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, September 29th, 2023. I'm Brian Pietrangelo and welcome to the podcast. In case you didn't know, tomorrow is International Podcast Day, celebrating the medium and positive influence for listeners all around the globe. And we are pleased to be able to bring our subscribers valuable content each week, so thanks for tuning in.
And with me today. 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, Rajeev Sharma, head of fixed income, and Connor Cloetingh, senior lead equity analyst. And 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 economic and market news, let's start with the potential for a government shutdown here on Saturday night as we end the month of September, which is the fiscal year-end for the government spending appropriations process. And so if there's nothing done, we could spill into that shutdown, but right now here on Friday, the House Republicans are trying to get a temporary spending bill in place for the next 30 days to avoid that shutdown. But again, if that can't be done and we can't get all 12 reconciled in terms of appropriation bills, we might spill into that government shutdown on Sunday morning. So we'll take a look at that because it does affect the overall economy and the United States in terms of various complications.
On the economic front, earlier in the week we saw house prices for the month of July increased modestly at 1%, and we saw overall initial unemployment claims that were released yesterday, basically stayed constant at 204,000 in terms of a modest increase. Overall, staying very low in terms of job resiliency for the markets. And also released yesterday was the final report for the second quarter measure of GDP, or gross domestic product, and it came in at 2.1% for the quarter on an annualized basis, which was the same as the previous second estimate. So no change there. Good news, it's a little bit stronger than expected, but again, we'll see where we head in to the third quarter.
And finally, probably the most important report for the week was this morning's read on consumer spending and overall inflation as measured by the personal consumptions expenditures index of inflation, otherwise known as PCE, and specifically, core PCE, which excludes food and energy, which is the Fed's preferred measure when they decide on policy. The good news is that inflation on a year-over-year basis in the month of August continued to recede from 4.3% in July down to 3.9% in August. So again, the policy of interest rate increases is continuing to work, but we're nowhere near where we need to be from a 2% target perspective. So we'll continue to see how this number plays out in terms of inflation and Fed policy for November and December's meeting.
So taking all of those factors into consideration, let's get the opinion from George in terms of what he sees and how it might affect the overall economy. George, what are your thoughts?

George Mateyo:
Well, Brian, I think it was a mixed week overall, but generally the market seems to be taking skews on other things, which we'll probably get into a little bit later on the podcast here. But I think if you want to just go through some of the things that were released, overall, I think it was a mixed bag. Again, the housing sector continues to struggle a little bit and process some of the higher rates that are really through the sector right now. Actually, one thing that we probably don't pay a lot of attention to is something called durable goods. These are big ticket items, and they actually were slightly better expected. So again, I think you wouldn't be buying a big airplane or a big refrigerator or something like that if you thought you were entering a contraction or downturn. So to see durable goods actually come in better than expected, that's not too bad.
And I think also on the jobless claims side, which again, is our early warning signal with respect to labor market, those were also lower than expected too, which suggest that the labor market is still really healthy. And as we've said before, one person's income is another person's spending, and as long as the consumer is spending the economy is doing quite well. We got more evidence of that this morning. So we also talked about consumer spending that was out for the month of August, was pretty much in line with expected. It was a little bit slower than the prior month, which is probably a good thing from the Fed's perspective because the prior month of spending was really quite strong as probably people spent a bit more on vacations and concert tickets, and so forth. And so we've seen some moderation there but not a collapse.
And then the all important PCE report, or personal consumptions expenditures, which is kind of a mouthful, but frankly it's the Fed's preferred measure of inflation, and it actually slowed a little bit as well, which is good news. I think it came in at 3.9% on a year-over-year basis, which actually is the first time we've actually been below 4% since, I think, it was probably mid 2021, so it's been over two years since we've seen a reading below 4%. But that said, we're still a long way from the Fed's target of 2%, so we've made a lot of progress, but the progress is going to probably be a bit slower from here.
I think the bigger story, irrespective of the economic data points that were released this week, is the fact that the markets are really taking its skews from other things it seems like, and particularly the credit markets, and more specifically, the bond market, more broadly I guess, is pegging off other signals it seems to me. So Rajeev, we've seen a really big jump in yields in the past few weeks or so, past few days even, and I'm curious to get your thoughts. Is that really because of inflation? Is the bond market now concerned about government debt? Frankly, the government debt situation has been front and center for a long time. We've kind of ignored it, but now maybe we're recognizing that we've got a lot of bills to pay. So what do you make of the recent backup in yields that's really caught the market by surprise, I think?

Rajeev Sharma:
It's a great question, George, and I really feel that a lot of this backup in yields and these higher yields that we're seeing the surge in the yields curve, we can attribute some of that to the FOMC meeting and some of that to higher for longer, which is the Fed's narrative. But I think underlying, there's a lot more involved here. I think that the market participants right now really feel that there's not going to be a lot of leeway, especially in the front end. And also, we've seen the tenure also move higher. So we've had an inverted yield curve for a very long time. People are wondering when will it uninvert. And we've seen the surge in the 10 year and the 30 year kind of make the yield curve a little less inverted than we've seen in a while right now.
And so, I really feel like there's a question about the economy. There's a question about whether we're going to have that soft landing or not. We know the Fed narrative right now, they're going to continue to push for that inflation target to be 2%. The PCE number that you mentioned, I think that that is going in the right direction, but it's not really getting the Fed to where they want to get.
I was at a lunch recently and at this lunch we had a lot of market participants talking about where they think the tenure is going to go, this move that we've seen this week and last week. There's some market participants that think that the tenure can go even higher. That is the pain trade. We've talked about duration in the past where it makes a lot of sense to stay short right now because there's more yields in the front end of the curve. The pain trade really is adding duration. And there are some people at the lunch, I was in a round table lunch, that talked about maybe the tenure goes above 5%, maybe it goes towards the Fed funds rate, and that would be very painful.
There were a couple of resistance points on the tenure that we've seen. Four and a half percent was one of the resistance points. We went right through that. The next resistance points is 4.73, which was the high of the tenure. It also seems we can get close to that as well. Do we go beyond that? I think that's going to have some ramifications in the market. There will be risk asset sectors that may start thinking that it makes more sense to go into bonds, out of stocks. So that would not be good for the stock market. I know Connor's going to speak about that in a little bit. But there's also the question of, where are the market participants? We have auctions that came. We did see the auctions do really well this week. We also have issuers that are coming to market, and they're going to start thinking about are these rates too high to come to market and raise debt?
So it could have implication in the credit markets as well. And we've seen credit markets really be well-behaved during all the last year and a half. Do they stay well-behaved? It would be very interesting to see if there's going to be some rotation out of corporate credit based on the move that we saw in yields. Now the aggregate index is really coming under a lot of pressure right now. We're having returns that are being negative for the month, last month as well. If we end the year with a negative return on the aggregate bond index, which is the biggest proxy for the bond market, if the aggregate index has another negative year, that would be three years in a row that we've had a negative returns on the ag. And that is very unsettling to a lot of market participants right now.

George Mateyo:
So I guess the question I keep asking myself, Rajeev, when I think about the backup in yields or the surge in yields that you talked about is not so much what or maybe where they might go, because nobody really knows, honestly. You've got a better view than I do, I'm sure. But the question I'm asking myself is, "Why?" Why would rates go up, as you said, to the Fed funds rate? That'd be a jump of about 100 basis points from here, a full percentage point. And your point about duration and people who [inaudible 00:10:39] income, I think you would see the benefit in your portfolio from higher yields at some point, but your price on those bonds would probably drop a bit if we saw that big jump in rates. So what do you think would cause that to happen? Why would they go up that much, do you think? Inflation, it's still kind of high, but it's coming down a little bit, so it's not inflation that seems to be the cause, but is there something else that we think we should be worried about?

Rajeev Sharma:
Yeah, there are a couple factors, George. I think that it's not just about the Fed saying higher for longer. I think there's other factors as well. You have the US sovereign debt, the downgrade of the US sovereign debt. I think that makes a big impact. You have Japan exiting the yield control. You have Fed QT, which is also very important, and you have the US budget deficit, which I think is also very important. So all these factors are playing their role in this, and there's also a large stockpile of T-bills and treasury that are increasing their auction sizes, so I think that's also keeping a lot of pressure. If you start seeing auctions that are going to be the intermediate and long-term market, or longer duration, I think that also plays a big factor.

George Mateyo:
So at the same time, Connor, we've seen backup in yields, the market's down a couple of percentage points, but nothing too concerned about, but the stock market seems to be turning around here at this level. What's your assessment of how this back up in yields, this surge in yields, again, that Rasjeev talked about is impacting stock prices?

Connor Cloetingh:
Yeah, sure. So I think the most basic assumption that we have is yields up, stocks down, which that correlation has been blown out the window in the last couple of years with what's happened in the market. But more recently, it seems to be holding true once again. So now yields move up, stocks move down as that occurs. But in this last week we saw a little bit of bounce. We think it's due to maybe some technical factors. The relative strength seemed to just tick into the undersold territory and stocks bounced off that and also bounced off 150 day moving average. So near term, we got a little technical breather. Longer term, if what we're seeing in rates holds, it'll be tough for equities to continue to rise in a higher for longer environment.
But I think if we want to dig in a little deeper in equities and split out between small and large cap, I think there's some interesting dynamics at play there. So right now, the S&P 500 versus the S&P 600 forward valuation wise is... S&P 500 is trading around 18 times and the S&P 600 small cap index is trading at around 12 times. That's the largest spread going back since the small cap index has been around since around, we have it dated at, 2005. And historically the long-term average, S&P 600 is traded at a premium because the general theory was small cap companies can grow faster, which we have seen is not the case with what's happened with this, now we're calling, the Magnificent Seven, this year.
So now what can change there, I think, is the question. Can small caps start to outperform again or are they just thrown out with the bathwater, and if you're not a mega cap, then it's not worth owning. That remains to be seen. I think with small caps, they're roughly 4% of the overall market capitalization at this point, one of the smallest portions of the market going back. You would think, "Mean reversion. Okay, maybe that can't hold forever." But that's been the call for the last few years and it hasn't been the case.
So we'll be looking for signs coming up in this next earning season to see if one, small caps can start to get a leg up as earnings revisions have been a little better there. And two, what are companies going to start talking about for 2024? While the near term earnings are important, I think third quarter, this is around the time that companies start giving generally more qualitative guidance and analysts start probing into what do you see for next year? And now we'll start to get a little more of a solid base on 2024 earnings. Because right now, growth for the S&P 500 is expected to be 13%, which in my opinion seems like a pretty high number in a higher for longer environment. And with recessionary fears continued to get pushed off, but still they're there nonetheless. So that's what we're looking for.

Brian Pietrangelo:
Hey Connor, we usually don't talk about individual securities and nor is this a buy or sell recommendations, but there was some interesting news on Amazon this week in terms of antitrust. What are your thoughts in terms of that, as you mentioned, the Magnificent Seven, and other concepts within the tech sector?

Connor Cloetingh:
Sure. So I think this antitrust suit was a long time coming given the FTC chair, Lina Kahn. Her claim to fame is her article, she wrote when she was a law student at Yale. And basically the argument there is that Amazon is using its market dominance to raise prices for its sellers and ultimately harm the consumer. But I think you have to look at it on the other side that if Amazon didn't exist, they've been pushing and pushing other competition to continually lower prices, and you could argue that they've benefited consumers over time.
But I think big picture, what does this mean for other mega cap tech in general? The FTC, in its current regime, will continue to try to find ways to reduce market dominance of these large cap companies. So far has not been very successful given the Microsoft Activision deal went through. Meta tried to acquire a virtual reality company that they tried to block that one through. So track record, not great so far, and I think they'll have a hard time arguing that consumers are harmed by Amazon, but remains to be seen.

Brian Pietrangelo:
Great. Thanks Connor. And George, let's go with you for any final thoughts you have for our listeners today.

George Mateyo:
Sure, Ryan, thanks. I think in listening to Connor and Rajeev, there's a couple of things I'd probably emphasize. One of which it sounds like based on Connor's reading, and I would agree with this, that earnings estimates are probably a bit too high. And also what Rajeev's saying that maybe interest rates are also getting to be a point of being too high. And then thirdly, we've got oil prices and energy prices that are getting to be a bit too high. So we've got these things that are probably staring us in the face that we need to acknowledge that they're going to start probably weighing on some sentiment in the near term, I would think.
I think, as kind of what they said, the recession risk really hasn't gone away, and just because we haven't had one doesn't mean we won't have one. And I'm not in the camp right now that this is a looming situation at our doorstep, but I think we have to be mindful that things probably will start slowing down as we head to the back half of this year and into next year potentially in the sense that the momentum that we've seen this year in the form of higher consumer spending, in the form of frankly higher fiscal spending too from the government, has been really similar to the overall market in general, and particularly the Magnificent Seven that Connor alluded to as well.
So I think against this backdrop, it's really important just to stay balanced towards risk, really emphasize qualities we've talked about, and be selective when you put your capital to work.

Brian Pietrangelo:
Well, thanks for the conversation today, George, Rajeev, and Connor. We appreciate your 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. And 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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