Is Your Portfolio Ready For What's Next? ft. Omar Aguilar & Sebastien Page

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2:00Welcome back to Real Vision. I'm Ash Bennington. Today, we have a special treat for you. We're joined by not one, but two industry-leading chief investment officers, Sebastian Page, head of global multi-asset and chief investment officer at T. Rowe Price, and Omar Aguilar, chief executive officer and chief investment officer at Schwab Asset Management. Our guests are here to discuss some of the most pressing topics in today's macroeconomic landscape. Gentlemen, thank you for joining us. Thank you, Ash. Thank you. Happy to be here. Guys, lots happening right now. Let's start out for our viewers with the 50 ,000-foot overview, the big picture of what you guys see going on in the macro landscape today.

2:44I'm going to go left to right. Sebastian, first to you. Ash, I don't expect a recession in the next 12 months. The probability is never zero, but that's not my base case. In our asset allocation committee, Ash, we're having the mother of all debates between the bulls and the bears. our portfolios are very close to neutral between stocks and bonds what are the bulls saying what are the top arguments for the bulls and what are the top arguments for the bears if i tried to make it really simple i would say that the bulls are saying look let's be very pragmatic rates are coming down and earnings are coming up.

3:34That's generally good for risk assets, for stocks. What are the bears saying? Well, their top arguments are pretty compelling too. The economy is slowing. If you look at manufacturing PMIs or economic surprise indices, for example, and valuations are really high. We're close to all time high on stocks. The price earnings ratio is 21. So slowing economy with high valuations, it gives the bears pretty good ammunition. So here we are. And when I say Ash neutral between stocks and bonds, it's all about being fully invested at a risk level that matches your long-term risk tolerance. So a lot of people like the 60-40 portfolio, but if you're early in your career, you might have 80 % stocks for the long run.

4:32Well, if that's your position, just stay at 80-20. If you're a 60-40, stay at 60-40. Just be close to how you're prepared to take risk in general in markets. Now is not the time to be a hero. There are opportunities for tactical asset allocation, and I hope we'll talk about them. but if you look at what the bears are saying what the bulls are saying it's a pretty good debate and it speaks to staying neutral as we get into the election i'll say one more thing ash on how we're thinking about markets you know we often say markets are expensive these days and that's a good argument for the bears but i think omar's talked about this as well you know it's very bifurcated.

5:20You're looking at an average valuation of 21 price earnings ratio. But I'm reminded of the analogy that I like to use of the statistician who apparently had their head in the freezer and their feet in the oven. And Ash, they claimed that on average, they felt awesome that their body temperature is perfect on average. Growth stocks have a price earnings ratio of 30, which is 10 points above their long-run average, while value stocks have price earnings ratio of around 15, which is actually right on their long-run average. So, and then you look at small caps and emerging markets, you have this bifurcated, concentrated market where some stocks look expensive while others don't, and the average doesn't tell you much.

6:10Sebastian, very well said, very crisply brimmed. Omar, over to you. Sebastian touched on some of the key issues that we've been talking about here on Real Vision. Big picture, what's your view of what's happening right now? Yes. And, you know, by the way, I'm a statistician, so I actually have never put my head in the freezer to begin with, but I actually can't understand, you know, how could that feel? Well, you know, a few things, starting just with the macro world and what we have observed, you know, and the way that we look at the bigger economical picture is that we have shifted from what used to be the discussion about inflation.

6:48If you recall, not too long ago, all of us were just talking about how high the inflation-wise, how this was historical for all terms, not just in the United States, but globally, how the big spikes and the inventory issues that we had, supply chain disruptions because of the pandemic, ended up putting a significant amount of pressure across the globe on inflation. And obviously, central banks, starting with the Federal Reserve, talk about the transitory version of that inflation. And therefore, their monetary policy started to just become incredibly tight to try to fight that. So when you think about that, that it was not too long ago, we were just talking about that even a year or a year and a half ago from this.

7:38going now into the opposite side where we see the effects of this inflation affecting the global economy. So it is a natural, you know, component to think that if inflation is no longer the discussion across central banks and across investors and across, you know, clients and corporations, obviously the focus now becomes on what is the state and what is the health of the economy. So the bigger question right now is that if we think about the decisions that central banks have to make, is that, well, if we think that inflation is no longer the issue, what will basically make us go faster in reducing rates for monetary policy and therefore sustain an economy that can grow at a good pace?

8:23And the answer to that is labor market. So a lot of the discussion goes from now, you know, going from inflation to now, you know, is the labor market something that will potentially put economies in recession? And the answer to us continues to be the answer is no. You know, we see the softening in labor market is being more supply driven, which means, you know, people are not getting fired. What happens is that there is a significant amount of extra workers that are looking for jobs, but there are not that many openings. And what that means is that, well, usually if the economy is in a bad shape or if we're getting close to recession, I think Sebastian said this earlier, if those probabilities of getting into a recession were very, very high and therefore we see that we're naturally going to go there, well, number one, we will see significantly more pressure in the labor market.

9:11And also we will see a reduction in productivity because basically corporations are just reducing costs at all costs. Now, what that does is that it would put the pressure on central banks to be faster in reducing rates. So the question that we have seen, obviously, and we have received from our clients is that we're starting the new cycle for the Fed, and then the ECB just cut rates this morning to second time, which means that every single central bank is in the process of going to the easing cycle. And when you actually go to that, is it going to be faster or is it going to be slow? And the answer to that is really the health of the economy.

9:51Since we're not in recession territory, since we're not even close to just getting to our recession, then central banks have a lot of flexibility to be able to reduce rates and therefore being able to sustain some level of control over inflation while at the same time don't disrupt the economy too much. So it is an interesting piece where it's going from what it was a hot economy, slowing down the economy going now to what we think is going to be a soft landing. But as Sebastian said, and we have established and published, is that it is all bifurcated because it's very confusing. On one hand, you see PMIs being under pressure, labor market being under pressure, housing being under pressure.

10:31And on the other hand, and then the economists and statisticians have three hands, the other hand usually talks about, well, earnings and corporations are good. Balance sheets are still pretty good. The credit market is still pretty good. Consumers still doing pretty good. And overall, you see that bifurcation that Sebastian was talking about and that we have discussed where there is enough emphasis on the potential headwinds for the economy that are countered by the tailwinds that also the economy will have. For us, what that means is we're all going back to the normal. And what that means is finally, and this is just the first quarter we see this, a lot of the numbers and a lot of the things started to make more sense, more than what we had after the COVID recession that we had several years back.

11:17We finally see that normalization of many things, normalization of the labor market, normalization of the housing market, normalization of the areas that produce inflation, like wage growth, or areas that produce challenges like supply in the rental market. So we see a lot of that normalization that will transpire into what monetary policy be that also will go to a more normal cycle. Guys, so much to talk about. Very well said, Omar. Let's talk a little bit about this idea of normalization, where we are right now. I mean, one of the interesting things about this particular moment, I know I've said this word a lot here, which is this idea of unprecedented.

11:55Obviously, when you look at the charts, be it CPI, when you look at the U6 numbers, the U3 numbers, when you go back decades, we've just not seen anything like this. We've had this bizarre kind of inflation snapback. Obviously, we got up to about 9 % on CPI two summers ago. Now we just got the latest August number trending at about 2.5 % on an annualized basis, trailing 12 months. Just an extraordinary snapback scenario. Is this true normalization? Do we have hysteresis effects? Do we have effects in these markets, be they the labor markets, challenges with inflation that may be durable, that may be just a little bit wobblier than we're used to typically seeing just because of the head snap that we've seen in all of these markets as a consequence of, on the one hand, the COVID shutdown, and on the other hand, the reopening.

12:50Ash, I would say there's a lot of whiplash from a lot of investors and a lot of economists. A couple of months ago, I had to tell my team, stop looking at year-over-year charts. Now, this sounds trite, but if you have a massive shock up in inflation or in house prices or in job creation or in liquidity, and you're used to looking at year-over-year changes, changes now pretty soon as you normalize those numbers are cratering because you're on the other side of the roller coaster and that's flashing a bunch of red signals in your macro dashboard and it's so simple but I think that's why a lot of economists got the last recession calls in 2023 wrong everyone's calling for recession the probabilities were in the 60 percent of recession according to the Bloomberg consensus.

13:49So I asked my team, okay, you can look at year-over-year charts, but show me the level as well. And so interpreting data in a normalization process with this whiplash involves thinking about levels as well as year-over-year changes. Take unemployment. It's at 4.2. That's actually not too bad. And it's not the average of, just look at the average of the last six, seven recessions. It was in the fives. And it's the same with job creation, right? There was a lot of market volatility after we got an unfarm payroll of 114 ,000. That's go back to the history. The average is something like 130. That's not from a level perspective.

14:34It's not that bad a number. So it sounds trite, but I think this whiplash is what's confused a lot of economists. And I'm not I don't want to just pick on economists. They have a really tough job. And I read a lot of economic research. I don't want to pick on anybody. And statisticians, what we do in investment management is hard, Ash. But just look at the end of last year. We had three months in a row where if you took the three CPI prints at the end of last year and you annualized it, we were running at 2 % inflation. That was at Q4 of 2023. And then what happened in Q1 of 2024? For the three months annualized, all of a sudden we were running at 4.5%.

15:31And then we went back down. So this is the whiplash. The base case is that inflation is coming down. Omar talked about it. He talked about the big, massive transition from inflation risk to growth risk. Have you ever wanted to trade Bitcoin but haven't dared try? With Plus 500 Futures, you can trade crypto without the hassle of opening a wallet. With just a few clicks, you can register and start practicing with their free and unlimited demo. See a trading opportunity? You'll be able to trade it in just two clicks. Feel ready? You can move to real money with as little as$100 once your account is approved.

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16:45I'm focusing on unemployment and central banks are really eager to lower rates. But I'm not ready to say that inflation risk has gone away. I'm not talking about going back to 6, 7, 8 percent. But I think you could have a commodity shock. the inflation outcome could be inflationary under certain scenarios. Housing is not that predictable. It's not that sensitive to rates anymore. You could have all sorts of things that would take you back to 3%, 4%, 5 % pretty easily over a 3%, 4%, 5-month period. What then? So I don't think the risk is gone. And I don't think Omar thinks the risk is gone either.

17:24He's just describing the base case. But so in our portfolios, we do have some hedges for inflation risk in this environment, even though the base case that inflation is coming down. And what I would probably add to all this is there, I guess, let's just remember a little bit of how we got to this point and how these, as you mentioned, unprecedented statistics, you know, ended up showing up in all our screens. And I agree 100 % on just not necessarily get fooled by, you know, the denominator and the basis of how you calculate things on percentages, because that will distort anybody's, you know, screens, and it will look weird.

18:06But if you think about just how we got to this place, it was because the unprecedented, going back to the word that you mentioned, of what we had during the pandemic. The pandemic basically created an unprecedented distortion of lives, an unprecedented distortion of balance sheets of corporations and consumers, because for a year or year and a half, or in some cases longer, people didn't use. They had a lot of that. They basically ended up accumulating cash and creating these very strong balance sheets. And then, you know, when you when you created that structure and created the supply, you know, issues that we discussed, all of a sudden all got together to create it that, you know, very real inflation pressure that translated into further escalation because of wage growth.

18:57So in other words, if prices of goods and prices of of of services started to go up, employers and employees will demand for higher wages and that therefore created more pressure for now, you know, another source, which is now wages are going faster. So when you combine those effects, you know, the inflation was real and the inflation was something that was completely underestimated by the majority of people, including central banks. And therefore, you know, we got to those levels where it became so real and so clear that needed to happen and needed to change. Now, what I believe is being the case, and I think that's what gives, you know, central banks, and all of us in the investment area, a little bit more of an account situation is to say, we know the trend on inflation has actually gone down.

19:46And we will see these flips and this volatility in the numbers on CPIs, PPIs, continue to just go up and down because, as Sebastian said, it is not very clear that all that is gone. There will be other reasons why these things may change. But we can see the trend is going into the right direction. And we can see that not only that, but central banks, because of the way that they raise rates during the periods of high inflation, they have a significant amount of flexibility to be able to work with that. In other words, you know, you know, the Fed today is at, you know, 525, 550, you know, and they have a significant amount of room to be able to reduce rates to stimulate the economy if they see a growth, you know, issue.

20:29Or they can stay if they think that inflation is coming back. In other words, they have created the right setup to be able to prevent for something else that may change, you know, the way they are. Now, again, in our view, there is one component, and I'll say the last, that has also not necessarily been well described, which is the effect of China. China, for the longest time, especially the years after pandemic, became a source of inflation. Basically, they were exporting inflation because a lot of their manufacturing goods were more expensive. Now, we are now in the opposite side because of the way that the Chinese economy has evolved over the last few years, particularly their challenges in terms of demographics as well as of some of the real estate issues.

21:16Now they're at the point where the economy has slowed down so significant that now they're basically importing this inflation to the rest of the world. So a lot of what we see in terms of goods and services, commodities and others, lower prices that have actually put a lot of the CPI, PPI numbers and others being lower in terms of inflation have also been directly or indirectly linked to the way that the Chinese economy has evolved. So when you put that in perspective, we see that in inflation side, the goods continue to go down to a trend that everybody seems to be very comfortable with. The services side, which is more of a local source of inflation, is still sort of the rest that we think we could potentially have.

21:58But with the labor market being our barometer, we can probably see that that's manageable going forward. Omar, important points there about China. I want to pick up on your prior point about where we are right now with the Fed, this expectation of a rate cut. By the way, I should say for our viewers and listeners who don't follow these markets as closely as you two guys do, the important point is if the last 10 minutes, what we've been talking about here, you hear words like hysteresis, unprecedented. We talk about base effects, all of these things. The bottom line is this type of economic cycle prediction is challenging enough under ordinary circumstances.

22:33If we're having this conversation, oh, I don't know, in 2019 with our two great guests, these are challenging questions. then. Now you add on this additional layer of complexity from the closing down of the economy, the reopening of the economy, base effects, all of these challenges. This is a complicated time for everyone. And it's great to have both of you here as we unpack these issues. So let's talk about what's on everyone's mind right now, which is what's happening with the Fed. You mentioned Omar ECB cutting. They are ahead of the Fed in this in terms of global liquidity. Let's talk about the expectations for where the Fed is going to move next week.

23:11Guys, Sebastian, over to you first. Big picture analysis on what's happening at the Fed. So the most likely case for next week is probably 25 basis points, but there's a little bit of a debate between 25 and 50. The core inflation that we just had was a little bit higher than consensus, and that might push the Fed to just do 25. But if you step back and you look at what's priced in, in terms of number of cuts, by the end of 25, that number is 10 cuts. That is a pretty rapid and aggressive cutting cycle. One of our analysts sent me this yesterday, where he looked at what's expected in terms of cuts as a proportion of the current level of rates.

24:06And he ranked all the cutting cycles in history. And this would be the second, by that measure, most aggressive cutting cycle in history. And it's kind of odd if you step back, right? Because Omar and I aren't talking about huge recession risk, which is usually when the Fed cuts. So what's going on? Well, the real rate is pretty high because if inflation really is coming down to, say, two and a half, and the Fed funds are at five and a half, the difference, that real rate, is pretty high. I also have a theory that about half the people I ask agree with me strongly and the other half disagree with me strongly.

24:51So let's see where you fit, Ash, on that and Omar. But, you know, the level of government debt is so high that I think it is making the Fed on the margin eager to cut rates. Because debt service is exploding, exploding. Talk about unprecedented levels of debt service, the cost. It's going to be like the number two biggest expense for the government. So I think that creates an environment where the Fed wants to cut. Now, if you ask an economist on the 50 % that disagree with me, they'll tell me, again, I'm not picking on economists today. Maybe I am. They'll tell me, look, the Fed is not supposed to do that.

25:39It's not supposed to look at the fiscal situation at all, right? And then if you talk to others who kind of just look at it on the surface without much of an economic lens, they'll say, well, yeah, you got to bring the cost of borrowing for the government down because that deficit is just exploding. So Ash, Omar, tell me where you stand. I even did a survey on LinkedIn of all my followers who are mainly finance people, and it was about 50-50. And the question was, is the Fed eager to cut because debt service is exploding for the government. And it was 50-50 kind of answer. So I'm curious where you all stand.

26:19Well, it's interesting. They're not supposed to consider debt service. They're also not supposed to consider U.S. equity market levels as well. So I guess you could take that all with a grain of salt. But to your point, and it's such an important one, you talk about the exploding cost of servicing the debt and the crowding out effects on the fiscal side as a consequence of that. I would also mention exploding public debt to GDP levels. If you look at that chart going back 50 years, certainly cause for concern. Omar, I'm curious about your thoughts and the question Sebastian posed. Big picture, where do you fall on this?

26:51Omar, notice that he dodged a question. Well, I would probably say, I don't know if I'm considered an economist, strategist, or a statistician, but regardless, our point of view, at least on the Fed, it is, and related to the specific question, is that the level of debt has always been a concern and the discussion in central banks, and this has gone back even to the Greenspan days, you know, and the discussion around it is probably less relevant to the current cycle of what their decisions are, and they will probably not make monetary policy based off that. With that in mind, the government and the Treasury Department seem to be more preoccupied for what that could mean going forward.

27:37But I mean, our approach, or at least our thinking right now is that the Fed decisions may not necessarily be influenced by what may happen with the level of the deficit, or what may be even with what would be the next tax policies that we may have after the election. So we believe that, you know, at least for now, you know, the Fed has two clear mandates that they continue to follow. And they have one that is unwritten, you know, which is, you know, On one hand, they're looking at inflation. The second mandate is looking at the labor market. And the unspoken mandate is financial stability. That I think, Ash, to your point, we believe that Jerome Powell, Chair Jerome Powell, has a big terminal in his house and in his office.

28:21Would you see the equity and the fixed income markets and see how they behave every day, even currencies? They want to see what the dollar is. And I think that's probably something they look at a lot. And I would probably say, which is the original question. Omar, Omar, connect. Give me one sec. Give me one sec. So the original question related to whether or not it's 25 basis points or 50 basis points had to do in many cases with what is the message they want to have. I think based on the pure structure of what the Fed has done and how they operate and how the committee works, the many things that they are looking at is that in their mind and in our mind as well, they have the room to do 50 and do several 50 basis points without having a significant effect on the economy.

29:08Because I think Sebastian said this earlier, we're not in recession territory. Usually the Fed cuts rates most aggressively when they see a significant challenge in the economy. Now, we believe firmly that they're not going to do 50 this time because they see inflation trend is going into the right place. They see the sources of the labor market being under control and in a certain way, just as Sebastian said, back to the normal, back to the averages. So they see that they're too mad. They seem to be in controllable territory. So if they do 50, the message they will send to the market is that something is wrong and that the economy may be in trouble.