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As we approach the first half of 2022, volatility is back with a vengeance. This follows an unusually tranquil 2021 where markets seemed to only glide upwards.
We recently assembled a great group of colleagues to discuss the recent volatility, market conditions and how we are positioning client portfolios. Sidney Ahl, Erika Pagel, Ryan Myerberg and Joe Pasqualichio recorded a webcast that analyze topics that are top of mind for investors in the current environment.
The themes and topics discussed include:
Inflation and the macroeconomic backdrop, including what the latest data tell us about whether recession or staglfation may lie ahead.
What the various phases of downside moves in equities might look like.
Trends and potential opportunities in the technology sector, which has faced meaningful headwinds in a rising-rate environment.
Decoding the consumer sector, which has seen declining consumer sentiment even as job availability and savings remain very strong.
Opportunities that recent dislocations may present to long-term investors and how we are positioned for them.
As always, we welcome your thoughts, feedback and questions. We look forward to discussing these topics with you in the coming weeks.
Welcome to our Investment Podcast where our CIOs explore issues of the day with leading investors from inside and outside Brown Advisory.
Welcome, and thanks for joining us. We're closing out the first half of 20 22, and volatility is back with a vengeance after a tranquil 2021. We've seen 20% plus declines in stock markets from their peaks, and that shifted the labeling of the market we're in from a correction to a bear market. The traditional 6040 portfolio of stocks and bonds is off to its worst start since 1937 as bonds have failed their traditional protective role this year. More speculative areas of the market, like recent SPAC, IPOs, and cryptocurrencies have fallen between 50 80% year to date, including big moves in the last few weeks.
Speaker 1:The latest data point that gave investors concern was a hotter than expected 8.6% CPI reading on Friday, which showed more persistent and broad inflation. And while the US consumer has been a key pocket of strength so far, there are signs consumer sentiment is waning as inflation is eating into their pocketbooks and the Fed is raising rates into a weakening economy. We'll ask the question today, is it time to rethink portfolios, or has sentiment and positioning perhaps become too negative? Investor risk appetite by some measures is at lows not seen since the financial crisis. And so while the chances of a recession may be rising, we'll try to put what that means into context.
Speaker 1:I'm Sid Ahl, the CIO for private clients, endowments, and foundations here at Brown Advisory, and I'm joined today by a terrific group of colleagues to discuss the market conditions and how we're positioning client portfolios. They include Erica Pavjal, the CIO of sustainable investing here, Ryan Myerberg, the co head of global taxable fixed income, and Joe Pasqualicio, an equity research analyst covering the tech sector. Team, thank you very much for joining today, to discuss what's been an eventful first half of the year. And while we're gonna discuss pockets of opportunity, we also wanna be clear eyed about the risk. And as we've spoken about before, it's important to be able to play both defense and offense in this kind of environment where there is such a wide range of potential outcomes.
Speaker 1:So let's get right to it with Ryan. Ryan, maybe you could share with us your analysis of the recent CPI reading we got on Friday. What are the implications for the macro outlook? Why did markets react so violently to it? And and do you think that reaction was warranted?
Speaker 2:I think the first thing we should say is that inflation is here to stay. This idea of the transitory narrative has officially been put to bed. But clearly, there have been a lot of people in the market who have thought that we may have seen the peak put in, you know, last month with inflation running north of 8%, and it obviously surprised to the upside. It's actually the composition of that inflation that's probably a more concern in the sense that, you know, core inflation continues to be very, very sticky. And and we had thought that perhaps, you know, some of the shift away from, you know, services to goods, you know, that transition would help to maybe decrease core inflation a bit.
Speaker 2:But in fact, it's really broad based. We're not really seeing relaxation anywhere with regards to inflationary pressure. And so I think the market's reaction was was after the print was exactly what it should have been, which is that the fed is still behind the curve in a way. You know, they've been clearly more hawkish, but there's a lot more to do to get in front of this this really high levels of inflation. You know, it's causing a lot of angst for the consumer.
Speaker 2:We're seeing a lot of slowdown fears across the globe. China has been slowing down. Europe has definitely been slowing down as we've talked about in March, post the invasion of Ukraine by Russia. But even the US is slowing down. And so what that's causing now are an increased fears around the risk of stagflation.
Speaker 2:So, know, when we came into the year as a team, we were talking about our different scenarios and we had stagflation as our as our bear case. We had about 25% probability described to it, which at the time felt very out of consensus. But now as we've migrated to, you know, June and and looking forward, stagflation is actually very much our central scenario. Thinking it's probably around 55 or 60%. Maybe it's important to kind of define what stagflation is.
Speaker 2:You don't have to be in recession to be in a stagflation environment. It's just a slow diminution of growth while inflation stays high, and that's very much sort of where we are. We have inflation running around the globe at multidecade highs with growth moving lower and forecast for growth continue to move lower for the next few quarters. So it's a really challenging market to to be in. And, again, it's not just the u the US phenomenon.
Speaker 2:This is the same story on the continent Europe, same story in UK, Australia. And so all the major central banks, I guess, with the exception of the bank Japan, are in full recognition that, you know, they need to act and they need to act fast. And so, you know, the Fed meeting coming up, you know, they're gonna have to hike aggressively 50 basis points, you know, even thinking that they might need to do more. The RBA has surprised the upside. Reserve Bank of Australia has gone 50 basis points.
Speaker 2:Their last meeting, even the ECB, you know, has said that they're gonna have to be hiking at least 25 base 1 increments, if not more. And so we're gonna have to, you know, see a really concerted effort from central banks to get in front of inflation. And it's kinda funny in a way that, you know, it wasn't that long ago where the Fed said it was transitory. Then it's, oh, we're going 25 basis point increments, and then it's 50 basis points. And now we're even talking about, you know, steps more material than that.
Speaker 2:So inflation is here to stay, and central banks are just are increasingly, you know, forced to act with a lot more vigor to get in front of it.
Speaker 1:So how do you think about, the potential effectiveness of, central bank activity to curb inflation when so much of this has been, supply driven. Obviously, we've had the war in Ukraine. We've had the supply chain issues from the pandemic. You know, the the Fed can't print oil or wheat or or what have you. I mean, is is that a big part of the problem here?
Speaker 1:And just how do you think inflation might play out with aggressive central banks, across the world?
Speaker 2:Central banks can only really manage the the demand side of the equation. So hiking rates, a, it takes a while for it to pass through to the real economy. But that's really all they can do is to try to dampen down demand. And I think the hope for central banks as we came into the year was that much of this supply side issues with commodity prices, etcetera, would just decrease, would go away. Now, obviously, the war in Ukraine has put a lot more upward pressure on those challenges, but they really can only control what they can control.
Speaker 2:And so the the challenge is that, you know, core inflation, tight labor markets, you know, sort of that wage price spiral is is definitely a risk for central banks, which means that they're gonna have to hike rates and it's gonna take time for that to pass through to the real economy. In a way, this is why recession risks and fears around recessions are are increasing because there really isn't hasn't been a past precedent for central banks to be able to engineer soft landing. You know, what can they do? Will they hike rates until they cause the labor market to weaken? You know?
Speaker 2:And we haven't seen that yet. We still have a lot of job openings in the US and UK and other places. And so, you know, the central banks are gonna have to hike rates, and they will hike rates. They're hoping that they can do it in such a way that they don't cause the economies to go into recession. But, again, that's a very, very delicate tight rope to be balancing on.
Speaker 2:And I think that's very much why the market is starting to focus much more on the growth side of the the equation now and why recession risks and and expectations recessions continue to increase.
Speaker 1:So 1 of the markets that's been impacted the most by rising rates is the housing market and mortgage market. I mean, we've seen the the fastest decline of home price affordability in the US in decades. Could you just talk a minute about what are the implications for the slowdown in the housing market and also just, you know, the mortgage securities market and and what, overall impacts that could have.
Speaker 2:I I think 1 of the most sort of stunning moves we've seen this year kind of setting aside just asset prices, equities, credit spreads, etcetera. It has been the move in 30 year mortgage rates in the US. We've gone from 2.8 to 5.9%. And if you think about that in to the impact to the homeowner, I mean, that's $700 a month more in mortgage payments that 1 would have to make for a median home in the US. And as you mentioned, housing starts at historical lows, which, you know, we look at as a leading indicator, of course, for the health of the housing market.
Speaker 2:And the other thing too is that, you know, home prices will likely stop rising. And if they fall, it creates this negative wealth effect, and that certainly impacts how consumers feel about, you know, their current economic situation, which is already sort of you look at Michigan sentiment and others with, you know, consumer sentiment indicators is at historical lows. We're also thinking about it in terms of the housing market with regards to to renters. You know, that's 1 of the the places when you look at the composition of inflation where, you know, it just continues to go up and up in a number of of sort of third party, providers for that information like Zillow, etcetera. Say rental prices are going up 60% year over year, which are sort of stunning numbers.
Speaker 2:And so that clearly is gonna have, you know, impacts in terms of, you know, the consumer and the and the health of the consumer. But we also in the in the mortgage market, you know, we've had, you know, low rates 2021. We had these pandemic lifestyle changes, You know, really boosted demand for housing and increased pricing at unprecedented rates. And existing homeowners refinance at really high rates as well to release home equity and to reduce their payments. And so you have this high burnout.
Speaker 2:And in in with current rates, there's really no remaining incentive to refinance, which slows down mortgage security issuance. And it also creates a dynamic in the market where most of the float is in, you know, low coupon and significantly discounted securities, which it has implications for the volatility of mortgages. And as we all know, the Fed's, you know, stepping away from QE and starting QT. And so that tapering effect, is really kind of the elephant in the room, you know, if and when they taper purchases and start to sell, which, you know, the feds really cause the mortgage market to trade so strongly on technicals for so long, because they have been this noneconomic buyer that that has single handedly influenced, you know, the supply and and and how things are traded. So, you we do have concerns sort of about the dynamic and the technical for for mortgages.
Speaker 2:The the benefit in a way in terms of asset allocation is that they are very high quality. You know, think about high quality mortgages versus comparable credit, and we we expect the volatility to remain lower than credit spreads. It certainly have some concerns that we will see increased volatility and potentially riding on on agency mortgages going forward.
Speaker 1:So maybe but before I go to Erica and talk a little bit about the equity markets, maybe you could share your thoughts on the action in bond markets this year given your focus. Clearly, they have not provided the protection that most investors have historically wanted. You know, the 6040 portfolio, I think, is off to the worst start since the 19 thirties because bonds have have lost actually nearly as much as stocks this year. You know? Do you think bond markets have have appropriately priced in inflation risks at this point?
Speaker 1:And, you know, how do you think about fixed income here?
Speaker 2:It has undoubtedly been a really challenging market for fixed income given that we haven't seen these levels of inflation for 4 years. You know, more rates have gone so low as a byproduct of QE. And we can talk about other factors like demographics, etcetera, that have caused sort of rates to to move lower over the years. And the market's having to sort of make its peace with this new regime that we're in. And it's not just that rates are moving higher.
Speaker 2:It's the volatility regime that we're entering as well. I mean, we haven't seen this type of daily volatility in fixed income in years. You know, really pre GFC where, you know, you would expect this kind of see kind of 5, 10 basis point moves in a day. And then we we ran a volatility regime post the GFC with all that QE and all the central bank action where rates move kinda 1 to 2 basis points. And so if you hadn't been in the market pre GFC, you know, this is a rude awakening for how markets actually trade when central banks aren't acting as this volatility damper.
Speaker 2:You know, is fixed income fairly priced now? A lot of it depends on where you think terminal rates are for central banks. And in a way, we've continued to just increase that terminal rate for, say, the Fed and other central banks over the last few months, and now the market's pressing north of 4% for the Fed's terminal rate, whereas, you know, kind of low threes just really a month and change ago. And so, you know, US 10 years at 3:32, today, still suggest that the market feels that the Fed can get inflation under control over the long term, and and that's important. But if we keep staying at these stubbornly high levels of inflation, you know, the Fed's gonna have to tighten policy really aggressively.
Speaker 2:And, really, you think back to past cycles, the Fed always had to get above inflation, you know, in order to kind of bring it down. And so, you know, the market's not really pricing that yet, but it's also expecting inflation to come down, you know, something, you know, to a much more manageable level, say, like, 4%. Now that's still 2% above the Fed's target. So I guess what I would say is, you know, we do expect volatility to stay very high in interest rates. And the challenge for investors is that, as you mentioned, it isn't providing that, that counterbalance to equity risk or other risks in portfolios.
Speaker 2:And so as we think about our portfolio construction and managing fixed income portfolios, our historical playbook, when you think you're going into an economic slowdown, is to buy treasuries. You buy yields. You buy bonds. That playbook isn't working now. So we're finding other ways to hedge portfolios like being long the dollar, for example, or using currencies, which tend to be there aren't currencies that are negatively correlated to discuss it that we can use as a way to to protect portfolio because right now, fixed income just isn't providing, the the defense that the clients need.
Speaker 1:That's great. Thanks. Maybe, Erica, I can move to you and talk a little bit about the stock market. So we've we've seen now a 20% decline in stocks. We've got a Fed that's behind the curve.
Speaker 1:We've got valuations compressing, but also some risk to earnings. Could you just talk about, you know, what we've seen already kind of priced in and and how things could play out in the stock market if if the Fed truly is behind the curve and and the economy really slows down?
Speaker 3:Yeah. So we can't, unfortunately, predict the downside in the market or upside for for that matter. And as both, you and Ryan mentioned, this has been a very challenging period for stocks and bonds for clients that are invested in that balanced portfolio. This is the first time in basically a 100 years that they're, or this is, you know, 1 of a few times in the past 100 years where both stocks and bonds have have both been negative. You know, a few things that I would add on on where we sit today.
Speaker 3:The S and P and the Nasdaq, are down the longest in consecutive weeks, since the tech bubble in 2, 000. You mentioned PE multiples have contracted substantially across the board for many, equity asset classes. You know, cash has outperformed most assets. And then when when you're looking at sectors on a on a price return basis just through the end of May, actually, the top 20 stocks in the S and P 500 this year, 19 of which are energy, and each 1 of those was up more than 40%. Another area to highlight, because I know we'll talk about the consumer, is this is the first time since the early eighties that we've seen food prices rise more than 10%.
Speaker 3:So in order to understand where we sit today, it's probably important to take a look at what we've already been through in the first, you know, almost half of the year. So in January, the first phase, was really multiple compression of highly valued companies. Technology companies were hit very hard. You know, we have been in a period of very unusually low interest rates, and, you know, investors have been willing to pay more for the same amount of earnings, really, up until this year. Then we entered the second phase, which is Q2 earnings, earnings revisions.
Speaker 3:Over the past several weeks, many companies have posted earnings misses, citing everything that was talked about earlier, margin compression, and some companies started to revise guidance for the full year. Some examples, well publicized out there are Target, Walmart, Cisco. You know, this has really been a perfect storm for for margin misses for companies. And this third phase, which which we're in right now, is companies and investors are starting to digest the impacts of slowing growth and high costs. So we're starting to see this unwinding of overinvestment, layoffs, hiring slowdowns, most of it is coming from the tech space.
Speaker 3:You know, on 1 hand, you have services and hospitality. Those sectors are having a hard time hiring. And then on the other hand, you have tech companies, many that still have, you know, extended valuations. They've gone from very large hiring goals, to recently announcing hiring slowdowns. So then there's also, Ryan mentioned this, the realization that inflation is no longer transitory and and may, actually be, cyclical and and more structural.
Speaker 3:If if you look at the most recent earning season, 85 percent of the companies in the S and P 500 cited inflation, and more than 75% cited, complexities within the within the supply chain. So what's up next? You know, we're we're watching the consumer spending and and consumer very closely to see if there's any deterioration. There's absolutely a gap between consumer confidence and consumer spending right now. We're watching, what the Fed, does from now, until the end of the year.
Speaker 3:And in many ways, the next couple of weeks, are a waiting game, and we're very much subject to economic and, fed news, until we reach the Q2 earnings season in July.
Speaker 1:It's really interesting you bring up consumer sentiment, kind of marvel at the chart of the Michigan, consumer, confidence index and and looking at it being at a lower level than even during, 2008. But, paradoxically, when you survey consumers about how they're feeling about themselves, they've generally felt pretty good because it's a good job market. They have a lot of excess savings. They felt a loss a lot less good about the national economy. And so when you survey, consumers, they seem to have a really big difference of opinion as to how they're doing versus how everybody else is doing, just kind of an interesting sentiment quirk that also popped up back in in 2, 008 and 2, 012.
Speaker 1:But maybe this is a good time to transition over to Joe. You cover consumer Internet companies for us. Consumer spending makes up 70% of US GDP. As Eric has mentioned, you know, the consumer and the tech sector have been kind of at the eye of the storm of the impact of rising rates here. What are you seeing from companies in terms of what Erica was talking about, the hiring and and spending changes, and what insights do you think that could give us to the macro situation?
Speaker 4:It's it's been a a tough 6 months investing in the tech sector. You know, part of it is, what I would call a pandemic hangover effect. So we're seeing companies that were undergoing 2 years of very rapid but somewhat unsustainable growth, now kind of know, and they have taken advantage of a captive and stay at home audience, plus with stimulus cash. They're now kind of getting back to a more normal rate of growth and maybe even dipping down a bit, to get back to that trend line. You know, you also have what we've talked about rising inflation and interest rates, which have taken a toll on the sector, and that's impacted both consumer demand, and valuation.
Speaker 4:So in in the tech sector, especially, we have a lot of growth companies that are unprofitable or barely profitable, and they need to reinvest their resources back into the company to capture as much of their addressable market as possible. This creates a dynamic where companies are having a disproportionate amount of their worth and their terminal value, and and that's really sensitive to the rising rates we're seeing. We talked about, you know, a challenged environment for hiring. It's a little bit different in the tech sector than it's been in other parts of the economy. So so in tech, we're seeing hiring freezes, and in some rare cases, we're even seeing offers being rescinded.
Speaker 4:Examples include Meta, Netflix, Uber, Amazon, Twitter, and Salesforce, just to name a few. And a lot of these companies simply hired too quickly during the unprecedented growth we saw during the pandemic, and they got a little bit ahead of themselves and needed to go through a digestive period. For many of these companies, headcount is actually their largest expense. A lot of them are asset light. It's really people that that drives the expense line along with cloud.
Speaker 4:And these hiring freezes or layoffs could be painful in the near term, but I guess the silver lining would be that it could produce some increased profitability, You know, once we get through, to a more of a recovery stage, you could see healthier margins coming out of this. So this is a good time for companies to to really kind of rationalize their cost structure.
Speaker 1:So, maybe in addition to talking about how they're dealing with their cost structure, could you just talk about what you're seeing in terms of their own business trends? We've talked about, you know, what's going on with digital advertising and some of the channel checks that you've done. Give us a little bit of more kind of real time insight into, what their customers are doing.
Speaker 4:We've we've done a number of digital advertising checks over the last month. It's been really interesting. I think the signal from these checks has actually been fairly clear. We're seeing a larger than expected slowdown from advertisers compared to what we saw or heard a few months ago. You know, to start, I would say there's a few newer ad categories that really took off during the pandemic that are now beginning to fade a bit.
Speaker 4:So, things like cryptocurrency and sports betting, which really just added to the advertising mix over the last 2 years are now coming down. Second, we're hearing that the financials vertical, is slowing down a bit as rising rates are causing advertisers to cut back on certain categories. We could think about mortgages and credit cards, for example. And then the third area of weakness would be CPG. So CPG tends to lean a little heavier on brand advertising as opposed to performance, and that's more readily cut by CMOs that are anticipating a slowdown within their organizations.
Speaker 4:The other thing that's interesting about CPG ad budgets is we've heard that some of that is moving back into physical stores after a long period, where people weren't going into the stores during the pandemic. So you could think about promotions or end caps at supermarkets. So we're seeing that shift back to physical, which is pulling money out of some of these online, digital advertising companies. And then finally, we've heard streaming media and apparel are also down a bit more than expected, in our advertising agency checks. On a more positive note, we've heard that the travel vertical is actually holding up very well.
Speaker 4:It's part of a broader trend that we're hearing about where consumers are spending more on experiences, relative to things in their lives. I expect that to continue. And then as we move to the back half of the year, I do expect midterm elections as well as the World Cup, to pick up some of the slack from some of these slower ad categories. And a final silver lining I could add, which would be the pullback in these online ad auctions, may actually offer a better ROI for advertisers that are still seeing a robust business, causing them to increase spend and even potentially take some more market share. So where we can find those very healthy businesses that could benefit, from a higher ROI in advertising, we think there's opportunities there.
Speaker 1:I'd love to, put a pin in some of the opportunities as well, which we'll come back to, as to, you know, how you sift through who the winners and losers in in a more challenging market like this are. But maybe we could quickly check-in with Erica. You used to cover consumer and retail back in the day. I know you follow a lot of these companies closely. What's going on with the retailers?
Speaker 1:You talked about Target and Walmart. They've had disappointing earnings and outlooks. We know they have built up large inventories, and that's been weighing on on margins. Maybe you could talk a little bit about what's going on there and just generally, you know, the health of the US consumer right
Speaker 3:now? Consumer and retail companies can't escape the headwinds that we're experiencing today. As Joe mentioned, consumer habits are shifting. So there have been signs, that the low end consumer has been weakening, but now we're also starting to see that trickle into the middle income consumer as well. And that shift, that we've talked about from purchase of goods during the pandemic to more services such as travel and restaurants, you know, I think we're all very happy to finally be doing that again.
Speaker 3:But the reality is is consumers are starting to feel very stretched, and they're pickier about items in their baskets. Another important area to mention is there's a lot of press about wages going up. But when you look at real wages and include inflation, that is actually negative, and is not keeping up with the rate of inflation growth that we're seeing. That coupled with higher gas and food prices is causing a drag on the consumer purchasing power, and less room for discretionary purchases. So as far as stock performance this year, consumer companies have actually held up well, just given their more defensive posture.
Speaker 3:But consumer discretionary and retail have been pretty hard hit. You know, just the variance that we're actually seeing, staples are down roughly high single digits and consumer discretionary is now down more than 30%. So you are correct. There's been a slew of earnings revisions, Kohl's, Target, Walmart. The magnitude of margin resets has been big and for a lot of high quality companies.
Speaker 3:And it's it's across a lot of different areas. Many of these companies have already taken pricing. The question remains is, will there be consumer push back going forward if there's more price hikes? And then something that we haven't talked about in years is this concept of shrinkflation. So this is actually when a manufacturer or a business quickly, or quietly shrinks the size of their product or packaging sizes while charging the same price.
Speaker 3:And this has been around for years. We're just starting to see more of it. I saw some pictures of tissue boxes, you know, that are that are out there. Last year, there were 65 tissues. Today, some have 60.
Speaker 3:You know, these might seem, you know, mediocre and and small to to many of us, but in scale, these shifts can help companies in in improving their positioning on on margins. So, you know, Target is an example. They had a merchandise mix. They they are going to have to clear inventory, and that merchandise mix was because of that shift, away from seasonal seasonal items to to, you know, to see from seasonable items to, you know, to kind of more staple items. The other area that that I would point out, is in times like these, you know, down trading or downshifting of consumer purchases does happen.
Speaker 3:So, we're starting to see a renewed interest in private label or own brands. If you recall, back in the eighties, private label, kind of coming out of the recession gained share, and then growth stagnated for for many years. And right now, if you look at various categories, private label market share is nearly 20% in household personal care and food. And many branded food companies actually are priced at a 30 to 40% premium in some of their categories. So the first time in in a few years, Neil Nielsen's consumer data is showing private label gain market share.
Speaker 3:And interestingly enough, Walmart just actually announced recently that they are going to and have been putting more emphasis on their own brand in stores. So own brands carry higher margins, but they have lower price points. So, clearly, retailers are starting to think about the ship shift and and, you know, the opportunity for them.
Speaker 1:Maybe we could try to pull this all together a little bit before talking about some of the opportunities that we're seeing. But maybe, Ryan, I'd go back to you and just say, you know, with everything you're looking at and the discussion we've just had about the weakening consumer, the pressure on the consumer from inflation, how do you think about the chances of a recession right now in the US or Europe, and and how much does that matter versus what I know we've talked about in the past kind of what kind of a recession we might have?
Speaker 2:Well, I I think it's not, you know, breaking new ground to say recession does does matter. You know, that that is a a very negative, backdrop for for markets undoubtedly, and trying to ascribe probability is is tough. I think sort of the street forecast is sitting kind of in the low thirties right now. But, you know, Jamie Gorman and others have been on the tapes and could be as high as 50%. You know, it's in a way it's a bit of finger there, but but the the signs that we're looking at in consumer, etcetera, the tightening of policy, you know, it certainly seems in our view to to be increasing all the time.
Speaker 2:Probably less focused on, you know, the probability of recession in the immediacy. I think it certainly feels like it's 2023 story for the US. I think the UK is likely to go into recession much sooner than that. Europe is continuing to see, you know, growth slow down. It could possibly be in recession towards the end of this year.
Speaker 2:But I think what's even more important, we talked a bit about it earlier just about sort of stagflationary backdrop is it's really in the direction of travel. You know, growth just continues to move lower and lower on a monthly and quarterly basis, and and that just sort of primes the pump in a way for, you know, the market to really start to become more and more concerned, and we're seeing a way on risk assets undoubtedly. So, you know, I think it's it's something that we need to keep front and center. I mean, you kind of are sitting in our scenario, kind of putting around 40% for US recession in 2023. But, again, I we're not very optimistic that the fed, again, can sort of navigate, you know, this this very sort of small, eye of a needle to to generate a soft landing.
Speaker 2:And so, I'm certainly very, very focused on on that downside risk from an economic perspective.
Speaker 1:And maybe, Joe, I'll go to you next and just say, you know, from your seat looking at how consumer tech is is dealing with this, Maybe you could share what your views are on kind of, you know, can can the US consumer withstand this level of inflation and and still keep growing their spend? And then a second question would be, do you think the businesses that you're tracking can kind of, you know, maintain margins in a period like this?
Speaker 4:Yeah. We're we're watching the consumer spending patterns very closely. It's probably the top thing that that I'm watching right now. Consumers are obviously spending more time outside, but in the in the stimulus money from last year is largely spent. They're left with higher rent, paying at the pump, and and a larger grocery bill as well.
Speaker 4:So the the increase to in the cost of basic goods is obviously unhelpful for consumer Internet businesses, that I'm looking at. The default is probably that we'll see these consumers pull back on discretionary spend, in the near term, which will impact digital advertising businesses, ecommerce, and and some of the other businesses in the consumer Internet sector. So, you know, long term, this could be a great entry point over the next 6 months into secular winners that are gonna gonna continue to compound over the longer term horizon. But in the near term, there probably will be a bit of an impact to margins. We may get some margin benefit from a slowdown in hiring, from these businesses, which might offset some top line pressure, which will ultimately potentially help the bottom line.
Speaker 4:But I I do expect it to be a bit of a challenging period here. There are companies and opportunities out there, though, that we're still looking at, which we think can be great opportunities in this environment. For example, you know, a company that's benefiting from, fundamental changes in the tech landscape is The Trade Desk. It's 1 that I've been looking at recently. They're a dominant player in ad tech with a solid secular growth story, a high quality management team, and they're growing revenues over 30%.
Speaker 4:And they're a big beneficiary of the move to connect away from linear TV to connected TV, which I expect to be a long term secular trend. Both Disney Plus and Netflix recently announced they're launching ad supported models. This is an excellent opportunity for some of these ad tech players to get involved in a in an advertising ecosystem on TV that they weren't a part of in the past. And regulation can actually force some of the walled gardens like Google to open up their advertising inventory to some of the ad tech players over time, which is another opportunity. On top of that, The Trade Desk recently reiterated their guidance following some negative comments, from Snapchat that got people a little bit nervous about the sector.
Speaker 4:And this provides some near term confidence as well. So that that's a stock that we're excited about right now. In addition, outside of the consumer, there's pockets of tech, like enterprise software where we think there's opportunities that will hold up better in this environment. So, for example, ServiceNow is a company that does workflow automation software focused on enterprise customers. We think there should be this should be a much more stable part of the tech sector relative to consumer and some small business focused software.
Speaker 4:It's mission critical software. There's a total addressable market there of over $200, 000, 000, 000 in 2024, and the way the company works is they typically start out being used in enterprise IT departments and expand on into other workflows to expand, their share of wallet at the company. They're expanding into nontechnology workflows such as HR, ESG, and risk management, and they have very strong metrics. A 125% net retention, 20 24 free cash flow margin target of 33%. And management also there, as well as Trade Desk, just reiterated guidance a few weeks ago at their investor day presentation.
Speaker 4:So those are 2 companies that we're we we think can outperform in this environment.
Speaker 1:So maybe that'll kind of transition into positioning and and and opportunities as well. And maybe, Joe, before we leave you, you could talk just a little bit about valuations. Obviously, we've seen you know, you mentioned enterprise software. Valuations spiked to nosebleed levels in 2021, and and now they've come back down below the kinda averages of the last, you know, 5 to 7 years. Obviously, we don't know if the average of the last 5 to 7 years is is as relevant in in a changing inflation and interest rate regime.
Speaker 1:But, you know, could you just talk about the kind of bargains that you're seeing, the confidence in those bargains, and then a little bit more about, what you just mentioned of kind of, you know, the types of businesses that you really want to look for in this kind of environment. You mentioned kind of mission critical b to b, enterprise software. You know, where are you zeroing in?
Speaker 4:Yeah. So on the valuation piece, obviously, multiples have become much more attractive in tech. Some of the hypergrowth names that I follow, their multiples have shrunk 70, 80% or or more, which is quite phenomenal from the peak of 6 to 7 months ago. So there's a lot of companies out there that are extremely attractive on a multiple basis trading at multiyear trough multiples. The question that we're asking ourselves as we go through our models and do do the work is how much more room to the downside do we have for numbers cut?
Speaker 4:So on consensus numbers, these multiples are very attractive. My sense is that numbers still need to come down possibly in the 10 to 20% range for some of these companies, and then and then we'll be able to kind of bottom out and and have a much better, opportunity set looking forward. So so I do think there's a great opportunity here over a 3 to 5 year view to buy these long term secular winners who are gonna be compounding for many years to come. So now is the time to start thinking about who those winners are, and taking advantage of the current market environment. You know, to your question on others, you know, types of stocks we're looking for, you know, you're you're right.
Speaker 4:It's the enterprise, customer that we think is gonna be more resilient through this market, period. It's mission critical software, stuff that these companies have to have to do their business. The nice to haves might get pushed back or the timing to get those sales done may be pushed back. So we're focused on the mission critical, must have software. We're focused on companies that are innovating or taking advantage of catalyst within the tech sector, and and companies that are just more stable.
Speaker 4:You know, Google is a great example, you know, that we like. It's it's they're they're very stable. Search advertising is the last ad format to get cut. Typically, you'll see more experimental budgets. Money that's going to Snapchat, Pinterest, Twitter, get cut well before you'll see a search advertising budget get cut.
Speaker 4:So we think there's more resiliency in Google search. We do expect some softness in YouTube, but we expect cloud to continue to do well. And we have innovation at Google and AI and machine learning. And there's a new ad product there called Performance Max, which is actually kicking out a very good ROI. We've heard from customers that they're seeing 2 to 3 times the ROI that they were seeing on Facebook, for example.
Speaker 4:So there's innovation happening at Google, which which we will think expands the TAM for them and and carries them through this period as well.
Speaker 1:So, Erica, another dynamic we've seen this year, that's been grabbing headlines is is underperformance of sustainability related strategies driven by the outperformance of energy. Could you just give us some comments on what you're seeing?
Speaker 3:Yes. I had a a few points, here. So many ESG strategies have historically leaned toward growth sectors, particularly technology. And growth equities have been very hard hit this year, as far as performance and and multiples as investors look to a rising rate environment. So I would not say that that growth, impact phenomenon, is ESG specific.
Speaker 3:You know, energy has moved from 2% of the S and P 500 to 5% today, and many ESG strategies do not have exposure to traditional energy companies, and energy has been a top performer this year. So after years of it being a nonissue, that lack of energy exposure is is a headwind currently. You know, a couple other areas we've seen a flood of new ESG strategies launched over the past few years. There are a few 100 ESG ETFs available. Roughly 30 or so are focused on clean energy, and more than 20 have actually been launched so far in 2022.
Speaker 3:Flows into and out of, ESG funds have been mixed this year. Morningstar just released detail about ESG funds having more difficult performance on a year to date basis, particularly if you look at thematic and category specific areas like clean energy. You know, the WilderHill Clean Energy Index is is down, roughly 35% this year. And then areas like EV and and solar, has also been been very volatile. You know, names that have gotten a lot of attention over the past year, like Tesla and Rivian, You know, Tesla shares are down more than 45%, and and Rivian is is down more than 70% this year.
Speaker 3:So although we pay attention to a lot of this detail, we're very manager specific in in client portfolios. And, you know, there are pockets of opportunities. You know, over the past couple of years, we've looked for dividend focused and value focused ESG strategies. Those have held up well on a on a relative basis. Additionally, as investors look for uncorrelated or differentiated ways to protect their portfolio from inflation, there's some high quality renewable energy infrastructure funds that have also done well this year.
Speaker 2:Yeah. Maybe on the fixed income side, you know, ESG has actually played a really important role in in fixed income performance this year, and the reason is is Russia. When you look at, the amount of capital loss that's come from ownership of Russia going into the year, and it was held across, obviously, emerging market funds. But a lot of global fixed income funds owned Russia because it had really high real yields. And people are looking at it as a large component of their portfolio, both the sovereign and companies based in Russian.
Speaker 2:So, you know, applying ESG to ownership of sovereigns has been really, really important, sort of more about the the the names that you don't own as much as the names that you do on. And so I think certainly from a fixed income perspective, you know, having that sort of secondary lens or accretive lens to view risk, especially in the sovereign space, has been incredibly important this year in terms of performance.
Speaker 1:Maybe, Erica, I could turn to you and just ask a little bit about kind of broader, big picture positioning. When you think about it from a kind of, you know, balanced portfolio perspective, do we need to think about this environment of higher inflation as a a kind of paradigm shift? I mean, really, the only things that have worked this year are shorting the market, buying commodities, and and holding cash. Do you think people should be doing more of those things, or or should they be sticking to the kind of framework they've they've been with, you know, for for many years?
Speaker 3:Yeah. Thanks, Ed. So aft over the past 15 months or so, we have focused our asset allocation recommendations for client portfolios on diversifying, preparing for a wide range of outcomes. So, how can we protect portfolios from rising interest rates and inflation, but also, how can we find income in the low yield environment? So a lot of the the changes and and recommendations, that we've put forth, really center around taking a look at growth versus value within equities, taking a look at finding dividend income, or dividend focused equities, to offset that loss of income from fixed income.
Speaker 3:Being underweight duration in fixed income, has protected, our bond portfolios for clients. We've also had an underweight to international equities, and we've been using alternatives, like real estate or other diversifiers, to really play that uncorrelated investment in client portfolios. And, you know, we've stressed the importance of trying to create that all weather portfolio. And, you know, going forward, you know, I don't think anybody could have predicted, you know, where we are today. But going forward, we continue to look for investment strategies, that Joe mentioned, high quality companies, strong cash flow, recurring revenues, those that can take pricing, to mitigate this environment.
Speaker 3:And, you know, at at this point, you know, where we sit today, you know, taking a look at your long term, targets and long term goals, revisiting your cash in short duration to make sure that you have enough to kind of get through a period of time for your spending needs. And then, you know, most equity portfolios are down, so this could be a good time to think about rebalancing within your, portfolios, rebalancing risk within your portfolios. You know, with the market down 20%, we mentioned before that, you know, we can't, predict, what the downside or the upside will be. We don't know if this environment will be another by the dip, environment. But, you know, we do recommend revisiting long term targets and rebalancing to those targets, you know, in this type of environment.
Speaker 1:So, you know, we've seen some pretty high profile investors come out and talk about how challenging this environment is, how uncertain it is, some hedge fund managers going, you know, to 80, 100% cash, and so that's led to a lot of kind of questions about maybe getting out of the market at a time like this. What would you say to someone who came to you and and said, I am very certain we're going into a recession, and and and this argument makes sense to me, you know, and I'd like to reduce exposures. How do you feel about a decision like that at a time like this?
Speaker 3:Yeah. So it's it's it's a good question. Obviously, it depends on each client's needs. Many companies, like Joe mentioned, are on sale or are going to be on sale, in this type of environment. So valuations have been rerated.
Speaker 3:You know, typically, when, it feels most uncomfortable in the market, is often the time that we get questions from clients about selling. It's at that point in time, number 1, to revisit your long term targets, but to take a look at those investments in those companies that are on sale, kind of reunderwrite them, you know, and consider, when you might, kind of reinvest in those strategies. You know, this is this is probably a difficult time to to sell out of equities. And, you know, it it does feel uncomfortable right now. But for long term investors, these types of markets, these types of market draw downs have resulted in, some of the best, opportunities for long term growth going forward.
Speaker 3:Again, we don't know when the markets will ultimately rebound or what the downside will be. But, you know, we continue to look for those opportunities in the near term and and over the coming months to help guide investors through making those decisions.
Speaker 1:Yeah. It always feels like a very challenging decision, especially in the kind of fog of war in a time like this when volatility is high and and markets are down, to kind of change your your game plan dramatically. It's like you have to get the timing right of the exit. You have to get the timing right of the reentry. And so much of this game is kind of being in the market and compounding your returns over time, so kind of cutting into the core of your portfolio at a time like this, has always seemed counter to that that goal.
Speaker 1:But let me quickly go back to, Ryan here, and let's close by talking about what are some of the catalysts that could turn this market around.
Speaker 2:What's the $1, 000, 000 question? Is it what what is the the catalyst that can sort of cause all the pain to go away? And, it's really an inflation story, isn't it? I mean, if if inflation starts to moderate, then central banks can take the foot off the gas pedal. And and then to us, that that is that is the catalyst.
Speaker 2:I mean, so much of of what's been happening in the market has been a byproduct of inflationary pressure. So, if we do start to see relaxation in in inflation, in near term or even in sort of medium term, you know, that will allow the market to take AAA breath. I mean, it's really been sort of nonstop for 6 months, and it and it is very, very tiring. And I think that's why you're starting to see people kind of throw in the towel. And I think to Erica's point, it isn't the best time to be doing it.
Speaker 2:You really have to take a step back and think about what does the landscape look like going forward over the next, you know, few months or quarters, and and what are my opportunities ahead of me? And so, but from our perspective, you know, a fed that is in Uber tightening mode, isn't good for markets. And so I think that ultimately is is the catalyst. You know, we're not gonna go back into sort of the QE world that we lived in before. That that game is over.
Speaker 2:But in a way, we've talked a lot about kind of the cycle and what it looks like, you know, going forward. We have lived through some really odd economic cycles over the last 15 years. We had the GFC, which was this massive financial crisis crash. And that led to the longest expansion that we've ever had in the US, kind of post GFC. It was all byproduct of quantitative easing and so much easy fiscal monetary policy.
Speaker 2:And then we had this really short cycle that was kind of COVID recession, and then you bounce back in a couple months time and and getting whipsawed. But now we're heading into, you know, what is a very normal cycle for markets. You know, markets tend expansions tend to end when central banks tighten policy to get in front of inflation. So, you know, this isn't a bad thing in a way. We kind of go through this normalized cycle.
Speaker 2:We go into potentially recession. But, recessions don't last that long. Economy spends so much more time in expansion than in recession. The post war average recession is about 10 months. You know?
Speaker 2:And so kind of get into that dip. And as Erica said, be looking for those opportunities. Try to find opportunities to be buying really good companies at at attractive valuations. You know? Be buying fixed income at, you know, higher levels of income and yields that can really provide, you know, interesting opportunities on a long term basis for investors.
Speaker 2:So, you know, it is, it is a challenge. The fog of war, as you said, is is a very difficult landscape to navigate, but opportunities are are rising. That's really what we need to be focused on in the months ahead.
Speaker 1:And maybe, Joe, what are the things you're looking at most closely, to monitor for, you know, when it's the time to be more aggressive?
Speaker 4:Yeah. We're we're really just looking for, you know, maybe a first numbers cut, try to see where things shake out within within our consumer Internet stocks, hear from companies, you know, where are they more resilient than others. We have a thesis on where that might be, but but go through this next earnings period, go through conference seasons, meet with a lot of management teams, and and see where there's differentiation in these businesses. We you know, we can find alpha on a relative basis, within the sector. And then kind of coming out of this period, once once numbers are cut, you know, we think we will resume trend on a lot of these longer term secular growth drivers.
Speaker 4:So e commerce, you know, we don't think we're done with e commerce just because we're taking a step back. Digital advertising, we still think there's a lot of headroom, especially in connected TV advertising. So there's a lot of areas that we think will resume growth. Not everything was just a pandemic winner that isn't coming back. So it's differentiating between those things that may have benefited from the pandemic and aren't really long term secular growth opportunities and and those high quality businesses that have a very long runway.
Speaker 4:And and we should hear strength from from those companies as we kinda move through this period and hear from their management teams.
Speaker 1:And, Erica, maybe I'll close with you, just thinking about the bigger picture of portfolio positioning for clients. We we came into this period pretty conservatively positioned, pretty diversified, a balance between growth and value, short duration, and that stance hasn't really changed much. A lot of changes over the last 18 months, but it's a lot of of of the same kind of positioning and messaging. What would cause you to be more aggressive and, you know, increase your target equity allocation rather than just kind of rebalancing or or just take on more risk in portfolios?
Speaker 3:Yeah. So and some of these have already been mentioned. The the catalyst that we'd be looking, you know, that would turn the market around or at least stabilize the market, would be stabilization of rising rates and inflation. The Fed has to really balance this seesaw right now, and central banks may be living, with supply chain driven inflation for a period of time. You know, that shift back to services from good spending by consumers, that could help, curb demand, a little bit as we head into the back half.
Speaker 3:But, you know, there's there's a few things, supply chain improvements, supply and demand within the energy complex, COVID lockdowns and restrictions overseas ease. And Joe, hinted at this. It's probably likely that in Q2, we have, some sort of a reset from various companies and sectors on earnings. And, you know, probably setting the bar a little bit lower before we head into the back half of the year would be would be a good thing to to see. You know, another area that we're spending a lot of time looking at is share buybacks, very strong, you know, from company or corporate share buybacks so far this year.
Speaker 3:So we'll be watching this closely, as we enter the the second quarter. But there there are some positives, you know, over the past, you know, 12 to 15 months. We've talked a lot about corporate balance sheets that still remain healthy. I think that does distinguish this environment from previous cycles that that Ryan discussed. There's there is still a a fair amount of cash.
Speaker 3:It's, you know, just how do companies deploy that cash? Do they start to pull back on CapEx targets, which some companies had started to kind of, revisit and reramp up late last year. So those are those are all areas, that that we'll be watching.
Speaker 1:That's really good, advice. There's a lot of the same things I'm thinking about. I mean, I I feel like after watching the market's reaction to Friday's inflation print, it just seems like a lot to kind of extrapolate out the trend of the the last 3 months, which has been a little bit disappointing when there's so many things going on, some of those dynamics you just talked about. And, clearly, you know, the Fed is slamming on the brakes. We've seen, you know, fiscal and monetary tightening, and still a reasonable amount of the inflation that we've seen has been related to the war and the pandemic, and there should be some easing of that.
Speaker 1:So I just think, you know, having a view that that this is exactly, what the inflation picture will be like and this is the the market we're gonna be dealing with in 6 months' time is is a really, a tough view to have. And and I think there's a chance that in the coming months, we could get some, some evidence with inflation potentially easing somewhat. Anything at this point, I think, would be a huge benefit to the market and more, realistic earnings, which are still predicted, by Wall Street to kind of grow, you know, nearly double digits this year. So, you know, more realistic earnings picture, a bit of of easing, on the inflation inflation front, and and I feel like we could have a fairly different setup. But, thank you all so much for joining today.
Speaker 1:And for all those listening, please don't hesitate to reach out to any of us or your your client teams if if you wanna talk more about any of these topics. Thanks so much.