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November 2023 / VIDEO

Asset Allocation Viewpoints Webcast - Mixed Signal: Soft Landing or Recession?

Transcript

Hi, everyone. As we mentioned at our last webcast, Chris Dillon has taken a new role in the Fixed Income Division. So congrats to Chris. I am pleased to announce that we have a new moderator for this quarterly webinar—Christina Noonan.

Christina is an associate portfolio manager in the Multi-Asset Division, and she's the lead writer for a document that I'm going to bet most of you are reading. It's our Asset Allocation Viewpoints, which actually is the most read piece of content that T. Rowe Price publishes. Christina, welcome, and over to you.

All right. Thanks, Sébastien, excited to be here, and thanks, everyone, for joining us for today's Asset Allocation Viewpoints webcast, Mixed Signals: Soft Landing or Recession? At the start of 2023, recession concerns were top of mind for many investors. Since then, resilient U.S. economic growth has been bolstered by strong corporate and consumer balance sheets, a solid labor market, and fiscal support measures. Meanwhile, the Federal Reserve has remained hawkish, and we've started to see evidence that Fed policy and higher rates are finally slowing the economy. Is this telling us that the Fed is potentially navigating a soft landing or that we're headed for a deeper recession at the lagged effects of monetary policy continue to take hold?

So with that, now a quick review of T. Rowe Price's Multi-Asset Division, the host of today's discussion.

The multi-asset group is an experienced team of professionals responsible for managing more than $450 billion in multi-asset strategies. Highlights of the platform include over 25 years offering multi-asset solutions, more than 80 dedicated investment professionals, and over 240 individual portfolios managed. Some of the key features of our multi-asset investment approach include strategic portfolio design that is complemented by tactical asset allocation process with 6- to 18-month time horizon, as well as active security selection in the underlying portfolios, and a range of overlays and alternative strategies designed to enhance the risk return profile of our multi-asset portfolios.

Now let's introduce our panel for today's discussion. As Sébastien mentioned, I'm Christina Noonan. I'm an associate portfolio manager in the Multi Asset Division. My role in these webcasts is to help provide a broad perspective into the views of our equity, fixed income, and multi-asset investment groups here at T. Rowe Price.

Joining us for today's discussion is our head of Multi-Asset and CIO Sébastien Page. And today's special guest Blerina Uruçi. Blerina is T. Rowe Price's chief U.S. economist in the Fixed Income Division. She contributes to the formulation of investment strategy and supports investment and client development activities throughout T. Rowe Price while specifically focusing on the U.S. economy, inflation, and monetary policy.

Thanks for joining us today, Blerina.

Thank you for having me. It's a pleasure to be here.

Of course.

Sébastien Page is head of Global Multi-Asset and chief investment officer, overseeing a team of investment professionals dedicated to a broad set of multi-asset portfolios. He is also a key member of the Asset Allocation Committee, which is responsible for tactical investment decisions across our suite of asset allocation portfolios. Sébastien is also an author of award-winning research papers as well as an in-depth book on asset allocation called "Beyond Diversification."

Thanks for joining us again today, Sébastien.

Thanks, Christina. I am fired up. This is—I was thinking it's my favorite thing to do in my job. This webinar specifically. We're already getting questions. We already have four questions, and some of them we're actually going to hit, I think, along the way, but very happy to be here today.

Great. Looking forward to it. So for today's discussion, we're going to focus on three broad areas: first, whether recent data is suggesting a soft landing ahead or a harder landing into a recession; the key risks and considerations for each of these scenarios; and, as always, we'll discuss what this means for asset allocation and tactical positioning in T. Rowe Price multi-asset portfolios. We've got a lot to cover, so let's dive in to our discussion.

So, starting with you, Sébastien. A lot has changed in the market since our last webcast in July—notably, the sharp runup in rates and economic data remaining resilient, although showing some cracks but still well above pre-COVID levels.

In our last webcast, you described yourself as a reluctant bear. How would you characterize your views on the market today and, importantly—you tend to disagree with some of the popular narratives of the moment—which narratives do you disagree with, and why?

So I'm trying to shed the reluctant bear moniker. I used it early in the year on CNBC, and it's it, it's sticking in the narrative, in the ether, and I keep being invited back on CNBC to talk about why I'm a reluctant bear. So thanks for mentioning it.

You know, it may sound boring on financial TV, but the macro distortions are as high as ever. So now is not the time to be a hero.

We're actually now in our asset allocation portfolios, only 75 basis points underweight stocks relative to bonds. So a 60% stocks portfolio would be at 59.25%. And, in fact, when you add our overweight position to credit and high yield and other well-valued, well-priced asset classes, we actually end up being neutral on total portfolio risk.

So it's a bit boring, but it's appropriate. You know, my dentist sometimes asks me for investment advice—and this is not the beginning of a joke. It's just like, it's true. My dentist asked me for investment advice, and when you only have a few seconds, what do you say?

What do you tell your dentist?

I always say, "Stay invested. Stay diversified." It's trite advice, but it's relevant in the current environment. It's a good way to think about the macro distortions we're going through. Stay invested. Don't panic. Stay diversified.

Growth continues to surprise on the upside. I'm sure Blerina will talk about this. And, by the way, Blerina, thank you for being here. Blerina just flew back from London, so I really appreciate it.

But growth is surprising on the upside and, you know, we have yet to feel the full effects of higher rates. In fact, I don't know if most of you realize: This has been the longest yield curve inversion, in terms of the number of days, in history.

Now, you mentioned, I disagree with some of the popular narratives.

I wonder where you stand, Blerina, on some of them, and maybe we'll disagree on some of them.

The first one that I'm not prepared to say that I agree with—is another way of saying I disagree, I suppose—is the job market is softening. This is a popular narrative. We've heard economists say for eight, nine, 10 months, "I see cracks in the labor markets. I see cracks in the labor markets." And somehow these cracks aren't really cracking.

So I disagree that the job market is softening, at least for the next maybe three, four, five, six months. It's normalizing, but it remains strong and may remain strong for longer than expected. We're going to pull up a slide that shows the evolution of the unemployment rate over time. So we're at 3.8%, significantly below the historical average.

And now here's another slide where we're going to show more detailed data. Claims for new unemployment are near the bottom of their pre-pandemic range.

Nonfarm payrolls, new jobs created are near the top, and job openings are basically pretty close, Blerina, to an unprecedented level. And moreover, so you look at this and it shows a hot labor market even if economists have been saying we're seeing cracks for 10 months or more.

If you look at the latest data from the last few weeks, as we're recording this, claims are going down, not up. New farm payrolls, new jobs are going up, not down, and open jobs surprisingly, just ticked up, not down. So I don't know if the labor market is softening at this point. 209,000 jobless claims last week, same range for the last three months.

And the trend in new jobless claims is actually down since June. So that's a low number. For the 20 years leading to the pandemic, the monthly average was 345,000 jobless claims per week.

So compare that to the 209 number we just printed. Job openings are at 9.6 million—9.6 million open jobs, and they just ticked up, not down, as I mentioned. The pre-pandemic average, if you look at 2000 to 2019, for job openings was 4.5 million, and the max we ever hit before the pandemic was 7.6 million. So 9.6 million open jobs is a very high number.

It means that if everyone who's unemployed found a job, we'd still have about 400 million openings. Nonfarm payrolls surprised last week on the upside at 336. The 10-year pre-pandemic average was 180k.

OK. A lot of these data are backward-looking.

Blerina might have more leading indicators of unemployment, and we might discuss if we're seeing cracks or not, but overall, the direction of things—even over the last few weeks—makes it really hard to say with conviction that the job market is indeed softening, even though it really should given that we've had 500 basis points of rate hikes. But it doesn't look like it is.

Second narrative I disagree with is the inflation dragon has been slayed.

Inflation is a risk that's behind us. My view is that, yes, inflation is coming down. Blerina'll probably agree with that because the data showing that it's coming down, so consider this the base case. But, again, backward-looking data, but still the last two months' headline, if you just analyze the number for the last two prints, is running at 6% annualized. If you are familiar with nowcasting, these are methods, econometrics to try to get a live picture of inflation.

The last number from the Atlanta Fed, you can get it online, for core inflation is at 4%. So we know the employment market is still strong, as I just explained. We know there is upside risk to oil prices, especially with rising geopolitical tensions. We know the demand for services remains pretty high, and curiously, house prices—with 8% mortgages—actually going up, not down. So things are moving in directions that don't necessarily agree with popular narratives. And this speaks to the macro distortions.

The trade here for tactical asset allocation that we've implemented in our Asset Allocation Committee is to buy real asset stocks. So this is a diversified portfolio of energy stocks, metals and mining, REITs. It has attractive valuation as an asset class, real asset stocks, a strong inflation response, and over time, you get the tailwind from equity beta, that you get, you know, better long-term expected return than you would get from TIPS, for example. It was one of the questions—and it's remarkable, you're all asking questions. You're jumping—before we're even starting—you're asking questions about whether TIPS are still appropriate.

What are our thoughts on TIPS? TIPS don't always do well when you get a spike in rates unless you're using short-term TIPS. If you get an inflation shock and you want a 6X, 7X kind of response, if growth is still decent, it's more with real asset stocks. Third, narrative quickly.

Uh, not all my answers are gonna be this long-winded, I promise, Christina. Excess savings are running out—popular narrative.

I'm not sure. Excess savings incorporate a bunch of adjustments.

I like to look at raw data. Excess savings adjust for trend, inflation, excess borrowing, all sorts of things.

If I look at actual raw data on cash in the system, I see what we've been calling in our investment teams the blob of money, the blob of money that is eating all the negative headlines.

Here's a slide.

We're going to pull a slide that shows money in checking accounts over time.

This cash is still at very high level, even though it's coming down. It's not distributed equally, and that matters. The bottom quintile of wage earners is tapped out and borrowing and using credit cards.

But the aggregate number is meaningful. The AUM in money market funds is going up. It's now close to $6 trillion. Cash and checking account is at over $4 trillion.

There's just a lot of cash in the system. I'm not sure we've completely run out of excess savings. And like the narrative on cracks in the labor market, it's one that we have just kicked the can down the road every time. Excess savings are running out—or maybe they're running out next month, or maybe they're running out in two months, or maybe they're running out in three months.

So I kind of take a somewhat contrarian position to some of these narratives, at least for the next quarter, for the next six months, maybe even for the next 12 months.

I think we just—I hate to say it—we need to be a little bit more data dependent when we look at these trends.

Dark. Thanks, Sébastien.

So building on that point of resilience, Blerina, now let's bring you into the discussion.

The U.S. economy has been surprisingly resilient this year. And more recently, the Bloomberg consensus flipped from expecting negative growth in the third quarter of this year to expecting 3% quarter-over-quarter growth on a seasonally adjusted basis. In your view, what are some of the factors that have driven the U.S. economic resilience and led to those large forecasted revisions?

You're absolutely right, Christina. We are faced with a very significant upward revision for Q3 GDP growth. Not only that, but the pattern of revisions for growth since the beginning of the year has been one-directional, always upward revisions.

And then, we get GDP data, actual Q3 GDP data later this month. I wouldn't be surprised if the actual numbers are higher than consensus expectations.

Looking at various GDP tracking measures, both from Wall Street as well as the Fed itself, we're looking at growth of closer to 4% for Q3. So it's a pretty strong indication that the economy is resilient, and it is doing pretty well. Sébastien already discussed the importance of the labor market, how it is actually strong, despite moderation in the pace of employment growth. It is slowing but it's not rolling over—that's how I like to describe that to our fixed income PMs, and then the strength of consumer spending in the U.S. And for consumers in the U.S., the interaction between aggregate incomes coming from strong employment and the excess savings story is pretty important.

But one factor that we don't hear a lot about is what I like to call the latent fiscal impulse and fiscal support. This is something that, going into the beginning of the year, if you look at traditional measures of fiscal policy—the Hutchins Center measure of fiscal impulse as well as what the government deficit as a share of GDP is—they were pointing at very significant headwinds.

However, what we saw in the data was support from fiscal policy, a laden tailwind from CHIPS, from the Inflation Reduction Act, as well as the employment reduction credit payments to small businesses. What this altogether did was to support corporate spending and intentions for investment.

So we see this in data: Corporate business investment intentions and announcements have gone up quite a lot. I like to look at the NFIB survey of small businesses, a very, very rich survey. This is also pointing to small businesses intending to spend more on capex since the beginning of the year.

There has been a pretty significant uptick. I think that's important, and that is related to the employment retention credits. There were about $200+ billion paid to small businesses in the first six months of this year.

So then, where does this leave us? We've had this laden fiscal support, and many may argue that this is behind us. We've seen it in the construction spending data. We've seen manufacturing firms build and that building growing at a historical fast pace. It's almost offsetting all of the drag from residential investment since mortgage rates spiked significantly last year.

So this is very important. And most people may argue that this is behind us now, but I take the opposite view: I think the multiplier and spillover effects are still playing out and are going to prolong this recovery.

And my argument is that manufacturing firms, first, they will build factories, then they will buy equipment—and the multipliers from the equipment are quite large, and we haven't really seen that in the GDP data yet. And then they will hire people.

And even if you may argue that employment share of manufacturing and output share of manufacturing is relatively low for the U.S. economy, I think it will still be important to prolong this recovery.

Blerina, you're sounding a bit bullish right now on the economy. I know it's not fair to ask you about markets necessarily, but you sound a bit positive.

Yes, and I have been since the beginning of September, and I highlighted this to our fixed income PMs that I see upside risks to the outlook, and even though people may argue that a lot has been priced in, I felt that the Fed would really take signal from this resilient data in their communications.

But if you ask me now, a lot has happened in fixed income markets since the middle of September. And I think a lot of my view has already been priced in.

I'm not supposed to ask the questions; I am going to stop. You're driving this.

No. A great segway. The resilience of the economy, fiscal support, and then how that lends itself to our committee positioning. So we've recently pared back our long Treasury exposure. Timing of this move has proved beneficial as the long end has continued to move higher.

Sébastien, why, in your view, have long rates been rising?

That's a great question because we have someone in the audience that asked the exact same question. So I don't know if you picked it from the audience, but I count, I think, as many as 7½ reasons why the long end of rates is rising.

So let me walk you through them. Fed expectations probably higher for longer; long rates, ultimately, are the accumulation of expectations for the short rates—that's one. Let's see if I can get to 7½, and I'll tell you why I get to a half at the end. Growth, surprising on the upside. This year, we started the year with expected GDP growth at basically 0%. Right? Roughly. And we're tracking for 2% for the year. That's a 200 basis points upside surprising growth for the year.

We started Q3 with expectations for Q3 at 0.3%, and now we're tracking at 3% for Q3. So, I mean, Blerina, I'm not gonna take shots at economists today, but let's just say, like, sometimes the macro distortions, the macro distortions make it difficult to forecast growth, and growth is surprising on the upside, which means higher long-term yields if those get extrapolated a little bit.

Third factor, inflation with rising energy prices, rising geopolitical tensions, probably some of that is being priced in the long end as well, deglobalization—pick your long-term secular factor—maybe we have rising inflation expectations.

So we're at three; I'm trying to get to 7½.

Number four, Treasury issuance, to finance those big deficits that Blerina mentioned. It's well known in the Treasury's increasing issuance, the Treasury's selling bonds. OK.

Number five, foreign buyers are selling Treasuries—foreign buyers in China and Japan.

So we're at five. Number six, who else is selling Treasuries?

The Fed, with quantitative tightening. Number seven—and this one is a bit more theoretical—but the term premium is probably going up.

You see the volatility in the 10-year and the uncertainty around longterm inflation expectations? That means that investors want a higher return compensation for holding longer-term bonds, and, therefore, the term premium goes up. It's sort of the risk term in the equation.

So we made it to seven. The one-half—I don't know what, Christina, what you think about it, Blerina, what you think about it—but is there credit risk that is starting to get priced in U.S. Treasuries with the debt ceiling debates?

In my mind, it's not really possible for the U.S. to default, but are we pricing in some sort of credit or default risk into it? What do you think?

I think it's fair that it's a half a reason. I think it's fair because we do notice every time there is a geopolitical risk, you want to be in a safe liquid asset, and we do see Treasury yields come down. And that, that continues. So long as that continues, I think it tells us something about credit risk. Yeah, it's still the safe asset. And if it's not, I don't know what is.

Exactly. That is, that is maybe cash.

But, so 7½ reasons—most of them are still heading in the same direction. Which one will reverse? We know the Fed will continue to do QT. We know a lot of those factors are going to prevail for a little while, so if we peaked in rates, that's a tough question.

But did I miss any for people streaming the questions in this webinar? I don't know if there are more, but that's all I can think of. That's a lot of reasons why the 10-year is rising.

All right. Thanks, Sébastien.

So let's shift back. You mentioned mixed data from the labor market.

We gonna go to Blerina, see what signal you're taking from the U.S. labor market.

You know, in spite of the recent slowing and employment growth, many measures, including the unemployment rate, remain at levels that are consistent with a very tight labor market, similar to 2018–19 time frame. In your view, have we seen enough in the labor market to fulfill market expectations that the Fed will start cutting interest rates by the middle of next year?

So, Christina, here's how I'm characterizing the U.S. labor market to the fixed income PMs that I talk to on a daily basis: that it's gradually cooling, but it's not rolling over. In the forward-looking data that I see, there is no indication that a recession is imminent.

So then the short answer to that question is that, no, the Fed is not going to indicate cutting interest rates as soon as the market expects. And, in fact, I expect them to push back against those early 2024 rate cuts.

And here's why I think that: When I look at employment growth, it has been slowing from the sizzling hot pace of 2022, but it remains at levels that we saw at the peak of the labor market strength back in 2018–19.

And then hiring intentions and vacancies, they are actually declining. So it's cooling over. But when that trend is going down, it's merely normalizing from peak tightness that we saw last year.

And in this slide, I show an aspect of the labor market that I don't think it is widely discussed—it's not discussed enough. It's small business hiring intentions. I mentioned earlier NFIB is a very rich survey, and I like to look at it because small and medium-sized corporate companies in the U.S. make about half of the overall employment in the economy.

So they are a very important driving force, and what they are telling us, that hiring intentions remain pretty solid even though they are slowing.

And then the other aspect is unemployment. Unemployment claims, as Sébastien discussed, are all, are still very, very low, and then job cuts are not very widely based or spread in the economy.

Now, we saw some very significant job cuts in the tech sector last year, but that didn't show up in the claims data. And I think what's happening here is that we have a very tight labor market.

And so all those workers that were laid off, they were reabsorbed in the labor market pretty quickly. And that's why we haven't seen that in the data.

And then the final pillar in my framework for analyzing the labor market is wage inflation. Again, here wage inflation is moderating, but it's not anywhere near consistent to being where the Fed needs it to be.

So, what is appropriate wage inflation that ensures the Fed is going to get to the 2% inflation target on a sustained basis? I think the rule of thumb for the Federal Reserve is about 3.5% inflation. And the way they come up with this number is that they look at inflation expectations and the inflation target—that's 2%—and the rest is made up of productivity growth.

Productivity growth in the U.S. has been averaging about 1.5% for the last decade. We don't want to look at near-term measures. We want to look at the long-term trend.

So 3.5% wage inflation is where we need to be right now, and we are about one percentage point above that. So we are not where the Fed needs to be in order to cut interest rates.

So, do you see cracks in the labor market? I do not.

I do not. I see a very gradual normalization. So gradually slowing but not showing signs of rolling over just yet.

So shifting gears a little bit ... Sébastien, you shared some interesting research on historical regimes and which one the current environment most resembles. Which regime do you think we're in today? And how does today's environment compare to those historical periods?

So this is gonna hit again at one of the questions, which is "How long do we think it's going to take for rates to come back down, assuming they're coming back down?"

So I'm going to answer part of this while talking about our research on risk regimes.

You can go to my LinkedIn page, and you'll see there's an article titled The View From the Knife's Edge. And the idea is that we're on the edge of a regime shift, and it's not clear which one we're shifting towards.

Here's how I parsed the data—four historical regimes: post war boom, stagflation, old normal, and new normal.

So we're in a new regime, something that has never happened before. Let's just get that out of the way. But which of these regimes most resemble the current conditions with inflation, the level of fed fund rates, unemployment, and growth?

Let me define each of these four regimes quickly.

The post war boom is from the 1950s to 1969. This is how I defined it: It was an era of prosperity. The regime had the highest GDP growth, the lowest unemployment. It's been called the golden age of capitalism. The economy made significant productivity gains due to automation technologies, a broadening of the labor force, women, minorities, immigration, and globalization. Just lots of tailwinds for economic growth.

Second regime: stagflation. And some are worried that we are entering a stagflation regime. I define it as going from 1970 to 1981. Defining the regime is actually a topic of academic debate, so bear with me. I know the "stag" in stagflation means economic stagnation. But then, people argue: How do you define stagnation? Inflation refers to inflation. So during stagflation, inflation can spike due to supply shocks, even when demand is weak. In the '70s, there were major oil shocks. Sounds familiar? Like there are risks for oil shocks nowadays. And right now, Europe might look more at risk of stagflation than the U.S. But the bottom line is that the stagflation regime was not a happy regime. And pessimistic members of our Asset Allocation Committee are asking whether we're headed that way. You know, we have pessimists and optimists on the Asset Allocation Committee—makes for good debates. Inflation was high and often unanchored. GDP growth was low and unstable. Stock returns were the lowest of those four regimes.

This brings us to the old normal, which I define as starting in '82 and ending in 2007, right before the great financial crisis. The number one characteristic of this regime that I call the old normal: It was a long bull market in interest rates. It starts with the Volcker era—Volcker slaying the inflation dragon—and ends with the financial crisis of 2008. Declining interest rates was the rising tide that lifted all boats. In the old normal, stocks and bond returns were both the highest of the four regimes—wonderful for the 60/40 portfolio. Growth and inflation were "normal" at about 3% each. Capital markets outperformed the economy due to rising valuations and cheap leverage. So this was the old normal. There were business cycles, bull markets, crashes, and so on, but what separates this regime from the new normal is that fed funds were positive. We hadn't reached the zero bound.

Which leads me to the fourth regime: the new normal, 2008 to 2019. After the financial crisis, we entered an era of extreme central bank accommodation. The economy got stuck on neutral with low rates, low growth, and low inflation.

The world is different now. We're in a new regime. The environment will look different than these four. But what does it look like based on those broad regime definitions? My conclusions from the analysis—and you can get more detail in the paper that's posted on LinkedIn. But, number one, we've exited the new normal.

That's my view. I don't know if you agree, Blerina. Have we exited the new normal?

I would tend to agree with that. And the question— The old normal. Yeah, well, so you had the old normal, which was the bull market in rates, and then you had the new normal, which was you stuck at zero. I think we've exited zero interest rate policy, at least for quite a while. And one of the questions was like, kind of hinting at "When do we go back to that?" I don't know if we go back.

So that was first conclusion. I can't say with reasonable confidence that we've, for now, exited that regime. Current conditions do not look like the stagflation of the '70s.

I do not think so, and statistically either.

And third, we shouldn't get too bearish, because historically, there was plenty of life above 5% fed funds. Higher rates don't necessarily have to take all the oxygen out of the system, especially if the blob of money joined forces with AI, productivity gains, and so on. So let's not get too bearish.

Maybe today, kind of, the takeaway from the discussion is we're not too bearish, right? We're not going all in in risk assets, but with this pretty balanced view you're getting today, we can buy stocks that aren't trading at nosebleed valuations, like we talked about real asset equities, SMID, maybe even EM if you're brave. And if you see a spike in the VIX or market itself, it may be an opportunity to buy stocks.

Thanks, Sébastien. Another topic on a lot of investors' minds that we've seen questions come in—Blerina, come to you: We've seen inflation come down from the highs of 9%, now close to 3.5%, and it's been a relatively smooth ride down. Many think that it may not be a smooth of a ride from here. And we're seeing some elements showing signs of inflation reigniting, for example, the pickup in energy and labor costs. What do you see as the path for inflation from here?

This is a very good question, and I'm going to say when I answer this, I'm going to look back to Sébastien's comment that there is plenty of life at 5%, because I think that's quite important because we might end up being there for quite some time.

And so to understand where inflation is going, I think it's important to touch upon the progress that we've had so far in inflation. We've come down a lot, but we may be facing the last-mile problem—or the Fed may be facing that—because when you look at what has been driving inflation down in recent months, it's two very volatile components: food and energy. And actually, the contribution from core inflation has been pretty stable and elevated.

But, so the good news—let's focus on the good news—is that inflation is coming down, and we're seeing some moderation in the labor market. The other good news is that inflation expectations remain anchored. We were pretty worried about that at the beginning of 2022, but then, central banks around the world started increasing interest rates at a ... pretty aggressively to fight inflation. Energy prices came down. And so that helped with anchoring of inflation expectations. But going forward, I think we are going to see stickier core inflation.

And to answer this question, I want to take a very long picture of U.S., the history of U.S. inflation going back 60, 70 years.

What we used to see during the post-GFC period, the new normal, that energy—sorry, core goods inflation was actually zero or negative. We were importing deflation for a number of reasons: hyper globalization, wage differentials between DMs and emerging economies. And then core services was elevated, was above 2%, and that was reflecting strong domestic demand in labor markets. Fast forward to where we are now: It feels like there is a regime shift in inflation dynamics too.

I think there is good reason to expect higher core goods inflation going forward.

We're doing a lot of friendshoring. We're making supply chains more resilient. That all comes at a price, and I think it does lead to some pass-through to consumer prices. We have a smaller wage differential between EMs and DMs, so we are not going to continue to import disinflation at the same rate.

And then domestically, we have these very tight labor markets with a declining labor force participation rate and labor supply because of demographics and the aging population.

I think these two forces are going to combine together to produce higher inflation. And the natural reaction from central banks is going to be to keep interest rates higher for longer to fight these higher levels of inflation.

Thanks, Blerina. So building on that point, Sébastien, with one of the biggest risks that the market is facing right now—inflation remaining stubborn from here and possibly reigniting—how would you hedge a portfolio for the risk of inflation reigniting? The AAC has added to our real asset strategy recently, which largely consists of commodities and REITS and is designed to protect against unexpected inflation. Do you think that move could potentially protect portfolios in a riskoff inflationary environment?

Yeah, that's a tricky question. I think longer term, and as long as you don't get a complete sell-off in stocks, you know, you do OK. It could do better than tech stocks in the market overall in a risk-off environment—and it did so very much in 2022, but these are still stocks.

So it might not do as well as short-term TIPS or cash in a drastic market sell-off. But, by the way, long TIPS didn't do well in 2022, given their duration, and so it's an asset class that's sensitive to rate shocks. So part of the answer depends on what happens to rates. It makes sense to me, from a strategic perspective, to have real asset stocks, maybe as a standalone asset class in the portfolio, and to have TIPS or short-term TIPS. So you kind of balance, you get different kinds of inflation protection.

You know, it's just ... now is the time to have a boring portfolio.

I go back to what I tell my dentist: Stay invested. Stay diversified. Before he starts hurting me, I just tell him that. Calm him down.

All right, thanks, Sébastien. So switching back to the Fed—we've touched on it a little bit, but, Blerina, as we know, monetary policy works in long and variable lags. And, arguably, we have yet to feel the impact of the 525 basis points in rate hikes that the Fed has done so far. Do you think that the Fed is making a policy mistake by remaining steadfast in its fight against inflation? And does this pose the biggest risk to a soft landing?

So this is a very tricky balance that the Fed is trying to strike right now, which is bringing inflation down, making sure they don't cause unnecessary economic pain here. And so, but the thing is when we look at the data, we have had this unprecedented tightening in monetary policy. And here we're discussing upward revisions to growth, a still resilient labor market that keeps adding jobs at a fast pace even if it's slower than it was before.

So the economy and the data—and I love that you say we need to be data dependent, focus on the data because things—I sound like Jay Palo. Sorry about that. — But things are getting revised so quickly. The traditional frameworks that we have been using to predict the economy and the outlook are failing us at this moment. Forecast errors are pretty large, uncertainties off the roof. So, if we can't rely on the R-stars to tell us the equilibrium interest rate, to tell us how restrictive monetary policy is, is the Fed doing the right thing or not, what else can we do, right?

And so, one way to do this is to use this backward-looking approach, where you are looking at real yields and you're measuring that versus actual inflation. If you look at real yields versus actual inflation, they only turned positive at the beginning of this year.

You can look a more forward look, we can take a more forward-looking approach, and we can say, "OK, let's measure real yields against inflation expectations." In that case, they turned positive in late 2022. So, by both measures, rates have not even ... real rates have not been restrictive or positive for very long at all.

And then adding to this, to complicate the pictures, because we have so many things going on at the moment, you have the fact that both firms and consumers and the U.S. government have locked borrowing at very low interest rates.

Mortgages, most of them are locked at 3% even though current mortgage rates are higher. Same for investment-grade bonds and so on. So I think this is adding to the evidence that the lags of monetary policy are quite long.

And so it may be the case that monetary policy is restrictive, but we are not going to see their effect hit the real economy for some time—until later next year actually. But I think what's important for me is that when you look at history, it has a rather sobering message about where we are right now.

Historically, if we've had inflation in the U.S. above 3% and the unemployment rate below 5%, the U.S. economy has crossed what we call this danger zone. And what does that mean? Historically, when you have this combination of a tight labor market and high inflation, the Fed comes in, increases interest rate to fight inflation, and then the probability of the economy entering a recession within eight quarters increases to 50%. And so we are crossing that dangerous period of time next year, and I think we will remain vigilant and focusing on that.

But, for sure, the Fed does not have an easy job right now. Very tricky balance.

Thanks, Blerina. And, Sébastien, you've mentioned the blob of money is alive and well as a key component, keeping the U.S. economy afloat, which references the massive amount of COVID stimulus that was pumped into the economy and distortions in liquidity that it has created. As we started to see some of the consumer delinquencies, excess savings coming down, student loan repayments about to restart, fiscal stimulus tailwinds starting to fade, etcetera, etcetera, do you think we're simply returning to a pre-COVID-2019 environment, or are these precursors for a deeper slowdown?

Well, that's a tough question. And I appreciate your questions are leaning a bit on the bearish side, so you're balancing this. It's the most important question.

A lot of these recession signals—and someone asked in the questions about the LEIs, leading indicators—they're flashing red, but they're flashing red because we're normalizing from 10% GDP growth, nominal, in 2021 and 9% nominal GDP growth in 2022. Those are extraordinary nominal growth numbers.

So we're normalizing from that, but we're still running hotter in many ways—to your question—than 2019, which was a strong year for the economy. Excess savings adjust for trend savings, and maybe trend savings, if we go back to that, that's pretty good, in terms of net spending. There's too much of a focus on rates of change.

I got another chart on the blob. So, today, the theme is "The blob of money." If you compare to 2019, and you look at present levels of liquidity—money markets, checking accounts—you're basically $2 trillion in money markets above the level of 2019, $3 trillion in checking accounts above the level of 2019.

So, no wonder the economy's been resilient to rate hikes, as Blerina was describing this.

For the lagged effects, when are they coming? And maybe there's a small probability that they're not really coming. The manufacturing PMI is up for three months in a row. It's kind of interesting; maybe we're bouncing off. There's a question about rolling recessions.... I think that's part of it as well.

On fiscal, you have student loan repayments and justified worries about the deficit, but it's clear that fiscal is not necessarily slowing down. Blerina explained this earlier, right? You have the inflation—the IRA, the CHIPS Act, and those effects are only sort of pushing through in the economy.

Now, all that being said, there are risks, and the bearish narrative can be really compelling, and you can convince yourself to be bearish pretty easily. Rates, that's the big risk. 10-year is moved up 140 basis points in six months. These types of moves can break things, and we still worry about long and variable lags.

Second, inflation risk, sticky. Oil prices up, still about 25% in six months.

Third risk, valuations. They're pretty compressed. If you look at the last 20 years, you have the most compressed equity risk premium. Now there are different ways of defining the equity risk premium. But let's just look at the fact that the earnings yield on the S&P 500 is about the same level as the yield you get on cash. And that's not been that way for over 20 years.

But let me just give you some reasons not to panic. Economic growth, as we have mentioned today, continues to surprise on the upside. Demand for services is strong. ISM Manufacturing has recently surprised on the upside—it's moving up, not down. Things are moving in directions that are different from the narrative basically. Employment is strong, so the consumer is strong. When people have jobs, they spend. You have AI as a boost to spending and productivity, new weight loss drugs that are really changing the makeup of consumer spending in some ways. Manufacturing construction, Blerina, you mentioned, is more than double 2019 levels.

Of course, the blob is a reason not to panic; you just keep an eye on it, but it's eating all the negative headlines. It's still alive.

Our sentiment and positioning indicator is negative one standard deviation. We have this aggregate measure of sentiment and positioning. So, when people are negative, that's usually a bullish, a positive signal. And then you have what I mentioned earlier, the history of past regimes.

The 60-year average for the 10-year rate—you know what it is, Blerina?

It's 5.8% for the last 60 years, and that includes the new normal where we were stuck close to zero. So there's oxygen. You had the old normal, you had.... So the starting conditions are different, but there's historical evidence that there's oxygen above 5%. Rates actually used to be normal. It's truly, truly a strange macro environment that has surprise on the upside.

Let me give ... let's do a thought experiment, Christina. You didn't expect this. You're new moderating this webinar. Let's do a thought experiment. Imagine that it's February 2022 and you buy out of the money put options on the S&P 500. And, unfortunately, you fall into a coma. You just woke up. So you fell into a coma on February 2022, and you bought puts on stocks, and you just woke up. And you ask, "What has happened?"

"Well," I say, "the Fed is hiked by 550 basis points.

"There's a war in Europe.

"We've had the number two, number three, and number four biggest bank failures in history and, oh, there's another war in the Middle East now.”

Your reaction would be naturally, "Oh, my puts are in the money." And, you know, risk assets have performed quite well over that time period. So it is a strange, distorted macro environment.

Economists, we strategists have been calling for a recession. It hasn't happened.

We put it all together and you look at our tactical asset allocation positioning—it's fairly close to neutral. We have a slide that we often use in those webinars. The little white arrow tells you whether we're underweight in the red or overweight in the green for that specific asset class. If it's two notches, it's a larger position.

You'll see that, in general, we're running relatively small tactical positions. Neutral growth versus value—there was a question on that on diversification with equity styles. Overall, at the portfolio level, short duration, long credit, long, cheap equities, small EM, and close to neutral on stocks versus bonds. And what you don't see in that chart is we remain long cash.

It's a portfolio that's balanced tactically to navigate those macro distortions without trying to be a hero.

All right. Thank you, Sébastien. Panelists, any final thoughts. Can I say—can I say something? We had someone from Canada ask a question. I'm excited about this. Expanding this webinar to a Canadian audience. I'm originally Canadian. I'm a dual citizen. So, great to see that the audience is expanding. Just wanted to give a shoutout to the Canadian person who asked the question. We didn't answer it, but....

Well, that about wraps up today's Asset allocation viewpoints webcast, Mixed Signals: Soft Landing or Recession?

It's been a great discussion. I want to thank our panelists for joining us today. Thank you, Blerina. And thanks to Sébastien.

Finally, we want to encourage all of you to join us again in January for our next Asset Allocation Viewpoints webcast.

Our special guest will be David Giroux, head of Investment Strategy and chief investment officer for T. Rowe Price Investment Management, and portfolio manager of the US Capital Appreciation Strategy.

So thanks again for all of you for joining us today, and we hope to see you again soon.

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