Themes, forecasts and pockets of value

Linda Duessel: Hello, and welcome to the Hear & Now podcast from Federated Hermes. I'm Linda Duessel, senior equity strategist. Today's episode is a special recording of a roundtable discussion I led on December 8th with my Federated Hermes colleagues, Phil Orlando and R.J. Gallo. And with that, please enjoy this special episode.

Linda Duessel: Hello, and welcome. Thank you for joining us for our roundtable today. I'm Linda Duessel, senior equity strategist at Federated Hermes, and I host the Federated Hermes Hear & Now podcast, which you can find on your favorite streaming platforms. I'll be the moderator today. I'm joined by my Federated Hermes colleagues, Phil Orlando, chief equity strategist, and R.J. Gallo, senior portfolio manager and head of the Muni Bond Group and the Duration Committee. For those of you who are not as familiar with Federated Hermes, I'll give you a brief introduction to our company.

Linda Duessel: Federated Hermes is a global leader in active responsible investing with more than 600 dollar billion in assets under management. At Federated Hermes, responsibility is central to our client relationships, our long-term perspective, and our fiduciary mindset. It's part of our heritage in the foundation of our future. Our investment solutions include equity, fixed income, alternative/private markets, multi-asset and liquidity management strategies. Today we're talking about our 2023 outlook. We have a lot to cover in one hour. Now, let's get to it.

Linda Duessel: Okay, gentlemen, welcome, and another year under our belt and here we are looking forward. As we look into 2023, we remain concerned about the Fed's inflation fight. For those of the media who were with us a year ago, I remember each of the two of you suggesting that the Fed would be walking a tightrope this year, and you were both very, very cautious in terms of each of your stock and bond market's asset classes, and we were suggesting Cassius King looked like the right call in a very, very volatile year. So I'll start with you here in terms of the Fed's inflation fight and how that's going, R.J. What is the inflation message today as you look at the TIPS market, what is indicated there, an implied inflation, and then how it's evolved throughout this year?

RJ Gallo: Well, I would point out that I agree with you, Linda, last year at this time we were very cautious. I think that cautious has proven to be very warranted. As we stand today, the total return on the Bloomberg Aggregate Index of investment grade US bonds is a loss of 11%. That puts it at the worst performance in the index' history, which goes back to 1976. Treasury securities are down over 10%. A bunch of academic studies have put that the worst performance since 1788 or 1790, depending upon who you talked to. So that's an astounding storm for the bond markets. The storm was predicated upon 40-year highs in inflation, that occurred at a time when bond yields were at record lows. And the result, the negative total returns I just mentioned.

RJ Gallo: Fortunately, as we start to look forward now, after this brutal year, we think the storm clouds are starting to clear. I think the bond market is pricing that in as well. If you look, for example, at the inflation expectations one year from today from the TIPS market, call it two and a half percent. If you look at a one-year forward rates over two and three years, they're all in that mid to high 2% range. That is much, much more tolerable to the Federal Reserve than the 9.1% CPI that we once had, the 7.7 that we got in October on a year-over-year basis. The inflation outlook is improving, and the markets are nicely priced for that. That's why we think the storm is clearing as we look forward.

Linda Duessel: Yeah. And a big shift in the message even since July, hasn't it been, R.J.? So a lot, lot of damage has been done and I think, as boring as I on the equity side have thought, that the bond market has been all these many years. What an interesting year this year and maybe an interesting one next year. Phil, I turn to you here. R.J.'s painting maybe some money to be made in the bond market next year. Consensus thinks now, through the TIPS markets, that inflation will reach just two and a half percent back in that two and change level that the Fed says they want. But are you concerned, Phil, about a structural inflation that remains problematic, particularly in the labor and shelter markets?

Phil Orlando: We are. We think the markets may be too optimistic at which the pace by inflation will come back to normal. This has been an argument that we at Federated Hermes have been having with the Federal Reserve for better part of two years now, that we thought that inflation was more persistent, more structural. The Fed was sort of waving it off, 'Don't worry, it's temporary, it's transitory.' Well, that tug of war is over, and I think we can look at things like the labor market and the shelter market as reasons for that. In the labor market, there is not a lot of slack. The rate of unemployment, the U-3 at 3.7% is just off a half century low. You look at the section of the labor market skilled workers, their rate of unemployment right now sitting at 2%. That fractional unemployment is thought to be at 4%. The government thinks that any point in time, 4% of us want to be out of work for whatever reason. That number's at 2% right now. So that's keeping pressure on wages.

Phil Orlando: You look at that rail workers agreement that was just signed by the president a week or so ago, that calls for a 24% increase in wages over a five-year period. You don't think that every labor union in America is going to be going head in hand into their next negotiation with the rail workers' contract saying, 'We want this plus something else.' And then on the shelter side, houses hit an all-time record 480,000 dollars a couple of months ago. Rents, which are normally up one, two, 3% a year, up 25% in the last two years. When we take out a mortgage, when we buy a home, we're taking out a mortgage 15 year, 30 years. We sign a lease for an apartment, it's a year or two, whatever. Those are long cycle commitments. So we don't think the inflation is going to come down quite as quickly as the consensus believes.

Linda Duessel: Okay, R.J., Phil's making an excellent point, and I don't believe I've heard Jerome Powell and the Fed saying, 'All right, we're back to transitory inflation.' And the storm clouds aren't clearing necessarily for them yet, and I've come to learn a lot about the bond market and the Fed funds in this year. One of the lessons being that whenever the Fed starts a tightening campaign, they don't finish their tightening campaign until Fed funds exceeds that of the level of inflation will. Inflation I guess depending on what number you pick, could be give or take 7% at this moment.

RJ Gallo: I think monetary policy is staying dramatically over many decades.

Linda Duessel: I mean, do we have to get there at this time around-

RJ Gallo: During many of the historical tightening periods, if we might look that way-

Linda Duessel: ... in terms of looking at that rate and what it might be in '23, R.J.?

RJ Gallo: ... you see that the Fed doesn't stop until they get above current realized year over year inflation. You didn't have something called forward guidance. You didn't have the dots, you didn't have a published summary of economic projections, and you didn't have what I sort of like to deem open-mouth operations. The drumbeat of FOMC participants from Powell to the Federal Reserve presidents all across the country who are telling the markets and giving the markets much, much more than Paul Volcker did back when... And Bill Greider wrote a book about it called Secrets of the Temple. The Fed doesn't keep a lot of secrets anymore. It's an open book.

RJ Gallo: So the economy as seen by the Fed is, you see their projections, they tell the markets what they're planning on doing. The markets start to price things in before the Fed even does it. As you can see, for example, what happened to bond yields this year. Yield surged, once the Fed opened the door to the tightening and started telling us they were going to tighten by hundreds of basis points, the markets priced it in well before they ever did the tightening. So I think the markets and the bond market are really looking forward at this point in time. They might be a little bullying or a little too optimistic on the inflation front. I agree with Phil, it's probably going to be a little stickier than most to anticipate. We think the Fed is going to get to five, five and a quarter, and probably stay there for the whole year. That's what they keep telling people.

RJ Gallo: The bond market is priced right now for an ease at the tail end of this year. That might be a little bit too optimistic. I do think how is that consistent with the storm is clearing, it's consistent in the following way. The yield on the 10-year Treasury is 350 basis points. Back in July of 2020, it was like 50 basis points. The carry that you get from a yield that is so much higher today than it once was provides some defense. It allows bonds to behave in a manner that is more traditional in the way we think of fixed income, that they can be a diversifier, that they won't be a source of large double-digit negative returns. So the picture is improving for the bond market. It's not the perfect bottom. I wouldn't be surprised that the 10-year Treasury yield ends up at the end of the year at 3.75 as opposed to 3.50 today. So it might back up a little further, but-

Linda Duessel: I think a very clear viewpoint from our bond department, as R.J. is describing it, storms are clearing. Of course, in Pittsburgh, Pennsylvania where we live, where R.J. and I live, and we get storms here, but then when the storm's clear, we still have cloudy skies. I guess that's higher for longer. But I'd like to go back to you before we move on here and look at the rest of the world. Phil, as you were discussing the structural inflation, and I know you didn't say that this is the '70s again, I kind of think it's the '70s again because I was around at that time, the labor market was very, very strong at that time, as you are suggesting it is. Those low unemployment rates up the skill ladder are very strikingly low. So there is that ability to get the wage hikes. What I think is really interestingly different this time, and maybe in a manner worse, is what I like to call the revenge of the boomers. I'm sitting with a few boomers here, maybe not R.J., maybe not R.J. It's hard to tell-

RJ Gallo: No, Gen X here, Gen X.

Linda Duessel: It's hard to tell, it's hard to tell. But back in the 1970s, we were the boomers then with the boomers now, and something I like to think of at call the revenge of the boomers where you had three million more retirements than were planned since 2019. Since the end of 2019, three million more boomers retired than was on the trajectory, and they're not coming back. So that might be a difficult problem and a stubborn problem as we make our way into next year with this cloudy Pittsburgh sky that may stand all the way up to New York, where Phil goes to work every day. Now, but in terms of shelter and before I should leave that, I just wanted to make sure that we understand what's going on in shelter as we look at CPI, Phil, and versus rents and what's happening with the rents as this year's progressing. Is there some good news as that big piece of structural inflation goes?

Phil Orlando: Well, as it relates to shelter, we touched upon a little bit of this. The single-family home prices are an all-time record high of 480,000 dollars. Now, that's not sustainable. Those prices will probably come down. We look at what happened the last bursting of the housing bubble in the '07, '09 period, those prices came down about 20% over the next couple of years. We could absolutely see that happen over time. Mortgage rates went from 3% to 7% over the course of this year. They've peaked out a little over seven. They've come back, they're somewhere in that six and a half percent neighborhood. So mortgage rates are moving in the right direction. You had the affordability index within housing. Not only your mortgage rates up, not only your prices up, but the inflationary impact on our wages. Our wages are growing 5% a year, that's great, but if inflation's growing at 8%, that means that we've lost three percentages of personage power.

Phil Orlando: So for all those reasons, the marginal buyer has been pushed into the rental market, and that makes perfect sense because rents historically would only be up one or 2%. And as we talked about a moment ago, rents have actually been up by 25% over the last two years. Those have peaked, and I think those are starting to come down as well. So I guess the good news is that markets correct, price is correct. Trees don't grow to the sky, housing prices, the rents on apartments are not going to continue to go straight up. They've peaked, we think, at an unsustainable high level and they're starting to come back in. And that's part of the process. I think what the Federal Reserve is trying to do by taking interest rates up is certainly engineer slower growth, maybe a recession, but certainly try to choke off demand to some degree, and that brings prices back to more reasonable levels over time.

Linda Duessel: And not to put words into your mouth, but I think you'd be making it very clear here, as rent and owner's equivalent rent represent a third of CPI, I guess 40% of the core, seems clear that it's coming down next year. We definitely seem like we're coming off the boil here in terms of inflation, and I'm not going to have a quick yes or no from you, R.J., before I move on to the next section. Phil mentioned the 7% maybe and plus mortgage rate might be the peak. Is that our view on the bond side, that we've seen the peak in mortgage rates here for all those looking to buy a home next year?

RJ Gallo: Yes, they've already come off that peak. We think that the spread between new origination mortgages and the 10-year between mortgage-backed security yields and the 10-year, and these are all linked, we've already seen the wide. As I noted before, if the 10-year ends the year between 3.50, 3.75 ish, those mortgage rates probably will continue to ease up. Housing has borne the brunt of the Fed's tightening already. It's one of the engines of the slowdown that we anticipate will happen. But we do think those mortgage rates have peaked.

Linda Duessel: Again, storms are clearing, still cloudy. Those poor young people all trying to buy a home and they think it's unaffordable. As a good boomer, I remember signing up for double-digit interest rates and not eating into the principle for years. So don't call me a curmudgeon. But let's move on. Let's move on, if we could, R.J. Look at the US inflation as versus the rest of the world and what comparisons we can make. How does US inflation today compare to other countries around the world, R.J.? And can you bring in the effect of the Russia, Ukraine war and what that has done particularly to other areas around the world?

RJ Gallo: Yeah, I mean recently we just sort of scanned across a number of countries. The last print for the US CPI year over year of 77, very, very high, like I said, near 40-year highs. It was 91 a couple months back, so we're heading in the right direction. That said, you see double-digit rates of inflation in the United Kingdom, north of 11% there. And in Germany and in the Netherlands, for example, it's up over 15%. So core Europe is experiencing extremely high inflation. Part of that is due to the energy and food, cost, inflation that rose from Putin's invasion of Ukraine, which of course is an ongoing problem for the world really, not just for those countries. Of course, it's particularly challenging for the people of Ukraine. So the inflation ramifications of the war have had a greater impact on the countries of Europe than say, in the United States.

RJ Gallo: I would note that the inflation problem has been global. Canada, Australia inflation rate is currently around 7%. Japan's starting to see its highest inflation in decades. Why is this? It's because much of the inflation was born out of the reopening, as herky-jerky as it has been, out of the pandemic. As demand resurge, as people started to travel again and consume services again, the demand for so many products rose rapidly while the supply, including labor supply in many cases, remained relatively constrained. That's called scarcity. That causes inflation, and that inflation has been worldwide. The Ukraine, Russia situation inflamed that inflation, for sure, but it was already high. One other factor to consider, I think that countries that had a larger and later fiscal response to the pandemic, such as the American Rescue Plan, that probably poured a little extra fuel on inflation in those countries. So for example, the CARES Act wasn't probably all that terribly inflationary, but the American Rescue Plan probably added to the inflation that was really already born of the scarcity coming out of the pandemic.

Linda Duessel: So we'll dig into that with Phil, but I'd like to, before I move on to Phil here with this inflation versus the rest of the world, what is our central bank's progress as versus those around the rest of the world, R.J., in terms of the inflation fight?

RJ Gallo: Well, the Fed is hiked. I mean, the top end of the Fed funds rate right now is at 4%. It's moved at an extraordinary pace faster than at any other time since Paul Volcker's time, the head of the Fed back in the early '80s. So they've made very good progress. I think the market is telling you they're making good progress. If the market still had high expected inflation rates of 5% or more and 1.1 year TIPS had expected inflation well north of 5%, then that would be telling you the market thinks the Fed is not making progress. So clearly the Fed has restored some of the credibility that was starting to crack due to the transitory situation when they argued it would be transitory. I think this inflation might be better term to be episodic. Transitory suggests very short term, episodic does not. I think episodic is what we're facing, and I think the Fed has made good progress in trying to counter the inflation problem, and that's why some of the optimism that the storm is clearing in terms of bond returns.

Linda Duessel: I like that word episodic because the episode ends and you move on to the next episode. I love that. I love that. And of course, our central bank's tightening is in a much stronger economic situation, I guess, than many areas of the world, so we're lucky that way. But Phil, I'd like to bring you in here to something that R.J. alluded to, which was the particular fiscal policy largesse, if I may, that the US has provided its citizens as versus what happened around the rest of the world. How much of the inflation rate would you say, Phil, or has been calculated to be explained by this fiscal policy? And then what can you tell us about what's going on here with the consumers today in terms of their savings, their excess savings, what they're doing to continue their spending spree?

Phil Orlando: Yeah, great question, Linda, and one that's extraordinarily controversial. I'll just say that upfront. The Federal Reserve at their annual monetary policy symposium back in Jackson Hole in late August tackled that question head on. They produced a white paper that a number of their economists defended at their Saturday session. And the gist of the white paper was that based upon their analysis, 60%, 60% of this 40-year surge in inflation that we've seen over the last couple of years was related to poor fiscal policy decisions.

Phil Orlando: Now, I'll sort of jump on where R.J. started. I've got absolutely no problem with what the Federal Reserve did back in early 2020 as we're getting into the throes of the COVID pandemic in terms of taking interest rates down at zero and doubling the balance sheet. I have no problem with what Congress and the administration did in terms of the CARES Act, literally putting trillions of dollars into the economy to extricate us from the shortest but the deepest recession in history. But, the economy enjoyed a very powerful, the bottom recovery in the middle of calendar 2020. The recession ended in April of 2020.

Phil Orlando: So with the benefit of hindsight, by the time we got to phase four of the CARES Act in December of '20 and then the ARP program in March of '21 and then more recently the Inflation Reduction Act and various other programs, those proved to be inflationary, and I think that's what the Federal Reserve was referencing. So when we look at the savings rate, for example, as a result of those programs, the savings rate was up around 34% in April of 2020. It was around 26% in March of '21. Today that number is now at 2.3%, a 17-year low, just a couple of ticks away from being the lowest in history. You look at excess savings, we had 2.3 trillion dollars of excess savings a year 18 months ago. That number is now down to 1.7 trillion.

Phil Orlando: And importantly, if you break that number apart by sort of the top half of consumers versus the bottom half of consumers, the top half has about 1.35 trillion dollars of those savings. The bottom half of America are about 350 billion. So the dry powders starting to run out. So what happens? People are using their credit cards more. Particularly the bottom half, credit card usage is up by 18% so far this year through the month of October. And, not surprisingly, there's been a surge in delinquencies over the last couple of months. So I think the personal balance sheet situation is degenerating based upon the high levels of savings and how those savings levels have come down pretty sharply, and people are using their credit cards now and their excess savings to try to get through.

Linda Duessel: Okay, so now just as we leave our Fed inflation fight topic, Phil, can you just ever so briefly tell us what is the inflation message from Federated Hermes' own proprietary work?

Phil Orlando: I think we've touched upon it here that our view has been, and continues to be, that inflation is more persistent than I think the consensus believes. We absolutely believe that inflation peaked earlier this year. Where we differ, I think, is the trajectory of getting back to the Fed's 2% sort of normal target. We measure that decline, that trajectory in years, not weeks, not months. So we're very comfortable with a 2% inflation level maybe by the end of calendar '24, but not tomorrow, not next month. And that's where I think we get that.

Linda Duessel: And not the end of '23, Phil?

Phil Orlando: No, not the end of '23. Too early.

Linda Duessel: So that is definitely a difference I think from our work as versus consensus out there. Now, R.J., bringing you back in. Let's look closer at 2023 and what's to expect. What indicators do you see that indicate that really say for sure, maybe, that inflation is going to fall next year?

RJ Gallo: Well, we think that the direction is down. As we've been describing, as Phil mentioned, we're probably a little higher than consensus in terms of how the destination that we get to over the next 12 months. But supply chains, global supply chains were deeply challenged. They were kinked, they were clogged, whatever metaphor you want to use, in coming out of the pandemic, as the reopenings occurred gradually across the world and now we're starting to see even in China. The supply chain indicator from the Federal Reserve Bank in New York was developed to try to measure the stress on supply chains. At one point it had a four standard deviation move away from normal. In other words, the clog was four standard deviations worse than normal conditions in terms of providing goods around the world. That number is now just a one standard deviation divergence from normal. So, a sharp improvement is occurring.

RJ Gallo: I think one of the challenges that the Fed faced with their transitory argument, they believed in a market economy, if prices are high because of scarcity, that will invite capital to enter into the provision of those scarce goods and services to therefore profit from the high prices and then the prices would come down. That's market economics. I think that finally started to happen. It just took a while. I think the jury is still out on the labor market, as Chairman Powell just elaborated extensively at the Brookings Institution a couple weeks ago or a little more than a week ago. The question for inflation now has to do with wages because other factors that suggest inflation's coming down include commodities are way off their peaks, broad-based commodities, not just fossil fuels, not just gasoline. You're seeing the supply chain improvement that I mentioned before. Rents are already rolling over. Chairman Powell provided a lot of data to show that high frequency indicators of current renting rates are already declining, decelerating from the nearly 20% year-over-year increase that was occurring not that long ago. So that's helpful for the CPI and the PCE.

RJ Gallo: It all really comes down to what happens in the labor market. And the last employment report we saw average hour earnings were still too high, the job market is still tight. We need to see, as 2023 unfolds, fewer jolts job creations. We need to see slower job postings and job creations in the non-farm payrolls, and we need to see those wages decelerating. We don't need to see them dropping. We don't need to see average earnings being negative, but we do need to see them declining. So there are a number of factors suggesting yes, inflation's off the boil. Commodities, supply chain improvement are two of the big ones. I think the question now really turns to the labor market and the cost of services.

Linda Duessel: Of course, that's very potentially problematic here in the United States where we're a services oriented economy. But Phil, R.J. makes a very important point that the supply chain indicators are really improving dramatically. Now, I know that you do some special work on back-to-school and Christmas sales information. What are those pricing indicators telling you? Are they in sync with what R.J. is saying?

Phil Orlando: Yeah, they are. And what it points to is a picture of an economy that's slowing and a consumer that's slowing, but from a very elevated level. So you look at, for example, back-to-school spending, which has a very high 80 to 90% correlation with Christmas spending. Back-to-school spending this year was up a little more than 9%. That's really good. Historically, that number might be up three or 4%, but it's down 9% this year from up 16% last year. So we're working back towards normal. Same story with Christmas spending. Christmas spending last year was up like 16% year on year. Normally, that number's around 4%, this year we're thinking it's going to be sort of a mid-single-digit number, maybe five, 7%, something like that. So, the consumer's still spending, we're going to have a decent Christmas, but from a year on year perspective, there is going to be a deceleration in part based upon the spike in inflation, higher energy prices, higher housing prices, et cetera. So the consumer is under stress, but we're not canceling Christmas. We're going to still celebrate the season in some manner.

Linda Duessel: In some manner. I don't think I like that. I think I have to go and do some of my own Christmas shopping for me. I don't trust the mister here even with the prices coming down. But I do want to touch on one little corner of pricing that's I guess kind of controversial, Phil, and that is energy prices. We all know there's two sides to look at the energy patch. Where does Federated Hermes come out when we don't know about supply necessarily next year or a global recession?

Phil Orlando: We've had a very sort of out-of-consensus view on energy for the better part of the last two years. With energy crude oil prices, two years ago, down around 35 dollars a barrel, we thought they would go materially higher. They did. We got up to about 135 dollars earlier this year, and they've come down nicely. We're probably sitting crude oil WTI at about 70 or 75 dollars right now.

Phil Orlando: As we look out over to the course of next year, there are three global fundamental drivers that are impacting our decisions. Number one, Russia's weaponization of energy in terms of their sales to their European customers vis-a-vis. Europe attempting to put price caps on natural gas and energy prices. Number two, the OPEC nations have reaffirmed a cutting production by two million barrels a day. And number three, we don't think that we've done a particularly good job here in the United States managing our energy infrastructure, particularly taking the strategic petroleum reserve down by half over the course of this year. So for all those reasons, we would expect to see energy prices amidst a cold winter here in the United States and or Europe move back into that 120 dollars neighborhood over the course of calendar '23. That is not a consensus view. If we're right, if crude oil prices, if gasoline, if home heating oil prices go higher, that probably crimps consumer spending to some degree because people are spending more money filling up their tanks as opposed to buying stuff for their kids at Christmas.

Linda Duessel: Yes, 120 dollars is a reasonably high figure as versus where we are now. Of course, that'll have implications as we discuss what sectors of the market we think are interesting to own equities in. But again, if I harken back to the 1970s, and I remember that we were a lot more vulnerable to prices of energy back then as a country, I think over 11% of our pocketbook needed to be spent on energy more like under 4% this year. That's not helping Europe one little bit though as they pray to the meteorological gods, I guess, for a reasonable winter and then next. But R.J., you did make comment earlier on that though the consensus believes that the Fed is likely to cut rates sometime next year, we are in the higher for longer camp. We're thinking that they may not. But what should we be on the lookout for in terms of what would make the Fed pivot prematurely?

RJ Gallo: Prematurely? I would think that the Fed is loath to pivot prematurely. I mean I think Chairman Powell's appearance at the Brookings Institution, which I alluded to earlier, he cast a little bit more of an optimistic light on the prospect of achieving that soft landing. I think that's going to be hard. I think the Fed is focused on fighting inflation. He listed the factors that should lead to disinflation, and he suggested they don't want to over tighten. So what does a Fed do that doesn't want to over tighten? They get to a level they deem sufficiently restrictive and they stop. They let that restrictive policy and all the inherent lags that monetary policy faces work out over time. That's why a five to five and a quarter Fed funds rate, so long as inflation continues to decelerate, might be a plateau for the Fed funds rate for much of 2023.

Linda Duessel: If I may, it's said a lot out there that the moves that the Fed makes could take one to two years to make their way through our economy. This has been the fastest pace of tightening that we have ever seen. And when you do something like this, it lets the weakest links show themselves and a financial accident is, I don't know, I've read it numerous times, absolutely in the cards. Thoughts on a financial accident, R.J.?

RJ Gallo: Well, that's where I was going to go. I think that the Fed right now is relatively optimistic that we're not going to have a financial accident. If they were concerned about that, I think they would've slowed their pace faster than they already have. They're shedding light now on the prospect that they're getting closer to a sufficiently restrictive level. They're slowing their pace, they're probably going to go 50 basis points in the next meeting, not 75. It's almost certain, really. A financial accident or a financial crisis would have to be sufficiently large and almost systemic in nature, in my opinion, for the Fed to turn tail and abandon the inflation fight. I think it's fascinating that crypto has been a pretty big deal. There have been a lot of crises within crypto, and hasn't caused the Fed to blink, probably because crypto is not yet systemic.

RJ Gallo: I think it's also worth noting that the cumulative capital and liquidity of the banking sector is still in pretty strong condition. So I think the Fed feels comfortable that the financial system, over which they are a very important regulator, is in pretty sound state to allow them to act as boldly as they have. That said, if you were to get an unexpected systemic shock, that could cause the Fed to backtrack. It also could accelerate the recession that we think is somewhat likely in 2023 and that also would be disinflationary. So it's not necessarily the case that backtracking prematurely is what would result. That's my point. When you said prematurely, systemic financial crises and recessions are not inflationary, they're disinflationary. So I'm not so sure it would be a premature backtrack. It might be one that was based upon the Fed saying, 'Look, we're getting even more disinflationary forces and we now have to adapt in our plans for them.' That's my point that I was trying to make.

Linda Duessel: Yeah, and a great point as versus that arctic crypto winter that's going on now, and that hasn't changed things at all. But Phil, in terms of Fed Powell saying where you're going to experience some pain and some people think maybe that's going to be a recession and it's going to be a mild recession unless it's my job that gets lost in terms of the job situation, what do we see in terms of the economic recovery, the character of the so-called K economic recovery that you have been describing, and what that means in terms of the unemployment situation, the labor force, and what-

Phil Orlando: Yeah. So I think what the Federal Reserve is doing is utilizing their Phillips curve trade-off between unemployment and inflation, trying to manage this process. The rate of unemployment was down at three and a half percent, half century low, rate of inflation, 9.1%, 40-year high. So it was obvious that they were going to focus on the inflation part of the equation. But what about the employment part, which is the critical question here? In their September SEP, their summary of economic projections, the Fed told us that they're projecting the rate of unemployment to go from 3.5% to 4.4%. We're going to get another update on that next week at the FOMC meeting.

Phil Orlando: Now, two things: Number one, I think the Fed is being extraordinarily optimistic. Our work internally suggests the rate of unemployment might go higher than 4.4%, maybe 6%, 7% over the next couple of years. But importantly, we've never had a situation in which the rate of unemployment went up by a full percentage point, let's call it, to keep the math easy, where the economy didn't roll into recession. So that's something that the Fed, I think, is fully cognizant of and is attempting to manage. Now, in terms of this case shape recovery that you referenced, that comes down to this idea about early boomer retirements that we saw versus the labor force participation rate. Now, the early boomer retirements, I think, were a function of how well the financial markets, the housing market did over the last couple of years. The stock market was up 120% from March of 2020 through the end of last year, and high-end houses literally doubled in price. So a lot of boomers, they said, 'I'm cashing out, I'm going to retire early.' They're done.

Phil Orlando: At the low end of the spectrum, the worker bees, if you will, we talked about the fact that the savings rate is down substantially, excess savings are down substantially. So the dry powder that they built up as a result of this fiscal policy largesse that we discussed earlier, is starting to sort of level out. Those folks need to come back to work now to make the rent payments, make the car payments, keep the heat and electric on. So we expect to see the rate of participation move up as these lower skilled or less skilled workers come back into the market to be able to support their families because the dry power that they had built up is rapidly declining.

Linda Duessel: And if all that goes according to plan, it might actually give us that mild economic recession that you speak of, Phil.

Phil Orlando: Absolutely.

Linda Duessel: In terms of the Fed, R.J., you've said this before, I guess, I don't know the first time you said it, it really struck me, the Fed is inducing recession, they're inducing it on purpose. Can you tell us what the yield curve message is for the recession?

RJ Gallo: Yeah, I mean you have a very sharply inverted yield curve. The bond market folks like myself, we tend to focus on the two-year 1-year. The three-month 10-year has also been inverted. That's a number that a lot of research economists that the Federal Reserve system focus on. The inversion of the curve, longer term yields lower than short-term yields, suggests that economic restraint is being felt by the current Fed monetary policy, that that is going to produce a recession. It's got a very strong track record, the twos, tens, and the three-month tens, at predicting recession over the last 40 years or so. I think that the widespread expectations of a mild recession in 2023 are partly supported by looking at that market variable at the curve inversion.

RJ Gallo: I think that the Fed's goal in addressing inflation, I don't think they would tell you they want a recession. That's a no-no for them. But they have used words like pain. I think you alluded to it earlier today. The pain was a euphemism for recession. It was striking how Powell sort of walked that back a little bit at the Brookings Institution appearance, which I thought was a pretty big deal where he suggested a soft landing might actually be more probable than I think previously people had thought. That said, I think the recession is the odds on bet more likely than not in 2023, just because monetary policy is an extremely blunt instrument. The curve inversion is telling you that the recession is more likely than not in the year to come.

Linda Duessel: Okay. That's the bond market. As we know, Phil has very long history of being pretty accurate as versus the stock market. As we look at the economy and we look at the ISM indexes, both manufacturing and services and of course the regionals, I presume there that you would agree they are suggesting there's going to be a recession and perhaps a mild one. Would you agree with that? And in terms of the housing complex, what you think in terms of what will the average price of homes fall to if indeed we're having a mild recession?

Phil Orlando: So we always follow the lead of our more erudite bond colleague. So R.J. directionally is absolutely right. I'd look at the leading economic indicators, the LEIs, which are now down negative territory eight months in a row, nine months out of the last 10. You go back and look at the last, oh, I don't know, 75 years of data. Whenever we've seen a pattern like this from the LEI, with a hundred percent accuracy, that's been a very reliable recession indicator. You look at manufacturing, the ISMs for manufacturing, which was in the mid 60s, last year has dropped below 50. Now we're at 49. We're not in recession yet, but typically when you get into that mid 40s, that's suggesting recession.

Phil Orlando: The six regional Fed indices that we look at, Philly Fed, Empire, Chicago, et cetera, are all sitting at two-year lows right now. Contrast that with where we are in the ISM services index, that's very strong. That's in the mid 50s, up around 55 or 56. So there's a clear dichotomy between the manufacturing and goods portion of the economy, which is in tough shape, the services portion of the economy, which is in pretty good shape. So for all those reasons, I think R.J. is right, we agree with him, we are sort of on a glide path in a recession. At this point, we'd like to think it's going to be a relatively mild recession, but we don't know if there are going to be any exogenous shocks to the system that will make an alteration in that forecast.

Linda Duessel: And now, before we move into our own suggestions for where pockets of value might be and what our forecasts are next year, before we do that, Phil, we are suggesting there's a mild recession next year. As far as my research says, a hundred percent of CEOs, a hundred percent of people in the investment community, think that there's going to be a recession next year. Why then is this being priced into the market? And if not, why then is the S&P recently doing a FOMO trade and 4,000 S&P?

Phil Orlando: Well, we've seen a bunch of these bear market rallies over the course of the year. The big one was in the summer. From mid-June into mid-August, the stock market was up 19%. That was a head fake in our view, and ultimately the stock market came back and retraced that move and went lower. More recently, from mid-October into last week, we had about a 17.5% typical seasonal midterm election rally. Again, we don't think the fundamentals support that longer term. We understand the sigh of relief rally, change in control, divided government, and all of that. We think, ultimately, fundamentals win out. So we're expecting that there will be a retracement back to those mid-October lows that was around the 3,500 level, maybe a little lower. As we get into the fourth quarter earning season over the next month or so, we think fourth quarter earnings are going to be a little choppy, a little guidance, a little weaker. So we would expect to see the market begin to focus on this recession question with lower economic growth, lower earnings. Ultimately, we think that will be reflected in lower stock prices.

Linda Duessel: So that could be our gift for this year, the ability to sell before the lower stock prices. Merry Christmas.

Linda Duessel: Okay, R.J., let's now talk about opportunities as we see them from the bond aspect next year. You made several comments during our talk today that we saw the worst bond market. I guess you alluded to the 1970s, and then maybe even the 1700s, I think you may have alluded to, maybe sets us up for some good opportunities next year. But then also with the notion that Federated Hermes' view is that inflation will be more stubborn than maybe the market is pricing into next year, what then are the opportunities for next year? Is cash as much king going into '23 as it was in '22 for you?

RJ Gallo: No. No, I think cash provided a positive nominal return when stocks and bonds were posting deeply negative returns. That's what the king is. I think if you look into 2023, yes, our firm thinks inflation is probably going to be a little more stubborn than the market. But yes, we think it's coming down. If it doesn't come down fast enough, the Fed holds a plateau at 5%, that merely increases the chances of recession as 2023 unfolds. Right? So the short end of the curve, cash rates are going to continue to rise, and that's great for cash investors, but I think it's time now to start legging out of cash and moving into bonds because you're going to get some price upside in the year or the 18 months to come. That's the overarching point. We don't think we're going to come out of this rapid Fed tightening unscathed. A slowing economy is the recipe for disinflation, is the recipe for better bond returns.

RJ Gallo: Currently, if you look out at the 10-year Treasury, you have a 10-year Treasury yield called around 350. You would need yields to back up about another 50 basis points for that bond to return zero. That's a vastly different world when the 10-year Treasury yielded 50 some basis points in July of 2020 or about a hundred basis points back in 2021. You now have the cushion of income because the corollary or the result of the worst bond market since the 1780, 1790s is that you're buying an asset that's much cheaper. In our business, you want to buy low, not buy high, and I think now you have the opportunity to do that for high-quality bonds. The worst return since 1976 is because the Bloomberg index only goes back to 1976, but it is the worst return in over 200 plus years.

RJ Gallo: If inflation reaccelerates, a lot of what I said isn't going to work. Because if inflation reaccelerates, then yeah, cash is going to be a little bit better than bonds in the very near term. On the other hand, if inflation reaccelerates, the Fed will just tighten more. That will increase the prospects of recession, and again, bonds will have a better return in the year to come than in the year we just passed. And it still would likely be low single-digit positive. I think personally, risk assets would struggle in a scenario like that. If the CPI in the coming week, in the coming months starts to go back up at 8% year over year, 9% year over year, personally, I think risk assets would struggle very mightily with that. Stocks wouldn't like it. High yield bonds wouldn't like it. But high-quality Treasury securities out the curve, yeah, they'll reprice somewhat higher. But I think over time, that's going to attract investors because you're merely increasing the risks of recession as the Fed keeps fighting more aggressively.

Linda Duessel: So R.J., I think I hear you saying a leg into bonds and you like high quality. When should we go after those juicy high yield bond returns?

RJ Gallo: So we've gone underweight, and we have been underweight for quite some time, and it's been wrong lately in the last six to eight weeks for sure. We've been underweight high yield, we've been underweight investment grade corporates. The average credit quality for investment grade corporate bonds in the US is BBB. Those are not high-quality securities. Those are lower quality investment grade securities. Our view is that with a recession being more likely than not, spreads are not wide enough to compensate you for that outcome.

RJ Gallo: As a result, we've reduced our weights. We didn't own none, but we've reduced our weights in our multi-sector portfolios. We've taken that money, we've bought treasuries, we've bought mortgage-backed securities, and we've put our durations at neutral. That is a big change from where we were for much of the year where our durations were at times as short as in the mid 80s relative to our index. And for much of the time in the 90s relative to index, now we're at neutral. So we think it's premature to start chasing the higher yielding lower quality buckets of the bond market until spreads are wider, starting to compensate you for that risk of recession.

Linda Duessel: Okay, great. And then moving over to you, Phil, our expectation for earnings versus consensus is much lower into next year, even though we still see a modest contraction in GDP. What is our theme for equities for the year 2023?

Phil Orlando: Well, I guess we've got to sort of start understanding that when we came out of the bottom of the pandemic in March of 2020, we were all in on growth stocks, and growth stocks had a phenomenal run from March of 2020 until Labor Day of 2020. So much so that the valuations in our view had gotten completely out of whack. And we took growth stocks, technology, for example, down from an overweight to an underweight and elevated value at that time. And that's a trade that has worked well over the course of the last two years, through '21 and '22, and we think has legs into calendar '23.

Phil Orlando: So, areas like energy, consumer staples, utilities, healthcare, what we refer to as the stable demand categories, regardless of how well or how poorly the economy performs in calendar '23, there will be consistent demand for the products and services of those categories. Those stocks tend to be cheaper, they tend to have higher dividend yields, and we think that that's really a good place to hunker down and preserve some capital as we wait for some clarity on this giant cloud regarding inflation and ultimately the fed's monetary policy response to it.

Linda Duessel: Okay. So Phil, in keeping with that, sounds like we're keeping defense on the field here in terms of our suggestions, and also I guess looking for pockets of income even in the equity side. So diversified income maybe is an overall theme here in what could be... I don't know, what do you think, Phil? Arranged by market. I see that our year end target for the S&P for this year was 3,900. That's looking really, really good right now. What is our S&P target for the end of next year based on our outlook?

Phil Orlando: So our target for the end next year is 4,000, but we think there's a decline coming first, and that's the unraveling of this bear market bounce that we've seen relating to the midterm election cycle. Stocks rallied from about the 3,500 level to about the 4,100 level over about a seven-week period from mid-October into last week. We think that that's starting to come off the boil. We very much would expect to see a retracement back to that 3,500 level in coming months based upon slower economic growth, slower corporate earnings growth, maybe even a level slightly below that.

Phil Orlando: But if we're right that the economy bottoms, perhaps we actually go into the recession at some point in the second half of the year next year. The equity market tends to bottom out as we go into recession and against the price in the eventual exit from recession based upon the expectation of more accommodative monetary policy somewhere down the cycle. So that would allow the market, we think, to get back to that 4,000 level by the end of next year after having gone back and tested 3,500, 3,400 or something like that maybe in the summer and early fall month. So we think it's going to be a choppy year, rollercoaster kind of year. We're at 4,000 now. We end the year at 4,000. But there's a lot of stuff that's probably going to happen in the middle of the year.

Linda Duessel: Okay, don't go to sleep, you can potentially make some money in through there. And as we then kind of summarize in these last few minutes for our group, and many thanks for our group for listening in today, our GDP forecast, Phil, for next year, our earnings per share estimate for next year and S&P target, you said 4,000 PE ratios, what do we think for next year?

Phil Orlando: We generated GDP growth last year of about 6%. That number this year will be around 2%. That number next year will be around breakeven, possibly slightly negative, possibly slightly positive. So you can see there's a clear downshift or trajectory of slower growth. In terms of corporate earnings, we have cut our S&P 500 earnings estimate for next year down to 200 dollars versus our forecast for 220 this year. So we're looking at a 10% decline in earnings year on year. The consensus was up around 250 dollars in the summer of this year, June, July. That number's down to 235 dollars now, but still substantially above our number. So if we are right that the economy continues to slow and that corporate managers bring their guidance and their forecast down, there could be another significant leg down in corporate earnings over the course of the next year. We don't think that's in the market yet, and that potentially will serve as the catalyst to have stocks go back and retrace that mid-October bottom we talked about at about the 3,500 level.

Linda Duessel: And I've known Phil for many years and he's generally quite an upbeat fellow. Once again, I don't know, I'm looking at R.J., he's my upbeat fellow for this time around. R.J., can you tell us, for the year end 2023, what is our inflation target, our expectation for the 10-year bond will be, and our Fed funds target for the end of '23. What do you think?

RJ Gallo: So the Fed funds for the end of 2023, personally, I think the Fed is more apt to get to five and to stay there. I think the 10-year could be heavily inverted to the fed fund's target at that time. It could be as low as three and a quarter, or currently where it is right around now, 350. Why is that? It's because the 10-year reflects the cumulative expectation of the Fed funds rate over the holding period of 10 years. The idea that the Fed is going to hold at five while inflation is coming down and the economy is experiencing basically couple negative quarters and zero growth on the calendar year, eventually the market's expecting eases over that horizon. So you can have a bond, a 10-year yield that is significantly inverted to the Fed funds rate. On the inflation side, look, the confidence intervals are extremely wide on inflation. I think the macro committee that Phil chairs, the number, correct me if I'm wrong, Phil, is four, the CPI?

Phil Orlando: Yep, yep.

RJ Gallo: That's the headline, CPI or the core?

Phil Orlando: Core.

RJ Gallo: That's the core. That's what I thought. And I think I would probably put it in the mid three handles myself. As a member of that committee, I vote, and I'm a little less than the committee's number. I think we'll be seeing a little bit more disinflation than the number suggests, but that's not a two handle. So I agree with Phil that inflation is slowing and it's not fast enough for the market's expectation, but it's heading in the right direction.

Linda Duessel: Thank you very much, R.J. And just to close us up, Phil, in terms of our suggestive, I know R.J. suggested where he thought there was some pockets of value over in the bond market overall recommended sectors, size, regions for next year. Thank you very much, R.J. And just to close us up, Phil, in terms of our suggestive, I know R.J. suggested where he thought there was some pockets of value over in the bond market overall recommended sectors, size, regions for next year. Ever so briefly, please.

Phil Orlando: So we ended last year with a 5% equity overweight, our 4,800 target. Over the course of this year, we've cut that to a 1% underweight with a 4,000 target. Again, we like the defensive sectors, energy, healthcare, consumer staples, utilities, lower PE, higher dividend yielding sectors. We're overweight value, we're underweight growth, and we've got a lot of cash in the portfolio. Cash is a real asset class now, yielding three, 4%. So we're still playing defense. Hunker down, wait for some clarity.

Linda Duessel: Great. That's our time for today. Thank you, Phil and R.J. for your insights. And thank you to all of the attendees for joining us, and 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 plus our other series, Amplified and Fundamentals, for a global perspective on the issues, challenges, and trends shaping the investment landscape. I also encourage you to subscribe to our insights email updates for the latest market commentary from the many great minds of Federated Hermes, and follow us on LinkedIn and Twitter.

Disclosures: Views are as of December 8th, 2022 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. Bond prices are sensitive to changes in interest rates and arise in interest rates can cause a decline in their prices. High yield, lower-rated securities generally entail greater market credit/default and liquidity risks, and may be more volatile than investment grade securities. Due to their relatively high valuations, growth stocks are typically more volatile than value stocks. Value stocks tend to have higher dividends and thus have a higher income related component in their total return than growth stocks. Value stocks also may lag growth stocks in performance, particularly in late stages of market advance. There are no guarantees that dividend paying stocks will continue to pay dividends. In addition, dividend paying stocks may not experience the same capital appreciation potential as non-dividend paying stocks. Diversification does not assure a profit nor protect against loss. Phillips curve, an economic model that portrays an inverse relationship between the level of unemployment and inflation on a historical basis that has come under doubt in recent decades. The U-3 unemployment rate is the most commonly reported rate in the US, representing the number of unemployed people actively seeking a job. Consumer price index, CPI, a measure of inflation at the retail level. Gross domestic product, GDP, is a broad measure of the economy that measures the retail value of goods and services produced in a country. The Institute of Supply Management, ISM, Non-Manufacturing Index is a composite forward-looking index derived from a monthly survey of US businesses. S&P 500 Index, an unmanaged capitalization weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index. FOMC stands for Federal Open Market Committee. Yield curve, graphs showing that comparative yields of securities in a particular class according to maturity. Securities on the long end of the yield curve have longer maturities. Credit ratings of A or better are considered to be high credit quality. Credit ratings of BBB are good credit quality. And the lowest category of investment grade credit ratings of BBB and below are lower rated credit securities. Junk bonds and credit ratings of CCC or below have high default risk. Federated Advisory Services Company.