Jonathan Forsgren: 2022 was a year marked by global inflation, rising interest rates and supply chain constraints, which all encumbered global markets and had a lasting impact on economies worldwide that will carry over into 2023. I'm joined by ClearBridge CIO Scott Glasser and portfolio managers, Eliza Mazen and Sam Peters who will analyze bear market headwinds and assess opportunities and risks for equities in the year ahead. Scott, Eliza, Sam, welcome.

Scott Glasser: Thank you.

Elisa Mazen: Nice [inaudible].

Jonathan Forsgren: So 2021 was a record-breaking year for equities. We saw the S&P 500 make a charge towards 5,000, reach 4,700 and then as soon as '22 hit, it seemed to take a nosedive. Scott, could you give us a high-level summary of the headwinds that equity's faced in 2022 and which of those do you think we'll continue to see in 2023?

Scott Glasser: So the market peaked actually the fourth day of 2022. And since that time obviously it's been a tough year. I think that if you want to think about the markets as a whole, 2001 to 2022, you have to think of an environment in terms of liquidity. Liquidity in 2021, and liquidity is broadly defined as interest rates, but it's the dollar, it's credit spreads, it's a whole number of things that basically go to the availability of money. And liquidity was incredibly abundant in '21 and the situation changed as we went into '22. It was obvious the Fed was going to raise rates. It was obvious at that point that we had an inflation issue. It was first called transitory. It wasn't really transitory, it was much more permanent than people believe. And so the market started to react ahead of that tightening of liquidity.

                                    And as we said, the market peaked the fourth day of the year. What happened very soon after was that we had the war in Ukraine. And so what you took was a situation where you had inflationary pressures that the Fed had to react to and you made them much more severe by constricting or limiting supply chains around the world, by raising the price of energy, by taking a situation that was a little bit precarious and potentially transitory and made it more permanent. And so as the year unfolded, you saw rates climb significantly, you saw liquidity tighten. And markets don't like tightening liquidity. You took an environment that was very easy, you went to a situation that was very tight and the end result was that equities were under pressure. And for the most part the valuations people paid, or the discount rate went up, and therefore the valuations came down across the board. And essentially the story of 2022 is one of multiple compression due primarily to a rise in the discount rake and tightening liquidity across not only the US economy but the global economy.

Jonathan Forsgren: And Scott, staying with you, you mentioned that the aggressive rate hikes taken by the Fed in the US led to that multiple compression. How much of that trend do you expect to carry on into 2023 now?

Scott Glasser: I think 2022 was the year of that compression. If I had to back into how much of that is already discounted in rates, I'd say 75, maybe 80% of that multiple compression is already reflected in multiples and stock prices. I think the remaining 20% will be a function of how long the Fed stays at high levels. I think that consensus expects them to be there but to rapidly, not rapidly, but to transition maybe to an easier or maybe even a series of rate cuts perhaps later in the second half of 2023. I think that actual consensus thought may be a little too hopeful. And so I think that rates will stay high and they'll stay high, probably a little longer than investors expect. And the result of that will be some more multiple compression. But again, not significant. We've already seen the bulk of the multiple compression, I believe, in stock prices

Jonathan Forsgren: And the Fed is raising interest rates to fight inflation, so I'm going to go to Sam with this one. We've seen inflation seemingly come down slowly, but it remains stubbornly high. What do you expect the pattern to be in 2023 in terms of inflation? What do you expect it to look like?

Sam Peters: It'll go lower, it'll come down. That's the good news. And we saw that on the last CPI and how sensitive the market is to that marginal change. And so there's a couple things that are just baked in the pipeline. We clearly had goods inflation, that's cooling supply. Chains are starting to loosen up, demands coming down a little bit. And that's material shelter. Rents were a big... We're already seeing rents come down. It takes time for that to come in. But the pipeline of these that are actually proving to be transitory depending on your time they're coming down. The challenge is there's a core piece that's stickier and we talk to companies all the time, we talk to the CFOs, first question we ask them "What's going on with labor?" Unfortunately inflation expectations started to get embedded in labor and that's where the main battle the Fed has to take on.

                                    And the second piece is, for this cycle we did, in my opinion, we overinvested in bits and digital, but we underinvested a little bit in atoms and physical things like commodities and whatnot. There's a lot of supply curves out there that are steep, meaning as demand goes around, especially on the upside, it puts pressure on that. The Fed has their task of bringing down those wage costs, changing those expectations and dampening down demand, so we don't just go rocketing up those supply curves. Something that Scott and the team are all over, the big known unknown for 2023 is how much damage does the Fed have to do to the labor market? That's the big question that'll determine a lot of which way, what sort of recession, do we have a recession? It all hinges on that part of it.

Jonathan Forsgren: Continuing with recession, I'm going to bring this to Scott. The recession we've, we've been talking about it and there's been talk about a soft landing. And technically the US hit a recession in the first half of the year, but it felt mostly a name only. What recession signals are you looking for in 2023?

Scott Glasser: If 2022 was about multiple compression, 2023 will be about earnings compression. And it's a really good question because in my mind the degree of weakness we eventually see in the economy will really dictate what market returns look like. In a more mild downturn, I think that you know, could contain the weakness in the market to the old lows that we've seen. If in fact it becomes more severe, I think there's probably greater downside. I think that remains the key question. What's complicated about the question is that for two years prior to the recession, this period, you really didn't have the type of economic excesses that you would have in a normal recession. You didn't have a buildup inventory, as a matter of fact, you couldn't get... Demand was greater than supply. You couldn't get things because of semiconductor shortages and other shortages. So you really didn't have the access.

                                    I'll give you a quick example. Usually in a market that's... A billion car sales will be somewhere around 18 million. You never got above 14 million because you couldn't get semiconductors to build cars. So you never met that demand and because you didn't meet that demand, you didn't have the excesses. And you can take that to other industries as well. There's a good argument to be made that what will eventually be a tightening of liquidity causing a downturn in earnings, and that's likely to happen, could be mild and we hope it will be mild because of course the impact of that will be less severe on overall market returns.

                                    I think the most important thing, I shouldn't say the most, I think one of the important things to look at is the PMIs and how PMIs move throughout the course of the next year. It looks like PMIs should bottom in the second to third quarter. Of course, PMIs are representative of both manufacturing and services in the broader economy. They're really good in terms of being forward-looking indicators in terms of future profits. And so if you follow that path and you project out what they are likely to be, you're likely to see that weakness second to third, quarter, maybe even third quarter here.

                                    But I do think, just coming back to the bigger question, there's a lot of debate in how severe the downturn might be. And look, there are pluses and minuses. I talked about some of the pluses. On the negative side, we have things like housing that are just collapsing or starting to collapse. It's a really mixed picture and because of that I think the market... Creates volatility in the market and the market struggles with that answer. But I'm looking at... To get back to your original question, I'm looking at PMI on the manufacturing the services side as a forward-leading indicator of profits.

Jonathan Forsgren: And now Eliza, you cover Europe, among other countries, is Europe in a recession and is it at higher risk than the US of recession and going deeper in 2023?

Elisa Mazen: No, Europe is not in a recession. Whether it gets in a recession is a question. If there is a recession, we don't think it's going to be particularly deep. Part of really what happened in Europe obviously has been the invasion in Ukraine by the Russians. Europe is a huge importer of Russian gas and the prices have been astronomical in terms of the increases and they've had to figure out how to solve for suddenly the lack of energy. You've had to increase defense budgets, which is something they've always been talked about, but it hasn't actually quite happened.

                                    There's a lot of things we think that really can hold Europe up. First of all, there tends to be larger social safety nets in Europe. Unemployment is starting from a much higher place. We were peaking in employment back in 20... Or unemployment rather in 2013 and we've been steadily coming down, but it's at more of seven to 10% rather than the 4% very, very tight where we have today. And that's still continuing to come down. So we think that that's going to help cushion things a bit.

                                    It's been a warmer winter, so actually the gas storage is full so that looks to be a little bit more moderate. The UK has had its challenges with the exit from Europe and what that's meant. That's really created additional layers. The UK may go into recession, but really what you've seen is astronomical utility bills. Many governments are trying to cover for that with additional handouts. We don't think that's going to be permanent, but there are ways to, we think, moderate an impact of a recession there.

Jonathan Forsgren: Whether or not we've hit a recession in Europe and we'll go to the US afterward, global economies have contracted, everyone's looking for a bottom. What signals will you be looking for to mark a durable bottom in Europe?

Elisa Mazen: I think globally so, obviously we do Europe, Japan, Asia, everything. We look for a number of different things. A lot of the European economy is not just dependent on Europe but dependent on things that are going on in the global economy. So we are looking for the end-of-rate rises, that's going to be something we think is significant. Obviously, we're watching CPI numbers very carefully and CPI Ex Food & Energy, which has been really the thing that has taken things up. We are looking for the end of COVID in China, because again, many European companies have meaningful businesses there. We're looking for a number of different things and we're looking at obviously the Fed and what they're doing because that makes obviously a very big difference.

Jonathan Forsgren: All right. So Scott, Sam, you want to add to that very comprehensive answer?

Scott Glasser: The only thing that I'll add is that I think that calling bottoms are very difficult and it's a function of trying to project economic statistics and make economic projections. But really the way I look at the market and try to evaluate the market, it's both economics and it's the market itself. What's the market telling you? And when the market's made to bottom, what you will see is that small caps and more risky stocks will start to do better. You'll have sectors of the market that are more risk-oriented and more growth-oriented that will start to do better. And you'll see a transition in the market itself from large defensive to small and more aggressive.

                                    And when you see that play out and when the breadth of the market, breadth of the market is the participation, how many stocks are participating, where they are, how far they are from prior highs, what the advanced clients look like, when you see the breadth of the market start to actually broaden out in a durable way and you see certain sectors start to lead the market, that will be a good signal. Again, not a hundred percent guarantee, not a guarantee, but it would be a good signal that we've hit a durable bottom. So I watch the market itself and I watched the action of the market as a whole and the sectors that are actually contributing to returns and how they contribute to returns.

                                    And then just to add on, which I think has been mentioned, you'll see economic green shoots, you'll bring back that phrase which was so common I think in 2022 and then earlier. You'll see consumer confidence start to improve. You'll start to see things like consumers that are now trading down start to trade up. You'll see that start to play out in terms of their basket of goods. And I think it will be obvious. Unfortunately, some of these will be seen after the bottom. So projecting the bottom ahead of time is very, very hard, but looking back and saying, "Okay, we now have confidence and growing confidence." The good news is generally, even if you identify it after the fact, there's plenty of time and plenty of return in the market that clients and market participants will be able to participate in. That would be my answer.

Sam Peters: Only thing I would add is a little bit from a different lens, maybe a little more bottom up. Scott alluded to it, I think we have done, I agree with him, most of the multiple compression, most evaluation damage, the big question everybody's asking and it's all related, is how much earnings damage. One of the things we're, Eliza, Scott, everybody at ClearBridge is focused on is how can we do better. We know that there's going to be some earnings damage out there, bottom up who's going to be more resilient, spending lots of time on that? Even before we get to those indicators that everyone's watching, how can we be resilient to slow down in a lot of earnings risk potentially in 2023?

Elisa Mazen: I think one of the things that's always important to look at, consumer discretionary is a big part of the economy and consumer spending in every geography around the world is anywhere from 55 to 65 plus percent of total GDP. And right now we're seeing obviously big cuts in consumer, certainly, discretionary spending. I think watching that is always an interesting forecaster of maybe where we're going.

Jonathan Forsgren: We're coming to you Sam, as Scott shared, the tightening liquidity in the market has forced compression in earnings multiples and for projections. Specific to the US market, are you seeing areas where compression might be overstated leading to opportunity or the inverse, areas that you would recommend to avoid right now?

Sam Peters: Yeah, as Scott alluded to in the beginning, liquidities come out. We're arguably in the most liquid market environment ever leading into this and the Fed, I think this is the most aggressive liquidity's ever been drained. And so one of the things we did is we just said "This is a new environment, new market cycle, what's going to be resilient to that?" And so we're focused on really high free cash flow yields. Companies that are almost drowning in cash. No debt. Didn't want to take a lot of credit risk on that side, buying back their own stocks, high dividend yields, those sort of things. Ironically, a lot of those are in more cyclical value areas, at least in the US, that were disfavored before but now have that. Conversely, we all know this, but speculative parts of tech, which ClearBridge mostly... It really does avoid, things that don't have good free cash flow, that had convertible debt that's now real debt. Those things have come down a lot and are not that resilient. We're looking through things that can mark their own way regardless of the environment, create their own liquidity.

                                    And the other thing I'd just say in that, all multiples have come down, so there's really been... Nothing's been spared from that. What people do at every cycle, they anchor off the past cycle. It's the ghost of cycles past. They have in their mind the two big events of the last cycle, the great financial crisis that started off, COVID at the end, culminating in oil going to negative 40 in April. There's been equal compression in those things that I said that are resilient, these cyclical things with high free cash flows, their multiples have come down tremendously. You look at their earnings multiples for going into next year, they're the cheapest they've ever been on relative. There's a huge opportunity for me to just say, "Let me buy resilient things. I'm paying absolutely no premium for good balance sheets, good dividends, good free cash flows. And then if we do have a recession, if history repeats itself, we have a GFC, they're in shape that withstand it. If it doesn't happen, we should do a little better."

Jonathan Forsgren: Eliza, you focus on Europe and other regions including Asia and Canada. Let's start with Europe. How have earnings been impacted over the last year and where do you see areas of opportunity and areas to avoid on the continent in 2023?

Elisa Mazen: In terms of what's been impacted, it's been both style impacted and sector impacted. Growth has been a style that's been very much in favor with rates coming down, that obviously around the world in Asia, Europe, what have you, that's been impacted. And on a sector basis, things like energy generally have done well in virtually every geography to different degrees. So you have a little bit of that. Small caps, Sam talked about that or rather Scott talked about that earlier. Small caps have been very poor, small and the mid cap space as liquidity has come out of the market, have been poor, earnings have generally not been great. They tend to be very domestically-focused and if the economies are not doing great, neither typically are earnings. Those are things that have been sort of treading water, the big multinational companies which have lots of areas to pivot to. If China's doing well, they can benefit from that, the US and so on.

                                    And then currencies, we've had huge volatility in currencies with the yen down 20%, Europe down 10%, Canada only six. All of that has been contributing to earnings. Now, Europe and the Euro has been quite weak because of Ukraine because, because but that's actually benefited earnings. So earnings have actually done quite well. If you looked at earnings revisions, what you see in many markets is actually they're fine. The place where it's been weak has been China, obviously China, Hong Kong, everything has been down into the right and we think that that's something that hopefully there is an opening, there's a way to get that economy restarted again and that we think will benefit a lot of different areas and of course different sectors.

Jonathan Forsgren: So you mentioned that Japan has had a contraction, just like so many others, but are there any headwinds in particular that Japan has faced that are unique or more unique to Japan than other global economies?

Elisa Mazen: One thing that people don't quite appreciate I think is the pace that different countries have come out of COVID has been very different. So Japan has been in lockdown quite a bit later than the US and then Europe. And so it's really only recently come out of that COVID environment. Prior to COVID, one of the things that had really been bolstering the Japanese economy had been tourism. Japan was having a real renaissance with tourism. We had a lot of Chinese tourists and others coming to Japan and really spending money and bolstering the economy, earnings of companies, et cetera. And that really fell away obviously with of COVID lockdowns. There are no Chinese tourists either in Japan or in Europe or anywhere else. That has really impacted consumption in Japan and consumption is an important event.

                                    You're back to waiting for the domestic economy and the domestic consumer to grow and that grows very slowly. Labor, it's very tight and wages don't particularly grow much. So one of the challenges has been to try to generate real inflation so that they could grow out of their very big debt and lots of other problems that they have. And this is what the Bank of Japan governor has been doing, he's been doing really tight yield curve control, buying up a lot of bonds and really trying to generate inflation, which they've been successful at. You now see CPI going up meaningfully, they're really trying to generate wage inflation. They don't have that yet.

                                    But the other thing that they've done by keeping rates so low is they've really crashed the yen. The yen down more than almost any other currency. If you look at where Japan is, Japan is in very good company with Hungary and Turkey and Argentina this year in terms of at the bottom of the list. So it's pretty weak, but that has certainly flattered certain companies earnings. Japan has a big export economy that's definitely benefited from that.

                                    The other thing is there are big Japanese companies, big industrial companies that really do benefit from food inflation, which is a feature of everything globally. And so these are big trading houses, they're very cheap companies valuation-wise and those have benefited as well.. Japan is a mixed picture. Some things have been doing well, some things have not been doing particularly well, but we actually are pretty optimistic. If you look at Japan, first of all, one of the things that has is these companies have phenomenal balance sheets and they have a lot of cash and they don't really have a lot of debt. That's pretty good. Valuations we think are quite cheap and there has been a top-down move to really drive efficiency and better profitability of Japanese companies. That's been an effort by the government in total. And that's slowly working year by year by year.

                                    You're seeing operating margins actually trending up, you're seeing better returns and you're seeing activists come back into that market, which is something that hasn't been there for quite a long period of time. There's lots of assets that really don't belong in certain companies getting disposed of, doing share buybacks. So we think there's a lot of interesting things actually happening in the Japanese market and valuations we think are quite attractive.

Jonathan Forsgren: Bringing it back to the US for a bit. Over the last year, there has been a shift from growth to value and equities in the US. Sam, you manage value portfolios. Despite the resurgence in value, you pointed out that there are still a wide divergence between styles. Can you explain why that is and what value investors can expect in 2023?

Sam Peters: Sure. Just to contextualize this, the last cycle was the worst relative cycle for value relative to growth in the US ever. US-centric answer. And really from 2018, 2020, the pain for me at least, for the value guys, accelerated. And we measure the disparage and we measure the value of value. How's value relative to growth. And you got to the hundred percentile in March 2020. March was actually the worst month in over a hundred years for value relative. So you're there. Despite value actually outperforming growth for over the last two years and not just by little in the US, we've only started this journey. We're very early. We're only at about the 95th percentile. Value has only been cheaper than now 5% of the time, and that's the recent past.

                                    And as I mentioned earlier, none of this is because the multiples expanding. It's because the fundamentals of value, when we got into this more inflationary environment, higher nominal growth, it was just great for these cyclical value names, energy, materials, parts of financials. They've generated their own earnings and fundamentals and so that's why it's all been fundamentally driven. It hasn't been a tailwind for valuation. So you have a long way to go. And just to dimension it for you, every 10% that you claw back, if that happens, it's over 10%, over a thousand basis points of relative performance. I'm biased, but if history... It's never just gotten stuck there, these things flow through the tails. It's not sustainable. I think it's early.

                                    As you look at 2023, my own hypothesis is I think the value of value will start to get more expensive. We got the most concentrated market in US ever with the fang at the top, that's an ocean of capital. There's still a lot hanging out there. I'm in a little value pond, all I need is a little bit of leakage and the flows to start going and you'll start getting the multiple coming. I think that feedback loop starts in 2023, we'll see, that would give you another tailwind and it would feed on itself. I still think it continues, the fundamentals are sustainable and we'll start to get some valuation.

Scott Glasser: I'd like to add onto that a little bit. I think that you need to also think about the starting point, which was the extreme starting point for growth. When performance is good and a certain type of stock is doing well, it attracts flows and it builds on itself. It's self-perpetuating. And I think we have to remember that a lot of the growth stocks disproportionately benefited during COVID because of technology spend, because of a lot of the spend went online spend, anything that made it easier to live and to work during a two-year lockdown period essentially. And so a lot of that from a growth investor perspective was assumed to be secular as opposed to be a one-time acceleration of that growth. And that's why you saw multiples expand so rapidly and so much money growing into the growth sector.

                                    That is now starting to leak out as Sam said, and I think it's reasonable to expect the extreme growth rates that you saw that attracted those funds will normalize over the next several years. And what does that mean? It means it'll be a much better balance between growth and value as we go. Because you won't have those extreme growth rates. And because of that, what does an extreme growth rate do? It makes a stock look cheap based on current earnings, because the multiple doesn't reflect all of that growth. But when you bring in that growth rate, you bring in the multiple rates that's attached to that growth and then you've got actually competitive or more competitive stocks and sectors on the other side of the equation value. My point is we went through an extreme period, you're deflating that or you've deflated a lot of it, but you will continue to deflate it, as Sam says, leak out. And it creates a more balanced situation as we go forward between growth and value. I think that's likely to be the environment.

Sam Peters: And I think it also helped, Eliza, outside the US because it was so US-centric. She'll get a lot of that leakage too, in my opinion.

Elisa Mazen: We hope so.

Sam Peters: Yeah.

Jonathan Forsgren: Staying with you Lisa, you manage growth portfolios, can you talk to us about the changes you've seen in growth leadership in the last year and what you expect to see in the growth space in '23?

Elisa Mazen: We bracket growth into three different groups, emerging, secular and structural, which tends to be a little bit more cyclical. And it's the emerging growth side. These were the companies that came, a lot of them came up during COVID. Online retailing, online shopping, online supermarket shopping, lots of different digital forms of things that people had done more offline. And those businesses we're still trying to grow, get to scale, get more profitable, but they're not there yet. And those businesses, which again people thought this was going to be a more permanent growth rate, it really hasn't been. That particular area has really come down pretty meaningfully and likely will continue. We don't really see very much in the way of good earnings growth there. If you think of something like Shopify as an example in Canada, it had a phenomenal run, but people are just doing less spending online.

                                    The other thing is those stocks did get expensive. The way that we value them is using a discounted cash flow rate. And when you take interest rates up 500 basis points, that really compresses what they're actually worth because the terminal side of when the cash flow really grows is very far in the future. We think that those stocks will remain challenged. The good news is there isn't a lot of them overseas. There's some, certainly. and we think some of these bigger companies, the more secular growing companies, companies that can grow in all kinds of market conditions will be the ones that can continue to work. If growth gets a little bit weak organically, they also have the option to do acquisitions. And so we're actually starting to see acquisitions of small companies. Many companies have said things were too expensive, private equity bit it up, but now we're starting to see valuations normalized. We think there's lots of ways to get growth and it doesn't all have to be I think what people typically think of as growth, which is go-go growth.

Jonathan Forsgren: Scott, growth value, what are you going with in '23?

Scott Glasser: I think '23, as I think about it now is actually going to be '23 first half and '23 second half. In two six-month periods. Let's go back to the growth value. And the value is really two types of value. Value is more cyclical stocks and value is generally more defensive stocks. And what you've seen so far is it's been more the defensive stocks on the value side that have been in favor. They generally have a quality bias, they generally have more balance sheets, they're generally more resistant on the downside. Healthcare, utilities, some certain consumer stocks. And those are the ones to date that have done well. I think they will continue to do well for a period of time.

                                    And this goes back to the earnings question, what's going to happen on the other side in terms of earnings compression in 23? Because if you look at estimate revisions, you've seen the least amount of estimate revisions in that group because the earnings is more durable and that's why monies flow there, that's why they've done better. I think that that will continue for a period of time, it doesn't change just because the calendar changes. I think that will continue.

                                    There will be a period of time, maybe it's midyear where the other side of value, which is the more cyclical side that Sam's talking about, depending again on the extent of what the economy looks like, what the earnings look like will come back into favor and or will... You'll see a shift within the value pie is what I'm saying. And so if you ask me, overall for the year, I'd probably be more biased towards value than I would be growth. I run a core portfolio, had the benefit of being able to go in one direction or the other. It doesn't mean I give up on growth. And I do think there's a whole segment of the growth area or the growth universe that will continue to do well. But what are they? They are the reasonably valued, high cash flow, as Sam said, good balance sheet, where people understand what the growth is and where they're hitting it.

                                    And you're not seeing the bubble that existed in growth for the two years, I do think there's a place for both. And by the way, growth stocks tend to do fairly well in recessionary periods. Hyper growth stocks don't because their multiple gets impacted. But growth just as a general, and I'm talking about more moderate growth stocks tend to do well in that environment. So I think there's a place for both. I really do. I don't mean to play both sides of it, but I think that it's defensive on the value side leading to cyclicals and a combination of growth on the other side.

                                    There's no doubt, again, when the market makes a bottom, small caps, more risky stocks we'll have. We see it, we saw it in 2009, 2010. We saw it in 2003. What they call the... Well, I'll say it nicely, the low quality trade. There's other ways to say that. I think you'll get a spurt in those stocks. But in terms of the whole year, I think there's, as [inaudible] mentioned, more balance as we go forward in the growth versus value question, with value continuing to make incremental gains in that one or the other game that we play.

Jonathan Forsgren: Another key phrase that's been thrown around a lot in 2022 is volatility. And so Sam, starting with you, how is volatility creating opportunity in the value space?

Sam Peters: Volatility is part of our process. We're designed to take advantage of it. And a lot of people say this, but it's like the Mike Tyson quote, "When someone gets hit in the face, the plan goes out the window" basically. When volatility rises, it's painful, including for us, we don't like it. But the advantage for us is price is a lot more volatile than the underlying business values. We end up in that sweet spot where we get more things on the menu where price is more than 30% below business value, as we calculate it, those are the opportunities we see. And so we've seen more of that and that's where we take advantage of it.

                                    The other key opportunity here is, I mentioned a lot of the companies that I own have had great fundamentals and they're using it the right way. They're paying down debt. Many, almost all my [inaudible] companies have net cash balance sheets now, very high free cash flow yields. They're buying back stock, you name it. And so they're resilient to that volatility. Despite that, and I'll give you the clearest, despite the balance sheets going from bad or stress to net cash to fortress-like, the stock price volatility is still incredibly high.

                                    At some point that reduction in risk at the stock level is going to get recognized in volatility and volatility will come down. And that's another way that supports that I think that the value of value will go up, by definition the cost of capital will come down and it'll go up. Conversely, more of the speculative growth areas, that is not the core area focus for anyone at ClearBridge, we're seeing a lot of volatility there. Their cost capital is going. So we all know that volatility is transitory, meaning it bounces around. I think my volatility, value volatility comes down and goes up and it's supportive of what Scott just said where some of that cyclical value that has way lower real risk than perceived risk, they'll benefit from that tailwind.

Scott Glasser: Don't forget, volatility is a reflection of uncertainty and there's a lot of uncertainty in the market. And really there's a lot of still cash floating around that will unfortunately in some cases come out of the market and in some cases it'll find other homes. Maybe it's on the fixed-income side. We don't talk about, and that's not our area, but we talk about growth versus value and I'll talk about equities versus bonds. There's probably more money big picture that will float back towards bonds where you have real rates. Which is fine, it's a normalization. I talked about a normalization in the growth versus value dynamic. I think there's going to be a normalization in the equity versus bond dynamic as well.

                                    But volatility, as Sam said, creates opportunity. Volatility is a function of uncertainty for people that are doing, I think, work for active stock pickers. It creates opportunity. And it's really... I feel bad saying this, but I love the volatility. I thrive off the volatility. When a market is trending it's hard to add value because things just get more expensive and more expensive and you say, QI own it, I like it, I'll continue to own it." When there's volatility, you're always working on stocks that you want to own. They may come into a price finally where you get that opportunity to own them. I think to professionals, the volatility is not a bother, it's actually what we seek out and like and gives us the opportunity to add value in the process.

Jonathan Forsgren: Eliza then, could you share how volatility is creating opportunity in the growth space?

Elisa Mazen: It's creating a lot. The emerging growth area, which I had referenced earlier, that's very volatile and we think that likely continues. We're not really seeing a lot of opportunities there. A lot of those were really COVID stories. They'll probably get consolidated, but we don't really see a play there necessarily. But there are some really great businesses that got very expensive into 2021 when rates got very low and growth really soared. And that some of those companies have come down 60, 70%. Those are meaningful declines. We've been doing our homework knowing that we like these companies, trying to figure out what they're worth at much higher value, at much higher interest rate levels. And so we've been chipping away at that, walking ourselves into what we think are really good growth businesses that have deflated materially in line with big global trends.

                                    The other thing about [inaudible] is, and a lot of it is created around fear, is it gives you opportunities to sell things at very attractive prices. You can buy things cheaply, you can also sell things pretty well. There've been some trades like the energy trade, which has been a phenomenal trade. We as a growth fund don't usually see a lot of growth investors in energy, but we found some really interesting opportunities. It was really quite cheap back in 2021. The stock, they did poorly. People asked me, "Why do you own this? You're a growth investor, why do you own energy?" Because we think the energy prices are depressed and there's a place for that. But on the converse, you've had some very, very big moves. And so some of those stocks that have been really, really convenient to trim and look for other ideas.

                                    I think the point with volatility is you want to manage it, you want to make sure it doesn't upend your portfolio, you want to size your positions for risk, you don't want to get out over your skis, you want to understand where it is. And then you also want to identify interesting opportunities early so that you can take advantage of that.

Jonathan Forsgren: You brought up a risk, how has this increased volatility we've seen in '22 impacted your risk management in growth and then we'll move on to [inaudible] and-

Elisa Mazen: It hasn't changed anything at all. Our process is designed to manage risk at the front end. We have very specific levels of risk that we take in factor risk, stock specific risk, how big will let certain positions get, sectors get, et cetera. We manage that very tightly. And also individual position sizing is something that I think never gets enough attention. The size of an individual position relative to its benchmark, its active risk is very important. The risk here, the stock we think the smaller [inaudible] it should be. So we manage that very carefully. We also have a front end process designed to find ideas that have really come down and offer interesting opportunities. It's a constant iteration of selling the riskier stocks that have gotten expensive and then trying to find some cheaper stocks that have good earnings power that we think offer less risk with more upside.

Jonathan Forsgren: And have you seen your risk management strategy change over the last year?

Sam Peters: No, not really. But managing volatility, just something that we automatically do. It's obvious portfolio construction, but we look for negative correlating. If I'm going to have a highly volatile value stock that I like a lot, two things, I'm immediately looking for something that's negatively correlating. And if I can do that, it creates a risk budget for me. And a lot of times it ends up in a barbell, and Scott alluded to this, we own value defense. We'll own healthcare, which we still think is pretty reasonably valued, some of the names and we'll offset that with some of the more cyclical value names like in energy or materials, in that area. So that's the first thing and that's just the state. That's always going to be with us.

                                    The second piece of this is no permanent losses of capital. The quickest way as we've been reminded once again to lose a lot of money quickly and have a permanent capital loss is leverage. We don't take a lot of leverage. And I always am thinking real versus perceived risk. I alluded to it earlier, many of my cyclical names, many of my value names have net cash balance sheets. They really do have fortress balance sheets now. The volatility's going around, but that's a good thing because the payoff's going to be positive at some point, even with the volatility. And Eliza just touched on it too, we do have smaller... If it's highly volatile name, smaller position size. It just makes the portfolio management efficient because I don't need as much in the portfolio to express my view there. That's an advantage.

                                    And then the final thing I'll say, we look for companies that are taking advantage of the volatility, the managements that get the joke that their business value is doing this, but the price is all over the place that buy back stock intelligently. We have many companies in the portfolio literally that are shrinking their share base, buying in 10 to 20% of their company, of the company a year and they're adding net cash to the balance sheet. Free cash flows are that high. That weaponizes the compounding of intrinsic business value per share. And at some point the price will chase that intrinsic business value up, creates a very powerful dynamic for us where we can monetize volatility over time.

Jonathan Forsgren: All right. Bringing Scott back into it, 2022 has been a strong relative performance year for active management. What could drive the continued outperformance of active management in 2023?

Scott Glasser: '21 was a terrible year. I think in '21, if you use large cap managers as a proxy, maybe 15% of large cap managers outperform their respective index. '22 has been quite good. And active managers generally do better in times of volatility, in times when there's huge or big earnings dispersion. People don't know and those again, who are doing the work and are meeting with their companies and have, I think, an educated view on what's a reasonable amount of earnings to expect and what are better companies versus bad companies, tend to do better in that environment.

                                    The other thing I'd say, this year as an example, about 50, 55% of active managers are beating their benchmark. Just to put it in perspective, you went from a terrible year to a very good year. A normal year is maybe a third of active managers are beating their benchmark to give you some perspective. Again, dispersion, high earnings dispersion, which just is an indication of that there's a lot of uncertainty about what earnings will be and there's a lot of question, there's a wide range of outcomes.

                                    I think that as we go forward into '23, I do think it will be another good year because, A, I think the volatility will continue certainly again into the first half of the year and hopefully by then we have discounted a lot of that earnings compression that I talked about, '23 being. I think that will be front loaded to the first half. I also think there's another dynamic at play, which we need to consider, which made it harder for active managers to outperform, which was, at least in some of the big indices, a huge concentration of a few stocks at the top of the index. In the S%P 500, you had five stocks that represented 25, 27% of the overall index, or 26%. And there were also 1000, I think the top five or almost 40% of the [inaudible]. That huge concentration that you saw as investors piled into the same stocks and as they had to own certain stocks to compete with each other from a performance, in a performance race, you're starting to see the money leak out of that. You're starting to see those waitings go down.

                                    And while I don't think they're going back significantly, you're coming off those extreme levels, which makes it easier for a manager who has a concentrated index to buy other stocks and not just focus on those top--heavy stocks. And because of that, I think that will be helpful to active managers too. You're not focused necessarily only on the top five stocks, I'm exaggerating, but now because they have less relevance to the index, which you are trying to be, which is your benchmark, which your other peers may own, it gives you the opportunity to make more evenly weighted or other highly weighted bets as well in the portfolio. I think that dynamic is playing out. We got to an extreme and we're coming off that extreme and I think that will be helpful to active managers as well.

Jonathan Forsgren: All right, we're going to take it international here. Lisa, are you seeing advantages of a more international positioning at this moment and looking out into 2023?

Elisa Mazen: We think there's some really interesting things going on in the international market that certainly is not getting a lot of attention from investors. If you look at fund flows as an example, they've been pretty negative. A lot of money has left Europe, that's continental Europe and the UK. Japan has had negative flow. So it's been pretty bad. People have just generally been selling and so that's created very inexpensive, we think, stocks. Earnings have actually been going up because of currencies and a lot of other things. Additionally, you have higher savings rates in Europe, much higher savings rates than you see in the US, which is around four, 5%, you're talking about 17% in Europe.

                                    There's very interesting things we think that are going on in these markets that will allow these... It's an opportunity we think to get involved at inexpensive prices. We're valuation-driven, we're growth investors but our approach to getting involved in something is from finding an attractive valuation. So we think valuations are very attractive. If you look, generally Europe has always had a discount to US stocks. Typically it's been on average about 18%, we're over 30 today. Things are very cheap right now. I think it's an interesting time to get involved in European and other ideas as well.

                                    At the end of the day, the economy is not just the US, it tends to be a global economy. There have been a lot of things that have deglobalized it for a while. But I think if we get China working together, the Russia situation sorted, there's a lot of things that we think could really lift earnings and then coming from a very low base could make these things very attractive.

Jonathan Forsgren: And Sam, for an investor that's looking for or more concentrated on a domestic position, where do you see opportunities looking into 2023?

Sam Peters: It's going to echo obviously a lot of my comments and I'm keeping it simple. From a valuation standpoint, I still think we're really early with the value of value's 95th percentile. Really what I'm focused on ironically as a value guy are the fundamentals, are we going to get the fundamentals right? And whether we have a recession or whatever the outlook, I want my earnings and cash flows to hold up better in that environment. And so we look for resilience there. And that's hard, that's easier to say than do, but we're really focused on that. But what are we observing today outside of what's... I want the highest free cash flows, I want net cash balance sheets, I want the highest dividend yields, I want buybacks, I want things with great fundamentals.

                                    And then ironically also as a value guy, I want price leadership. I mentioned that value's been leading for over two years. I personally think big parts of value are going to continue to lead next year. I totally agree with Scott. The market will continue to broaden out as we get this leakage out of that concentrated market. Where can I get tailwinds from that? But capital's going to go where it's treated best. You got to get the fundamentals right.

                                    And so it is those traditional value sectors like energy, materials, parts of financials, you got to be a little choosier there because of credit risks and then value defense, parts of healthcare staples. And true, there's value opportunities emerging in growth. It's not monolithic. We're looking there too. But the beauty is I can focus on getting the fundamentals right by really resilient fundamentals and I don't have to pay for it. I'm still buying things with relative multiples that are at one two standard deviations cheap, cheapest relative multiples I've seen. If I get that, that's a tailwind. If we have a terrible recession, get the fundamentals right, make sure you're resilient.

Jonathan Forsgren: And coming back to you, Eliza, US sanctions on China and COVID as well have made investors quite reluctant to invest in China more recently. Do you think this carries on into 2023?

Elisa Mazen: I think it could carry into the first half of '23. We'll see what happens in the second half. I think there's a few things that have led up to it besides just sanctions. First, the Chinese government was actively going against their technological leadership companies, Alibaba, Tencent and so on in a pretty meaningful way and really changing the profitability profile there. That already had people a little bit concerned. They're not going after other people, they're going after their own. That was very strange and that changed how people were thinking about the Chinese market, certainly foreign investors.

                                    Then there was the audit trail for US-listed ADRs. That seems to be getting addressed. This is the PCAOB issue where the US government wants to have access to audit records. That is something they have asked for, the Chinese government has finally agreed to that. And so we will start to see that in the beginning of 2023. It happens with every annual report, whether you're on the naughty list or not, whether you get taken off. We do think that there will be, maybe not all the companies, but there will be some that will be taken off. That will relax investors a little bit more.

                                    The COVID zero policy is a huge issue, a huge issue. China has not vaccinated to the same extent that we've seen everywhere else in the world. Their elderly population is not as vaccinated. So there's some real concern in a population of 1.4 billion people and you have a lot of elderly people dying without an adequate healthcare system, this could be a problem. That is in the process of being sorted out. Now that will take some time. So we think it's going to be very, very bumpy. And then we have to watch what leadership does in terms of what is it telling its companies, it's capitalism with socialist characteristics, it's everybody should be a little bit wealthy, how does that redistribution get managed? I think it'll be challenging, but it certainly is a big market and there's potential there.

Jonathan Forsgren: Big picture, what are you recommending to investors that are interested in taking an international position in 2023?

Elisa Mazen: We're a big believer of the diversification of international. You can buy companies that you cannot necessarily get in other geographies. Certainly you have access to different talent pools, to different valuations and even interest rate structures. A market like Switzerland and Europe is very different than what you see in the United States. So valuations can be different. We think trying to find inexpensive companies that are unique with real brand value pricing, et cetera, good cash flows, that's something that you should want to do on a global basis anyway. So we're big believers in that.

                                    Demographic change, it can be a big driver of performance, market growth, et cetera. Markets like India, we have a very young population that's growing very quickly, that could grow things for a very long period of time. We think the idea of being invested internationally is something that makes sense. Everybody has to do what they're comfortable with certainly, but we think it's an attractive asset cloud, certainly.

Jonathan Forsgren: And then Sam, what are you recommending to investors interested in US positioning in 2023?

Sam Peters: Echo, similar thing, it's just focus on the fundamentals. And you don't have to pay up for great fundamentals right now, so don't overcomplicate it. Just go with great balance sheets like I said, great free cash flow yields, things that should be more resilient regardless of what happens with the economy. And again, there's a widening menu of that, but just go out there, it's great opportunity for active managers go do some work there, which is what ClearBridge does, and then position yourself accordingly.

                                    But I still have the value bias. I still think value is going to lead broadly, but there's opportunities that are coming across the market, as is always the case in bear markets. Bear markets are painful. But this is our... We've all been through this, this is not our first rodeo. We've been through several of these. We will take advantage of this as the situation evolves, but right now I'm sticking with the value side with great fundamentals, no valuation issues, buying back their own stocks, high dividend yields that you can get paid to wait protected as we go through this volatility and take advantage of it.

Scott Glasser: Maybe I could provide you with a little bit more of a macro perspective what I'm looking at. When you look at the markets and you look at, I've always believed that the fixed-income markets are very good indicators in terms of making projections for the equity markets. And currently when you look at the yield curve, the yield curve's been an excellent predictor of recessions and it's an inverted yield curve now. I'm sorry, the inverted yield curve has been an excellent predictor of recessions in the past. And we do have an inverted yield curve and really it's quite inverted, it's 2s to 10s. I believe, it's 75 basis points inverted. It has been inverted for a long time. And really the power of that indicator is one that depends on how inverted it is and how long it's been inverted. That's giving a strong signal that the US will face some type of recession.

                                    I marry that with credit spreads. Credit spreads also, which is the relationship of two credit instruments, are also excellent predictors of how much stress is in the general economic environment. And what's interesting there is you've actually got conflicting data because credit spreads have grown and are much higher than they were. And I'll give you some perspective, high yield spreads have gone from two to 600 basis points. Now they've backed off to about 500 basis points with the latest rally in the equity markets, which is showing signs of stress. But if in fact it was indicative of recessionary fears, it would be closer to 900 to a thousand. And you can go through a whole bunch of different credit spreads.

                                    And again, they show stress in the system, they're elevated significantly for where they were, but they're still much lower than they would traditionally be showing signs of recession. You've got contrary indicators there. That's good news because maybe that means it will be more minor and maybe the credit markers don't really believe that there's that much stress in the marketplace and that much downside. And it creates the scenario for a potential more mild recession. You have those two indicators, which I like to look at.

                                    I think jobless claims will be a huge factor to continue to watch, because ultimately that gets... As that gets to what the Fed is likely to do, how long they're likely to be there. And what it's also gives you obviously indications of what's going on in the general economy. So jobless claims would be something that I would also watch. Earnings revisions, I think that you've started to see a significant decline in earnings revisions. Again, using probabilities, you're probably 50% there in terms of overall market revisions coming down and expectations for next year. Those need to continue to come down. When stocks stop reacting to bad news, it gives you some sense that that bad news is already reflected in stocks.

                                    Final thing, from a sector perspective. To me, banks are really interesting. And again, it goes back to the general economic scenario. Banks are in interesting because they, in my opinion, reflect potentially one of the best barometers of credit in the system. People will now at this point with banks, net interest margins are doing really well. The balance sheets and the capital is really strong. The valuations are not high, they're pretty modest one could argue. But people are fearful of the balance sheet and credit. The extent that banks do well in the marketplace, remember I said I watch sectors, I watch what the market tells us. The extent to which banks actually perform well would give you some indication that the credit losses would maybe not be as bad as people feared in that sector would do well.

                                    The inverse is also, or the converse, the inverse is also... The opposite is also true, which is if you see that sector start to do poorly, very poorly relative to other sectors, that would make me fearful that maybe economically things would be worse than I expected. So that's a sector I'm watching just to see how it performs and to see whether that gives me any clues about the broader macro situation.

Sam Peters: Something, and Eliza and I talk about this a lot, and the whole team at ClearBridge, there are big problems to solve, but that's opportunities. We have energy transition, energy security. This isn't a small thing. We have to spend trillions of dollars on this. So there's big investments that need to be made. The market does provide solutions to this. It provides high returns on capital to solve real problems. And we're seeing this globally. These are global, massive global problems.

Over the coming market cycle, we're finding areas that are both analog, the old value side, but also digital where it has to come together to attack these problems. And so from an even longer time scale, we're seeing big opportunities in there. And we've got ourselves 30% in power in the portfolio. But that's alternative energy, that's legacy energy, that's enablers. Those are digital things. There's a huge opportunity there to take advantage that ClearBridge is really all over right now. That's not just an opportunity next year, but an opportunity over the next market cycle and potentially for decades, given how big the problem is.

Jonathan Forsgren: Well, Scott, Eliza, Sam, thank you for sharing your 2023 outlooks with us today.

Scott Glasser: Thank you.

Elisa Mazen: Thank you.

Jonathan Forsgren: And to our viewers, thank you for watching. For Asset TV, I'm Jonathan Forsgren. We'll see you next time.