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Fed Chair Powell’s inflation remarks ‘surprised the market,’ strategist says

Federated Hermes Chief Equity Strategist Phil Orlando joins Yahoo Finance Live to discuss Jerome Powell's latest comments and what the next steps from the Fed may be to fight inflation.

Video Transcript

- Well, let's take a deeper dive now into the Fed, and of course, the markets as well. Let's talk about that with our guest, Phil Orlando, Federated Hermes Chief Equity Strategist. Now, Phil, Good to have you on the show. Obviously, in your notes, you talk about how much the markets were not correctly pricing in what the Fed was going to do.

PHIL ORLANDO: Exactly right. Just over the last couple of months, from mid-June into mid-August, the S&P 500 had rallied by about 19%. And our sense was that there was a misperception by the market, that inflation had somehow peaked and was going to enjoy this immaculate decline from 9% down to 2% in a matter of months and that at this speech this morning, Chair Powell was going to take a very dovish turn suggests that Fed rate hikes were almost done, and then the Fed would turn around and start cutting interest rates in the second quarter of next year.

We felt that was completely wrong, that inflation is real, it is sticky, it is sustainable and that at this morning's Jackson Hole speech, Powell was going to lay out a hawkish tone, which suggested that the Fed was going to remain vigilant and continue hiking rates until it got the inflation level down to 2%, a process that we believe is measured in years, not months. So if and when that message got out, we felt that the markets would reprice. And that's what we're looking at today. That process is starting.

- Phil, in contrast to the volatile markets, and we just saw the rates that have spiked up and down and shown volatility, I would argue that Jerome Powell has really been very flat the last several months. Nothing he said today surprised me. Did it you?

PHIL ORLANDO: There's nothing that he said that surprised us. But clearly what he said surprised the market. And that gets to the perception of where are we within the inflationary cycle? From our perspective, the Fed is trying to manage the Phillips curve tradeoff with their dual mandate, employment and inflation.

And the rate of unemployment, as you know, is sitting at a half century low at 3.5%. Inflation is sitting at a 40-year high. So from our perspective, the obvious choice is the Federal Reserve needs to address the inflation question and act aggressively to bring inflation back to trend. The tradeoff is that we're going to see slower economic growth and an increase in unemployment. And I think that was news to the market this morning. And at least for one day, we're seeing the market react to that news.

- Yeah, the market has just had its collective earmuffs on. You talk about unemployment. Where do you think it needs to go, will go in the months ahead, when that pain that Jerome Powell talked about comes through?

PHIL ORLANDO: Sure. So we're sitting here, as I said, at about the 3.5% level. We're going higher. Perhaps that number has a five handle. I've heard former Treasury-Secretary Larry Summers talked about maybe a 7% level. I don't think we're going to double digit unemployment levels. But something in the mid-single digit neighborhood over the course of the next year or so I think is a reasonable expectation.

- And Powell did talk about drawing on three lessons for the Fed and one delivering obviously low and stable inflation. But he also talked about the public's expectations about future inflation and said that the third lesson is that they must keep at it till the job is done. When you hear those sorts of words, how do you position your portfolio?

PHIL ORLANDO: Well, I thought that was a brilliant touch by Chair Powell. He invoked three of his predecessors, Alan Greenspan, Ben Bernanke, and of course, Paul Volcker. And for those of us who have as much gray hair as I do and lived through the Volcker years professionally, it was an ugly period in the late '70s and the early '80s that Volcker realized that in order to break the back of inflation, he needed to take interest rates up so high to literally create a recession that would wash out those inflationary expectations.

I don't think that we're looking at a situation like that. It's not that bad. But we do think, and the way we've positioned our portfolios, is that we are under neutral in terms of our equity allocation. We're 1% underweight in equities. But within that equity allocation, we've got a 4% overweight to domestic large-cap value, a 5% underweight to domestic large-cap growth. And right now, we're sitting with a 10% allocation in cash. That's 7% above neutral.

In the 20 years I've been at Federated Hermes, we've never had a cash position as high as 10%. So I guess what I'm saying is, we're playing defense right now, domestic large-cap value, dividend paying stocks, lower PEs, and a lot of cash that we can put to work if and when we think this market is bottom.

- Yeah, that's what I was going to ask you. Where do you think this market bottoms?

PHIL ORLANDO: Well, the stock market has just rallied 19% in the last two months. In our view, that was a dead cat bounce, a bear market rally, call it what you wish. But we think the market has got to retrace some or all of that 19%. That would take the market back into that-- let's call it 3,600 level. So that's a good place to start.

And at that point, we've got to be data dependent ourselves. How does the economy look? What's happening with economic growth, employment, inflation? How aggressive is the Fed at the September 21 meeting, the November 2, meeting the December 14 meeting? So there's a lot of variables at this point. Given the strong rally we've seen in stocks over the last couple of months, prepare for lower stock prices and then look for an opportunity to get the offense back on the field.

- And Phil, obviously when you see a selloff like this, it's easy to panic, especially if you're a retail investor really trying to make sense of this between now and the next potential rate hike of-- I think you estimated perhaps 75 basis points. What should investors do at this time? What's the mindset they should have?

PHIL ORLANDO: Well, take a deep breath. Pour themselves a nice glass of wine over the weekend. We're not going to zero. Talk to your financial advisor. Make sure you've got an overweight in value stocks, an underweight in growth stocks, that you've got some cash to deploy at the appropriate time. We're going to get through this. We've gone through cycles like this over the last 40 or 50 years. We're going to get through this. So take a deep breath and relax.

- Nice bottle of cab. What are we doing, Phil?

PHIL ORLANDO: Nothing wrong with a nice California cab, that's for sure.

- I'm going to do tequila, but same effect. Good to see you, sir. Enjoy the weekend.

PHIL ORLANDO: Thanks for having me on.

- Phil Orlando, everybody. All right, good stuff.