MASTERCLASS: Mid Year Outlook - July 2021

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  • 01 hr 06 mins 56 secs
On the heels of record highs in the stock market and historic stimulus measures, investors will be keeping a close eye on inflation as we head into the second half of 2021. Three experts share how they are finding income opportunities and navigating the current macroeconomic landscape.

  • Brian Smedley, Chief Economist and Head of Macroeconomic and Investment Research - Guggenheim Partners
  • Jay Gragnani, Head of Research and Client Engagement - NASDAQ
  • Tom Wald, CIO - Transamerica


Jenna Dagenhart: Welcome to this Asset TV Mid-Year Outlook Master Class. On the heels of record highs in the stock market and historic stimulus measures, investors will be keeping a close eye on inflation as the economy continues to recover from the coronavirus pandemic. Joining us now to share their perspectives, we have Tom Wald, Chief Investment Officer at TransAmerica Asset Management, Brian Smedley, Chief Economist and Head of Macroeconomic and Investment Research at Guggenheim Partners, and Jay Gragnani, head of Research and Client Engagement at Nasdaq Dorsey Wright.

Jenna Dagenhart: Everyone, thank you so much for joining us and great to have you with us. Thankfully the world is in a very different place than one year ago when we were hosting this same panel. Tom, starting with you, how are gauging the current market environment?

Tom Wald: Hello, Jenna, and thanks for having me on today. It's very interesting because we are of course in the business of looking forward, but I think occasionally you have to stop and take a look back on all that has transpired in a fairly short period of time. And I think now is one of those times. If you look back to when we started this year, the year of 2021, the predominant investment concerns were COVID-19 trends which were reaching absolutely horrifying levels and what that might mean for the economic growth for the year ahead. I think most forecasts for a first quarter GDP were barely positive and calendar year growth was expected to be in the three to four percent range. Corporate earnings, where consensus estimates were about in line with pre-virus 2019 profits, and it was very questionable as to whether Congress would in fact be able to pass more fiscal stimulus. That's where we were back in January.

Tom Wald: Fast forward six months to today, the vaccines pretty much have COVID on the run. Most annual GDP estimates are for north of seven percent growth this year. The S&P 500 operating earnings are now looking to blow through pre-pandemic records. And in March, Congress passed another 1.9 trillion in new fiscal stimulus, but in the process, a new set of investor concerns have emerged in large part and ironically in my opinion, driven by the very resolution of last year's concerns at the top of that list and because of what looks to be like a sharp V-shaped recovery in the economy, we now have as pretty much the top investor concern being higher inflation, at least on a transient basis, and this is something the markets really have not worried much about in the past decade.

Tom Wald: The fast-paced recovery has also resulted in a higher long-term interest rates. While the 10-year yield is down some in recent months, it's about a full percent higher than where it was last summer and also, with the passage of the $1.9 trillion stimulus package back in March, it now looks like any future infrastructure spending legislation might have to be passed with a higher federal income tax attached to it, which could have market and economic implications. And of course, with the big move stocks have had since the depths of last year, we could see a short-term market correction.

Tom Wald: Jenna, I've always been a believer that markets climb a wall of worry, so to speak, and since March of last year, we have climbed perhaps the biggest wall in history, all things considered and our reward for that is a new wall. But that's what markets do; they hand out very few hall passes as the saying goes. It's often about the obstacles ahead. However, I think if we are able to climb this new wall in the next year or so, which is certainly not as daunting as last year's wall, markets can continue to move higher.

Jenna Dagenhart: Building off of that, Brian, what's keeping investors up at night that perhaps wasn't even on their radars one year ago or at the beginning of this year?

Brian Smedley: Sure. I would agree with a lot of what Tom said, and I think the key concern right now is that policy makers might be overdoing it in terms of adding too much fiscal stimulus, too accommodative a monetary policy stance. And so tied up in that mix is the reality that there are a host of supply side constraints in the global economy that are limiting our ability to grow in the short-term, but also putting upward pressure on prices, particularly for sectors that are maybe facing supply chain issues like semiconductors, but also sectors in the service area that are specific to COVID and the recovery process, like used car rentals, hotels, airfares, et cetera.

Brian Smedley: You've got this combination of factors that's leading to, as Tom said, a concern among investors that we may see a persistent high level of inflation in the future that might require the Fed to scale back policy accommodations sooner than they've been advertising since they first started aggressively easing in the face of this pandemic.

Jenna Dagenhart: Jay, as US markets continue to hit new highs, do you think the strength of stocks can continue into the second half of the year?

Jay Gragnani: Jenna, I think that's a big question on many investors’ minds these days especially given the mood that we've seen off of the March 2020 low. We have basically gone straight up, really, without much in the way of a correction. You've seen certain pockets and certain areas of the market see what would be considered to be a correction, but really, if you look at the broad of the market, you haven't seen really a meaningful pullback so far and so that's the biggest question I think today. But the market has been very, very resilient over the past, call it 16 months now, and it has continued to push onto new highs, and it's done so with a lot of breath. And what I mean, so when we look at the market, at Dorsey Wright, we look at the markets through the lens of technical analysis and paint very, very particular attention to how those trends are moving for the market by looking at the price performance. And so, when we look across the board, it's not too surprising if I look out today and say the vast majority, as a matter of fact, all of the major market indexes are trading in positive trends today as all of the major market indexes are very close to, if not, pushing to new highs.

Jay Gragnani: But when I say the breath of the market has been very strong, I'll mention a couple of things. One, we continue to see positive returns so far this year across all broad economic sectors. Some have certainly done better than others, but all of the broad economic sectors are in positive territory so far this year. That's an important thing. The second thing that I'll mention is that if we look across the board and we look at just all individual stocks, say for instance, the S&P 500. Last year, in 2020, there was a handful of stocks at the very top end of the S&P 500 that were accounting for a vast majority of gains, if not all of the gains in the S&P and what was happening in much of 2020 is the bulk of the performance was coming from a handful of large mega-cap growth [inaudible 00:07:26]. That has really been a different dynamic that we've seen so far this year, really, over the course of the end of the last quarter of 2020 through the first half of 2021 where you've seen a lot of stocks participating to the extent that, if we look out today as of June of 2021, a vast majority of stocks are in positive trends.

Jay Gragnani: As a matter of fact, 86% of stocks on the S&P 500 are in positive trends as of June 2021 and that is a very strong number. Historically, just to give that a little bit of context, Jenna, a number or reading above 50% is a positive, healthy sign for the market environment from a technical perspective. And really, all that means to us is that a vast majority are above 50%, a majority of stocks are in positive trends. Today, we're up in the 80s and we would consider that to be still a very strong sign, a very healthy sign. The only way stocks stay in positive trends is continue to move higher in absolute prices. That's exactly what we've seen so, from that perspective, when we look out today, we look out through the rest of the year and into the second half of 2021, certainly there's a lot of positive backdrops from a technical perspective as it relates to US equity specifically.

Jenna Dagenhart: Yeah, Tom, you mentioned the potential for correction earlier and given these positive trends across the board and the strong first half, are you concerned about a correction?

Tom Wald: Yes. I think there is a fairly high probability we see a short-term correction of 10% or more in major stock indexes sometime in the next year or so, but I believe this will be more a result of human nature and history more so than market fundamentals and valuations. It's only human nature for investors to take profits at some point and with the S&P 500 having posted total returns of better than 90% since late March of last year, I don't think too many investors will probably feel all that foolish about hooking some of those gains at this point in time. And I think history also serves as a bit of a guide here.

Tom Wald: Since 1950, the S&P 500 has had 36 corrections of more than 10%, translating to an average of about once every two years. Moreover, the average time between the end of those corrections and the beginning of new ones has been about 18 months and the median time is about a year. During those past seventy years, there's only been four times the S&P has doubled without a correction so we're bumping up on that criteria too. But with all that said, Jenna, if we do see a 10% or greater pullback in this environment, I would say there's a strong possibility it will prove to be a buying opportunity given the current market environment of stronger than previously expected economic and corporate earnings growth combined with the current low-rate environment. I believe a correction is likely in the next several months or so, but in my opinion, those investing for the long haul, probably shouldn't sweat it too much.

Jenna Dagenhart: A lot of positive trends across the board, as you mentioned, Jay. But energy has been the best performing broad sector this year. What's the driving force behind that?

Jay Gragnani: There's a couple of things when you look at energy. Obviously as the reopening economic has happened, the demand on energy has just surged. Crude oil prices, raw energy prices have gone higher, which has benefited a lot of the bottom lines of a lot of energy companies and that is very, very different than what we've seen in years past. The energy sector has been a sector that has perpetually been out of favor for a number of years. As a matter of fact, if you look prior to this year, six out of the past seven years, energy has been the worst performing economic sector of the market. This year, very, very different story as you're seeing energy stocks in the broad energy sector move higher and by far outpacing all of the other sectors of the market.

Jay Gragnani: What's interesting about the energy sector is, as weak as it's been over the past number of years, it's not a big component of a lot of major market averages. So, the S&P 500 accounts for about less than three percent of that index is accounting for energy stocks. So, when you get these big, outsized returns in a sector like energy, you don't necessarily see that float through in the same way to the S&P 500. That's something like the technology sector would with technology being about 25% of the S&P 500. Nonetheless, there's a lot of strength within the energy name across the board. Last year was all about a lot of the clean energy names, this year we've seen with raw energy prices, crude oil, natural gas, and the likes continuing to do well. We've seen a lot of the strength move from some of those cleaner energy to some of the more integrated oil companies out there so we're seeing that strength across the energy sector really for the first time in quite some time.

Jay Gragnani: While technology, we mention that the big growth sector that was a driver of returns in the market over the course of the past few years, is actually at this point through the first half of the year, underperforming the S&P 500 for the first time in quite some time. That's going to be an important dynamic that we're watching as we move through this market. As we move through the middle part of any year is right smack in the middle of what is typically and historically a seasonally weak period in the market. The seasonally weak period being that period from May through the end of October. We'll continue to see, to Tom's point, about seeing a pullback, a correction, it's certainly not unlikely to see that during those seasonally weak periods in the market, but when you look at the market today, you mentioned energy, Jenna, as being a leadership area of the market and that is really new with a lot of the value oriented sectors, energy, financials, and the likes, really taking the leadership reins over a lot of the growth sectors through the first half of 2021.

Jenna Dagenhart: And moving onto the macro economic landscape, Brian, how would you describe the discrepancy between GDP growth and job growth? Could we be closer to full employment than we think?

Brian Smedley: Thanks, Jenna. Last year was just an extraordinary decline in both the level of GDP as well as unemployment. Both fell from peak to trough in the span of about six weeks, by roughly 16% unannualized when COVID first hit. We've been tracking the recovery in GDP, of course, and jobs since that time and GDP has made, essentially, a full recovery back to the level that existed at the peak. We actually have monthly GDP data that we monitor and as of April, we were right about in line with the February 2020 peak in terms of real GDP and we anticipate that for the full year on a Q4 over Q4 basis, we'll probably see real GDP in the US close to eight percent year over year so pretty phenomenal recovery.

Brian Smedley: The same has not been true of the labor market. While we've come a long way from the depths in the early phases of the COVID outbreak, the labor market still has quite a distance to travel to return to full employment. So, looking on a [inaudible 00:14:50] basis, as I mentioned earlier, the monthly data on the level of household employment shows, or the measure of employment from the household survey, shows that in May, employment was still down four and a half percent relative to its prior peak versus GDP that had essentially fully recovered.

Brian Smedley: How do we explain that discrepancy, as you asked, that has a lot to do with gains and productivity. We have, over the course of the pandemic, out of necessity, pulled forward a lot of labor-saving technologies and business practices, et cetera, in order to operate in a social distance environment and as a lot of workers, particularly service sector, person-to-person contact workers have been displaced. And so, the result is, the productivity gain that has allowed the output side of the economy to recover quite well whereas the labor market still is falling far short of most definitions of full employment.

Brian Smedley: There's a lot of questions too about the potential for policies such as the extended unemployment benefits to maybe suppress individuals return to the workplace. Of course, we're still in the midst of the pandemic. We still have new cases and new deaths ongoing and not everybody has been vaccinated, of course, so there is the potential that the ongoing pandemic is also limiting the return to the job market of some of these people who have been displaced. But we do think as we move through the year and the extended unemployment benefits expire or are ended early in the case of some states, that we will see an increase on the supply side of the labor market with more people coming to look for jobs and reconnecting with old jobs or finding new jobs increasingly and that is going to lead to pretty strong job growth over the course of the next six to 12 months.

Jenna Dagenhart: Tom, how are you interpreting GDP growth in corporate earnings?

Tom Wald: It's really interesting, Jenna. Last year about this time a lot of people were talking a lot about the expected economic [inaudible 00:17:01] and they were throwing around a lot of different letters of the alphabet. Would we have a V-shaped recovery, an L-shape, a U-shape, W-shape.

Jenna Dagenhart: Nike swoosh, we were inventing [crosstalk 00:17:15]

Tom Wald: I was going to say they were also inventing new shapes, the K shape, [inaudible 00:17:22] shape. The jury, I think, is pretty much ruling right now and for both GDP and corporate earnings, it's looking like they are soundly, as Brian mentioned a moment ago, on the verge right now of officially completing a V-shaped recovery for both of those metrics by year end. In other words, it now looks soundly like we'll see both GDP and S&P 500 operating earnings grow substantially of the suppressed 2020 levels and really blow through their 2019 pre-pandemic record levels. And in my opinion, this will take us out of recovery and into an expansionary mode.

Tom Wald: For GDP, and this is very similar to what Brian just mentioned, we're expecting north of seven percent growth for calendar year 2021 and if we exceed seven percent, that would be the highest annualized rate of calendar year GDP growth since 1984. And if we hit eight percent for the year, which is certainly not out of the question by any means, that would be the highest annualized growth since 1951, so we could be looking at a big year in terms of annualized economic growth. And as we speak, the Atlanta Fed is tracking second quarter GDP better than 10% annualized so if that's achieved, that would put us at about eight percent the first half of the year following the 6.4% first quarter we had. So, eight percent for the year is certainly not a stretch, in my opinion.

Tom Wald: We think the momentum on economic growth is being driven by a few catalysts. The vaccines have really brightened the light and shortened the tunnel, so to speak, on reopening’s for the second half of the year. And we should see a lot of consumer activity as public venues reopen and social distancing constraints are lifted. And there is $5 trillion of fiscal stimulus floating through the system and short-term interest rates remain close to zero. And there is massive amounts of consumer spending. There are estimates out there that there could be as much as few trillion dollars in aggregate sitting in savings accounts higher than where we were at this point last year. Remember, a lot of people that received stimulus checks are going back to work or have stayed in a work-from-home environment and have had no real avenue to spend money and all of this could add up to a record amount of pent-up demand to be unleashed to the economy the second half of the year.

Tom Wald: On corporate profits, for the S&P 500 operating earnings, we're conservatively looking at about $195 for calendar year 2021, which would be up north of 35% in 2020 and up about 20% from the pre-COVID 2019 record so again, big numbers here too. And one more very important point in our opinion, if you look back over the past four post-recession recoveries dating back to 1981, at the point in time that corporate earnings surpass their pre-recession highs, stocks have done extremely well in terms of three year returns thereafter. So, when you put all this together along with what is very likely to be still a zero, close to a zero short-term interest rate environment for the next couple of years, we think the equity markets could still be moving higher at this time last year even with the potential correction along the way, we have a year-end 2020 price target on the S&P 500 of 4600 and a one-year price target of 4800.

Jenna Dagenhart: Certainly a lot of big numbers being thrown around so thank you for putting them into context for us. Jay, looking at the strength of the dollar. The dollar has been weak over the past year but shown some signs of life recently. Why should investors pay attention to the trend of the US dollar?

Jay Gragnani: You're absolutely right and the US dollar is something I don't think gets a lot of publicity, especially in the environment we've been in in the past 18 months. There's frankly just been a lot of other things out there that people have been far more interested in, what's going on with everything from the COVID pandemic to recent market events as crypto-currencies and everything else going on. But the US dollar, historically, has played a very important role in a few areas and namely within the international equity market as well as within the commodity market. And when the dollar is weak, historically when we've seen a weak dollar, which we've seen for the better part of the past year now, that has provided a tailwind or a positive backdrop for specifically commodities and that's exactly what we've seen over the course of the past year as well as international equity.

Jay Gragnani: And so you mentioned the recent surge in the US dollar on a near-term basis, we haven't seen that long-term down trend broken. The US dollar is still in the negative trend longer term, but that's going to be very important to watch. If we see that break higher, if we see the US dollar break through some of that resistance on the upside and get through some of that near-term resistance, that could provide a headwind for the first time in well over a year for things like international equities and commodities. And you think about some of those areas, and you just think about the tremendous growth that a lot of those commodities have seen over the past couple of years, it's all come while that dollar has been weak. And if you look back historically, that's not uncommon to see across the board, crude oil, and lumber prices alike.

Jay Gragnani: Now, with that said, while a weak dollar is historically positive for non-US stocks. A weak dollar or a strong dollar is not necessarily bad for US stocks. As a matter of fact, the US stock market hasn't really seen any correlation to movements in the US dollar and so I think that's important to keep in mind because while a negative dollar is good for non-US, it doesn't mean a positive dollar is bad for the US. And so, as we alluded to earlier, still we see a lot of strength within the US equity market, but I think it's interesting and I think it'll be important to continue to watch the dollar. And as the dollar has fallen, you've seen people that are getting paid, getting those unemployment checks, by definition, their dollars are buying less goods as prices are going up and so you're starting to certainly see that shine through into some of the inflation numbers that we're starting to see out there. But the dollar is certainly something that we're keeping a close eye on right now and we'll see if it's able to break through and move into a positive trend heading into the back half of the year.

Jenna Dagenhart: Tom, it's been so long since inflation has been viewed as a real market risk. I think two years ago I was doing a story about turkey disinflation on Thanksgiving, a very different time. But how have you accessed inflation this past year and what should investors be watching for in the months ahead?

Tom Wald: Over these past few months, we've seen inflation shoot up both monthly and year over year rates the likes of which we have not seen in decades. For example, on the latest CPI report for May, headline inflation rose more than five percent annualized, the highest increase since August of 2008. And of course, CPI rose 3.8%, its highest year over year jump since May of 92. So, this is a big breakthrough particularly in light of the fact that over the past decade, inflation has averaged less than two percent annually. Now, this upshot of inflation has set off some pretty spirited debates pertaining to how much of these new price increases are coming from the "base of facts" versus last year's suppressed levels of inflation during the historic economic detraction and whether or not these higher levels of inflation we're seeing right now will turn out to be transitory and somewhat temporary in nature or reflect a longer-term shift in the inflationary environment and might be more permanent.

Tom Wald: In terms of the base effects, the argument is that inflation was so low last year, for instance, in May 2020 it annualized just .1%, one of the lowest months on record so that makes the rate of change in May 2021 appear a lot higher in isolation. The second larger and more complicated debate is whether or not the current rise in inflation is transitory in nature as the Fed has stated they believe it will be, or if it will be more permanent perhaps for getting a cycle in the longer-term cycle. We are prone to agree with the transitory perspective in large part due not only to the base effect’s comparison, but also because a large portion of the price increases in the recent inflation reports seem to be heavily concentrated in a handful of business areas most sensitive to their reopening’s such as used cars, car rentals, hotels, airfares, and restaurants.

Tom Wald: Under this scenario, once the economy begins to normalize toward pre-pandemic type growth rates the supplier bottlenecks in these more sensitive subsets in the economy will probably begin to subside and then structural factors previously keeping inflation low for the past 10 years or so such as age demographics in the workforce and globalization in the supply chains and technology based distribution channels could once again revert inflation closer to the Fed's long-term target of two percent perhaps by the early months of 2022. What I do want to emphasize for the remainder of 2021 monthly inflation reports are likely to keep running hot and when all is said and done, we are sort of in uncharted waters here. We've simply never had such a sharp recovery off such a steep economic contraction in such a short time frame so investors will need to watch these inflation trends very closely.

Jenna Dagenhart: Building up to our conversation around monetary policy, Brian, what's your view on rates and inflation?

Brian Smedley: Thanks, Jenna. I think I'll start with our view on inflation and there I think our view shares a lot in common with what Tom just laid out. There are two very powerful transitory factors at work in the inflation data today. One, as Tom mentioned, is the base effects which are pushing year over year inflation sharply higher. That's essentially a mirage. That doesn't mean that you will see that repeated in the future. In fact, the higher inflation is right now, the lower it's going to be or the more challenging the base effects will be in particular, a year from now. And so, as we move through 2022, we'll be looking back at very elevated inflation prints around this reopening process and that's going to push down all else equal the year over year comparison as we move into the coming year.

Brian Smedley: So that's the first factor, the second factor, as he also noted, is these relatively small components of the core inflation basket that, the items he mentioned have comprised only five or six percent of the core CPI index and those are very COVID-sensitive, and those COVID-sensitive sectors have driven a substantial majority of the price increases and decreases over the course of this pandemic period. That also, we think, is going to subside partly because as the reopening process plays out, you will see a supply response and more people coming back to work, settling into a pre-pandemic trend, we think, for prices across those categories which is going to mean that their influence on the core inflation data is going to wane and potentially turn into a drag as we move further into the future.

Brian Smedley: I also share the view that the dominant factor driving inflation is these longer term really secular trends, elevated debt, challenging demographics in terms of weak population and labor force growth, competition that is intensified through technology and globalization that limits the ability of producers to pass on price increases to end consumers. These things are all alive and well. If anything, we've increased our use of technology in the COVID era in a way that I think enhances price competition and price discovery and I think will limit on an ongoing basis the ability of inflation to move much higher on a sustained basis.

Brian Smedley: The other key component, and this ties into the interest rate outlook is, inflation expectations. There is various measures of inflation expectations we monitor, there is survey data, surveys of consumers. There are surveys of professional economists that the Fed conducts called the Survey of Professional Forecasters. There's also, of course, market measures that we get either from CPI swaps or from the tips market, the tips corner of the treasury market. All of those have shown I think some very interesting patterns over the course of the last decade. When you go back to 2014, the last time the Fed tapered their asset purchases to wind down QE3, that was the beginning of a period where inflation expectations by all of these measures moved meaningfully lower than they had been over the previous 10- or 20-year period. That persisted up until the COVID pandemic and so a year, 18 months ago, the Fed's primary concern was if inflation expectations were too low and risked being stuck, as you mentioned with regard to turkey prices, getting stuck at a very low level which would hamper the Fed's ability to conduct monetary policy and achieve its stated objective from Congress.

Brian Smedley: What's happened over the course of the last year, clearly the success of the vaccines and the reopening process associated with that, as well as a really aggressive fiscal and monetary policy response have all come together to revive inflation expectations and have pushed us back up to levels that are broadly consistent with where we were in early 2014. Now, I think, we can talk more about the Fed, but I think the Fed is very pleased to see inflation expectations in line with the current levels that are more consistent with them succeeding in their goal of achieving an average inflation rate of two percent over time. The issue is that they don't want to see inflation expectations continue to ramp higher at the current pace. And I think that's, bringing it back to the yield curve and our view on rates, we expect the Fed is going to remain very patient, notwithstanding the shift in the dot plot in the June policy meeting.

Brian Smedley: We think that the core leadership of the committee at the Board of Governors in particular is going to want to keep the pedal to the metal, keep short-term rates at zero and continue to allow time for as full and complete a labor market recovery as we can possibly achieve, and I think that's going to take quite a few years. In the meantime, the inflation data have certainly caught the Fed's attention and again, they are watching inflation expectations that have moved sharply higher. So, I think what they wanted to do was tap the brakes on the reflation narrative and that seems to have been the very early days after that meeting, that seems to have been successful. We'll see how it goes from here.

Brian Smedley: But to tie it back to our views on treasury yields and the yield curve, we expect the front end to stay at zero for quite some time. We think the belly of the yield curve sort of a two-to-seven-year part of the curve is pricing in a premature Fed rate lift off, the start of the hiking cycle and too many hikes over the course of the next few years. We think the Fed would prefer to be late in starting to hike and ultimately maybe go a little farther to slow the economy rather than risk hiking prematurely and doing too much too soon. And to tie back into what Jay mentioned with the commodities and the tie-in to the dollar, the experience of 2015, 2016 is very vivid in our memories at Guggenheim as a firm that invests. We have significant corporate credit and structured credit investment capabilities, it's good to remember that back in 2015, the Fed had started hiking rates late in that year, had lifted off of zero and pretty quickly had to do a complete U-turn, pause the hiking cycle because the dollar was appreciating sharply, the rest of the global economy wasn't ready for the Fed to embark on a steady hiking cycle.

Brian Smedley: The dollar appreciated, commodity prices fell, inflation expectations fell to a level that the Fed was uncomfortable with and ultimately, they had to pause the hiking cycle for a year until conditions changed. And so, I think this is also something that we have to bear in mind, if the Fed were to proceed to hike rates as soon as the bond mark is pricing in, which we have liftoff now priced at the early beginning of 2023. We think that if the Fed proceeded on that path that's priced into the market and hiked a few times by the end of 2023, you'd probably see a replay where you'd see financial conditions tighten abruptly with the dollar appreciating, prices falling, credit spreads widening, equities selling off and that would, I think, limit the Fed's ability to have a more complete or fulsome hiking cycle, which is what they prefer to see.

Tom Wald: I'll just add, I agree with a lot of what Brian just said. In terms of where we're seeing Fed policy, I think we're of the thought, we're not going to see any form of paper prior to at least 2022. We're not anticipating a rate hike at least into 2023. And when we look at the last, the June Fed meeting, I think a couple of points are important. One is that there is a lot of talk about the dot plot, but Chairman Powell was quick to say that dots should be viewed with big grains of salt and that dot plots are really a snapshot of views at a point in time rather than a real forecasting mechanism so I really wouldn't have read too much into that following the meeting.

Tom Wald: And I think another really important point along the lines of what Brian just said is that the Fed has used the term substantial further progress in the economy a lot in recent months and we think that's really a single focus, that's jobs. And that pertains to the 7.6 millions jobs that are still missing versus peak employment in February 2020. When the Fed thinks about their legacy and history, I think that really could weigh a lot on their minds in terms of if they were to hike rates too soon when a lot of these jobs are still missing from the economy. I think that's something that is going to play a role in the timing of when the first-rate hike is going to show up, which I think won't be for at least a few more years, at least probably about two more years.

Jay Gragnani: Jenna, I'll add too, I think Tom started off at the beginning of our session talking about the market liked to climb a wall of worry and I love that, agree with that. The market doesn't like uncertainty and when we go out forward, we're talking about inflation, the Fed June meeting already had them moving up the timeline to increase rates then you saw very short-term volatility, things seem to revert back to normal, but we'll continue to see how the month over month numbers come out because if you go out in the economy, inflation is real. When you go into a restaurant and see lines now in a restaurant, you see restaurants packed, not only are they paying more in raw input materials for the food that they are serving, but they are having to limit the service because they can't get enough new workers to come back into the jobs. Inflation is real for the average consumer out there.

Jay Gragnani: The auto industry was mentioned a little while ago. You drive down past any car dealership, at least around where I am in Richmond, Virginia, lots are at a very fraction of what their inventory is as a result of supply chain disconnection and the semiconductor manufacturing concerns there and we don't know when that's going to end and so we could continue to see these month over month numbers move on. And to the extent that there is information that comes into the market that is surprising to the market, the market doesn't like uncertainty. The market likes a bit of uncertainty but what is true now is we've certainly are in the midst of seeing inflation, and what we also know about inflation is that historically, unless it just goes rampant and crazy, is that stocks tend to be a pretty good hedge against inflation. When you're investing in stocks for all the reasons that I think were mentioned here today, there's lots of positive reaction, lots of positive news for stocks from a technical perspective as well as other perspectives. But that is one thing too to keep in mind is that historically stocks do provide a pretty good hedge against inflation, something that we are absolutely seeing in the midst, seeing inflationary numbers pick up here today.

Jenna Dagenhart: And Fed, J. Powell, has reiterated that he is not concerned about 1970s style inflation, but the Central Bank did move up its timeline for raising rates as you highlighted with the June meeting dot plot. Brian, as someone with experience working at the New York Fed, it would be great to hear your thoughts on the Fed's reaction function.

Brian Smedley: Certainly. Thanks, Jenna. I think one thing that maybe if I could share one insight that may not be obvious to people who haven't worked inside the Federal Reserve System in some capacity, it's that you're dealing with a whole host of personalities and opinions. The Fed is not a monolithic entity that has one consensus opinion. It's far from that. And we see that in the speeches and the diversity of opinions that are shared in the public, but it's certainly the case behind the scenes and I think when I look at the totality of Fed communications and in particular the June FOMC dot plot, it's clear that there is a growing split among the FOMC participants. And by participants, I mean those who are voters and non-voters, so everyone around the table is part of the discussion. And there is clearly a contingent led by some of the Fed presidents in the regional banks that are uncomfortable with what they see in terms of the recent inflation data, the fiscal impulse, the reopening process and what that may mean for inflation down the road. Those folks are inclined to start hiking rates, some of them, in 2022, and many of them in 2023.

Brian Smedley: There is another camp that I think is led by the core leadership of the Federal Reserve, that's the Chair, the Vice Chair, a few others who I think are very, very important to watch. And if I had to give some advice to investors, I would say, put 90 plus percent of, 90, 95% weight on what the Chair says and distribute the rest, the remaining portion equally among all the other Fed officials. And I think the Chair and his key lieutenants around the table are going to ultimately be the deciders on the path of policy and I think Chair Powell and anybody who potentially replaces him, of course, Powell's term ends in February. The Vice Chair Clarida, his term ends in January, Vice Chair, Randall Quarles, a former mentor of mine, his term ends in October as Vice Chair of Supervision. There is an opportunity for the Biden administration to replace some of those folks if they choose to.

Brian Smedley: But I think that the core leadership of the Board of Governors is firmly committed to seeing this new framework through and that new framework involves a new definition of full employment, which is, as they say, broader based and inclusive. So, a three and a half percent unemployment rate may or may not constitute full employment if we see ongoing structural disparities in labor market outcomes across racial and gender and socioeconomic and education groups. This Fed is very focused on addressing those shortfalls of full employment among a broad swath of indicators that traditionally the Fed hasn't been as focused on. I think there is a long way to go to achieve full employment and they have identified a three-part test to start hiking rates.

Brian Smedley: One is that full employment has been achieved by their definition. Second is that inflation has risen to two percent, and third, that inflation is expected to overshoot at two percent to some degree for some period of time. And that's not an either-or condition, that's an all of the above condition and I think the establishing of those conditions has been led by, again, the leadership of the Board of Governors and I think they'll stick to it. That means to me that even though we're hearing a lot of talk by some Fed officials in a more [inaudible 00:43:37] direction that the Fed may need to get going and remove accommodation. I think others are going to slow walk the process. And I think for investors, what that means is that as I look through the shape of the yield curve, as I mentioned earlier, I think the front end of a yield curve is pricing in too soon a start of the Fed hiking process and our forecast is actually that the Fed may not get going until the beginning of 2025 so we're several years away from where we are today, a couple of years behind where the market is pricing liftoff.

Brian Smedley: But then ultimately the Fed will probably raise rates to a level of around two percent, which we call the terminal rate at the end of the next hiking cycle. And so, we've seen an interesting reaction to the FOMC meeting, which is the market took at face value this risk that the Fed might actually start hiking rates a little sooner based on a dot plot and so that has led to a selloff in the front end of the yield curve and the belly led by the five-year tenor of the treasury curve. Meanwhile, the long end of the yield curve, 10s, 20s, 30s, actually those yields declined, and the yield curve flattened fairly substantially.

Brian Smedley: I think this is very instructive for investors because it shows, if we're correct and the Fed's decision, or some officials decision to pencil in more rate hikes in the next couple of years is due to their concerns over the potential risk of inflation overshooting. This tells you that there's a limit to how high long-term treasury yields can go. If you go back earlier in 2021, one of the key concerns, and it certainly hit the tech sector of the stock market pretty hard, as well as the long end of the bond market, was that the Fed would just allow inflation to run higher and higher and that we would have to ultimately price in much higher long-term interest rates. And if anything, I think that what we learned at the June FOMC meeting is that the Fed may very well try to thread the needle. They can keep policy very accommodative in real time, but by hanging out in the future this idea that eventually we will normalize and yes, we're committed to this new framework, which is very [inaudible 00:45:50], but no, we're not going to be recklessly irresponsible.

Brian Smedley: That's the best of both worlds for investors and I think it's very bullish news at the end of the day for the stock market, but it's also very favorable for the bond market because we have so much priced in. We've got, again, an early liftoff price done in our estimation, which limits the ability of treasury yields to rise too much from where we are today.

Jenna Dagenhart: Jay, would you agree, good news for the stock market potentially?

Jay Gragnani: Sure, yeah. As we talked about, the stock market's typically good as an inflation hedge and if you see inflation that is really, if you start to see a meaningful amount of inflation, you're certainly going to see that benefit the bond borrowers, the issuers of the debt versus the bond buyers out there in the marketplace. But if you see low interest rates, certainly investors are going to continue to look for yield in some places and if interest rates continue to stay low, as a lot of people expect them to or at least believe them to be, then investors are going to look elsewhere. A lot of places that investors are going to look outside of traditional bond markets for income is they are going to turn to the stock market for yield and so that certainly has the potential to benefit another potential benefit for the stock market going forward, absolutely.

Jenna Dagenhart: And Brian, pivoting the fiscal policy here, what could be the impact of infrastructure spending?

Brian Smedley: I think that's the last big question or the last big fiscal to-do on the Biden team's agenda as we prepare or look down the road to the mid-term elections later in 2022 and I think so far, the Biden team has been focused on trying to make some headway on a bipartisan basis to get buy-in on their infrastructure plan. They haven't made a lot of progress, I'm not sure that they genuinely expected to get a bipartisan deal done, but they are giving it their best effort and I think that's the smart thing to do politically. Ultimately, if we do get a deal passed and I would say it's slightly higher probability, it's better than even odds that we will see a watered-down infrastructure deal passed later this year.

Brian Smedley: I think it's going to take place through reconciliation with the democrat-only support, but if we do get that, what's our expected impact on growth? The spending is going to be spread out for several years. It's not going to have an immediate impact on the growth trajectory, but it will be modestly positive boost, maybe several tenths per year in the next several years as that infrastructure spend is deployed. The other thing though is the take-back on the revenue side. And that's a big question now. There is push-back certainly among republicans, but also among moderate democrats. The democrats have a razor thin majority in both the Senate and the House, and you have moderate House members who say on the one hand, my district isn't going to support tax increases, or we need to water this down. Then you have others who say, we need to reinstate the SALT deduction or the state and local tax deduction, increase that at a minimum or do away with the cap of $10,000.

Brian Smedley: This makes the politics very difficult and the vote counting very difficult. I mention that just to say that there is a high degree of uncertainty as to whether the tax increases will actually go forward as proposed. But to sum it all up, I think assuming we do get an infrastructure bill of a trillion, maybe $2 trillion later this year, we would expect that to be positive for growth over the next three-to-five-year period and we see that positive growth impulse from the spending side outweighing any concerns we would have from the drag of higher corporate or personal income taxes.

Jenna Dagenhart: Tom, what are the implications for investors given the Biden administration's proposed tax changes?

Tom Wald: Jenna, along the lines of what Brian just mentioned, I think the prospect of higher federal taxes potentially coming is directly linked to funding sources, the infrastructure spending legislation is going to be, in my opinion, one of the really big dramas during the second half of 2021 to potentially play out both in terms of economic and political terms. The potential tax provisions and the proposed legislation that's been drafted by the White House coincide pretty closely to what the Biden tax plan was as communicated originally last summer during his presidential campaign and they include things like raising the marginal tax rate on corporations from 21% to somewhere between 25 to 28%, instituting a 15% minimum corporate book income tax on certain corporations, raising the maximum individual tax rate from 37 to 39.6% and raising the maximum capital gains tax rate on individuals from 24 to 43% at the $1 million threshold and also eliminating the step-up in basis tax treatment on inherited assets also at the $1 million threshold so these are nothing to sneeze at in my opinion.

Tom Wald: Basically they repeal a lot of the Trump tax cuts from 2017. And I think there could be an adverse reaction in the market if they were to be passed in their entirety. Specifically, there are some estimates out there that these tax hikes, again, in their entirety and in isolation, could have an impact on GDP growth in the one to two percent negatively on annualized basis and of course going from a 21% corporate tax rate to a 25% or a 28% rate for corporations will, by definition, negatively impact the corporate earnings. So, I think the impact of a capital gains tax rate on individuals with higher incomes could be mitigated somewhat by the fact that about 75% or so of US stock ownership is currently in tax deferred retirement plans exempt from that sort of treatment, so I think the market might be a little less concerned about that.

Tom Wald: And I think what could be flying under the radar here a little bit is the step-up in basis on [inaudible 00:52:35] assets which could have reverberations going out several years because it could definitely affect some of the transfer of wealth expectations, but there is a lot to play out here. Most importantly, whether or not a bipartisan compromise can be met or if democrats will take the spending legislation and the tax hikes to a straight majority vote in budget reconciliation, which of course would require the support of a couple of moderates, specifically Joe Manchin and Krysten Sinema who have worked on the bipartisan legislation so far. But if these tax increases are passed close to their entirety, I think they could have a negative incremental in fact on the economy and the markets all else being equal and of course, that would have to be netted out against everything else that's still [inaudible 00:53:27] talked about today. There's a lot more to follow here and it will be an important market development in my opinion to keep an eye on as the year moves ahead.

Jenna Dagenhart: And we've covered a lot of ground so far, but before we wrap up this panel discussion, I want to talk a little bit more about where you're finding specific opportunities, Jay, alternative assets like many commodities have performed well this year. Is this an area that you're focused on?

Jay Gragnani: Jenna, it is, and we talked a little bit about that earlier as it relates specifically to some of the energy related commodities. Obviously, the commodities market in general is one of those areas where you see very much a supply demand battle play out in earnest. And very much you're seeing within the energy space specifically not only new demand for energy, but then you saw earlier in the year a crimp on the supply given everything that happened in Texas earlier in the year which cut down supply in there. But you continue to see crude oil prices, new demand for it as the economy is reopening, as more and more demand is on not only crude oil, gasoline, jet fuel, and the likes as people are beginning to take vacations again, beginning to travel again, beginning to open up and just consume a lot more energy in the market. There is absolutely more pent-up demand there for energy and you're seeing that continue to play out in crude oil moving back up to multi-year highs above 70, 72, $73 a barrel, nowhere near the all-time highs that we saw crude oil back in 2008 when it hit, touched a $147 a barrel briefly back in June of 2008.

Jay Gragnani: We're basically half of those values now, nonetheless, continuing to move higher there. But you think about alternative investments in commodities specifically, it's not relegated to energy. Lumber prices, look at lumber prices from June of 2020 to June of 2021 are basically doubled over the course of that time period. You look at cooper, is up over 60% over that same time period and you look at a lot of other commodities that are out there and the vast majority of the commodity markets have moved higher so very similar to what we discussed earlier on with the US equity market in that there's a lot of broad strength across the US equities market. We continue to see a lot of broad strength across the commodity market as there's just continually, seemingly more demand for a lot of these raw materials, a lot of these inputs across the board whether it's energies, whether it's some of the base metals and industrial metals, even with some of the precious metals which had lagged, a lot of the commodities, but seeing some demand from there.

Jay Gragnani: So when we look out at the market and think about constructing portfolios and putting together portfolios, one of the biggest things that we keep in mind is the ranking of all of those asset classes and one of the most popular areas of our subscription research tool is a tool that we call Dolly, and we see US equities is number one. US equities, for a lot of reasons, continues to be number one. But sitting right there in the second spot is commodities and, again, because of the broad-based strength that we're seeing there because we continue to see prices generally positive trends, the backdrop of a negative US dollar has certainly benefited that, and we continue to see the US dollar in a negative trend today. And so, for all of those reasons, commodities, alternative investments are certainly an area that we're paying attention to, that we're focused on today.

Jay Gragnani: And then also throw in the inflation, the commodities, as the inflation moves higher, commodities is another area that can provide a hedge against inflation. So, I guess that's a long way of saying, Jenna, yes, it's absolutely an area that we're focused on today, an area that can be accessed and utilized within portfolio construction.

Jenna Dagenhart: And Brian, turning to you, where are you finding value within the credit space?

Brian Smedley: If you go back over the course of the last year, we've seen a tremendous rally in credit markets that has pushed corporate credit spreads down to pretty tight levels compared to their history. We think that's entirely justified. Our positioning has evolved significantly at Guggenheim Investments over the course of the last 18 months. We came into 2020 being very cautious on credit. Number one, we had a view that we were getting close to the end of the business cycle and nearing a recession. But number two, we saw credit spreads being fairly tight relative to their history and we felt like there wasn't a lot of value to be had in maintaining a benchmark or an overweight credit position so we had pared back credit exposure quite a bit, increased the duration exposure in early 2020 and we did a U-turn in March of 2020 adding significantly to our corporate credit exposure in particular where we're able to buy meaningful size to flip our credit exposure from an underweight to a significant overweight. And we have watched as credit spreads have tightened in the last year plus.

Brian Smedley: We think there is still scope for some credit spread tightening, but there's limited room for corporates to outperform on a total return basis so we're looking at other avenues. At Guggenheim, we have deep expertise not only in corporate credit, but also structured credit, an area that traditionally requires a deeper level of due diligence, a great deal of legal legwork. We have a very big legal team, an analyst team that analyses structured credit deals, everything from CLOs to whole business ABS to aircraft lease deals, et cetera and a bunch of things that are kind of off the beaten path. I think there we can find some very interesting structures where not only are you offered better spreads for a given rating, and we've seen spreads in that segment have tightened, but not to the extent that they have in the corporate credit market, which is normal. You tend to see a lag in structured credit so that's the first opportunity. But also, a lot of these segments of structured credit offer shorter weighted average maturities and less interest rate exposure.

Brian Smedley: So if you're mindful or if you're focused on maintaining more limited duration exposure, then structured credit is an interesting place to do it in and you're paid to be invested there, again, if you can understand structure and do the legwork and again, that's where we spend a lot of time. Final point I would make is in the leveraged loan market. Leveraged loans are not as tight in terms of their spread valuations as we see in high yield bond markets. So, if you're looking at something that has the unlimited interest rate risk because of a floating coupon that generally floats off [inaudible 01:00:25] in the future and something that has a decent yield pickup, then leveraged loans, we're seeing relative value in that space as well.

Jenna Dagenhart: Tom, what about you? Where are you finding income without taking on too much interest rate risk?

Tom Wald: Yeah, great question and I think one of the most fascinating developments in the market recovery since last March has been just how much credit spreads have narrowed since prior to the COVID crisis. As Brian was mentioning a moment ago, since last March, high yield credit spreads have tightened versus [inaudible 01:01:03] maturity treasuries from just under 11% to now slightly above 3% and investment grade spreads have fallen from a high of 4% to about 90 basis points so high yield is actually trading at noticeably lower credit spreads than where investment grade was at the height of last year's crisis.

Tom Wald: The good news for investors is if you bought high yield or investment grade last year any time between say the spring and the fall, you've done fantastic. But if you're looking for yield or total return of the bond markets right now, it's a pretty tough proposition. You have low yields by historical standards, some threat of continued [inaudible 01:01:47] in the yield curve and it's really hard in my case to make the case that credit spreads can really narrow much more from where they are right now so it's "happy to get your coupon" as a total return environment for traditional investment grade and high yield accommodation portfolios. And on top of all that, we've had 40 years of declining long-term interest rates which have also served to increase bond durations of high interest rate risks.

Tom Wald: One way we see for investors to achieve yield and mitigate interest rates would be to perhaps combine your traditional investment grade and high yield bond portfolio with some less traditional income-oriented asset classes such as [inaudible 01:02:33] bonds, emerging market debt, even preferred stocks, and high dividend common stocks, which can help to create higher yields and lower overall durations with less interest rate risks. We think this sort of a mix could be a good diversifier and or perhaps a satellite approach to traditional high yield investment grade portfolios. No question, it's a very tough environment right now for yield oriented investors and there are no easy answers, but perhaps some outside the box portfolio construction could be advantageous.

Jenna Dagenhart: It really is amazing how much things have changed and how quickly, I'm afraid we only have time for one more question. Jay, where do see opportunities overseas?

Jay Gragnani: Overseas, it's interesting throughout the whole discussion I'm not sure we talked much about overseas markets, but there's a lot of interesting things happening over there, not only on the equity side, but on the bond side as well. And to Tom's point earlier, emerging market bonds, for investors looking to help increase yield in fixed income portfolios, certainly emerging market bonds is one area to do so. And really, fixed income, we talk a lot about sectors of the equity market, you don't tend to talk about sectors of the bond market, but there's a lot of opportunity there for investors willing to look out at different sectors of the bond market because historically you can see some pretty big spreads just trailing 12 months ending June of 2021, there's a pretty big difference between when you look at convertible bonds versus US treasuries. There's a difference between being up well over 40% on a total return basis versus being down 10% so I think some of those opportunities that Tom mentioned are great ideas to look at, emerging market bonds in the overseas market certainly compelling area of the bond market that's going to provide some higher yield.

Jay Gragnani: Within the equity market though, there's a number of opportunities and I would say just kind of broadly speaking, big picture speaking, we would look at favoring emerging market equities slightly over that of developed market equities. We've talked a lot about US market indexes moving to new all-time highs, very quietly though have a lot of the broad based emerging and developed equity indices have also recently within the past, June of 2021, move into new all-time highs. The market has rallied, the equity market has rallied, but it really has been that global markets rallied. If I had to pinpoint a couple of areas that are identifying strengths specifically within the emerging markets space geographically, I would say Asia with Taiwan and China and that's coming with specifically as it relates to China coming out with some news at the end of the second quarter of 2021 lifting restrictions on the number of kids that families can have now and that's going to continue to provide a backdrop towards the emerging market consumer which is just such a big, big global trend that's happening in the marketplace right now. And so those are going to be a couple of areas to watch.

Jay Gragnani: I'll say recently as of about June of 2021, some of the up-and-coming area of emerging markets, we're looking at Latin America and Brazil with some interesting opportunities there.

Jenna Dagenhart: I wish we had two hours, but I'm afraid we only had one and we better leave it there. Thank you so much for joining us everyone.

Brian Smedley: Thanks for having us.

Tom Wald: Thank you, Jenna.

Jay Gragnani: Thank you. That was great. It was a pleasure everybody.

Jenna Dagenhart: Thank you for watching this Mid-Year Outlook Master Class. I was joined by Tom Wald, Chief Investment Officer at TransAmerica Asset Management, Brian Smedley, Chief Economist and Head of Macroeconomics and Investment Research at Guggenheim Partners, and Jay Gragnani, Head of Research and Client Engagement at Nasdaq Dorsey Wright. I'm Jenna Dagenhart with Asset TV.


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