Get your popcorn ready

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. So as our macro policy committee sat down a couple of weeks ago to sort of get into the weeds on that, we said, you know what, we think the weight on the economy over the next couple of quarters is slower, not stronger. And so at Federated, we're forecasting roughly a 1.5% GDP in the fourth quarter, and then we've got essentially a 1% run rate in the first three quarters of next year. So our best guess is that that 5.2% number in the third quarter was abnormally strong. It was a head fake and we think the trend is much slower over the next year or so.

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.

Phil Orlando: 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.

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.

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.

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: 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.