Inflation, the Fed, Midterms & Portfolios: What’s Ahead for Markets
Tony Roth, Chief Investment Officer, Wilmington Trust Investment Advisors
Luke Tilley, Chief Economist, Wilmington Trust Investment Advisors
Meghan Shue, Head of Investment Strategy, Wilmington Trust Investment Advisors
OPERATOR: Thank you for joining today’s webinar – Inflation, the Fed, Midterms, and Portfolios: What’s Ahead for Markets? – from Wilmington Trust, a member of the M&T Bank family. Before we get started, I'd like to mention that this webinar is being recorded and you are currently in a listen-only mode. We will be answering your questions at the end of today’s webinar, and you may submit a question or comment at any time by using the Q&A panel located on the lower right-hand side of your screen. To open the Q&A panel, click on the question mark icon. Type your questions into the text field at the bottom, then click on submit to all. Please do not send privately to speakers.
At this time, we will begin today’s webinar, Inflation, the Fed, Midterms, and Portfolios: What’s Ahead for Markets? Allow me to introduce our host for today’s call, Tony Roth, Chief Investment Officer of Wilmington Trust. Tony, the floor is yours.
TONY ROTH: Thank you very much, Amanda. Good morning, everybody. Thank you for joining our conversation today. We felt that this was a good time to have a conversation around the markets and what’s happening in the economy and how we’re positioning in portfolios. We haven’t spoken to the group in several months and a lot’s happened in terms of the inflation trajectory, as well as geopolitical stresses, and of course how the markets are reacting. And lastly, we have a, an election coming up in November and we wanted to be able to address how we’re seeing that potentially impacting markets as well.
So, we are going to start with a conversation around inflation, since inflation, of course, has been the dominant theme that continues to buffet markets. The place to start, I think, is with the agenda, if we move forward, Luke, to the next slide and thank you very much. And let me introduce my two colleagues, who you probably all know, Luke Tilley, our Chief Economist, and Meghan Shue, our head of Investment Strategy. So, the three of us will be handling the conversation today and you can send questions into the box on the bottom right-hand corner of the screen during the course of the conversation and we will take questions at the end.
So, the takeaways for the conversation today are going to be that importantly we think that inflation is going to moderate fairly quickly over the next 12 months. And so, while we’re at a moment right now that seems pretty scary from a market standpoint given how hawkish the Fed is and we believe that the Fed is intentionally being quite hawkish even though the Fed itself is not sure whether it’s going to need to raise rates as quickly and to the point that it’s expressing that it will need to, because the Fed needs to have credibility with the markets. But having said that, we do think inflation’s going to continue to come down, we’re past peak inflation and we believe that a year from now inflation will be not yet at the 2% target of the Fed but a lot closer than we are today, of course, and not that far off.
Associated with that, the change in inflation, we think that a recession next year, a mild recession is almost a coin toss at this point, so a little bit over 50%, a little bit under, excuse me, 50% chance of a recession and we’ll cover that with Luke. But if we do have a recession, we expect it to be mild and we don’t expect the incremental impacts on the market to be all that severe given that we’re already trading down to the earlier lows, about 23 to 25% off of the all-time highs. We don’t see the downside from here as being all that extreme, maybe another 5 or 8%.
We’re going to talk about the election and then we’re going to talk about what’s happening in Europe. And, indeed, we’ve recently made a change in our portfolios. Yesterday, our investment committee met and we’ve moved some risk out of Europe, out of developed market equities and into, back into the US, because we believe that even though from a valuation standpoint the developed market, non-US developed market area looks interesting, compelling, cheap, we believe that the geopolitical stresses and the economic stresses that are falling out from those geopolitical events within energy are really going to have a very profound impact on the economy in Europe over the coming 12 to 24 months and we want to be underweight to that area of the world.
So, we’re going to start the conversation again with inflation, because inflation is clearly the dominant theme that is impacting markets and it’s a trend in the economy that we haven't seen in 50 years, inflation like this. And I think it’s important to start with the idea that inflation, the inflation that we’re experiencing was not the byproduct of a single factor. There were – it’s really a perfect storm, if you will, in terms of supply side and demand side factors that came together to cause this inflation. And the other side of that coin is that it’s not going to be one factor. It’s not just the Fed acting on its own in terms of moving the Fed funds rate upwards, which will solve the inflation conundrum that we have right now. There’s going to be a variety of factors that are going to work together to help bring down inflation.
So, let’s start with just setting the table around where the inflation came from in the first place. So, on the one hand we had the pandemic caused very significant supply side shocks where there was not enough availability of material goods, manufacturing, etcetera, and we’re seeing that continue to some degree with China as a result of their COVID lockdowns. So, there’s been significant easing of the supply side stresses, but they’re not abated completely, mainly because of the COVID situation that continues in China, which is much worse, frankly, than almost anywhere else in the world. And we could have a whole conference call on the policy trajectory of China and handling COVID. But suffice it to say that their lockdowns, their rolling lockdowns are going to continue to have an impact on supply chains, at least through the end of their political agenda, excuse me, their political conferences that they have this fall where they’re going to be getting together and setting a new five-year plan, etcetera. So, that is a big part of the inflation story that continues.
Secondly on the supply chain side again, we had a lot of inflation as a result of energy. We all, we’re all aware of course the heightened prices of gasoline that have now come back down. We’re all aware of the impact that the war in Ukraine has had on global energy supplies and energy prices. What’s interesting is as we stand here today, oil has broken down below $80 a barrel, since the first week of January that hasn’t happened.
So, we're sort of on the other side of that energy hill, if you will, as it relates to crude oil. Natural gas is a very different story. It’s a much more localized, regional market and there we have deep concerns around the situation for Europe and their dependency on Russian natural gas and how they’re going to close that gap. But when we look at our domestic situation and the overall inflation situation, that drop in crude has had a very positive impact on the overall drop in headline inflation.
And then lastly, demand. We saw record amounts of demand, first for goods and then that wave of appetite for goods continued over into the services arena. And that appetite, that record appetite for consumption was fueled very much by the record amount of fiscal stimulus that we had during the pandemic. And that was important to get us out of the pandemic, but it then led to inflation.
And so, part of the equation for the drop in inflation is going to be essentially the exhaustion, if you will, of the consumer. The consumer is in good shape, but they’re not nearly as well-stocked, if you will, in their ability to consume from a resources standpoint as they were 12 months ago. I mean they’ve burned through a lot of that excess cash. They’re going into credit now. And so, we think that the consumer is actually in a good place for where we stand in the economy where they’re going to hold up; they’re not going to continue to consume at the same rate and that’s going to be positive for inflation as well.
So, Luke, if we think about what’s happened most recently on the inflation front, we had a reading last week that sort of sent the market into a downward spiral, if you will. The Fed has said that in order to start to pull back on the tight, the increase in the funds rate, what it needs to see is compelling evidence that inflation is moderating. And it’s defined for us compelling evidence as generally a series of readings month-over-month that shows that inflation’s dropping. And what happened last week was we had had some readings where inflation was dropping and then last week it sort of set us back a couple months because we got a reading that was in the wrong direction on CPI, both headline and core, due to food on the headline side and within the core due to shelter, healthcare, and some other items.
So, when you think about where we’ve come from and the idea that we’ve passed peak inflation and we’re going down, we need, excuse me, what we need to dimension, of course, is how fast are we going to come down that hill? So, given that surprise reading that we had last week and everything else you’re seeing, can you please start by taking us through where are we right now in that decline in inflation and how fast do you think we’ll come down the backside of that inflation hill?
LUKE TILLEY: Yeah, sure, Tony. And I think you really described it well, especially those forces that have really created the inflation and the different ways that they are moving. So, I’ve brought up our outlook here with our baseline forecast and also a high, you know, risk scenario and also a low scenario, which I think is relevant. Our baseline expectation is for inflation to come down in a year-over-year sense from where it is now at 8.3% down to 7.1 by the end of this year. You know, there’s less than six months of readings left. And then to come down even more quickly to that 3% on a 12-month forward-looking basis.
And a couple of things I'd like to say about that. The 7.1% is obviously still an incredibly high number in a year-over-year sense. Mathematically a lot of that is sort of in the months that are behind us. And what it implies in sort of the underlying month-over-month numbers is that we do expect to continue to see slowing inflation in the months going forward.
And we do this with each of the components that you’re talking about, Tony. And what we are projecting and what we are seeing is some continued high numbers for shelter. We know that there’s a big delay. We know that the housing market is very challenged right now, and rents are starting to slow down and that is good for inflation, but it’ll take a while to play out in the numbers. So, we actually do keep that number pretty high.
We keep the food inflation pretty high. We know what’s happened with some commodities. Even though they’ve come back down, the food is very challenging. But what we expect to see is this downward movement because of exactly what you said. I'm going to quote you, Tony, the exhaustion of the consumer. The – I think that really paints it well, because what we’ve seen over the course of this year is a movement from consumers who had a ton of savings and that were ready, willing, and able to pay for price increases and now we don’t have that anymore.
And with last week’s upside surprise of inflation, we still did see a lot of price declines in a lot of the goods where consumers are cutting back. A couple categories did move up in a little bit of a surprise. But we do expect the weight of all of those things to be bringing inflation down, as we describe here, Tony.
TONY ROTH: So, it’s important to understand for our listeners and our viewers that this is a very fast-moving situation, that the overall narrative is going to be very different in 90 days than it is today as it relates to inflation, because it is coming down so quickly in our view. And as we understand that it’s good to, it’s important to appreciate that it’s not just the Fed hiking the funds rate that’s doing this. You’ve got the Fed hiking the funds rate. You have the consumer. You also have what we call quantitative tightening, which is to say that the Fed is essentially removing about $95 billion per month starting this month of November of assets from its balance sheet. And what that does effectively is it pushes those assets back into the financial economy and it takes an equal value of cash and brings it back into the Fed. So, it lowers the money supply. And then, lastly, we have a higher dollar and the dollar also actually as a, effectively a tightening on the economy by making imports less expensive.
So, can you just take a moment, Luke, to talk about how those four factors are working together to lower inflation? Because I think that everyone’s familiar with the Fed. We’ve talked about the consumer. But the quantitative tightening and the dollar are forces that are playing here that are important that are less familiar to the audience.
LUKE TILLEY: Yeah. The quantitative tightening has really taken a backseat in terms of it showing up in the debate with so much focus on Fed rate hikes. And that is, I think, appropriate. But as you said, in the background we do have the Fed pulling money out of the economy essentially, as you described. And really what it does, they’re not taking dollars away from individuals, but they’re taking back a lot of the excess liquidity that they had pumped into the system that would otherwise be there to generate loans and create stronger growth, and this is them taking away that proverbial punchbowl. And as they pull back on the amount of liquidity in the system, it does have that restraining impact on growth and on inflation. That's exactly what they’re trying to do.
Estimates vary. There’s – this is only the second time that they’ve actually been reducing their balance sheet in their, you know, more than 100-year history in such a significant way. But this is probably worth another 50 basis points of hiking at the short end of the curve in the sense that it’s restraining growth.
And then, the last impact, the fourth one that you mentioned, Tony, the dollar, this is really important. You know, the Fed, the dollar has been moving up and we’ll talk about it a little bit more with positioning. And that’s because the exchange rate reflects strength in the economy and also relative interest rates and the US economy is stronger than most others and interest rates are higher. So, it, that, that’s going to drive the dollar higher and that definitely pushes down on inflation with so many imported goods that it definitely helps, and it plays into the energy and the oil prices that you described as well, Tony.
TONY ROTH: So, Luke, we’ve painted a picture that I think is somewhat compelling around these forces acting together to push down or act against the persistent increase in prices in the economy, push down prices. With that, is that why you think that the Fed may not need to move to 4.6% on its terminal rate? And what I'm referring to is when the Fed announced its 75-basis point interest rate hike earlier this week, there was somewhat of a surprise in that the so-called dot plots, the Fed’s projection of where it will take interest rates going forward was as high as it was at 4.625% I think was the number.
And we looked at that and we said, gee, we’re not sure that the Fed’s really need to – is going to need to go that high. Take us through that thinking, Luke, in light of those forces that are all acting to push down prices.
LUKE TILLEY: Yeah. That was – the baseline inflation forecast that we were just walking through, Tony, would imply that they do not need to hike rates as much as they’ve projected and that 4.6 that you’re citing is at the end of next year, a little bit lower at the end of this year. And where we have them, as you – we can see on this slide with the orange line, a little bit lower peaking at that 4.25 later this year. And then we actually think coming down because that would be the natural outcome of what we’ve described, which is that slowing inflation picture.
And I think you said it well at the beginning, Tony, when you said the Fed might not even think that they need to hike this much, because the Fed has really moved over the past several months to more of a risk management mode. Their inflation forecasts are actually pretty similar in the sense that they expect it to be coming down if they have the, this interest rate policy. But that risk management view that they’ve taken is basically saying if we are wrong, we need to guard against the risk to the upside and they’re willing to take that risk and push rates higher. We just think that the forces we see that are, that we described that are pulling down on inflation will have it moving down and that they won’t need to end up hiking that much.
Because let’s remember, the actions that they’ve already taken, not just the federal funds rate, but the two-year, the ten-year mortgage rates are already pulling down on inflation. They’ve hit housing. They’re hitting consumers and businesses. And so, we’ve already started to see that play through and we think that’ll continue.
TONY ROTH: So, I wanted to come to you, Meghan, more broadly on the markets recently. But I think it’s important to talk just for a quick moment to corroborate what Luke is describing about inflation expectations, because there are a number of different technical ways to look into the market and see what inflation expectations are, whether it’s treasury breakevens, whether it’s swap rates, etcetera. And the market is essentially telling us that it believes the Fed has this and inflation expectations have been very stable, which is really important. Can you just tell us a little bit about where inflation expectations are in the market and how you read that as a strategist in positioning portfolios?
I think you’re maybe on mute.
MEGHAN SHUE: How about now?
TONY ROTH: That's better. Thank you.
MEGHAN SHUE: Okay, sorry. Having some technical difficulties this morning.
TONY ROTH: No, you’re all good.
MEGHAN SHUE: Yeah. So, inflation expectations are a very critical part of the market. We have been looking at inflation expectations actually coming down pretty nicely since the summer. As, you know, we talk about with our team there is that close correlation with oil markets, and we’ve seen oil under significant pressure. We can talk more about that too and why that is.
But I do think this is really important and it is something that the Fed watches. It’s also really critical from the perspective of looking at real rates. And, you know, when we think about real rates, we’re looking at not only nominal but also that expectation of inflation and subtracting that expectation of inflation gets you to real rates. And generally, when you see real rates moving up, as they have been, that increases the appeal of safer assets and maybe makes riskier assets like equities less attractive. So, I do think that’s part of the reason why we’ve been seeing the market under pressure.
TONY ROTH: Thanks, Meghan. So, I wanted to ask Meghan a question, because it’s important to understand a couple really key things. One is that the market itself is corroborating our view that inflation is under control given how aggressive the Fed has been. And then lays the foundation for our conversation in a moment with Meghan around how we’re positioning portfolios given the relative weakness in equities at the moment.
So, Luke, let’s just finish with a conversation quickly around the forecast for growth as we go through the next 12 to 24 months and that’s a shorthand, that’s a longhand way of saying I do expect a recession.
LUKE TILLEY: Yeah. It’s I, it’s as you said at the beginning, I think we’ve reached the spot where it’s close to a coin flip in terms of 50% chance of recession. The more – the way that we expressed it recently is the more aggressive the Fed gets now, the increasing the likelihood that they’ll have to reduce rates later, either because inflation slows so much or because they do push the economy into recession if the inflation readings don’t come in as much as they expect.
Here we’re showing our 2022 forecast finishing the year at 1.5%. Of course, we still already – we already have two quarters of this year, the beginning of this year where it’s more on the weaker side. The math works out that you’ve got that’s still a pretty big emphasis from last year, impact from last year.
But we’ve reduced our expectation for next year, the growth, to 0.8%. That's obviously very much on the weak side and mathematically for a year to go up 0.8, you could still have some negative quarters in there.
So, our baseline is still that we’re going to have growth, but it is very low. It is based on, you know, our belief, the strongest thing I think is the labor market, which we’ll show in a second. But we do continue to see capex by firms, which will be contributing to the economy, rebuilding of inventories, so making extra stuff to rebuild inventories. We know what’s going on in the auto sector and when they do see those supply chains improve and get more semiconductors, there’s going to be more production there that’ll show up in the data.
But I think that the most encouraging thing that we have going on is that companies are still hiring. They still have job openings, still hiring at a really solid clip here, more than 300,000 jobs in the month of August. You can see the six-month average has been coming down and slowing. But still, these numbers that are above 300,000. But before COVID, a long time ago, it’s sort of hard to remember, a really strong jobs report is something like 150,000 to 250,000 jobs and we’re still well above that.
So, you still see companies that are getting enough orders that they need to staff up for them. I think it’s really encouraging. And the openings are still high. Clearly, this could change if companies, if sentiment sours and if things get too negative. But we think this is the strongest argument for continued growth, even if it is going to be slower, Tony.
TONY ROTH: Thank you, Luke. And I would just add to that analysis that one of the dynamics that’s going to be occurring as we move forward over the next quarter within the economy is that we’re going to continue to see wages, increased pressure on wages. So, as nominal wages go up, continue to elevate and as inflation comes down, we will reach an inflection point where real wages turn positive. So, right now what’s happening in the economy is that even though people are getting increases, inflation’s so strong that their actual spending power’s dropping. That's going to change sometime, in our opinion, in the next 90 days where inflation will come down below the level of wage growth and real wages will start to grow again and that will be positive for consumers and help act as a buffer against a recession. So, with that observation ...
LUKE TILLEY: Yeah. And if I could, Tony?
TONY ROTH: Yeah, please, Luke.
LUKE TILLEY: No. And I should have mentioned this as we talk about the possibility of a recession. That wages question, like how strong are they, if they’re just a little bit too strong, that’s going to keep the Fed on this aggressive rate hike cycle and that is the real risk. And I'm really glad that you pointed it out, because the picture you painted, which of course is a baseline expectation it would be supportive. If that labor market stays too tight and if wages are too high, so to speak, then the Fed is even dismissive of low inflation numbers. They say, well, we think this is still a problem and they get aggressive. And so, that’s why it’s so challenging with the probability of a recession right now is that labor market question.
TONY ROTH: Yeah. And of course, you know, we believe that the dynamics of the labor market really lie at the foundation of the economy, both in the short and the long-term. And our Capital Market Forecast for next year is going to very much focus on the changed relationship that we think has been one of the key byproducts between work and life from the pandemic. And we’ll talk about that a lot in some coming research.
So, getting back to today, Meghan, you’ve heard Luke’s discussion around the economy. And as you know, a recession is almost a coin flip right now. We’ve never had a situation where we’ve had an economic recession and not had an earnings recession in equity – in US companies. We’re now down around 23% or so from the all-time highs on the S&P. We're pretty close to the June lows. We’re actually below the June lows on the Dow now, I mean the intraday trading. So, we’re pretty much retesting those lows.
Now the question, of course, Meghan, is can you take us through what’s been going on in the markets and do you see us possibly breaking through those lows? We’re pretty close right now. And how much further might we go with this economic forecast that Luke has laid out for us of either no recession or, if anything, a mild recession?
MEGHAN SHUE: Yeah. Tony, great question. So, here we kind of just give a little bit of a snapshot. It’s been a wild ride so far this year. The gray line is the S&P 500, and the purple is the ten-year treasury yield. And what you can see is that we’ve had a lot of volatility in the equity market, actually even more volatility in interest rate and bond markets, where you’ve seen pretty historic moves in, you know, across the curve.
And I think a real pivotal moment was between June and August of this year when, as you can see, we had some signs of peaking inflation. That gray S&P 500 line goes up pretty nicely. And really what was underpinning that was a narrative that had taken hold in the market that the Fed was going to hike to a certain level, you know, not that hawkish and then start to pivot pretty soon after and cut rates.
And that was really dashed at Powell’s Jackson Hole speech on August 19th, actually the last day of my summer vacation and a really fun way to go out, because we had the market just kind of wake up to the idea that, oh no, the Fed is really serious. They’re going to raise rates. They’re going to keep them there. And that, of course, sent interest rates higher, the ten-year treasury yield moving from a summer low of 2.6% to 3.7% and a massive rerating from the market in terms of what they expected from that peak Fed funds rate.
And, you know, talking a lot about equity market volatility, and that is critical, but what I, you know, what I think continues to be one of the most important themes for this year has been the challenges in the bond market and for a diversified investor this has been very painful. So far, year-to-date core municipal bonds, one of the safest asset classes, are down 10%. So, anybody looking at their diversified portfolio and wondering why it seems to be so, you know, down so much, it’s that combination of weakness on both the stock and the bond side.
You know, I think as we think about the recession risks, one of the things that strategists like to, you know, like me like to look at is the yield curve. And so, what we’ve been monitoring are two measures of the yield curve on the next slide. And why this matters is, you know, we tend to look at the short end of the curve compared to the long end of the curve, the short end of the curve, so call it the two-year treasury yield or the three-month treasury yields, being more anchored to the prospects for monetary policy and the long end of the curve essentially being a signal of can the economy handle that policy.
So, when we look at the short end moving higher than the long end, that has historically been a very negative signal for the economy. So, we’re showing two measures here. The orange is the ten-year minus two-year yield and the purple is the ten-year minus three-month yield, a slightly more respected measure of the yield curve.
The orange line is significantly inverted. It inverted in earnest in July, now at about call it 50 basis points where the ten-year treasury yield is about 50 basis points below that two-year treasury yield at 4.2%. The ten-year minus three-month, importantly, is not yet inverted. It’s actually spiked back up in recent days. But it was as low as 14 basis points this month.
And, again, why this matters is that if you look historically on the next slide, what you see is a pretty good signal of when you have that, in this case the ten-year minus three-month yield slope invert, you get about anywhere from one month to, you know, call it a year until the market peaks and on average about 11 months until the recession. And it’s not yet proven wrong. So, the ten-year minus three-month slope, again, not signaling recession yet, not inverted. But it’s something that we are watching very carefully. And then –
TONY ROTH: Right. And as the Fed continues to raise rates, we almost, it’s almost a certainty that it will invert before the end of the year, probably next month, right?
MEGHAN SHUE: If the Fed were to hike even close to what they telegraphed at their latest meeting, I would expect this to invert, yeah.
TONY ROTH: So, okay, Meghan. Given that the yield curve has never – it, it’s predicted some recessions that didn’t happen, but it’s never failed to predict a recession that did happen, which is to say that there have been a couple times where it inverted, and you didn’t have a – or it didn't invert, and you had a recession. But you’ve never had an inversion without a recession.
So, given that, the fact that it is inverted if you look at the two tens or the three-month to ten-year it’s about to invert, let’s assume for a moment that we are going to have a mild recession next year. Shouldn’t we, therefore, be selling risk out of our portfolios today? What’s your take on that question?
MEGHAN SHUE: Yeah. That's a good question. And the answer is no, in part because of what we’ve already experienced. So, the, this slide here is, I think, something that sticks with me. So here we’re plotting on the Y axis the max drawdown from the S&P 500 around prior recessions and on the X axis we’re looking at the duration of that decline in months. And we’ve broken it up by severe recession and mild recession with the breakpoint being that a mild recession is an unemployment rate increase of less than 3%.
So, as you mentioned, Tony, if we do have a recession, we do think that there are, you know, all the signs are pointing to it being a fairly mild recession. And if that were the case, if you look at the average of those blue dots, the average drawdown’s been about 23%, which is right where we were as of June, probably where we’re going to end up today.
So, I would say the market's already pricing in a mild recession. And that might seem weird because, you know, it seems like it’s so far in advance and we’ve had, you know, still signs of strength in the economy. But the market does tend to look ahead. So, the fact that it is discounting a mild recession already would tell me that while we might have further to go, you’ll notice that the current, the yellow current circle here is a little bit further to the left of the – along the X axis of many other recessions. This could take a while to play out. That's something we’ve been saying for a while.
You know, we might not see a real strong market rally until we get a sign that the Fed is stopping or even starting to cut rates. But that said, I don't think we need to go down too much further. So, the important point being to stay invested and to look ahead 12 months and, you know, we do think that markets can be higher.
TONY ROTH: Thanks, Meghan. So, to summarize, we’re certainly in the ballpark already in terms of the pain that we would expect to feel if we have a recession next year. And so, that’s really good to understand.
So, I want to just take a moment and pause. I want to come back to you, talk about Europe in a moment, Meghan. But before we do that, I want to just talk a bit about the midterm elections here in the US.
So, there are a few different outcomes that could occur relative to the division of power in the US Congress between the House, the Senate. You could have a republican sweep, a democratic sweep, or of course a split within the two chambers. And anything other than a democratic sweep would essentially result in a divided government since the democrats control the White House. The republicans need to take either the House or effective control over the Senate in order to be in a position to create the outcome of gridlock for the next couple of years.
And probably no surprise to folks, the markets prefer the gridlock than they do power concentrated in one party. And certainly, in this particular case, given the propensity on the blue side of the aisle for potential tax and spending policy which creates a lot of uncertainty in the short-term and potentially in the long-term, inflation or deficit spending, the market would be biased very strongly right now towards having a gridlock outcome in the forthcoming Congressional elections.
And I just want to say we’re nonpolitical here at Wilmington Trust. We’re not trying to make any, express any view one way or the other. We’re just simply trying to understand factually how the outcome of the election is likely to impact markets.
And so, when we look at things today, what we see is that the democrats have probably a 60% chance, so a little bit less than two out of three chance of increasing their technical control of the Senate today and the republicans have been dropping in their likely victory in the House of Representatives. So, if we go back to the abortion case, the Dobbs case that came out in June, that was really the touchstone that changed the trajectory of the political environment here in the country where a lot of folks on the blue side of the aisle really became energized around personal rights, etcetera, and that seems to have had a big impact on the odds for the outcome within these Congressional elections. So, the republicans had been favored by 90% to 10% to take over the House. Now they’re only, that’s down to around 68 or 69% if you look at FiveThirtyEight or other pollsters that follow closely the Congressional elections.
So, we’re not sure what’s going to happen. But since 68% or 70% in the House is still suggestive of a split or a gridlock government, so let me just cover what would happen if we have a gridlock government quickly. And then if, in fact, the republicans fail to hold onto or retake the House, because they don’t have it today, and the democrats indeed add to their margin in the Senate, which is razor-thin of course today, what would that mean for policy, in which case you didn’t, you would not have gridlock. You’d have a clean sweep for the democrats.
So, if we have a grid, a gridlock outcome, there are a few things that are bipartisan, believe it or not, that we think we’d make progress on. One is defense. There seems to be bipartisan support for more spending on defense, increased as a percentage of our overall budget, and specifically to have new legislation around cyber security in general and specifically around defense. So that’s an area that we would expect to see movement of legislation.
Secondly is supply chain. We’ve already seen this year, in fact, a pretty significant fact that directly targets US supply chain within semiconductors. That's an area that we expect, supply chain generally, not semiconductors per se, but supply chain resiliency, more onshoring of manufacturing capacity, etcetera, that’s an area that we would expect in a gridlock situation to find some common interest among the parties, among the two parties.
Thirdly is antitrust legislation. We think that there continues to be bipartisan support for legislation that targets the big tech companies, which have become very dominant forces in the economy and they’re monopolies. So that’s something that we would expect.
And then lastly is regulation of cryptocurrencies. So, we haven’t talked much about crypto, and the financial economy continues to play a pretty significant role. But interesting to watch cryptos. They seem to be almost a proxy for equity risk or risk in markets and that’s so interesting, because it seemed that a lot of the assets that went into crypto were at the expense of the traditional flight to safety trade, which was gold. But crypto is hardly trading as a flight to safety asset. It’s trading as a much more volatile asset that’s much more highly correlated to risk. So, regardless of that, we think that if the Congress comes out in a gridlock situation that would be an area of interest for Congress to go after.
Now on the other hand, if the democrats are able to sweep the House and the Senate and of course with President Biden in the White House, we would expect to see a pretty aggressive approach to fiscal spending and taxation. And we don’t know whether or not this would be deficit spending or whether or not it would be fully funded. We don’t know whether or not, therefore, it might be inflationary in and of itself. Hard to imagine they would enact something that was too inflationary too quickly given the environment we’re in, but you never know.
But just the prospect of higher taxes and higher spending can really throw havoc into a market. And you can see just today, for example, with the UK coming out with its fiscal plan in order to cap energy prices, it’s had a record impact on pound sterling, downward impact on the pound in energy markets as, excuse me, in currency markets as the FX markets start to price in the impact of that additional spending in the government on the currency. So, suffice it to say that the markets would probably not like a democratic sweep, but it would all depend ultimately on the details of their legislation to see whether or not it would, in fact, be inflationary or at least deficit spending.
So, that is the outlook for the election. So, Meghan, let’s just come back before we move to questions. Let's just talk for a moment about Europe. We have a lot of geopolitical stress in Europe obviously with the situation in Ukraine. That's led to very specific economic stresses around energy for companies in Europe and will – risks impacting life in Europe, if you will as it relates to home heating.
So, a pretty drastic situation. We've seen and we’ve heard anecdotally about a lot of companies actually looking already to shift manufacturing out of Europe given the high cost of energy. They can’t actually make a profit. Can you give us an update on that situation and how it impacts portfolios? Because we’ve made a recent change that I alluded to at the outset of the conversation and maybe you could give us a little bit more detail on why we made that recent change. Thank you.
MEGHAN SHUE: Sure, yeah. So, just a quick update on the energy situation. You know, as you probably now are all familiar with the stats, the EU imported about a quarter of its energy from Russia in 2020. Russia gas flows to Europe have been reduced – that’s what we’re showing here – have been reduced by 80% on a year-over-year basis after the halt of Nord Stream 1 and Russia announced that they’re cutting gas pipeline exports by 40% in 2023 through 2025.
Importantly, Russia can afford to do this. So with the 220% year-to-date increase in natural gas prices, Gazprom is actually making more revenue in 2022 so far this year than they did in all of 2021. So, this reduction is not hurting Russia, importantly.
Now, Europe has been successful in getting their storage levels up to about 80 or 90% and this has come with significant demand destruction. We are, you know, watching carefully. It’ll – a lot of it will come down this winter to weather and how cold the winter is. If it is a colder than normal winter, we could see storage depleted again with more trouble for the ability to restock next year. That would result in, and we still could see this here, managed blackouts, power rationing. This could be particularly painful, as you pointed out, Tony, for the industrial sector with demand cuts of, you know, 10 to 15%.
So, this does materially increase the risk of recession in Europe. And, actually, they’re probably already there and likely to stay there in terms of recession for the near future. So, we’ve reduced our equity allocation to international developed equities, which includes Europe but also UK, Japan, and other developed economies and we’ve rotated that into US large cap equities. So, we’re keeping our overall equity allocation at neutral, not risking up the portfolio. But we’re picking our spots and we're looking for a better opportunity for recovery and a quicker recovery and a more sustained recovery in the US than we’re likely to see in international developed economies.
TONY ROTH: So indeed, to that point – thank you, Meghan – Luke, how deep could this recession be in Europe? We’ve talked about a mild recession here in the US. Same thing for Europe but just earlier or could it be a lot worse?
LUKE TILLEY: Yeah. I think it’s deeper because the ripple impacts of those cutbacks could be much deeper. We have, I just brought up, I went back up a slide to the Bloomberg consensus forecasts for the Eurozone and the UK, which of course Meghan just said are the big parts of that international developed along with Japan. The sustained nature of the energy price impacts that Meghan was just talking about and no quick fix we know are devastating to consumers and there are, you know, new policies that are being put forth to support the economy, to limit the energy price that households are paying. But then, those just spill over into the governments’ budgets, weaken their currencies even further.
So, there’s no easy way out. These are the Bloomberg forecasts, which are showing basically flat in 2023. But there’s clearly a risk to the downside where you could have a fairly deep recession of 1 to 2% and on an annual basis for the Eurozone or the UK. Those are very painful and would be painful for equity markets we think.
TONY ROTH: Thank you, Luke. And I just wanted to point out for our listeners that when we look at the year-to-date performance of European developed market equities, excuse me, developed market equities versus US large cap equities, what we see is as of yesterday when we made this trade the developed market area was only down around 2% year-to-date more than the US. And so, we felt that the markets were not fully pricing in the significant incremental risk of a deeper recession in Europe given the very present situation in Ukraine and the knock on effects in energy, so on and so forth, that we’ve just talked about and that’s why we took our positioning down in international developed and added it to US equities.
So, when you look at the positioning here, what you’ll see is that we are neutral to equities. We're not overweight equities. We have a full allocation of equity risk. But on a regional basis, we’re overweight to the US versus the non-US developed arena. And then you see that we have an overweight to cash is the only real place that we do have an overweight, a couple percent or so, of dry powder if you will waiting for an opportunity to deploy those assets as the markets continue to drop. And we don’t think that the dropped markets, as we’ve already covered, will drop more than another 7 or 8% in the cycle. We think they’ll find a bottom as the inflation readings come out further into the year and continue to demonstrate quieting of the inflation problem that we’ve been experiencing.
So, with that, I want to thank Luke and Meghan for your great comments, and we want to turn to questions. We have quite a few questions that have come in. So, we have about ten minutes left, and we will jump into the questions.
So, why don’t we start with you, Meghan. Here’s a question that’s come in around the idea of let’s say you had $100,000 today to deploy or some amount of cash. Given that we’re sort of wrapped in this volatility moment that which is really a pseudonym for falling markets, what would you do with the $100,000? Would you try to just throw it into the falling market, or would you be patient and where specifically would you put it today?
MEGHAN SHUE: Well, the way we think about having a large amount of cash is to really think about, you know, setting up a plan and getting it into the market in a predetermined but relatively short fashion. And I would say even with the volatility and how, you know, violent the recent market drawdown has been, and going back to our earlier chart about what you would expect in a mild recession and, Tony, I agree with your comments about how much further potentially the market could fall, I would definitely start legging it in. And, you know, you might think about putting a chunk in with the market down, you know, last time I looked about 23% and, you know, setting up a periodic schedule to have the rest of it deployed, because looking out over one year we do think equity markets will be, you know, could be higher. And then, importantly, looking out over what most of our clients have as their timeframe, five, even ten years plus, we don’t think that you’re going to be hurt by putting that money to work in a fashion starting today.
And I would put it, I would allocate it as you see here where, you know, you maybe save a little bit of dry powder on the side, but favoring US large cap over international, equities, and importantly fixed income. We haven’t talked about that yet where the ten-year treasury yield at 3.7%, across the curve bonds and the yield you can get from bonds even, you know, notwithstanding potential for further interest rate hikes, we think you’re going to do quite well in bonds going forward, even with, you know, potential further increase in rates here. The yield you’re getting could offset that price decrease from a move higher in interest rates. So, we would think, you know, having that allocation to fixed income as well as equities is where I'd be.
TONY ROTH: Okay. Thanks, Meghan. I would just add to that. Our portfolios are very focused on, have been very focused for most of the year on portfolio, on companies that have earnings power so that as you start to see the consumer be pinched as the consumer reaches that point of exhaustion, if you will, having the pricing power, if you will, to keep their goods priced appropriately given the supply chain problems that people are having from a cost standpoint, that companies are having. And so, we’re seeing our portfolios hold up reasonably well in this drawdown due to the pricing power that the companies in the portfolio have and that’s an important thing to focus on at this stage in the cycle.
As we start to power out of the cycle and once the economy recovers, there’ll be a different, more cyclical type of company that we want to own. But right now, you want those noncyclical companies that have better pricing power as well in your portfolio. So, I would add that.
So, let’s go to the next question. And, Luke, why don’t we get you a question here. So, talk about the economy of emerging markets and especially China. They seem to be facing a lot of headwinds and a lot of them are artificial with the shutting down of the economy repeatedly with the COVID closures. What do you expect to happen going forward?
LUKE TILLEY: I think that emerging markets are really challenged. They’re challenged for a number of reasons. One is China and their COVID policy that you just mentioned. The second is that China’s very challenged because of what they’re dealing with with their property sector which had gotten too overheated. It was pricing so many people out. And they’ve really clamped down on that and that was a source of growth.
So, what we've seen over a course of a year is Chinese officials continually marking down and basically saying that they’re not going to be able to reach their growth target of 5.5%. They’re moving in the other direction of other central banks where they’re trying to prop up the economy a little bit. But they are still challenged by COVID, by those other things.
And with, more broadly, general emerging markets, they’ve been hiking interest rates, aside from China they’ve been hiking interest rates to get ahead of the Fed and try to defend their currencies. So, emerging markets are incredibly challenged. Obviously, we didn’t change our allocation there. But one thing I would say is our action that we took in developed international markets, places like Europe, UK, and Japan, those international markets the emerging markets are their customers. Europe relies heavily on exports to China, which is a slowing economy, a lot of automobiles and other machinery and refined products sent there.
So, the question is about emerging markets. And, yes, it’s about their economies and it affects the decision we made to reduce international developed, Tony.
TONY ROTH: And I would add to that, Luke, that the dollar has a big impact on emerging economies, because many emerging market countries issue debt in dollar denominated terms. And so, as the dollar goes up, their debt burden increases. And so, when we see a change in the dollar’s direction to downward, we – the currency markets are so difficult to predict. That may be a moment that suggests it’s time to invest in emerging markets. And, of course, professional investors know this and so you should see a big flow into emerging markets when the dollar starts to shift directions. So that’s another thing that to keep a, keep an eye on.
So, Luke, another question for you. I'm sure Meghan doesn’t want to touch this one. Where will the peak be in the ten-year yield over the cycle? So, we’re going to leave the hard question for you.
LUKE TILLEY: Yeah. How many decimal points do you want me to go out?
TONY ROTH: If you get right to three, that’d be great.
LUKE TILLEY: Obviously, it’s very challenging to – very challenging to predict where exactly it’s going to head. But let me characterize, you know, the ten-year yield is going to keep moving up if it’s driven by a couple things. One is Fed rate hikes, but those are at the short end and, you know, it takes a, it’s a lot. It gets filtered out as you move out to ten years. But it comes back to strong economic growth and high inflation are the things that are going to drive the ten-year higher.
We are projecting weaker growth, unbalanced, you know, when we, we’ve reduced our GDP forecast a little bit, and we’re expecting inflation to come down. So, I still see room for it to move up from where it is today. I think I saw 3.70-something as we were getting started here. And I think that there’s room for it to move up to 4% and perhaps above that in a short-term.
But more broadly, I think that the slower growth, our expectation of lower inflation will keep it from going much higher than that. And even if it went up to that, I don't think it would be for very long. What we’re looking for here is as the Fed continues to hike getting flatter and flatter on the curve, closer to inversion, Tony.
TONY ROTH: Yeah. And I think that, again, and I would come back to the inflation expectations that we derive from the pricing of TIPS securities, treasury inflation-protected securities, really telling us that inflation expectations are very contained right now for longer-term. And we have to remember the demographics investing in this country and much of the developed world. We have a potential shortage of consumption going forward due to demographics. And that all suggests more of a disinflationary environment like what we were in the last ten years.
So, when you put all that together, relying on those inflation expectations as a gauge of how high nominal rates will move is not a bad way to do that. And, as Meghan talked about, inflation expectations are very anchored right now in a healthy area. So that’s, I think, something I would look at.
So, let’s go to the next question, Meghan, and it’s about REITs specifically. What do we think of REITs right now, both global and US domestic REITs?
MEGHAN SHUE: Well, we have a neutral allocation to REITs. It’s a relatively small part of the portfolio. We’ve seen REITs have a really tough time of it this year, US REITs down about 24%, global down about 25%, actually more than equities. And I think part of that is the cyclical nature of REITs as well as what’s been happening in the rate market, where if you’re looking at REITs as a, you know, a potential yield type of investment with rates moving up so dramatically, not only does that put pressure on real estate price in the market, but it also makes them less attractive as a relative yield type of play.
I would say going forward though, you know, one of the things that we look at a lot with the economy, with the inflation trajectory that’s happen, happening in housing and while, you know, the sharp move up in rates is putting significant pressure on the housing market, one of the themes that we’ve been looking at is the real, the inventory shortage. And inventory is incredibly low, whether it’s single-family homes or especially multifamily. And I think that could be one area that has a little bit more structural support as we look out over the next few years.
TONY ROTH: Thank you, Meghan. And we have time for one more question and we’ll grab one for you, Luke, which relates to the recent executive action. We’ve had this question posed from two people in different ways. So, let me try to frame it here. We’ve had some executive action from the President on student loans, which if I'm not mistaken is about a half a trillion dollars of relief, debt relief. That would seem to be inherently stimulative and inflationary. Is that correct? And, if so, how much is that single act contributing to our inflation environment today?
LUKE TILLEY: Yeah. I think on the – I mean that’s obviously a huge dollar amount in terms of the total balances. When you get down to the share of payments for an individual who was paying those, it is not as big, clearly. On the margin it helps those individuals’ ability to spend on other things. So, on the margin it would help to keep inflation a little bit higher and prevent it from coming down.
I don’t think it’s a major driver of inflation right now. It affects the overall debt picture too, of course, with the government spending that amount of money. I don’t think of it as a major driver, but it would affect it a little bit, Tony.
TONY ROTH: And I'm going to – I lied. I'm going to ask one more question because this question came in from a couple people as well and I think it deserves to be heard, which is the couple questions that have come in around the debt burden of – on the country as the ten-year rate goes up to we’re now at 3.75. We're more than 200 basis points over where we were six months ago and I’ve, you know, we’ve read, we’ve calculated in fact that every 100 basis points is around $400 billion, just under $400 billion of additional debt service. So, if we’re looking at 200 basis points, $700-800 thousand, $800 billion of additional debt service, maybe not quite that much. What impact does that have on the economy, both in the short and the long-term in your view?
LUKE TILLEY: Yeah. In the short-term, not very much. I think the short-term is much more about how do those higher interest rates affect businesses and consumers? Over the long-term, it adds to the challenge. We know that we’ve got a long-term debt problem in this country and the debt projections are scary, to say the least, if you go out over a few decades. Could do an entire other webinar on that and clearly that provides, that’s a challenge because it crowds out private investment.
And over time that net interest, I mean if we don’t change anything, over time that net interest would just eat up so much of the budget we wouldn’t even have a discretionary budget. So, perhaps another topic for another webinar or a, you know, a written piece. But it’s it just increases the challenge of that long-term deficit, and we keep an eye on it and it factors into our long-term views, Tony.
TONY ROTH: Okay. Thank you so much, Luke. Well, we’re at time now. We want to remind everybody that we’re going to be publishing our Capital Market Forecast at the end of the year, and that will very heavily focus on inflation and labor markets, among other issues. And so, please look out for that. We’ll answer a lot of questions in that realm then.
And in the meantime, have a wonderful weekend. Thank you for joining. And thank you so much to Luke and Meghan for your great comments today.
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