The Fed is trying to ‘remain weak while growing below trend,’ strategist says

Alessio de Longis, senior portfolio manager at Invesco Investment Solutions, joins Yahoo Finance Live to discuss the latest inflationary trends, recession indicators, the Federal Reserve, and global markets.

Video Transcript

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JULIE HYMAN: Well, Wall Street's gloom might be here to stay as markets deal with what our next guest calls inflation shock, but that pessimism may not mean big trouble for the broader economy. Let's talk about all of this, parse it out. Alessio de Longis is Invesco Investment Solutions senior portfolio manager. Alessio, what a pleasure to see you. It's been a while. So welcome, welcome.

Let's talk about this idea that we are, indeed, seeing issues in the broader economy. You say in your note to us that we've moved to what is now a contraction regime. What does that mean, and how are you sort of applying that framework to how you're thinking about investing right now?

ALESSIO DE LONGIS: Always good to be with you guys. A contraction regime is a regime where the economy is expected to grow below its long-term trend and to continue to decelerate, so to remain weak while growing below trend. And that is exactly what the Federal Reserve and the global central banks are trying to do.

We saw Chair Powell specifically say, in order to bring inflation down, it will be necessary to have the economy grow below its long-term trend for some time and to increase slack in the economy. Increase slack in the economy simply means we need to see the unemployment rate rise. Now that's the way to adjust-- there's no other way to adjust inflation down from the demand side, which is what the Fed controls.

Now, what is difficult about that environment? What is difficult is that it's a very tight rope. It's very difficult for the Federal Reserve to strike the balance between growing below trend, but avoiding a recession. And that is an environment that becomes particularly tricky for risky assets, for financial assets in general and market volatility.

BRIAN SOZZI: Alessio, all this sounds like a train wreck between what the Fed is doing here in the US. Now we have the Bank of England out this morning, 50 basis point rate hike of its own, potentially pushing the UK economy into a deep recession by the fourth quarter of this year. So you're getting all of these coordinated rate hikes around the globe. Isn't this a perfect environment to start raising cash?

ALESSIO DE LONGIS: Well, there is no other way, right? You are highlighting correctly what the relationship is between raising interest rates and hurting the economy. The issue is that central banks don't have that option. Central banks today have one job alone, which is to bring down inflation. And they need to reduce growth. They need to reduce demand in order to accomplish that.

So it's not a great environment for financial assets, which have been holding up quite well, despite-- why do I say that? Because despite the double digit underperformance in risky assets this year, they have basically matched or even outperformed government bonds. So in that sense, in my opinion, global financial markets have not really priced a recession yet. What they have repriced is the higher dividend discount yields, is the higher discount rates that are applied to future cash flows.

BRIAN SOZZI: Well, then, Alessio, if the market hasn't priced in, how overvalued is the market here?

ALESSIO DE LONGIS: Valuations are a lot more attractive today than they were a while ago. So that is comforting. I think in the classic recessionary environment, even of a relatively mild recession, what you tend to see is a gap between global equities and global fixed income by about 15% to 20%.

So you could see a more-- an additional correction in equity prices by about 10%, 15% in a recessionary environment, coupled with the long end of the curve, long global bond yields, global bonds to deliver a positive 5% to 10% return, right? So the order of magnitudes does not need to be a shock in our type of situation. Not every recession has to translate into a panic and financial crisis.

JULIE HYMAN: Alessio, I want to ask you about what's going on in Europe as well. Today we heard the Bank of England was raising interest rates. The ECB is expected to continue to do so as well. You could argue the economic situation there is more alarming, perhaps, than here in the United States. So would you apply some of what you're talking about there, or do you have to think about that differently?

ALESSIO DE LONGIS: No, certainly, certainly. Next to the global picture which you highlighted, which affects everyone, Europe is additionally hurt by the energy shock due to the Ukraine-Russia conflict. The energy shock hurts Europe much more. And its current account surplus has basically evaporated. The inflation shock and the impact on demand is going to be-- and it is already-- larger in Europe.