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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 open doors in the world of investing. Today is Friday, April 12th, 2024, I'm Brian Pietrangelo and welcome to the podcast.
And if you're a golf fan, you know that this is Masters week, beginning yesterday, with the 88th year of the famous event at Augusta National. So it's always a fun time of year to see who will bring home the green jacket in terms of winning the championship this particular week.
And with that, I'd like to introduce our panel of investing experts. You might say they might be able to wear their own green jacket of investing. Here to share their insights on this week's market activity and more. George Mateyo, chief investment officer; Steve Hoedt, head of equities; and Rajeev Sharma, head of fixed income.
As a reminder, a lot of great content is available on key.com/wealthinsights, including updates from our Wealth Institute on many different subjects and especially our Key Questions article series addressing a relevant topic for investors each week. 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 market and economic news. The economic calendar of releases was fairly light in terms of the number of reports. However, the reports that were released were pretty heavy in terms of the impact that it will have on the markets and the overall outlook for the Federal Reserve. And we'll touch on that as we get to our panel.
First, initial unemployment claims for the week were fairly low in terms of the consistency of where they've been for the last six to nine months. So good news there, that we're seeing a continued robust jobs market in terms of the filing for initial unemployment claims.
Second, the meeting minutes from the Federal Reserve's FOMC meeting in March were released and it showed us that there was some additional conversation happening behind the scenes for the potential outlook for Fed rate cuts this year being a little bit more conservative than not. We'll get Rajeev's take on it as the rest of our panel as we cover that particular item in a few minutes.
And certainly third, the largest impact of the week, was the release of the consumer price index of inflation print on Wednesday, and it showcased the fact that it's unfavorable news, that inflation continues to not go down as expected and in some cases actually went up. So when we look at the year-over-year inflation read for overall CPI for March, 2024, the number went up to 3.5 in March, 3.5%, from 3.2% in February. The core excluding food and energy stayed the same at 3.8%. And a number of sticky inflation items continued to show their reports in terms of overall items such as shelter, which continues to be around 5.7% year-over-year. And we've also seen other factors continue to not moderate.
So we'll get our take from our panel on that specifically item because this was a pretty important read for inflation. So George, let's start with you. And just like the wind and rain put a damper on yesterday's first round at the Masters, do you think this week's inflation print we'll put a damper on the economy and the Fed's plan for interest rate cuts? George.
George Mateyo:
Well, Brian, I think it's fair to say that inflation has retaken the investment narrative of the moment. And yeah, I think it has put a damper on things. It's actually not because ... I should say it's not really causing a damper on the economy as much as the other way around, where the economy I think is probably putting a damper on inflation. Meaning the economy seems to be doing better than expected, and that's one of the reasons why inflation is also higher than expected.
And I think we've talked about this for quite some time, but inflation is one of these things that just impacts everybody, businesses and consumers, in the sense that it's higher than expected. It does create maybe some headwinds going forward. And to be sure, I mean, inflation is not running away, it's just, I guess, to use a different metaphor, we've had three strikes and they're out so to speak in the sense that we've had three better than expected or higher than expected inflation readings. And now rate cuts are coming out of the forecasts from the Fed.
And when we've talked about the Fed this past year in terms of their outlook for cutting rates, we came into this year with the Fed thinking or markets thinking rather the Fed would be cutting rates seven times. And they've dialed that back. And just a few weeks ago it was down to three times and now it's down to one or two times in terms of rate cuts.
So I think we've talked about the fact that instead of just worrying about how many cuts, I think the bigger question in our mind always has been why are they cutting? And why would they be cutting in the light of a stronger than expected economy is logical. I mean, they probably would need to dial back policy easing if the economy is strengthening and it seems to be going along pretty well.
I mean, inflation is running in the 3-3.5% range, which by no means is exorbitant, but it's higher than the Fed would like it to be. So they probably shouldn't be cutting rates in that environment. It's pretty simple in that regard.
Where we've gotten into some trouble is the markets, as I said earlier, were anticipating more accommodation, more easing, and now that the economy is stronger, it doesn't make sense for them frankly.
What could be concerning is if inflation does get out of hand a little bit, and we'll see how that plays out. But I think there's probably still some things that are on the surface that are slowing down a little bit that maybe will allow the Fed to consider easing later this year. The consumer is doing okay, but there are some segments of the consumer that aren't as strong. And there are still some segments of the overall business economy as well that probably aren't as strong as you might think.
So I do think that the Fed has some room to consider easing later this year. It makes it a little bit more difficult against the election dynamics that we talked about. But overall, I do think that the Fed is right to probably pause a little bit, continue to reassess things where they are, and now the market's readjusting their expectations too. So we've had a lot of Fed speakers this past week, Rajeev, try to get their, I guess, opinions out, talking about this very dynamic too. What's your take on what we've seen this week with respect to inflation and also the Fed?
Rajeev Sharma:
A lot to discuss here, George, as far as the fixed income markets goes and the impact from that CPI report. When the hotter than expected CPI released, all hopes that we would see a steeper yield curve, they're dashed. We saw two-year treasury yields, which are the most sensitive to Fed policy, move 20 basis points higher immediately. And we got very close to touching that 5% mark on the two-year. That resulted in a flatter yield curve.
So overall, the CPI report's really pointing towards stubborn inflation. And it's likely going to delay those Fed rate cuts that the market has been anticipating. And what we heard from the Fed share power back in March. We may not get those three rate cuts based on that report.
So the pain trade right now is the treasury market. You can see that market probabilities were, before that CPI report, you had a market probability that was pointing towards maybe 53% probability of a 25 basis point rate cut at the June FOMC meeting. Those probabilities now stand at 26%. So the market's pretty much discounted a rate cut in June and has now started focusing on July's meeting for the first rate cut.
It puts the Fed in a really tough position because the Fed is trying to make sense of these three consecutive year-on-year hotter-than-expected headline CPI reports that we're seeing. It's getting difficult for the Fed to justify cutting rates and support that narrative that three rate cuts this year.
So I think you're going to hear from a lot of Fed members that are going to really point towards, we need to be calm, we need to be patient with inflation, we need to see inflation move towards our target of 2%. That's not happening. It's going to cause us to remain higher for longer.
And we've seen that impact on the yield curve itself with those higher yields. Now with the higher yields, we also had treasury auctions this week, bad time to have those, as these yields started already moving before those auctions. We had the three-year, 10-year and 30-year bond auctions. All of them required large concessions to get investor demand. And none of them did really well to be honest with you. Alls it did was really put more pressure on yields to remain higher.
Now if we look at the impact on the credit markets, credit spreads remain pretty well-behaved, they are actually tighter on the week. And now investors are getting even higher yields for investing in corporate bonds. And that's bad news for borrowers that have to come to market in this environment. But I could see that cause continued market appetite by investors that are looking for high-quality bonds with yields of about 5.5%. These yields we haven't seen for even before 2021.
So it's going to be really interesting to see if that demand continues. I think it will. We have $35 billion of new money that has flowed into short intermediate investment-grade bond funds this year. That's almost three times the entire amount of inflow that we had last year. So the demand is there. I think borrowers are going to have a hard time in this environment.
And there are a couple of other things that are also shaping the market for fixed income. We did have the release of the Fed minutes this week, that was from last month's FOMC meeting. It seems like it should be an obsolete report because so much has happened since then. But there were some useful insights that we gathered from those minutes.
Looking at the minutes, there was discussion that the Fed plans on quantitative tightening and doing a taper. In other words, the Fed wants to slow the runoff of their balance sheet. In particular, there were some talk about adjusting the treasury cap to slow the runoff. There was also talk about reducing the monthly asset runoff pace by nearly a half. And in terms of timing, I would say something like this could happen as early as maybe June where they make the official announcement.
And we also had other central banks chiming in as well. We had the ECB was in the news, nobody expected the ECB to cut rates, they left rates unchanged as expected. But they did signal that they may be ready for a rate cut in June. And that's in contrast with the Fed. So the ECB has said the incoming data has confirmed their inflation outlook.
It's very rare for other banks like ECB or Bank of England to cut rates before the Fed does. We haven't seen that. It's going to be interesting if this is the time when that could happen because I can say that I don't feel like the Fed is going to be focused on a June rate cut. But you are hearing narrative out of the ECB that they are focused now on a June rate cut.
For now, alls we can say is this inflation is sticky, it's going to cause the Fed to reevaluate. And I think we're going to have to wait for more Fed members to come out. And all of this is going to have its impact in keeping yields higher for longer.
George Mateyo:
Well, Rajeev, I think the biggest take away from your comments there that I heard was the fact that the credit markets are still pretty stable. So notwithstanding the fact that we see volatility in the markets, we see some concern about inflation, it doesn't seem to be expressed in credit spreads, which is something we look at, I know you watch very carefully, with respect to the overall health, if you will, of the overall credit market. And that's important because that has read through towards the broader economy and broader risk in the equity market.
And so Steve, I guess, I'll turn over to you. We've seen the markets pull back a little bit here. You've seen, again, credit spreads however remain pretty stable. I would think that investors will be focusing on earnings for their next q's in terms of where markets might be heading. What's your thoughts?
Stephen Hoedt:
Well, maybe, maybe not. I mean, I think really, George, it still comes down to this outlook for inflation overriding the earnings numbers that are going to be coming out in the next couple of weeks. I mean, that CPI report was a mess to be honest, to use the technical term. I mean, it was really ugly, lots of complicated stuff inside of there. And none of it was good for the current market outlook.
When you take a look, will it mark some kind of a major turning point for US equities? I think it's still too early to make that call. Clearly there would be a lot more upside to stocks if the Fed was cutting rates into an accelerated growth cycle. I mean, it's hard to make the case that that wouldn't occur.
But when you take a look, what clearly is happening right now is you have to ask yourself, when you look at the market, are you positioned for a market where a 21 PE is consistent with things running hotter for longer? Because that's the scenario we're in right now, growth running hot and inflation running hot.
And the stuff that's worked over the last year, namely the mega cap seven, other high-tech names, that's not necessarily where you want to be positioned in a hotter for longer scenario. You want to be long cyclicals, over defensives, you want to be long value over growth, you want to be long high quality over low quality, to a certain degree you want to be long large cap over small cap, stuff like this because that's where you're going to see the bias in the current market. I mean, I know that we've had a fairly strong view of small cap for a while, but I got to tell you, if you don't get Fed rate cuts, it hurts small cap performance relative to large very clearly.
So when we look at things that are maybe different today than they were a couple of days ago, based on that outlook, I mean, it's very clear to me that you've got to be long things that are leveraged to this cyclical upswing, that's like the old economy stuff, energy, materials, to a certain degree financials.
And we can talk about the earnings there. The earnings came in decent for the large cap banks this morning. Nothing to be upset about there. And the real question, to your point, is is the market going to change its focus from this inflation macro driven Fed stuff to focus on micro? And I got to tell you, I really do feel like it's the macro that's driving this market right now.
Brian Pietrangelo:
So George ... Thank you, Steve, by the way, that's tremendous content for our listeners on the stock market and your thoughts for the outlook. George, earlier in the week, on Wednesday, we hosted our national Key Wealth client call and we had a number of guest speakers to talk about the topics. And it was a great call. So can you give our listeners a little recap of that call with regard to an outlook on commercial real estate and possibly other areas of the market?
George Mateyo:
Of course, Brian. We spent time talking to a couple of people, one of which is a foremost bank analyst who's been in the banking industry or covering the bank industry say for 30 plus years. And it was a good precursor to the conversation around real estate in the sense that there is some concern that certain banks might have some exposure towards real estate. Every bank usually does. I mean, it's been a pretty key asset class for many banks.
But he provided a really interesting backdrop in the sense that the banking industry actually is probably the most well-capitalized it's been in quite some time. And I think Esther Lau on our team had a really great article just a few weeks ago that talked about that as well. So that signals the fact that, notwithstanding some headwinds and some softening in office real estate given the fact that more people are working from home, that's going to continue and that's going to be a slow bleed, a slow, I guess, I'm not sure what the right metaphor is, but maybe a slowly melting story in the sense that it's going to take some time for certain banks to work off those pressures.
So that said, again, as our friend mentioned, I think you're going to see banks overall navigate this, not with ease, but I think overall they're going to be able to navigate this fairly easily in the sense that this is not a 2008 situation. Banks' balance sheets are strong, as I said, stronger than they have been in quite some time. And we haven't really seen really a significant deterioration in credit, as Steve just mentioned, with respect to bank earnings. So I think the banking sector is in good shape and can manage that situation fairly well.
Transition to real estate, again, the office sector in particular is going through some adjustment we can say, put that in euphemistic terms. But it's really very specific. As the saying goes in real estate, it's really location, location, location. And that can be more true in the office market where there are certain offices that actually are seeing stabilization right now. We've seen some general trends of positivity with respect to what's happening in people releasing things at generally favorable terms. And the supply of new office real estate, not surprisingly, is really quite low, so there isn't a lot of competition.
But that said, it's going to take some time for the situations to work out in real estate, in the office sector. But as our guest also talked about, there are other segments within real estate that are doing quite well, logistics, warehouses. Again, as Steve mentioned with respect to the economy itself, the industrial sector is doing very well right now. And that's not lost in the fact that there are pockets of strength that can be manifest itself in real estate too.
And when Steve talked about looking at cyclicals, one thing that we've often talked about is looking at real assets to really further complement a portfolio. So beyond financial assets like stocks and bonds, real assets such as real estate or even commodities, gold has done really well lately, given maybe some geopolitical concerns, and things in fixed income such as treasury inflation protected securities or TIPS have also provided some stabilization and maybe some diversification too from traditional fixed income.
So again, I think the point was that the real estate market is really nuanced, as more things are in life, but I do think that there is probably some inflation protection that could be had from real estate and other things like real assets. So in this environment, I totally agree with Steve, that I think quality is the theme of the day for sure. But also really broadening your definition around diversification couldn't be more paramount right now as well.
Brian Pietrangelo:
Well, thanks again for the conversation today, George, Steve and Rajeev. We appreciate your perspectives. And thanks to our listeners for joining us today. Be sure to subscribe to the Key Wealth Matters podcast through your favorite podcast app.
As always, past performance is no guarantee of future results. And we know your financial situation is personal to you. So reach out to your relationship manager, portfolio strategist or financial advisor for more information. And we'll catch up with you next week to see how the world and the markets have changed and provide those keys to help you navigate your financial journey.
Speaker 5:
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