How might factors like higher interest rates, still-strong economic data and war in the Mideast affect financial markets? Bernstein’s Matt Palazzolo shares his perspective.
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Stacie Jacobsen: [00:00:00] Thanks for joining us today on The Pulse by Bernstein, where we bring you insights on the economy, global markets, and all the complexities of wealth management.
I'm your host, Stacie Jacobsen. [00:00:15] In our last episode, we had Bernstein's chief economist, Eric Winograd, on the show to give us an update on the state of the economy and his outlook for 2024.
Now, while there hasn't been a drastic shift in the state of the economy since that [00:00:30] conversation, there has been additional data released and coupled with current events.
Many investors are asking what's next. So our guest today is going to offer his perspective on the impact of these events to the financial market.[00:00:45]
And today is Matt Palazzolo, senior investment strategist here at Bernstein.
And many of you will recognize his voice as the previous host of the show, Matt, good to have you back.
Matt Palazzolo: Oh, it's wonderful to be here, Stacie. Thanks for having me on.
Stacie Jacobsen: All right. Now on our last [00:01:00] episode, we did have Eric Winograd on to discuss the current state of the economy and his outlook at that point in time.
Since then, there have been additional data points that have been released and the horrific war between Israel and Hamas broke out.
So [00:01:15] let's start today with the recent data and then I would like to ask you to give your assessment of the economic impact of the war.
Matt Palazzolo: Yeah. The two major data points that we had over the period of time, since you spoke to Eric, we had a labor market report for the month of September and a [00:01:30] CPI report, i.e. an inflation report also for the month of September.
And both those data points were consistent with what I know Eric told you, when you got together, the economy in the United States continues to be robust.
The jobs market in the United States, we added [00:01:45] more jobs than were expected and inflation while not.
Terribly hot, as we call it in the industry, was a little bit higher than anybody would like to see at this point after the Fed has raised rates as much as they have.
So this all leads to the [00:02:00] continuing narrative that the economy in the United States is stronger than anybody would have expected, or should I say another way, more resilient than anybody would have expected given all the headwinds, uh, that, that we faced over the last 12 to 18 months.
Add on top [00:02:15] of that, as you mentioned, this, this terrible war between Israel and Hamas and, and the humanitarian tragedy that, that is.
You know, we're getting asked the question, which I'm sure is on your mind, all of your listeners mind about what's the Economic impact again, [00:02:30] apart from the humanitarian tragedy, the economic impact.
When we get into any type of conflict, we look at what's the what's the transfer mechanism into the economy into profitability for companies for sales for [00:02:45] companies.
And for this war, it really is the energy market.
It's oil prices, given the location in which it is occurring at this point in time, based on all of our checks and all of our conversations with analysts, there has been no interruption to the [00:03:00] production of oil over the last couple of weeks.
Um, but we have to watch that closely. I think the two major risks that we're watching as it relates to oil. Over the foreseeable future.
First of all is whether or not there's on the U. S. [00:03:15] side, any fingering of Iran for their role in the lead up to the war.
And if there is that, that it may lead to a stricter enforcement of the sanctions that have already been levied against Iran in the production of oil.
[00:03:30] And then second. Any disruption to the flow of traffic through the Strait of Hormuz, that is a major throughput for energy, uh, and oil in particular.
And so if that happens, then that, that or the prior issue around [00:03:45] sanctions on Iran and their production may lead to oil prices moving somewhat meaningfully above 100 a barrel.
Stacie Jacobsen: That’s helpful. Thank you so much. And as you have said, the economy has been able to really stave off countless headwinds, yet we [00:04:00] still are anticipating this recession that might be one of the most widely publicized in the history of recessions.
Where is it? And where do we stand?
Matt Palazzolo: Yeah, you're right. It's probably the most widely publicized recession that at least to this point hasn't occurred.[00:04:15]
The economy, at least in the United States, has been, as I mentioned a moment ago, very resilient. It's still in the offing. It's still out there.
It's not with us at the moment. And the reason why really comes down to the U. S. consumer. The [00:04:30] unemployment rate in the United States is still comfortably below 4%.
So the vast majority of Americans who want to work have a job now. They've been getting wage increases, they're working more hours.
So, despite all of the [00:04:45] inflation that we've had over the last 18 months, the U. S. consumer has been able to, um, earn enough.
In order to offset the cost increases. Couple that with the fact that there were these transfer payments in the wake of COVID [00:05:00] that made U.S. savings balances larger than they otherwise would have been.
And so consumers are also paring that down or been able to use those savings balances in order to go out and spend.
And so that's what's really kept the economy as resilient as it [00:05:15] has been over this period of time.
Now, all that being said, it is our expectation that the U.S. economy will slow.
Thank you. during the balance of 2023 and into 2024. We don't see how it doesn't. There are just too many headwinds. The FOMC raising [00:05:30] interest rates as much as they have.
That's one major headwind. Those savings balances that I mentioned are pretty much pared down to the level that they were at pre COVID.
So that's another headwind. We also have student loan repayments that have increased.
So there's [00:05:45] a number of issues that we think lead to a modest slowdown in the U. S. economy, and we'll be pretty close to what the people in our industry call a recession.
Whether or not it ends up technically being one, it'll be slow enough that [00:06:00] we'll see it and we'll feel it in many parts of the U.S. economy.
Stacie Jacobsen: We'll certainly feel that slowdown. Now might be a good time to remind us of that technical definition of a recession. What
Matt Palazzolo: is that? The non technical definition is that we have two consecutive quarters of negative GDP.
But [00:06:15] that's not what the National Bureau of Economic Research or the NBER actually uses.
They use a whole host Of economic metrics that they look at from, um, the rise in unemployment rates to consumer spending and a whole host of issues.
So there's not [00:06:30] one single definition that has to be met and either you check that box or you don't check that box.
So they're looking at a number of economic metrics and if they turn meaningfully downward, then that organization determines a start to the recession and then ultimately [00:06:45] once it gets a little bit better and end to the recession.
Stacie Jacobsen: All right, let's talk about another surprise in September. I'd say that was a move in interest rates in the long term. Why did that occur?
Matt Palazzolo: Yeah, so interest rates certainly didn't move up. So, you know, if we were to say at [00:07:00] the beginning of the summer, just to have round numbers, the 10 year treasury rate as a Proxy was right around 4%.
If I look on my screen right now, we're upwards of 4. 8%.
So there was a meaningful move higher in interest rates. I'd argue that the [00:07:15] vast majority of the reason why is because the economy has just gotten stronger.
And that's moved real interest rates higher to reflect the strength in the economy. And that's despite inflation slowing over that same period of [00:07:30] time.
So we have seen a backup in, in interest rates. It's our opinion that we're closer to the top during this cycle, particularly given that we do believe that.
The economy is going to slow and when it does over the next three, six [00:07:45] months or so that should push money into bonds because there's often a flight to safety.
And as all your listeners know, when, when bond prices go up, yields tend to fall.
So we think right around these levels of 4. 8 percent is likely to be. Close to the top, if not the [00:08:00] top
Stacie Jacobsen: right now, the FOMC is meeting again November 1st. So where do you think rates are going to go at that meeting and what might
Matt Palazzolo: make them move?
Yeah, I have conversations with our economist as you do as well, Eric, and he would say it's a pretty [00:08:15] close call for this next meeting.
If he has a bias, he's leaning more towards that the FOMC will not make a move, that they will not hike, and that they would push off until the next meeting, which I believe is in December, to collect even [00:08:30] more data points on the economy to see whether or not another 25 basis point hike is justified.
I think what will give the FOMC some air cover to not hike at this next meeting in November is that. Interest rates in the [00:08:45] marketplace have moved up as much as they have that tightens financial conditions.
And so you could argue easily. And in fact, many Fed governors and Fed presidents have made the same argument within the last 10 days or so that the market is doing the [00:09:00] FOMC's job for them.
By moving interest rates up for the 10 year to move as much as it has that that helps to slow down the economy, push up borrowing costs.
And so maybe that incremental move is unnecessary because longer term interest rates have moved [00:09:15] up themselves.
Stacie Jacobsen: Got it. So given everything you've told us this far, there's a tremendous amount of cash on the sidelines is now a good time to move into bonds.
Matt Palazzolo: We would argue that that it is. And this is I want to be particular with my word [00:09:30] choice here.
This is really for longer term investors that have, for whatever reason, accumulated in excess amount of cash in money market funds. To be honest, money market funds provide, at least at this point in time, an attractive [00:09:45] yield.
If you're in a government money market, you're looking at something north of five and a quarter percent. That being said, that money is taxable.
So a taxable investor has to consider the after tax return on that five and a quarter percent. But then for longer term investors, where [00:10:00] Cash or a meaningful amount of cash is not in your long term strategic allocation.
We think the yields that you're getting today, four and a half, five, five and a half percent are particularly attractive.
And yes, you have to take on interest rate risk, meaning interest rates might go [00:10:15] up and there might be some temporary degradation of price, but it could have worked the opposite way.
And in fact, we think it will work the opposite way in that interest rates will start to move down.
As the economy slows, and so not only will an investor who's moved money out of money [00:10:30] market funds and further out to intermediate duration bonds, not only will they collect that attractive yield, but also collect some incremental price appreciation if we're correct, that interest rates will move down.
So this is all a tightly fitting [00:10:45] narrative that the economy slows, interest rates move down.
And there's some nice capital appreciation for those investors who are moving back to their long term strategic allocation, if that's the right place to be.
Stacie Jacobsen: So how does that affect the stock market? [00:11:00] What are your expectations over the next year?
Matt Palazzolo: Yeah, so I guess the other side of the coin that we have to think about for our clients is not only fixed income, but also the equity market.
So if we were to assume that interest rates were to come down, that the economy is going to slow, but not going to [00:11:15] into a meaningful recession from here over the next 12 months or so, it's our belief that The U S stock market, just as a proxy will maybe have a bumpier ride for the next handful of months.
Nothing terrible, not a meaningful sell off.
We've already had [00:11:30] somewhat of a pullback over this period of time, but from here that the market could appreciate high single digits between, you know, the fourth quarter of 2023, all the way through until the end of. 2024 that assumes a modest amount of earnings growth, not [00:11:45] much on valuation change.
So P. E. Ratio should be right around where they are today.
But given the resilient economy that's slower from where it is, but lower interest rates, we think the market, you know, more towards the back end of that forecast period can appreciate [00:12:00] high single
Stacie Jacobsen: digits. So for those investors that do want to get into the market, or at least stay in the market, but have some hesitation are worried about risk management.
What might they be looking into invest in?
Matt Palazzolo: Yeah, so I think there's a couple of ways to answer that question.
First of all, [00:12:15] there's a approach which many of our clients utilize, which is just dollar cost averaging.
So if we were to assume that the next handful of months are going to be a little bit choppy or range bound, then it would be in their best interest to [00:12:30] dollar cost averaging, put a little bit in over a period of three or four or six months in order to take advantage.
If there is a Slight sell off in the market to be buying lower.
In addition that, you know, you have to think about the long term strategic allocation of that client, but you know, there are [00:12:45] opportunities and different strategies where you can have equity market exposure, but some protection when and if there is some volatility in the market, whether that be a hedged equity product or something as some type of alternative, if it's appropriate for that client, something that [00:13:00] does provide less volatility.
But still some upside participation if by the end of that forecast period we're right and the markets are up high single digits.
Stacie Jacobsen: Okay, so we've talked about the bond side of the portfolio, the stock side of the portfolio, you know, [00:13:15] for those investors that can take on some illiquidity, what opportunities are out there today?
Matt Palazzolo: Yeah. So we've been an advocate of alternative investments.
You noted illiquidity, so illiquid alternative investments beyond just publicly traded stocks and bonds for, for quite some [00:13:30] time.
We think they add diversification to stocks and bonds, and in some cases, incremental return above and beyond what you can achieve just through a plain vanilla stock and bond portfolio.
At times when you have dislocation or opportunities because of some [00:13:45] distress, then those returns can be higher.
Again, there's an illiquidity trade off that investor has to be willing to take on at that point in time. At the moment, commercial real estate is one of those areas that we think is certainly in the crosshairs and concerns [00:14:00] for many investors.
Given the rise in interest rates and the challenges certainly for the office market, but we've been advocating for that sector for some time now, given the fact that office is only 15 percent of overall commercial real estate [00:14:15] and prices are down somewhat 20%, depending on the region and depending on the sector and for an investor to perhaps lend into that opportunity, provide, thank you.
Liquidity where there has been a drying up of liquidity, then we think the [00:14:30] return should be good for the foreseeable future.
Same thing for loans to private corporation or sometimes called private credit, that's an area that we've recognized, given the stresses on the small bank or regional bank system, that there's [00:14:45] been a lack of liquidity into the areas that traditionally borrowed from the banks.
And so at points in time like this, we want to step into that void, be lenders into that illiquidity, and hopefully you're likely to get higher returns than you otherwise would in normal [00:15:00] times.
Stacie Jacobsen: All right, Matt, thanks so much for joining us today.
It was great to have you back. And thanks for letting me turn the mic on you.
Matt Palazzolo: Thanks a lot, Stacie. Good to be with you.
Stacie Jacobsen: That's all for this week on The Pulse.
Thanks again for listening. And please remember to like, share and subscribe. We'll be back in [00:15:15] two weeks with another episode. So don't forget to tune in.