Economy remains ‘far more resilient’ than expectations: Strategist

Baird Investment Strategy Analyst Ross Mayfield and Morgan Stanley Investment Management Managing Director and Senior Portfolio Manager Andrew Slimmon join Yahoo Finance Live to discuss the state of the U.S. economy amid the latest PPI and consumer sentiment data as well as inflation and market opportunities.

Video transcript

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- All right. Well, that rounds out the trading week, what was a tough week for Wall Street. All three of the major averages ending not only the day in the red, right around the lows of the day, but all three of the major averages in the red for the week. And that is also the case for all 11 of the S&P sectors. Energy, the underperformer over the last five days.

For a closer look at what we're seeing, we want to bring in Ross Mayfield, a Baird Investment Strategy analyst, and also Andrew Slimmon, Morgan Stanley Investment Management managing director and also senior portfolio manager-- a mouthful there. Andrew, let's start with you just in terms of the takeaway that we've seen over the last several trading days. Certainly all three of the major averages ending the week in the red. What do you make of it?

ANDREW SLIMMON: Well, I'm, you know, disappointed in the PPI number today. I thought today could reverse the market selling off after a pretty good run over the last month or so. Look, we've got the CPI number on Tuesday, FOMC minutes on Wednesday. All this could reverse. But I think we're just working off a near term, a little bit of an overbought market. I still think there's a decent chance we get kind of a year-end push if we get good news on the CPI, which is more likely than PPI, or the FOMC continues to suggest they are, you know, beginning to take their foot off the brakes quite as hard.

- Ross, it could reverse next week. Do you expect it to though?

ROSS MAYFIELD: Well, I think it all depends, as has been said on CPI and what the Fed says. I think while the PPI number this morning was a little disappointing, it wasn't enough to probably shift what the Fed thinks they're going to do next week. If CPI comes in in kind of a similar way, you know, then you expect 50 basis points from the Fed. The market can probably feel comfortable in the year end. You know, I think a lot of the rally was probably already pulled forward over the last six to eight weeks on some of that softer inflation data.

But yeah, I think we can certainly rally into next year. And then I think there's probably, you know, a coming-to-grips moment with what's happening on earnings and where valuations should be. But I think that is a 2023 story. So pretty much two main data points and they're both next week. And then we can get to year end.

- Andrew, I know you said the FOMC continues to suggest that they are beginning to take their foot off the brake. What does that mean just in terms of the next two policy meetings and what we can expect then from the Fed next year? Has all of that already been priced in?

ANDREW SLIMMON: Well, I think what's really going on here is the yield curve that the Fed watches is now inverted, and they're worried that they're going to drive the economy, you know, into a recession. So that has started to weigh on them at a time when you're seeing marginally better inflation. My view on next year is actually-- it seems overwhelmingly consensus that the first part of next year is going to be weak. I actually think it's going to be strong because I think what we're going to see is inflation continue to come down.

But the economy remains far more resilient than what many people think. And one of the reasons I say that is because the cyclical stocks, they would be rolling over hard if the economy was about to roll over in the first quarter or the stock market was about to drop 10%, 15%. So I think you're going to have this combination of better inflation print, but the economy is going to hang in there. For the first half of the year, I'm more worried about the second half when we get down to the 4% level and the Fed has to come to grips with the fact either they're going to drive the unemployment rate up or they're going to back off on kind of their 2% target.

- Yeah, that really is the big question, whether they accept something less than that goal somewhere in that 3 and 1/2 to 4. Ross, what do you make of that? And given the strength of the consumer, it points to what early next year?

ROSS MAYFIELD: I think that's the exact right question to be asking, is does the Fed feel comfortable saying mission accomplished if CPI is heading in the right direction and gets to something like 3% to 4%? I don't think they would go as far as to adjust their target. I think that would be a credibility issue for them. But, you know, if it's heading in the right direction and if we know that there's this lagged effect from tightened monetary policy, will they be comfortable if inflation is in that range and don't feel like they have to go deep into restrictive territory, and probably hurt the economy, send us into recession-- obviously, negative implications for stocks.

On the consumer, there's this latent strength from, you know, all the pandemic savings, all the reopening, but we're starting to see that wear out. You know, they're drawing down on savings. There's tapping into revolving credit.

And then as was mentioned, the labor market is probably the key here. Earnings were strong. That's not what the Fed wants to see. But I do think there's a lingering confidence in the consumer sector from what has been a historically tight labor market. And the question is just how far does the Fed have to go bringing unemployment up, bringing job openings down to get to what they view as an acceptable level of inflation?

- Andrew, we have heard the Fed talk about the weakness that we are starting to see in the housing market. RH CEO was on his earnings call after the bell yesterday, saying that the housing market is the worst he's seen it since 2008. Do you agree with that sentiment?

ANDREW SLIMMON: Yeah, but the stocks aren't acting that way. What's interesting is if you go look at the housing stock, they peaked long before the housing cycle turned down. They peaked when mortgage rates started to head higher. And they have stopped underperforming not because the news is better on housing, because rates are lower. Mortgage rates are coming down.

So what you need-- the point of this is there is a lag between the housing cycle and what's going on in mortgages. And these stocks respond to mortgages. That's why the stock's up today.

I think that that's the story, is when I-- I'm a portfolio manager. And when I'm looking for names, I want to buy stocks that have already gone through a recession. We all talk about the economy. But there's a lot of areas that have already seen a recession, namely a lot of these housing stocks. They're down 40%, 50%, 60% peak to trough. That's already a recession.

- Ross, your notes suggest a scenario in which we could have a flat year for stocks in '23. What could lead to that?

ROSS MAYFIELD: I think, look, earnings estimates for 2023 have come down, but probably need to come down a little bit further given what we expect to be pressure on profit margins, and probably the consumer is starting to fade a little bit more. At the same time, with rates where they are, valuation historically has bottomed quite a bit lower than we saw in this cycle. So I think there's a world where maybe valuation stays, you know, a little flat. Earnings have to come in a bit. But I do think a lot of the pain has already been priced into the stock market.

So I think, you know, there's a real likely scenario where you have a choppy year. Maybe you have some weakness in the first half and strength in the second half as the Fed starts to ease or at least gets to a place where they pause, but a volatile year that could totally be moot by the end because earnings come down. Maybe valuation expands a little bit, but it all equals out to kind of a flat year.

- Andrew, another big driver in the news this week-- obviously, the reopening hopes in China, that boosting some of the US-listed Chinese stocks. Are you seeing any opportunity to invest over in China?

ANDREW SLIMMON: Yeah. I mean, I think-- look, near term they're very overbought. But look, you have two very, very important points. First is the dollar. If you look at how Asia ex-Japan did, it outperformed the United States for a decade until 2018 when the dollar started to rally. And it has been a horrible relative performer to the US since then.

Now, the dollar has broken. And I think what gives me confidence is I'm seeing gold is rallying, and you're seeing the emerging market currencies start to go up. In other words, emerging markets respond very much to dollar weakness. That's good news.

And then secondly, what's going on in China is the long-term goal of the Communist Party is common prosperity, moving people from poverty to the middle class. Can't do that under zero COVID when you're locking people in their house. So unemployment's gone up. Income growth is going backwards. It was only a question of when, not if, they would have to pivot from zero COVID to pursue their common prosperity goals. So I think combination of a weaker dollar and China reopening, in my opinion, make China probably the best equity major market in 2023.

- All right, we're going to have to leave it there. Andrew Slimmon, Ross Mayfield, always great to have you. Thanks for joining us. Have a good weekend.