Third Quarter Market Outlook: The Fed, Housing, AI & What’s Ahead

Thanks for having me. So in terms of the Fed, I think that what's really interesting in the pace of the change of them turning hawkish and now hiking rates is the fact that for most of this year, I think that what they were waiting to see on the labor front was kind of this continued stabilization in the labor market in the US, where unemployment rate kept moving lower, payroll growth kept rebounding, layoff activity was relatively low. And on the inflation side of things, things were still sort of moderating from before the war. You were kind of on this gentle downward trajectory. Then of course the war happened. They wanted to look through a lot of that supply disruption, especially as it pertains to the energy crisis, and then see how that shaped out and lasted throughout the year. So now we're at a point where, you know, late summer, early fall, they don't see a lot of progress on inflation. And the labor market, if anything, I wouldn't say looks outright strong, but it continues to strengthen and sort of continues to rebound. So the one thing that I would point to is the fact that you didn't have a lot of that inflation progress, but the labor market is still holding together. That, in conjunction with inflation being above their target for five and a half years, almost six, to me that's a very simple sort of equation to getting to why they've hiked rates. It feels very abrupt, but I would argue that's because when we got the June inflation data, that was actually pretty great in the sense that, you know, the CPI actually declined, so you didn't have any inflation technically in that month in month-over-month terms. But a lot of that was driven by what was happening with oil prices, how much they had come down at that point. But then of course we had the reversal higher. Now things look a little bit more sustained, and we're sort of dealing with the energy issue that we had earlier this year. So what it means for policy moving forward, I would say that I wouldn't be surprised, and I think we should be open to the idea that this could be a more prolonged hiking cycle.

Not that it becomes an aggressive cycle, because I think those two can be very different things. In an aggressive cycle, the Fed is going at every single meeting. Sometimes they're upping the increments of hiking from 25 basis points to 50 basis points. That's what they had to do back in 2022. I still think that that's more of a sort of distant possibility and a lesser risk, a lower risk right now. But at the same time, the nature of inflation being so much embedded on the supply side of the economy and on the services side of the economy means that it's pretty sticky. And when you look at all of these surveys, in particular businesses and what companies are facing from an inflation standpoint, it's pretty widespread, and these price pressures are pretty significant. So the job of the Fed is to ultimately, you know, combat that and figure out how to engineer an environment where you get some sort of price stability. And I think a useful framework for this environment is, I'll borrow from what the Chicago Fed president Austan Goolsbee says a lot to talk about inflation. It's sort of a Midwestern proverb, but he says that there's no such thing as bad weather. There's only bad clothing. And at some point, you know, the Fed has to stop wondering about, okay, why is the weather so bad? Why is inflation being driven by these things that we can't control? And they just have to act and be better dressed for the weather. So in this case, better is hiking interest rates. Whether they believe that they can directly affect the demand side of the economy enough to bring inflation down at this point is irrelevant. So that's the way I would sort of think about how at least the rest of the Fed or the entirety of the Fed is thinking about inflation, because it was a unanimous vote in September. And I have a feeling that you're not going to get a lot of dissent in the next couple of meetings if they decide to hike rates, because I do think that there is that pretty strong commitment right now, at least, to take policy in that direction.

So I think that what may be sort of fair value for the 10-year, when I talk to the fixed income folks on our team, right where we're at seems about normal when you take into account structurally higher federal deficits, which we have and we're running, and that's not changing anytime soon. And then a relatively sticky inflation backdrop. And then I would add a positive, which is a strong nominal growth environment. So before inflation, if you just look at raw economic activity and growth, it's pretty great. We're expanding the economy at 6.6% on an annual basis, which for context, you haven't really seen that kind of a growth rate since the early 2000s and the late '90s. So that's pretty great. But we of course have the inflation issue. So that depresses, you know, real, inflation-adjusted growth. So all of that together, when you put it into some sort of model for a 10-year yield, I think gets you in this, you know, call it upper 4%, lower 5% range. So I don't think that changes anytime soon for the 10-year to come down and actually react to what the Fed is doing. I think you would have to see more of a slowdown in the economy. So in some ways, that's what they're looking for, because you want to be able to depress inflation and get it back down to, you know, to trend towards 2%. But at the same time, you want to calibrate policy enough to where it doesn't put the economy into a recession. Very tough thing to do. You know, it's not all up to the Fed. There are other forces at play that will determine whether you go into a recession or not. But I think that where we're at sort of seems probably appropriate in terms of the 10-year's current level.

Yeah, I'm not very optimistic on housing. I think for residential, there's so, I mean, there's a lot of different angles to housing. So you've got the rates picture, you've got home prices themselves, and then you've got income growth, and all three of those are struggling. So if you just kind of break it down, rates, of course, the rapidity with which mortgage rates went up and then the level ultimately that they've settled at, which is now hovering closer to 7%. It's a really big shock for people who have been in, who haven't been in the housing market for a while. So you kind of take out that new homebuyer cohort almost automatically from just the rapidity of that move. But from a home price perspective, they went up so much during that pandemic lockdown phase and really haven't seen the growth in home, we haven't seen the growth in home prices ease. And that is contributing to a pretty significant sort of sticker shock mentality where, you know, the average down payment has to be pretty large now to be able to, you know, afford a home. And then you add on what's going on in the income side of things and the fact that you've still got a pretty significant inflation problem that is sort of eroding real wage growth over time. So all of those are working against certainly the new, you know, a first-time homebuyer. Certainly aiding those who have had homes and who are benefiting from, you know, that appreciation and the value over time. But we're also, so we're just sort of seeing that, you know, that low mobility and less exchanging of homes, and ultimately that depresses residential investment and that brings down that component of GDP. What's been really interesting is that over the past five to six years, pretty much in the post-pandemic world, we've been able to grow the economy without housing altogether. So the housing component of GDP is down by almost 20% over the past five years. Yet GDP itself, real GDP, is up almost the exact opposite over that time frame. So it's an entirely unique cycle where before, if you told somebody, hey, the housing market's basically going to subtract from growth for five years, I don't know if anyone would have come back at you and said, yeah, but the rest of the economy will be totally fine. Yet we've figured out ways to plug that hole and then more, whether it's, you know, via strong consumer spending or whether it's via now this capex boom that we're seeing on the business investment side of the economy. So it's a very strange dynamic and backdrop to look at because a lot of us are asking ourselves, you know, what is it going to take for housing to get back up and running again? And I'm not sure still today, I'm not sure if it's more of a rate story or if it's going to be a price story. And even with both of those, I don't know how they resolve themselves quickly. And I don't think it is a quick solution. I think it's something that sort of heals over time. But no question is that industry sort of in its own recession of sorts, but it depends on who you are in that industry. It's not a recession for everybody. It's certainly a recession more so for, definitely for builders having to adjust prices to come down more because, you know, to meet lower demand, but also for buyers, there's just no, there's virtually no access and that market is basically frozen right now.

Well, and what's interesting too on your note about housing, this is so recent too, but we have now crossed the chasm or the point where now the stock market is a more dominant factor of household wealth than housing, than real estate, which is kind of hard to wrap your mind around. But the exposure that households have now to the market is higher than it is to real estate in percentage terms. So you normalize both of them as a percentage of household net worth, and it's bigger now for the markets, which is, if anything, you know, just puts more of a microscope on how important and central the stock market has become to having an economic outlook and an economic forecast. But the other part of that, as you mentioned, is this buildout that's going on with AI. It is pretty amazing to look at some of these investment statistics and what's happening in the US economy. And what I think is the most interesting component being that when you actually look at all of that investment that's happening, a lot of it is in equipment that's imported. So what this investment is doing is significantly blowing out our trade deficit and actually making the goods deficit much wider, which in and of itself is not a bad thing. But the way that GDP math works is that if you're importing more than you're exporting, that's not gross domestic production. That's production that's happening elsewhere and you're purchasing it. So it's actually subtracting from growth as well. So it's a little bit of a kind of artificial depressant because at the end of the day, that business investment is a good thing for the US and businesses here are definitely seeing that return, that stronger return on that, you know, invested capital, and we're seeing that reflected in the core parts of GDP. But it's very interesting that you have that dynamic where the other kind of main inflation driver is a tariff policy that is meant to sort of engineer more production, you know, ultimately back here. Yet we continue to see that import bias getting raised by what is a pretty strong business investment cycle. So it's a little bit of this kind of strange vicious circle that's taken shape. But I would call it still, you know, clearly a benefit for the US growth picture, has certainly helped carry us through and smooth out a lot of the bumps that we went through last year on the consumption side of the economy because of how much, number one, payroll growth had slowed last year, but number two, how much, you know, wage pressure there has been, especially from inflation. So where we go from here, I think that, you know, assuming the job market continues on its trajectory that it's been at on this year, I do think that the consumer can actually come back into the picture a little bit in terms of contributing to growth. But the clear overhang and the thing that's, that no one, none of us can predict is what happens with energy prices and gas prices, how much of a depressant that is on consumer spending. Because I do, you know, as much as I believe in the resilience of the US consumer, and I've been proven wrong, you know, many times in terms of how strong the consumer is, I think it's hard to get to a point where if you get to the winter and diesel prices are where they're at or higher, and gasoline prices for the end consumer are where they're at right now or higher, it's hard to imagine that you don't see some more dramatic shifts maybe in how people spend. And at the end of the day, it's not recessionary if it doesn't hit the labor market. So I'm not at all suggesting that we're going to see some massive economic slowdown just because gas is, you know, above $4 a gallon on average, but I think that the longer that lasts, the longer you have consumers treat that as a permanent increase just in their psyche, and that starts to chip away potentially at their spending power. So we'll see where it ends up, but I think that the main takeaway would be it would be more of sort of this mid-cycle slowdown than it would be some kind of recessionary hit, because for the latter, you would need to see more of a crack in the US labor market.

Yes, I mean, I think some of it to some degree, some of it is showing up in the sense that the mega caps and the AI kind of big, the big, you know, the big companies in the AI trade, they are, they are not the best performers this year. And sometimes I think there's this conflating between, you know, the biggest companies and the best performers that they have to be the same. And we've found over the past year and a half that that's just not the case, which I think argues in favor of the average investor and diversifying your portfolio and having exposure outside of these companies. Not that they're bad. I mean, we're not making a call that you should just get rid of all your, you know, your mega caps. But there have been, there has been a broader set of opportunities and performance within even the US stock market in the S&P 500. I mean, the best performing sector this year is the energy sector, traditional oil and gas. Not surprising as to why. But you'd be surprised as to the fact that that sector is doing better than, you know, Nvidia or Apple or Microsoft, you know, on a year-to-date basis. So I think it's important to remember that even if you're not thinking about it in terms of who are these AI beneficiaries and what sectors are going to do well because of the technology, there are other macro forces at play that are keeping other parts of the market, you know, that are helping prop them up. So I think that's one way to think about it. The other one is, yes, from a technology standpoint and who is going to benefit from this. I mean, our own way of rating sectors and how we have sectors ranked right now, we're pretty favorable on, you know, industrials and materials and even healthcare. Healthcare probably is that one that takes a little bit longer for the gains to be materialized or the benefits to materialize over time because it's such a big sector. There's so many industries in there that are, you know, in different parts of the AI build. I mean, you've got pharma, you've got biotech, healthcare equipment. I mean, very, very diverse set of industries. But that's a beneficiary that we see sort of long term where profit margins can hopefully get a little bit better, maybe efficiencies can be realized. But that's not going to happen in sort of one direct line, and it's certainly not, you know, linear for a year-to-date, you know, in a year-to-date time frame. So the message from us is really to look beyond what has become sort of the big AI trade in terms of just the creators. There's certainly a benefit to be had looking at the adopters, but the evidence of the energy sector's performance this year is that there are often other macro forces at play that dictate a lot of these sector moves. So I would argue that the war is sort of in the driver's seat right now, not just for, you know, the energy trade doing well, but also anytime virtually these days that you see oil prices going up, the S&P 500 goes down and vice versa. So that is the dominant macro force that is driving markets basically on a day-to-day basis.

So the ones that we have rated favorably now, as I mentioned, you know, industrials, materials, healthcare, financials, I had left out, but that's still kind of the core of what we think will do well. So there's of course a little bit of a cyclical tilt. You know, industrials and materials don't tend to do well when you're late in the cycle and that, you know, cyclical part of the economy is faltering. So we're still, it's still very much consistent with how we feel about the economy being in an expansion. But I do, we have energy rated as neutral, but I do think that there are interesting ways to maybe tackle adding that more to a portfolio in the sense that, you know, energy as a sector is just over 3% of the S&P 500. So compare that with tech, which is close to 40%. Completely at odds with each other, but at times in the past several years, you've had energy outperforming tech by a significant degree. And it comes in these really quick bursts because it tends to come after you get a significant increase in oil prices. So I think the fact that you've got in the current, in the near term, you certainly have upward pressure on oil prices because there doesn't seem to be a resolution to this war, you know, anytime soon, or at least oil flowing the way that it was. But then number two, you've had so many stockpiles around the world of oil that have been drawn down to help guard against what could have been a more egregious price increase. It's happened in the United States. It's happened in China. So the rebuilding of that and the restocking of that, it does add a kind of a fresh wave of demand for energy prices. So if it doesn't send them higher than where they're at now, it at least acts as a powerful force to keep them more elevated. So that's why to me energy is interesting, especially from a sentiment standpoint. I mean, when we look at investor behavior and flows into different sectors, energy is consistently ranking at the bottom. So it is just this beleaguered, unloved sector from a price performance standpoint. And I can't wrap my head around what kind of performance it's going to take for people to ultimately be like, oh, maybe I should add some to this sector. So from a sentiment standpoint, it kind of continues to be unloved and a little hated. And that tends to be, you know, a relatively positive force for any sector, not just energy. I'm just picking on it because right now it's the, you know, it's the least loved. So that to me is something that sort of scores as interesting as we think about the end of the year and turning into next year.