Me start with you Jim. What do we read into this market are
happy days here again. I mean we did have a really nice gain
this week. David I think you could spend a couple
hours looking through all the fundamental data and not find anything
that really supported a big increase in risk appetite this week.
So you really have to attribute it to the fact that we had a couple of weeks
of softness preceding this and then sentiment is terrible.
And then technically the market is making higher lows.
So technically it looks OK here. But if you think about what's going to
drive the market over the next six to 12 to 18 months the growth outlook is
deteriorating. Europe's likely in recession.
China's is clearly in recession. The US 50 50 we think over the next 12
months the Fed and the ECB are raising rates resolute Lee and the inflation
picture while improving is probably overly discounted in the markets.
A one year break even on the tips is at 2 percent.
So we think that the environment is probably not as robust as this week's
market action might indicate. Well I'm sorry Sarah.
When I heard 2 percent one year break even that sounds like maybe inflation's
coming back down again. I think that that number is coming back
down. Inflation's moderating.
We'll likely see a little bit more moderation when CPI comes out next week.
But that slope is probably too aggressive.
I think inflation will remain sticky. We have higher wages and higher shelter
prices. Those likely stick around and that's
going to keep core inflation numbers probably much higher.
I would would would be wouldn't be surprised to see that break even
actually increase over time. The other thing we're watching for is
the Fed. Before we decide if this rally is
sustainable we'd want to see more signs of a Fed pivot and we're not seeing
that. So we agree with Jim.
This is probably not a sustainable recovery.
What about the Fed pivot. Is it dead effectively.
I mean it certainly sounds like Jay Powell recently has not been saying much
because of the pivot. I don't think we're going to see a pivot
in early 2023 with Jay Powell has been saying is that he's going to do what's
necessary to fight inflation even if that comes somewhat at the expense of
the economy and given that inflation likely has these sticky components to
it. I think he continues to raise rates
likely 75 basis points at the September meeting and then more moderate rate
increases from there. If anything you'll see a pause in 2023
but you won't see rate cuts until we hit a recession and we see that demand
destruction. Know David we've seen in the last month
a reduction in the cuts that the market is priced in.
They were pricing in 50 basis points of cuts in twenty.
It's now come down to just 25 basis points.
And what I'm most interested in keeping an eye on is the labor markets.
I think the Fed can't stop raising rates because growth is hurt.
They can't stop because the market is struggling.
They need to see the unemployment rate increase to give them cover to be able
to start slowing down the pace of increase.
So next week we at CPI numbers right at where is going to tell us Jim what do
you think about the headline and core. Well I think the key is going to be the
pace of improvement. I think there's very little doubt we're
going to see improvements in the overall rate.
But as Sara mentioned earlier the progress on housing and the progress on
labor are really the two most key. And they're key because the supply
issues on both of those are really considerable.
And the only thing the Fed could do is hurt demand.
They can't increase supply in either of those areas.
So this doesn't sound that road rosy about the U.S.
economy and where we are. But if you compare it with Europe or you
compare it with China for that matter we're in a lot better shape aren't we.
What about that divergence among the economies.
I think the U.S. is still the safe haven region of the
world to be in the economies much more resilient.
That's giving the Fed leeway to continue to raise interest rates.
We're not seeing that resiliency in the rest of the world.
And that's also why the dollar is so strong.
We expect it to remain strong because the U.S.
stronger growth higher interest rates the currency will be that safe haven
trade. And that's an issue for earnings going
forward. Another Jim mentioned employment.
We're also worried about earnings. Consensus has been pretty positive this
year on earnings growth. And our concern is that earnings and
will eventually get hit because of the strong dollar margin compression because
of inflationary costs. This is gonna be an issue for companies
that don't have pricing power. So that was one of the big stories that
we write generally. The dollar is setting record after
record after record. We had Bill Dudley the former New York
Fed president on Bloomberg this week saying he thinks the Fed actually wants
that strong dollar because actually slows down the economy.
But what does it mean for investors. Well it's an issue for investors from
the standpoint that it is positive that will slow growth but it does hurt
earnings and it's a negative for the international investments where you're
seeing the depreciation of those currencies.
Foreign markets have actually done not as badly but when you've translated back
into dollars it's really been a much more difficult market.
Does this say anything. What small casters is big caps.
Well it does. The small caps would tend to have a
little bit less exposure there. But conversely small caps are more
exposed to higher interest costs and more difficulty in handling higher input
costs. They tend to not have as much pricing
power. So they went on one front they lose on
the other. So Sarah what are we all missing in your
new vein. And you see all this stuff.
I know you've got some secret sauce there.
What are the markets missing. What are we missing.
I think one of the key issues for the markets is valuation.
This is what we're surprised to see is that valuations for stocks actually are
not that. Cheap and even with earnings at risk
they could look even more expensive. If you look at history during periods of
high inflation where you tend to eventually hit a recession market
returns can be quite strong after that. But if you look at valuations in those
historical periods there are much lower when that happens.
So that's why we're more concerned about the markets and think that it's likely
that valuations need to crack before we would get interested.
Oh that's usually so we got further to go down.
You think. At least.
So do you agree with that Jim. Or do you have something else you think
the markets are missing. So our experience is that while
valuations clearly are important they're much more important to long term returns
than they are to 12 month returns. There's a very little statistical
relationship on a short term basis. So we don't look at valuations as a
timing tool but they're very important for intermediate to long term returns.
So what about the cause and effect. Is the US dollar scrip strength in this
area. Is that because our economy is that much
stronger. Actually I talked to Larry Summers who
said it's because we've got such a strong energy position particularly
compared to for example Europe which is struggling so badly.
It's a combination of many factors. I think it's correct.
It's because of our strong energy position is because of our relatively
strong our economy our pace of aggressive rate hikes.
All of the things make the dollar stronger.
And another headwind for the economy and the markets going forward particularly
earnings. So as you look forward Jim you think the
dollar is going to continue at this strength or even get stronger.
It probably will continue at this level. I'm not sure how much stronger we'll get
from here because we are going to get towards the end of the Fed's cycle
sooner than we will. Other central banks.
But an important part of our investment philosophy is you do not want to take a
lot of risk in predicting where currencies are going to go because it's
an incredibly difficult thing to do. Hedge your liabilities and use your risk
budget on other investment ideas. Certainly sounds sound to me.
You agree Sarah. I do.
I think that's a great philosophy.