Making Sense: August Market Update

Amy: Hi. I'm Amy Thomas, a strategist here for First Citizens Bank. Today is August 23, 2023, and I want to welcome you to our monthly making sense market update series, where Chief Investment Officer Brent Ciliano and Director of Market and Economic Research Phil Neuhart provide their insight to help make sense of what's going on in the markets and the economy.

Before I turn it over to Brent and Phil, I do want to share a couple of housekeeping items with you. First, we received a number of questions throughout our registration process, and we will answer as many questions as possible during today's recording.

We do try to keep our discussion broad, so if you have a specific question about your financial plan or we're not able to answer your question during today's discussion, please reach out to your First Citizens partner. And lastly, as always, the information you're about to hear are the views and opinions of only the authors at the time of recording and should be considered for educational purposes only.

Brent, with that one, we're ready to go. So I'll turn it over to you.

Brent: Great. Thank you, Amy, and good afternoon, everyone. Hope you are well. Phil, I cannot believe it. Summer is basically over. It's amazing. Kids going back to school. My back still hurts from moving in. So here we are still talking about inflation, the Fed interest rates. When will it stop, Phil?

Phil: No time soon, Brent.

Brent: Yeah. So speaking about inflation, interest rates in the Fed, Phil and I are going to cover all of that and then some. Then we're gonna talk about markets. We'll specifically talk about where equity and fixed-income markets are and where they actually go from here. So let's jump right in, Amy.

So let's start first with an update on where we are as it relates to US and global growth, Phil. 2022 was an average year, right on the 20 long-term average of 3.5 and 2.1%. Coming into the year, expectations for consensus were a significant moderation lower in return in actual yields.

Phil: That's right. I mean, if you look at GDP as of December 2022, world 2.1%, US 0.4%. As of today, world 2.7%, US 2%.

Brent: Yeah. So we're basically back to long-term average on real growth. Right? So and when we think about the better-than-expected expectations that we had, you know, right now compared to where the reality of it is a much more resilient US economy.

And looking forward to 2024, again, consensus leaves that growth is going to moderate lower and go from 2% down to 0.8%. I guess sort of that long and variable lags of monetary policy likely kicking in and expecting a deceleration.

Phil: It is interesting given all the optimism this year and really, you know, talk of soft landing, et cetera. The consensus still remains pretty muted when you look to next year.

Brent: Absolutely. And when we move forward, Amy, when we think about US growth specifically, US economic activity, Phil, is significantly decelerating from the highs that we saw back in 2021. Gold line here is manufacturing. Gray line is services. Let's start first with manufacturing, Phil. So from March of 2021, we've seen significant moderation of manufacturing, and now we find ourselves in contraction. You can basically say that US manufacturing is basically in recession.

Phil: It is, yeah.

Brent: The good news is, is that the gray line, which is services, has certainly moderated lower, but is still an expansionary territory. And the good news is is that services is more than 75% of our economy. So again, services is kind of keeping the US economy afloat.

On the next slide, when we think about one of the reasons why, Phil, that economic activity is moderating lower is certain more restrictive monetary policy. What we're looking at here, and Phil, we've covered this on a couple of Webexes, are you know, all Fed rate hiking cycles post-1982.

The gold line is this most recent cycle, and you can see the significance of this cycle, Phil, it's the most significant hiking cycle that we've had in more than 40 years, from a from a basis points of hike in a compressed time period. And where we are right now from an expectation perspective, we're sitting right now between 525 and 550 on Fed funds and, Fed fund futures are pricing in about a 40% chance of another 25 basis-point rate hike by the end of the year. September's looking like a like a hold, and potentially November or December being that timeframe. I think the important thing here is that much of the heavy lifting, Phil, has been done as it relates to monetary policy, and whether or not the Fed goes another 25 basis points is really not the point.

Phil: Right, and in all these hikes as we as we flip ahead pushed us into restricted territory from monetary policy standpoint. So here, we're showing global real policy rates. So what is that? Well, that's the central bank policy rate for whatever central bank in that region, minus consumer inflation. So we are restrictive in that we are above zero. We're the only one when you look globally. So we're actually ahead of the curve in terms of restrictiveness.

Likely, when you look at inflation in parts of Europe and England, they will get there. But for now, we are one of the major economies where we're in restricted territory. That is one of the reasons we talk about those variable lags impacting the economy going forward could certainly happen. Additionally, it's why the market's pricing, maybe one more hike, maybe no more hikes, because you are in restrictive territory.

The Fed's done a lot of work, and you now have pretty tight real policy rates. So, all this work, of course, is due to inflation as we flip ahead.

Consumer price index, we show this chart regularly. The headline, which is all consumer goods, peaked at 9.1% last June, has fallen precipitously, is at 3.2% today. Not at the Fed's target of 2%, more on that in a moment, but has fallen quite a lot. Core CPI, which just as a reminder, excludes the impact of food and energy. Right? So, it's a good measure of underlying inflation because food and energy prices are really volatile and kind of outside the Fed's control in a lot of ways. Think about the war in Ukraine as an example. But when you look at the gray line here, core CPI, it's above headline and has been for a few months. So if the Fed speaks to the concept of underlying inflation being too high, this is really what the talking about. So there's something for market participants to cheer for. It's for that gray line to fall.

Brent: That's right.

Phil: Right? Now when you look at things like Zillow, or in an index that's like some other indicators, there were reasons to think that it will continue to moderate but has yet to do so to the extent we want to see.

Brent: Right.

Phil: So back to headline inflation, looking at expectations on the next slide, consensus does expect further moderation in inflation. What you'll notice is it's kind of, you know, going from 9 to 3.2%. That last five pounds is the hardest to lose, right?

Brent: Why are you looking at me, Phil?

Phil: Exactly. So, look, we have all the way down to 2.3% as of fourth quarter of next year, but that's still not quite the Fed's target. Now, my belief, I think yours as well, is that the Fed would be pretty pleased with 2.2% inflation.

Brent: Absolutely.

Phil: But it just shows that it we are not necessarily going to just continue to fall in a straight line, sort of like we have since last June.

Brent: Absolutely. And I think we also have to be thoughtful and expect that we're going to have inflation variability and volatility as we get to this last leg, and we expect much of the inflation to be volatile in the readings that we get into 2024.

On the next slide, one of the things that has been really, really resilient has been our labor market. Right? And certainly we've seen an awful lot of job creation a year to date, though we're starting to see some softening in the labor market. And if I look at the most recent July print, we saw 187,000 jobs created. It was a little bit below expectations of 200,000. June got revised down. Again, 2 months in a row where the actual print was below consensus expectation. So softening at the margin, and we did see the unemployment rate, though, fall from 3.6% to 3.5%, a little bit more technical than substantive. But at the end of the day, we're only about 10 basis points away from the lowest print that we've had on unemployment in more than 50 years. So again, the labor market is broadly strong and resilient, but we're starting to see some softening at the margin.

On this next slide here, I think additional signs of loosening, what we're looking at is US job openings per unemployed person. And we showed this slide before, and you can see the incredible levels that we got to, you know, earlier, you know, this year and in '22. But we're starting to soften a little bit, sitting at about 1.7 job openings per unemployed persons. Significantly, Phil, above the long-term average, but starting to moderate lower. And I know that you've been on the road and speak to clients an awful lot, I have as well, we're talking to small and medium-sized businesses. The persistent theme that we hear from them is it's still very hard to attract and retain and hire talent.

Phil: That's right. I mean, the availability of laborers is by far the number one complaint we hear from businesses when we're on the road. So there might be some improvement, but we have a long ways to go. And a lot of those issues are more structural than cyclical. So they're probably here to stay, but a little bit of loosening is good to see.

But by and large Americans have jobs, as we flip ahead, when Americans have jobs, they spend. It's the American way. When you look at personal consumption expenditures on the left side, what is really keeping spending elevated is services spending. Now the good news is, the vast majority of personal consumption is services spending. But it has been a real reversal from what we saw during the pandemic in which people were buying new laptops, new couches, you know.

Brent: Tripping over Amazon boxes coming out my front door, for sure.

Phil: That's right. That was spending on goods. Now people are spending on the services. If you've been in an airport lately, if you try to get a dinner reservation. It's pretty clear that we are very much in a service expansion. So you can see well above long-term growth on services. Goods has moderated.

Now not all is well, though, on the consumer front. A lot of those savings that consumers accumulated during the pandemic, physical stimulus checks, et cetera, coming in, have started to wane, and especially in lower wage cohorts, people are accessing their credit cards. So the right side, this is growth and revolving consumer credit. That's just a fancy way of saying, credit card debt. And not too surprisingly, when you have this type of inflation, think about gas prices last year. Think about food prices. People are accessing their credit card.

So we do not want to portray that the consumer is just, you know, 100% in great shape. The truth is there is some strain, and I think you do absolutely consider that when you think about chances of contractions.

Brent: Yeah. And you think about all the fiscal spending surplus that we had, and all the stimulus checks that came to US consumers and the excess savings at one point in time was in excess of $3 trillion, starting to burn through that and adjust and start taking out debt.

Phil: That's right. So, to that point, as we flip ahead, we often get the question, So are we going to have a recession or not in the next year? Our official probability, full disclosure, has been 60%, it's been there for quite a while. Consensus has been at 65%, 60% also for quite a while. So the truth is the economy's been more resilient than most expected. But we're at 60%, not 90%.

Brent: Yes. Right. Exactly.

Phil: So that means there's 40% chance of a soft landing. So what we're showing here, and we've shown this for a couple months, but want to continue to update this and keep you all apprised, is how do we avoid recession? Right? What are the pauses and potentially where are the negatives that could pull us into recession? So on the positive side, first, in terms of soft landing. One, that resilient labor market. We are a consumer economy. If the labor market's resilient, that is great news. That resilient labor market feeds to the US consumer who is still spending, and they're particularly spending on the third bullet point in this service economy. And so that is helping to boost it. Another thing we haven't discussed in detail today, I'll just mention is residential construction. If you look at measures like housing starts, they are really pretty high compared to say pre-pandemic 2019 level.

And residential construction, of course, is a boost to the economy. Why is that, even as sales fall and mortgage rates are so high? Well, people are not listing their homes. They've locked in low mortgages. You have limited supply. And what that's doing is boosting construction, which does help the economy.

Brent: Yep, And, you know, when we think about, items for, are we going to have a recession? The list is a little bit longer. Again, no less important, but when we think about tighter monetary policy, which we just covered, you know, again, the most restrictive cycle that we've seen post-1982. Again, thinking about the concept that we've been talking about for quite a while is that monetary policy works with long and variable lags.

Right. So, when we think about what that normal lag is, sort of, that 18 to 24 months after that first Fed rate hike, which was back in March of 2022, kind of looking at if we're going to see a weakness potentially in that first half of 2024 as that policy effect starts to affect the real economy and hit home. We've talked about tighter financial conditions for quite a while, whether it's senior loan officer surveys, what you just talked about with revolving credit, commercial loans and leases have moderated lower. So again, financial conditions are significantly tightening.

We just talked about the manufacturing economy and that we've seen significant moderation in ISM manufacturing. We're in contraction, if not outright recession in US manufacturing. We've had an inverted yield curve. So in essence, the difference between 2-year notes and 10-year notes has been negative for quite some time. Pushing more than 100 basis points.

Historically, an inverted yield curve has been a harbinger of a recession. It hasn't been 100% of the time, but more often than not, an inverted yield curve has portended a recession to come. Time will certainly tell. And as you just talked about with residential construction, we've talked about the commercial property market for quite some time, and we've seen significant contraction in commercial real estate across the United States in various sectors.

So with that, Amy, why don't we flip in and Phil, let's talk about markets. So let's start with the chart on the left and, you know, the first quarter and second quarter, whether it's US equities, developed international equities or emerging market equities, was strong and certainly a welcome change from what we saw in 2022. Basically, year to date through the end of July, Phil, you know, equity markets were double-digits positive across the board for global stocks. We've seen a little bit of volatility and moderation here in August. But by and large, it's been a strong year-to-date performance for equities.

On the right side of that dotted line on that left chart, we're looking at fixed-income taxable bonds, the US aggregate bond index and municipal bonds. Again, great first quarter for fixed income. Second quarter through now has been volatility and rates, and fixed income both taxables and municipals has moderated lower. Again, aggregate bond, basically, about flat through Friday the 18th. Municipal bonds slightly positive. On the chart on the right, where specifically in equities have we seen strength? It's been a very mega-cap growth-oriented market so far, driven by the top ten names. AI themes that I know that you're going to touch upon the top ten names in just a second, but broadly a pretty narrow rally. We're waiting for that to widen.

Phil: Right. As your as your eye moves across the rows—large, mid, and small—you see that the numbers larger are just higher and growth particularly. So the upper right large cap growth has really been what's pushed the US stock market higher.

Brent: Absolutely. On the next slide, again, when you look at the chart on, the left. Again, tale of 2 years looking at where we saw significant double-digit losses for US stocks, international stocks fixed income. This year, knock on wood, let's hope that it sticks, double-digit returns for equity markets in the US, international hanging in there and bonds hanging in there.

I think the chart on the right is critically important. From the October 12th of 2022 lows for the S&P 500, we bottomed out at about 3,577. We're up more than 20%, Phil, from those low levels. So the market was pricing something in in the fourth quarter of 2022. We'll see if that's the bottom in the markets.

Phil: And that 22% includes the recent sell down.

Brent: Absolutely.

Phil: Of course, you feel that turn down. So really pretty remarkable rally, far better than the consensus expected, but we'll take it.

Brent: Absolutely. And we're still, as you can see, only 9% off roughly from, you know, the all time high. So again, equity market's doing pretty well.

On the next slide, I think one of the things when we talked about volatility, Phil, is this year so far, volatility despite the moves that we've seen in August relatively sanguine, right?

So what we're looking at here is the last 33 years of S&P 500 calendar returns. Gold bars are how the year ended up. The dots underneath those bars are the intra-year drawdown that we see in those calendar years. And what's interesting is when I look at the average intra-year drawdown over those 33 years, we've averaged a drawdown of negative 15%, despite 75% of those 33 years ending up positive. This year, you know, we've only seen about an 8% intra-year drawdown, which is only slightly more than half the average drawdown. So again, we're expecting a little bit more volatility later in the summer into the fall. But again, we're still far from average.

Phil: Yeah. It's always a nice reminder to remember that that in the average year, 15% drawdown. So when you have a drawdown, it's a reminder not to panic.

So let's talk about the microstructure of the mark on the next slide. Brent mentioned really a narrow rally. What does a narrow rally mean? It means that the largest companies in the S&P 500 have pulled us higher. So what we're looking at here is the S&P 500 contribution of the 10 largest companies in a given year going back in history. This is for positive performance years. So on the right side, that's this year. Of course, very narrow rally. We're talking about 70% of return. It was even more narrow earlier in the year. It's broadened out a bit.

But what you'll notice as you move to the left is it's not that uncommon to see pretty high bars here. It's not that uncommon to see what we've described as a pretty narrow rally. Even draw a mental line at 30%. There's a lot of years where say 30% of return is from just 10 stocks, meaning there's another 490 that are accounting for the rest of the return. So it is narrow. The hope, of course, is always that it broadens out. There's a lot of evidence that happens a lot, but we need to see it. That, of course, is what we're hoping for, but it has been a narrow rally.

So let's talk about corporate earnings for a moment on the fundamental side. So last year, and Brent mentioned, the market priced something in and we settled down almost 25%, peak to trough. And maybe what it was pricing was sort of muted earnings this year because earnings were pretty decent in 2022. Well, right now, earnings in 2023 are tracking 0.8%. Basically flat. That's improved a little bit of late because second quarter earnings beat an incredibly low bar. The most predictable beat in the history of earning season. They beat a low bar, but we're only two quarters in. We still have two quarters of earnings left, which is always, hard to believe when you're this late, when you're already in mid-August. So it's still early to tell, but muted earnings this year, I think, is a pretty safe assumption.

Now next year, there's a lot of optimism. So you think about the market rally, well, you're starting to look towards next year. Bottom-up consensus, this is company-level analysts summing that up to 500 companies, expect 12% earnings growth next year. Now, that number most years is too optimistic and because these are company-level analysts. You're covering your 20 companies. You feel good about them, and you aren't really seeing the forest for the trees. But even if that number were to be cut in say half, 6% earnings growth would be pretty good next year. So certainly, there's a lot more optimism next year. 7.6% percent is the long-term averages for perspective.

Maybe more important than just earnings growth is the right slide, though, the right chart here. This is operating margin looking ahead. So estimated operating margin, profit margin, another way to say it, for S&P 500 companies. Late last year and coming to this year, the expected margin was really high. We felt that need to come down. And it did. But what you're seeing now is a flattening in those margin expectations and even a little bit of an improvement. So some, you know, the concerns around inflation abating, is that going to really hurt margins? You're starting to see margins kind of where we were pre-pandemic and improving a bit. This is good news for the market.

Brent: Yeah, and I and I think specifically as you as you highlighted, 12.2% might be too high. We'll have to wait and see. But even if you take sort of the average haircut that we see analysts revised down, you're still within spitting distance of the average growth rate that we've seen since 1950. So again, hopefully that reacceleration could also bring valuations and approvals more in line with what we do expect at this part of the cycle.

Phil: That's right. And next slide is our price target. We, set this 2 months ago and talked about it quite a lot. I won't dwell too long on it, but our base case 4,500 as of Friday's close, that is up—Friday the 18th, I should say—that is up 3%. We've had recent volatility. If that continues, of course, we'll have more upside. If you believe in sort of, the soft-landing goldilocks, as our bull case—5,150. That's up about 18% from last Friday's close.

So certainly, we still have cautious optimism. And remember, when we set this price target, it was up, I think, 4% or so when we set it. But that was on the heels of 20% plus rally since last October. So it's really a continuation of the rally. We just think that a lot of the good news has been priced in our base case.

Brent: Yeah, and if you think about if we go all the way back to our 2023 outlook that we had in in December of last year, we were calling at that time for roughly about a 6 to 7% return for the S&P 500. We didn't see 20% coming. We were cautiously optimistic. But again, a lot of variability, especially as we go through this part of the cycle. Economic momentum starting to slow. Earnings, variability, you know, you got to expect a lot of volatility.

On the next slide, I think, Phil, is a new slide. I love this slide because, I mean, how many times a day, Phil, do we get asked the question? Well, Phil, Brent, the markets run 20% plus. I have money to put to work. Should I put it in the equity market? Brent, Phil, the market's down 25% October 12th of 2022. Should I put money into the market?

There's always this question, when should I put money into the market, and what I want to highlight here is we're looking at hypothetical $12,000 annual investment each year in S&P 500 over the last 23 years. The bar on the left is if you put that S&P 500 each year for the last 23 years at exactly the lowest point in the S&P 500 each calendar year. Perfect timing, divine intervention. You basically could time it perfectly. Your $12,000 over those 23 years grew to about $1.3 million, which is significant growth. The bar in the middle is what every investor fears—is Murphy's law's going to kick in and you're going to put your $12,000 each year for these 23 years at the S&P 500 's highest level during that calendar year. Even if an investor did that, their $12,000 each year over 23 years grew to more than $1 million. So the difference between perfect timing and the worst timing is only about $290,000 difference.

Where if I look at the bar, Phil, on the right—which is what happens with most investors—they overthink the decision, they sit in cash and they never get into the market. So for us, it's more about what you invest than when you invest because if you think mathematically and statistically, the probability of being on the far, you know, left bar, right, or the middle bar is virtually impossible. You're going to find yourselves if you dollar cost average or just pick any random date to get into the market somewhere between that high bar and that middle bar. So again, it's getting invested with your long-term plan, investing in the market, not sitting on the sidelines. If you have cash to put to work, related to your long-term investing.

Phil: Yep. And we hear this as you mentioned this question a lot. And the key is, look, have a financial plan if you're an institution have your goal and allocate to that goal. It's about having the proper equity allocation, not the day in which you choose to initiate that allocation.

Brent: Absolutely. Right. So one of the things that we get asked again, a lot I mean, we certainly saw a lot of volatility in fixed income over the last 2 years. 2022 was one of the worst years, if not the worst year for fixed income in the history of fixed-income investing. And what we're looking at here is, despite that selloff, where are yields today versus where they were, let's say, coming into 2022? Coming into 2022 across all these various fixed-income asset classes, yields were relatively low in sanguine. Right? You had low yields across both governmental bonds, municipal bonds, investment-grade corporate bonds, high-yield bonds. Again, the premium wasn't there.

Look at where we are right now, Phil, you're looking at let's say for the US aggregate bond index, a yield to worst of about 5.12%. When I look at US aggregate bonds or global aggregate bonds, we're at one of the highest yields in more than 15 years. We've talked about a lot that, you know, these high yields, these high starting points tend to be a very good approximation for your total expected return over the duration horizon.

Phil: Yeah. So to that point, let's actually study that concept. So the question as we flip ahead is if I buy a bond in a given year and it has a 5% yield to worst, you know, I buy a bond index and the duration of that that bond index 6 years, do I get 5% annualized return over those 6 years? I mean, it's a really fair question. So, what we did is we went back and the team looked at, okay. in a given year, what was the yield to worst, what was the duration and what was the percent capture of the return of that bond index? In other words, 100% capture means you got that full 5% annualized over those 6 years. So if you look back on average, the capture is 111%. Meaning that and you can see we have 100% marked there, that's the goal, and you're above it very often, meaning that you're capturing on average 111% of the yield to worst of those bonds. Now, there are exceptions. And if you look in one of those exceptions, the most severe exception was most recent, if you look to the right there, the 2017 last few bars, in that period, the duration of the aggregate bond index was 6 years. So you're looking forward 6 years return.

You can see very low capture. Why was the return disappointing? Well, last year, 2022, a real outlier—which we'll show in a moment in terms of return—reduced your percent capture. So in complicated terms, all that means is that really bad year deteriorated how much of the yield towards capture you were to achieve.

Brent: Yeah. And I think, you know, that takeaway is, again, more often than not, yield to worst is a very good approximation for your expected return over the duration of horizon. And I think you have to overlay what do you see the cycle being over that horizon. And again, you know, time will tell. But we've gone through one of the most significant hiking cycles that we've seen in more than 40 years. If you were to say to yourself, am I going to see rates fall and then have another significant hiking cycle over the next 6 years? A lower likelihood of that happening. So again, in our opinion, we're probably more likely to see something at or above the bar for the next horizon than something that we've seen in the most recent period.

Phil: Yeah, yield to worst is a decent approximation. So speaking to those annual returns of fixed income, this chart is similar to what we showed for stocks showing annual returns of the aggregate bond index and then the intra-year drawdown. What you'll notice, first of all, is that the average drawdown is 3.5% compared to 15% for equities. So, one, a more docile asset class. Two, as your eye moves across these bars, you'll notice what an outlier 2022 was for bonds. Right. Equities, it was it was a down year, but that happens a lot. For bonds, it was severely down, by far the worst year in the history of the aggregate bond index with a 17% entry year drawdown.

So when you think about, percent capture et cetera, this was really quite an event. Now this is of course, through end of July, 2% up intra-month. That's more flat because of the rise in rates. But certainly aggregate bond index, more muted returns, but tends to be more stable than equities.

Brent: And again, historically, we see this quite often. When you have these significant outsized or outlier-type events, it doesn't always, you know, present itself, but investing usually when you have these significant outliers are usually pretty good for your forward expected returns.

Phil: That’s right. And look, bond prices went down because yields went up.

Brent: That's right.

Phil: And you're now able to take advantage of those yields. So as we flip ahead, let's talk corporate bonds for a moment. What we're showing here are credit spreads. All the credit spread is is, what's the premium the market's demanding over the risk-free rate, over treasuries? So if a credit spread goes up for an index, well that means that the market is saying there's more risk. We're more worried about corporate bonds. So look at 2020, for example, that big spike, high yield is the gold line. That means there was a lot more risk in both high yield and investment grade. So high yield, this is more speculative-grade bonds, lower-grade fixed income. Investment grade, of course, is that core balance to your portfolio of investment grade corporate bonds. What you'll notice as you as you look, more recently, is that neither are really pricing what we describe is dislocation. Right? Their bond yield or spreads rather are fairly tight. That means that the market feels pretty good, much like in the equity market, about risks to the outlook.

Brent: Yeah. And take a if you take a look at, let's just say either the gold line or the gray line, go back to March when we had a a little bit of a banking crisis hiccup. Basically credit markets took it in stride and kind of moved right past any of that fundamental noise.

And on the next slide, the question, Phil, I think, again, second to the when do I get into the equity market is, hey, should I be moving some of my cash or some of my investments to longer duration to sort of capture what you guys are talking about? So what we're looking at here is in the gold line is the upper bound of Fed funds. And in the darker lines, we're looking at 3-year and 5-year treasuries. And the dark circles that you see here are Fed hiking cycles. And if we go back to these three previous hiking cycles, what you can see is after the last Fed rate hike, you usually see, first of all, maybe a little bit of rates volatility, but by and large, each one of these cycles, once we start getting past that last rate hike, and then ultimately into the Fed starting to cut rates, rates tend to fall pretty precipitously.

And the closest analog we see is going back to that '06 to '09 period of time where you go back to you know, July of 2006, and Fed stopped at 5.25%, but they kept the Fed funds rate there for 15 months and didn't start cutting rates until September of 2007. So you saw a little bit of volatility, but once the Feds start cutting rates, you saw that yields fell like a rock. When yields fall, bond prices rise.

So when you go to the next slide, Amy, when you think about what that means for total returns, the gold line here is cash. The gray lines—bars, sorry—is the US aggregate bond index. And what we're looking at is those three circles that we saw plus one more of the 1989 cycle. And you can see that the 3-year annualized return following that last Fed rate hike, you saw duration significantly outperforming cash as it relates to total returns. Now history doesn't always repeat itself, but if you think about where we are in the cycle and we're getting, we think, closer to the last Fed rate hike, time will certainly tell. We think that we're going to be higher for longer. But once the Fed starts coming down the other side, we definitely think that duration will start to outperform cash and shorter-term investments. So we do believe moving some of your position into longer duration does make sense if you're an intermediate to long term investor.

Amy: Thank you, Brent. Phil, thank you so much for that in-depth analysis of both the bond and the equity markets, as well as a general overview of the economy. Lots to consider as we finish out this summer.

Just a reminder for anyone who's interested, we do offer a number of publications for our subscribers throughout the month, including weekly videos from Phil on the economic outlook for the week ahead. We deliver that every single Monday morning to get your week started. We also offer updates throughout the month, whether it's from the Federal Reserve or the inflation reports just to keep you informed on what's happening in the economy and the markets. If you're not already subscribed, you can hit the QR code and get signed up or visit firstcitizens.com.

Alright. Phil, let's go ahead and turn over into our Q&A session. As I mentioned, we received a number of questions in the registration process and we will get to as many as we can during our time today.

Brent, first actually, Phil, first question is for you. What are the potential long-term impacts of the Fed raising rates so quickly?

Phil: Yeah. It's a really good question. We talk about the long of variable lags of Fed monetary policy. And we've had the most severe hiking cycles since the early '80s. That hiking cycle only started March of last year. Right. So, if you think 12-, 18-, 24-month-type lags, we are still very much in the meat of the impact of this hiking cycle we're showing here.

So what classic economics would tell you is that it should dampen expected growth of the economy, right? And when we look at the previous slide as well, you see lower expected growth not just in the US but around the globe because central banks are tightening policy around the globe. So there are always implications—I'm sorry. One more back, Amy—there are always implications, to tighter in monetary policy. Typically, it results a recession eventually. Does not necessarily mean that happens. Maybe the Fed walks a tight rope, but we don't have the answer to that question today. The Fed is potentially still hiking. If not, they're going to remain higher for longer is our belief. That is gonna take time to feed in. It may be something we don't really see for a few more quarters down the road.

Brent: Yeah. I mean, look, despite being exceedingly late to the game and really not reacting to data, right, the Fed is in the driver's seat, right? So they've significantly raised rates, right? They're gonna remain restrictive until inflation, both core and headline, are under control and get closer to that 2% target, right? And I think that they are going to remain data dependent from here. And again, if we don't see those long and variable lags feed into the real economy, it would be probably one of the first times in a long time that that significant of a monetary policy didn't have a significant effect on the real economy.

Amy: Brent, let's talk a little bit about next year. Will the upcoming presidential election indicate the market?

Brent: Wow.

Amy: Yeah.

Brent: Another election year.

Phil: It's already here.

Brent: It's already here. I shudder a little bit thinking about it. Look, election years certainly are going to prove interesting. I think the one thing that we certainly would say as it relates to a presidential election year is you're likely to see some volatility. Certainly. I think it's too early to talk about, what's going on as it relates to candidates that it'll be certainly something that we see later in this year coming into 2024. I know that specifically we're going to probably spend a lot of focus, working a lot of presidential election slides and information and market effects into future Webexes. But what I will say is definitely expect volatility in presidential election years.

Phil: And one thing we always spend during presidential and even midterm election years reminding people, though, is it is about the fundamentals.

Brent: That's right.

Phil: Like, in the end, the market trades on corporate earnings and the multiple you're willing to pay for those corporate earnings. So, election years are a lot of fun to talk about. We'll have a lot of interesting slides. But in the end, what is happening in Washington often is far less important than what's happening in the global economy and thereby corporate earnings. So in the end, bring it back to fundamentals, markets perform very well in in all kinds of makeups in Washington. It really is about fundamentals.

Amy: Brent, we have a question here around long- versus short-term fixed income. If I have excess reserves sitting in a money market, should I be thinking about buying longer-term fixed income?

Brent: Yeah. It's a great question. For those types of questions, I think the first thing that Phil and I always gravitate to is what does your financial plan say? If you're an institution, what does your investment policy statement dictate? And certainly, let's just take it maybe from the personal side, and I'll have you comment on the institutional side. Right, from the from the personal side of the equation, right, having, you know, cash reserves as you go through your plan is certainly critically important. But if you do have excess reserves, we do believe that, you know, taking and implementing a little bit of duration beyond what you're getting in cash yields right now, the median money fund is just a little bit shy of 5%. So you're finally getting compensated for cash on the sidelines.

But again, it's very, very difficult to time markets as we showed on slide 26, the previous slide. And between the last Fed rate hike and the Fed starting to cut, you end up with a lot of rate volatility. So, again, that's kind of where we think we roughly are now. We are somewhere close to maybe the last hike, but certainly maybe on that plateau of staying high for a bit of time. And we certainly don't think we're close to a Fed cut, at least anytime in the next several months, which again, ultimately, if you're an intermediate-term investor, buying duration could potentially be a good outcome as we highlighted on slide 27 where longer-duration bonds when yields start to fall usually bodes well for bond prices.

Phil: And that's total return. If you're just thinking about yield, if you're a hold-to-maturity investor, you're locking in the yield.

Brent: That's right.

Phil: Right? So when the Fed fund rate starts to drop very quickly and, you know, money market rates are going to drop very quickly along with it, and you own, say, a 5-year treasury, you are getting that yield for 5 years. So some of it's just very simple, investing. Right? You're locking in a yield. There is some certainty there. On the institutional side, look, the concepts are very similar. For excess reserves that that might not be needed day to day, right? You are able right now to get some yield moving a little bit further around. That may only be 1 or 2 years out. But buying a little longer maturity, you are locking in, and it it's hard because I because right now money market might be ahead of one of those—

Brent: Yeah. Very enticing.

Phil: So it's very enticing, but at the same time you do get that certainty over a multi-year period versus day to day.

Brent: Yeah. Money market yields are not going to stay at 5% for the next 6 years.

Phil: Right.

Brent: And we're pretty sure of that. Again, I think even bigger picture, right, one of the things that we highlighted back on our 2023 outlook is that we think over the next decade, having balance and diversification in a portfolio is going to matter. As you highlighted really nicely, Phil, the yield to worst than the starting point is indicative usually of longer-term forward returns of that duration horizon. So again, given where yields, having duration and having positions in fixed income broadly to balance out your equity positions we think will provide nice balance and diversification and good returns over the next decade.

Amy: Phil, I've got a global economy question here. What does the worse-than-expected economy in China mean for the rest of the world?

Phil: Yeah. It's a good question. It's something that that there's a lot of focus on, particularly in the last few months. You know, the belief was as China reopened that it was going to be really a dramatic recovery and it has disappointed—it being weaker than expected does matter for the global economy. China is the second-largest economy in the world. Right? You just cannot discount how important that is. We're obviously the largest. So it does have implications when you think about corporate earnings companies selling into China. Right? What is the impact to those corporate earnings?

However, there's a lot of evidence that most recessions in the US really start here. We do not catch a cold from, say, a recession in Europe. Usually, the issue starts here. So not necessarily enough to pull the US down, but it but it does, I mean, European companies have a lot of exposure to China, so you can't discount that there is an impact. Is it enough to bring the rest of the globe into recession without other factors? Pretty unlikely in our view. Most likely, a global recession would be driven by more factors than just China's slowdown.

Brent: Absolutely. I think the key points that you highlighted, you know, might be more on the corporate side. Right? So if we have a slowdown in China and corporations selling into the Chinese economy, which is you know, 1.4 plus billion people, expectations for corporate earnings growth for companies that do have a focus on the Chinese economy. You could see that being an impact. I really like the point that you highlighted that is we've never had an exogenous event outside the United States that's driven the US economy into a recession. So we are a very resilient economy. So ultimately, we think that, yes, China slowing down matters.

But as you can see here, when I look at 2022 to where we are going to be for 2023, better than 2022. And again, certainly analysts can change their expectations for 2024, but more of a modest deceleration in Chinese growth rather than a fall-off-the-cliff type thing. So again, we're probably less concerned that a any type of deceleration in China would have a major, major impact on the global economy or the US economy.

Amy: Phil, you talked about the Federal Reserve's Jackson Hole Symposium this week. Do you have any great expectations for them coming out of that meeting?

Phil: Well, so all focus will be on Chairman Powell's speech. Likely—not likely—certainly, every word he says will be studied very carefully and would not be surprising to see market participants read into a law what he says. I honestly think he's going to be very careful because, look, there's another inflation print. Before the next Fed meeting, there is more employment data. They do not have all the information. I think he's being very careful talking about near-term policy. I think he will walk the party line in terms of underlying inflation still too high. We still think that, that restricted policy, as you can see here, is justified. I think he's going to be pretty careful. That said, just him being careful doesn't mean the market doesn't read into it. So Jackson Hole is always interesting. Remember Jackson Hole happens in August when volumes are pretty low.

Brent: I was just going to say—when no one is around.

Phil: When you're out of the bulk of earning season, news is slower in August than it is, say, after Labor Day. So it always makes a lot of headlines, but I think some of that is because there is lack of other headlines. So we'd not be surprised to see it move markets. I think he's going to be pretty careful.

Brent: Yeah. And I think, I love what you said. Ultimately, whether it's presidential election, whether it's Jackson Hole, the fundamentals are going to matter, whether that's economic growth, corporate earnings and profitability, that's ultimately going to matter. And once we get people back from vacation, you're going to potentially see the market being a little bit more reactive to those things.

Amy: Well, Brent and Phil, thank you so much for answering all those questions and sharing your knowledge with us this month. We'll do this again next month. I want to thank everybody for being with us and for trusting us to bring you this information.

We'll be back again in September, and we'll be sharing information about how to get signed up for that in the coming days. Until then, we hope you have a great rest of the summer, and we will see you again next month.

Making Sense In Brief Outro Slide

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