Market is ‘whistling past the graveyard’ amid inflation, strategist says

Federated Hermes Chief Equity Strategist Phil Orlando joins Yahoo Finance Live to examine the market outlook against the Fed's inflation-fighting policies, in addition to discussing positions in the S&P 500 and bond markets.

Video Transcript

- Well, now, for more on the broader markets we're joined by Phil Orlando, Federated Hermes chief equity strategist. Phil, good to have you back on the show. So obviously, a lot for markets to digest between-- the Fed minutes as well. What are your big takeaways in terms of what you think the markets are reacting to?

PHIL ORLANDO: I think the most important elements in the market right now are probably inflation and the Federal Reserve's policy response. So what we've seen with inflation is that the retail inflation, the nominal CPI, peaked out in June at about 9.1% year on year, and we have improved over the last four months. We're down at 7.7% in the month of October. That's good, but we're still a ways away from the Fed's 2% target.

So while I agree that it's probably appropriate for the Fed to downshift from the 75 basis points we've seen at each of the last Federal Reserve's for policy meetings, our best guess is the December meeting will probably be 50 basis points. Maybe we see two quarter point rate hikes in the first quarter. So by the time we get to the end of the first quarter, We think the Fed funds rate will be up at about the 5% level.

The question is, where will inflation be at that time? And right, now our best guess is that might be in the 6.5% to 7% neighborhood. Now here's the tricky part. Historically, you go back and look at the last Federal Reserve eight rate hiking cycles. The Fed would stop hiking rates once they got the funds rate above the level of inflation. If the Fed brings the funds rate up to 5%, let's say by the end of March, but inflation is still above that, let's say 6.5% or 7%, does the Fed go on pause and make the heroic assumption that inflation is going to continue to grind lower? Or do they continue to take the interest rates up to a level above where inflation is at that point?

That's not in the market right now, and, frankly, we don't know what's going to happen in the second quarter of next year because we don't know what the trajectory of this decline in inflation is. So there's a lot that needs to happen, a lot of moving parts here, and right now, the market is whistling past the graveyard and expecting the best things to happen.

- Phil, good to see you. So just to be clear, you think we're still around 7% after an additional full-basis point hike. We're talking, in February, you still think we're at 7%, right?

PHIL ORLANDO: So our best guess is that we will get back to the 2% level eventually, but that trajectory might be by the end of calendar 24. So we're probably going to be, by the end of the first quarter of next year, maybe in that 6.5% to 7% neighborhood.

- OK. So did anything surprise you today in what we saw from the Fed minutes?

PHIL ORLANDO: No it did not. We've expected that the Fed would downshift. The question now is, when will they go on pause? Will that be the end of the first quarter, or will they continue taking rates up, however gradually, into the second quarter, depending upon how quickly inflation levels come down?

- And, Phil, you still have a defensive position right now in the markets. What sort of fundamental changes would you need to see before you change-- change that position?

PHIL ORLANDO: So where we are right now is, as-- Rachelle, as you said, is absolutely defensive. We're sitting here with a 1% underweight in equities. We were 5% overweight at the end of last year. Within the allocation, we are very much overweight value stocks, stocks that are cheaper with higher dividend yields. We are underweight growth companies.

What I think we would need to see is a more significant decline in inflation, the Federal Reserve going on pause, and, importantly, the financial markets being able to somehow skirt the glide path into recession that right now appears inevitable. Given the trajectory of economic growth, we're thinking that the economy could very well go into recession at some point during the next two years. And as a result, we've taken our GDP-- GDP estimates into negative territory for each of the four quarters of next year. We've taken our earnings estimate for the S&P 500 next year down to $200.

We think we're going to end the year this year at about $220, so that would imply that we're looking for a 10% decline or so in earnings next year versus this year. In order for us to get more aggressive in stocks right now and to go back to an overweight in growth, let's say, we would need to see all of those conditions bottoming right here, and we just don't see that. We think we need to be patient and allow the markets and the economy and the Federal Reserve more time for the cycle to play out and materialize.

- Phil, no shortage of emphasis on the Fed on the rates and the hikes coming. Is there enough about the yields? And what are they telling you, in particular, the spread between the 10 and the 2. Well, that's a great point. You've got about a 70, 75 basis-point inversion right now between 2-year and 10-year yields, which historically has been a very good indicator of an impending recession. You look at the Fed funds rate, the 10s relationship right now. The 10s are sitting at about 3.75%, 3.80%. The upper band of the funds rate is at 4%. We think that's going to be at 5% by the end of March. So that means we're looking at a pretty sharp inversion on funds rate, the 10s as well.

So if you look at just those two indicators alone, that's telling us that at some point over the next year or so, the US economy is probably going to enter into recession.

- And so, Phil, then as we look towards the end of the year, what are your expectations? And any chance of a Santa Claus rally?

PHIL ORLANDO: Well, what we're seeing right now, you've got a nice 15% rally over the last six weeks or so. That's very typical of midterm election years, that the market tends to be very choppy over the first nine months or so, and then a month or so before the midterm election, the market takes off. And you tend to see, historically, 15%, 20% rally over the course of the fourth quarter of the midterm election year and into the first part of the next year. And I think we're absolutely seeing that based upon the fact that we now have divided government and a legislative check and balance in Washington.

The question is, will this 15% rally that we've enjoyed over the last six weeks or so-- is that sustainable? Will that have legs over the course of calendar '23? And we don't think so because of the heightened levels of inflation, the sharp increase in interest rates, the deceleration in economic growth. The housing market, you can see, has weakened considerably, with mortgage rates more than doubling over the course of this year. The labor market is starting to show signs of fatigue.

So there are a number of points of weakness that we think is going to point to a move down in stocks, you know, At Some point next year once this midterm election rally has played itself out.

- We've got some very interesting news on mortgage rates. We'll have that for you later in the show. Surprising couple of weeks there. Phil Orlando, good to see you, sir. Happy Thanksgiving.

PHIL ORLANDO: Happy Thanksgiving to you. Thank you very much for having me on.