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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, July 28th, 2023. I'm Brian Pietrangelo, and welcome to the podcast.
As a fun fact, today is National Milk Chocolate Day. So if you need a pick-me-up this afternoon, find your favorite and have a taste. Mine is the Swiss chocolate Toblerone. With me today I'd like to introduce our panel of investing experts here to provide their insights on this week's market activity and more, including a few data points that have been pretty sweet. George Mateyo, Chief Investment Officer, Steve Hoedt, Head of Equities, Rajeev Sharma, Head of Fixed Income, and Cindy Honcharenko, Senior Fixed Income Portfolio Manager. 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 news, we have three data points to share with you, beginning with initial unemployment claims that came out yesterday at 221,000 for the prior week, which showed a decrease of 7,000 from the week before that, again indicating some resiliency in the overall jobs market as one of the data points that we follow. Second, overall GDP, or real gross domestic product. With the advance estimate for the second quarter of 2023 came in at a rate of 2.4% annually for the second quarter of 2023, which was above expectations and also above the first quarter, which came in at 2%. These numbers indicate an increasing economy, in spite of the Fed's policy to continue raising interest rates to purposely slow down the economy. So we'll continue to look forward at some of this uncertainty, but an upside surprise so far this year.
And finally, just this morning, the inflation read came in for the personal consumptions expenditures inflation index, which by the way is the Fed's preferred measure of measuring inflation, which came in at an annual rate for the month ending June at 4.1% year-over-year inflation, which was a decrease from the prior month in May at 4.6 and was the first meaningful decline in roughly six months from a measurement of five-tenths of a percent decrease to 4.1% year-over-year. So this is good news as inflation continues to moderate and gets closer to the Fed's preferred target of roughly 2%. Again, looking at how the Fed's increases in interest rates have had an effect on overall inflation, plus some year over year numbers that we call the base effect, which begin to show declines from the last year.
Also speaking of the Fed, the FOMC, or Federal Open Market Committee, did have their July meeting this week, ending with the press conference on Wednesday where the Fed raised rates by another 25 basis points. Here with us today, we've got Cindy Honcharenko to give us an update on what the Fed did, what they said, and what the implications are for the future and the next six months or the remainder of the year. So Cindy, what are your thoughts?
Cindy Honcharenko:
The FOMC delivered a broadly expected 25 basis point rate hike this past week, setting the Federal Fund's target range at five and a quarter to five point a half percent. This is the highest level in 22 years. This is also the 11th time in 16 months that the Fed has raised rates during this tightening cycle. The policy statement was virtually unchanged from June's, aside from the dubious upgrade of the assessment of the economy from modest to moderate and the announcement of the rate hike after last month's skip pause. Fed Chair Jerome Powell was very clear during the press conference that the September rate decision is undetermined at present and will depend on the upcoming data on inflation and especially labor. The committee refrained from taking too much signal from the June CPI surprise, as Powell noted that one data point does not make a trend.
Powell also showed his cards on the policy lag debate, suggesting that additional tightening of lending conditions was coming in lagged response to Fed actions, which I thought was very dovish of him and came as little surprise, as I believe he was very instrumental in orchestrating the June skip pause. The committee does not see a recession coming, nor do they plan any rate cuts for the remainder of the year. At the June meeting, the median expected 100 basis point of rate cuts in 2024, with the range skewing toward fewer reductions. That could easily be accomplished with cuts of 25 basis points apiece starting at the July 2024 meeting, though Powell will surely be among the first to note, the uncertainty around that is incredibly high.
The committee looks to maintain maximum optionality by not committing to the timing of additional rate hikes and emphasizing data dependence, and that seemed apparent throughout Powell's press conference. So for investors, while rates reaction suggested a highly dovish read on Powell's press conference, investors would probably be wise to remain somewhat patient before engaging in an end of cycle, end of recession type trade. The labor market data needs to send a clear signal to give the market confidence that tightening is in fact done.
Rajeev Sharma:
Well, I agree with you Cindy. I think that this was an interesting meeting. I personally feel that the Fed is done at this point. This 25 base point rate hike was highly anticipated and it was important to note Fed Chair Powell's press conference, as you mentioned, where much of his comments were very measured. What we saw back in the June FOMC meeting, it was not as measured as this one. And I think what we're trying to say here is that he didn't commit to another rate hike at this time around. He obviously did not take it off the table, but he steered away from really talking about it. I felt that he identified the lag effects of monetary policy. And obviously just like every investor, the Fed also wants to be remaining very data dependent.
The issue that we have here, I think, and this is what the market is grappling with, is whether the Fed moves again one more time or not, does it really matter if they put another 25 base points in September or not? We've been known to always see the Fed overshoot. It's happened in the past. It could happen again. But considering the 525 basis points of rate hikes that we've seen since March of 2022, I think the market could handle another 25 basis points if it came down to that. We've seen that in the reaction in the front end of the yield curve. It was very muted after the FOMC statement and the press conference. If we look at Fed swaps, they're pricing in about a 33% chance of a Fed rate hike in September. So we're still not at the 50% point there to make it real, but we do have data between now and September. We also have the Jackson Hole Symposium in August, which I think Fed Chair Powell will have some more data to give us some signals at that point. It'd be very important to look at that.
If you look at the week for fixed income, the two-year fell two basis points to 4.9%, the 10-year yield rose 10 basis points and it's approaching that 4% resistance point, where we've seen buyers step in at that point. So all in all, the yield curve is further inverted. The twos tens now stand at a 91 basis point inversion. So it's really interesting to see how these markets are digesting the information that's coming out every day. Every point of economic data that we see, it has an effect on the markets. But one thing's for sure, credit spreads have remained extremely resilient through all of this. We saw investment grade spreads and high yield spreads both tightened by four basis points during the week. And without any significant credit spread widening, it's still bodes well for risk assets and they continue to have a runway to outperform.
One additional newsworthy item that I think is going to be important to keep an eye on is this morning, Bank of Japan came out and said that they were going to start to think about ending their yield curve control program. Now, that policy has been in place for a while, where they artificially kept yields very low in Japan and it anchored interest rates across the world. And just this morning, the Bank of Japan governor came out and announced that the central bank would allow yields to rise above this self-imposed ceiling on rates for Japan. This did cause Japanese government debt yields to rise and we will have to see the global implications on yield, but the immediate reaction was the Japanese yen strengthened against the dollar. But my big question, I think the question that many investors are asking themselves today is, will Japanese cash flow start to go outside of the global markets and back to Japan? What signal would that send to the market? And does this support the idea that the Fed and other major central banks are at the end of their tightening cycle? More to watch on this.
George Mateyo:
Well, Rajeev, I'm really glad you mentioned that story of Japan. I think it's still an emerging story, and this definitely deserves a lot of monitoring for sure. I guess going back to the Fed for a second, it's curious to see this morning we also got another couple of key indicators on inflation, including the one that the Fed typically signals as their favorite inflation indicator to watch, which is something called PCE, or personal consumption expenditures. Just a fancy way of talking about inflation, I guess at the consumer level. If you look at just the overall top line number, I guess if you look at everything baked in, it actually fell below 3% for the first time in a long time at 2.97. So I guess people are rounding up to three, but if you take out a couple basis points there, investment points, you can see that we're slightly below 3%.
At the core level, however, inflation's still in that 4% range. Do you think that's sufficiently cool enough for the Fed to really pause for an extended period of time?
Rajeev Sharma:
I think it's cool enough for maybe the Fed to pause for an extended period of time. Definitely not cool enough for them to pivot and cut, and that's why rate cuts are off the table. But I do think this supports the notion that Fed Chair Powell was talking about, that the FOMC was talking about, that there is a lag effect to all the monetary policy that's come underway. And again, this is part of their data, but they really want to see that 2% goalpost that they're trying to reach, and I don't think they're going to change that. It does support the notion that you could have elevated Fed Funds rate for a while.
George Mateyo:
So also, I guess in the context of these rate hikes that we've been living through for the past 15 or so months, we had some data that we showed in our Monday morning investment review that talked about just what happens when the Fed is actually raising rates as much as they've done. It was an interest analysis that looked at the time, but if you see rates go up 500 basis points, as they've done this time around, 93% of the chance, 93% of the time, excuse me, we're actually in recession one year afterwards. So that's curious. And then if you factor in other variables, such as the fact that inflation is starting as high as it did, your probability of a recession one year hence after the rate cycle begins, the probability jumps up to 88%. Then again, looking back over history over the last 60 years or so, there is I guess a slightly less probability of a recession when growth is resilient.
So you mentioned the R word, Rajeev, which is resilience, and that seems to be the case too, but even notwithstanding a pretty resilient labor market and a resilient economy, given the level of tightening that's already taken place, usually two years in, and we're not quite there yet, but maybe halfway through that, usually two years in, we're in a recession 88% of the time. So again, that's just looking back at history. Maybe this time is truly different, but it does suggest that maybe things will start slowing down eventually at some point, and the Fed seems to be banking that as well.
In the near term, however, Steve, it seems like earnings are also quite resilient. We're getting more evidence of that all the time. And most estimates I've seen suggest that earnings are going to be moving upward throughout the rest of this year into next year. But what's your early take so far on earning season so far?
Stephen Hoedt:
Well, George, I just was flipping through some charts this morning and what struck me was the similarity for this reporting season compared to the March reporting season, because if you remember, back in February, earnings started to inflect higher and people really were like, "What's happening here?" Because they didn't want to believe that there was something that was going counter to the recession narrative that was so prevalent at the time, just shortly after the turn of the year. And what we saw was we saw earnings move sideways after balancing into the beginning of earning season, and move sideways for a month and a half before breaking out definitively to the upside, and seeing earnings numbers move from $224 up to $229 heading into this earning season.
Now we've basically marked time, doing the exact same thing. For a month and a half, we've gone sideways with the earnings number. Then I just was looking this morning and we've finally seen the forward 12-month number breakthrough 230 on some positive revisions here in the last couple days. So it looks to me like we're starting to see the earnings number confirm what we've seen in the underlying economy, and that is surprising growth. I mean, growth for the quarter came in at 2.4%. That was higher than expectations. This is third quarter in a row now we've seen growth numbers exceed expectations. Really this year, for all the talk about the Fed and inflation, this year's been all about growth surprising to the upside and seeing those earnings numbers inflect, and it's really hard to be bearish on stocks when earnings numbers are going higher.
George Mateyo:
On that bearish note, Steve, it's curious that I think if you take a look at our own assessment things when we came into this year, I think we've been probably somewhat neutral overall, and we could have been probably more constructive, but we certainly weren't bearish, to your point. It's curious to me though, that there are some pretty big bearers out there that seem to be capitulating of late. They're saying that yeah, they were definitely wrong for sure. What do you make of that in respect to the overall market narrative where you see a lot of people, as I said historically, were quite bearish and really thought that the world was going to come to an end maybe? Throwing this out?
Stephen Hoedt:
Well, it's interesting, George, because I know a couple of the ones who you're specifically talking about, and they've been out there in the press here in the last week or two, and while they have backed away from being uber bearish, they're still actually bearish. So they haven't quite capitulated yet. I think a lot of folks believe that when those guys actually throw in the towel and turn bullish, that'll be the time to turn bearish. The ultimate contrarian move is when the last bear throws in the towel, then you turn and go short.
George Mateyo:
You could be right about that, I think. Yeah.
Stephen Hoedt:
But I would tell you the thing that really has gotten my attention here too, just to finish up on earnings, is we've had a really mixed earning season in terms of the mega cap tech names. Some of them have had good earnings, some of them have had middling reports, so we've seen those stocks all over the place. But really what we've seen is we've seen pretty middling responses or muddle through at the corporate level from all across the board. I mean, industrials companies and defense companies in particular the last few days have had some pretty poor earnings reactions. If you look at the reaction, and I know my colleague Connor Cloding is going to be talking about this in a key question, the reactions have been really muted, both to the upside when companies beat and to the downside when companies miss. So it seems like macro really is dominating the overall market outlook right now.
Brian Pietrangelo:
Well, thanks for the conversation today, George, Steve, Rajeev and Cindy. We appreciate your insights and perspectives as always. 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. 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.
Disclaimer:
The Key Wealth Matters podcast is produced by the Key Wealth Institute. The Key Wealth Institute is comprised of financial professionals representing key entities including Key Private Bank, Key Bank Institutional Advisors, Key Private Client, and Key Investment Services. Any opinions, projections or recommendations contained herein are subject to change without notice and are not intended as individual investment advice. This material is presented for informational purposes only and should not be construed as individual tax or financial advice. Bank and trust products are provided by Key Bank National Association, a member of FDIC, an Equal Housing lender.
Key Private Bank and Key Bank Institutional advisors are part of Key Bank. Investment products, brokerage and investment advisory services are offered through Key Investment Services, LLC, or KIS, a member of FINRA, SIPC, and SEC Registered Investment Advisor. Insurance products are offered through Key Corp Insurance Agency USA, Incorporated, or KIA. KIS and KIA are affiliated with Key Bank. Investments in insurance products are not FDIC insured, not bank guaranteed, may lose value, not a deposit, not insured by any federal or state government agency. Key Bank and its affiliates do not provide tax or legal advice. Individuals should consult their personal tax advisor before making any tax related investment decision. This content is copyrighted by Key Corp 2023.