Discussing their predictions for markets and beyond for the second half of 2023 are Frank Cooke, head of International Solutions for the Systematic Edge team; Danny Sarnowski, portfolio specialist for the Plus Fixed Income team; and Ozo Jaculewicz, senior portfolio specialist for the Discovery Growth Equity team. A more complete discussion can be found in Allspring’s 2023 Midyear Outlook: https://allsprg.co/3JjJ0kM
Frank Cooke: I’m Frank Cooke, head of International Solutions for the Systematic Edge team, and welcome to this special edition of On the Trading Desk®. It’s an Allview face-off roundtable. Joining me today are Allspring’s very own Danny Sarnowski, portfolio specialist for the Plus Fixed Income team, and Ozo Jaculewicz, senior portfolio specialist for the Discovery Growth Equity team. Today, we’ll be talking about our predictions for markets and beyond for the second half of 2023. Thanks for being here, everyone.
Danny Sarnowski: Thanks for having me.
Ozo Jaculewicz: It’s great to be here, Frank. Thank you.
Frank: So, recently, we saw the U.S. Federal Reserve pause rate hikes for the first time in 15 months at the June 14 meeting. As always, we are all watching interest rates and inflation very closely. U.S. inflation, as measured by headline CPI (Consumer Price Index), is currently 4%. Where do you both see U.S. inflation ending the year? Less than 3% or more? Danny?
Danny: Frank, do you want the short answer or the fixed-income-person answer?
Frank: I want the short answer.
Danny: Less than 3%.
Frank: That was really short.
Danny: The slightly longer answer is that I do see headline CPI being below 3% by year-end, but that’s not the only metric that matters to the Fed (Federal Reserve). You’ve got core CPI. The Fed’s own preferred gauge is core PCE (Personal Consumption Expenditures). So, there are a number of ways to look at inflation and I don’t think that all of them will be sub-3% by year-end. And I think the Fed is also going to be looking at a variety of additional factors, such as the unemployment rate; wage growth; economic growth; and, certainly, having to weigh any exogenic shocks to the financial system or financial conditions to help guide their ultimate policy path.
Frank: Ozo?
Ozo: I would agree. I think it’s unlikely we’ll be under that 3% target. And, in particular, I think what’s been notable recently is that wage gains for workers have been largely eaten away by higher inflation. But now that we’re seeing signs of cooling of inflation, real wage growth is slowly improving, which actually improves purchasing power for consumers. Maybe it won’t be a jet fuel for new rounds of consumer demand, but it could be a positive trend, which sort of complicates the Fed’s job of pressing down on demand. So, I think it’s unlikely we’re below that 3% level.
Frank: I mean, I would agree with both of you. I think, if you look at the one-year inflation swap, it’s pricing about 2.4% at the moment. Obviously, this downward trend is continuing. We have rent disinflation lying ahead for the second half of the year, which we’ll factor in. I think some problems potentially for me would be an energy surprise. We’re seeing some shocks in natural gas in Europe, for example. Also, commodities, agricultural commodities in particular, are rallying at the moment. So, that could drive some food inflation. Services are still quite strong, but I agree with you. I think below 3% at the end of the year for me.
Ozo: One interesting element on the equity side as a result of lower inflation, that trend in general, is it seems like we’re ending this sort of price-over-volume dynamic where a lot of companies had their financial results driven by raising prices and passing along higher inflation to their customers, which in a way kind of masked a lack of true underlying growth. So, I think the market starting to sort out, regardless of where CPI lands, the market is distinguishing between companies that no longer can pass along price because of high inflation. And now companies need to provide actual true fundamental growth over cyclical benefits of that high inflation.
Frank: Yeah, thank you for that. So, if we turn to you, Danny, do you believe the yield curve will still be inverted at the end of the year? Yes or no?
Danny: Again, the short answer is yes. The slightly longer answer is I do think portions of the curve, let’s say the 2’s/10’s, the spread between the 2-year and 10-year Treasury, would be inverted at year-end. But other areas of the curve like the 5’s/30’s may not be because we do expect the curve to steepen throughout the year as the risk of recession continues to grow. We look at it as there’s a one in eight chance of a recession on any given year, given over the last 50 years, about every 8 years we have one. And we see the risk this year is higher. It’s not 100%, but it continues to grow. So, if you think those risks continue to become elevated, markets start pricing in a reduction in the fed funds rate, and the curve starts to normalize, the curve starts to steepen, I think that process begins in the second half of the year, but I don’t think, let’s say, the 2’s/10’s is positive by the end of the year.
Frank: Yeah, I would agree with you, Danny. I think if you look at what the market was pricing just two months ago, the market was pricing a 100-basis-point (bp; 100 bps equal 1.00%) cut, short end, obviously. Now, it’s only pricing around 25 bps, if that. And then, on the longer end, I just don’t see the 10-year rising, say 1.5%, with inflation coming down and with recession worries looming. So, yeah, I would agree it’s still inverted at the end of the year. OK, Ozo. Let’s pivot to equities. Are you bullish, bearish, or neutral on the S&P 500 Index for the second half of the year? And continuing with that thought, do you believe growth will outperform value in the second half of 2023?
Ozo: Frank, our team is generally constructive on U.S. equities, but selectively. Let me share a quick metaphor. If any of you have ever done a fun run or an endurance event to raise money for a fundraiser, think of the period when interest rates were extremely low with zero rates, with liquidity everywhere, as a nice, easy 5K. Whether you walked or jogged, everyone was pleasant and high-fiving. There were balloon arches and bands playing. It was really jovial. Well, the last couple of years, that event has been more like a slog because of very high inflation and tightening by central bankers. It’s been raining cold and there’s really been nowhere to hide. And it sort of feels like your old knee injury has flared up. Right now, it feels like we’re more in an environment that’s sort of like a Tough Mudder. For equities to perform, there’s mud and walls to climb and ropes to climb. We’re crawling on our hands and knees. But for those companies that can finish the event, there is a celebration. There are strong returns on the other side of a Tough Mudder. And that’s what it sort of feels like within equities right now. We are no longer in a period where a rising tide is lifting all boats. We are seeing great differentiation by fundamentals at this point being the key signal driving stocks. So, whether it’s growth or value, I really think it’s quality of profits and underlying business models, which argues to favor secular growth stocks over cyclical and inflationary and policy beneficiaries. If we think about the biggest events this year, innovation around AI (artificial intelligence) has created a new source of growth for many companies. And the banking crisis has compressed GDP (gross domestic product). As a result, there has been a strong rotation toward companies with earnings stability and secular long-term growth. And those companies that have the ability to control their own destiny and have that underlying quality of their fundamentals, we think will stand out, be rewarded, and have that euphoria of finishing the Tough Mudder.
Frank: Really interesting there, Ozo. I think, personally, I would be neutral, just given what’s happened in the first half of the year. And if we think about the S&P 500 Index, at the moment, you’ve got eight companies that make up 30% of that index. And those mega-cap companies have rallied a lot. You alluded to the AI wave, the AI premium. Is that fully priced in or not? Obviously, a huge debate to be had there. I think it depends. Can the rest of the index constituents catch up? If they can, we’ll see a really strong second half of the year. But, obviously, with recession looming, and these higher interest costs for consumers and corporations, that could be challenging. So, it’s very difficult to call it the moment, so I’m going to stay neutral on the S&P 500 question.
Ozo: Thank you, Frank.
Frank: Now for a related question and for both of you, is the contagion from the global banking crisis contained? Yes or no? Danny, why don’t we start with you?
Danny: Well, I think the short answer is yes, for now. In that, I think that the global banking crisis that started in March was met very swiftly by global banking regulators with some effective controls, guarantees of deposits, and a lot of hard work to find buyers for those weaker institutions. And I do think that the risk of broad contagion has largely been reduced. But that doesn’t mean that the impact of the banking crisis is over, meaning we could see higher borrowing costs or tighter lending standards impact the broader economy. And we broadly think that this is not the last place where we’re going to see the cost of monetary policy tightening show up. So, while you could say that something finally broke with the regional banking crisis, we don’t think it’s the last thing that’s going to break. I think if you raise borrowing costs, or the cost of credit, by hundreds of basis points in 12 months on top of all the other pressures that are facing corporations and the consumer here and around the world, we do expect that something else is likely to go wrong. So, while this banking crisis, I do think is contained, I don’t think it means the coast is clear and it’s blue skies and clear sailing from here.
Frank: Ozo?
Ozo: I completely agree, Danny. The contagion may be contained, but let’s not forget that credit is the lifeblood of a modern economy. And we are now in a period where credit is being restrained and conservatism and risk aversion by lenders is extremely high. So, you are seeing signs of cancellation of projects, stress in the commercial real estate market, and REIT (real estate investment trust) prices falling. The fallout of this is slower economic growth. If you constrain credit, you’re going to see less GDP expansion. I think it’s that second derivative effect that is really yet to be seen.
Frank: Yeah, I tend to agree with both of you. If you think about the savings and loan crisis, we had 1,300 banks fail. So far, we’ve had four. Obviously, with the yield curve inverted, that puts a lot of pressure on banks’ business models. If you think about their net interest margins, you’ve got huge shifts out of bank deposits and into money market funds. That puts banks under pressure. But to Danny’s point, the Fed’s interventions, like the BTFP (Bank Term Funding Program), they’ve been quite successful so far. So, I would agree with you, Danny. For now, the contagion is over, but we need to be vigilant.
Danny: Yeah, vigilant is a good word.
Frank: So, let’s talk multi-asset. What do both of you believe will be the best-performing asset class for the 2023 calendar year: 10-year Treasuries, the S&P 500 Index, the Bloomberg Commodity Index, or bitcoin? Ozo, let’s start with you.
Ozo: I’ll go with the S&P 500, Frank. You made an excellent point earlier about the concentration of that index. And I realized that’s concerning how narrow the market has been driven on the equity side so far this year where breadth has been extremely low and something like eight stocks have really been driving the equity markets. I actually think that’s going to start to broaden out. And, in particular, I think companies that, again, have that secular growth profile, you’re starting to see signs of them catching up. I think of these companies that have great underlying fundamentals and long-term growth as beach balls that are being pressed underwater. Over time, as they produce good earnings and profits that show resilience and can meet expectations, those beach balls snap back up. And I think that broadening out to see small- and mid-cap stocks participate in this rally is going to be the next trend that plays out that helps drive broad equity markets and, again, I think favors companies that are on the right side of change and that are technologically being propelled by things like AI and software in semiconductors. I really think that growth profile will remain a key signal that drives leadership in the equity markets.
Frank: What do you think, Danny?
Danny: Well, bitcoin is already up 50 plus percent year to date. So, I think it’s going to be a tough bar to climb. So, the real question is what do you think’s going to do the best in the back half of the year? I think it’ll be a closer race between the S&P and the 10-year Treasury, especially if we do see recessionary pressures build over the next six months in that equities may still be positive but will see lower levels of growth. And longer-duration bonds add more value beyond the higher yields they’re getting today. So, I think that could be close. But I think at the end of the year, as long as bitcoin doesn’t drop off a cliff, I think mathematically you’d say that’s going to be the highest-performing sector. What about you, Frank?
Frank: Well, I’m known to be a little bit of a bitcoin bull. And, so, I find it difficult to disagree with you there, especially when we have the halving event next year in April 2024 when essentially bitcoin’s inflation rate will half. So, historically that’s been quite bullish in the run up to that. So, yeah, I definitely wouldn’t bet against bitcoin here. So, we’re running out of time. And with the time we have left, I want to ask one more question. Are you currently overweight, underweight, or neutral on U.S. equities versus bonds? I’m thinking in relation to a traditional 60/40 equity/fixed income portfolio. Danny?
Danny: It should not shock you to hear that I am overweight fixed income and underweight equities, given that I do see recessionary pressures building and the highest all-in yields out of fixed income in 15 years. I feel like fixed income is a sort of a heads we win, tails we don’t lose scenario from here. And that’s a great risk/reward profile, so I’m overweight fixed income, underweight equities.
Frank: Ozo?
Ozo: You won’t be surprised to hear that I’m meaningfully overweight equities. We’re now at a period of time where the Fed is starting to get to the later stages of its tightening campaign. There are signs of cooling inflation. We have a tight and healthy labor market in the United States. And corporate earnings have been surprising to the upside. I think the negativity that was priced into equity markets in late 2022, that pessimism is starting to dissipate and we’re starting to see signs that we may have some sort of a soft landing. And in that scenario, where equities saw their multiples compressed by such a historic amount last year, there is a coiled spring element to the recovery in stocks. And I think investors should be getting ahead of that recovery and, again, favoring companies with secular underlying growth fundamentals. I think that’s where you’ll see some very strong performance in the future. Frank, what do you think?
Frank: I’m going to go with neutral. That’s actually how we are positioned at the moment in the Systematic Edge team. Our cross-asset quantitative indicators are signaling neutral. I think we’re probably going to look to overweight bonds soon as inflation and growth coming down in the second half of 2023 should give them support. So, we’re very well balanced with those three answers.
Danny: Yeah, we’ve got you covered.
Frank: OK, so that was the Allview face-off roundtable. I want to thank everyone for listening. Danny Sarnowski and Ozo Jaculewicz, thanks for being here.
Danny: Thanks for having me.
Ozo: Thank you.
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Disclosure: 100 basis points equals 1.00% Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses. Asset allocation does not ensure or guarantee better performance and cannot eliminate the risk of investment losses. The S&P 500 Index consists of 500 stocks chosen from market size liquidity and industry group representation. It is a market-value-weighted index with each stock’s weight in the index proportionate to its market value. You cannot invest directly in an index. The Bloomberg Commodity Index is a broadly diversified index that tracks the commodities markets through commodity futures contracts. You cannot invest directly in an index.
