In this episode, Chris speaks with Putnam’s Capital Market Strategies Team, including Senior Market Strategist Rick Polsinello and veteran Portfolio Manager Jason Vaillancourt, Co-Head of Global Asset Allocation at Putnam.
During the discussion, the team provides Putnam’s 2022 investment framework for equities, fixed income and the market as a whole. In doing so, many topics are discussed including:
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Putnam Retail ManagementAD20206262/22
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Putnam Retail Management AD2557752 11/22
Patrick Laffin: Welcome to Putnam Investments Active Insights, a podcast series hosted by Chris Galipeau. Chris is the Senior Market Strategist in the Capital Market Strategies Group at Putnam Investments. Each episode, Chris has an in-depth conversation with a different Putnam portfolio manager to share timely insights on the markets and global economy.
Hello everybody, this is Chris Galipeau, Senior Market Strategist at Putnam and welcome back to the first Active Insights Podcast episode of 2022.
Today’s format will be a bit different, as it will feature our Capital Market Strategies team who will help you frame client discussions for success in 2022 and beyond.
This podcast includes contributions from Senior Market Strategist Rick Polsinello, and veteran Portfolio Manager Jason Vaillancourt, Co-Head of Global Asset Allocation at Putnam.
In our discussion we will talk about three key topics:
As always, for more from the team, like and subscribe where you listen to your podcasts, and please feel welcome to follow me on LinkedIn.
Thanks for tuning in!
All right, welcome, everybody. Thank you for joining our webcast today. We will be talking about our investment framework for 2022. I’m Chris Galipeau, senior market strategist and team leader of the capital market strategies group here at Putnam, and on behalf of your Putnam consultant team, welcome. As you would expect here, we’ve got an awful lot to cover today and I’m really happy and pleased to introduce my colleagues who will be providing their insights on the economy, on markets, and we’ll also talk about risks and opportunities that may exist here in 2022. So joining me today are Rick Polsinello and Jason Vaillancourt.
And Rick is a senior market strategist at Putnam. He’s got about 20 years of experience in the investment industry. He is responsible for conducting economic and financial market research and sharing his insights with Putnam’s clients. Previously Rick was a senior investment director specializing in fixed income. Alongside Rick and joining us today is my friend Jason Vaillancourt and Jason is a co-head of Putnam’s global asset allocation team. He is responsible for managing about $16 billion in multi-asset portfolios. Jason has about 21 years of experience as a multi-asset portfolio manager and has about 30 years of experience in the business. Jason is also the author of our capital markets outlook which is sent out quarterly and is responsible for conducting in depth research on global macro themes and providing thought leadership to our colleagues and clients alike. So Rick, Jason, thank you so much for joining us today.
During our discussion we really want to hear from all of you so feel free to pose your questions in the area that you see on the screen here marked ask a question. We’ll try to get to any questions and maybe all the questions through the discussion and following our formal remarks. If we can’t do that, we will respond to your questions directly via email. Also, if you’d like a follow-up with your Putnam consultant team, please click on the red envelope icon just to send us a message. And then finally a replay of today’s event will be shared with all of you in a few days via email.
So Judith, we can go to slide four here. Folks, here’s the agenda. We’re going to spend some time first on global economies and inflation. We’ll then pivot and talk about equities. We’ll go and discuss fixed income markets and we’re going to weave in the risks and opportunities as we move along here. So that’s what we’re going to talk about today. And before we get to that we have a quick poll question. We want everybody’s input on this. And as you can see here, we’re asking you what you think is most likely to happen in 2022. So you’ve got four choices there from Fed policy to style to supply chain and so nominal yields. I’m going to pause here for a second and give everybody a chance to put their answers in.
All right, let’s kick this off just by talking about the economy. And so, Jason, I want to go to you first as probably the best macro thinker we have in the shop. Let’s talk about how you’re thinking about both economic growth and inflation as we looked at 2022.
Yeah, thanks, Chris. Look, I mean I think the message primarily is that the kind of policy backdrop and the economic backdrop as we start 2022, certainly in the first half of the year, continues to be very solid. It’s obviously going to be sequentially lower than the kind of goldilocks environment that we had and the strong growth environment that we had in 2021, but certainly in the first half of the year we still think that the backdrop for earnings generation and for free cash flows are pretty solid. Now, I think, remember, we’ve been talking a lot about inflation. It’s in the headlines seemingly every day. It’s in the financial press seemingly every day. I think ironically inflation tends to be pretty good for the equity markets in general, right? If you’re a highly levered company you get to pay back that debt in nominal dollar terms and so inflation kind of helps with sustaining debt burdens and it helps kind of nominal earnings growth which are both kind of great characteristics for equities.
And so we still think it’s not going to be certainly a straight line. I think the second half of the year could be a bit more challenging as the Fed kind of gets further along in their tightening cycle. But if you think about the global central bank balance sheet, if you look at kind of G4 kind of major central banks’ balance sheets as a percentage of GDP we really didn’t see those start to roll over until kind of early 2018 in the last tightening cycle and that’s kind of really where you started to hit some bumps in the road and a little bit of an uptick in volatility in equities. And so we’re certainly nowhere near that now and I think the main message from a policy perspective, even though every single Fed speaker kind of coming into the meeting that we’re going to have next week has tried to outdo themselves and sound kind of more and more hawkish than the last person, I think there’s a couple of things going on.
So first is obviously inflation is a political problem and so we have midterm elections this year. We have to get through both the Powell and the Brainard confirmation hearings and so it’s very possible that they start to kind of ease off with the kind of extremely hawkish rhetoric once we get through those confirmations. And I think the year-on-year percentage change is in some of the base effects problems that we’ve had in inflation will also start to ease starting in March forward. And so I think the Fed may get a little bit of a chance to take a breather and politicians might be able to breathe a little bit of a sigh of relief as some of those base effects start to ease and some of the reopening sensitive parts of inflation start to ease. But I think the message is the Fed is still extremely easy. They’re nowhere near actually balance sheet runoff yet. They’re still buying treasuries and mortgage-backed securities. We haven’t even started to talk about what the tapering plan is yet. And so if you think about where growth and inflation are, where unemployment is, we’re probably pretty close to maximum employment now, I think both of those things would suggest that policy continues, as I said, for the first part of this year to be extraordinarily easy and that should be supportive of risky assets.
I think those are good points and I think it’s lost on some people that the concept of a little inflation push, I think some people might say that’s a death sentence or they’re terrified of that when in reality, as you said, that’s actually a reasonably good backdrop for equities, and some more than others. We’ll get to that in a little bit. Let me ask this because you touched on the base effect problem. So base effect, of course, is a fancy way to talk about easy year on year compares and that’s going to shift from something that’s very easy to something that’s going to get more difficult here and probably very quickly. So that in and of itself will start to put some downward pressure on the [core rating?]. But we know that the biggest component of core inflation is actually shelter costs. Owners equivalent rent. We know that’s the biggest part of the core calculation and I think that’s something that doesn’t get a lot of air time. I know you have thoughts here. Maybe let’s flesh this out a little bit and talk about what you think might happen here as we move through 2022. The base effects start to roll down, but the shelter cost is something to keep an eye on.
Yeah, certainly. I think the politicians care more about the headline number and obviously they’ll get, as I said, a bit of a reprieve as the headline number starts to roll over which it more than likely will. But certainly, the Fed has in the past primarily cared about core personal consumption expenditures and inflation. And so when you think about core PCE certainly the biggest component is the shelter piece. The Dallas Fed has actually done some really interesting research to look at how long it takes increases in house prices in general at the national level to pass through into core PCE and the mechanism through which that happens is through both rent and owners equivalent rent. And so those two components make up something close to a third of the overall core PCE number. And it takes something on the order of kind of 12 to 15 months for those effects to pass through. And so, as we see, whether we’re looking at the Case-Shiller national house price indicator, we’ve just now started to kind of decelerate in terms of house prices, starting to show a little bit of disinflation, but they’re still rising very, very strongly and very rapidly. It looks like the pace of increase on a year-on-year basis maybe peaked out sometime in the summer of last year.
And so when you think that needs a good year at least to work its way through the system and the core PCE number through owners’ equivalent rent, we’re still going to be dealing with pretty healthy and robust underlying core inflation and that’s going to keep some pressure on the Fed to kind of understand that their job is not done yet. And so I think for me probably the closest thing that they’re looking at, probably the most important number that certainly I would be paying attention to as we progress through the year, would be the University of Michigan consumer survey that they do every month. And they ask consumers what your expected change in prices are over the next year, but then also what consumers expect for their changes in prices over the next five to 10 years. And so I think the Fed very likely would have been worried in the middle part of the last decade, in the teens, that it looked like the longer-term component of inflation expectations was actually becoming untethered to the downside. It was kind of like seeking closer to 1%. We’ve made up a lot of ground in that number and they’re probably pretty happy with where we are now, but if it rises further from here it’s very likely to signal that inflation expectations are becoming unanchored and that’s when I think the Fed could start to panic. I don’t think we’re there yet, but that’s one thing to keep a very close eye on.
Okay, so we know that there’s a correlation between home prices, home values, lagged by 12 or 14 months [expected?] to flow through to OER and other shelter costs. So we’re still talking about upward pressure, at least in your mind, into the early part of 2023 here at this point?
Certainly, the second half, into the second half of the year.
We just happened to have a question pop into the queue here so, Lauren Lindsay, I’m going to take your question here for Jason. Jason, can you explain how shelter is calculated? You probably don’t want to get into that, but one part of Lauren’s question is I find it interesting that housing prices are not included in the core calculation, which I think that’s a very common misconception. But the OER part, the theoretical value that you could rent your house for, is a little esoteric, right? Can you talk about that a little bit?
Yeah, it’s essentially just a way that the government statistical agencies will actually take -- you know, you can measure rents obviously. Like we know when rental contracts come and renew. We can measure those year-on-year changes, but it is a little murkier when you think about the shelter cost for people who own their houses, what that looks like. They’re obviously very closely linked, as you would imagine, and extremely highly correlated, but it’s basically just trying to imply from ownership costs based on rent what is going on with not just renters but also how much shelter costs are rising for people who own their homes as well.
Okay, thank you. And Lauren, thank you for the question. So that’s a big part of what you’re watching in terms of inflation. I want to shift a little bit and just talk about something that we’re asked about on a daily basis and something everyone that’s listening today certainly sees and feels and that’s wage push inflation. We see the help wanted signs everywhere. And so I wanted you to talk a little bit about how you’re thinking about wages and wage inflation and maybe even what tools or data sets do you use to monitor wage inflation?
Yeah, absolutely. So I think this is something that doesn’t necessarily show up very clearly or well in the headline and CPI statistics, for example, but it is something that the Fed is very, very concerned about and watches very closely. Before the Fed switched to this kind of flexible average inflation targeting regime that they’re now in and using -- the Fed was very focused on something that’s called the Phillips curve which the Phillips curve essentially just posits a relationship between the unemployment rate and wage inflation. So I think the Fed has kind of gone away from that and it’s maybe probably ill-timed because I think it’s very likely that the Phillips curve has been extremely flat which basically showing a very low correlation between the two, but it is likely the case that the slope of the Phillips curve changes as you get closer and closer to full employment or maximum employment and that relationship starts to be positive again. And I think that’s probably what we’re seeing now, to be honest. It is a little murky. The Atlanta Fed does a pretty good job of measuring wages, but it is a little murky through the course of the pandemic because we’ve had massive shifts in terms of what’s going on between the kind of traded goods sector and the services sector in terms of the composition of employment, in terms of hours worked in different parts of the economy, in different sectors of the labor market.
The Atlanta Fed has actually done a pretty good job and some pretty good research on this and what they’ve tried to do is through the course of the pandemic essentially adjust for the mix shift in the segments of the individual parts of the labor market in certain industries and for the variations in hours worked between segments. And so if you try to hold those things constant, hold the composition of the labor market constant to pre-pandemic weights across sectors and industries and hold hours worked component constant through the pandemic versus where we were pre-pandemic, you can actually get a much clearer picture on what’s going on with wages. Wages have been rising pretty steadily to the point where they’re now rising closer to a 5.5% annualized rate and that’s something that we obviously haven’t seen for a very long time. And so it’s very likely that unfortunately the Fed in terms of their thinking is like an aircraft carrier. It takes a long time to kind of change this kind of dogma with which they approach the world and the tools and the lenses through which they view the world. And so I think part of the issue and part of the thing to be worried about is through this flexible average inflation targeting regime they’ve kind of gone away from the Phillips curve just at a time when it actually might be reemerging as an important tool to think about the relationship between the unemployment rate and wages. And so that is likely to be probably an inconvenient and an ill-timed transition for them as we move through the year. And I think if we get to the end of the year and they’re still scratching their heads about kind of why wages are not more contained, it’s probably going to be because they’ve kind of abandoned the Phillips curve at exactly the wrong time.
Okay, interesting. So I want to try and wrap this section up here. So I don’t want to put words in your mouth here, but all in it seems to me that you’re of the view that inflation probably stays elevated here for a little longer maybe than consensus, right? Four and a half [laps?] for PCE? How would you gauge the glide path really for the rest of the year?
I think I would certainly be looking for inflation to stay higher than consensus estimates. So if you kind of look through what consensus forecasts for headline CPI or for core PCE by the end of the year, most economists have it kind of retracing all the way back to where we were kind of a year ago. And so I have a hard time believing that it’s going to be that simple to wring a lot of these price pressures out of the economy. Now, having said that, the Fed funds futures market has actually priced in now north of [four hikes?] from here to the end of the year and I think if you think about where the Fed is going to be moving and how kind of the pace at which we see the Fed contracting the balance sheet or starting to run down the balance sheet, I still think the reality is that leaves -- I don’t expect them to get a lot more hawkish, as I said, from where we are now, but that still leaves policy extremely easy, certainly for the first half of this year and likely into the second half of this year.
Now, obviously talking about balance sheet contraction sounding hawkish is likely to kind of keep -- we’ve had a governor on market volatility and on risk asset volatility because the Fed has been growing their balance sheet so substantially and so rapidly and I think we’ve probably taken the governor off of that, right? So it’s very likely to see elevated volatility this year. That’s not surprising, but again, we really didn’t see pressure on risky assets in the last cycle, last tightening cycle, until we started to see active, sizable balance sheet runoff and I think we’re still nowhere near that yet.
Yeah, to your point, we had an awful lot of jawboning in Q3 of ’18 running into -- right? You had QT, you had policy rate moving up, forecasting, multiple hikes into ’19, and then of course the S&P came unglued there in the fourth quarter. All right, Jason, we’re going to give you a break, but thanks for that synopsis. That’s a pretty good segue into, I think, to talk about equities. And so I’m going to take this piece for us today.
I think one of the things that we’ve talked with our clients a lot about here in the last couple of months as we’ve thought about 2022, the first thing that we want to communicate here and table is this, that I think it gets a lot harder from here in equity space in terms of returns. And in terms of the ride, frankly. And if you think about what we’ve seen here in the last 20 months the S&P 500 has doubled because S&P 500 earnings have doubled. And that rate of change is in the rear-view mirror here now and I think going forward the onus will be on corporate earnings more than anything else. certainly, we wouldn’t expect any multiple expansion and if what Jason just talked about, i.e., high levels of sustained core inflation that may even pull nominal rates up, that would augur for multiple compression. But I think the onus here on individual companies and forward stock price movement is going to be very idiosyncratic and I think that’s very different than what we’ve seen in the last 20 months where essentially risk on, the rising tide lifted all boats for the last 20 or 21 months. I think that part of the move is over and so I think it gets harder from here.
And so with that being said, one of the things that we would start doing if you haven’t done already is talk to the client base and lower their expectations for forward returns. And so what we’re thinking about here for 2022 is the return to something more akin to the historical run rate, annualized run rate of return, for the S&P 500. And of course, you know the annualized return rate back 100 years is somewhere in the vicinity of 9.5%. Our guess is we’re thinking somewhere around seven, eight for this year and I’m going to give you our price target here for the S&P 500 for Dec 31, 2022. I want to caveat that by saying in the 31 years I’ve been an analyst and a PM I know for sure I can’t forecast with any precision and no one else can either.
That said, we have our target for the end of the year tagged at 4,900 which, based on today’s close just sub-4,600, represents about 7% upside here into year end. You know, Jason made the comment earlier about economic growth for this year, I think, being reasonably strong, possibly mid three handle on real GDP, is strong enough to continue what we have seen in the last 20 months in terms of corporate earnings growth. right now, the consensus forecast for 2022 is somewhere in the ball park of 10ish percent baked in for earnings growth for 2022. That’s actually pretty good. Now, the rate of change is coming down of course because we’re coming down from almost triple digits here in the last 20 months, but I think what we’ll see, all of us together, is names that report good earnings and give good forecasts, a la Union Pacific this morning pre-market, will probably do pretty well. Names that disappoint and give poor guidance, a la Netflix 15 minutes ago, are going to have a rough go of it.
And so in my mind to me that sets up a pretty good environment, at least theoretically, for active stock selection and active management. So that’s the first part. Lower expectations for forward returns, I think somewhere in the ball park of 4,900, but the ride should get rougher. And we’ve already seen that here in the last, I don’t know, two months where there’s a lot of opposing forces going on. Jason talked about what’s likely to happen in the economy and Fed policy. The market has to adjust to all that. So volatility I think is probably here for a little bit where in the last 20 months we had eight or nine, fiveish, five 8% pullbacks in the S&P. Every one had to be bought and it was almost like you were chasing here for the last year and a half. I think that is over with too. Volatility should be here so the Sharpe ratio probably comes down, the ride gets rougher, but what I think is really important for everybody, including us, is to be prepared for this. Be prepared for days like today or other rough days or rough weeks, rough months, maybe rough quarters. And I think about how you’re positioned and have your list ready. Have your list ready to go whether it’s equity mutual funds, fixed income mutual funds, ETFs, whoever gets your exposures. Write down what you want to own, make sure you understand why, test your conviction in that name, and when the market gets upset, volatile, and corrects like it’s doing, also those are probably going to turn out to be pretty good opportunities. So for this year I think it’s an environment where you’re judicious when you’re allocating capital irrespective of asset class. I think you’re putting money to work on weakness, certainly on significant weakness. As Jason said, the backdrop is constructive, but I don’t think you have to chase like we had to do for the past 20 months where very buy worked. I don’t think that’s going to happen here in 2022.
There’s a couple of interesting relationships that I want to talk about here with regard to style. So we’re asked an awful lot about growth and value and of course at Putnam we run both growth and value styles with high efficacy, but I want to talk about our outlook here for the year when it comes to where we think the strongest earnings growth is going to come from. And I would sum that up by saying we think the better part of valor here is to expect the strongest year on your change in earnings to come from parts of the economy, sectors and industry that are very sensitive to real GDP. You can call these a lot of things. You can call these early cycle parts of the economy, you can call them values, you can call them cyclical, you can call them all of that, you can call them none of that, but specifically when we think about that, that mosaic, we’re thinking about the financials. We’re thinking about the industrial companies. We’re thinking about the materials and energy companies and all the business and ancillary companies that feed into that, feed up into that tree.
And we had that view coming into 2021 and lo and behold, it was those exact sectors and industries that produced the strongest year on year rate of change in earnings and I think that’s probably going to continue. So that’s something to keep in mind. What we also know empirically is that if you look at every recession in the United States in the last 50 years, every recession, that coming out of recessions value as a style outperforms growth as a style. And we published was white paper on this back in August of 2020 so we can give you the empirical evidence and you can make your own decisions obviously. But value worked and I think there’s a couple of components to why that works. Number one and most importantly, most significantly, is the year-on-year rate of change in earnings, as Jason talked about in his prepared remarks. Levered companies that are levered may be in a balance sheet sense net debt to EBITDA, but also levered to the economy have very high -- will see very strong acceleration in revenue, earnings, and free cash flow generation. It’s exactly what we saw last year and we think that that continues. And of course, stocks follow earnings over time.
So that’s one point on value on growth. The other point I would make, and again we have this captured in a white paper as well that we published over a year ago, is we look back knowing that inflation is probably the most significant part of all of your conversations and people are concerned about it and the impacts on risk assets. What we know is that in periods where core inflation has moved up by at least 100 basis points going back 50 years, right? At least 100 basis points which we absolutely have now, we’re overshooting, we’re probably up a couple hundred basis points, but in all those periods -- there have been six of them since 1970, this is the seventh -- and so if you assume for a second that we’re not in the hyper inflationary period that we saw in the mid ’70s and the early ’80s before Chairman Volker knocked that out, value performed very well. So if you look at equities as a risky asset and you decompose the return stream what you find on an annualized basis, post 1980 now, post hyperinflation which we don’t think we’re in here -- I’ll let Jason chime in on that in a second, but we don’t think that’s what we’re in for here -- that value as a style is the leader in the clubhouse, specifically small cap value annualizes at just over 6% and that’s post 1980 where there were four periods of core inflation moving up by at least 100 bips and again now we’re in the seventh. What happened last year? Did small value outperform? Sure did. certainly, relative to small growth.
So that’s one point. The second, the runner up in terms of returns, is large cap value at just under 6% and the third is large growth. But the taboo is small cap growth and it’s not really close. It’s maybe 2% annualized relative to six for small value. So just something to keep in mind there. The other thing I want to talk about a little bit, and Jason hit on this too in his comments, is the relationship between high quality companies and companies that might be highly levered or of lesser quality. And there’s a lot of ways to measure that, but I think Jason hit this talking about free cash flow generation which I think is critical. What we know from history is that every time the US economy exits recession that small cap names outperform large cap names. That tends to last about three years. Small tends to lead by about 500 bips a year. Has that happened? It has. Coming out of recession, we wrote a white paper on that in September of 2020. I think now we’re probably, if the average business cycle in the US, the average expansion rather, lasts 4.85 years we’re somewhere 12, 18 months into this thing.
So I don’t say we’re in the middle of it, but we’re kind of getting to the third, fourth inning of the ball game here. What we will probably see is higher cap and higher quality earnings growers with higher and stronger free cash flow generation probably outperform smalls. And we have certainly all seen that together here in the last couple months. What has come under the most severe pressure here since Thanksgiving have been spec tech companies, the long duration assets, which is a fancy way to say their earnings growth or earnings in general won’t materialize to maybe out three, out four, out seven years. Very different performance characteristics here in the last couple months -- you know if you own them -- relative to some of the higher quality names. So we’ve put a little emphasis there on large over small.
And I want to touch on the international question because we can see it here. Bill, I’m going to try and weave your question into my answer here. We have been constructive on US equities relative to developed international, i.e., European equities, for probably the last 10 years. And of course, US has significantly outperformed European equities. Why is that? Well, if you actually look from the GFC forward to 2020 what you will find there is the US earnings growth was significantly stronger than European earnings growth. Of course [stocks?] (inaudible). It’s probably going to play out again this year. You can probably find some good relative value plays in Europe. So we like the US and we like EM. I’m going to finish with this in equities. The biggest risk here probably is if you end up with higher sustained core inflation and that pulls up nominal rates and then you get a whammy of the Fed really behind the curve, policy rates go up, etc., multiples will compress and compress rapidly. Today the S&P is 21 times forward earnings and the 50-year medium is 16.8 so any move back to the median is going to hurt. So I will end it with equities there.
Rick Polsinello, I want to come to you and I want to talk about, we want to talk about fixed income. We realize this is top of mind for everybody. Let’s just start with your thoughts around the Fed winding down QE here. Still similar, but it’s just sort of winding down QE. How are you thinking about that here going forward?
Thanks, Chris, and thank you everyone today for joining. In terms of quantitative easing and just the monetary policy that we’ve seen, and obviously we’ve been in an extremely easy policy era. If you think back to just a few months ago just to kind of recap where we’ve been, in terms of the response to the pandemic we saw 120 billion per month purchased in terms of US treasuries as well as mortgage-backed securities in kind of this two-one ratio. So essentially the Fed buying 80 billion per month in treasuries, 40 billion in mortgage-backed securities. That was obviously a very powerful backstop to the economy is what was going on. That at the end of last year basically they came out and said, “We’re going to taper now” and initially it was we’re going to take 15 billion a month off the table in that same two-one ratio. So 10 billion of treasuries, five billion in mortgage-backeds beginning about November. And that was going to take essentially 15 billion more a month off the table. Basically, the math showed you that by, call it May or June at the very latest, essentially they would have no more monthly purchases. That came out in late October. November, they began to taper and they actually pre-announced December. So they pre-announced that even though they were only tapering by 15 billion in November, December would be 30 billion, and then we got kind of in this period of enhanced tapering.
So if you look now at what the expectation is in the market and essentially when they’re going to stop buying on a monthly basis these treasuries and mortgage-backed securities, it looks like they’ve really kind of sped that up somewhat. It looks like March is going to be the end there. So in terms of that part of the tool in their toolkit, and I would argue there’s probably three big tools, that’s kind of the first one when you talk about QE versus QT. The thought there is by the end of March they’re probably done purchasing in terms of the monthly purchases and that’s obviously going to have an effect for risk assets especially within fixed income.
Okay, so we run that off by March. And then we’re faced with the potential liftoff, right? So maybe we can pivot there and talk about what our general expectations are, what your expectations are here for liftoff, how many hikes, and then after that we’ll get to maybe the quantitative tightening part of it which is, as Jason said, probably a ways off, but.
Yeah, so in terms of liftoff, the way the market’s pricing it right now and the last time we went and talked to the portfolio managers we told them, as you know, back in early December the thought was two hikes, possibly three. That’s sort of what we were looking at. Obviously, the Fed got a lot more hawkish in the rhetoric back in December. When the Fed minutes were released, you saw that again and then you heard Powell speak. And really the thinking now is probably three hikes this year, possibly four like Jason mentioned. Right now, it’s actually we’re fully pricing in four hikes, I believe, in 2022. The Fed’s not going to admit this, but they’re probably a little bit behind here. They’ve started to see -- you talked about core inflation before and obviously their preferred gauge there is core PCE being four and half to close to 5%. You know, for a long time we had a real tough time even hitting that 2% bogie and as Jason mentioned, they went to that average core inflation target. You see the headline number over 7% at this point.
So there’s no doubt that the Fed is a little bit behind the curve here. They’re not going to admit it, but what we’re thinking for liftoff is you see the first hike probably in March at the quarterly FOMC and it’s probably 25 basis points. We actually heard from some of the PMs earlier today and they indicated that they probably could do 50 basis points, but that might raise some added volatility in the market. So they’re probably going to go on this, I don’t want to say preset course, but really the base case here is 25 basis points per quarter for the rest of this year. That would be three, possibly four, hikes and that would obviously get Fed funds from where it is right now. The target range of zero to 25 basis points up to about 1% or so. So that’s what we’re expecting for the rest of 2022.
And then if you look at the summary of economic projects, essentially the [dot plot?] that comes out from the Fed, if you look at where that is right now it looks like three to four hikes this year, another three in 2023, and probably a couple more hikes in 2024. That would get that front of the curve somewhere around 2% which is essentially where [tens?] are trading today.
All right. rick, what about the dollar? Any thoughts on [Dixie?] here?
I mean typically during a tapering process that is really constructive and it’s usually (inaudible) US dollar. We’ve actually seen some weakness over the last three or four weeks with the US dollar. And in terms of the currency plays that we have right now, and you look kind of across our accounts, the currency risk is being kept relatively low. The thought being in terms of the rest of this year the US versus kind of the major currencies out there, and Jason probably has an opinion here too, and we would include the euro there, the sterling, and the yen as kind of the big three other currencies, it’s probably going to be kind of a give and take here. We don’t really foresee the dollar strengthening too much versus any of those (inaudible), but we also don’t see a lot of weakening. We think that that has kind of already happened here and it’s going to be tough to make some money in currency trading for the rest of 2022. Again, there’s been this massive stimulus. Some of this is getting taken off the table. You have the Fed potentially raising rates, like we said, three to four times, and then you also have the other actions of the major central banks out there.
Good segue thinking about other major central banks. And so, Jason, I want to go to you first here on this and then, Rick, I’m going to come back to you. Let’s talk about, again, best guess, forecasting is a tough job as we know, thoughts on 10 year yields here, Jason, maybe by year end and maybe the path of that. And I know you have some thoughts there.
Yeah, I think I have a hard time seeing, at least in the first half of the year, 10-year yields going much past 2%. I think the Bank of Japan has basically come out and said they’re not moving, they’re not doing anything with policy for the foreseeable future. The ECB is a pretty decent ways behind the Fed in terms of their route to normalization. The People’s Bank of China is actually in easing mode now and so I think if you think about the competitive assets to 10-year treasuries, treasuries are actually a reasonably high yielding sovereign bond market right now. And so I think if you’re an Asian life insurance company, if you’re a European pension plan, even after adjusting for your hedging costs the yield pickup on treasuries by moving outside your own kind of sovereign bond market, your own home multiple market, is still pretty attractive. And I think at some point that bid has to come back in and I would expect we’re not that far away from that now.
Good points there. rick, anything to add to that?
Yeah, I think that’s right. I mean the hedging costs, we typically look at the yen and the euro. They’re definitely a little higher today than they were, call it six to nine months ago, but Jason brings up a good point. If you had talked to the PMs a few months ago 185 on tens here is somewhere in the 180 range, that was a pretty swift move, but even though it’s increased hedging costs, call it half a percent to maybe a percent on the high end, you’re still getting basically half that yield pickup. And they obviously have to convert that back into their own currency, but even after doing that, assuming that we have a more stable government than they do, you still have the ideal pickup, right? You’re still capturing about half of that even after paying for the currency.
All right, perfect. So Mike (inaudible), I see your question in the queue here. What Jason and Rick just talked about being a potential disconnect between elevated core inflation and nominal yield. As Rick and Jason both laid out, because US paper looks so attractive on a relative basis it’s unlikely that, in our view anyway, that 10-year yields run away from us. And Brian, I see your question here asking about weakening of the US dollar. We don’t expect much really either way. Jason might argue that interest rate differentials drive currencies and with that view potentially the dollar could be marginally higher. Rick, I want to pivot here and I want to quickly get your thoughts on corporate credit. Maybe we can start with investment grade corporates and then hit on high yield corporates as well.
Sure. Yeah, when we think about corporate credit there’s kind of four buckets that we put it into and the first two you mentioned, investment grade and high yield. We also do quite a bit around convertible securities and floating rate bank loans. So I think in high yield and investment grade we actually come out with a spread chart at the end of every month, potentially to look at, and this is all duration match, we basically look at US agg versus outside US agg and where we are in spread terms today versus historical. And I think you can’t really argue with this. You have to, again, know that rates have already moved up here, but in terms of spread, so a duration match treasury versus investment grade versus high yield, those spreads right now are under 100 and 400 respectively, 100 in IG and 400 in high yield. When we look at the JP Morgan [develop?] which is kind of our preferred index within high yield, those spreads are relatively tight. And I think when you listen to the portfolio managers in those areas it seems like a little bit of coupon clipping for probably the rest of this year.
Again, there’s going to be some give and take there, but if we can get 2-2.5% investment grade, if you can get that 5.25-5.5% type of yield in high yield, that’s a pretty good year. And we talked about active management before. There’s obviously going to be some things you can do on the yield curve in terms of where you want to be positioned. Obviously, the sector kind of shifts that you can do there. And then security selection. That’s going to be more important now than ever, especially in a rising rate environment. I think it’s important to look at the investment grade bond index here in the US and say you know what, that has a seven-year duration. The bond math makes that pretty challenging in a rising rate environment. High yield not quite as high, probably more along the lines of four years.
But that’s why in those areas we do look a little outside of that. We look at convertible bonds which over the last 20 months are essentially up 50%. We still think they could have a pretty good year here. Obviously, a little bit more sensitivity to the equity markets than some of the other pieces. And then floating rate bank loans. We should have a nice tailwind. If we’re right about rising rates floating rate bank loans, they’re at the top of the capital structure, there’s collateral behind them. It’s also a good way to get exposure within corporate credit and again get yields in the range of, call it 3.5-5%. So that’s kind of the way that we’re looking at corporate credit right now. Again, it’s not that we mind high yield and investment grade, but I would say all else equal floating rate bank loans and converts look a little bit more attractive to us, at least on a relative basis.
Okay, good points there, Rick. I would say that muni bonds you’re going to give the same sort of answer, right? Spreads tight, tax equivalent yield looks pretty good, diversification potentially as well there. And the other thing I wanted to hit on just really quickly because we’re getting up against it in terms of time here, we talk a lot about and make reasonable use of some of our fixed income strategies in the mortgage space, something we term structured credit kind of broadly. Can you give us a 30-second high-level view on that?
Sure. Yes, I would say one of the things I believe Putnam does particularly well in a big diversifier across portfolios is structured credit. So typically, in the search for yield, and obviously investing in fixed income you want the diversification, you want the yield, there’s traditionally been two ways to do that. It’s either [spin?] duration or [dipped out?] in terms of credit quality. We think there’s kind of a third way and that’s when I talked about the spread chart before comparing inside the US agg versus outside, you can get a pretty good pickup in terms of yield when you start thinking outside the US agg. So typically, within the US agg the spreads are, call it 30 to 100 basis points historically, maybe up to about 125. When you get outside of that you look at things like US dollar denominated EM and high yield you can get, call it 350 to maybe 450 off. And then structured credit and for this we would say potentially mortgage-backed securities on both the residential side, typically non-agency residential mortgage-backed securities, as well as subordinated or what we term mezzanine commercial mortgage-backed securities and interest only securities. Those are kind of the three buckets that we look at [structured land?].
From a relative value perspective, they offer a really attractive yield. They’re also a big diversifier amongst portfolios. If you look at interest only securities for a minute -- I know we can’t get in the weeds here -- but they actually have a modestly natural negative duration, meaning that when rates rise less and less refinancing activity and prepayment [speeds?] can really happen. So it’s actually a nice diversifier across portfolios. It’s a differentiated balance sheet, right? It’s not the corporate balance sheet or the US balance sheet. It’s all about the homeowners and that type of sector. And then non-agency residentials. You know, we’ve seen home prices do very well throughout last year. It obviously can’t go on forever. We’re in kind of this rising rate environment. But home prices have done pretty well and just looking at the pandemic and the response there, obviously with vaccine distribution and limited lockdowns that we’re seeing at this point, those all kind of bode well for that structured credit area within mortgages as well as prepayment risk.
Okay, Rick, great synopsis. Folks, let’s take a look at your poll response here. We want to pull that up here as we’re up against the clock. And 38% of you think the most likely thing to happen on our list is for US 10 years to hit 2%. We’re 15 basis points away. And people aren’t worried about -- oh, supply chain issues as a result. Interesting. All right, so we’re up against the clock here. rick, Jason, thanks so much for your insights. Folks, if you have additional questions, you can submit them to us, we’ll answer. And I want to just take you here to the resource page at the end. You can follow Rick, Jason, and I on LinkedIn. You can go to Putnam’s website, Putnam.com, and the advisor tab. You can read everything that we’ve published in terms of white papers. You can listen to the podcast that we host with our portfolio managers across all asset classes. And then the final thing I would say is if you like to do this on a one-on-one basis with your team you can absolutely contact your Putnam specialist, a consultant, and you can set up a private briefing. Rick and I, JV, any additional experts that we need, we’re happy to talk with you for 20 minutes, 30 minutes, whatever you’d like. So we’re done for the day here. Thanks, everybody, for hopping on the call with us. Good luck in 2022. Let us know how we can help you. Take care.
Patrick Laffin: Thank you for listening to Active Insights. For more information on Putnam, please visit Putnam.com. All opinions expressed by the podcast host or podcast guests are solely their own opinions and do not represent the opinions or views of Putnam Investments or any affiliates. This podcast is not investment advice and is not intended as a recommendation to buy or sell any type of securities. This production is for informational purposes only.
Online Title and Description:
2022 Investment Framework
In this episode, Chris speaks with Putnam’s Capital Market Strategies Team, including Senior Market Strategist Rick Polsinello and veteran Portfolio Manager Jason Vaillancourt, Co-Head of Global Asset Allocation at Putnam.
During the discussion, the team provides Putnam’s 2022 investment framework for equities, fixed income and the market as a whole. In doing so, many topics are discussed including:
This material is for informational and educational purposes only. It is not a recommendation of any specific investment product, strategy, or decision, and is not intended to suggest taking or refraining from any course of action. It is not intended to address the needs, circumstances, and objectives of any specific investor. This information is not meant as tax or legal advice. Investors
should consult a professional advisor before making investment and financial decisions and for
more information on tax rules and other laws, which are complex and subject to change.
All investments involve risk, including the loss of principal. You can lose money by investing.
Investors should carefully consider the investment objectives, risks, charges, and expenses of a fund
before investing. For a prospectus, or a summary prospectus if available, containing this and other
information for any Putnam fund or product, call your financial representative or call Putnam at 1-
800-225-1581. Please read the prospectus carefully before investing.
Putnam Retail Management AD2020626 2/22