Making Sense: July Market Update

Amy: Hi. I'm Amy Thomas a strategist here at First Citizens Bank. Today is July 27th, 2023, and I wanna 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 insight to help you make sense of what's going on in the markets and the economy.

Before I turn it over to Brent and Phil, I do have a couple of reminders for you. First, we received a number of questions in our registration process, and we will answer as many as possible during today's discussion. 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 on today's discussion, please reach out to your First Citizens partner. Lastly, as always, 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 Intro that, I'll turn it over to you.

Brent: Great. Thanks, Amy, and good afternoon, everyone. Hope you're all having a wonderful summer. Phil, a lot to talk about. We just had a Fed meeting on Tuesday and Wednesday, the 25th and 26th, another 25-basis point hike. Equity markets now just passed through 20%. So a lot for us to chat about. Why don't we jump in, Amy, and get into the economic update.

On the next slide, so, basically, Phil, economic activity has been slowing significantly since the highs that we saw back in 2021. What we're looking at on this chart, the gold line is manufacturing, gray line is services. And you can see back at the 40+ year high in manufacturing, Phil, though, we've seen manufacturing fall from March of 2021, consistently lower month after month, and we now find ourselves in contraction territory. Now we've had some recent data that might suggest that July might be a little bit better by and large still in contraction territory. Services, on the other hand, coming from an all-time high in the data series back in November 2021. Moderating lower, flirted with contraction, but still in expansion territory. Broadly, if I pull it all together, what are we seeing, Phil, as it relates to real GDP expectations for this year and next? Sitting right now, 1.5% real GDP expectation for this year. That's up, Phil, from earlier this year. So the economic data and mosaic has gotten a little bit better time will tell we're getting to print this week.

Phil: Right. So slow slowing growth, but, but still positive. And it has really improved this year in terms of least expectation.

Brent: Absolutely. Now where we see a slowdown, Phil, is in 2024. Expectations for growth have come down a little bit sitting at about .6% for 2024. Again, relative to the long-term trend of 2.7 and 2.1, both materially below the long-term averages as it relates to growth. So we are seeing a material slowing in our economy.

One of the reasons for that on the next slide, Amy, is Fed policy, Phil. Right? When we look at this cycle, this has been the most significant cycle, Phil, post-1982, so more than 40 years. We just had a 25-basis-point hike yesterday. So we've gone from 0 to 5.25 to 5.50 in 16 months. Very, very fast cycle. And when you think about potentially where we go from here, Amy, on the next slide, and we think about, future Fed rate hikes, the market doesn't believe the Fed. The Fed came out with their statement of economic projections back in June, called for two additional hikes. We got one of the two, calling for one more before the end of the year. Fed funds pricing doesn't believe that less than a 30% probability of an additional hike this year. I guess time will tell, as Jay Powell said in his press conference, they're likely going to be data dependent from here.

Phil: Right. So as we as we flip forward, we have an aggressive Fed in terms of tightening monetary policy. But financial conditions are tightening more broadly as well. So if you look at, senior loan officer surveys, right? We are seeing banks reporting they are tightening conditions, which makes sense, when in a slowing growth environment rates are higher. And of course, we had the events of March. You're also seeing that in the real data. Here we're showing loans and leases in the weekly bank credit report, the 2-week change. So this is a volatile series, but you'll see in that circled area that we are seeing some contraction in in bank lending. So it's not all Goldilocks out there. The truth is there are there is certainly some tightening within the financial system, which, of course will have implications.

So why all of this tightening from the Fed? It's about inflation, right? We've shown this chart for many, many months—

Brent: Quite often.

Phil: And, of course, in CPI headline, the gold line here peaked last June at 9.1%, has fallen for 12 consecutive months to 3%. When you think about the stock market's performance since last October, this is part of the story. We finally entered a downtrend in inflation. Now, for the Fed and policy makers, they are also focused on that gray line. That's core CPI that excludes the impact food and energy. It's kind of underlying inflation. Now, it never reached the peak of headline inflation you can see here, but also hasn't fallen as much. It's still 4.8%, well above the 3% headline inflation. So when you hear the Fed, first of all, when they hike this week, right? Why are they hiking? Well, they're hiking because of core inflation, not because of headline. And when they speak to underlying inflation, this is the story. The mark is going to be very focused on the level of core inflation as we move forward. Now, there are reasons to think inflation could potentially continue to fall, some we're not showing here. Look at Case Schiller home price in the next year on year. Look at Zillow Rents. That should feed into core inflation. But there's also some financial reasons. This is M2 money growth and consumer price inflation on a 16-month lag. CPI tends to track money supply growth with a 16-month lag. So M2 peaked that the early in early 2021, and CPI peaked mid 2022. Right? So you're talking about roughly 16 months. If you believe that relationship holds, that will, as you can see here, put downward pressure on CPI as we move forward. And consensus agrees, as we look at the next slide, Here on the left is actual quarterly inflation data. On the right in the gold is consensus estimates. And you can see basically on trend, it consensus, this is Wall Street economists expect inflation to continue to moderate to 2.4% in fourth quarter 2024. Again, the exact number, don't get too caught up in that. It's really the trend. And the and the point that it's all above 2%, which is the Fed's target. Right? But let's be honest, the Fed can't come out and say we're changing our target. But if we're at 2.4% percent sustained, and core inflation is coming down. The Fed is obviously, pleased with that. And the market would be as well.

Brent: Yeah. And when you think about this in broader perspectives, right, if I look at, you know, longer-term inflation trends post 1980, you had inflation averaging 3.1%. Last 20 years, it's been about 2%, right? So we have seen higher levels of inflation. And as Chair Powell said in his press conference the other day, that they're not looking to get back to that 2% long-run inflation until potentially end of '24 more like 2025. So it's going to be that last five yards to get from where we are today to that actual policy rate might take some time to get there.

So, on the next slide, yes, we're looking at one of the pillars of strength that we've had in our economy, which has been the labor market—incredibly robust labor growth. So look at the job creation field post the pandemic lows. The labor market engineered itself to the best shape in more than 50 years. Unemployment fell to 3.4%. And despite inflation, rising all the way to 9.1% and then subsequently falling down to 3%, we only had the unemployment rate move from 3.4% to 3.6%. So very, very resilient labor market throughout this cycle. So let's focus on June here. And what we saw, 219,000 jobs created in June. Expectation was 230,00 jobs, Phil, this was only the second time in 13 months where the actual, payrolls number undershot consensus expectations. But still, 6-month moving average, 278,000 to almost 300,000. You only need about 100,000 jobs to keep the unemployment rate from moving higher. So a little bit of softening in job creation, but very resilient labor market overall. When we talk about a little bit of that softening, Phil, when we think about initial jobless claims, and we get we get another print today, we've seen that move up just a little bit, but, you know, perspective is certainly important. We hit a low back in September of 2022 at about a 182,000 jobs, and we've seen initial jobless claims move up moving up modestly. Again, the average is about 383,000 jobs. So while we're moving higher at the margin, still far from average, and again, very variable data series, but it's something definitely keeping our eye on.

Phil: That's right. Resilient labor market. That's having impacted consumer spending as we'll talk about in a moment. But are there, you know, early signs of some softening, yes. And honestly, that may be a good thing for early inflation picture.

Brent: For sure. So when we think about what's truly important, Phil, which is the US consumer, right—and we've talked about this before—consumption explains more than 68% of US real GDP another 4% as housing. So more than 72% of our economies explained by the, you know, everyone listening on this phone. What we're looking at on the lefthand chart is personal consumption expenditures. Gold line is spending on goods, gray line is spending on services. And what you can see similar to what we explained earlier with ISM manufacturing and ISM services, both good spending and services spending has moderated lower from the highs that we saw back in 2021. Looking at good spending, significant deceleration at 2.2% below the 20-year average now materially. The good news is when I look at services spending, at 8%, almost double the long-term average. So, you know, look at what's going on in in airports, hotels, restaurants—significant activity on the services side. The good news is, Phil, that when I disaggregate consumption, more than two-thirds of consumer spending is services. So it's good to see that services spending is still elevated and above the long term trend. On the righthand side, you see the visa US spending momentum index, and what this basically is showing you that is readings above 100 basically means that spending momentum is increasing, readings below 100 means that spending momentum is decreasing or decelerating. And what you can see is know, again, from 2021 to now, we've seen at the margin that spending momentum start to decelerate. So while spending is still robust, It is starting at the margin to decelerate.

Phil: And that index looks at the breadth of spending, right? So it means it's not quite as broad across all consumers as it once was, and the momentum is starting to slow. So let's switch gears to the housing market. Right now, we have a really interesting housing market. Mortgage rates have skyrocketed, and affordability fell. What is interesting is that has certainly hit existing home sales, as you can see on the left side, well below the 2019 level. But there's very little supply. People are hesitant to list their home because they locked in a low mortgage rate. So that low supply has actually helped US housing starts on the right side here hanging better than you would think, right? In fact, as you could see, above sort of that average 2019 pre-pandemic, level, obviously below the peaks of where we were. So it is interesting that the housing market is hanging in there better than you'd expect, given sales. Look at home price appreciation, Case Shiller. Basically, flat year on year. Well, if I showed you just that home sales data point and mortgage rates, you'd think, are we are we only flat? We aren't down? So, certainly, this is good news for the economy. We are seeing some residential construction.

Commercial real estate on the next slide, unfortunately, is a little bit more of a straightforward negative picture. Here, we're showing home commercial property year-on-year appreciation has been quite negative for some time. You see that little tick up. That's a base effect. The truth is month to month it fell again. This index includes everything from office, retail, industrial, health care. You name it, apartment. It is in there. And what you see is nationally, it's pretty negative. Now, this is certainly a risk for the economy. It is a known risk. You can't really open up The Wall Street Journal not seeing article about commercial real estate in some metro area or another. But nonetheless, it is something we feel that that that we need to highlight as a risk to the outlook.

So speaking of the outlook, as we turn ahead, the number one question we get in terms of the economy, really for at least five quarters now, maybe six quarters, is, are we gonna have a recession?

Brent: It's and everyday question.

Phil: In fact, in the Q and A, we've already got a question with exactly that question. Right. So, beginning, I believe, last month, we started with this T-chart. And then the reason is risks are somewhat balanced, if you told us, convince me we're gonna have a soft standing, I think we can probably do that. You say, convince me we're gonna have a recession next 12 months, I think we could probably do that. I'm at least a mild recession. So we started looking at the balance of risk. So if I take the optimistic tone this month, on the avoider session, one, resilient labor market. That fuels the second point, US consumer. First term assumptions, almost 70% GDP. As long as you have a resilient labor market, people may be spending less, but they are spending, and that helps to drive the economy. The service economy, as we showed with the ISM surveys, doing better than the manufacturing economy, that is the majority of our economy, and very important. And then as I just touched on residential housing, you are seeing residential construction hang in there compared to where one might expect. That is positive for GDP as well.

Brent: Yeah. I'm not quite sure how I got the short end of the stick and got the glass half empty. It's a complete opposite of our personality. Let's take the potential for a recession. We talked about it deeply on tighter monetary policy, tighter financial conditions as you nicely highlighted. Again, this has been the most significant tightening cycle that we've seen in 40+ years. We went from 0 to 550 basis points on the upper bound of Fed funds in only 16 months. If you believe as Chair Powell said yesterday in his press conference that monetary policy works with long and variable lags. The fact that, that full extent of that monetary policy has yet to fully feed itself into the real economy, right? You know, you think about where we are in that graph that I showed on the second slide. The central point of tendency was, you know, from 0 to 2.5% right around September of 2022. We got to 5% in, let's say, March of 2023. If you say on average, it takes at least historically 12 to 18 months for that to feed through. Now we've had some cycles where it's been quicker, but let's just be conservative and say 12 to 18 months. From those dates, that basically puts a slowdown in the first half of 2024. Maybe more specifically, kind of in that March to September timeframe. But you know, you're not going to feel have this lifeguard whistle that they're going to let's say, hey, everybody out of the water. We now have a recession. We're gonna see this broader mosaic of economic and financial conditions deteriorating as we go from here to then if in fact, we're going to have a recession. We talked about the correlation and the fact that manufacturing has fundamentally deteriorated, you know, over history, we've seen a tight relationship between ISM manufacturing and recessions as it starts to get into contraction territory. We have a deeply inverted yield curve. I mean, we're still negative more than 100 basis points today. That has been a harbinger of recessions to come. We'll see if this time holds. And as you said, nicely, the commercial property market is not getting better and we, as in bottom. So again, a very mixed, economic bag and time will tell as to whether or not we have a recession.

Phil: And the only thing I'd add for market watchers, when the stock markets we're about to talk about is is moving up virtually in a straight line, it's easy to conflate that concept with the idea that the economy is just doing great. Well, those are two separate things. There are absolutely risks in this economy. And just because the stock market is up doesn't mean those risks have gone away.

Brent: Absolutely. So speaking of that, why don't we shift gears away from the economics and let's talk about the market. And man, Phil, talk about a tale of two halves. If I look at the chart on the left and I think about where we were in the first half of last year, January through June of '22. You had stocks down more than 20%. Right. You had fixed income that balance one's portfolio down more than 10%. Fast forward to this year, despite the economic volatility significant, monetary policy tightening environment that we found ourselves in, stocks through June 30 were up more than 16%. Bonds were positive 2%. Fast forward to today. We're now more than 20% up in the S&P 500 bonds still hanging in there in positive territory. So really just a complete turn of events. A welcome turn of events, I would say, for most clients and client conversations, but just completely polar opposites. So when we look at the chart on the right, you can see the incredible significance of that. We are up more than 28% from the October 12 lows of 3577 on the S&P 500. So a significant recovery retracement of those lows And, Phil, we are less than 5% away from the all-time highs. So to your point, the equity markets has basically brushed off all the economic noise and has moved itself higher.

Phil: Yeah. And look, maybe we priced something last year and the 25% sell down. And that economic downturns has yet to come, or maybe it doesn't come. One thing that's interesting in in the rally this year is, our max drawdown intra year so far is 8%. That was during a regional banking crisis. And that is really modest. The average drawdown on the S&P 500 since 1990 is 15%. So going into any year, you should expect on average a 15% entry of your drawdown. So when you think about the rest of the year, if it bounces around, that's the norm, not the exception. This year has been unbelievably resilient in terms of the stock market., given what we faced, especially in the March/April timeframe.

Brent: So speaking of that, so there are a lot of questions that we get, Phil, is alright, well, that's great, Brent and Phil, but where is where does the market go from here? Well, one of the slides that we wanted to kinda bring back in, and I think we covered this in a couple of WebExes ago, is what do equity markets do 12 months after the last Fed rate hike? And maybe yesterday was the final rate hike. So what we're looking at here is all cycles post-1984. The dotted line in the middle is that final hike. And you can see that dark black line in the middle is the average of all those cycles. And you can see 12 months post the final Fed rate hike on average, the S&P 500 has done a little bit more than 10% on average. And you could see, every cycle post 1984, except for one, has actually ended up positive 12 months post. The one cycle that didn't was the 2000 cycle. And if we remember what happened back then, the Fed was still raising rates through May of 2000, only then to turn around and cut rates in December of 2000. So, again, that hiking and then cutting cycle because of that economic deterioration that we saw. It was one of the few cycles where we saw stocks not do so well. So let's all maybe knock on wood that the Fed does stay higher for longer.

Phil: That's right. And it does make you wonder with the real rise in the market leading up to the potentially the final high. If the market has priced a little bit of this gain, earlier than normal, pull forward. Pull forward. Exactly. So what about market participants outside of just those buying and selling stocks? And one thing we like to watch in terms of a gauge of how cautious or optimistic the market is IPO volume globally. And what you'll notice is what does it look like when there is great optimism in markets. Well, that's 2021. Look at the enormous IPO volume, really dramatic. 2023, it tells you a lot about the caution coming into this market, and really even in the first half, look how low the first half of 2023 is versus the first half of prior years. And really muted IPO volume. Some of this has to do with higher interest rates has to do with just concerns around the macro environment. I think you can certainly see a change in this as we enter latter parts of this year and into next year, but just to remind you that there is still some caution within the marketplace outside survey data. Sometimes we like to just look at the dollars and cents.

Another positive, in terms of the market and some of those really driven stocks this year is earning revisions have finally started to bottom. We came into the year expecting further-down revisions to earnings. And we did get that. Here, we're showing 2023 and 2024 bottom-up consensus S&P 500, EPS. So when we say bottom up, what do we mean? We mean company-level analysts. So an analyst that maybe all they're really worried about is 20 companies. What are their estimates you bring that up? They tend to be a little too optimistic. So you do usually see downward revisions, which we have seen. What is nice to see is that we've seen some bottoming. Right? And we are in the middle of an earning season. So far, 83% of companies are beating. There has been some guidance that's disappointed, as always there's been mixed results, but on net companies are beating what admittedly is a lowered bar as you can see here. But this is feeding into the optimism in the marketplace.

Brent: And it's interesting. There's truly, you know, kind of a symbiotic relationship between, you know, corporate earnings and profitability, you know, and hiring in the in the labor market. Right? So if we believe like you said, I mean, operating and reported earnings physically bottomed the fourth quarter of last year. If in fact this turns out to be the bottoming, right, and also profit margins are expected to bottom at 11.1% and then go higher, earnings expected to go higher in the third and fourth quarter, right, so maybe we don't see that massive unwinding in the labor market even as those monetary policy changes come through into the real economy. Companies have a way of navigating turbulent markets better than many expect. So hopefully, knock on wood, we've seen the bottom and we start to turn the corner as it relates to earnings.

Phil: That's right. So speaking of earnings and margins, if we flip to the next slide, a narrative we've heard in the marketplace is the idea, well, if CPI is coming up, if inflation's coming down consumer inflation, well that has to be bad for margin. But what that that misses is that companies have input costs, companies pay employees. There's a lot more going on here than just simply CPI. So if you look at what is the relationship between margins and inflation on the left side here, this is the T statistic. Don't worry about that. Think of this as like correlation. Over time, 2001 really until this cycle, the average is basically 0. So there's not much relationship between CPI margin to begin with, right? But what's interesting in this cycle, the relationship's very negative. In other words, higher CPI is worse for margins than what has happened, right? CPI skyrocketed and margins have come down. But now if CPI is really gonna be lower for longer, it's not necessarily negative for margins. It could be positive. And by the way, if you look at consensus, next 12-month margin estimates, they start to bottom. Right? So there is reason to think just because CPI falls does not mean margins fall as well. In fact, the opposite could happen. That's a real positive for the for the marketplace. On the right side, we're just showing that the same holds for PPI. So just something to think about and a reminder not to get too caught up in sort of financial media and narratives.

So let's talk about our S&P 500 price target. We raised this last meeting to 4,500 at the time that was another 4%, the stock market. And sure enough, this incredible market just continues to rise. Right. Now the market's slightly above our base case of 4,500.

Brent: Yeah. And look, I think it's important to remind everybody when we did our outlook in December of 2022, at that time, Phil, the S&P 500 was at 38, 39. And we had forecasted 4,100, which is about you know, a 6.7, 7% percent increase in fiscal 2023. Well, we directionally got it, right? I don't think anybody forecasted we would be up 20%. Yeah. You know, 7 months into the year. I'll take being wrong in that direction, but again, you know, we had thought that we would be positive a, you know, a little bit more muted from an earnings perspective.

Phil: Yeah. The truth is we've been optimistic, what has been the surprise to us and most market watchers, it is the price-to-earnings multiple. The market just continues to become more expensive. And that has driven price higher. You could see, of course, our bear case and bull case here as well. Something when you think about price changes, this year. I think some of it's that the probability of the bear case for us and any investor has lessened. Think about what the bear case was 7 months ago versus today. And the probability of the bull case has improved throughout the course of the year. Our bull case, 51, 50. In that scenario, that is, earnings beat expectations, and the market remains expensive, and we see further multiple expansion.

Brent: Yeah. So I think I think, Phil, the question that you and I get on this next slide here, I mean, is I mean, literally, it's probably an everyday question. Should I get out of the market? Should I get into the market, right? So, timing when to get out and conversely back into the market is a fool's errand. Nobody can and has proven that they can do it consistently with any modicum of success. So what we're looking at here is the S&P 500's growth over the last 30 years. Right? So if I look at that first bar, if one invested hypothetically, $10,000 in the S&P 500 back in 1992, held it for almost 30 years, their investment would have compounded it more than 20 times to more $208,000, just incredible growth. Over that period of time, on average, Phil, there's about 250 trading days in a year. So roughly 30 years times 250 trading days. We're looking at about 7,500 trading days in these 30 years. The next bar on the right is if an investor missed only 10 of those 7,500 best days, they would have less than half of that growth. Just an incredible, reduction in cumulative earnings are cumulative, compounding and growth in in their investment. And God forbid they missed 20 of the best days, almost 3/4 less. And I think what's really important for investors to remember is the box that we're calling out here on the right. More than 48% of the S&P 500's best days, Phil, 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. You combine them together a full 76% of the S&P 500's best days occurred when you never wanna be an investor. So, again, we say this time and time again, Phil, it is time in the market, not timing the market, that accretes to long-term wealth growth over time.

Phil: And really, the rally since October and the rally of this year is a great example. The rally this year has far exceeded estimates, right? So whether that be, the professionals, our clients, whoever you talk to, think about where people were on 12/31 of last year and where the market is today, it's very hard to call the market in the near term. It's why we recommend clients be invested.

Brent: Absolutely. So, what are the byproducts of all this this monetary policy and rate hiking is that bond yields across various fixed-income asset classes have moved up materially. And if you look at that middle column on where we were fill about 18 months ago, yields across various fixed-income asset classes were relatively sanguine. And where we are now, you're seeing yields that are two, three, four times higher than where we were some 18 months ago. And as we've said time and time again, and we're looking at yield to worst here, which is nothing more than yield to maturity adjusted for the optionality in some of these bonds, is that the yield to worst or your purchase yield or starting point is a very, very good indicator of that expected return for that asset class over the duration horizon of that specific investment or index here. So just an incredibly good starting point.

And Amy, when we look at the next slide, when I look at global aggregate bond yields or US aggregate bond yields, we are sitting near 15-year highs in starting points for yields. So when we think about the future expected return, and if I think about something like the US aggregate bond index sitting at a yield to worst of about 4.75, 4.8%, but has an extended duration of 6.28 years, you're thinking about a very, very reasonable yield and ultimately return over that duration horizon. So very good, expected returns.

Phil: And something, you know, keeping with the theme of fixed income, on the next slide, one thing interesting that we've noticed is, okay, you had this incredible run up in inflation in the upper charter. The 10-year treasury rose with it, which you'd expect. Right? Rates are going up. Further inflation. What's interesting is as CPI has fallen really dramatically from 9.1 to 3%, the 10-year treasury has been fairly range bound, right? So something is going on in terms of the 10-year did not believe the full 9%. Right? But it is showing that you're still getting value in yields as we showed on previous slides, even as inflation has come down. This is an opportunity. It's definitely an opportunity.

And sticking with that theme on the next slide, when short rates, meaning, money market rates are much higher than longer term rates, think 3, 5-year treasury, for example, 10-year treasury as well, it is very hard for clients to buy that longer duration fixed income. But that doesn't mean it's not necessarily a bad idea depending on your situation. The reason is you are locked in that longer duration yield. Right? So let's look at past cycles. Here we're showing the Fed funds rate and then the 3- and 5-year treasury. The circles here are periods much like today. Right? The Fed funds rate is above longer duration fixed income. And even in periods where that last 2006 for over a year, it eventually changes. And what you'll notice is when the Fed funds rate falls, the cycle after that. The 3- and 5-year yield much more than the Fed fund. Right? And that cycle's much longer. So you are able to lock in at those higher yields, even if it's below short-term rates and benefit through the cycle, by those higher yields.

Brent: Yeah. And a perfect example of that, you just highlighted in that 6 to 7 period. When the Fed started cutting rates in September of 2007, If I if I look at from September 2007, let's just say it's pick a day 12/31 of 2012 when rates kind of bottom, right? The US aggregate bond index compounded at an annualized rate of return of 6.2%. So again, following in line with treasury rates, as interest rates fall and Fed cuts rates, you end up having yields down, prices up.

Phil: And to that point, on the next slide, is the question is, okay, well, yields are better. What what's my total return? Well, if you look at the 3 years, return, the return of these 2 asset classes, following the final Federal Reserve interest rate hike. So what's the 3-year forward return? The 3-month T bills in gold. Look at the 1- to 10-year treasury, right? Just a little longer term, enormous spreads of return. Why is that? Yield goes down, price goes up, but also you're locking in longer yields throughout that period.

Brent: That's right.

Amy: Thank you, Brent. Thank you, Phil. Just wanna remind everyone that we bring information to our subscribers throughout the month. It's not just this one publication each month. For example, yesterday after the Fed meeting, we released a one-page document explaining what we saw in the release and heard during Chair Powell's comments and giving you a little bit of our take on things. If that's something that interests you and getting directly sent to you in your inbox, I'd encourage you to hit the QR code and sign up for our subscription service.

Brent, Phil, we did receive a number of questions as we as we discussed. Let's jump into those now. We touched on this a little bit, but we’ve received a number of questions on this astounding housing market. Can you give us a little bit more information on where you think that's heading and what's driving it?

Phil: Yeah. And, and we can flip to that slide as well. And I touched on it so I won't dwell too long, but the real key here is that supply remains constrained. Right? And when you just don't have supply, because people are hesitant to list their home because they lower their mortgage rate, really people that are buying homes are moving, they're forced to change right now. What does that do? Well, it drives the need for supply. And that means residential construction. So you think in the economic sense that is a good thing. It does not mean, look at housing sales on the side, it doesn't mean the housing star is just, you know, wow, you know, unbelievable sales levels. That that is not what it means. What it means is that construction has been stronger than what you'd expect given what's happened with mortgage rates and given what's happened with home sales. When we get the question of well, is, you know, Fed tightening is it not having any impact? Well, it's obviously having impact. Yeah. The housing market's a great example in that it's driving consumer behavior to do something they might not do otherwise and is driving construction, hurting sales, it is having an impact. The housing market does not look like this if mortgage rates did not rise.

Amy: Brent, let's talk a little bit about whether or not you believe we've been in a recession. You mentioned we get this question a lot. If we definitely got it in our registration. If we if we haven't seen a recession yet, do you think we will, and what's your definition of seeing one?

Phil: And, Brent, before you jump in, we recently received, second quarter GDP data came in at 2.4%, perfect assumption 1.6%, both above expectation.

Brent: Yeah. It's, again, this economy has been incredibly resilient filled despite the massive amount of policy tightening. And again, as you and I, I think, covered nicely in that teach are, right, the economic mosaic is significantly mixed, but what I wanna really get to is the significance of this rate hiking cycle. We went from zero to 525 to five 550 in 16 months. Most significant hiking cycle that we've seen in the last 40 years. And as Chair Powell said in his conference, and we certainly believe that monetary policy acts with long and variable lags and that the full effect of monetary policy has yet to fully find its way into the real economy. And as we mentioned, that monetary policy acts with usually a 12- to 18-month lag. Again, again, in in some cycles, it's been shorter, but let's be conservative and say 12 to 18 months. If you just think about what we said earlier, September 22 is sort of the midpoint when we got to two and a half, we got to 5% in March of 2023. We'll just add 12 to 18 months, and then kinda solidly puts you in that first half of 2024. Right. Again, if we're gonna have a slowdown, you're likely to see that financial economic mosaic start to deteriorate between now and then. But again, we're just not gonna wake up and just be in a recession. We're going to hopefully see the sign along the way. And we did talk about this earlier, you know, while Fed fund futures are relatively against sanguine as it relates to further hikes this year—and whether we have an additional one, the time will certainly tell—but when we think about, you know, fed fund futures and what their pricing for 2024, they are looking for cuts. So again, market participants believe that we will see somewhat of a slowdown, and I'd say, again, probably we'd love to see a soft ending. But again, if we don't see a recession, even a modest one, with this degree of tightening, I'll be surprised.

Phil: And, you know, just the question of, you know, how do you define recession? Recessions, you know, are significant declines in economic activity that last for, for more than a few months. The, rule of thumb is, 2 consecutive quarters of declining real GDP. That is not the definition of recession. That's a rule of thumb. In fact, 2001, which anyone who went through that, will agree that was a recession. GDP did not fall for 2 straight months. It put two straight quarters rather. It fell for two out of three quarters. The truth is that was something we felt much more in say the Nasdaq. Then in the economy, So it is a mosaic. It's not just GDP, which is we've just found out continues to grow, but it's what happens with the unemployment rate et cetera. So it is not an easy thing to call, and it is a reason that the NVER does not call recession until well after the recession. Has actually happened. So you don't know until you're in it, but right now, certainly, feels like we're still in expansion territory.

Amy: So kind of in that same vein, as we know the Fed raised rates by a quarter percent yesterday, and it's potentially the last one in this cycle, what do you think the Fed will need to see in order to avoid another increase this year?

Brent: Yeah. I think Chair Powell said it pretty nicely yesterday that, you know, we have about 8 months—sorry, that would be funny—8 weeks between now and the next meeting. So we're gonna get two inflation prints. Right? We're gonna get 2 labor market trends. So we're gonna get a good bit of incoming data. And again, while the Fed in action has not demonstrated over this entire cycle that they're data dependent, I'm gonna kinda believe that maybe for this last or 25 basis points, maybe 50, that they might be data dependent. They're gonna get another 8 weeks of data. And I think right now, at least from a fifth futures perspective as we've seen in markets, less than a 30% chance of an additional hike. So, you know, maybe we've seen the last hike. Again, I don't really think that's really as important from an economic perspective, Amy, because, again, like I said, when I went from 0 to 550, whether I go from you know, 525 to 550 or 550 of 575 is not that material from an economic perspective. From a financial asset perspective, it might be but not from an economic perspective.

Amy: So, Phil, as we talked about, the S&P 500 has been on a tear. Since January. Do you think there is a correction in the future?

Phil: Yeah. So look, it depends, what size. Right? So correction, let's say, you know, 5, 10%, type move that that could absolutely happen. As I mentioned, the average entry year drawdown on the S&P 500 is 15%. We, we've done 8% percent this year. So just doing the average, you could absolutely see a correction. As you can see in this chart, pretty dramatic move up with not too many draw downs. If you're talking something more significant, say, 20% plus, sort of thing that wipes out our year-to-date gains. Absolutely, that's more the bear case, but that's not our base case. The equity market is humbling. Yeah. It can do things you don't expect it to do, but in our framework, that's moving more towards our bear case than our base case, you know, something like a 20% plus drawdown. But a correction, some volatility in coming months, considering what we've done and where the market's trading in terms of its multiple, that is in no way surprising.

Amy: Hey, Brent, do you think we'll ever see mortgage rates drop?

Brent: It doesn't feel like it. Especially given, like I said earlier, the, you know, speed and magnitude of this hiking cycle. But mortgage rates tend to move pretty tightly with 10-year yields. And again, certainly, we've seen significant move in inflation, both up and down. It might take some time as you highlighted from a fixed-income section. But, you know, we believe that that intermediate to longer on the yield curve will start to come down, we'll likely over the next—it might not be a couple months, it could take several quarters, maybe even several years—but I believe the directional vector for both the 10-year treasuries yield as well as mortgage rates is is one that's lower, not higher. So hopefully knock on wood, throw salt over my shoulder that we've seen the high in mortgage rates we don't go higher and we get ourselves lower in the future.

Amy: Brent, Phil, thank you so much for sharing all of that information. On behalf of all of us here at First Citizens Bank, thank you for trusting us to bring you this information. We hope you have a great rest of the day, and we will see you again next month.

Making Sense In Brief Outro Slide

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