Market Conversations: The contraction has begun

Brian Levitt (00:00):

I'm Brian Levitt.

Jodi Phillips (00:09):

And I'm Jodi Phillips. And today, we have Alessio de Longis Global Head of Tactical Asset Allocation

Brian Levitt (00:34):

The tactical asset allocation model, the framework that we all support, that Alessio uses, that we all follow, moved into contraction territory.

Jodi Phillips (00:47):

Contraction territory. That doesn't sound very good, Brian.

Brian Levitt (00:51):

No, I guess it's not ideal. I mean, it's what we always say though. High and rising inflation leads to the type of policy tightening that can end cycles.

Jodi Phillips (01:03):

Yeah. I've heard you say that more than a few times this year. I mean, starting back in January, you wrote a piece. I think the headline was, ‘What keeps me up at night?’ Am I remembering that correctly?

Brian Levitt (01:15):

Yeah. I'm glad you remember that. That does sound familiar. I guess it's time to break out the warm milk then, if we're officially in contraction.

Jodi Phillips (01:23):

Or a white noise machine to block out the market rumblings, that might be helpful. But look, the question for investors is, does a contraction have to be a nightmare?

Brian Levitt (01:33):

Yeah, it's a good one. I mean, look. This has been a very, very unique cycle. We haven't really had time for big excesses to build in the economy, and perhaps maybe a contraction could even be mild by historical standards.

Jodi Phillips (01:49):

That would be great, right? So, all right. One question answered, the contraction is here. More questions, how long will it last? How damaging could it be for markets? And how might investors think about responding to it? So let's bring on Alessio to discuss all of that and more. Welcome, Alessio.

Alessio de Longis (02:07):

Jodi, Brian, always a pleasure to be with you.

Brian Levitt (02:11):

Alessio, thanks for joining. You talk about the different regimes that the economy goes through in a cycle, whether it's recovery, expansion, slowdown, contraction. What's so stunning about this is I feel like we're going through all of them at a very rapid pace. So I guess first, how rare is that? And then second, how do you define a contraction?

Alessio de Longis (02:35):

Yeah, Brian, certainly this has been a rollercoaster cycle that seems to have started only two years ago. And we are approaching its end when we look at the sequence, right? Just for our audience, we registered the last contraction between February and May of 2020. We entered the recovery June 2020, and here we are. Two years later, we have moved back into contraction. Really a two-year cycle, basically. What is a contraction? A contraction we define as, very simply, as growth expected to be below its long-term trend or its potential, and to continue to decelerate.

Alessio de Longis (03:14):

So to be clear, a contraction includes recessions, but is not limited to recessions, right? When we think about recessions, we think about negative economic growth across a wide spectrum and indicators. And so in other words, a contraction in our case includes also periods where the economy is still growing positively, slowly, and growing below its long-term trend. So it's a little bit more broad ranged.

Alessio de Longis (03:43):

So this goes into the other question that Jodi was asking. Does every contraction mean a nightmare? Does every contraction mean a financial crisis? Absolutely not. Just like, as we said, not every contraction that we register in our framework even means a recession, so to speak. Can mean a period of weakness, but not necessarily a recession. And certainly, not necessarily a global financial crisis.

Jodi Phillips (04:12):

So Alessio, were you surprised that your model is signaling a contraction right now? Or was this something that you would've been expecting at this point in time?

Alessio de Longis (04:22):

Not surprised because if anything, this is one of the few instances where I feel our model has lagged the actual perception on the street, right? And needless to say, of course, we haven't categorized the first two quarters of this year as a recession yet. But technically, we did have very soft growth, two negative quarters of GDP (gross domestic product) growth. Even though we can explain them statistically through some anomalies, they certainly don't feel like a recession, but they are clear evidence of weak economic growth.

Alessio de Longis (05:00):

So this contraction does feel a little bit pre-announced, so to speak. Not really a leading signal this time around. Doesn't mean it has to be a wrong signal, but I don't think anybody was shocked when we printed the blog this month, compared to other instances.

Brian Levitt (05:21):

Alessio, help me square it, though. So the market applauds a Consumer Price Index (CPI) showing that it looks like the pace of growth, or the rate of growth of inflation slowing a Wholesale Price Index, which was actually negative for the month.

Brian Levitt (05:40):

So the markets seem to be applauding this peak in inflation. Is the idea that the economy's in a contraction or the regime is contraction, does that tend to suggest that the market's not going to continue to applaud this?

Alessio de Longis (05:54):

Yeah. A great question. And to me, it's the biggest question mark right now. So what is the typical behaviour of a contraction, right? Brian, as you always say, every contraction or every recession is usually brought by the Fed, right? It's brought by inflation and the tightening cycle that the Fed needs to extend in order to slow the economy. It's exactly where we are today. Like, even if you read word for word what Chair Powell said in the last FOMC (Federal Open Market Committee) press conference. He said, we need to get the economy to grow below its long-term trend for a prolonged period of time in order to get the unemployment rate to rise and build slack in the economy.

Alessio de Longis (06:35):

Obviously, this is what we're trying to do. So what do you typically see in that environment, from a markets perspective? Which is the nature of your question. We tend to see during a contraction that inflation has peaked already, or is falling ...

Brian Levitt (06:56):

Do we want to stop there and applaud, all of us? Do we have streamers or the horns that you blow ... what are the horns, Alessio, they blow at the soccer games? The vuvuzelas?

Alessio de Longis (07:07):

Oh, yeah. The vuvuzelas, yes. I don't feel yet as excited to celebrate, I think ...

Brian Levitt (07:24):

A peak in inflation?

Alessio de Longis (07:24):

I'm going ... yes. Look, I think it's a good sign to see a peak in inflation. The part that is still not ... let's look at a glass half full. A glass half full would be one where we are in a contraction that doesn't turn into a recession. How does that happen? Inflation begins to roll over, which is probably what we're beginning to see. The economy actually holds up. The unemployment rate rises, just modestly. It turns out that the Fed, even though it hiked aggressively, the economy was more than able to handle it. We continue to grow below potential. The inflation comes down. In that environment, the markets are actually going to trade more like a recovery, right? Eventually the market is going to rally, substantially led by credit spreads, which is exactly the reaction that we saw after the CPI report. And we basically are able to say, yeah. We printed a contraction. It never turned out to be a recession. The cycle moves on.

Alessio de Longis (08:24):

There is another side. The glass half empty would be one where this rollover in inflation is still driven predominantly by rolling of supply factors. Rolling over in supply factors and the well-known supply chain issues. But that we haven't even begun to see the demand-induced slowdown by the Federal Reserve. Even though we know mortgage rates are at cyclical highs of 5.5% coming from 2.5%. Affordability in the housing sector is down to the all-time lows of 2006. And consumer sentiment is already very weak. But by-and-large, the unemployment rate is still at all-time lows. It hasn't even begun to move. So it's very hard to say that this rollover in inflation is due to the demand side of the equation.

Alessio de Longis (09:14):

Now, if the supply side of the equation for inflation rolls over very quickly, the Fed may actually be able to stop very soon. So that is the glass half full scenario. I think we are dancing a very, very difficult tango here, and it takes two to tango, right? It's the Fed, it's the economy. All right, let's say three. There is the market involved as well. I think monetary policy is a very powerful tool, but it's not a precision tool. And there is the lag by which the Fed will impact the economy and that the Fed will be able to see the response from the economy. I think that's the balance. That's the equilibrium. That's the tight rope that we're trying to walk at the moment.

Brian Levitt (09:58):

And Jodi, you and I have discussed this, the demand that exists out there. I mean, even just in our everyday lives. The restaurants being packed, the hotels being packed, the airlines being packed. And it does seem like the consumer's hanging in there.

Jodi Phillips (10:14):

Well, yeah. So Alessio, I'm curious, is this contraction signal unique to the U.S., or is this something that you're looking at globally?

Alessio de Longis (10:30):

So at the moment, this is a fairly broad-based observation. We find that basically all of the developed markets, UK, eurozone, the U.S., of course, China, emerging Asia in general, they are growing below trend. And our expectation from a market sentiment standpoint, as well as the rate of change in some of those leading economic indicators is that basically, we expect these regions to continue growing below trend and decelerate. So that's a contraction in our playbook. Where we see growth still holding up better is in Japan and the rest of emerging markets, Latin America. The smaller parts of emerging markets.

Alessio de Longis (11:14):

But let's say that on a forward-looking basis, by our metrics about 80% of world GDP can be considered to be growing below trend, and therefore being at risk of a contractionary or potentially recessionary regime. So it's broad-based. And what we typically see is the average duration of this state of the world is about seven months. Now, we're talking really just models and technicalities, right? Just sticking to the facts, right? So if we want to be overly precise, take it with a grain of salt. But on average, we see these type of regimes lasting seven months. The shortest instances have been about two months, which we would call basically a fake. A fake signal, right? A scare that didn't materialize.

Jodi Phillips (12:04):

Got it.

Alessio de Longis (12:05):

Which can certainly still be the case. But in some instances, we have seen contractionary regimes that have lasted for a year and a half. So look at instances in the double-dip recession of the ’70s or the double-dip recessions of the ’80s. So those have lasted a little bit longer. It's hard to say where we are going today, because frankly, I think that it's all dependent on this latent supply factor that Brian and Kristina (Hooper) have discussed at length recently. That if energy prices, if food prices, if some of the supply chain bottlenecks were to resolve themselves unexpectedly well, inflation may actually fall more rapidly than we think. And the adjustment, the growth adjustment, the growth sacrifice that the Fed has to induce might be shorter lift, or less severe in magnitude.

Brian Levitt (13:00):

And it actually does look like we're starting to see some signs. Actually, not some signs, pretty good signs that the supply chain challenges are starting to ease. Maybe we'll get that short one. I guess I can quote Green Day then and say, "Wake me up when September ends." And we'll get back into this recovery.

Brian Levitt (13:19):

But Alessio, I know you're a long watcher of the Fed. Is what they're doing ... I mean, they already seem to have made the policy mistake, right? That's the 9.1% inflation. Is what they're doing now doubling down or creating another policy mistake? And the reason I ask that, it almost seems like at some point, the medicine, i.e., tight policy, higher unemployment rate. May be worse than this disease, given that long-term inflation expectations still remain very well anchored in this country.

Alessio de Longis (13:55):

It's a great question. And it's the question that you could answer in many different ways. So at the cost of being a little bit dogmatic about it, what is the definition of a policy mistake? Especially for a central bank that has a dual mandate. And if you take the letter of the law, as of today, they're failing on both mandates. So I would say that I ...

Brian Levitt (14:21):

But why are they failing on full employment?

Alessio de Longis (14:24):

Because the idea is that they, at steady-state ... which is obviously a theoretical concept. But on average, they want the economy to grow at the NAIRU. They want the economy to grow where the unemployment rate is at the non-inflationary level. And we know it's a very difficult concept to estimate, but if you look at the CBO (Congressional Budget Office) or the Fed, these estimates for the natural rate of unemployment that does not generate excess inflation, is somewhere around 4.5%, maybe 5%. Take it with a grain of salt. It's an estimate, with error bands. But we are at 3.5% (unemployment rate), and so we are at all-time lows. And inflation, to your point, core inflation, core PCE (Personal Consumption Expenditures) is at 4.8%. Core CPI's at 5.9%. We're two to three times higher than what the desired target is.

Alessio de Longis (15:18):

So as a confirmation of why I would give slack to the Fed and say that maybe the policy mistake was certainly in the past, but they are remedying it now. And this is a point that you, Brian, has made very eloquently in the last few months. Inflation expectations read in the market are coming back in. Six months ago, 12 months ago, two year breakevens, five year breakevens were at 4%, at 5%. The 10 year was at north of three, three and a half. Now, the entire breakeven curve ... so the spread between nominal Treasuries and real Treasuries. Has come back in below three across the spectrum. So it's telling us that ... so if anything, there was a policy mistake when we were above three across the board. Both on a cyclical and on a long-term basis, right? And now all of those measures have come back in.

Alessio de Longis (16:13):

A further confirmation is the surveys on inflation expectations have peaked and are beginning to roll over. So even consumer surveys are responding to that. And another positive sign in my mind ... and this is a point that, Brian, you and I have discussed for the last 12 months. The consumer sentiment surveys were at recessionary levels when the economy was booming, and this rise in interest rates hadn't even begun. And we were scratching our heads and saying, wait a minute. The economy is booming. Consumer sentiment surveys are at the recessionary lows because they're complaining about things being too expensive. So there was a message from the consumer: “I don't like this. I am losing confidence on the price signal that I see in the economy.”

Alessio de Longis (16:58):

What happened today? We are seeing an uptick in consumer sentiment for the first time in three months. Which is ironic, when you think that rates have risen so much, and usually we associate it to a sign of trouble. So it's a very interesting message that we're getting from the market. So I prefer now to give some slack to the Fed and saying, they're doing what the letter of the law wants them to do. And if there will be a policy mistake, it will probably be later the time to evaluate that.

Jodi Phillips (17:32):

So Alessio, what do we do with all of this information? When you think about it from that asset allocation perspective, portfolio positioning, what should we be thinking about right now in a contraction?

Alessio de Longis (17:44):

So again, knowing that any macroeconomic analysis, any regime analysis does not carry 100% certainty, right? Over the long term, you're a very successful investor when you are right 60% of the time. But that still means you're going to be wrong 40% of the time.

Brian Levitt (18:04):

Wait, wait, wait. We're not guaranteeing future results here?

Alessio de Longis (18:09):

No, I didn't see the banner come through. But I think it's an interesting perspective, right? I tell everybody, especially people that enter this industry, the younger generations and say, look to be an investor, you need to be prepared. Even when you are a rockstar investor, you need to be prepared being wrong, let's say 40% of the time. And assuming you have a 30-year long career, that's many, many years to be wrong. And you have to be prepared to handle that.

Alessio de Longis (18:39):

So with that said, let's assume that ... it's not a silver bullet, but let's assume that we are more in that 60%. So if we think that we have better than a coin toss of being right in identifying this recessionary or growth scare regime, what is an investor supposed to do? Well, the first question, as Brian always says, the first question is, remind yourself of your template and your playbook. If you have a long-term horizon, maybe the best thing to do is do nothing. If you are sensitive, let's say to an outcome over the next 12 months, two years, and you want to do some adjustments to your portfolio, I think the first question to always ask oneself is, “if the market were to sell off today or over the next few quarters by 15%, would my portfolio be able to handle it? Would I be able to stomach it?”

Alessio de Longis (19:37):

I think that is, first of all, a behavioural question. The market gives us what it gives us, right? Are we prepared to handle a 15% drawdown in the market? Just to say a number – it can be 20%. If the answer is yes, maybe the answer is do nothing. Or maybe the answer is even, you look for the opportunities to keep adding to your portfolio. Now, if the answer is no, I would not be comfortable with that outcome over the next 12 or 24 months, now typically what we see in contractionary regime is that it is appropriate to reduce portfolio risk, typically by reducing marginally your exposure to equity and to risky credit. Increasing the allocation to quality credit and government bonds within your equity portfolio. But alternatively, together or alternatively, other wise decisions in the portfolio historically have been to increase the defensiveness within your equity portfolio.

Alessio de Longis (20:40):

For example, you may decide not to reduce your equity allocation, but you can increase the defensiveness in your portfolio by allocating to defensive sectors, away from cyclical sectors. So that suggests consumer staples, health care. In this environment, possibly even technology and communication services, because they have quality characteristics. And maybe reducing your exposure to cyclical sectors, such as financials, industrials, materials. Or you can act in the factor space, in what is the so-called beta space. And investors are very familiar with low volatility stocks being more defensive than value or quality stocks, being more defensive than small caps, right? So those are ways in which you can build defensiveness. You can reshape the risk of the portfolio, build defensiveness in your portfolio without necessarily selling equities outright.

Alessio de Longis (21:34):

Obviously, if you have a short-term horizon, or if you are concerned about the next 12 to 24 months, in a recessionary environment, you have to worry about defaults, right? So the ability of getting your principal back. So worrying about your exposure or the maturities in your high yield portfolio, in your EM (emerging market) credit portfolio. So the riskier parts of your credit markets, because if by definition, you don't have the period ... the time to wait. You may be subject to realizing losses that can be very short lived, but somewhat painful.

Brian Levitt (22:14):

I enjoyed that answer so much.

Alessio de Longis (22:17):

Thank you, Brian.

Brian Levitt (22:18):

I just love the way you went through that from a longer-term perspective, to why you may want to make adjustments in your portfolio if you can't stomach a 15% decline. That was really well done, Alessio. My ask of you, and I think Jodi's ask for you as well would be, will you come back on to tell us when the recovery's starting to form?

Alessio de Longis (22:39):

I'm available anytime to come, and to deliver good news, especially.

Jodi Phillips (22:48):

That would be wonderful. And hopefully, Brian won't have to write a sequel about what still keeps him up at night, right? I think this has definitely helped me a lot in that regard, for sure. So thank you, Alessio, for joining us once again, so soon after your last appearance. But it was really great to get this update from you and figure out what you're looking at and what you're seeing and what we should be thinking about too.

Alessio de Longis (23:09):

Thank you, Jodi. Thank you, Brian.

Brian Levitt (23:11):

Thank you.

Alessio de Longis (23:11):

And really looking forward to the next update and what the market will bring.

Brian Levitt (23:15):

As are we.

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The 30-year fixed-rate mortgage averaged 5.51% in the week ending July 14, up from the same time last year, when it was 2.88%, according to CNN.

According to the Wall Street Journal, the National Association of Realtors' housing-affordability index fell to 102.5 in May, the lowest level since July 2006.

The minimum, maximum and average length of contractions is based on Invesco analysis of proprietary leading economic indicators as of July 31, 2022.

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 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. Headline CPI rose 9.1% over the 12 months ended June 2022. Core CPI rose 5.9% over the 12 months ended July 2022.

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The actual US unemployment rate hit 3.5% in July 2022, according to the US Bureau of Labor Statistics

CBO stands for Congressional Budget Office.

Personal consumption expenditures, or PCE, measures price changes in consumer goods and services. Expenditures included in the index are actual US household expenditures. The PCE rose 4.8 % in June 2022 according to the Bureau of Economic Analysis.

Breakeven inflation is the difference in yield between a nominal Treasury security and a Treasury Inflation-Protected Security of the same maturity. Statistics on the 10-year, 5-year, and 2-year breakeven inflation levels are from Bloomberg and the US Treasury.

A double-dip recession occurs when an economy sees two periods of contraction, separated by a brief period of expansion.

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