- [Announcer] Welcome to the Key Wealth Matters podcast. A series of candid conversations with leading experts about how individuals and organizations can grow and protect their finances. Tailored around current events and trends. Here's your host for today's podcast, Brian Pietrangelo.

- [Brian] 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 28th, 2022. I'm Brian Pietrangelo and welcome to the podcast. And so far, October has been a positive month for stocks and we hope to avoid any unexpected scares as we head into the Halloween weekend. With me today, I'd like to introduce our panel of investing experts here to provide their insights on this week's market activity. 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. For the economic news for the week, there were a significant number of data releases that were reported so we'll try to give you a quick summary on each one of the topics. Earlier in the week, housing data showed significant signs of slowing, not only in the report from new house sales that dropped 10% in September from the prior month. But also on the price index side, housing prices showed signs of declines. Not a surprise in both areas given that we're seeing mortgage rates get above 7%, which hasn't happened in the last two decades. The first estimate or the advance estimate as it's known, for Q3 GDP for the United States was released on Thursday with a positive 2.6% annualized rate for the quarter. This breaks the cycle we saw earlier in 2022 where first quarter was down 1.6% and second quarter was down 0.6%. So healthy signs in the economy to some degree. Although we see the overall economy having signs of slowing. Also on Thursday initial unemployment claims came out at 217,000 which is right in line with the steady pace that we've seen over the past four to six weeks. Indicating that although we may be headed into a recession later this year or early into next year, we have not yet seen signs of the job market deteriorating. Also on Thursday, the ECB raised rates 75 basis points on the other side of the pond for the second time in a row. And also, this has implications for what we might see next week when the Federal Open Market Committee, here in the U.S., meets on November 2nd to give us their policy update on the Fed funds rate and what they see happening for the rest of the year. And on Friday just this morning, there were a number of releases related to consumer spending and inflation. Consumer spending for the month of September remained positive at a 0.6% growth rate month over month. And on the inflation side the Fed's preferred measure of inflation, the overall personal consumptions expenditures index, also known as PCE, was up 6.2% year over year which was the same as August. But if we look at the core PCE indicator, which removes the volatile food and energy components, it was up 5.1% year over year. Which is slightly up from August, which was 4.9%. So although there are some of the underlying components that we're seeing relief in terms of inflation, the overall numbers remain persistent in terms of high inflation above where the Fed's target wants to be. And lastly, on the employment front, the employment cost index for the quarter was released. And as of September, 5.1% increase in overall wages and salaries for the 12 months ending September of 2022. This is important because it continues to show the imbalance in the labor market where wages are going up because of the high demand for labor. So what does this all mean for investors? Let's turn to Rajeev as we get his thoughts on what that might mean from a perspective of the federal open market committee's decisions next week, and implications longer term for the markets. So, Rajeev?

- [Rajeev] Well the anticipation, Brian, is that next week and throughout the week we're going to see volatility until the Fed meeting. We saw it this week. The thoughts are that the Fed has a lot to still do to cool down inflation. And even though we do not see inflation cooling down to a point where the Fed would be happy, the market anticipated a pause during the week. The market was thinking that perhaps the Fed's going to stop. In fact, I feel the Fed is not going to stop until they feel inflation has gotten to a place where they feel comfortable, right, which is a target range of 2%. So the Fed will maintain their hawkish stance next week at the FOMC meeting, is my anticipation. They'll lay the groundwork for the Fed funds rate to get to about 5% by March of 2023. So we're thinking about a 75 basis point rate hike next week, that is the consensus. And then another 50 basis point rate hike in December. And now if you look at the expectations, the Fed continues with quarter point rate hikes for the following two meetings. So we've talked about Fed forecast in the September meeting where they said that, "You know, we'll get to 4.4% Fed funds rate by the end of this year, 4.6% next year before any cuts start in 2024." So I don't understand this market kind of feeling that the Fed's going to pivot too soon or maybe do a 75 basis point rate hike and stop for a while and kind of look around. I just don't see that messaging coming out of the Fed. But I do see the market with a disconnect and they're thinking the Fed will be done this year. And then pause and kind of like take an assessment of where we are. 75 basis point December is not off the table, it's definitely on the table as well. So I think that the notion was that 75 basis points in November and then 50 basis points in December. But there is still a 33% chance that the Fed does another 75 in December. And I get questions a lot about whether the Fed can do a soft landing, is that possible? And my response has always been that, at least recently, that the recession is likely to be imminent. And a hard landing with a period of zero growth seems a little more likely. There remains that risk that the Fed overtightens rather than not raising enough and failing to contain inflation. The full effect of four is 75 basis point rate hikes, we might not even see the effect of that until the middle of next year. And by then we'll have an idea if there's a policy mistake or not. But if the Fed does another 75 basis points next week that we anticipate, then the combined rate hikes of 375 basis points since March, that's what we're going to have. That would be the steepest rise that we've seen by the Fed since the 80s. And the Fed will most likely er on the side of doing too much. Another thing we have to focus on is the Fed's balance sheet. The Fed has announced reduction in its balance sheet, which started in June with a runoff maturing securities by the Fed reducing their assets by about 1.1 trillion a year. And economics project that this will bring the Fed's balance sheet to 8.5 trillion by year end. And maybe 6.7 trillion by the year end of 2024. The effect of reducing a balance sheet is also another rate hike, essentially. But will the Fed's sell mortgage-backed securities? Will they do some kind of asset reduction? That has not been announced yet nor has there been any indication by the Fed yet. So I expect, next week that the language should be the same that we're going to do whatever it takes to increase rates until inflation gets contained. But it's going to be very important to keep an eye on all the rhetoric after the meeting.

- [Steve] Rajeev, I agree with you. But you know what I'm curious about, is your take on whether or not really what the market is focused on is this idea that we've hit peak central bank hawkishness. So you know, we saw this week the Bank of Canada come in and hike less than the market had expected. You know, maybe it's just as simple as while we're not seeing a pivot at all, we're just not getting any more, things are not getting any worse.

- [Rajeev] I could see that, I can see that. I mean, I think that is what the market's kind of hoping on and almost looking at that maybe there's underlying issues in inflation that have cooled down a bit. And that the Fed has just not come out and said it yet.

- [Steve] You know, the thing that really concerns me as we look forward, it's almost like people have forgotten the fact that hiking has a lagged impact on the economy. And when I look at this inflation data that the Fed is focused on, this is lagging data and it's like they're setting policy based on lagging data and then we have a lagged impact of the hikes. So we've only had seven months worth of hikes. And when we think about that possible economic impact, say you know, nine to 12 months after we enter this hiking cycle, which puts us squarely in Q1 next year, I mean I think that this idea that the economy could be in a difficult place is something that's starting to gain traction. And you know, we're seeing it play out in some of these earnings forecasts from mega-cap tech companies this week. I mean there is a clear deceleration going on in portions of the economy. And it just seems like there's a complete disconnect between policy and what's going on in the real economy right now.

- [Rajeev] Well, your point about lagging indicators and the fact that whatever the Fed does right now, we won't know the full effect, I think you're absolutely right. And the market anticipates what the Fed is going to do and by doing that, it causes more volatility in the market. We saw it before at Jackson Hole in August where the market really thought the Fed's going to be done. There's going to be a pause. I don't see any indication besides a few Fed speakers that have come out and said that maybe we should pause after two 75 basis point rate hikes this year and just look around. But by doing that, this whole week we haven't heard any Fed speakers, there's a Fed blackout period. And the market kind of went on its own and kind of started thinking about you know, maybe there are indications in the market that the Fed, whatever they've done up to this point has worked. At least is working. Is that enough for the Fed to stop? I always have seen, and I know you have too, Steve, that the Fed tends to overshoot. And I think that's kind of where I'm leaning towards.

- [Steve] Yeah, I mean the overshooting I think is the thing that gives us the most concern, right? I mean, some of the stuff that's been coming out of the housing segment of the economy in the last couple of weeks has really been eye opening. I mean, we've seen the NAHB, National Association of Home Builders survey, plummet to levels that are consistent with a forward year over year appreciation, and home prices consistent with a -10 to -15% sometime in the next six to 12 months. I mean, those numbers are really significant when you consider you know, there's been a lot written over the last 15 plus years about how housing is the U.S. economy. And if we are going to see declines like that you know, I struggle to see how we are able to navigate into a soft landing from the Fed, irrespective of what some of the commentary is. I mean, it just seems to me like if we're looking for something that's broken, it's pretty clear that mortgage rates at 7.3% have broken the housing market.

- [Brian] You know, Steve, that's an interesting comment because we talk about monetary policy with a lag but there's also the housing prices with a lag that ends up translating into shelter. And so that's about a six to seven month lag as well. So there's going to be confluence of those tightening policies together with inflationary pressures coming down in the housing market, leading to a decrease in CPI, might put us in that first quarter of 2023 to see what's really going to happen. And whether the Fed continues their policy or they pause or they pivot. So, interesting timing

- [Steve] Yeah, and what's funny about this is that you know, we could still, like if you look at the underlying commodity picture, right, globally you know, we could still have elevated crude oil prices and things like this. Elevated gasoline prices, but yet have a disinflationary impulse ripple through the economy from what's going on in the housing market as we look into 2023. So like I think we got a lot of puts and takes that are going on here and I think that it's going to be a really tough period of time to continue to navigate, you know? And like we've continued to talk and say, "Look." I don't know that I've ever seen a period of time that has had this many crosscurrents in my investment career going back to the early 90s. I mean, this is a really difficult macro period that we're seeing right now. And I think a lot of people continue to be confused . And frankly I think some of the policy makers are also confused. I mean, just listen to Jenny Yellen this last week talking about how she's learning on the job. I don't know about you, but when I hear a treasury secretary use the phrase learning on the job, that's kind of disconcerting to me.

- [Brian] So Steve, you mentioned something about earnings this week and some pullback relative to what's happening in the economy. What are your thoughts on this week?

- [Steve] You know, I think that we've seen a two-way trade in equities as we've gone through earning season. We're now over, we're right in the ballpark of 50% of the S&P 500 having reported by number of constituents where it's 66% of market cap having reported. Numbers have come in generally in line, but I think that we all know that there's a game that goes on there in terms of expectations management. What really has come across is these negative surprises out of the mega cap tech companies that we're all familiar with. Whether it's Amazon, that we all get stuff delivered to our house from, Microsoft that we all deal with on our work or home computers every day, or Alphabet Meta with Facebook. All these companies have had fairly large scale earnings misses this week and have had commentary that has said that they're seeing a slowdown. You know, I think that when you combine this with the fact that tech companies have continued to have pretty high multiples coming out of the Covid period, this has created kind of a headwind for equities to make progress. These companies still account for 20 to 25% of the S&P 500 by market cap. So even if we have cyclicals improving, energy stocks improving, I mean that's one of the things too that I've noticed this week is that we've continued to see strength in both, not only energy as market leadership, but also industrials. You know, I think that these cyclicals look like they're set up for a pretty decent rally as we move here into the fourth quarter deeper. Driven largely, Brian, by the fact that we've had a fairly significant pullback in the U.S. dollar this week. So I think that when we look at things that could be themes for the fourth quarter, a weaker dollar. You know, maybe we've hit peak dollar bullishness here in the last couple weeks. That could really be a tailwind for some of these cyclical companies that have large scale international exposure. But I think that it's going to be hard for maybe the headline market industries to make much headway given the fact that these mega cap tech companies are having this multiple compression problem with the fact that their earnings are also disappointing right now.

- [Brian] Yeah, speaking of international exposure, the ECB raised rates 75 basis points. Rajeev, what do you think about that relative to the U.S. and other things going on in the yields and the treasury markets from your perspective?

- [Rajeev] Well, you're right Brian, the ECB raised rates by 75 basis points. And the interesting thing was they tweaked their forward language. So they signaled that they have raised rates three times in a row and they actually have said in their language, that they've maintained substantial progress in withdrawing the accommodation. And we saw German rates drop on that news. They thought that, "Okay, the ECB is done." It might be a little premature. I think the ECB continues to say we're going to look at inflation, we're going to look at the impact of our rate hikes. I think this just feeds into the entire narrative that there is this global inflation, fear of global recession is still there as well. And all the central banks are working in the same direction to try to raise rates. 75 basis points for ECB made sense. I think it was very well telegraphed. It doesn't really impact what I think the U.S. is going to do. I think that 75 basis points pretty much baked in as well. But I do think that yields have reacted. We saw German rates go down. We didn't see the same type of magnitude in U.S. rates. But the whole week we've been seeing yields in the U.S. treasury market drop, the whole week we've been seeing that. And it's been more about a Fed pivot or a Fed pause. And today again, we're starting to see rates climb up again. Not tremendously significantly, but we are seeing some kind of pullback on that. And I think the reason is, is that again we are waiting for what happens next week. The ECB statement however was very interesting 'cause they actually said they've made substantial progress. And that's something that we have not seen any U.S. statements say yet based on 375 basis points of rate hikes.

- [Brian] Steve, any last thoughts that we could share with our listeners today?

- [Steve] Yeah, I'll just say that we've now cleared through pretty much the month of October, Brian. And we've entered the best part of the calendar year historically for equities. So even in years where we have a Fed tightening, we still see positive equity performance over the back end of the calendar year. So I will not be shocked if we see a rally in the market even in the face of continued tightening from the Fed and difficult you know, economic commentary and forecasts for 2023. A rally between now and the time that Santa visits in December would not shock me at all.

- [Brian] Well, great conversation today. Steve and Rajeev, thanks for sharing your wisdom, we certainly appreciate it. 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.

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