R.J. Gallo: Hello and welcome again to the Hear & Now Podcast. I'm R.J. Gallo, Senior Fixed-Income Portfolio Manager and head of the Fixed Income Duration Committee at Federated Investors. I'm here with Phil Orlando, Chief Equity Market Strategist. Phil and I are going to discuss what each of us expect from the markets in 2020, so let's start first with Phil. Phil, you and our colleagues in the Federated equity department expect the economy to perk up. You're calling for 3,500 on the S&P 500 by the end of 2020. What are the key factors behind this bullish view?
Phil Orlando: Well, I think the most important factor is that we're very confident in our outlook relative to how this last year has played out. Think back to the fourth quarter of last year, R.J., the stock market was in a free fall, we were down 20%, the market was pricing in with absolute certainty the imminence of recession. P/E multiples had contracted from 18 times earnings down to 14 times earnings.
Phil Orlando: And as we looked at that environment from a macro economic standpoint, we didn't feel there was any risk of recession in 2018, or 2019, or 2020. Our current recession dashboard is suggesting mid '21 is the earliest that we could be at risk for recession. So we thought the stock market, which bottomed out at about 2350 Christmas Eve a year ago could get up to the 3,100 level by the end of this year. We got there last month.
Phil Orlando: So we're feeling pretty good that we've got a beat on this in terms of the way the economy is performing. So as we're looking out over the course of the next year, how do we get to 3,500? We think the consumer stays strong. The consumer's been strong for the last year. And we think that strength continues. Manufacturing has been the fly in the ointment, if you will.
Phil Orlando: But we think the key issues that have been negatively impacting manufacturing, the ongoing trade and tariff war with China, the Boeing situation and the General Motors strike, we think we're close to an inflection point, a positive inflection point in those issues such that we start to get some more constructive contribution from those areas as we get into the second quarter, let's say the middle of the year. So given benign inflation, benign interest rates, we think multiples ought to be up at around 18/18.5 times earnings, a mid to upper single digit earnings growth.
Phil Orlando: We think we get to 3,500, so we're feeling pretty good about where the equity markets are going. Let me turn the tables on you, RJ, that we had an inverted yield curve earlier this year. We'd like to look at the relationship between benchmark 10 year treasuries and the Fed funds rates. That relationship was probably a hundred basis points inverted earlier this year. Now we've sort of flattened that out. We've actually got a slightly positive bias. What does that mean? Is the fear of recession off the table for you and your team? How's the fixed income team looking at the economy in the markets in this environment?
R.J. Gallo: Sure. Well, starting first with the curve, we expect some steepening in the yield curve as well in the year ahead. A moderate amount, not a surge in the steepness of the curve and we believe that's a good thing. It's really not a source of concern. Let me elaborate a little. We got to look where we came from in order to assess where we're going. We're finishing up 2019 as a very strong year for bond returns. The total return on the Bloomberg Barclay's Aggregate Index of investment grade U S bonds, 8.7%.
R.J. Gallo: It's pretty big number. Driven by this sharp drop in bond yields with the 10 year treasury yield down 90 basis points for 2019; simmering trade conflict between the U S and China, which still lingers. We're optimistic, but it still lingers. Slower global growth, below target inflation and Jay Powell, his mid cycle adjustment at the Fed, which constituted three eases in monetary policy, all drove bond yields lower and bond prices higher supporting that 8.7% return. Total returns if you took higher levels of credit risk or even stronger HIO corporate index from Bloomberg up 12.7% for 2019 year to date.
R.J. Gallo: So prior to the Fed's adjustments, as you were saying, Phil, the curve was not only flattening it fully inverted, sending off a classic signal of oncoming recession. Whether you look at Fed funds to tens three month bills to tens or the two year treasury note to 10, they all inverted at some point earlier in 2019. But once the Fed layered in all three eases their adjustment in the summer and the fall, the curve shape restored to a modest upward slope where it sits today, which is consistent with modest growth expectations going forward.
R.J. Gallo: Like I said earlier, that's a good thing. So let's look forward in 2020 we think the Fed is likely on hold for the whole calendar year and they pretty much have told us that if you look at their dot plot. This view is supported by the idea that U S growth will persist somewhere around 2% plus or minus a 10th of a percent here or there.
R.J. Gallo: Inflation does seem like it's edging upwards, but still well under control and still below the Fed's 2% long-term goal. In a world like that, the curve is only slightly biased to steepen somewhat more. I wouldn't think it's a surge. The level of treasury yields in this, what I'll call my base case scenario, they'll probably edge higher as well with a 10 year treasury rising, you know maybe to 2% maybe a little more. If we get this base case scenario, we expect to see relatively muted returns on the fixed income side of the world.
R.J. Gallo: You'll get some modest price loss, recall with the 10 year treasury right now is lower than 2% and your yield on the Bloomberg Barclay's Aggregate Index is just 2.3, so you can't sustain much price loss before you have a zero or a negative return. Our base case would be the return should be give or take around 1% if my base case scenario comes true. Now as active managers of multi-sector fixed-income, we at Federated, should be able to add a little more to that by proactively taking and managing credit risks and other risks within a bond portfolio.
R.J. Gallo: But it still seems likely that low, maybe mid single digit returns at best are what you're going to get in the fixed income market. And we could be wrong if we only ended up getting a modest phase one deal and nothing more with the U.S. and China. If the U.S. Election uncertainty later in the year provides headwinds to investment or consumer behavior or if global growth decelerates then U.S. recession fears which just faded will re-emerge and the Fed likely could ease again maybe multiple times.
R.J. Gallo: And that scenario, I'm going to call it my scenario B, bond yields fall and returns are strong for the Bloomberg Barclay's Aggregate Index, the 10 year treasury yield, it could end up around 1% in this scenario, you'd have returns around 5% maybe even 7% on diversified investment grade bonds. Alternatively, a rosier scenario, I'm going to call this C, if the stingy German government institutes fiscal easing.
R.J. Gallo: If the wave of global central bank easing causes global re-acceleration U S rates would move higher, say 225 to 250. In this world, you might even have mildly negative returns on a diversified Bloomberg Barclay's Aggregate Fixed Income Index for 2020. If you do a probability scenario, those we think our base cases most likely low single digit returns, slightly higher yields, bonds are not the roads to riches, but they continue to be an important part of diversifying the risks in your portfolio, just in case you get scenario B. So Phil, what's your main concern heading into 2020 what would need to change in order for you to change the relatively bullish outlook on the equity market?
Phil Orlando: So I think you touched upon two of them. I don't have one main concern. I'd say China goes badly and the election goes badly because those are two inputs that we have embedded in, in our constructive framework. So let, let's talk about China. And you touched upon this. We as our base case are expecting that we will have a skinny phase one deal in which we're going to be exchanging some tariff relief for some agriculture purchases by China at a minimum. Now we'd love to see a big structural deal, intellectual property theft is resolved, currency manipulation, that sort of thing. But I think that's sort of pie in the sky. Those are longer term issues. The things we're looking for to happen near term are sort of the skinny phase one deal. But suppose we're wrong.
Phil Orlando: Suppose that doesn't happen now. We think that both countries desperately need this deal and certainly given the deceleration of economic growth in China over the last several years and the problems they're having feeding their people with regard to the swine flu in China and the decline in their hog herd, et cetera, we think it makes perfect sense that they'd want to buy more soybeans and corn and, and pork products from us. But there's always a chance I'm wrong. And therefore if this deal didn't happen, that potentially could have a deleterious impact on our outlook.
Phil Orlando: To put some numbers around that, our equity divisions, GDP forecast for the U.S. Economy next year is 2.4%. the blue chip consensus is 1.8%. in a 21 and a half trillion dollar economy. You can drive a Mac truck through the difference between those two GDP forecasts. And by and large, I think the most significant Delta there is China did that, that we've got a more constructive view on China than I think a lot of our competitors do.
Phil Orlando: So, if we're right, you start to see a better CEO confidence, more CapEx spending, higher productivity levels, GDP growth goes up, corporate earnings growth goes up. Those are all the things that we're looking for, but obviously if China doesn't happen, that could be a risk. The second thing is the election that we are looking at this entire 2020 presidential election, we have built a proprietary election dashboard where we've gone back and looked at every election in the postwar history of the United States and have been able to correctly identify every incumbent successful or failed bid for reelection, looking at a basket of macroeconomic variables. So the way we're viewing the economy right now, again, relatively benign inflation, no recession, et cetera. Our view is that we end up with constructive election results, which is to say market friendly, economy friendly.
Phil Orlando: Obviously there's risk there. Suppose we're wrong. Suppose we get market unfriendly election results in which there's a radical change in fiscal policy. In that environment, the economy, perhaps we have to accelerate our recession call. Perhaps we're looking at a decline in share prices, so that's obviously a risk as well. So those are the two things that sort of keep me awake at night. Does China happen the way we think it will end? Do we get sort of the election results that we think we're going to get?
R.J. Gallo: I would agree. I think that we as investors are dealing with an uncertain world. So it does help to sort of lay out the scenarios and think about which ones you think are most likely to come true. Some areas I think that could also knock either one of our views. I mean both of us agree. We don't think there's a recession in 2020 it seems relatively unlikely. That's a pretty good outcome for investors. The risks of that outlook include China, the election. Couple other things that just linger out there, and you really can't price them in until they happen, would be if Iran foments greater instability in the Middle East. Iran, their society, their economies seem to be under pressure. There's more social instability. They have a bit of a track record recently of already acting out.
R.J. Gallo: After all they attacked some Saudi Arabian oil assets, which was a very aggressive move on their part. You worry a little that something could come out of left field from them. And also Kim Jong Un in North Korea. Despite the discussion between president Trump and Kim Jong Un, we really haven't achieved a denuclearization of the South of the Korean peninsula. Excuse me. And that remains to be a potential aggravating factor. I think China's got sort of a leash on him, so I don't know if he's going to just go do his own thing without Beijing being involved. So I'd put that as a second order risk relative to Iran on the geopolitical stage. I don't know, what would you think about those two?
Phil Orlando: I think those are certainly potential black swans you've got to consider. I would throw three other international concerns into the mix. This ongoing Brexit situation, does that get resolved favorably in terms of economic growth in the UK? In Europe, you've got the ECB a leadership transition from, from Draghi to Lagarde. Does that go as smoothly as the market is pricing in? And Japan at the beginning of October implemented the third level of its value added tax from 8% to 10%. the last two times Japan increased the VAT, it pushed the Japanese economy in a recession. They assure us that's not going to happen this time. I'm somewhat skeptical and probably well warranted. So there's plenty of things that can go wrong. I guess our job is to sort of evaluate them in real time and tweak or adjust our forecast based upon the impact that may have on what's going on here in the United States.
R.J. Gallo: No, I agree with you. In fact, I use the scenario A, B and C or base case B and C. No matter which one emerges our goal in Federated fixed-income is to stay nimble with our duration credit curve and security selection levers within a fixed income portfolio to try to best position our funds for the best relative returns we can. I do think one factor that that gets a lot of discussion lately is this idea that Lagarde is taking over at the ECB.
R.J. Gallo: She's not an economist, sort of like the Fed chair here. She in particular is very tied into a fiscal policy making, having had that portfolio within the French government in the past. There is considerable pressure within core Europe to ramp up some fiscal stimulus to ease up on their purse strings, if you will. Germany basically runs a balanced, if not a surplus in their budget, which seems odd when you consider their low growth rates, why they need to persist in that a relatively stingy policy. So we're on the lookout to see if that comes along. That can be a bit of a game changer.
Phil Orlando: No, I think that's very valid. I mean here's Germany, the fourth largest economy in the world. They're running a balance, a budget balance surplus right now. Yet their GDP growth is sitting marginally above zero. They are one revision away from going into a technical recession. I think Lagarde's strength is her fiscal policy capabilities and the ability to try to convince Merkel and Germany to open those purse strings and spend a little of money. But to your point, she like Jay Powell, does not have a PhD in economics.
Phil Orlando: Is this transition going to be as smooth as the market expects? Powell's transition from a communication standpoint was somewhat rocky to begin his tenure as the chairman of the Federal Reserve. Are we being too optimistic? Are we whistling past the proverbial graveyard with regard to Christine Lagarde getting this new job? So we'll just have to evaluate and see what's going on.
R.J. Gallo: All right, well with that hopefully we've provided our listeners with some good insight on what we think is most likely to occur in 2020 and it's still an uncertain world. I know for sure that we'll be monitoring closely and adjusting our positions as needed. Thanks Phil and thank you to all our listeners. We look forward to joining you again on the Federated Hear & Now Podcast.
Views are as of Dec. 13, 2019 and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector. Past performance is no guarantee of future results. There can be no guarantee that any investment strategy will be successful. Federated Equity Management Company of Pennsylvania.