Themes to watch, forecasts and potential surprises Themes to watch, forecasts and potential surprises\images\insights\webcasts\weather-station-small.jpg February 8 2022 January 21 2022

Themes to watch, forecasts and potential surprises

Our outlook across asset classes.

Published January 21 2022
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Podcast Transcript
Linda Duessel: Hello, and welcome to the Here and Now podcast from Federated Hermes. I'm Linda Duessel, Senior Equity Strategist. Today I'm joined by Phil Orlando, Chief Equity Strategist and Head of Client Portfolio Management, RJ Gallo, Senior Portfolio Manager, Head of the Municipal Bond Group and the Duration Committee, and Silvia Dall'Angelo Senior Economist from our International Business in London. We're talking about the outlook for 2022, including our picks for themes to watch, forecasts, and potential surprises. Well, I guess there's nothing to do but start with a virus. I guess we have to continue to talk about the virus here in 2022, what it might mean for our global economies and for our markets, and this Omicron that is so very, very contagious. Let's start with you, Silvia. Tell us what's going on, particularly in the United Kingdom, where I think you were suffering this ahead of us by a few weeks here in the states.
Silvia Dall'Angelo: Yes, that's right. Here in the UK, we suffered an earlier Omicron wave, and I think there are a couple of messages from this variant. First of all, the pandemic is not over yet and we might see new variants basically still disrupting supply chains and production, and at the same time sustaining inflation. And second, I guess that it is also reminder that the pandemic is not over until it's over everywhere, and so we really need to make sure... We're policy makers, we need to make sure that vaccination rates pick up everywhere, not just in the developed worlds, but also in emerging markets. That said, there are also some silver linings, as it looks like this Omicron is clearly more infective, but also according to available evidence, somewhat milder. So that might be really the beginning of the end of the pandemic, meaning that the viruses typically evolve in this way. So they become more transmissible, but also less problematic in a way.
Linda: Yes, yes. And Silvia, as you bring that up, and over in the UK, other parts of the world responded to this new variant and said, Okay, I suppose we're going to have to shelter in place, lock you down to a certain extent. And the American citizens are very much adamant that we won't do such. What's the status on lockdowns over there and in terms of how it's affected the economies over there?
Silvia: So at the moment, well, the government has responding in two ways. First of all, ramping up boosters. So for instance, I've received probably 20 reminders to book my booster while I was on holiday, just in terms of anecdotal information. And of course the second measure that was adopted was basically a recommendation for people to work from home where possible. But apart from that, I'd say that restrictions have been limited and we know that working remotely now is quite productive and works pretty well. So of course, there will be a hit to services as people are locked indoors, but it should be more limited compared to previous waves.
Linda: Okay. Phil, let's bring it back here to the United States. How are we reacting? What are you seeing as we start 2022 in terms of companies' reactions and people getting back to the workplace? Phil Orlando: Well, I think it's important to understand, as Silvia said, that Omicron is level one in terms of how companies are trying to manage their business in terms of bringing their employees back, managing the supply chain problems, et cetera. So we've actually dedicated a person to be our Omicron or COVID guru, if you will, to try to figure out what the cycle is. And I find it very interesting that the analysis that we've done is somewhat similar to what Silvia has talked about. Omicron became a big deal here in the United States right around Thanksgiving. There has been a surge, but as Silvia said, our people suggest that while it's much more easily transmissible, it's much less virulent than the Delta was.
Phil: So when you look at development, say in South Africa or Europe or the UK, where Silvia is, and contrast or compare that with some of the experts here in the United States, like Dr. Scott Gottlieb for example, or or Tom Lee over at Fundstrat, our view at Federated is that we're getting close to a peak here over the course of the next couple of weeks by the end of January, and then we're hoping for a pretty sharp roll off. So I think what companies are doing is trying to take all that information in and they'll let employees work from home now for a couple more weeks, maybe into Martin Luther King or maybe into the beginning of February. And then if the Omicron does what we think it's going to do, we can start to resume normal business practices, more business travel, more dinners out, and then that has significant economic implications. So clearly there was a hit to GDP perhaps at the end of the fourth quarter, perhaps here at the beginning of the first quarter. But again, as we're tracking the trajectory of the Omicron variant, we've got to make that adjustment in our models and then try to figure out where the rest of the year is going from there.
Linda: Yeah, I still am very curious about people saying still we need to fear a new variant. And of course, the populations all around the globe are fatigued about this, markets don't seem to care, CEOs don't seem to care either because, as you suggested, Silvia, many of us are working very well and very productively at home. Let's move on now and start this next question with you, RJ. Looking at a recap of 2021, look back. What surprised you the most versus your own expectations?
RJ Gallo: I think the biggest surprise in the year we just completed, certainly to fixed income investors, but I'd say maybe to all markets and policy makers for that matter, the absolute surge in inflation. It outpaced the Fed's intent, it outpaced anybody's expectations. For context, when you're looking at year over year inflation, headline or core, CPI or PCE, all those numbers range from 4.7 to 6.8. Currently on a year over year basis, you're looking at some of the highest levels since the early or late '80s on each of those main inflation indicators. That was really not in the cards. The Fed wanted flexible average inflation targeting to allow inflation to rise to 2% and somewhat above 2%. The numbers I just shared are well more than somewhat above 2%, and it's causing significant change in the policy outlook as we go forward.
Linda: It's really very, very interesting that we were all so caught off guard by this. Of course, they stuck to their transitory comments, didn't they, for as long as they really could? But the stock market seemed to be okay with it and the bond market, I know we're going to discuss this in some greater depth here in terms of what we need to be watching, but is it interesting how the bond market behaved itself really fairly well throughout this timeframe?
RJ: I would note the 10 year treasury yield gets a lot of attention, and it should, it's a key benchmark. But if you look at the yield of all treasury notes and bonds, so it's the index yield from the Bloomberg US Treasury index, that index went from 65 basis points at the start of the year to 123 basis points at the end of the year, a larger increase there than say what you had for the 10 year alone. The curve flattened at various points as the inflation story prompted expectations that the Fed would end up getting more hawkish, which indeed has occurred. The treasury index lost, in terms of total return last year, had one of its worst years in many years in terms of its return to investors. We focus so much on basis points, sometimes it's helpful to put it in total return sense. And the US Treasury index posted a loss last year, getting it up here, I had the wrong number, of 2.32%. That's huge under performance relative to what our equity friends put forward. And if you consider that number in contrast to say high yield corporate bonds, which were up 5.28%, it's abundantly clear what happened. The economy was getting better, credit risk was a winner in absolute and a massive winner in relative terms compared to treasuries, which posted a pretty rough performance.
Linda: That's really very, very interesting. We focus on the equity side so much on that 10 year bond yield, and you've told us actually it was a pretty bad year in the bond market. Silvia, what about internationally? What surprised you the most internationally versus your expectations to start '21?
Silvia: So first of all, I agree with RJ. Inflation was a big surprise, not just in the US, but also elsewhere. Of course, to a different extent, for instance with the latest state for Euros on inflation were 5% for December. But core inflation was somewhat more contained at 2.6% in December 2021. But still, inflation was a big surprise everywhere. There was an expectation of inflation would increase at some point in 2021. But I think there was also an underestimation of the impact from the swing in GDP in just two years. In some countries like the UK, it was the biggest swing in 300 years. And so I think that the (inaudible 00:10:54) effects were the most underestimated also in terms of inflation. That said, I think the other big surprise internationally was China, and a very pronounced slowdown that the country experienced over 2021. China experienced what looked like a V shape recovery in the second half of 2020, but then that was followed by a very sharp slow down during 2021 and there were several factors contributing to it. First of all, an early withdrawal of policy support as policy makers are trying to have a very measured and targeted approach in terms of stimulus. And of course, we also did see some regulatory efforts, mainly targeting the tax sector and education sector. And probably most importantly, we did see a crackdown on the property sector as clearly policy makers are trying to address some of the imbalances that basically have built up in the economy since the early 2000s when basically China joined the WTO and started to experience very strong growth rates.
Linda: That's something that I really would like to follow up with you on. China's the second largest economy in the whole world and it's very hard to imagine the second largest economy going on a roller coaster like that. Big strong recovery, and then a surprise to the downside, and we'll talk about that on our outlook for '22 from your perspective. But with regards to the regulations and the tech sector crackdown and the schooling crackdown, and I've read people suggesting, Well, then it's uninvestible. China, the second largest economy in the world, is uninvestible. I'd love your view on that.
Silvia: I don't quite agree. Obviously, the Chinese model is very different compared to, let's say, the Western model, but it looks like what Chinese policy makers are trying to achieve is a transformation in the economy. So from an investment intensive and export oriented model to a more advanced growth model which relies more on domestic demand. And at the same time, they're trying to address some of the imbalances such as over leverage in the system, imbalances in terms of inequalities, environmental damage. And so all these regulatory efforts need to be read within this context. And in particular, Chinese policy makers are pursuing these common prosperity plans, whereby they are trying to focus more on the core quality of growth rather than just the quantity, which had been the target for 20 years or so. And so I think that within this context, Chinese policy makers' efforts make some sense. And of course, there are also some shorter dynamics that will affect Chinese growth. We are heading into the 20th Congress of the communist party at the end of this year, about October this year, and at that point, President Xi will basically seek reelection forever. And of course, you need some social stability and some stabilization in growth rates in order to make that Congress successful. And so we might see some policy easing and somewhat stronger growth in China in coming quarters.
Linda: Lots to consider there, sounds like we shouldn't turn our backs completely on China as an investment, then. Phil, what about you? What surprised you the most versus your expectations? Phil: So I don't disagree with anything that Silvia or RJ mentioned. In order to diversify the content here, I'm going to talk about the speed of the economic and corporate profit recovery, that we plunged into the deepest recession in history as a result of the pandemic in February of '20, and second quarter numbers were terrible. But we had a very strong rebound in the third quarter of '20. Well roll forward into last summer, July of 2021, the National Bureau of Economic Research comes out and announces that the recession actually ended in April, two months. It was the shortest, but the deepest recession in history. And then the second quarter of last year, corporate profits were up 88% on a year on year basis, very, very strong. Now we were expecting that there would be easy comparisons, but I don't think we expected that the numbers would be that good. I think it's important to note that it's our belief that the second quarter of 2021 will represent the peak of the cycle. We are on a glide path lower, but there's just such a tremendous amount of stimulus, both fiscal and monetary stimulus, in the pipeline, that I don't think that we run the risk of an immediate recession. It'll take us a couple of years to work through all of that stimulus. So we'll get back to normal over the course of the next couple of years, calendar '22, calendar '23. No risk of recession in my mind before calendar '24. But the speed of that recovery from the depth of the worst recession in history is really the thing that I think surprised me.
Linda: I like that a lot. I like that, a happy surprise from 2021, and then there's no wonder, I guess, maybe we saw 70 new record highs throughout the course of last year in the stock market. And I guess there's no wonder that you had, I think maybe but one 5% fallback, certainly not the 10% correction that we often look for every year in the stock market. So sticking with you, Phil, here as we move along, it seems everyone is expecting more volatility this year after last year's quiet rise. I think that's got to be one of the most commonly used terms this year is volatility expected. So what are the three things that you think we ought to be watching for this year in 2022, Phil?
Phil: Well, I would put Federated Hermes at the top of that list that you just mentioned. As we look at calendar '22, we are looking at the prospect of much greater volatility. And the things that we are focused on are probably the trajectory of COVID, where are we over the course of the year? Deferring to RJ, what's going on with inflation and Fed policy? And then looking at the other end of Pennsylvania Avenue and Washington, what's going on with fiscal policy in terms of the Build Back Better deal that didn't get passed at the end of last year. Are there other things that we need to anticipate as we roll into the midterm elections in November of '22? And that we think could represent the potential for a significant change in leadership in Washington. So there's a lot of stuff going on, which in our mind suggests that we are going to have one of those, maybe two of those 10% corrections that you talked about in your question. We think by the end of the year, we end up at about the 5,300 level, which would imply roughly a 10% year. We were forecasting 4,800 last year. We're forecasting 5,300 this year. That's about a 10% increase.
Phil: But importantly, the bulk of the earnings gain is behind us. Earnings last year, we think when the dust settles will be up 50 to 55%. We think earnings this year are going to be up maybe eight to 10%. The multiple expansion is behind us. RJ, I think, did a great job of articulating a withdrawal of fed accommodation so we don't see multiples expanding in that environment. So in our mind, a more normal amount of earnings gains, a more normal amount of equity upside, but with a lot more volatility over the course of the year as we as investors grapple with the destitutes of what's going on with COVID, what's going on with inflation and fed policy, and what's going on with fiscal policy in the midterm elections over the course of the year.
Linda: All right, Phil, I think you gave me more than three things to watch, but boy, there are a lot of things to watch, aren't there? And I guess a lot of opportunities for catalysts for the volatility to increase, but I know we did make the expectation for 4,800 last year. We were nearly spot on. And so I love your 5,300 figure. We need to taper our expectations for only 5,300, which would be a lovely 10% return, wouldn't it? I think that would be just fine if it all works out this way. How about you, RJ? What three things do you suggest we watch for in 2022?
RJ: Following on with the big surprise in inflation this past year, looking forward, we have to watch how inflation behaves and how inflation expectations behave. The Fed is working hard currently to try to prevent inflation expectations from rising too high. They've done a decent job of that. So for example, if you were to look at the sort of slope of inflation breakevens from US tips, you'll see that near term inflation breakevens say out three years or around 297. That's about half of where headline inflation is now. So everybody expects inflation to roll over as the years start to clock by going forward. But if you look at five year inflation expectations or out 10 years, those numbers are quite a bit lower. The 10 year inflation break even as we speak this morning is at a 252, which is pretty benign in a longer term sense. So the Fed is behaving now to prevent these expectations from becoming unhinged because they're not unhinged right now. So that's a key thing to watch.
RJ: How do they do it? Well, how hawkish do they need to get? The FMC minutes from the December meeting just came out. They were really hawkish. They're talking about quantitative tightening, shrinking the balance sheet. Market expectations are now for three or four hikes in 2022, taking the Fed funds target to 100 basis points or 125 basis points, depending whether you get three or four. Reducing the balance sheet, that took years the last time the Fed tightened. They waited years before they resorted to that lever and they're talking about that, it seems more and more likely actually, in the coming year in 2022. Can the Fed find the sweet spot with all these monetary policy levers, tightening just enough to address inflation, helping inflation go back down, keep being inflation expectations under control, but not rocking the markets too aggressively, both risk asset markets and treasuries? And then finally, the other key thing to watch in 2022 is the behavior of the yield curve. Sharp flattening of the yield curve spooks everyone. It sends a signal that the Fed's over doing, it becomes a challenge to risk assets. So it's sort of the corollary to the second point. Can they find the sweet spot? And the yield curve is the key thing to watch to help gauge whether or not they're being successful at finding that sweet spot.
Linda: A couple of follow ups for me on that one. It almost sounds like you're suggesting the Fed is walking a tight rope this year. Would you look agree with that? And what are the odds that they can stay on the tight rope? Sounds daunting. RJ: It is daunting. I think the Fed is in a very unique place. Silvia said a few minutes ago, it was the largest swing in GDP in the United Kingdom in 300 years I think she said. I bet you it's the largest swing in the United States ever. And we haven't been around 300 years. Meanwhile, in the middle of that, when the history books look back, they're going to note that the Federal Reserve put in place the flexible average inflation targeting framework, which was intended to take a structurally underinflating economy and get it back to a sweet spot of around 2%.
RJ: Maybe they should have waited. Maybe the extraordinary challenge of the pandemic, the start stop economy, the massive uncertainty, the supply chain disruptions, all the things that have contributed to this inflation surge, maybe they should have just waited. We want inflation to rise, sure, but we're not going to change our framework in the middle of a storm. And that's sort of what they did. It could prove to be a policy error, really, in a broader strategic, structural sense that they should have just focused on fixing the markets, which they did very successfully and deserve great praise. But shifting their policy framework in the middle of the torrent might have proved to be ill advised. So we'll see. We might be paying a high price in terms of inflation and the tight rope they're now walking to try to manage it is a very real challenge.
Linda: Well, and also you said in your comments that we need to watch out for inflation expectations and we don't want them to become unhinged. You follow inflation expectations. Are there parts of the yield curve that investors ought to be watching for instead of just laser focusing on that tenure? RJ: If you look at the slope of the breakeven curve, so look at the difference between the two year breakeven and the 10 year break even, right now it's about 70 basis points. If that starts to steepen, uninvert if you will, with the long inflation expectation going up and the short one, the two year not moving much, that becomes a problem. That's a sign that the Fed is not succeeding in keeping inflation expectations under control. Right now, the Fed has to be very happy about the inversion of the break even curve. They don't want the yield curve to invert, but the breakeven and curve inversion is happy news for them. That means that the markets are not letting long run inflation expectations become unhinged. That's what's to watch, the slope of that breakeven curve.
Linda: Okay. Silvia, I always thought the bond people were somewhat less interesting than the stock people and RJ's getting very, very interesting, very interest. Let's move over to you. And what are the three things internationally that we ought to watch for in 2022, please? Silvia: Well, first of all, and perhaps let's say obviously, is the economic recovery, which is likely to continue this year. However, it'll probably have a slower pace compared to last year as basically the reopening dynamics and also the support from the fiscal and monetary stimulus will start to fade.
Silvia: However, demand will probably stabilize as basically household and firms in most major economies have managed to build up a decent cash buffer, which will basically allow them to weather basically this fiscal cliff because of the expire of the emergency fiscal measures. And at the same time, we should also see some supply constraints basically easing and basically these supply chain disruptions sorted themselves out over the year. Of course, they won't disappear completely. But if we see this demand supply imbalances lesson, we should also see some moderation in inflation in the second half of this year. This is the base case scenario. And of course, that leads me to the second point. The second thing to watch, as RJ said, is clearly inflation. In my base like scenario, inflation should moderate in the second half of the year. Of course there are base effects contributing to it. There's a moderation of commodity prices, but more fundamentally basically is lessening of supply demand imbalances. And of course, as RJ suggested, inflation expectations need to be monitored very closely, both market based inflation expectations, but also consumer and survey and business survey inflation expectations, as clearly that's the channel through which high inflation can become ingrained. And of course, we also need to monitor wage inflation as the labor market is the other channel that can allow elevated inflation to become ingrained going forward.
Silvia: I also add that crucially, this view that inflation will moderate rely on the assumption that we go back to some pre-COVID trends. And so conception patterns will revert back to services from goods, easing the pressure on goods prices. Also, the labor participation rates should go back to their pre-COVID levels. And of course, supply constraints and supply chains should rearrange in line with their pre-COVID equilibrium. But of course it is also possible that some of these COVID induced changes become more structured, more permanent. So that would also have an impact on inflation and monetary policy. And of course, the last point, the last theme to follow is China. As I said earlier, China is in transition and this transition also implies slower growth rates. The base case is that policy makers will manage the process and there will be a soft landing. But of course there are also risk of policy error in the process. That said, in the short term from a tactical perspective, it is quite possible that we see some subsidization and better growth rates in China because of basically policy stimulus going into the 20th Congress of the Communist Party later this year.
Linda: And picking up off of that comment, I had read somewhere that in the one year leading up to the last five National People Congresses, the Chinese stock market was up, I think 33% on average as the leader wants to be reelected. And Xi of course really wants to be reelected. Do you think China's position for that this year, I guess it's tough to say with all the things they're dealing with? Silvia: This time around, there's a different context. As I said, Chinese policy makers are also leading this transitioning economy, which implies slower growth rates down the line. They're also trying to address these structuring balances, over leveraging the system inequalities and so on. And so there are other goals, not just short term growth. But nonetheless, I think from a tactical perspective, we might see better growth rates in the short term in China as we head into this political event.
Linda: Okay. And just picking up off of the Fed tight rope here in the United States, are the central banks around the globe walking their own tight ropes in '22? Silvia: Well, I think that we'll see some policy divergence across monetary policy paths. Clearly the Fed is leading the way among advanced central banks in terms of normalizing monetary policy, of course, to a normal. We don't know exactly what the terminal status will be. While basically in Europe, and in particular in the Eurozone, the ECB is liking the Fed. Of course, ECB is also facing a different stage of the recovery, as arguably the Eurozone recovery is at an earlier stage compared to the US. And so I think that here in the Eurozone, we'll probably see more commodity monetary policies. The ECB will probably keep its policy rates and change this year and the lift will probably be a story for 2023, probably late 2023. And also basically at the last meeting in December 2021, the ECB announced and end to its emergency purchasing program at the end of March of this year. But it'll be a gradual process as basically the asset purchasing program, so the ordinary, let's say, purchasing program will be ramped up in the following months in order to allow for let's say... Well, not to avoid cliff edge effects and allow for a gradual winning of monetary policy support. So in other words, the ECB will continue to provide to monetary policy support, but at a slower pace over this year.
Linda: For my part, I look for the positives, seek some things for the positive. And I think as we look for the more volatile year in 2022 in the US, we still have over two trillion in excess savings versus what you would normally see throughout our consumer balance sheets. That represents 16% of the annual consumer spend. So should keep the demand fairly high, should be good for earnings per share. And I think also picking up off of what Phil was saying about the speed of our economic and market recovery. And a lot of that had to do with the fact that Wall Street analysts were too shy in their expectations for earnings growth, kind of the sticky pricing power, and to the extent, fingers crossed, all around the world as supply constraints ease up, you could see a seventh and even maybe more in terms of consecutive surprises on the earnings per share side. So some things maybe from the positive side to be looking out for. But now as we consider what we're looking out for in each of your areas now, stay with you, Silvia, on the international side, how might one position their portfolios as for your area in terms of 2022? How might they best position?
Silvia: So I will adopt a more, let's say top down approach here. So basically in my baseline scenario, the economic environment should remain quite supportive of financial markets, and in particular, of the equity market, I would say. I would also like to stress that, of course, we'll see some withdrawal of monetary policy, especially in the US, but overall monetary conditions, financial conditions should remain price supportive. And indeed, in the last dot plot, federal plot, terminal rate in 2024 is still below the estimate of (inaudible 00:34:44) for the US policy rate. And so I think that in broad terms, financing conditions will remain quite supportive. And of course, if we broaden the view outside of the US, as I said, with ECB (inaudible 00:35:03) plenty of accommodations and it will continue to add to its balance sheet. Same story for the Bank of Japan. And so in aggregate, if we look at the G4 Central Bank, their balance sheets should remain quite ample and stable over this year. And again, that means that despite conditions being less supportive compared to 2021, we should continue to see a fairly favorable environment or risky assets.
Linda: Favorable environment. And there's certain areas of the globe that you would have us focus on? Silvia: Well, as I said earlier, from a tactical perspective, China and countries related to China might be in a good place this year as we should see some fiscal monetary stimulus coming from China and basically supporting growth going into end of this year. Of course, longer term, there are still challenges and risk of policy errors. But in the short term, I think that there's a tactical reason to be more positive on China and the Asian Region.
Linda: In emerging markets, they would like a weaker US dollar, wouldn't they? RJ: The dollar strengthened a bit of late, but we do think over time, it's going to start to calm down. The headwind to that call, of course, is the disconnect in terms of the central banks. So we probably have to get through a period now where the Fed's greater hawkishness relative to much of the rest of the world's central banks, that's in fact dollar supported in the near term. But I think as the year unfolds, we still sort of have a bearish view in the dollar as it unfolds.
Linda: Okay. So internationally, we like China, tactically, you suggested Silvia. And as far as Europe is concerned, and your comment that still reasonably easy money still stable central bank balance sheets as versus what the fed is about to tackle might be a more benign area, might suggest even Europe maybe worth considering, do you think? Silvia: Yes, the Eurozone might outperform the US, in terms of GDP growth this year, just because basically the Eurozone cycle typically lags the US fund by one to two quarters. And so there's a bit of a catch up story there. And of course that is also reflected in terms of monetary policy cycles, where DCB is likely to maintain easy monetary policy conditions for longer. And so the expectation, as I said, is that the policy rate will remain unchanged this year and the balance sheet will continue to increase at a slower pace. So again, in the short term, there's also room for some out-performance of the Eurozone.
Linda: Phil, bring us to the United States now, and tell us how one ought to position their portfolio as versus US stocks. Phil: Well, we are very much driven by valuation. And as we look at the improvement in the equity market, coming out of the trough for the pandemic recession, back in March of 2020, we felt that growth would certainly lead us out of the abyss. And technology and healthcare were sort of at the top of our list. And over the course of calendar 2020 that played out, so much so that technology, in our view, by Labor Day of that year had really gotten ahead of itself, led by the very popular FAANG stocks, Facebook and Apple and Amazon and Microsoft, et cetera. And so we took domestic large cap growth in technology back to neutral at that point and we've shifted in another direction. But given the recovery in the economy, we felt that the sectors of the market that we as investors that left for dead had come back to life, much like Lazarus, and they were going to enjoy a positive rebound as the market sort of got back on a more equitable footing.
Phil: That's exactly where we stand today. So the areas that we like are domestic large cap value. Sectors within that category might be financial services, energy, materials, industrials, consumer discretionary. We still like healthcare. And when you look at valuation, the technology stocks, the growth stocks, forward PE in that category... Right now about 35 are times earnings. The valuation for these value stocks is about half that, about 17 times earnings. Yet when you look at, say, third quarter corporate earnings, obviously that's behind us, the technology stocks had a nice quarter. They enjoyed earnings that were up 20, 30% year on year, but these value categories, they were up 50 to 100%. And so I think you've got the potential for greater catch up in terms of earnings, as the economy gets back on a better footing. And you've got cheaper valuation. Similarly, small cap stocks compared with large cap stocks, much cheaper. And particularly when you adjust those valuation levels for growth. So the PE to growth ratio, the PEG ratios for small cap stocks, much more attractive than large cap stocks. And then, a nod to Silvia. We like international. Internationals, obviously, struggling right now with the COVID, but as we take a longer term view and literally look across the valley as Omicron quiets down and international economies are getting back on track, we think there's a catch up trade coming with the international stocks. They're trading much more cheaply than the domestic stocks. And we think that's a nice diversification for US investors as well.
Linda: Yeah, that's really very interesting that even after... And that was a great call with the cyclical stocks last year. Even after those big, massive moves, they're still reasonably valued as versus the growth stocks. And what I found very curious in 2020 was that the big FAANG stocks, the big growth stocks, of course, they were big beneficiaries of the stay at home situation we were in, but they were used as defense. And with all that money that was printed out there and everything being bid up, stocks, bonds, all manner of financial assets, NFTs, even, real estate, et cetera. I thought that the one stone that hadn't been turned over was the high quality dividend area. And who needs high quality dividends, I guess, when the government's putting money into our bank accounts, and we look over and see some more money in our bank accounts and all that money that was printed. But it seems to me that as this Fed of ours tries to walk a tight rope this year and sort of the volatility that may come with, that the high quality dividend strategy may get a look see. And in fact, had started that as recently as September of last year, you started to see some turns on some of those sectors. So I think that's very interesting too.
Phil: That point, Linda, you've got the dividend yield on the S&P 500 right now. Less than one and a half percent benchmark, 10 year treasury yields are around 1, 75. So if you can find some high quality dividends in the US yielding, 3, 4, 5%, that's a very attractive investment, particularly given the fact that these stocks tend to be slower growth, lower beta, lower PEs, less risk. So in this part of the cycle, given the volatility that we talked about earlier in the fall, dividends, in my mind, make a lot of sense. Linda: Yeah. And of course they are stocks in the end. They're not bonds. And this baby boomer generation that continues to retire, and the great resignation that just exacerbated, that I've been seeing the still lots of money flowing into bonds, lots of money flowing into bonds over 10 years, even, as equities suffered in here. RJ, you're telling us that last year was a particularly bad year for the bond market. Maybe some of these investors see a negative sign. They're like, Well, how do I get a negative sign next to what is supposed to be high quality investments. So yeah, those high quality events stocks may get more of a look-see. But RJ, how would you suggest that investor's position in the bond portion of their portfolios?
RJ: Last year, the way to play defense against the rising rate environment, which depressed total returns and made them negative for investment grade corporates for, the aggregate index was negative, the treasury index was negative, was to taking a lot of credit risk, own high yield. And you got five plus percent total return. Bank loans, pretty comparable. That's a low quality floating rate instrument, generally speaking. We still believe that early in the year, those strategies probably still make some sense. So we remain overweight high yield, but to a lesser degree we remain overweight EM, but to a lesser degree. There's a lot of challenges in EM. Some of them Silvia touched on before. Bank loans, we've peeled back, and tips we've peeled back. We still like tips, but the easy money in tips, the biggest money... Tips were up over 6% less year in total return, positive, total return. Easy money's already probably been made there. On net, we think that the Fed's hawkish turn, which is raised rates and is apt to be a bit of a challenge to valuations say in high yield suggests some caution was warranted in fixed income. It is interesting to me how much money flowed into bonds. It's hard to argue. They were performance chasing when the returns were negative. And I think that demographics have a lot to do with that. So there is caution in your asset allocation that I think manifests itself in those flows. There is some risk as this year unfolds, if the fed can't walk that tight rope successfully. That if we have a bit of a tantrum like surge and rates, 20, 30, 50 basis points in short order, that will bring up about the opposite. Where people will be like, I don't want to own these bonds. And you'll have a period of outflows.
RJ: I don't think it'll begin a multi-year period of outflows because of demographics, but that's a particular risk. So we're looking for relatively muted returns again, because the inflation problem and the hawkish Fed for high quality bonds. And you can pick your spots on credit risk and try to eek out some better returns in that environment. I think the big challenge for investors, we had a gusher of monetary policy, a gusher of fiscal policy. Both are headed in the other direction. What does that do to asset markets broadly? Some caution's probably warranted in answering that question.
Linda: Along those lines, something I'd read just recently is we're watching some of the rotations. Some of the violent moves here early in the year was one of our sources suggested that they're very particularly watching the high yield market. Because we've said, credit is strong. And you mentioned that you're still overweight, but pulled back. Are you overweight, but pulled back as you're starting to concern yourself about credit, or are you in that we're watching valuation camp, as Phil suggested, for stock market? RJ: Pulling back is entirely predicated on valuation. The default rates in high yield are a pittance. The economy is probably the strongest of our careers, having a lot to do with where we came from. The pandemic was a rough ride, and the fiscal and monetary stimulus was unprecedented. And the economy reflects that. So we are getting more cautious due to valuation, not due to some concern that default risk is suddenly on the rise. That's really not the issue.
Linda: Very important thing to underline. And so now, as we've discussed, where we think we're in my best position for the new year, we're going to turn to our forecast for some of the major data points out there. And here we are coming along the end of the first week of January, it looks like might be a negative week, Phil. And I don't know, there's some old adage box, so it goes the first week of January, so goes January, so goes January, so goes the year. And here we are talking about a 10% return. Phil, do you poo poo those old adages? And what again is your suggestion for earnings, the S&P and GDP growth this year, please? Phil: I don't poo poo that at all, Linda. Actually, it's an important thing that I look at and there are three indicators that we look at the beginning of the year in conjunction. There's the Santa Claus rally, which takes the last five days of the last year. And the first two days of this year, that was pretty good. That was up about one and a half percent. Then you've got the first week of January indicator that closes today. As you pointed out, not looking good, we may be underwater there. But I would argue that we had a couple of nuclear blasts this week. Number one with the minutes from the Federal Reserve on Wednesday. And with this very confusing jobs report this morning. So the third indicator will break the tie, and that is the full month of January indicator. And we are not going to know the answer to that for another couple of weeks.
Phil: So we're still constructive for the year, that we think that earnings are going to be up about 8 to 10%. We think stocks are going to be up 10% or so, from 4,800 last year to 5,300. But we go in expecting that there's going to be a tremendous amount of volatility, that there could be multiple 5 to 10% air pockets over the course of the year, based upon concern, confusion, with inflation fed policy, fiscal policy, midterm elections, et cetera. So just buckle your seatbelt, boys and girls. It's going to be a Rocky year and we think we'll end up at a good place. And there may be opportunities to invest at some really good points during that year.
Linda: Well, your earnings per share 8 to 10% kind of matches your return expectations for the market. So I suppose you're suggesting, No multiple contraction this year, maybe not. Until next. And have we initiated a 2023 target? Phil: You're quite right, that we are not looking for any multiple expansion over the course of the year. A lot of this, 115% rally, we've enjoyed in stocks from the bottom of the market, March of 20, to the 4,800 level of the end of last year, earnings are up 50, some odd percent, last year. We got some very strong multiple expansion. With the Fed raising interest rates, we think perhaps four times over the course of this year, multiple expansion is probably not a high percentage bet. But we're not looking for a significant amount of multiple degradation because bond yields in our view are at an extraordinarily low level to begin with. So if they were to go from 1.3%, as they were about a month ago, up to, let's say, 2.5 percent this year, or maybe 3% the year after, that would be just sort of getting it back to normal. Remember the math and the Fed model suggests that the equilibrium point is around a 5% treasury yield around a 20 PE. So theoretically, we should have had much higher PE multiples when treasury yields were down around 1.5%. We didn't do that because we felt it would've been suicidal. We felt that bond yields needed to move up. We're right on, completely, on board with RJs duration committee and their 90% target in terms of the expectation that yields were going to rise. So we were sort of holding ourselves back, if you will, providing a much less generous PE multiple on stocks, because we fully expected the treasury yields were going to rise. And it appears that we're now in the early stages of that cycle.
Linda: Did we initiate a 2023 expectation, Phil? Phil: From a corporate earning standpoint, we already have a 250 dollar earnings target. And that implies, again, about a 10% increase, give or take from the 230 dollar forecast that we're making for this year. Our early S&P500 forecast for calendar 23 is a very muted 5,500. Literally, a mid single digit increase over our calendar target for this year at 5,300. Now there's an asterisk associated with that, which is that at some point during calendar 23, investors are going to start to look out to calendar 24 and our crystal ball's very cloudy there in terms of whether the potential for much higher inflation levels, and, possibly, eight interest rate hikes by the Fed in between now and the end of calendar, 23 begins to imperil the economy to a recession in calendar 24. Now, my colleagues in the bond market, who are much smarter than my colleagues in the equity market, they're going to sniff that out much quicker than the dopes on the stock side. And so, we may see treasury yields peak get around 3%, let's say, in the middle of calendar 23. And actually, start to go down as the bond market starts to price in the risk of recession in calendar 24. So we're very concerned about what may be a transition then to outright defense in the equity market in calendar 23. Going to healthcare and utilities and-
Linda: Excellent. Phil: People and real estate. So we'll see how that plays out. Linda: Okay, excellent. Before I leave you, our GDP forecast for the year? Phil: We right now are at 3.9% for calendar '22 on a base of what we think is a five and a half percent increase in calendar '21. And then you're going to say, Well, what about '23, Phil? We're looking for a more normal two and a half percent GDP gain in calendar '23. Linda: Actually, I wasn't going to say that, Phil. I was going to say 3.9% this year. What about just in case inventory? What do you think? Is that in that figure? Phil: We're expecting inventory builds over the course of the year, which would be additive to GDP. We've also, I will point out, have been looking for an inventory build over the last couple of quarters. So that's sort of like waiting for Gadot, with all of the supply chain problems and we're short 80,000 truckers and we've got the log jam in the west coast ports. The inventory build happened yet. So we think it's going to come this year, but again, we'll have to see.
Linda: Okay. Thank you much. Moving on to you, RJ. What are your expectations for, say the 10 year by year end, Fed funds? RJ: It all comes down to inflation, as we've talked about, and how the Fed can behave in the context of either an inflation that tops out and rolls over and starts to come down in their direction, or one that remains stubbornly high or even accelerates. Let's assume that the inflation is getting close to a peak in the next quarter or so, and really starts to roll over. That's something Chairman Powell has said up on the podium in his press conferences, is that if we see inflation in the second, third quarter starting to come down, that'll be reassuring to the Fed. So let's assume that that is apt to happen. Our view, on the Federated Hermes' fixed income side is that although that might happen, it'll remain higher than the Fed ever wanted, and that's going to necessitate probably four hikes this year to maintain a prudent monetary policy in the face of too much inflation and trying to manage those inflation expectations we discussed before.
RJ: How does the Treasury market behave in that world? Probably a flat or curve. More likely than not the 10 year Treasury ends the year somewhere around two and a quarter. Another difficult year for total returns for very high quality bonds. The jury is out on whether or not that type of suite of policies is enough to start to erode returns and risk assets too. We'll see. I think a key factor to consider is the Fed is facing an economy with debt to GDP at the federal level of well over 100%. Nobody on the Fed has ever seen this before, nor have any of us. The last time debt to GDP in the United States government was over that was the end of World War II. That might mean that the ability to tighten or the response to the tightening might be more burdensome than recent history would suggest. Maybe rates can't go up that much without causing a lot of fiscal pain. If that's the case, it would be interesting to see if the Fed starts to follow up with their discussion evident in the minutes about reducing the balance sheet.
RJ: Another way to tighten financial conditions without just driving short rates up would be to sell some bonds, something that a lot of us thought we wouldn't think the Fed would do. But the word never, probably shouldn't be used to describe Fed expectations ever again. No one believed the Fed would buy corporates. Who thought they would buy junk? Heck, they even bought munis, my home market, which I thought they should have done 20 years ago. The Fed is very innovative, and faced with the challenge of debt to GDP at the highest levels of any of our lives, they might actually resort to balance sheet as more of a primary tool, when it's always been viewed as a secondary one. Only one that's invoked when you're at the zero lower bound. But now they can raise rates. Maybe they'll use the balance sheet because they don't want to raise short rates so much, driving build yields up too high and making the federal government face more and more cashflow demands.
Linda: Should we fear the 50 basis point hike at a time? RJ: That's a great question. If I recall, the last 50 basis point hike was from Allen Greenspan when he was at the Chair. Prior to Greenspan, it had been employed a number of times. The Fed's policy framework obviously has evolved quite a bit compared to where it was in the '70s and '80s, but that 50 basis point increment is not often used. It could be very destabilizing if they do it. I think this Fed has been innovative, but they have worked very hard not to be shocking. They like to lay an expectations foundation for everything they do. So these minutes that we just saw were more hawkish than expected, but they weren't shocking. A lot of the things that were in there had been talked about, had been previewed by policymaker speeches, the FOMC and the Federal Reserve Bank president's speeches. So, I think a 50 basis point move out of nowhere is unlikely. On the other hand, if inflation just keeps going up, you can't rule that out. Although I think they would try to telegraph it. I think they would just say that more extreme measures are in order, or something. As an equity lady, from your lips. Okay. Fingers crossed on that one. Silvia, can you give us some forecast, particularly what you're expecting for global GDP growth this year and any central bank tightening around the world?
Linda: As an equity lady, from your lips. Okay. Fingers crossed on that one. Silvia, can you give us some forecast, particularly what you're expecting for global GDP growth this year and any central bank tightening around the world? Silvia: So starting from the global GDP growth, the expectation is that there would be a bit of a slowdown to, say 4.5% this year from almost 6% in 2021. Of course that needs to be read in the context of the large 3.1% drop in 2020, but still, I mean the bottom line is that we continue to see above trend growth this year globally. Of course, there will be divergencies across areas and countries. Emerging markets will somewhat suffer from a lack of resources and early tightening in many, especially in Latin America, where basically central banks have already tightened quite aggressively in response to high inflation and some threat to their credibility. In terms of timing cycle and, well, monetary policy, I would say, as I said for ECB, I don't foresee any policy rate change this year. It's more of a story for 2023 and possibly the second half of 2023, as basically there will be a very gradual path for ECB in terms of withdrawal of monetary stimulus. That's also because ECB is wary of overreacting to high inflation, which is basically something that happened in the past, like in 2008 and in 2011 when basically the ECB hiked rates too early. So I think that there's also that element playing out for the ECB.
Silvia: Moving to the UK, the UK is facing a different set of challenges. Inflation has run quite high. Growth has somewhat disappointed, but of course we are seeing the same catch-up dynamics in the UK. The Bank of England has already started its hiking cycle after some back and forth at the end of 2021. For this year, I expect a couple of more policy hikes, but also I think that the Bank of England will probably resort to quantitative tighten. So as RJ said for the Fed, the Bank of England will probably adopt a similar mixed approach using different levers, not just the policy rate, where hikes can be very detrimental in an environment of high debt. So I think that the Bank of England will adopt a similar approach. And in general, it's a story of divergence. In some emerging markets like Latin America especially, we continue to see some aggressive tightening, while for the ECB and the Bank of Japan, we'll probably see no change in the policy rate this year.
Linda: Excellent. Thank you so much. Now before I say goodbye to you and wish us all good luck for 2022, there's a fun parlor game in our business, where starting a new year, we discuss what would be a surprise, but you think it might actually have a decent chance of happening? One per person, if you wish to do, please ever so briefly. Phil? Phil: I think the surprise may be the magnitude with which the Republicans enjoy a red tsunami in the midterm elections next November. I think there's a consensus expectation that the House of Representatives may flip from Democrats to Republicans. I think looking at the midterm elections over the post-war history of the United States, I think that the magnitude of that victory could be more significant. So, we'll see.
Linda: Excellent. RJ, what do you think? RJ: I think the biggest surprise- Linda: That could help. RJ: ... might just well be the pandemic's over, that we have reached the point where extremely high transmissibility and lower virulence lead us to a manageable place. It's no fun for people who are getting COVID. It's certainly not for people who are having severe cases, but for the vaccinated community, Omicron, knock on wood, seems to be relatively manageable. Perhaps this will be the final, big throes of the pandemic.
Linda: That would be a great one. Silvia, what do you say? Silvia: Well, we are all aware of the upside risk to inflation. So I guess the biggest surprise would be a sharper drop in inflation, at least for a time because of base effects and lower commodity prices and maybe some correction of supply constraints. So I agree with RJ, that inflation might stabilize at higher levels, higher than Central Bank's target levels. But for a time this year, we might see a sharper than expected fall in inflation.
Linda: I would say all three of your guesses would be market positive, if any were to come out or come close to being out. And I being the moderator, I get to have the last word here, because I think a really fun, positive surprise would be that after the supply constraints, which we're looking so hard for anecdotes, any anecdotes that they're easing up, are going to come gushing open. There will not be enough supply on the shelves, big sales and I for one, and ready to go shopping and check out the sales. So now, thank you, Phil, RJ and Silvia. We will see how our predictions play out this year. And thank you to our listeners. We look forward to you joining us again on the Federated Hermes' Here and Now podcast. If you enjoyed this podcast, we invite you to subscribe to the Federated Hermes channel to get every Here and 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 Insights, email updates from our website, and follow us on LinkedIn and Twitter.
DISCLAIMER: Views are as of January 7th, 2022, and are subject to change based on the 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. International investing involves special risks, including currency risks, increased volatility, political risks, and differences in auditing and other financial standards. Prices of emerging market securities can be significantly more volatile than the prices of securities in developed countries, and currency risk and political risks are accentuated in emerging markets. Stocks are subject to risks and fluctuate in value. Growth stocks are typically more volatile than value stocks. Value stocks may lag growth stocks in performance, particularly in late stages of a market advance. Small company stocks may be less liquid and subject to greater price volatility than large capitalization stocks.
DISCLAIMER: 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. Bond prices are sensitive to changes in interest rates, and a rise 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. In addition to the risks generally associated with debt instruments, such as credit, market, interest rate, liquidity and derivatives risks, bank loans are also subject to the risks that the value of the collateral securing a loan may decline, be insufficient to meet the obligations of the borrower, or be difficult to liquidate.
DISCLAIMER: The S&P 500 index is an unmanaged capitalization weighted index of 500 stocks designated to measure sure the performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Beta is a measure of the volatility or systematic risk of a security or a portfolio in comparison to the market as a whole. PE, or price to earnings ratio, is ratio comparing the company's current share price as compared to its earnings per share. The yield curve is a graph showing the comparative yields of securities in a particular class, according to maturity. Securities on the long end of the yield curve have longer maturities. Federated Advisory Services Company.
Tags 2022 Outlook . Markets/Economy . Fixed Income . Equity .