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The bond market is pricing in ‘several futures’ amid Fed tightening, strategist says

Research Affiliates CIO Chris Brightman joins Yahoo Finance Live to discuss Fed policy and inflation.

Video Transcript

BRIAN SOZZI: All right, I'll stay on the markets here, Chris Brightman is the CEO and CIO of Research Affiliates and joins us now. Chris, good to see you here. Top of the morning to you. What-- should one of the takeaways from the comments from Fed chief Jerome Powell yesterday be that investors should just expect lower long-term returns because interest rates are headed higher?

CHRIS BRIGHTMAN: I think that's the correct message. And not just lower long-term returns from the bond market but lower long-term returns from the stock market as well. Remember, the stock market's trading at near all-time highs in terms of prices relative to say, cyclically adjusted earnings or extraordinarily low dividend yields.

And that's perhaps justified by extraordinarily low interest rates. But as extraordinary low interest rate environment comes to a close, equity pricing is at risk as well. And certainly the higher-flying more expensive names more so than the cheaper names. The discrepancy between the pricing of growth and value names remains near all-time highs. And as we see inflation rise and particularly real interest rates rise, you can expect the continued outperformance of value stocks, banks, commodity, the oil companies, et cetera, relative to transportation services, and technology.

BRIAN SOZZI: So Chris, how low is low? Over the next two years, rates are going higher, perhaps pretty steadily. Are we talking sub 5% returns for the markets?

CHRIS BRIGHTMAN: Well, there's of course, a lot of uncertainty right now. The bond market's pricing in sort of perfection of a soft landing with no recession. And I think the way to think about that is there's really-- that's a possibility, I think it's a rather unlikely one but there's two other possibilities around that. One is that we're in a recession by 2023, and the other is that we're in stagflation. The recession obviously bodes very poorly for stocks and temporarily maybe not so bad for bonds. Stagflation is just terrible for bonds and generally not a great environment for stocks as well, and one that favors value stocks.

So rather than thinking about the bond market as pricing in one future, I think there's several futures that they're pricing in and one is stagflation. And I'll remind you that during the 1970s, cash returned negative 1% for the full decade, which is not great but both bonds and stocks returned negative 4% real for the full decade compound annually. So that's-- in response to your question, it could very easily-- it just as easily be negative returns as positive returns.

JULIE HYMAN: And you know, when chair Powell spoke yesterday-- it's Julie here by the way. Hi, Chris. You know, he seemed to maybe be stirring folks to not focus on the longer end but maybe focus on very short-term Treasuries and look at a potential inversion or not an inversion there as an economic signal. Do you think that we are looking at the right things when we're trying to predict whether indeed a recession is going to happen?

CHRIS BRIGHTMAN: Well, I think the inversion of the yield curve is a tried and true predictor and it makes sense. There's intuition behind why when the cost of funding exceeds the return on capital people pull back, and that's a negative signal. Plus, it has about a 100% batting average. Every time we've seen a significant inversion, we have a recession following not long after.

And we're at the very first, you know, we just experienced the first rate increase over which it promises to be many, many more, whether there's a 50 or a 25 next, I think is not the point so much as that we're going to see continued tightening all through this year, likely through into at least the first half of 2023. And where it stops, nobody knows including the Fed. And so the fact that we're pretty darn flat and close to inverted today means that you know, gosh in the next couple of tightening moves it's highly-- it's reasonably likely that we're going to see an inverted yield curve and that has always been a signal for recession in the past.

JULIE HYMAN: And a signal for value maybe. So let's come back to that because that's what you guys focus on, right, is the value area. If you look at the Russell growth versus the Russell value, at long last, value is outperforming. And this is something that folks in the value space have been calling for for quite some time. Now that we are finally seeing that move, how sustained-- I mean, does it last during the whole duration of the rate hiking cycle for example?

CHRIS BRIGHTMAN: Yeah. I know it seems like we're perpetually touting value. And you know, I think there's good reasons to say that paying attention to prices relative to fundamentals is always a sensible thing to do. But the point is for quite a long time value stocks have been extraordinarily cheap relative to growth stocks. An entire market has been priced extraordinarily expensively relative to history, and it's that environment that has resulted in us favoring value stocks.

But if value stocks weren't cheap and growth stocks were unusually attractive, we'd have no compunction about favoring growth stocks. And not everything's equally expensive. But just generally speaking, if you put a scatterplot together of returns over the decades past and plot that against the level of inflation during those decades, you see that there's a pretty strong relationship that favors value stocks during periods of high and volatile inflation and rising interest rates. And you've seen that recently, as real rates go up, the high-flying tech stocks have tended to go down and vice versa.

BRIAN SOZZI: You know, as a value-focused firm, I'm curious on what you thought of Warren Buffett yesterday spending close to $12 billion on Allegheny. Of course, he's one of the most well-known value investors of all time. Is it time for investors to go looking for value in insurance stocks? How do you think about it?

CHRIS BRIGHTMAN: Well, I think over a multi-year horizon if we normalize the level of interest rates and funding costs, that's probably bullish for the financial sector, both banks, and insurance companies. But first, we have to get through the inverted yield curve and potentially a recession. I really think the chances of a unforeseen liquidity-driven event are quite high. You know, we've got experimental monetary policy with the Fed having ballooned the balance sheet enormously. And that inflated financial assets of all sorts, and houses for that matter. I mean, yeah, we got inflation at 8% but that doesn't mean that house prices should be going up 20% a year. And as the-- speaking of Warren Buffett, I think he reminds us that when the tide goes out, we see who's been swimming naked.