The market is experiencing an extraordinary amount of volatility right now. Obviously all things tech/meme/crypto are getting crushed. But it's more than just that. Traders are having to digest a hawkish Fed, and inflation at multi-decade highs. Plus there remain numerous shocks, whether from Russia’s invasion of Ukraine or the Chinese lockdowns. To make sense of what's going on, we spoke to Luke Kawa of UBS Asset Management and Neil Dutta of Renaissance Macro. Below is our lightly edited transcript of the discussion. The discussion took place on Friday May 6.
Points of interest in the pod:
Is the economy good right now? — 3:07
The data shows a deceleration — 5:44
How the move in rates explains the tech plunge — 10:00
Why this recovery was different from the last one — 12:55
How high can rates go? — 21:05
The role of the strong US dollar — 38:57
Are stocks cheap yet? — 40:55
Joe Weisenthal: (00:10)
Hello, and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal.
Tracy Alloway: (00:16)
And I'm Tracy Alloway.
Joe: (00:17)
Tracy. It has been a week.
Tracy: (00:20)
That's one way to say it. I am so tired. I got about two hours sleep last night and there's just been so much that happened. We were both at Milken in Los Angeles. And for anyone who's ever been at Milken or any large conference for that matter, it is just a whirlwind of meetings and discussions. And we also recorded a couple episodes. And meanwhile, against that entire background, the news is actually happening. The Fed raised rates by 50 basis points and the markets crashed.
Joe: (00:53)
Crashed? They had some rough days that's for sure.
Tracy: (00:57)
Okay. The markets went down a lot.
Joe: (01:01)
The markets had some really rough days and particularly tech, growth, that kind of stuff. It just continues to get absolutely killed. We also had a jobs report. We're recording this May 6. We also got a jobs report today, which seemed decent. There is a lot going on right now and yeah, we were at this conference, I kind of feel like I missed a lot of it. I almost wish I was just behind my computer the whole time.
Tracy: (01:29)
That's a very Joe thing to say. Well, one thing that was interesting to me, so I was actually at a credit-market panel right when the Fed raised rates and I got my phone out and I started videoing the audience because I thought like maybe the headline would come out, right, and something would change in the room. Absolutely nothing happened. I mean the 50 basis point increase was well telegraphed, but the really interesting thing was we didn't even really get much of an immediate reaction in the market. It wasn't until the next day on Thursday that everything started happening.
Joe: (02:05)
On Wednesday I think the Nasdaq was up like 3% and it was like "the coast is clear, they took 75 basis points off the table,” maybe policy is, some signs of inflation, turning a corner. And then the market tanked. We have two great guests this time. Excellent commenters both. I want to welcome to the show, Luke Kawa. He is an allocation strategist at UBS Asset Management, as well as Neil Dutta, head of economics at Renaissance Macro Research. And I think it's Neil's first time on the show, which is amazing, because we've known Neil for a long time and are big fans of his work. So thank you both for coming on the show. Neil, you haven't been on Odd Lots before, is that correct?
Neil Dutta: (2:55)
I haven't Joe. What took you so long?
Joe: (3:00)
I know, I know, it really is shameful. But let's start with you, like what's going on? What's your read of everything? Put it in a tweet for us.
Neil: (03:07)
Oh, I think the economy is fine. You know, I think obviously if you look at just the total hours worked so far this year, it's running around three to three and a half percent, so aggregate hours worked, if you assume underlying productivity growth of, you know, conservatively around 1%, I think underlying economic growth is around four to four and a half. So I'm not particularly worried about the economy, but clearly there's an adjustment that's happening with respect to the interest rate outlook. That's been going on really all year and I think that's having some predictable consequences on equity markets. I don't know what happened one day. I mean the Fed signaling something and the market rips and then the next day the market tanks. I mean, it's a very bizarre sort of situation.
Yeah. But generally speaking, what I can tell you — and what I've learned throughout the year — is that, you know, the economy is a much slower moving entity than the financial markets and ultimately good economic news can help the financial markets. And you know my sense is that whatever selloff we have seen, and tightening of financial conditions we've seen, isn't gonna have a significant impact on the economy. I mean, in the sense that, relative to what's baked into the consensus, remember the consensus expects a slowdown this year, that's what's priced in.
If you look at the blue-chip consensus, it's at 2.3 for this year, the Fed's at 2.8, so you're gonna see some slowing. And when, when the economy slows, there'll be some days where the news comes in good. And some days when it's not. And you know, in my mind, the data hasn't really deviated from, from that, you know, trajectory really one way or the other. And if you had to put a gun to my head and say, you know, do you think growth is gonna come in stronger than what hat consensus is for Q4 2022? My guess would be probably yes.
Tracy: (05:10)
So there's a lot to unpack there. And before we do, why don't we bring in Luke and I guess two questions for Luke. But one, do you share Neil's assessment of the economy that he just described? And then two, what do you think happened between Wednesday and Thursday? What was the trigger? Because it feels like that's what everyone's trying to figure out at the moment.
Luke Kawa: (05:30)
So you know, couple of tough ones. First off, as a default, I think Neil's a great person to defer to on the on the US economic outlook in particular...
Joe: (05:41)
Now comes the shiv. What now? Now you're gonna shiv him.
Luke: (05:44)
No, no. I completely agree. All of the data, basically all the data we've got recently on the US, confirms the idea that the US is decelerating, but at a level that's still consistent with nominal growth. That's far superior than what we got last cycle. The problem is that simply doesn't matter right now. That simply is not the proximate mover of risk appetite right now. And what's even more concerning is it's very difficult to tell what actually is. So I know one phrase that, you know, Tracy loves to use is, you know, flows before pros. Just this idea that, you know, money moving, even from, you know, potentially unsophisticated investors can run over the more sophisticated crowd right? Now the flows are the pros.
So it's more of a story for me about flows before pros, but P-R-O-S-E. There's no story we can use that is going to adequately explain why risk appetite changed on such a dime between Wednesday afternoon and Thursday morning, there's nothing that does it. So what we have to do as asset allocators, we have to take a step back and say, well, you know, there's really three big risks we see on the table.
One is kind of Fed tightening, which is going to be, you know, possibly if it's too much, it's bad for growth, bad for risk assets. If it's too little, it's probably just, you know, bad for risk assets, financial assets generally. There's the Russian invasion, which is just creating kind of persistent supply issues and threatening to exacerbate kind of some of the negative supply commodity price issues we've seen weigh on forward consumption.
And then there's China, which is both, you know, a supply and demand issue. And I think that's one thing that did spook people a little when the Chinese yuan depreciated a bit there, because it's like, OK, well, if China's supposedly, you know, everyone thinking is about to go on this decent credit, old-school stimulus, but smaller binge as the public health situation improves, or if they're kind of more durably moving to a consumption-driven model. Well, that doesn't comport with a lower currency at all. The lower currency comports with the trying to be the demand sinkhole for the rest of the world and sop all of that up. So that's, you know, that's something that's concerning. All three of those risks are still there. And what we have to do when markets are this volatile are demand a higher margin of safety, but take a step back, increase our timeframes a little bit, and think about what are we pretty confident is going to be working in a year from now because rates volatility is so high, macroeconomic uncertainty is so high, that trying to really nail that one in a three month call seems like, you know, not something we should be devoting as much of our energy and our risk capital to right now.
Joe: (08:33)
I want to zoom out for a second and I want to start this question with Luke, and then I want to get Neil’s answer, but I want to zoom out because yes, we don't know what happens day to day. It's hard to tell a story, but if we zoom out a little bit, obviously this incredible tech boom that we've seen, or the growth stock boom has clearly, I think it's safe to say, come to an end. I mean, it's an incredible contraction, hundreds of billions of tech wealth lost. For a lot of people, this is something they've never seen before. We've arguably had like a 12-year tech bull market, a bull market in growth. Like what is the big story about this rotation and the turn?
Luke: (09:16)
So I think the big story does have a lot to do with the macro environment, a.k.a. the move in rates and the move in rates volatility. I think that's something just on a correlation basis. If you kind of plug in what you think should be moving stylistically based on what rates are doing then, you know, rates are to a certain extent driving the bus.
Joe: (09:37)
Just real quickly for people who don't understand it, we talk about this link a lot. It's like, “oh, rates are going up. So you sell Facebook or you sell ARKK.” It's not intuitive. Can you just walk through for listeners in a very sort of brief form, like why there's this connection between rates or rates volatility and the sort of violence of the tech market selloff?
Luke: (10:00)
So, totally. So I think there's some competing explanations. I'll go with my preferred and it has less to do with the long duration discounting stuff. This is more about I think generally speaking, are rising rates a function of an environment in which nominal growth outcomes are, you know, expected to be improving and are, you know, fairly firm? That's a kind of brief shorthand for why should rates rise. Rates should rise because things are good and things are good enough for central banks to remove stimulus. And, you know, that's a, generally speaking, you know, an OK environment for growth. If growth, if economic activity is doing well, then you don't need to focus on kind of the things that might be revolutionary or innovative, or be, you know, turned from a who knows what it was into a verb, like ‘Googled,’ 10 to 15 years from now. You can focus on, ‘ok, I know that energy companies are able to produce X oil with X margin and they won't be producing more than that. So prices are going to stay within X range. And that looks very good for me right now.’
nd we prefer that to speculating on something that might or might not be good 10 years from now. So that's my preferred explanation of how rates kind of affects the growth versus value argument. So that's the headline story there, but I also think there's a broader issue, both related to growth, but also related to the idea that kind of there's a bit of growth convergence to be expected as you come out of Covid. I think this is something that, you know, you've covered a lot, Joe, in that just the kind of the pandemic premium, both in multiples is kind of come back, but it's coming back in earnings as well. And when you have more and more tech companies talk about kind of, you know, right-sizing staffing levels or things like that, that to me translates into an environment in which, you know, yes, growth companies are no longer prioritizing growth. They're turning on some other tap, but it isn't growth. So it's a bit of a stylistic change that the group itself is undergoing right now. And, you know, when there's style drift within a cohort that might get investors to question whether the, you know, whether the thesis they've applied to the group is still valid, and that's something we see as an ongoing process right now.
Joe: (12:29)
I mean, Neil, I'm curious your take on that. I mean, you've been talking about the reopening a lot. I've had a million instant messages with you where you point out that, like, Peloton is going down and Planet Fitness, the actual gym where people go and work out in person has been surging. I'm curious, sort of your take on the same question of this sort of like bigger shift that we've seen in markets really since I guess November.
Neil: (12:55)
Well, I think a lot of this just comes down to the policy response, right? I mean, the policy response following the financial crisis period was not particularly robust. I think you could say, and as a result, you had a very, very, you know, not weak, but just not particularly strong nominal growth environment. I think we were basically hovering around four, four and a half percent for years. So that kind of, kind of churned the wheels of a very steady recovery. So things are always getting better, but we never really had that V-shaped recovery. And, so as a result, I mean, in that kind of environment, growth is not widespread. And so you have, you know, performance in the markets kind of narrow to, you know, a specific group of companies that can drive growth in that kind of an environment.
By contrast, in this period we had a very robust response. I think, you know, through a myriad of sort of fiscal support programs, I mean, the government was basically able to deliver, you know, a higher minimum wage to people without actually doing it legislatively. And, you know, the Fed basically put both of its feet planted firmly on the accelerator. And so, you know, I think that's been one reason why you've had such a strong nominal growth backdrop, and so growth is more widespread. And so as a result, it's not gonna narrow to a handful of mega cap tech names. Obviously the pandemic is important. As you mentioned, I mean I sort of pose that question to our clients as well. It's like, what if what we're seeing is really just the last gasp of the pandemic unwind, you know, I mean, I think it's more to it than that, but, you know, I mean, remember back in 2020, people were making the argument like the stock markets are just whistling past the graveyard.
And in reality, I think the stock markets were actually following a script that made a lot of sense. I mean, if you look at online retail sales, they were very strong, guess what? Those companies did really well in 2020, and by contrast brick and mortar retail didn't do particularly well. Restaurants didn't do particularly well. And they were punished. So it wasn't like the market was just, you know, turning a blind eye to all these things. I mean, the market, frankly, I think, was evolving the way you'd expect. And, you know, now a lot of that's working in reverse, right? And that is probably better for the economy, but it's, it's not necessarily the best thing for some of these trades that had been put on over the last number of years.
Tracy: (15:30)
Neil, you mentioned financial conditions at the start of this conversation. And this is something that a lot of people are talking about as well. This idea that the Fed has explicitly said that it wants to tighten financial conditions and one part of tightening financial conditions or one component of financial conditions — one of the things that hadn't moved that much or tightened that much — was stocks. So I guess my question is how is the Fed thinking about stocks at the moment, or how do you think the Fed is thinking about stocks?
Neil: (16:02)
I think they're probably encouraged to some degree that the multiple has come in quite a bit. I mean, obviously the earnings backdrop is quite strong still, and I believe projected earnings have continued to go up. And so, you know, I think they're probably looking at the sell-off equities as a good thing. Obviously, if demand is running really hot and financial conditions ease more, that means that demand is gonna get even stronger, which means that their inflation outlook will deteriorate in their mind. So, I think they welcome some tightening in financial conditions. And as I mentioned, I mean, the financial conditions tightening that we've seen so far is not enough in my view to really send the unemployment rate meaningfully higher. I mean, you know, we can talk about the folks over at Cameo laying off some tech workers.
But, you know, I just don't see it as enough to really weigh on the unemployment rate. At best, the unemployment rate probably flattens out in response to this tightening of financial conditions over the back half of the year. But, you know, I think in my mind, I mean the Fed welcomes the tightening. And given the kind of inflationary environment that we're in, this sort of idea that there's this, you know, put out there that the Fed will have your back. I mean, the strike price on that put is a lot lower than it used to be. And that's, again, it goes back to this idea that you know, in previous episodes when the equity markets were faltering, the growth outlook was faltering quite substantially as well. I don't think that that's as compelling this time around. And in an environment where inflation is still high, I think it's really a no brainer as Powell mentioned this week, their goals aren't intention.
Tracy: (17:52)
Right. So Luke, I wanna bring you in on this point, because I mean to me, the Fed never explicitly said that we want the stock market to go down. I mean, for obvious reasons, but they said financial conditions need to come down. The only thing in the financial conditions indices, as I mentioned, that had been staying up was stocks. Why did it take so long for the market to sort of accept this message? Because it did feel, like Neil just put it, as a bit of a no brainer.
Luke: (18:23)
Yeah. I find it interesting in that, you know, stocks were, and you can argue they still might be, but since, you know, more or less early February or late January, stocks have been kind of stuck in a boring range, you've just been going from the, you know, the bottom to the top of, of that range. It was more about the inertia with that. I also think it had to do with, you know, despite all, all of this and despite a pretty big rerating early in the year, like earnings have been coming in, you know, quite fine. The guidance outlook might be getting a little more dour in part because the strengthening of the US dollar, there's your financial conditions right there. As well as, you know, headwinds related to, to China and Ukraine.
But I think, I think it was a lot of complacency about the range we're in. But our view was that as we were getting to, you know, around those levels around top of range that, you know, those are good places to be selling stocks. What became more challenging is like when we get to the bottom of this range as we had lately, like, does it still make sense to be underweight stocks?
And the view there is that, you know, although we've had multiple compression, a lot of it we've had multiple compression at the index level essentially to pre-Covid levels. We also have rates more than a hundred basis points higher. So your layman's equity risk premia would suggest that you're still not being compensated enough for the risk that either the Fed overtightens, that China is a persistently larger drag on the global growth outlook for longer, or that kind of supply constraint.
So have essentially, you know, Russia, Ukraine exacerbating supply constraints there. So, you know, our view though, has been, even at the start of April, say, when you had, you know, stocks doing pretty well, even then you still had dollar at highs of the year, 10-year yields at highs of the year, mortgage rates rising, the kind of tightening that's going to show up more in the forward outlook, is going to come much more from what's happened, you know, in mortgage rates and the kind of knock-on effects to housing, than it will from the S&P 500 going from 4,600 to, you know, 4,200. So in terms of the Fed tightening the of financial conditions that matter in a way that kind of influences the forward growth outlook, a lot of that, you know, we'd argue was in place even before kind of stocks woke up to the idea that, you know, can't sustain these kind of multiplesat these kind of rates with a growth outlook that's, you know, still positive, but slowing.
Neil: (21:05)
You know, on the mortgage rate back up. I mean, I think it's worth pointing out that this is a highly unusual housing market. And I think Luke would obviously agree with that. But what I will say, is that when as economists, business economists, when we talk about housing, we're really talking about three things, right? I mean, it's residential investment. That's what is booked into GDP. And residential investment is really three things. It's sales, which is broker commissions, and then it's construction and housing renovation spending. Those are the three things that go into residential investment and the broker commission piece of it are the sales piece of it. That's only a fifth. Okay. The rest of it is renovations and construction. So what I think it's important for viewers to know is that even though rates are backing up, residential investment, the likelihood is that it's still growing. It's still contributing to GDP.
If you look at the gap between housing starts and building completions, there's still a yawning gap. That means, mechanically, that units under construction will continue going up. Ok. And as units can under construction, keep going up, that means construction spending will keep going up, which means that residential investment will keep going up. And to the extent that rates have backed up and that's creating some special lock in effects, you know, you can make a pretty compelling argument that, you know, people that wanted to move, maybe they spend more money on their existing home. I mean, I certainly think that's consistent with a lot of the anecdotal stuff that I'm seeing here in my neck of the woods. But, you know, look, I mean, I get why Luke is so concerned. He's a potential first-time buyer.
That's not everyone, for most people, your real cost of shelter is collapsing because your mortgage rates are fixed and everything, and your mortgage, your mortgage monthlies are fixed. You know, we know that adjustable rate and mortgages are not nearly as substantial in terms of a share of debt outstanding as they were back in the ‘04, ‘05 period. So your real cost of shelter’s declining for most people. So it's not, you know, as I say, I mean, yeah, the rates back up, yes, that's an unambiguous negative, but I would be a little bit careful about extrapolating how much that's going to do to overall residential investment, which will still be in my mind as descending in real terms.
Luke: (23:29)
Yeah. I'll definitely agree with that. Someone was asking me, because I've been, I've been pretty optimistic about the economy, but started to get a little more pessimistic and they were asking me why. And I said, you know, I'm essentially the modal millennial. I thought I was convinced that this cycle was going to be the one where I got into home ownership and now I'm no longer convinced and, you know, extrapolate that across the economy. Now I'm less optimistic.
I do agree that this could be certainly a case of me over-extrapolating my personal circumstances and definitely agree, Neil’s been kind of quite rightly banging the drum, that there's a lot of pent-up production coming coming to housing in particular, but, you know, the counterfactual of, you know, rates having not done what they've done due to the Fed signaling a quick and expeditious move higher in rates is it would've been definitely a brighter environment, both for home prices and for first time activity going forward on both ends. So, you know, I think the counterfactual seems also clear.
Tracy: (24:47)
Can I ask about one area where I think you guys disagree a little bit and correct me if I'm wrong, but I think Luke, at this point in time is more bearish on what's going on with China and the Chinese economy than Neil is. Could you maybe explain your, I guess your respective thinking around what's going on in China? We've seen, you know, parts of the country basically shut down because of Covid Zero policies, we've seen some supply chain issues and things like that. And there seem to be varying opinions about how much that actually matters for the global economy. How much of those troubles are going to be exported to the rest of the world. So why don't we start with Neil?
Neil: (25:29)
Sure. Tracy, well, I'm not, I don't consider myself an expert on China. I try to stick to my knitting, but what I will tell you is it's hard for me to see conditions in China getting substantially worse than they are right now. And so for me, it's about what the blow back is to the US economy. And so, you know, my sense is that the situation in China can't possibly get any worse than it is right now. And you know, my sense is that it gets somewhat better from here. And that'll be a tailwind, I think, for global demand and will help loosen supply chains in 2023. So that's sort of how I'm thinking about it,
Luke: (26:11)
Luke. Yeah, I think my main difference is that just, there's somewhat of a degree of caution warranted and it's kind of almost similar to the inflation story when inflation surprised us to the upside and forecasts are slow to adjust. Then the burden of proof is higher. On the other side, the burden of proof for thinking inflation has come down should be higher because you've been kind of beaten over the head with mistakes of the past. I think that's very much the case right now from a global macro perspective in terms of looking at China, I think, you know, pretty much everyone could point to five or six forward looking catalysts that would've inspired a lot of optimism on China over the past, you know, five or six months.
And it's been the kind of the story of Lucy pulling the football away from Charlie Browneach time, whether it's the, you know, underperformance so large in 2021 that, you know, forward performance should be good. Hey, you've got the, the Communist Party Congress coming up in November, you're probably going to get kind of firming of growth ahead of that, coming out of the Beijing Olympics, you should really see this kind of, you know, this end of blue sky policy, this pickup of industrial production in a way that kind of supports and underpins the real estate market.
A lot of these things can still happen, but the thing is when China has kind of consistently disappointed on the macro side and a lot of cases through, through no fault of its own, but in a lot of cases through policy responses that global investors do not have a lot of visibility into, then I think you, you know, the threshold then for saying, ‘Hey, China's decisively turned around,’ should be higher.
It is something that you should approach with a little more caution, even if I would tend to agree with Neil that, you know, the six month, 12 month are things better or worse, probably better, but how bad can things get in, you know, two to three weeks in China? I think we've seen in the volatility in that market, things can move quite abruptly to the downside. So, you know, I think it's a case of why not be a little late to the China upside surprise party.
Neil: (28:20)
I would just point out though that I think it is worth pointing out that outside of China, emerging Asia looks quite good. I mean, if you look at, you know, for example, the PMI data outside of China looks pretty healthy. If you look at mobility data outside of China, it's been up and to the right. So factories in the rest of Asia are open, a lot of final assemblies already leaked out of China, which could be one of the reasons why the supply chain effects, uh, of this haven't been as onerous, frankly. I mean, at least on the US economy.
I mean the impact of the Delta variant spreading all over Asia was a lot worse on, uh, uh, for, for us, um, you know, producers delivering goods to, to consumers here, um, than what we've seen lately. So, um, you know, I think if the US economy, I mean, the way I, for me, remember guys, is I'm trying to bring it back to the US because that's my, right, that's, I'm trying to stick to my knitting here.
And my sense is that China will reaccelerate. I mean, whether that happens in one month, two months, six months, it's going to happen. We know that Europe is frankly a lot more connected to China than the US is. I mean, Europe is a very large open economy that does a lot of trade with China. So if China is improving, it stands to reason that Europe will as well. Um, I think that's a 2023 story, but that remember that dramatically, dramatically undercuts this idea that the US is going to go into recession in 12 to 18 months. You wanna call for a recession in the US at a time when China and Europe may be accelerating. That to me is ridiculous. OK? And so, um, we're obviously not going into recession this year. And so I think that's something to keep in the back of your mind. And that may be, you know, I mean, this, this is why, again, it goes back to what we talked about earlier to start the program, right, is that it's a very bizarre period for financial markets. I mean, this, the moment the bond market basically priced the recession probability out is the very moment the stock market started pricing one in.
Joe: (30:27)
Well, so actually, so I wanna actually talk about US assets again, and to start with Luke because obviously a lot of people are looking at their portfolios. Maybe they're looking at their 401ks, maybe they're looking particular at their target date, retirement funds. And they're obviously sitting on a lot of losses so far year to date. And what's when you know, we talk about financial markets being weird. What's new is not just that stocks are down, cuz stocks sometimes fall, it's that the bond portion of people's portfolios is also down, right?
What four, what used to across the last several years, performed as this nice hedge — stocks go down, bonds go up -- has not working it stocks down and bonds down because of the rate increases. What is that? Luke, how does that change the thinking of portfolio management when, uh, the sort of these asset allocation models that worked extremely well, One part goes down while the other part goes up, are no longer working?
Luke: (31:27)
Well, first off, if you're in an environment where more things aren't working, it's gross down, it's not taking large tilts in any one direction. It gets back to risk control and prioritizing relative value environment. That's step one. Step two, though, is expanding the range of possibilities. And one reason obviously why bonds have been doing so poorly is because commodity prices have been doing so well. So our view is that both as a kind of a defensive ballast in portfolios, as well as kind of the, you know, the, the structural growth opportunities, particularly in, uh, in the industrial metal space that, uh, you know, commodities are still a good place to be right now with kind of questions about demand.
It's not necessarily something, you know, aggressively adding to at the, at the moment, but, uh, kind of on a, on a forward looking basis, you know, think of it this way. It's almost, it's almost incompatible to think, you know, inflation's going to normalize all the way to 2% and that we're going to have the necessary investments in developing commodities and in using them to support the, uh, the green revolution that we're able to get, you know, some semblance of, of energy independence. Those two things seem, you know, fairly incompatible. Uh, so in, in that kind of environment, that, that augers for more of a structural, uh, increase in allocation into commodities, which have been a very unloved asset class for, for such a long period of time. So that's something that's helped offset the, uh, you know, the correlation, uh, the correlation go to one environment that we, we found ourselves in.
Joe: (33:23)
Well, Neil, I mean, obviously, you know, we were talking about mortgages earlier but where can rates go? Can they keep going higher? I mean particularly at the long end.
Neil: (33:35)
You know, you know, I think so. I think we're in a strong nominal growth environment and you know, look, I mean, if you think about where rates were the last time, I mean, the Fed ended, uh, 2018, at 2.37, right? Two, I think it was a two and a quarter or two and a half. That's where the funds rate was. And we were in a four and a half percent nominal growth environment at the end of 2018. And the Fed promises to, uh, well, not promises, but they're guiding for something like that this year and will probably be, I mean, you know, let's say inflation's around three to three and a half percent, I think, uh, real growth will be around three. Right. That may be a little bit more. Um, so you're talking about something north of a 6% nominal growth environment. So if you're gonna ask me, do I think, uh, equilibrium funds rate is higher?
Yes, I do. Remember it wasn't that long ago where the Fed thought when they first started doing this, uh, you know, the summary of economic projections, they thought that ,they thought equilibrium funds rate was four and a quarter, four and a quarter with debt service ratios a lot worse than they are now with, um, labor markets a lot more sluggish than they are now with, um, business investment, a lot weaker than it was than it is now. Oh, and by the way, households are sitting on, um, you know, an excess savings pile, uh, you know, over $2 trillion and us hitting the most favorable demographic patch that we've seen in our careers. So yes, if you're gonna ask me, do I think equilibrium rates are higher, the terminal funds rate is higher? Yes, I do. And that makes me crazy. Um, you know, so, so be it, but, uh, you know, I mean, I think in the near term, there's probably some opportunity for fixed income, right?
I mean, you know, it's, it's one of these funny things that you've seen, right. It's like, it's not risk parity but risk parody. But I do think, I mean, look, there's, I don't think there's much more, the markets can price in for the Fed right now. And I think that probably, you know, helps, um, you know, the soft landing, the soft-ish landing case that, that, uh, the Fed wants to tell. Um, but I think whatever pause we see, um, you know, after they get to neutral is, um, you know, the next move after that is gonna be additional hikes.
Luke: (35:59)
So to like, to piggyback somewhat on what Neil's saying and right now, right now, our stance is that better to be neutral the, the long end, just by virtue of, you know, how much has been priced in already. But one thing that's clearly different this cycle versus the last one is that the, the global nature of central bank tightening and what that's doing to, to global term premium. So, you know, starting in 2012, you have the, you know, BOJ really cranking up, uh, QE. You have the ECB, uh, BOE joining, not too long, really cranking it up. Uh, after that, you know, this cycle, that's essentially all going in reverse. And even in the face of a, uh, you know, a pretty big shock to, you know, potentially real incomes and, and growth, the ECB is, is telegraphing a, a move out of negative interest rate policy.
This is, this is something that is, you know, clearly a, uh, clearly going to push global term premium a higher and, and has the lot. So if you, if you go back to Lael Brainard speech about quantitative tightening in early April, that a lot of people were, were focusing on is, you know, this is something that's going to drive global bond markets, well, bunds have underperformed since that period of time. We're in an environment where the, the fact that the ECB is, is kind of signaling what it's signaling. And it seems that every day there's a kind of pulling forward of, of some kind of ECB related, uh, tightening messaging. That's, what's driving still the bus in global bonds. So if you, if you look at lately and one thing that, uh, honestly, I, I found a little bit confusing in the aftermath of the Fed, is that us bond volatility, uh, implied volatility hasn't really calmed down too much. And it might be that US bond volatility can't calm down because of what's happening across the pond.
Tracy: (37:40)
I've what is perhaps a dumb question, but can everyone tighten at once? I mean, I know everyone can technically tighten at once, but does it have the same impact? Because back when we were easing many, many years ago, we used to talk about competitive QE and sort of competitive devaluations and things like that. So does it have the same impact if everyone is doing this at the same time?
Luke: (38:03)
I would argue that, uh, because like last time you had a, a much more focused impact on the US because essentially, you know, the, the US was the only one tightening, dollar up, and then you have dollar up also kind of exports tighter credit conditions to the rest of the world. So we have everyone going this time, but the dollar still, uh, with a lot of strength and largely due to still like very good growth differentials and the kind of possibility of more left tail, uh, economic risks in, in Europe and China, that still, you know, exist to, to varying degrees.
But you know, I would think conceptually in theory, an environment where everyone's tightening is, is on net kind of is less tight, uh, than, uh, than the, than the counterfactual. It's actually easier to go if it's synchronized, uh, rather than if it's kind of, uh, one country in particularly us centric.
Neil: (38:57)
One thing I would just add, I would tend to agree, I guess the one thing I would add to that is, you know, when you look at the dollar performance, you know, right now versus let's say back in 2014, when like Stan Fisher was making speeches about what the dollar impact is on GDP growth and inflation, um, you know, what's interesting now is just, I guess, is the differentiation that I'm seeing in, in some of the, in some of the dollar's performance.
I mean, obviously, uh, the dollar back then was like rallying against pretty much everything and here it feels like, uh, it's more like DM related. I mean, so, so it's obviously the dollar is very strong against the euro. It's very strong against the yen, but if you look at some of the emerging market commodity, uh, currencies, I mean to Luke's point about how all commodities are done, those currencies are actually hanging in there, you know? Um, and that's been something that's been a bit different, um, than what we've seen, uh, you know, saw before. So I, I just think that that's interesting, but generally speaking, yes, I think it's much easier on the Fed if everyone's also hiking.
Joe: (39:59)
I know have just a few more minutes here. You know, again, people looking at their portfolios, obviously we've talked about it a ton, tech and growth, getting clobbered, et cetera, Luke, you’re talking about OK, in this environment, maybe the answer is commodities exposure. It's sort of like the one thing that's breaking the “all correlations go to one.”
But you know, when I look at some of these, uh, tech names and SPAC names and all this stuff, I just see like a complete, like, in some cases it's a much bigger massacre than probably people are ever imagining. And people stocks down 95% in many cases for brands that people know. What would be the conditions in which you one would start looking back to this area that's gotten hit so hard, what would be the sort of either macro conditions or flows, uh, uh, that you'd look for to say like, OK, maybe this has been enough and start, start looking for opportunities.
Luke: (40:55)
So the, and the difficulty in so doing just as a starting point, is the fact that, you know, if you go from a, you know, a hundred PE to a 50 PE, well... so that, uh, that's, that's a bit of a challenge here. What would, what would kind of warrant it is a, is a larger pricing of, uh, of recession risk. So right now, in terms of like, if you look at what's the, you know, what's the, the hump in the eurodollar curve or, or anything it's, it's not, it's not material, it doesn't suggest, you know, traders ascribing a lot of odds to a material, uh, cutting cycle from the Fed after this kind of quick series of hikes. If that were to grow larger at the same time as you get, um, as the same time as you get, uh, kind of more visible slowing in, uh, in the US and the global economy as well, you know, that would be, that would certainly be something, uh, goods demand clearly coming off the boil and it to be, to be fair, goods demand, uh, you know, in, in terms of PCE basis, like hasn't really, you know, done too much for, uh, for about, for about a year now, you know, that's something that, you know, should the, should that side of the, you know, economy slow more, that's something that's going to, I, I would suggest, probably prompt investor attention to turn back more, to, to growth names. But it's, I, I think the fact that it hasn't happened yet is one of the, one of the signals along with the eurodollar curve that, you know, there's not a lot of recession risk being priced right now.
And that's you, that's something that's odd to think about as, uh, as stocks being as volatile as they are. But, uh, I think that's something to, to hang your hat right on, uh, on right now, in terms of, uh, looking at the forward outlook.
Neil: (42:42)
I mean, look, the, the equity markets, the setup really does look very much like a late-cycle type of, dynamic. Now, obviously there can be multiple sort of market cycles within a broader economic one. But if you look, I mean, for example, defensives, defenses are outperforming cyclicals. We've seen utility stocks better bid. Staples, better bid. We've seen, you know, significant selloffs in discretionary. I would just say that there's only so long that the markets can price in a late-cycle dynamic and then not actually have it happen in the economy. So if you're thinking about something like strategic asset allocation, my view would basically be to use rallies in defensive positions as opportunities to add to cyclical ones, because I do think that's probably the next leg of the market cycle.
So that that's sort of how I'm thinking about it when I, when I look at the, the broader economy, um, as I say, I mean, bringing it back to, to, to the US economy, there's really, uh, you know, my concern dial is not particularly, um, high. I mean, it, it's, it's sort of interesting to see like sell-side analysts tripping over themselves to see who can pencil in the highest recession probabilities over the next two years. But, you know, in my mind, it's really no higher than it normally is. I mean, what would actually decline if you were to have a recession? Like housing is we're talking about how we don't have enough cars and we don't have enough homes. Um, so what goes down? Commercial real estate? That's already as low as it could possibly be relative to GDP.
So I mean, it could be, I guess you could make the argument of durable goods, but even there, you know, things like motor vehicle sales have basically, you know, as a share of, of consumption they've already kind of reverted to trends. So, you know, I, I just don't really see it. I mean, what are we gonna talk about? “The great, uh, the great household furnishing recession of 2022.” It's just, um, it just doesn't, it doesn't make a lot of sense to me. And that's why I say if, if you're, if you're in, if you're asset allocation here, um, I think we're at a point now where it's probably it's it, to me, it makes sense to pick up some of these these cyclical names, uh, that have been quite beaten down. And as I say, I mean, this is something that Luke pointed to earlier, but if you think about the markets, it's been three things, right.
It's been the Fed, it's been Russia/Ukraine. So the situation in Eastern Europe. It's been China. OK. So like take each of those in turn. The Fed, the Fed in my mind is going to be less a source of instability for the financial markets over the remainder of the year. I mean, Powell has basically given us forward guidance for the first time in a while, right? I mean, basically 50 basis point moves, followed by there's a little bit more certainty in the Fed outlook than there has been. And you know, we talked about China. Um, I think I even got Luke to acknowledge that China will look better in the next 12 months, but if China's looking better in the next 12 months, then Europe will too, right? So those three areas that have been beaten down the markets and creating this sort of instability and volatility that we've seen, uh, I think that's likely to abate. So that's why I say, if I had to make a market call, that would be it.
Joe: (45:56)
Well, you guys are great. This could go on a lot further, but we gotta leave it there. Neil and Luke appreciate you coming on Odd Lots to help us understand what's been a busy week, but really an extraordinary year so far overall. So thank you for coming on and, uh, helping us make sense of the world.
Luke: (46:15)
Oh, we're, we're gonna stay on and keep bickering.
Joe: (46:18)
Just please record it, then send us the audio.
Tracy: (46:21)
Thanks so much, guys. That was really fun.
Neil: (46:24)
Thank you.
Joe: (46:38)
You know what that conversation made me think? This is gonna be a meta point that we could get to the substance. The best sort of discussions are between guests who agree on a lot and share a lot of the same premises, but disagree on a few key things, right? Like you have to sort of like share a common assumption about how the world works. Those are the best conversations.
Tracy: (46:59)
Right, because otherwise it's often two people talking past each other.
Joe: (47:02)
And that was not, they were not talking past each other.
Tracy: (47:05)
Well, I’ve got to say, I can't believe we hadn't had Neil on before, but he's great obviously. And Luke, every time we have Luke on I'm so proud because Luke used to be our colleague and I just love actually, you know, he used to write for our team, and I love the fact that he's now a guest on Odd Lots, talking so knowledgeably about macro.
Joe: (47:26)
Yeah. A little tear coming to my eye, thinking about Luke's trajectory. But yeah, no, I thought that was really helpful. I mean, so many interesting points. I mean, you know, Luke brought this up, that I hadn't really thought of, but you know, it's interesting for all of the double dip or not double dip, but like soft landing, hard landing fears, like actually so far like the classical recession signals and they talked about the eurodollar curve, like the market is not really pricing one in yet.
Tracy: (47:56)
Right. It seems like stocks have overreacted compared to fixed income. But the other thing I keep thinking is just how I don't wanna say, obvious, but yes, obvious is the word. How obvious it was that there would be a correction in stocks at one point, because I mean, the Fed, we spoke about this, the Fed hasn't explicitly said it wants stocks to go down, but it talked about tightening financial conditions. And then, you know, for years we were talking about valuations were frothy that this was something that was gonna start reverting once interest rates start hiking, and then lo and behold they did.
Joe: (48:32)
Right. Like I think the surprising thing, it's never easy in real time to make trades. So you it's never like, ‘oh, now here comes an easy trade.’ But I would say the sort of surprising thing is if you look at this sort of narrative of what happened this year, it's kind of straightforward. Inflation picked up and the Fed said, ok, now we're going to go in a hiking cycle. Oh and P.S., the way that we control inflation is through financial conditions and stocks are a key part of financial conditions. It was the obvious trade. Just teleport me back to November or January when the Fed started pivoting and I could have been a genius.
Tracy: (49:12)
Yeah. I guess it's like the timing aspect is the most mysterious of all of this and why, you know, we saw a rally on Wednesday after the hike actually happened and it wasn't until Thursday that stocks started dropping off. That's the only thing that remains something of a head scratcher.
Joe: (49:30)
Yeah. The week was super weird.
You can follow Neil Dutta at @RenMacLLC and Luke Kawa at @ljkawa.