MASTERCLASS: CIO Mid Year Outlook

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  • 59 mins 20 secs
The first half of 2022 will be remembered for its elevated inflation, consistently coming in at 40-year-highs. Now all eyes are on the Fed and its precarious battle to reign in price levels without sending the economy into a recession. Three chief investment officers break down the volatility and share a multi-asset road map for what’s to come.
  • Gene Goldman, Chief Investment Officer, Director of Research, Cetera Financial Group
  • Steve Brown, CFA®, Chief Investment Officer for Total Return and Macro Strategies, Guggenheim Investments
  • Malcolm E. Polley, CFA®, President and Chief Investment Officer, Stewart Capital Advisors

Channel: MASTERCLASS

Jenna Dagenhart: Hello, and welcome to the special Asset TV midyear outlook masterclass with our panel of chief investment officers. The first half of 2022 will be remembered for its elevated inflation consistently coming in at 40-year highs. And now, all eyes are on the fed and its precarious battle to reign in price levels without sending the economy into a recession.

Jenna Dagenhart: Joining us down to break down the volatility and share a multi-asset roadmap for what's to come, we have Steve Brown, chief investment officer, total return and macro strategies, and senior managing director at Guggenheim Investments, Malcolm Polley, president and chief investment officer at Stewart Capital Advisors, and Gene Goldman, chief investment officer and director of research at Cetera Financial Group.

Jenna Dagenhart: Everyone, thank you so much for joining us. And Malcolm, kicking us off here, will inflation moderate this year, or is the inflation that we're experiencing more sticky than initially believed?

Malcolm Polley: So, inflation is an interesting thing, but most people are really worried about is that we're going back to the 1970s, early 1980s, when we had really runaway inflation and Paul Volcker came in to break the back of inflation. In our view, that was really a demographic-led inflation.

Malcolm Polley: Yes, you had a money supply getting out of hand, but a lot of that it was due to the demographic backdrop. You don't have the same type of backdrop today. I mean, the reality is when you close the economy and you give people trillions of dollars to spend, they're going to spend it. And so, you get a classic economics 101 supply-demand imbalance.

Malcolm Polley: You had supply limited. Demand was really high. So, prices lifted off. That still hasn't abated. And certainly, bottlenecks have not helped that situation at all. But as the fed starts to raise rates, those bottlenecks or that demand imbalance will subside, starting of course with the lower end of the wage earner spectrum, and then gradually working its way higher.

Malcolm Polley: So, it's probably will moderate somewhat through the end of this year, but it will probably also stick around higher than the fed would like it to for longer than the fed would like it to.

Jenna Dagenhart: And the market has been volatile to say the least, Steve, as it continues to reprice for the expected future course of policy and economic performance. How does the CIO manage through an environment like this one?

Steve Brown: Well, thank you for having us, Jenna. I really appreciate it. It's obviously been a very volatile year. And depending on the market that you're focused in, you've had disproportionate impact from inflation change in yields, change in valuations.

Steve Brown: And when we look across our platform, we have a number of different strategies that we run. And so, one of the most important things to be this year is nimble. And I think you're seeing active management start to win out again. It has traditionally, in fixed income, one out but you're seeing it in equities too.

Steve Brown: I think rarely has data been under the microscope so much and rarely has the macro driven returns with such volatility. And so, I think being very mindful of the macro backdrop, trying to define bookends for your projections on the macro, whether it's inflation, obviously the associated monetary policy response, fiscal policy, the trajectory of the US economy, the global economy, all of those are extremely important in this uncertain time.

Steve Brown: And so, trying to come up with bookends for where you think those projections could come out, and then of course what that means for asset values, for yields, all of that will then drive your relative positioning. I let off with we have a number of different types of strategies ranging from very constrained to very unconstrained.

Steve Brown: And so, reminding yourself of what your performance objective is, what your benchmark is, and then trying to be positioned for the environment that we're in right now because well, inflation has proven not to be transitory. We would argue that maybe some of the valuations you're seeing, particularly in the credit markets and across fixed income, might be.

Steve Brown: And so, keeping an eye on that medium to longer term projection of where you think inflation will go, where you think yields will go, and ultimately asset prices could prove to be very prescient in this environment where we think there are a lot of opportunities.

Gene Goldman: And Jenna, to add to Steve's comments, so also as a CIO, I think Steve's comments were definitely right on spot. I think as a CIO, you have to remember, we need to go back to fundamentals. And fundamentals, the markets continually change.

Gene Goldman: I love a quote from John Maynard Keynes. He said, "Listen. When the facts change, I changed my mind." And earlier this year, we thought the economy could withstand less monetary stimulus. We saw some game changers last couple weeks. We've seen CPI come in well above expectations. We saw that really confusing press conference from Powell after the FOMC meeting.

Gene Goldman: What we've learned is that the fed is willing to induce a recession to prevent inflation. And you need to start to change your perspectives on how you're managing. You have to revisit all your downside potential. You have to revisit every part of your portfolio. And this is what we're doing in a very volatile environment. You need to look at your fundamentals and make sure that your best investments are positioned within your portfolios.

Malcolm Polley: I would agree. And I think in many cases, people ignored or forgot about the downside that you can lose money in various asset classes. And in being value-oriented long-term investors, downside has always been very important to us. So, you look and see where your upside versus your downside lies and you adjust your portfolios to protect yourself if things go haywire.

Malcolm Polley: And at the beginning of the year, we were looking at the standpoint that there's where you think the fed should go and where you thought the fed might go. And there was a big disconnect there. That disconnect has shrunk. And in fact, where you think the fed should go or might go is now a lot higher than what people thought at the beginning of the year.

Steve Brown: I mean, the first inkling was the fed minutes released one of the first few days of the year, going back to finally talking about balance sheet runoff which wasn't even on the agenda, and then moving expectations for the policy rate forward and higher.

Steve Brown: And even I was looking at the March commentary earlier today just to remind myself of what was priced in the yield curve. When we got to March, we had already seen six or seven hikes priced in. And we've essentially doubled since then. So, things are moving very quickly and require to plan around that volatility.

Jenna Dagenhart: Moving very quickly indeed. In response to this economic scenario that we found ourself in was slowing growth and stubbornly high inflation. Gene, how do we get here? How do we get into this scenario?

Gene Goldman: I love this question because it's a great point. It's always good to look at how do we get to where we are today? And what you said, Jenna, is perfect. We have high inflation. We have slowing growth.

Gene Goldman: The thing that we focus on is what causes the 2020 recession. This 2020 recession, clearly there was a lot of policy response. But I think most importantly, think about that recession we had. It was the shortest in the history of our nation. Two months, okay? It was services-led.

Gene Goldman: So, we were all at home. We weren't going to restaurants. We weren't going to bars. What we were doing, we were just sitting home and spending money, buying each, buying five Peloton bikes, buying refrigerators, cars. And that creates this unnecessary demand.

Gene Goldman: Think about, in the recession, you stopped spending, but we weren't spending. We were spending a lot more money. And the kicker, I think this is the big kicker, is that in the recession of 2020, income actually rose. In a traditional recession, people get laid off. Unfortunately, income goes down. We saw the ops income actually arose, although this created this big demand-supply imbalance. And unfortunately, this is where we are today. Now, we're paying for it.

Gene Goldman: And I know, Steve and Malcolm, you both said this, but the fed last year, making silly mistakes about inflation is transitory. I mean, you could just go out and go to your local store and you see clearly inflation is not transitory. If I'm paying a lot more for ground beef now, it doesn't make sense. So, again, that 2020 recession, of course policy response, but the 2020 recession is so fast, services-led. And really, income rose really caused where we are today.

Jenna Dagenhart: Transitory inflation, and the sky is yellow or red, it's just one of those things we know not to be true anymore. Your comments be directly into saying I wanted to get your take on, Mal. You mentioned supply constraints and bottlenecks earlier. How much of the current inflation do you think is because of these supply constraints and bottlenecks?

Malcolm Polley: I think the supply constraints and bottlenecks are certainly exacerbating the problem. It's something that will eventually take care of itself in certain areas like chips and so forth. You've also got other exogenous events that are creating additional shortages, the war between Ukraine and Russia.

Malcolm Polley: A lot of additional supply for natural gas and oil that was in Russia is basically not coming into the market. The food supply that is grown in Ukraine is not really available to the market today. If you're looking at fertilizer, which really hits across the spectrum across the world, a lot of the excess supply fertilizer is in Russia. That's basically gone from the market.

Malcolm Polley: So, you're seeing a lot of price increases created because of supply imbalances that are artificially in place due to a lot of different reasons that were really started by the base fact that we've never closed down the global economy before. And it just takes a long time to build those supplies back up.

Malcolm Polley: We'll eventually get there, but it's going to take a long time. Now, having said that, bottlenecks are not the sole reason for the inflation that we have, but it's certainly not helping the situation.

Jenna Dagenhart: And I can tell we all really want to talk about the fed. So, let's just dive right in here. Steve, did the fed's decision on June 15th matched your expectations? And how have your expectations shifted over the last weeks and months?

Steve Brown: That's a good question and picks on a lot of the points that we've all started to make with regards to volatility around data and markets. And in short, by the time we got to decision day that the decision met our expectations, we were debating internally between 75 BPS and a hundred BPS.

Steve Brown: But if you had asked us a week before that, we would've said that 50 basis points was the likely policy response. And that's because the fed, as we saw in a rather unorthodox day or harking back maybe to prior regimes, leaked out over the weekend and on Monday that they were likely to raise 75 basis points to give the market a bit of a preview.

Steve Brown: And you saw particularly after that very hot and wonky, as Gene said, inflation print on Friday before the fed meeting, the fed wanted to show that they were responsive to real time data. Now, as we've seen, this real time data can be very volatile.

Steve Brown: And particularly when you're looking at month over month changes in relatively broad statistics that have a high degree of variability and ultimately a high degree of revision, it can be a little scary to be setting policy that's so important based on those rather short time period of changes. But the feds backed into a corner.

Steve Brown: Chairman Powell is testifying today in front of Senate, inflation is the number one topic on everyone's mind, every consumer, every citizen. It's the big hot button for the political debates this year. And so, the fed has to forcefully act and not just talk down inflation expectations, but actually follow through with what's priced into the market. And by the time you got to around the fed meeting, 75 basis points was completely priced in.

Steve Brown: And so, the market is in many ways leading the fed. And the fed is going to take whatever the market will allow them to do. And I think this precedent's been set over the last couple of years with the focus on forward guidance. I think the fed had to show that they were a little bit more nimble.

Steve Brown: And despite the fact that Chairman Powell said that 75 BPS wasn't on the table at the time, in the prior meeting, I had to show that they were responsive to real time data and act a little more forcefully.

Steve Brown: They've previewed another 75 potentially in July. But it's interesting, when you look at the curve today, I mean, yields are drifting lower from their highs of last week. But you're now to the point where you're seeing multiple hikes priced into each of the next couple of meetings.

Steve Brown: But by the time you get to December, you now see less than one rate hike priced into the curve. And when you get into next year, you see very minimal rate hikes. And eventually towards the back half of next year, you see actually cuts priced into the curb.

Steve Brown: So, the fed wants to get above neutral. They want to go into restrictive territory. They're doing it very quickly. And we haven't even talked about the balance sheet yet, but they're showing that they need to act and deliver what the market is in a sense allowing them to do and broadly to tighten financial conditions.

Steve Brown: So, so far, it's met the test, but that's come with continued volatility as would be expected in this type of abrupt about-face and tightening pivot that they've made.

Malcolm Polley: It's really interesting. If you look, say, a year ago prior to Chair Powell reconfirmed as the fed chair, he was really quite dovish. And I think the fed not wanting, not intending, to be a political entity, I think they're clearly being political to try and get that reappointment. Because as soon as that came through, he did a complete 180 and became a hawk.

Malcolm Polley: Now, almost all the fed governors and so forth are hawks. And they're all trying to push forth their inflation fighting creds. But the reality is now you've got an issue before Congress today, where you're trying to build in more of a political aspect where they're trying to add a third leg, if you will, to the fed's mandate.

Malcolm Polley: It's already difficult to try and deal with a mandate of stable prices and full employment. If you add one of trying to use your monetary policy to even-out the employment statistics across demographics, it becomes very difficult and very political.

Malcolm Polley: And in my mind, it really forces the fed to stay even farther behind the curve than it is today. The fed's behind the curve. The fed's almost always behind the curve. And the fed almost never engineers a soft landing. So, that's all working against us, if you will.

Gene Goldman: And let me add to Steven Brown's comment. So, obviously the 75 basis points, it was leaked, as Steve said. I wonder if there's going to be some type of investigation because it was the fed's quiet time, but that's another conversation for us in TV. We'll have another call on that.

Gene Goldman: But it matched everyone's expectations after the leak. What we've been telling our advisors is the dot plot is even more important because we feel the fed is going to rip that band-aid right off. And it's going to be much more front-end loaded.

Gene Goldman: That CPI report, as Steve addressed and we've all talked about, was a game changer. And the fed needs to be much more aggressive earlier in the cycle. Now, what we think is more important, watch the dot plot, but watch the 2023 and 2024 levels for clues about the height.

Gene Goldman: If you think about what the fed did, especially at Powell's press conference, and I said this earlier, it was a very confusing press conference. On one hand, he said, "We don't expect to raise rates by 75 basis points in July." Then he says, "July, 75 basis points make sense." Then he says, "We don't target gas prices." Then he says, "We're responsible for headline inflation."

Gene Goldman: You take all this together and what really worried us when we left that was potential for a policy mistake. We do believe that could be a policy mistake. That means unfortunately a potential recession, which is not our game plan and not in our plan for 2022. But again, it increases that likelihood.

Gene Goldman: And then, you pivot and we do think it's going to be front-end loaded. But I think the good news, and this is what we were all talking about this a little earlier, we're more optimistic about what the fed will do. We're also more optimistic about the markets.

Gene Goldman: You think about inflation. And we do think inflation will start to roll over. I think, Mal, you made some great points and we need to agree, supply side issues, goods pricing starting to slow down. We see all this stuff. We also see this really helping the fed not to be as aggressive as they need to be later in the cycle.

Gene Goldman: Also, the pace, as the fed starts to raise rates, this slows the economy down. There comes a point, especially when you look at the dot plot, the feds start looking to ratchet some of the rates back for 2024.

Gene Goldman:The thing that we want to focus on that really a lot of people aren't talking about is Lisa Cook and Philip Jefferson. These are the two members of the fed. They're doves. So, now you have a bunch of hawks in the fed. All of a sudden, you get some doves coming into the system. Yes, they're all going to be hawkish right now. They have to be. They have to address inflation.

Gene Goldman: But then, Lisa and Phil, they start giving them more of their perspectives. Dove starts to increase. And we do think the fed will be very front-end loaded, but start to slow the rate hikes a little bit later down the road later in this height cycle. So, again, part of our optimism about where we are today.

Steve Brown: And Gene, to your point, they'll finally also have some policy room at least on the policy rate. The balance sheet, we'll see how long they're able to unwind or or shrink the balance sheet last go around. It didn't go terribly well. And they, in aggregate, reduced the size of the balance sheet by three or 400 billion.

Steve Brown: Obviously starting at a much higher base now, but they will have some room on the policy rate given how quickly they're taking the elevator up on the policy rate itself. And to your point as well and Malcolm's point, the policy response takes a while to flow through the system. We've seen mortgage rates go from 3% to six in change, all the associated consumer finance rates that are going up because of the moves in the yield curve.

Steve Brown: So, it's going to take a while. It's clearly constricting. It's not going to have immediate impact particularly on the inflation data. And this summer is wonky already. You have the first real summer, if you will, in two plus years and you still have excess savings and pent-up demand and a lot of abnormalities as Malcolm said in the supply chain.

Steve Brown: So, it's very hard to set a long-term policy with the couple months of data we're going to be living with throughout the summer. And so, I think the fed, we agree, will ultimately end up being flexible. And they have to be hawks right now and they have to be restrictive right now. But if the data changes, they will change.

Gene Goldman: To that point, think about the feds raise rates, 150 basis points this year. And you've seen mortgage rates go up. We're around 6% right now. If you think about from the beginning of the year, the mortgage payment on the median priced home versus five months at the end of May, it's 53%.

Gene Goldman: So, now you're my mom thinking about buying a home in January, now buying the same medium price home in May. Her mortgage payment has just jumped by 53%. She bought a new home. And again, this will affect the economy.

Gene Goldman: So, I know we're all saying some very similar points, but I do think inflation will start to slow down especially as the fed really affects the demand side. And I know CPI was a scary report, but PPI came in actually pretty good. Core PPI came in down. And a lot of the inputs that you look at into the PCE that the fed focuses on, like warehousing and transportation costs, have actually rolled over pretty fast.

Gene Goldman: So, I know, Mal, you mentioned inflation earlier, but again we're optimistic with you that inflation will moderate down though not necessarily to a fed's target at any time soon.

Jenna Dagenhart: In the meantime, we're stuck with that 8.6% reading from May from CPI. And of course, as was mentioned, the fed was backed into a corner there. And it was expected that we would get a 75 basis point hike, which it's unprecedented times when you've got the highest inflation in 40 years, and then, "Well, oh, of course, we'll do the first 75 basis point hike since 1994."

Jenna Dagenhart: So, very interesting times we were living in. And to your point, Steve, difficult to formulate a longer-term outlook sometimes. But following up on your point, Gene, about getting inflation under control, Mal, how high will interest rates and fed funds have to go in order to get inflation under control?

Gene Goldman: I mean, that's a great point. You look at the fed. I think right now in the dot plot, it's 3.4 by year end, 3.8, and then 3.4. So, we trust the fed. I mean, we think the fed will actually... everyone is too optimistic about the fed last year being inflation being transitory. We think everyone's a little too pessimistic about the fed this year. So, we do believe the fed were front-end loaded.

Gene Goldman: When the news leaked out over the weekend about July being 75 basis points, we were actually saying... I mean, sorry, July, excuse me. June being 75 basis points, we were saying, "A hundred basis points makes a little bit more sense." We know the fed's going to raise to a certain point. Maybe it's at three and seven eights maybe, but there comes a point where it needs to be more front-end loaded to address the inflation now.

Gene Goldman: So, Jenna, to answer your question, I'd say that three and seven eights. But again, it's a very changing situation. I know, Steve, you mentioned this earlier that it's a constantly changing, evolving, situation because inflation in our opinion will start to roll over, supply chains are improving, things will improve. The doves in the fed, the stronger dollar.

Gene Goldman: Dollar is up significantly. Last time, we saw the dollar in the 14, 15 height cycle up 20%. That basically stopped a couple of rate hikes because see the same thing. So, long answer to your short question, three and seven eight seems to be the point, but again I need some wiggle room around that.

Malcolm Polley: I think we were thinking in that range, three and three quarters, 4% top end. I mean, we've also got on a fiscal side some help there. Definitionally, you're not repeating the spending that went on during the pandemic. The fact that you're not repeating that spending by itself is restrictive. I mean, it's much more restrictive fiscal policy.

Malcolm Polley: You don't have the stomach within Congress today, particularly with the ongoing political fight between Republicans and Democrats as to what's going to pass and what's not going to pass particularly in the face of midterm elections coming up in a not-too-distant future. That fiscal tightening, if you will, just by not repeating spending will help the situation to a certain degree as well.

Steve Brown: I think we're a little on the lower end. I mean, we think that maybe they get to three low threes. Our view going into this whole cycle was it would be hard to eclipse the level of interest rates that we got in 2018. Obviously, we've already surpassed that.

Steve Brown: But there are too many potential landmines out there in our opinion. And history shows that usually once the fed pauses, their next move is actually to reverse policy rather than to continue along with tightening. So, we think that if the fed is setting itself up for some sort of a pause later this year, obviously the level of rates is what's up for debate. Our argument is maybe around 3%.

Steve Brown: Once they pause, it'll be hard for them to keep going and tighten further, given you have balance sheet runoff, you have uncertain economic environment and all the other challenges that we're all aware of. So, we would actually take the under, if you will, from the dot plots at this point.

Jenna Dagenhart: And Steve, I believe you mentioned earlier that the market has stayed ahead of the fed. Why is this?

Steve Brown: That's a good question. And we've been pondering it ourselves. This year, I think you've had a fed that's basically willing to do whatever the market has allowed them to do. Now, the fed is job-owning the markets quite a bit.

Steve Brown: They started with, as I mentioned earlier, more aggressive talking up of the yield curve and of the policy rate, and when they released the minutes in early this year, talking about a normalization of policy rate. And then, the evolution throughout the year has continued to see their own forecasts for higher and higher rates.

Steve Brown: But the market tends to do this usually. The market tends to lead the fed. It tends to be particularly in the environment of forward guidance. The policy rate will follow market interest rates. And then, eventually they intersect and market rates tend to go down faster than the policy rate. I mean, you saw that in the last easing cycle.

Steve Brown: You saw rates peak in the fourth quarter of 2018 and then the whole U-curve rally very considerably throughout 2019 to where the fed was almost behind the curve, if you will, in the other direction, where policy rates seemed too high relative to where market interest rates were.

Steve Brown: So, the market is a discounting mechanism and tends to lead the fed in general. But I don't know. I think the fed, as we've all said, we're not here to bash the fed, but most at least with the benefit of hindsight are saying that the risks were more clearly towards higher inflation and then being behind the curve. And the market clearly believed that and took the fed a little bit longer to wake up to that situation.

Jenna Dagenhart: And what about the balance sheet? I mean, as you said earlier, we have a very different starting point this time, starting at around near nearly $9 trillion. Can't really get rid of that overnight, can you, Steve?

Steve Brown: No. And that's where we've been flagging the biggest risk. I mean, you have a couple things going for the fed. I can't remember if it was Mal or Gene who mentioned it, but the deficit has shrunk considerably. So, treasury refundings are smaller, not by a lot but smaller than they have been in recent years.

Steve Brown: And you've seen some treasury auctions actually go pretty well in the last couple of weeks, given the higher rates and smaller auctions. So, the capacity or the need for the market to absorb the amount of treasuries that were being issued over the last couple of years is not there. So, the natural runoff of that portion of balance sheet is a little better.

Steve Brown: And then, you have the liability side of the equation and the reverse repo facility, and a lot of degumming up of the money markets and short-term funding markets that can be done a little bit easier.

Steve Brown: The mortgage portfolio is more nuanced. You're seeing considerable less origination this year as a function of very muted housing activity, and then of course higher interest rates so close to no refinancing activity. And then, actually in Powell's testimony this week, he mentioned that they would have no qualms about selling mortgages even at a loss. And of course, given when the fed was buying mortgages, substantially all of it is at a loss.

Steve Brown: So, we don't think they'll get to the point of actually actively selling. We think that they may, if things are going well, be able to raise the caps that will allow for more passive reduction of the balance sheet, but it's extremely large. And liquidity in the markets is already quite poor. And so, we just think back to the original point on the landmines that are out there.

Steve Brown: The fed aggressively taking money out of the system is probably not going to go unabated for a considerable amount of time. And they'll be lucky, we think, to make any kind of a dent significantly over a multi-year period if things go well. And I mean, that would be a good environment. That would mean you haven't had a financial accident and some market crash if they were able to significantly reduce the size of the balance sheet, but they're not going to do it.

Steve Brown: We think with blunt instruments, it's going to take time. And if it takes time and if it's working, that's a good thing for all markets, but we're a little more pessimistic.

Jenna Dagenhart: I think landmines is a good way of putting it. Gene, do you see a recession in the next 12 months?

Gene Goldman: Toughest question so far to see this recession. That's not our base case. And if you asked me this three months ago, we would see there's a very low chance. You look at the consumers in great shape. You look at inventory rebuild. You look at low housing inventories. You look at the 5.3 million more jobs out there than people looking for a job. That's a great labor market.

Gene Goldman: So, three months ago, we'd say very below, low chance. Today, we do see an increased chance. It's still not our base case, but we still do see an increased chance, especially with the comments we made about the fed. The fed clearly needs to address inflation and more likely is going to try. Could put the economy into recession. Could cause some type of policy mistake.

Gene Goldman: Here's the key point though. Again, that's not our base case. If we did have a recession, we do believe... again, a lot of the reasons I mentioned earlier, it would be a mild recession at worse. Consumer is still in pretty good shape.

Gene Goldman: I know savings rates have come down. I know credit card uses has increased. But remember, saving rates have come down from very high-elevated levels. Also, the inventory rebuild especially on the retail side is pretty strong. You look at supply chains are improving, seeing imports come in. We still have a very, very strong labor market.

Gene Goldman: The big wild card is clearly the housing. And housing, as we all know, is extremely interest rate sensitive. And we all know back in 2008 that the housing crisis led us to the financial crisis in 2008. But what feels good? What we like is the fact that if you look at homeowner's equity within homes, we are at levels not seen since as the early '80s.

Gene Goldman: Right now, on average, it's about 70% or so of price of homes is homeowners' equity. So, it's a good sign. You have that. You also have less debt. We do believe the consumer is in much better shape. We do believe that if there is a recession, it will be a mild one. But again, base case, no recession. But again, if there is one, it's a mild one.

Malcolm Polley: And I think from our perspective, the likelihood of recession this year we think is pretty small. I think the likelihood goes up in '23. I also think that if we have a recession, like I said earlier, the fed has historically done a poor job of engineering soft landing.

Malcolm Polley: I think it's happened four times in history that the recession we have is fairly shallow. I mean, if you look at the biggest impact, gas prices clearly attacks on the lower end of the compensation spectrum. And those people are clearly hurting. Anecdotally, my wife owns a retail establishment. She's clearly seen sales slow. A lot of her clientele, gas prices have really hurt them. And those don't look to be coming down anytime soon.

Malcolm Polley: So, as long as some of these pricings stay higher than people would like, particularly in gasoline, et cetera, and I think the likelihood of recession goes up, the farther we go in which probably is 2023.

Steve Brown: I think we would agree with both of your points. I mean, we're flying at stall speed in many ways anyway. And so, the likelihood of a significant contraction is low, which I think is probably the most important point to all of us. And I'm sure we'll transition into the fundamentals and valuations and things like that.

Steve Brown: And so, I think our opinion too is relatively shallow. I mean, we could technically be in one right now. I mean, you look at we had a negative print in Q1. The tracking estimates are relatively low in Q2. So, we're not in for a significant growth or significant contraction in our mind for a lot of the points you made.

Steve Brown: And then, Gene, the last... I just wanted to follow up too on your point on housing. We don't see it as a systemic risk right now either. I think to your point on home equity is important for consumer confidence and for household network.

Steve Brown: And I think even more importantly has been the speed with which housing prices have gone up. You haven't seen the degree of monetization of that equity that you saw pre-crisis. And so, say, housing prices stop going up, which most would welcome, or even go down a little bit. It would take a long way for them to go to have a meaningful negative impact on consumers and on the economy.

Steve Brown: And they've obviously been growing at an unhealthy pace on very low supply and low volume though. And so, you haven't had a lot of that cemented or crystallized, if you will, which I think if you reverse it, takes a little bit of the risk of that repricing out of the equation.

Malcolm Polley: You've seen apartment buildings, a lot of apartments being added. Cap rates have gone to ridiculously low levels in apartments. Rents have gone to unsustainable high levels. You've got certain cities where...

Malcolm Polley: I was talking with somebody that was in Seattle not that long ago. They see a guy coming out of a tent in a suit because he can't afford to rent an apartment in the city and go to work. The more you get that, the more you price people out of the market from a housing perspective that I think the bigger the risks are.

Malcolm Polley: And I think the risk really isn't in homes so much as it is in apartment buildings. And if cap rates go from, say, 3.8 to four, or five, which isn't that ridiculous in the values in these apartment buildings to clients substantially, and that's where a lot of the pain we think will happen.

Gene Goldman: And I know we're all talking about potential if we have recessions mild, but I think the key point for our advisors' clients is that we haven't seen a recession in a long time. Yes, 2020, we had a two-month recession. But really since 2001, we haven't seen a recession in our economy. So, we're not used to it.

Gene Goldman: So, again, a recession is a normal part of an economic cycle. And clients are just not used to it. And that's why when they turn the TV on, everyone is screaming recession. They're feared. But again, it's normal part of our recovery, of our cycle.

Malcolm Polley: Right.

Jenna Dagenhart: That speaks exactly to what you were discussing earlier, Mal, with, "Markets can't go up all the time either. It's healthy to get some of these rebalancing in there." And of course, one byproduct as the first six months of 2022 is higher yields and wider spreads. Steve, are you taking advantage or staying conservative, given everything we've been discussing?

Steve Brown: It's a good question. And it depends on the strategy, but in general, we're pretty bullish on the medium to longer term outlook for all of fixed income. And in particular credit, that's obviously come at the expense or as a result of the significant amount of pain and resetting evaluations that we've seen in every credit product and in most bond portfolios this year.

Steve Brown: It doesn't need to be restated necessarily. Everyone who's invested in the market knows they look at their own statement, but the drawdowns that we've seen have set new records by far. You look at the broadest fixed income index, the Barclays aggregate that's down something like 12% this year. The worst annual loss prior to this year was around 2%.

Steve Brown: And so, the multiples of drawdowns that we've seen has been record setting to say the least. And so, while that's erased trailing returns in most products, anywhere from three to five years worth of trailing returns, it's also reset the forward-looking returns.

Steve Brown: And so, speaking to that same index, you could... that the yield on that index is closer to 4% now. And the way we invest in credit products and position our strategies, we think you can get anywhere from five, six, seven, even upwards of 8%, again depending on quality and strategy, and allocations and fixed income.

Steve Brown: Because you've had wide spreads. We had that short period in March and April of 2020 where spreads were very wide, but yields were very low. And then, you've had periods of relatively high yields in 2018 and '19. I'm only thinking of post-financial crisis periods. But at that point, spreads were relatively tight.

Steve Brown: You now have a situation where yields are high and spreads are wide. And so, when you add it up, your forward-looking returns or your forward-looking yield is as high as it's been in most credit since the financial crisis. And so, you have markets that are pricing in a significant risk of recession. You have a yield curve that's pricing in a very hawkish fed.

Steve Brown: And so, there's a lot more wiggle room and margin of safety when you look at investing in fixed income right now. Because, again, looking backwards, your returns, whether you're invested in the best performing fixed income sector, like bank loans or securitized credit, or the worst which would basically be treasuries on a trailing five-year basis, your returns have been flat to marginally positive.

Steve Brown: Equity returns on a trailing five-year basis are still in the mid to high single digits to low double digits. And so, you had this real big disconnect from this resetting evaluations this year, where bond indices and stock indices have almost been moving one for one. And we think that going forward, bonds in particular look a lot more attractive from a relative perspective than stocks.

Steve Brown: And so, we are being relatively more aggressive, but it's hard to be... we're not near our max risk limits in anything because there's obviously still a lot of uncertainty out there and things could get worse before they get better. But if you're able to see through the noise and, again, think about your investment objective, your time horizon, if you're looking at medium to longer term, now could be a really great time to be investing in credit and fixed income in general.

Gene Goldman: Piggyback what Steve said, in our portfolios, we obviously run some fixed income components and with the fixed income. So, yields have had big... they've moved up significantly. We're taking advantage. We've been slowly, incrementally raising our duration. We're not above benchmark duration yet, but we still are raising our duration.

Gene Goldman: We do think that yields have run a little too much too fast, especially the fed is being aggressive in raising rates in the short term. This theoretically put downward pressure on longer term yield. So, we want to take advantage of some of that opportunity.

Gene Goldman: On the spread side, and to echo at Steve's points, I think we're also taking advantage. We're increasing our allocation to corporate bonds and high yield. We do believe that companies are just in a great shape from a balance sheet perspective. They're just flush with cash.

Gene Goldman: And unfortunately, they're able to raise prices on us as a consumer pretty easily. This is good for companies. You're seeing this manifest itself in better cash positions on balance sheets, in really just stronger balance sheets again. So, increasing our duration, still below benchmark, but at the same time, we're also taking advantage of some of the credit opportunities.

Malcolm Polley: I guess we'll take the opposite side of that. And our standpoint is really more of a long-term secular standpoint. I mean, we understand the cyclical forces that happen with knowing the fed moves rates and when the market looks at the cyclical economic issues. But what we also leave is that we've just come through a 40-year period where basically all I've known my entire career is declining interest rates.

Malcolm Polley: What people had missed is that the period from 1940 to 1980, which was the last time you had a major secular upward movement interest rates, is the average return in bonds was very low single digit on average. We've come through an environment where the return relationship in bonds is flipped. It used to be 75% of your return came from coupon. And now, you had 75% of your return coming from the movement and the price of the bond.

Malcolm Polley: Yes, interest rates have come up a lot. They're relative to zero. But the likelihood of getting that situation reversing again in 75% of your return coming from coupon still has not increased in our mind that much. So, we're much more concerned about the long-term secular move in rates.

Malcolm Polley: We really believe that we're at the beginning stages of a long-term upward move, where you get cyclical changes inside that, but that the long-term rate of return on bonds over the next decade or two is dramatically lower than people expect it to be. And so, we' staying relatively short and trying to do things particularly within fixed income portfolios to minimize or reduce left tail risk.

Gene Goldman: Sorry. The only counterargument to that would be, I mean, it's great. I mean, we do agree to an extent. But foreign buyers are taking advantage of our higher relative yields and a stronger dollar, which is putting downward pressure on yields and demographics, the greater demand for fixed income as people get closer to retirement. So, it's a great thing we can debate. We'll definitely take us offline and debate more.

Jenna Dagenhart: To be continued there.

Steve Brown: Well, and last point I'll make too is I think... and Malcolm, that could certainly be the case. I think what we're due, though, for is a period of consolidation and a normalization of relatively higher rates, to your point, off of an extremely low base.

Steve Brown: But it will be very hard for the economy and the financial markets to go from 0% rates to, say, five or 6% rates without something terribly wrong happening. And so, while we're in the middle right now, we think we're due for some chopping around.

Steve Brown: And then, to the price appreciation point, if inflation is somehow behind us at some point, the fed most likely easing of policy would come through that channel and lowering of interest rates again. But we agree, it's not the 40-year run that we've had that's going to go forward again. We're due for some period of consolidation and not necessarily though screaming higher right out the gate.

Jenna Dagenhart: And Steve, what's the yield curve telling you now?

Steve Brown: The yield curve is telling us that the market is concerned about the economy and the trajectory of growth. The most common signal from the yield curve with regards to growth is looking for an inverted yield curve. And typically, a recession is predated by an inverted yield curve, anywhere from 12 to 24 months prior to a recession.

Steve Brown: Now, we would throw some of those cautionary signals out the window a little bit. I think given the nature of the last recession, as Gene mentioned, the two-month recession and the associated policy response to it, this is not a normal environment. In some ways, this is a continuation of the 2018 hiking cycle, and if COVID hadn't happened, the ongoing trajectory of what was happening as the fed was tightening policy.

Steve Brown: So, the yield curve is telling us that short term rates are going to continue to rise, but that inflation expectations are still relatively subdued. When you look at forward yields and forward inflation expectations while they're not at 2%, they're in the high twos to low threes, so still somewhat of a normal environment.

Steve Brown: Particularly with long term rates being anchored and a very flat yield curve, the yield curve is telling us that the fed will get inflation under control. And then, the bigger concern might be growth.

Jenna Dagenhart: What's your view on credit, Steve?

Steve Brown: I think depending on the credit market you've seen, varying degrees of repricing, for us, a high-grade credit looks very cheap right now. We do a lot of rankings of each of the credit indices relative to their own history just to try to... back to one of our original points, think about what's a range of expectations we can have for a given asset class and where would we expect spreads to be.

Steve Brown: And so, when we look back, most credit indices are in their 60, 70, or 80th percentile, meaning that spreads are tighter 60, 70, or 80% of the time than where they are today. Of course, what we're all mostly concerned about are those tail events and how wide spreads can get. So, we think we've priced in, if you look at high yield or IG, a 60 or 70% of a recession. That's the probability of a recession based on where spreads are.

Steve Brown: So, back to that margin of safety comment, we think credit looks relatively cheap. Because regardless of whether we go into a recession, this is where active selection, prudent sector rotation, and active management ultimately pay off. Because I think we've all made the point that we're coming off of an extremely easy monetary policy environment. And one is, as Mal said, of declining interest rates for a long period of time.

Steve Brown: So, issuers have been able to refinance themselves to basically their lowest cost of capital ever. And that sea shift is finally changed. And so, picking the right issuers, picking the right sectors, they're going to be able to weather this storm going forward is going to be more important than ever because this isn't going to be a beta returning market. Clearly, beta is not performed this year at all.

Steve Brown: All the indices generally are trailing the active peers. So, now is an important point for credit selection. And in our opinion, being up in quality, and being in some of the less liquid credit sectors that we feel comfortable holding, regardless of whether we're going into a recession or not, something that you can set it and forget it, clip that relatively high coupon or yield and not worry about having to sell it if things turn out worse than we expect.

Jenna Dagenhart: And turning to equities and equity sectors here, Malcolm, have all stocks been under the same level of pressure? Or has the pain been particularly bad for specific types of equities and sectors?

Malcolm Polley: That's a good question. I mean, it's clear the last few years, not all equities have been treated alike. Up until this year, if you didn't own the top, say, 10 names of a benchmark, you underperform. And the market was really because of the ultra-low interest rate environment paying up for high duration assets in equity side.

Malcolm Polley: So, if your earnings were long dated and your earnings were grown to grow rapidly in the future, you didn't get much of any of a haircut to discount those earnings to present. We've reversed that flow right now so that the magnificent eight, if you will, the Amazon meta et cetera of the worlds have had their share of pain to the detriment of companies at the lower end of the index spectrum. So, the bottom eight names in general probably outperform the top eight names.

Malcolm Polley: We have generally moved toward lower duration assets across the spectrum. So, in equities, that means assets that have real earnings and potentially dividends as that cash flow, as rates rise don't get negatively impacted by the change in rates from a discounting perspective because your earnings are closer to today than say, "growth stocks".

Malcolm Polley: And it's clear that smaller market cap names have had a lot more pain than larger market cap names. So, those of us that are looking at trying to build positions and equities, we would encourage that you focus on, the market cap spectrum, the areas of greatest pain.

Malcolm Polley: So, looking at smaller cap names and mid-cap names relative to large cap, and then focusing particularly on companies with earnings today and with dividends today to mitigate some of that downside risk.

Jenna Dagenhart: And circling back to Steve's point about the importance of selection, Gene, how does your firm leverage active management?

Gene Goldman: We are big believers in active management. But I think if you think about the environment, we need to take a step back and look at the market volatility because market volatility is a huge benefit. Active management does a great job in a volatile environment.

Gene Goldman: And for us, obviously stocks been down. S&P, the bear market, Nasdaq has just struggled. If you take a step back, our perspective is that we do believe that we are limited market downside from these levels. If we're wrong, maybe the S&P, the worst-case scenario, is probably about 3,400 on this pre-pandemic high. About 10% where it is now, but the limited downside, there's been a ton of market capitulation.

Gene Goldman: You look at market breadth. Number of stocks, above the two-moving average. It's about 15%. Long term tends to bottom out around 10% in market pullbacks. Valuations are much more attractive, down about 29% from valuation standpoint.

Gene Goldman: And we talked about this high yield spreads are still in a pretty good shape right now, reflecting a normal market equity market pullback. The wildcard that we're focusing on, and this is where active managers are going to really do well, is earnings estimates. It's the big wildcard.

Gene Goldman: Equity analysts tend to be a little bit late to the game. They tend to be optimistic. They're very much focused on individual companies, individual revenue growth for each specific company in sale. They tend to look at macroeconomic factors a little bit too late. So, we are watching earnings estimate overall in the sense of, "Hey, is this pulling back too much?"

Gene Goldman: And this is the wildcard. We do believe that earnings estimate will not be revised down as much. So, with this uncertainty, basically what I'm trying to say is this. With all this market volatilities, this uncertainty, active managers are going to do really well, in our opinion, in this environment. And they've demonstrated this year. You look at all the different stats, active managers have done a great job this year.

Gene Goldman: We think it makes sense especially with, and Mal mentioned earlier, widening market breadth, widening not just in the magnificent eight. It's much more stocks doing much better in this environment.

Gene Goldman: I think the best example would be retail. You look at the retailers. You've got some retailers who are just kicking butt on earnings. And you've got other retailers who are struggling, the same environment, same focus on the consumer, same focus on consumer spending. And if you buy a passive index in that environment, you're buying every single company, good ones and bad ones.

Gene Goldman: Working with a large active manager with a vast amount of resources is a great way to take advantage of these market dislocations on a company by company basis. So, again, active managers, very, very important in this environment. This is why we have fully embraced active management in our portfolios today.

Jenna Dagenhart: And Steve, I'll let you elaborate on that for a minute if you want, but what's the benefit of active management in markets like this one, and where are you seeing opportunity?

Steve Brown: Well, I think it's shown for over decades now, I mean, fixed income has had your most bang for your buck in active management. I think Mal and Gene have made the point on the bias for returns and equity indices being to the top-weighted folks. And that's not the case in fixed income.

Steve Brown: The traditional indices are heavily dominated by treasuries and other government-related debt. And over time, it's shown that if you can invest in credit and invest in credit wisely, it minimize your losses and minimize your drawdowns. That's the surest path to outperformance over the long run rather than trying to pull macro levers and things like that that we think are much harder to predict and much harder to plan out long-term outperformance.

Steve Brown: So, to us, it's credit selection, sector rotation. And I think to all of our points, not every credit and not every sector is going to be feeling the same effects of this policy path going forward. And now's no better time than ever to be in active management, particularly in credit.

Jenna Dagenhart: Well, as we wrap up this panel discussion, Malcolm, what should investors be thinking about as we head into the second half of the year?

Malcolm Polley: Well, something unique happens from the street perspective this time of year is the calendar magically flips from the current year to the next year. As analysts start looking at, in this case, 2023 from an earnings perspective, you're looking 12 months out. So, June 30 comes along. It becomes 2023. And all of a sudden, we're looking at earnings growth next year as opposed to current earnings growth.

Malcolm Polley: If we get a recession, you would expect to see earnings estimates come down a little bit, but analysts tend to be behind the curve from that perspective as well. So, from valuation perspective, things look better if you look into 2023. Markets have come down a lot. I would agree that we've seen the biggest degree of the pain so far this year.

Malcolm Polley: If we do get a little additional drawdown, it's probably not dramatically. And we begin to work our way higher. So, we think that you can cautiously step into more risk assets as we get into the end of 2022 and start to build positions in places that you've been leery of because you're not sure where the next landmine is going to be.

Malcolm Polley: So, we're given a potential recession in the future. We're still somewhat constructive on the ability to build positions and names that we like simply because valuations have come down so much and downside is somewhat limited from here.

Gene Goldman: We would agree with Malcolm. Again, valuations have come down. You look at the forward P/E in the S&P was at 22 at the beginning of the year, pricing in absolute perfection. Now at 15 to 16, it's a little bit more attractive. It's some opportunities.

Gene Goldman: The other point is that the markets are always forward looking. It's our opinion. The markets have priced in a recession already. Let's say we don't have a recession. Let's say we have a mild recession. There comes a point, the market starts to pivot, starts looking at a recovery.

Gene Goldman: And the data historically has shown, as that pivot happens, market's forward returns, historically speaking, have done very well. And I think, Mal, a lot of the asset classes you mentioned, like small cap, look very attractive in our portfolios.

Gene Goldman: We've been repositioning our portfolios recently, started looking a little bit more growth. We've been value overweight for a long time. Started to dabble a little bit in growth, not overweight growth yet, but dabbling in growth. Also, looking at liquid alternatives as a way to mitigate market volatility within portfolios. And the other area is small caps. And small cap, you said it, they're extremely attractive right now. And they do well in their recovery.

Malcolm Polley: I would agree on the liquid al side, particularly things like merger arb or capital arbitration, where you're arbitraging between the capital structure of a company, or you've got very low risk strategies with some relatively reasonable return expected long term. It really manages the downside in a portfolio.

Jenna Dagenhart: And Gene, finally, what are you hearing from advisors right now? What are some of their top concerns as we head into the final stretch of the year?

Gene Goldman: I think the common concern is that they wish their clients would stop watching TV and hearing all the fear mongers out there. I mean, there's a lot of good data and bad data out there. But again, market volatility is a normal part of investing.

Gene Goldman: Ones that I love quoting is that if you look at the S&P 500, in 35 of the last 42 years, the market's been positive per the S&P 500. In those 42 years, the average intro-year loss is down about 14%. Market volatility, there's fluctuations. These moves, it's a normal part of investing. It's a normal part.

Gene Goldman: So, what we've helping with our advisors and their clients is really over communicating. I've grown up in the independent broker, dealer world. I know that our advisors out there need a ton of communication. You may not have all the answers. You may not know exactly what's going on exactly to a point, but your clients want to know that, hey, you're monitoring the situation. You are reviewing it. You're analyzing it, and you're reviewing the portfolios.

Gene Goldman: This is why for our advisors, we communicate a ton. Even just the market volatility in the last couple weeks, a ton of communications, a ton of videos, [inaudible 00:57:19], just to say, "Hey, we got your back. We're helping you go through this."

Jenna Dagenhart: Steve, any final thoughts you'd like to leave our viewers with?

Steve Brown: I think we've aligned quite a bit on our collective views. And I think the important points that we all highlighted is being nimble and reacting to the data accordingly, but keeping a medium to longer term horizon in mind because that's, as Gene said, what most investors are, and to see through the volatility and look longer term to valuations and opportunities.

Steve Brown: I think if you didn't look at your portfolio for a couple of years, I think you'd be happy starting today, and whenever you wake up and look at it at that time period with what's happened since then.

Malcolm Polley: I would agree.

Gene Goldman: Definitely.

Jenna Dagenhart: Well, everyone, thank you so much for joining us. Great to have you.

Malcolm Polley: Thanks for having me.

Gene Goldman: Thank you.

Steve Brown: Thank you, Jenna. Appreciate it.

Jenna Dagenhart: And thank you to everyone watching the CIO mid-year outlook masterclass. Once again, I was joined by Steve Brown, chief investment officer, total return and macro strategies, and senior managing director at Guggenheim Investments, Malcolm Polley, president and chief investment officer at Stewart Capital Advisors, and Gene Goldman, chief investment officer and director of research at Cetera Financial Group. And I'm Jenna Dagenhart with Asset TV.

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