MASTERCLASS: Multi-Asset

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  • 57 mins 29 secs
Markets have seen an uptick in volatility following Russia’s invasion of Ukraine, the highest inflation numbers in four decades, and uncertainty about how many times the Fed will hike interest rates - and how fast. Two experts share their advice for navigating this complicated macroeconomic and geopolitical environment.
  • Malcolm E. Polley, CFA® President and Chief Investment Officer, Stewart Capital Advisors
  • Thomas R. Wald, CFA® Chief Investment Officer Of Transamerica Asset Management, Inc.
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Jenna Dagenhart:  Welcome to this Asset TV Multi-Asset Masterclass. Markets have seen an uptick in volatility following Russia's invasion of Ukraine, the highest inflation numbers in four decades, and uncertainty about how many times the federal hike interest rates and whether it could push the economy into a recession. Joining us now to share their advice for navigating this complicated macroeconomic and geopolitical environment, we have Tom Wald, chief investment officer at Transamerica Asset Management, and Malcolm Polley, president and chief investment officer at Stewart Capital Advisors. Everyone, thank you so much for joining us. Let's start with inflation. The latest CPI reading came in at 7.9%. Tom, how's inflation impact asset allocation within multi-asset portfolios, and how should investors take that into account?

Tom Wald: Hello again, and thanks for having me today. I think what inflation does, particularly inflation at the level we've been recently experiencing, is to put everything in the context of real returns, actual returns, less the rate of inflation, which puts a lot of otherwise positive returns into negative territory. So returns on cash turns negative and returns on a lot of stocks and bonds, can also turn negative too. Inflation like what we're experiencing now, also forces the Feds end, as we are seeing right now to take short-term rates higher. For instance, currently market expectations are for somewhere in the range of about a 1% Fed funds rate by the end of July, and somewhere around one and a half to one three quarters range by year end.

Tom Wald: I think that sort of trajectory will also wind up taking the long end of the curve up too, in my judgment. We could see 10-year treasury yield of about two and a half percent per year. This in my opinion, means from an asset allocation point of view, you would want to take your fixed income allocation below benchmark durations in order to minimize interest rate risks. And from an equity standpoint, in an inflationary environment, you also want to take a hard look at the stock portions of your portfolio as well.

Tom Wald: Higher inflation and rising interest rates for the most part, I think favors value stocks over growth. This is because value stocks tend to derive a higher portion of their value from interim dividend payments over the course of time, rather than from higher earnings or cash flows further out in time, as can be the case with high-growth stocks. If you're counting on big numbers that are growth stocks four, six, eight, 10 years out, there's a higher probability the market is going to mark down that present value by a lot more during times of higher inflation, higher interest rates. Then there's also earnings risk for stocks during higher inflationary periods. If the business models of certain companies cannot pass on to these higher input costs to their customers in the form of higher-priced end products or end services, they'll be likely to see margin erosion and lower earnings and hence lower stock prices.

Tom Wald: So an inflationary environment favorite stocks within sectors or industries with pricing power such as healthcare, certain foods and beverages. Consumer products in the household [inaudible 00:03:35] segments, companies with high-brand loyalty are capable of weathering an inflationary storm like the one we are going through right now. So Jenna, with multi-asset or asset allocation portfolios, inflation sort of resets the playing field a bit. For bonds, that becomes more about reducing durations and interest rate risk, maintaining credit quality, and for stocks, it's more about weathering or riding out the storm with stocks that can at least have the storm at their back, so to speak.

Malcom Polley: Yeah, and we would agree with that, Jenna. We've been telling people really for the last six months that you want to focus on lower-duration assets, regardless of the asset class, whether it's fixed income. We've been telling people for really the last few years that durations had gotten really extended, because interest rates were so low, duration moved toward maturity, and bonds were in an environment where there was almost no way you could see positive returns. And that's really continuing, particularly as you see interest rates continuing to climb throughout this year. So across the asset classes, whether it's bonds, equities, what have you, really want to focus on asset classes and assets with lower duration.

Jenna Dagenhart: And Malcolm, with inflation rising do we need to worry about a repeat of the late 1970s and early 1980s? Looking at the most recent CPI readings, they've all been the highest since 1982.

Malcom Polley: Right. So that's what everybody's worried about come because that's the last thing we remember. But people don't really understand why we had the inflationary environment we had in the '70s and '80s. And that was really even though it was demand-driven, it was demand-driven by demographics. You had the baby boom generation, which was the largest generation in history in terms of both raw numbers of people and percentage of the total employment population. Fast forward to today, the boomers are retiring, a large number of them are retiring. And while the millennials are now the largest generation in history, they are large in terms of raw numbers, but not nearly so much in terms of percentage of the working force and the labor force.

Malcom Polley: So it's a different type of demand-driven demographic, it's one that's driven by the fact that demand largely stayed the same, we cut off supply because we closed on a global economy due to COVID. So we shut down factories, we shut down lots of things, we shut down food producers. Eggs are probably the best example. When you shut down restaurants, restaurants are the largest user of raw egg. Restaurant is not using eggs, so you don't need chickens to produce them, you kill all the chickens, you don't produce eggs and now you've got this huge lag, where you not only don't have eggs with growing demand, but you don't have chicken. So you get price increases across the food chain, whether it's eggs, chicken wings, which I now oddly enough see priced at market price in restaurants, and I used to only see that with lobster and so forth. But you're seeing that across the environment.

Malcom Polley: So yes, we're going to have inflation, but the inflation is not the longer-term demographic driven inflation that we had in the 1970s. I really think the inflation that we're facing today is much more like a post-World War II inflation, where you had a big increase of demand, you had manufacturing that was changing over from war production to goods production, and so you have this dislocation between the available supply and the demand that's always been there. And that type of inflation goes away relatively quickly. Having said that, it's not going to the level the Fed expect, which is a two, two and a half percent range, I just don't think we're going to get to that point.

Jenna Dagenhart: Turning to geopolitics, Tom, how should investors interpret the sanctions the US and Western allies have placed upon Russia from a market perspective?

Tom Wald: Well [inaudible 00:07:31] first of all, it goes without saying that the humanitarian crisis in Ukraine continues to exceed the tragic levels and our hearts go out to the Ukrainian people, as they endure and fight through this horrible invasion, and their courage is really an inspiration to the rest of the world. In terms of the sanctions themselves, what's very interesting is that up until recently, what the US and Western allies were imposing on Russia was almost entirely within the global financial system. This included the removal of Russian banks from the Society of Worldwide Interbank Financial Telecommunications or SWIFT, a prohibition on conducting business with Russia Central Bank, and an asset freeze on Russian reserves held outside the country.

Tom Wald: All that sort of got escalated up in knots in the White House with complete bipartisan support from Congress and most other political corners, announced a ban on Russian oil signifying a definitive move beyond just the financial realm. Just as a quick measuring point, Russia exported about 250 million barrels into the US in 2021, accounting for about 10% of their energy-based exports. So this is nothing to scoff at, and it sort of takes the sanctions to a new level, in my opinion.

Tom Wald: Now, know one thing to quickly keep in mind, there is no guarantee as to whether the European nations are going to follow the US lead here. The US have been counting on Russian supply for about 8% of its important oil supply. In Europe, it's more like 30%. And in particular Germany, it's close to 50%. So it's a different ballgame for them. Also, regardless of whether the US chose this particular sanction alone or not, I think there is little question of the oil ban by the US, and any potential future partnership on this will prove further inflationary. Anytime supply of this degree comes off the market for whatever reason, oil prices are likely to move higher and I think I would look for West Texas Intermediate Crude, Brent crude, to continue to march toward new highs in the months ahead.

Tom Wald: So in and of itself, expanding sanctions into the energy markets, which account for about 60% of Russia's aggregate exports, probably elongates the inflationary cycle in the US. So the sanctions are escalating both within the international financial system and now in the energy markets. Russia is going to feel real pain economically from this, but there will be sacrifices that will need to be made here in the US too. And for consumers and investors that could mean higher prices for longer at the gas pump and other energy-related costs. And of course, this is all coming at a time when both core and headline inflation is already running at 40-year highs. So of course, these sanctions are aimed at maximum financial pain upon the Russian economy. There's almost universal agreement from a geopolitical and war context that they're all the right things to do, but economically, they won't exactly create a day at the beach here in the US and other NATO nations.

Tom Wald: And Jenna, these sanctions and their expansion into Russian oil is also coming at a time when short-term economic growth in the US is slowing for at least this current first quarter. As you all know, the Fed is now tracking first quarter 2022 GDP growth at about a flat rate. So the stagflation concerns could also start to get a little louder over the next few months as well. So nobody is really arguing with the sanctions per se, financial or geo-related as they are in the greater good, of course, and it means to combat the humanitarian crisis in Ukraine. But I think we, from a market perspective, have to take into account, recognize they could create some economic and market headwinds.

Malcom Polley: I would definitely agree. The fallout from the rising energy prices, natural gas, for example, natural gas is a primary feedstock for fertilizer, particularly ammonium nitrate. Russia is one of the largest and Ukraine, are some of the largest producers of ammonium nitrate. That supply basically disappeared from the market. So now you've got prices in fertilizer going up, particularly nitrogen-based fertilizer going up, as you're entering prime planting season in the Northern Hemisphere, particularly the United States, so costs for farmers are going to rise fairly dramatically which means that their margins are probably going to be down. So their choices either apply less fertilizer, or watch margins go down to negative.

Malcom Polley: It also means that demands from other places in the globe are going to continue to be there, and you don't have access to Russian supply with all of the follow on effects that happen. Because people think about oil prices being higher just impacts what you put in your tank, but there is so much of what we use in society today, that is tied directly or indirectly to the cost of oil, that these higher prices are going to mean some pretty significant pain not only for consumers, but for producers throughout the supply chain.

Jenna Dagenhart: And what's the long-term impact do you think, Mal?

Malcom Polley: So war by itself is always inflationary. If you think about it, it's a retooling of the economy away from consumption-based goods to war production. Demand doesn't necessarily fall, plus you have increased demand for things that you don't always produce in large volumes when you're not in wartime. So war by itself is always inflationary. And I think it resets the stage a little bit and means that inflation is going to be higher for longer than people expect. I don't think we're going to see the double-digit rates for a long period of time that we have, particularly in a producer side over this last month, but we're going to see fairly significantly high inflation at a time that we're going to have basically a global tightening as the global central banks try and rein in inflation all over the place. So we're entering uncharted territory, particularly for people that are younger than myself that don't remember the longer-term higher inflation rates. And so it's going to mean that we're going to really have to think about how we invest and how we protect our assets against downside moves.

Jenna Dagenhart: And of course, there's a lot of focus right now on the war in Ukraine, as we've been discussing, and inflation here in the US and what the Fed will be doing with rates the rest of the year. But Tom, is there anything else that you see flying under the radar right now that investors should be focusing on?

Tom Wald: Yeah. And Jenna, this is going to sound a bit strange, but with all the focus on the war in Ukraine, inflation, that said, what I think really could be flying under the radar right now is COVID. COVID case trends have really come down immensely over the past couple of months. In fact, back in January, the week of January 13th to be exact, when the Omicron variant was just exploding, we hit a single day record of more than 900,000 new cases in the US and a seven-day average new case rate of 820,000 new cases a day. Now, just two months later, we're averaging about 30,000 new cases per day, that's a 96% decline in new case averages in just two months. And these cases are milder, requiring fewer hospitalizations, resulting in less fatalities than the original waves of the virus in 2020 and 2021.

Tom Wald: Another important metric right now, in my opinion, is that when you combine those people who are fully vaccinated with those who have experienced a case of COVID, and now have or will have added immunity from that, and I recognize there's an overlap between those two numbers, but still, those two numbers now add up to about 88% of the US population. I think what this all could mean, especially as these favorable trends continue into the summer months, is a good bit of pent up consumer demand, and we should in the economy. And I'm not so sure that something that everyone is focusing on right now, because it's an improving story on something that's been imposing on all of us so much for the last two years. And it's sandwiched between all these other layers of bad news, like the war in Ukraine, rising inflation, higher-interest rate, what looks to be a slowing rate of economic growth, at least in the first quarter, in large part because of the Omicron variant back in January in February, which is now pretty much burning itself out.

Tom Wald: So Jenna, I don't think anyone really knows what putting COVID into the rear-view mirror, at least in terms of it moving from pandemic to endemic status over the next year will ultimately mean for the economy in the markets. But something tells me it might be underestimated to some degree even in this environment of war, inflation, rising interest rates. So I would certainly discount what could be a very rough first quarter of US GDP growth, perhaps barely positive, as an anomaly in terms of it being widely-impacted early on by the record of Omicron numbers. And while there's a lot of pessimism and negative sentiment right now, I'm not really sure you want to bet too much against an economy about to embrace warm weather months with what could be very, very low COVID numbers. There's just a lot of people that have been in their homes too long, ready to go out and enjoy life again, even with inflation and higher interest rates.

Tom Wald: And as a related point on all this, COVID had also been cited as a major culprit of the great resignation and worker shortages contributing to global supply chain issues. People not wanting to work at various spots along the supply chain, factories, container ships, unloading docks and on the delivery lines, because of COVID. So if that eases, people perhaps even the inflationary side of the economy could get some relief from COVID going from a pandemic to endemic. So I realize this is a tailwind up against newer headwinds, and a lot of people think there's probably nothing left about COVID that everybody isn't completely aware of by now. But I do think the post-COVID economy will be stronger than most might think it to be right now, and it could create some renewed economic momentum in the second half of 2022 and in the calendar year 2023.

Malcom Polley: Well, I might tend to want to agree with Tom, I'm going to hedge that a little bit because it's pretty clear that dramatically high energy prices are really bifurcating the consumer. So the consumer that was marginal to lower end is clearly hurting. I'm hearing people with employees that are coming to them and saying, "If I can work from home, the cost of energy is making it very expensive for me to drive to work every day. Can I work from home?" We are seeing it show up in consumer goods companies that tend to sell to the lower end of the earning spectrum. They're hurting because their customers don't have the available cash flow to spend on extras anymore. A lot of it's going to funding, filling the tank with gas. I know I drive an F-150, I've seen the cost of filling my tank of my truck go from 50 bucks to 100 bucks, it's dramatically higher.

Malcom Polley: Another kind of thing is people are going to want to get out in the summer, but some of the things that we saw last summer, if you go to a lot of these amusement parks and a lot of places that you might go, a lot of their employees tend to come from overseas, whether it's eastern European countries, or what have you, I'm not seeing a return of any of those employees and this coming summer for a lot of different reasons, or in Ukraine and low ability to get those visas to bring them into the United States. And so you're still going to have a shortage. And so I think you're going to have issues with people, from a capacity standpoint, being able to go and enjoy themselves to as great an extent as they might otherwise have had this been pre-pandemic. So while I'm certainly optimistic that lower COVID numbers helps the economy for the summer and in the fall, I'm a bit concerned that some of these one-off items created, in part because of what's going on in Ukraine, might create stresses that would hold down those GDP growth numbers.

Tom Wald: Yeah, I don't disagree with that, Malcolm. And I think there are definitely some short-term dynamics that will certainly create very much a mixed bag between these two, counteracting dynamics with one another. I think what I'm what somewhat encouraged about is when you come out of a pandemic like this, which is a once in a 100-year pandemic, and then you come out of that, there's probably some longer-term momentum in the economy that might not necessarily be fully discounted at this point in time, and it certainly could get muffled, and some of the hidden by the inflation and the impacts of war and whatnot.

Tom Wald:  But similar to going all the way back 100 years of Spanish flu, when we came out of that war pandemic, and we came out... And it took a couple of years down in the early 1920s. But I just think that's a longer-term momentum factor that is caught up in a lot of very relevant short-term factors right now that could ultimately have an impact years down the line.

Jenna Dagenhart: Yeah. And, Tom, to your point about transitioning from a pandemic to an endemic, it's not like I asked you all about the flu during these multi-asset panels, it's just baked in. And it's interesting that two years ago, COVID was the first and one of the primary things we were talking about, it does seem like a lot of these other factors are taking over. But sticking with COVID for a second here, it is falling under the radar in Asia, we've seen an uptick in cases in China and some new lockdowns there. Are you at all concerned about slowing growth in China?

Tom Wald: I think that falls into where we might be saying, the entire international markets and the emerging markets opportunities as well, because I think they have to certainly work through. Even before these COVID lock downs in China, I think there was some apprehension about the China economy coming down in sort of the 5% range, going forward and what that might mean for some of their emerging market partners. And I've always been a believer that, particularly in China, in the emerging markets, whenever the rate of growth is slowing, that tends to be a challenge in those kinds of markets, not only economically but from investors market standpoint.

Tom Wald:  As well, and we're coming off this period of time where there's been strong relative outperformance in US markets, versus international and particularly among emerging markets. And as long as there continues to be challenges about growth in those markets, accelerating regardless of what the premium growth might be to the US, that just creates a challenging terrain for international and emerging markets versus the US. And that really has to get on more of a favorable trajectory for those markets really do better versus the US. So I think it's a very relevant point.

Jenna Dagenhart: And now going back to the Fed and monetary policy, Malcolm, now that the Fed has begun hiking rates with a 25 basis point increase at its March meeting, do you think that we will need to worry that they'll go too far and perhaps push the economy into a recession?

Malcom Polley: So that's the worry, right? Everybody has been trained that the Fed always goes too far, but making it more difficult is the Fed I think knew is going to be walking a tightrope, because for the first time while you had basically global easing happening in a coordinated fashion, and particularly going into the pandemic, now you've got a global tightening that's going to happen. And the Fed has not only got to raise rates to rein in inflation, but they know that you have a natural tightening coming into place from a purely Keynesian standpoint, and that you're not going to have a repeat of the five-plus trillion dollar spending orgy that the US government went through in the last couple of years. So that's going to be off the table, that by itself is a tightening.

Malcom Polley:             25:22                Plus, you've got to get the Fed to unwind its bond portfolio. So there's a lot of things that have to go on, and that's where I've been telling people, there's a difference between what you would like to see the Fed do from a rate hike perspective. I've heard some saying they'd like to see a rate hike at every Fed meeting this year, with seven rate hikes. And so I think there's a difference between what you'd like to see and what reality has, and reality in our mind might be closer to 1% percent total increases for the full year, simply because you've got these other tightening dynamics that are happening.

Malcom Polley: And if the Fed goes too fast, even though the market would like them to, that could push us more directly into a recession, than they would like to see. Although, ultimately I think the reality is, the Fed always goes too far. And so I think there's a better than even chance that we will get to a recession, it's just more of a question of when that happens. Now, I don't think it happens this year, I think if we have a recession, it's more likely that you could get into it in next year's go-around as the Fed is more into its tightening cycle.

Tom Wald: Yeah, I think it's really [inaudible 00:26:39] Malcolm, along the lines of where the market expectations have been going in terms of where rate hikes is. It happens so fast, it was just... Going into 2022, most expectations, and this is reflected in the Fed fund futures markets too, we're very two, three rate hike. That was the outer edge of where people were going. When you started, it was real hike so thank God we could get two or three rate hikes. And suddenly that changed so quickly into the new year. And for a while not too long ago, markets were discounting a 90% probability of 50 basis points at the first meeting, which is just basically reversed itself.

Tom Wald:  And I think Chairman Powell is very much in the camp of perhaps a more smoother pace of rates hikes and trying to jump in right away at a higher end. And I think you expressed a tight rope, is probably the perfect metaphor, because there is a lot of concern that the Fed was behind the curve and didn't address inflation soon enough, and they're going to be really behind the curve as the year moves on, versus so many rate hikes so fast that it might push the economy into a recession. And I think where this all shakes out in the second half of the year, it's going to be really interesting, because right now, I think expectations are that there's going to be probably seven rate hikes with 150 basis point in there, pushing us to somewhere around in the area of one and three quarters to 2% by the end of the year. And if that's not going to be the case, you risk markets worrying too much about inflation, getting the adverse impact there. So that's what certainly cut out for them in the months ahead.

Malcom Polley: No, I think the biggest risk in this whole process, and Fed Chair Powell stepped into this a couple of weeks ago, and in his effort to be fully transparent, said, "I will support a 25 basis point rate hike in the face of the market expecting 50." And I think the problem that we have is in this effort to become increasingly transparent, is you end up painting yourself into a corner. And that even if we need to have 50 basis point hike, that if they continually forecast or continually lead in saying, "I'm going to support X." They aren't going to be able to do anything different, and in fact, create a bigger problem by being that transparent than if they hedge their bets a little bit.

Tom Wald: And they've been [inaudible 00:29:27] and also says if they make abrupt change in policy of that nature, they're also then face a credibility issue, that they were similar to the proclamation that inflation was likely transitory, and here we are a year later where that certainly is not the case. So those are all things. And the markets continuous day-to-day focus on the Fed in this area, it's so different than in previous Fed areas when you get a lot of focus right around the Fed meetings and in-between the meetings. Markets came to their own interpretations, and now that the Fed watching angle the market, the volatility that creates for investors is also far different than it's been years past.

Malcom Polley: Yeah, because the reality is, the Fed always follows. The market does a great job of forecasting where the Fed needs to be from a rate perspective. Yes, they might overshoot one way or the other, but the reality is the Fed always follows what the market is doing.

Jenna Dagenhart: And circling back to your point, Mal, about there's always a fear that the Fed is going to go too far. But tying in what Tom said about credibility issues, what about the fear that the Fed has not gone far enough that the economy is over here, and interest rates are over here? What would you say to that?

Malcom Polley: Well, I think that there is certainly that danger, which gets back to the comment that Fed Chair Powell has tried to be overly transparent in explaining to the market exactly what he's going to do when. The danger is that he does a quick about-face. And the best example I can give you of that is, Chair Powell was extremely dovish before it was determined that he was going to be re-nominated for another term. And once that nomination came out, complete about-face, and he became a hawk. So that's the danger, that he says, "This is what I'm going to do, this is what I'm going to do. Oh, by the way, I made a mistake." And changes his mind. As Tom said, the Fed loses credibility in that environment.

Malcom Polley: I think the concern becomes in that being overly transparent, the Fed, in fact, does lose credibility, because then they have to do what they say they're doing, even if the market is telling them they need to do something completely different. So we're in a strange environment that we're in today. As I talked to some of us that have been in this business a long time, some of us almost pined for the olden days, so when you watch the money supply growth data that came out every Friday, and the Fed didn't tell you what they were going to do. Now, I don't expect that we're going to get to that point, but somewhere in between would be nice, and that you'd give the Fed a little bit of wiggle room to make up if they need to, without creating undue problems on the market.

Tom Wald: Yeah, those are great points, Malcolm. And I think another aspect here is you've got this whole other area of Fed policy, which is if they're through the balance sheet, now they're going to handle that going forward. And they've gotten this astronomical nearly $9 trillion level the balance sheet. And you start to think about the long end of the curve, and what the Fed does with the balance sheet is going to probably impact the longer end of the curve market. Obviously, much more so than just straight interest rate policy, in terms of rate hikes. And it's really the longer end of the curve that impacts a lot of the business world in terms of what corporate loans key off of, then also mortgage rates. And that also has a much greater impact on the durations of asset classes that we were talking about a few moments ago.

Tom Wald:  And that's a whole area that both the Fed and the investors, it's uncharted waters, right? You can't go to a textbook or Google and say, "Oh, the last time the Fed had a $9 trillion balance sheet, what did they do?" It's an entirely different scenario that they're under. And there's so much focus on how many and how large the rate hikes are going to be the short end of the curve, where in the end, what to do with the balance sheet, and how quickly they reduce that and how they reduce that in terms of letting bombs way off, or actually being in the open market at some point. That could actually have as much or greater impact on the entire interest rate environment over the next year, than just whether it's going to be 25 or 50 basis points the next meeting.

Malcom Polley: Most definitely, you get the mortgage market, it's geared more to the 10-year bond. If you can keep 10-year rates low, you can keep affordability somewhat low. But housing prices have risen so fast throughout the country that affordability is a real issue. So if the 10-year bond rises too rapidly, all of a sudden you make things completely unaffordable for anybody to buy a house, and the housing market then turns on its head and you create a bigger problem. So it's a tightrope walk.

Tom Wald: Yeah.

Jenna Dagenhart: Yeah, it's interesting. I read a Redfin article the other day that said more than 8% of homes in the US are now more than a million dollars, so just reinforcing what you're saying there. But let's talk a little bit more about valuations here, Tom. With stocks having already experienced double-digit declines in the first quarter of the year, are there any identifiable catalysts that you can see potentially reversing the trend and equity returns between now and the end of the year?

Tom Wald: Great question, yeah. And my answer here is probably going to sound a little counterintuitive, but given the unique market environment we're in right now, it makes sense, at least to me. So since January, the S&P 500 has had a pretty fierce sell-off, putting it well into correct territory. And since last November, NASDAQ is off even worse and fully into the bear market zone. And I think much of this sell-off is attributable to worsening expectations over that time really on a variety of fronts such as expectations the war in Ukraine will rage on, indefinitely we'll reach an unfavorable conclusion inflation as we've talked about, expectations that inflation will remain hot throughout the end of this year and into the next, those market expectations of seven rate hikes between now and year end. Expectations that the economy is at a high risk of falling into recession and corporate earnings growth is also expected to decline from where the most current estimates stand right now. Now, that's a pretty bad litany of changing expectations, that for the most part, none of which were really on the table about six months ago.

Tom Wald: So Jenna, unlike most market tabulous, in which you are waiting for, or anticipating good things happening, I would flip that upside down a bit and say, every time we get some confirmation that one of these bad things doesn't happen, it would be good for stocks. So in looking at the list that I just mentioned, I think the Fed is going to probably wind up raising rates, six or seven times. I think that is a high probability that they get to a one half to one three quarters Fed funds rate by the end of the yeah. They are behind the curve and inflation, and they probably have no choice but to normalize rates and not so normal timeframe. I think inflation stays hot, at least in the summer months, and the recent ban on Russian oil will exacerbate inflation longer. Although I think there's still a decent chance that mitigates to some extent, by the end of the year.

Tom Wald: And I would have to call the war in Ukraine a wild card for the markets for lack of a better term. Unfortunately, I really don't think anyone can say with any degree of confidence, how it will turn out, but I think it's important to realize any peaceful resolution here, regardless of how distant that might seem at times, will very likely result in strong upside moving stocks. That's just something we should keep in mind.

Tom Wald: Now, here's where I think it could get interesting for stocks. Right now, as Malcolm mentioned a moment ago, I'm not seeing a high probability of recession this year. This first war will probably just stagnant growth, but remember, we lived through the Omicron variant these past three months or so. And with the worst of COVID fading into the rear-view mirror, I think we could see a good bit of pent up by consumer demand in the second half of 2022. And given that, I'm not really so sure corporate earnings growth comes down a lot from current estimates. And given that mix of outcomes at current price levels, and perhaps an improving 2023 in terms of economic growth and inflation, stocks could start to discount that sometime in the second half of this year.

Tom Wald: Now what's also interesting to take into account just an extra minute or so, here is to hone in on one of those criteria be corporate earnings. Right now the official estimate for S&P 500 net operating earning is down to year 2022 as aggregated by FactSet agency, is at about 9% growth for 2022 estimated growth for calendar year 2023 for S&P net operating earnings. Now, as I mentioned a moment ago, there seems to be an overriding assumption that those earnings estimates will be coming down soon, probably in the next month or two as companies report first quarter earnings results.

Tom Wald: However, if they don't, if over this next reporting season, these estimates for calendar year 2022 and calendar year 2023 remain intact, I think you could see stocks rarely based on the estimates that coming down against the backdrop of more attractive stock valuations. So another way to look at all this, Jenna, is if corporate earnings just stay where they are right now, that could wind up being very good for stocks. And the same might be said about not going into a recession here this year, and inflation potentially not remaining as hot into 2023. So higher stock prices given where stocks have fallen over the last couple months, as the saying goes, may not be all about good things happening, it might be about bad things not happening as strange as that might sound.

Malcom Polley: The other thing that might play into this is the fact that indices are market cap-weighted, and so a large part of the performance over the last few years has been led by the largest of the large, those who certainly come back a bit. And so you really could have a situation where it's the, say, the bottom 75% or the bottom 50% in terms of market capitalization, have actually pretty good performance, because they lagged so badly over the last couple of years, and performance from a corporate perspective really looks pretty good. So they fall into that realm of being low-duration assets, more or less, low-duration assets should outperform higher-duration assets.

Malcom Polley: Couple that with the fact that energy stocks have been leading, and energy stocks should continue to do pretty well, because their balance sheets are in pretty good shape by and large. They're generating cash, by and large, and are not going bananas on their CAPEX. So they learn from the last couple of cycles of problems. So I think you got some situations where you've got a good portion of stocks that do very well, even though the broader benchmarks might not do quite so well.

Tom Wald: That's a great point. And I think what that also ties into is, the whole concept if you're in a long-term secular bull market and multi-year, multi-decade bull market, in order for that bull market to continue, there's got to be changes in leadership. And the change in leadership occurs at inflection points when there is maximum worry in the markets and typically, market corrections that proved to be a market corrections with longer-term bull markets. In order to come out of those corrections continue the secular trend, you need that change in leadership that you just mentioned right now, both in terms of sector market cap and style. And that could tie into a lot of dynamics that you just mentioned. And I think that's what you really need to be keeping an eye on during these types of highly-volatile market corrections as to whether or not extended a real change in the secular trend, or one that just creates an opportunity for a change in leadership in different types of stocks and asset classes and a continuing longer-term secular bull market.

Jenna Dagenhart: And Mal, do you think that the market is perhaps overreacted to tech stocks? Looking at the NASDAQ, it's been flooding with bear market territory.

Malcom Polley: You've got tech stocks, and you've got tech stocks. So you've got the FANG stocks that clearly in our mind, overvalued, dramatically overvalued. And you've got a large swath of the technology universe that did not enjoy the same run-up in price that the FANG stocks did. Still generating relatively large amounts of cash, their earnings are not going to change that dramatically. You've got opportunities for, particularly in a smaller component of tech, you've got opportunities for M&A as they generate cash, and there's a lot of cash on the sidelines looking for deals. So I think certain technology stocks will do fairly well as long as you, I don't want say ignore, but don't hunt for your tech exposure amongst the largest names. Look for smaller names that have niche products that still generate pretty good levels of cash flow that are expected to continue to see cash flow grow.

Malcom Polley: Because the reality is, with more jobs and unemployed people in the market today, and that continuing to be the case, the only way you're going to be able to close that gap is through automation and through creating more efficiencies, and that really drives a tech spin. So I would look for companies that can generate cash flow, that have earnings, that are expected to have earnings that are going to play into this increasing and increased need for automation.

Jenna Dagenhart: Tom, how about your thoughts on the fixed income markets right now and what may have recently changed in terms of opportunities for bond investors?

Tom Wald: Yeah, that's also a really interesting area just over the past couple of months. Because over these past few years, we've talked a lot about the quest for yield and how difficult it's been for investors to find income. In fact, just a few months ago, when the year began, we were looking at close to multi-year lows on both absolute yields for stocks and on credit spreads. And the challenges that pose to bond investors, both in terms of achieving income and the level of interest rate risk they were taking on to do that. In fact, if we were to turn the clock back about six months, the end of the third quarter of 2021, all of a sudden, even six months ago, which is not all that long ago, you had a five-year US treasury bond trading at a yield pretty much right at an even 1%. And if you were to produce high-yield that back then with credit spreads just north of 3%, you were getting yield of about 4% of high yield bonds. 4% had become the new definition of yield.

Tom Wald: And investment grade bonds were trading at credit spreads of less than 1% of about 90 basis points. So their yield was coming out at less than 2%. So fast forward to today, with everything that's been going on the inflationary and changes in Fed policy front, and the five-year bond yield, has now more than doubled. And spreads on investment grade bonds, are at about 150 basis points and high-yield credit spreads, or at about 400 basis points, about 100 basis points higher than where they were six months ago or so. So you have a 1% increase in rates themselves and between investment grade and high yield between a half percent and a 4% increase in the spreads off of those rates.

Tom Wald: Now, obviously, this has been a reaction to inflation, and short-term economic growth concerns. But if you're in the camp, that this quarter is more of an aberration in terms of GDP trajectory, and inflation peaks later in the year, and therefore not materially impacting the overall credit environment, you could be now locking in investment grade yields more than a percent and a half higher, and more than 2% higher than just six months ago. And for income and balance investors, that's quite meaningful. Again, like stocks, this is not to say that rates couldn't move higher and spreads to one further, but even so the low yield story on fixed income is starting to fade a bit. And again, if you believe the longer-term inflation economic growth story of this first quarter, is not representative where it might be a year or two from now. These yields are starting to look at a pretty decent, in my opinion, coming out of where we've been over the past two years or so.

Malcom Polley: I think in fixed income, the interesting story from my perspective is that, it used to be the story in fixed income was cash flow, cash flow represented more than half of your return. But for the last couple of years, it's been flipped. Cash flows represented much less than half of your return. And in fact, I think capital, the change in the price of the bond to the capital appreciation or depreciation has now accounted for close to three quarters of your return. And I don't know how that changes, even if interest rates move dramatically. I think in our mind, what's changed from a bond perspective is that we've been in a secular bull market in bonds for the last 40 years. We've gone from, call it 10%, down to basically zero, and you really can't get below that. And now in our mind, we're going to be in a secular bear market in bonds, which nobody in the market today has ever experienced. Because the last time we had one of those, it ended in 1980.

Malcom Polley: And what we understand in that environment is, fixed income investments rather than averaging 10%, 8%, a year as they have over the last 40 years, the last time we had a secular bear market in bonds averaged about two and a half percent dramatic differences. And so your focus really needs to be play defense, don't lose money, try and focus and stay shorter. So while yes, I would certainly pick up on take advantage of picking up higher yields and better spreads, paying attention on what your duration is, and paying attention on downside risk, is supremely important, with durations as high as they are.

Tom Wald: Yeah, I would absolutely agree. And one area that I've been taking a look at historically over the past year is duration to yield ratios and where those have been over the past few decades. And what I did just as sort of an exercise in magnitude is I went look back when the 10-year bond peaked in the summer of 1981, I think at about 15 and three quarters. And looked at the duration a yield and how much you lost in terms of interest rate payments on 100 basis point made in rates. So back then, the summer 1981, very few people [inaudible 00:49:51] could remember is that if you incurred 100 basis point increase in rates at that time, you lost about couple quarters of interest payments, which is certainly a manageable type impact today, or I should say, when we probably picked the loan center the rates last summer, when the 10-year bond went on the way down to about just north of 50 basis points.

Tom Wald: If you got 100 basis point increase, you lost four years of interest rate payments. So the whole notion of it, you have to look at, what is the... As for the defensive aspect of making sure that in trying to gain some incremental income, you're not losing sight of the big picture of how much you can do from principle standpoint, is absolutely imperative. And I think with this expansion of rates yield highlights, again, what we talked about earlier, and the necessity to stay below benchmark durations that at the lower side of the yield curve so to sort of make sure that you don't incur those magnitudes of capital loss and trying to create income.

Jenna Dagenhart: So, building off of that, it seems like there's so much more volatility in terms of price appreciation, depreciation with bonds, and there's just so many variable, so many wildcards, but different asset classes right now. So Mal, is there anywhere for investors to hang out and try to avoid any of the current volatility other than low-returning cash? Should people just sit on the sidelines? Where do they go?

Malcom Polley: Sitting on the sidelines means you're definitely going to lose money on a real basis, come back to Tom's point that real returns become incredibly important. Cash is improving, but you're still roughly zero. So cash isn't a real good opportunity. So what we have done is we've looked at a couple of different areas, and we did a lot of work on trying to find asset classes that might perform better in a rising-rate environment, assuming as we do that we're in a secular rising interest rate environment. Knowing that your best offense in case in that type of world, or it's kind of defense, don't lose money. By definition, if you don't lose money, you increase your average return.

Malcom Polley: So can we find asset classes that help you to not do that? That really took us into the world of hedge funds, and we think there are certain types of hedge strategies that make sense, that are relatively low volatility. And we would really focus on low-volatility hedge strategies that give you a modest amount of return but limited downside. The downside to this process is that the data that you have available doesn't go back very far. So if you look at mean variance optimizers that are used, excuse me, in most asset allocation processes today, it uses historic data. Unfortunately, hedge assets really have only existed from a database perspective for the last 20 or 30 years. You've never seen a secular change in rates in that environment.

Malcom Polley: So the best you can hope for is hope that when you had a cyclical bear market in bonds, it will look similar to what would happen as you get a longer-term bear market and bonds. And in that environment, there are certain hedged strategies like merger arbitrage that don't give you exciting returns, but also don't lose money. And those are the types of investments that we would focus on by building probably an allocation in a portfolio to not just one specific product, but to a number of products that allow you to hedge the various risks that are inherent in any strategy.

Jenna Dagenhart:  And Tom, turning to you, what would be your parting words of advice for investors as they look to further navigate this market environment that's getting more complicated by the day? We're seeing market sentiment turning pretty negative lately, too.

Tom Wald: Yeah, so Jenna, I'll probably leave investors maybe two big picture parting messages of how to perhaps best withstand these next several months, which could certainly continue to be bumpy at times. The first would be brace for more volatility, all those potentially negative outcomes the markets are wrestling with right now. War in Ukraine, inflation, higher interest rates, fears of declining economic growth and corporate earnings, they're all going to play out to some extent, between now and the end of the year. And as they do, this will probably not be a market for those with either faint hearts or short-time horizons.

Tom Wald: The second which I talked about the beginning of the COVID pandemic, which is sort of coming back now, is for investors to focus more on long-term entry points rather than trying to call a market bottom. Trying to call market bottom in an environment with this much short-term volatility and uncertainty, and emotion is kind of a fool's errand in my opinion. I think the more constructive route is to look for entry points, and the stock and credit markets that based on some set of identifiable criteria, realistically can imply a stronger probability of recognizing better than average long-term returns. And I would say in various areas, we're now quite look likely at some of those entry points.

Malcom Polley: Yeah, I would agree. It's always good to have some dry powder and pay attention to where the prices of your current assets are, harvest gains, don't be afraid to take some gains and take some money off the table. So you've got dry powder to put into all of these entry points that are created by volatility. People look at volatility as a bad thing. I've never looked at volatility as a bad thing, because it gives you the opportunity to buy things at prices you've not been able to access for quite some time.

Tom Wald: That's right. And there can be such a focus, especially in the financial media about, where's the bottom on the market? I'm calling the bottom right now. And I just think, when your short-term volatility and emotion, that can always be lower. But the key is, like you said, to identify where the volatility has created opportunities, and whether that puts the odds in your favor over a longer period of time, if that particular strategy or asset class can outperform over a multi-year period. And that's really where I think investors should be focusing.

Jenna Dagenhart: Well Mal and Tom, thank you both so much for joining us, always great to have you.

Malcom Polley: Thanks, Jenna.

Tom Wald:  Thank you.

Jenna Dagenhart: And thank you for watching this Multi-Asset Masterclass. Once again, I was joined by Tom Wald, chief investment officer at Transamerica Asset Management, and Malcolm Polley, president and chief investment officer at Steward Capital Advisors. I'm Jenna Dragonheart with Asset TV.

 

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