Brian Pietrangelo:
Welcome to the Key Wealth Matters Weekly podcast where we casually ramble on about important topics including the markets, the economy, human ingenuity, and almost anything under the sun, giving you the keys to unlock the mysteries of the markets and investing. Today is Friday, October 20th 2023. I'm Brian Pietrangelo, and welcome to the podcast. Right now I realize there's a lot going on across the world as well as continued human tragedies in the Middle East, and I am reminded of how fortunate we are to live in the United States and consider how we can show support for our fellow humans. As far as today's podcast, I would like to introduce our panel of investing experts here to share their insights on this week's market activity and more. George Mateyo, Chief Investment Officer, Steve Hoedt, Head of Equities and Rajeev Sharma, Head of Fixed Income. As a reminder, a lot of great content is available on key.com/wealthinsights, including updates from our Wealth Institute on many different subjects and especially our key questions article series addressing a relevant topic for investors each Wednesday.
In addition, if you have any questions or need more information, please reach out to your financial advisor. Taking a look at this week's news, there was a bevy of economic reports that were released during the month, some of them favorable and some less favorable. On Tuesday, we had retail sales that were up 0.7% for the month of September, which was higher than expectations. And in addition, August was revised upwards, so there's still resiliency in terms of consumer spending and retail sales. Also, on Tuesday, we looked at the industrial production from the Fed in terms of manufacturing across the country, which was up 0.3% for September.
However, August was revised downward, so it's a little bit of a mixed message there, but we'll take the good when we can get it. On Wednesday, the Fed released its Beige Book report, which basically showed that most districts across the 12 indicated little or no change in economic activity since the September report. And the near term outlook for the economy was generally described as stable or having slightly weaker Growth. On Thursday, leading economic indicators showed declines again for the month and going on roughly 18 months of consecutive declines.
Also on Thursday, the bright spot was the initial unemployment claims report, which showed a decline of 13,000 to roughly 198,000 initial claims for the week. And this might've been slightly less due to the fact that we had a Columbus holiday last week. However, still good news that unemployment claims remain low in a resilient jobs market, at least for now. And finally, in terms of Fed speak for the week, earlier in the week, Philly Fed President Harker seemed to favor a pause, whereas yesterday at the Economic Club of New York, Chairman Jay Powell seemed to make comments that were a little bit more hawkish in terms of keeping rates high or potentially another rate hike for the month of November or December. So with that, let's turn to Rajeev to get his thoughts on what Powell actually said and what it might mean for the Fed and the overall markets. Rajeev.
Rajeev Sharma:
So Brian, it's like Fed Chair Powell had his conference yesterday at Economics Club in New York. And the thing is, I think the market did not like what he said. He said basically that we're going to be higher for longer. And he also mentioned that there's uncertainty surrounding the geopolitical events and what the Fed's going to do based on economic data. So Powell's expectation is that the Fed will proceed carefully while noting that inflation is still too high. And I think the market at that point, as Fed Chair Powell was speaking at the economic forum, the 10-year was going to 5% at that point. So now it's very interesting to see that Fed Chair Powell did not point to the inflation coming down or inflation reduction or anything like that. What he was really saying was there's a lot more work to do. We're not higher for longer.
We have a lot more work to do. And I think that the market did not like that. And what we saw at that point was that Powell noted that significant tightening of financial conditions are still there, but they're not happy with the inflation story. That being said, I don't think that there's going to be another rate hike this year, and I don't think based on Fed Chair Powell's comments last night, that there would be any more rate hiking. But the market did not like the fact that he said we're going to be higher for longer. And I think that's the big trucks of the whole thing. And so I really think that Fed Chair Powell in his economic forum, I think that he has kind of gone back and forth in the sense that he understands that financial conditions are more tighter right now, but he also understands that inflation is out of the target.
And so we saw the tenure get closer to 5%, but it didn't really reach there. It got to 4.996 when he was talking, and I really think that it's probably going to be closer to 5% higher for longer. There probably won't be another rate hike this year based on the market expectations and what Fed Chair Powell is saying. But at the same time, I feel that all the Fed members this week, all the Fed speak that we saw this week was pretty much reeling back the fact that there's geopolitical tensions right now, and I don't think that there will be a November hike. There might be a December 25 base square hike, but I really think that Fed Chair Powell kind of reeled that back a little bit. So that's what we got for now.
Brian Pietrangelo:
George, how do you think that relates to retail sales and what else we're seeing in the economy for predictions of Q3, GDP and everything else going on relative to the market?
George Mateyo:
Yeah, I guess you could kind of separate this week's news and economic reports in kind of a couple different ways, Brian. I think we've continued to see some weakness in the housing sector, probably not as pronounced as people thought. I mean, I think home sales declined 2% month over month. So to put that in context, that was actually a decline... That was a smaller decline than people expected. I think people thought that housing would actually be a bit weaker, but it's still the lowest level in over... almost 15 years. So again, I think these higher rates are starting to bite a little bit and kind of take some of the wind out of the sails a little bit. On a year-over-year basis to kind of put the numbers in even further context, I think they were down some 15% from the prior year.
So housing still looks kind of weak in terms of the activity. That being said, the price increases of homes that actually do transact is still staying rather elevated. So inventories and housing more specifically, Brian, are still pretty tight. I mean, I think the average inventory is about three months, which suggests again, there's not a lot of supply, which is one of the reasons why housing prices anyway are staying still somewhat strong. So you take that into the mix, you take in the fact that savings for most people is still pretty... it's high-ish. I wouldn't say it's high, but it's still pretty relatively well-supported. And then you throw in this number that you mentioned around jobless claims falling below 200,000, that suggests that the labor market is still really quite tight. So when you throw in a generally benign or maybe a good backer for home prices, home valuations, people's expectations about what their homes are worth with a pretty robust job market, it's not surprising I guess that the consumer spending story keeps on chugging along.
So since you mentioned retail sales, I think it was kind of interesting to see that autos picked up quite a bit. It was the fourth strongest... I'm sorry, it was the strongest month in four months in terms of overall demand for autos, a pretty cyclical purchase I would add. And then more on the services side, people are still eating out a lot, so restaurant sales were also quite brisk. Restaurant sales, Brian, rev actually 9% year over year. And also it's kind of hard to really parse this out too much, but e-commerce sales were also really quite brisk. So I guess the backdrop, I guess that I kind of think that Powell is struggling with is the fact that the economy frankly is just chugging right along.
So despite the fact that there's some pretty notable headwinds geopolitically, that we're all very acutely aware of, and those are starting to provide probably some more gyrations in the market than most people would like, but not surprising that the overall economy is pretty strong right now. So Powell's got his hands full right now, and I sense that this in fact, Rajeev, he's probably struggling with that very thing. I'd also kind of point out that earnings continue to be better than expected, it seems like. But Steve, maybe you've got a better view on that. So how do we parse out the stronger economic data with what we're seeing and hearing from corporations as their reporting so far?
Stephen Hoedt:
Well, I think that earnings have been coming in above expectations this quarter, George, as we've started to get into the teeth of earnings season, really next week is the largest chunk of corporate America reporting. But I think it's been heartening to see numbers come in above expectations. And when you look at the actual numbers, I mean, everybody knows that the expectations game gets gamed going into the quarter. So when you take a look at the actual numbers, it looks like we're... If we get positive revisions this quarter, we'll end up with positive earnings growth year over year, and then that will kind of mark the end of the "earnings recession" that kind of started in late '21, early '22 where we had earnings rollover and then trough coming into this year. So I think that's something that equity investors are going to start to focus on as we move into year-end, the fact that we're back in a positive earnings growth environment.
We've talked multiple times on this cone in other forums that over the long-term, earnings higher equal stocks higher. So it puts a tailwind behind the equity market. And one of the things that I've been watching here is that it does seem like we're starting to see both here in the US and around the world, a number of different leading indicators start to inflect to the upside. I think it's kind of shocking for a lot of the folks who've been on the recession train for quite a while to maybe have to reevaluate their view because it's starting to look like we could be on the cusp of a cyclical upswing here. I mean, it's, I know, counter to the prevailing narrative sometimes, but when you look at what happened last year with the S&P 500 peak to trough going down over 20%, the earnings declining year over year and two quarters of negative GDP. In hindsight, even though the MBR isn't going to call it that, we may have had our "recession" a year ago and we could be on the cusp of some kind of a recovery here. And if that's the case, equities are going to look pretty good as we head into 2024.
George Mateyo:
What's driving the earnings story, Steve? I mean, it's kind of curious to me to see that other cycles when the Fed is tightening as aggressively as they are, they're kind of pulling out liquidity. So you've got kind of this strain of liquidity when the Fed is as aggressive as they are, but earnings are powering higher. So how do you kind of explain that divergence that we're seeing this year versus other cycles?
Stephen Hoedt:
Well, it's nominal growth. I mean, we've had an inflationary impulse this cycle. If you look at earnings, they track revenues and revenues track nominal GDP. So the fact that nominal GDP has been running hot, surprising to the upside, provides us with the tailwind for earnings. And then margins have remained relatively high. We have not gotten a crunching in margins. Labor costs have been a bit inflated relative to maybe where they were a year or so ago, but corporate America has done a pretty good job of holding the line on other expenses and being able to pass through cost increases to consumers. So I think the fact that margins have remained high in a high nominal growth environment is really what's driving the price cycle at this point.
George Mateyo:
I think you pointed out the resiliency of corporate profits. I mean, I think you also talked about the fact that people have been calling for a recession now for at least a year, right?
Stephen Hoedt:
Over a year.
George Mateyo:
Yeah, and so to some extent, probably CFOs and CEOs and business executives probably have been kind of positioning themselves somewhat conservatively for the past 12 months or so. So I would think that the margin story is still probably intact a little bit because they've been so disciplined on the cost side. But maybe, Rajeev, back to you for a second, at some point, rates are going to start to matter. So how high is your crystal... If you look at your crystal ball, how high might rates go in the next six months or so? You mentioned we're near the peak from the Fed's perspective, but the long-term part of the bond yield curve rather is still kind of moving pretty high, as you mentioned, kind of close to 5%. So do we go to five and a half? Do we go to six? What do you think might happen with the long end of the curve?
Rajeev Sharma:
Well, George, the 10-year 5% is the resistance point, and we are pretty much there. The next resistance point is 5.14%, and we could probably get there too. So there's no really reason why the 10-year would go lower. I think there's a lot of reasons why the 10-year keeps surging higher. You have less demand from China, you have less investors excited about the surge in prices on a 10-year. And I think that the most important thing right now is that the Fed is saying higher for longer. And I think that's really playing its case on the 10-year. And I think the 10-year and the 30-year have both surged 60 basis points over the last one month, and that is a lot.
And so I think Steve had mentioned it before that it's not the level that you're at, it's the surge, it's the pace at where you got there. And I think a lot of investors are really spooked by that. So the pain trade, which we've talked about before, is investing and adding duration on this type of environment, it's very difficult. So I really think that the 10-year could probably go beyond 5.14% very easily. That's the next resistance point. That was the resistance point on 2006 that we saw in July.
Brian Pietrangelo:
So Steve, let's finish up the podcast with the last question to you. Sometimes you talk about the volatility index known as the VIX. There was a lot of complacency between roughly May and September of this year under 15, and now we've seen it pop all the way up to 21.4. What do you think that's telling us and what are your thoughts?
Stephen Hoedt:
Yeah, I think that the market had priced in a very complacent outlook, no doubt. Anytime you're below 15 in the VIX, it's telling you that something... everybody's really maybe a little bit too comfortable with things and with 21.5, it's starting to get a little bit elevated. But quite honestly, when you look over the long-term track record of the VIX, the area of 20 is really kind of average. So it's more that we were too complacent and now we're kind of more back to normal.
Abnormal VIX would be standard deviations away from 20. So two standard deviations we've talked about in these calls is 36, 3 standard deviations is 45. So those are kind of areas where you start to think of a "bottom" being put in the market because there's just been kind of a chaotic trading environment with a lot of volatility. So we're a long ways away from that right now. We're more back to normal. Doesn't mean that we won't see volatility continue to stay a little bit elevated here. I think anytime you get geopolitical shocks like we got in the last couple of weeks, it kind of jolts people out of that complacency. Whether or not it actually impacts equity prices or corporate fundamentals is a totally different question, but it jolts people out of that complacent mood and gets people to start to price more volatility into the market.
So we'll see how that plays out. I will tell you that as we head from now to the end of the year though, both in volatility and in the market, we do have a bit of a seasonal tailwind. We're entering the best six months of the year for the market. We tend to see equity prices rise from now through year-end actually, and then into the new year. And on the flip side of that, we tend to see volatility fall while those equity prices are rising. So it's going to be really interesting this year to see if things run counter to the normal seasonal pattern based on both the fundamentals that we've got going on with the Fed and the geopolitics.
Brian Pietrangelo:
Well, thanks for the conversation today, George, Stephen, Rajeev, we appreciate your insights and perspectives. And thanks to our listeners for joining us today. Be sure to subscribe to the Key Wealth Matters podcast through your favorite podcast app. As always, past performance is no guarantee of future results, and we know your financial situation is personal to you. So reach out to your relationship manager, portfolio strategist or financial advisor for more information, and we'll catch up with you next week to see how the world and the markets have changed and provide those keys to help you achieve your financial success.
Speaker 5:
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