Putting the inflation genie into its lamp

Linda Duessel:Hello, and welcome to the Hear & Now podcast from Federated Hermes. I'm Linda Duessel, senior equity strategist. Today, I'm joined by Phil Orlando, chief equity strategist, and RJ Gallo, head of Municipal Bond Investment Group and head of our Duration Committee, to discuss the current state of inflation, recession risks, the looming debt ceiling, and recent turmoil in the banking sector. Thank you both for joining the conversation today. RJ, let's start with you. We seem to be counting how many quiet weekends we can put together here after we've seen the failure of three large banks here in the US and the collapse of Credit Suisse. Can you explain to us just how this happened and if we're likely to avoid a systemic banking crisis?

RJ Gallo: Well, Linda, I think we are likely to avoid a systemic crisis, I think that only became clear, however, after we started working through some of the difficulties. As recently as March 6th or 7th, most people had not heard of Silicon Valley Bank. Obviously, they exploded into the news reporting sort of a poisonous combination of two key things, number one, they had large losses of long-term Treasury securities and mortgage-backed securities held in the asset side of the bank's balance sheet. As we know, the US Treasury Index dropped 12.5% last year, a record loss for Treasury securities, longer-term Treasury securities, even worse.

RJ Gallo: And then Silicon Valley Bank had another problem that 90% of their deposits were uninsured, so announcing to the marketplace, as they did in the first week of March there, that they had experienced losses in selling Treasury securities from their balance sheet and that they needed to raise capital motivated the very large uninsured deposit base to reconsider having their deposits at SVB. It was a pretty tightly-knit community of startup companies that held their deposits there and they all started to pull their money out en masse and within two days, they had a massive bank run and the bank failed. The key ingredients? A large uninsured deposit base and large losses on Treasury securities. Those factors were uniquely intense at SVB, but other banks faced them, as well. In fact, at the end of 2022, about a third of all deposits in the banking system were uninsured, that number back in 2002 was 18%. It's gone up a lot, a lot of banks own long-term securities and they too would have losses. I think SVB was particularly bad at managing the crisis, however.

RJ Gallo: They had a 90% uninsured deposit base and they had very long-term Treasury securities that were unhedged. Most banks, I think are going to be a little better at managing their asset side of their balance sheet and secondly, I think that the various authorities, the Fed, the FDIC, the Treasury, put in a lot of stopgaps, a lot of measures to support other banks that could be facing similar stresses, if not to the same degree. Namely, they allowed for more lending from the Fed to banks, the Federal Home Loan Bank System lent a lot of money to banks to offset any deposit losses that were going on in the month of March and it seems to have calmed down the situation. All eyes now will be focused on going forward, as these bank earnings come out and these banks will report to us how much they lost in deposits and what their assets are doing in terms of total return, but I think we've gotten past the worst. I'd call it a banking stress, not a banking crisis.

Linda Duessel: So then, that's really comforting to hear, how would you assess the Fed's reaction to get the crisis under control?

RJ Gallo: Well, I think the FDIC, the Fed, the Treasury, the whole group of federal financial regulators and entities did a pretty good job, given the emergency of the situation, the last thing they wanted to do was make it worse. We had SVB and then Signature Bank also shut down because of bank run. They could, they being the federal authorities, they could have decided to only ensure the insured deposits, those less than 250,000 dollars. Had they done so, I fear that we might have had more deposit flight at other institutions and we would have potentially a propagating crisis at that time. Instead, and prudently, the FDIC, Treasury, Fed, they all decided to invoke a systemic risk exception and decided to basically ensure all depositors at SVB and Signature against loss.

RJ Gallo: That calmed other depositors at other midsize and regional banks with respect to any concerns they had that their bank might be in the same situation. That was a smart, very prudent move, it was taken in short order, and I think it was a key aspect of muting down this stress and preventing it from becoming a crisis. The Fed did lend more money, the FHLB lent more money, and it was what they needed to do in short order. Of course, if you step back and think big picture, if inflation hadn't surged as rapidly as it did in '21, '22 and the Fed hadn't raised rates 475 basis points in 13 or 14 months, the bond losses, which were part of the problem, wouldn't be as bad, but that's all with the benefit of hindsight. I think in the emergency moment, the federal authorities made the prudent decisions without rewarding the risk-taking banks. The executives of those banks are gone, the equity holders have lost a lot of money, so moral hazard is always a concern, but I think it was handled reasonably well, while preventing a broader crisis.

Linda Duessel: Before we leave this topic, RJ, I think there's confusion out there about the fact, particularly with the emergency lending program and the backstop that the Fed provided there, did that erase much of the progress they had made on quantitative tightening to reduce their exploding balance sheet?

RJ Gallo: Well, the Federal Reserve balance sheet hit 9 trillion dollars, growing rapidly during the pandemic as the Fed was buying billions and billions of dollars of Treasury securities and mortgages, and then as we know, they started unwinding that in what's come to be known as quantitative tightening, allowing the balance sheet to gradually decline, which was the right thing to do in the face of the inflation problem that we just mentioned. But in the face of the bank runs, the Fed liberalized some of their lending programs, introduced a new lending program, as well, and the banks availed themselves of this opportunity to offset deposit losses by going out and borrowing money from the Fed. The Fed's balance sheet actually, strangely, went up from about 8.3 trillion to a little over 8.7 trillion in just a couple of weeks, which tells you two things, number one, the banks needed the help, they went and borrowed the money from the Fed, number two, people start to think, well, the Fed's expanding their balance sheet again, isn't that stimulative?

RJ Gallo: I would argue that this is being done to address the risk of financial instability, this money is replacing lost deposits. Although the monetary base does go up when the Fed's balance sheet goes up, the Fed's not buying bonds, they're not looking to stimulate financial markets, and they're not looking to drive interest rates down with this action, this is to help the banks through a temporary rough spot. I would suggest people don't misinterpret what's happening to the Fed's balance sheet. Once these loans are paid back, the Fed is still, right now, in quantitative tightening, allowing their portfolio of Treasury and mortgage-backed securities to continue to decline. I think the message didn't change as a result of these emergency lending programs and the balance sheet should resume a downward trajectory in coming months and quarters.

Linda Duessel: Phil, let's bring you into the conversation here now. RJ makes a compelling case, 'This is not a banking crisis, it's banking stress,' but wow, the regional bank stocks in particular have just received a shellacking here in the last number of weeks, the whole sell now and ask questions later, I suppose. Do you think we have a buying opportunity in these regionals?

Phil Orlando: In a word, yes. I think you hit the nail on the head here, Linda, that we are viewing what happened here as a banking tremor or banking stress, importantly, not a crisis. Our view is that this is a one-off, bank-specific kind of issue, not the sort of systemic problems we saw with Bear Stearns or Lehman Brothers back in 2008. I think RJ sort of hit the nail on the head running through the litany of Silicon Valley bank's problems, half their deposit base was in one industry, technology, 90% of their deposits were uninsured, they lacked adequate risk controls. I might throw in there that senior management was actually selling personal shares into the market before they had revealed any of what was going on, so there might have been some greed involved here.

Phil Orlando: When you look at all of that, you say, 'Silicon Valley Bank was a poorly managed company and maybe the senior management were crooks,' but does that mean that the entire banking industry is going to hell in a handbasket? Our view would be no, yet you look at the banking sector, which is 25, 30% below where the S&P 500 is based upon developments over the course of the last month. So if you conclude that the banking industry as a whole is still okay and we had a couple of bad apples, then doing some good due diligence, it would allow you, I think, given some patience, to lock in some attractive prices here on some bank stocks and let the market heal over the course of the next 12 to 18 months.

Linda Duessel: And then just to wrap up this whole area of discussion with you, RJ, and we're talking with Phil about the bank stocks and they had a real tough go and maybe that's a buying opportunity, and the instability prompted a widening of corporate bond spreads, as well, during the last month. If the worst is over, do you see a buying opportunity in either investment grade or high-yield bonds, RJ?

RJ Gallo: Not just yet. We're still counseling remain underweight investment grade and high-yield corporate securities, primarily because the banking stress did cause a widening and we did take some opportunity to maybe reconsider and increase some of the weighting in investment-grade corporate bonds, but we're still underweight in both, because we believe that the bigger challenge isn't the banking stress that we've gone through here, the bigger challenge is the likelihood of a recession later in the year. The spreads that you see now in high-yield corporates and investment-grade corporates don't compensate you for the rising risk of recession later in 2023. Recessions are going to take a bite out of corporate cash flows, credit statistics will erode for high-yield and investment-grade companies, we'll probably see some more defaults among high-yield companies. Spreads should be a good bit wider, quite a bit wider, really, on both IG and high-yield before we would recommend moving in and getting more aggressive and overweighting those two sectors at this time.

Linda Duessel: Well, let's move on now to really, what's got so much of this started is the 40-year-plus inflation we've been suffering and the Fed's inflation fight. When we look at the Fed's rate hike campaign, RJ, they say, 'The Fed hikes until something breaks,' was the banking sector stress enough for them to stop raising rates and when you consider the success so far on bringing the Consumer Price Index down further towards their goal of 2%?

RJ Gallo: I think the Fed's making good progress. The year-over-year headline CPI change that we just got this week is down 5%. The high in that number was a 9.1% back in October, and that's a lot of progress. Recall, though, that the Fed has a 2% inflation target using a different index, but a CPI of 5 is not consistent with a 2% inflation target, so the Fed's making good progress. As far as hiking till something breaks, we just saw something break, we had a couple of banks with bank runs. Admittedly, some of the challenges there were idiosyncratic, but it wasn't independent at all of the Fed's policy challenges.

RJ Gallo: I think that caution in the banking sector is now apt to spread. That's another form of headwind to economic growth, another disinflationary force. I wouldn't call it a credit crunch, but I think the availability of credit through the banking system will be less generous than it had been, so I think the Fed is making progress here. The market had gone from expecting the Fed to hike as high as 6% on the fed funds rate and now, the market is expecting the Fed to hike maybe once more. Why? Because the impact of the banking stress is yet another manifestation of monetary restraint, so the Fed is making progress, but they're not completely there.

Linda Duessel: Not completely there, Phil. Several inflation figures, and I know there are a number of them out there to look at, definitely seem to show some good progress. What are you focusing on in this area?

Phil Orlando: Well, I think you're exactly right, Linda, and we look at the wide spectrum of inflation data, retail inflation, the Consumer Price Index, wholesale inflation, the Producer Price Index, and the Federal Reserve's preferred measure of inflation, the Personal Consumption Expenditure Index. Regardless of what data point you look at, I think it's clear that inflation peaked at some time probably mid-last year and we've been grinding lower. The disconnect, though, for a lot of market participants is what will the trajectory or the pace of that improvement be in coming months, coming quarters, coming years until the Fed's comfortable that it's gotten back to target?

Phil Orlando: Now, RJ talked about the fact that the nominal retail inflation, the CPI on a year-over-year basis, peaked out last year at about 9.1%, the most recent reading we've gotten was 5%. That's a phenomenal improvement in less than a year's time, but I would respectfully suggest that the easy money has been made, to borrow an analogy, that it will be more of a slog to go from 5% down to 2% or 3% over the next couple of years than the significant progress we've made over the course of the last year. Looking at the Fed's preferred measure, the core Personal Consumption Expenditure Index, we peaked out last February, February a year ago, at 5.4%. February of this year, we improved to 4.6%, that's an improvement of 8/10ths of 1%. That's progress, slow but steady.

Phil Orlando: Now, in the most recent summary of economic projections that the Fed made last month, in March, they said, 'Look, we're making progress. We're going to get our core PCE inflation number at 2.1% by the end of calendar '25.' Well, that's 2.5 years from now, which means that the pace of progress we've seen, about 7/10ths of a tick per month is probably the right pace, sort of watching paint dry. So are we moving in the right direction? Absolutely, but lickety-split, we are not going to have this immaculate disinflation where we're going to click our heels three times and get back to 2% in an eye blink. It's going to take a while, we need to be patient.

Linda Duessel: I think that's a very important point you make, the idea of the slog, taking time. RJ, I just want to give you one last chance to comment on this, which is we keep hearing commentators saying, 'The Fed is overdoing it, they're going to overdoing it, why don't they just stop? They keep insisting on 2%.' Must they insist on 2%, RJ, if that's going to potentially cause stresses that would be not worth it?

RJ Gallo: I'm sympathetic to those who question the prudence of holding to that 2%. I just think that the Fed at this point, in the middle of the fight, as we've been calling it, the inflation fight, it wouldn't be prudent for them to move the goalpost and change the objective. If we get to the point where inflation's down to, say, 3% in a year or a little more maybe and the economy is showing severe signs of strain and a recession is emerging, then the Fed might need to rethink that 2%, maybe they could shift it a little bit, but I think it doesn't serve their purposes right now in the midst of a fight, when you still have an unemployment rate that's among the lowest in 50 years, the economy is still pretty strong. It wouldn't be prudent for the Fed to say, 'We're going to move it to 3,' because that actually sort of undercuts their own message. They want the markets to believe that the Fed wants inflation down and they're not going to move the goalpost in the middle of the fight, at least not now.

Linda Duessel: Phil, come back with you now. The fight has really been a mighty one, the fastest hikes that we've seen, I guess, in history here. Let's discuss now who is really suffering in this inflation fight.

Phil Orlando: When we look at the manner in which gross domestic product is broken down, we can glean some very important information. There are six principle components of GDP, three of them matter more than the others and frankly, are forecastable, consumer spending, which accounts for about 70% of GDP, probably the most important, then there's housing, then there's corporate CapEx. Those three pieces together combine into something that we refer to as private domestic final sales and that's like the true, underlying, sustainable level of inflation. If we just go back six quarters, the second quarter of calendar '21, that number, private domestic final sales, was running at 10.7%, very, very strong, largely a function, I think, of a lot of the extraordinary fiscal and monetary policy stimulus that we saw.

Phil Orlando: Now, fast forward six quarters to where we are now, the fourth quarter of calendar '22, that number, which was a 10.7% 18 months ago is now sitting at zero, literally, so the economy is essentially at breakeven. As we look at the future trajectory of GDP growth, the Blue Chip consensus believes that we're likely to see negative GDP prints in the second and third quarter of this year. Our forecast at Federated Hermes is negative GDP prints in the third and the fourth quarters of this year. We think the first quarter, the quarter that we just finished that's going to get flashed at the end of April, is likely to be the high-water mark of the year. So the economy, to use this slog word again, I think is on a decelerating, downward-grinding path based upon the collective input of high inflation, higher interest rates, the bank stress that we've spent some time talking about. All of these things, we think, are going to come together and pressure economic growth as we get into the middle and back half of calendar '23.

Linda Duessel: Well, it's a slog, but while the unemployment rate, Phil, is at its lowest in 50 years, I understand there are today, just under two jobs for each unemployed person out there. Even with the fastest tightening cycle in history, is the Fed losing its battle as versus labor?

Phil Orlando: So the labor question, I think, is a very important one, Linda, and the Federal Reserve is utilizing one of their tools, which is the so-called Phillips curve trade-off in the manner in which they're managing this. The Federal Reserve has two goals that are congressionally-mandated: maintaining low levels of unemployment and maintaining moderate levels of inflation. Well, when they finally got on the case and realized we had a problem last year, we had, as you pointed out correctly, the lowest levels of unemployment in half a century, we bottomed out at about 3.4%, and the highest levels of inflation in 40 years, nominal CPI year-on-year was at 9.1%, so the obvious question is what's the Federal Reserve going to do? Well, the answer was simple. They were going to tighten policy, try to bring that inflation down, and recognize that the rate of unemployment was probably going to go up. How high?

Phil Orlando: Well, at their most recent summary of economic projections that they published in March, the Fed told us that we fully expect the rate of unemployment to go up to 4.5% by the end of calendar '23. Well, we're sitting at about 3.5% now based upon the March data, so over the course of the next nine months, the Fed is telling us we expect the rate of unemployment to go up by a full percentage point. Now, that may not seem like much, but you go back and look at the 110-year history of the Federal Reserve, in their execution of the Phillips curve, we have never had a situation where the rate of unemployment increased by a full percentage point without the economy going in a recession. So the Federal Reserve is telling us, I believe, that we fully understand that we are going to increase the rate of unemployment, maybe push the economy in a recession, but that is a price that we are absolutely prepared to pay in order to get inflation back to what we believe is a more reasonable level.

Linda Duessel: So RJ, what is the yield curve's message as to timing and how has it changed versus the banking crisis?

RJ Gallo: Well, once we got the banking stress out into the market, we had a rapid repricing of the entire Treasury yield curve. All yields across the curve declined, short-term yields declined more than long-term yields, so for example, the two-year Treasury yield before SVB versus a couple weeks after SVB declined 117 basis points and the 10-year decline over that same interval by about 54 basis points. What does that tell you? It tells you two things, number one, that the emergence of the banking stress and the economic implications of that, which will only become clear as we roll the calendar forward, likely have the Fed's trajectory. No longer is the market expecting the Fed to have to go to 6%, the Fed's probably one more tightening and done, say, call 5.25 as the top of the Fed fund's target range.

RJ Gallo: And then number two, the steepening of the yield curve, where its shorter-term yields came down more rapidly than intermediate and long-term yields, suggests that the proximity of a recession is getting a little closer and that the Fed's ultimate reaction to that recession will be easing of policy at some point in quarters and years to come. Those are the two implications of the rapid shift and the steepening of the yield curve as the banking stresses emerged and the markets reacted to them.

Linda Duessel: And as just a bit of a follow-up to this is I've seen conflicting comments as to what the severity of the inversion of the yield curve means as versus history. Does it tell us anything about whether we should expect a hard or a soft landing?

RJ Gallo: That's a great question. I think that the severity of the inversion, at one point, the 2- to 10-year was about 100 basis points, it's not there anymore now, suggests that the market believes that the current level of monetary restraint, the levels of the fed funds rate, call it getting close to 5%, maybe a little higher, is not going to last, that over the 10-year horizon of a 10-year Treasury security, the federal funds rate will not average 5%, it'll probably average something closer to 3% to 3.5%. Does that tell you anything about the severity of the recession? I don't think so. I think it tells you about the degree to which current monetary restraint is viewed as extraordinary to fight extraordinary inflation, and it endorses the idea that the inflation won't persist at these elevated levels, that there'll be a reversion back down over time in the Fed's policy stance, and so the yields out the curve can remain lower than the short-term yields today.

Linda Duessel: Well, we were talking with Phil just a few moments ago about whether or not the Fed in its efforts is still at odds with the labor market. But it also seems, RJ, as if the Fed may be at odds with the market in terms of its questioning their resolve in light of the banking crisis, what do you think?

RJ Gallo: The Fed and the market at times can be pretty far apart, with the Fed delivering projections or expectations of a policy path that the market doesn't necessarily embrace. We're facing that right now. There's no doubt that the implied federal funds rate at the end of this year, 2023, and the market, and you can see this in futures and swaps, is quite a bit lower, call it 40, 50 basis points, maybe more over time, relative to the Fed's own projection of where the fed funds rate will end 2023. That same condition where the Fed projects a higher policy rate and the market projects a lower one is very true for 2024, as well. Only time will tell.

RJ Gallo: The market believes the Fed is going to be in the easing game, because the market believes a recession now is more probable, more likely, in 2023 than was the case even just a couple of weeks or months ago. The Fed is telling us that they still have an inflation problem to deal with, and so they are not signaling as much of an ease in 2024 and the Fed is signaling no ease in 2023, because the Fed is very focused on their dual objectives. They believe that the inflation is still problem number one and they are trying to balance out the risk of recession as problem number two, and they're sort of taking them one at a time.

RJ Gallo: There's no doubt that the Fed believes that the economy will slow. It's in their own projections and the Fed does project an ease in 2024, but they still think they need to hold rates a little higher to fight the problem number one, inflation, first. They're trying to balance these two objectives. The market, I think, is right now, casting its lots in the direction of a recession's coming, inflation's not the problem anymore, and the Fed will be easing by the end of the year. Only time will tell to see which of these visions of the future proves to be true. One thing for sure, Powell's Fed changes its mind when the facts change. They have multiple times reversed their policy trajectories when it's very clear that conditions change, so we'll have to see what those conditions are over the next 6 to 12 months.

Linda Duessel: What are those conditions going to be? Everybody's expecting a recession, Phil. I know a few months back there was a big debate as to could we be in a real recession or is it a technical recession when the unemployment rate is so very low? What sort of measures do you really focus on to give us a clue as to whether a real recession here in the US is inevitable?

Phil Orlando: Great question, Linda, and there's a wealth of information that we look at. A moment ago, we were talking about the U3, the rate of unemployment, and what that means in terms of recession. The ISM manufacturing index has now been below 50 five months in a row, that's not good in terms of recession. The Housing Market Index dropped by 60 points over the course of the last couple of years, we're probably in a housing recession, the Consumer Stress Indicator, looking at energy prices, food prices, mortgage rates, an important historical relationship.

Phil Orlando: We've got our own federated dashboard internally that analyzes a lot of these indicators, but one of the best indicators that we like to look at is something known as the leading economic indicator, and that number right now has been negative month-over-month 11 consecutive months. When you go back and study the history of this indicator over the last half century, literally, every time, the previous seven times we've seen the metric perform as poorly as it is performing now, the economy's gone into a recession. So again, there's a preponderance of data that suggests that as we look out towards the end of this year, maybe the beginning of next, but the economy is definitely slowing, and the question is is that slowness consistent with the recessionary environment?

Linda Duessel: Well, thank you for that very, very, very much, Phil. Let's stay with you here, and I think we would be remiss if we didn't bring up what could be a debt limit showdown here in the next number of months. Do you think that it's a potential market-moving catalyst and are we likely to witness another 2011, Phil?

Phil Orlando: I think you're quite right that we've got this political game of chicken that's going on, we have triggered the 31.4 trillion dollar debt ceiling and the two sides, the Republicans and the Democrats, are going to try to use this as a talking point looking ahead to the '24 election. Treasury Secretary Yellen has talked about the fact that she's about to run out of money and needs the Republicans in Congress to lift the debt ceiling so she can pay the government's bills. I don't know that that's completely accurate. We've got a ton of money coming into Treasury as relates to the tax filing situation on April 18th, so I think Dr. Yellen has plenty of money through the end of the second quarter to pay our bills. I do think this situation comes to a head in the third quarter.

Phil Orlando: Part of the issue is that both sides, frankly, Democrats and Republicans have perfectly valid talking points here. President Biden and the Democrats are warning the Republicans that it would be catastrophic for them not to lift the debt ceiling and continue to pay our bills, and President Biden's absolutely right. But then Speaker McCarthy and the Republicans are saying, 'Well, look, you've spent 5 trillion dollars over the last couple of years, we've got the total debt-to-GDP ratio up around 125%,' which I believe is a record level, 'We don't have anything to show for it to speak of. What we need to do a better job of improving economic growth, getting spending on a better trajectory, and try to grow our way out of this over the next 10 years or so.' The Republicans are absolutely right, so the question is how do we get this resolved?

Phil Orlando: I look back to a very similar set of circumstances under President Obama in the third quarter of calendar 2011, where you had the same dynamic. During the month of August in 2011, the stock market, the S&P 500, dropped about 10 or 15% in the space of about a three-week period. Looking at the entire third quarter of calendar 2011, peak-to-trough, stocks went down about 20%. That represented the bottom of the cycle. We lifted the debt ceiling investors began to focus on fundamental issues again, which were relatively favorable post the debt ceiling crisis, and I think that that could be a blueprint of what we're looking at here. Again, a temporary shock to the market, we may see an air pocket, but I think ultimately, as we get into the fourth quarter and the Federal Reserve starts using open mouth operations in terms of coming back in at some point and cutting interest rates because of the slowdown in the economy, I think the market takes great comfort in that and we get a nice strong year-end rally off of wherever the trough is in the third quarter.

Linda Duessel: RJ, before we leave this subject, Phil's talking about how the spending has been out of control, they're going to lift the debt ceiling as they always have. I've seen some chilling numbers, though, about the need to balance the budget, and if you really wanted to balance the budget by cutting out expenses, kind of how draconian that could be and nearly impossible. Do we need to balance the budget, RJ?

RJ Gallo: The statistics are pretty shocking. If you were to balance the budget, literally have no red ink in Washington, which we haven't done now in what, almost 30 years, 25 years, since Clinton and Gingrich were gracing the halls of the White House and Congress, the balancing the budget on spending alone, you'd have to cut 26% of all spending. And then if you start carving out entitlements and defense and veterans, the amount of spending you would have to cut is huge, so huge it would just be unrealistic. I think there's a hopeful twist to this here, because that's sort of a dark thought, number one, the government doesn't need to balance the budget, per se. I think what the government needs to do is to stabilize the debt-to-GDP ratio, Phil mentioned it's around 125%.

RJ Gallo: That's the gross number, it's an accurate number, but that also includes the debt held by the Federal Reserve System. That's like the Federal Reserve is the government's right pocket, the Treasury is its left pocket, so the right pocket owns some of the debt that the left pocket issued. You don't count that debt, that's not debt held by the public. Debt held by the public is about 100% of debt-to-GDP, still a bad number, that number used to be 70 and 50 over decades past and we still need to do something about it. To stabilize debt-to-GDP around 100% debt held by the public to GDP, the Brookings Institution, the think tank in Washington, estimates that you'd have to cut spending by 15% as opposed to 26 or 27%. That's a little bit more doable, if you will.

RJ Gallo: I think another key point to make is what if you also adjust revenues a little bit? I know people don't love taxes, but it's very clear that our government spends a lot of money, and I'm sure there's a lot of spending that can be cut, but if you take a balanced approach with both spending cuts and some revenue increases, it might get even more feasible. I think it's true that the US government has a spending problem, there is no doubt about it, but I also think it's fair to say that why did we spend so much money over the last three years? I think it's because we went through a historic pandemic, the scale of which is likened only to a war. Governments spend a lot of money in wars and borrow a lot of money in wars, that same thing happened in the pandemic. Now, we have to rightsize our budget, that's where we need to go next.

Linda Duessel: Good points, a bit more hopeful than what I've been reading there. Let's now move on to our suggested forecast at Federated Hermes and start with you, Phil, as to where we see GDP finishing this year and then into next.

Phil Orlando: The short answer is lower. The peak of the cycle in calendar '21, we had GDP growth of 5.9%. Again, that was largely a function of the extraordinary fiscal and monetary policy stimulus that we put in place in calendar '20 that worked its way through the system with a lag. Growth last year, calendar '22, slowed down to 2.1%. We're expecting GDP growth this year, calendar '23, and next year, calendar '24, to slow down to 1.1%. But embedded within that, we've got negative GDP prints in the third and the fourth quarter of this year, the consensus has negative GDP prints in the second and third quarters of this year. It appears that, whether they're right or we're right, I think directionally what we're saying is that growth is slowing, we're probably looking at a couple of quarters of negative GDP growth at some point this year, and then the question is is that going to be sufficiently negative to push the economy over the edge into recession?

Linda Duessel: RJ, what is our outlook in terms of inflation metrics and what the yield curve will do in the fed funds and where they're stop?

RJ Gallo: Well, first of all, we think that we are in a disinflationary phase right now. We've made good progress, there's more to come. You look on the core CPI and the core PCE, we believe both of those numbers are going to be down in the mid to high 3s, call it 390, by the end of 2023 on the core CPI and say 350 on the core PCE. That's still too high for a 2% inflation target at the Fed, but it's still in the direction that I think should prevent the Fed from feeling that they need to take the fed funds rate sharply higher.

RJ Gallo: So on the fed funds rate, we believe that the Fed is close to being done, apt to take the top part of the Fed funds range to 5.25% in the next meeting or so. And then lastly, the 10-year Treasury yield is apt to stay somewhat low, we believe it's going to probably end the year, say, around 3.25% lower than it is right now. The banking stress drove the yields down, now they're retracing a little higher, but we don't think it's heading back to 4, we think it's going to end the year a little south of where it is right now.

Linda Duessel: And then to close it up with you, Phil, in terms of earnings and the market corporate earnings, are we expecting at earnings recession this year into next, and then where we see the stock market finishing the year and are we going to test those lows?

Phil Orlando: We are just starting the first quarter earning season, we are not expecting the numbers to be good. Revenues are probably going to be up about 2% year-on-year, that compares with the 14% increase in the first quarter a year ago. So this would be the worst quarter since third quarter of calendar '20 in terms of revenue growth. From an earnings standpoint, we think earnings are going to be down about 7% year-on-year, that compares with a 10% increase in the first quarter of calendar '22. That would be the weakest quarter for earnings since the second quarter of calendar '20. Again, we're revisiting the depths of the pandemic. Corporate guidance has been running negative by a 3:1 ratio, profit margins are going to decline by about 8.5% in the first quarter, that's the fifth consecutive decline in profit margins.

Phil Orlando: We know the reasons for all of this, wages are up, commodity costs, transportation costs, warehousing costs. We at Federated, we've taken our numbers for the full year down for the S&P 500. We're now sitting at 190 dollars a share this year versus 219 last year, so that's about a 10% or 15% decline. The consensus is still up around 220, 225. The consensus is still looking for an increase in earnings, a modest increase, but an increase nonetheless. So if we're right directionally and earnings in the first quarter, second quarter, third quarter are not particularly good, consensus numbers are going to need to come down, we think that that ultimately is going to drive share prices lower.

Phil Orlando: We believe we could see the stock market retesting the mid-October from last year lows we saw, let's call it 3,500, give or take, on the S&P 500, and then, of course, there was that debt ceiling debacle that we talked about. Ultimately, we think that by the end of the third quarter, that will represent the bottom of the market for stocks, and then we expect to see a rally in the fourth quarter, based upon the expectation that with the slower growth, maybe recessionary growth, the Federal Reserve will start to make some noise, that they will come in and start to cut interest rates at some point. I think the market will be very excited about that and will bid stocks up in the fourth quarter of this year into a strong year-end rally.

Linda Duessel: Great. Well, thank you, Phil and RJ, for this wonderful discussion, lots to keep our eyes peeled for, and of course, thank you to our listeners. We look forward to you joining us again on the Federated Hermes Hear & Now podcast. If you enjoyed this podcast, we invite you to subscribe to the Federated Hermes channel to get every Hear & Now episode. I also encourage you to subscribe to our Insights email updates for the latest market commentary from the many great minds at Federated Hermes and follow us on LinkedIn and Twitter.