Making Sense: October Market Update

Amy: Hello, everyone. Welcome to the First Citizens Wealth Management Webinar Series, Making Sense, where Chief Investment Officer Brent Ciliano and Director of Market and Economic Research Phil Neuhart help you make sense of what's going on in both the markets and the economy. I'm Amy Thomas, a strategist here at First Citizens Bank. While everyone's signing in, I will walk through a couple of housekeeping items with you.

First, today's webinar is being recorded, and a replay will automatically be sent to you following today's conference. Secondly, this webinar is interactive. If you'd like to ask a question, please use the Q&A or the chat feature on the right-hand side of your screen. All questions are confidential and only visible to myself and the panelists. I do want to remind you that we try to keep our discussion broad. If you have a specific question about your financial plan or we're not able to answer your question during today's call, please reach out to your First Citizens partner. As a reminder, the information you're about to hear are the views and opinions of First Citizens Bank and should be considered for educational purposes only. Brent, with that, we're ready to go, so I'll turn it over to you.

Brent: Great, Amy. And good afternoon, everyone. Hope all of you are well. Phil, boy, do we have a lot to unpack today. So we're going to break down today's call into three sections. First, we're going to give you an update on the labor market, the consumer. We're going to talk about inflation, interest rates in the Fed. But we're also going to talk about residential and commercial real estate and what's going on there. And then Phil, it's hard to believe, two weeks to midterms.

Phil: Crazy.

Brent: Crazy, crazy. So we're going to give you an election preview, where bidding odds are right now, what that means for markets. Then we'll talk about where markets go from here. We'll talk about corporate earnings and profitability. And what would a corporate earnings recession mean to stocks, at least historically? So why don't we jump right in, Amy, and let's go to the economic update? Let's talk about the labor market. Phil, the labor market remains resilient. We had a strong jobs creation in September, 263,000 jobs. Consensus 255,000.

Phil: Yep.

Brent: Unemployment rate falls from 3.7% down to 3.5%, matching the 50-year low in unemployment, just incredible jobs growth. Six-month moving average, 360,000 jobs created. Remember, we only need 100,000 jobs to keep the unemployment rate from ticking back up. So the labor market continues to be that bastion of resiliency. On the right-hand side, we talk about the labor market. We talk about wages. And average hourly earnings came in at 5%, down a little bit, Phil, from the 5.2% that we saw for the last couple of months, but still 70% above the 15-year average of 2.9%. So average hourly earnings, wages still very, very resilient despite some of the economic frictions.

So let's talk about the labor market wages. But Amy, if we advance and we talk about how consumers feel. University of Michigan Consumer Sentiment, we saw that really bottomed out in June at 50.0, which was the lowest reading, Phil, in the entire data series going back to the early 70s. Well, thankfully, consumer sentiment has picked back up and has stayed a little bit high, so that's good. And when we think about that feedback loop into spending like we see on the right-hand side, spending on goods, spending on services, and we're looking at the gold line, which is goods, gray line, which is services, both triangulating to a year-over-year growth rate of 8.2%, certainly moderating lower, but almost double the 20-year average of 4.2% and 4.4% respectively. So again, labor market consumers still doing well.

Phil: That’s right, so the yeah, the consumer is hanging in there. But the real issue if we flip ahead remains inflation in this economy. So consumer price index, we're showing the left side. We show this chart every month. Headline inflation, which is the gold line, is still 8.2%, so—

Brent: Very high.

Phil: So it's ticked down. You can see from north of 9%, but, but, just unbelievably high, four-decade highs, essentially, and core CPI, which excludes food and energy, a preferred Fed measure, excluding those volatile components, has actually re-accelerated. So you're not back to the previous highs of the year, as you can see in the gray line, but you are seeing re-acceleration. This is problematic and something that has swung markets around.

Brent: Absolutely.

Phil: And inflation is broad-based on the right side here. We're showing the percentage of CPI components by various cohorts, right, so the greater than 5% cohort or tranche here, 66% of components, CPI components—

Brent: Yeah, incredible.

Phil: Inflation north of 5%. So this is not a couple components pushing CPI, higher gasoline prices, for example, et cetera. It is broad-based and this is why the Fed is moving so actively. So where might inflation go if we flip ahead? A common question is something we already saw in questions leading up to the webinar.

Brent: Yeah.

Phil: On the left side, we're showing actual inflation on a quarterly basis. That is the gray bars as you can see. Third quarter is finally in a little bit lower than second quarter, still unacceptably high. And then the gold bars are consensus estimates. Now, when we say consensus here, this is economists' estimates.

Brent: Yeah.

Phil: So these are people with models that hopefully are decent at predicting inflation. We'll get to that in a second, how good they may or may not be. But basically the models are showing that inflation ticks lower but remains unacceptably high. Right, you don't see any negative numbers here. Inflation is still positive. And if the Fed target is 2%, you don't hit 2% all far-forward as first quarter of 2024.

Brent: That's right.

Phil: First quarter of next year, 5.9%. These are far too high. And the other thing we'd like to point out is, as of March 2022, this year, right, the black diamonds, that's where consensus was.

Brent: Right. So it shows how much lower consensus was and how wrong. Unfortunately, the Fed was wrong also.

Brent: That's right.

Phil: So the experts really missed this. Hopefully they aren't missing where we are today. We are seeing a tick downwards. We'll talk about in a moment a lot of reasons why inflation we think can moderate, but it's going to remain high. So we don't want people on the phone to think, oh, inflation can be low.

Brent: That's right.

Phil: Moderating is not low.

Brent: Yeah.

Phil: Now all this inflation is forcing the Fed's hand. So on the right side, this is the Fed funds rate probability as of the December 14th meeting. So we have two meetings left. One is next week, right, November, November 2nd, and then of course, December 14th. So these are the probabilities of where the Fed funds rate is at that December 14th meeting, after that meeting, the next two meetings. So the current target rate is 300 to 335 basis points, as you can see here. That's, that's a fancy way of saying 3% to 3.25%. Right, basically, Fed funds futures are split 50/50 in terms of the probability that the Fed funds rate goes up to either top-end range of 450 or 4.75%. So you're talking, what, 150 or 125 basis points. Right, so what does that look like? Likely 75 basis points. That's pretty much in the bag next week. And then in December, is it 50 or another 75 basis points? The real takeaway here is the Fed is very active and very aggressive. And to that point, if we flip ahead, we can see the path of the Fed funds rate. Right, which you notice here. And the most recent hiking cycle is that's basically a straight line up, right? The last hiking cycle is this nice stair-step here. We are seeing very aggressive Federal Reserve because they were late to the party, and the last meeting, September 23rd, the Fed increased rates by 3/4 of a point. That was expected, but it did surprise markets where their summary of economic projections, which they release on a quarterly basis, and what they said is what we're showing here. And the gold bar is that's their estimates as of June for the Fed funds rate looking forward. Their update in September is the green line. And look how much—

Brent: Imperial increase.

Phil: So, and look, also in those projections, they said, we expect higher unemployment, we expect lower growth. And that's no coincidence. They need higher unemployment, lower growth to get inflation down.

Brent: Absolutely.

Phil: So that's how they achieve what they want to achieve. So we are in a situation where the Fed is very aggressive. They are speaking to that. Unfortunately, we don't get the next set of economic projections till December.

Brent: Right.

Phil: So we're in this period where there's going to be a lot of guessing and it is going to make next week's meeting important from the statement perspective and the press conference—both will be important as we look ahead to next year.

Brent: Yeah, and the Fed rhetoric that we've heard over the last several weeks, fighting against and causing market volatility both in fixed income and equities is that, not only to your point, are rates likely to move higher, but to stay high. That, that second dot, when you really pull that down, that's expectations all the way through the end of next year. So they're being steadfast in their verbiage to say that, hey, we're taking rates higher and we're going to stay higher for quite some time. They want, they want to get the phrase "Fed pivot" out of the market—

Brent: Exactly.

Phil: —consciousness. They are saying we need to be aggressive to fight inflation. It's not just about interest rates. If we flip ahead, it's also about Fed's quantitative tightening.

Brent: That's right.

Phil: So quantitative easing is when they buy treasuries, mortgage-backed securities. Quantitative tightening is when they let their balance sheet roll off and reduce. So what you're seeing on the left side, this is Fed purchases of treasuries as a percentage of the US public debt, that's falling.

Brent: That's right.

Phil: And this is something that we've also seen some questions on this as well. We'll dig in, too. But you are seeing less Fed activity in the Treasury market and this, with higher rates, is leading to tighter financial conditions. The right side, this is the financial conditions index which uses a lot of metrics underneath the hood, but a negative value here indicates tighter financial conditions. We are there and we've been there this year. That is playing out not just in the fixed income market but also in the equity market as well.

Brent: Yeah, and when you look at the chart on the left. And when you look at that year-over-year purchase of public debt, remember, the Fed just really started quantitative tightening in earnest in September at $95 billion a month. Fast forward over the next several months or quarters, you're expecting that to come down significantly, potentially even getting negative. So let's talk about a great picture for all of you on why inflation, you know, reared its head and is so high. The chart on the left is looking at M2 money growth, or in English, money creation from 1961 all the way through to today. And when you look at that huge spike up, that is a manifestation of the post-pandemic infusion of more than $5 trillion in fiscal stimulus, more than $5 trillion in monetary stimulus. The increase in money printing and money supply is double the highest level that we have seen in history. So when you think about it, you look back and say, well, jeez, no wonder inflation is rearing its head—if the panacea to any economic ill was for central banks or governments just to print their way out of problems, then we would be doing it all the time. Right, so when you look at the chart on the right, we're taking a magnifying glass to that big supply, that big shock up. And what we're looking at, the gray line, is core CPI on about a 13-month lag. And what you can see is that core inflation is very, very correlated to the rate of money supply growth.

Phil: Right, it's on a lag.

Brent: Yeah.

Phil: Money supply comes down, doesn't mean inflation falls the next week.

Brent: Absolutely.

Phil: It does take time to feed into the system. On the left side, what draws my attention is if you think back to 2008, it felt like so much stimulus—

Brent: Exactly.

Phil: So much money printing, and look how small that 2008 uptick is versus what we saw post-pandemic.

Brent: It's the order of magnitude, just incredible, incredible. So let's talk about some other data points to your point, Phil, that might mean that inflation could potentially moderate at a faster pace going forward. I know that we showed this slide on the last Webex, but if you look at the chart on the left, you know, retail gasoline price on a national average continues to fall down. I know a lot of our listeners in California are probably thinking that we just fell off the Christmas tree here as it relates to lower retail gasoline prices. But on a national basis, gasoline is still coming down. When you look at the right and we look at University of Michigan Consumer surveys as it relates to whether or not it's a good time to be buying a new or used car. Lowest observation in the entire time series of history. We think that will likely feed back into the prices of new and used cars, hopefully bringing down some of that egregious inflation.

Phil: And just this week, we heard from automaker supply chains improving some.

Brent: Exactly.

Phil: So we know supply is improving even if it's on incrementally. At the same time, consumers are saying it's, this may not be the best time to buy. Eventually that should feed into, to price inflation.

Brent: Absolutely, on a lag for sure. So when we think about the global supply chain issue, as we advance the slide, Amy, and we look at the chart on the lot, on the left, and we look at the Federal Reserve global supply chain pressure index. So we're thinking about transportation costs, delivery times, back-order logs, all that into one graphic. You can see that global supply chain pressures are starting to ease, and they've continued to tick down. Now, certainly when you look at that, still significantly high relative to history, but the directional vector is moving in the direction that we want. We heard from some automakers this week, some from shipping companies that we're talking about in their analyst calls, that they're starting to see global supply chain pressures ease a little bit, knocking on wood whether that continues. On the right-hand side, when we look at a component of that global supply chain pressure index, looking at the container freight rate or the cost to ship a 40-foot box, the things that we see on those big ships that we ship out of the ocean. Right, right. We've seen the cost of shipping containers continues to fall. Still again, significantly elevated relative to history, but again, moving in the right direction. So again, hopefully the cost of freight shipping, the cost of shipping in general coming back down.

Phil: That's right. And it really is something that we hope continues. Still elevated versus history, but the directional vector is certainly hopeful on the inflation front. So let's turn to housing. So housing is a double-edged sword when you think about one, obviously, housing slowing impacts all of us. Right, but it also can be disinflationary. And what we are seeing, and it's something we talked about for a long time, it wasn't that big of a prediction in the first quarter. Say, housing, is this going to slow? Right, given some of the irrationality we were seeing in the fact that mortgage rates were moving up, but it is slowing. It's slowing precipitously. So on the left side, this is existing home sales. This is the largest market compared to new home sales. And what it's doing is it's falling pretty quickly. We are well below the levels of pre-pandemic.

Brent: Which is incredible.

Phil: Now, some of that was probably sales being pulled forward into 2020 and 2021 and early this year as mortgage rates were still very low. What's happened is mortgage rates are higher and home price appreciation was so incredible that affordability has fallen dramatically. And just not as much of a sentiment to buy a house. And what you're seeing is that's feeding into prices as you would expect. So on the right side, we're showing the percentage of active listings with price drops. Recently that was 5%. If you were cutting your home value 9 months ago, that was pretty surprising, right?

Brent: Something wrong with your house.

Phil: That's right. And now, now you're well north of 20%, right? That, that sounds right. And that's what we're seeing anecdotally in markets. And it is something we are seeing in the broader data. And speaking of that data, if you look at national home prices on the next slide, this is the Case-Shiller Index. Just got an update on that this week. Now it's August data, right? So it's a big lag. But what you saw was that home price appreciation year-on-year fell to 13%. That was recently around 20, north of 20. So it's coming down now. We're sitting here in late October. I think it's pretty safe to say this is going to keep coming down as we get more data points. But the home. We all know that the housing market is slowing, and we are seeing that in the data. Housing starts, you're seeing it as well. Right, so let's talk about supply, right? Why might this not be a 2008-type scenario? Well, there's a couple of reasons.

First, let's talk about what is called Months' Supply. So this measure is the number of months it would take to sell current existing home inventory given the rate of sales. So rates, the rate of sales has fallen. Right, so you see that multiplier has ticked up and probably will continue to tick up. But it, coming into this slowdown and where we are today is still well below. If you look at that '06, '07 levels going into the '08 period, supply is much more constrained. And that is a good thing in terms of supporting what is a slowing housing market.

Brent: Absolutely, and if we shift gears and we talk about the commercial real estate market.

Phil: You know, quickly, let's touch on FICO score real quick and then we'll hit commercial. So that supply is pretty tight. The other thing that I think is important is underwriting is different today than before the Great Financial Crisis. Right, so here we're showing the median FICO score of mortgages. Where were we this cycle? And recently, I mean, peaking at 788. Look at where that is from the 2008 recession to the pandemic of 2020 to the average FICO score before the Great Recession. Right?

Brent: Right.

Phil: So this has been a much better credit quality, much tighter supply type market. We do think that that is a reason to think this is not an '08 type period. Now, we are always hesitant to say to combine the words soft landing and housing.

Brent: Exactly.

Phil: Because—

Brent: Exactly.

Phil: There are always going to be regions that are going to feel pain. They're always going to be those who got over their skis in housing. It takes a long time to build a house.

Brent: Yes.

Phil: So it's very hard for supply and demand to be in line. It is why inevitably in housing you will see some trauma. There is going to be some real pain. But there are reasons to think this is not a cataclysmic-type environment.

Brent: Absolutely, so now let's talk about commercial real estate. I was just chomping at the bit to get there. So—

Phil: I understand.

Brent: When we look at the chart on the left and we look into The Green Street Commercial Property Index, the last time we covered this, Phil, we were looking at a moderating price in commercial real estate, but still clocking in at about 10% with that updated data, which again, just like residential real estate is on a lag. We are now at 0. Right, and it somewhat makes sense, right. That that commercial real estate is now catching up to where residential real estate was, but on a lag. And if I think about it from existing property sales, certainly far less transactions on the commercial real estate side than there are on the residential real estate side. But then when I think about not only existing commercial property, but also new commercial property. Think about where cap rates are, sub 4%. Look at where the Treasury Yield Curve is. Everything from 6 months out to 3 years is 4.5% or higher, right? So it naturally makes sense that existing commercial property as well as new commercial property starts is starting to fundamentally decelerate.

Phil: And this will be regional as well.

Brent: Absolutely.

Phil: But to that lumpiness in commercial property, you notice here that after the pandemic, commercial property went negative.

Brent: That's right.

Phil: Residential never did.

Brent: That's right.

Phil: Some of that's because, were we ever going to go back to the office? That was part of it, we're going to use hotels, et cetera. But there is lumpiness here and you can get bigger moves on a national level.

Brent: Yeah, and on the graph on the right, similar to what you just covered on the residential real estate with FICO scores. When I look at the percentage of banks tightening their lending standards for CNI loans, you've seen on that, right. It'd come up precipitously, which is a good thing, because interestingly enough, the absolute aggregate number of CNI loans is not decelerating. It's maintaining a good bit of stability. But the underlying CNI credit quality standards for loans being originated is increasing significantly, which we think is a good thing because then you have a higher quality portfolio as it relates to CNI lending.

Phil: And it makes sense that the opposite, if you're showing the opposite, it wouldn't really be right. We know that the economy is slowing. Banks are taking that into consideration when they issue loans.

Brent: Absolutely, so let's talk about consumers' inflation expectations. You covered the economic professionals and where they are. Let's talk about what consumers believe might, inflation, might be over the next 1 and 3 years. Gold line is 1 year ahead. The gray line is the 3-year ahead, forgetting the actual number, Phil, and just looking at the directional vector. Both consumers' expectations for 1-year ahead inflation and 3-year ahead inflation has fallen pretty significantly, which, which is a good sign. And obviously the consumer driving consumption and prices ultimately is certainly important to make sure that that directional vector is similar to what the economists are projecting. Certainly a lot of noise and volatility. We see that a little bit of an uptick on the 3-year ahead. But by and large, expectations 1 and 3 years ahead from a consumer perspective is in fact moderating. So let's knock on wood and hope that that continues.

Phil: And this is important for the Fed, right? Right, if you're a central bank, what you're worried about is inflation getting into the consumer expectations, then you're in an inflationary spiral. And that's kind of where it felt like we were so seeing these lines come down, while they need to come down further, is really welcome relief for market participants.

Brent: Absolutely, so let's bring this home and let's talk about what is the risk of entering a recession over the next 12 months? We updated this on our last Webex, increasing that likelihood to 60% over the next 12 months. And the reasons are unchanged. The rate of inflation is just not moderating yet, at a pace that's congruent to what the Fed believes, what market participants believe is necessary to have us have that soft landing. And again, I think even more importantly, you covered it really well, is the Fed's reaction function to that lack of inflation moderation and continuing to tighten financial conditions another 125 to 150 basis points into the end of next year, another 25 potentially into the first half of next year or more. And keeping rates high increases the likelihood of a recession over the next 12 months.

Phil: Look, the Fed, in their own projection materials, are saying we want to increase the unemployment rate. We want to slow growth.

Brent: Exactly.

Phil: So we're taking their word for it.

Brent: Yeah, exactly.

Phil: So let's flip ahead to a midterm election preview. So, so, you might have heard, there's a midterm if you watch TV, you can't avoid the commercial.

Brent: I don't think I can take any more. I'm dying.

Phil: I look forward to it being passed so we can escape the commercials if nothing less. So, so what issues are most important to voters? This is poll data on both sides of the aisle. Just looking at registered voters. Not too surprisingly, the number two issues leading into this election are the economy and inflation. And if you look, you have the July poll in gold, the October poll, and October in gray, rather, it's increasing. So not only are the economy and inflation important, they're more important as months pass. Why is that? It's a slowing economy of elevated inflation. So suddenly things like social issues take a backseat compared to the economy. So this is going to be a referendum on the economy and on the current administration, as it always is. And we'll talk about that more in a moment. So on the inflation front, if you ask registered voters, is the Biden administration doing all it can on inflation, what is that? About 70% are saying it could be doing more. So not pleased. Again, when you have inflation at 40-year highs, it would be pretty surprising if this wasn't the result, but clearly inflation is on voters' minds and is going to be a major component of this election. So let's turn to the next slide.

Midterms, as I mentioned, are usually a referendum on the president. And what you tend to see if you look at the left side, is that the presidential approval rating and the number of seats lost or gained in the House are correlated. So if you look, the y-axis here is seats lost or gained in the House. So negative, of course, is seats lost, and the presidential approval rating is the x-axis. So lower approval is further left on the x-axis. So we have there the triangle for Biden. And what you tend to see is that, first of all, most presidents lose seats, right? W. Bush, President W was the exception. That was after 9/11. Very high approval rating. But also the lower your approval rating, usually the more seats lost. If you look over many midterm elections on the right side, the average loss in the first midterm for a president is about 30 seats in the House. And you also see that seldom do they gain seats. And we're showing blue and red here to represent the two parties, doesn't really matter which party. Usually seats are lost in the House as voters who just elected a president tap the brakes in the House.

Brent: Yeah, and when you think about that average 30 seats lost this time around, the Republicans only need four seats to swing the House alone. So again, if history were to repeat, you can kind of see where it's triangulating.

Phil: And to that point on the next slide, what are odds markets saying? Now first, I'll just point out for anyone who does quick additions in the room, this does not sum up to 100 and the reason these are individual markets, but it gives you—

Brent: These are betting odds.

Phil: That's right. That's right. These are not polls. These are betting odds. What are the most likely outcomes? So the most likely outcomes are Republican House and Senate or Republican House, Democratic Senate. Pretty heavily favored. And then, of course, Democratic House, Republican Senate is a small probability, but those three in the green box are all divided government. Let's talk about what that means for markets in a moment. So hold on to that. But that's the most likely outcome. One thing that's changed the last couple of weeks is the probability of a Republican sweep has increased due to the Senate. The House has remained pretty heavy Republican in terms of odds, but Senate odds have moved. Still kind of a toss-up is the truth, as you can see here. But nonetheless, we have seen an increase there. Divided government looks to be the outcome, although we've been surprised on elections—

Brent: Yeah, many times.

Phil: —in recent years. So what might that mean on the market front?

Brent: Yeah, so let's talk about what that might mean for markets. And we've covered this a number of times. You know, looking back at all midterm elections post-1950, the 12 months following midterm elections has been positive for the S&P 500 100% of observations since 1950, with an average return of 15.1%. And as you can see on the bottom right-hand chart variable, right, some very big bars, some very low bars, but by and large, positive 100% of observations for a nice return of 15.1%. And when you go to the next slide and you look at the top left-hand graph, and we talk about those odds that you just covered and the two potential consensus expectations, that's what's in the green box up there. And you can see that when you have a Democratic Senate—

Phil: Right.

Brent: Republican House, Democratic president, that's actually been the best combination of government for the S&P 500 returns with an annualized return of 13.6%. The next best, which you also covered, was an all-Republican Congress and a Democratic president with an annualized return for the S&P 500 of 8.4%. So regardless of disposition, all-Republican Congress, split Congress, divided government has, at least historically Phil, been very good for the S&P 500. On the bottom right, we also talked about equity market returns in the third year of a presidential cycle. The last time we talked about it, on average, the S&P 500 was up 22.2% in the third year of a presidential cycle. We wanted to break it down for you by quarters. And what you can see is that in the fourth quarter of, quarter of the second year of a president leading into the first half of that third year is when you tend to get more of those equity market returns, at least historically. So if history were to repeat, that would potentially mean a strong fourth quarter for the S&P 500 and a strong first half of next year for the S&P 500. Again, if history were to repeat.

So then why don't we just move forward and let's talk about the market update and where markets go from here. And let's start, first of all, with fixed income markets, and certainly all of you on the phone have seen where fixed income markets have gone this year. The Bloomberg Barclays Treasury Index down about 14 and one-half percent year-to-date. The AG Bond Index down 16% year-to-date. Municipal bonds down 13 and one-half percent year-to-date. Investment grade, corporate bonds, Phil, are down 20% year-to-date. And even when you go out further for long-duration treasuries and corporate bonds, off more than 35% year-to-date. We have seen the largest drawdown in Aggregate bonds, Treasury bonds, Municipal bonds and corporate bonds in the history of bond market indices. So an awful lot of volatility, awful lot of downturn. The silver lining to that, though, is when you look at where yields are today and you go run your eyes down that column, 10/21/2022, which is basically yields as of last Friday, yields in excess of 4%. Look at municipal bonds, spot yield of 4.13%. On a tax-adjusted basis, you're above 6%, right? So forward expected returns for fixed income tend to be a manifestation of current spot yields. So while it's significantly painful now for fixed income, expected forward returns for fixed income look very, very attractive at these levels. The graph on the right we've covered before, which is the Sherman Ratio, in English, we're looking at yield per unit of duration or unit of risk at the highest level in over a decade. So again, from a yield per compensation perspective as it relates to risk, much, much higher than where we've been over the last decade.

So a question, Phil, that you and I get, I think every single day, is, with all this equity market volatility, what might be the floor under equity markets? And certainly knock on wood, we've seen an almost 8% move up. Fifth time's the charm. Sixth time's a charm or not?

Phil: We'll see.

Brent: What might be the floor from a valuation perspective, under markets where we start to see a more durable and sustainable recovery? So what we're looking at here is the next 12-month PE ratio. In English, what that means is what are investors willing to pay for a dollar of next 12-month earnings? And what you can see is over the last decade-plus, we've seen an average valuation floor or support level for stocks at about 14.8, 15 times earnings. The lowest that we've seen over the last decade-plus is about 14 times earnings. So if I do a little bit of quick algebra here and I multiply the earnings per share, which is about $231 per share times the average valuation floor, puts you at about, we'll call it 3,400. If we saw the lowest PE ratio, forward PE ratio that we've seen over the last decade-plus, 14 times that would take you to an S&P 500 level of about 3,200, understanding that we don't have a crystal ball and that often equity markets can systematically trade through and below averages and below lows depending on the environment today. And we have a lot of volatility. But to think about it from a valuation floor perspective, 3,400 or 3,200 feels right, at least historically from a valuation support.

Phil: Right, so that's the valuation. Let's talk about the denominator, the earnings on the next slide. So first we should mention we are in the middle of third-quarter earnings season. Companies, roughly 72% are beating their earnings, their earnings estimates. Now, a couple of caveats there. One, pretty severe downward revisions coming to this earnings season. You can see that on the right, right-hand side here. And two, the last 5 years, on average, 77% of companies beat earnings estimates. So we're at 72, a decent earnings season. But as we were reminded this week, it's been choppy, good autos report, good shipping number in the transport space, disappointing big tech. So it is still early in earnings season. It's been an okay earnings season—market has traded pretty well through it as things have not been as bad as they could be.

So let's talk about earnings estimates as we do every month for you all. So consensus for full-year 2022 now has earnings growth at 6.7%. That's $223 of earnings. That number, of course, has come down by—

Brent: 10.4% at the beginning of the year, now to 6.7%.

Phil: That's right.

Brent: That's a positive.

Phil: The long-term average is 7.6%. So you're kind of in the range of the long-term average, but well below expectations coming in. And speaking of expectations coming down, 2023 now at 7.3%, $239 per share. That was over $250 per share just a few months ago. So earnings are coming in. It's a pretty safe bet that 2023 number continues to fall. But right now, consensus does have earnings growth. But let's say we do see a material recession on the next slide. And we have our earnings recession as well. What does that look like? So if you look at the 12 recessions since World War II, the median decline in earnings is 13%. Now, there's wide range around that—

Brent: Right, Great Financial Crisis.

Phil: 2008, which again, we're obviously scarred from this, but we have 45%, whereas early 1980s, the first of a double-dip recession is -3%. Right? So there is a wide range of outcome, but averages is 13%, just for some context for you. But when you look through a cycle on the right side here—so despair, hope, growth, optimism—when you look through that cycle, do earnings, are earnings recessions necessarily bad for stock returns? Right? Just because earnings fall, does that mean stocks fall? So let's focus first on despair and hope, which sounds like a Tolstoy novel, but we're in the despair phase or, we're either just coming out of the despair phase. But that is when you see a severe drawdown in real price return, the gold bar here. Earnings are actually usually still growing. Right?

Brent: Right.

Phil: Think about this year. Stocks have fallen, earnings are growing. The hope phase is where you start to see that EPS growth go negative. The charcoal bar there, that is potentially what we're entering next year in the severe downturn phase. Often during that phase, real price returns are actually positive.

Brent: That's right.

Phil: So you say, how is that possible? Well, think about 2020, but market bombs in March of 2020, earnings are just starting to fall.

Brent: That's right.

Phil: We had just entered lockdown, and what happens? Market moves up very rapidly. It does feed into something we'll talk about in a moment. How hard is it to tie markets? It's a reminder that just because you have an earnings recession does not mean stocks move lockstep. In fact, historically, they do not move lockstep. They have not moved lockstep this year, right, as price has fallen and earnings have risen. Another point for potential optimism as you look forward to next year. On the next side is the Fed and their tightening cycle. So generally when you enter the end of a tightening cycle, which in this case, we're not there yet, but we might be in the first half of the year, is the market tends to perform well when the Fed stops tightening. Not when they start cutting, when they stop tightening. And the reason is there's some more certainty in the market, might tie into midterm elections when you think about why do markets perform well after midterms? There's just a little bit more certainty. So we are not there yet, but we know, and Fed governors are even pointing it out, they are pulling hikes into this year. So we're going to get to the end of this hiking cycle potentially faster than in past cycles. But usually when you hit the end, it is a good time to own stocks.

Brent: It just highlights that markets are an expectational pricing mechanism. They bid themselves up or down in anticipation of what's to come, not what's actually in front of you.

Phil: Right. The things we see coming, markets see it, too.

Brent: That's right.

Phil: So if we flip ahead, what about inflation and markets? Right? So if we look at the average monthly S&P 500 return under different inflationary conditions. Right? So let's look at the first bar. This is an example to familiarize you with this chart. And in that first bar, this is inflation above 4% and rising. This is bad. This is not what we want. This is what we've been, where we've been this year, right? Generally on average, the S&P 500 falls, you can see the line, or the bar rather, below the line. What we think we are entering and what we think we might already be in is high inflation above 4% and declining. Does not mean inflation is at acceptable level. It is high, but that directional vector is downward. That tends to actually be pretty good for markets, right? So one of these days when these bear market rallies is going to stick. And we're going to look back and say this makes some sense, the best performing market, of course, within inflation is below 1.5% and declining on the far-right side. That, of course, is Goldilocks. That is disinflationary environment and declining. But there is reason to think that getting inflation moving in the right direction is positive for stocks. It's not just the level of inflation.

Brent: Absolutely, so let's get to one of the top questions, second top question that we get is, Phil, Brent, with all this market volatility, I just think I'm going to sit on the sidelines for a little bit. Let me just step out of the equity markets. Let me just step out of the fixed income markets just until it's safe to swim in the waters again. So what you're looking at is a graph to show you how fundamentally dangerous that would be to do. On the left-hand side, we're looking at investing $10,000 hypothetically, back in 1992, almost 30 years ago, putting $10,000 into the S&P 500. Over that 30-year period of time, $10,000 grew more than 20 times that initial investment, Phil, to $208,000. Over that period of time, there's roughly 250 trading days in a year, 30 years, 7,500 trading days. If you missed only the 10 best trading days out of that 7,500, you would have less than half of that investment. If, God forbid, you missed 20 of those 7,500 best days, you'd have almost 3/4 less money. So you might be asking yourself, well, Brent, Phil, what's the probability of me missing those 10, 20 or 30 best days of the market if I just sit on the sidelines? Well, the answer is—

Phil: Pretty high.

Brent: Very high. Right? So when you look at the callout box on the right, almost half of the S&P 500's best days occurred during a bear market. Another 28% of the S&P 500's best days occurred in the first 2 months of a bull market when nobody knew it was a bull market. Combined together, 76% of the S&P 500’s best days occurred when you never want to be an equity investor. So what are the chances of you missing out on growth of your money if you step out of the market? The answer is very, very high.

So let's bring this home, Phil, and I can see the questions piling up. Let's talk about our bottom-line view. Let's first talk about consensus. There are 12-month forward bottom-up price target. So we're talking about individual analysts' expectations at a company level all rolled up into the S&P 500. Their 12-month forward view is 4,600 for the S&P 500 or 23% above where we are today. We've talked about on many calls, our price target for this year for 2022 has been lower. 3,800 is where we believe that we're likely to finish the year. You know, if today's stocks were above that already, reasons why we believe that earnings for this year or, sorry, for 2023 will be below consensus expectations of $239 per share. And we believe the price that investors are willing to pay for those earnings will be relatively unchanged from where they are today. Thus, thus being at about 3,800 for year-end. Going forward, we're going to be publishing a 12-month forward price target going forward versus sort of a yearly one. So stay tuned for that. So with all that said, Amy, I can see all those questions. Why don't we get to the Q&A section?

Amy: Yeah, thank you, Brent. Thank you, Phil. Phil, I love the hope and despair section. That was really interesting. So yeah, we do have a number of questions coming in. Also, we received several in our registration process. We will get to as many as we possibly can. If your question isn't answered, please reach out to your First Citizens partner. Brent, to kick us off here, how do you see the macroeconomic environment affecting the commercial real estate investment market over the next year?

Brent: Yeah, so, so, so commercial real estate had been fundamentally resilient in the beginning stages of this, this economic downturn for one of the main reasons is that underlying commercial property growth was nowhere near as accelerated and buoyant as the residential real estate construction market. And as such, wasn't impacted as much as you showed in this slide earlier. You know, we did see a downturn in commercial property prices post the pandemic to the points that you made, Phil, as it related to, are people going to continue to have a flexible work environment? Are they going to actually go back to the office? And commercial property had hung in there, but it's starting to fade a bit and certainly we've seen that come back down. And as I talked about earlier, cap rates now below 4% relative to what the alternatives are. Again, one or more illiquid investment, another one more liquid investment. If I look at treasuries or fixed income across the board, we're starting to see that impact come back to the commercial property index. We are not expecting a cataclysmic fall off the table in commercial property prices, more of a moderation in prices and a more moderation in additional breaking of ground and development.

Phil: Yeah, residential and commercial are different markets but, but some of the factors, they share a lot of factors. Right? What's the cost of borrow? What's our interest rate?

Brent: That's right.

Phil: What is the economic framework? So it would be strange to see one slow and not the other.

Brent: Exactly.

Amy: Just a reminder to everyone. If you have a question, feel free to submit it in the chat feature or in the Q&A section for questions. We will get to as many as we can. Brent, current, we talked about this a little bit, but I'm still seeing a lot of questions around it. The current consensus for the midterm outcome. Do you see that as a positive or a negative for marketed, markets?

Brent: Yeah, as Phil highlighted nicely. Look, what we showed you were betting odds, not polls of people and what they think, actual people wagering money on the outcome of the midterm election. And right now the high likelihood is for divided government. Right, which again, forgetting the legislative side or the political ramifications and what's going on, let's just squarely talk about the stock market. Historically, divided government has been good for forward stock market returns. As we showed post-midterm elections, positive 100% of observations. And as you're showing here on the screen, Amy, top left-hand graph. The two current consensus expectations have historically seen the two best outcomes for the S&P 500 over the last 150 years of data. So, again, we don't know how the midterm elections are going to shake out, but at least from a betting odds perspective, divided government is where we are right now. And from a stock market perspective, divided government has been good for stocks on a forward basis.

Amy: So Phil, is there actually a market for all of the US government debt without the Federal Reserve monetizing it? What are the implications for the stock and bond markets and also the national debt level?

Phil: Yeah, it's a good question. I'll hit it all. A lot of good stuff in there. So, so first, in terms of just demand for fixed income, if you look at the Fed is buying fewer treasuries, as we showed, that is impacting liquidity within the Treasury markets, things like bid to ask. Right, but when you look at Treasury auctions, the bid to cover in other words, the demand for treasuries is still well over 2. And in fact, there was just an auction yesterday that was pretty well subscribed. So there's still demand for treasuries. So the question is, are people willing to buy treasuries? The answer is yes. And some of that's the yield.

Brent: That's right.

Phil: I mean, there's a lot of yield out there, as Brent alluded to, whether you're an individual or a pension or an endowment, there is yield to be had within the Treasury markets and that is bringing participants in. But the liquidity has been impacted. I think you can certainly say when you think about deficits coming out of the pandemic, we, of course, had an explosion in the budget deficit, huge amount of fiscal stimulus. A lot of that has rolled off. And you've seen still a deficit, but a narrowing of the size of the deficit pretty severely, about 1% per month as a percentage of GDP since spring of 2021. That said, a lot of that's now behind us. Right? So when you think about a lot of those programs rolling off temporary programs from the post-pandemic period and the fact that revenue is probably peaking. Tax revenue. Why is that? Think about capital gains. If the market's not as buoyant, capital gains collections aren't as buoyant either. The economy is slowing. That has an impact. So a lot of the fiscal contraction is behind us. And the revenue spike we saw coming out of the pandemic is coming down as well. So deficit should rise. Now, the other point we would mention is the cost to borrow for the government has gone up a ton.

Brent: A lot.

Phil: Right? So we said, look, if you're an investor, buying a Treasury is more attractive today, but it's more costly for the government. So when you think about their interest expense, it's going be dramatically higher, which will also feed into the deficit. So certainly not an issue that's going away.

Brent: Yeah, and to put some numbers on it. I go back 12 to 18 months, the cost of carry for all of that debt, that $28 now $31 trillion of debt was 1.39%. We'll just go across and look at yields from 3 months all the way out to 3 years. It's much higher than 1.39%. And 54% of all of our debt matures inside of 3 years. 67% matures inside of 5 years. So when you overlay that cost of carry relative to where rates are on the short end of the curve, it's significantly higher. In fiscal 2022, the total aggregate amount of interest expense was roughly $330 billion. Going forward, where rates are, that's likely to be a significant drag on fiscal expenditures for sure.

Phil: And in terms of the question on markets and fixed income markets is pretty clear. Rates have moved higher. That's had a major impact in terms of fixed income markets. When you think about equity markets, well, it's tightening financial conditions. We mentioned that as well. Rates are higher. Liquidity and things like the Treasury markets is lower. That will find its way into the equity markets and already has.

Amy: So, Brent, I know you said you didn't have a crystal ball, but I'm seeing a lot of questions around estimating when the market may turn around, and tied into that, if people have cash sitting on the sidelines, when should that be deployed?

Brent: I think it's March... Yeah, we don't have a crystal ball, Amy, and it would be impossible for anybody to predict. But when you think about what we covered today, what we covered on the last Webex that we had last month, which are sort of five reasons why equity markets could be higher going forward, we do believe that we are closer to an end than a mid-point or beginning. We've already seen a 25% drawdown in equity markets, significant drawdown in fixed income markets. We had a published piece that talked about forward equity market returns 1, 3, 5 and 10 years post every recessionary period post World War II. And you saw equities significantly positive from a cumulative return 1, 3, 5 and 10 years post with a very high probability of occurrence. 92% on a 1-year, 100% on a 3-year, 100% on a 5-year and 100% on a 10-year, at least historically. So again, we do not have any crystal ball, but I think the most important thing to think about is, do you have a financial plan? Is your asset allocation allocated congruent to what you need to achieve within that financial plan? It is nearly impossible to tactically time when to get out and when to conversely get back into markets. If we had the ability or anyone had the ability to do that successfully, ask yourself the question, how much would they manage and what would they charge? All answers to those two questions for you. They would manage all the money, and they would charge you a whole heck of a lot. So at the end of the day, nobody can tactically time when to get in and when to get out of the market successfully. If you have a thoughtful financial plan and you stay invested relative to that plan, as we're showing here on the screen, more often over time, you will be successful in your financial goals and objectives.

Amy: Phil, what is a realistic timeline for inflation to get under control? Is it 12 months? Is it 2 years? Is it 8 years? What are we looking at?

Brent: Shaking your crystal ball right now?

Phil: Yeah, you know, the short answer is it's going to be a long time.

Brent: Yeah.

Phil: It's going to be longer than any of us want. I mean, if we pull up sort of that consensus estimate, slide, slide 7. Look, one thing you always know is consensus is going to be wrong.

Brent: That's right.

Phil: It's on which side are they going to be wrong? No, no one gets it right consistently. I think that there's reason to believe the rate of inflation falls. I also think it is going to remain well above a level that is acceptable for a long period of time. So if you're looking at the first quarter of 2024 at 2.7%, the Fed's targets was 2%, right, now, I tend to think that the market would be really happy with an inflation rate with a three handle, honestly, with a four handle.

Brent: That's right.

Phil: Anything that's, if it's half of eight, the market would like that. The real question is going be as you move further out into the out years, does the Fed accept an inflation rate above 2%? I tend to think they will.

Brent: That's right.

Phil: And let's say run rate of inflation is 3%. That's still not a scary rate. I think they'll accept that and start to focus on the other side of their dual mandate, which is full employment. So the answer is it's going to be a while, I think, of those options, 12 months, I think we probably see a rate that's more acceptable. But is it going to be where we were before the explosion of inflation, post-pandemic? I don't think so. I think that that's potentially a thing of the past.

Brent: And to your point, just because the 25-year average inflation has been around 2%, when I go back further, 50 years, 75 years—

Phil: Much higher.

Brent: You're looking at 3.7%, 3.2%.

Phil: Much higher.

Brent: So for the Fed to accept what's actually occurred over the full cycle of our economy is not incongruent to believe. And I think the other thing that we covered was money growth and money supply. If we saw double the highest amount of money creation in the history of our country and inflation just magically overnight went right back down to 2%, I think foreign central banks and our central bank and governments would just be printing money all the time because it would just go up and we'd solve the world's problems and then come right back down. It's going to take time, like you said, Phil, for inflation to moderate back down to a pace that's more acceptable to what our Fed would be comfortable with as well as market participants.

Amy: Phil, same kind of question around timeline. What are we thinking for the future of supply chain hiccups? Is that just part of the new normal now?

Phil: Yeah, so there's two answers. Near term, and we showed this on slide 12, near-term supply chains have improved. Still not where you want them, right? I mean, if we look at the container freight rate on the right side of 12. It's improved. But look at where it was in 19 and 20. Right? So, so one, things are better than they were. That's a good thing. We're hearing that from companies as well. This is not just the data, but as you look beyond this unbelievable supply and demand curve shift post pandemic, which drove incredibly tight supply chains and huge disruptions, you look beyond that. I still think supply chain disruption and volatility is a permanent state now. And the reason is the geopolitical framework. So the relationship between US and China is obviously deteriorating. We've now seen it for 6 years or so. And when you think about our number-one trade partner, a deteriorating relationship, that's going to have supply chain implications, think about Taiwan. Think about our relationship with Russia. Right? Not nearly as big of a trade partner, but a trade partner, nonetheless. No longer is that a trade partner. So this is going to have implications for companies. A real topic is going to remain, deglobalization's probably an overstatement, honestly, but diversification of supply chains and companies are going to try to be less exposed to charts like this going forward. So I do think supply chains remain a problem. Does that mean we have a repeat of back half of 2020, early 2021? I don't think so. Outside something really dramatic happening like the pandemic or just shutting down trade with a major partner. Certainly volatility and issues, I think, are now a permanent state. The world of truly open trade seems to be faltering.

Brent: Yeah, for sure.

Amy: Brent, we've got a couple of questions, and I think this would be really helpful for a lot of people on the line. What are some key concerns for retirees to consider and what are your thoughts for them?

Brent: Yeah, it seems like Murphy's Law that when one goes to retire or about to retire, the world goes to hockey sticks in a handbasket, and things start to deteriorate. At the end of the day, again, I hate to beat a dead horse, but financial planning, making sure that you have a cogent and systematic schematic or blueprint for the years that you're about to enter retirement or in retirement to make sure that you have the right plan in place, the right asset allocation, and more specifically for somebody that's entering retirement or about to enter retirement or in retirement, making sure that you have a good enough liquidity ballast to make sure that you do not sell risk assets at exactly the worst time, now being the worst time or one of the worst times, because then you are truly impairing your assets. Right now, if you have unrealized losses, impairing those assets by selling them and making them a realized loss is going to make it more difficult for your nest egg to fundamentally recover. Having liquidity, making sure that you have the right asset allocation, balancing the risk in your portfolio relative to your own behavioral risk tolerance is absolutely crucial when you're about to enter retirement. And even if you're in retirement now and you haven't done that financial plan, I think it's best to engage with us to make sure that you don't make a mistake that would impair your ability to live the life that you want to live as you're in retirement years. So to me, Amy, financial planning is absolutely the way to go as it relates to making sure that you can live the life that you need in retirement.

Amy: Thanks, Brent. Thanks, Phil. We do have one more question here, and it's around the insights that you both have around markets and the economy for 2023. I want to invite everybody to stay tuned for that. That is coming in our December presentation. So more to come there. We will certainly be covering that in the future. Before we wrap things up today, I just want to thank everyone for being with us. Our next market update webinar is Wednesday, I'm sorry, Thursday, November 17th, and that is because of the Thanksgiving holiday. I just want to remind everyone, we'll send out the replay for this webinar as well as information for getting you registered for the next one. I also want to remind everyone, in case you missed it, please visit FirstCitizens.com/wealth and take a look at our 2022 Year-End Planning Guide. That's from our Director of Wealth Planning, Nerre Shuriah. There's a lot of information in there to help make sure that you are buttoned up before the end of the year, which is very, very quickly approaching. On behalf of all of us here at First Citizens, I want to thank everyone again for being with us today. We thank you for your trust in us, and that is something that we never take for granted. We hope you have a great rest of the day, and we look forward to seeing you next month. Thanks, everyone.

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