Ann Berry: Hello everybody and welcome to the public podcast. I'm your host, Ann Berry, and today's show is brought to you by iShares. We are joined by Nick Morales, who focuses on investment insights across asset classes, both retail and institutional clients are those that he works with. And he's there in iShares investment strategy team. Also joining us today, we have Faye Witherall, who delivers thought leadership on the broad market and economic outlook also at iShares. Nick and Faye, welcome. to the public podcast. It's great to have you both on.
Nick Morales: Thank you so much, Ann. Pleasure to be here.
AB: Let's start with some research, Faye and Nick, that you and your team have been releasing to the market late last month. iShares released the 2023 mid-year outlook, the half-time report, and it mentions that for the first half of 2023 it's been quote characterized by opposing narratives. So I'm excited to jump right in and get to the heart of what exactly does that mean? What are those two opposing narratives that you have been focused on?
NM: Yeah, so what we've really been focused on, and I think the market at large has too, is this idea of whether or not we're actually going to be in a recession at this moment or whether or not we're going to have this soft landing. So that's when you hear on all the headlines and all the talk radio shows and the like, when we hear soft versus hard landing, it's whether or not we're in a recession or not. So our contention is whether or not we're in a recession is really going to come down to semantics at the end of the day. really matters for the time being is that the Federal Reserve is going to keep holding rates a bit higher for a bit longer. And this is because the battle against inflation isn't really over quite yet. Though we did get a really good inflationary disinflationary print last week on Wednesday, where it came over to point 2% month over month, we like to look at that month-over-month number, still doesn't mean we're quite out of the woods yet. So we think the Federal Reserve will hold rates where they're at, maybe hike another time. but for the most part, they're gonna hold them there until probably March of 2024. So in that sort of context, it means that we have a preference for fixed income at the moment. We think that the front end of the curve looks really attractive right now. So there's some really good opportunities for investors overall, but when it comes to the underlying economic backdrop, the hard and soft landing, both of those camps are still definitely competing and there is varied data. So we're a bit uncertain of where that kind works itself out. But in the time being, there's some great opportunities in fixed income that we can talk more about.
AB: So, Faye and Nick, that you've brought up a lot there, let's just unpack some of the terminology. Let's talk about what you mean by a soft landing. It's one of those terms that's being bandied around a lot because it seems to be increasingly likely, but no one's really defining it. So, Faye or Nick, help us understand exactly what you mean by that.
Faye Witherall: Yeah, so this has been a very topical term, as you mentioned. We've heard this a lot over the past few months. So a soft landing is the goal of a central bank when it lowers inflation to an acceptable rate without leading to a severe economic downturn or a large increase in unemployment. So we can just back up for some context. The Federal Reserve's delivered 10 consecutive interest rate hikes over the last 15 months, paused only in June in this attempt to really tame surging inflation. So typically, when interest rates rise, we see a reduction in economic activity, and borrowing costs increase. So in essence, the Fed is maneuvering the plane. It's using monetary policy to do so.
FW: Trying to touch the runway without any breaks or hiccups. That's your soft landing.
AB: So, and it just is sort of really unpacked that using some numbers. One definition of a recession is one of several, and it's not the only one. It's not the only factor that is technically two consecutive quarters of GDP decline. Am I hearing that soft landing can mean no growth or very slow growth, but certainly not decline. So again, just in terms of numbers, soft landing is 0% growth or more.
NM: Yeah, the way I would go and think about it there is that we have what we call the real growth of the United States. That's GDP growth. It's our potential at the end of the day, which is around that 2% number. We know that we're going to be coming in below that. And whether or not you're in a recession is whether you come in below that and also dip below that 0%. So you're contracting on a GDP basis. And I think no matter what, we're gonna be below that 2% number, kind of like our potential as an economy, but whether or not we dip into that negative territory, we'll see. And right now, what we're really seeing in the market is kind of these pockets in which we are seeing that negative growth, but then there's other pockets that are really strong. So, for instance, in manufacturing right now, we're definitely looking at recessionary territory. Industrial production is really low, and capex spend is really low. But then you look towards the US consumer. You have real income rising. You have low unemployment. So that part of the economy, which to be fair, represents around 70% of US GDP, still remains really strong. So you can definitely be in a recessionary environment in different pockets of the economy, while other parts are still remaining strong. And that's really the mixed data that macroeconomists are kind of grappling with at the moment. That's why there's so much divergence in whether or not we'll be soft landing or hard landing, what the actual... impacts of tighter monetary policy are, because it's showing up really differently in different parts of the economy.
AB: Yeah. And Nick, thank you for that breakdown, because one of the things we love to do here for the public community is really unpack. What does the jargon mean? Let's take some of these terms, let's demystify them so that we can help folks make better investing decisions. And it's a great segue to going back to how you open the show, Nick, who said that you guys believe that there are some great opportunities out there in, quote, high quality, fixed income. So tell us where you're seeing some attractive debt out there.
NM: Yeah, so if they can go and speak to this. Overall, when we go and talk about what we mean by high quality fixed income is, again, with the Federal Reserve raising interest rates, there's really good opportunity and that yields are higher. And they're at a point where we haven't seen them in 10, 15 years. But we do still have preference for that higher quality fixed income. That's because, again, The economic backdrop is a bit more muddled at the moment. So I'll let Faye speak a bit more to that though.
FW: Yeah, just to add some color, maybe some numbers to what Nick was saying, if you consider that you're holding this one-year Treasury bill today for a full year, you're looking at a return of more than 5%. And compared to the last 10 years, that looks a lot closer to 1% when interest rates were extremely low. So as Nick mentioned, we're not expecting the Federal Reserve to cut interest rates this year, and instead will be in this higher for longer environment for the immediate future. So in short, this really means first, that investors looking for income can now do so in these really high quality portions of the bond market. And this is something that we haven't seen in a really, really long time. And second, that bonds can now act as a diversification for portfolios as well.
AB: Faye, let's talk a little bit more about that and how in practice, retail investors can go get the benefit of some of those yield levels and the income we've talked about. On the one hand, we know that folks can go by treasuries. We know that you can do that for the public platform, for example. But in terms of corporate credit, unpack for us how someone with a public account can go invest in that asset class.
FW: Yeah, so when we're talking about fixed income, it's really important for investors also to consider kind of the credit worthiness of the bonds that they hold. So riskier fixed income reflects higher yields, but the reason for that premium is due to the perceived risk that, you know, there's a smaller chance of being paid back, also known as defaulting. So we're constructive, as Nick mentioned, on high quality exposures, which is typically less volatile than those high yield counterparts. And these are called investment grade exposures. So we're leaning into the investment grade side of the fixed income market versus the more risky high yield exposures.
AB: And how does the retail investor get exposure to that? Are there ETFs out there that you're watching? Are there specific direct purchases that's a little bit harder to execute on? How exactly can the public investor get their money into these assets?
NM: This is a great question, Ann, because one of the ways in which the bond market is sort of set up, and historically it's been this way, is that you most literally have to call your broker-dealer to buy a particular issuance or something along those lines. But with the advent of, like you said, ETFs, is that we can go and take all those bonds, we can put them in an easily accessible wrapper. public.com for instance and they can go and buy a bond ETF. And what that allows is an instant single line item in which you go and get diversification and you get access to all the cash flows associated with the underlying bonds themselves. So it's really a revolutionary way in which investors have access to the bond market in a fashion that they really didn't even 5, 10, 15 years ago. So when we talk about ways to go and access it, ETFs are our primary tool investors can use. You can trade them on exchange during market hours. And it's really easy for investors, rather than going to a website that looks like it was designed in the 1970s to buy treasury bonds. You can go to public.com and actually get access to those through ETFs.
FW: Yeah, and there's a large variety too, like Nick was mentioning. We have investment grade ETFs, treasury ETFs. So there's a lot of choices for investors depending on where they're trying to park their money.
AB: Let's talk a little bit about how an investor may have a different profile. Depending on income level right now, your report, I'm just looking at it right now, mentions that saving rates have fallen, especially for lower income households. Conversely, the labor market remains strong, depending on which numbers you read, there's somewhere between 10 million and a net 4.4 million of, quote, excess jobs or open jobs out there, depending on how you define these things. How does that translate this declining? household savings rate yet a strong wage rate environment. How does that translate into opportunities for equity investors right now?
NM: Yeah, this is a great question because one of the things that we're seeing is this U.S. consumer that has been very resilient over the past six months to a year. And so when we go and talk about the savings rate, the reason this matters is because at the end of the day, we had a really high savings glut over the COVID era, and that's been slowly spent down. Over that same time, if many people know, is that the labor market's been relatively tight. That means people could switch jobs and people could look for higher wages elsewhere. So those two combinations mean that the U.S. consumer effectively had a lot of extra cash to go and spend. They could spend down their savings while also either moving jobs or looking for higher pay elsewhere. And as a result, we get the environment which we have now in which the US consumer remains in a fairly robust place. Going forward, however, we think that kind of maybe that sort of works itself out and we get back to trend. And in that type of environment, that's where we wanna lean into what we like to call the quality factor. And this is for two reasons. It's because first of all, with the Federal Reserve hiking interest rates, there's a higher cost of capital, costs a lot more for businesses to go and borrow. And in that type of environment, a lot of small companies and their business models start to come under pressure in that world. Also, when you have a slowing US consumer and their ability to spend is not gonna be as much as it was six months ago, that continues to go and put pressure on many of those companies. Means that the inventories that they had may not get sold and will have to start discounting things. It means that their top line, their revenue growth won't be as strong on a year over year basis. So what we really talk about in terms of the opportunities out there, It's leaning into what we call quality, like I said. These are companies with strong balance sheets, really strong free cash flows, who have strong return on equities, and they can continue to go and pass back also a lot of their profits back to shareholders via dividends. So when we talk about quality, that's really what we mean. That's the opportunity out there. And as it relates to where the U.S. consumer is, where those savings rates are, and where the underlying economy is kind of working itself out in the back half of the year.
AB: It's interesting Nick and Faye to hear you describe the pockets you're looking at because this idea of quality is core to both your thesis on the fixed income side, Fay specifically said you're focused on investment grade, which is the lower risk, higher free cash flow, stronger balance sheet company typically that gets investment grade ratings. Nick, you're looking for the same thing on the equity side and that profile often translates into dividends. So let's talk about valuation. in that context, right? We've seen this rally in the S&P to highs not seen since before the Fed started to hike rates in 2022. We've seen NASDAQ, which got absolutely beaten down and drumming down last year, have a roaring return this year. So what does that mean, guys? Does that mean you're saying stay away from... growth equities right now to hunker down into dividend yielding equities and investment grade or are you saying something else about portfolio construction?
NM: Yeah, so the way it actually kind of works itself out is when you go and apply this quality factor especially to the S&P 500 for instance, no matter what you actually go and get this overweight towards those mega cap tech companies such as Apple and Microsoft. And the reason being, makes perfect sense, they are the most profitable companies in the United States. So when we go and look towards that quality factor, it does go and give us that mega cap tech overweight no matter what, but it also goes and gives us exposure to other pockets of the market that continue to also exhibit those same characteristics. It means we're avoiding right now, again, those small caps, those companies whose business models are gonna come under pressure, especially with a higher cost of capital. With that said, there's also a lot of those tech companies that are unprofitable. those companies are reevaluating. They're looking towards profitability, but they're not quite there yet. We think they continue to come under pressure. So if we look at one of the most rewarded factors year to date, it is profitability, and we think that will continue to go and be the case for the back half of the year. So there are opportunities out there. It's not just looking away from those mega cap tech companies and towards what often people say is, the less exciting parts of the market. We still think there are really great opportunities out there. They're just not gonna be in maybe those unprofitable tech names that many people like to invest in, or that are a bit more exciting on a day-to-day basis because of the volatility around them.
AB: Nick, what are some other pockets that you're seeing the quality factor apply to? And I think about some sectors in that muddy, I think it's the word you use, Nicholas, uncertain environment have tended to fare quite well. It's been the likes of healthcare, pharmaceuticals with relatively predictable flow of cash, at least from those drugs, which they've had on patent for a long time, or they've got established distribution. We've often seen it in certain financials. You saw J.P. Morgan had a rip roaring earnings report. You know Goldman a little bit weaker today, but by and large the financials post the regional bank crisis, the big ones seem to be coming out quite well. And then you've got consumer staples. So when you look at the quality factor, what is it saying about those sectors completely separate and apart from tech?
FW: Yeah, so as Nick was mentioning, we're leaning into that strategy that, you know, screens for those fundamentals that you think of, those high return on equity, that low leverage. And actually, this is a sector neutral strategy. So as Nick mentioned, it does have that inherent overweight to some of those mega cap tech companies. But instead of taking, you know, specific sectoral bets, our team is instead remaining really constructive on kind of these broad, more sector neutral exposures. So when we think about quality from a factor perspective, that's how we're leaning into it. We're not so much going out, really loud overweight any specific sector. So instead we're taking this broad kind of more benchmark approach.
NM: But when you go and also say, Ann, one of the things that you mentioned was that where are the other pockets of opportunity away from what we would call the boring stuff? And Faye can go and talk more to this because this is her model at heart, which is growth at a reasonable price. So one of the things that we need to talk about is there are growth pockets of the monk. Exactly.
FW: One of the uglier acronyms, for sure.
NM: There is growth out there, but what really matters is what valuation are you getting in that?We don't want to be going and buying expensive growth. The companies that – because the relative value that you'll go and get from that is just not going to be as high. So we do go and see growth at a reasonable price in different pockets of the market out there. I would say mostly that's concentrated in places like healthcare and energy right now.
NM: We think there's some really strong fundamentals there that continue to go and push those sectors forward. But at the same time, you get a really reasonable price, and that's because they've suffered here today. That's because the overweight that many investors had to them last year has moved back. A lot of investors have sold out of those positions, and it means that it's an under-owned part of the market. And in that case, we think that they can go and continue forward in order to go and offer some attractive returns for investors.
AB: Interesting. Let's take a little bit of a different take on this idea of a gap and let's call it mega forces that might be driving longer term growth. That's the term that you use in your report. And these are the kinds of factors that have the potential to impact the inflationary environment to the positive, meaning upward price pressure coming down at longer term. What are some tangible examples of these? Are we going to have to talk about AI? It's impossible to have this conversation at this moment without talking about AI. So let's start there. But I do want to make sure we talk about some other factors as well.
FW: I can hop in here. So as you mentioned in our newest publication, we discussed the notion of, you know, the new macro outlook and asset returns being shaped by these structural forces which we've dubbed mega forces. So these are the powerful transformative forces that drive innovation and then therefore kind of, you know, also drive efficiency. So investors have been really laser-focused on these monthly inflation figures over the past couple of years, but we think you know, beyond just this economic cycle. So as you said, you know, we can't get away from this without talking about AI. It's been, you know, seemingly turbocharged since the rollout of ChatGPT at the end of last year. So we're talking about AI, you know, having the power to revolutionize industries outside of just technology, which is how, you know, we've commonly discussed this theme and instead thinking about it in all sorts of different ways from creating new art forms to improving healthcare outcomes. And in turn, that's impacting different companies in all of those industries.
AB: And others, let's find others other than AI. What are some of the other mega forces that you guys have identified?
NM: Yes, one of the big ones that we often go and talk about is actually demographics and how those are shaping economies. what it comes down to and just, you know, we have to go back to the basics, which is our classic macroeconomic model of the world and what drives economic growth. It's mostly labor, labor growth, and then labor productivity. So obviously AI goes and influences labor productivity side of the equation. Me and my daily job can go and get things done a bit more efficiently because I'm not responding to, you know, dumb emails or, writing things here or there that normally would take me a while. I can be more efficient in my job overall. But then there's the labor growth side of things. So when we talk about demographics, that's what we mean is where is labor growth actually taking place? In developed markets, labor is actually coming down, and that's because birth rates are relatively low. But when you look towards emerging markets, you continue to go and have this labor growth that's taking place. And as a result, it means their economies are going to continue to go and grow overall. So we look towards places like India as a clear example of a country in which they continue to have a strong or growing population, especially in that 30 to 35 age cohort, because that drives a large part of the economy at the end of the day. So demographics is another big one, but there's also many examples of various mega forces. One of my favorites is actually, when it comes to healthcare, we know that there's gonna be aging populations. People are living longer than ever. That means the healthcare sector overall is gonna have to continue to grow in order to go and ensure that there's positive outcomes for an aging population. So these are things are shaping economies as a whole. They take place over five, 10, 20-year spans. They're not necessarily something that can be, that plays out in the coming months. These are large, broader trends and they should go and influence how as an investor, especially if you're investing for a long term, how you start to go and think about allocating capital at this time.
AB: Sounds like we're gonna have to hurry up and wait on some of these mega trends then, Nick and Faye. Thank you both so much for joining. Again, that is Nick Morales and Faye Witherold from iShares, a division of BlackRock's investment strategy group. Thank you for joining us today. Come back, we would love to hear more of your update on what's going on in the macro economy and how that translates into investment strategy for public. Thanks all folks, join us another time.
FW: Thanks, Ann.