Economic outlook: Tomorrow never knows

BRIAN HESS: Hello, everyone. Welcome to our fourth quarter macro webinar. I'm Brian Hass, Investment Strategist on the Solutions Team at Natixis. And joining me today, as usual, is Jack Janasiewicz, Lead Portfolio Strategist at Natixis, and our esteemed colleague Garrett Melson, who covers all things macro for us.

 

Both Jack and Garrett are members of the Natixis Investment Committee, and Jack is a Portfolio Manager on our multi-asset hybrid models. Our models are a popular solution for advisors looking to partner with Natixis for investment management. And positioning in these models reflects many of the themes we discuss during our webinars.

 

We have a lineup of topics today that we'll hit on the usual hot button issues we'd like to cover during these webinars, but please let us what's on your minds too by putting some questions in the chat box and I'll try to work through them as we move through the webinar. Now, let's get started. Jack, I think there was an election last month and maybe it moved markets a little bit. So let's kick off by checking in on a few popular Trump trades and comparing the situation today to how it looked in 2016. What do you have for us?

 

JACK JANASIEWICZ: Yeah, thanks, Brian. It's interesting because we've kind of been here, done that. And so when we start to think about the potential for market reaction and maybe some of the trades to be putting on here for the end of this year, obviously, and into next year, there's a little bit of a blueprint that's already been out there, right? We've been through this in 2016. And a lot of the same agenda items are basically up for grabs, I think, here.

 

So when we look at what was going on in 2016, we get somewhat of a playbook in here. And I think the common theme from that playbook is, really, the idea of US exceptionalism. We like to call it US secular exceptionalism, because it will, obviously, be a little bit of a short-term phenomenon. But I think that's the theme that had played out in 2016, and probably, to an extent, we'll see that again here.

 

And what does that mean? Well, it's basically that the growth backdrop in the United States is really a lot better than what we're seeing around the world, and that lends itself to, I think, a little bit of an edge in terms of asset performance. And so things like seeing the yield curve steepen, inflation expectations picking up maybe at the margin, US performing better than the rest of the world, small caps over large caps, the stronger dollar, those sort of things, which played out back in 2016, are likely playing out again this year. The question is, how long will it take for those things to run its course?

 

But a couple of things. I wanted to point it out with regard to those Trump trades and that blueprint. And keep in mind that, in 2016, we really didn't know who was going to be elected at that point. So the timing from when a lot of these trades went on in 2016 were really effective on the day after election day. Whereas, the market in today's backdrop really started to price in that Trump victory, I would say, looking at the betting markets, for example. They really started to price in that aggressively and maybe September.

 

So a little bit of a different start date here. But the point being, when we start to look at some of these analogs, which I'm pulling up right now, those analogs, when you overlap them and adjust for the timing and the start of these things, carry a lot of the same different metrics. And so what you're simply looking at here, you're looking at 2016's performance overlaid on what we've seen thus far, and you're looking at, basically, starting from left to right on the x-axis 10 weeks pre-election, or in this case, 10 weeks from really when we started to see the Trump odds increasing for a presidency.

 

And then, moving left to right, you see the 0 point there sort of rebased to 0, and then, everything to the right 15 weeks post. And you can see I've got the 10-year yield, the trade weighted dollar, small caps relative to large caps, and the S&P versus the rest of the world here. And you can see how we're, basically, mimicking those same backdrops.

 

But I think there's a few things to note here when you start to look at these analogies. Again, notice how, as we start to move a little bit farther out after election in 2016, a lot of those Trump trades actually started to basically trade sideways. And in some cases, if you look at the full extended version of these themes well past what I'm showing here, you actually had some of them even rolling over.

 

So there is an expiration date in terms of when these trades either get fully discounted or, I think, the other thing, what's said on the campaign trail doesn't necessarily translate into what's actually put forward from a policy perspective. And so as we move from today into, basically, inauguration day, you're getting bits and pieces of additional information that tells us a little bit more on what that policy might be.

 

And so maybe you start to see the market pricing, and originally, a lot of the commentary that you heard from Trump on the campaign trail being priced in. But as we get some more details, you start to drift back a little bit, maybe more to center, tone down some of those ideas per se. And I think a couple of examples to throw out there.

 

Scott Bessent, we've heard a couple of interviews with him talking about tariff implementation where he's implying that you're not going to see, for example. 60% Chinese tariffs put on right off the bat. You're going to see them slowly implemented over time. So you're starting to see some of the tariff rhetoric maybe being toned down a little bit.

 

And we also, I think, the market's getting a little bit more comfortable with tariffs being used as a negotiation tactic. And we already saw the threats of a 25% tariff from Trump on Mexico and on Canada. And what have we seen subsequent to that? Conversations between, for example, Claudia Sheinbaum and Trudeau up North with Trump. And they've both basically said, we're willing to work with this. And as a result, you've seen a little bit of that rhetoric already starting to fade.

 

So as the market gets more and more comfortable with what's going on here, you start to see these trades sort of manifest in a little bit of a different fashion. But what's key, I think, here is simply that, again, the market had been pricing Trump at his word, you're starting to see him move more back a little bit to-- I wouldn't say center, but you're seeing a little of those edges being dulled a bit. And as a result, you're seeing the market, I think, give back some of the initial price reaction.

 

And one of the charts here I'm showing is simply one year inflation one year forward. And we're just looking at this, basically, in the swaps market. And I've got a couple of highlighted dates here. The first one being when Trump odds really started to take off there you could see it back in mid-September. You can see inflation expectations really bottomed at that point, and then, steadily rose and really spiked right after election night.

 

And again, since then, we've seen that give back a little bit. And basically, we're right before pre-election levels, so to speak. So again, some of these trades certainly might have some legs. But as we get, again, more details coming out, maybe some of that rhetoric not quite as aggressive, and as a result, you start to see the market adjusting accordingly in here. And I wouldn't be shocked if that's one of the themes that we continue to see play out over the next couple of months.

 

But the big point I want to highlight here is simply that starting points matter. And all I'm simply trying to look at here, we're comparing the backdrop in 2016 to the backdrop today. And that starting point, I think, has a big differentiating factor in terms of how the potential going forward for the Trump 2016 versus today would look.

 

And if you think about where we were in 2016, right, you're coming off a pretty substantial Chinese equity market correction. The local shares there down almost 50%. Oil had gone from, I think, close to $107, $108 bucks a barrel. We corrected all the way down to the low 20s. By the time the election kicked around, it had drifted back up to $45 a barrel. But the US economy certainly was downshifting there. We were looking at GDP running at closer to 5%, downshifted to about 2.4%.

 

And so you're, basically, coming off what I would call a troughing level when Trump was, basically, starting to come into office in 2016. So that base effect really was quite supportive. And if you think about all the factors that were, basically, involved from an economic perspective, they were quite benign. And that's what I'm trying to list here.

 

You're looking at the Fed fund rate being at, basically, 75 basis points and we're just slowly coming off that 0 lower bound. Where are we today? You're looking at something closer to 4.75%. So a lot more restrictive from that perspective. You're looking at the potential for cutting tax rates. So you went from 35 down to 21. I'm not sure how much lower we can go today.

 

From an equities valuation perspective, PEs at almost four to five turns lower than where we are today. The 10-year yield, for example, 2 and 1/2, 2.45 relative to where we are today, closer to 4 and 1/4. So the point being, when you're looking at these starting points, they're much more elevated today than what we had seen back then. And as a result, that starting point, less supportive, less room for error, a lot more trickier, I think, in terms of thinking about these things.

 

And so maybe that upside-- doing the comparisons from 2016 versus today might not be quite as aggressive, but we certainly think that there is upside. Maybe we just have to tone things down a little bit because that backdrop, that starting point, very different today than where we saw back in the first go around with President Trump.

 

BRIAN HESS: So maybe we need to temper our enthusiasm about a potential repeat of the strong late 2016 into 2017 market environment, which 2017 was a phenomenal year for risk assets with a smooth trend the whole year, as far as I remember. But at the same time, I know we're not concerned about a recession right now, so we're trying to be sober in our assessment of the potential, yet realistic about the growth outlook, which we still think is supportive.

 

So, Garrett, let's update the viewers on our near-term economic thinking with respect to the US and a focus on the first half of next year.

 

GARRETT MELSON: Yeah, absolutely. So keeping in line with what Jack just ran through, starting points do matter. And I think that's really important to consider when you're assessing the potential impacts of the policy agenda for the incoming Trump agenda administration. That said, we don't know a whole lot about what the exact policy will entail. And so I think it's really important to just get a sense of what our starting point is on growth and where things are headed in the near term.

 

And so from that perspective, it certainly is an environment, as we've been talking about, where growth has been holding up fairly well. It's been very robust this year and continues to outperform expectations. And that's very much been the case for much of this year. That said, I think when you start to look at where we've been and start to think about how strong growth has been, there are some reasons to expect growth to moderate at the margin here.

 

So just thinking about that starting point, just assessing where growth has been, we've been running about a little bit over or right around 3% real GDP growth for the last six quarters. And when you think about where trend is in the pre-COVID environment, it's closer to about 2.4. Now, that's really impressive given the fact that, over that time, we've also seen core PC inflation fall from about 4.8% to 2.8% So that's kind of been a story of very strong growth paired with disinflation, that kind of immaculate disinflation story.

 

But we're starting from a healthy point, but I think what we see in the near term horizon into this end of year and probably the first quarter or two of next year is a couple of headwinds that are starting to rise up that might just kind of shave off a little bit of that upside on growth and bring us maybe a bit closer to what that pre-COVID average looks like.

 

So jumping right into those, the first one really starts with government spending. And I think this is an area where it's gotten a lot of attention. And I think a lot of investors have kind of pinned a lot of this strong growth on the fact that we've had very big deficits. And ultimately, that has to be, in some sense, fueling some of the robust growth.

 

But if you actually dig into the numbers, federal spending is actually only contributed about 20 basis points to real GDP growth over the last seven quarters. And so, on this next slide, what you'll see is one of the biggest drivers, actually, in just the most recent quarter was not just overall federal spending, but it was actually explicitly defense spending. And that's what you can see here in this chart, that last latest bar in the purple line, just taking that back over the last 15 years or so. We, basically, had the highest contribution to GDP growth coming from defense spending or the second highest since 2009.

 

So very, very robust levels of growth coming from defense spending. And I think when you consider what the prospects are for that over the next quarter, you're probably going to be hard pressed to see that repeated. So when you think about contributors to growth here, not to say that's going to 0 or actually will be an outright detractor from growth, but mechanically, it'll probably be a bit smaller, maybe closer to the size of some of these bars that we've seen over the last couple of quarters. And in that sense, on a mechanical basis, that means slightly slower growth in Q4 and probably bleeding over into the first quarter of next year as well.

 

The bigger story, I think, takes place on the consumption front. And so most certainly won't be ones to bet against the US consumer. If there's one thing the consumer does well, it's to spend incomes here. And we've talked quite a bit about how this has very much been an income-driven cycle. And so while we've heard a lot about pandemic savings being spent down, that was really a story of the consumption in the early part of the recovery.

 

But since that point, really, over the last couple of years, it's been all about consumer spending, just organic income growth. And so robust income growth has been fueling a lot of that robust spending, which as we know, drives about 70% of the economy here. But if you take a look at this chart, we're just mapping real PC in the green bar-- the green line, that's consumer spending. And then, we've included disposable personal income both outright and then net of transfer payments from the government here.

 

And so if you look at the growth rate on a three-month annualized basis, what tends to happen is this game of cat and mouse, this oscillation where you tend to have periods where growth in incomes outpaces consumption, and then you flip where you start to see consumption actually outpacing income growth. And that's what we've actually seen over the last six months.

 

So in a sense, what the driver of some of the robust growth this year, especially from consumer spending, has been a little bit, in a sense, unsustainable just given the fact that it has been outpacing what consumers are actually earning here. And so as you look out over the next couple of months and quarters, I think there's a case to be made here that you'll see another case of that oscillation here where you probably get a little bit of a pickup in real personal income, just as, I think, you're going to start to see a little bit of a pick back up in that disinflation story. So that helps from the real disposable income sense.

 

But at the same time, you probably start to see a little bit of a moderation in the pace of consumption. And again, that probably takes a little bit of the edge off in terms of the contribution to the broader growth picture. Now, another area of the economy that we focus quite a bit on is housing. And as we like to say, housing is, basically, the economy. And historically, that's been true. Generally, as housing goes, so goes the economy. When you aggregate all the components together of residential investment and then some of the adjacent categories of consumer spending, you get to about 16%, 17% of GDP, so it's pretty important.

 

This cycle has been a bit different because housing has, basically, been in stasis. And so you've seen it thaw and freeze and thaw and freeze again. And we're kind of back into this environment of a little bit of a freeze in housing activity purely because of the dynamics going on in the rates market. So as mortgage rates have backed up close to 7%, we've come back off the boil a little bit here. You've seen a lot of that demand get sidelined here.

 

So it's not a story of demand being destroyed, it's more so a story of demand being derailed and delayed-- excuse me-- until probably some point as rates start to cool back down in 2025 here. The big story, I think, is the fact that you had a little bit of a buffer for some of that activity in 2023 just because of the robust pipelines of growth for a lot of home builders. There were a lot of units under construction. So that helped to support employment and that helped to support some of that residential fixed investment to some extent. You still certainly got a big drag from that in 2022 and early '23. But this was a story that helped to prevent that-- or put a floor in, I should say, on activity.

 

If you look at now, you can consider activity in residential investment as a flow in stock dynamic here. So when you look at what really flows into the investment figure, it boils down to the activity that's underway, the amount of units under construction. And essentially, if you look at the change or the number of housing starts versus the number of housing completions, if you're completing more homes than you're breaking ground on, what does that suggest for units under construction? It means units under construction are actually falling.

 

And so that suggests that you should expect to see a little bit of downside here coming from residential fixed investment. And that's, historically, what you see on this chart. Anytime starts are outpacing completions, so that light blue line moves lower, that means that you're seeing residential and fixed investment in terms of contribution to growth likely falling at the margin here.

 

Now, there is an offset to that, the golden handcuff effects of homeowners that are sitting on low rate fixed rate mortgages. You're seeing a lot of activity of potential upsizing of homes and upgrading, just shifting to maybe renovations and remodeling activity. And so that does help to actually support some activity to that extent.

 

But for now, I think, we're back into an environment where, at least for the foreseeable future, housing is somewhat back into that stasis and demand is sidelined for the foreseeable future. And that means, again, another modest drag. Now, the last thing I'll just caveat all this is these are all, at the margin, headwinds to the growth impulse. But again, think about what your starting point is.

 

And if you look at the last slide here, the floor for growth is still pretty robust. And what you're looking at here is just GDP, but strip out some of the volatile components. So strip out government spending, net exports, and then, inventory investment. All of those can be very volatile and can deviate in the short run from some of the broader macro trends and growth trends.

 

And so looking at what's called real final private domestic sales, it's kind of a mouthful. But basically, that's a better reflection of what underlying growth dynamics are within the US economy here. And you're still holding up right around 3-- just north of 3%. So that's your baseline and that's your best estimate of where growth is really headed in the next quarter. So all in all, take a strong starting point right around 3%, and then, start shaving a little bit off for a lower defense spending, a little bit softer consumption in the short run, maybe a little bit of a housing drag.

 

And on the inventory front, maybe a little bit of a headwind from inventory investment just because you don't have a whole lot of impulse to rebuild inventories right now as retail inventories are fairly-- at fair levels. So put that together and you're looking at a picture where maybe we're not looking at 2 and 3/4 and 3% growth for the next quarter or two, but maybe something closer to 2 and 1/4 to 2 and 1/2. By no means is that a weak growth backdrop, It's, just a little bit more modest.

 

So again, when you think about what the market narrative has been, it feels like we've overshot, once again, to that no landing narrative. If we start to see some modestly slower growth that's a little bit closer to trend, I think you'll probably start to see some of that narrative shifting back towards, basically, Goldilocks soft landing. And that probably brings with it a little bit more of a moderation in the rate story.

 

BRIAN HESS: Thanks, Garrett. So guess if I can summarize the first two segments, Jack highlighted how there's a lot of good news priced into markets given that we've had strong performance all year, really, but especially in the past couple of months. And at the same time, the backdrop is a bit different than it has been throughout the post GFC environment where rates were very low and so we used the 2016 analogy as a different backdrop.

 

And now you're saying, in terms of the economic outlook, we still don't see reason to fear a recession, but housing isn't doing much for us and consumption is likely to slow, which means we're probably going to get a continued moderation in activity. And if you put the two together, markets having priced a lot, economy likely to slow, it means that we're still constructive, but we want to temper our enthusiasm and not get carried away in terms of our optimism right here.

 

JACK JANASIEWICZ: Yeah, and I would add one thing, Brian, on the back of that. When we look at two years ago, equities returned north of 20% This year, probably going to return north of 20%. When you've had back to back 20% years, that third year usually is good, but it's not close to replicating that 20%. So to your point, we're tempering down our enthusiasm. Still expect a robust market, but not nearly what we've been seeing over the last two years.

 

BRIAN HESS: Now, one idea that's gaining traction recently, and Jack, you even mentioned this term early on-- earlier in the webinar is the notion of US exceptionalism. And Jack, you've shown some charts in our various investment meetings that have driven this point home. And I thought we could use that concept as an opportunity to talk about the relative growth outlook between the US and the rest of the world and how this US exceptionalism is likely to impact relative performance from risk assets here versus internationally.

 

JACK JANASIEWICZ: Yeah, and this is, again, one of the questions that we continually get from clients. They're asking, is it time to start allocating to the international markets? Should we start to take a little bit of our chips off the table from the US perspective and put it elsewhere here? And one of the things that we like to joke about is, we will date international, but we like to marry the US here.

 

So I think that kind of drives home the point that, from a tactical perspective, there might be times when it makes sense to allocate outside of the US, but I think the long-term core backdrop is still supportive for US markets going forward. And to your point, as you just mentioned, this is, basically, that thesis of us secular exceptionalism at play in here.

 

And one of the reasons why we have a core underweight to international equities, I'll go through a couple of these things to highlight what's going on. But from the perspective right now, I still think there's some structural headwinds that are going to persist for a little bit in the interim where it might make a little bit of a difficult strategy, I think, to allocate outside of the US for now.

 

So I'll pull up a couple of charts here to walk through some of this. And as you mentioned, we're looking, basically, at a proxy for that growth differential. And so we're just looking at composite TMIs here between the Eurozone and the US. And you can see we've really had a pretty substantial divergence over the last couple of months in here.

 

And if you think about it, what's going on, and Garrett sort of mentioned this, the US is really a domestic driven economy. Europe is much more export reliant. And as a result, the US is much more insulated when you think about that consumer backdrop that we just walked through, it still remains very resilient. So it's not surprising that you start to factor in some of the things that we heard from the potential for the Trump 2.0 perspective pulling through that at least gives support to, I think, that backdrop and probably put a floor in at the worst case underneath growth.

 

But from a European perspective, it's a little bit more of a struggle because much more export-oriented. I think we all know the issues that have been plaguing the Chinese economy. But I think the key turnaround story for Europe would certainly be seeing a much more aggressive stimulus package coming in support of domestic consumption there, and that would then spill over into the broader European backdrop. But we're not there at that point.

 

So that's a headwind. And I think, also, you really have a two-speed European economy, right? I think when you look at core Europe, core Europe, much more manufacturing-driven. And they're going to be, I think, a lot more correlate to that ECB policy backdrop. So until you start to see, I think, the ECB really cutting rates in earnest, that's going to be a headwind, I think, for core Europe. When you start to look at periphery Europe, much more driven by the services segment, they're actually doing quite well.

 

So listen, the backdrop in Europe, I think, is still maybe less so-- less impressive than it is in the US. There are pockets in Europe that I think are worth taking a look at. But in the interim, in aggregate, I think the story still remains that US backdrop is probably where you still want to be focused in the near term.

 

And to highlight that structural backdrop that I had alluded to at the beginning here, you can really see, I think, the differences in terms of personal consumption. And when you look at US consumption, and basically, I rebased everything on this chart going back to the fourth quarter of 2019, so right before we went into the pandemic, you get a sense as to how much these different countries have recovered since the pandemic. And obviously, that red line there representing the US, well above that pre-pandemic level.

 

And so when you think about all those stimulus checks that were sent out, that, basically, that social safety net backdrop that the US went with during COVID, we're seeing the fruits of that manifest. And as a result, I think consumer balance sheets really were repaired during that point. You had some of that paying off debt. You certainly gave the opinion of making a little bit more of a rock solid balance sheet. And that balance sheet lets itself manifest through, I think, more confidence in the system.

 

And so the other thing to take away here, too, is also, when you think about that stimulus backdrop, it actually lowered barriers to starting a business. And that's key because if you think about what happened in Europe, Europe really paid employers to keep their employees on payroll. Where here, we didn't go that route. We just simply said, here's a cushion through the stimulus package. We're going to give you money, go and do whatever you want.

 

And I think that is a very important backdrop because, when we go to this next chart here, the big difference that we continue to harp on is the productivity growth that we've seen coming out of the US. So again, recalibrating these indices back to that fourth quarter in 2019, and you can see the productivity growth coming in the US really taking off. And that's key because when you think about the US economy, much more dynamic, and that also plays into a much more dynamic labor market, we're getting a lot more production out of each employee.

 

And what does that enable us to do? Well, you, basically, can have a higher wage growth backdrop with not necessarily having the associated inflation that goes along with it. So I think a lot of things that happened during the COVID pandemic era and the responses from the policymakers in the US have really started to play themselves out right here. And that's really, I think, helping to lend into this backdrop of exceptionalism.

 

So when you look at what happened during COVID, all that money that was basically reinvested into potential for higher productivity gains, now you start to back into the idea that some of maybe the deregulation that Trump is putting in, this is also certainly going to lower those entry costs and promoting competition throughout the system with less regulatory backdrop and better regulations. Again, these are all pro-supportive for productivity.

 

Also talk about that great resignation where you had workers that were, basically, moving on from their current jobs to something else, and probably, they're moving on to other jobs because they actually find them to be more productive. And obviously, that's going to start to manifest and that's probably what we're seeing as well taking on.

 

So from this perspective, bring this all full circle, these productivity gains that we're talking about, you're basically going to see them manifest back into income support. And that's a big difference, I think, between what we saw here in the US relative to what we had in Europe. And that's really making a big difference in terms of that growth backdrop that we're seeing. The last chart here to talk about, bring this all full circle and really back to investing, it comes down to earnings. What drives the stock market? Well, it's earnings.

 

And you're just looking at next 12 month earnings expectations, the S&P 500 relative to the STOXX 600, so that'll be our proxy for the European backdrop. And you continue to see the European estimates continuing to trade sideways here while at the same time you're continuing to see the US backdrop grind higher.

 

And so when I start to think about the differences between the US markets and the relative to Europe, for example, you start looking at metrics like return on equity. Those are really significantly higher than what we're seeing come out of Europe and a lot of this simply being driven by profit margins. And where do we see some of that productivity gains that we're just talking about manifest? It's in those profit margins.

 

So as a result, you start to see these things, putting them all together. It's not surprising that we've had quite around here post COVID where US has been outperforming the broader world. And I think we just laid out a few of those highlights as to why that might be happening.

 

BRIAN HESS: And so, Jack, it sounds like it's still premature in your mind to think about tactically allocating to an overweight position internationally, at least on the equity side.

 

JACK JANASIEWICZ: Yeah, and I think, again, one of the triggers we've been paying attention to, again, it goes back to that China story. I think if we get a significant stimulus package from the Chinese authorities there, that might move the needle and maybe a little bit more of an aggressive ECB in here. But until we start to see that, I think there's still some significant headwinds right now.

 

BRIAN HESS: And in the model portfolio as we run, we are still underweight international equities. We neutralized our emerging markets equity exposure, but still, underweight developed international with an emphasis on Europe, so that's where we stand with our portfolios.

 

Now, one of the risks of US exceptionalism is that stronger growth. And Garrett, you highlighted the potential for a slowdown. But if we just think bigger picture longer term that this leads to a stronger growth backdrop and then we layer on top of that tariffs, which are likely to materialize next year, it could create problems for the idea of inflation moving back to its 2% target, which would complicate the Fed's ability to lower interest rates.

 

And so I think that's a theme that markets have grappled with and which is why rates have sold off from mid-September up until very recently. So why don't we update the viewers on our thinking about inflation and how we're incorporating the idea or the risks of tariffs and even the continued large US budget deficits into that inflation view for next year?

 

GARRETT MELSON: Yeah, absolutely. And I think you kind of hit it the nail on the head. Markets have this reflexive reaction function that any time we see stronger growth, that just gets extrapolated into firmer and stickier inflation. And I think, if anything, the statistic I just shared where we've run, basically, 3% growth and yet we've continued to see core inflation fall dramatically over the last 18 months speaks to the fact that, one, maybe potential growth is a little higher than we think. And so it takes a little bit more growth to actually translate into inflationary pressures and an impulse.

 

But more so, maybe there's other dynamics at play that are actually keeping inflation in check. And so, ultimately, I think what we're seeing is that, yes, you've had a predictably growing contingency of concerns that inflation is going to stall out above target. But from our perspective, I think it's pretty clear that the trend is still unchanged here. It's been volatile, it's been noisy, that's been the case the entire way down from the peak and inflation. And I think that continues to be the case.

 

But the trend, in our view, still is intact that we're still moving back towards 2%. And ultimately, as you look out over the next couple quarters here, I think 2% is still very much within target as you continue to see shelter disinflation come through, core goods prices remain benign, and super core services prices moderate as well.

 

But to the market's concerns here, I think this chart kind of speaks to it. And this is just simply looking at core PCE and stripping out the shelter component. So we all the story there. The fact that that's the fly in the ointment. We know the disinflationary pipeline there just given where market rents are trading right now and that should eventually filter through. So let's just look at the rest of the basket.

 

And if you do that, well, OK, on a year-over-year basis, the red line here, you can see we're basically closing in on 2%. We're not quite there, but we've kind of flatlined around 2.3-- the low 2s for the last five or six months here. And I think that's where the markets are starting to worry that you're getting a little bit of stalling out. And especially when you look on a shorter term basis, that light blue line is your three month annualized average, and that has ticked back up to about 2.4 from well under 2.

 

So you are starting to see a little bit of a firming here, especially in the last two months. And I think that started to get markets a little bit concerned, especially with that stronger growth impulse that we've seen over the last couple of months here that maybe things are going to stall out above target. But I think this is actually being muddied because if you actually think about what is behind the recent firming in prices, what's driving that very much matters, and that's very similar to what we saw early in the year.

 

As opposed to being really broad inflationary impulse, it's actually been a little bit more idiosyncratic in nature. I think the most recent PCE print is a great example of that. 4 basis points of the month-over-month print. It was actually just driven by magazines and periodicals. So is that something that we're all spending a whole lot of money on a monthly basis and that the Fed is really going to be adjusting a policy on? And is that giving you a good read about what inflationary impulses are throughout the broader economy? Probably not. It's a little bit more noise than anything else.

 

But the other factor is imputed prices. And these are prices for services that, basically, can't be directly observed. So one of the biggest imputed measures in the PCE basket is financial services. So those aren't costs that are necessarily paid directly out of pocket and they're hard to measure. But portfolio management fees, talking about our own industry, the fees that our clients pay that, basically, comes out of their portfolios, that is imputed, and that's, basically, a function of equity prices.

 

Again, is that a measure of or a reflection of broad inflationary pulses? Probably not, and it's probably not going to be meaningfully changing the Fed's reaction function. So if we actually strip out some of those imputed prices, which can deviate pretty dramatically from the broader macro trends over short periods, over long-term, it tends to net out, but over the short run can introduce quite a bit of noise here.

 

And if we do that, sure. Do you see a little bit of flatlining? Absolutely. But take a look at that six-month average. You're still clearly trending down. I think the bigger story is you do have volatility, again, in the short run. But over time, I think the trend is still pretty clearly moving lower here. And so I think there's noise and imputed prices are part of that. When you look through some of that noise and some of the idiosyncrasies, I still think the trend is pretty clear here that the bigger risk is for inflation to continue drifting down towards target. It may still take some time, but that is still the direction of travel.

 

Now, that said, it might take some time, but we actually do have somewhat of a cliff looming. And this is the inverse of what we heard last year where there was kind of base effects that were going to make the comps difficult. They actually flipped pretty favorable over the next six months. And what you're looking at on this chart is simply, think about the contribution to the year-over-year number. So right now, we're at about 2.8% on core PCE on a year-over-year basis. And if we look at on a three-month basis, what's really driving that 2.8?

 

Look at the yellow and the gray bars. So those are prints that happened 9-- or I should say 7 to 12 months ago. So those are the 6 months that we are going to be rolling out of that 12 month look back. And in essence, that's responsible for about 1.6% of that 2.8% annual rate that we're sitting at on core PCE.

 

So put that another way, unless we average 0.27% monthly prints for the next six months, year-over-year core inflation is going to be declining over the next six months. And if we actually start to return towards some of the prints that we averaged over the summer months, which is closer to about 15, 16 basis points per month, that progress could be very, very swift here.

 

So I think it's too early to say that we're stalling out just because growth is strong. And certainly, from our viewpoint, some of that growth impulse might be moderating a little bit. But the bigger story is some of those comps get pretty easy over the next couple of months. Yes, there's a risk of some of that residual seasonality again in Q1. But I think the direction of travel remains pretty clearly skewed towards the downside.

 

The last thing that gives us confidence there is just, take a step back, get out of the weeds of the month to month, and just think about it in broader terms. What really drives and leads to an inflationary impulse? And you can boil it down to this economic identity, which is that inflation equals compensation, less productivity. And Jack kind of alluded to this.

 

Productivity growth has been very robust here in the US, and that can be a very powerful buffer to elevated wage growth. Now, we've seen wages really materially come down, not quite back to pre-pandemic levels, especially if you're looking at the Fed's preferred measure, which is the ECI. But if you put that to-- those two together and think about compensation, so ECI, less productivity growth, you get the purple line, and that actually tends to be a decent kind of directional proxy for where core inflation is headed.

 

And right now, we're, basically, sitting right about 2%, just underneath that. So when you think about some of the macro drivers of inflation within the economy, you're just not seeing a whole lot of an upside impulse right now. And I think that speaks to the fact that you should probably continue to expect to see inflation prints move lower as we push through into the year end and into 2025.

 

Now, obviously, there's some noise and policy that we'll have to contend with, but again, we don't know a whole lot about that just yet, so it's hard to make decisive conclusions about where the direction of travel is on some of that unknown policy right now.

 

BRIAN HESS: So bottom line, you're sticking with the disinflation call, sticking with the call that we can return to target, you think looking at the market based PCE versus the traditional measurement highlights the distortions that are evident within the traditional form of calculating it. And we've also got maybe a kicker through base effects that are going to come in soon and help us get closer to that 2% target.

 

Even if we get a little bit of an upward impetus on import prices from tariffs, it's probably not enough to move the needle relative to these other factors that should weigh on inflation.

 

GARRETT MELSON: Yeah, I mean, I think you could expect maybe a level step higher, and that's really what tariffs are, and not necessarily an inflationary process. So that is certainly a risk over the 12 months. But I think, broader picture, from a macro perspective, it certainly seems like the direction of travel is lower.

 

BRIAN HESS: And I'm going to ask you about rates in a minute, Garrett. But first, we got an interesting question in the chat, and I to put that back to Jack as it relates to one of his segments. So we got a question that if you strip the Mag Seven out of the S&P 500, how does this change the overall picture for the United States? And so my interpretation of the question is, Jack, would you be comfortable owning the S&P 493 versus international equities?

 

JACK JANASIEWICZ: Yeah, that's actually a great question, and I think that's part of our outlook for 2025. If we look at earnings estimates for the Mag Seven relative to the 493, they're compressing. And when you get out to, I think, fourth quarter of '25, you're basically almost at that same level where earnings per share expectations are the same for both.

 

So from that perspective, we certainly do expect a broadening out of market breadth. And as a result of that, I think that's really our call for cyclicals with a barbell with tech. And so as we continue to see growth holding up, I think, better than expected, but maybe not to the upside that we had talked about in the previous portion here, but I think it also puts a floor underneath growth at the bottom side. So we're sort of, I think, in a nice range. That should continue to play well for that broadening out theme.

 

So yeah, we do expect the 493 to really be the trade for next year as that cyclical value component of the market continues to work. Now, that's not to say the Mag Seven doesn't work. We think it does, but maybe the performance-- the outperformance that we've seen starts to slip back a little bit, and so it will come back to Earth relative to the rest of the market. So there may be market performers going forward in here.

 

BRIAN HESS: OK, thanks, Jack. That's great. Now, I think a natural follow on from the Inflation discussion is to talk about our interest rate outlook. And so, Garrett, we've had volatility in the rates market, like we talked about. But right now, the belly of the curve pretty much sitting right above 4%. Given what you said on growth earlier, given what you just mentioned about inflation, I'm guessing we're not too bearish bonds. But my question is, how much upside do we see for bond prices or downside for interest rates from here given that we're also not looking for a recession?

 

GARRETT MELSON: Yeah well, I think that's exactly the takeaway is we'll cut right to the chase. And I think it's somewhat a story of rates remaining range bound. And it becomes really or continues to really be a story about coupon and carry. And so over time, and I think what we've seen over the last couple of months here, again, is the narrative getting a little bit overzealous and overshooting. That does give you a short term opportunity to capitalize on duration, whether that's going long or short. But broadly, I think the story is about carry.

 

Now, in terms of how the narrative has evolved, we talked about how we've moved back into the no landing outcome, and some of that's been fueled by some of the prospects for the growth agenda under Trump. But I think, bigger picture, what was behind the big backup in rates leading into the election? And there were a lot of different explanations and it's kind of-- has been the hallmark of all these widenings and sell-offs in the rate markets over the last year and a half. But I think it's really a function of a couple of things.

 

We've heard about unwinding recession odds, pricing in stronger growth, stickier inflation, deficit hawks and bond vigilantes. In our view, I think it is a little bit about the Trump trade, but a lot of it was just simply a point of the starting point. Again, starting points matter and the data flow since that. And so won't go back to how the narrative was sitting back at the beginning of September, that's really when recession fears hit a zenith. And we were hearing a lot of concern about an imminent collapse in the labor market.

 

Well, basically, since that point, you've seen a sharp reversal in the flow of data, not just outright, but more importantly, relative to expectations. And that's what you see here on this chart. The light blue line is the Citi Economic Surprise Index. So as that moves higher, that means that data is coming in ahead of expectations. And no surprise, what does that tend to track closely with? It tends to move with shorter term moves in the 10-year Treasury yield.

 

So in this case, we're looking at just the 13-week change, your three-month change in yields. And there's a pretty tight relationship over time, and you can see that playing out over the last couple months here. So, yes, I do think that there's a lot of components that led into it, but probably one of the biggest drivers is the fact that we were just overly cautious and pricing in too much recession risk. We had to walk that back and then start pricing in a stronger growth backdrop here.

 

So when you think about decomposing rates, I think that also tells a similar story. If you look at the next page, we're just talking about nominal yields at the wides backing up about 85 basis points. So that's a pretty sharp reversal or sell-off. But what was behind that was a little bit of a combination of real rates and inflation break evens in the early stages, and that's exactly what you should expect to see if you're coming off the edge of imminent recession fears. You're pricing back in probably a little bit firmer inflation because you're not going to have disinflationary risks in a recession, and you're pricing back in stronger growth.

 

So a little bit of a combination of inflation, break evens, and real rates driving it. And that's what you can see, basically, through the middle of October. But that's when it kind of leveled off or break evens, they just went sideways and it was all about real rates. So yes, that's maybe a little bit about stronger growth getting priced in, good data that wasn't necessarily inflationary, probably a little bit of the Trump trade, maybe some other just explanations just tossed in there for term premium widening.

 

But that also suggests that maybe we lost the script again, which is something that's happened a couple times in these narrative repricings where you get a little bit of an overshoot and it just kind of spirals and feeds on itself without really much fundamental backing here. And one way we've been able to measure that over time is by looking at our fundamentally driven model here.

 

And it's not perfect, but over time, it actually does have an R squared of about 92%, 93%. So it does a really good job of explaining moves in the 10 year Treasury, and that includes a couple of fundamental factors. It has growth revisions, estimates, inflation expectations, short rate expectations, so basically, the path of policy rates in the near term, and then, we do include some technical factors, what global bonds are trading at, some futures positioning as well. So it gives you a little bit of a sense of the technicals.

 

But I think the hallmark here is that any time you see these gray bars, which is basically the difference between where fair value on our model is versus what the prevailing yields are on the 10-year, you tend to see as you hit about 20 basis point overshoots, that's probably getting pretty extended where you see a little bit of a reversal. Over the last three material sell-offs, we've gotten closer to about 35%, even closer to 60%-- 60 basis points back last fall. The more recent one, maybe 40 bips.

 

But that's a pretty material overshoot. And what does that suggest? It means the technicals have kind of taken over here. And so, as you see the market pulling back towards the fundamentals, again, think about what we just walked through on the growth front. Growth is strong, but maybe some modest headwinds in the near term. Disinflation is still set to continue as we look into next year.

 

And yet, you've gotten a little bit of that Trump bump, but some of those inflationary concerns from a Trump agenda have been walked back, as Jack mentioned, with the one year, one year inflation swap. So bottom line here is I think our model is pretty well pinned to 4%. It hasn't moved a whole lot. Now, I can see that drift a little higher as growth estimates maybe start to bump up as we get a little clearer expectation on what the Trump agenda is.

 

But I think the story is you've clipped the tails in terms of yields. The top end is capped by nominal growth continuing to slowly moderate. And at the floor, you basically have to puts in play, the Powell put if you see weakness in the labor markets, and the Trump put just because you have a pro-growth agenda here. And that means kind of a rangebound environment for tents, probably somewhere between 4% and 4 and 1/2. So, yes, some opportunity to play some of those oscillations. But I think the bigger picture is a story of just carry right now.

 

BRIAN HESS: OK, sounds good. So we're looking at 4% or 4 and 1/2% is the likely range for the 10 year. If we were to push above that 4 and 1/2, it would suggest something has changed with respect to inflation or growth that we haven't incorporated into our outlook. So that's good for, I think, our viewers to keep in mind that those are the levels where we have to start reevaluating our thinking and what we might be missing.

 

Now, really quickly because we are getting a little bit short on time here, Garrett, can I get your thoughts on the Fed? We have a meeting this month and then maybe an idea about the trajectory for cuts during the first part of next year. The market's walked back a lot of rate cuts over the past couple of quarters. So just can you quickly hit on your Fed thinking?

 

GARRETT MELSON: Yeah, you've seen about a 100 basis points of cuts by end of next year walk back over the last couple months. I think 25 basis point cut is a lock in the next meeting here. It would take a lot-- a huge upside surprise and probably jobs and inflation to change that at this point. But after that, I think it becomes a story of maybe every other meeting type pace for the Fed where they're getting closer to where they think neutral is, and that means that they can slow the pace of recalibration down. It doesn't mean they're stopping, but it suggests that maybe they can go every other.

 

And to be honest, markets are basically pricing that in if you take a look at futures pricing. You can see that in expectations here. So I wouldn't differ too much from what the consensus pricing is. Maybe skew a little bit towards more easing than less. But right now, I think we're somewhat fairly priced based off where the markets are.

 

BRIAN HESS: OK, sounds good, Garrett, thank you. And we got one good comment in the chat, which is something I probably should have mentioned earlier when we were talking about the risk of tariffs being inflationary. But someone mentioned the possibility that if Trump's discussion about potentially deporting illegal immigrants were to play out, that could definitely put some upward pressure on wages and create a more inflationary backdrop.

 

I think that's one of the risks that we have to highlight, and guys, feel free to chime in. But I think that's something we're watching as a potential risk. We feel confident that the tariffs will happen, at least in some way, but the operationally making the deportation happen seems a bit trickier. So we don't for sure how much that will happen to the extent it will play out.

 

But if it were to occur on a large scale basis, yes, certainly that would constrain labor supply into an already tight labor market, and probably, change that trajectory we've seen for average hourly earnings growth, which has been a source of disinflation recently as evidenced by Garrett's chart earlier. So I do want to address that. That's a great comment by Doug.

 

So, Jack, last topic here. We are running out of time. Let's Zoom way out. Big picture issue, but something that's on a lot of people's minds, and that has to do with US debt sustainability. Now, the US, along with many other countries around the world, has had a really difficult time reining in the budget deficit after COVID. I mean, we blew out the deficit to support the economy, provide a backstop, which was the right thing to do.

 

But you fast forward a few years, and today, we're still running really large deficits despite being at full employment and with inflation still above target. And so my question to you is, we've seen debt to GDP move to new highs. We're hearing talk about potential crowding out via-- in the bond market, rising term premium, perhaps putting upward pressure on longer term interest rates as investors demand more compensation for the risks of this growing debt pile.

 

And so we've even seen, like in the UK, for example, back in 2022, a bit of a debt market revolt and the Gild market had a meltdown and that catalyzed a change of government within the UK and an immediate response. So in your view, how problematic is the current US debt trajectory, the large budget deficit, and how close could we be to some kind of a US fiscal crisis, whether it be just a mini crisis, like what happened in the UK, or something more impactful?

 

JACK JANASIEWICZ: Yeah, listen, this is the elephant in the room, right? We've been hearing about this concern for quite some time and it just, I think, gets elevated year after year because there certainly seems to be limited appetite from Congress to address this, so to speak. And as a result, it just seems like it keeps getting pushed out, out, and out.

 

But I think a couple of things to highlight on the back of this to drive the point home, and I'll try to go through these a little quicker. This is the chart of the 10 year Treasury, and I tried to pull points in history where we were at, basically, these sort of same yield levels and pull real rates relative to where we were with regard to inflation and then where we are with regard to debt to GDP.

 

And you can see, we've had two previous periods where we've been right around 4 and 1/4, 4.3% on the 10-year yield. Let's call real rates roughly at the same level, inflation, roughly at the same level. But yet, the one key difference here is that debt to GDP level here. And you can see, today, we're significantly two to three times higher than where we've been in the past.

 

And I think the point I'm trying to make here is simply that we've been at these same economic backdrop points, and yet, the key difference today is that debt to GDP level. And yet, here we are, the 10-year still trading at those same levels. And it's not like the deficit really isn't something that's understood by the markets at this point.

 

So I think the ultimate backdrop for us here is simply that what matters most is, basically, going to be the fundamental backdrop. Its growth expectations and inflation expectations. And so if those were to change, then we start to become a little bit more concerned about that backdrop. But looking at historical relationships, and this one here, we're just trying to plot quarterly changes in the deficit against changes in the 10-year yield.

 

We see plenty of times where you get a spike in the deficit and yields have rallied. You get times when the deficit shrank and yields widened out. Again, there's really no definitive relationship here. And again, I keep harping on this, but we're falling back to it's really about that growth and inflation expectation backdrop. And as long as those remain under control, I think that the concerns on the deficit will lurk in the backdrop but really won't, I think, come to the forefront here.

 

And we also get a lot of questions about, well, who's going to buy all of this debt? And we're just looking here at rolling aggregate of cumulative purchases of US treasuries. And you can, basically, see how we've had a little bit of a shift. Sure, the Fed has been a significant marginal buyer. We've talked about this on past webinars.

 

But I think the key here is looking at, for example, the gray line. You've got asset managers picking up significant slack, the red line households, and then, foreign investors on the green. And if you actually combine these three into one cumulative aggregate number here, that 12-month look back, they've been picking up close to $2 trillion of slack in here.

 

And I would also add in the potential for the Fed to halt or slow quantitative tapering, which means if they're going to be trying to keep that balance sheet level consistent, they'll start to reinvest some of those proceeds as they roll off here. So when we think about who's going to buy all of this debt, we've certainly seen plenty of other people stepping in here. And I think that's really a function of value in the marketplace.

 

And so you can see here, just looking at the relationship between 10-year yields and cumulative foreign purchases of the US Treasury bonds, as yields have pushed higher, foreigners have come back in. And so I think this isn't necessarily a supply and demand issue thing, it's a function of confidence in the ability to make those payments, receive those payments come at maturity time, and the trade-off with the yield you're getting relative to the rest of the world here.

 

And so I think whenever you start to see the US yields pushing up a lot higher than competing fixed income markets, you're going to see foreign investors come back into the market and take advantage of that. And that's roughly what we're seeing here today. But listen, I think to summarize this whole backdrop, it comes down to really what we call as exceptionalism. And that's the theme, I would say, that you're hearing about quite a bit today. And what does that mean? Well, the US exceptionalism really has its privileges here.

 

And this, basically, comes to fruition with investors who are willing to take on increased debt, basically, to fund and finance larger fiscal deficits because they have the confidence that they're going to be repaid here. And to say this is a different way, I guess, that exceptionalism allows a country to run a higher deficit and still finance themselves at reasonable rates. What defines that US exceptionalism?

 

And we've talked a little bit about it today, but it's strong relative growth to the rest of the world, strong equity markets, a strong dollar, in this case, or strong local currency, superior demographics. And again, the demographics aren't great in the US, but relative to the rest of the world, still better. Strong military and global alliances, cutting edge technologies, and a resilient political system. And these are all things that investors want to see because it helps give them that incremental confidence here.

 

And so in a world where it's geopolitically very dangerous out there, the US is the safest and strongest country with the strongest economy and a currency that provides market depth with confidence that's required to help finance these perceived large fiscal deficits in here. So that was a mouthful. But the bottom line, that exceptionalism has privileges, and that lets you finance these deficits because investors have confidence in that backdrop.

 

How does this change? What are the risks? Again, we're going to go out on a limb and say these are probably low probability events in the interim, but maybe losing a war, having a significant recession ultimately bordering on the precipice of a depression or a significant spike in inflation, I think, those are some of the risks where you would see that exceptionalism fade and that potentially wider deficit.

 

And then, we start to manifest in a bond market route. But like I said, low probability event from our perspective in the interim. And so, while it certainly makes for good political fodder in here, I just think the deficit concern is still a ways away before it starts to manifest in significantly higher rates.

 

BRIAN HESS: So we're so comfortable with US treasuries. We're not necessarily pounding the table on long duration, but we're also not expecting a fiscal crisis anytime soon. And so that means, for investors who are worried about a lower policy rate and maybe reinvestment risk at the front end, feel free to extend duration and lock in those 4% rates for a longer period of time. And we'll keep monitoring the situation because, Jack, you and I know from our experience in emerging markets, a lot of times these factors don't matter until they do, and that can come up quickly.

 

But for now, it does look like that exceptionalism story is giving us some runway. So great response there. I think that's it for this quarter. We're up against the top of the hour. And so I want to thank Jack and Garrett for their insightful comments. I also want to thank our viewers for taking the time to tune in. We do appreciate your support on these quarterly webinars. Happy holidays to everyone and best of luck as 2025 gets underway.

 

If there are any questions on anything we covered today, please reach out to your Natixis sales person and they'll be happy to help you, and we'll see you next year.