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Hello and welcome to another episode of the All Thoughts Podcast. I'm Tracy Alloway and I'm Joe.
Wasn't thal Joe?
Look at the screen. That's that's painful.
So if you're just tuning in right now, we are recording this. It is four to twenty one pm at twelve on twelve, eighteen, twenty twenty four. So we just had a FED decision. They cut raids, but you know, they call it a hawkish cut because various reasons which we'll get into, and Stockscott, cloudbird s andp ended down two point nine to five percent. Again that we're doing this, we're recording this after the bell on Wednesday.
Yeah, I guess maybe we fixed that breadth problem at a minimum. But yeah, everything is read bonds down too as well, which is kind of interesting to see them go in the same direction. All of which means we need to talk about markets. It's been a while since we've had like a chunky market discussion.
It has been a while since we've just talked about markets. I mean, we sort of talked about them. We did an episode with the top strategist at Goldman recently, but what I would say, the sort of defining aspect of markets right now and you hinted at them, is how narrow this You know, we've had extraordinary gains inequity markets in twenty twenty four, but the gains have become incredibly narrow.
So basically, if you looked outside of anything that is an AI, chips, crypto and quantum computing, things have been sputtering for a while. A lot was really writing on a handful of sort of hot momentum names. You sort of wondered how long that could last. And again, if you look at the NAS deck as of right now, up twenty nine percent on the air dowd Jones as we're talking about ten straight days, longest sellout since nineteen seventy four.
That's a crazy stat I know.
It's a great statu isn't it only up twelve percent for the year.
It's one of those days where we get to trot out all these superlainness because everything's moving all at once. But we need to talk about why this is happening, how long it might last, and what it means for next year. Obviously, and we do have the perfect guests to be talking to. We are speaking with Jim Karn, the Chief investment Officer of the Multi Asset Portfolio Solutions Group at Morgan Stanley Investment Management. It's quite a title, Jim, Welcome to the show.
Thank you, Thank you for having me.
So let's start with the basics. You know, Joe described it as a sort of hawkish cut. Was that your takeaway as well?
Well, yeah, I mean I would say that it was even more than that. So, for example, we have to put this into context. Right, so today December the FED meeting, we have to go back to the September FED meeting. That's when the Fed basically laid out the plan that they were on a mission to cut interest rates, that the terminal policy rate, that they were on a mission to get down towards a three percent fund FED funds rate,
possibly even lower than that. Today they reverse course to an extent that they actually if when we look at their dot plots, that they actually raise the dots by about fifty basis points across the board. Let me say that again, they raise the dots by fifty basis points across the board, and the dots are really just an estimation of what many of the of the Fed governors are thinking. The voting members on the FED are actually
thinking about policy going into the future. So instead of having about four or five rate cuts in twenty twenty five, now it's closer to two rate cuts in twenty twenty five, so they've cut that in half. This is probably I've been doing this for thirty two years. This is probably one of the sharpest reversals, or I should say adjustments. Not really a reversal, but an adjustment. The FED still cutting interest rates, so it's not a reversal to that extent.
They're not going from cutting to hiking, but it is significant in that they've really made a big adjustment from just where they were three months ago. They typically are a little bit more longer term thinking, but I guess they're reacting to some of the inflation data, some of the equity market performance, and potentially even President Alec Donald Trump.
It's a tricky moment. You know, there was a good summary. I'm just going to read it real quickly from the Bloomberg Tea live blog from end of current. You know, he says there are a few different needles in this press conference to thread explaining why disinflation remains on track, but why they will slow their cuts, explaining why the job market is not a source of inflation even though it's strong, Explaining why they're thinking about Trump's new policies yet,
even though they don't know the specifics. These are all tricky questions. It occurs to me. I was thinking about late twenty eighteen when we had a very intense sell off at the time, but they was kind of simple. Paul had said, oh, we're a long way from neutro. I started getting this sell off at the end of the year. All they had to do was say, we're actually not going to hike as much as we thought. There really are a lot of crosswinds.
Now, yeah, there are. And I think that comment on the jobs market is really what the key is, because look, you can make the argument. You can basically say that wait a minute, and inflation's coming down, but it's really kind of stalling out at this point. It's making some progress lower but not a lot, so that might be a concern. You could potentially look at the equity markets and say, well, equity markets have done pretty you know,
pretty pretty well. Credit markets, credit spreads have been very very tight, so financial conditions are are very easy, So why would the FED continue to cut interest rates in this environment, albeit at a slower pace. And I think the answer is actually in the jobs market. So my suspicion is that the jobs market is actually much weaker than what the published data is suggesting. Now that's an outlier view because I can't back that up with the data, because look, I'm not the BLS. I don't have the
information all the information. But what I do know is that the QCEW data, which as a quarterly census of employment in wages, that data is a longer term series of jobs that are created in What it's been showing over the past eighteen months is that on a monthly basis, there's been significant downward revisions to the non farm payroll
data that gets released every single month. So I think the FED believes that the jobs data is actually or the job environment is actually weaker than what's actually being stated by the economic statistics. It will eventually come out into the future, and what they're worried about is an accelerated rise in the unemployment rate, which they call reflexivity, which could create a more severe downturn. So why are they still cutting interest rates? Is really an exercise and
risk management. They'd rather get closer to their neutral policy rate at this stage because it might avoid them having to move faster later.
But then, what does that mean for the inflation outlook, because you think, I hear weaker job numbers and maybe the official data is hiding some weakness, and we have seen those big revisions that you just talked about. But on the other side, you know, inflation still very much stubbornly above the two percent target.
Yeah, look, it's a great question. So really it's a tradeoff. It's a trade off of basically saying that they are willing to tolerate slightly higher inflation above target. They're willing to tolerate it's stalling, not rising, but stalling out right now, just to make sure that the jobs market will be hopefully a bit stronger going forward. Because still what they're looking for in their forecasts are about four point two percent unemployment rates. That's a pretty low rate. That's where
we are right now. They don't have a lot of room for error. So I would say that as long as inflation doesn't start to move higher, that they're going to continue on a slow path and pace of of rate cuts, and they're going to be laser focused on that labor market.
The real thing that we all noticed, Tracy mentioned it is just that big move in the equity market. But as we talked about, you know, there's been this like I would hate to be a portfolio manager. I would hate to even in an up year, because I'm only beating the market if I were more concentrated in tech than the market, which is already heavily concentrated in tech. And if our portfolio manager, I'd probably consider myself to be a very intelligent, intellectual person and I would swim
away from the crowd. So I probably was not overly invested in tech. And so I'm in this situation which is middle of December, and the only thing that's doing well up until the century today has been tech. Talk to us just about the dynamics and how tricky that is for an investor here in mid December of twenty twenty four.
Yeah, this really gets to the heart of portfolio management. So in many of the portfolios that we manage, we come across this risk a lot. We call it concentration risks. So what you're referring to is that it's a very narrow breath, meaning that the several tech names, big big names that are out there that have really been responsible
for driving a lot of the performance this year. So if you want to have a more diversified portfolio, which is a good thing to do, what that meant is that you actually slightly underperform the market because the tech sector and those and those and those seven names, the Magnificent seven as we call them, have actually done really really well. So what has those started to happen? And I think will happen. And this is what our view is going into twenty twenty five is we're starting to
look away from those big mag seven names. We're not going underweight, we're going more neutral weight like those top ten performers, but we're starting to broaden out and we're starting to go into more of the MidCap sectors. So when we look at MidCap, MidCap is an area that we're looking at pe multiples that are around sixteen or seventeen versus the twenty two or twenty three forward pees that the that you know that the index sits at around. Now,
these are companies that you've know. These are companies know anywhere between five billion in twenty billion in market cap that have better earnings potential, and essentially, especially in the
new administration that is seemingly more business friendly. If you get some deregulation, this can also feed down to the MidCap sectors that get better access to capital, cheaper access to capital that were maybe under banked, and can also lead to better performance there as well as the cyclic cyclicality of the economy, meaning that we're not forecasting a
recession in twenty twenty five. As long as there's some decent growth, we think that the MidCap sector will actually do better, so that diversification may start to pay dividends going forward.
Why didn't it this year though, Because markets, we are told at nauseum are always forward looking, presumably they could see this positive MidCap environment coming. But if you look at the performance so far this year, I think the SMP four hundred is up, well, this was before the big drop today, but it was up something like sixteen percent versus like the twenty seven percent jump in the S and P five hundred.
Yeah, well, it didn't happen this year. That's a great question, and the one word answer is earnings. Effectively, when we talk about the Magnificent seven and we talk about those great performers. They've also had great earnings, and really the earnings growth rate was down to those magnificent few stocks that were out there, and that's what really stood out this year. So they've earned the title of being magnificent just through their earnings. The earnings, though, have been in
much more of a lagged space in the mid cap sector. So, for example, if you look at the S and P five hundred, that index is going to have a very very large weighting towards those large cap tech stocks. When you look at the SMP four hundred or the SNP six hundred, those indices are going to have a more diversified weighting towards the mid cap sectors. If you look at the earnings trend of the S and P five hundred over the past two years, it's been straight up.
It's been absolutely magnificent. But if you look at the earnings trend in the S and P four hundred or the S and P six hundred, it would look like the economy was in a mild recession or a slowdown.
It's been very very flatlined. So what we think is that as these as these multiples and as the earnings growth rates for these bigger tech stocks have really reached maturity at this point that there's going to be a shift in a reallocation into these better earning potential sectors and stocks in the marketing.
Over the years. You know, there are these hot names for baskets of stocks these days. It's the Meg seven now, the old days used to be. You know, there was the dot com stocks, there was the nifty to fifty, there were the radio stocks, and the nineteen twenties things going. First of all, has there ever been the historical parallel to what we see in the Mag seven of such big companies also putting up such big year over year EPs growth numbers?
The answer is not, really, it is it is a pretty rare event to see this type of deviation or just distinction of a handful of stocks really performing so well relative to their peers for this long of a period, And.
What's going to happen in twenty Why do we why do more people seem to think that in twenty twenty five something is going to pivot on this?
You know, it's really not that people are turning negative on these on these on these mag seven stocks as we're talking about it. It's just that when you look at their earnings growth rates, it is starting to and we've seen this in the recent you know, the fourth quarter and it's right third quarter earnings and you'll probably see in the fourth quarter earnings too. Is that what you've started to see is that the earnings growth rate
is now starting to flatline. So, as I was saying earlier, what made these stocks magnificent was that their growth rates, We're magnificent. If their growth rate is just average, well then I'm not willing to pay a thirty pe a high multiple for these things anymore. And as long as as long as you believe their earnings growth rate will be fantastic, well then yes, maybe, you know, maybe a thirty pe multiple for many of these stocks is worth it.
But if it just turns out that it's more of a flat, flatter trajectory in their growth rate, I mean, still a good, solid, you know, growth rate, but nothing magnificent, you're not going to pay those high valuations, and the markets are going to turn towards these other sectors that have been left behind.
So a bunch of the outperformance from you know, the mag seven stocks, the big tech stocks has come as a result of enthusiasm around AI, and we have seen this bifurcation in the market where it seems like anything that is attached to AI or chips or something like that has seen this massive outperformance and then everything else is sort of doing fine but kind of left in
the dust relatively. Is there a moment and would it be next year where you would assume that, like some of the productivity gains from AI would eventually leach into smaller companies or companies that are not directly at the sort of forefront of that technology.
This is the big opportunity. This is a big opportunity going forward. So what AI effectively can do is it can ring out inefficiencies in many sectors of the market that are more inefficient. Let's take healthcare for example. The healthcare sector is doing very poorly this year and even last year, I mean historically, very very poorly. This is a segment of the market that we think that AI can bring in a lot of efficiencies. Whether it's on
the healthcare side. We have to be very very very very careful because sometimes you bring in pharma and big pharma with this, and that's not exactly what I'm talking about, but essentially, you know more in the medical services, you know, segments of this. If you're very specific and if you're very active in how you manage this, and you're a stock picker, not just building in a big index with just a bunch of pharmaceutical names, you can actually do
pretty well. You know, other areas like materials, industrials. You know, these are other areas that you know a little bit far afield from healthcare, but still can get the benefits of some of the AI technologies coming in. And what you're going to find is that more and more brick and mortar types of companies are going to start to incorporate it. The impact of AI is to really bring in higher productivity, which is higher growth with lower inflation,
into sectors that are relatively inefficient. So people look at like tech and they look at like financials. Yes, absolutely, but you know what financials. Financial companies are already pretty efficient just by definition, I mean they're financial companies and that's what it effectively operates on. Tech is the engine that creates a lot of these things, but again a
lot of that is in the price. So we have to start to move to areas that have been the laggards that we think that there could be some technology gains that can really drive the earning cycle.
So one of the things that comes up a lot of times when we talk about multisset portfolios is that really the only thing. I mean, yeah, you can maybe diverse away from big tech into medium tech or medium tech into small cap tech. But there's been no jews in em There's been no jews in Europe. There's no
juice really even in treasuries. They haven't done anything to even head you on a day like December eighteenth, twenty twenty four, what is the role for non US equity right now in a multiset portfolio?
So so non US equity and many people will.
And no, we're non equity at all. So international equity.
Or fixing Yeah, okay, okay, Well let's start with international equity first of all, and let's start with Europe. Europe is really a large cap value play. And what has large cap value done? Not so well, right, because the growth sectors and the tech sectors have done really, really well.
So I would say that that the role that international equity plays as a large cap value style of looking at the markets is it's really more of it's more of a stabilizer so it's a diversifier in that when you typically have these downturns in markets, those large cap value segments actually outperform. They do better than the higher beta growth sectors in the marketplace. So there is a
positive cash flow there. There are dividends there, you know, there is there are some opportunities we can move to places like Japan. Japanese equities one of my favorite markets. So here we are, we have some inflation. Inflation is going to drive earnings, and I think the inflation is sustainable and durable in Japan. Plus you have changes to the corporate governance. It's becoming much more dividend friendly, shareholder
friendly buybacks, all of the various components there. Pension funds are turning into less savings plans which is fixed income, and more into investment plans, which is more equity. And if the world is going to on shore, particularly in the US, and you know Japan is larvae is very very well leveraged to large scale cap X. So I think there's a lot of things that are pointing in the direction to you know, to Japanese equities in the
long term. I know we've had three bad decades, but I think that's this is the decades, this is the decade, this is the decade. That's that's going to happen. Let's try to fixed income. One thing that you said right in the beginning of this podcast is that that there's you know, fixed income and equity. There's no place to hide, right. If we look at the screens today, everything's read bonds
and equities. When the bond when the equity markets go down two or three percent like they're doing today right after the FED, you would expect to get some safe harbor from bonds. Bonds should definitely do well typically, but they're not. And this is the big issue with acid allocation going forward, is that the correlation of returns between fixed income and equities is very high. It's at multi
decade highs. What that means is that if the correlation of returns are high between bonds and stocks, that means it's hard to have a diversified portfolios. Right, It's hard to own stocks and bonds, and that hopefully bonds bail you out or help you when the equity market turns lower.
So essentially, what that means is that we all have to think very very differently going forward because what's happened is that the markets become very complacent on the fact that from nineteen eighty one to twenty twenty one we were in a forty year bull market in fixed income, all you had to be is a passive investor, buy and hold, and you did really, really well. It diversified your portfolio perfectly. What if today interest rates just move sideways.
That would be a structural shift in the way that we think about a diversified portfolio. That means some years bonds do well, some Eurobs bonds don't. They correlate with
equities many times in many cases. So that would suggest that when we think about acid allocating across fixed income and equities in a multi acid portfolio, and let's not forget about alternatives too, that now we have to think about being much more actively managed, particularly in fixed income, as opposed to passively, meaning by passive means active managers
as opposed to passive. Same thing with equities. It's less going to be about the beta, it's going to be less going to be about multiple expansion and these mag seven, and it's going to be much more about sector rotation. It's much more about the alpha and picking sectors and even picking stocks. So again, more active management versus passive
management is a big change. Alternatives Alternatives are another way to diversify your portfolio because essentially, when we look at that, these are longer term investment profiles that typically aren't necessarily just trying to track the economic cycle like fixed income inequities do. They're really looking at valuations, mergers and acquisitions LBOs. They're looking at a very very different timeframe, and your
returns are coming from different areas. In other words, it's orthogonal to your stock and bond portfolio, and that's what creates a lot of the diversification. So going forward, you're going to have to mix alternatives into this multi assets. It's not just stocks and bonds.
Just out of curiosity, I mean, you are. I'm going to say your title one more time, even though it is a mouthful, Chief Investment Officer of the Multi Asset Portfolio Solutions Group at Morgan Stanley Investment Management. On a day like today, when bonds are going down, stocks are going down, it feels like just about everything is going down. Maybe private credit is doing okay because it's not marked to market on a daily basis. Yeah, there we go.
There's your safe haven. What is a day like today actually like for you? Like, what are you doing other than here in the studio talking to us.
Look, I'm excited about today, and I'll tell you why. I'm not just saying that because we've been looking for a good entry point into the markets. We are not bearish going into twenty twenty five. We think the economic fundamentals are going to be good. Why is the Fed increasing potentially not cutting interest rates as much. It's not because of the economy's weakening. It's because I think the economy is stronger, so that should be a positive for equities.
So when I look at equities today and they're down almost three percent on the day, I'm pulling out my shopping list, right, you know, and I hope you know, I'm checking it twice, and I'm going after all these things, all the Christmas references. But effectively, this is a very interesting opportunity. The other thing, too, is that bond yields have spiked. You know, ten year yeels have gotten up to four and a half percent. Well, guess what that means.
As I look at my shopping list for equities, and I can look at this, and I can I can increase my equity allocation. I can also buy bonds at a good yield to actually hedge that. So this is actually as long as we're in the context, as long as this is not the start of something bigger where the FED is now completely going to pivot. They're going to surprise the market and start hiking interest rates, which is not our forecast, not our base case. That all
they're making is an adjustment. By the way, this adjustment that the Fed made one hundred percent in the price bond market was already anticipating this. This is not a surprise to the bond mark.
Yet this actually confused me a little because when I saw the headlines, Joe and I were doing some stuff, but when I saw the headlines, it was like, okay, they cut and then to for next year, Like okay, that's pretty much what was expected. And then a little while later you had the big reaction. It was like, what, how did the press conference go?
What didn't they say, Racy, I'm going to sell some stocks so I have some cash to buy the market. That's my plan twenty twenty five.
All right, all right, well, Jim, I'm so glad that we wanted to have you on the show for a long time and it just kind of happened to be.
A perfect time, perfect guest.
Yeah, absolutely great timing. Thank you so much for coming on all thoughts.
Oh, thank you very much to.
Joe. I feel better about my my crazy bye like terribly inefficient European stocks thesis on the back of AI. Oh idea, that's that's my big twenty twenty five trade.
I like that thesis that basically that you know, some random chemical company in Germany they've never heard of, is going to be the big winner because they will be the users of AI to make their processes more streamlined and will does benefit from the rotation to value and AI itself very intriguing, very intriguing.
I'm going to build that index you'll see. Uh No, I thought that was great, I mean, truly the perfect guest for the perfect moment in time, and it is. It is kind of crazy, you know. You you brought up that great point of how often we have seen in recent years bonds and stocks moving in the same direction, and even on a daylight today, that's a pretty big move in the SP five hundred, so.
Gold got hammered today. I don't know if you know the really really, there's no really, yeah, for real, there was. Right, Let's see how much did gold fall today? Gold was down two point two percent, Bitcoin got clavered, it clovered. It was like at one hundred and seven thousand yesterday or something, down four point nine percent on the day, all the other coins truly a day. The only line it's really going up the entire world right now is BBDXY,
the Bloomberg Dollars Spot Index. It is the dollar wrecking ball.
As they say, America wins again. Yeah, all right, shall we leave it there.
Let's leave it there.
This has been another episode of the Authoughts podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway.
And I'm Joe Wisenthal. You can follow me at the Stalwart. Follow our producers Kerman Rodriguez ed Kerman Armann, dash Ol Bennett at Dashbod and kel Brooks at Kelbrooks. Thank you to our producer Moses Ondem. From our Odd Lags content, go to Bloomberg dot com slash odd Lots. We have transcripts, a blog in the newsletter, and you can chat about all of these topics. Twenty four to seven in our discord Discord dot gg slash outlines.
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