Greater possibilities

Brian Levitt:      

Welcome to the Greater Possibilities Podcast from Invesco, where we put concerns into context and opportunities into focus. I’m Brian Levitt.

Jodi Phillips:     

And I’m Jodi Phillips. This is the second in a two-part series with Justin Livengood, a senior portfolio manager for the Invesco Midcap Growth Strategy, and a senior research analyst for our discovery and capital appreciation strategies. Justin’s focus is on financials, real estate, and healthcare. If you missed the first part of our conversation, we focused on the state of the US banking system. Now, we’re going to talk about market concentration, artificial intelligence, and more.

Jodi Phillips:     

So, Brian, where do you want to start? Should we want to start with market concentration? I know that's been a huge topic of discussion and talk to Justin about what it might take for that to broaden at some point.

Brian Levitt:      

I do, and Justin had talked about how smaller and mid-cap businesses have been participating more. It felt to me like we saw a lot of performance in November and December in small and mid-cap, and maybe it's become a little bit more concentrated again as we sit here at the end of February. And so why is that the case and how long can this persist?

Justin Livengood:            

Yeah, so the rally you saw in small caps, particularly in November, December, was all about interest rates. That was when (Federal Reserve Chair Jay) Powell was-

Brian Levitt:      

Yeah, fixed cuts.

Justin Livengood:            

Right. Rates were peaking. He said, "We're done raising rates." Effectively. And there was this perhaps understandable swing in the pendulum to, "Oh gosh, the Fed's on the verge now of cutting." And that's going to be great because undeniably small cap companies are...

Brian Levitt:      

Can I let you in on a little secret?

Justin Livengood:            

Okay.

Brian Levitt:      

When you do what I do for a living, you write outlooks in September and October and they come out in December, and we wrote Fed's going to lower interest rates this many times. That sets the stage for a really nice backdrop for small and midcap, and then it all happens in eight weeks.

Justin Livengood:            

That's right. Then you're like-

Brian Levitt:      

Do you feel bad for a guy like me or it's just part of my job?

Justin Livengood:            

I hear you. Well listen, I feel your pain. Well, I don't. I sort of do because that was a tough relative time for us. I'm totally going off script, I don't even know if we're still rolling here, but when November and December happened, you had not just a small cap rally, but it was a pronounced rally by the weakest companies, the companies that were the most poorly financed, that looked like, "Okay, wow, they managed to survive. Now they're probably going to get bailed out by an accommodative Fed." And so lower quality businesses outperformed dramatically, and that's not helpful to the kind of investment process that we run. Having said that, the euphoria around the Fed pause and cut, hoped for cut, is what sparked that Q4 rally.

So what's happened in 2024 so far is first an awareness, a correct awareness that, "Hey, the Fed isn't about to cut. They are done raising rates in all likelihood, but they aren't about to cut any anytime soon." And then the second thing is you've had really good earnings from large cap companies. So we've largely finished Q4 earnings season and the high level statistics are telling. Small cap earnings, Russell 2000 earnings in the fourth quarter were negative, slightly negative as a overall group. Midcap earnings were slightly positive. Large cap S&P 500 earnings are tracking almost up 10%. So large cap again, and this is a trend that was persistent through much of last year, is winning in terms of earnings growth. And at the end of the day, earnings often, if not always move stocks and move valuations.

Now within that large cap earnings growth number, a lot of it was the largest companies. So one of the other questions that I know we're going to address is market breadth, and I'll just continue my prior illustration. Roughly a third of the S&P 500's market cap is in the top 10 companies. 50% of that earnings growth in Q4 was from the top 10 companies. So the big guys, the NVIDIAs and the Microsofts, they came through with excellent results and powered that outperformance and the stocks followed. And that's why we're looking at a lot of, and it's not just by the way, tech companies, Eli Lilly is up 25% year to date, Visa and MasterCard are up a ton, had great quarters. The other companies in the top 10 are doing well. It's not just the tech companies.

Brian Levitt:      

So it's an AI market and a weight loss market?

Justin Livengood:            

Those are two of the big things. Those seem like huge things that could materially change the U.S. economy.

Brian Levitt:      

You're laughing? They're huge.

Justin Livengood:            

Now in technology, there's a lot going on in addition to AI. AI's, I think, taking a lot of attention and somewhat deserved, but Microsoft and Amazon's cloud businesses are doing well for a lot of reasons, not just artificial intelligence. The semiconductor industry is doing well in part because of all the activity around NVIDIA and investments in AI, but in part for a lot of other reasons. And so it is a little more, I think, diversified on the technology side than perhaps the headline suggests. But away from that, the healthcare sector right now is absolutely being affected by this emergence of the GLP-1 obesity drug class and its benefits for Novo Nordisk and Lilly, but it's got a lot of implications on the rest of the sector.

Brian Levitt:      

Even consumer staples.

Justin Livengood:            

Absolutely.

Brian Levitt:      

If you're not going to snack as much.

Justin Livengood:            

Food companies, restaurant companies for sure, for sure.

Brian Levitt:      

Yeah.

Justin Livengood:            

So there's a lot of investing implications as it relates to that, but then there's just good solid things going on. I mentioned Visa, MasterCard, people are traveling again. People are, even though they're maybe not spending quite as much as they used to, consumer behavior's still pretty good. The best part of the market year to date though, isn't tech, it's industrials, especially in the small, midcap sections of the market. Industrials are thriving. There are some great, great, great industrial businesses. There's this whole trend of reshoring, we're having a lot of jobs and a lot of companies bring back projects and bring back work to the United States from the Middle East, and from Asia, and China. There's a lot of infrastructure investing going on partly because of AI and the cloud, but even partly just more basic and traditional infrastructure. So there's a lot of the industrial ecosystem that is thriving right now.

Orders are great. Some of our favorite companies in our funds, small, mid and large cap are industrials. They're not tech, they're not health care. And so it's fairly broad. So I'm happy to see that, but it's still tilted back to your original question, a little bit up cap right now. I do think though, as soon as we get a little further through this Fed pause, you're going to see that small cap and to some degree, midcap, performance perk back up. Perhaps not as much as we saw in the fourth quarter last year, but I think you'll see the rest of the market close the gap with those biggest companies

Jodi Phillips:     

Justin, you did touch on this, but I did want to ask a little bit about AI in the longer term, but in terms of companies that are using it, not the tech companies that are enabling it, but the companies that are using it in the longer term. You did talk a little bit about health care, but what about the intersection of, for example, AI in health care, or is that too much of a regulatory question, privacy questions? What are you looking at in terms of keeping an eye on the longer term ways that AI can fuel the other industries that you cover?

Justin Livengood:            

Absolutely. So I got several comments on that. I'll start with health care. It's a little unclear how much AI is going to impact drug development in the near term for some of the reasons you just listed, Jodi. The big pharma companies and the biotech companies are dabbling in it, they're using it, but it's going to be more, I think in early research and helping identify targets and benchtop science. It's not going to be useful as much in actually running in-person clinical trials, which still have to be done, I think in a more hands-on traditional way. So I think there will be applications, I think it will be helpful, but I'm not sure that's the use case that's going to be most visible to us, at least in the very near term.

I do think though, there are some emerging use cases that are really interesting. So I'll give you a couple of examples. The first is IBM on their earnings call, or maybe it was at a recent conference, but in the last six to eight weeks said that they were, through the investments they've made in artificial intelligence, able to reduce the headcount in their HR department from 700 to 70 people.

Brian Levitt:      

Wow.

Justin Livengood:            

So now they're further along than probably a lot of people, and I don't want to suggest everyone's going to be able to do that day one or year one, but that is a flex.

Brian Levitt:      

I'm going to keep my job.

Justin Livengood:            

I know. That's my first thought too. I'm like, "Wow."

Brian Levitt:      

I got two kids getting ready for college.

Justin Livengood:            

Just hang in there.

Brian Levitt:      

Just two more years.

Justin Livengood:            

Just a few more years. That's all you need, Brian. So don't go work for IBM is my point. Yes. Stay here. So there's an example though of a very real use case that is clearly helping IBM's bottom line. However, they had to make investments upfront to get there. And I think the other thing that needs to be considered is a lot of other companies are earlier in their AI journey and trying to figure out where to make those investments. And one such example is Moody's, a company that I know well that's actually headquartered right across the street from us here in Lower Manhattan. Well, they reported earnings last week that were excellent. However, they guided 2024 expenses well above all of our expectations entirely because of investments they feel they now need to make in that analytics business targeted on artificial intelligence.

They see a lot of things, use cases that they think their clients are going to want, but to get there, they're going to have to spend a lot and they're pulling forward a lot of different projects into 2024 because they feel some urgency. So there is a bit of a back and forth. Whenever AI comes up in an investment discussion, everyone wants to look at the semiconductor companies and NVIDIA and, "Oh, this is all great." Well, on the other side, somebody's got to be actually writing the checks and spending the money. And not everybody's IBM, not everybody's already gotten to the point where they're seeing the rewards of those investments. We're actually in a lot of cases still early in the process of figuring out, "Okay, I know I need to be doing something, what do I do?" And so there's going to be more of the Moody's like updates I think, over the course of this year, which is fine. I think investors just need to be prepared for this to be a pretty big theme, an investment consideration as the year plays out.

Brian Levitt:      

I get excited just hearing you talk about it. And so as we come to the end of this podcast, just talk a little bit about the opportunity cost of not being involved in markets, not being involved in the growth companies that you look at over the next couple of years or even beyond.

Justin Livengood:            

Yeah, and I'd start by saying there's been disruption in the markets for a while.

Brian Levitt:      

Forever.

Justin Livengood:            

Forever.

Brian Levitt:      

I'd hope so.

Justin Livengood:            

But even we were talking before the podcast, Brian, about how growth has done really well as a category for over a decade. Well, a lot of that is explained by companies disrupting various industries, many of them technology, but also health care and industrials and the like. So there's been disruptive opportunity to capture and invest in for a long time. It just happens that right now, two of the more prominent things happening are artificial intelligence, and then in health care I would agree, this whole obesity dynamic and they're getting more attention and they're arguably driving a little bit more value creation than some other types of disruption in the last 10 to 15 years.

But there's always really interesting secular growth opportunity to participate in, and I think I've mentioned this with you in the past, and I referenced it a second ago when I was talking about industrials. It's not just the stuff on the headline. So when I come to work, whether it's in the office or at home, I'm not thinking about NVIDIA and AI and a lot of the big cap stocks very much. I'm spending a lot more time thinking about companies that most people listening to this podcast will have never heard of that are either benefiting from some of these themes or that are just in their own unique little opportunities and disruptive situations, but that are thriving. I can think of dozens and dozens of companies in the last few years that have gone from 2, 3, 4 billion in market cap to 15 or $15 billion companies that have gone to 30. And the speed with which this is happening is increasing a little bit the Moore's law kind of concept.

Ron Zibelli, my boss and longtime colleague, loves to talk about this. He's like, "The pace of disruption is only increasing." And so you're seeing more and more companies taking advantage of that, that are not on the main playing field. They're off on one of the side fields, but they're still really, really exciting companies. So you go through the last two, three year period where the macro environment was extra volatile and sometimes that gets in the way of the stock performance of some of these really interesting secular stories because you've got to worry about what the Fed's doing and pandemics, and that's all understandable. But now that we've seen hopefully, the world calm down a little bit-

Brian Levitt:      

Back to basics.

Justin Livengood:            

Right. The Fed has gotten inflation somewhat under control. We seem to be in a little bit more of an equilibrium long-term macro wise. I think it's going to allow those really interesting disruptors, those really interesting secular companies to again, shine. And that's partly why you're seeing growth continue to outperform. That's why sitting here today at the end of February, the NASDAQ and the S&P are up almost 7% already this year, and you tear that apart, that's mostly these higher growth disruptive companies that have just continued what they were already doing for much of 2023. It’s been a really interesting group to invest in, and I think there's definitely going to be opportunities going forward. So I would strongly encourage people not to try and time the market, especially in this part of the market where there's so much long-term opportunity.

Brian Levitt:      

Jodi, as you know, I've been taking copious notes, so when we come back six months or a year from now with Justin, I will read that back to him and once again, hopefully he will tell us, "I feel very good about what I said."

Jodi Phillips:     

That's right, that's right. We'll definitely have him on again, and hopefully there doesn't need to be a bank concern or bank issues to do it.

Brian Levitt:      

Yeah. No crises.

Justin Livengood:            

Yeah. Hopefully, it won't be a crisis that is required for me to be here.

Jodi Phillips:     

No, not at all.

Brian Levitt:      

Thanks so much for being here.

Justin Livengood:            

Thank you.

Jodi Phillips:     

So Brian, where can our listeners find more market commentary from you?

Brian Levitt:      

Well, Jodi, as always, visit invesco.com/brianlevitt to read my latest commentaries, and of course you can follow me on LinkedIn and on X at Brian Levitt.

 

 

Important information

You've been listening to Invesco's Greater Possibilities Podcast.

The opinions expressed are those of the speakers, are based on current market conditions as of February 27, 2024, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Invesco is not affiliated with any of the companies or individuals mentioned herein.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

Should this contain any forward looking statements, understand they are not guarantees of future results. They involve risks, uncertainties, and assumptions. There can be no assurance that actual results will not differ materially from expectations.

All investing involves risk, including the risk of loss.

Past performance is not a guarantee of future results.

Diversification does not guarantee a profit or eliminate the risk of loss.

An investment cannot be made directly in an index.

All data provided by Invesco unless otherwise noted.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

Investments in financial institutions may be subject to certain risks, including the risk of regulatory actions, changes in interest rates and concentration of loan portfolios in an industry or sector.

The profitability of businesses in the financial services sector depends on the availability and cost of money and may fluctuate significantly in response to changes in government regulation, interest rates and general economic conditions. These businesses often operate with substantial financial leverage.

Growth stocks tend to be more sensitive to changes in their earnings and can be more volatile.

The health care industry is subject to risks relating to government regulation, obsolescence caused by scientific advances and technological innovations.

Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.

Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

Many products and services offered in technology-related industries are subject to rapid obsolescence, which may lower the value of the issuers.

Investments focused in a particular sector, such as industrials, are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.

References to small and mid-cap performance sourced from Bloomberg. Based on performance of the Russell 2000 and Russell Mid Cap indexes in November and December 2023.

References to lower quality businesses outperforming in the fourth quarter sourced from Bloomberg, based on quality metrics as defined by FTSE Russell.

References to the earnings growth of the Russell 2000 Index, the Russell Mid Cap Index and the S&P 500 Index sourced from Bloomberg.

The percent of the S&P 500’s market cap in the top 10 companies sourced from Bloomberg.

Performance of Eli Lilly, Visa and Mastercard sourced from Bloomberg as of February 27, 2024.

Comments about the performance of the industrials sector sourced from Bloomberg, based on the sector’s performance of the Russell Mid Cap Index and Russell 2000 Index.

Nasdaq Index and S&P 500 Index performance year-to-date through February 2024 sourced from Bloomberg.

The statement that growth has done well for a decade sourced from Bloomberg, based on the returns of the Russell 3000 Growth Index versus the Russell 3000 Value Index.

The Russell 2000® Index, a trademark/service mark of the Frank Russell Co.®, is an unmanaged index considered representative of small-cap stocks.

The Russell Midcap® Index is an unmanaged index considered representative of mid-cap stocks.

The Russell 3000® Growth Index is an unmanaged index considered representative of US growth stocks.

The Russell 3000® Value Index is an unmanaged index considered representative of US value stocks.

All Russell indexes mentioned are trademarks of the Frank Russell Co.

Moore's Law states that the number of transistors on a microchip doubles about every two years with a minimal cost increase.

The Greater Possibilities podcast is brought to you by Invesco Distributors, Inc.

Brian Levitt:

Welcome to the Greater Possibilities Podcast from Invesco, where we put concerns into context and opportunities into focus. I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. And this is the first part of a two-part conversation we’re having with Justin Livengood. Justin is a senior portfolio manager for the Invesco Midcap Growth Strategy, and he's a senior research analyst for our discovery and capital appreciation strategies. His focus is on financials, real estate, and health care. So we last talked to Justin almost a year ago. Brian, did you know that episode was our most downloaded episode for 2023?

Brian Levitt:      

Oh, is that right?

Jodi Phillips:     

It is. I checked the numbers.

Brian Levitt:      

I don't think I knew that. So I guess I'm glad that we're having him back on then. Jodi, as you know, I am paid by the downloads, so.

Jodi Phillips:     

Oh, really? Okay.

Brian Levitt:      

Yeah.

Jodi Phillips:     

You'll have to tell me later, how you got that deal.

Brian Levitt:      

Oh, you didn't get that deal?

Jodi Phillips:     

No, no, but we'll worry about that later. As you will remember, Justin came on the week that Silicon Valley Bank failed, and so we brought him on then to give his perspectives and to help ease concerns at that time.

Brian Levitt:      

Oh, okay. I see. So are you saying it wasn't about Justin, it was just about a crisis? So maybe we just need to manufacture some crises in order to get downloads here?

Jodi Phillips:     

That is not at all what I'm saying. Those things do tend to go hand in hand, but I would be more than happy to give up a few downloads if it meant fewer crises to deal with.

Brian Levitt:      

Oh, I would 100% take that trade off also.

Jodi Phillips:     

All right, look, so do you remember what Justin said on that March 2023 podcast?

Brian Levitt:      

I do, and I've been rereading it this week. I always write down my key takeaways. So here are the two things that I wrote that Justin had said that month.

Jodi Phillips:     

All right.

Brian Levitt:      

Number one, it's not a systemic crisis, and he said that the credit picture in the banking system is clean. And number two, he said, we're returning to a proper equilibrium in monetary policy that may help provide a stronger base for the economy and the stock market from which to operate in the next two to three years.

Jodi Phillips:     

That's some very thorough note-taking, Brian. That's great. And it feels like he was two for two.

Brian Levitt:      

It does. Credit to Justin, which is why we're having him back.

Jodi Phillips:     

Yeah, because despite that, the questions about the health of the US banking system keep emerging, don't they?

Brian Levitt:      

They do. And I get the sense that investors just feel like something has to break. We can't have the type of interest rate hikes that we've had over the last year without anything meaningfully breaking or impacting the banking system.

Jodi Phillips:     

So potentially concerns about office space, commercial real estate?

Brian Levitt:      

Yeah, I think that's the first candidate being put forward by investors.

Jodi Phillips:     

All right. So these are the questions we'll talk about in the first part of our conversation, and then we've got a lot of other questions we can focus on for the second part. We have a growth manager here, let's take advantage of it. So market concentration, the excitement about the Magnificent 7? Things like artificial intelligence. Is that excitement warranted or are we getting ahead of ourselves?

Brian Levitt:      

Right. And what would have to happen for markets to broaden out or do we just own growth stocks for the rest of our lives?

Jodi Phillips:     

All right. Well, let's bring on Justin to discuss. Hi, Justin.

Brian Levitt:      

Hey, Justin.

Justin Livengood:            

Hi, Jodi. Hi, Brian. Thanks for having me.

Brian Levitt:      

Absolutely. Thanks for coming back. So you probably felt pretty good when I was reading verbatim, what you said on the last podcast. So did it feel good what you said and has anything materially changed in your mind?

Justin Livengood:            

Well, I'm glad the economy has hung in there. I'm frankly shocked the economy has hung in there to the degree it has in the last year. I think the Fed would say the same thing. I think everyone was expecting more of a slowdown than we've seen. I'm also pleased the banking system has hung in. You're right. At the time of the failures of First Republic, Silicon Valley and Signature, there were some very anxious days and weeks, and we got through that relative well. So yeah, I'm happy that all that played out. And as you pointed out in your earlier comments, there's definitely some incremental concerns now to consider, but I don't feel it's nearly as much of a dangerous situation as it was last March.

Brian Levitt:      

And one of the critical points that you had made last March was that it was not a credit event, it was a mismanagement of the interest rate sensitivity of the bank.

Justin Livengood:            

Exactly. It was a liquidity event. Those three banks in particular were somewhat unique in how they were built, and they had concentrations in terms of clients and deposits. And especially at Silicon Valley and First Republic, when those depositors got spooked and a meaningful portion of those ran for the exits, it just started a downward spiral in terms of liquidity. And that's what forced the hands of those two. And that's why they were not anticipated properly by the regulators. The regulators don't historically look at much asset liability issues and liquidity. They spend more time looking at credit. So what we're going through right now is actually right in the sweet spot of what the regulators have all been trained to do, dealing with bad loans. That's Banking 101 for a regulator. So this next phase of, we'll call it the slow moving banking – not crisis, but banking challenge – is at least something that the regulators are more adept at handling and we can talk about that.

Jodi Phillips:     

Yeah, great. Let's do. I think, what was it, late January, Justin, where we saw the concerns flare up a bit around New York Community Bank?

Justin Livengood:            

That's right.

Jodi Phillips:     

When it declared its earnings had been well below expectations. And so some concerns may have been lingering in the background, but that really brought it to the fore pretty suddenly for some investors, it may seem. So what are maybe some of the similarities or differences between what happened then versus maybe where we were a year ago?

Justin Livengood:            

So let's step back a second and think about the banking industry and particularly the regional banking industry. So put aside maybe the top five or six banks, the Chases and the Wells Fargos. Going back three years or so when the pandemic began, you began to see a little bit of concern and emerging pressure on certain types of loans tied to commercial real estate and specifically office. And those have been building for a while. So that didn't just appear in January of this year for the first time. That's been an ongoing issue. Most loans in those categories made by regional banks are five- to seven-year duration loans or term loans. And so those loans are starting to get late in their life at a point when they would typically get refinanced and replaced with new loans.

And of course, as the values of those underlying buildings have come down, the owners of the buildings are having to face the difficult choice of either accepting less equity, writing off a lot of their investment in the property as they take on the new loan, or putting in new equity and trying to take on new debt, but at higher rates. And that puts more pressure on cashflow. So it's a difficult but somewhat predictable and slow process as it plays out over time. It's not a flash like again, we had last March. Last March, again, was not a credit event. It was a reaction by depositors to a — turned out to be a false concern that forced these banks into effectively the regulators' hands. Here, the regulators have had several years to watch and work with a lot of these regional banks as they've been starting to cull their loan portfolios and sift through some of these commercial real estate loans.

And so the good news is what happened in January with New York Community Bank was actually somewhat precipitated by the regulators. It was during the year-end audit of 2023 that the regulators sat down with those bankers, New York Community, and said, "Hey guys, look, you've got a handful of loans that are just not performing and it's time that you accept this and we reclassify them as non-performers. And in doing so, you're going to have to now make some adjustments to your capital ratios. You're going to have to move some things around your balance sheet. You're probably going to need to cut back your dividend."

And this was also happening as New York Community Bank was absorbing, ironically, the legacy assets of Signature Bank. And in doing so, they became bigger in terms of assets, deposits, et cetera. And so that put them under even more and greater requirements, capital ratios and things were changing. So they were under more scrutiny by the regulators just because of that transaction. And as part of that review with the regulators end of the year, said, "Hold on, you've got to come clean on a few of these loans." And that's what was confessed during the Q4 earnings call by New York Community.

Brian Levitt:      

So should you never come to the rescue, if you're a New York Community Bank or there are spots where if you step in and take over a Signature Bank where it actually works out over time?

Justin Livengood:            

Oh, it does and I'll show you another example. JPMorgan has absolutely come out like a hero with First Republic. They took over First Republic last March, and it has been a huge home run, both financially I think, as well as just building capital for JPMorgan with the regulators and in the eyes of Washington. So I don't want to suggest that coming to the rescue of a bank isn't a good thing. In this case though, New York Community, by helping take some of those signature assets, got bigger than perhaps they should have in hindsight and it forced them into this new bucket of regulatory scrutiny. As the regulators applied those new rules, they realized, "Wait a minute, you guys aren't completely onsides with at least some of these loans," and that reset is now happening.

It's probably also worth noting. New York Community is a pretty unusual bank. As the name suggests, they're geographically focused in New York and really the Long Island area. They have a very high proportion of their loans in multifamily and office. Although when they say office, they're not talking about buildings in Midtown, they're talking about five- to seven-story buildings in some of the outerlying boroughs and so forth. So it's a much more concentrated loan portfolio in terms of commercial real estate and office than the typical bank. A typical bank has a single-digit percent of its loans in these types of categories, whereas New York Community, it's 30%, 40%. So it exaggerates the optics, the risks, the issues that are very much under scrutiny here.

Brian Levitt:      

So let's talk about office. You and I are sitting here right now in downtown New York City. We're back in our high rise. I'm here half the time maybe.

Justin Livengood:            

Right.

Brian Levitt:      

Same, right? Flexible program. Jodi, you're in the office today or you're-

Jodi Phillips:     

Not today, not today, but yeah, we definitely have this office in Houston.

Brian Levitt:      

Well, right now you're in the Phillips office in Houston, Correct?

Jodi Phillips:     

That's right, that's right. Correct.

Brian Levitt:      

Yeah. And so how concerned are you about office space? To me, it seems like businesses were needing less office space even before the pandemic happened. You no longer needed rooms for file cabinets or you no longer needed rooms for servers. All of that was moving. Now, I think the last I saw in terms of the number of people swiping in at offices is around 50%, New York City might be a little bit less than that, although my commute would suggest otherwise. And the line downstairs for the salad might suggest otherwise.

Justin Livengood:            

Exactly.

Brian Levitt:      

How worried are you when you talk about a slow moving, did you call it a train wreck? A crisis?

Justin Livengood:            

Yeah, yeah, yeah. It's maybe not quite a train wreck, but it's a slow moving-

Brian Levitt:      

Derailment?

Justin Livengood:            

Process.

Brian Levitt:      

A derailment?

Justin Livengood:            

Right.

Brian Levitt:      

And so how worried are you that there's something lurking within that, that's unforeseen? it's comforting to me to hear you talk about the regulators being in front of it with New York Community Bank. Are you concerned that there's something lurking out there?

Justin Livengood:            

I don't think there's something lurking again, because I think it's fairly well known what everyone in the regional banking industry particularly owns at this point, where their exposures are. And I think there's stress testing that goes on that forces banks to consider what is going to happen to their loans and their assets in different economic scenarios. And there's some pretty punitive scenarios that the regulators make you consider. And then based on how you do in those tests, you have to adjust your dividend policies and perhaps your capital. So the industry right now is really well-capitalized in general, and that even goes down to a lot of the smaller banks. Even New York Community by the way, despite having to disclose those and write down some of those big loans last month, they're still above what is defined as well-capitalized. It removed a cushion, but it wasn't like they had to go out and do a dilutive financing overnight to suddenly get back onsides.

Here are a couple more interesting statistics that I recently read to help maybe frame this. So there are about $40 billion of reserves right now in the banking industry set aside specifically for office and commercial real estate loans. And that represents about a one and a half... Let me put it this way. Right now, one and a half percent of all office loans made by banks are considered delinquent.

Brian Levitt:      

Okay.

Justin Livengood:            

If things get as bad as they did in the global financial crisis (GFC) in 2008 and 2009, that delinquency rate would go to 6%. That's where we topped out at in the worst situation that these banks have probably ever faced. And that's the kind of stress test scenario that the banks have been getting put through in recent years. So in other words, you've got room for delinquencies and losses on this category of loans to quadruple, and you're only back to where we were in the GFC on losses.

Brian Levitt:      

Well, we don't want to be in-

Justin Livengood:            

We don't want to be there. But if we were hypothetically, you know what the dollar value of losses would be, round numbers? $40 billion.

Brian Levitt:      

$40 billion.

Justin Livengood:            

Which happens to be where the industry is roughly reserved. So again, it's not a scenario I want, but if it happened, it wouldn't happen overnight like back in March of '23, it wouldn't be like all of a sudden on a weekend, we're worrying about six banks going under because they suddenly realized they had two bad office loans. Furthermore, as they were taking writedowns on loans, they would presumably just be drawing on reserves already set aside. So the only thing that really concerns me, and I've heard bank CEOs say this, so this isn't really just my opinion, is if the economy were to take a left turn and get worse and other property classes started to struggle, other types of loans-

Brian Levitt:      

Like multifamily or?

Justin Livengood:            

Right, or even just residential mortgages.

Brian Levitt:      

Oh, don't say residential mortgages.

Justin Livengood:            

Traditional commercial loans. Exactly. If other pockets of a bank's balance sheet started to also see growing losses, which right now isn't happening, then you'd have other things eating away at bank reserves and capital, and then this office/commercial real estate situation would perhaps become more of a concern. But I think at the end of the day, as long as the economy cooperates, and I don't think it needs to do much more than it currently is, it is remarkably resilient at the moment. I think banks are going to have enough time, as will the regulators, to over a two-to-three year period, get the worst of these loans around office buildings and commercial real estate to where they need to be in terms of refinanced, re-equitized, and the industry will be on more solid footing. Now, having said that, there's a second reality that these banks are facing as this process slowly flipped out.

Brian Levitt:      

Jodi, were you feeling better?

Jodi Phillips:     

I was.

Brian Levitt:      

I was feeling so-

Jodi Phillips:     

I wasn't until we're entering the alternate reality.

Brian Levitt:      

I'm not good with second reality. My brain only works on one reality.

Jodi Phillips:     

One reality at a time.

Justin Livengood:            

It's not all bad. It's not all bad.

Jodi Phillips:     

Okay, okay.

Brian Levitt:      

Okay.

Jodi Phillips:     

If you say so.

Justin Livengood:            

But banks aren't making as many loans as they used to because of this.

Brian Levitt:      

Okay. Right.

Justin Livengood:            

So this isn't just back to business as usual at banks. So this is one of the things we talked about a year ago that I suspected like, "Hey, it's going to take a long time for underwriters and staff at banks to be told and allowed to go back to writing as many loans." And those loans they are writing, they're of course, and I'm not just talking about office, I'm talking about again, loans to individual companies and individuals.

Brian Levitt:      

If you have 3% inflation, isn't that a good thing? Maybe not 3%, but we were at 4% or 5% inflation. Isn't that a good thing? We were trying to slow down this economy, right?

Justin Livengood:            

Right.

Brian Levitt:      

But the problem is you get to 2% inflation and then things continue to slow and then the Fed's got to ease and try and reinvigorate credit creation and economic activity again?

Justin Livengood:            

Right. Some of this. Okay, there's two issues. One issue which I was driving at is just because banks are still trying to get properly capitalized and reserved for some of these lingering credit issues, they can't make new loans and grow as much as they used to. In fact, the industry basically did not grow in the fourth quarter. New loans were flat in the fourth quarter of 2023, and the outlook that banks gave for '24 is pretty flattish. It varies by type of loan, it varies a little bit by geography, but basically, there isn't credit formation from the banks. Now, there is credit formation happening outside of the banking system.

Brian Levitt:      

The shadow banking system.

Justin Livengood:            

This whole private credit phenomenon is real. It's going to have legs and we can come back and talk about this because I'm very close to a lot of the firms that are involved in that space, and I think that is a big durable trend. So what's happening is a mix shift away from the regional banks to other providers. We can call it shadow banking, but that has a little bit of a negative connotation that I'm not sure is fair. I think actually, it's somewhat healthy to have some incremental growth in the private side of the lending market. Now the second thing that you were referring to is what do we want to do in terms of interest rate policy and the Fed?

So the other thing the banks are having to deal with right now is the curve's still inverted and the front end of that curve is still five and a quarter, five and a half percent. That's not good.

Brian Levitt:      

But they're not paying that, right?

Justin Livengood:            

Oh, on incremental deposits and borrowings to the Fed window, they are.

Brian Levitt:      

Okay. But if I go to the bank, I'm getting 0.1%, right?

Justin Livengood:            

Well, if you're at one of the big banks who don't want your deposits. You're right, chase and BofA aren't going to pay anything. But if you're a smaller bank, a lot of regional banks are still dependent on time deposits like CDs and some money market checking type products, which are, if they're not at the Fed funds rate, they're still elevated. It's three, four and a half percent type things. Bank funding costs over the last 12 to 18 months have gone up faster than anyone expected, notably the banks. And that has squeezed their margins because their loans are priced quickly to rates, but only up to where usually the five or 10 year is because most loans are priced longer term. Deposits and funding are priced short term. So this inverted yield curve that has stubbornly stuck around is slowly squeezing margin on the banks on the industry.

So yeah, the Fed is watching this and having to, of course, juggle lots of different things when they're thinking about setting monetary policy. And one of their concerns is, "Boy, the longer we leave the Fed funds rate where it is in our attempt to fight inflation," which I think is the right move, "We're pressuring those banks who at the very same time we're telling to get their houses in order on some of these loans and get your credit ratio, your capital ratios up." So it is a little bit of a moving game that the banks are having to deal with.

Brian Levitt:      

Jodi, I got two things for you. One, it sounds like I might have my deposits in the wrong place. I might've been sleeping for the last year and a half.

Jodi Phillips:     

Perhaps you were.

Brian Levitt:      

And two, did you notice Justin doing the shape of his yield curve on his elbow?

Jodi Phillips:     

Yeah, no, that was really impressive.

Brian Levitt:      

In a podcast. It's going to be good for the podcast.

Justin Livengood:            

Exactly, right?

Jodi Phillips:     

We have to add a video component for this one.

Justin Livengood:            

It was not ideal for an audio only.

Brian Levitt:      

He's a New Yorker. He speaks with his hands.

Justin Livengood:            

Gestures. That's right. That's right.

Jodi Phillips:     

For sure. So Justin, what about any ripple effects in the broader markets? It doesn't really feel like we're feeling anything at this point in time, but in terms of banking concerns, what would you be watching out for just in terms of any broader market impact?

Justin Livengood:            

I think that as it relates to the economy, we're largely okay in terms of what the banks are doing. And I don't think the banks pose a major risk. Again, there has been now a multi-year period where the majority of banks have been able to get their houses in order, and it's only going to be outliers like New York Community that are going to be in the headlines and running into issues with regulators. The system, by and large, is in great shape.

Jamie Dimon just said that yesterday at a conference. I've heard that song and verse from other large bank CEOs in the last few months. And you listen to the larger banks, the top 25 banks, they just came through Q4 earnings with mostly flat loan loss provisions and non-performing assets were flat to down. So the big diversified banks are if anything, having a great stretch of performance, they're not posing a risk to the economy, they're not posing a risk to the markets. They're very healthy and happy. And smaller banks, again, have had time for the most part, to get into the position they need to be in to manage these credit risks.

So I think they'll continue to be outliers like New York Community. I think there'll be some headlines and some moments of concern, but as long as the economy continues to chug along at an okay rate, and as long as the Fed has at least done tightening and tilting towards making rate cuts as we move into next year, I think the banking industry in general is going to be fine and it's not going to be an impediment to growth.

Brian Levitt:      

We talked about private and credit as a durable theme. I get a lot of questions, "What are your thoughts on private markets." It's like the new, everybody's focused on it. So somebody says to you, what are your thoughts on the private credit market when you think of it as a durable theme? Should investors be looking in that space? I know you're focusing on it from the financial players in that space, but investors looking for incremental yield or opportunities they may not otherwise have, private credit, makes sense to you it sounds like?

Justin Livengood:            

Absolutely. So I'll back up. I think credit makes a lot of sense right now. So I also think that public credit is really interesting.

Brian Levitt:      

Investment grade corporates, 5% yield?

Justin Livengood:            

Or high yield corporates, even.

Brian Levitt:      

8%, 9% yield.

Justin Livengood:            

Yeah. Going back to where we started a minute ago, Brian, I am stunned at the resiliency of the economy and its ability to absorb what the Fed has done. As we sit here today, unemployment, Q1 expected GDP (gross domestic product), and inflation are all between three and a half and 4%.

Brian Levitt:      

And people are miserable.

Justin Livengood:            

Well, okay, people are miserable.

Brian Levitt:      

And that's cost of living.

Justin Livengood:            

But the stock market is making new highs.

Brian Levitt:      

New highs, right.

Justin Livengood:            

But my point is it's stunning that you would have at a moment when the Fed has pushed rates to their highest in over a decade, those three numbers I quoted a moment ago, and as long as those three numbers stay there, I don't think the Fed's going to be in any rush to go anywhere in terms of cutting rates. So I think that's really bullish for credit in general because I think a lot of loans... Now I'm going to segue a little bit to your private credit comment. I think there's a lot of value in, again, high grade and high yield public credit, but even on the private side, they're getting to underwrite new loans to businesses, whether it's tied to real estate or it's just straight up corporate-type lending as though you're going to have a normalized credit experience. And that's not what's happening.

I'm hearing all the time from the Blackstones and the KKRs that I get to talk to, that this is a once in a decade, maybe once in a 20-year career opportunity. You're getting interest rates on new loans that's low double digits with terms that are typically only seen in the best of times from a lender standpoint. And it's because borrowers don't have those regional banks. Those companies that are on the line from a credit standpoint that can't tap the public markets that would normally go to a regional bank or some bank to get that next piece of financing. The banks are saying, "Hold on, I'm in this shutdown mode. I got to finish getting my house in order. I can't give you a competitive loan." So they turn to a lot of these private pools of money. So yeah, I'm actually quite bullish on credit.

It's also a good thing for someone like me that sits in the small-midcap equity world because a lot of my small-midcap companies are in fact those same companies tapping private credit or at least the high yield kinds of public credit markets, and this is fine for them. They're able to get decent funding and execute their business plans and do well. And that's partly why now you're seeing the stock market, both the large cap and smaller cap parts of the market do well. People are comfortable that we've threaded the needle on a soft landing and they're able to get financing where they see growth opportunities. So even though loan growth in the banks I said earlier, has stalled out as an industry, this private capital opportunity, particularly on the private credit side, is adequately filling the hole. And I don't think it's reckless. I don't think it's for the most part-

Brian Levitt:      

Shadow.

Justin Livengood:            

Shadow type institutions.

Brian Levitt:      

It does sound very concerning.

Justin Livengood:            

I think it's good money and frankly, it's good money or it's a good trend in some ways because it's removing some of the risk from the regulated banking industry. If sophisticated institutional investors at a private credit fund take a loss on a loan, that's probably not a systemic risk. But if a bank goes down because they made a bad loan, well now we've got to tap the FDIC trust fund to repay the depositors and we've got to go deal with the broader systemic risk that could pose to the banking industry. Well, if we're moving some of those risks off to, at the moment, what seems to be a relatively thoughtful and sophisticated private credit industry, that's not a bad thing.

Brian Levitt:      

Jodi, should we pivot to part two?

Jodi Phillips:     

Well, I think we should, unless there's a third reality he's about to spring on us, which I hope not because I’m feeling pretty good with where we are. … And that’s the end of the first part of our conversation. In the second part, we’re going to talk to Justin about market concentration and what it might take for market participation to broaden. And we’ll spend some time on the potential impact of artificial intelligence – not only on tech companies, but on other sectors that are using this technology in interesting ways. Thanks for listening.

 

Important information

You've been listening to Invesco's Greater Possibilities Podcast.

The opinions expressed are those of the speakers, are based on current market conditions as of February 27, 2024, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Invesco is not affiliated with any of the companies or individuals mentioned herein.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

Should this contain any forward looking statements, understand they are not guarantees of future results. They involve risks, uncertainties, and assumptions. There can be no assurance that actual results will not differ materially from expectations.

All investing involves risk, including the risk of loss.

Past performance is not a guarantee of future results.

Diversification does not guarantee a profit or eliminate the risk of loss.

An investment cannot be made directly in an index.

All data provided by Invesco unless otherwise noted.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

Investments in financial institutions may be subject to certain risks, including the risk of regulatory actions, changes in interest rates and concentration of loan portfolios in an industry or sector.

The profitability of businesses in the financial services sector depends on the availability and cost of money and may fluctuate significantly in response to changes in government regulation, interest rates and general economic conditions. These businesses often operate with substantial financial leverage.

Growth stocks tend to be more sensitive to changes in their earnings and can be more volatile.

The health care industry is subject to risks relating to government regulation, obsolescence caused by scientific advances and technological innovations.

Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.

Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

Many products and services offered in technology-related industries are subject to rapid obsolescence, which may lower the value of the issuers.

Statistics about the loan portfolio of New York Community Bank sourced from the US Federal Reserve.

The Magnificent 7 refers to Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla.

Statistics about the number of people swiping into offices sourced from Kastle Systems.

Reference to $40 billion in reserves set aside for office and commercial real estate loans and references to delinquency rates sourced from the US Federal Reserve.

The hypothetical estimate of the value of losses if the delinquency rate were 6% sourced from Invesco analysis.

References to the rates on the yield curve sourced from Bloomberg as of February 2024.

The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity. An inverted yield curve is one in which shorter-term bonds have a higher yield than longer-term bonds of the same credit quality. In a normal yield curve, longer-term bonds have a higher yield.

References to interest rates paid on bank deposits sourced from Bankrate.com.

The federal funds rate is the rate at which banks lend balances to each other overnight.

References to investment grade yields sourced from Bloomberg, based on the yield to worst of the Bloomberg US Corporate Bond Index, which measures the investment grade, fixed-rate, taxable corporate bond market.

Yield to worst is the lowest potential yield an investor can receive on a bond without the issuer actually defaulting.

References to high yield bond yields sourced from Bloomberg, based on the yield to worst of the Bloomberg US High Yield Corporate Bond Index, which measures the US dollar-denominated, high yield, fixed-rate corporate bond market.

References to unemployment data, gross domestic product (or GDP) and inflation sourced from the US Bureau of Labor Statistics.

References to small and mid-cap performance sourced from Bloomberg. Based on performance of the Russell 2000 and Russell Mid Cap indexes in November and December 2023.

The Russell 2000® Index, a trademark/service mark of the Frank Russell Co.®, is an unmanaged index considered representative of small-cap stocks.

The Russell Midcap® Index is an unmanaged index considered representative of mid-cap stocks.

All Russell indexes mentioned are trademarks of the Frank Russell Co.

FDIC stands for the Federal Deposit Insurance Corporation.

The Greater Possibilities podcast is brought to you by Invesco Distributors, Inc.

Brian Levitt:

Welcome to the Greater Possibilities podcast from Invesco, where we put concerns into context and opportunities into focus. I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. And on the show today is Jen Flitton, Head of US Government Affairs at Invesco.

Brian Levitt:

Must be general election season already, Jodi.

Jodi Phillips:

Yeah, it feels like it, doesn’t it?

Brian Levitt:

It sort of came early.

Jodi Phillips:

Yeah, it sounds like we skipped over the primaries a little bit. Just went straight to the main storyline, right?

Brian Levitt:

Yeah. It's too early. So now we get to do this for 10 months.

Jodi Phillips:

We've drained all the suspense out of the whole process, absolutely. But look, to your point, it's early February. What about investors' radar screens? Is this something investors are already focusing on?

Brian Levitt:

Yeah, I'm not sure they ever stopped focusing on politics and news flow in terms of what the implications are for their portfolio.

Jodi Phillips:

Despite your best efforts, despite your best efforts. I thought it was your life's work to tell people not to worry about the election, or at least in terms of market impact, right?

Brian Levitt:

Well, clearly I am not doing a good job.

Jodi Phillips:

I don't know. We're getting there, maybe.

Brian Levitt:

Slowly, one blog at a time.

Jodi Phillips:

One podcast at a time.

Brian Levitt:

Yeah, I don't know. I think there's some people who just maybe they hear it, but they don't want to change their mind. I remember my mom used to say, it reminds me of this, she said, "If you never change your mind, then why have one?"

Jodi Phillips:

I love that you're quoting your mom. I hope my boys one day find some wisdom for me to quote from. We'll see. But okay, so then what is something that could help investors change their mind about elections?

Brian Levitt:

Okay, so here's one that I've been using that I love. This has worked out so nicely for my message. So I was looking at when Biden was elected on November 3rd, 2020, and he was elected 820 or so market days ago, and the performance of the S&P 500's in the high 40%s since the day he was elected. And so then you go back and you look, when Trump was elected over this, what the performance of the market was over the same time period since Trump was like, any guesses?

Jodi Phillips:

I don't know. About the same, I would guess.

Brian Levitt:

Yeah. What gave it away?

Jodi Phillips:

I know your message, Brian. I know your message.

Brian Levitt:

So it's actually mid-50s. So if you're a Trump fan, you could say, "Great, we're slightly ahead." But the reality is, high 40s, mid-50s, this whole thing is really much ado about nothing.

Jodi Phillips:

Yeah. Much less stark than what the campaign rhetoric would have you believe.

Brian Levitt:

Exactly. Remember that whole, "Your 401k is going to zero if I don't win,” or “the US is going to go bankrupt if I don't win?"

Jodi Phillips:

Mm-hmm. All or nothing.

Brian Levitt:

Yeah, it's just not how things work out. Fortunately.

Jodi Phillips:

Fortunately. So that's S&P 500, that's the broad market, which is certainly important, but there are a lot of other issues and nuances that investors will want to have greater insight on, and so that's why Jen is here.

Brian Levitt:

Yeah. I just try to keep people calm. Jen actually knows stuff, so it's good to have her.

Jodi Phillips:

Oh, great! We like guests who know stuff, so let's not waste any more time and bring on Jen to discuss everything she knows about DC. Hi, Jen. Where do you want to start, Brian? Should we start with some of the major legislation that Jen's keeping an eye on right now?

Brian Levitt:

Yeah, I would love to hear it. We've been all focusing on this will we have a deal to fund overseas allies militarily and also have some money for the border, and it seems to be up in the air, and curious Jen's thoughts on it?

Jodi Phillips:

That's right. $118 billion package, bipartisan package in the Senate, to provide aid to Ukraine and Israel and some border security. So what do you think the fate of that's going to be, Jen?

Jennifer Flitton:

Okay, so we just had a vote. Today is February 8th just for context.

Jodi Phillips:

Yes, for sure. Let's timestamp that.

Jennifer Flitton:

So we just had a vote in the Senate. It's no longer a $118 billion package. It's now a $95 billion package. They are moving on Ukraine, Taiwan money, Israel money, some humanitarian assistance into Gaza money, but they've taken the immigration language out. So this was a negotiated language that Langford and Chris Murphy and Kyrsten Sinema have been working on for the last two months of negotiations, but it fell very flat in the Senate when they finally unveiled the legislation and the language in order to secure the border. They went through a number of really strong restrictions, I mean some of the strongest immigration restrictions, especially in a negotiated package that we have seen in recent memory. But it wasn't enough for especially very conservative members of the Senate.

Brian Levitt:

Was it not enough or was it viewed as perhaps a political challenge for Donald Trump running for election that if Biden had a win on the border, that would take away one of the key messages?

Jennifer Flitton:

So that is the argument from the Democrats. That's exactly what they're saying, that this is a cynical move by the Republicans in order to keep a live issue live going into the election.

Brian Levitt:

Well, I don't want to be cynical.

Jennifer Flitton:

Right. Not in politics, no. But yeah, so that's exactly what the argument is that they want to keep this a live issue, and it will stay a live issue if they can't reach any sort of agreement on even a few amendments to this national security bill. And it looks pretty unlikely they have 17 Republicans who are voting cloture to move forward. The Senate is about to recess for two weeks, so they'll probably get this bill done over the weekend, and it will be sent over to the House, where there are giant question marks how it will be processed.

Jodi Phillips:

Always question marks, no shortage of question marks, for sure. You mentioned that the immigration language was taken completely out of this, right? So what about that issue? I think that was it December marked a record monthly high of migrants crossing over the US southern border. It's certainly an issue that is top of mind for a lot of people. How can it be addressed?

Jennifer Flitton:

Yeah. Seeing what happened over the last 48, 72 hours in the Senate, I think it's highly unlikely that you're going to see some sort of solution coming out of Congress. So then you're looking to the executive branch. The complaint from the Republican standpoint, going into the Biden administration, the first several months of the Biden administration was that he repealed through about 64 executive orders, the actions of the previous administration on the border, and their argument is that that has led us to this point right now. And their argument is, "So you can undo by going back." It's not quite that simple, right? And one of the biggest restrictions was the "Remain in Mexico" policy. That can't be renegotiated with a snap of the finger. So the question really is what is the Biden administration willing to do? What is the Department of Homeland Security willing to do over the next several months, to your point, to try to bring those numbers into a more controllable sort of situation at the border.

Brian Levitt:

So as we move forward through this year, we know we have an election in 9, 10 months. Is there anything that investors need to be worried about in terms of the state of our politics or how things will operate between now and the election, or do we have to be worried about a shutdown or something else that perhaps is done to make one side or the other not look good ahead of an election?

Jennifer Flitton:

Yeah, we're always worried about a shutdown, right? Because Congress has not been willing or ready or able to get appropriations bills done on time. And so this constant kicking of the can with continuing resolutions brings into question whether they can do the business, the most important business of Congress, which is the power of the purse. But we are getting to a point where you finally have the negotiations happening between the House and Senate. They have their top line numbers, which are known as the 302(b) numbers. The subcommittees are negotiating as we speak, and signs are positive in my conversations with staff on The Hill they seem to be getting there.

Brian Levitt:

Oh, good. Yeah, that seems to be how we do this, right, Jen?

Jennifer Flitton:

Yeah.

Brian Levitt:

We seem to get to the 11th hours, and either we cross it, we cross some breach, and we have to deem everybody's necessary so people all work anyway, or we pass it.

Jennifer Flitton:

Yeah, you're right.

Brian Levitt:

Essential, not necessary. Essential. My apologies.

Jennifer Flitton:

Essential employees, yeah.

Brian Levitt:

Essentials, yeah.

Jennifer Flitton:

It's always darkest before dawn, I think, with the appropriations process, and as we approach these March deadlines, I think we're probably going to see two packages hitting right at those threshold dates. And that is also a big week, that first week of March, because not only is it Super Tuesday where we will then see almost 50% of the Republican primary vote in, we also have the President addressing Congress for the State of the Union on March 7th. Shortly after that, the President will release his 2025 budget, which will really set the parameters for his priorities both on spending and tax, and it will also sort of telegraph where he's going as far as his campaign message and his agenda going into this general election season.

Brian Levitt:

Jodi, have you ever actually played kick the can?

Jodi Phillips:

No, I sure haven't.

Brian Levitt:

Jen, have you?

Jennifer Flitton:

Yeah.

Brian Levitt:

You have?

Jennifer Flitton:

I'm from Ohio. Where are you from, Jodi?

Jodi Phillips:

Texas.

Jodi Phillips:

Jen, primary season, you mentioned primary season. So I don't feel like I understand primary season this go around. I know Nevada had both the Republican caucus and a Republican primary, and “none of these candidates” won the primary. I don't know. I don't know what's going on. It just feels like it's quick and chaotic, and can you maybe help explain what's going on and what you're looking at?

Jennifer Flitton:

Nevada is a funny story, and it's really just this year that they're trying to get two caucuses in on both the Republican and Democratic side, and now the primary's sort of leftover, but if you filed to be in the primary, you can't file to be in the caucus. And so Haley filed to be in the primary, but then the Trump campaign put a campaign against her telling his supporters to vote, "None of the above," or "None of the …"

Jodi Phillips:

Sure. I don't know why I'm having trouble keeping up. This totally makes sense.

Jennifer Flitton:

Yeah, exactly. And then they managed to beat her by like 60-plus percent to her 33%. So it was a little humiliating. I think that was their intention. And now Trump runs in the caucus today, so we'll see what that number is. It should be strong. And then we go into the end of February here with the South Carolina primary, which will be the primary to probably define whether Haley stays in this election or not.

Brian Levitt:

None of the above. Sounds like a good theme for the 2024. So Trump versus Biden, probably a foregone conclusion. And is there anything that's going on right now with the Supreme Court or the Colorado case that changes that?

Jennifer Flitton:

Yeah, I was just watching the oral arguments. So the constitutional question as to whether Colorado and Maine, also relying on the Colorado decision to take Trump off the ballot in Colorado, that is being decided right now by the Supreme Court. Listening to oral arguments pretty much indicates that by the questioning of both sides of those who were put onto the court by Democrats and those put on the court by Republicans seems to indicate that this will be overturned, and Trump will be back on the ballot in Colorado and Maine.

Brian Levitt:

So this will be determined by the voters, not the Justice Department.

Jennifer Flitton:

I think that is very likely the decision that comes out of the Supreme Court.

Jodi Phillips:

So given how crazy the primaries have been this time around, does that change the landscape or the complexion of the general election at all? I know my impression has been, and maybe this is true or false, but that primaries were sort of auditions for folks who wanted to be the VP candidate, right? So what do you think in terms of a running mate for Trump?

Jennifer Flitton:

Yeah, I'll first answer that first question. This is going to be a strange election in the sense of the court system being as involved as it'll be, and not just in the indictments of Trump and him having to maneuver his way through different courts in different states in America, but also these questions of taking him off the ballot and his own question of immunity. The Supreme Court is clearly going to have to get involved in some of these issues, most likely on the immunity case. We'll see if he files appeal.

But to the question of the vice president, right now, as we've been told, it's been reported, and some of us have been in contact with the different campaigns, and it's clear that Trump and his team are vetting potential vice president nominees right now. And so I think it's very likely he will announce come late spring, early summer who his running mate is.

Brian Levitt:

What are the big issues that investors should be focusing on, Jen? What are the big issues that you're focusing on?

Jennifer Flitton:

Well, I'm trying to get through the noise, right? There's so much around this election that is going to be incredibly hyperbolic. There's going to be manufactured crises, and what we're trying to do is keep our investors' eye on the ball. This is where it is actually going to come down to Joe Biden policies versus Donald Trump policies on taxes and immigration and the economy and spending priorities. And I think the more we can cut through the hyperbolic rhetoric and the more we can focus on what is actually at stake, the better, and I think that just keeps our investors better informed.

Brian Levitt:

Good luck.

Jodi Phillips:

Absolutely.

Brian Levitt:

I've been trying to do this for years, Jen.

Jodi Phillips:

And at the risk of injecting any hyperbolic rhetoric, I see people mentioning that the next president is going to face a tax cliff, so to speak, because of certain provisions of the Tax Cuts and Jobs Act (TCJA) that are set to expire at the end of '25. Obviously, tax is an extremely important issue. How would you describe what the different issues are in terms of what the next president will face?

Jennifer Flitton:

Yeah, this is going to be a major point of contention in the general election, and if we do see debates out of these two men come fall, I think this is going to be a major focus, because in 2017, Donald Trump was able to get through his TCJA, which is the tax reform restructuring of our code, but a number of those provisions do expire, as you indicated, Jodi, in late 2025. We also have a tax bill. In all of this mess in Congress, they were able to negotiate a bipartisan tax bill that not only extends the child tax credit, but also does important work on research and development, expanding that and extending that along with accelerated depreciation. These things mean a lot to farmers and small businesses along with big corporations here in America. And so that would also, though, the way that they've structured it, would expire at the end of 2025. So there's going to be momentum going into 2025 to do something about this. There's other expiring provisions that have to be taken care of, the SALT issue, which is the state and local income tax.

Brian Levitt:

Yeah, I'm in New Jersey. Tell me about the SALT issue.

Jennifer Flitton:

Yeah. So unfortunately for those New York and New Jersey delegation members, they were not able to include some SALT changes to this latest tax bill. They're trying to get a standalone vote. I think it's going to be hard to get it out of rules committee. I don't think it has a good future, but it does expire along with the others at the end of 2025, and that would mean a huge revenue decline for the IRS. So they have to deal with all of this, and it's going to look very different between a President Biden or a President Trump. That's probably one of the issues that swings strongly one way or another come 2025.

Brian Levitt:

Well, Jen, I was getting a little bit of deja vu when Jodi said tax cliff. So I was thinking back, what I remember now is the fiscal cliff, which was maybe a decade ago, and I think that was the end of the Bush era tax cuts, to which ultimately I think all the concern investors had about the fiscal cliff, I think Obama ended up extending many elements of them, some of the elements of the Bush era. So is that a blueprint that we could draw in that if investors do have concerns that Biden will win the election and these things will potentially expire, can we draw on the 2014 or 2008 example? I'm trying to remember the date.

Jennifer Flitton:

I do think you're right. It is much more a mixed outcome if Biden is reelected, because in the run-up to his first election in 2020, he made clear that, as it relates to tax or tax increases, that he won't raise taxes on any families below $400,000. And so as we look at the tax framework, the individual tax framework, the tax brackets that currently exist under this, will expire at the end of 2025. I'm curious to see if some of his messaging comes out as we get into the general campaign season as not increasing below $400,000, but then looking at those tax brackets above $400,000.

Brian Levitt:

I also vaguely remember when he was running in 2020, a lot of concern from investors of where the capital gains tax rate would be. Wasn't it a very large number that had people very concerned that actually did not come to pass?

Jennifer Flitton:

Yeah, right. And that withered on the vine pretty quickly. But there's also members of his own party, and important members like the chairman of the finance committee, Chair Wyden, who has his own legislation. It's kind of a wealth tax. It's basically taxing on income that isn't income yet. And so how some of those questions are going to be answered, how he's going to put together his own tax plan, we're going to see that here very shortly. And I think some of this, like I said, is going to be telegraphed in his budget, and we're going to get an idea of what his economic plan is partly through his budget that he's going to release at the beginning of March.

Jodi Phillips:

So Jen, as someone who has aspirations to retire one day, someday, should I be concerned at all about the SECURE 2.0 implementation, the bipartisan act, lots of implications for retirement savers? Obviously, with a multi-year rollout of these provisions in the middle of an election, is there anything you're watching with that?

Jennifer Flitton:

So we're basically in implementation mode now, and members of Congress are watching very closely what sort of effects this legislation is having on the retirement community in getting more people to save for retirement because that's the whole point of it. It's not just those currently saving for retirement, but those who are sort of underserved in the retirement industry. And so that's really what the focus is for members of Congress in watching this implementation.

But you're right, the Department of Labor and Treasury, they still have to write guidance, they still have to write regulation. There's a technical corrections bill that's going to have to move through the Senate, but because of other priorities, they're going to have to get to the more controversial first, because there's a reason it has to do with the Congressional Review Act and we'll get into that, but you're right, the first half of the year is going to have to be spent on the President's agenda and his priorities and what he needs to get promulgated and finalized within the first half of the year. So that's going to push some of these less controversial issues towards the second half of the year.

Brian Levitt:

Is there anything else that the asset management industry needs to be particularly focused on or the advisory business needs to be focused on?

Jennifer Flitton:

Yeah. Like I said, there are a number of regulations that are going to be finalized in the first half of the year. I'm talking to advisors a lot about the DOL's (Department of Labor) new fiduciary rule, which we do expect to come out at the first half of this year. It will have a CRA attempt at it, which is Congress's Review Act, which tries to get regulation eliminated because they deem it not at the discretion of the regulatory agency, and it should be at the statutory authority of Congress. And so that's going to be a fight. But also, the SEC is putting out a lot of proposals. Those are going to be finalized, and what is the aggregated effect on the capital markets? I think that is one of the questions that's out there that we're watching very closely.

Jodi Phillips:

Is there anything we should be watching with artificial intelligence, crypto, any of those issues?

Jennifer Flitton:

Now, that's a favorite issue, artificial intelligence (AI) first, on The Hill, and that's a bipartisan favorite, and there's been a lot of time and effort spent. Especially, it started this last half of last year in 2023. Chuck Schumer, the majority leader, put together a number of briefings with corporate America, tech America to come in and really sit down and help members of Congress, senators really understand artificial intelligence and how it could be regulated and what needs to be done on a governmental level. And so that question is going to continue into 2024.

If you sit down with some of these senators who are really focused on it, it's all they want to talk about. It's hard to get them off the topic, in fact. And so I think you're going to see some of them, who are most challenged and want to be champions on the issue, really trying to come together on some bipartisanship. We'll see if they're able to get there this year. But those talks, that's the sausage being made, that's the side of it where it takes time for these things to come to fruition.

Brian Levitt:

Do you think they're able to get their heads around a topic that's so potentially complex?

Jennifer Flitton:

I know. Can the world get their heads around AI and all the good and bad that can come from it? Yeah, you're right. It's a hard one to answer.

Brian Levitt:

And what about crypto, to Jodi's point, about crypto regulation?

Jennifer Flitton:

Yeah. So there's a market structure proposal at the SEC (Securities and Exchange Commission). There is also a big attempt by the chairman of the Financial Services Committee, Chairman McHenry, to try to get some stablecoin legislation through, to get some digital asset market structure legislation through. They're going back to the drawing board on stablecoins with his Democratic counterpart, Maxine Waters, really trying to work through some of that illicit financing angle that still is really concerning a lot of members on both sides of the aisle.

And then we saw Secretary Yellen. Secretary of the Treasury make clear at a hearing this week that the Treasury generally supports legislation on stablecoin digital asset market structure. But it's really the devil's in the details, and getting there has to come out of the House, because those conversations just aren't really happening in the Senate.

Brian Levitt:

So how's this going to play out, Jen? Do you have a horse in the race for the election?

Jennifer Flitton:

Yeah. I know that Wall Street investors love a theory of the case, but with the polls where they are right now, it is a virtual 50/50 race, and it is all within the margin of error that it could be either candidate, I'd say incumbent, but they both are sort of ... One's definitely an incumbent, one's sort of a quasi-incumbent. And you're talking about a second term for either one, which would mean a lame duck sort of term. This is going to a very interesting race.

Brian Levitt:

Unprecedented since Grover Cleveland? Is it Grover Cleveland?

Jennifer Flitton:

Is it?

Brian Levitt:

Born in my hometown, by the way, Grover Cleveland.

Jennifer Flitton:

Oh, congratulations.

Brian Levitt:

Yeah, thank you. So when we talk about that 50/50 so tight, one of the things that I've asked you before, but not on the podcast is, is there concern that we don't know who won for a long while, and should investors have any concern about potentially two men showing up on January 20th, 2025, to take the oath of office?

Jennifer Flitton:

I don't think it'll take that long. We may not know the night of, but it's really going to come down to six states. So it's going to be Arizona, Nevada, Wisconsin, Michigan, Pennsylvania, and Georgia.

Brian Levitt:

Georgia. So Jodi and I'll sit these out, Texas and New Jersey?

Jodi Phillips:

Yeah.

Jennifer Flitton:

We all know where you're going. But those six states are really the swing states, those are the presidential makers. And so going into election night, you're probably talking about 100,000 votes total that are really going to decide where this race goes.

Brian Levitt:

So these guys better go start knocking on doors, huh?

Jennifer Flitton:

Oh, yes. I think those states are going to have a lot of commercials coming their way, lit drops and phone calls, and I'm sure it will be very annoying.

Jodi Phillips:

It's going to be a long nine months. All right. Any more questions, Brian? I think we've covered everything.

Brian Levitt:

Well, we're going to have Jen back on many times over the next nine, 10 months, correct?

Jodi Phillips:

Absolutely, and I'm going to take the lesson that I've learned from whenever we have Jen on the podcast, which is to check X, Twitter, right before she comes on. I think last time, we had someone drop out of the Speaker's race about five minutes before we talked to Jen, and now they took all the immigration language out of the immigration bill. So always late-breaking news that Jen's here to put into context for us.

Brian Levitt:

Because Jodi, you and I are working too hard. We're not keeping up to it.

Jodi Phillips:

That's right. Next time.

Brian Levitt:

Well, Jen, thank you so much for joining us.

Jodi Phillips:

Thanks again for joining us, Jen.

Jennifer Flitton:

Thanks for having me.

Jodi Phillips:

Okay, Brian, where can listeners find more information from you throughout election season and beyond?

Brian Levitt:

Well, thanks, Jodi. Visit invesco.com/brianlevitt to read my latest commentaries, and of course, you can follow me on LinkedIn and on X, formally Twitter, that's @BrianLevitt.

 

Important information

 

You've been listening to Invesco's Greater Possibilities Podcast.

 

The opinions expressed are those of the speakers, are based on current market conditions as of February 8, 2024, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. Invesco is not affiliated with any of the companies or individuals mentioned herein.

 

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

Should this contain any forward looking statements, understand they are not guarantees of future results. They involve risks, uncertainties, and assumptions. There can be no assurance that actual results will not differ materially from expectations.

 

All investing involves risk, including the risk of loss.

 

In the 815 days following Joe Biden’s election as president (Nov. 3, 2020, to Feb. 2, 2024) the S&P 500 Index was up 47%. In the 815 days following Donald Trump’s election as president (Nov. 8, 2016, to Feb. 7, 2020), the S&P 500 Index was up 55%. Data sourced from Bloomberg.

 

Past performance is not a guarantee of future results.

 

An investment cannot be made directly in an index.

 

Based on US Border Patrol figures reported by multiple news outlets, migrant crossings at the US southern border reached a record monthly high in December 2023.

 

All data provided by Invesco unless otherwise noted.

 

Stablecoins are cryptocurrencies that seek to peg their market value to an external reference such as a currency like the US dollar or a commodity like gold.

 

The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.

Brian Levitt

Welcome to the Greater Possibilities podcast from Invesco, where we put your concerns into context and the opportunities into focus. I'm Brian Levitt.

Jodi Phillips

And I'm Jodi Phillips. Welcome to our first podcast of 2024, Brian.

Brian Levitt

Yeah, it's good to be here. We made it.

Jodi Phillips

We made it. We'll see if you still think it's good to be here — you're on the hot seat today, so this is all resting on your shoulders today. But look, I know you closed out '23 with a lot of traveling across the US, speaking to investors. So I thought today we'd cover the top 10 questions you've been getting. And just to up the level of difficulty a little bit, let's give you three points or fewer to answer each of those questions. What do you think? Can you do it?

Brian Levitt

I'm a kid from New Jersey I can't really say my name in three points, but we'll give it a try.

Jodi Phillips

All right. Well we won't count too formally, but you get the gist.

Brian Levitt

No buzzer?

Jodi Phillips

No buzzer, no. We don't have sound effects.

Brian Levitt

No buzzer. No shocks. Okay, good.

Jodi Phillips

All right. You want to dive in?

Brian Levitt

Yeah, let's do it.

Jodi Phillips

Question one. All right. Brian, why wasn't there a US recession in 2023 despite all of the predictions to the contrary?

Brian Levitt

I'd say first the consumer in good shape, the job unemployment rate is low. So that would be one, the consumer's feeling good. Two, there's not a lot of leverage in the economy. Typically, when you see the Fed raise rates that impacts people. A lot of people have loans that they have to come back to market to fund, just not a lot this time. And three, we never really got a chance to build up cyclical excess meaning... Remember the challenge was businesses didn't even have inventory. There weren't a lot of homes for sale. We couldn't find cars. So we never built up the cyclical excesses that typically lead to a recession. How's that? Three bullets.

Jodi Phillips

Three bullets. You did it.

Brian Levitt

Was that too much? Or three bullets, that's good?

Jodi Phillips

Three bullets. That's good. All right. That's only question one, too. So …

Brian Levitt

Nine more to go. Let's see this.

Jodi Phillips

Question two. All right. Let's focus in on US stocks, specifically the S&P 500 last year, largely driven by a handful of stocks. I think some call them, what? The Magnificent Seven?

Brian Levitt

Yeah, the concentrated market.

Jodi Phillips

That's right. So where are we with that? Is that trend going to continue? Is this going to broaden? What are you expecting to see this year?

Brian Levitt

Well, the first thing is I like to remind people that it wasn't always a concentrated trade. People make it out as if the whole year was very concentrated. When the market bottomed in the middle of October 2022 and it rallied through February of '23, that wasn't concentrated. That was a soft landing trade, rising tide lifted a lot of boats. Then Silicon Valley Bank failed. So there was concern about the banking system and the economy. And then we actually got concerns that the economy was too hot and so the Fed was going to have to really, really raise rates. So that was really post February, and then into the spring and summer, that was the concentrated market. Not November, December. The market was not concentrated at all in November, December. That's when the soft landing trade reemerged, that's where we've been. We'll see if things get a little bit more concentrated as things slow down here in the economy.

Jodi Phillips

My memory fails me. It seems like just yesterday and a million years ago at the same time. I don't know how that works, but that's the phenomenon.

Brian Levitt

I know, right? I know.

Jodi Phillips

Question three. We're going to stick with the S&P 500. So the index, it gained what? Nine something percent, 9.1% in November, about 4.5% in December. So I heard you say the other day that you wished those gains hadn't been quite so sharp over those past two months. And that seems a little counterintuitive to me, Brian. So what's driving that? Why do you think, was it too much too soon?

Brian Levitt

Yeah, and it wasn't even just the S&P 500. If you look at the Russell 2000, which is the small cap index, that was up 21%. Mid-caps were up 18%. So we had a market call of a soft landing trade, and the soft landing trade was going to be beneficial to multiple capitalization or the capitalization range, smaller cap. So one my point would be I just wish it played out over a longer period, giving investors more time to get involved if they weren't in favor of small or mid-cap or value, you had these really big moves over a very short period of time.

 

Two, it's unlikely we see those outsized schemes again in the near term. And that's not a negative call on equities, it's just to say that was a tremendous move and it was broad. And so unlikely we'll see those broad market moves that favor all stocks.

Jodi Phillips

Is that the “everything bull market” you like to say?

Brian Levitt

Yeah. It felt a lot like an everything bull market, whether you were in bonds or whatever type of equities. And then three, look, the environment still favors equities over the next few years, peak inflation, peak tightening. It's just to say that we got a lot quick and I would've rathered investors had more time to enjoy it.

Jodi Phillips

Okay. Four, so you said it's unlikely we'll see those same types of gains in the near term. Why not?

Brian Levitt

Yeah, and I think it makes sense to say near term, call it the next three to six months. Well, the market priced in six interest rate hikes very quickly.

Jodi Phillips

Yeah, that's a little bit to absorb. Sure.

Brian Levitt

It was like rates are going to go from 5.25%, to the big CEOs of the bank saying going 7%, now all of a sudden it's 3.50% by the end of next year. So that was a lot quickly. I understand what the market is thinking, but the Fed could still very well underwhelm that and they probably will underwhelm the market.

Two, US growth is back below trend again. So you and I and the consumers, we did a good job of moving this thing along and we were actually above trend growth latter part of '23, we're back call it below trend again. That doesn't mean that we're heading into a recession, it just means that we're slower than what we typically are. So you take those two. I would say number three, we could just be left waiting for a catalyst, like a sign that the Fed is really going to ease or a sign that the economy's not going into a recession. We probably just need some type of catalyst, but that may not come over the next few months.

Jodi Phillips

Understood. What might a catalyst look like?

Brian Levitt

I mean, the catalyst typically would come from the view that we're going to really renormalize the yield curve, normalize the yield curve. So inflation, passe, it's over, which I think we're getting there, growth hanging in and that soft landing trade can reemerge. In the next weeks it might be, well, we just might not get as much from the Fed, inflation's too sticky or well this economy. So you just need more clarity now on the soft landing trade and it may take a little time to get there.

Jodi Phillips

Okay. Well that was a follow-up, so we're not counting that against your three points-

Brian Levitt

That's not fair.

Jodi Phillips

So your streak continues.

Brian Levitt

That is fair then. I thought that-

Jodi Phillips

It is fair. It is fair.

Brian Levitt

No. Okay, good. I thought you were going to say you're not counting that as a question. So are we doing 11 now?

Jodi Phillips

I wasn't counting that as an extra point. No, no. Still good. Still good. All right. So question five, S&P 500 hit a new record close in January, is that something to worry about?

Brian Levitt

No. And the first thing I would say, I quote Sir Arthur Clark, I've done this for years in meetings, which is to say that only small minds are impressed by large numbers. Now-

Jodi Phillips

I feel called out now.

Brian Levitt

Well, yeah, no, not you. I know it's bad. So I'm telling an audience that they have small minds. No, I'm just reminding them not to be impressed. Nobody has small minds, just reminding them not to be impressed by large numbers.

Jodi Phillips

Fair enough. Fair enough.

Brian Levitt

So when we hit the new high, was it Friday, January-

Jodi Phillips

19th.

Brian Levitt

19th. That was the 1158th new high of the... Yeah, I counted them. Thank God for Excel. Of the S&P 500 since 1957. So that's once every fortnight. That's once every couple of weeks. So you shouldn't be all that impressed by a new high when they on average happen once every couple of weeks.

And three, I think the biggest thing is that the market averages are not mean reverting. So they're not going to come back to some mean. If you think that the world is going to get better for us, for people, for economies, and I guess most importantly the 500 biggest companies in the United States, then markets should see many new record highs over the course of our lives.

Jodi Phillips

All right. All right. Question six, so January is a notorious month for those investors who'd like to see patterns in the calendar, the January effect, the belief that in any given year, January tends to be the strongest month for US equity returns. So do you believe there's some kind of predictive power to what happens in January? Is this going to set the stage for the rest of the year?

Brian Levitt

Yeah, well you started talking about January and perhaps some challenges that we had in the beginning of the month, I thought you were going to mention the NFC East. I can't point out your Houston Texans…

Jodi Phillips

Don't do it. Don't go to the AFC South, please.

Brian Levitt

No, no. That was impressive. They're ahead of schedule.

So yeah, I mean January started off challenging and I think that's why this question has come up, the first couple of weeks weren't great, so I think people got a little concerned about that. No, the reality is that when January is positive, so this is where this comes from, the market is positive in 80% of the years that are looked at, that sounds very impressive. But when you consider that markets go up 75% of the time or every three and four years, it's probably not that statistically significant.

Also, its predictive power is significantly less when January is negative. So the probability of having a negative year when January is negative is really no better than a coin toss. And so as always, don't try and time these things. A buy and hold approach-

Jodi Phillips

Buy and hold.

Brian Levitt

... is much better than trying to time things based on whether January is good.

Jodi Phillips

All right. Question seven, market leadership, how do you think that's going to play out over the next, say, year or two?

Brian Levitt

Yeah, so that gets back to what we were talking about with the everything bull market and what did we wish took longer. We talked about it, small caps, mid caps, value, all did well. I would say one, you may see more quality leadership in the near term that goes back to that catalyst. We need to reaffirm that soft landing trade.

Two, ultimately if you're an investor and you're not just looking very near term, I would view all of this from the perspective of getting out of this bizarre COVID environment finally once and for all. And so the clock has started on the Fed cutting interest rates. The next few months are going to be will they, won't they, should they, can they? But then over time it's pretty clear to us that the Fed will normalize the yield curve. And as that happens, you tend to get the broader market participation and that's when you'll get the shift away from what we think will be in the near term a quality trade back towards more small cap value and international.

Jodi Phillips

International, okay, so let's talk about that a little more. What's the story there? What are some of the reasons in your opinion that investors might want to consider international?

Brian Levitt

Yeah, so Jodi, that's question eight for you.

Jodi Phillips

It is.

Brian Levitt

I think that's question one that I typically get... Well one might be about elections, but we're going to cover that in other podcasts. But this idea about international after multiple years of under-performance, let's do the one, two, three.

One, the post global financial crisis environment was very slow. All these years of under-performance, that was a slow growth world. You could pretty much set your watch to 2% GDP growth in the US, very slow growth. And so international markets, value markets, they tend to need better macro environments. They tend to need growth picking up, nominal activity, picking up. And we didn't get that.

Now two, each time it appeared to be coming like some synchronization, some pick up in global growth, the US tightened policy. And in hindsight, and I was saying it at the time, inexplicably tightened policy. So 2015, the Fed raised rates attempting to be the first central bank in the history of the world to raise rates during a slow growth deflationary environment. Then they backed off and said, okay, just kidding. And 2016 and 2017 were great years for international markets, particularly the emerging markets. It's really good times, the Fed had backed off. Well what did we get in '18? The trade war, more interest rate hikes. And then the Trump administration gave us more clarity on trade. The Fed said, okay, just kidding again. And then 2019 we got started to get more broader regional participation — then COVID hit and we shut down.

So you'd never really got a chance. And so investors think of it as, well, never happened for 10, 15 years, can't ever happen again. That was a very unique post-GFC, global financial crisis, environment. So what may be happening now is, if you think about it from that perspective of tightening policy at inopportune times, we haven't even started easing yet.

Jodi Phillips

Right. That's right.

Brian Levitt

So maybe a long time before we're tightening policy. That tends to suggest the dollar peaks and may have already peaked just because of interest rate differential between the US and the rest of the world. And valuations are more attractive. So if money's going to be looking for a different home than the US dollar and the economy's good, money may start to flow to other parts of the world where valuations are more attractive.

Jodi Phillips

Okay. All right. Question nine, yeah. So we've already established that I'm not supposed to be impressed by large numbers, but US debt, it's over $34 trillion. Come on. That's an impressive number.

Brian Levitt

That does impress you? 34 Trillion?

Jodi Phillips

Yeah, 34 trillion - with a T - for sure.

Brian Levitt

But that scares people.

Jodi Phillips

Sure. Sure, it does.

Brian Levitt

So what do we say about this?

One, very happy to live in a country that was able to respond to the last two crises. So the reason that we've seen significant rise in debt over the last decade plus is we had to respond to the global financial crisis. We had to respond to COVID. And COVID was, call it, 4 to 6 trillion of additional spending. Now maybe we overdid it. But I'm happy that we got beyond each of those environments without depressions. Really, really critical and really, really impressive that we were able to do that. So that's one, before we get nervous, let's be happy we can fund this debt.

Two, I think people underestimate how wealthy a country the United States is. So Jodi, you want me to impress you with some large numbers again.

Jodi Phillips

Please. Please do.

Brian Levitt

The debt is $34 trillion. US household net worth is $150 trillion, five times the size of the debt. So think about it. I mean, are we a good credit? The net worth of our household is 5X-

Jodi Phillips

Sure sounds like it. Yes.

Brian Levitt

I wish my household net worth was 5X the size of mortgage, right? I mean, think about it.

Jodi Phillips

Yeah, it's all relative.

Brian Levitt

And then there's a captive audience for US bonds. The government buys, the Fed by some of it, the Social Security Trust Fund, so government entities, US savers like my dad and US financial institutions, US mutual funds, US endowments, US pensions, US insurance companies, and then foreign investors like the Germans, the Japanese, and the Brits who can't get higher yields in their home countries. So there's a pretty captive audience. So no, I'm not worried about the US debt.

Jodi Phillips

Good. And now neither am I. Thank you.

Brian Levitt

But impressed. You're not worried, but you're impressed. Still impressed.

Jodi Phillips

Still impressed. It's still a big number.

Brian Levitt

It is impressive.

Jodi Phillips

All right. Question 10, how concerned should investors be about geopolitical events? We look at what's going on, particularly in the Red Sea. We've got shipping companies that have been diverting their routes like an extra 4,000 miles in order to avoid attacks in that area. And so are those shipping disruptions going to lead to the type of inflation we saw a few years ago when ships were backed up at the Port of Los Angeles, for example?

Brian Levitt

Right, that is one of the iconic images of COVID. There's actually too many iconic images of COVID, but that was one of them.

Okay. One regional events have tended to not disrupt markets. I say regional, I think that's the critical word. If this gets significantly broader and the powers that be don't seem to want it to, even with the tit-for-tat that's going on, regional events have tended to not disrupt for markets. And since October 7th when Hamas went into Israel, this time has been no different. The markets have looked beyond it.

So point two, I always tell people ask yourself is what's going on going to change the direction of the US economy or what the Fed will be doing? Usually the answer to that, particularly after Hamas went into Israel and then Israel went into Gaza, the answer to that was, no, not really. It's not going to change the direction of the US economy or what the Fed will be doing.

But then your point about trade. So point three, it's not insignificant, so I don't want to sugarcoat it. But, let's at least put it into perspective. So the ships going through the Red Sea, that amounts for about 15% of global trade. So 85% is not going to necessarily be impacted by this. And going around the Cape of Good Hope, to your point, at Southern Africa does add costs. And so some of that may be inflationary. It's not ideal, particularly when your market outlook is based on inflation being tamed.

But I'd argue that if we really think about where inflation came from, it really came from businesses slashing inventories and slashing workers when COVID hit. And in hindsight, they did it at a really inopportune time and then struggled for a couple of years to rebuild inventory and get workers back. That's not the case now. We're looking at record levels of inventory, not from an inventory to sales ratio, but in nominal terms, record levels of inventory and record number of workers and near record low unemployment rates. So it's just, yeah, we watch geopolitical, but it doesn't drive the base case of our views.

Jodi Phillips

You made it.

Brian Levitt

10.

Jodi Phillips

10 questions. Three points each.

Brian Levitt

So did I speak more or less than you expected?

Jodi Phillips

I don't know. I'll gauge when I get the transcript, I'll do the word count.

Brian Levitt

You can edit me.

Jodi Phillips

We always have that power, so yes. But, seriously, thank you. Thank you for doing this little exercise and rest assured you will not be on the hot seat for the next episode. We've got some great episodes that are coming up. Planning one to talk about the presidential election, of course. Definitely a hot topic of conversation. We're going to talk about Bitcoin in a future episode, so looking forward to that. Be sure to subscribe to get the latest episodes, if you haven't already. You'll get them as soon as they release. And Brian, where can listeners get more from you?

Brian Levitt

Oh, thanks for asking. So visit Invesco.com/BrianLevitt to read my latest commentaries. And of course you can always follow me on LinkedIn and on X, I think I'm supposed to say formerly known as Twitter @BrianLevitt.

Jodi Phillips

All right, thanks for listening.

Brian Levitt

Thanks Jodi.

 

Important information

You've been listening to Invesco's Greater Possibilities Podcast.

 

The opinions expressed are those of the speakers, are based on current market conditions as of January 23, 2024, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. Invesco is not affiliated with any of the companies or individuals mentioned herein.

 

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

Should this contain any forward looking statements, understand they are not guarantees of future results. They involve risks, uncertainties, and assumptions. There can be no assurance that actual results will not differ materially from expectations.

 

All investing involves risk, including the risk of loss.

 

Past performance is not a guarantee of future results.

 

An investment cannot be made directly in an index.

 

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

 

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

 

Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

 

A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.

 

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

All index returns sourced from Bloomberg, L.P., as of Dec. 31, 2023.

Russell 2000® Index is an unmanaged index considered representative of small-cap stocks, and returned 21% over November and December 2023.

References to mid-cap stocks refer to the Russell Midcap® Index. The Russell Midcap Index is an unmanaged index considered representative of mid-cap stocks, and returned 18% over those two months.

The Russell 1000 Value Index is an unmanaged index considered representative of large-cap value stocks and returned 13% over those two months.

Russell indexes are trademarks/service marks of the Frank Russell Co.®

The S&P 500® Index is an unmanaged index considered representative of the US stock market.

An investment cannot be made directly in an index.

Statements about the market pricing in interest rates cuts are based on Fed Funds Futures, sourced from Bloomberg as of January 24, 2024. Fed funds futures are financial contracts that represent the market’s opinion of where the federal funds rate will be at a specified point in the future. The federal funds rate is the rate at which banks lend balances to each other overnight.

The number of new market highs sourced from Bloomberg, as of January 24, 2024. Based on the S&P 500 Index from 1957 to current.

Discussions about historical market performance in January are based on yearly S&P 500 Price Index data from 1928 through 2023, sourced from Bloomberg as of December 31, 2023.

Comments about the 2016 and 2017 performance of international and emerging market stocks based on the returns of the MSCI ACWI-ex USA and MSCI Emerging Markets Indexes sourced from Bloomberg. The MSCI ACWI ex-USA Index returned 4.50% in 2016 and 27.19% in 2017. The MSCI Emerging Markets Index returned 11.19% in 2016 and 37.28% in 2017.

The MSCI ACWI ex USA Index is an unmanaged index considered representative of large- and mid-cap stocks across developed and emerging markets, excluding the US.

The MSCI Emerging Markets Index captures large- and mid-cap representation across 26 Emerging Markets countries.

Data on the size of the US debt, COVID spending, and US household net worth all from the US Treasury Department as of January 24, 2024.

Information on the amount of global trade passing through the Red Sea is from S&P Global Market Intelligence.

Tightening monetary policy includes actions by a central bank to curb inflation.

The Magnificent 7 refers to Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla.

The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates.

Gross domestic product, or GDP, is a broad indicator of a region’s economic activity, measuring the monetary value of all the finished goods and services produced in that region over a specified period of time.

The Greater Possibilities podcast is brought to you by Invesco Distributors, Inc. 

Brian Levitt:

Welcome to the Greater Possibilities podcast from Invesco, where we put concerns into context and opportunities into focus. I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. It's December and we've decided to use our last podcast of the year to answer the most frequently asked questions that we've heard throughout 2023. And we've asked Turgut Kisinbay, Chief US Economist for Invesco Fixed Income, to join us in answering those questions.

Brian Levitt:

Last one of the year, Jodi?

Jodi Phillips:

It is.

Brian Levitt:

Oh, good. So, I guess a little hiatus for a couple of ... I feel like one of those late night talk show hosts like a Jimmy Kimmel or something, we get to do a little hiatus here.

Jodi Phillips:

All right, well, don't get too excited because we're going to be back before you know it at the start of the year.

Brian Levitt:

Yeah, I figured but we'll enjoy it while it's here. So, I guess I'll ask you, what are some of those questions you think you want to ask Turgut?

Jodi Phillips:

Well, first and foremost, does he think the US is going to have a recession in 2024?

Brian Levitt:

Yeah, that one seems to be pretty popular and why didn't we have one in '23? Can we have a soft landing? These are the most frequently asked.

Jodi Phillips:

Yeah, most popular questions.

Brian Levitt:

Most popular. Yeah, it's like a high school superlative. Instead of smartest student, prettiest eyes, we'll go with most asked questions here.

Jodi Phillips:

Something like that. Well, okay Brian, so did you win any superlatives in high school?

Brian Levitt:

No. I peaked in middle school. In middle school, I won most energetic, although I'm not sure in hindsight if that's good or bad.

Jodi Phillips:

Yeah, no, that's a nice way of saying you drove the teachers crazy.

Brian Levitt:

Yeah, I think I did. Anyway, you? You win any?

Jodi Phillips:

I did. I was actually named most likely to succeed in high school.

Brian Levitt:

Wow.

Jodi Phillips:

Yeah.

Brian Levitt:

Wow.

Jodi Phillips:

So, fun fact though, I mean, the first thing I noticed when I got the award was that succeed was misspelled.

Brian Levitt:

Ooh, irony. Interesting.

Jodi Phillips:

I suppose no big surprise I became an editor, but there you go, there you go.

Brian Levitt:

And now you get to host the Greater Possibilities podcast.

Jodi Phillips:

I do.

Brian Levitt:

So, I would say your classmates could not have been more spot on.

Jodi Phillips:

They nailed it, but I digress.

Brian Levitt:

But we digress. Yeah, we both digress. We like digressing here.

Jodi Phillips:

We do. So, question two after the recession question. Question two, what's the Fed going to do? And question three, have interest rates peaked? And if so, where are they heading?

Brian Levitt:

Right, and how long does it take to normalize the curve? How should we be invested for it? Those all seem to be, should we say, the superlative questions?

Jodi Phillips:

The superlatives, most popular.

Brian Levitt:

Most popular. What about the dollar? Has it peaked? Can we expect a new dollar environment? What does that mean for international investments, et cetera, et cetera, et cetera?

Jodi Phillips:

That's it, those are the questions so let's bring on Turgut. I don't know which superlative he might've received in high school but I know he has a PhD in Economics, so we're just going to leave it at that. Welcome, Turgut.

Brian Levitt:

I would've thought PhD in Economics means that he won the life of the party.

Jodi Phillips:

I don't know, we'll have to ask him. We can add that to our list.

Turgut Kisinbay:

Yeah. Hi, Jodi and Brian.

Brian Levitt:

Turgut, welcome.

Turgut Kisinbay:

Thank you, thank you.

Brian Levitt:

It's good to have the life of the party here.

Turgut Kisinbay:

I don't know if I'm the life of the party. I was maybe earlier. Brian, I think I peaked earlier than you in primary school and I was really energetic at the time and then adolescence happened and I got introverted and shy. And I'm trying to recover from that all my life.

Brian Levitt:

Well, not shy enough to be a podcast guest, which is great.

Turgut Kisinbay:

I've been told this is the place to be, this is maybe where I'm going to do my takeoff.

Brian Levitt:

The coming out party. So Turgut, why not a recession in '23 and how surprised were you by it?

Turgut Kisinbay:

So, we were not surprised, our baseline was no recession and some sort of the soft landing, which we can discuss what that is. But we didn't expect a recession in Invesco Fixed Income, IFI because this is actually not a typical cycle, this is not a typical economic cycle. In most cycles, obviously there are differences and not all of them are the same, but in most cycles there is a leverage component. Households, corporates borrow quite a bit during an expansion and the economy overheats, we get inflation, at that point central banks in the US Fed hikes interest rates. And then, all of this is reversed with high levels of debt and difficulty to basically handle debt at high interest rates. That creates a downward spiral, defaults, delinquencies and all that.

This is the household and corporate side. Of course, there's the financial side. Usually, banks are exposed to that cycle so then that makes the cycle even worse, right? This downward spiral is challenging. This cycle was different, we didn't have that. Unusual for a cycle, we actually have incomes increasing during the cycle and debt levels not increasing or actually decreasing, credit card and others. We didn't have a leverage cycle even in the previous expansion before the pandemic because we had the GFC, global financial crisis, a big housing bubble and a big mess. But after that, households didn't borrow that much relative to their incomes.

Brian Levitt:

We learned our lessons, huh?

Turgut Kisinbay:

We learned our lessons, banks were prudent and tightly regulated so high capital ratios. So, the debt to income ratios are not high. In housing actually, usually housing is a problem in cycles, housing versus the bank nexus. This time around we have actually a shortage of housing because maybe we learned our lesson too much and there is not enough building in the US relative to the demographic trends. So, inventory was very low and so none of that is there. Of course, there are pockets of leverage here and there, but usually most of the debts of the household sector is mortgages and we have no problems there. So, I think that was the main reason basically, there are others, but the vulnerability coming from leverage was not there.

Brian Levitt:

Jodi and I both levered up to buy Taylor Swift tickets this summer so that doesn't count?

Turgut Kisinbay:

That's less than your mortgage, I assume.

Jodi Phillips:

Yeah, good decision though, good decision.

Brian Levitt:

I don't regret it at all.

Jodi Phillips:

Turgut, you mentioned soft landing, which is a phrase that sounds awfully reassuring, but can you dig into the details about that a little bit and what that could potentially look like?

Turgut Kisinbay:

Yeah. So, it's not well-defined admittedly so we can kind of narrow it down. I mean, it's definitely not a recession. It's definitely, I think on the upside. It's not an economy that is growing above potentially, let's say, high 2% for a sustained period of time. And it's not an economy where inflation doesn't come down, it's sticky. But within that range, between a recession and no landing, there are I think a range of outcomes that can be considered as soft landing. In our case, I think maybe I can go to that. Again, in Invesco Fixed Income we have our monthly process so we have specific GDP inflation and policy forecasts, Fed policy forecasts. So, that's our baseline, rather than trying to define what soft landing is, we go with our numbers.

But I think maybe I'll also tilt a little bit towards that is we expect the economy to slow down a little from 2% plus to below 2%, which is the potential, close to the potential. So, a bit of a slowdown for a couple of quarters but no recession because of the reasons we just discussed. And on the inflation side, we expect inflation to continue to come down. And so, that is our definition basically. A couple of quarters of one, one and a half percent GDP growth. And then, slowly growth goes back up to its potential and inflation continues to come down through 2024.

Brian Levitt:

What drives inflation down now, is it the lagged shelter impact on the Consumer Price Index? And if so, why does that happen and why does the Bureau of Labor Statistics calculate it the way they do or is it something else?

Turgut Kisinbay:

That shelter component is by design because they want to consider all the contracts, not just the latest contracts. So, you have new contracts throughout the year and the current trend is not necessarily what accrues to everybody but in a year you have that convergence towards market trends. But there are a couple of things, shelter is definitely a big one. We also try to model using macro variables, what drives shelter inflation. So, that's one inputs to our process. The other one is basically the market trends and the lag between market trends and the measured CPI and other indices. So, I think that's on track because market trends are back to pre-pandemic norms, by some measures it's actually even lower by some measures. It's right there.

Brian Levitt:

What do you mean by market trends, market trends for prices?

Turgut Kisinbay:

So, current market trends are running close to let's say 4% year-on-year, new rents, whereas the CPI measure will be seven, six, seven, I don't know what it is.

Brian Levitt:

Got it. Right.

Turgut Kisinbay:

So eventually, if the current trends, new rents are back to pre-pandemic levels a year from now or something like that, the measured inflation will also converge to pre-pandemic levels, which was three and a half to four. If you want to be on the conservative side, you can say 4% but it could be lower given that market trends are back to where they were. That's one component. The other one is we have goods deflation now and we expect that to continue. That was the norm in the last 10, 15 years. Goods prices come down because of improvements in technology, because of globalization. So, we don't expect the same outcome because globalization may have peaked and these low cost producers are not necessarily as low cost as they were before.

But we also had very inflated prices. For example, car prices and used car prices, those are really, really high. So, I think they will come down for two reasons. First, the prices are high. Second, global supply is improving substantially so that is the other reason, supply improving. 

It's expensive to buy a new or used car now because of financing costs. So, if you look at car sales, we had two years of shortages of cars. So, car sales came down from 17 million to 15 million for a long time. So, that means that there's pent-up demand probably. But despite that and despite improving supply, we don't see an increasing car sales, it's going sideways. I think the reason is because A, cars are very expensive and B, relative to incomes so you can't just go and buy with the cash.

And if you want to borrow, it's very costly to borrow so we expect deflation in cars — and that's new and used cars. That is another driver. And I just want to generalize a little bit to the rest of the goods side. During the pandemic, there were demand and supply imbalances. So, we consumed a lot of home exercise equipment and new electronics because kids were at home and studying from home. We were working from home. We were at home all the time and you have money 'cause we didn't lose incomes and then you look at the furniture that you're sitting all day and I'm like, "You know what? I'm going to buy a new one." So, there was a very high level of consumption on home goods and furniture and that kind of goods relative to services. So, that's also normalizing. So, there are two components of that. First, the demand we consumed so much, so now we do a little bit less. Yeah.

Brian Levitt:

Yeah, we bought too much. What else is there to buy?

Turgut Kisinbay:

How many computers do you need?

Brian Levitt:

Here's my holiday gift, 32-inch $75 television smart TVs, I'm like wallpapering the house with them.

Turgut Kisinbay:

So, there's still demand of course, but ...

Brian Levitt:

Just me, just me. I don't even watch television.

Turgut Kisinbay:

Well, on the aggregate, so that kind of goods consumption has been going sideways so the demand has been satiated to some extent. It's not collapsing, it's just not growing as it used to. And supply improved substantially so that imbalance that was created, that was a pandemic problem, that's also improving. And finally on inflation, we also look at the labor market is slowing down. We have trackers for wage growth, that's slowing down. It's not where the Fed wants wage growth to be, that's not the ideal level, but it's still, we are talking about inflation at the levels five, 6% levels coming down to below four and eventually below three. So, current wage growth is consistent with that.

Brian Levitt:

Jodi, that's a bummer for us.

Jodi Phillips:

Well, what's a bummer for me is I bought a used car this year, so of course the prices were destined to go down -

Brian Levitt:

And your wages are slowing.

Jodi Phillips:

I saved up that demand as long as I could, but at some point you have to get from point A to point B. You just have to do it.

Brian Levitt:

Yeah, you're not walking, right?

Jodi Phillips:

So Turgut, what does all this add up to in terms of the Fed and what they're going to do next? Are they done hiking rates and when could we potentially see cuts?

Turgut Kisinbay:

Yes, they're done hiking rates, I think — this is now becoming market consensus too because again, just going back to our baseline, which is economy slows down a little bit for a variety of reasons but including because of tight policy and a slowing labor market. So, a couple of quarters of slow growth and inflation is coming down for the reasons we discussed. So, Fed is now in a position to cut rates. When? So again, one or two quarters, couple of more or maybe more inflation prints we penciled in May not March, which is being debated now. But May because I think there will be enough macro evidence on this inflation and also on the slowing economy. At that point, if the economy is growing, let's say 1.5 and inflation is 3%, that's 4.5% nominal growth. Whereas the risk-free rate in the economy will be 5.3, that's very high to sustain. So, I think at that point the Fed will be in a position to slowly cut interest rates, not aggressively.

Brian Levitt:

That is such a critical point. I really love the way you explain that with regards to where the risk-free rate is versus the nominal growth. Because what I hear from people when they hear rate cuts by March or May or June or whenever next year, their minds immediately go to 2020 or 2008 where you had to immediately bring interest rates to zero. And so, it seems like investors, even though you had one in 2019, you had a 94, 95 rate cut, investors seem to have forgotten that the Fed will try to fine-tune this, they won't necessarily wait for a disaster to cut interest rates. I would say if we're talking about frequently asked questions I'm getting all the time now, "Well, what happens between now and May that they have to cut interest rates?"

Turgut Kisinbay:

Yes. If our baseline is correct, if we get a soft landing, then the current policy will be too tight. And if we don't get a recession, but there is still a case for gradually removing monetary accommodation, that's our story.

Brian Levitt:

And they stick that landing. No recession.

Turgut Kisinbay:

Sorry?

Brian Levitt:

They stick that landing, no recession '24, maybe even '25?

Turgut Kisinbay:

No, because well, I mean assuming that they will gradually cut rates as we expect. We also don't expect them to cut very aggressively. Currently, market is pricing in five cuts, which I think is not a soft landing, consistent with soft landing. I mean, we need to remember that there's still segments of the market that expect the recession so that's their pricing. Obviously, the market pricing is the weighted average of different opinions. But I think 5, 4, 5 is a bit too much and here is the reason. If our baseline is correct, if the economy manages to slowly, gradually slow down with also this inflation, markets will see that and the financial conditions will change substantially. For example, bank lending. The surveys are telling us that banks are still tightening lending conditions. Credit is more difficult to get. So, those will start to change. Equity market may react to that, risk assets may like that. 

And maybe that may be too much by, we are talking about May and June here, inflation is still higher than Fed's target. They have to be cautious. So, they will talk hawkish but I don't think they will be hawkish. But they just need to basically lean against the markets a little bit. That's why we don't expect a lot of cuts but measured amount of cuts. Basically, Fed will follow the market here, but it's good for risk assets.

Jodi Phillips:

So, Turgut we mentioned obviously at the top of the show that you're positioned within Invesco Fixed Income. So, for income-seeking investors in particular, I mean, this is a lot going on and a lot to think about for the year. So, in your opinion, trying to position a portfolio in times like these and changing conditions, how might income-seeking investors think about all this?

Turgut Kisinbay:

So, this is peak interest rates for us. You have volatility around whatever the long-term rate is, but basically inflation has peaked and coming down and Fed rates will also come down. So, macro drivers will, I think mean that interest rates will be peak-ish around here. And I mean, the speed of decline and even if it's stable, even if interest rates are stable, you earn your income, so it's pretty attractive I think.

Brian Levitt:

Lock them in.

Turgut Kisinbay:

Lock them in, exactly. And it's true globally too by the way. Europe is in stagnation, it will be a while for them to I think catch up with the potential. So, I think the inflation has peaked in almost everywhere that I can think of now. So, that also means lower interest rates, global factors for those I think support stable or lower interest rates.

Brian Levitt:

You mentioned international, so it's been a while where investors have preferred US dollar assets. So, implicit in your point would have to be perhaps the end of a dollar cycle, the time to look around to see where other opportunities may exist?

Turgut Kisinbay:

Yeah, I mean, I think global assets do well when global growth improves and when there is a recession or a risk factor, dollar is the safe asset and people come back to dollar assets. So, if our outlook is correct and that's also broad Invesco outlook that we expect the recovery next year in 2024 globally, maybe more in the second half, but markets anticipate developments. So, if global growth picks up, that's generally good for global assets, emerging market assets are kind of high beta to global growth. There are also a couple of other things that support emerging markets, local assets, local and dollar base too. But emerging markets were the first or early to hike interest rates because given their inflation histories, they're more sensitive to inflation developments.

And inflation is now coming down in these countries and they are also in a position to cut interest rates, which is just kind of attractive for local bonds. And finally, during this pandemic and then war, global assets were not the most favored. We had seen years of or a prolonged period of outflows from emerging market assets. And now I think it's basically positioning is not there. Most people are underweight or at least they don't have enough global and emerging market assets. If the environment changes, I think there's also room for growth there.

Brian Levitt:

That's great. Anything you worry about as we head into the year? I mean, anything that could potentially go wrong or are you feeling pretty sanguine about these views?

Turgut Kisinbay:

So, I mean as an economist, I guess part of our job is to worry about things. Yeah, we worry. On economics one risk, I mean not these days, but one risk is of course inflation remains or it is, inflation is sticky, doesn't come down so we have another round of hikes. That was maybe a risk like six months ago. But now I think generally inflation developments are going in the right direction. We have energy prices coming down, food prices coming down, supply sites improving. So, those look good to me. Another risk is of course, central banks do not ease policy when it's warranted and they remain too hawkish too long. I'm not worried about that but the risk is there. So, that's another risk. Let me underline that. They have to remain a little bit, at least in rhetoric, they have to be a little hawkish because of the past mistakes. I mean, they said this is transitory and all that and we had 10% inflation in Europe, in the US. So, they cannot-

Brian Levitt:

Credibility matters.

Turgut Kisinbay:

Credibility matters so they will be cautious and that's bit of a risk.

Brian Levitt:

Jodi, I don't know, it sounds to me like a happy and healthy new year. I think I'm going to stop at yes on this one.

Jodi Phillips:

Yeah, a great way to end the year. I was going to ask you in that bucket of et cetera, et cetera, did we get to all of your et cetera questions?

Brian Levitt:

I think we did. Maybe even a couple of et ceteras I didn't expect to get to.

Jodi Phillips:

There we go. All right, well thank you very much Turgut, we really appreciate your time.

Brian Levitt:

It's been a pleasure.

Turgut Kisinbay:

Thanks for having me. That was fun.

Jodi Phillips:

All right, so Brian, where can our listeners follow you for more?

Brian Levitt:

Well, first Jodi, happy and healthy to you and your family.

Jodi Phillips:

And yours as well.

Brian Levitt:

Thank you. And visit Invesco.com/BrianLevitt to read my latest commentaries. And of course, you can follow me on LinkedIn and on X @BrianLevitt. Thank you.

Jodi Phillips:

Thanks for listening.

 

Important information

You've been listening to Invesco's Greater Possibilities Podcast. 

The opinions expressed are those of the speakers, are based on current market conditions as of December 8, 2023, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. Invesco is not affiliated with any of the companies or individuals mentioned herein.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions. 

Should this contain any forward looking statements, understand they are not guarantees of future results. They involve risks, uncertainties, and assumptions. There can be no assurance that actual results will not differ materially from expectations.

All investing involves risk, including the risk of loss.

Past performance is not a guarantee of future results.

An investment cannot be made directly in an index.

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

Market trends for rents represented by US apartment real estate effective rates from Moody’s Analytics CRE, as of September 30, 2023. References to the CPI measure and rent inflation refers to the yearly percent change in CPI shelter prices from the Bureau of Labor Statistics, as of October 31, 2023. 

Car sales from the US Bureau of Economic Analysis as of November 30, 2023.

Wage growth from the US Bureau of Labor Statistics as of October 31, 2023. Based on yearly percent change in average hourly earnings.

The risk free rate is based on the federal funds rate, from the US Federal Reserve as of November 30, 2023.

Information on how many interest rate cuts the market is pricing in is from Bloomberg, based on fed funds futures as of November 30, 2023.

US inflation sourced from the Bureau of Labor Statistics as of November 30, 2023. The peak rate of the US Consumer Price Index was in June 2022.

The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity. An inverted yield curve is one in which shorter-term bonds have a higher yield than longer-term bonds of the same credit quality. In a normal yield curve, longer-term bonds have a higher yield.

Bank capital ratios are their capital divided by assets.

Gross domestic product (or GDP) is a broad indicator of a region’s economic activity, measuring the monetary value of all the finished goods and services produced in that region over a specified period of time.

Nominal economic growth is inclusive of inflation, while real economic growth is not. 

Fed funds futures are financial contracts that represent the market’s opinion of where the federal funds rate will be at a specified point in the future. The federal funds rate is the rate at which banks lend balances to each other overnight.

Safe haven assets are investments that are expected to hold or increase their value in volatile markets.

Beta is a measure of risk representing how a security is expected to respond to general market movements. 

The US Consumer Price Index (or CPI) measures change in consumer prices as determined by the US Bureau of Labor Statistics. Core CPI excludes food and energy prices while headline CPI includes them.

The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.

Brian Levitt:

Welcome to Greater Possibilities podcast from Invesco, where we put concerns into context and opportunities into focus. I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. And today we'll be discussing our 2024 annual outlook with Kristina Hooper, Chief Global Market Strategist, and Alessio de Longis, Head of Investments for Invesco Investment Solutions.

Brian Levitt:

2023, that was fun.

Jodi Phillips:

2024! 2024! That's what's blowing my mind. Are you ready?

Brian Levitt:

That was a fast year.

Jodi Phillips:

It was. And look, my normal answer to that observation would be something like, "Time flies when you're having fun," but I don't know, from a market perspective, is that anywhere close to reality?

Brian Levitt:

Yeah, it was definitely... It has been more fun than last year. I mean, we're not through it yet, but it's certainly been more fun than last year, at least for the market.

Jodi Phillips:

Well, it's all relative, I guess. Yeah. I mean, look, there's certainly no shortage of challenges and conflict in the world. Speaking from the market perspective, I guess it's been a better year than 2022.

Brian Levitt:

Yeah, I mean the difference is 2022 is one of those rare years in which things just got worse relative to expectations.

Jodi Phillips:

All right. So 2023 was a year in which conditions were generally better than expected?

Brian Levitt:

Yeah, I would say the economy has been more resilient than many had expected. Good news.

Jodi Phillips:

Well, good. Yeah. We definitely had so many predictions for a recession that didn't seem to come to pass this year. And along with that, so many mea culpas from the economists who made those predictions.

Brian Levitt:

Yeah, it's funny. Apologies always sound better in Latin.

Jodi Phillips:

They really do.

Brian Levitt:

But not only the economy being more resilient, inflation came down faster than many had expected. So, that also has been treated as good news this year.

Jodi Phillips:

So I know that's true, but Americans don't seem to be feeling all that good. You've been showing me some of the polls, Brian, what's 78% say that the US is heading in the wrong direction and about 80% say the economy is only fair or poor and getting worse. So why isn't this matching up?

Brian Levitt:

That's a very good question. I guess I'll go back to a Clinton-era line, “It's the prices, stupid." Even though inflation rate has come down. If you were up 9% year over year last June, and you're up 3% year over year now, it's a lot better for the market, but prices are still higher for people. So it's like you think about even Thanksgiving, right? Or think about cooking. People have been looking at the price of eggs. Yeah, they're down to $2 now from a high of over $4, but they were $1 before the pandemic, so it still feels not great for investors.

Jodi Phillips:

Again, it's all relative. So look, okay, so what you're telling me is consumers aren't happy, but if you're an eggheaded market strategist, things maybe look okay.

Brian Levitt:

Yeah, I like what you did there. Yeah, we actually have a misery index, unemployment plus inflation, and it's falling, and it's below the long-term average. So it's a bit different than how people are feeling.

Jodi Phillips:

There's an index for literally everything isn't there? Misery index. So maybe the economy isn't as miserable as it seems, as people might think.

Brian Levitt:

Yeah, I would say, but far be it for me to tell people how to feel. And look, we're not here to tell people how to feel, we're here to assess opportunities and markets. And yeah, we're feeling pretty optimistic as we head into 2024.

Jodi Phillips:

Well, good. Well, on that note, then, let's bring on Kristina and Alessio to discuss that level of optimism and where they see opportunities for 2024. Welcome.

Brian Levitt:

Yeah, thank you both for being here.

Alessio de Longis:

Thank you, Brian. Thank you, Jodi. Always a pleasure being with you.

Kristina Hooper:

Yes. Thank you, Jodi. Thank you, Brian. Really excited to be on.

Jodi Phillips:

So Kristina, let's start with you. I think what I got from Brian's analysis about egg prices is that as far as markets are concerned, it's not necessarily about labeling things as good or bad, but about are things getting better or are things getting worse? So I'm curious what you might say to the 80-some-odd percent of people who are telling pollsters that the US economy is getting worse.

Kristina Hooper:

So it's about the lagged effects of monetary policy at the end of the day. It's that we are still seeing, and there's much more to be seen in terms of the impact that rate hikes have had, both good and bad. So we're likely, very likely to continue to see significant disinflation, but it comes at a cost. So as we look ahead to 2024, we think of this as a balancing act, right? It's will inflation get under control faster than the economy deteriorates? And that is the very significant balancing act. So hopefully, in a few months in a poll, consumers will feel better, because we'll have made more progress on disinflation, but we won't have had a very significant impact in terms of depressing economic growth.

Brian Levitt:

Alessio, what happened to this recession? I thought it was the most anticipated recession ever, destined to come. What happened this year and does it ever come?

Alessio de Longis:

Well, I think what happened is exactly the super important element that Kristina just highlighted, the balancing act between inflation and unemployment, right? Unemployment is at all time lows. You don't have a recession. Obviously, unemployment is a lagging indicator, but even the leading indicator of unemployment are suggesting, if anything, a moderate rise in unemployment that would be perfectly consistent with that Goldilocks scenario that Kristina has outlined. Where inflation comes down faster than the unemployment rate rises, growth remains good enough, not too hot, which is exactly the perfect development for monetary policy.

And Brian, we have multiple times over the last two years flagged the rising probabilities of a recession. I think we have never had an official recession call, but we have rightly multiple times in 2022 and 2023 highlighted when we felt that the risks of a recession were rising and offered the template on how to think about that. I think what we are seeing in my mind is a scenario that is very reminiscent of what we saw in 2011 or in 2014, 2015. If you recall, the US economy and the world economy went through a meaningful deterioration in growth. In some instances, even a couple of negative GDP (gross domestic product) prints struggle in credit markets, but eventually both all those instances turned out to be meaningful soft patches that did not really translate into a recession and the cycle extended on for a few more years. That's the closest analogy that I find today with respect to historical standards in our lifetime.

Brian Levitt:

And I remember those well. And of course, in 2011, and correct me if I'm wrong, but it took some type of a policy shift or a policy response to get us there. So 2011, or what was the exact year where Mario Draghi said, "I'll do whatever it takes to maintain the stability of the euro and keep the eurozone together"? And 2015 into 2016, was it at the Federal Reserve who said, "Okay, we were just kidding about raising interest rates"? So it likely warrants some type of response by policymakers, and are you seeing the expectations of that type of response?

Alessio de Longis:

I think you are highlighting exactly what the issues were. There was an economic shock or a geopolitical shock, whether it was the European debt crisis, the US sovereign debt downgrade, the energy crisis in the States, the policy response, either fiscal or monetary or both, helped set the economy on track. In other words, the fate of the economy is not written, right? There is policy mistakes and there is policy responses that affect that path. If we draw an analogy today, if inflation, as Kristina highlighted, if inflation declines, or was starting in a credible way, and it's nice to see oil prices are not contributing to that problem despite the terrible escalation of conflicts in the Middle East. We are seeing a rising probability of an actual soft landing on monetary policy where rates may stay high for longer, but markets are correctly pricing, as of today, lower policy rates by about a hundred basis points into the end of 2024. If that pans out and the unemployment rate remains fairly stable as Kristina suggested, I think that is a scenario that would be consistent with us postponing the recession risk by a few years.

Jodi Phillips:

Okay. So Kristina, just kind of boiling this down into a nutshell in terms of the Fed, and we definitely want to talk a little more globally later on, but expectations and predictions that the Fed will start to ease in 2024. What is the base case that’s laid out in the outlook for how you're thinking about the timing of when that might happen and what that would suggest for what the economy's doing?

Kristina Hooper:

So, Jodi, great question. And we anticipate that rate cuts would begin by the end of the first half of '24. Now, this will be dictated very much by the data we see going forward, but from where we sit today, we think that's very likely. Now, you may recall, if we just go back to September, there was a huge market reaction and the start of yields skyrocketing, especially on the long end, when we got the Fed's September dot plot. The June dot plot had implied four rate cuts in '24, and then the September one implied only two rate cuts in '24. And that was sort of the “dot plot heard around the world” as opposed to the shot heard around the world that triggered this big rise in yield. And I think markets have finally come to the realization that the Fed can be incredibly wrong, especially the further out they look.

I mean, all we have to do is look at the December ‘21 dot plot and the expectations for the Fed funds rate at the end of '22 to know that. And so, clearly, markets have been going through this repricing process. I think, in particular, what we've seen is that recently with the CPI (Consumer Price Index) print for October, there is this great realization that, in fact, the July rate hike was the last one. And that if we use that rule of thumb that it's about eight, eight and a half months to the first rate cut, that'll take us to the second quarter of '24, and that we'll probably see around a hundred basis points in cuts. But again, we just don't know about the lagged effects of monetary policy. Maybe it's even more than that in '24.

Brian Levitt:

Alessio, let's create some conflict here, a little debate. Would you push that back a little bit? Would you suggest that the rate cuts may become a little bit later than what Kristina's saying?

Alessio de Longis:

My baseline aligns with Kristina, but since you want a little bit of a match, I have to find a narrative and a scenario that would be perfectly consistent with that higher rates for longer. And again, I think we shouldn't discount the risk at this stage in the cycle where there's tight labor markets. If commodity prices, be it food or energy prices were to increase, it takes very little, six months of rising commodity prices, which it's somewhat exogenous, geopolitical risk. It's not only demand-driven, it's also supply-driven. There is a non-negligible probability of a scenario where the inflation picture changes on a dime. And this, I'm fairly convinced of, central banks around the world have been so shocked by how wrong they were on inflation that they will be very reluctant to deliver any rate cuts when the optics of inflation are not supporting that decision. So not my base case, but I would say that's more than a 20%-30% probability, which is not negligible. Right?

Brian Levitt:

Okay. So the base cases are aligned, Jodi.

Jodi Phillips:

Good. Well, good. I know you were trying to prompt something there, but we've got some consensus.

Alessio de Longis:

We're shaking hands instead of using boxing gloves.

Kristina Hooper:

Listen, Alessio is absolutely right. There is that significant alternate scenario, significant probability of an alternate scenario, in which we get more of a hard landing because rates are higher for longer, because of persistently high inflation. The other sub-scenario within a hard landing is that so much damage has been done to the economy, that it is sent into recession by the restrictive level of rates as they are now, which I think is a lower probability than that first scenario about a higher for longer. But again, I think our base cases are aligned in that it's certainly not the highest probability scenario. The highest probability scenario is that that D-train, that disinflation train, continues and it's significant.

Jodi Phillips:

Pulling back a little bit from that US perspective and maybe getting a little more detailed about what you're seeing in Europe, the UK or Canada, what kind of timeline would you see in 2024 for that type of policy to see a shift?

Kristina Hooper:

I think a lot of the central banks are going to be quite aligned in terms of when they act, but it might be for different reasons, right? For some, you could argue they've seen more progress with taking down inflation while for others it's more about the economy deteriorating enough to necessitate cuts. I certainly think that we're likely to see the Bank of England move sooner rather than later there. But I suspect that the second quarter is going to be something of a sweet spot and that we'll see more than just the Fed acting.

Brian Levitt:

Alessio, let's get down to “brass tactics” here. Let's talk about your regime analysis. Let's talk about how your positioning as we move through the end of this year into the beginning of next year. And so I love that you talk about things from the perspective of whether we're in a recovery, an expansion, a slowdown, a contraction. What are you seeing right now? What are your indicators telling you and what are the implications for markets early on in the year and how that may play out throughout the year?

Alessio de Longis:

So from a market implied growth expectations standpoint, which we monitor through our more asset price-based indicators, we have seen improving sentiment and improving growth expectations since late June, early July. And so we have positioned for that recovery in the global cycle already in the middle of the summer, and we continue to be positioned with that view. We see a consistent improvement in growth optimism as implied in the market, in market prices into year-end. Interestingly, in the last couple of months, we have also seen validation of this forward-looking market view in the economic data, where consumer sentiment surveys continue to improve globally. Manufacturing business surveys are frothing. They're stabilizing at cyclical lows. And even housing indicators, which as we know, housing because of the rising mortgage costs, you should expect to see an ongoing deterioration there. Instead, we've seen some stabilization in building permits, housing starts, and so on and so forth.

Brian Levitt:

And what's that about? There's just not enough supply and there's still going to be demand given the demographics of this country?

Alessio de Longis:

There is certainly an element of that, but also going back to the important point from Kristina about the lagged effects of monetary policy. We have spent, post-GFC (global financial crisis), 15 years where the private sector has extended duration, has locked in very low interest rates, so the effective cost on consumers from interest rates has not fully passed through yet. So to your point, that limited supply is not due to the fact that we're not building new homes, but there's not enough turnover. There's not enough mobility in the housing market because a large portion of consumers have locked in interest rates that make them perfectly capable of sustaining their life expenses.

Brian Levitt:

I'm so happy for my two and a half percent mortgage rate. I refinanced the day COVID hit, and the big debate in the house was whether we let the appraiser in because we didn't know whether we were all going to get COVID from the appraiser, but best decision I ever made.

Alessio de Longis:

I had the exact same thing, yes.

Kristina Hooper:

And that creates golden handcuffs, right? No one wants to leave their house because that's a more important consideration sometimes than if you have four bedrooms or a pool or whatever.

Brian Levitt:

Right. Alessio, you must've been feeling good at least the day that the Consumer Price Index report came out and it was weaker than expectations, and you just had one of those days where value stocks, small cap, international, did very well. It's one day, but it was aligned with your expectation of how these things were going to play out between now and the end of the year and into 2024.

Alessio de Longis:

Yes, because, as I said, from July onward, have markets necessarily validated in the different aspects of capital markets, whether it's asset allocation, style factor allocation, and regional performance. The evidence of this recovery in the cycle has not been really, really clear. The day that you're referring to, which is it's one day, but it's very indicative of what the market cares about, and the market cares about the nexus that Kristina described. Inflation trends compared to labor market trends is really where the balancing act is today. And on that day, which I believe is significant, we saw that perfect cyclical, favorable cyclical reaction. To your point, sizes like small caps, mid caps, value stocks, meaningfully outperformed quality, meaningfully outperformed tech and large caps. We saw emerging markets perform well, credit spreads compressed. So it's saying that the market is ready to react to good news. The good news are not fully priced in. So the question is, will we be right about the cycle? And if we are, the potential for outperformance is there.

Brian Levitt:

Jodi, I know what you're thinking. That's a lot of footnotes that we have to put in. But I was in New York City that day, I presented with Alessio that day, and let me just say he was smirking. He was grinning. He wasn't a full smile, but he was grinning a little bit.

Jodi Phillips:

Always glad to see that for sure. And Brian, look, I've heard you quote, what is it? Investors have more than $22 trillion, is that right? Sitting in bank deposits and money market strategies. So when investors are feeling good and they start to smile and want someplace to put that money, what type of risk is that going to cause? I mean, whether it's reinvestment risk or just the force of all that money potentially coming into markets at once. What is on the lookout for when that money goes in motion?

Brian Levitt:

Yeah. I mean, I would pose that to Kristina. I mean, when she's talking about rate cuts potentially in the future, for these investors that seem to love five, five and a half percent in short yields, what does that mean for them? At some point, those rates have to come down, right?

Kristina Hooper:

Oh, absolutely. Those rates will come down and investors will move their money. What we have seen is very mobile money over the last few years. They might as well have sneakers on them because they've moved. They've moved out of traditional bank accounts into high yielding accounts, and they are poised to move, in my opinion, in a significant way. And they're likely to follow the path of historical recovery traits. So that ultimately means a broadening of the market because it won't just be the defensive, the large caps, the traditional areas where investors have focused recently, it's going to be about the small caps, it's going to be about the international, especially emerging markets.

Brian Levitt:

And Alessio, that would suggest to me, that's how we normalize the yield curve, right? But I would expect, given this conversation, you would think that perhaps you would see... Would we be in a slowdown regime at some point in 2024? And then how does the yield curve respond within that? Where do we think rates settle? And will you make sure to tell all of us how we want to be positioning for that type of an environment when it happens?

Alessio de Longis:

To start from the last question, yes, we'll continue to provide our market pulse on a monthly basis. I think what you outlined, I think is certainly possible-

Brian Levitt:

Hold on, one sec. Invesco.com/PortfolioPlaybook, right?

Jodi Phillips:

Oh, very good, Brian. Nice.

Brian Levitt:

Sorry to interrupt. Go ahead, pardon me.

Alessio de Longis:

Perfect. No, thank you. Thank you. So we could have a situation where, yes, actually in the US we find that growth is leading. We believe the US is already reemerged to growing above its long-term trend while Europe and emerging markets are lagging somewhat behind. So let's fast forward by a couple of quarters and assume that we are correct on our cyclical rebound. Now, a slowing and eventual normalization or re-slowing of the economy in the second half of the year, which would then justify and amplify the rate cuts that Kristina is talking about.

The yield curve has been inverted or flat now for a prolonged period of time. The natural shape of the yield curve is upward sloping. And the direction of the yield curve is, I don't want to say easy, but easier to predict than the level of rates. The yield curve is more stable and tends to have mean reverting properties. So an upward sloping yield curve driven by lower interest rates in the front end of the curve would be cyclically a very natural outcome for markets.

Jodi Phillips:

Brian, we're very much in the details of yield curves and monetary policy. I do have a question though. I'm just wondering when you're faced with a task of creating an outlook for the next year and just thinking about all of the other things that are going on in the world at the same time, whether it's geopolitics or whether it's an election coming up in 2024, just curious how much these types of factors weigh in on how you're creating your base case or thinking about your alternate scenarios.

Brian Levitt:

I mean, I try to look beyond. I mean, I'll pose that to our guests. From the geopolitical, I always try and contemplate whether it's going to remain regional, in which case you can largely look beyond. Everyone knows my opinion on elections, so we could ask-

Jodi Phillips:

They don't matter to markets. They don't matter to markets.

Brian Levitt:

Jodi came up with the title for my election paper this year, which is "People care about elections, and markets don't." So you know my opinion, but let's see if our friends on the podcast have any opinions.

Jodi Phillips:

Yeah, Kristina, let's start with you, if you don't mind.

Kristina Hooper:

Yeah. I don't think elections matter. Certainly, not in a material way over more than the very short term. Certainly, we can see short-term gyrations as a result, but I don't think it really matters in the medium or longer term. Now, geopolitical issues, they can have a bigger impact, although again, very much in the shorter term, in my opinion. We always have to ask ourselves, is it contained or is it contagious? And I think that's a question you ask about any kind of crisis, whether it's a financial crisis or a geopolitical crisis. But I tend to not let myself get concerned about geopolitical crises because we know the history, and what the history has told us is that it doesn't matter to markets in any material way over the longer term.

Brian Levitt:

And so far, we would categorize Russia, Ukraine, and what's going on in the Middle East as contained?

Kristina Hooper:

I would say so. I mean, certainly there is that risk that it becomes contagious in the Middle East, but we can certainly hope that it's contained and that it ends soon.

Alessio de Longis:

I agree with Kristina. We mentioned earlier, oil prices as being a real time barometer to determine when a regional problem becomes a global systemic problem. Oil prices is a very simple way to think about that transmission mechanism that affects everyone. But Kristina said something important earlier on monetary policy and recessions, which applies also here with geopolitics. You don't position a portfolio ahead of geopolitical risk, which is kind of like a lottery ticket in terms of probabilities, in terms of how rare and difficult to understand they are. But once a geopolitical risk hits, there is also often the right or wrong policy response. So again, we're back to that template that Kristina described. Watch for that policy response. Watch for what policymakers will do to exacerbate or remedy to the problem. And yes, agreed, elections. We need to make a distinction. Politics don't drive markets. Economic policies drive markets.

So once an election outcome is clear, going back to the drawing board and understanding what are the economic policies that come with that election outcome, now you can go back to a sound investment process and determine what the impact on market is. So you don't position ahead of an election. But as investors, we need to understand once the election outcome is certain, what are the economic policy implications, if any, and have they changed? And historically, what we find is that economic policies tend to impact more the relative performance between sectors because taxation and fiscal policies are often redistribution policies, say between industrials and materials or financials and energy. But economic policies rarely go and affect the predetermined direction of bond markets, equity markets, and around the growth cycle, as you, Brian, have always described with analyzing the historical analogies between different administrations,

Brian Levitt:

You just say it so much more eloquently than I do.

Alessio de Longis:

I'm learning from you. I'm listening to you all the time. It's the accent, Brian, it's the accent.

Brian Levitt:

We're coming up on the end, Jodi, I think we've exhausted our time, but I want to make sure we get parting shots from both guests. I want to make sure that they've been able to articulate precisely what they want to say before we end the podcast. So Kristina, maybe we'll start with you.

Kristina Hooper:

Sure. What I would say is that this is an environment that is changing as we speak. Markets are processing the reality that the Fed has almost certainly stopped hiking rates. And that means there is a change in markets because they start to discount an economic recovery. So we're already starting to see that. Of course, in the early stages, there will be a lot of volatility because there is still some level of policy uncertainty. The Fed has not come out and said they've ended rate hikes, and in fact, we might get some hawkish language from the Fed trying to tamp down financial conditions. But in my opinion, this is the beginning of a recovery trade. And I think that's important for investors to understand. I'm very excited about the coming months for markets and investors.

Brian Levitt:

Alessio?

Alessio de Longis:

Yes, I think, from an investment standpoint, this is an environment where we believe investors are still compensated for adding cyclical risk in the portfolios, maintaining overweight exposures to things like credit or equities. This is an environment where compensation for risk-taking should still play out. We are in a cycle that is already somewhat extended and accelerated because of the policy response to COVID. And so this is not a close your eyes and forget your investment strategy. You need to reassess and evaluate how monetary policy is impacting the economy. We have a long way to go on that. And given the geopolitical risks that are real and alive, maintaining basically a fluid approach to analyzing the situation. And if the facts change, being prepared to change your investment posture.

Kristina Hooper:

Yeah, I can't agree more with Alessio's last statement. If the facts change, right? Because of the lagged effects of monetary policy, we can guesstimate, but we don't know for sure until we see the data.

Brian Levitt:

So Jodi, you ready to join Kristina and Alessio in the 20% of Americans feeling good about the economy?

Jodi Phillips:

Sure. As of today, unless the facts change.

Brian Levitt:

Unless the facts change. So Kristina, Alessio, thank you so much. As always, we look forward to speaking with you again soon.

Alessio de Longis:

Thank you, Jodi. Thank you, Brian.

Kristina Hooper:

Thank you. Bye.

Brian Levitt:

This has been the Greater Possibilities podcast. Visit invesco.com/BrianLevitt to read my latest commentaries. And of course you could follow me on LinkedIn and on X, formerly known as Twitter, @BrianLevitt, the real Brian Levitt. Jodi, great chatting with you.

Jodi Phillips:

You too. Thank you so much.

 

Important information

You've been listening to Invesco's Greater Possibilities Podcast.

The opinions expressed are those of the speakers, are based on current market conditions as of November 17, 2023, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. Invesco is not affiliated with any of the companies or individuals mentioned herein.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

Should this contain any forward looking statements, understand they are not guarantees of future results. They involve risks, uncertainties, and assumptions. There can be no assurance that actual results will not differ materially from expectations.

All investing involves risk, including the risk of loss.

Past performance is not a guarantee of future results.

An investment cannot be made directly in an index.

Polls on the direction of the US economy are from the Associated Press-NORC Research Center and Gallup as of  October 2023.

The United States Misery Index tracks the mood of the country by adding the unemployment rate to the inflation rate. The index was at 7.1% in November 2023, compared to the long-term average of 9.22% from January 1947 to November 2023. Data from Bloomberg.

Discussions about the US inflation rate are from the: US Bureau of Labor Statistics as of October 31, 2023. Based on the yearly percent change in the US Consumer Price Index, which tracks changes in consumer prices. In June 2022 inflation rose 9.1%. In October 2023 inflation rose 3.2%.

Data on the price of a dozen eggs is from the US Department of Agriculture as of November 14, 2023.

Statements about US unemployment are based on the U-3 Unemployment Rate, Total in Labor Force, Seasonally Adjusted, from the US Bureau of Labor Statistics as of October 31, 2023.

Statements about the markets pricing in lower policy rates are based on Fed Fund Futures data as of November 20, 2023, sourced from Bloomberg.

Fed funds futures are financial contracts that represent the market’s opinion of where the federal funds rate will be at a specified point in the future. The federal funds rate is the rate at which banks lend balances to each other overnight.

Statements about the dot plot based on data from the Federal Reserve.

The dot plot is a chart that the Federal Reserve uses to illustrate its outlook for the path of interest rates.

The discussion about the release of the Consumer Price Index and the one-day reaction of various asset classes is based on data from Bloomberg on November 14, 2023. On that day, the Russell 1000 Value Index returned 2.24%, the Russell 1000 Growth Index returned 1.95%, the S&P 500 Information Technology Index returned 1.92%, the S&P 500 Quality Index, returned 1.48%, the Russell 2000 Index returned 5.47%, the Russell Midcap Index returned 3.33%,  the Russell 1000 Index returned 2.08%, the MSCI All Country World Index ex-US returned 1.74%, and the MSCI Emerging Markets Index returned 0.72%. Credit spreads fell from 125 basis points at the beginning of the week prior to the Consumer Price Index report to 114 at the end of the week that the Consumer Price Index was reported. Credit spreads represented by the Bloomberg US Corporate Bond Index option-adjusted spread.

The Consumer Price Index (CPI) measures change in consumer prices as determined by the US Bureau of Labor Statistics. Core CPI excludes food and energy prices while headline CPI includes them.

The Russell 1000® Growth Index is an unmanaged index considered representative of large-cap growth stocks.

The Russell 1000® Value Index is an unmanaged index considered representative of large-cap value stocks.

The Russell 2000® Index is an unmanaged index considered representative of small-cap stocks.

The Russell Midcap® Index  is an unmanaged index considered representative of mid-cap stocks.

The Russell 1000® Index is an unmanaged index considered representative of large-cap stocks.

These Russell indexes are trademarks/service marks of the Frank Russell Co.

The S&P 500 Information Technology Index includes stocks in the S&P 500 Index classified as information technology companies based on the Global Industry Classification Standard methodology.

The S&P 500® Quality Index screens holdings based on three fundamental measures of quality – profitability, earnings quality and financial robustness.

The MSCI All Country World ex USA Index is an unmanaged index considered representative of large- and mid-cap stocks across developed and emerging markets, excluding the US.

The MSCI Emerging Markets Index captures large- and mid-cap representation across 26 emerging markets countries.

The Bloomberg US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market.

Option-adjusted spread is the yield spread which must be added to a benchmark yield curve to discount a security’s payments to match its market price, using a dynamic pricing model that accounts for embedded options.

Statements about the amount of money investors have in cash are sourced from the US Federal Reserve and Investment Company Institute as of October 31, 2023. Based on total amount in US bank deposits and money market strategies.

Statements about the level of short yields sources from Bloomberg as of November 20, 2023, based on the 3-month US Treasury rate.

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.

Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Many products and services offered in technology-related industries are subject to rapid obsolescence, which may lower the value of the issuers.

Gross domestic product is a broad indicator of a region’s economic activity, measuring the monetary value of all the finished goods and services produced in that region over a specified period of time.

A basis point is one hundredth of a percentage point.

The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity. The front end of the yield curve refers to bonds with shorter maturity dates. An inverted yield curve is one in which shorter-term bonds have a higher yield than longer-term bonds of the same credit quality. In a normal yield curve, longer-term bonds have a higher yield. A steepening yield curve means that the difference between short term and long term is increasing.

Credit spread is the difference in yield between bonds of similar maturity but with different credit quality.

GFC stands for global financial crisis.

The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.

Brian Levitt:

Welcome to the Greater Possibilities Podcast from Invesco, where we put concerns into context and opportunities into focus. I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. And on the show today is Jen Flitton. Jen is the head of US Government Affairs at Invesco.

Brian Levitt:

So Jodi, we're talking politics again.

Jodi Phillips:

Well, it's kind of hard not to at the moment. We won't discuss it at cocktail parties or family dinners, but we can't help ourselves when it comes to this podcast.

Brian Levitt:

Yeah. And I don't think we should. I've been out seeing clients, seeing investors. It is top of mind. It's among the one or two top questions that I'm receiving right now.

Jodi Phillips:

Well, sure. I mean, there hasn't been a Speaker of the House since when? Early October.

Brian Levitt:

I don't mean to laugh.

Jodi Phillips:

That's something to talk about.

Brian Levitt:

Yeah. Is that a problem? I mean, it's not even clear there's a path to getting one, although there's some options I think that are starting to emerge.

Jodi Phillips:

Yeah. Yep, definitely. And so Jen will give us a scoop on all of that, but it's certainly unprecedented. I mean, as much as you like to make historical comparisons, Brian, when big events happen, ousting a Speaker like this hasn't happened before. So an unprecedented territory here. And it happened just a few days after we were able to avert a government shutdown.

Brian Levitt:

Yeah. So you and I were happy about that. We had talked about that on the last podcast, and I've got a friend at the federal prosecutor's office, so we weren't sure if he was essential or non-essential, but he's still getting paid, so he's happy right now.

Jodi Phillips:

Well good. Well good. And importantly, the animals at the National Zoo are being fed. I know you,

Brian Levitt:

Yeah. Good.

Jodi Phillips:

Always like to ask that question, but.

Brian Levitt:

We were happy about that.

Jodi Phillips:

But look, the next shutdown deadline isn't that far away, November 17th. So the question is how is all of this uncertainty going to impact what happens between now and then? Can we avoid the next one without a speaker?

Brian Levitt:

Right. And we had said that even if you have them, they don't last that long. So I don't know how you do this without good leadership in the House of Representatives. So I think it's a good question.

Jodi Phillips:

Yeah, I mean, I think you've said something about seven or eight days on average is usually about how long shutdowns have lasted in the past, but what would that look like if this Speaker thing isn't settled?

Brian Levitt:

Right. And right now, and I'm not sure it's front and center in the markets, I mean, it seems like Americans have gotten used to these things working out, but there's no shortage of challenges for the US government to contend with right now.

Jodi Phillips:

Nope. There's funding for Ukraine for one, and of course significant concerns with the Israel-Hamas war.

Brian Levitt:

Right. And all happening on the eve of an election year.

Jodi Phillips:

It's always the eve of an election year, right? I mean, that's what it feels like. There's always one upon us. So,

Brian Levitt:

Do we really have to do this again?

Jodi Phillips:

The calendar says so and the Constitution. So yeah.

Brian Levitt:

I guess we'll start dusting off those presidential elections don't matter as much for markets as you think they do content. At least that tends to be popular with our friends.

Jodi Phillips:

Yeah, maybe you can talk about it at cocktail parties too. It's always a crowd pleaser. So in any case, look, let's bring Jen on to discuss each of these issues and more. So welcome, Jen.

Jen Flitton:

Hi. Thanks for having me.

Jodi Phillips:

Sure. Well, thanks for joining us, especially when there's so much uncertainty going on to help us figure this out as much as possible. As we're recording this, still a lot of questions about the speaker. Jim Jordan failed to get the gavel after two rounds of voting, and I'm starting to see headlines that he may not go for a third vote and instead could support a plan to give additional powers to Representative Patrick McHenry who's now serving as temporary speaker. So I definitely want to get your views on all of that. But first I'm hoping you can kind of set the stage and explain to us what can and can't the House do without a Speaker right now?

Jen Flitton:

Well, first I'll say, so we're a bit whipsawed. Right. So that was the news this morning and now it's two hours later post conference. And the members erupted over that idea.

Jodi Phillips:

Oh, goodness.

Jen Flitton:

And so there were a lot of tweets and a lot of talk with press as they left the conference meeting. And they right now are not at all interested in empowering the current Speaker Pro Temp, Mr. McHenry.

Brian Levitt:

Why?

Jen Flitton:

So there is a lot of frustration over the idea that they would require Democrat votes,

Brian Levitt:

Okay.

Jen Flitton:

For this. And there's not a majority of the majority currently that's backing this type of empowerment that would essentially take us over the next two months into January. So past some of the biggest legislating, right, over the next two months. And so you saw the hardliners, the conservatives really rally against that. So the expectation is that potentially we will see a third round,

Jodi Phillips:

Okay.

Jen Flitton:

With Jordan as of 2:30 right now.

Brian Levitt:

2:30 on Thursday on the East Coast.

Jen Flitton:

Right.

Jodi Phillips:

Okay. Well, Brian, that's a note to self. I should always check X right before we start recording a podcast.

Brian Levitt:

I mean, we have other jobs to do also, but you're not refreshing the internet every couple minutes for your latest news.

Jodi Phillips:

No, that was my mistake.

Brian Levitt:

Hey Jen, I have a question. I've been getting this from people. When we used to do these things in the past, was it always only one party voting for the Speaker or did you used to see crossover votes from other parties? For example, in the ’80s we used to hear about how these guys and gals would get together and hang out and drink. Was Tip O'Neill getting votes from the other party?

Jen Flitton:

No, this has always been a partisan exercise. I mean, there are occasionally you have independents who aren't members of either Republican or Democratic Party, but then they caucus or conference with those parties. And you see that happen in the Senate. Right. We have three independent senators right now. They all caucus or have some sort of negotiating agreement with the Democrats. But in the House, because majority rule is so strong, the minority, it's easy to stay together because you're in the minority, right, you're the opposition party. What we're seeing over the past two Congresses, the last one in which Pelosi was the Speaker, she had a similar margin, right, a similar margin of votes, four to five votes,

Brian Levitt:

Right.

Jen Flitton:

But she had changed the rules. So there would not be a motion to vacate unless there were a certain number of members who put it forward. They changed the rules back to only one person being able to issue this motion to vacate.

Brian Levitt:

Regrettably. Well, that was,

Jen Flitton:

Regrettably.

Brian Levitt:

That was because Kevin McCarthy had to go 15 rounds, right? And this all stems,

Jen Flitton:

That's right.

Brian Levitt:

Back to the expectation you would have a wave Republican election perhaps in the midterms that just didn't play out.

Jen Flitton:

That's right. It did not materialize. And so what they were left with was a four to five vote, depending on a good day, right, margin. And so because McCarthy had become somewhat of a polarizing figure within the House Republican membership with such a small margin, it took him so long and then he had to start making deals to get to the speakership.

Jodi Phillips:

So Jen, on the second ballot, Jordan got even one fewer vote than he did on the first ballot. So going into this third vote, and maybe votes 14 through 15, who knows? I mean, what would you think might we be looking at next?

Jen Flitton:

You're right. So if he does not gain in numbers, right, it's going to continue to sort of unravel within the conference and the temperature is incredibly heated. I mean, these are very tense moments. Typically, conference meetings stay very private. They're not, they're literally playing out on X right now. And so you see these members just throwing out the family meeting and putting all of their dirty laundry on the floor and in front of the press and all over the Twittersphere. So it needs some time to calm down. That was the whole intention of empowering the Speaker Pro Temp for two months is to allow some calm to come over the conference.

There may be a way in which the Speaker Pro Temp can bring legislation to the floor with without further authority, assuming that they make the argument that the authority is currently within statute. And that is a debate that's happening within Washington right now. And what we could see is the Biden administration bringing the supplemental draft to the Senate next week, the Senate passing it, and that essentially triggering the House to do something. Right. Now they have something, a forcing mechanism, and that we could see potentially next week.

Brian Levitt:

Speaker Pro Temp, I don't remember learning about this in high school. Is this a post 9-11 type of thing? Is this to make sure, what was the show with Kiefer Sutherland the last survivor? Is it that type of thing?

Jen Flitton:

Well, yeah, it's sort of, right, because that would be in an emergency, right, the one cabinet member who doesn't come to the State of the Union, that was sort of that reference, but this was also devised after 9-11 in case of an emergency where potentially there's devastation within the chamber. And so this would allow for, the Speaker has to provide a whole list of members who could then fulfill that position. And it's written in such a way that he would have the necessary and appropriate, he or she would have the necessary or appropriate and appropriate authorities deemed by the speaker. Right. But his main goal is to allow for the election of a new Speaker.

Brian Levitt:

Why should Americans care? What should we worry about if this persists?

Jen Flitton:

Well, right now we have a lot of volatility, right, around the world in the Middle East. What the Biden administration is proposing is to bring a supplemental that funds Ukraine, Israel, Taiwan, potentially and includes some border money. And so these are all threats within the world and at our own border. So this is a real exercise and I think that there will be a lot of pressure. Right now, there isn't really that forcing mechanism. There isn't legislation that has to get done this week. Right. And the House was already scheduled to be out in recess for the last two weeks. So while we're approaching the supplemental draft coming to the House floor and we have the appropriations process, we're running into that November 17th deadline where the continuing resolution, the stop gap funding runs out. It's really over the next week, two weeks, three weeks, where there's going to be a need to get legislation passed. We're not quite there yet. And we all know Congress doesn't work without forcing mechanisms, so we're going to have to see what happens.

Jodi Phillips:

So Brian, a lot of issues definitely on the table. I don't know if we want to break this down kind of one by one, maybe looking at the shutdown first. Definitely hopeful for another solution to this, but Jen have to ask, what does a worst case scenario look like in terms of if we can't get things together before November 17th and the shutdown happens?

Jen Flitton:

Right. This is pretty embarrassing for House Republicans right now, but embarrassment will turn to humiliation if by next week the House and Senate pass a supplemental funding, they're able to bring forward a bipartisan supplemental bill that will aid in the crisis that we're seeing play out in real time in the Middle East, and then the House can't bring it to the floor. That would be an emergency. Right. And so that's why it's a big question whether that may be the moment that the conference decides, okay, we just need to figure out what we're going to do till the end of the year. And maybe that is a way to get more empowerment into the Speaker Pro Temp.

Brian Levitt:

Are there are all options open on this? I mean, you say that typically you don't see the two sides come together and think of an option. I mean, are there Democrats willing to put their votes behind a Republican candidate in exchange for some of the concessions that they want to? I mean, clearly they weren't with Kevin McCarthy. Do you think they're regretting that or is it possible that something may happen in the future?

Jen Flitton:

Well, there's been a lot of chatter about that in Washington, whether they regret. I mean, Jim Jordan could still become Speaker by next year. Right. And so the idea that some of the Republican rhetoric that came out after McCarthy was removed and deposed was that Democrats joined with Matt Gaetz and friends to kick out Kevin McCarthy. Right. And at the time I thought that was – okay, wow, that's quite a reach. But apparently some of that's resonating.

I don't think there's a real understanding over the process and procedure of the House in most American kitchen tables, that's not what they're discussing. But when you try to present yourself as the pragmatic party, the party who's serious about getting things done and making government function, and then you vote to remove the speaker, apparently there is in some circles that's resonating in the sort of independent, those who can kind of go both sides depending on the election. And so they're starting to feel some of that in certain districts. And so I think they want to be part of the solution. But of course that is then getting the hardliners, the Gaetz and extended into the rest of the Freedom Caucus, really frustrated over the idea of an electing a Speaker with Democratic votes.

Brian Levitt:

As always, where you stand depends on where you sit.

Jen Flitton:

Right.

Brian Levitt:

Right.

Jen Flitton:

Right.

Brian Levitt:

You hear what you want to hear. I've got to imagine that Benjamin Netanyahu and Volodymyr Zelenskyy are watching this pretty closely.

Jen Flitton:

I would imagine that the need to replenish the Iron Dome and the need for Ukraine to have further support, which quite frankly right now, of the $100 billion that the administration is drafting, the talk is that $60 billion of that is for Ukraine. Now, that's a lot over the $24 billion that the White House had originally asked for earlier this fall. So I would imagine that is not going to be well received by House Republicans, many House Republicans. And so that number is going to be really difficult to get to. The House Republicans if they want to play here, they have got to come together if they want to negotiate around this package, because it's not just money. They'll have to be accountability. They'll have to be policy and direction for exactly where that money goes. And the House Republicans are going to want to be part of that conversation, but they can't. They have no leverage if they don't get a Speaker or empower a Speaker Pro Temp.

Jodi Phillips:

So speaking a little more specifically about the crisis in Israel and Gaza, I mean, does all this dysfunction and distraction in the US have potential implications about this expanding into a broader regional conflict while we're busy infighting? What's the broader perspective globally?

Jen Flitton:

Well, that's the ultimate fear. And so you've seen the administration today, or maybe it was last night, provided a briefing to members, the leadership of the House and Senate, bipartisan to really bring them up to speed as to what they're seeing. And of course, the fear is that this could spread, that Hezbollah could become involved, that Lebanon could become involved, and what does that mean for the spread of this in the region? And so that is definitely a concern that is shared by both sides. That's a bipartisan concern.

Jodi Phillips:

Absolutely.

Jen Flitton:

I mean, that's the consensus of Washington right now. And then you saw the State Department just a few hours ago issue a concern to American travelers around the world, that they need to be vigilant because of the protests and potential terrorism.

Brian Levitt:

I guess I was very naive six months ago, walking around the Holy Land without much of a care in the world. It's amazing how quickly things change. Did you get a sense based on President Biden's trip to Israel, did you get a sense of everybody's talking about the morning after, the morning after, or how does this end? Do you have a sense of whether we're stepping into a prolonged conflict similar to perhaps what we saw after 9-11 with what the US was seeking to accomplish in Afghanistan? Or does this seem to be a more limited mission with a potential reasonable outcome?

Jen Flitton:

Well, I think the key question right now as things stand today is the Israeli entrance into Gaza and what they will need to do to extract Hamas from Gaza, what is left in Gaza after that?

Brian Levitt:

Right.

Jen Flitton:

Right. And so as much as the US and Biden's rhetoric has been, we don't want Israel to have to occupy Gaza. Israel doesn't want to have to occupy Gaza. But there's a famous saying, right, in defense and going into and occupying, “if you break it, you bought it,” right, you have the responsibility of those people. There is discussion and you saw that as President Biden left Israel, he apparently immediately had phone calls with president of Egypt and the president of the Palestinian Authority because they're trying to get a handle on what happens after they remove Hamas, which was essentially the governing force there in Gaza after 2007 when they rather viciously took over the strip.

Jodi Phillips:

So Brian, I know on our list of questions that we wanted to ask Jen, we definitely wanted to ask her about 2024 election. Is there anything else before we pivot, anything else you wanted to ask about the shutdown or should we just jump straight into the election picture?

Brian Levitt:

I guess before we get to that, I mean, I think investors want to know what they should be concerned about most or what they should fear most. And one of the things that I've been hearing lately is inflation is still a challenge. We can debate how much of a challenge in the US. We've seen interest rates go up a lot, and obviously there's rates kind of settle based on where supply and demand are. And the concern that I'm hearing is more supply, the more need for money, not only at the US border, but also Israel, Ukraine, and whether there, I don't know necessarily if this is a question for you, Jen, but whether there's demand for all that supply coming to market and is now the right time for more spending. Not that the United States largely has a choice in this instance, but is there really the reasonable ability to sop up this supply that's going to come to market?

Jen Flitton:

Yeah, I think the appetite for additional spending is incredibly low. And you saw out of this debt ceiling deal, the parameters that were set were to bring that fiscal spending down considerably. And I think no matter what comes out of this, we will not be growing spending here in the government. And there will be a restraint. How they do it on discretionary spending specifically, right, which we know isn't the main growth of spending. It's really entitlements, it's Social Security and Medicare.

Brian Levitt:

Sure.

Jen Flitton:

But within that discretionary spending and the non-military discretionary spending, they will start to contract that, whether it's at the House level of really restraining it, or it's the Senate level, which is a compromised restraint, it will be restrained.

Brian Levitt:

I think a lot of investors will be happy to hear that.

Jen Flitton:

Yeah.

Brian Levitt:

So to Jodi's point, do you think that what is going on in the House of Representatives right now is being closely followed by the American public, and do you believe that by the time we get to the conventions next summer or the debates in the early fall that anyone's even going to remember this?

Jen Flitton:

Right. Exactly. And I was with a few members this week who were saying the same thing, right? I mean, they're hearing from their base, right, the base voters who of course are political junkies or they pay attention and they're sent little messages, email or text otherwise. And so they're engaging in calling up their office, their congressional office, and having their own opinion about Jim Jordan or a Scalise or what have you. But the vast majority of people don't know who the Speaker of the House is, don't care who the Speaker of the House is. And quite frankly, once we get into the general election season, the presidential will be the main stage and everything will just be sideshows. It's going to be two main characters. And we can in a point in time right now, it looks like it's going to be President Biden and former President Trump, a sort of redo of 2022, two very well-known figures who also have their own polarizing forces. And so that will be the vast majority of the focus come 2024.

Brian Levitt:

Yeah, this will seem like a distant memory.

Jen Flitton:

Yeah.

Jodi Phillips:

So do you have any, I don't know if predictions is maybe too strong of a word or just thoughts in terms of what the most likely outcome might be in ’24?

Jen Flitton:

Well, I think the consensus right now, if you're looking at the polling, the aggregated polling is that Donald Trump is quite a force and he is only growing in that and short of being sent to prison, which by the way, you can run for president and you can be president if you are in prison, short of experiencing some sort of issue along those lines, it does look very likely that he will be the Republican nominee. And we have the caucuses meeting here in Iowa in January, and then that will follow for the first primary in the country in New Hampshire in February, and then it'll go to South Carolina and all of a sudden you're at Super Tuesday. The momentum if he takes Iowa and New Hampshire and then South Carolina is just going to be unstoppable. So really that's why you see sort of the next rung of characters, DeSantis, Haley, Tim Scott, they're focusing all of what they have on Iowa and New Hampshire.

Brian Levitt:

What about 2028? No, I'm just kidding.

Jodi Phillips:

So Brian, is this the part where you pull out your presentation about how 2024 isn't going to matter much to markets and make us all feel a little bit better about that at least?

Brian Levitt:

I mean, at least what I've been able to tell people, people get so worried around the elections on what it's going to mean for markets. If you look at the market performance under Trump from the day he got elected in 2016, so I think that was November 8th, 2016, for the first 720 or 740 days in office, which is what Biden has now done. And you look at Biden's performance, the S&P 500 from November 3rd, they're pretty close. Trump's got a slight advantage, but they're pretty close. Nowhere near what the amount of concern that we heard from investors. So Jodi, Jen, I will keep going back to those points. I know these things mean a lot with regards to policy and direction of the United States and what type of country we're going to be and how we're going to form a more perfect union. But ultimately, markets seem to be focused far more on what the Federal Reserve is going to do.

Jodi Phillips:

We promise not to ask you any Federal Reserve questions Jen. We'll save that and put Brian on the hot seat there.

Brian Levitt:

Jen, is there any parting shots, anything we missed, anything that you can tell us to maybe calm the concerns of people that are watching this too closely?

Jen Flitton:

Well, I think we will have a resolution here. It's going to be, it's already dragging out, but it's going to drag out further. And if you watch too much news, and right now people are because of all the volatility in the world, so they're seeing all of this playing out in real time. But I do think that by the end of this year, there will be some sort of resolution to the government funding, to the continuation of the NDAA, the reauthorization of the Defense Act, which is how we fund our military and some sort of resolution on supplemental funding for the Middle East and the war in Ukraine. And so I think by the end of this year, we will find ourselves resolved around Christmas.

Brian Levitt:

All right, my blood pressure just went down quite a bit.

Jen Flitton:

Merry Christmas.

Jodi Phillips:

Merry Christmas.

Brian Levitt:

Happy Holidays.

Jodi Phillips:

And Happy New Year. Thank you so much, Jen. We appreciate you joining us.

Jen Flitton:

Thanks so much.

Jodi Phillips:

So Brian, as we track these issues through the next couple months, where can people find your market views?

Brian Levitt:

Yeah, it's not going to be hard for us to come up with topics, right, Jodi?

Jodi Phillips:

Not at all.

Brian Levitt:

Visit invesco.com/brianlevitt to read my latest commentaries. And of course, you can follow me on LinkedIn. And on X. Do we have to say formerly known as Twitter?

Jodi Phillips:

Why not? Formerly known as Twitter.

Brian Levitt:

At Brian Levitt, the real Brian Levitt.

 

Important information

You've been listening to Invesco's Greater Possibilities Podcast.

The opinions expressed are those of the speakers, are based on current market conditions as of October 16, 2023, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. Invesco is not affiliated with any of the companies or individuals mentioned herein.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

Should this contain any forward looking statements, understand they are not guarantees of future results. They involve risks, uncertainties, and assumptions. There can be no assurance that actual results will not differ materially from expectations.

All investing involves risk, including the risk of loss.

Past performance is not a guarantee of future results.

Information on the frequency and duration of US government shutdowns is from the US Department of the Treasury.

All data provided by Invesco unless otherwise noted.

NDAA stands for the National Defense Authorization Act.

The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.

Brian Levitt:

Welcome to the Greater Possibilities Podcast from Invesco, where we put concerns into context and the opportunities into focus. I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. Brian, I have questions about a lot of different topics today, so I didn't bother booking a guest. I didn't want to subject them to my stream of consciousness, so you're in the hot seat.

Brian Levitt:

I am in the hot seat.

Jodi Phillips:

Congratulations. Yeah.

Brian Levitt:

I like being in the hot seat. I just want to know where you want to start. I have some sense of the things you want to ask, but I'm wondering where you want to start with all of this?

Jodi Phillips:

Okay, short list: interest rates.

Brian Levitt:

Okay.

Jodi Phillips:

Central bank policy.

Brian Levitt:

Makes sense.

Jodi Phillips:

Government shutdown fears.

Brian Levitt:

Sure.

Jodi Phillips:

Worker strikes.

Brian Levitt:

Yeah, that's all?

Jodi Phillips:

Do you want more?

Brian Levitt:

Well, we'll see. Let's see the runtime. It seems like a good list, so let's see how long this goes.

Jodi Phillips:

That's enough to start with. Okay, then without further ado, let's start with interest rates. Have you been surprised by the rise in interest rates in August and September?

Brian Levitt:

Yeah, I've always promised to be honest with the listeners, so yeah, I have been, and why have I been so surprised? Mostly because, Jodi, as we know, inflation peaked over a year ago. We see inflation peak in June 2022 at 9% with rates at — 10-year rate at four and a quarter, I would've thought that that was the move.

Interestingly though, the move in rates has not been driven by inflation expectations. Inflation expectations are very well anchored. It's been a sharp move higher in what we call real yields, and that is the result of US economic strength. Now, I just simply underestimated how strong the economy would be by the second half of 2023. I mean, we figured that things would not be as robust as they are right now, and yet people continue to shop.

Jodi Phillips:

Okay, so it's not about the political turmoil. The high rates have been about the strong growth?

Brian Levitt:

Yeah, I don't think it's about the political turmoil. I mean, we could talk about that in a bit, but that doesn't seem to be what's caused rates to jump. We've had political turmoil before. This has just been a strong economy.

Jodi Phillips:

Sure, and look, you're far from the only one who underestimated the strength of the US economy, so lots of economists are all offering their mea culpas on their recession calls.

Brian Levitt:

Yeah, a lot of mea culpas.

Jodi Phillips:

Yes, for sure. Why? What do you think folks got wrong?

Brian Levitt:

Well, it might just be timing.

Jodi Phillips:

Timing.

Brian Levitt:

Yeah, the expectation was that we got a lot of tightening and we would've had a recession by now, but maybe it's just more timing than anything else.

Jodi Phillips:

All right. The lagged effects that I keep hearing so much about. I mean, 550 basis points in a short period of time. Yeah, that's a lot to digest.

Brian Levitt:

Yeah, it is. And maybe it's just taking longer to work its way through the system than it usually does.

Jodi Phillips:

For sure. Well, whatever the case, I'm definitely glad I have a fixed rate mortgage.

Brian Levitt:

Right, that's exactly what I'm talking about. It's been negligible to a lot of people, at least to this point. I mean, why does it matter if rates went from zero to 550 basis points if 80% of us have fixed rate mortgages? Whether that's most of us, 30, some 15-year mortgages, but fixed, and you think about it from the chief financial officers of businesses, they were also paying attention. I mean, they locked in low rates when they could. It's just not hitting, all these rate hikes are just not hitting the economy as soon as we would've expected.

Jodi Phillips:

Okay. Well, I mean, that's all well and good, but ultimately it's going to start to weigh on the economy, right?

Brian Levitt:

Well, that's the idea. I mean, the Federal Reserve wants things to slow down. They don't want to see the job market remain so strong. There'd be a dearth of workers' wages to go up. That's the idea here. And you can look back at other cycles, which always does provide us some comfort. I looked at 1988 before the early nineties recession, '94, '99. Rates rose either before a recession emerged or the Federal Reserve had to back off its tightening stance. This feels pretty similar to that. The last leg up in growth, the last leg up in rates, and then people extrapolate that to be forever, but unlikely to be the case. Rates will ultimately start to moderate, in my opinion, as the economy moderates.

Jodi Phillips:

Okay, so you're not in the “high for long” camp?

Brian Levitt:

“High for long.” No. I've been joking that that sounds like it should be a Grateful Dead song. No, I am not in the high for long camp. Rates will be higher than they were in the last cycle. Let's be honest. I think sometimes when I say I'm not in the high for long camp, people think I mean they're going back to zero or 2%. No, that's not what I'm saying.

Jodi Phillips:

Okay. Okay. Not likely to go back to a negative real yield after inflation then?

Brian Levitt:

No, and I think that that's probably a good thing, but importantly, I expect rates to be at or nearing a peak as the economy's likely to moderate going forward. Now, some might hear that and say, "Oh, he is calling for slow growth, or maybe even a recession," but I'm in the camp that peak rates, peak tightening, all tends to be quite good for markets over the subsequent years.

Jodi Phillips:

Okay. All right then that brings us to the next topic, Federal Reserve. Will they, won't they, and Brian, do we care anymore?

Brian Levitt:

Yeah, unfortunately Jodi, I think we care.

Jodi Phillips:

Okay. All right, fine. We care.

Brian Levitt:

You know you care.

Jodi Phillips:

I care very much. Yes. Tell me, what do you expect?

Brian Levitt:

People have been asking me why this year was so much better than last year. Now, it hasn't felt like that over the last couple of months, but why has this year been better? And it's mostly because we've been moving towards more policy clarity. Markets don't like uncertainty, and last year we had so much policy uncertainty because inflation was so high, just how many times were they going to have to raise interest rates? And now we're still debating it, obviously, you just asked. We're still debating it, but we've got to think we're getting closer.

Jodi Phillips:

Okay. But the past few weeks, I mean, that's been the opposite of clarity, right? You're saying we're closer than we were last year?

Brian Levitt:

Yeah, it's like those kids in the Station Wagon. You ever go on that road... I know you go on the road trip, you take out the Winnebago, you go across the great divide.

Jodi Phillips:

Yeah, I've done that a couple of times. Yes.

Brian Levitt:

You have, and the kids are always, "Are we there yet? Are we there yet?" "No," and then I don't know about yours, but mine say, "Are we getting closer?" And we're raising geniuses. Yeah, I mean, we think we're getting closer.

Jodi Phillips:

Well, we're driving an awful long time, so we're closer – unless we make a wrong turn. Okay, let's just hope the Fed isn't navigating by a crumpled up map in the glove compartment.

Brian Levitt:

Yeah, they're using their GPS. As I say, Jodi, inflation expectations are generally contained, and so they have restored credibility, which is great, but at the same time, I do worry about them overtightening. I mean, I look at inflation expectations and say, "Well, why keep going? We're pretty contained here. Why don't we see what this all will ultimately do?" I do worry about them overtightening, but the reality is they don't answer my phone calls.

Jodi Phillips:

They don't?

Brian Levitt:

No, they don't answer. I mean, most people don't.

Jodi Phillips:

Well, I do. I answer your phone calls.

Brian Levitt:

You do, but be honest. You have to because of your job description, right?

Jodi Phillips:

Yeah, I couldn't negotiate that out. All right, so why? Why are you worried about overtightening?

Brian Levitt:

Well, think about it this way. The Fed famously tells us that they're data dependent, so they're looking each month at the data, but we know that policy operates with a lag.

Jodi Phillips:

Mm-hmm. All right. That by definition leads to overtightening.

Brian Levitt:

Right. I mean, if the challenges don't hit a few months out, data dependent's not really going to have you recognizing that. And so yeah, most of these things and most of the Fed tightening cycles end in recession or some type of challenge. I do fear that they're overtightening, which is largely takes us back to our first conversation, which was asking have rates peaked. I mean, at some point they tighten too much, growth slows and rates start to come down.

Jodi Phillips:

Okay, after overtightening comes easing, right?

Brian Levitt:

Usually.

Jodi Phillips:

The futures market, I mean, what's that telling us? The Fed funds rate will be about five and half percent — four and a half percent a year from now. Yeah, let's get that right. Four and a half percent a year from now. That suggests we'll get a few cuts between now and then, right?

Brian Levitt:

Yeah, I mean, although after that September jobs report, five and a half percent might have felt...

Jodi Phillips:

Right, right. No, that's...

Brian Levitt:

And that's what scared the market initially after that jobs report. Yeah, I mean, Jodi, the futures market had suggested rates as low as 4% at one point a year from now. The market's had to reassess recently. If the market's pricing 4% at one point and now things have still been strong and okay, a year from now we're pricing four and a half, well equity markets, risk assets adjust. Now, this is all very nuanced and very short term. To me, the most important point, I'll say it again, is that we're getting close to peak rates. And again, historically that's a good backdrop for risk assets.

Jodi Phillips:

A good backdrop. Okay, that's good to hear. Let's stop there with the good backdrop and jump from the Fed to Congress. Have you tried putting in any calls to those folks lately? Maybe they should be answering your calls?

Brian Levitt:

Talk about people who really don't answer my phone calls.

Jodi Phillips:

We avoided a government shutdown, okay, but it cost the Speaker of the House's job. Would you call that a good trade-off?

Brian Levitt:

Oh, I don't know.

Jodi Phillips:

It's a hot seat, Brian. It's a hot seat.

Brian Levitt:

My mom told me not to discuss politics in mixed company.

Jodi Phillips:

All right, fair enough. We don't want to make her mad.

Brian Levitt:

I'm not sure if I'm the right person to answer that, but look, I guess if you're a non-essential worker, you're probably pretty happy to be getting a paycheck this week.

Jodi Phillips:

Oh, sure, right? I mean, the park rangers, the NASA experts, the zookeepers at the National Zoo, they're all happy, at least for now. We'll see-

Brian Levitt:

Yeah, you're down in Houston, you probably know some NASA rocket scientists.

Jodi Phillips:

Oh, sure. Yeah, we all hang out.

Brian Levitt:

You all hang out, right? Yeah.

Jodi Phillips:

We'll see if we can avoid another shutdown scare in November.

Brian Levitt:

Yeah, round and round we go. I guess at some point we just get used to this.

Jodi Phillips:

Yeah. There's the view from being a constituent and then there's a view as an investor. As an investor, how caught up do you get in these things?

Brian Levitt:

Well, you framed that correctly. I mean, I watch as a concerned spectator, and maybe occasionally get out the popcorn, but I don't change my investment approach. As I said, I'm getting used to it at this point. There's been enough of these things.

Jodi Phillips:

21. 21 shutdowns since the 1970s.

Brian Levitt:

21 times. Ferris Bueller reference? Nine times. No, that's a lot. And I mean, the good news is, you've had them. The good news is they tend to not last very long. On average, if the government does shut down, it lasts seven to eight days and then we move on. Now, there may be some hit to the credibility of the US government or the ability to run the US government, but for the most part, markets look past it.

Jodi Phillips:

Great. And the zookeepers get paid.

Brian Levitt:

Yeah, they get their back pay as they should. I mean, hopefully the animals were being fed the whole time.

Jodi Phillips:

Yes, I have no doubt. You mentioned earlier that you don't believe that the move in the treasury rates is related to this political turmoil. Why is that?

Brian Levitt:

Yeah, I don't believe it is. I mean, if you think about it, government spending is an input to GDP and the 10-year rate is going to be a reflection of what growth is likely to look like. And so if you don't get a spending bill, you don't get spending, then the G in the old GDP equation, C plus I plus G plus NX, the government spending slows. And so in actuality it may be paradoxical, but I would actually think rates would've rallied if investors were so concerned about it. And if investors were concerned about a component of US GDP not being an input to growth, I would've thought rates may have rallied. This move, again, seems far more attributable to stronger than expected economic activity than political concerns.

Jodi Phillips:

Okay. If I asked you about the recent stock market volatility, a similar answer?

Brian Levitt:

Yeah, I think so. Political uncertainty doesn't help, but it's part and parcel of the same thing you were just asking. I mean, if equities are going to adjust as rates go higher, then it goes back to why did rates go higher? And historically, markets have looked past shutdowns. What would you guess the average return during shutdowns is the last 21 times we've done this?

Jodi Phillips:

I couldn't guess. I would guess it's not great though.

Brian Levitt:

Yeah, no, it's 0.1%. You've had a few up, you've had a few down, a couple that were maybe down 3% or so, but essentially flat.

Jodi Phillips:

Essentially flat. Okay. Well, markets must've heard the quote, "Americans always do the right thing, but only after exhausting all of their other options."

Brian Levitt:

Yeah, I guess you're my co-host on this. I think you've probably heard me say that a few times as well.

Jodi Phillips:

Once or twice.

Brian Levitt:

Once or twice, right. Well look, I mean, what number episode is this? Like our 50th episode? Something like that.

Jodi Phillips:

I think it's close to that. It sure feels like it.

Brian Levitt:

I mean, you think I'm still going to have fresh material after all of these? I have to go back to the tried and true.

Jodi Phillips:

Go back to the classics. All right. Well, the last topic we promised to cover are strikes.

Brian Levitt:

Strikes, yeah. Well, at least the writer's strike is over. Are you happy to see the late night hosts back on the air again?

Jodi Phillips:

Yeah. At least they have new material.

Brian Levitt:

Right. Right, because none of them are... You just hit the problem. I don't need writers.

Jodi Phillips:

All right. All right. The writers have a deal, but the auto workers don't. That strike continues. And what is it, 75,000 healthcare workers have just walked off the job at Kaiser Permanente? I mean, that's one of the United States's largest not-for-profit healthcare providers. That's definitely a big deal. Again, how should investors put this into perspective?

Brian Levitt:

Well, look, I'll focus on the auto sector. The automobile sector is very cyclical. I mean, the first thing you want to think about is growth. And obviously, there'll be a hit to economic growth at a time when I'm already telling you that the economy is poised to slow. Now, ironically, I think markets are hoping that the economy slows here so we don't see additional moves in rates, but it's estimated that the drop in motor vehicle production would be a tenth to two-tenths percent drag on gross domestic product per week. Over an entire quarter, you could see one and a half to 2% drag on growth, which could result in a flat quarter. It's not tiny, but it obviously depends on how long it goes on and is unexpected to be the catalyst to really create a recessionary environment or something far more damaging to the economy.

Jodi Phillips:

Okay, then are car prices going to drive up inflation at just the wrong time?

Brian Levitt:

Yeah, I mean, that's an excellent question because new and used vehicles have been a source of deflation in recent months. In fact, used car prices are negative on a year-over-year basis. Now, the percent change, I think the rental car companies have done a pretty good job rebuilding their fleets. Now, whenever I go to an airport, I'm on the one that has the long line. There's 10 rental car companies. I don't get that. But anyway, I digress. Now, if you do have a long-term hit to new production, you could, again, put upward pressure on vehicles. New cars haven't come down a lot. They've been slowly grinding lower. That wouldn't be ideal, again, as the market tries to look forward to the end of Fed policy tightening. There's some risks here. I don't want to overstate them, but there's some challenges we'll have to grapple with.

Jodi Phillips:

Okay. Well, I guess the good news then is that much like government shutdowns, strikes have not typically lasted for too long.

Brian Levitt:

Yeah, I mean, that's generally been the case. I mean, the United Auto Workers Union does have a finite strike fund. I think I had read that the strike fund, which is there to pay workers, provided they strike, I think I've read that it could last 11, 12 weeks. That's that flat quarter that we warn against. But again, it goes more back to that inflation story. And again, most domestic car manufacturers have rebuilt supply, used car companies have rebuilt their fleets. Supplies increasing at a time when consumer demand's supposed to be slowing, we'll see. But I would expect any upside move on inflation to be relatively limited.

Jodi Phillips:

All right, I'm out of questions. I mean, we've covered an awful lot here, Brian.

Brian Levitt:

Did I answer all of them?

Jodi Phillips:

You did.

Brian Levitt:

We did?

Jodi Phillips:

You did.

Brian Levitt:

I mean, I'm trying not to be too Pollyanna, but I'm looking ahead to what I think will be a better environment. We're like 1010 WINS here for those New York radio listeners, you give us 22 minutes, we'll give you the world. I mean, that's what we just did. I don't know if this was 22 minutes, but it felt about that.

Jodi Phillips:

And I don't think it was the world either. At least the United States, but maybe we'll tackle the world in the next one.

Brian Levitt:

You give us 20 something minutes, we'll give you the US.

Jodi Phillips:

Yeah, that's a tagline that writes itself... Thank goodness those writers are back so we can come up with something a little better than that. All right, that wraps up this episode of Greater Possibilities. Brian, where else can listeners find your views on the markets?

Brian Levitt:

Yeah, thanks Jodi. Visit invesco.com/brianlevitt to read my latest commentaries. And of course, you can follow me on LinkedIn and on X.

Jodi Phillips:

X.

Brian Levitt:

X, at Brian Levitt. That's two T's.

Jodi Phillips:

At Brian Levitt. All right.

Brian Levitt:

Thanks Jodi.

Jodi Phillips:

Thanks for listening.  
 

Important Information 

You've been listening to Invesco's Greater Possibilities Podcast. 

The opinions expressed are those of the speakers, are based on current market conditions as of October 6, 2023, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. 

Should this contain any forward looking statements, understand they are not guarantees of future results. They involve risks, uncertainties, and assumptions. There can be no assurance that actual results will not differ materially from expectations. 

All investing involves risk, including the risk of loss. 

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions. 

Not a Deposit; Not FDIC Insured; Not Guaranteed by the Bank; May Lose Value; Not Insured by any Federal Government Agency 

Data on the June 2022 inflation peak and 10-year rates comes from the US Bureau of Labor Statistics as of August 31, 2023. 

Information on moves in real yields comes from Bloomberg as of October 6, 2023. Real yields are calculated by subtracting the 10-year inflation breakeven from the 10-year US Treasury rate. Breakeven inflation is the difference in yield between a nominal Treasury security and a Treasury Inflation-Protected Security of the same maturity. 

The 550 basis point rise is from the US Federal Reserve as of September 30, 2023, and is based on the federal funds rate. The federal funds rate is the rate at which banks lend balances to each other overnight. A basis point is one hundredth of a percentage point. 

Statistics about the percentage of Americans with fixed rate mortgages come from Bankrate.com as of September 20, 2023. 

Information about rate increases and recessions in 1988, 1994 and 1999 are from Bloomberg, based on the 10-year US Treasury rate. 

Projections about the federal funds rate are from Bloomberg as of August 31, 2023, based on fed funds futures. Fed funds futures are financial contracts that represent the market’s opinion of where the federal funds rate will be at a specified point in the future. 

Information on the frequency and duration of US government shutdowns is from the US Department of the Treasury. 

Stock market returns during government shutdowns comes from Bloomberg, based on the average return of the S&P 500 Index during each shutdown. 

Past performance does not guarantee future results. An investment cannot be made into an index. 

Information on used car prices comes from the US Bureau of Labor Statistics as of September 30, 2023. 

Information on the strike fund for auto workers comes from the United Auto Workers union. 

Estimates about the potential impact of the auto workers strike on gross domestic product comes from Bank of America. Gross domestic product is a broad indicator of a region’s economic activity, measuring the monetary value of all the finished goods and services produced in that region over a specified period of time. The GDP formula is Consumption + Investment + Government Spending + Net Exports. In other words, C + I + G + NX. 

Tightening monetary policy includes actions by a central bank to curb inflation, such as raising rates. Overtightening is the risk that a central bank harms the economy by raising rates too much. 

The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.

Brian Levitt:

Welcome to Greater Possibilities from Invesco, where we put concerns into context and opportunities into focus. I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. And today in studio, we have David Nadel. David is a senior portfolio manager for the global equities team at Invesco, focusing on small and mid-cap international companies. Okay, Brian, so is now the time for international investing?

Brian Levitt:

Well, I guess if I had a dollar for every time somebody asked me that question, Jodi.

Jodi Phillips:

Yes. What would you have?

Brian Levitt:

Oh, I'd have a few dollars.

Jodi Phillips:

Okay. So you get this question quite a bit then, I'm assuming. So where does this question rank. Is it right up there with: Should I own bitcoin, and what's the US going to do about its debt?

Brian Levitt:

Yeah, those are the big ones. Those are the Mount Rushmore, they're on the Mount Rushmore of questions. I guess we have to come up with a fourth one. But yeah, those are the questions.

Jodi Phillips:

Something about artificial intelligence, I'm sure.

Brian Levitt:

Okay, we'll add that.

Jodi Phillips:

Yeah. Look, it's understandable.

Brian Levitt:

That'll go in the Teddy Roosevelt spot.

Jodi Phillips:

It's understandable though, that's a really popular question for you. Right? The so-called lost decade of US equity performance, 2000, 2009, had investors looking elsewhere trying to figure out what to do next. But then the decade after that favored US stocks. So yeah, investors are wondering about what comes next and if it's the time to do something differently.

Brian Levitt:

Well, I do have a theory about this and I'm sure that David will as well.

Jodi Phillips:

All right. What's your theory?

Brian Levitt:

Well, at first, these things tend to go in cycles. So I think what's critical to note is that the past decade wasn't lost in international the way 2000 through 2009 was lost in the US. It did generate positive returns. But the under-performance was similar to what the US experienced versus international in the so-called aughts. Is that what we call it, the aughts, the 2000s?

Jodi Phillips:

Sure. We still haven't figured that out. Have we? But yeah, I guess to your point, to everything there is a season.

Brian Levitt:

Yeah, turn, turn, turn. It's a very strong dollar environment, and each time it looked like non-US assets would participate, a US policy decision or something unexpected would disrupt it.

Jodi Phillips:

Unexpected, like a trade war and a pandemic, that kind of unexpected?

Brian Levitt:

Yeah.

Jodi Phillips:

Yeah.

Brian Levitt:

Exactly, and the Fed raising rates a few times in a slow growth environment.

Jodi Phillips:

So you mentioned strong dollar environment, Brian. So as we all know, a strong dollar environment means that returns generated overseas by US investors translates into fewer dollars when that money is brought home. So I guess to put a little bit of a finer point on the original question, is the strong dollar environment finally over?

Brian Levitt:

Well, let's see what David says. But it does tend to happen when policy cycles, policy tightening cycles end, money can then start to look for other opportunities where valuations are more attractive.

Jodi Phillips:

And we may finally be at the point where the Fed stops raising rates and we can all start anticipating an easing cycle.

Brian Levitt:

Oh, that's the fourth question.

Jodi Phillips:

There you go. That's the Mount Rushmore question. We got it.

Brian Levitt:

When's the Fed going to be done? All right, so we got the four, bitcoin, US debt, international investing. And when's the Fed going to be done?

Jodi Phillips:

Perfect, there it is.

Brian Levitt:

There it is.

Jodi Phillips:

All right. So now we've got that settled. Let's bring David on to discuss the opportunities that he sees in international stocks, especially in that small and mid-cap space and where money might flow as investors look for opportunities in a potentially new dollar regime.

Brian Levitt:

David, welcome.

David Nadel:

Good to be here.

Brian Levitt:

So you have the answer to all four of the questions on Mount Rushmore.

David Nadel:

Possibly.

Brian Levitt:

Possibly.

David Nadel:

We can handle them one at a time.

Brian Levitt:

We can go one at a time. Well, let's start with your wheelhouse, then we'll see your thoughts on crypto. No, we're not doing crypto today, Jodi.

Jodi Phillips:

No, okay, good. I'll refrain.

Brian Levitt:

Thank goodness. So when you look at investors' portfolios, I have to imagine they're pretty overweight, the United States, whether that's by design or just performance that we've seen in recent quarters or years. Correct?

David Nadel:

Yeah. I mean, I think you're exactly right. It's a combination of design, which probably put those investor portfolios overweight the US in the first place. And then the relative performance of the US, out-performance of the US over international during the past decade has stretched that to kind of garish levels of imbalance. And therefore, it's elevated the risks at multiple levels. So if you think about, for example, our benchmarks or the benchmark for global SMID companies, in the last 10 years, that's moved from about a 45% US weight to a 60% US weight. All 10 of the top 10 positions, companies in that benchmark are US stocks.

Brian Levitt:

And that's because it's a market cap weight. It doesn't rebalance.

David Nadel:

Exactly, exactly. And so dynamics like that I think create kind of overlapping risks for investors, where if one of those risks doesn't hurt them, another one is very likely to hurt them. You have valuation risk because these companies are much more expensive, the US companies, than the international ones. And you have the risk of these being very crowded trades, so that the companies that make up the benchmark are very heavily invested in, and when people exit, it may not be pretty. And the dollar and US outperformance are all basically cyclical. To your point, Brian, that you mentioned earlier, they trade leadership. And it's looked like for the last 20 years, it's looked like roughly sort of a 10-year cycle. But there's no magic to that.

Brian Levitt:

Nothing magic, right. And when you think about that underperformance, I mean, in the conversation I had with Jodi, I had categorized it as any time it looked like international was really going to get going, I remember years like 2016 into 2017, I remember 2019, something happened that disrupted it. Right? It was trade wars or pandemics. Is that an accurate way to think about it?

David Nadel:

Yeah, I think that's right. I mean, investors react, US investors at least I think suffer from significant home country bias, and so the devil that they know is more comforting than the devil they don't know. International equities is the devil that they don't know, which is understandable. But I mean, I will say, abroad, it would be unthinkable to have the level of home country bias that US investors have. If you're a UK manager, you're not going to be 60% in UK equities and 40% in everything else. But it is understandable because the US economy is so broad and the leading economy of the world. So yeah, let's leave it there.

Brian Levitt:

So Jodi, do you have your portfolio structured based on the Mississippi River, so half is, 70% of companies headquartered to the east and 30 the west, or anything like that?

Jodi Phillips:

Interesting. I'll have to check. I'm not really sure how that allocation works out. David, you mentioned the devil you know, the devil you don't know when it comes to US investors. And so do US investors tend to see international small and mid-cap in particular as a distinct asset class the way they do in the US? Right? What do allocations tell us about that viewpoint?

David Nadel:

So Jodi, I think US investors see international SMID cap in all the wrong ways. They not only do not see it as an asset class, as indicated by their allocations, which are less than 1% to international SMID, versus around 14% for US SMID, again, massive home country bias.

Brian Levitt:

Less than 1%.

David Nadel:

Less than 1%. But I think they also see international SMID as very high risk, high volatility. And international SMID is higher standard deviation, higher volatility than international large. But when you look at risk adjusted returns, because the returns historically have been so much better from international SMID versus international large, those risk adjusted returns are better. So when you look at things like Sortino ratios or Sharpe ratios, you're looking at an asset class which is producing very attractive risk adjusted returns. But again, investors are not really treating it even as an asset class in the first place, even though the opportunity set of international SMID is twice the size of US SMID. It's twice the number of companies in the benchmark, and so it really is an asset class. Right? But if you're thinking about asset classes from the vantage point of how US equity investors are allocating, it doesn't look like an asset class, less than 1%, which creates a tremendous opportunity.

Brian Levitt:

I think I have more Beanie Babies in my portfolio than people have. Right? Those things are going to make money. We're getting there.

Jodi Phillips:

Eventually. Keep holding, keep holding onto them, Brian.

Brian Levitt:

Keep holding. Define Sortino ratio real quick.

David Nadel:

So Sortino ratio is sort of a better version of the Sharpe. I mentioned the Sharpe as well.

Brian Levitt:

Which is return per unit of risk.

David Nadel:

Exactly. The Sharpe is return per unit of risk, where risk is defined as both upside and downside, whereas the Sortino ratio eliminates the upside risk, because people talk about risk and volatility, but they actually never complain about it when it's on the upside.

Brian Levitt:

I think they just assume volatility means downside.

David Nadel:

Yeah, the bad stuff, so that's what the Sortino ratio does, it's your kind of more specific and fine-tuned version of a Sharpe ratio, where it's eliminating... It's not punishing returns for upside. It's only punishing them for downside.

Brian Levitt:

So if I come up with one that's just upside, can I call it the Levitt ratio? Does that exist?

David Nadel:

Yeah, that'd be a great plan. I think a lot of people would be fighting you for the name rights on the upside only ratio.

Jodi Phillips:

So then with an asset class like that and a space like that, the way you described it, for an active manager, such as yourself, then that seems like it would be a particularly good space to find opportunities. How do you think of it in that way?

David Nadel:

Yeah, that's exactly right, Jodi. So it's a very large universe. It's really inefficient. I mean, we're looking at something like 13,000 companies that have market caps between $300 million and $10 billion outside the US. That's a lot of companies. And as I mentioned-

Brian Levitt:

That's small to mid.

David Nadel:

That's small to mid, yeah. As I mentioned, again, this is a much larger opportunity set than US. You have a very large portion of the companies that have no analyst coverage whatsoever, even among the private ... Among the more prominent companies within the asset class, it's common to have much less coverage than for example, a prominent company in US SMID. So it is a place where active managers have consistently added value, and that really distinguishes international SMID as an asset class versus other equity asset classes. So if you think about rolling returns, which we love to use because rolling returns really represent a true investor experience as opposed to, no one invests on January 1 and sells on December 31st, or ridiculous periods like that.

So if you look at rolling returns, three year returns, five year returns, 10 year returns, international SMID active management in growth has added on average about 330 basis points of out-performance per year for three year rolling periods over the benchmark. And if you look at five year periods, it's more like 250 basis points, 10 year periods, it's more like 180 basis points.

Brian Levitt:

That's a lot.

David Nadel:

And that's per year. So even on the 10-year basis, 180 basis points of outperformance per year for 10 years, that's going to make a huge difference in people's returns. And it's the reason that there really is not a viable benchmark strategy for international SMID. In other words, for asset allocators to get exposure to this asset class, they're almost certainly going to go with active. You look at the portion of assets of the asset class that are in passive strategies, it's tiny.

Brian Levitt:

David, you talk about looking at thousands and thousands of companies. What are you looking for? And what type of themes emerge in the portfolio that have you very excited?

David Nadel:

Yeah. So Brian, what we're looking for, I mean, our strategy is very much about high quality compounders. So we're looking for companies that can grow regardless of what the economy is doing. In other words, acyclical growth. And we're looking for companies that generate consistently high levels of profitability, particularly internal rates of return, so things like returns on capital, but those derived from let's say high profit margins, which in turn tends to derive from very strong pricing power. So what that essentially means is that we invest in a lot of industry leaders. We're often invested, about a third of our portfolio I like to describe as global number one businesses, meaning that they have the undisputed world leading market share in what they do. This is a little counterintuitive I would say for investors to hear about SMID cap companies.

Brian Levitt:

Small and mid, yeah.

David Nadel:

Because in the US, a SMID cap company is rarely a global leader. You can be a $4 billion company in the US and sell to a single state in the country, like California, or Massachusetts, or something. On the international stage, it's a much tougher and more demanding standard. So if you're coming from a small country, you don't have a large home market. You have to figure out how the whole world works. You have to adopt basically global standards. And so these are really battle tested businesses. And it's not surprising in that context that a lot of international SMID companies become global number ones.

Brian Levitt:

Can you give an example without necessarily mentioning the company? Just talk about what they do and how they've grown to that place.

David Nadel:

Sure. I mean, there are so many. I'll talk to you about a couple of our investments. So one company makes transducers. Transducers are devices that basically regulate the amount of electricity flow, so they would be used in something like an elevator, for example, to have a very consistent flow. This is a small market globally. It's something like a billion dollar market total in terms of sales. This is a tiny market. Right? We're talking about niche businesses here. But this company has about a 50% share of the global market, so that's one example. Another company literally invented the cochlear implant. I don't know if you're familiar with...

Brian Levitt:

I am very familiar. One of my best friend's sons wears the cochlear implants. It's unbelievable.

David Nadel:

Yeah. It is totally an unbelievable technology because it literally gives the gift of hearing. And you mentioned a son…

Brian Levitt:

And speech, right?

David Nadel:

And speech, right, because without the hearing, you're really at a disadvantage. And you mentioned it's a son, probably a young child, the typical, or maybe a growing child. But the typical beneficiary of a cochlear implant is a child.

Brian Levitt:

He was a baby.

David Nadel:

A baby, yep. And this is a technology that will last the life of the child. And it requires a lot of software updates, so there's about a third of this company's revenue and even more of their profit is coming from recurring revenue. That's another thing we really like to look for in our businesses, high portions of recurring revenue. We like these businesses to just compound. And you can literally with this company run a discounted cashflow per patient because you're going to get the lifespan of that patient 75 year lifespan of beneficiary of a cochlear implant.

But essentially what we're looking for, I mean, maybe those give you a couple of illustrations, but companies that are going to ... They're built to last. They have a capacity to suffer. They are going to do well in any sort of an economic environment. A lot of them tend to be quite kind of, I might say boring or almost hum drum type of B-to-B (business-to-business) companies that are below the radar. I mean, another one of our prominent holdings does steam systems. No one even thinks about steam systems. But two thirds of Nestle's expenditures on energy are for steam. It's a mission-critical service that the company is providing. And that's typical of our holdings, is mission-critical. So when things get tough, their customer, which is a corporation rather than an individual, is very unlikely to cut that service.

And so what you'll see in our strategy is kind of a de-emphasis on consumer discretionary because we find that consumers in the small and mid-cap space are quite fickle. We rather deal with a corporate buyer, much more reliable. Everything we're doing is we try to de-risk the portfolio at the level of each company, so we have extremely high conviction in each company we invest in to the level that we would be comfortable having the entire portfolio in any of our individual holdings.

Brian Levitt:

Wow, that's a bold statement. And you know management well, you visit them, you kick the tires.

David Nadel:

That's right, yeah. We certainly do all of that fundamental research that is pretty standard across our industry.

Brian Levitt:

But you have good status on your airline, I'm sure.

David Nadel:

Yeah. It's a perk of the job. That's right. But we do a lot more than that, we also do strategic research. We have a person fully dedicated on our team to do strategic research which is talking to former executives at companies, talking to customers, talking to suppliers, understanding the ecosystem of a business. That's work that a lot of other mutual fund managers or management teams don't really do. And so we're getting a really full picture of these companies. Yes, we do visit them on site. Next month, I'm going to Sweden to see companies. The month after that, in October, to the United Kingdom to see companies, hence, those frequent flyer miles. And two people on my team will be in Japan next month seeing companies where I was last September. So yes, we do that work, but I think supplemented by the strategic research, which really adds a nice edge to our process.

Brian Levitt:

Jodi, you willing to be a companion on some of these trips?

Jodi Phillips:

Oh, sure. I could collect some frequent flyer miles, for sure.

Brian Levitt:

I was getting the sense from David he wanted company.

David Nadel:

Definitely, definitely. They're a lot of fun and you learn so much. I mean, it really makes the job so engaging and gratifying to travel and see these companies.

Jodi Phillips:

Oh, sure.

David Nadel:

The idea of being paid to learn is really-

Brian Levitt:

That's not bad.

David Nadel:

It's really a gem of this profession.

Jodi Phillips:

Not at all.

Brian Levitt:

You spent a lot of your childhood paying to learn. Right?

David Nadel:

That's right.

Brian Levitt:

That's nice.

Jodi Phillips:

If I tell you I'm interested in steam systems, does that help? Does that get me a ticket on the plane?

Brian Levitt:

You're big into transducers, aren't you?

Jodi Phillips:

There you go.

David Nadel:

You would be the one out of a million who if you're able to convince someone you're genuinely interested in steam systems. But steam systems are not ... Just to clarify that in case people are picturing a steam engine or something and wondering why you'd invest in a 19th century technology, steam is used in so many processes that are literally day to day processes, so pharmaceutical production. It's a bacteria side, it's a sealant, it's used in beer production, which people can relate to.

Jodi Phillips:

Okay, there you go.

Brian Levitt:

Now we're talking.

David Nadel:

Petrochemicals. It's just got an incredibly broad level of applications, which is why Nestle again, two thirds of their energy outlays are for steam systems. But for us from an investor perspective, you know what's great about steam is it's corrosive. Right? So it means that all these parts need to be replaced, and so they can put in the initial traps and all of that, set up a factory floor with all of these items that look sort of like Charlie and the Chocolate Factory.

Jodi Phillips:

Sure, absolutely.

David Nadel:

Parts wear out, and so that gives them, in the case of this company it's something like 80% of their operating profit comes from recurring revenue. And for us, that's the secret sauce of what we do strategically is when you have this recurring revenue, you can build models that you can rely on for predictable cashflow for years to come. And that tends to result in favorable outcomes for investors over time.

Jodi Phillips:

You've described a pretty wide range of companies. Are there any themes, commonalities that are emerging lately from all those different types of businesses that you're interested? I mean, tech, innovation. Our last episode of this podcast focused on artificial intelligence (AI), which is on the Mount Rushmore now. So are there themes that are kind of gathering from all of these different types of companies that you're looking at?

David Nadel:

Yeah. So Jodi, I would say definitely there are themes that emerge. I mean, I guess the one caveat I'd give is the themes are the result of a bottoms up process, as opposed to being us as a PM (portfolio manager) group saying, "AI is hot. We've got to get exposure to as much AI as possible," that's not how we invest. We want to invest in companies that meet the financial characteristics that are going to result in compounding and more predictable, lower volatility returns for investors. But that having been said, we're happy to invest with companies that are closer to the action on some of these mega themes that are happening in the marketplace, like AI, for example. One way that we benefit from that is through IT consulting companies. So IT consulting companies are kind of an agnostic play on these mega themes. And you never know where an individual mega theme will go. I mean, we all remember disk drives. Do we? I don't know. Maybe not anymore.

Brian Levitt:

Vaguely.

David Nadel:

There have been so many mega trends in technology that people got extremely excited about and send valuations into the stratosphere, and then literally three years later, no one's talking about them. But IT consulting companies are going to be there to advise on those issues in a much more comprehensive way, and benefit regardless of whether the technology is long-lasting, medium cycle, or extremely short cycle and just dies a quick death. So I'm not making a prediction on AI that it's not going to disappear over the next couple months. That's not what I'm saying. I'm saying that we like to align ourselves with businesses that take a more agnostic approach.

And let's see, I mean, other themes I would say value-added distributors are a big part of our portfolio, so these are companies that are involved in the distribution of highly sophisticated products, where they have very close customer relationship with corporate customers, very technical products, so distributors that are not subject to, let's say an Amazon effect at all because this is stuff that requires a lot of consultation and a lot of implementation. So value-added distributors are a theme. Businesses, and those are businesses which have tremendous pricing power, great in an inflationary environment. They can immediately pass through inflationary increases to their cost structure onto the customers.

I'd say medical devices are a theme that we come back to repeatedly. I mentioned the company that created the cochlear implant. But there's many medical device companies that we own. In the SMID cap space, medical device companies are a natural fit because they will often have a very large portion of recurring revenue from some sort of backend service. And other areas of health care are less of a fit for us, like pharmaceuticals, because those are typically companies where they'll have one productive drug and then a pipeline. That's too risky for us. Right? We like more certainty. So medical device I'd say is another theme that is recurring in our portfolio.

Brian Levitt:

Okay, so I can listen to you talk all day about bottom up and themes and I'll eat it all up. But for the investors who are listening, who have now dealt with the decade of under-performance of international investing or concerns about geopolitical risks, or regional hot spots outside of the United States that are now sitting here looking at valuations more attractive, you talking about all these really interesting ideas. How do you get them over the hump to think about international? Are there certain catalysts that you would look for as an investor, where you would say this is the type of environment that starts to favor non US dollar assets?

David Nadel:

Yeah. It's hard to identify catalysts with certainty for sure. And we can almost say with some confidence that whatever it is will not be what people predicted. But I think an obvious area that people should be tracking and what will likely be a catalyst is just reversion to the mean with currency because the dollar ... Currency is always a mean reverting phenomenon. And the dollar has reached these points of incredible strength before, only to return to that mean. You saw this in the '80s with Paul Volcker's supercharging of interest rates and then they agreed we can't have a dollar that's strong, and suddenly, it's back to 80 on the DXY (US Dollar Index), the dollar benchmark …

Brian Levitt:

It usually is about the Fed.

David Nadel:

It is usually about the Fed. I think by many measures, we're about 15% to 20% overvalued where we are now on the DXY. And I think a lot of people will recognize that. It's just a question of when you look at long-term charts, that's certainly what's implied. And you're seeing rates higher from a lot of regimes around the world, a lot of other currency, so the US is not the only place where yield is possible in terms of the currency. So I think that's one catalyst.

I also think international SMID cap companies have historically been much more profitable than US SMID cap companies, much higher margins, higher internal rates of return, and by the way, stronger balance sheets too. But they haven't had the level of margin expansion since the global economic crisis that US stocks have had, so I think there is also, we see it in our holdings, the potential for incremental margin expansion. Again, these are already more profitable, but they have scope to get even more profitable with higher margins and higher returns, so that could be a catalyst.

I think on the geopolitical stage, seeing how some of these economies integrate and manage immigration is going to be an important catalyst. I am personally optimistic about Europe's absorption of immigrants and that tends to be a catalyst for growth and innovation. When countries like Sweden, which are a fraction of our size, are taking more immigrants on an absolute basis by a factor, by a multiple than the US is, from certain countries, you're going to get an impact. And in the short-term, that can be a little volatile or a little rough, and there's cultural chafing and sometimes things that are even worse than that. But over the long-term, you're getting a whole new base of more motivated workers and people that are going to innovate. And I think Europe's already been through a lot of the tougher period of the immigration boom. And I don't think that's going to end because global warming means more immigration. It's just going to continue. This is going to be a secular issue, and by that way, an important issue for the US to figure out as well. I'm not sure we're doing a great job with that yet.

But a lot of these countries in Europe, where we're heavily invested at least in terms of the headquarters for countries, a lot of them are in Europe, about 60% of the portfolio. I think they are going to benefit from that less expensive labor force and hungrier labor force.

Jodi Phillips:

All right. Well, Brian, it looks like our time is winding down. And since we promised we wouldn't ask any bitcoin questions, I guess we can't go there. So is there anything else, Brian, that you have on your list while we have David here?

Brian Levitt:

My last question would be, so you had talked about the exposure to Europe. Where else is the exposure in your portfolio? Do you ever think specifically about the country? It sounds like it's always from the bottom up. And do you have exposure to emerging markets?

David Nadel:

Yes. So the bottom line is we are companies, not countries, in terms of how we invest, so it is very much the bottom up. The way I'd like people to think about our approach and the way I think about it is really more in terms of revenue exposure than…

Brian Levitt:

Geographic.

David Nadel:

… than the exposure of the listing of the company, the stock exchange it's listed on, or where the headquarters are. Again, we're invested in so many of these world leading businesses, either global number ones, or let's say global number two, but they're multinational businesses. If you're providing a mission-critical service, everyone in the world wants to work with you, and that means emerging market companies want to be your customer as well, so that's how our companies interact with the world. So from a perspective of kind of cumulative revenue in the portfolio, we probably have about 30% exposure roughly to the emerging markets, so quite substantial, and that again is what matters.

If you look at the portfolio from the perspective of headquarter, we probably only have about 7% emerging markets. But this is very deliberate because we rather, all other things being equal, we rather get the world-class corporate governance that you're going to get investing in a European company, particularly north of the Alps in Europe, global number one, those types of corporate governance standards selling to China rather than investing in a local player in China where corporate governance on average is much lower. That's just an objective assessment, that's not a controversial statement. And so that's kind of how we go about it, we'd rather ...

For a market like Russia, for example, we much rather invest in a Finnish company that sells to Russia than invest in a Russian equity. Why? Because Finnish corporate governance standards are completely different. The Finns have been trading with the Russians for hundreds of years. They know them a lot better than we do. But I don't really want to get exposure to the Russian corporate governance and kind of the capricious approach to shareholders' rights, et cetera, et cetera. But we don't mind having exposure to the Russian consumer. So Finland, that's the answer.

Brian Levitt:

Right. Finland's the answer. Well, we could listen to you all day, but we'll let you get back to your regularly scheduled program.

David Nadel:

It's been a pleasure, Brian. Jodi, thank you.

Brian Levitt:

And thank you so much for joining us.

Jodi Phillips:

Thank you.

David Nadel:

Thank you.

Jodi Phillips:

So that brings us to the end of another Greater Possibilities Podcast, but the conversation doesn't stop here.

Brian Levitt:

It does not. Visit invesco.com/brianlevitt, to read my latest commentaries. And of course, you can follow me on LinkedIn and on Twitter at Brian Levitt.

Jodi Phillips:

And if you missed any of that, that information is on our podcast page. Thanks for listening.

 

 

Important Information

You've been listening to Invesco's Greater Possibilities Podcast.

The opinions expressed are those of the speakers, are based on current market conditions as of August 16, 2023, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Not a Deposit; Not FDIC Insured; Not Guaranteed by the Bank; May Lose Value; Not Insured by any Federal Government Agency

Before investing, investors should carefully read the prospectus and/or summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the fund(s), investors should ask their financial professionals for a prospectus/summary prospectus or visit invesco.com/fundprospectus.

The investment techniques and risk analysis used by the Fund's portfolio managers may not produce the desired results.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

Should this contain any forward looking statements, understand they are not guarantees of future results. They involve risks, uncertainties, and assumptions. There can be no assurance that actual results will not differ materially from expectations.

All investing involves risk, including the risk of loss.

Discussions of specific companies are for illustrative purposes only and should not be considered buy/sell recommendations.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

Many products and services offered in technology-related industries are subject to rapid obsolescence, which may lower the value of the issuers.

The health care industry is subject to risks relating to government regulation, obsolescence caused by scientific advances and technological innovations.

Growth stocks tend to be more sensitive to changes in their earnings and can be more volatile.

As with any comparison, investors should be aware of the material differences between active and passive strategies. Unlike passive strategies, active strategies have the ability to react to market changes and the potential to outperform a stated benchmark. Other differences include, but are not limited to, expenses, management style and liquidity. Investors should consult their financial professional before investing.

All data sourced to Invesco as of July 31, 2023, unless otherwise noted.

From 2000 through 2009, the S&P 500 Index lost 9% while the MSCI All Country World Index gained 37%. From 2010 through 2019, the S&P 500 Index gained 256% while the MSCI All Country World Index gained 71%. Those are total returns sourced from Bloomberg as of August 2023.

Past performance does not guarantee future results. An investment cannot be made into an index.

The MSCI All Country World Index is an unmanaged index considered representative of large- and mid-cap stocks across developed and emerging markets.

References to the growing weight of US stocks in global benchmarks and the number of US companies in the Top 10 positions is from FactSet Research Systems, based on the MSCI All Country World Index as of June 30, 2023.

US investors’ allocations to international versus US small and mid-cap stocks is from Morningstar as of June 30, 2023.

According to Bloomberg, there were about 12,800 non-US small and mid-cap companies with market caps from $300 million to $10 billion, as of June 30, 2023.

References to returns, Sharpe ratios and Sortino ratios are from Morningstar data from July 1, 2007, through July 31, 2023. Over monthly rolling 10-year periods:

• International small and mid caps had an average annual return of 5.89%, compared to 4.47% for international large caps.
• International small and mid caps had an average Sharpe ratio of 0.40, compared to 0.33 for international large caps.
• International small and mid caps had an average Sortino ratio of 0.60, compared to 0.49 for international large caps.

International small and mid caps represented by the MSCI All Country World ex USA SMID Index, which captures mid and small cap representation across developed and emerging markets, minus the US.

International large caps represented by the MSCI All Country World ex USA Large Index, which captures large cap representation across developed and emerging markets, minus the US.

References to the opportunity set, profitability, and balance sheets of international SMID versus US SMID are based on the MSCI All Country World ex USA SMID Index versus the Russell 2500 Index as of June 30, 2023. Sourced from FactSet Research Systems.

The Russell 2500® Index, a trademark/service mark of the Frank Russell Co.®, is an unmanaged index considered representative of small- and mid-cap US stocks.

References to international small and mid cap active management outperforming the benchmark is from Morningstar as of June 30, 2023. Active managers represented by the Morningstar Foreign Small/Mid Growth category. There were 129, 115, and 82 funds within this category for the three-, five- and 10-year periods, respectively. Benchmark performance represented by the MSCI All Country World ex USA SMID Index.

The Sharpe ratio is a measure of risk-adjusted performance calculated by dividing the amount of performance a portfolio earned above the risk-free rate of return by the standard deviation of returns. The Sortino ratio differs from the Sharpe ratio in that it only considers the standard deviation of the downside risk, rather than upside and downside risk.

Standard deviation measures a portfolio’s or index’s range of total returns in comparison to the mean.

Return on capital measures the profitability of a company by dividing earnings by capital employed.

Internal rate of return is the annual rate of growth that an investment is expected to generate.

The US Dollar Index, or DXY, measures the value of the US dollar relative to the majority of its most significant trading partners.

A basis point is one hundredth of a percentage point.

Nestle is not a holding of Invesco International Small-Mid Company Fund as of July 31, 2023.

Holdings are subject to change and are not buy/sell recommendations.

The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.

 

Transcript

Brian Levitt

Welcome to the Greater Possibilities podcast from Invesco, where we put concerns into context, the opportunities into focus. I'm Brian Levitt.

Jodi Phillips

And I'm Jodi Phillips. And we're talking artificial intelligence today. Ashley Oerth is here. She's a senior investment strategy analyst at Invesco. So Ashley will be here to make sense of the optimism and the fear surrounding AI. So Brian, which side are you on - excitement or fright with AI?

Brian Levitt

Yes. Is that okay?

Jodi Phillips

Yeah, sure. Great answer. Probably most people would echo that, but yeah, no, I think that's pretty common.

Brian Levitt

Yeah. I'm not sure if I even know enough yet to be excited or frightened, but yeah, I'm still trying to get my head around it. I think everybody else is as well. I can look to certain things, like if you were to ask me, am I excited about autonomous cars that get safer and safer over time, then yeah, sure, of course I'm excited about that.

Jodi Phillips

You sound like the father of teenage girls.

Brian Levitt

Yes, no doubt. No doubt. And my oldest one will be 16 next year, so that'll be really front and center in our minds. Very real.

Jodi Phillips

Yes. Well, as the mother of teenage boys, including a 17-year-old, I 100% agree with you that safer cars would be an amazing, amazing development. And look, beyond that, really exciting possibilities. You think about the medical field, robotics and hospitals, predictive software that can diagnose diseases earlier. That's just amazing.

Brian Levitt

Yeah, exactly. And look, so the possibilities can boggle the mind. And I know deep in my soul, everything about history tells me that I shouldn't fear technology. And so I'm very much, Jodi, pushing back against any instinct to be frightened. You look at history, it's always hyperbole. It's always overblown.

Jodi Phillips

Yeah. Well, it's like the quote I read the other day, right? "Once a technology rolls over you, if you don't get on a steamroller, then you're part of the road."

Brian Levitt

Yeah, it's so true. It's so true. So you want to lean into it. Although I will tell you, I'm not going to watch the Terminator again anytime soon.

Jodi Phillips

Oh, yeah. We were warned about this back in 1984, and we didn’t listen.

Brian Levitt

We were. But look, as we're saying, almost all technologies are initially feared until they are embraced. And typically what you see, standards of living generally climb as a result of it. Concerns of mass unemployment have historically not materialized and of course-

Jodi Phillips

No, in the US what is it, 3.6% unemployment?

Brian Levitt

Yeah. So technology's not killing all the jobs and the human race persists. But I think what investors want to know beyond-

Jodi Phillips

Thank goodness.

Brian Levitt

... all of this is how do they prosper from AI? How do they identify the types of businesses that will benefit from this?

Jodi Phillips

Absolutely. And that's why we're so happy that Ashley's here. She's going to put this all into the proper perspective for us and help us to think about the investible opportunities. Ashley's got a framework to help us categorize companies that are directly and indirectly involved with AI. And I think that's going to be really helpful to wrap our arms around all of this.

Brian Levitt

Ashley, welcome to the show.

Ashley Oerth

Thank you so much for having me.

Brian Levitt

Yeah, I promise you that I'm not a cyborg from the year 2029 sent to hear your best investment ideas.

Jodi Phillips

Well, that's a movie pitch right there. I'd watch that.

Brian Levitt

How far away did 2029 seem when we first watched The Terminator?

Jodi Phillips

All too fast.

Brian Levitt

All too fast. So Ashley, why don't we start, what is all this? What is artificial intelligence? What does it mean to you?

Ashley Oerth

Sure. So artificial intelligence, I think it's one of those words similar to so many we've heard in the not too distant past of metaverse and cryptocurrencies and all this, that it carries a lot of meaning, but we don't really know exactly what that is. So artificial intelligence, it's a pretty nebulous concept, but in its most basic form, it's really about mimicking some kind of human intelligence or decision making. It's really about helping us process and categorize data, make decisions based on available data, or even create new data, as we're seeing today, based on some kind of prompt. So really what we have today, it's not the Terminator, it's not HAL from a Space Odyssey, it's really what we call narrow AI. It's task specific, it's designed to accomplish something in particular.

Brian Levitt

How did we forget a Space Odyssey?

Jodi Phillips

Yeah, that's a classic reference for sure. But Ashley, so what's driving all the excitement now? We're making all these old school references and we've been talking about AI since, I don't know, what, the '50s or so? So what is it about today? Why is it all of a sudden, or at least it feels like all of a sudden, everywhere you look?

Ashley Oerth

So we're excited today because of generative AI. It's really this topic that has taken us by storm since the release of ChatGPT late last year. Really, this tech has been around for a while, but really through this combination of incremental gains and computing power, greater data availability, better models over time that have really just been incremental improvements, we're now able to have these generative AI systems that are able to match human capabilities in natural language and a whole host of other possibilities.

So what we have today are these systems that are able to, for example, pass the bar exam or score well on the LSAT or the GRE. And we have similar systems as well, not just for text, but also for images, for audio and video, all sorts of capabilities that are cropping up and the capabilities are impressive. So I think that's why people are excited is because suddenly we have these tools that they're not the stuff of science fiction, they're the stuff that we can go online and play with at any given moment. And I think that the possibilities are boundless, but also I think there's a great deal of fear that comes with that. So possibilities plus fear, I think is excitement, right?

Brian Levitt

Yeah, exactly. And is this different than Deep Blue beating a chess master in the 1990s? Or Jodi, do you remember when IBM Watson was on Jeopardy and-

Jodi Phillips

Yes.

Brian Levitt

... and was doing quite well? Is this all that different? Have we made huge leaps and bounds since then?

Ashley Oerth

So in those cases, I would say AI was really purpose built. So you mentioned the examples of Deep Blue and of Watson. So these tools were really designed for that task at hand. They were within that context of narrow AI that I mentioned, they were even more narrow than what we have today. So things like these large language models that we've been hearing about and have been able to play with since late November, these are exciting because they are quite flexible. They're able to understand and respond in natural human language. And it is something that I think seeing is believing. You're able to play with these things and they're able to write you a poem or write you a paper or summarize a document or all sorts of everything from menial tasks to things that are more, I think, intellectually demanding.

Jodi Phillips

That's right.

Brian Levitt

It's pretty remarkable.

Ashley Oerth

It's amazing.

Brian Levitt

A friend of mine was having a religious service for his daughters, and we asked for a speech and it spit out a beautiful speech for him. I don't know if he used all of it, but it was almost too lovely to use all of it. But Jodi, you're a writer. Are you using the shortcuts now? Is the great American novel by Jodi Phillips coming from ChatGPT?

Jodi Phillips

No. No, not at all, although I am mindful that the more I write, apparently that helps ChatGPT get smarter. And Brian, you have a monthly column, Above the Noise, and you occasionally do a segment in there that I really like where you ask ChatGPT a question and kind of critique its answer compared to how you would answer it. And I think in most cases it was maybe a little off base, not quite the full story, so it's got a lot of room to improve. So Ashley, when does that happen? When can ChatGPT just write the whole column or write my whole book?

Ashley Oerth

So you know what they say, Brian, right? Prediction is very difficult, especially if it's about the future. And really to me, it's not clear if it ever will be able to do our jobs. I think we can create increasingly convincing facsimiles of our jobs with AI that can sort of give the impression that it's able to think and learn, but ultimately there's not a whole lot of deep thought that's going on here. In other words, AI can learn, but it can't think, it doesn't have ideas. It can't really critically analyze a problem. It can really, at best, give the impression of ideas by recognizing interconnected topics based on the training data it was initially trained on.

So that said, data science, it's really a field that's been developing at a breakneck pace for quite a while now, and predictions about future capabilities are often exceeded, and the timeline of them is something that maybe will say, oh, this will happen in five years, but it ends up happening in two, or maybe nothing happens for a decade, but then suddenly everything happens in two years. So I think that the most likely outcome right here, is that AI, I think, will be used as a tool paired alongside knowledge workers as part of our regular workflows, rather than something that really just takes our jobs. That's my prediction, but of course, we could all be very wrong about what the timeline is here and what its ultimate capability is.

Brian Levitt

I love that Ashley assumes that there's deep thought going on here or in the rest of the US workforce.

Jodi Phillips

Very optimistic point of view.

Ashley Oerth

I have aspirations for our lives.

Brian Levitt

Do I need to know how it works or am I just going to be harnessing the... I don't really know how the World Wide Web works. I'm not really sure I know how my telephone works, so do I need to know how it works or it's just that these are going to be tools that I'm going to harness?

Ashley Oerth

So it's similar to what you just described with the phone. It's something that you can appreciate how it works, but it doesn't necessarily change how you interact with it. So I think that when we're talking AI, everything that we're talking about today is really centered on this generative AI topic, and I think there's a lot that's exciting here. So when we think about exactly how it's working, it's essentially a prediction model. If we're using the example of text, if we ask one of these chat bots a question that it's able to predict the series of words that flow from that. So if you ask it, how are you? It's going to, based on the training data it's seen before, sort of throw at you what the next most likely words are from that. So I think what's exciting about what's going on here is that these models, they're not just giving you the same response every time, in the parlance of the space, they're not deterministic, they're not always arriving at the same output given some kind of prompt or input.

So in other words, they're probabilistic. There's a sort of dice roll that's happening every time there's a new word that we're getting new content that flows from that. It gives us the impression almost of creativity. So if we take this idea and apply it to a model that has been trained on a mindbogglingly huge amount of data, we get this sort of large language model that's able to understand natural language, understand topics, and provide intelligent sounding replies with variety. So if we can ask it to write a screenplay or write an academic paper or whatever, each time that we do that, we'll get a different output because it is probabilistic, which I think is one of the really cool things about this generative AI craze, is that there's so many things that can come from it that, again, it can feel like creativity and we can make use of that.

Brian Levitt

Now, I've heard that ChatGPT may have been getting dumber. Is that true?

Ashley Oerth

Well, I think that there's a lot of fervor to question what's going on here to try to cast doubt on the capabilities, so maybe look at that with a grain of salt. But so far there have been some studies that have suggested that because some of these models are live models, in other words, they're learning over time, given how people interact with them, that then maybe that's a commentary on society.

Brian Levitt :

Yeah. It's idiocrasy.

Ashley Oerth

… that it’s gotten dumber over time, which go figure on that. But it has been documented that on certain tasks that performance has degraded in certain categories, but in others it's actually improved. So maybe this is a challenge for engineers to figure out how exactly to wrangle how exactly these models we're learning.

Jodi Phillips

Putting it in that context, it's a tool, it's a predictive model, what it actually is versus what people either hope or fear it could be, understanding that, do you feel like the market's become too excited about it in that context? Is the excitement that the market is showing, do you feel like that's appropriate for the potential or how do you view that aspect?

Ashley Oerth

So that's a tricky question for sure. I think that from what I've seen year to date, I'm feeling like the euphoria is there. I try to look at any sort of tech trend or anything that's driving the markets from two perspectives. So on the one hand, how reasonable is the growth that we're pricing in? So what are the earnings estimates of the companies that are pushing up the markets? And then two, what price am I willing to pay for that? So we've got earnings on the one hand and the valuation we're paying for it on the other.

And so from the earnings growth side of things, we have seen companies that are involved in this AI craze be marked up about five percentage points. If we look at some of the mega cap tech names since the release of ChatGPT, which that's not too crazy. So that's five percentage points over the next three years. That's a compound annual growth rate there. So again, seems reasonable. And then on the valuation side of things, if we think of it from the price to earnings perspective, we've really moved up from about 36 times earnings earlier this year to 51 times earnings on a trailing valuation perspective. And then on forward PEs, we've also moved up from around 32 times earnings to 37, which-

Brian Levitt

And that's on the mega cap growth names?

Ashley Oerth

These are the mega cap tech names.

Brian Levitt

The mega cap tech names.

Ashley Oerth

The typical FAANG names that we like to pick on. And so you have to ask yourself, do you believe that earnings growth, and again, if so, are you willing to pay for that? And I think the earnings growth has been marked up, but so is the valuation. So I think that from the sort of perspective, yes, it has moved up in price and I think that it's gotten quite expensive, especially if you look at these names, but it doesn't seem too outlandish.

However, in the context of all of this, we've got rising interest rates, we've got a backdrop that's macroeconomically speaking fairly weak. So at this stage I'm sort of thinking, okay, maybe that's a bit expensive to get it on this trend, but maybe you could say that it's just been priced in.

Brian Levitt

Now I'm old enough to remember the craze around the dot coms and the original launch of the internet. And of course some of those businesses were famously overvalued, and some of them of course did disappear. But yet there was a lot of way to profit and a lot of ways to take advantage from this new platform that was going to connect billions of people around the world and change really how we do everything. So regardless of cyclically whether it's expensive, how do you think about the structural investment opportunities and what type of businesses should investors be watching?

Ashley Oerth

Yeah, so I think that this is always tricky to think of who's going to win, who's going to lose, and over what timeframe. If you go back to the tech bubble days, a lot of the ideas that were at play there eventually did play out. It's just it was a bit ahead of its time, that the rest of …

Brian Levitt

Right. You had to own Amazon eventually, not pets.com.

Ashley Oerth

Yeah, exactly.

Brian Levitt

But I've heard you categorize the types of businesses in this space. I'd love to hear you talk through that to the Greater Possibilities audience.

Ashley Oerth

So the sort of buckets that I put all of these investment implications, if you will, there are sort of three categories of business that I think broadly speaking would benefit from this AI craze. So on the one hand, and I think we've already seen a lot of this, are the enablers. So this is everybody from, if we go to hardware, so the hardware that's used to train these AI models, so if you think semiconductors, those are in the sorts of enablers or picks and shovels approach, if you will. And then we also have those companies that are building the models themselves. These are often, again, the mega cap tech names that really have the development capabilities to make this happen. And also companies that have large treasure troves of data. If data is the new oil in our information economy, then you're well positioned for being somebody who can develop a differentiated AI model.

So those are the enablers that I see behind this whole AI craze. The second bucket would be sort of the adopters. So those are the companies that are able to use these AI models that have been built and integrate them into some kind of part of their business, whether that's their product or how they actually run themselves. Maybe it's internal efficiencies that they can gain. There's a long list of possibilities of how exactly this can be applied and in different sectors. And then on the third bucket, I sort of view this as responders. So AI brings all sorts of new threats that society must address, and we have companies that can also use AI themselves to respond to that. So I think that's a third bucket that can perhaps benefit from this AI trend. So there you have it, you have the enablers, you have your adopters, and then you have your responders.

Jodi Phillips

When you're thinking about those buckets, are there any that you think are, I don't want to say better than others, or just a better position to be in than others? Or are there buckets that you're watching particularly closely to see how either the adoption plays out or the enablement plays out? What are your thoughts in terms of that?

Ashley Oerth

Yeah, so I think that from what I just laid out there, you can sort of view it almost like a timeline. So in this theory I've laid out, the enablers would benefit first, and I think we've already seen a lot of that in the price action so far. Then the adopters would be those companies that are able to actually make use of AI. And I think that we're seeing the beginnings of that, although it's still early stages.

Brian Levitt

And that could be pretty much anyone in any sector or industry. We started this talking about autonomous vehicles or robotics and hospitals, that could go to even some people like us analyzing markets, writing emails.

Ashley Oerth

Absolutely.

Brian Levitt

Yeah. So that's a broad bucket.

Ashley Oerth

That's right. And I think the broad bucket, broadly defined like that, it's done that way for a reason. We have so much that AI can impact that it'd be a mistake, I think, to just focus on one particular sector. I would say though, from studies I've seen on automation and in general, they tend to focus more on the information economy and less on more manual tasks. So perhaps those adopters are those that are less manual labor and more information economy, which is, in the US at least, some a hundred million jobs. So it's a pretty large chunk to sift through.

Brian Levitt

Now, let's go with an FDR quote here, "The only thing we have to fear is fear itself." Is the only thing we have to fear, fear itself? How fearful should we be when... You hear some of these people who have worked in AI over the course of their lives say, look, we got to slow this down. There's big challenges that face humanity here, and you already have the Biden administration speaking with some of the leaders of those mega cap growth companies that you had mentioned to try and put some parameters around this. Do you have concerns?

Ashley Oerth

So I do have concerns, and I think that my concerns are less focused on what people normally talk about, which is this going to replace me? And it's more about what its implications are for society at large. So my biggest fear is really about how AI can be used for malicious purposes. So you've probably heard of things like deep fakes, voice mimicking, image manipulation, automated code generation, and all sorts of threats that are brought on by generative AI.

And there's already been examples of this. We had last year, deep fakes of Ukraine's President Zelenskyy. This year just in May, we had a faked image of an attack on the Pentagon that briefly moved markets on a morning late in May. And these threats are real. I don't think as well that our tools as a society are really evolving fast enough to appreciate and tackle those problems. We're already struggling with how to handle the internet, cryptocurrencies, misinformation, and all sorts of other challenges. And I think these problems will only add to that pressure.

Brian Levitt

And this whole idea that the machines will rise up, is that just science fiction nonsense I joke that I'm not a cyborg from 2029, but I do get questions from investors about the fate of humanity. Are you unwilling to even go there in your mind?

Ashley Oerth

I'm not worried about the fate of humanity. Maybe we could all live in a WALL-E world, maybe the good parts of the WALL-E world, maybe not so much the other side of things, but I think that the risks to what this means for humanity, it's not like we're going to have something that's in control of the nuclear codes or something like that, that we have some kind of tool like HAL that's able to go rogue and cause all kinds of mayhem, rather these tools are really built for a particular purpose. Their abilities are limited to a specific set of functions. It's not like we can just give them free rein over whatever they want to do, right?

Brian Levitt

Right.

Jodi Phillips

So Ashley, tell me, we've talked a lot about the capabilities and what AI is and isn't, but what excites you the most? What are you most looking forward to watching develop as time goes by?

Ashley Oerth

Yeah, I think like we've been talking about, there's a lot that people I think are nervous about, but there's a lot I think to be really excited about. So for example, if we're thinking of generative AI involved in our day-to-day work, this could mean faster summarization of content that we're looking to read but don't have time to get to. It could mean helping us with task prioritization. In essence, we're kind of getting this personal assistant that could be embedded into our work streams that really helps alleviate distractions and enable the kind of knowledge work that our livelihood center around.

There's this author Cal Newport who's really written at length about this idea that he calls deep work. And his argument really is about how in today's knowledge economy focus is a sort of precious commodity, but really what we see happening is evermore notifications and things that are distracting us that pull away from our ability to do real quality knowledge work. So in other words, every interruption costs us, whether it's our phones or an Outlook email or other distraction. And if AI can be integrated into our work streams to help minimize those sorts of distractions and alleviate menial work, take care of those rote tasks and allow us to focus, I think we can all be more productive. So that's what I'm excited about with AI, that it can really make us more productive in our day-to-day jobs and help us grow the economy and ideally our livelihoods.

Jodi Phillips

So Brian, how are you feeling on your own personal fear/excitement scale? This helps?

Brian Levitt

Yeah, of course it helps, and I love listening to Ashley, and like I said in the intro, I'm pushing against my instincts for fear because I really liked your quote. I can't get it exactly right, but I'm either going to be steamrolled into the road on this, or I'm going to get on board and I'm going to get on board, right? I'm going to look for opportunities to best take advantage to make my life and my career more efficient, and I'm going to look for opportunities on how to invest and take advantage of what I think is a strong long-term structural theme.

Jodi Phillips

Yeah. And I might try to write my book a little faster just in case. Ashley, thank you so much for joining us and help putting all this in perspective.

Brian Levitt

Ashley, thank you.

Ashley Oerth

Absolutely. So great to be here. Thanks so much for having me.

Jodi Phillips

So that brings us to the end of another Greater Possibilities podcast, but the conversation doesn't stop here.

Brian Levitt

Yeah. Visit invesco.com/brianlevitt to read my latest commentaries. You can follow me on LinkedIn and on Twitter @BrianLevitt.

Jodi Phillips

And if you missed any of that, that information is on our podcast page. Thanks for listening.

 

Important Information

You've been listening to Invesco's Greater Possibilities Podcast.

The opinions expressed are those of the speakers, are based on current market conditions as of July 25, 2023, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

Should this contain any forward looking statements, understand they are not guarantees of future results. They involve risks, uncertainties, and assumptions. There can be no assurance that actual results will not differ materially from expectations.

All investing involves risk, including the risk of loss.

Discussions of specific companies are for illustrative purposes only and should not be considered buy/sell recommendations. 

Brian Levitt:                       

Welcome to a special edition of the Greater Possibilities podcast from Invesco, where we put concerns into context and opportunities into focus. I'm Brian Levitt, and today I will be handing the hosting duties to Justin Leverenz, Team Leader and Senior Portfolio Manager for the Emerging Markets Equity Team at Invesco.                                                

Justin had the unique opportunity to interview Joey Wat, the CEO of Yum China, which of course is the operator of the KFC and Pizza Hut chains in China. Justin and Joey talk about the spectacular rise of the Chinese consumer and the formulas for anticipating and meeting the needs of the Chinese customers. We will also gain insight into how China is emerging from the Covid challenges of the past eight years.                                           

So grab your eight-piece chicken meal and your stuffed crust pizza, and sit back and enjoy the conversation. This is a real treat.

Justin Leverenz:              

This afternoon, I'm delighted to host a good friend, Joey Wat, who's been the CEO of Yum China for approximately five years and has spent almost a decade with Yum China in various different capacities. Before that, I believe you were also CEO of Watson's in the United Kingdom.

Joey Wat:                           

Yep.                                                

I thought we could divide this into four or five sections. The first is talk a little bit about the contemporary consumer in China.

Joey Wat:                           

Okay. Yup.

Justin Leverenz:              

And so the evolution of the consumer. The second was formulas for success, if there are any, in the consumer market across China. The third, about competitive evolution and possibilities that still exist in terms of the restaurants industry across China. The fourth, I think we'd be remiss without touching upon the spectacular rise of technology in China and what that has meant for businesses.

Joey Wat:                           

Right.

Justin Leverenz:              

And the fifth, and I suspect most of the audience is probably most interested, is really about the context of China.

So the first, ingredients for success with the contemporary Chinese consumer. So China has changed dramatically in the last 20 years. I think if you go back 20 years ago, it had a total economy is $1.5 trillion. Today, it's nearly $18 trillion. And early this morning, I discovered that during this 20-year period, consumer disposable incomes across China have increased tenfold in 20 years.

Joey Wat:                           

Right.

Justin Leverenz:              

So there's been a lot of change. China now has a broadly more affluent population, a more urbanized population, a more connected population. And alongside this, a continental sized economy. In addition, we've seen a profound shift in this past 10 years towards a more service-oriented consumer economy across China. Actually, perhaps the first time in China's 5,000 years that we've got a really large consumer economy. So I guess the question, Joey, is what do you believe have been the most profound set of changes during this period of time?

Joey Wat:                           

Let's start with some number and then we can hopefully see few things that might be interesting. Yum China, right now, we serve customers in 1800 cities in China, out of 2,800 cities. That's KFC. Pizza Hut is only in 700 cities in China. And  even in my last whatever years here, what amazed me is the growth of these new cities. I mean, the number of new cities just keep growing, still growing. So the addressable market right now-

Justin Leverenz:              

And a city in China is defined as sort of more than a hundred thousand people?

Joey Wat:                           

Yeah. I mean, the highest, Beijing, Shanghai, I mean, 20, 30 million. And then you go down to a tier five, tier six city, it could be 100,000, could be 50,000 in eastern part of China. But then if you go to the poorer province, like more inland province, the number of population's bigger.

So it's quite different depending on the regional. But we as a company, we track these cities in terms of development because it would determine our short-term and long-term plan about how many cities we enter a year, or next year, and then in the coming five years.

So that is really amazing. And secondly is the disposable income per capita is still growing and that's exciting. Although in the last few years, the disposable income for customer, for the consumption part, like for food or in general consumption, is not necessarily going up. It's actually become tighter for many reasons. One reason is pandemic, but also very expensive housing price. So when consumer companies or quick service restaurant companies, the tier two, tier three, tier four cities, they are actually quite attractive. They're not too bad.

Justin Leverenz:              

Because housing prices have been less dramatic.

Joey Wat:                           

Correct. And people in those cities have more disposable income than we thought. So these dynamics are exciting. And then the lower tier cities, tier five, tier six, they're still growing. And because it's such a big market and we have to embrace the scale with such a big market, there's still just so many opportunities. Because the white space there, I mean, if you are in a consumer product business, then you can reach these cities via online platform. But if you are in food business, then you still can continue to build the stores in the lower tier cities. And the white space is still there. So that's exciting.

Justin Leverenz:              

So many of the clients of this podcast, when they think about Chinese multinationals, the poster child to them is the success of European luxury good companies. So the Cartier, Chanel, Hermes of the world. Broad recognition that China has been an important factor. But there's also a lot of unheralded, idiosyncratic businesses which don't get the same amount of attention. I think about the success of certain western spirits companies like Pernaud, or alternatively, L'Oreal  navigating the whole omnichannel environment of China. I guess the question is, are there broad characteristics shared by successful multinational companies in China? So very different categories, very different segments, but-

Joey Wat:                           

If I have to generalize, I would like to say yes, but then the devil is always in the details. One is amazing products. Second is ability to grow with the customers, to offer what customers want. Some sort of business, for example, the luxury groups, that's what I call... They're in the supply-led industries. What you can produce decides the total industry dynamic because customers just are happy to see what are being offered by the European luxury goods. Whereas the Chinese luxury goods business still at probably infancy stage. And how things will evolve in the future, we don't know. But if we look at the more affordable items, the consumer products. Start with something, shampoo, right? Long, long time ago, I mean, two or three decades ago, at one point it was supply-led as well, but now it's more consumer-led.

There's some exception, like telephone, it's a different story. It was consumer-led and then later on becomes supply-led when there's a big technology breakthrough. But compared to this, one is the amazing product. And secondly is when the industry moved from supply-led to consumer-led, can the company grow and change with the development of the consumers? Some companies could, some companies could not. But actually, many companies could in China.

And what happens when we go to the consumer-led industry stage, you will see a lot of local competitors, and they're doing really well. So when an industry, consumer product industry or the food business, are in that consumer led stage, then I would always focus on three costs. All three costs are not directly on your P&L, but if companies, particularly the multinational, if they cannot control all three costs, then we know what's the result.

One cost is communication cost. Second cost is decision-making cost. Third cost is the cost of making mistakes. When a company is too big, then the communication cost is not small. And when a company runs... If they make the decision from far, far, far away and there's not enough attention to what's the local competition, it becomes a problem. So the communication costs, decision-making costs, then the cost of mistakes, all are very high. It becomes, really, a big problem. But even for a company that is completely based in China, you still have to look at these three costs. Because China is a big country, it's a big market. And I would say some companies can do it better than the others. And I see some multinationals say, "Oh, there's sort of preference towards the domestic product or not." I really think that kind of thinking just oversimplifies things because it's very easy to bring the cultural difference or the preference into the picture. But in reality, if you grow with the customer, if you offer what they really are passionate about, what they really want, and you can be part of the community... Customers are very sophisticated in China right now, particularly in tier one, tier two cities. There might be some regional small area that's not so sophisticated, but it's very small. I would say, in general, customers are very sophisticated.

Justin Leverenz:              

I recall you telling me years ago that the best way to fail in China is copying what works in the United States. That's sort of what you're alluding to?

Joey Wat:                           

That's correct. The best way to fail in China is copy your successful model in United States or Europe and then have a-

Justin Leverenz:              

Impose it on China.

Joey Wat:                           

... And impose into the Chinese market. That's the guaranteed way to fail, so don't do it. For a very simple reason. The legal setting is different, the market setting is different, the logistics setting is different, your customers are different. Why in the world could you just replicate what worked in US and Europe, and then expand it to work in China? The mix is not right. The formula is not right. I mean, we all can learn many good things from around the world, from Southeast Asia, from Africa, everywhere. And then we adjust, and then we test it with the customers, and we listen to customers. What works, what doesn't work? And then we change, and then make it work there. That's the only way.

Justin Leverenz:              

So coming back to the restaurant industry, unlike some of the other industries we touched upon, it's much more operationally intensive.

Joey Wat:                           

Correct.

Justin Leverenz:              

Every store is a manufacturer of sorts.

Joey Wat:                           

Yeah.

Justin Leverenz:              

What do you think are the unique requirements for success, both for foreign restaurant competitors and then of course the local chains?

Joey Wat:                           

Oh, really good question. First is the credibility about food safety. Without that, you're building your business on sand. And that credibility is very, very hard to earn, and at some point-

Justin Leverenz:              

And very easy to lose.

Joey Wat:                           

Yes. It only takes one small incident to lose that. But every successful, well established company in restaurant industry probably will have to go through that stage and challenge, and learn how to manage the PR crisis, how to take that challenge into opportunity to further enhance your internal capability in protecting food safety, and also protect the company, and also earn the trust from the customers again. I mean, one food safety incident could destroy 20%, 30%, 40% of the business overnight. But once you earn it, customers, they really appreciate it. You might still make mistakes, but customers will know that you have bottom line. The bottom line there is one incident is not system-wide. So that's first.

Second is very strong operation team. Because at the end of the day, no matter how amazing the strategies are, without the strong operation team, people who work in a store day in and day out, nothing will happen. Whatever beautiful decision made by the headquarter won't happen. It just won't happen. So that operation team, I would like to believe that it could easily take 10 years or 20 years to build. And any successful restaurant industry needs to build their operation capabilities and build the pipeline for talent internally. Without that ability to build internal talent, it's not very sustainable. So that's the second.

Third is non-stop innovations, particularly in food. Because Chinese customers love food, but they are also so demanding about food. And I believe, and I encourage whoever in the industry, just to keep innovating. It's not only about western food or Chinese food, it's about good food. In many of these restaurant companies, they even have the regional menu. Other than the national menu, the food that everybody can have in the entire country, the local menu. And the local menu, particularly the breakfast items, these can be food that local people have been enjoying for 100 years, 200 years, or maybe 1,000 years.

And why this is so important, because if we think about it, when it comes to food, we are not very adventurous for the breakfast. We can have the same breakfast every day. We become more adventurous for lunch, but lunch is very functional. Fast, convenient, affordable. We become very adventurous with dinner. Anything goes. So for the food that companies offer for the breakfast, actually the best strategy is just to go to the local taste. Sell the breakfast food that has been popular for 1,000 years or 100 years. You cannot go wrong. Because you can't change the habit anyway, because that food habit for your breakfast is actually determined by your mother when you're a kid, not by any company right now.

So once you understand the insight, then you will understand why it's so important to go local and to embrace the local flavor. And of course, you need to take the challenge that whatever the local food you produce in your restaurant needs to be as good as the local, if not better, with the plus side of food safety compared to the street food. Right? You have to pass the local people test. Then, if you're good enough, then you can hopefully bring the food to other provinces, other cities in China, and make it even bigger.

Anyway, it's a lot of hard work. But for people like myself, I absolutely love food. I think when you have good food, Chinese call it [foreign language], heaven and human are together at the same time. Because [foreign language], what is heaven for normal people? Good food is heaven for normal people.

Justin Leverenz:              

Moving on to technology, I think another surprising difference for those who haven't spent much time in China or have never been to China before is the sort of deep penetration into consumers' life. And perhaps, I would say, the unparalleled competitive fight that goes on in China. We're still stuck with Amazon that looks about the same after 25 years, Google, and Facebook. But in China, there's enormous amount of innovation that comes because of competition. You know, Beijing and its whole ecosystem. Douyin, which is now going global with TikTok. We don't have one e-commerce company in China, we have multiple fighting over the growing GMV (gross merchandise value) pile. So how has this kind of digital innovation, whether it's payments or communications through ads, loyalty, this sort of thing, how has this evolved in the restaurant industry in China? And how do you think the future looks in terms of the importance of technology, not just on the consumer side of the business but also on the operational side of the business?

Joey Wat:                           

I mean, the technology play cannot be more important. And when I start to work on the investment of technology, I remember, I share with my team that this is a strategic move. There is no regret move.

Justin Leverenz:              

In fact, I often think, you have this highlight RMG, right?

Joey Wat:                           

Yeah.

Justin Leverenz:              

Resilience mode-

Joey Wat:                           

Growth and then strategic mode.

Justin Leverenz:              

Oh, okay, resilience, growth mode. I think you should add a T to it, right?

Joey Wat:                           

Tech-

Justin Leverenz:              

Maybe that's the fourth element.

Joey Wat:                           

I'll put a technology into the resilience and growth. Or, well, actually, we'll put it in-

Justin Leverenz:              

In all of them, I guess.

Joey Wat:                           

... The strategic mode. Yes. It cannot be emphasized even more. It's absolutely no regret move. And I am very grateful. I'll come to the impact of the restaurant industry later. I am very grateful that China still offers one thing that we don't necessarily think about it, but we absolutely benefit for it, is the number and the corps of engineers. Because I spent 10 years in UK, and even 10 years ago, an engineer who can do the coding for you will cost 2,000 pounds, easily. I don't know what it costs in US right now. Everything's so expensive in the US. But today, it's still the case that you can hire an engineer for 2,000, maybe 2,500 or 3,000 pounds in the UK. But in China you can get a really good one for 2,000 renmibi. I mean, the cost difference is so big. So it allows restaurant companies, to invest so much into technology. So that is just something that I'm very grateful.

Secondly, I'm very grateful customers are very open-minded. I mean, I feel bad for my mom, my dad, who struggle to really keep up with the technology change. But most of the customers are so open-minded and very well educated too, to embrace the new technology. Then come to the restaurant industry. We deploy technology in many, many, many different ways. But if I dial the time back to seven, eight years ago, the starting point actually was the customer-facing bit, is the loyalty, is the marketing, is the digital payment. All that bit to simplify the operational complexity and costs when it comes to customer-facing. And then later on, we extend that. I mean, this is a quite... I won't say common, but it's really happening in the industry.

Then the digitization happens for the production of food, restaurant operation, and then all the way to supply chain.

Justin Leverenz:              

Supply chain.

Joey Wat:                           

So you can imagine right now, when customers come to a restaurant sort of with the good technology background, before they walk into the restaurant, there's already LBS technology, location-based technology, to have some special promotion for that particular customer before they walk in. And then the customer also will do huge amount of digital ordering, particularly for breakfast. The insight is, when would the customer order their breakfast? Before they come to the store and pick up the breakfast? They usually order when they wake up. Before they brush their teeth, they order it, and they will specify what time it is for them to come pick it up, and then they come pick it up. And then, once they're in the store, the payment's all done. There's no payment. The payment's done when they do the digital ordering. But then the staff will take the order from the computer system, and then they will prepare food. And actually, the system, the digitization, can be good enough that with the sales number over many years, you can predict what do you need to prepare before certain hours.

And for dining business, they can integrate the dining order and delivery order, and then decide the production schedule. Which, in high-end restaurants, you will have someone who's very capable to decide the order. You want the food to arrive at the same time. But in a restaurant company in China with the digitization, that's all done by machine. There's no human involved. And then, what about the inventory? The inventory, in the past, you have to do the stock-take. You know? First in, first out. Right now, no need. It's all with the scanner. You bring the stock out, it scans, and the system will have, you know?

Justin Leverenz:              

Automatically replenished.

Joey Wat:                           

Automatically. And there's no need to do the ordering of the inventory either because the system will push the right amount of the ingredients into the store. So you can imagine then the process continues all the way to the logistics center with the supply, to minimize the food waste. Because I am very big on the food waste because we can of course challenge ourself to grow more food, but in reality, industries in countries where logistics system is not so efficient, the percentage of food waste in the process, outrageously high. And there's so much for a restaurant company, once we have this technology, to absolutely minimize the food waste. And I certainly focus on that because it's not only about cost to the shareholder, it's just the right thing to do.

Justin Leverenz:              

Maybe we move on to context, just given limitations on time. The recovery of China post-pandemic, removal of the mobility restrictions, has been... Our team was in Shanghai last week... Sort of mixed, perhaps even disappointing to many observers. What are your observations about the macroeconomic challenges and opportunities today?

Joey Wat:                           

Well first of all take a step back. We sometimes forgot, during Quarter 1, China still have Covid. And the recovery really does take time. We still see the concern in people's mind, the consumer's mind, and people are more careful with their spending. When it comes to the macro implications, we are living at very, very uncertain time and nobody has the crystal ball to tell what is to come. But what companies of restaurant industry could do is to change, to be agile, to offer what customers want. And customers want right now is very good value for money. And that's something not too wrong either. You see that in Europe, you see that in many countries. So there are always many competitors. The competition, or the market, is always uncertain. But what restaurant companies can do is we continue to build the fundamental capabilities in food innovation, in supply chain, in operation, in marketing skill.

Justin Leverenz:              

So that's sort of one of our views as well, which is China at present has a number of challenges, but nevertheless, that we did not discount that within the context of perhaps even a slower growing economy in China, there are significant opportunities. I mean, it's a very large market.

Joey Wat:                           

Innovation is always the way to go. For example, right now we also have another concern, is that there's not enough birth of babies for the country.

So what some restaurant companies are doing, well, we start to market to the pets. The pet’s toy, the pet’s home, all sorts of stuff related. Also some marketing things related to pets are doing really well. And in restaurant companies, you can start to see some industry players or leaders, they convert their store to be more pet-friendly. So you see the bowl of water, you see the little place to have your dog next to it. It's okay. There's always some opportunities in such big, gigantic market.

I would like to believe that innovation, and particularly really big innovation, happen because we are pushed to. We have to. It's tough, but it just gives us that extra challenge to be more innovative. And someone clever said, "Great companies are always the children of the winter." And I think we will see some really great companies coming out of this winter.

Justin Leverenz:              

Well, we're entirely out of time. Thank you, Joey. Thanks for your time this morning.

Joey Wat:                           

Thank you.
 

Important Information

You've been listening to Invesco's Greater Possibilities Podcast.

The opinions expressed are those of the speakers, are based on current market conditions as of May 30, 2023, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

Should this contain any forward looking statements, understand they are not guarantees of future results. They involve risks, uncertainties, and assumptions. There can be no assurance that actual results will not differ materially from expectations.

All investing involves risk, including the risk of loss.

Discussions of specific companies are for illustrative purposes only and should not be considered buy/sell recommendations.

All data sourced to Invesco unless otherwise noted.

Not a Deposit - Not FDIC Insured - Not Guaranteed by the Bank - May Lose Value -Not Insured by any Federal Government Agency

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Investments in companies located or operating in Greater China are subject to the following risks: nationalization, expropriation, or confiscation of property, difficulty in obtaining and/or enforcing judgments, alteration or discontinuation of economic reforms, military conflicts, and China’s dependency on the economies of other Asian countries, many of which are developing countries.

Many products and services offered in technology-related industries are subject to rapid obsolescence, which may lower the value of the issuers.

The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.

Brian Levitt

Welcome to the Greater Possibilities podcast from Invesco, where we put concerns into context and the opportunities into focus. Hi, I'm Brian Levitt.

Jodi Phillips

And I'm Jodi Phillips. And we're talking about the midyear outlook today, which means Alessio and Kristina are back. That would be Kristina Hooper, Invesco's Chief Global Market Strategist, and Alessio de Longis, Head of Investments for the Invesco Investment Solutions team. So Brian, welcome to the middle of the year.

Brian Levitt

That was quick, wasn't it?

Jodi Phillips

Yeah, all too quick.

Brian Levitt

I mean the kids are already just about done with school. We've got to slog through the summer, keep working, but the kids seem pretty happy. But I mean fortunately, it wasn't too bad of a winter up here in the northeast. We got through it.

Jodi Phillips

Yeah. I can't say we had much of a winter on the Gulf Coast either.

Brian Levitt

Yeah, exactly. Maybe one day I get to live in the south too.

Jodi Phillips

Well keep in mind, it's supposed to hit 99 degrees here this week, so there's a definite trade-off for that benefit. But what's important here is the temperature of the markets, and I think the first half was a lot like your winter, Brian, milder than most expected, would you say?

Brian Levitt

Yeah, I think that's true. I mean the way I would categorize it, I've been talking to investors a lot trying to put last year into perspective versus this year. I mean last year was one of those years where things largely got worse relative to expectations, inflation, the amount of policy tightening, you remember all this? Russia going into Ukraine.

Jodi Phillips

It's ringing some bells, yes.

Brian Levitt

Yeah. I mean this seems like a year in which things are generally getting a bit better. Inflation's coming down, Fed is likely at or near the end of its tightening cycle, the economy's been resilient and so the market has taken some comfort in that.

Jodi Phillips

Yeah. And let's not forget that despite all of the last minute drama, the debt ceiling was raised without incident.

Brian Levitt

That's right.

Jodi Phillips

So that was a nice way to mark the middle of the year. And before the debt ceiling became such a focus, I mean we were all focused on bank failures over the spring. But here at the midpoint, it feels like policymakers have been able to manage all of this and avoid the types of financial accidents that tend to happen at the end of policy tightening, would you say?

Brian Levitt

Yeah, at least to this point. And it's funny, it's like how can I forget the things that you just mentioned? It's a reminder that I think investors and we all collectively jump from one issue to the next and we almost forget when that issue is overcome or moves to the background. It's like, "Okay, yeah, we knew that that was going to be fine," but did we? Yeah.

Jodi Phillips

Been there, done that, on to the next thing.

Brian Levitt

Right, exactly.

Jodi Phillips

So how did market leadership change during all of this?

Brian Levitt

Yeah, I would say the beginning of the year, and I know Alessio will talk to this, had a soft landing feel. It was broad participation in the markets, types of things you would think would do well if the economy was doing well. Lately the market's been driven by a handful of names, which also has some information as well. That's what we call “bad breadth.” So I guess improving economic activity would be the mouthwash to that bad breadth.

Jodi Phillips

Bad breadth... I don't even know what to do with that. Is that technical humor? What is that?

Brian Levitt

I think it's dork humor, maybe dork and dad humor combined.

Jodi Phillips

Oh, that's the best kind of humor. Yeah, for sure. For the sake of our audience, Brian, I'm going to brush past that though.

Brian Levitt

Oh, I like that. We'll paste over it.

Jodi Phillips

Yeah. Mom humor is almost as bad as dad humor. But look, all right, we're done, we're done with this. We don't have time.

Brian Levitt

We don't have time for this.

Jodi Phillips

Too much to talk about. Let's get to Kristina and Alessio. Welcome.

Kristina Hooper

Thanks for having us.

Alessio de Longis

Thanks for having us, Jodi, Brian, always a pleasure being with you.

Brian Levitt

Do you have any puns about bad breath or should we just get into the questions?

Kristina Hooper

I've been racking my brain, I've been panicking thinking about what I could come up with that's dental related.

Jodi Phillips

Don't put them on the spot.

Brian Levitt

You'll pick your spots.

Jodi Phillips

So yeah, we all heard us hitting a couple of the highlights and some lowlights of the first half. So Kristina, can you offer us a quick post-mortem from your perspective?

Kristina Hooper

Sure. It was a very different environment from 2022, which I dubbed the annus horribilis, channeling my inner Queen Elizabeth. What we saw was equity markets around the world, with the exception of one major market, China, making gains. And so this was a fairly positive environment, although of course, bad breadth noted in the US market. One highlight that I don't think has gotten a lot of attention is the Japanese stock market. Japanese stocks have been on a tear. The Nikkei 225 Index closed at its highest level since 1990. It's up well over 20% this year. So a lot is happening and I think some of that certainly is being driven by monetary policy. The BOJ (Bank of Japan) is of course unusual in that it has held out and remained incredibly accommodative.

Brian Levitt

Also, a reminder that a little bit of inflation in a place like Japan can go a long way, be supportive of nominal growth -

Kristina Hooper

It's not a bad thing.

Brian Levitt

- be supportive of profitability. Alessio, have you been surprised by what we would categorize, or I think the media has categorized, as the sustainability of this economy?

Alessio de Longis

It's been really remarkable. If you think about what we have had in the backdrop, the sharpest most rapid tightening cycle we've ever experienced, and hints of bank failures left and right, the resulting tightening credit conditions, the flattest or most inverted yield curve since the 1970s. I mean you go down the checklist of all the red flags ahead of recessions, it's absolutely remarkable how we sit here today with the unemployment rate at all-time lows, not just in the US, also in the eurozone. In the UK, the economy globally has remained remarkably resilient. So it really speaks to how much pent-up demand there was in the system and how tight labor markets were.

So it is certainly a confirmation that the inflation spike that we saw last year was fundamentally justified. It was not just a one-off due to supply chains and inventory cycles, right? The strength of the labor market to this day is a confirmation of how tight the inflationary picture was in 2022. And we're seeing how slowly that inflation is rolling over today because we still have very resilient labor markets. So yes, I do think if you had asked me where we would be today a year ago, I find today's results for the economy much more positive than we would've expected.

Jodi Phillips

What about the question of recession in the US? And I know Kristina, you've called it the “recession obsession” in a recent column. And look, while you were joking about needing to come up with a dental-related analogy, I do recall one you sort of made about zombie bites, the fact that central bank policy and Fed tightening bit the economy, and everyone was anxiously waiting to see what was going to happen and what the result was going to be of that and if it was going to turn to recession. So what do you think of this situation and what do you expect to see?

Kristina Hooper

Well it is clearly a very unusual economic environment, a tight labor market. It is both a blessing and a curse because certainly, it has, as Alessio aptly pointed out, created an environment in which inflation is high. I mean that has been a big contributor. But at the same time, it's also the reason why the economy has been so resilient. I think about something that the United Airlines CEO said last week, leisure demand is really, really strong. Business demand hasn't fully recovered yet. We're probably in either a mild recession or moderate economy. I think actually in the US, we're in a business recession and the consumer is just fine, the consumer is strong.

And I think that that quote encapsulates or is emblematic of the unique economic environment that we're in where we have areas of real strength, including the consumer, which is of course a very large part of the economy, but also areas of weakness. And we are still waiting to see all the effects of monetary policy because there is that lag, just like there's a lag between when someone is bitten by a zombie and they turn, there is that significant policy lag between when it is implemented and when it has an effect on the real economy.

Brian Levitt

That was exactly what I was going to ask. Alessio, you talk about that a lot, the lag, the effects of policy tightening. And one year ago, so 12 months ago, the Fed funds rate I think was 1.00%, right? And so we've had an awful lot of tightening from where we were a year ago, some 425 basis points. So when you talk about the checklists on the path towards recession, I mean doesn't that still give you some cause for concern the amount of tightening that we've had? And should we still expect economic moderation or dare we even say a recession from here in the United States?

Alessio de Longis

I think when you look historically at the evidence, the lead and lags of monetary policy, of course, we try to simplify them, but they are uncertain and there is a large degree of variation, right? And when you look at historical episodes, anywhere between 12 to 24 months, it's a safe assumption in terms of the lagged effects of monetary policy and the impact on the economy. So that meaning we are just entering now the hot zone so to speak.

Brian Levitt

Right.

Alessio de Longis

But with that being said, I think our generation has a little bit of an obsession with the recession word because, well, the last two recessions that we had were literally implosions. They were not just recessions, they were financial crises. It was the end of the world, right? 2008, 2020, everything required the bazooka to come in with zero rates, negative rates, quantitative easing and so on and so forth. I think that's what really caused the obsession with the recession. But to Kristina's point, we have done a lot of de-leveraging on the consumer side, which is still 70% of the economy, let's not forget that. A lot of the regulation also on the business side has prevented some of the leverage reverberation through the system that has created those atomic bomb type recessions that we've seen, right?

So is it reasonable to still expect a recession? Yes, absolutely. Does it have to be an obsession that paralyzes us from making investment decisions or remaining fully invested with capital deployed? Absolutely not. I think several asset classes are already priced for those recessions risk to be manageable, so to speak. I don't know if, Brian, that answers your question, but I would say the answer is yes, we are still waiting for a recession, and no, that recession does not have to be an obsession that prevents us from making sound investment decisions.

Brian Levitt

Not only does it answer my question, it exceeded my expectations in terms of how you were going to answer that question. And as you were talking about it, I was thinking about 1991, which of course we all lived through. I mean I was only in high school, but I remember a recession that in hindsight had some challenges, a bunch of banks failed, but we still got through without significant incident to the broad equity market. So it's an interesting parallel. But what I was also thinking as you were talking, and either one of you can chime in on this, why is the Fed still talking about raising interest rates? I mean we've had so much tightening in such a short period of time, I've been calling them day after day, they don't answer my phone calls. Can we please stop raising interest rates?

Kristina Hooper

The ghost of Paul Volcker, that incredible fear that this turns into a situation in which inflation becomes very entrenched. I think that is the concern just given that we haven't seen inflation prints like this in so long. Now, logically, we can understand how we got where we are, but I think the Fed is just so concerned that it may repeat the mistakes made many years ago that it would prefer to go full Volcker to a certain extent on this economy.

Jodi Phillips

So let's timestamp this conversation just a little bit, right? We're recording this right before the June Fed meeting and chances are pretty good, most listeners will end up hearing this maybe after that meeting happens. So when you think about going into the June meeting and then especially into the second half of the year, right? I mean what are you expecting to see? And I know that more recently we've seen maybe some surprises from Bank of Canada and Australia. So what do you think this all adds up to for the second half?

Kristina Hooper

So if you don't mind, I'll start. Well Jodi, luckily we did a poll on LinkedIn last week. So what our readers are saying is what I agree with, that we will see a pause this week. I believe though that it will be a hawkish pause, that it will come with lot of language that is somewhat scary, the proverbial sword of Damocles will be hanging over markets so that the Fed can try to keep a lid on an easing of financial conditions.

I think what's more important is going to be the Summary of Economic Projections. I want to see what expectations are with the dot plot, not just about the terminal rate, but also when a rate cut or cuts are anticipated because that to me is actually the bigger question facing markets right now.

Brian Levitt

A skip and a pause. Wasn't that all the rage at the sock hops in the 1950s, wasn't that the dance, a skip and a pause?

Kristina Hooper

I'll have to watch some more Happy Days episodes and get back to you on that.

Brian Levitt

Alessio, when you think about these markets, you had talked a lot — and I stole a little bit of your thunder in the intro — about the soft landing market early in the year, and then the bad breadth market that we're dealing with now. What is that telling you about the expectation for the near-term direction of the economy? Thinking tactically, what does that all suggest to you?

Alessio de Longis

Well I think the market price action always needs to be respected, right? I think in the interpretation of that price action, it does raise a question when the entire year-to-date performance of the market, primarily in the US, this is not true elsewhere, primarily in the US is really driven by 10 names. And these are your typical tech sector, mega-cap, quality names. So everything else being equal, a rally led by these types of “defensive” names, let's call them quality names, does feel a little bit more of a defensive rally than a rally led by the risky cyclical sectors of the economy or names, which much more of a value bent. We can see the laggards are cyclicals everywhere. Emerging markets that have more operating leverage to the global cycle are lagging, small and mid caps are lagging. So I think that begs the question-

Brian Levitt

Financials.

Alessio de Longis

Financials, exactly, financials are lagging. With this yield curve inversion, you can understand why, right? How much more risk banks need to take farther out in the curve in order to try to make a positive spread, right? So I think that speaks to, in my mind, a rally that is not indicative of a new cycle, right? Usually the beginning of the cycle is led by cyclicals, is led by value, is led by small caps, but it's a rally nonetheless. My interpretation, I think the risks into the second half of the year are actually tilted towards a bit of a repeat of what we saw in November last year where we wait, we wait, we wait for that something to break, it doesn't break, policy or global monetary policy takes a pause, the markets welcome that, basically inflation slows or inflation decelerates more evidently than the growth is actually breaking, right? So it could give us another round of, call it those three to six months where actually the market does fairly well because market participants simply get tired of waiting for that dreaded recession, right?

So it could be an environment where 2023 goes down as a year where we waited for Godot, it never arrived, and markets delivered healthy high single-digits or low double-digit returns across equities and fixed income. You were mentioning should we be overly tactical in this or are there things that we can do to navigate these type of market conditions? We said it many times in the past, these type of market conditions, if you for example focus on investment grade and collect your five and a half, 6% yields with very low volatility or even high yield, right? With eight, 9% yields, at the moment with very, very low volatility, those are equity-like attractive returns, but with a much better risk profile. And these type of exposures allow you to really wait for the cycle to take a direction.

Jodi Phillips

So Alessio, of course one of the things that we're seeing right now is investors are doing a lot of their waiting in money markets, right? Money market balances have hit historic highs. And so what are your thoughts on that in terms of people who are maybe waiting with a lot of their cash in money markets and trying to figure out maybe what to do next with that and are just sitting and waiting and trying to figure it out? What would you say to folks who are there right now?

Alessio de Longis

Well obviously, we haven't seen this type of short-dated yields in 20 years, so the temptation is incredible, right? But at the same time, we look at these annualized yields and don't realize that unless they persist for multiple years, you don't really get to collect them. So what I'm saying is there is reinvestment risk, right? So I would say that extending a little bit of duration and increasing a little bit of the credit spread can allow you to actually achieve much higher yields and avoid a little bit of that reinvestment risk. I think it's always a function of the investment horizon. It's a strategy that has worked well for the last six months of course, but at some point that reinvestment risk question comes in.

Brian Levitt

Should we turn to a conversation on equities?

Kristina Hooper

Sure.

Alessio de Longis

Sure.

Brian Levitt

Kristina, let's start. Last year was a valuation adjustment largely, we've seen earnings moderate, but I don't think they've been as bad similar to the economy as many people thought. Do we still need to go through an environment in which there will be an earnings adjustment and evaluations adjusted enough to warrant what type of earnings decline we may see?

Kristina Hooper

Well certainly we are going to see deterioration and earnings, but I think it's important to recognize that typically what we see is that at the same time that happens, we're seeing yields go down, and that tends to lead to multiple expansions. So they can be countervailing forces. So if your question is really are we going to retest lows from last year? I think that's very unlikely in this environment. Certainly we could see the stock market at periods of time this year come under pressure, but I do believe that a drop in yields is likely to lead to multiple expansion and that will be a fairly potent force.

Jodi Phillips

So Alessio, can you give us some of your thoughts too looking at equities in terms of size and style and region too? I mean US versus international or even emerging markets. Where are you paying attention very closely right now and seeing potential opportunity?

Alessio de Longis

I think in analyzing basically the cyclical risks, which may still be tilted to the downside for what we just discussed versus what is really at risk more from a structural standpoint, I think there is a compelling case to begin to rotate more and more into international equities. We have discussed the dollar side, dollar valuations, but it's important to remember they don't affect just the currency of the denomination of your investments, expensive dollar valuations will mirror also cheap currency valuations in Japan, in the eurozone and how those cheap currency valuations really boosted the local equity returns. You had mentioned, we know how in the last six to 12 months, Europe surprised to the upside in terms of performance and now we are seeing Japan delivering good outperformance. All these equity markets are very attractive both from a local valuation standpoint and currency valuation.

So I think there is really a case too, after 15 years of US excellence, we know that these regional cycles tend to last about 10 to 15 years. I think that is one important theme that investors can begin to deploy systematically and rebuilding a way for US-based investors, right? Building an exposure that reduces that home country bias towards international markets. And that strategy does not need to be overly focused and obsessed with the next Fed hike, the next inflation print. But it's a strategy that you can begin to deploy methodically, and it allows you, by the way, to also diversify not only away from a regional exposure, but diversifies away from that mega cap quality bias that we talked about that is inherent in almost any US equity exposure today.

Brian Levitt

So should we get to the circadian rhythms portion of the conversation? Kristina, relatively optimistic tone to this conversation, although acknowledging some of the potential risks to the economy, is there anything that you would identify as keeping you up at night?

Kristina Hooper

So I can't say that anything keeps me up at night because I do believe that if you have a long enough time horizon, you can weather any volatility you experience.

Brian Levitt

Clearly, I mean look how well we've done since we first learned the words COVID or coronavirus 19.

Kristina Hooper

Exactly. What does worry me though, I will say, and this is something I learned living through the global financial crisis, was that there are some who get spooked from the market environment, lock in losses, leave when the stock market is down, sit on the sidelines and don't know exactly when to get back in, miss out on a lot of strong performance. And that certainly happened last fall. I think many were spooked, they got out, they sat on the sidelines, certainly they're getting paid a little more in yield, but I do worry about being able to reenter the market missing out on what has been very strong performance since then. So that's probably my biggest concern for investors. In terms of the macro environment and the pitfalls we might see, of course some are worrying about commercial real estate and I think there are valid concerns there.

But when I look at the space, I think that there are certainly some tailwinds in addition to the headwinds. Return to office policies mean to me that we've already seen the trough in terms of office occupancy. I think it only gets better from here. And of course, commercial real estate is not just office space. There are many other parts of commercial real estate that are doing quite well. So certainly there are concerns also when it comes to commercial real estate loans and when they mature and need to be refinanced, but actually the vast majority of them are coming due later in 2024, '25, '26. We could be in a very different interest rate environment as well as a different environment in terms of credit conditions. So I think that it's premature to become obsessively worried about what could happen in coming years.

Brian Levitt

Alessio, a similar question for you and I would add onto that. Based on Kristina's comments, do you worry that commercial real estate is a next shoe to drop and do you have concerns about the implications for the regional banks?

Alessio de Longis

I think the valuations, as always, markets reflect these things well in advance and valuations have adjusted and reflected that. I don't think this is a stage in the cycle where you look at all the office empty buildings and derive now a conclusion that commercial real estate may be in trouble, right? Valuations have been there, have gotten there. I think Kristina raises with her examples of our return to office policies, it brings back the eternal phrase which is “what matters is, are things getting better?”

Brian Levitt

Better, yeah.

Alessio de Longis

Is the rate of change improving no matter how poor the starting level of conditions is? So I'm not concerned about commercial real estate at this stage. I think that adjustment has largely taken place. I think where the balance of risks may still be, as we discussed earlier with learning from our mistakes on inflation over the last 18 months or so, where I look at position still being extended from a secular standpoint after 15 years of a bull market is in long duration US equities, right? There's quality names, there's the dominance of growth styles. I think there is still an overhang of exposures there. And if we are still underestimating what the real drivers are of inflation from both a cyclical and a secular standpoint, and if this tightening cycle were to indeed be higher for longer, I think that's where in my mind the positioning could still see some downside, hence diversification into more value, into smaller capitalizations, into other regions.

I think where there's been concentration risk is in the equity markets, in the public equity markets with a growth bias. And I think diversifying those exposures is probably still where the balance of the risks may pay some dividends and some better sleep at night.

Brian Levitt

So when Jodi and I first came up with the idea for this podcast, we said it should sound like a group of us having a cup of coffee together. And now that we're all going to be back in the office, I hope that we can actually have those cups of coffee together. So can we make that promise here on the Greater Possibilities podcast?

Kristina Hooper

Absolutely.

Jodi Phillips

Sounds like a plan.

Alessio de Longis

That's a promise.

Brian Levitt

Well thank you both so much.

Jodi Phillips

Thank you so much. Appreciate your time.

 

Important Information

You've been listening to Invesco's Greater Possibilities Podcast.

The opinions expressed are those of the speakers, are based on current market conditions as of June 12, 2023, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

Should this contain any forward looking statements, understand they are not guarantees of future results. They involve risks, uncertainties, and assumptions. There can be no assurance that actual results will not differ materially from expectations.

All investing involves risk, including the risk of loss.

An investment cannot be made directly in an index.

Past performance is not a guarantee of future results.

Diversification and asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns and does not assure a profit or protect against loss.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.

Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.

Data on Nikkei 225 Index performance is from Bloomberg, L.P., as of June 9, 2023. The Nikkei 225 Index is a price-weighted average of 225 top-rated Japanese companies listed in the first section of the Tokyo Stock Exchange.

Information on the federal funds rate is from the Federal Reserve comparing June 2022 versus June 2023. The federal funds rate is the rate at which banks lend balances to each other overnight.

Data on bond yields from Bloomberg L.P. as of May 31, 2023. Investment grade bonds represented by the Bloomberg US Corporate Bond Index, which measures the investment grade, fixed-rate, taxable corporate bond market. High yield bonds represented by the Bloomberg US Corporate High Yield Bond Index, which tracks the performance of below-investment-grade, US-dollar-denominated  corporate bonds publicly issued in the US domestic market. .

The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity.

An inverted yield curve is one in which shorter-term bonds have a higher yield than longer-term bonds of the same credit quality.

A basis point is one hundredth of a percentage point.

Tightening is a monetary policy used by central banks to curb inflation.

Quantitative easing is a monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective.

Duration measures a bond's or fixed income portfolio's price sensitivity to interest rate changes.

Data measuring the impact of consumer spending on the economy is from the US Bureau of Economic Analysis

The Federal Reserve’s “dot plot” is a chart that the central bank uses to illustrate its outlook for the path of interest rates.

The Summary of Commentary on Current Economic Conditions is a summary of anecdotal information on current economic conditions gathered by each Federal Reserve Bank.

A multiple is any ratio that uses the share price of a company along with some specific per-share financial metric to measure value. Generally speaking, the higher the multiple, the more expensive the stock.

Credit spread is the difference in yield between bonds of similar maturity but with different credit quality.

The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.

Brian Levitt:

Welcome to Greater Possibilities Podcast from Invesco, where we put concerns into context and opportunities into focus. I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. We're talking about the debt ceiling today. Jen Flitton is here. Yes, I know. Favorite topic, right? So Jen is Invesco's Head of US Government Affairs, and she's going to shed some light on the negotiations happening in DC and let us know where she thinks this is all heading. And since she's here, we'll also ask for her thoughts on the national political mood and how things might be shaping up for 2024. I know you always like to get a sneak peek into that, Brian.

Brian Levitt:

Feels too soon.

Jodi Phillips:

It feels a little too soon. But in any case, are you ready for another debt ceiling crisis?

Brian Levitt:

I'm ready for it. I feel like I may already be living it, although hopefully we're getting some slightly positive news here. Jodi, life is strange when you're constantly refreshing your screen to see how high the one-month US Treasury yield is going. That's where I am in life right now.

Jodi Phillips:

No, I hear you. If you don't know if you'll be paid the income on it, makes sense to keep an eye on it. So, look, with that question Brian, what are you saying to investors who have that same question?

Brian Levitt:

I'm trying to be optimistic. Look, we've done this 86 times since John Kennedy was president. We usually do it without incident, usually a mere formality. And so I think we'll raise the debt ceiling. I keep coming back to that line about what Churchill was said to have said about Americans.

Jodi Phillips:

We always do the right thing, but only after exhausting all other options. I think I've heard you say that in a podcast or 10.

Brian Levitt:

Exactly. I probably need some new material here, but we keep-

Jodi Phillips:

No, stick with the classics.

Brian Levitt:

We keep repeating over and over, so I keep coming back to it. But another favorite of mine is that market volatility doesn't emerge out of nowhere, it's always the result of policy uncertainty. And so that's what we're looking at here, perhaps.

Jodi Phillips:

Well, we are, but it's a little ironic. Just when we get maybe some clarity or close to clarity on monetary policy, now we get uncertainty about fiscal policy.

Brian Levitt:

And hopefully short-lived. And the good news is we do have a historical parallel to consider. If you remember 2011, you had a very short-lived risk-off trade. And I still think it's ironic — Treasuries rallied. Something's going to potentially default, let's buy the thing that's going to potentially default. So Treasuries rallied and ultimately, it created a buying opportunity for investors in the early stages of a new cycle.

Jodi Phillips:

Very good. Well, on that note, let's bring in Jen to help explain what's going on in the here and now. Welcome, Jen.

Brian Levitt:

Hey, Jen.

Jennifer Flitton:

Hi guys.

Brian Levitt:

Hey Jen, why do we still do this when this is happening?

Jennifer Flitton:

Well, it depends if you're a Republican or a Democrat, what your answer would be to that.

Brian Levitt:

Well, I'm not allowed to answer that question. I'm everything to everyone.

Jodi Phillips:

What about both sides? Let's get both sides.

Jennifer Flitton:

You're right. From the Democratic perspective, they would love to push this off. In fact, some say if they had their way, if they were able to get rid of the filibuster or had the reconciliation process back, they would extend debt ceiling forever, get rid of this congressional authorization of debt ceiling raising. From the Republican perspective, we have a $31.4 trillion debt. So we're looking at austerity arguments from the right for a while now, and I think that this will be used consistently as leverage going forward.

Brian Levitt:

Jodi, I had read that if you take 31.4 trillion dollar bills and stack them, you would get to the planet Uranus.

Jodi Phillips:

Well, that's some trivia that you're not going to find on any other podcast. So Jen, let's talk about the calendar a little bit. Personally, I was surprised when Janet Yellen came out and said June 1st was looking like the X date. I thought with incoming tax receipts, the Treasury had extraordinary measures, I was under the impression that they could buy some time until the fall. So what's behind June 1st, and can we still extend that a little bit?

Jennifer Flitton:

Well, yes, and she did give a caveat when she said June 1st is the X date. She did hedge herself a bit stating that it could be a few weeks, a few days from June 1st. So the real magic number would be June 15th, because if they could get to June 15th, the quarterly tax receipts, then you could extend it probably till the end of July. But it's just not clear. She's going to make another announcement next week.

Brian Levitt:

But we were originally saying September, October, November, right?

Jennifer Flitton:

Well, we always said it could be as early as June. Treasury did warn us.

Brian Levitt:

Maybe I was saying September, October, November.

Jodi Phillips:

Maybe that's why I was so surprised, Brian. I know where I got that from.

Brian Levitt:

I just make it up and sound confident.

Jennifer Flitton:

And we saw on the horizon from some of the analysts, whether it was Goldman or JP, I can't remember, but they were saying some of the tax receipts coming in after April were looking like maybe cap gains were a little too low and that that could affect this X date, and it may have.

Brian Levitt:

What is an extraordinary measure?

Jennifer Flitton:

Basically, once the Treasury Secretary gets to a certain point, she has to extend into extraordinary measures. And because we spend a lot more than we bring in, that usually is in the first quarter of the year where we start to acknowledge the fact that tax receipts and payments aren't going to match up.

Brian Levitt:

And so what does that mean? We're not going to invest money in government pension funds? Are there things that we do that let us push this out a little bit?

Jennifer Flitton:

It's a little gimmickry in the way that Treasury accounts for things, without getting too technical, that allows for them to extend their budget.

Brian Levitt:

And so what do the Republicans want? I obviously used the word austerity, and I remember in 2011 when we went to the brink, correct me if I'm wrong, the Obama administration ultimately conceded to $2- to $3 trillion in spending cuts over a decade. Seemed like some pretty large numbers. Are we talking something similar here?

Jennifer Flitton:

Well, where the Republican stand is on the bill that they were able to pass last month, which was April. And now Democrats are coming to the table and coming up with a different negotiating position. That's what we're seeing. But included in that original House bill, I think it was a cap to 2022 spending and it extended only a 1% increase in discretionary spending until 2033. So that's a 10-year move. That's not going to be acceptable to the White House. So reports are they're coming back with a 2023 cap, but only for two years. I think they'll probably land somewhere in the middle, but closer to the White House's position. But you're right, this is very similar to 2011, and that's what brought on the sequester. And that really comes out through the appropriations process. Because it's a promise into appropriations, how they're going to spend the framework.

Jodi Phillips:

Sequester. That word takes me back a little bit.

Brian Levitt:

Remind me of the sequester. What did that mean?

Jennifer Flitton:

It was a little bit of budget gimmickry, because what ended up happening was a promise of decreased spending, and then the constituencies of federal government spending came in around the appropriations process and they were able to kick some of that sequestration down and basically out of actually happening through the appropriations process. So this is the easy part. You're just setting a framework with these budget caps. Actually doing that comes later, during the appropriations process.

Brian Levitt:

I have a really dumb question, Jodi.

Jodi Phillips:

Go for it.

Brian Levitt:

So let a little bit more than 10 years ago, so this was Obama in 2011, they agreed to the spending cuts over a decade, and yet we just saw $6 trillion of spending in 2020 and 2022 for COVID. So most of that's within the 10-year period. So did we accomplish anything the last time we did this?

Jennifer Flitton:

Well some of the sequestration happened, but a lot of it that was difficult to do didn't happen because there were... Especially when it came to some physician payments, and I was on the Hill at the time, I remember just the health care community coming down and being really concerned with some of the cuts and how that would affect patients and hospitals, et cetera. So some of it happened, some of it didn't. I think what you're looking at with the COVID payments, that was outside of the ordinary budget. It was emergency appropriation money. And so a lot of that is still sitting at Treasury. It's sitting in the coffers of the states. But a lot of it's still sitting at Treasury and that's why it's on the table for this negotiation.

Jodi Phillips:

So looking at the math and the makeup of Congress right now, how many Republicans would need to break party line to raise the debt ceiling? What does that look like? How does that shake out for getting this done?

Jennifer Flitton:

So McCarthy needs a majority of the majority. So he needs at least 120 members, somewhere around there, to vote for whatever he negotiates with the White House. So keep in mind, this last meeting that was announced on Wednesday, or was it Tuesday when they met. They decided that it would just be McCarthy and his team. So Garrett Graves, who is McCarthy's right hand man. McCarthy's team and the Biden team. So Steve Richetti, who has been a longtime advisor, and Shalanda Young, who is the OMB Director, the Office of Management and Budget, and she used to be the staff director of appropriations. She's well liked, she's well respected on both sides of the aisle. So now with these brains in at the table and only them... Because before it was too big, there were too many people at the table. They've really narrowed it down. And so they're negotiating right now and McCarthy is socializing it with a few folks and getting his top people, his top members of Congress, together. They had a table session yesterday to get ready to socialize to a larger segment of the conference.

Brian Levitt:

Jen, what I think in some ways Jodi was getting at there is the last time we did this in 2011, the Democrats had just gotten shellacked in the midterms and I purposely use the word shellac. That was Barack Obama's word, that was not my personal word. Now this time, there was an expectation of a red wave that didn't materialize to the extent that some expected it to. So can I have any confidence in the fact that the Democrats had to figure out how to get 50 or 60 Republicans on board for this in 2011, versus today they need to get five or six. Can that make me more hopeful or is that just being too Pollyanna?

Jennifer Flitton:

Well, I think Democrats, you mean in the House?

Brian Levitt:

Yeah.

Jennifer Flitton:

Hakeem Jeffries, who is the minority leader, the leader of the Democratic Party, he's going to have to bring a number of folks to the table, for the voting actually.

Brian Levitt:

So it's going to be hard to get all of his because of the cuts that are being made. So if Biden plays hardball and they can get all of the Dems, are there five Republicans or no?

Jennifer Flitton:

Oh no, you mean in a discharge petition. Because they have a discharge petition that they put out. But you don't have five or six Republicans who are going to undercut…

Brian Levitt:

They're not going to do it.

Jennifer Flitton:

... right now. No, that's not going to happen.

Brian Levitt:

So even though you needed 50 in 2011 and today you need five or six, it still doesn't matter.

Jennifer Flitton:

Yeah, no. It would be like voting for Hakeem Jeffries as speaker. You're just never going to get this vibe.

Brian Levitt:

It's the end of your political career if you do that.

Jennifer Flitton:

What's going to happen is McCarthy and Biden are going to come to some sort of agreement, and then McCarthy has to go back and sell it to his people. His very right are not going to vote for it. But can you shave off a few of them? Can you get a few of those Freedom Caucus members? And to give cover for others who are going to get hit from their right, that it's not enough. And then you have Jeffries who is going to have to make sure that his moderates and his establishment Democrats are voting for it as well, even though the progressives are going to rail against maybe some of the work requirements that might be included in it. And so they have to be concerned about each of their right and left for length.

Brian Levitt:

I'm singing Schoolhouse Rock in my head right now.

Jodi Phillips:

Just a bill.

Brian Levitt:

Just a bill.

Jodi Phillips:

So what about other methods of getting around this? There's a lot of talk about the 14th amendment, the validity of the public debt shall not be questioned. Does that give cover to just forget about the debt ceiling?

Jennifer Flitton:

Yeah, it would be a constitutional crisis. And so you've seen Secretary Treasury Yellen, pretty much outright rejected. Now, I think there are others within the White House who may be a little more open minded to that or to minting a trillion dollar coin or something. But ultimately that would go into the court system, it would be litigated, and it could really be devastating as far as the process.

Jodi Phillips:

Brian, the trillion dollar coin, I know that was your preferred method of fixing this, right?

Brian Levitt:

Yeah, I was very excited about that. We mint a coin and we make it available to ourselves. Oh yeah. Well, it doesn't sound like we're going to be minting that trillion dollar coin. So Jen, we don't mint the coin, unfortunately. What would it look like if we breach it? I know Jodi and I had joked up front about the one-month T-Bill. People don't want to invest there because they don't know if they're going to be generating any income in that particular month. Is it just the thing, if you own it, you're going to get paid back at some point, you just may have lost income? What does it mean to default on this?

Jennifer Flitton:

And what is a technical default and how can Treasury prioritize payments in order to pay the debt first? And I think that's really the larger question.

Brian Levitt:

Can we do that? Shut down a national park and keep paying the debt?

Jennifer Flitton:

I don't think we're going to save too much there, but we could potentially.

Brian Levitt:

Don't pay the prosecutors? What are we doing?

Jennifer Flitton:

Think of infrastructure or military infrastructure where 13% of our budget goes. Defense projects, et cetera.

Brian Levitt:

So it's not rangers at the park.

Jennifer Flitton:

That's not really our money maker. That could happen in some sort of prioritization. So you get the Social Security checks, you get the veterans checks, and you get the debt paid for. And really think about it this way, say June 1st is the true X date. You have two weeks you really need to account for in the prioritization. Now, what would actually happen to the credit rating in the United States if we get past the X date? That's a much larger question. What do the markets do? But technically, we know the New York Fed's been running tabletop exercises on this sort of thing happening for the last decade. So there is a way to buy time, at least it's been suggested in reports, that there is a way to write buy time through prioritization.

Brian Levitt:

And thus far, the markets have been pretty sanguine about this, at least it seems

Jennifer Flitton:

It seems, right?

Brian Levitt:

It seems. We haven't had a big drawdown, little range bound on broader markets, S&P 500 type of thing, but nothing extreme. So the most likely outcome, Jen, you still believe that we get past this without significant incident?

Jennifer Flitton:

I think we either go right up to the X date with some deal, or maybe just go a little bit past it. And I think the framework of the deal is going to be budget caps of some sort. It's going to be COVID funding rescissions, it's going to be energy permitting reform, and some degree of work requirements around TANF, definitely not Medicaid, possibly around food stamps, the SNAP program.

Jodi Phillips:

So Jen, while we have you here, let's talk about legislation. Are there any big topics that investors in particular need to be focused on?

Jennifer Flitton:

Well, again, going back to this legislation, this is probably one of the biggest that we're going to see happen. And then the next big move will have to be appropriations. Then we can get back on this podcast and talk about a potential government shutdown.

Brian Levitt:

Wait, will the national parks be open?

Jennifer Flitton:

Now that actually might close the national parks. But so that you give some runway then to the appropriations process can really begin, because they've had a hard time doing budget resolutions on either side of either chamber because this looming debt ceiling is so large and it's just sucked all the oxygen out of the room and taken a lot of the folks who are needing to draft on appropriations into this negotiation.

Brian Levitt:

So Jen, given that this is the Greater Possibilities Podcast and we give the public, we give the people what they want, we're going to ask about 2024. I'm not even ready to start thinking or talking about 2024, but the people want to know what you're thinking. Are we running it back again? The fans want to know, are we running it back again? Is it Biden v. Trump? Who's going to win?

Jennifer Flitton:

Right now, Biden has said he is running and he's the president of the United States, and Bobby Kennedy Jr. is what? Running at 20%. Although that is rather high in some-

Brian Levitt:

Is he at 20%?

Jennifer Flitton:

He's 19%, 20% on some polls.

Brian Levitt:

Wow. Talk about name recognition, huh?

Jennifer Flitton:

Well look, President Biden obviously has some issues in his favorability, and the fact that Kennedy is running against him, and I think Marianne Williamson threw her hat back in the ring too, although I don't think she's polling. That's going to cause a bit of a headache for the Democrats, because that's a little too high in the polling. And we'll see if that's adjusted as we get closer to the general. But in the primary for Republicans, you have a lot of folks throwing in their ring.

There are going to be a number of people around the Memorial Day period that are going to formalize their run, like Tim Scott's expected to announce, for example, on the 22nd on Monday in Charleston. He just launched his exploratory committee. Some of these guys have just launched exploratory committees and are now going to officially get in the race. But of those currently in the race, you have Nikki Haley and Asa Hutchinson, and DeSantis has not announced yet, but he will. And it's going to be a very wide field. You're going to start to see the debates then around the August, September period for Republicans, and that's really going to feel like the kickoff for the American people who aren't paying attention quite yet.

Brian Levitt:

The big stage with a lot of podiums again.

Jennifer Flitton:

Exactly.

Brian Levitt:

And that probably favors the former president?

Jennifer Flitton:

I think the more Republicans in the primary, the better for former President Trump. How many stay in, I think is the larger question.

Brian Levitt:

And does it feel like a change election, 2024, or too soon to say?

Jennifer Flitton:

Too soon to say. I think we have to allow the process to play out a little bit to see where these numbers start to fall.

Brian Levitt:

And you had made an interesting point about where Hillary Clinton was polling in the 2008 primary before, just to put a finer point on how early it is.

Jennifer Flitton:

That young first-term-

Brian Levitt:

Junior senator.

Jennifer Flitton:

... Democratic junior senator from Illinois, Barack Obama, had the gall to go up against Senator Hillary Clinton. And she was polling much higher than he was. And I think that's why you have to take some of this and step back and realize that we're going to have... Americans really just aren't paying attention yet.

Jodi Phillips:

All right. Well, what I'm getting, the theme of this podcast is let the process run its course, whether it's the debt ceiling or elections. So Brian, are you feeling any better than you were at the top of the show about that process?

Brian Levitt:

Yeah, I feel good. Yes, I'm one of those people who believes in the Churchill line. Ultimately, we will do the right thing, we will get past this, and we'll be back to focusing on what's most important for investors, which is where are we with regards to monetary policy? Is a new cycle starting to play out? And I'm looking forward to getting back to that focus, but I'm thrilled that we were able to have Jen here as we're dealing with these current challenges.

Jodi Phillips:

Yes, thank you for joining us, and hopefully we won't have to have you back to talk about a shutdown, but would love to talk about anything else that's going on. So thank you.

Jennifer Flitton:

Thanks.

Brian Levitt:

Bye Jen. Thank you.

 

Important information

You've been listening to Invesco's Greater Possibilities Podcast.

The opinions expressed are those of the speakers, are based on current market conditions as of May 18, 2023, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. Invesco is not affiliated with any of the companies or individuals mentioned herein.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

Should this contain any forward looking statements, understand they are not guarantees of future results. They involve risks, uncertainties, and assumptions. There can be no assurance that actual results will not differ materially from expectations.

All investing involves risk, including the risk of loss.

Past performance is not a guarantee of future results.

Number of debt ceiling increases from the US Treasury as of December 31, 2022.

Information about Treasuries rallying in 2011 is from Bloomberg. US Treasuries rose 6.7% from July 2011 to September 2011.

All data provided by Invesco unless otherwise noted.

TANF stands for Temporary Assistance for Needy Families.

SNAP stands for Supplemental Nutrition Assistance Program.

The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.

Brian Levitt:

I’m Brian Levitt. Before we launch into our latest conversation about commercial real estate, I wanted to note that this conversation took place shortly before the failure of First Republic Bank as well as before some of the other challenges that have emerged within the regional banking system. So as we talk about the lending landscape, you’re not going to hear their name mentioned. But that’s OK. What’s most important about this conversation are the long-term opportunities that our real estate experts see ahead. And that’s just as true today as it was when we first recorded this in mid-April. Enjoy the podcast.

INTRO MUSIC

Brian Levitt:

Welcome to the Greater Possibilities Podcast, where we put concerns into context and opportunities into focus. I'm your host, Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. Bert Crouch is on the show today. Bert is head of North America and a portfolio manager with Invesco Real Estate. We're getting a lot of questions, Brian, about commercial real estate. So Bert will be addressing those and discussing why he believes some of these concerns may create opportunities.

Brian Levitt:

Ooh, very on par with the branding of the podcast, right?

Jodi Phillips:

I listen. Yeah.

Brian Levitt:

Would you say that we're going to put concerns into context and opportunities into focus?

Jodi Phillips:

I would. I would say that for sure. But hey, before we get to Bert, I do want to add that I did enjoy your conversation last time about Silicon Valley Bank with Justin Livengood. I got to experience that as a listener instead of a host this time. Terrible timing for my kids' spring break to coincide with such big news.

Brian Levitt:

It's funny you said that. I was talking to Bert a few minutes before starting this and he said the exact same thing. It's got to be Murphy's Law for both of you. You finally get away a little bit and we get this little financial crisis that we have to deal with.

Jodi Phillips:

A “little crisis.”

Brian Levitt:

A little crisis.

Jodi Phillips:

Yeah. That sounds like an oxymoron, Brian, like “organized chaos.”

Brian Levitt:

What's your favorite oxymoron? I'm going to go with, maybe I'm going to go with “accurate estimate.”

Jodi Phillips:

I like that one. I mean, look, “jumbo shrimp” is a classic menu-oriented oxymoron.

Brian Levitt:

“Awfully good.”

Jodi Phillips:

Awfully good. I like that one, too.

Brian Levitt:

Awfully good.

Jodi Phillips:

All right. But little crisis is where we're at.

Brian Levitt:

Little crisis. Yeah. I mean, it might sound like an oxymoron, but it's accurate and it could have become a bigger crisis had we not seen policymakers respond quickly. So we learned in fairly short order that depositors will be protected, the Fed opened the discount window widely to any bank that needed emergency liquidity. And I would say it also hasn't hurt that the bond market at least primarily has rallied recently.

Jodi Phillips:

Yeah, not at all. No. It does feel like things have calmed down. And as you were telling me before, the deposit flight from the small banks seems to have ended.

Brian Levitt:

Yeah, it looks like deposits have bottomed, they're climbing again. So that's a good sign. Maybe it's a little bit of confirmation bias on my part, but that feels like a good sign. And I don't know. I mean, probably a lot of that's just from you, Jodi, right? You got your bonus in February and you put it in a small bank, and that's why deposits are up so much?

Jodi Phillips:

“Podcast bonus.” Yeah. Is that one for the oxymoron list? Oh, nevermind. Nevermind.

Brian Levitt:

We need a few million more listeners.

Jodi Phillips:

So look, now everyone is focused on what's next and how does commercial real estate fit in. So we've all seen the headlines. Some say commercial real estate may be the next shoe to drop from this little crisis.

Brian Levitt:

And I don't think we can disentangle the interest rate environment, the challenges at regional banks, the challenges for the economy from the real estate market. Obviously, it's all connected.

Jodi Phillips:

And that's why Bert's here. So let's bring him on to address the current environment and how he's navigating it. Plus we'll ask about the structural themes that he believes are intact and likely to offer opportunities to investors.

Brian Levitt:

Bert, welcome to the show.

Bert Crouch:

Yeah, thanks for having me, guys. Appreciate it. And I've got to go with “cautiously optimistic.”

Brian Levitt:

Ooh, I like that one.

Jodi Phillips:

Ooh, nice, nice.

Bert Crouch:

That's a real estate oxymoron, if you'll work with me there.

Brian Levitt:

And you hear it a lot, right?

Bert Crouch:

All the time.

Brian Levitt:

Cautiously optimistic. Just me, that's like Harry Truman's one-handed economist, right?

Bert Crouch:

Well played. Yes, exactly.

Brian Levitt:

So, first condolences on Spring break. My apologies that you didn't get as much time off as you probably deserved.

Bert Crouch:

It's all good. I think my kids were thrilled.

Brian Levitt:

Your kids were thrilled that you were working and they were-

Bert Crouch:

Correct.

Brian Levitt:

... were enjoying some leisure time?

Bert Crouch:

That's right. That's right.

Brian Levitt:

Good, good. It's hard to open a newspaper, I don't know, do people still open newspapers? Or maybe swipe on the phone now without finding warnings about commercial real estate, which is probably why you were working on spring break. So I'm just going to tick off a couple of these things that I think investors are hearing, and maybe we can take them one by one. So, just a couple of problems I'm hearing: the challenges in the regional banks, this whole work from home phenomenon, retail at a crossroads, higher rates, a wall of maturity on commercial real estate loans.

So let's start with the regional banks. Why was Silicon Valley banks such an issue and why did you have to work on Spring Break as a result of it?

Bert Crouch:

Yeah, it is a good question, and that was a tough intro. I think I need a cocktail for this morning.

Brian Levitt:

There'll be cocktails. There'll be cocktails.

Bert Crouch:

For the morning podcast.

Brian Levitt:

It's coming.

Bert Crouch:

But joking aside, I do get a lot of questions on SVB, Silicon Valley Bank, and why was it so relevant to commercial real estate? When you look at their balance sheet, it was irrelevant. I mean, it was of their total loan books sub 4%, total assets, sub 2%. So why did it matter? And it mattered for a couple of reasons. I think most importantly, liquidity was already at a premium in commercial real estate. When you think about just year over year, it's Tale of Two Cities, and you touched on a lot of the aspects out of the gate. But I mean, a year ago, Fed funds was essentially zero.

Brian Levitt:

Zero, yeah.

Bert Crouch:

SOFR, Secured Overnight Funding Rate was essentially zero. So you could borrow in commercial real estate at 2%. You had capital markets were humming, Commercial Mortgage Backed Securities, CMBS, CLOs, Collateralized Loan Obligations wide open.

So you had capital flowing excess M2 coming off the stimulus out of COVID, and the regional banks were playing a huge role in that. So when you think about banks, generally, I like to break it up a little bit simpler because we debate regional and super-regional, money center, bulge bracket. Think about it this way, just on assets, zero to $10 billion, small. $10 billion to $250 billion, the mid-size. And then $250 billion up, whatever you want to call it, bulge bracket. And then you've got the G-SIBs, the Systemically Important Banks at the top tier.

When you think about the regional, let's call it the mid-size, so $10 billion to $250 billion. Why SVB mattered is because Signature failed right after. And Signature failed on a Sunday and Signature was very much overweight commercial real estate, especially here in the New York City metro area. And it created a couple of things. It changed the mindset of bankers generally, which was one of the last bastions of liquidity. If you look at CMBS already being down really to a two-decade low in the first quarter.

Brian Levitt:

And that's because of the interest rate move?

Bert Crouch:

Interest rate move, but also just broader capital markets dislocation. I mean it's down over 80%. Basically nothing got securitized. And we can hit on that again later to the extent of interest. But going back to the regional banks, last year, so 2022, they were over 40% of market share. They've grown — their total loan book has grown over the last decade from just under 20% to just under 30%. They did, I think it was $1.3 trillion of origination last year. So they have been loading up on commercial real estate because they've had excess deposits and the excess deposits, excess liquidity coming out of the Fed stimulus, M2's gone through the roof, where to house it? Back to SVB. Why is that relevant? Social media and technology. We saw a bank run in 24 hours. $42 billion on Thursday, a hundred billion teed up for Friday, and then Signature is failing on a Sunday?

Brian Levitt:

And nobody even had to line up.

Bert Crouch:

No one. I mean, it happened so quickly. It has forced "bankers", their credit teams, to reassess how sticky really are deposits. And you mentioned, they've stabilized a little bit, but some headlines this morning, whether it was M&T or State Street, I mean just everyone is focused on deposits and are they sticky? The better question is, will you now lend them out at the same velocity that you would before if they can be pulled back so quickly?

Now go to your interest rate comment. What was SVB's issue? They had hold-to-maturity assets in fixed income, and when they had to liquidate those to stem the deposit withdrawal, you realize they weren't worth what they showed. Why? Because of simple convexity, right? It's Finance 101.

Brian Levitt:

Convexity?

Bert Crouch:

Right? This is me-

Brian Levitt:

That's like Finance 401, isn't it?

Bert Crouch:

This is me trying to act intelligent. I'm just a dumb real estate guy at the end of the day, you and I both know it. Let's just be honest. But when you look at that, it exposed it. So it changed, it furthered... If you think about inflation and what happened in the wildly unfortunate situation with Ukraine, it really just exaggerated a trend that was already moving forward. And I'd argue somewhat similarly here, an exogenous circumstance like SVB and then ultimately Signature took a dislocation just to the next level.

Brian Levitt:

So Jodi, are we going to need a “It's a Wonderful Life” for the new digital environment that we went through? I could already start casting it in my mind.

Jodi Phillips:

Well, while you do that, I'm going to ask Bert, as we mentioned in the intro, of course, some say commercial real estate's the next shoe to drop from all of this banking turmoil and banking crisis. So how would you respond to that statement?

Bert Crouch:

Yeah, again, Brian kind of hit on it out of the gate. A lot of sensationalist headlines right now we've got to be careful about. So the next shoe to drop, euphemisms aside, I mean there's clearly some headwinds there. You read about the wall of maturities, $900 billion maturing over the next two years. Good news is relative to the global financial crisis, leverage is lower. It was more prudently done. So if you look at the fixed rate universe and CMBS, Commercial Mortgage Backed Securities, loan-to-values — global financial crisis started in the mid to high sixties. Now they're sub 60, at least going in. Debt service coverage ratios were higher. Now, base rates were lower, and that's changing now, but your starting point is better. Leverage was less utilized, it was more prudent, and CMBS is a smaller part of it. So I think that's the positive news.

The negative news is all the things, again, Brian, you just touched on, and Jodi you as well, you got SOFR at almost 5%. You got spreads up. So if you financed an apartment asset a year ago that was going to be done at low two percents, that's now somewhere high sixes to maybe as high as 8%. So you've seen that fly up. And what does that mean? Even for good assets, there could be challenges on the refinance front. Does that mean widespread distress post Lehman? I'd argue no. But does it mean that we're facing some real headwinds from a, if you go back to the comments we were just making, regional banks are going to want to decrease exposure to commercial real estate.

The regulators are all over them. You read about it over the last week and a half, Dodd-Frank rollbacks, they want to refocus on the sub $250 billion asset banks. Uncertainty around is there a recession coming or not? I don't know. But a chief credit officer is worried about that. They're pulling back, CMBS nonexistent, rates up. It just creates a tricky picture that candidly, Jodi, we feel like is going to create some real opportunity.

Brian Levitt:

Bert, let's take a giant step back for a second and talk about the mechanics of this. So the regional banks are lending money over a set period of time at a certain interest rate to who? And what's coming due for them and at what rate versus where they were not so long ago?

Bert Crouch:

Yeah, good question. So when you think about regional banks, usually they're floating rate. So your life insurance and commercial mortgage-backed securities are going to be your five- to 10-year fixed rate.  Your regional, and really all banks mid-size, large to small are going to be usually three-year initial term, two-year, one-year extension options, all floating rate. Why that matters is most of them required you to buy some sort of interest rate hedge. Layperson's terms, what does that mean? It means the interest rate could only go up so high before your hedge kicked into place. In large part, that's the case now. Think about what the Fed's done. They've taken rates up almost 500 basis points in around 12 months. That is twice the average on a monthly basis. So the last nine rate hike cycles, it's been sub 20 basis points a month. This is 40. People have to put that in context. It's not just the absolute amount, it's the time in which they've done it.

Punchline for real estate and your question, when those hedges expire, suddenly they're exposed to significantly higher debt service costs. And that creates that decision point. Do I continue to feed this asset? What does it look like on a refinance? How much capital do I have to inject to right size that loan? And that's going to create that stress in the system. And again, as I just alluded to Jodi, we think some real opportunity here.

Jodi Phillips:

All right, Brian, so do we pivot to the putting opportunities into focus section of the podcast?

Brian Levitt:

Yeah, I mean, why do we want to focus on the negative for so long? I mean we've laid it out. Bert understands it. He's got his hand on the tiller of this portfolio, and let's think about how we take advantage-

Jodi Phillips:

All right. Yes.

Brian Levitt:

... of all this negative sentiment in the asset class.

Jodi Phillips:

All right, let's go then. So, Bert, are there any dislocations emerging that you're viewing as opportunities at the moment?

Bert Crouch:

Yeah, of course. So, in the old Winston Churchill, “you never want to waste a good crisis.” And that's kind of how we're viewing this. You don't want to exploit the market. You want to take advantage of it. And so our job as a global real estate investment manager, people ask us all about what differentiates Invesco Real Estate and how does that translate to opportunity today? 21 offices, 16 countries, truly global. We play across a risk-return spectrum: core equity to high-returning equity, and then across the capital structure, equity to credit, and then also listed real assets to private. And so today you've got to play all aspects of that, and that's the key.

So you asked me about the banks earlier? I referenced the wall of maturities that you read a lot about, banks, specifically $550 billion over the next two years-ish. There's going to need to be gap financing that's going to need to be injected there.

So we've been pivoting a lot of our strategies where historically we'd say, why wouldn't we buy that asset? Today, the question is why wouldn't we lend on it? It's just a better inherent opportunity. So if you're a seller and you don't like today's pricing, so the cap rate on an industrial asset, well leased, you like, has gone up a hundred plus basis points. So values down 15% to 20%. You say, "I'm not a seller, but I've got to pay down my loan to extend or refinance." We're a great preferred equity investor there.

And you answer the question that everybody wants to ask, where are values today? You say, "I don't care because I've got a significant cushion to the last dollar value here and my return is more current than upside." The other way to play that is just be a lender. That's what we've done. We've originated over $4 billion annually the last two years, just filling the void, whether it's CMBS or now going to be the regional banks.

So what we're really leaning into today in the private side is some aspect of credit. We expect there to be consolidation in the banking industry. You're already starting to see that on the regional banks. We expect to see more of it, and/or they're going to start to move some of these scratch-and-dent legacy portfolios to take — if the regional bank has, whatever, 20% to 30% of their asset base, and they probably want to take that down, whether it's five points or cut it in half, they're going to want to move some of the best product. We can be a great buyer of that on a moderately levered basis. So you can kind of play the credit dislocation three or four different ways.

Brian Levitt:

Now, are there parts of the market that you're looking to avoid versus parts of the market that you're diving into when you hear about things like work from home, or retail at a crossroads, or demographics, people are going to need different types of living facilities. Are you leaning into and out of some of those different structural stories that are taking place?

Bert Crouch:

Yeah, absolutely. So when you think about commercial real estate at UC, it was kind of the big four. Think about the old accounting. It was office, industrial, multi and retail, and now it's not. We've redefined our index to really have nine different sectors.

Brian Levitt:

Nine? Nine times.

Bert Crouch:

So, if you think about it-

Nine times, I'd say it's a great... Oh, we named our dog. We got a dog in the middle of Covid, named him Ferris.

Brian Levitt:

Love it.

Bert Crouch:

But back on point. So when we think about the different sectors, instead of looking at it as apartments, we call it residential. Single family rental is an area that we're leaning into hard. If you think about today, affordability prices are still high, but mortgage rates are an all-time high. We've seen new supply pull back and the regional mom and pop investor that needed that accretive leverage to invest is gone. So competition, down; market opportunity, better; and pricing more attractive. So we're seeing some entry points like that where we're leaning in more.

I'd say there's also an inelastic story, so take medical office, some of your questions. Life science, the 75 and over demographic is expected to increase almost 50% in the next 10 years. That's huge. We want to take advantage of that. That demand driver, again, whether it's life science on the R&D (research and development) side, or whether it's MOB (medical office buildings) around a hospital, that has been shockingly resilient, very attractive, and very financeable. Flip it on the other side, to answer your question. Retail is misunderstood. Neighborhood and community retail today, vacancy is sub 7%.

Brian Levitt:

It is?

Bert Crouch:

Yeah. It's better than it was pre-COVID.

Brian Levitt:

Is that right?

Bert Crouch:

Yeah. Why? Because new supply didn't hit. It's been pulled back. Footprints have been right-sized. Now there's still some struggles in power centers at times, but on the whole, it's better than it was. Regional malls, a little bit of a different story. But if you look at, just take apartments and regional malls in the public universe, multi-family's down, call it 30% just because it got so highly valued where regional malls had already gotten hammered. So it's only down 9% year over year. So there's been some anomalies there. Office is the tough one.

Brian Levitt:

Before we get to office, I want to talk a little bit about the retail. You've seen sort of a changing face of it, where it's more experiences rather than necessarily going to buy a shirt that you could just get on the internet. I mean, I'm seeing it's a Starbucks, it's a Pliable, it's a Dave and Busters, it's these types of places, right?

Bert Crouch:

Yeah. Look, it's the omnichannel experience. You know, want to have enough in the store to attract. I mean, in the experiential mindset, you got to get people open air, foot traffic where they can do more than just shop. And that's what people want to do. Whether it's safety, whether it's fun, whether it's actually shopping, usually it's a combination of those things. It's gotten much more creative. But at the end of the day, those that are most successful have the online presence, but have the brick and mortar presence.

Brian Levitt:

Jodi, you got one of those strip malls by your house that you dropped the kids off and you don't see them for hours?

Jodi Phillips:

Yeah, no, I was about to say I have two teenage boys. And somehow they manage to spend so much money at the mall and never come home with a shopping bag. What did you do with that money, right? They're eating, they're playing. It's a virtual reality center and shooting zombies. They don't bring home anything.

Brian Levitt:

And those pretzels are usually pretty good.

Jodi Phillips:

They're not bad.

Brian Levitt:

Yeah, those pretzels with the cheese sauce? That's really good.

Jodi Phillips:

Good stuff. Well worth the money.

Brian Levitt:

I want to hear about the work from home. I mean, I'm enjoying the flexibility, but I want to know, two of us are sitting here in the office. Actually our whole multimedia team is here as well. And Jodi, you're home today. So how's that working? Are you productive? Are you making it work through the phone?

Jodi Phillips:

You can hear me. I can hear you.

Brian Levitt:

Oh yeah.

Jodi Phillips:

We're making a podcast, it's seamless.

Brian Levitt:

Yeah. So where are we going with this, Bert?

Bert Crouch:

Everyone starts with the Kastle data. So Kastle with a K, does card swipes. We come in and out of the office and they have a very statistically significant sample set of who's returning to the office and when. Two or three trends I'd highlight, one, we've all been kind of waiting for some sort of normalization. We're starting to see it. Nationwide, we're around 50% that are actually coming into the office and it's stabilizing like that, which is well below pre-pandemic. And we're seeing that, Brian, very coastally focused, meaning it's very different. San Jose, California, generally in the mid-thirties, Texas up to mid-sixties, New York, somewhere in between. But very challenged.

Now, it always takes a good recession, a good scare, market dislocation volatility, and people want to come back to the office. Not to mention a lot of our younger cohort on the investment professional fund have not seen a downturn in their careers. So we're feeling that's driving people back. We saw Jamie Dimon put out MDs (managing directors) have to be in five days a week to show certainty, to tutor, to mentor their younger people. So we are seeing a positive trend there. But where they're going - very bifurcated. If you look at office space built between 2017 and 2020, that's 200,000 square feet or more, so large institutional space, that's new. New means it's well-amenitized, it's got great light, it's got everything -

Brian Levitt:

Ping pong tables?

Bert Crouch:

Ping pong tables, got your beer tap. Nothing that any Invesco offices have anyway.

Brian Levitt:

Maybe a coffee, a coffee cold brew. Not the cold brew you may want.

Bert Crouch:

Yeah, we got one of those new flavored water dispensers.

Brian Levitt:

I like that.

Bert Crouch:

That's the new, right, folks?

Brian Levitt:

Right. You save the bottles.

Bert Crouch:

But the punchline there is occupancy is way up or said the inverse, may be vacancy is sub 10%. If you go to that 2016 older cohort, it's over 20%. So that obsolescence is a huge debate. And right now capital flows, whether it's equity or credit, it's just not there. So it's really pushed values down. If you look at the public REIT (real estate investment trust) space down over 50%, trading at an almost 60% discount to the net asset value, historically high cap rates approaching 10%. So you look at the fundamentals, very “Tale of Two Cities.” And from a valuation standpoint, at least what the public market's telling you, pretty tough.

Brian Levitt:

Are you trying to avoid that part of the market?

Bert Crouch:

You know, you are. With the outlook there, you just want to be careful. Now again, we have office holdings that we fundamentally believe in. You just have to position yourself to get through this. And I go back to your question on retail. Retail went through a similar period. You had winners and losers. We very much believe the same to be true here. But in this broader capital markets environment, what you truly believe in, you need to hold and live to fight another day.

Brian Levitt:

Okay, so we talked about experiential retail, we talked about life science, we talked about being very specific with regards to office space. We talked about tech centers, apartment rentals. What else? Anything else that we missed that gets you excited?

Bert Crouch:

Well, industrial.

Brian Levitt:

Industrial?

Bert Crouch:

Yeah, industrial. Yeah, a hundred percent. The e-commerce trend continues. The biggest change over the last 6, 9, 12 months is Amazon. Amazon drove the market and they've really pulled back. Pulled back on capital investment, pulled back on new leasing, net absorption. So that's something that needless to say, everyone in the market is very aware of. That said, demand continues to be strong. Now the second derivative, it's tailing off the rental demand, the net absorption is starting to slow, which you would expect to see. But overall, the sector's one that we believe in long term.

Brian Levitt:

Second derivative and convexity in the same podcast.

Jodi Phillips:

Yes. Yeah.

Bert Crouch:

Hey, I named my dog Ferris man, come on. I'm just trying to provide some balance here.

Jodi Phillips:

Balance. You balance it out.

Brian Levitt:

You remember that book?

Bert Crouch:

Yeah, “You Can't Fix Stupid.”

Brian Levitt:

You remember that book? Clearly not fixing stupid here. You remember that book, “All I Needed To Know in Life, I Learned In Kindergarten?” I think we're going to change it to All I Needed To Know in Life, I Learned in Calculus Class. Now the second derivative, the change in the rate of change.

Bert Crouch:

I have no idea what that means.

Brian Levitt:

Amazon, why is Amazon pulling back? Is that just, they overbuilt?

Bert Crouch:

Yeah, I mean they were the largest and when they say built, majority of that was done third-party. So someone built it for them and then they leased it. But yes, extremely aggressive over the last three years as they should have been coming out of COVID. And a lot of COVID stories, they pulled demand forward five years. So what they would've done in a five, maybe even a 10-year period, they did in a three-year period. So I look at it, they're just being smart, hitting the pause button a little bit, reassessing the efficiencies where they want to focus their capital allocation. And I would expect them to expand again at some point in the near future.

Brian Levitt:

I wish they would stop sending one box at a time. Can we just group these things together and be a little bit more efficient, A little bit greener?

Bert Crouch:

My 15-year-old daughter would beg to differ with that statement.

Brian Levitt:

Yeah, I'm sure she would. I'm sure she would. So Jodi, now do you want to ask your famous question?

Jodi Phillips:

Yeah. Well I don't know how famous it is, but I think it's important. What did we miss, Bert? What should we have asked you that we didn't?

Bert Crouch:

I think we covered the bases fairly well. The environment right now is challenging in a good way. The dislocation, it breeds opportunity here. We're really leaning in, as I said to start, and I'll say again to finish. From a private credit standpoint, just seeing a lot of opportunity in the three areas that I touched on, whether that's non-bank origination, gap financing or what we're expecting to see in some secondary scratch and dent, maybe even some distress in the second half of the year. But if you can be convicted today and reallocate dollars, it's something that we think from a current income and portfolio fit, too.

Jodi, correlations have really gotten uncorrelated, meaning, and I'm kind of saying that in a double negative, stocks, bonds, gold, crypto, it's moving very similarly in a correlation that has defied historical norms. And one of the things that we've really liked as we talked to clients about portfolio fit, efficient frontier, how does private credit, how does real estate credit fit into that? Whether it's Sharpe ratio, looking at risk relative to return, whether it's correlation, how does it play into my real estate equity? How does it play into my stock positions? Historically, it's fared incredibly well as a complement to a broader portfolio. So maybe that's a good tag along. It's not just the opportunity set, it's not just the total return. It's not just the relative return, but it's also portfolio fit.

Brian Levitt:

So Jodi, we've got jumbo shrimp, we got challenging in a good way. We got correlated in an uncorrelated way.

Bert Crouch:

I'm just trying to stay on theme, on point.

Jodi Phillips:

We've got jumbo shrimp to convexity. I don't know how we covered so much ground in this short amount of time.

Brian Levitt:

My new favorite one is correlated in an uncorrelated way.

Bert Crouch:

We are fishtailing beautifully. I love it.

Brian Levitt:

I love it. Bert, thank you so much, very informative. Great having you on the show, we'd love to have you back again soon.

Bert Crouch:

Appreciate the invite guys.

Brian Levitt:

Absolutely.

Bert Crouch:

Thanks so much.

 

Important information

You've been listening to Invesco's Greater Possibilities Podcast.

The opinions expressed are those of the speakers, are based on current market conditions as of April 18, 2023, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. Invesco is not affiliated with any of the companies or individuals mentioned herein.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

Should this contain any forward looking statements, understand they are not guarantees of future results. They involve risks, uncertainties, and assumptions. There can be no assurance that actual results will not differ materially from expectations.

All investing involves risk, including the risk of loss.

Past performance is not a guarantee of future results.

An investment cannot be made directly in an index.

Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.

Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

Mortgage- and asset-backed securities are subject to prepayment or call risk, which is the risk that the borrower’s payments may be received earlier or later than expected due to changes in prepayment rates on underlying loans. Securities may be prepaid at a price less than the original purchase value.

Leverage created from borrowing or certain types of transactions or instruments may impair liquidity, cause positions to be liquidated at an unfavorable time, lose more than the amount invested, or increase volatility.

Information on the size of commercial real estate on the loan books of Silicon Valley bank is from the Federal Deposit Insurance Corporation as of February 28, 2023.

Information on the level of the federal funds rate and the amount of rate hikes from the US Federal Reserve as of March 31, 2023. The federal funds rate is the rate at which banks lend balances to each other overnight.

Information on the level of the Secured Overnight Funding Rate from Bloomberg as of March 31, 2023. The Secured Overnight Financing Rate is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.

Information on the market share, total loan book size, and level of origination of regional banks from the US Federal Reserve as of March 31, 2023. Based on regional bank commercial real estate assets compared to the total amount of commercial real estate assets on all US banks.

Information on the size of the bank run in March from the US Federal Reserve as of March 31, 2023. Based on the daily change in small domestic chartered commercial bank deposits.

Information on the size of the wall of maturities from Bloomberg and Morgan Stanley as of March 31, 2023.

Information on the loan to values of Commercial Mortgage-Backed Securities from Bloomberg as of March 31, 2023, based on the Bloomberg US Aggregate CMBS Index, which is a benchmark of the US CMBS market.

Information on the size and scope of Invesco Real Estate is from Invesco as of April 18, 2023.

Information on US industrial cap rates and property values is from Green Street as of March 9, 2023, the most recent data available for metro-level data.

Information about the growth of the 75-and-over demographic from the US Census Bureau as of December 31, 2022.

Information on vacancy rates in neighborhood and community retail from the Association for Neighborhood & Housing Development, as of March 31, 2023.

According to Green Street’s Commercial Property Price Index, apartment prices declined by 21% year-over-year ending March 2023, whereas mall prices declined by 15% for the same period.

Office card swipe data from Kastle Systems as of February 28, 2023

According to Green Street on April 14, 2023, public office REITs on average were trading at 50.2% of net asset value, with some individual office REITs discounted in even deeper negative territory. Cap rates implied from office REIT valuations averaged 9.8% on that date.

M2 is a measure of the money supply that includes cash and checking deposits as well as savings deposits, money market securities, mutual funds and other time deposits.

A systemically important bank is a financial institution that US federal regulators say would pose a serious risk to the economy if it collapsed.

Convexity is a measure of the curvature in the relationship between bond prices and interest rates.

The loan-to-value ratio is used by lenders to compare the amount of a loan to the value of the asset purchased.

The debt-service coverage ratio measures a firm's available cash flow to pay current debt obligations.

The efficient frontier is a set of investment portfolios that are expected to provide the highest returns at a given level of risk.

The Sharpe ratio is a measure of risk-adjusted performance

Correlation is the degree to which two investments have historically moved in relation to each other.

A basis point is one hundredth of a percentage point.

Cap rate is the rate of return on a property based on the income that it is expected to generate.

The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.

Brian Levitt:

Welcome to the Greater Possibilities Podcast, where we put concerns into context and opportunities into focus. I'm your host, Brian Levitt. Jodi Phillips is off this week. I think today we will be leaning into that line about putting concerns into context.

Justin Livengood is coming up. He will be helping us put recent concerns into context. Justin is the Senior Portfolio Manager of the Invesco Midcap Growth Strategy and a Senior Research Analyst in Healthcare, Financials, and Real Estate sector on the Invesco Discovery Growth Strategies.

So real quick, anyone who has not been paying attention over the last couple of days, we did have the second-largest bank failure in US history — that would be Silicon Valley Bank. And I know that sounds particularly disconcerting to a number of people. Now this was a bank that was heavily focused on banking for tech startups. And those tech startups had their deposits at the bank, but they were largely funded by venture capitalists. And when that money dries up and the tech startups need access to their deposits, money starts to leave the bank.

Over 90% of those deposits for some reason or another — which Justin may help us understand — were not insured. And the banks were sitting on what seemed to be high quality assets, but many of those high quality assets were US treasuries or mortgage-backed securities, which had become worth less as interest rates had gone up.

Selling those assets to meet deposits would've resulted in sizable losses for the banks and ended up in a bank failure and concerns that would then lead to crisis throughout the regional or smaller bank parts industries as concerns that deposits would then move and more banks would fall under similar pressure. So, of course, we got a policy response by the Fed, the FDIC, and the treasury.

The bank did fail. It's not a bailout. Don't listen to what you hear on Twitter. The bank did fail. The depositors were protected, and regional banks get access to a line of credit from the Fed.

So that's the backstory. Let's bring in Justin. Justin, thank you for joining.

Justin Livengood:

Thanks for having me.

Brian Levitt:

You and I have known each other for a long time. Have we done this enough? I mean, are we through cycling through crises or is this just the rest of our career?

Justin Livengood:

I can't believe if I think back a week ago that I'd be sitting here today talking about the failure of actually two banks, not just Silicon Valley, but Signature was a $100 billion bank that went under on Sunday night.

Brian Levitt:

And Silvergate…the crypto one.

Justin Livengood:

And before that Silvergate…exactly! So this is definitely more of a shock than perhaps even some of the crises we've dealt with in the past.

Brian Levitt:

And Justin is such a good resource for me and somebody I always talk to when things like this happen. And we have just been through way too many of these. I mean from having conversations about a Global Financial Crisis and a pandemic and on and on, it gets a little tiresome. But here we are again.

Let's start from where we were before all of this happened. You always hear that when the Federal Reserve tightens interest rates significantly, something ends up breaking. Had you been concerned that something could break? And were you particularly concerned about anything in the banking sector?

Justin Livengood:

I wasn't concerned about a break, at least in this degree. And the reason is the credit picture in the banking industry was, and still is, quite clean. The bank CEOs were actually pretty surprised, and I'm talking about large and small banks, that they haven't been seeing more non-performing assets and loans starting to slip past due, which you might expect at this point of an economic cycle. That's typically where a bank crisis starts — on the credit side. And that's what happened in 2007-2008 etc. That wasn't happening here. In fact, Silicon Valley Bank was not on, nor Signature, any watch lists of any regulators.

Brian Levitt:

Yeah, some of the analysts had them as outperform.

Justin Livengood:

Oh, absolutely. Now what I was concerned about, particularly as a growth investor, the banking industry was struggling with the yield curve and the downward slope of the yield curve, which was pressuring net interest margins and their ability to grow profitably their loan book and their earnings. And so, through the back half of last year, and certainly here at the start of 2023, earnings estimates for the group have been coming down. The stocks had not been performing well and valuations had been compressing, but it was again entirely related to yield curve dynamics and just the bank's inability to grow more. It had nothing to do with credit, had nothing to do with people expecting some sort of an exogenous shock like this to suddenly put a run on the banks in front of everyone. So while the group was struggling, this was not on people's radars.

Brian Levitt:

Can I hear you say again that it's not 2008?

Justin Livengood:

Yeah, it's not 2008. This is not a systemic credit issue where there are going to be other problems on the left side of banks’ balance sheets, this is all on the right side. This is all funding, liquidity, deposits, and confidence. This is not, oh boy, everybody's sitting on a bunch of bad bonds. As you said a moment ago, the Silicon Valley balance sheet, the securities portfolio, was a bunch of treasuries and AA-rated mortgage-backed securities…Fannie, Freddie stuff.

Brian Levitt:

These are not subprime loans that are packaged up and put on the balance sheet.

Justin Livengood:

And what happened, and we don't need to dwell on this too long because I think it's increasingly well known, but Silicon Valley grew…they doubled their deposits in 2020-2021 over that two-year period by a magnitude of almost a $100 billion dollars. And they just couldn't lend that deposit inflow out quick enough, which is understandable. And so, when banks find themselves in that situation, they put that deposit overflow into securities.

The mistake, in hindsight, that Silicon Valley made was they went out the curve as they were investing those excess deposits in 2020 and 2021 by buying things with 4, 5, 6-year duration — but again, they were high quality instruments. And when the Fed started to tighten, they were slow to either adjust the duration of that portfolio by hedges or however you want to risk manage it. And so they ended up with a pretty big unrealized loss in that portfolio.

They opted last week to try to sell some of those securities in a transaction that, in isolation, kind of made sense in terms of taking a loss, backfilling it with some capital, they had already kind of booked the loss on their balance sheet. So from again, blinders on sort of perspective, what they were trying to do here in the last couple weeks wasn't nuts. The problem was it was misinterpreted by their deposit base. And this gets to where now you really had the crux of this crisis.

That deposit base of Silicon Valley was way too concentrated. Because it wasn't just that they had all these small tech and healthcare companies that were their depositors, it was really that they had a hundred key relationships with the venture capital and private equity firms that owned all these companies. And when a couple of those VC and PE firms last week sensed, or got wind, that there might be something wrong at Silicon Valley, they sent an email to their entire portfolio of 50 companies, I'm making that up, and said, ‘Hey everybody, get out, get out.’

And that is a very small clubby world. And as soon as a couple of them did it, everybody did it. And the stat that now is becoming, I think, well known but is worth repeating, on Thursday in a six hour span, $42 billion of deposits were withdrawn or attempted to be withdrawn from Silicon Valley Bank because of this stampede created by a very small number of depositors of VCs. Compare that to 2008 when Washington Mutual went under and had to be taken over the Fed and JP Morgan in the two weeks leading up to their collapse, they had $17 billion of cumulative outflow. So two weeks to take out $17 billion at WAMU versus six hours.

Brian Levitt:

Everything's so much faster these days.

Justin Livengood:

So much faster.

Brian Levitt:

You put something out on Twitter, get out and…

Justin Livengood:

Exactly. So, Silicon Valley was essentially done on Thursday night, which is why Friday morning California time, the regulators had to take the bank over. They couldn't even wait until the weekend.

Brian Levitt:

Help me understand this number…something like 93% or 97% — depending on where you read it — of the deposits were not insured. Was that a mistake of the CFOs at these tech startup companies? Do these tech startup companies have CFOs?

Justin Livengood:

They should, most do. It's a fair question. I think part of the problem is Silicon Valley Bank was around for 35 years. They have long-standing relationships and well-earned good relationships with all these constituents in this ecosystem — the venture capital firms, the management teams of these companies, they'd earned their trust.

90% of the innovation economy out there was in some way banking with Silicon Valley. It's just what you did. And so that mentality exacerbated this and created, I think, a higher amount of uninsured deposits than you might see in sort of a normally diversified set of clients. And for over three decades that wasn't a problem. So again, it's amazing that when all of a sudden there was someone yelling ‘Smoke’… the proverbial smoke in a dark movie theater…it caused, otherwise you would think sophisticated financial people, VCs, private equity folks to panic, and no one hesitated to just pull everything.

Brian Levitt:

And Silicon Valley on HBO was one of my favorite shows, and I remember…

Justin Livengood:

Great show.

Brian Levitt:

Right? Richard had a deal with so many different issues. I don't think he ever actually had a deal with his deposits being uninsured.

Justin Livengood:

That's true.

Brian Levitt:

Is this typical of other banks, the deposit issue?

Justin Livengood:

Being uninsured?

Brian Levitt:

Yeah.

Justin Livengood:

I mean it's typical in that certainly for commercial banks, yes, the majority of their clients are keeping more than $250,000 with them in various deposit accounts. Again, I think what might have been atypical here is these clients weren't diverse. They didn't have six operating accounts. Because if I'm a CFO of a startup tech company, I've got a lot more to do than worry about properly diversifying my cash when I'm just burning it anyways trying to come up with the next product we're working on.

So they weren't spending their time, as other companies might or sophisticated or larger companies, building out a whole portfolio of relationships and properly moving accounts. Silicon Valley can do most of the things that these startups needed, and so they were all comfortable working with them as their primary if not exclusive bank.

Brian Levitt:

So speaking of being comfortable, was the policy response enough? Are you comfortable with what the Fed, the FDIC, and the Treasury have done?

Justin Livengood:

I think so, and it's still evolving as we talk on Tuesday morning here, but I'm glad that yesterday, Monday, went relatively well in terms of no additional failures. I do think that the regulators over the weekend had to insure all the deposits or provide a discount window and a backstop for the uninsured deposits, as much as that created a now well-discussed moral hazard that we can in a moment chat about.

But I do think it was necessary and I think it will get us through the shock part of this crisis. I think people will, over the next few weeks. finish moving deposits around to get comfortable that they aren't going to be vulnerable to a situation like this with everyone's legacy banking relationships. And so I think we've weathered the worst of that storm.

Now there are definitely some additional issues that need to be dealt with in the industry, and I'm sure going to talk about those. But I do think upfront this was a relatively effective coordinated response and I'm glad the regulators sort of pushed back on the political rhetoric over the weekend that suggested maybe we let Silicon Valley fail. I think that would've been, especially with Signature right behind it, if you would let both these banks fail, that's $300 billion of failed assets…commercial assets…with a lot of important corporate and commercial relationships, that would've been a tough blow.

Brian Levitt:

Now you and I are both sitting here in downtown New York City. I did walk by Zuccotti Park this morning. I did not see people occupying Wall Street…at least not just yet. This idea of a bailout or this idea of taxpayer money being spent on this, is that largely a misnomer? Is the FDIC overfunded so that they can provide support on the deposits?

Justin Livengood:

Well, they're properly funded…I don't know if they're overfunded after this, but what they have said is they are going to assess all the other FDIC banks a fee — an assessment fee to essentially pay for this retroactively. So, at some point in the next few months, every bank CEO in America I guess, is going to get a bill in the mail that says, ‘Hey, you owe X to pay for Silicon Valley and Signature’s mistakes.’

And they're not going to have to pay the full amount because again the FDIC does have a decent amount in the trust fund right now and they're selling down assets. I mean they're actually going back to what we talked about a minute ago…there's a lot of good collateral at both banks, but particularly at Silicon Valley Bank, that the regulators can now sell and use.

Brian Levitt:

Sell the assets, right?

Justin Livengood:

…to help manage this so this isn't going to end up being a $100 billion hit to the industry. But to the extent there is a little additional needed to kind of true up the trust fund after that, they're going to charge the member banks. And that's just going to be one of many incremental new things the banks that survive this are going to have to be grappling with.

Brian Levitt:

It feels like a small price to pay to avoid a run on the banks. So let's talk about the issues that the banks are now facing as an investor and somebody who works in the financial sector. Are you optimistic about the banks or you still have concerns?

Justin Livengood:

So, I still have concerns and I can discuss a few different issues here. The first is you still have an inverted yield curve, albeit less inverted than a week ago, but still an inverted yield curve and a lot of pressure on just their core fundamentals — putting aside all the liquidity stuff that just happened. Now the next issue is every bank CEO in America right now has no idea what his or her deposit base is going to look like tonight or tomorrow night…things are still moving around. It will be incredible to listen to these Q1 earnings calls next month and see where the quarter balance sheets ended up and what that's going to mean just in terms of near-term earnings and growth outlooks. I mean banks are going to have to potentially shrink and reset expectations to the extent they've seen outflows…maybe they've seen inflows of deposits. This could go both directions.

Brian Levitt:

Some of the larger money centered banks.

Justin Livengood:

But ironically, the larger banks that are probably taking deposit inflows are going to have to put up more capital. They almost don't want it. Yeah, if you noticed, Chase and B of A aren't paying you a lot for your checking account.

Brian Levitt:

Right, right. I notice it every month. I'll notice it on my tax returns also. I put down my 12 cents.

Justin Livengood:

And that's not changing because they don't really want our deposits given how, again, the way the regulators treat excess deposits like that. So my point is there's still a lot of stuff moving around that is going to require these banks to step back, be cautious, be conservative, just in terms of near-term operating funnels. Intermediate term, the issue here I think particularly for the regionals and that group of banks just below the top 10 SIFI banks, is that there is going to be a whole swath of new regulations and capital requirements. I'm already hearing things. After the Global Financial Crisis, the Fed, and the regulators put in a whole set of rules for those top 10 banks, but they cut it off at banks with $250 billion of assets.

Brian Levitt:

How did that go?

Justin Livengood:

It sort of worked. But these banks, which ironically got just up close to that…

Brian Levitt:

They were very close.

Justin Livengood:

…$100 billion and $200 billion respectively in assets. So they're going to lower that threshold, and so are they going to lower it to 50? or who knows? But I guarantee that the next 75 to 200 banks on that list of assets are preparing for a whole bunch of incremental disclosures, new audits that are going to have to go through with the regulators, increased capital charges, carrying more capital for all the different activities they're doing. This is going to be incremental operating — I remember vividly going back after the French crisis meeting with lots of banks, including banks First Republic and Silicon Valley, who I knew well back in 2010, '11, and '12, and how much they were complaining about all the hiring they were having to do right after the financial to manage all these new rules and regulations that they were being asked to comply with.

In fact, the joke for a while was the best job you could try to get coming out of school was to be someone that had any interest in or expertise in bank regulation because there was a feeding frenzy for these people.

Brian Levitt:

Absolutely. I think Eisenhower probably should have warned us about the regulatory industrial complex.

Justin Livengood:

That's right. So, I don't think it will be quite that severe, but there's going to be an element of that for these regional banks now as we move into the back half of this year and next year.

Brian Levitt:

Which I have to assume means slower nominal growth for the economy as well. This whole idea that we're moving to a new level of nominal growth in this inflationary world, does this take away some of that?

Justin Livengood:

It might in two ways. First, just in general, as banks overall are pausing a little bit to make sure they understand ‘what's my deposit base look like?’ And then ‘what are the rules of the game going forward, regulatory-wise?’ They're going to be less inclined to make a new loan, maybe less inclined to onboard certain types of clients.

But then very specifically, the second thing I'd mentioned is in the technology, healthcare verticals that are directly affected by the Silicon Valley failure, there's going to be a period of friction here where you've got to go find a new bank. You've got to move, and it's not just, ‘oh, I've got to move my deposits over.’ It’s ‘I've got to move my payroll system. I had a line of credit that I was using with vendors, and I had 16 vendors hooked in and now I got to move that.’

Well, guess what? The banks that you want to move to either aren't going to be able to do everything because they're now afraid to bring on all those relationships as quickly as they otherwise might, or they're only going to do two things. Okay, Brian, you can bring me your deposits, but I'm not going to do all the other stuff that Silicon Valley was doing. I can't or I don't want to. So now I'm going to have to go find three new relationships and that may take me four months. And in the meantime, I can't do all the growth investing that I wanted to do as a …

Brian Levitt:

That's a shame. I mean, that just means a less innovative economy in the near term.

Justin Livengood:

Exactly. And it'll sort itself out, so I don't want to suggest this is a long-term issue. But it's definitely a short-term disruptive issue, particularly on the smaller end of the innovation economy. And I think the broader growth outlook could be a little bit impaired by this.

Brian Levitt:

And if the broader growth outlook is impaired, then that should potentially support the type of strategies that you invest in or the type of strategies that you manage. Because if you're back to a slow growth world, we probably need to pay up for growth wherever we can find it again.

Justin Livengood:

That's right. I think companies that are secular growers, that have products and ideas that are not as sensitive to the economy, and are well managed and well capitalized, are going to have increased advantages and get better valuations. And that is exactly the universe that we try to focus on in our different portfolios. The economy wasn't ripping, and all of a sudden this is going to tip it down. The economy was already, I'd argue, moving into a slow growth environment, and this is perhaps just going to nudge it a little bit more down that trajectory.

Brian Levitt:

Recession.

Justin Livengood:

I don't know.

Brian Levitt:

Semantics, probably.

Justin Livengood:

I agree. Exactly. I think it's less important whether we actually go negative for a couple quarters on nominal GDP or not. I do think the inflation topic is important because I think the Fed and monetary policy matters more than anything.

Brian Levitt:

As always.

Justin Livengood:

Ironically, the events with the banks here probably caused the Fed to be a little more dovish than they might have wanted to.

Brian Levitt:

Silver linings…perhaps.

Justin Livengood:

Perhaps, but we just saw a few minutes ago a CPI number that was for the month of February in line with expectations at least, but still 6% overall, 5.5% ex-food. That is not the 3%-ish number that I think the Fed ideally would like to get to. Forget two. I think three is what they're really... I don't think you're seeing 3% this year.

I mean, the pace of improvement in inflation is slowing. It's going to keep declining, but it is not going to collapse, I think, just based on the latest trends. So that's perhaps the biggest impediment is that the Fed is going to have to keep rates elevated at whatever the ultimate terminal rate is — probably well into next year — and that's going to continue to be a drag on the economy.

Now you layer on top of that what's just happened to the bank system where the banks are going to be a little more reluctant to lend and be as aggressive as they might have otherwise been. Particularly in certain parts of the economy that were serviced by banks like Silicon Valley. And yeah, it's a recipe for a slow growth environment.

Brian Levitt:

I can't let us end on a negative though. I've got a growth manager here, his last name is Livengood. Give me some optimism.

Justin Livengood:

Well, first of all, I do think, again, we're through the shock part of this banking crisis, so on the topic of this podcast at least, I do think we've seen the light at the end of the tunnel. Again, there's going to be a lot of subsequent stuff to deal with for the banks, but I think it's all manageable and I think our regulators and our banking system came through this relatively well. And again, this is not a credit related issue, which suggests this isn't going to be as pervasive as the financial crisis of '08-'09, so hopefully that's some good news.

Brian Levitt:

I'll take it, we'll take it.

Justin Livengood:

Even though I just said the Fed is the most important thing for the economy, they are essentially done or near done raising rates. And so there is some optimism in my mind that we've reestablished a proper equilibrium in monetary policy and that's going to let people adjust to a more normal yield curve —whether that's in the housing industry or industrial parts of the economy.

And as that reset happens, I think that's healthy and that's good, and that's going to be a stronger base for the economy and for the stock market to operate from in the next two to three years. I'm not saying that's going to cause anything perhaps in 2023 that's particularly exciting, but we needed to get away from some of the things that had happened the prior three years between COVID, the war — this has been an incredible stretch of volatility and just really unusual circumstances. We needed to get back to a more normal operating environment, and we're getting there.

Brian Levitt:

Well, let's look forward to that more normal operating environment. Justin Livengood, Portfolio Manager of the Invesco Midcap Growth Strategy, as well as a Manager on the Discovery Growth Strategies. Thank you so much for being here. This has been incredibly informative, and we look forward to having you again soon.

Justin Livengood:

Thanks, Brian.

 

Important information

You've been listening to Invesco's Greater Possibilities Podcast.

The opinions expressed are those of the speakers, are based on current market conditions as of March 14, 2023, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

Should this contain any forward looking statements, understand they are not guarantees of future results. They involve risks, uncertainties, and assumptions. There can be no assurance that actual results will not differ materially from expectations.

All investing involves risk, including the risk of loss.

Past performance is not a guarantee of future results.

Data on the size of bank failures sourced from the Federal Deposit Insurance Corporation, or FDIC, as of March 13, 2023.

Data on the amount of uninsured deposits at banks sourced from the FDIC as of March 10, 2023.

Information on the growth of deposits and makeup of assets on Silicon Valley Bank’s balance sheet sourced from the FDIC, as of March 13, 2023.

Information on the speed and amount of withdrawals at Silicon Valley Bank compared to 2008 events sourced from the FDIC, as of March 13, 2023.

Data on the Consumer Price index, or CPI, sourced from the US Bureau of Labor Statistics as of February 28, 2023. The CPI measures changes in consumer prices.

The profitability of businesses in the financial services sector depends on the availability and cost of money and may fluctuate significantly in response to changes in government regulation, interest rates and general economic conditions. These businesses often operate with substantial financial leverage.

Growth stocks tend to be more sensitive to changes in their earnings and can be more volatile.

Mortgage- and asset-backed securities are subject to prepayment or call risk, which is the risk that the borrower’s payments may be received earlier or later than expected due to changes in prepayment rates on underlying loans. Securities may be prepaid at a price less than the original purchase value.

A systemically important financial institution, or SIFI, is a financial institution that US federal regulators say would pose a serious risk to the economy if it collapsed.

The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity. An inverted yield curve is one in which shorter-term bonds have a higher yield than longer-term bonds of the same credit quality. In a normal yield curve, longer-term bonds have a higher yield.

A credit rating is an assessment provided by a nationally recognized statistical rating organization (NRSRO) of the creditworthiness of an issuer with respect to debt obligations, including specific securities, money market instruments or other debts. Ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest); ratings are subject to change without notice. NR indicates the debtor was not rated, and should not be interpreted as indicating low quality. For more information on rating methodologies, please visit the NRSRO website for Standard and Poor's, Moody's or Fitch Ratings.

The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.