Progress over perfection

Linda Duessel: Hello and welcome to the Hear and Now Podcast from Federated Hermes. I'm Linda Duessel, Senior Equity Strategist. Today I'm joined by our two returning guests for the podcast, Phil Orlando, Chief Equity Strategist and R.J. Gallo, Head of our Municipal Bond Department Group and Head of the Duration Committee. We're going to dive in to discuss what they're expecting and what they're watching for the new year. Thank you both for joining the conversation today.

Phil Orlando: Thanks for having us back.

Linda Duessel: This has lots to talk about after a fascinating year, I just have the idea 2024 is going to be even more interesting. And we'll start with you, Phil. It was a strong finish to the year 2023. How has GDP growth surprised this year and then how have we adjusted next year's growth outlook on the heels of this?

Phil Orlando: Well, you're right, third quarter GDP in the U.S. was a lot stronger than expected. It was actually revised up to 5.2% not too long ago, but when we got into the weeds and looked at some of the reasons for that, the quarter wasn't as strong as we thought. That personal consumption, which accounts for about 70% of GDP actually was revised down from 4% to 3.6%. And things that are kind of junky in terms of quality inventory accumulation and government non-defense spending, that's what actually drove the GDP higher.

Linda Duessel: A nice deceleration then into the first half of the year and maybe pick up at the back half of the year. But R.J., all those calls for recession this year and it seemed very much consensus given so many of the historical indicators that were flashing red all year long. What did consensus missed and what happened in November?

R.J. Gallo: It's very clear that the market signals from the inverted curve and the leading economic indicators had been flagging a very high probability of recession. Most economists most in the market had agreed that that recession was coming. Previously, we felt at Federated Hermes on the macro committee that a recession was more likely than not. The markets I think were rationally adjusting to the fact that we've witnessed the most drastic fed tightening in four decades. It seemed more likely than not that that would take prisoners in the sense that it would cause a recession. I think what foiled it came from two different fronts. First, with respect to households and personal spending, household spending, personal consumption expenditures, there was a big hangover of a lot of excess savings from the Covid relief bills. Households had not worked through that yet. It helped to drive strong. So-called revenge spending as people continue to respond to the new world as the pandemic really has wound down and it gives people an opportunity to go out and enjoy their lives again, buying more products initially, now buying more services. So that led to a very strong consumer expenditure across the economy. So that's one factor that has foiled the recession calls. And the second I think is government spending. Under Biden and the current composition of Congress and the prior composition of Congress, we put in place a variety of acts, the stimulus bills in the form of the Bipartisan Infrastructure Bill, as well as the Inflation Reduction Act, which motivates a lot of green spending on the part of a lot of heavy industries. Those two created further tailwinds for the economy. So fiscal policy in short, sort of offset monetary policy to some degree. Jury's still out on whether or not we'll get that recession in the year to come. We expect at Federated that there's a significant slowdown that's already in the works, whether it tips over into a recession is not our base case, but you can't rule it out. History of soft landings is short. There aren't many of them in history. Usually when the Fed tightens this much you get the recession, but it's quite possible that the particulars of the pandemic and the fiscal policy I just described forced all that recession.

Linda Duessel: All that extra money out there. And of course, however long it takes to run out, it certainly is being drawn down, isn't it? Considerably so as we look forward now, then what do we have as our year-end target GDP? What's 2024 GDP growth going to be, we think?

Phil Orlando: I think 2024, about 1.7%. Which is not a bad year. We're probably mid-twos this year, maybe about two and a half percent. So there'll be a deceleration, but again, where I think we differentiate ourselves from others is we've got this soft landing, rocky landing call as opposed to an outright recession. I mean there are a lot of our competitors out there that think that, well, we think a 1% growth rate for a couple of quarters next year is our best guess. A lot of our competitors have negative numbers, so it'll be interesting, get a bucket of popcorn to see how it plays out over the course of the next year.

Linda Duessel: Yes, that kind of dovetails nicely with the slowing down that you've both spoken of, but now let's look at the inflation fight and the CPI and the PCE inflation has come in more benign than many thought. It's come down very much apace here. So what are our thoughts for the trajectory for inflation next year? R.J.?

R.J. Gallo: I think huge progress has been made. At one point we had the year-over-year CPI, I think it was 9.2%, mid-year in twenty-Twenty-two, so it's come down a lot. The Fed is very happy with that. The bond market is very happy with that. We had a huge rally in bonds in November we just completed. A lot of it had to do with the fact that inflation continues to come in a little softer than many had expected or had feared maybe is another way of saying it. And the economy has clearly shown signs of decelerating. That caused the bond market to go on this huge rally in November as it, instead of being concerned about more fed hikes, they've switched to an expectation of fed easing. Where did we go from here? Jury's out. We started the year thinking that we'd have a CPI with a three-handle on it. That worked. We started the year thinking that bond returns would be modestly positive, not negative. That worked. It didn't feel like it was going to work in October, but as a result of November it has worked. And we think that inflation is still on a gradual path downward. The risk is that the easiest part of the inflation fight is behind us in this last percent or percent and a half to get back to the Fed's 2% area might actually be a little bit more difficult. We'll have to see.

Linda Duessel: Yeah, and Phil, just as R.J. is suggesting that CPE is down, but the fight carries on, how do we feel about that core CPI figure that had just come out recently?

Phil Orlando: Well, the reason the fight carries on is that a lot of investors make the mistake of thinking that the utilization of monetary policy to adjust things like inflation is flipping a light switch on and off. And the reality is, it's more like trying to turn a battleship in the ocean. I mean, we're a 25 trillion dollar economy. The cumulative weight of what the Federal Reserve has done over the last roughly two years now is taking the funds rate from zero now to 5.5%. We think that's probably terminal value. And the Fed shrunk its balance sheet from 9 trillion dollars. I think we're at about 7.8 trillion dollars right now. So it takes a while for that to sort of filter through the economy. So here we are now with the core inflation that you talked about, Linda, the PCE inflation, we probably peaked out at 5.5%, 6% a couple of years ago. We're sitting at about 3.5% now. So we're making good progress as R.J. said. But the Federal Reserve, if you look at their summary of economic projections, they've been saying, yeah, we're going to get to our 2% target, but by the end of calendar '26, well, that's three years from now. I think R.J., I think you'd agree the Fed's probably a little too conservative there. So I think that gets pulled into next year, 2025. So as R.J. pointed out, I think correctly, we've made good progress on this inflation fight and I think we're going to be where we want to be perhaps by the end of '25, not 2026.

Linda Duessel: And then when we look at the 10-year bond yield and what that is reflecting, R.J., And then what we have expected as a reflection of inflation, wow, it was up over 5% at the moment, wasn't it? And then a very spectacular pullback on yields out. What are we thinking about where the 10-year might finish next year and how that matches with the trajectory of however long it takes to get to 2% inflation? Yeah.

R.J. Gallo: Well, if inflation does fall closer to 2% by the end of 2024, some might think, well, does that mean the 10-year is down below 3-year? And I think the answer to that's no. I think that the post-pandemic world, we've seen higher inflation, more volatility of inflation. We've also seen plenty of optimism that productivity is going to pick up due to technological progress, specifically AI. And we also have huge demands for capital large structural budget deficits that have not been addressed in the United States, as well as big demands for capital relating to the green transition away from fossil fuels. All those factors suggest yields should be higher going forward than they were say three to five years ago. So the 10-year treasury can probably finish the year somewhere around 3.75%, maybe 3.50% to 4%, something in that range in 2024, even if inflation is down to 2%, that means that real rates are higher, greater demands to capital, larger budget deficits, faster growth due to productivity, all should lead to higher real rates going forward than we have experienced in the last decade. So that's a change admittedly, but for those reasons, I think that that's a reasonable expectation. It's relatively bond-friendly. You don't need a huge rally when bond yields, when the 10-year treasury yields 4.20%, you can get 4.20% with no price change. You got a 4.2% total return. It's not so bad. Now that incomes were restored to the fixed-income asset class, you don't just have to bet on price changes to generate your return. So even if we just go to 3.75%, that's still a pretty good return on a government security with relatively low credit risk.

Linda Duessel: And sticking with you, R.J., now, I'm stuck on something that Phil said about the Fed suggesting we want our 2% target and we will get it and we won't get it until 2026. And then I was just watching one of the financial programs just recently and they said, we're going to have a pivot party next year. There's going to be a pivot party because they're going to cut rates and just casually observing, they're going to cut this many rates and it's going to be now. Actually it's going to be six months from now. Actually it'll start 12 months from now. And what are our views here at Federated Hermes as goes the cuts?

R.J. Gallo: Yeah. Well, we've certainly flipped the script. Just a couple of months ago, people were very concerned that the United States Treasury is borrowing so much that they were going to keep pushing yields higher. The 10-year treasury hit 5% as you noted a few minutes ago. Then we got a few signs that the economy's decelerating and inflation keeps going down and that was enough, that as well as the Treasury moderating if you will, some of their long-term borrowing plans to unleash this massive rally in November. The market probably reversed a little too aggressively. They went from pricing in the prospect of another tightening into pricing up to 5, 25 basis point easings in the next 12 months. Our view, that's a little extreme. Soft landing outcome of the sort that we're calling for, should suggest to me that the Fed will ease. They won't ease five times. They probably won't even ease four times. Two to three eases to try to secure the soft landing as real GDP decelerates, but remains positive, sounds very reasonable. It maps really nicely to the last soft landing. Really one of the only soft landings you can find in history from Fed hikes, and that was in the mid-nineties when the Fed hiked drastically in '94 and then eased two or three times '95 up into '97 as sides of a slower economy emerged and it worked. They actually secured the soft landing. So I say two to three eases next year. That's less than what the market has priced in when we look for 2024.

There's an important and potentially interesting complication here in that next year, 2024 is also a presidential election year, and we took a deep dive on this a few years ago and found out that in the post-war era, the Federal Reserve is very reluctant to change monetary policy right in the heart of the presidential election for fear of injecting themselves into the process. And so the Fed historically, if they can avoid it, has tried to stay away from changing policy between Labor Day and the election. So as you take R.J.'s comments, which I totally agree with, and then overlay the presidential election cycle on that, that might suggest that we've got a second quarter GDP flash that's going to come out I think on July 26th. And then there's an FOMC meeting coming out a week later on July 31st. So I've sort of got that date circled on my calendar. But then you come up, the next FOMC meeting is not until after Labor Day, so the Fed probably avoids that, if they maintain their historical consistency. And then the election is November 5th, the FOMC then has another meeting two days later on November 7th. So I've sort of got that date circled on my calendar. So if R.J.'s right that we get two cuts and if the Fed's consistent with their desire not to interject themselves into the election, then July 31st and November 7th would seem sort of two likely dates that the Fed might be active.

Linda Duessel: And as goes the pivot party. Phil, you and I are both equity people. Are we rooting for cuts as equity people?

Phil Orlando: Well, so my colleague Steve Chiavarone has done a lot of work on this with his team in the multi-asset solutions area. And the Fed historically, or stock markets historically rip on pauses, but then things are a little choppier on cuts because the market reads through and says, well, okay, if the Fed's cutting, they must know something that we don't know in terms of a deceleration in economic growth or corporate earnings growth or whatever. So if the Fed does start to cut interest rates, let's say at the end of July, that suggests that maybe the late summer, early fall months might be a little rocky in terms of the read-through that the cumulative weight of what the Federal Reserve has done from tightening is starting to come to bear in terms of slower economic growth, slower corporate earnings growth.

Linda Duessel: And this is interesting also to what you said, R.J., as to cutting rates is a rare thing to do if you don't see a recession on the horizon, which is what I guess we're kind of betting on, and it maybe is appropriate given that real interest rates could continue to rise here if inflation does indeed come down and the Fed doesn't cut. So where do we have an opinion on where real interest rates should reside after we had them So very low for so long?

R.J. Gallo: Yeah, for a while there, certainly post pandemic or during the heart of the pandemic, we had negative real yields throughout the developed world, the U.S., Europe and otherwise, that is not a normal state of nature. The normal state of nature is to have positive real yields. If you look since the Volcker-era all the way up to just before the pandemic, there were plenty of periods where real yields at the 10-year spot of the curve were higher than 2%, and there were some periods when they were lower than 2%. I think it's fair to say a 1.5% to 2% real yield looking forward is a reasonable expectation. We're above that level now. We anticipate that as the economy decelerates and inflation keeps cooperating and moving down towards the Fed's target, we'll probably get some decline in real yields as well. In a world like that, if the underlying real yield is 1.5 or 2% and then you have inflation 2%, 2.5%, you can see how you get between say a 3.50% to a 4.50% sort of equilibrium nominal 10-year treasury in the long run. Obviously when periods are challenging in the markets, when there's risk, when the economy's decelerating, you might go much lower than that. Conversely, when the economy's doing strong, you might go higher than that, but I think that that's sort of a reasonable gravitational pull to think about 3.50% to 4.50% somewhere around there is probably an equilibrium nominal 10-year treasury going forward.

Linda Duessel: Okay, great. Well, now I think I'd like to move over to the corporate earnings side as we've spoken about maybe a slowing down of our economy in general, and then Phil, in terms of corporate earnings, are they reporting for 2023 or have they done as we expected and then how have we adjusted our expectations for next year's corporate earnings?

Phil Orlando: So the corporate earnings recession that we thought was going to happen has in fact happened and it looks like that process wrapped itself up by the middle of this year, calendar '23. So third quarter earnings in 2023 actually represented a positive surprise for the first time in about five or six quarters. So that was good. Revenue's a little better than expected and earnings were actually positive year-over-year. So as we saw that trend starting to materialize, we're still looking for 230 dollars in S&P 500 earnings for this year. We're looking for 250 dollars in earnings in calendar '24, and then we've got a preliminary working number of 275 dollars in earnings for calendar '25. Now, those may sound like big numbers, but they actually represent sort of a mid-single digit year-on-year increase. So I think the key here is that we are not calling for an outright recession, and we are expecting that the Federal Reserve is probably going to cut interest rates twice in the back half of next year, which will provide some impetus to economic growth in corporate earnings to improve in calendar '25. So the earnings recession probably behind us and we're making some slow and steady progress to do better over the next two years.

Linda Duessel: Yeah, yeah. And as you said, even if the third quarter was the first quarter where you had positive year-over-year, even the first and second quarters of 2023 surprised in a positive manner, and I think a lot of that may have to do with the strength in corporate profit margins. I think maybe just 1% below an all-time high now, was that strength in profit margins broad-based, and if so, why such a narrow market this year?

Phil Orlando: So a really good question. So while you had about four or five quarters in a row where earnings were negative on a year-to-year basis, they weren't as negative as the street was expecting going in. So I guess there was a positive surprise even though the earnings were poor. The margin question is a fascinating one, and we just got an update not too long ago on the progress of productivity and unit labor costs in the third quarter, and those are key contributors to the profit margin question, and the key trends there is that productivity improved and unit labor costs actually went negative. So the workers that are there doing a better job and they're costing their employers less money, so that is a positive for corporate profit margin. So if those trends continue at the same time that the Federal Reserve is beginning to ease policy and the earnings recession is behind us and the economy starts to do marginally better over the course of the next two years or so, all of that is good news for corporate earnings and that supports the estimates of 250 dollars for next year and 275 dollars that we have in place for the next couple of years.

Linda Duessel: So that was fairly broad-based in your view?

Phil Orlando: Oh, yeah, a great question. So technology probably enjoyed the greatest improvement in margins, and that I think dovetails beautifully with the performance of the Magnificent Seven that we saw, which drove equity returns as meaningfully as they did in the first seven months of this year. Those seven stocks roughly doubled in the first half of the year and the rest of the S&P, the other 493 companies were up 6% or something like that. So there was a significant divergence in performance, and I think to a significant degree aside from the AI FOMO argument is that these companies were enjoying a much more robust corporate profit margins and the expectation for growth because of the AI phenomenon, regardless of what was going on in the broader economy, led investors to get extraordinarily enthusiastic about this very narrow band of companies.

Linda Duessel: Boy, that's for sure. So in order for us to get the earnings expectation that we have for next year, then Phil, what are the keys that we're looking for to happen for this to occur?

Phil Orlando: Certainly you touched upon the profit margins, which we think have probably bottomed and are working higher. We've talked about the need for the Federal Reserve to execute this pivot, which you think is likely in the second half of the year, although at a much more modest pace than a number of our competitors. R.J. talked about the consensus view being 4, 5, 6 cuts over the next year or so. We just don't think that's going to happen. We think a couple of cuts in the back half of the year is more reasonable. And then our international partners, Europe, Asia, which are probably ahead of us by a year or so from an economic standpoint, they're probably already in recession now and over the course of the next year or so will be coming out. So that will allow us, I think to do a better job of trading imports and exports with those countries and potentially will lift our economic activity. So for all those reasons as you sort of put them together, those are the key things that we're looking at and we think we're on track to see all if not most of them.

Linda Duessel: Yeah, I think that could be an important point is that for the rest of the world, they're not doing as well as what we've been doing this year and really kind of migrating slower and slower towards a recession that could really be required next year, wouldn't you think, to keep our economy going?

R.J. Gallo: Yeah, I think that it's a bit of an outlet from... The inflation fighting has been global. Central banks in many economies that have tightened extraordinarily and are now pivoting in the path of easing. Right now there's more eases priced in for the ECB, for example, than the Fed because the Eurozone is just struggling economically more than we are here at home. I think ultimately a slowdown in China, which is very much underway, a slower growth path in Europe and even eventually Japan, it actually could be consistent with the idea of further disinflation in the US and some precautionary eases here in the US and a soft landing outcome. If we have sharp deceleration globally that is not consistent with continued inflation problems. That's consistent with disinflation. So that's what the Fed is expecting. That's probably what we're apt to see.

Linda Duessel: Yeah, fingers crossed that way. And Phil, my concerns about the profit margins being surprisingly high this year is that that many companies have enjoyed the ability to raise prices to pass on their inflationary costs. And because of all the stimulus monies that we've spoken about here, we've ponied up the money, we complain, and then we pony up the money and we fill the airports and we fill the restaurants and etc. And I know I'm not the only one out there shopping because malls even locally are full. So what I'm wondering is, and I just saw small business optimism index and business leaders, small business leaders are not in a good mood and only 25% have been able to raise prices. That figures come down a lot this year. They're unable to raise prices. And that Atlanta Fed wage tracker, I think has inflation for salaries 5%. Is this not going to be a more challenging year in 2024 to defend those margins?

Phil Orlando: Well, the 5% wage tracker number from the Atlanta Fed, and I think the Bloomberg consensus probably closer to 4%, those numbers are extraordinarily problematic for the Federal Reserve because when they are trying to achieve their 2% core PCE inflation target, the appropriate wage number in their mind is a number that has a three handle, let's call it three, 3.5%. So if the number is actually 4% or 5%, then that argues for the Federal Reserve sort of sitting on the sidelines higher for longer, which I think is consistent with our house view that the Federal Reserve is not going to be jumping in and cutting interest rates in March of next year because they want to take a patient, vigilant approach to make sure that these inflation levels, including wages, are coming down. Early in the pandemic, given the supply and demand imbalance and the issues with the kinks in the supply chain and like, and literally a couple trillion dollars of excess savings just sloshing its way through the economy, companies had no problem raising prices to recapture their additional cost of goods sold and their additional labor costs. It's a little more like hand-to-hand combat right now, but the administration, President Biden not too long ago admonished companies to stop price gouging. Now, I don't think there's any price gouging going on. Companies are doing what they feel they need to do in order to maintain their profit margins and reflect the fact that labor costs and commodity costs and the like are a lot higher today than they were a couple of years ago. So it's sort of a confusing landscape right now in terms of how this thing is going to shake out. We think that the trend, the deceleration longer term is going down, but timing and destination are uncertain points that we've just got to try to figure it out over time

Linda Duessel: And all that put together what is our year-end target for the S&P 500 in 2024.

Phil Orlando: In '23, we had expected that once the S&P 500 had achieved what we felt was a dramatically oversold 4,100 level in late October, we were all in, raised our equity overweight to 5%. We felt the S&P 500 would get up to the 4,600 level by the end of this year, and we're essentially there. So we're feeling pretty good about where the market is right now. As we look ahead to calendar '24, we think that stocks continue to work higher to the 5,000 level, not in a straight line of course. We think there's going to be a lot of variability and chop over the course of the year. We think the first part of the year is going to be pretty good based upon the fact that the market, I think will realize if they haven't already, that the Fed has hiked for the last time, that we are on pause. Stocks historically rip on pauses, so that we think will generate a decent first half. We talked about the summer months, late summer, early fall in terms of when's the first Fed cut and some concerns of variability going into the election. That tends to be choppy, at least it has historically. But then post the election, the market and presidential election years tends to enjoy a very strong year-end rally as investors and voters feel very excited about the change in leadership they've put in place and the prospect for better fiscal and fiscal policies that are more business friendly and market friendly. So 5,000 by the end of the year with sort of a barbell-shaped pattern over the course of the year.

Linda Duessel: Yeah. Yeah. And that is, as you said, commensurate what historically has happened during election years. Now election years, R.J., as versus the Fed, how does that going to play out in terms of their timing? What does history teach us there?

R.J. Gallo: Well, as Phil suggested earlier, the Fed does tend to steer clear of changing policy for maybe the two, maybe three meetings leading up to the November election date. They want the appearance of just staying out of the political fray. Chances are they'll do that again. When circumstances have warranted, they've departed from that behavior. During the global financial crisis in the 2008 election, the Fed was acting aggressively in all kinds of ways, easing, ultimately intervening in all kinds of ways. In September of 2008 when the markets were in distress, for lack of a better term, even though there was an election coming up, they didn't allow the election to force them to sit idly by and watch Rome burn. Obviously, our call is not for a reburning of Rome. Yeah, we're not thinking we're going to have another global financial crisis. Our view is that disinflation will work. I mean, I think if you look in 2024, there's probably about a 60% chance of our base case, soft landing. That leaves about 40 percentage points to be accounted for. So put 30% chance on the soft landing, becoming a little harder than expected, i.e, you get some sort of recession and a very low probability of the remaining 10% on a re-acceleration in growth in inflation. A world like that I think is pretty friendly for fixed income returns. That's probably pretty friendly for risk assets since our base case is the soft landing. That's a fairly investor friendly outlook for 2024.