Fed needs to ‘show the market they mean business’ on inflation, strategist says

Hennessy Large & Small Cap Financial Funds Portfolio Manager David Ellison joins Yahoo Finance Live to discuss expectations for the Fed's policy decision, inflation, the 363 rule, and the outlook for bank stocks.

Video Transcript

- Welcome back, everyone. Investors await the Fed's decision this afternoon on rates as expectations for 75 basis points in a rate hike are on the table. Here to discuss how this could all play out for financials is Hennessy Large Small Cap Financial Fund's Portfolio Manager. We've got David Ellison joining us here. David, what cap do you fall in? You're looking for 75, you're hoping for 100. What's going on?

DAVID ELLISON: Well, I'm hoping we'll get 75. I'm wishing for 100 just to get it over with. They're going to go there anyway. They're pretty far behind with mortgage rates at 6 and Fed funds at 1. So we'll see what happens. But I think the more they do, the better the market's going to react to it, in my opinion, because they need to show the market that they mean business on inflation. The big problem with the market is inflation, everything else is pretty much OK.

- David, do you think that bank stocks have priced in a mild recession?

DAVID ELLISON: Well, the bank stocks-- they're not as cheap as they've ever. I've been doing this for a long time, which hopefully it doesn't show too much but you know valuations are at the low end of the range, but not disaster ranges. I think people are fearful of loan growth slowing as the economy slows as rates move up. They're worried about housing prices coming down and creating credit issues. Corporate debt becoming a problem and creating issues there.

So I think that's going to be there until people feel more comfortable. In the meantime, because rates have moved up, there are market hits for some of these banks and that's going to curtail buybacks and potential dividend increases. So we have to work through this. The opportunity is ahead of us, certainly not behind us. But in the meantime, the banks are historically very safe from a capital perspective, from an earnings perspective. And we just need to sort of muscle through this rate increase and get to the other side.

But again, you have mortgage rates now at 6%. When I started in the business in '82 the joke was the banks were about 3:00, 6:00, 3:00. And that was you'd borrow money at 3:00, you'd lend it at 6:00, and your tee time would be at 3:00. and we're kind of back to that. And so we've got rates, especially mortgage rates at 6%. That is a good rate historically to lend into, both for risk and obviously return relative to the cost of funds.

So we are there from a pricing perspective. The question now is, the market's going to be afraid about mortgage rates going to 8% or 12% and home prices crashing and credit kicking in. It's amazing how when you're in the banking sector, 2008 is always yesterday. People are just incredibly fearful of that 2008 cycle where they just got completely wiped out. And that is that still in the minds of a lot of historical bank investors in the business.

- A couple thoughts based on that, A, I don't know how many bankers you'd find kicking off at 3:00 PM these days for a tee time. I don't know. And also, 6% mortgage rate in the '80s, you were sitting pretty. You were feeling good probably if you were as a home buyer getting that kind of a rate. So if we are still sort of scarred by the financial crisis and the effect that had on the banks, does that mean then effectively what you're saying is that people are overlooking opportunities probably if they are still feeling that kind of fear from that period?

DAVID ELLISON: Well, I think that's part of it. As a long-term investor and obviously I run two financial funds at Hennessy for 10 years now and did it at Fidelity for 12 years, and so on and so forth, you make money when credit goes from good or bad to good. And so I would love to see a credit cycle, the stocks reflect that, and then we can really make money coming out of that.

And I think that's what-- I think the pandemic was a good example. We had a real quick credit fear. The stocks got completely annihilated. And as we came out of that, the stocks did quite well for two, two and half years. And this year it's been awful because we're back into that sort of, well, credit's going to deteriorate and earnings are going to go down.

So to me in a big macro sense the problem with the market is valuation and now we have an earnings problem. And you see that starting with Peloton all the way through. And you got people like Snap coming out you know reporting numbers. And then three weeks later saying, look, we were wrong. They're a lot worse.

That's a recipe for lower stock prices. So I think we've taken care of a lot of the valuation issues. Now we have to take care of the earnings issues. And I think that's up to the companies and that takes another year or so to resolve.

- All right. Well, a little bit of a grim picture, but hopefully we'll get out of it. David Ellison, good to catch up with you and to get your perspective. 6:00, 3:00, 6:00, I learned something-- or 3:00, 6:00, 3:00. I learned something new today. Hennessy Large Small Cap Financial Funds Portfolio Manager, thank you so much, Large Bank Portfolio Manager.