Month to month the markets have been performing differently, but throughout 2022 the story has remained the same. Inflation is high, the Fed is fighting inflation by raising rates – it’s surprising the markets are so sensitive and seem to be getting surprised by this repetition.
In this market update, Sammy Azzouz and Heritage Financial’s CIO, Bob Weisse, discuss the future of large rate hikes, what we need to see before inflation can come under control, the return to more normalized mortgage rates, why it’s a great time to put money to work across the markets, and some end-of-year ideas for keeping more of what you make.
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November Market Update: The Beginning of the End?
This automated transcript may contain grammatical errors.
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Welcome to Wealthy Behavior, talking money and wealth with Heritage Financial. The podcast that digs into topics strategies and behaviors that help busy successful people build and protect their personal wealth. I’m your host, Sammy Azzouz president of Heritage Financial, a Boston based wealth management firm working with business owners, executives, and retirees for longer than 25 years. Now, let’s talk about the wealthy behaviors that are key to a rich life.
Welcome to the November investment edition of the wealthy behavior podcast where I talk to Heritage Financials, chief investment officer Bob Weiss about what’s going on in the markets and investment universe right now. So, Bob, another month and it feels like another change in direction for the markets. We don’t usually analyze markets months to month as long-term investors, but sometimes a bear market and a potential recession can do that to you. We talked in our October podcast about the strong start to the month after a painful September and despite some volatility in October stocks in the U.S. and internationally did well, I believe global and U.S. stocks. There’s been more talk and prognostications about whether we’re going to have a recession or we’re in one already, more companies have been reporting earnings with some big tech names struggling, which has been a theme of ours in the past. What are you seeing out there? Yeah, it’s an interesting introduction Sammy, because on one hand, it seems like month to month the story has been quite different September was a terrible month for stocks and October was a great month. So, you have a totally different result in markets, but at the same time, we’ve been saying the same thing. It’s a very redundant year with what’s going on in the story’s inflation is high. The fed’s fight inflation feds raising rates on the same ole. So, it is interesting that markets are so sensitive to the course of this and seem to be getting surprised so easily. But I think in short, we’re nearing the end. We’re closer to the end of the beginning. As far as the fed raising rates, so okay. That’ll raise rates 75 basis points. And that’s expected to be the last 75 basis point increase of that magnitude. So, following it might be a 50, a 25, and then done. When you say that’s expected, Bob, are you just talking about what the market’s expecting, which you can see in the futures? Or where are you getting this from? That’s what the markets pricing in, but the fed has been talking to a Wall Street Journal reporter who leaks it out to the market, and they don’t want to surprise people. So, we’ve seen that basically they are doing what the market expects. Like the fed and the market are one. So, the last one of this magnitude, but there could be smaller rate hikes. And that’s what you talked about when you talked about the end to be clear you’re not calling for the immediate end of this bear market. But where is inflation then? I know we get an inflation number monthly. Well, we got a couple different numbers, but once a month, where is inflation in all this, what have you been seeing? Yeah, so inflation, the CPI print continues to remain elevated, but there is lagging data in CPI, the largest component of CPI. You might have talked about this last time as shelter, think housing. It’s measured by owners’ equivalent rent. So, rents. And the last month, it was the biggest component that not just by size, but by magnitude, it increased it. Well, meanwhile, a housing prices are declining. So, you’re seeing housing prices decline in for the second month in a row, and yet in CPI, shelter is pushing inflation up. It’s coming in hot. So, there’s a lag in that. Way to think it through is rents typically have a one-year term. So, if someone’s renewing their rent as of November 1st, good chance the rent is higher now than it was a year ago, the landlord can say, well, values are up and I’m going to increase it. So, you see inflation there, but month to month housing is turning. So, there will be a bit of a lag before that makes its way into CPI through the ownership of one rent. So critical question is, well, does the fed know that it’s lagging data? And will they be bold enough to actually believe that it will flow through or are they going to wait for it to come through? If that makes sense. It does make a lot of sense. And it connects to what you opened with in terms of the rate hike. It will be the last one of this magnitude. And I kind of cut you off a little bit because I wanted you to explain where that was coming from. But what are the implications of that? Why do you lead off with that today? Well, it’s been the story of the year.
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It’s inflation is high, the fed is raising rates to hit inflation and they used to do 25 basis points at a time. And a double move would be a 50. And they’ve been doing triples. So, we’re looking at a fourth triple. And the markets are pricing in a 50 and then a 25. So, you hear the plane analogy is soft landing hard land and like the planes coming down, they’ve done a lot of rate hikes and then it’s kind of like step back and see what happens to the economy because there’s a lag in the effects of their actions. So, they raise rates and then see what happens. So did you answer your own question there is the market is expecting the end of the 75 basis point rate hikes. Does that lead you to believe that the fed understands the impact of the lagging housing data on the CPI? There is some of that, but it’s also the market expectations are based on fed expectations. So, the fed showing dot plots, the fed talking about what they’re thinking. So, it is all kind of one in the same. Has the fed or any of the other central banks that have been tightening, have they kind of signaled that they’re easing their stance going forward on this tighter monetary policy and has that contributed to any of the market rebound in October? That’s, I think, the big thing to look out for at a press conference. Okay guys, you’ve been raising rates a lot. Are you starting to look at look for damage? And starting to have what they might call a more dovish tone. And we talked about that briefly at the last podcast looking at global risk, but not much. They’ve been more in the camp of we are aggressive. We’re going to cause pain. Okay. No, understood, and we’ve talked about a recession and that the marketing, the market is a leading indicator, but I think we haven’t maybe given enough attention to the idea that people should know not every bear market does signal a recession. You do have bear markets that don’t lead to recessions. This 25% sell off that we’re having or that we’re in the midst of is probably telling us something, but GDP growth in the third quarter was strong after a couple of negative quarters to start the year, unemployment is still strong. What do you see with the economy and also of your viewpoint that we will not avoid a soft landing that we will have a recession? Yeah, unemployment is the real stubborn factor without unemployment being low and it really, we’re not seeing what they call softening in the labor market. And I do think we need to see it. The fed’s not going to rest until we see it because the best predictor of inflation is wages. Okay. And when you have a tight labor market, so say more jobs than people, then companies fight over employees and you see wages go up and when wages go up, people spend more money and if that gives you an inflation spiral. So, they do need to see a softening of the labor market, otherwise inflation will get under control. You’re not going to have a hot labor market at 2% inflation. So, I guess that’s where fundamentally they’re going to have to raise rates and keep at it until wages slow and labor markets soften and that’s your shallow recession. So, more rate hikes, but maybe not more 75 basis point rate hikes to continue on what we started with or what we opened with. Okay, you’re nodding your head there. So, another thing you touched on housing is struggling. That happened pretty quickly. I would say. Other pockets of excess in the market are being hit. I touched on large cap tech names. Well, whether or not they reported great earnings or disappointing earnings. Some of those names, those FAANG M stocks have continued to get hit pretty hard. Are you surprised by the housing rollover? Are you surprised by some of the growth of your areas of the market struggling and continuing to struggle this year? No, definitely not housing. I’d like to say that that’s one of the things we’ve been talking about for going on, I don’t know, four months or so, that this was coming. Many even just housing given up 6 months of gains. Residential real estate just went through the roof during COVID it overshot, and it’s coming back down. So, with that, to me, makes perfect sense that I think there’s more to come over the next year is that it sorts itself out. The other area that we’ve seen come down just broadly that I would say makes sense is what I would call unprofitable businesses on profitable tech is kind of the tag name and that stuff needs to come down and in many cases go bankrupt. That’s just a matter of time. You can’t just have businesses around not making money backed by private equity money indefinitely.
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It just doesn’t work. So seeing that deflate makes sense to me. So, you can get into specific companies like Facebook or meta and what’s going on there. It has started. Or even Google and Amazon’s earnings have led to I think weaker stock performance this year than the overall market. Yeah, yeah, so Facebook slash meta that’s priced at cheaper than the market because of the challenges that they have. They’re very real business challenges. The CEOs chasing after the metaverse that same, I think might make money and 2030 or something. Yeah. Company specific challenge, yeah, that’s way out there. So, the market’s punishing them. And they’re trading at a discount company like Google is right around the market. It’s had a bit of a premium for a good business. That to me seems pretty reasonable. So much better than it was almost double the valuation a year, year, and a half ago. So, you touched on housing, it is declining, but it hasn’t led to an increased ability for people who want to borrow and buy their first home to buy because mortgage rates have skyrocketed. What is your outlook if you have one at all, just in terms of will mortgage rates back down or maybe since you don’t have a crystal ball? What would cause mortgage rates to back down so that there can be a little bit more of a balance in terms of, yeah, prices have gone down, but your rate is doubled. So, you really haven’t improved your affordability. Mortgage rates are tied to the ten-year treasury and the ten-year treasury is kind of the barometer for risk appetite and markets and you’ll see and it ties a little bit to fed policy. So, I think you’re not going to see the ten-year treasury fall until inflation is no longer a concern. So, when the fed is off the war raising rate direction and more we’re concerned about deflation and falling asset prices, that’s when you’ll see the ten year treasury yield fall when the fed starts cutting rates. And then you’ll have better mortgage levels and that’s them stimulating the economy. The fed has been supporting though the mortgage market right with quantitative easing and bond purchases that they have stopped as well. So, has that been a factor in maybe how high rates have gone up even relative to the ten-year treasury? You really want to get technical Sammy. The fed was doing quantitative easing by buying mortgages. So, they were basically creating money out of thin air and just buying mortgages, which was pushing yields down in the mortgage market. They stopped that. What they have not done is reversed it. So, they have not done quantitative tightening in a sense of selling mortgages. Okay, they just stopped buying. They stopped buying them. And they are letting them mature. They’ll let them what they call roll off the balance sheet. They bought the asset, and it matures, and it rolls off the balance sheet it disappears. Some market participants some Bond managers are a little concerned that the fed may start selling mortgages. Oh wow, okay. And that would then really push up mortgage rates. So, it’s a tool. Everyone talks about the fed funds rate, us included. But one of the tools they have is open market activity like quantitative ease and quantitative tightening. And the tool they have that they could use would be selling mortgages. And why would they do that Bob? If they thought that their rate hikes weren’t having enough of an impact on the inflation story. Exactly, okay, so that’s in their pocket. But I don’t think they’re going to need to do that because we’re seeing housing cool off if housing wasn’t cooling off. That’s what they could do. It would be sell mortgages. And then you’d have what they call market technicals and you’d see just more pressure on rise in mortgage rates. So that’s a possibility it’s not what you think will happen. So basically, then it comes back down to the same story we’ve been talking about since this podcast started, which is inflation and rising rates when we see some light at the end of the tunnel with inflation and rate hikes, mortgage rates may stabilize or even level off. And then you do get a little bit of a benefit as a buyer of the cheaper prices, but not the crazy higher rates. Yeah. Yeah, the yield curves inverted showing that the fed funds rate getting at its peak somewhere around Q1 or Q2 of next year. And then it declines. So, markets expecting the fed to raise rate of interest and then start cutting and it’s around that time when they start cutting that you would see rates fall. And mortgage rates go down and start to become cheaper and homes become more affordable. Well, we’ve been in this regime of what people would call artificially low rates for a while until this year, obviously.
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What is a more normalized interest rate environment for the ten years for mortgages? I just worry people are just going to anchor forever to that 2% to 3% mortgage that they could have got and maybe delay or avoid home purchases. What is a more normalized interest rate environment? Yeah, it’s a great question. So, go back to the ten-year treasury and what is a good fair value, a good yield on a tinier treasury where should it be? And if you say inflation should be in a 2% to 3% range over time, so say inflation is two and a half percent long term to buy a ten-year treasury what yield would an investor want, what would an investor demand. I would say you’d want more than two and a half. You’d want more than inflation. You want a real return, return above inflation, but you’re buying a treasury. You’re not taking a ton of risk. So, an extra 1%, 1% above inflation. So, call it a three and a half percent, three and a half to four. Three and a half to four and we’re at four right now in the ten-year treasury. So, it’s not outrageously high. So yeah, maybe it comes down from four to three and a half. So, mortgage rates could pull in by .5%. But yeah, the days of easy money and seeing a ten-year treasury sub two. I wouldn’t build a financial plan on getting a mortgage with ten-year treasury at 2%. But even if they backed up by half a percent, that’s still a mortgage rates above 6 for a third year. And you think that’s a normalized rate environment. Yeah. Okay. And just looking out at the international markets, moving off of, I guess, real estate in the U.S. for a bit. I know the strong dollar has impacted some U.S. companies who generate a lot of their sales and revenue overseas has a strong dollar hurt international markets this year and what’s the outlook there? Yeah, it’s hurt returns on foreign equities for U.S. investors. Because as a U.S. investor, when you make investments in non-U.S. companies, you’re taking currency risk. So, if you’re buying a Samsung electronics or whatever you name a company overseas, you’re buying in that local currency. So, all else equal, you’re dealing with the currency differential. So, if the U.S. dollar is up 10% relative to a basket of foreign currencies independent of what the company is doing, you’re down 10%. The strong dollar has hurt from a currency standpoint. Just through conversion. Okay. And what has led to our strong dollar? Is it the rate hikes? Yeah, it’s the rate hikes. It’s that global investors look around and US Treasury is yielding 4% as attractive for foreigners. So, is there a case for international investing when our rate hikes slow down? Well, I mean, will that weaken the dollar and be a tailwind for international investors? Or investing internationally, not international investors? Yeah, the strong dollar makes a good case for foreign investing now because if you think about it, we wrote a fun blog piece a little while ago about now’s a good time to travel to Italy because with the dollar Euro at about parity you’re going things are cheaper than they used to be. You can go and whatever by dinner cheap hotels are cheaper will stocks are also cheaper too. Just based on your purchasing power, you’re going over there with dollars that buy more shares. So, when you look at it at that level, those markets are cheap and one area if we really want to get in the most controversial part of market side today is China. And with everything China has going on, that market is now trading right around book value. I’d look at book value as about a sensible floor. You can have fire sales and go below that. But book value is like you buy the company as you liquidate them and that’s what you’re paying. It’s like Benjamin Graham value investing levels. So not even recognizing the value that the companies have for generating earnings beyond the assets. So, it’s one of our managers. So, this isn’t like bottom docile cheap. This is like bottom .5% in history cheap. So, we think China’s looking attractive emerging markets are attractive. That scenario we have an allocation, of course. And clarify for me, maybe I missed it. Sorry, what’s the connection to China and the strong dollar? It’s more just talking about overseas investing. So, dollar is strong, but I wouldn’t, it’s not like just because of the strong dollar, foreign markets just stepping back and looking at global investing. We’re looking at China as one of the areas that sold off the most down the most. For a variety of reasons, currency being one of them, but there’s also political risk that’s rising quite a bit in China.
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That’s also led to the sell off. Got it. So, we have an allocation, but it’s a not nearly at the size of our exposure to the U.S. or international developed. You want exposure there, but you do want to limit it, I guess, to a certain extent. Correct. What advice then do you have for investors right now, Bob, just in terms of, you know, these market moves from month to month. They look different. There’s a lot of it does come down to what inflation does. What rates are going to look like? What are you telling new people that you’re meeting with? I mean, there’s the behavioral side emotional side. Don’t get caught up in it. And just in general, we think that asset prices really across the board are attractive now for long-term investors. U.S. stocks, international stocks, bonds, these are all good levels, levels we haven’t seen in a long time. We’re in a bottoming out process. So, there is volatility that probably will be more volatility this year and early next year, but it’s a great time to put in money to work and investors are also fortunate that diversification works. So, for retirees, you can buy stocks and bonds on both good places to be. So, it’s just a, frankly, a good time to be investing. That will probably surprise some people just given the year that we’re having, and that stocks and bonds have both struggled in the same calendar year. Talk a little bit about that. If somebody were to push back and say, Bob, well, that sounds great, but diversification with those two asset classes necessarily hasn’t worked and why is it a great time to invest in a down market? So, two kind of loaded questions there. Well, it’s funny, that just totally hits the behavior of investing. Because you can look at it and say, well, it’s down 20%. How can you like it? And it’s like, exactly, that’s why I like it. Stocks and bonds are both down almost 20% there on sale. That’s why it’s attractive. So, bond yields, I saw just a fun chart the other day, a JPMorgan 11-year bond sealed in 7%. So, you’re taking credit risk of JPMorgan, JPMorgan, the bank. They’re pretty good business, probably not going to go bankrupt. And to get a 7% return on their bonds. That’s a pretty good return. And then stock market, if you take out the FAANG’s, the big tech in U.S. mainly, it’s around 11 times earnings, which is cheap just seeing good valuations and that’s as a result of it selling off this year. So yeah, the process to go from fair value to a little expensive to cheap isn’t a fun one. And that’s why there are losses. Basically, across the board and the stock and bond world, but now it’s a nice setup. It’s a good setup from here on out. So, investors who have cash. It’s a good time to put it to work investors who had alternative investments, real assets, real estate, any of that stuff that held up and made money short term bonds, any of that. Take profits in those areas and put it into the two main areas core bonds and stocks that have sold off. And that’s the diversification point. There are more than just those two asset classes and you’ve had the opportunity to invest in them. And now you also have the opportunity to unwind them to a certain extent and get into the asset classes that people understand traditionally that are on sale. Basically, which was the point that you were talking about. You got it. Love it. And my advice for investors is maybe not necessarily investment advice, but just control what you can control. You can’t control the markets right now, but you can make sure that you get your timely financial planning done by year end. Calendar year, sometimes you miss out on tax opportunities if you haven’t taken advantage of them. And so instead of getting hung up on your portfolio and watching it, you know, make sure that you get the rest of the financial house in order. And for ideas you can check out our blog at heritagefinancial.net where we just posted an article with 7 things that you can do to maximize your wealth before year end, that have nothing to do with watching the markets. You know, I love your outlook on that, Bob. And I would just add to that control what you can control and focus on getting some stuff that’s important related to your wealth scratched off your to do list. Good advice, Sam. Anything else on your team’s mind as you look out over the next couple of months? One in the weeds thing that we’re working on now is year-end tax law selling. Sure. So mutual funds typically make year-end distributions around December 15th to December 25th, sometime mid-December. Sometimes they’ll be capital gain distributions in addition to ordinary income distribution. So, what we’re doing is the managers as we speak. And now one manager came out today in the next few weeks. They’ll be providing estimates for what the distributions will be.
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And then we’ll know the estimate and the date. And for clients who have losses in these positions will sell it before the distribution. So, they get to book the loss they are out of the fund when the distribution happens. And then we’ll buy back into it afterwards. So, you kind of get a double one on the tax side. You take the loss, and you miss the distribution. As opposed to having done tax law selling say now, and then buying right back in it just in time to get hit with the distribution. So, it’s in the weeds stuff, you know, our tagline still every detail matters, but its I think just working hard around tax law selling. So, the least we can do is be friendly with our clients on the tax front. Always try to keep more of what you earn, even though it won’t necessarily show up in the performance numbers. So, thank you, Bob. And thank you all for listening today. If you’re enjoying wealthy behavior, please subscribe and leave us a review wherever you get your podcasts. And please send in any questions or feedback to wealthy behavior at heritagefinancial.net. We’d love to start answering listener questions, so don’t be shy. Thank you.
Thank you for listening to Wealthy Behavior. If you found the conversation useful, please consider leaving us a review wherever you listen to your podcast and sharing this episode so those around you can live a rich life too. For more insights, subscribe to our weekly blog at heritagefinancial.net and follow heritage financial on Facebook, Twitter, and LinkedIn. Check out my personal finance blog at thebostonadvisor.com. Wealthy behavior is produced by Kristin Castner and Michele Caccamise. This educational podcast is brought to you by Heritage Financial Services, LLC located in the greater Boston area. The views and opinions expressed in this podcast are that of the speaker, are subject to change and do not constitute investment advice or a recommendation regarding any specific product or security. There is no guarantee that any investment or strategy discussed will be successful or will achieve any particular level of results. Investing involves risks including the potential loss of principle. *This automated transcript may contain grammatical errors.
About Wealthy Behavior: Heritage Financial Services
Wealthy Behavior digs into the topics, strategies, and behaviors that are key to building and protecting personal wealth and living a rich life. We’re Boston Massachusetts-based wealth managers who have been helping busy, successful people pursue their financial goals for more than 25 years. Hosted by Sammy Azzouz, President of Heritage Financial, Wealthy Behavior digs into the topics, strategies, and behaviors that are key to building and protecting personal wealth and living a rich life.