Market Volatility: Will it Last?

Stephen Dover: So, let's jump right into this and start with you, Scott. What is your view on the short-term volatility we've seen these last few weeks?

Scott Glasser: It's really not surprising to see the volatility. Maybe it's a little surprising to see it so quickly after the end of the year. But just to remind everyone, we're coming off a period of extreme fiscal and monetary liquidity, and liquidity historically tends to dampen volatility and we've seen that over the last couple of years. But with the expectation that liquidity will tighten, it's really not a surprise. When I think about, though, the short term and what we've just been through the first month of the year, there are a couple things I'd like to just point out. Statistically, when you look at the correction we've had the average stock in the S&P [500 Index] is down 19%. In the NASDAQ, those numbers are larger. But it's really the Russell 2000 [Index] where you see the significant correction, the Russell 2000 down around 19-20%. The average stock there down over 40%. So, I had talked about at the end of the year, how I watch kind of the breadth of the market and what we'd like to see is, is an improvement in the small- and the mid-cap, but the small-cap market, specifically in terms of the health of the market. Unfortunately, it's gone the other way. And you've had significant corrections, mostly in the most speculative stocks, the IPOs [initial public offering], solar stocks, the SPACs [special purpose acquisition companies]. And quite honestly, they could go down more. Just because they're down that much it doesn't mean they found a bottom, clearly. I don't think that the final lows have been seen. I don't know whether it's a week or two weeks from now, or quite honestly, six months from now that we come back and we test those lows.

Stephen Dover: Okay. Scott, is the volatility created from profit taking or institutional investors bailing out of high valuation in the tech field?

Scott Glasser: I think it's a function of certainly the fear of reduced liquidity pressuring high, multiple and long-duration assets, where equities, you have to remember that this is a market that probably from a duration standpoint is as long as it's been in terms of duration since 2000. And because of that, it is incredibly sensitive to changes in liquidity and even the perception of changes in liquidity. So I think that is certainly one of the reasons. It might be some profit taking, but I think that's a secondary issue. I don't think that's primarily it. I think it's starting the year, it's positioning. I think it's quantitative funds kind of feeding themselves on the downside. I think it's panic set in, as you look at sentiment indicators, and then, you start kind of the year with some questionable earnings results where maybe expenses are going to wind up being higher than we've expected. And the last six to eight quarters of significantly better-than-expected earnings releases, maybe that's coming to an end. And I think it was the kind of the combination of those factors that led to the to the quick selloff we've seen.

Stephen Dover: So, Scott, when you say duration of the equity market, can you just give us a quick definition of that? What you mean by that?

Scott Glasser: Equities are long-duration assets—not all equities, but in general, they are, meaning that a lot of the present value is determined on what the results are in the future. And the extreme example of that are high-growth companies, where you're paying very little for the value of current results, but you're paying a lot for the expectation of growth and future results, which means that you are truly looking into the future 10, 15, 20 [years], trying to figure out what the growth and what the market would be and how much they can make in the future. And because of that long-dated expectation, it's much more sensitive to the discount rate. So, when I say duration it's future, future earnings, and first future cash flows being discounted back. Again, the higher growth you are, the more of that that's in the future. The reverse is also true, which tends to be more value and cyclical stocks where a lot more of the current value is less long-dated and in the present. So, you're paying for current assets and, you know, a smaller amount of the future of the value is future growth. Some of it, clearly, but not as much as compared to a long-dated or high-growth stock. So, that would be the definition.

Stephen Dover: Thanks, Scott. Let's turn to Mark for a moment and just talk a little bit about the fixed income market. Mark, in Western's outlook, just a month ago, you mentioned that you saw that this was going to be a year of volatility, and certainly that's the case. What is your take on the month so far and the volatility, particularly in the fixed income market?

Mark Lindbloom: The way we are looking at the fixed income markets and the broader markets for that matter is in terms of what the Federal Reserve is doing. And I think our point of view, a lot of what we're seeing and talking about, as Scott just mentioned, is monetary policy and fiscal policy, as we've known it for a long, long time, certainly over the last few years, is changing and changing rapidly. And, think about it this way, that over recent years, the Federal Reserve has been well-defined in terms of expectations, intentionally, to all of us. They've had a very moderate, gradual approach, not even talking about—very, very clear about—their expectations and what we should expect the Federal Reserve to do. And that has changed in a big, big way quite recently. And we've all seen that over the last several months on the part of Chairman Powell and the FOMC [Federal Open Market Committee] to where we sit today, and somewhat shockingly, at least from our point of view at this pivot that they have all taken. And now, basically, say we don't know the path, and we can't say if it's going to be gradual, if it's going to be fast, or if it's going to be something in between when it comes to rates, when it comes to the balance sheet, and it all depends upon, well, what the economy's doing, the pace of inflation, unemployment, and all the other things that we have to take into account.

Consequently, we've gone from an environment where central banks around the globe were very, very predictable in terms of their actions to one now that it is indeed very data-dependent and whether they increase rates one time this year or seven times this year is subject to great debate.

Now, our take on this is the pendulum has swung very rapidly from this very measured approach on the part of the Fed to complete uncertainty as to what we'll end up seeing at the end of 2022, that we do believe that the market is in a sense, a little deep meaning, that we've probably factored in a little bit too aggressive Fed, although Scott and I go back, many, many years, there's an old song about don't fight the Fed. And it was pretty clear as to what Mr. Powell was saying in terms of their intent as we go through this year, which is much different than it was even six months ago.

Stephen Dover: So, when you're in this period of uncertainty, how do you react to that? And, some of the response I've heard is you think of opportunities very much from a bottom-up perspective, that maybe gives you an opportunity to not focus so much on duration, but rather other ways of looking at it. Can you elaborate on that a little bit?

Mark Lindbloom: We are, we're enjoying our 50th anniversary this year. And I think what has made us survivors has been, not only the philosophy and how we go about managing fixed income money and particularly, being agnostic in terms of the sectors around the globe that we can choose on behalf of our clients and for the benefit of our clients. But our primary focus is to look at yield. I mean, after all, we're talking about bonds and fixed income here, and that's what the returns are all about over time. And therefore, our belief is we always want to rotate amongst sectors that offer some yield to our investors over that period of time. Important against that, is certainly a macro view and duration yield curve volatility, but what we are certainly doing on an ongoing basis is providing yield through those sectors around the globe that we feel are going to provide attractive risk-adjusted returns.

You know, we're not thinking that this volatility is about to put the economy down significantly anytime soon. We push back on that a little bit. If that's right, and we see trend growth in 2022, we feel that there are sectors that will benefit from that. Let's call them reopening sectors, as they have in 2021. Against those favorite sectors, we want to balance the risk, if you will, in case something goes wrong in terms of an ultra-aggressive Fed that puts the economy down. We doubt it, but it's possible. China, Ukraine, Europe, the [US] administration. There's a lot of things that surprise us and against our favorite yield and spread sectors, we always like having some duration, particularly from high-quality sovereign debt, like US Treasuries, bunds, JGBs [Japanese Government Bond], China government bonds, etc, to offset that potential risk.

Stephen Dover: So, let's go back to Scott for a moment. Scott, let’s talk a little bit about your earnings outlook, uh, for this year.

Scott Glasser: This year in the equity markets is about adjusting from an incredibly excessive liquidity environment to a more normal environment. So, I am not long term bearish on the economy. As a matter of fact, I don't expect any kind of recession. I think the economy is really vibrant, and I think that will save us ultimately from an equity perspective. But I do think that we are going through this adjustment on the liquidity side and it's more about earnings expectations and forward look than it is anything else. They will moderate. They will have to deal with increases in inflation, whether it be wage inflation or input inflation, they're dealing with that now. And so, the whole US equity market is going through this adjustment period. And that's what creates the volatility.

And what you've seen going through earnings is in fact that supply problems are not going away as quickly as had been anticipated. I think that plays into the longer-term inflation or the kind of more aggressive inflation scenario. So, supply problems, as particularly relates to goods inflation, is not dissipating as quickly as anticipated. There are wage pressures, and then the question becomes for equity investors: What does that mean for margins? And, you know, margins are at all-time highs, and I think demand's going to be great. And I think revenue's going to be great. And I think the key question, which is going to be a sector question and a company question. Is to what extent can you leverage that good revenue growth on the margin line? And for some companies they'll be able to get through it, and for a lot of others, you're probably not going to get the leverage on that revenue. And you probably have either similar or lower margins on that higher revenue line. So that's the adjustment we're going through. The positive that I take away, which is a general economic positive from earnings, and it's not only this quarter, it's the last six months, but it seems to be increasing, is that capital investment is significant and increasing. You're hearing large-scale company capital investment projects, and it's across the board. It's not only in semiconductors, it's not only in technology, it's across the board. And so, that is going to be very positive for the US economy and for growth in general. So that's kind of the offset. You've got more expense pressures coming through than maybe people perceive. Part of that is the persistence of inflation and the persistence of supply problems for a longer period of time. But on the other hand, you have demand that's very strong, so it's going to vary by company. It's going to vary by sector.

Stephen Dover: So Scott, do you see opportunities of entering the market? Would it be a time to reduce exposure? And how would you make that decision different for clients that are accumulating versus clients that are older and needing to readjust their portfolios?

Scott Glasser: I would advocate an allocation that is diversified. It has paid not to be diversified over the last several years. Let me put this in perspective for a second. Over the last several years, the NASDAQ market, this is the last three years, the NASDAQ market has annualized at 34%, putting it in the 98th percentile of all returns, okay, going back to 1971, which is when they started keeping the data. So that's extreme. My point is, those are unlikely to happen the next three years. We were fortunate to have those type of returns. It doesn't mean your returns are going to be negative, and it doesn't mean they're going to be horrible. It just means expectations need to be lowered. I would advocate an equally weighted S&P over a market-cap weighted S&P. What does that mean? It means that a more diversified portfolio, I think value continues to work well. Last year, value worked for the last three months and then the last six or seven months you had this kind of surge and blow off in growth. I think value continues to work. I think commodity and basic material-oriented sectors, which actually benefit from some of the inflationary trends we're talking about, continue to work. I think that industrials continue to work fairly well. I think technology is a mixed bag. I like software over semis. I like cheap hardware companies. They have the ability to raise their prices and they've got high gross margins, which means they can absorb increases in things like labor fairly easily. So, there are, there are ways to navigate the market. There are times to take risk and there are times to kind of pull back from risk. And my viewpoint is, the course of the next year is to stay involved, be diversified, but pull back from kind of the more risky parts of a portfolio.

Stephen Dover: Mark, let's just turn back over to you. Maybe just give us some of your views on both the health of the consumer and also the labor market.

Mark Lindbloom: Yeah, the consumer, Stephen, we think is in very good shape. A couple points of view. The jobs market, as Mr. Powell talked, is hot. And, people are looking for workers. It's been a bit of a mystery and huge debate as to why the labor participation rate has fallen as we have come back online, so to speak, as we all learn to deal with COVID. Some of those reasons are pretty obvious, but the bottom line is that there are jobs out there if people want them. Therefore, incomes are supported for sure. Secondly, savings rates are at healthy levels. So given those two, consumer has the wherewithal to continue to spend. We think that'll come in a little bit different way than it has over the last year or year and a half when we are all stuck in our homes and unable to do what we like to do. And to a certain extent we saw a huge spending on goods, less on services, of course. And we expect as we go through ‘22, that more will be spent on services, we all hope as we get past this virus, which is our expectation, we all hope that for sure. And, we will start spending on services. The question is, will the goods part compensate for that? And will we see a leveling off if not an actual decline in the consumer's support of the overall economy? And we think that'll be the case. You know, we think 2-3% is probably the right number for real growth in ‘22, consumers still healthy, still have the wherewithal to spend but that as services spending goes up, perhaps the goods goes down in terms of pent-up demand on housing and furniture, on autos, etc., and, still in fine shape. And that does support opportunities in our market, in the fixed income market. When you look at things like mortgages or commercial real estate, or specific corporate opportunities in the investment high-yield market, that healthy consumer certainly leads to greater opportunities there, Stephen.

Stephen Dover: So, Mark, we're heading into a period in which interest rates are going to rise, and that's something we've all dealt with historically and we understand, but can you just help us understand a little bit the implications of quantitative tightening, particularly how that might affect the bond market?

Mark Lindbloom: Yeah, it's a great question, a very topical question. Mr. Powell at his news conference was asked several times as an attempt to try to see how the Federal Reserve defines this very, very important topic. And I think that the withdrawal of liquidity on the monetary side together with significantly less fiscal side, is something we have to watch very, very closely, because we're always thinking in our minds of, you know, mistakes, or financial markets have a way of making our lives miserable. One of the things we do worry about in that regard is much slower growth, which isn't our call for ’22, but on this topic, I think both the monetary and the fiscal are important. We've gotten a little bit of clarity, just a little, on the monetary side from Mr. Powell. And while the week before the FOMC meeting there was a lot of speculation, not only in terms of how many times the Fed would increase interest rates, which, as Scott said earlier has gone from two to three to four, now we're on five and there are some out there suggesting they go every meeting, which gives you seven. But also importantly, to your point, Stephen, in terms of the balance sheet, the balance sheet has been used going back a couple crises, but most recently with the pandemic as another tool, as the Fed has reached a zero lower bound and not wanting to push rates negative. And the thought there of course is to buy securities in the open market to help support capital markets, number one, and provide liquidity that's primarily been done in US Treasuries and agency mortgages. But during the onset of COVID and it seemed like the world was ending there for a while, they even got involved in other markets like corporates, munis, etc., which they have since exited. So, the uncertainty is the flip side of that. Things are better. We're not in that emergency situation. Things are running pretty darn hot according to the Fed and to a lot of analysts from an economic point of view, from an inflation point of view, why is the Fed here? Well, they've recognized that, and they're adjusting. We know the rates side, they have said to us as we go through this period of time, the way they will progress so-called principles that they have laid out is that the rates will be their primary tool. That's understandable. That's what we thought they would do. It's much more uncertain as they go about tapering their purchases, and those will end in March and then they will begin the discussion, how they actually lower their balance sheet.

And so far, what they've decided is we think probably in the summer, they will begin to let the maturities of their mortgages and Treasuries and the interest payments roll off—that is they won't be reinvested. The bigger question I think what you're getting at though, Stephen, is a lot of speculation out there as to whether they more aggressively bring the size of the balance sheet down, just given what inflation is, what unemployment is, and their view of that. And we think that that is a possibility, but it's unlikely. Mr. Powell, on that question also, said there's a possibility, but two things he pointed out: number one, rates are the primary tool. Secondly, most of the decline in the balance sheet and they do want it to go down, can be accomplished from maturities and from interest payments rolling off, not reinvesting those, the duration of that is shorter. Therefore, over the next year, year and a half, you will see trillions of dollars come off of their balance sheet. It's a good question. It's a complicated one. There's been attempts to equate every trillion dollars to a Fed funds level, but honestly, it's a bit of guesswork on the part of the Fed and amongst analysts. I think that the fact that we can look at rates and understand rates more so in trying to, calibrate the level of the balance sheet is a good thing and it could provide some stability going forward.

Scott Glasser: I agree and think it's very positive that the Fed probably either doesn't or kind of drags its feet on any kind of quantitative tightening. I think the Fed is going to talk tough the way they are, but we may be surprised by their actions. I mean, they clearly don't want to slow things down so much that the economy eventually rolls into recession. This is not a normal economic cycle. Okay. And there's nothing normal about the market activity that we've seen, whether it be bond or stock or everything else, it's all been kind of distorted by the pandemic. And so, we are hopefully going back into a normal market environment. We have over the last several years benefited from outsized returns. We are probably going back into a more normal return scenario. Okay. We are probably going back into a more normal volatility scenario. It's just been so long, we forgot that it's normal to have a 10% correction every year. We just had one, but yet everyone's freaking out because it's not what we're accustomed to. And I understand that, but some of this volatility is completely normal. Some of this volatility is also very helpful. It gives us the chance sometimes to reposition portfolios because things come down. This is an adjustment period. That's the way I would frame it. It's an adjustment period that we're going through both from an equity perspective and even on a fixed income perspective. We will get through this, and it's kind of stay the course, The bad decisions are made when you're reacting emotionally. The good decisions are made when you're thinking long term.

Stephen Dover: Well, thank you for the very interesting insights. Thank you, Scott. Thank you, Mark.

Host:  And thank you for listening to this episode of Talking Markets with Franklin Templeton. If you’d like to hear more, visit our archive of previous episodes and subscribe on iTunes, Google Play, Spotify, or just about wherever else you get your podcasts. And we hope you’ll join us next time, when we uncover more insights from our on the ground investment professionals.