Market action shows ‘a bit of delusion going on here’: strategist

Julian Brigden, Macro Intelligence 2 Partners (MI2) co-founder and President, and Michael Kushma, Morgan Stanley Investment Management CIO of Broad Markets Fixed Income, join Yahoo Finance Live to discuss the market trends against the Fed's interest rate hikes, inflation, earnings season, and the outlook of a recession.

Video Transcript

[BELL RINGING]

- And there you have your closing session on the 13th. 13 not an unlucky day for the markets today, as we see how all three major indices end of the day in the green. We see the Dow up over 1% there at 345 points. The S&P 500 there up almost 50 points there at 1.12%. And look at the NASDAQ. Up over 2% there at 272 points. What a difference a day makes indeed.

But let's break this down with Brad, Dave, and myself, as well as our market panel. We have Julian Bridgen there, Macro Intelligence 2 Partners MI2 co-founder and president and Michael Kushma, Morgan Stanley Investment Management CIO of broad markets fixed income. A big welcome to you both. So, Julian, I want to start with you here. Looking at what the markets are digesting right now, what do you think that optimism is attached to?

JULIAN BRIGDEN: Well, I think it's a bit of delusion going on here. I'll be brutally honest. I think today we bounced very hard on the announcement that Amazon is going to hike prices 5% and push through that fuel surcharge. At the same time, we've run into a natural buffer in sort of fixed income in this sell off that we've been seeing in the rise in yields because we've hit some massive, massive technical levels. 40-year downtrends right off across the curve when you look at 2-year yields all the way out to sort of 10-year yields. And I think the equity market is forgetting that if people like Amazon keep pushing through price increases, then bond yields haven't stopped here.

So I just think it's one of those days where we're trying to sort of adjust to a bit of indigestion and position adjustment. I really don't think any of the fundamental trends have changed. So, Michael, with that in mind, at what point do you believe some of the price increases would create some demand destruction on the other side?

MICHAEL KUSHMA: I think it's already happening at the margins. The stories about consumers substituting lower priced goods for higher priced goods, postponing purchases of durable goods-- consumer confidence is at multiyear lows because income growth is not keeping pace with inflation. So I think there is demand destruction going on underway. That's actually a good thing from the point of slowing down the economy in the future.

- Julian, do you believe that inflation has at least at this point peaked? We heard about your delusion regarding the stock performance today. But what about inflation? Most see some positive signs that it's on its way down.

JULIAN BRIGDEN: No. I don't, I'm afraid. I think our work continues to suggest we see materially higher inflation pressure, particularly on the core side, through to the, let's say, beginning of Q4. And it's going to materially higher. I mean, I think if you looked at the PPI price pressure that we saw today, I mean, the market had been set up for very by the CPI.

And I think it was oversold, as I said, the fixed income market at big levels. But we got horrible, horrible PPI data. There was absolutely nothing in that data which suggests a slowdown. We have goods demand rising, or pricing rising, at 15.7%. And we have services rising at 8.7%. And yet somehow people think that we're going to shift demand from the goods sector smoothly into the service sector and we're not going to take that price pressure with us. I just think that's wrong.

I think if you saw what Delta announced today that they've got the strongest order book basically in their history, we are starting to see that transfer of the service into the service side. I think the consumer is very well placed to afford that. They've got lots of credit available for them. I don't know if anyone's been on a plane recently and had a credit card application form shoved down their throat. But I certainly have been. And I think this means that you've got very, very robust inflation pressures going to continue.

- So then, Michael, in these conditions then, what are the opportunities that you see in the fixed income market?

MICHAEL KUSHMA: Well, it's very challenging. When you have an inflation shock, it's the worst possible scenario for fixed income unless you also have a real interest rate shock, which is where we're also having because the Fed is pushing up interest rates to combat inflation. So a combination of real interest rate increases, inflation increases is pushing nominal rates up very, very sharply.

We've seen that in the past month. One of the worst months. Even though we've had a really bad year, the last month was almost even worse. Real interest rates on TIPS are up 1%, which is almost unfathomable to see a real interest rate rise that fast. So the places to hide we see is in floating rate assets. Assets that reset over short-term interest rates.

So as rates go up, you get higher income. Fairly short durations. We don't know how the economy's going to perform in the out years. So keep your maturity structure fairly short. And take on a bit of credit risk, particularly as it pertains to consumer and households because their balance sheets are still very strong. House prices are going to moderate. But they're not going to suddenly crash and burn. So lending to households through asset-backed securities markets, shorter duration assets, investment grade, you can still earn a decent yield, which will not be hurt if inflation and interest rates continue to rise.

- So, Julian, with the Easter pastel palette picture that we've been painting here in this conversation, is there any measure at which the Fed can avoid a recession and triggering one?

JULIAN BRIGDEN: Well, statistically, if you look at their performances since sort of 1970, they've got a one in four chance. I mean, it's that simple. I would suggest it's actually lower than that given hellaciously overvalued assets that we've got, particularly here in the United States and particularly in some of the mega-cap tech.

I mean, I think as they start to remove accommodation in terms of the balance sheet, I think we're going to find out-- and history suggests is the case-- it's a much, much more powerful tool than interest rates are. I think the market is increasingly immune to interest rates because they are just high on this wave of Fed balance sheet. I think, as I said, when that starts to shrink, I think we're going to find things may get a lot more bumpy and a lot more quickly.

- Very optimistic today. Julian, that one in four chance of avoiding a recession, your thoughts on that, and how much should we be focusing on the balance sheet reduction rather than the interest rate hikes? So I'm actually reasonably optimistic. I'm just not optimistic on Apple. People criticize me because it's gone up 240% in the last two years and I don't want to buy it here. I think there's lots of things that you can buy. I'm buying an awful lot of metals, mining resources, energy, overseas stocks. I just don't want to be invested in the stuff that's gone off an awful lot.

I think, look, when it comes to a recession, I don't see that yet. I think as Michael pointed out, I mean, part of what you're supposed to see in a tightening of financial conditions, which is how the Fed influences the economy, is some slower data. And we're beginning to see that. You're certainly I think going to see it in some of the housing activity going forward, also with Michael, I don't see a crash in house prices though at this point.

A slowdown maybe might be nice. But it's not a crash. And when I look at the broader economy, I actually think it's pretty robust. I mean, both of the PMI reports that we had in the last couple of weeks have been very, very strong. Very, very strong. And the service one toits about 17 of 18 sectors seeing growth gains. The manufacturing sector is basically their order books are full through the whole of this year.

I don't really see a recession. That's why I'm not really that bullish on the interest rate side. And I don't see the inflation pressures abating because until you get materially slower activity, I think companies have the pricing power to push through those increases. It's just that that has a consequence. The consequence is higher inflation and higher bond yields, which have to keep going until the equity market slows down.

- So then, Michael, just quickly, as we look at some of the three shots, obviously, we've been talking about the Central Bank raising interest rates, tightening policy there. Also then you have things that are outside that couldn't be predicted, things like COVID and geopolitical events like Ukraine and Russia. How should that be informing how people view what happens outside of what the Fed is actually capable of controlling?

MICHAEL KUSHMA: Well, you have to look at how those shocks have impacted behavior and prices, whether it's commodity prices, whether it's housing prices, whether it's policy making. So one of the issues we have in the US is that ex post it looks like the US government handed out too much money. Demand has been too strong relative to the ability of the economy to deliver those goods and services that people want with all the income they have.

Now, it's easy to say, look, we didn't need that much money. But it was not clear back in 2020 and 2021 how bad this was going to be, how long it was going to last, et cetera. The surprise has really been the supply side being so messed up on all levels. We haven't seen this if ever.

So we've had a very unusual combination of factors which have hit us which has made it very difficult because when you have a big supply shock like the pandemic has caused and the Russian-Ukraine situation, a further exaggeration of that effect, you have the ability to produce fewer things as things are locked down and people don't go to work. People have the same amount of money before, but government replaced everything that's lost. So something has to give. And that's inflation.

And inflation now is the consequence of getting out of the economic pandemic that we've had. So what you really have to look at is where are the sources of stress. And right now, it's interest rates. When inflation is high and demand is strong and the supply side is not being rebalanced fast enough to meet higher demand, you need to slow demand. The Fed works through higher interest rates.

And that will take time because households are in really good shape. Corporate sector is in really good shape. So it may take outsized interest rate increases through this year and maybe next year to actually slow the economy down. So if there is a recession, it's not going to be for a while, as it was just mentioned. At the earliest I could see it is in late in the second half of next year.

- Joe and Michael, appreciate the commentary and the insights here this afternoon. We'll have to continue the conversation in the future. That's Julian Bridgen, who is the Macro Intelligence 2 Partners MI2 co-founder and president and Michael Kushma, who is the Morgan Stanley Investment Management CIO of broad markets fixed income. Gentlemen, thanks so much for joining us here this afternoon.