The risk of an economic contraction is ‘growing,’ strategist says

Bill Northey, U.S. Bank Wealth Management Senior Investment Director, and Jason Draho, UBS Global Head of Americas Asset Allocation and Chair of the U.S. Investment Strategy Committee, sit down with Yahoo Finance Live to talk about the Fed's interest rate hikes, inflation, and how markets may react to future economic data.

Video transcript

- For more on the markets, let's bring in Bill Northey, US Bank wealth management senior investment director, and Jason Draho, UBS global head of Americas asset allocation and chair of the US Investment Institute. Nice to see you both. And, Jason, let's start with you. What are the markets reacting to on this Friday?

JASON DRAHO: I think the biggest data point this morning was the University of Michigan long-term inflation expectations. Two weeks ago, it came out at 3.3%, a big jump from last month 3%. That was something that really triggered the Fed to move 75 basis points last week. Chair Powell even made a comment that those were, I think, eyebrow raising.

This morning, it was revised down as the final print from 3.3% to 3.1%. So it's the first really kind of positive data point we've got on inflation in a while. You can really look at the markets around 10:00 AM after they came out, they moved up significantly higher from that point and drifted higher.

That sort of eases a little bit of the concern about inflation expectations accelerating. And the margin eases some of the concerns about the Fed having to hike aggressively. And therefore, it also kind of reduces, at least on the margin, some of the growth concerns.

And if you look across asset classes, it's all kind of consistent with that. If equity's going up, bond yields, especially real yields, going down, commodities going higher. That, I think, was the catalyst for today.

- And, Bill, obviously, we've seen a lot of people were wondering what was going to happen after the 75-basis point hike, how aggressive the Fed is going to be. Do we get a sense, though, that it will be a 50-basis point hike? And will that be enough to avoid a recession? Will that be enough for the markets, you think?

BILL NORTHEY: Well, as Jason pointed out, the University of Michigan survey this morning certainly did lean in the direction of the Fed maybe having a possibility of only going 50 basis points at the next meeting. The Fed funds futures curve has headed towards 3 and 1/2% by the end of this year, which is significantly more aggressive than what was priced in the market even four weeks ago. And as we progress through the balance of 2022, our base case is that there will be continued economic expansion through this year. But the risk of a contraction is growing at this point. And it's certainly a non-zero probability.

- Is the Fed winning this, Jason? And what do you expect in the next two meetings?

JASON DRAHO: So the Fed certainly wants a soft landing. Given what we know thus far, that's still on the table. But as they would acknowledge, it's a difficult task to reach it.

If inflation data comes down according to the Fed's expectations, I think they end up probably hiking less than they expect. And the market can price out some of the hikes certainly for next year. I think that's one of our catalysts for kind of getting more of a soft landing.

That things kind of break in favor of the Fed and sort of investors about this year. What it means, I think for the next two meetings, at least if the rhetoric stays the same, the market's still pricing, I think, something like a 75% chance of a 75-basis point hike in July. So I would lean in that direction. We get some more data between now and then. That could sort of tip the scales one way or another.

September, I think, becomes more kind of a toss up. Still have to be aggressive, probably 50 basis points. Because the inflation data, at least the headline number, aren't going to come down much from their current levels of around 8 and 1/2% probably until late summer and the fall. Given that, it's really difficult for the Fed to take its foot off the brake unless the economic data really slows significantly between now and then. And we don't think that's likely.

- And, Bill, as we look at some of the repricing that we're seeing in the market, we saw in "The Wall Street Journal," they said that FAANG stocks are now considered value stocks. What is your take on that and big tech?

BILL NORTHEY: Well, you're absolutely correct. There's been a repricing that has occurred thus far, which is really based in interest rate moves. The two-year Treasury's gone from 75 basis points to 3% just this year. And that has had an effect across a broad swath of asset classes. And particularly as you start to look at those long-duration assets, like technology where earnings may be distributed further out into the future, those interest rate increases are really more impactful to present values.

The second repricing that we do believe is potentially in the offing is the fact that, as inflation begins to work through company income statements, higher labor costs, higher input costs, there could be some margin erosion that takes place over the balance of this year into a slowing economic environment and, largely, would put what we believe the earnings estimates for 2022 at risk from where they currently stand.

- And, Jason, what's the next data point that the markets will react to? What are you await next week specifically?

JASON DRAHO: So actually, there's some important data next week. One, we get personal consumption expenditure data for May. A lot of concern about the consumer weakening. Last week, we got retail sales data. That showed kind of a negative growth essentially after inflation.

So seeing how that's holding up because retail sales skews towards goods. Consumption is going to be both goods and services. And we're seeing people going from goods to services. So that kind of give a more positive tone in terms of the economy, the resiliency of the consumer.

Then we get, right after that, the ISM next Friday for June. We get the June payrolls number shortly after that. So a lot of data in a very short time period that is both inflationary but also indicates how the economy is kind of holding up and if there are also signs of maybe like slowing down but also inflation pressures easing. If that's the case, then you could say I think the markets will get a little more comfort of the macro outlook being a little more favorable than certainly the sentiment has been very pessimistic in the past few weeks.

- And we do know that, obviously, after today's close, the Russell is going to be rebalancing, potentially some stock market volatility. What should we be keeping an eye on there, Bill, as some perhaps retail investors are wondering, look, does this mean things are getting worse? Or what should they really understand about the rebalancing?

BILL NORTHEY: Well, anytime you have an index rebalancing, there's a lot of funds that follow indexes. So you're going to have money moving between stocks, money moving between different sectors of the market. But as we broadly step back, we think the really informative element of this is that the Federal Reserve policy is going to lead to a wide range of potential outcomes for the balance of this year.

It's one where from a portfolio positioning standpoint, we've become a little bit more defensive as we go into the end of 2022. That may be a temporary position. We recognize that economic cycles will occur.

But we're certainly heading into a difficult environment where the economy is already slowing. The Fed is very vigilant in their fight against inflation. And the range of outcomes as we move into the balance of this year is very wide. So we've taken a somewhat more defensive positioning with an overweight fixed-income position.

- Certainly a lot of moving parts to keep an eye on. A big thank you there. Bill Northey and Jason Draho, thank you for joining us.