                    And in fact, if you look back through history, other than the period from about 2005 until current, really 2021, early 2022, value really outperformed growth over almost every market, over almost every time period, with that exception. And if you look at and understand why that exception occurred, it's because from 2005 to 2021, early 22, interest rates were basically zero. So what that says, unless you're in a zero rate environment, then you probably want to be in shorter duration equities, which are more value-oriented equities that have more cash flows upfront. And so those stocks should outperform, and value stocks should again reassert their historic out performance relative to growth stocks. That doesn't mean you're going to have periods where growth doesn't do well, but it means that over the long period of time, particularly if you believe that interest rates are going to generally trend upwards over some longer period of time, that value stocks and stocks that have better cash flows currently should provide much better performance. And you should start to see PE ratios trend down as the indexes reorder themselves.

Jenna Dagenhart: It's also been an extremely tough year for bonds, and a lot of fixed income investors are looking at negative returns unlike anything that they've seen in their lifetimes. This asset class that was typically known as a ballast in the portfolio. Tom, how are you viewing opportunities in the fixed income markets right now?

Tom Wald: Well, yes, Jenna, first of all, you are certainly correct that this has been an extremely tough year for bond investors. In many ways it was like a perfect storm, 40 years in the making, low interest rates, narrow credit spreads, made for not only relatively secure levels of income, but higher durations of greater price sensitivity, which when the inflationary and higher interest rate environment took root, really hit bond values hard, resulting in negative total returns, something no fixed income investor likes. But all that said, Jenna, I really like corporate bonds here, both high yield and investment grade. And let me tell you why. First, yield is back. Just looking at your average high yield and investment grade corporate bonds right now, let's say in the middle of the curve at about five years, both categories are yielding about two times what they were about a year ago.

                                    And your average investment grade bond today is yielding close to a hundred basis points higher than the average high yield bond a year ago. Second, if the pending recession turns out to be more moderate than severe, I don't think the credit cycle will be all that bad, given the fact that so many corporations refinanced it, the favorable terms during the Covid crisis when the Fed provided great amounts of liquidity and credit backstopping. So by and large, balance sheets are stronger, and in a high yield space we probably wouldn't expect default rates to move a lot higher than their current long-term, or what has been their longer term averages of just north of about 4%. Particularly in light of the fact that maturity schedules were also pushed out during the refinancing of the Covid crisis, and we're not going to see the bulk of required principle repayments and associated refinancings for about another six or seven years.

                                    Finally, history seems to be on the investor's side now. Since high yield bonds became formally categorized as an asset class back in 1987, this is only the eighth calendar year of negative total returns. And in all those previous seven instances, the following year was positive, and in some cases quite substantially. The same goes for investor grade bonds which have only had six negative years over the same timeframe, all with positive returns in the subsequent year, and on average disproportionately higher than historically compounded returns. So yes, we are wrapping up an absolutely brutal year for bonds by historical standards, no question about it. But Jenna, I think the reset may now have put the odds in investors' favor going forward.

Malcolm E. Polley: I would agree. Back at the end of 2021, you had a situation where there was almost no scenario in which you could reasonably assume positive returns in any fixed income asset class. Fast forward to the end of 2022, you've got a situation where coupon has risen enough that even if rates go up by 200 basis points, which is not the forecast, you still have positive returns in fixed income. So I think that for the first time in a long time, you can expect decent returns and non-negative returns, which is a huge positive. This is only the second time in my career interest rates have risen anywhere close to this much. So people are leaning learning what happens in that type of environment. But that type of environment is not repeated in successive years. So bond metrics, I think, are much better today than they were at the end of 2021.

Tom Wald: Yeah, and that's a great point, Mal. Marketing back to a conversation that we had, one of our earlier panels when we joked that the new disclosure should go from past returns in the future, not guaranteed to past returns in the future are mathematically impossible, given the nature that we were looking at interest rate declines, that unless we went into a negative interest rate environment simply were not mathematically possible going forward. And the other interesting thing, and what's so interesting about bond math I think is when you sit down and you actually look through the numbers, but when you get to higher yields on bonds, what that means is, of course, not just lower durations, but it means that if you do get a rise in interest rates, it's a shorter period of time for those interest payments to make up for that loss.

                                    And we had gotten, when we were down in the zero interest rate environment, really narrow credit spreads, we had gotten some pretty scary levels, where a one or 2% increase in bonds was going to take years and years of interest rate payments to make up for that. Even going back to when in the 1980s when we had those big interest rate rises in the 1980, 81 period of time, the coupons, as you mentioned, were so high that actually those price losses were made up for in less than a year, versus where were last year, where one or 2% increases in yield were creating price losses taking years to increase. And so now we're back to a far more reasonable yield to duration ratio, making the overall risk reward of just bonds in general, much more favorable for investors.

Jenna Dagenhart: Now pivoting to monetary policy here, no pun intended there, but given the magnitude of the rate hikes that we've experienced in 2022 with four back to back 75 basis point increases, Jeff, what are your expectations for 2023, and what are the implications for investors?

Jeff Schulze: Well, we couldn't be doing 75 basis point rate hikes in perpetuity, naturally going to step that down. And the markets are obviously cheering that. But looking out into 2023 markets are pricing in about another 50 basis points of rate hikes over the course of this year. And I think maybe the bias is to the upside. I think that's probably a fair pricing as the Fed tries to reassess the cumulative effects of tightening that has taken place. But the reason why I feel like you could have a right tail event and you could have more hikes on the horizon comes back to the labor market. Again, very tight labor market and looking at wage growth, wage growth is hot across all three measures of it, whether it's average hourly earnings, the Atlanta Feds wage tracker or the employment cost index, all of them have wage growth consistent with inflation well above the fed's 2% target.

                                    I think the Fed, again, going back to that 1966 soft landing example, if you don't start to see some cooling of the labor market and increase of the unemployment rates, cooling of wage growth, I think the Fed is going to have to continue to push until they get their desired outcomes. While I think the market pricing is fairly accurate at this point, I would make the argument that you probably have a bias to the upside for a surprise for markets.

Malcolm E. Polley: I would agree. I think that the Fed funds rate probably ends up higher than a lot of people expect simply because wage growth is going to be a problem, and it's just the demographics behind it, and you don't have enough people available to fill the jobs that are out there. That's basic economics, right? If demand outstrips supply, price has to go up, or in this case, if supply undershoots, demand price has to go up or demand has to come down. There's really no other way to fix it.

Jeff Schulze: Thinking about the average hourly earnings report that you got from November, it came in at 0.6% on a month-over-month basis. You annualize that. That's a 7% run rate. I think you're going to see hot wage growth numbers as you move through the next number of months, because a lot of employees are looking for cost of living adjustments. They want their pay to reflect the higher inflation that they had to endure through 2022. And with a lot of employers really not having a lot of options at this point, I think you're going to see hot wage growth over the next three to four months, which is really going to make the Fed's job a pretty difficult.

                                    Also looking at quits. Quits are down from record levels, they're down to 2.6%, but at 2.6%, that's higher than any other level that you've ever seen prior to the pandemic. So it's not only employees asking for these wage gains and employers not having many options, but employees know, given how hot the labor market is, they can go and find another employer that can give them the cost of living adjustments that they need. So again, all comes back to a tight labor market, stickier wage growth, and it complicates the Fed's job of trying to restore price stability.

Malcolm E. Polley: And in many ways, what we're seeing today is simply an uncovering of an event that had been occurring for some time. Unfortunately when people are looking at the headline number and wage growth, it didn't look like much was happening. But if you actually broke the wage growth into cohorts, what you found is that the youngest cohorts, their wages were growing very rapidly. It was because of the offset of the older cohorts, particularly the baby boom generation, whose wages had stopped growing a decade ago, that you really had a leveling out in wage growth that was happening simply because of the demographics that existed in the labor pool. Now with the boomers largely out of and exiting the labor pool, all of a sudden the speed with which the younger age cohorts were seeing their wages rise is really coming to the fore, and demographically, that's not going to slow down in the near future.

Jenna Dagenhart: No. And Mal, given this employment situation, what's the impact to the economy? And circling back to one of your prior points, could that help mute the economic downside of the current interest rate cycle?

Malcolm E. Polley: Probably, to the extent that the unemployment rate stays lower than it otherwise would be in a traditional recession, to the extent that people have money to spend, which they probably will, because the unemployment will be lower than it would be in a typical recession. Look, the consumer still represents two-thirds of the economy. As long as the consumer is spending, then the economy avoids what would be considered a typical recession. You can get a slowdown in spending, in business spending, you could get a slowdown in government spending, but as long as the consumer doesn't slow down and wants to continue to buy things, then the economy does not slow as rapidly as many think. And so we think that really translates into the fact that we don't think we're going to get a traditional recession. And if it occurs, then it will be a relatively muted recession. I don't know if you'd call it a soft landing, but definitely muted in its performance.

Tom Wald: Yeah, and I'd agree, Mal. And one of the reasons I think I'm in the camp that the recession's more likely to be moderate than prolonged and severe, is a couple of reasons along the lines of what you just mentioned. If you look back at the four recessions going back to 1981, 1990, 2001, 2007, and I don't put Covid recession in there because that was a flash contraction for pandemic purposes. But we're at a much lower level of unemployment versus where those recessions were in the onset. We're at 370, the average of those recessions at the point the economy actually went into recession was about five and a half percent. So we're starting from a much lower base, which can help support, maybe not as much damage on the consumer side when we do go into recession.

                                    And also there's this large balance of individual savings from the Covid pandemic that's still out there. It is depleting, but it's still out there. It's still north of a trillion dollars of estimated savings that consumers have from their spending habits during the quarantine that can help support during that period. So I think those are a couple of anomalous conditions going into this recession that we haven't had in the past that supports, in my view, not as high a probability of a severe and prolonged recession going forward.

Malcolm E. Polley: And most recessions are caused by credit overhang, right? So you don't have credit problems in corporate America. By and large personal balance sheets are in pretty good shape. People haven't gotten over extended, so you don't have the same credit overhang that you would in a traditional recession.

Jeff Schulze: Yeah, I would agree with both of your points. Obviously our base case is a recession, but consumers, a lot less interest rate sensitive than they have been historically. Household leverages are at levels last seen in the early 1970s, less than 10% of mortgages are adjustable. Very big difference compared to 05 when 50% of mortgages were adjustable. So housing is clearly in a recession right now, but it's only really affecting a small subset of the US population and may not have as much of an effect as you traditionally think housing does as the tip of the economic spear.

                                    But obviously one of the reasons why a soft landing could also happen is margins have just started to deteriorate. There may be a reluctance from corporations to let go of their employees and fear of maybe a soft landing happens or a shallow recession materializes, and they're not able to get those employees back on the other side of this potential storm. So clearly there's a case for a soft landing, and if we do have a recession, I think it's going to be shallow. But again, I think the Fed's going to just keep its rates restrictive long enough until they get the desired outcome, which is more labor market slack on a recession.

Tom Wald: I would agree with all that, and I would categorize probably the biggest risk to a prolonged severe recession is simply a Fed policy error where they go too far and put us in a worse recession than would be necessary to get us out of this inflationary cycle. What I'm hoping for from them is that they recognize that there is a filtering through effect of rising interest rates, that all of the rate hikes that have been in effect since last March have not fully filtered through the economy. It's generally about a six months to a year type of situation.

                                    So what I'm thinking is maybe they get to 5% in the first half of this year, and if not, simply say, okay, let's take a step back and see how these filter through the economy. Because if we're at 5% in, let's say May, logically speaking, it would probably be till the end of the year that you would see the full effects of that 5% in rate hikes actually day-to-day impacting the economy. And that's where maybe the hope is that they just want to sit back and let that go without necessarily going too far and creating a worse economic situation than would be necessary. But I think that's on everyone's mind right now, is recessionary risk coming from a Fed policy error.

Jenna Dagenhart: One other point too, Tom, GDP seems as though it could be on a little bit of a roll as we close out the year. Is a soft landing out of the question or still possible?

Tom Wald: Well, along the lines of what Jeff and Malcolm mentioned, I think base case is for a recession, that's our base case. But I don't think, certainly a soft landing is not out of the question by any means, but I would consider it to be a lower probability. When I look at the recession oriented outcomes that are possible for 2023, I would put a soft landing defined as moderating inflation and no recession could be about a 20% probability. So that's by no means outside the realm, but it is a bit of a long shot. Assuming inflation remains at elevated levels through the first half of 2023 and the Fed keeps raising rates, I think we're going to need a very strong level of consumer spending to avoid the type of GDP declines likely to send us into a negative economic growth later in the year.

                                    So I also think that we'll be seeing the labor market continue to soften unemployment above percent, potentially it's 5%, which probably curtails consumer and business activity, so that's your stronger case for a non soft landing. But along the lines of what I think I mentioned a couple of moments ago, a couple of areas that could maybe support the notion of a soft landing was we would be starting a recession at lower levels of unemployment than we have in the past four recessions going back to the early 1980s. And also what's this built up level of aggregate consumer savings going back to the quarantine, the pandemic. So I would maybe categorize soft landing as being behind the eight ball, but not necessarily off the pool table, so to speak.

                                    However, it may be worth mentioning that we are in a very steeply inverted yield curve right now, which is flashing bright a red recession warning signal. And it's really a quite wide inversion by historical standards. So if we do get a soft landing, I think it will be the first time the three month to 10 year yield curve has inverted without a recession to follow. Going all the way back to that 1966 cycle that Jeff mentioned a couple times, I think that was the last time we saw an inverted yield curve between the three months and the 10 year that did not result in a recession. So it would be unusual, at least, from that particular metric.

Malcolm E. Polley: While we have been in the camp of not an official recession, I think the one thing that keeps us from looking at that term is that the Fed always goes too far. The Fed does a terrible job of engineering soft landings. They always go too far. And you're in a situation where the data that they have, I truly don't believe, and have not for some time, really fully explains what's going on in the economy. By and large, most of what we have is built to explain a manufacturing economy, which we don't have. We have a knowledge-based economy, or in some many cases, a service-based economy that just is not easily explained by the data that we see today.

Jenna Dagenhart: And Jeff, I saw you perk up a little bit when Tom mentioned the yield curve, so I'll let you weigh in on that and then would also love to hear your thoughts on the trajectory of the bear market and encounter trend rallies.

Jeff Schulze: Yeah, almost all yield curves are inverted at this point, even the Fed's preferred measure, which is the 18 month, three month yield curve is inverted. So obviously the bond markets are signaling that a policy error is near. And there's an old adage out there, the longer that a yield curve sees inverted and the deeper it is, the longer and worse recession you're going to have. So we're at levels not seen since the early 1980s. Again, I think there's always a reason why this time is different with the yield curve. I think we'll be proved right again, that the yield curve is all knowingly right when it comes to the US economy. But in thinking about bear markets, obviously we're experiencing counter trend rallies, dead cap bounces, bear market rallies, all synonymous for pockets of strength within a bear market that ultimately give way to a lower low.

                                    And we've been spoiled as investors. We haven't had a proper recessionary selloff since the global financial crisis 15 years ago. So you have these starts and stops that you got to endure, and our view was that you're having bright conditions for a counter turned rally in October due to offsite positioning and really negative sentiment. We've seen that happen, but we ultimately think that the low will be retested until you go through those two phases of a bear market. First phase, which is really a story of 2022, is multiple compression. Second phase, which is the next shoe to drop, in my opinion, which is lower earnings expectations. And although multiples could probably move down another turn or two, maybe revisit 15 times forward earnings like we saw back in late September, I think that story has played out.

                                    But looking at the last three recessions, earnings expectations have gone down by about 26% on average. So far they've only gone down by about 4%. So again, I think we've talked about this earlier in the program, too much optimism when it comes to earnings. Markets are anticipating margins actually expanding next year, which, I think, is very unrealistic. I think that keeps the market volatile and choppy until we can get visibility on the path of the economy, recession or soft landing. And then ultimately, what's that impact on earnings? So we're expecting a bumpy ride.

Tom Wald: And I think, getting back to yield curve for just a minute, I think what's really interesting is the level of the inversion between the short end and the long end is very steep right now and people are comparing, this is the widest yield curve differential since the early 1980s. But if you look at that from the percentage of the yields, it is by far the widest inversion. So in other words, if we're going back and saying, oh, well there was a 200 basis point inversion between the two and the 10 back in 1981, well that was when you were talking the difference between 13% and 15%. So the difference in the percentage of the yields in the inversion was much lower than where we are right now. So if you're looking at something like a 70, 80 basis point inversion, when the three year is at 430 and the 10 year is at... I'm sorry, the three months is at 430, and the 10 year is at 360, in terms of the percentage of those yields, that's as wide an inversion as we've ever seen.

                                    So I think that's something that speaks to the potential accuracy. The conviction of the yield curve right now in the bond markets is whether or not they see a recession coming. When I was growing up, the old joke about yield curves was yield curves were so accurate since 1900, they've correctly forecast 29 of the last 23 recessions. Meaning that every recession is preceded by an inverted yield curve, but every inverted yield curve doesn't necessarily proceed with a recession. That's not really shaping up, giving a case, as we talked about, 1966 from a three month 10 year metric, it's really the only time since World War II that inverted yield curve on that metric hasn't resulted in a recession within 18 months. So I think this is just a very glaringly red signal of recession that I think is a tough one to argue with right now.

Jenna Dagenhart: And Tom, anything you'd add about your overall expectations for stocks in the year ahead, and what sort of variables do you think will impact the market most?

Tom Wald: Yes, Jenna, there really is a slew of what I would refer to as power variables in terms of factors and upcoming developments that could have a serious impact on stock prices in the year ahead. Of course, at the top of that list is pretty much everything we've been discussing, inflation, short and long term interest rates, potential recession, corporate earnings, along with that. What I think is also a series of wild cards that could also alter the mix such as the war in Ukraine, potential energy crisis in Europe, the strength of the dollar and activity of global central banks throughout the world. So there is a lot of unknowns, and of course, every year begins with that to some extent. But I really think the difference here, Jenna, is the wide variants of potential outcomes. For all of these variables translating into a wider range of variability for the market itself over the next year, in terms of a final expectation and final price target on the S&P 500.

                                    In addition to all these variables, I also did take a hard historical look at how markets have reacted historically to the passing of peak inflation and the conclusions of fed rate hike cycles, both of which, I think, could occur in the year ahead, as well as years following midterm elections when Washington transitioned from single party to divided party leadership. And taking all of that into account as well, I have a year end 2023 S&P 500 price target of 4,400. So Jenna, that is my best shot at incorporating a lot of moving pieces with a lot of variability to them. So we'll see.

Malcolm E. Polley: I would agree. I think we're in a situation where asset class returns could once again be very similar. Whether it's stocks, bonds or cash, you're looking at probably mid single digit returns, cash returns for bonds, returns for stocks, return five to eight. The dangers to that scenario is that it looks like we're going to get a divided Congress trying to decide how to do the fiscal 23 budget. And you've got a situation where they're going to have to deal with the debt ceiling in order to fix that problem.

                                    And I don't know how easily with a divided Congress that's going to happen. So you could run into a situation like we had where the Democrats don't want to raise the debt ceiling, they want the Republicans to do it. The Republicans want the Democrats to take ownership. And so you get into a situation where you've got a real danger of nothing being done, and freezing government credit at some point. I'm not saying that's going to happen, but that probably weighs on the market a little bit, which we don't see a whole lot of upside beyond that mid single digit returns, pretty much across asset classes.

Tom Wald: Yeah, I would agree too, and I think if you do get upside outside of what we're looking at, at probably start at about 4,400, that would clearly have to be the soft landing scenario. So you would have to get a case where soft landing looks pretty apparent by mid-year to really get much upside beyond these high single digit, low double digit in stocks, even in the best case scenario. Where the longer term upside comes as, if we get through this, we get through this stormy period, and suddenly year 2024 and beyond starts to look really good. I think the market could react to that in the second half of the year, but I think clearly to get much higher than those returns, that return range that you just mentioned, Mal, I think we're going to have to see evidence of a soft landing and also support from the Fed as well from that [inaudible 00:51:31]

Jenna Dagenhart: Jeff, any final thoughts on your end that you'd like to leave with our viewers? Any market catalysts you want to highlight?

Jeff Schulze: Yeah, I think it's going to be a tale of two halves, right? You're going to see some choppiness as we enter into potential recession and lower expectations for earnings needs to be priced. And then obviously as you get through the other side, I think the markets have significant upside as you start a new expansion. But I do think that for longer term investors, just the fact that we've hit bear market territory is probably a good time to start allocating money into the markets on a regular basis. If you look at all bear markets since 1940, the day you entered bear market territory for the S&P 500, what happens? Well, markets go down another 15.6% on average.

                                    But if you had bought the day you hit bear market territory, yes, the markets went down initially, but 12 months out, the S&P 500 was up 11.8% on average. 18 months out the market was up 18.5% on average, and we hit bear market territory over six months ago. So history would suggest, given how rare these op opportunities are, these occurrences are, it's probably a good time to start thinking positively about your equity allocation, if you do have some cash on the sidelines at this point, even though again, it's going to be a little bit of a bumpy ride as we make our way through this.

Jenna Dagenhart: Well, Tom, Jeff, thank you all so much for joining us.

Malcolm E. Polley: Thanks for having me.

Tom Wald: Thank you.

Jeff Schulze: Thank you.

Jenna Dagenhart: And thank you for watching this 2023 Outlook Masterclass. Once again, I was joined by Tom Wald, chief Investment Officer at Transamerica Asset Management, Mal Polley, president and Chief Investment Officer at Stewart Capital Advisors. And Jeff Schulze, director and investment strategist at ClearBridge Investments. And I'm Jenna Degenhart with Asset TV.