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Risk volatility shows rally doesn’t ‘distinguish where the quality in the market is’: Strategist

First Republic Private Wealth Management CIO Chris Wolfe and WisdomTree Global CIO Jeremy Schwartz sit down with Yahoo Finance Live to talk about the bond market's fortitude against Fed interest rate hikes, the inflation outlook, and the risk behind recent rallies.

Video transcript

[AUDIO LOGO]

[BELL RINGING]

DAVE BRIGGS: All right, and there is our closing bell to close out the action on the week. And let's see how the markets finished up. We had a four straight win winning streak for the S&P. And we broke it. The Dow drops almost 300 points. The S&P down 1.3%. And the NASDAQ leading the way with the losses of 2% on this Friday, as the rally has come to a bit of a stop.

Let's talk about it with Chris Wolfe, First Republic Private Wealth Management CIO, and Jeremy Schwartz, WisdomTree Global Chief Investment Officer. Good to see you both. And Chris, let's start with you. What did we learn this week when you take it all into perspective?

CHRIS WOLFE: I think two things. One is that the rebound off a second quarter earnings season that wasn't as bad as expected was really exaggerated by a lot of the momentum players. And I think the second thing is we learned that inflation is probably going to be more sticky than most folks realize. And that's part of why I think this week has been a little bit tougher.

Commodity inflation is down. It's been called, I think rightly so, the gasoline rally because as gasoline prices have dropped, we've seen the equity market rally on the hopes the Fed wouldn't hike rates as much. But our expectation is that services inflation-- that's what we learned this week and the last two weeks, really-- is what's going to be a bit stickier and require the Fed to be in the game longer than I think most investors anticipate.

SEANA SMITH: Jeremy, what about the action that we're seeing in the bond market? The 10-year yield just below 3% right now. What's your big takeaway from that?

JEREMY SCHWARTZ: Yeah, I think the bonds are what's driving the stocks this year. I mean, you had a sharply rising rate environment, the Fed being aggressive confronting inflation. And just like Chris was saying, the Fed's continuing to be aggressive fighting inflation. All the narrative from the Fed is that they have one mandate, not concerned about the slowdown. They really want to get this inflation under control.

You got up to almost 3 and 1/2 percent on the 10-year. Then you lost some 100 basis points to 2 and 1/2, creeping higher. I think that's what pressured tech stocks this week was just this higher rate. That's what's been the big trade.

You had a reprieve on rates. That caused tech to rally a bit last six weeks. Rates going higher has been more pressure for those more expensive parts of the market.

DAVE BRIGGS: Yeah. And Chris on that, what are the bonds telling you?

CHRIS WOLFE: Well, I think a couple of things. The first is I think the bond market's like the parent. If the parents are in the house and they're upset, which the bond market certainly is, then everyone else is upset, stocks, commodities, you name it. That's one of the things. So I appreciate the point about the bond market volatility. That's going to be with us for a while, as the Fed has to both raise rates and run on quantitative tightening. That's all about reducing their balance sheet.

I think the other piece though, is that we've just seen this lockstep move of credit spreads with equity markets. It's just risk on, risk off, which just tells me that there's not a rally here that's distinguishing where the quality in the market is. So it's all about the Fed. And I think that's just the game that we're seeing hedge funds, momentum players, and others move this market around. So for us we're, not getting overly excited about it and using this opportunity as a repositioning one in both equities and fixed income.

SEANA SMITH: Jeremy, all eyes are going to be on the Fed, especially over the next couple of months. What do you think has been priced into the market at this point in terms of Fed policy and what could play out with rate hikes?

JEREMY SCHWARTZ: The market's saying we're going to get about another 120 basis points through January. So we've got another few meetings for the rest of the year. We've been saying maybe they only have to do 100. We see the trend in inflation heading down. But they're saying we're going to get another five hikes. So will they get 50 or 75? We'll find out from Powell. Does he have anything to say next week?

But I think the key is going forward, will they just raise and hold, or will they raise and lower? The market was starting to think they're going to start lowering rates pretty quickly next year. And it's more likely that they raise and hold. See the long-term implications of the policies, see if inflation really is coming down. They don't want to have a start-and-stop type of situation on their hands.

And so I think here, the bigger risks for the market is that they're on hold longer than people are currently expecting, where they start to expect cuts coming in pretty quickly next year.

DAVE BRIGGS: And Chris, a pretty important week next week. What are you expecting from PCE? How crucial is it? And what type of guidance do you expect to hear from the Fed at Jackson Hole?

CHRIS WOLFE: So I think on the inflation data, our expectation is that the trend of a slow bleed, meaning it's coming down a little by little, is what we would want to see. I think most folks are going to read into the data probably a little bit too much. I tend to agree with WisdomTree that we're going to see the Fed on hold. It's very rare that they raise rates and then immediately about face and turn it back down.

I expect, I think as many market watchers do, that the Fed's going to try to walk back a little bit the market expectations that they're going to just do a quick reversal, that they're actually going to make certain that they get the inflation genie back in the bottle. And as a result, I think any commentary coming out of Jackson Hole is going to be along those lines.

SEANA SMITH: Chris, what are you favoring in this environment?

CHRIS WOLFE: In equities, it's really a much more narrow group of stocks. The sectors we like are health care, energy. I think the energy story hasn't played out yet. It's down a bit, so there's a little bit of a reload. A little bit more cautious on the consumer. Negative real incomes right now are a big dent for consumers, at least between here and the end of the year.

And really, we've been underwriting a stay at home strategy, meaning more focus in the US relative to international markets. Some of that's fairly straightforward with Ukraine and the Russia war. But it's also the China story, which is increasingly getting more negative. The housing markets there in particular have been under extreme pressure. And some surprise actions by the Chinese central bank make us a little bit more concerned that their financial condition still has a long ways to go before it plays out and we find a fundamental bottom there. So US equities, stay at home strategy, and where we can, looking to manage risks by upgrading portfolios into quality names that pay dividends.

SEANA SMITH: Jeremy, you said the bond market's very important to watch. The equity market though, we certainly have seen the rally stall, at least today. What's the catalyst that's needed in order for this momentum in the market to continue?

JEREMY SCHWARTZ: Well, I think you would love to see inflation actually come down so that the Fed doesn't have to be more tight. I think that's going to be one of the key things. There's been a lot of fears about recession. And I think for the slow growth that we had in the economy, how well earnings came this quarter, it's sort of a question. Was the economy that bad?

We had negative GDP growth in the first half of the year. The earnings certainly didn't show that. So as long as the earnings continue to hold up well and the recession fears go away, if the Fed doesn't have to over-tighten us into that recession, those would be some of the key inputs that would get people more positive on the markets.

SEANA SMITH: All right, Jeremy Schwartz, Chris Wolfe, thanks so much for joining us this afternoon. Have a great weekend.