‘We don’t want to disrupt capital markets,’ strategist says

Hal Reynolds, CIO of Los Angeles Capital, and Keith Lerner, Chief Market Strategist of Truist, join Yahoo Finance Live to examine the market’s sell-off amid rising inflation and CPI data, defensive portfolio investments, Fed interest rate hike cycles and soaring oil and gas prices.

Video transcript

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SEANA SMITH: The selling is accelerating here in the last hour of trading. The three main averages end the day in the red. You can see it on your screen with the Dow Jones closing around 881, the S&P almost 3%. The NASDAQ closed around 3.5%. This strong impression of inflation we had this morning, the record low consumer sentiment weighing on the markets, and then just mentioned the jump we’re seeing in yields. The 10-year rebounded a little today. Sector equity, consumer discretionary, tech finance all lost just over 3%. We see this rotation out of the cyclics.

Well, join us now for more, let’s bring Hal Reynolds. He is chief investment officer of Los Angeles Capital, along with Keith Lerner, co-chief investment officer of Truist. Keith, let’s start with you. What do you think of the impression we got today and the selling action we saw in the markets?

KEITH LERNER: Well, first, Seana, nice to be with you. I wish we had more green on the board to end the week. You know, I think what happened today was that there was a lot of hope that we would get a CPI figure that would show some sort of spike in inflation, and we didn’t didn’t understand that. And one of the reasons why in early April we downgraded stocks to neutral after being very bullish is that we were concerned about a policy error by the Fed, but also that they might break an ankle or two. trying to make a soft landing.

So I think it’s a single number. It was an important number for the market. But it also reminds me now, like, how monthly employment was the main number. Sometimes you have a bit of a knee-jerk reaction when people reevaluate the weekend and also come back. So we will have to see. But in itself, that was a negative impression.

Hal, what’s the argument against the 75 point hike next week?

HAL REYNOLDS: Well, a lot of people make that argument today. I prefer to see the Fed stay the course. I think it would be less disruptive to the market, and there’s not much they can do. But I know there is a great call for it today.

The number was notable for two reasons, both its level – this is the third time in the last year we’ve had a reading of 1% on inflation. It doesn’t happen very often. It happened in the 1940s during a period of great growth and, of course, in the 1970s, so it’s kind of a rare event and of course, much higher than a month ago, but also for its magnitude. Each category has increased. So there’s no doubt it’s a serious number. But no, I think the argument is to stay the course. I think the likelihood of continued rate hikes in the fall has obviously increased a bit.

I think the other thing we really need — we can’t ignore the fact that the ECB announced this week that it’s going to end its quantitative easing this summer. And let’s be honest, we’ve all gotten used to quantitative easing over the past decade. It’s really boosted stock valuations. And we’re going to see a return to circumstances where the market controls the long end of the curve. And we saw that today with a parallel move up, and that’s bad for equity valuations.

So Keith, what are your clients telling you about how they plan to position their portfolios in this type of environment?

KEITH LERNER: Well, you know, I’ll say, that’s more– from our group, we’ve basically advised a few things here over the last few months. Really since February, we say– been very positive. Let’s make bets, improve the quality of the portfolio. And also, in terms of the sector position, we have been more defensive and focused on more commodity-related sectors. So as an example, I mean, we’re all in the red today, but the consumer base is overweight – you saw that today. When there are concerns about the economy, this sector outperforms. We have seen health care outperform.

And then, even on a day like today, where there are concerns about economic weakness, you see the energy sector also outperforming, as well as materials. So we think that makes sense. We have also added high quality dividend type positions. So the main theme is whatever risk you’ve taken over the last two years, we have a different market environment and you want to be a little more defensive.

A potential offset in a day when most news is negative, at least when we’re down 19%, people are worried about the recession. Right now, if you look at the average pullback from the recession, it’s about 29%, while the median is 24%. So you’re already pricing somewhere between a 65% to 80% recession, based at least on historical market averages. Of course you can overtake, but I think it’s important to think about it on a day when everything is in the red.

SEANA SMITH: Hey Hal going back to what you said before just in terms of the Fed maybe they shouldn’t be more aggressive at this point the flip side of this argument is we might see inflation – it takes much longer in order to curb this. What do you think ?

HAL REYNOLDS: Well, it took them 10 years in the 1970s after the actions of Arthur Byrd in the early 70s, so it’s going to take some time. It’s not a quick process. But we don’t want to disrupt the capital markets either. And so I think moving steadily, in terms of 50 basis points, which is the message they gave to the market, is the right course of action. And they’re going to be data-driven, and they can keep doing that through the fall.

Then I do not know. Frankly, I don’t see that making a big difference. I think we have seen what has happened in the past. You know, I think back to the early 2000s when rates were increased by 4.5%. And again, it caused problems, real disruption in the markets by raising the short end of the curve so quickly.

Again, I like the path they are on. I don’t think it will be an easy process. It will last until 2023. Inflation is not going to disappear quickly for all the reasons that we all know. Wage inflation is there. COVID is not going away. We have a headquarters in Ukraine which is not going to disappear quickly. That will take time.

Keith, with inflation and fastest growth since 1981, groceries since 1979, some people are making comparisons to our economy versus the late 70s, early 80s. How are they different, overview ?

KEITH LERNER: Well, I mean, there are a lot of differences between now and then. I mean, the first thing, in terms of energy prices, back then we were much bigger consumers. We didn’t have this big production. I mean, right now, when oil prices are going up, it’s definitely hurting the consumer. But at least there are profits coming back to our companies, so I think that’s one thing. We also don’t have unions like we had in the 1970s.

And don’t forget, we had… I mean, it wasn’t just a year of inflation, as the other guest mentioned. We were also 10 years old. So I think that comparison may be a bit overstated. But either way, I think the Fed’s position is more difficult, probably the most difficult position we’ve seen since the 70s. So I’ll say that side of it, but also, again, the demographics was very different then as well, and the geopolitical situation is also different now.

HAL REYNOLDS: That’s absolutely correct. The biggest difference is the long-term deflationary pressures, which we didn’t have in the 1970s. So that’s another reason. I mean, the idea that the Fed can get it right is just not possible. I mean, they’re either going to overshoot or undervalue. But we have these massive deflationary pressures. We all remember them in 2019. Not so long ago. And those conditions haven’t changed, so it couldn’t be more different from the 1970s.

And so as we see these comparisons, in terms of what we can expect in some kind of recovery, based on what we’ve seen in past recessions, what’s the best way people should be position, Hal?

HAL REYNOLDS: We believe that its positioning has really not changed. This has not changed for our institutional clients – going long on energy, going short on consumption and consumer discretionary. Clearly, real wages are falling. The fiscal stimulus of perhaps the remaining $1 trillion will run out by the end of the year. And so I think you can’t help but be long energetic and short discretionary at this point. I think the most important thing, because you can find good stocks in all sectors, is the very high quality of earnings, with a focus on current earnings rather than long-term growth. The sentiment is still going in that direction, and we expect that to continue for much of this year.

I will say one thing, growth stock valuations have fallen, as we all know. And our dividend discount models actually like some of the mega cap growth stocks, so it’s been a long time since we said that. And so, in terms of, you know, if inflation were to be longer than many expect, I think some of these companies have pricing power. Obviously, they will be under wage pressure. But I think some of the growth companies, once interest rates normalize a bit — and that’s months away — I think they’ll be able to withstand some level of inflation once we’re in the kind of — where we have real interest rates come back into normal territory where it’s not such a headwind for valuations. So I don’t think you can totally ignore growth. But right now we are long energy and short consumer cyclicals.

Alright, we’ll have to leave it at that. Hal Reynolds, Keith Lerner, thank you both and enjoy the weekend.