Surprises to come

Linda Duessel: Well, I want to dive in a bit more with you, R.J., into the job market situation and the November jobs report, I guess some would say was mixed though you did have lower than expected unemployment rate and wage growth still strong. So should this concern the Fed or are there mixed messages as we're going into the new year with regards to job market?

R.J. Gallo: I think big picture, if you look over the last 12 months, there's been a notable deceleration in job creation, non-farm payrolls soundly below 200,000, especially when you adjust the most recent number for the returning strikers. the Fed is happy to see that. They're happy to see that the pace of job creation has moderated. It's very consistent with their objectives. A number of a hundred thousand non-farm payrolls per month is consistent with the general growth rate in the labor force. So any number higher than that is consistent with a pretty tight job market. Any number lower than that is consistent with an easing job market. So right now we still have a pretty tight job market. You look at the unemployment rate, having a three-handle on the unemployment rate historically is a very tight indicator. The Fed's estimate of the long-run rate of unemployment is, I think it's 4.1 or 4.2%. Right now, we're a good half a percentage point below that. So I don't know that it would concern the Fed as much as it sends, like you said, a bit of a mixed message. They're happy that job creation has slowed. I'm sure that the unemployment rate going down wasn't necessarily what they exactly wanted to see, but I do think that Chairman Powell and the rest of the FOMC have in their minds that a soft landing is achievable. So if they're seeing decelerating job growth and an unemployment rate that's not spiking, it's not going up rapidly, they're probably sort of happy with that. But I do think it's consistent with the view that the market has outrun the Fed in terms of policy expectations for '24. Does the Fed ease four or five times when the unemployment rate is not above four? No. So in order for the Fed to ease in a manner consistent with the market, you would need to see a sharp slowdown in all the above. You'd need to see job creation go negative. Non-farm pay rolls be negative. You'd have to see the unemployment rate rise fairly rapidly and well above 4%. That's when the Fed starts to get into inflation, excuse me, recession fighting mode instead of being in inflation resistance mode. Right now there's still in inflation resistance mode.

Phil Orlando: Linda, remember that the Fed has this dual mandate where they're trying to maintain low levels of unemployment and moderate levels of inflation. This is the so-called Phillips Curve tradeoff that we studied in business school, and if you sort of set the clock back 18 months or two years or whatever, you had the funds rate literally at zero and you had inflation spiking up to 9%. Well, that's obviously a problem. So the Fed started to raise interest rates with the hope of bringing that inflation down, but recognizing that the cost was that some people were going to lose their jobs and the rate of unemployment was going to go up and the hope was that you could try to find some happy medium. So here we are now with inflation, as we talked about nominal CPI inflation's come down from 9% to 3% over the last couple of years. That's great. The rate of unemployment has just moved up to 3.7%. That's not such a big deal. Federal Reserve's probably done raising interest rates with the funds rated in an upper band of five point a half percent. So the Fed's probably sitting there high-fiving themselves right now saying We did a pretty good job given the set of cards we were dealt in terms of managing that Phillips curve tradeoff.

Phil Orlando: One of the things that I pay particular attention to is what I refer to as the widening of the so-called K-shaped recovery, and the government in the monthly jobs report, they look at what they refer to as educated workers. Those who have college degrees or more. At the bottom of the cycle, their rate of unemployment got as low as 1.8%, and right now it's increased to about 2.1 or 2.2%. So just literally a couple of ticks off the bottom. Now, what they refer to as the uneducated cohort, individuals who were 25 years of age and over who haven't yet completed high school, their rate of unemployment had bottomed at about 4%, and that number's already up to about 6.5% right now. So you look at the data over just the last couple of months, disproportionately, businesses are holding on to their skilled labor and the folks that are losing their jobs tend to be those without the skills, without the education. So the point that you're bringing up from your consulting contact, that may play out over time, but at least this year, the data suggests that the skilled labor is still doing pretty well. It's the unskilled labor that's struggling a bit more.

Linda Duessel: Yeah, and as we look within the jobs situation, we talked about how the stimulus monies have been getting used up, and this is bringing back a lot of people that weren't working or were only having one job, maybe to have two jobs in the lower-income cohort. And of course we know that there were a lot of layoffs in the higher-income groups from the tech sector and companies that over-hired. But I saw an interesting statistic that looked at the biggest increase year over year in those filing for unemployment benefits. And it was for people making a 125,000 dollars or more. And I've been thinking about the labor hoarding that companies have been doing, labor hoarding still too high of wage hikes year-over-year, and they're concerned about their profit margins. And I've been reading about the potential for a rich session, a rich session instead of a recession where the more highly paid people are getting laid off. And I bring this up too, because it's a statistic that I saw that I thought was really very, very interesting, but I also spoke to a gentleman who was a senior regional manager for a big consulting firm. He said, I won't tell you what it is, but we have all these young people, and he said, why did they stop quitting, is what he asked me. We have maybe 3000 people in our company and we have 700 people more than what we need. And I just wonder if that's a drumbeat that we may start to hear more of next year as that labor hoarding has to be eased.

Linda Duessel: It has done for sure. And then of course, R.J., the other sticky part of inflation shelter, how's that going?

R.J. Gallo: It's making progress, although the rate of progress is diminished, the shelter impact on the PCE and the CPI inflation data is inferred in a sense from what's happening in the rental markets, rentals of homes, rentals of apartments, and the year-over-year rates of change in rents. At one point it was like 17%, it was outrageous, and that fed through over time into the inflation indicators. Now we're seeing the opposite. The year-over-year change is I think down to about 3, 3.5%, using data, for example, from Zillow, in a sense it's return to normal. There's actually greater risk that the rental inflation continues to decline because there was a large investment in multifamily housing, apartments, condos, etc. And now it's quite possible that the landlords out there to try to fill up their units, are going to continue to cut rents, and that ultimately is good news for the inflation fight. Lower rates of inflation from rentals feeds through over time, over six to 12 months into the shelter cost that's in the CPI and the PCE. Today's data, the shelter costs were still a little higher than that. I don't remember the exact number, but they were probably like 5%, I think it was around 5% year-over-year. Still a little high relative to probably what the Fed wants to see, but I just think it's a matter of time. I think that that actually is a tailwind for inflation progress. It should continue to persist going forward.

Linda Duessel: If not necessarily for those who want to buy a home, right?

R.J. Gallo: Well, again, this is the rentals feeding through to the purchase of homes. The actual price of homes is not in the CPI or the PCE, and right now you're dealing with mortgage rates that are still in the sevens. People who are trying to buy homes largely have had to focus on newly built homes because a lot of individuals in the much larger existing home market refinance their mortgages and have mortgages of 3% or so, and they don't want to sell that house, go out and get a mortgage at 7% and then move. So the housing market has been very severely impacted by the monetary policy changes with the surge in mortgage rates, sharply diminishing residential investment. And in the GDP data you saw residential investment had detracted from GDP for I think it was eight or nine consecutive quarters. It is now turning the other way because in the housing market with the upside down mortgages, most people have a mortgage much lower than the new mortgage they could go out and get if they moved. That has funneled all the activity into the new home market. So now residential investment is actually adding to GDP because we're building new homes, but the existing home market is sort of in stasis. The impact on the CPI and the PCE from that doesn't come straight out of those markets. It comes from the rental markets. So it's an inference on shelter cost. It's not a direct observation on what's going on in the price of a home.

Phil Orlando: We've seen a significant divergence between the purchase market for single-family homes versus the rental market for multi-family units for exactly the reason R.J. talked about. We're underbuilt by something like four or 5 million single-family homes across the country. Yet we've made a significant improvement in multi-unit, multi-family rental units. So on the purchase side of the market, just last year we were at all-time record highs in prices. As R.J. pointed out, mortgage rates have nearly tripled from 3% to 8% before they peaked out. The affordability index for the rental market or for the home market hasn't been this bad since the mid-1980s. So you put all of that together for that marginal home buyer, that sort of forces them out of the purchase market into the rental market, maybe to rent a multi-family unit for another couple of years until they get a bigger down payment or whatever. And that to a significant degree, that dynamic is driving some of the shelter components of the inflation data that R.J. is talking about.

Linda Duessel: Okay, so now let's stay with you, Phil. What then is our bottom line in terms of stock positioning for the market for 2024, favorite style sectors? I think you did mention that we're suggesting an overweight on equities.

Phil Orlando: We do have an overweight in stocks. We got aggressive when the S&P got oversold, we thought at the 4,100-level, sort of mid to late-October. And our view was that the balance of this year and over the course of calendar '24, we would see a significantly broadening out of the rally, that it wouldn't just be this very narrow sliver of the Magnificent Seven technology names. And frankly, from my perspective, they really got overbought. So we felt that over time the market would sort of figure that out and domestic large cap value, small cap and international stocks as a group that are probably 40 to 50% below where they should be trading would start to catch a bid and that would manifest itself over the course of next year.

Linda Duessel: So lots of bargains out there outside of the Magnificent Seven, that could really help for the broadening that could really fuel next year. That would be great news. Then how about on the fixed income side? What is our bottom line in positioning if we're 2024?

R.J. Gallo: Expectations are for favorable fixed income returns where yield has been restored to the asset class after a very long period of time where if you wanted a positive total return, you had to expect yields to go down and prices to go up. Now that yields, 10-year treasury is around a 4.40%, the yield on the Barclays aggregate index is well above that, if you buy a bond now you can get income and if prices don't change, you're in the mid-single digits. That's a much more attractive place to be for a fixed-income investor. We think that bonds will start to behave in a manner where they did historically, going back beyond 10 years ago when you had Fed interest rates well above zero, when you had significant income in the fixed-income asset class and then your bonds don't move in lockstep with your stocks. Over the last number of years when the Fed went into extraordinary easing during the pandemic, bond prices would go up, stock prices would go up. During the period of the Fed's inflation fight, you had the opposite. As the Fed was raising rates, bond prices went down as yields rose and stock prices went down. That has not been a good environment for the investor because it gets very difficult to manage risks through any form of diversification. Some return to a more normal environment where you have bond yields that are in the mid-single digits, where you have income from your fixed income suggests to us that fixed income will have a place they don't have to move the returns on your bonds don't have to move in lockstep with your stocks. Diversification as a strategy should come back for investors. In terms of duration, we've been long or neutral all year. We were long when the 10-year treasury hit over 5% yield, we've paired back to neutral once it got down below, say 4.50% or 4.40%, we're at neutral now. Looking out into 2024, given our economic outlook, we are going to be neutral to long duration probably for the next 12 months, more likely than not, unless something comes along to surprise us. When it comes to sector, we're overweight mortgage-backed securities on valuation, and we're underweight corporate related assets. So high-yield corporate, investment grade corporate, not because we think that the credit quality is falling off a cliff. There's been an increase in default rates in high yield, but we think it'll be somewhat manageable. We just don't think the valuations compensate you for the risks to corporate profits and to the downside as the economy decelerates, if we go into a recession, then we would think investment grade corporate and high-yield bonds will really underperform. If we had that soft landing, high yields probably more of a question, investment-grade might do okay. But for now, we're underweight both as we have to see how things unfold on that side.

Linda Duessel: Kind of pricey.

R.J. Gallo: Yeah. It's evaluation question, not a concern.

Linda Duessel: Not that we don't have time to discuss in any depth our views on the geopolitical risks out there, it's a very dangerous world that we live in, but what I'd be interested from either of you is what do you think is priced into the stock and bond market right now? Is it priced appropriately for whatever may happen?

Phil Orlando: Well, I think the unknown unknowns are that the Israeli situation is evolving on a daily basis and I don't think the market's pricing an expansion of what's going on there. And then you've got the whole Russia-Ukraine situation that's been dragging on now for almost two years. And then there's the horizon uncertainty of what China may or may not do with Taiwan at some point in the future. So to your point, Linda, the world's a dangerous place. I don't think the market, from my perspective, has a somewhat laissez-faire approach to all of these hot spots right now. And if things get uglier, certainly that could represent an air pocket for the market at least for a short period of time.

Linda Duessel: And I think I'd like to ask you then, R.J., not so much about the geopolitical, but the elections, and I understand that next year will feature many, many elections worldwide and a really interesting one here or is it going to be interesting and does the market really care at the moment at all about our election?

R.J. Gallo: I think the markets clearly will care. I think right now we're sort of in an early phase. President Biden has people in his own party suggesting that he shouldn't run again. Former President Trump has support a number on the Republican side of the aisle, but certainly not all. There are plenty of people, including very large donors who are looking for an alternative to President Trump. I'm not sure how the path will play out, whether or not we will have the most likely outcome, which is a Biden-Trump rematch, or will something change? Will President Trump's legal challenges produce some shifting in support to an alternative candidate on the Republican side? So far that hasn't appeared to happen, but if he gets indicted, if he gets found guilty or convicted of a felony, maybe it will. Does President Biden stand down? If President Trump, former President Trump is viewed as less likely to run, it's quite possible Biden would pull a Lyndon Baines Johnson and would not seek and would not accept the nomination from his party. It's just too early to know. I don't think markets traditionally start focusing, start behaving in a manner in which they're moving on election outcomes until the election gets a lot closer. This one is particularly unusual because it's a potential rerun of the prior election, and we have some very unique circumstances surrounding both men.

Phil Orlando: And talking about that unique nature, let me throw another curveball in. You've got independents right now, which are the most populous group of registered investors at about 45%. Democrats and Republicans are roughly about 25%, which has never been the case. And so you could legitimately have a third party bid. There's been some scuttlebutt about Joe Manchin who not too long ago announced that he wasn't going to run for election in the Senate in West Virginia. Well, that wasn't a surprise. He's 30 points down in the polls there, so it wasn't really that magnanimous, but he's got quite a national following. He could launch a third party bid. I've heard speculation that retired Republican governor Larry Hogan from Maryland or soon to be retired Republican Senator Mitt Romney from Utah might be on the ticket with him. That would be a very interesting alternative to a Biden-Trump rematch. So the next 12 months or the next 11 months is going to be extraordinarily interesting in terms of how this thing plays out and how the markets ultimately respond to it.

Linda Duessel: I know we really like election season. I can't possibly wait. I'm buying a case full of popcorn, all different flavors. I think it's going to be too much. Let's have fun with it. Let's have fun with it. But it's interesting though, geopolitical risks and the election and markets like, whatever, we'll deal with what we know at the moment. That's very important that way. So just as we conclude our time together, I just wonder, and I think I'd throw this to you, R.J., in terms of the ever-increasing debt and budget deficits, and I get this question almost all the time when I travel, when are we going to have to pay for this largesse? Do we have any idea on that?

R.J. Gallo: It's tough. I've been in the markets in some form for over 30 years. At one point I worked at the Federal Reserve System in an ex-Department of Commerce, Secretary Pete Peterson wrote the Federal Reserve Bank of New York, the head of the Federal Reserve Bank of New York, and he sent the letter to the Fed's Trading desk, of which I was a member and asked this very question. It was 1996. The debt to GDP was less than 50%. Mr. Peterson was very concerned that it was so high and that the markets were mispricing, the long-term risk from a credit risk standpoint of the United States government, he thought yields should be higher. How can they possibly be this low? Fast-forward to today, we have debt to GDP in excess of a hundred percent, well in excess. If you look at a gross debt to GDP, if it's net, it's closer to a hundred, net being the Social Security Trust funds and the Fed's holdings. So the debt to GDP has more than doubled over that timeframe. We're coming off a period when yields were their lowest during the pandemic in 50 years. Common sense would suggest there has to be a limit to this. There has to be a point where a trillion and a half or 2 trillion dollars in deficits each year, which has to be borrowed to be financed, will eventually have a market impact. And as recently as September and October when yields were rising rapidly and many people were wringing their hands as to why, the treasuries borrowing the large structural deficits were credited as one of the key factors that kept driving yields upwards. Here we are yields are almost a hundred basis points lower. We haven't addressed the deficit at all. I think ultimately it is starting to matter. I think that the prospect of higher post-pandemic yields than prior to the pandemic is in part linked to the capital that is being sucked up, if you will, by the United States Treasury as we have a large structural deficit. I don't know if one could predict exactly the point when the US bond markets will go through a sharp correction, higher yields, lower prices linked solely to the debt. But the pattern is clear. We've been downgraded by S&P about 12 years ago. We were downgraded by Fitch most recently. Moody's put us on negative outlook. It's pretty clear that debt to GDP north of a 100% has sort of the arbiters of public market debt, the ratings agencies, telling investors that this is not your parents' government anymore when it comes to this credit worthiness. Now, AA Plus, Aa1 is not a junk bond, but it is already starting to matter. And I think that investors need to take that into account. I wish voters would take that into account. People should vote in a manner that would lead to better fiscal outcomes. I think that would be better for the long-run trajectory of the country.

Phil Orlando: R.J. makes some, I think, critically important points that you just go back to the beginning of this century, not that long ago, President Clinton passing the baton to President Bush, we had approximately 10 billion dollars in debt. As you said, the debt to GDP ratio at about 50%. Here, we are now at 33 trillion dollars in debt. So in the first 230 years of our country, we amassed 10 trillion dollars in debt. Over the last 15 years, we've added 23 trillion dollars. I mean, that's not sustainable. And I couldn't agree more with R.J. that this is an issue that's real. It matters. It matters now. And voters are going to have to wake up to the unsustainability of that trajectory of adding debt and the debt to GDP ratio. So it's a real issue and I think it becomes a significant issue as we get into the debates and the nomination process and ultimately the vote in November next year.

Linda Duessel: Okay. Well on that note, thank you so very much Phil and R.J. for a wonderful and robust discussion. Of course, thank you to our listeners. We look forward to you joining us again on the Federated Hermes Here and Now podcast. If you enjoyed this podcast, we invite you to subscribe to our Federated Hermes channel to get every Here and Now episode. I also encourage you to subscribe to our weekly insights email for the latest market commentary from the many great minds at Federated Hermes. And follow us on LinkedIn and Twitter.