Jim Caron on the Market Selloff and the Fed's Historic Adjustment

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1:19Hello and welcome to another episode of the All Thoughts Podcast. I'm Tracy Alloway. And I'm Joe Weisenthal. Joe, look at the screen. That's painful. So if you're just tuning in right now, we are recording this. It is 4.21 p.m. on 12-18-2024. So we just had a Fed decision. They cut rates, but they call it a hawkish cut because various reasons, which we'll get into. And stocks got clobbered. S &P ended down 2.95%. Again, we're recording this after the bell on Wednesday. Yeah. I guess maybe we fix that breadth problem at a minimum. But yeah, everything is red. Bond's down too as well, which is kind of interesting to see them go in the same direction.

2:05All of which means we need to talk about markets. It's been a while since we've had like a chunky market discussion. It has been a while since we've just talked about markets. I mean, we sort of talked about them. We did an episode with the top strategist at Goldman recently. But what I would say the sort of defining aspect of markets right now, and you hinted at them, is how narrow this, you know, we've had extraordinary gains in equity markets in 2024, but the gains have become incredibly narrow. So basically, if you looked outside of anything that isn't AI, chips, crypto and quantum computing, things have been sputtering for a while.

2:41A lot was really riding on a handful of sort of hot momentum names. You sort of wondered how long that could last. And again, if you look at the NASDAQ as of right now, up 29 % on the year. Dow Jones, as we're talking about, 10 straight days, longest sell-off since 1974. That's a crazy stat. I know. It's a great stat, isn't it? Only up 12 % for the year. It's one of those days where we get to trot out all these superliners because everything's moving all at once. But we need to talk about why this is happening, how long it might last, and what it means for next year, obviously. And we do have the perfect guest to be talking to.

3:15We are speaking with Jim Caron, the Chief Investment Officer of the Multi-Asset Portfolio Solutions Group at Morgan Stanley Investment Management. It's quite a title. Jim, welcome to the show. Thank you. Thank you for having me. So let's start with the basics. You know, Joe described it as a sort of hawkish cut. Was that your takeaway as well? Well, yeah. I mean, I would say that it was even more than that. So, for example, we have to put this into context, right? So today, December, the Fed meeting, we have to go back to the September Fed meeting. That's when the Fed basically laid out the plan that they were on a mission to cut interest rates, that the terminal policy rate, that they were on a mission to get down towards a 3 % Fed funds rate, possibly even lower than that.

4:02Today, they reverse course to an extent that they actually, when we look at their dot plots, that they actually raise the dots by about 50 basis points across the board. Let me say that again. They raise the dots by 50 basis points across the board. And the dots are really just an estimation of what many of the Fed governors are thinking, the voting members on the Fed are actually thinking about policy going into the future. So instead of having about four or five rate cuts in 2025, now it's closer to like two rate cuts in 2025. So they've cut that in half. This is probably, I've been doing this for 32 years.

4:43This is probably one of the sharpest reversals, or I should say adjustments. Not really a reversal, but an adjustment. The Fed's still cutting interest rates. So it's not a reversal to that extent. They're not going from cutting to hiking. But it is significant in that they've really made a big adjustment from just where they were three months ago. They typically are a little bit more longer term thinking, but I guess they're reacting to some of the inflation data, some of the equity market performance, and potentially even President-elect Donald Trump. It's a tricky moment. You know, there's a good summary.

5:19I'm just going to read it real quickly from the Bloomberg T-Live blog from Ender Curran. And, you know, he says there are a few different needles in this press conference to thread explaining why disinflation remains on track, but why they will slow their cuts, explaining why the job market is not a source of inflation, even though it's strong, explaining why they are thinking about Trump's new policies yet, even though they don't know the specifics. These are all tricky questions. It occurs to me, I was thinking about late 2018 when we had a very intense sell-off at the time, but that was kind of simple.

5:50Paul had said, oh, we're a long way from neutral. we're still getting this sell-off at the end of the year. All they had to do was say, we're actually not going to hike as much as we thought. There really are a lot of crosswinds right now. Yeah, there are. And I think that comment on the jobs market is really what the key is. Because look, you can make the argument. You can basically say that, wait a minute, inflation's coming down, but it's really kind of stalling out at this point. It's making some progress lower, but not a lot. So that might be a concern. You could potentially look at the equity markets and say, well, equity markets have done pretty well.

6:24Credit markets, credit spreads have been very, very tight. So financial conditions are very easy. So why would the Fed continue to cut interest rates in this environment, albeit at a slower pace? And I think the answer is actually in the jobs market. So my suspicion is that the jobs market is actually much weaker than what the published data is suggesting. Now, that's an outlier view because I can't back that up with the data because, look, I'm not the BLS. I don't have all the information. But what I do know is that the QCEW data, which is a quarterly census of employment and wages, that data is a longer term series of jobs that are created.

7:09And what it's been showing over the past 18 months is that on a monthly basis, there's been significant downward revisions to the non-farm payroll data that gets released every single month. So I think the Fed believes that the jobs data is actually, or the job environment is actually weaker than what's actually being stated by the economic statistics. And it'll eventually come out into the future. And what they're worried about is an accelerated rise in the unemployment rate, which they call reflexivity, which could create a more severe downturn. So why are they still cutting interest rates is really an exercise in risk management.

7:50They'd rather get closer to their neutral policy rate at this stage because it might avoid them having to move faster later. But then what does that mean for the inflation outlook? Because I hear weaker job numbers and maybe the official data is hiding some weakness and we have seen those big revisions that you just talked about, but on the other side, inflation is still very much stubbornly above the 2 % target. Yeah, look, it's a great question. So really, it's a trade-off. It's a trade-off of basically saying that they are willing to tolerate slightly higher inflation above target. They're willing to tolerate it stalling, not rising, but stalling out right now just to make sure that the jobs market will be hopefully a bit stronger going forward.

8:38Because still what they're looking for in their forecasts are about 4.2 % unemployment rates. That's a pretty low rate. That's where we are right now. They don't have a lot of room for error. So I would say that as long as inflation doesn't start to move higher, that they're going to continue on a slow path and pace of rate cuts, and they're going to be laser focused on that labor market. the real thing that we all noticed, Tracy mentioned it, is just that big move in the equity markets. But as we talked about, you know, there's been this like, I would hate to be a portfolio manager. I would hate to, even in an up year, because I'm only beating the market if I were more concentrated in tech than the market, which is already heavily concentrated in tech.

9:23And if I were a portfolio manager, I'd probably consider myself to be a very intelligent, intellectual person, and I would swim away from the crowd. So I probably was not overly invested in tech. And so I'm in this situation, which is middle of December, and the only thing that's doing well up until essentially today has been tech. Talk to us just about the dynamics and how tricky that is for an investor here in mid-December 2024. Yeah, this really gets to the heart of portfolio management. So in many of the portfolios that we manage, we come across this risk a lot. We call it concentration risk.

9:56So what you're referring to is that it's a very narrow breath, meaning that there's several tech names, big, big names that are out there that have really been responsible for driving a lot of the performance this year. So if you want to have a more diversified portfolio, which is a good thing to do, what that meant is that you actually slightly underperformed the market because the tech sector and those seven names, the Magnificent Seven, as we call them, have actually done really, really well. So what has though started to happen, and I think will happen, and this is what our view is going into 2025, is we're starting to look away from those big MAG7 names.

10:34We're not going underweight. We're going more neutral weight like those top 10 performers. But we're starting to broaden out and we're starting to go into more of the mid-cap sector. So when we look at mid-cap, mid-cap is an area that we're looking at PE multiples that are around 16 or 17 versus the 22 or 23 forward PEs that the index sits at around now. These are companies that you know. These are companies anywhere between$5 billion and$20 billion in market cap that have better earnings potential. And essentially, especially in the new administration that is seemingly more business friendly, if you get some deregulation, this can also feed down to the mid-cap sectors that get better access to capital, cheaper access to capital that were maybe underbanked and can also lead to better performance there.

11:26as well as the cyclicality of the economy, meaning that we're not forecasting a recession in 2025. As long as there's some decent growth, we think that the mid-cap sector will actually do better. So that diversification may start to pay dividends going forward. Why didn't it this year, though? Because markets, we are told, ad nauseum are always forward-looking. Presumably, they could see this positive mid-cap environment coming. But if you look at the performance so far this year, I think the S &P 400 is up. Well, this was before the big drop today, but it was up something like 16 % versus like the 27 % jump in the S &P 500.

12:04Yeah. Why didn't it happen this year? That's a great question. And the one word answer is earnings. Yeah. Effectively, when we talk about the Magnificent Seven and we talk about those great performers, they've also had great earnings. And really, the earnings growth rate was down to those magnificent few stocks that were out there. and that's what really stood out this year. So they've earned the title of being magnificent just through their earnings. The earnings though have been in much more of a lagged space in the mid-cap sector. So for example, if you look at the S &P 500, that index is going to have a very, very large weighting towards those large cap tech stocks.

12:43When you look at the S &P 400 or the S &P S &P 600, those indices are going to have a more diversified weighting towards the mid-cap sectors. If you look at the earnings trend of the S &P 500 over the past two years, it's been straight up. It's been absolutely magnificent. But if you look at the earnings trend in the S &P 400 or the S &P 600, it would look like the economy was in a mild recession or a slowdown. It's been very, very flatlined. So what we think is that as these multiples and as the earnings growth rates for these bigger tech stocks have really reached maturity at this point, that there's going to be a shift in a reallocation into these better earning potential sectors and stocks in the market.

13:27Thank you.

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14:42EasyCater, your business tool for food. To learn more, visit easycater.com slash podcast. Over the years, there are these hot names for baskets of stocks. These days, it's the MAG-7. The old days used to be, there was the dot-com stocks, there was the nifty 50, there were the radio stocks in the 1920s, things going. First of all, has there ever been a historical parallel to what we see in the MAG-7 of such big companies also putting up such big year-over-year EPS growth numbers? The answer is not really. It is a pretty rare event to see this type of deviation or just distinction of a handful of stocks really performing so well relative to their peers for this long of a period of time.

15:29And what's going to happen in 20 – why do more people seem to think that in 2025 something is going to pivot on this? You know, it's really not that people are turning negative on these MAG7 stocks as we're talking about it. It's just that when you look at their earnings growth rates, it is starting to, and we've seen this in the recent, you know, fourth quarter and third quarter earnings, and you'll probably see in fourth quarter earnings too, is that what you start to see is that the earnings growth rate is now starting to flatline. So as I was saying earlier, what made these stocks magnificent was that their growth rates were magnificent.

16:07If their growth rate is just average, well, then I'm not willing to pay a 30 PE, a high multiple for these things anymore. And as long as you believe their earnings growth rate will be fantastic, well, then, yes, maybe a 30 PE multiple for many of these stocks is worth it. But if it just turns out that it's more of a flatter trajectory in their growth rate, I mean, still a good, solid growth rate, but nothing magnificent, you're not going to pay those high valuations. And the markets are going to turn towards these other sectors that have been left behind. So a bunch of the outperformance from the MAG7 stocks, the big tech stocks, has come as a result of enthusiasm around AI.

16:49And we have seen this bifurcation in the market where it seems like anything that is attached to AI or chips or something like that has seen this massive outperformance. And then everything else is sort of doing fine, but kind of left in the dust relatively. Is there a moment and would it be next year where you would assume that like some of the productivity gains from AI would eventually leach into smaller companies or companies that are not directly at the sort of forefront of that technology? This is the big opportunity. This is a big opportunity going forward. So what AI effectively can do is it can wring out inefficiencies in many sectors of the market that are more inefficient.

17:31Like let's take healthcare, for example. The healthcare sector is doing very poorly this year and even last year. I mean, historically, very, very poorly. This is a segment of the market that we think that AI can bring in a lot of efficiencies, whether it's on the healthcare side. We have to be very, very, very, very careful because sometimes you bring in pharma and big pharma with this, and that's not exactly what I'm talking about. But essentially, more in the medical services segments of this, if you're very specific and if you're very active in how you manage this and you're a stock picker and not just building in a big index with just a bunch of pharmaceutical names, you can actually do pretty well.

18:12Other areas like materials, industrials, these are other areas that are a little bit far afield from healthcare, but still can get the benefits of some of the AI technologies coming in. And what you're going to find is that more and more brick and mortar types of companies are going to start to incorporate it. The impact of AI is to really bring in higher productivity, which is higher growth with lower inflation, into sectors that are relatively inefficient. So people look at like tech and they look at like financials. Yes, absolutely. But you know what? Financials, financial companies are already pretty efficient just by definition.

18:48I mean, they're financial companies and that's what it effectively operates on. Tech is the engine that creates a lot of these things. But again, a lot of that is in the price. So we have to start to move to areas that have been the laggards that we think that there could be some technology gains that can really drive the earning cycle. So one of the things that comes up a lot of times when we talk about multi-asset portfolios is that really the only thing, I mean, yeah, you can maybe diverse away from big tech into medium tech or medium tech into small cap tech, but there's been no juice in EM.

19:22There's been no juice in Europe. There's no juice really even in treasuries. They haven't done anything to even hedge you on a day like December 18th, 2024. what is the role for non-US equity right now in a multi-asset portfolio? So non-US equity and many people - And over non-equity at all. So international equity - Or a fixed income. Yeah, or anything like that. Okay. Well, let's start with international equity, first of all. And let's start with Europe. Europe is really a large cap value play. And what has large cap value done? Not so well, right? Because the growth sectors and the tech sectors have done really, really well.

20:01So I would say that the role that international equity plays as a large cap value style of looking at the markets is it's really more of a stabilizer. So it's a diversifier in that when you typically have these downturns in markets, those large cap value segments actually outperform. They do better than the higher beta growth sectors in the marketplace. So there is a positive cash flow there. There are dividends there. There are some opportunities. We can move to places like Japan, Japanese equities, one of my favorite markets. So here we are. We have some inflation. Inflation is going to drive earnings.

20:42And I think the inflation is sustainable and durable in Japan. Plus, you have changes to corporate governance. It's becoming much more dividend-friendly, shareholder-friendly, buybacks, all of the various components there. Pension funds are turning into less savings plans, which is fixed income, and more into investment plans, which is more equity. And if the world is going to onshore, particularly in the US, you know, Japan is very, very well leveraged to large scale CapEx. So I think there's a lot of things that are pointing in the direction to, you know, to Japanese equities in the long term.

21:16I know we've had three bad decades, but I think that this is the decade. This is the decade. This is the decade that's going to happen. Let's turn to fixed income. One thing that you said right in the beginning of this podcast is that there's fixed income and equity. There's no place to hide, right? If we look at the screens today, everything's red, bonds and equities. When the equity markets go down 2 % or 3 % like they're doing today right after the Fed, you would expect to get some safe harbor from bonds. Bonds should definitely do well typically, but they're not. And this is the big issue with asset allocation going forward, is that the correlation of returns between fixed income and equities is very high.

21:57It's at multi-decade highs. What that means is that if the correlation of returns are high between bonds and stocks, that means it's hard to have a diversified portfolio, right? It's hard to own stocks and bonds and that hopefully bonds bail you out or help you when the equity market turns lower. So essentially what that means is that we all have to think very, very differently going forward because what's happened is that the market's become very complacent on the fact that from 1981 to 2021, we were in a 40-year bull market in fixed income. All you had to be is a passive investor buy and hold, and you did really, really well.

22:32It diversified your portfolio perfectly. What if today interest rates just move sideways? That would be a structural shift in the way that we think about a diversified portfolio. That means some years bonds do well, some years bonds don't. They correlate with equities many times in many cases. So that would suggest that when we think about asset allocating across fixed income and equities in a multi-asset portfolio. And let's not forget about alternatives too, that now we have to think about being much more actively managed, particularly in fixed income, as opposed to passively, meaning by active managers as opposed to passive.

23:08Same thing with equities. It's less going to be about the beta. It's less going to be about multiple expansion and these MAG-7. And it's going to be much more about sector rotation. It's much more about the alpha and picking sectors and even picking stocks. So again, more active management versus passive management is a big change. Alternatives. Alternatives are another way to diversify your portfolio. Because essentially, when we look at these are longer term investment profiles that typically aren't necessarily just trying to track the economic cycle like fixed income and equities do. They're really looking at valuations, mergers and acquisitions, LBOs.

23:49They're looking at a very, very different timeframe, and your returns are coming from different areas. In other words, it's orthogonal to your stock and bond portfolio, and that's what creates a lot of the diversification. So going forward, you're going to have to mix alternatives into this multi-asset sector. It's not just stocks and bonds. Just out of curiosity, I mean, you are, I'm going to say your title one more time, even though it is a mouthful, Chief Investment Officer of the Multi-Asset Portfolio Solutions Group at Morgan Stanley Investment Management. On a day like today, when bonds are going down, stocks are going down, it feels like just about everything is going down.

24:24Maybe private credit is doing okay because it's not mark-to-market on a daily basis. Yeah, there we go. There's your safe haven. What is a day like today actually like for you? What are you doing other than here in the studio talking to us? Look, I'm excited about today. And I'll tell you why. I'm not just saying that. because we've been looking for a good entry point into the markets. We are not bearish going into 2025. We think the economic fundamentals are going to be good. Why is the Fed increasing, potentially not cutting interest rates as much? It's not because the economy is weakening. It's because they think the economy is stronger.

25:00So that should be a positive for equities. So when I look at equities today and they're down almost 3 % on the day, I'm pulling out my shopping list, right? And I hope I'm checking it twice and I'm going after all these things, all the Christmas references. But effectively, this is a very interesting opportunity. The other thing too is that bond yields have spiked. 10-year yields have gotten up to 4.5%. Well, guess what? That means as I look at my shopping list for equities and I can look at this and I can increase my equity allocation, I can also buy bonds at a good yield to actually hedge that.