Market sell-off indicates investors think the Fed is ‘behind the curve’: Strategist

Invesco Global Market Strategist Brian Levitt joins Yahoo Finance Live to discuss the latest statements from the Fed regarding interest rate hikes, volatility, shifting consumer demands throughout the pandemic, and the outlook on markets and tech stocks.

Video Transcript

DAVE BRIGGS: For a closer look at the market sell-off, let's bring in Brian Levitt, Invesco global market strategist. Good to see you, man. Happy Friday, except for the markets. Let me reread what Janet Yellen said. I don't expect a recession. She added, a reflection of the underlying economy is not the stock market. Let's hope it's not. But what does this day indicate?

BRIAN LEVITT: Oh, it indicates that the market continues to believe that the Federal Reserve is behind the curve. And so any time you get inflation up where it is, it does speed up an economic cycle. And any time that you see a Fed behind the curve or policy uncertainty persisting, it does create volatility in markets.

And in the last days, we've had very hawkish comments recently yesterday, from Fed Chair Jay Powell, and yet inflation expectations moved higher. And so it's that the market's suggesting that the Fed is behind the curve, now pricing in three 50 basis point hikes over the next three meetings, a Fed funds rate to 3% by early 2023. And so the investors are grappling with the potential for the Fed having to tighten the screws pretty significantly here.

BRAD SMITH: Brian, in addition here to the Fed being behind the curve, part of this, too, is what we've already been seeing in this year's tape, which is some of the pandemic darlings and pandemic plays, they're seeing some of that unwinding of the growth of that deceleration of the growth. How much of that is also intertwined within these moves that we're seeing lower?

BRIAN LEVITT: Yeah, so you had a lot of those names that were trading at pretty lofty valuations amid expectations that the environment that we were living in was going to persist. And ultimately, what we've seen a shift to is some of the more reopening as the Omicron variant has dissipated. Of course, we're still dealing with other strains, but also the move higher in rich interest rates.

And so, for a lot of the names that the market had deemed perhaps a bit more speculative or needed a really perfect environment to do well, as soon as interest rates started to move higher, the markets took out those more speculative names or what they viewed to be longer duration assets. And the attention since has been to focus more on higher quality cash flow generating equities, as opposed to what some would view to be more speculative.

DAVE BRIGGS: Brian, the markets, as you say, pricing in that 50 basis point hike, which we haven't had since 2000. But you said three straight meetings of 50 points. What indication do you have that that's going to happen?

BRIAN LEVITT: That's what the market's pricing in. So if you look at the Fed funds futures implied rates, you're looking at 50 basis points at the next three meetings. You're looking at 3% Fed funds by early 2023. Now, investors can look at that and look at where the two-year has gone and say, OK, the bond market has priced a lot of this in. The challenge that we're dealing with is that inflation expectations keep going up.

And that suggests, you know, you've got a 10-year breakeven in the TIPS market at over 3%. And so that's above the Fed's comfort zone. And it suggests that the Fed has to move. And, you know, we're seeing the equity markets adjust for what is now an expectation of more significant tightening. I mean, remember, December of last year, the market was pricing in two rate hikes this year. Now we're looking at 3% by early 2023. Valuations were elevated, and they're adjusting accordingly.

BRAD SMITH: Brian, when we think about how strong the consumer needs to be right now to weather for the Fed, what they're navigating, the flight towards this tightening policy that is very much contingent on employment sustaining and that participation rate increasing, even at higher wages, as well as, right now, the price stability measures that the Fed is looking to implement.

BRIAN LEVITT: Yes, so the Fed feels comfortable with having reached full employment. They don't feel comfortable with price stability, which is why they're moving. You know, it's almost a paradox. The consumer was too strong in the pandemic and in the months after the initial hit of the pandemic right when businesses were cutting workers and right when businesses had slashed inventory. And so you ended up where we are today, which was an environment that there was just too much money chasing too few goods.

And so the way this was likely to play out this year, what we all had hoped to play out, was that the consumer demand would start to moderate. You had already seen American consumers, when polled, saying, prices were just too elevated. They were going to back off big purchases. That was going to enable the businesses to rebuild inventory. That's how this story was supposed to play out this year.

And then, of course, the Russian move into Ukraine, which has led to a shock in prices in energy and agriculture and other commodities and is also continuing to disrupt supply chains. You put on top of that China's zero COVID policy, and the supply chain challenges persist, and the inflationary pressures persist. So the Federal Reserve's job now is to tighten financial conditions. And they're going to slow demand through tightening financial conditions. And the markets are adjusting accordingly.

DAVE BRIGGS: Yeah, not enough attention, given those China COVID lockdowns. They are out of control, and the few reports you see, they are devastating lockdowns, taking over skyscrapers. Now, Brian, a couple of things Jared Blikre said I want to point out and get your reaction. He said Friday crashes like this are usually followed by a similar one on Monday. Do you expect that? He also showed all the mega-cap stocks just getting pummeled in the last 12 months, down between 20% and 50%. Do you expect that trend to continue throughout the quarter?

BRIAN LEVITT: So in terms of whether Monday is going to follow Friday, I mean, I don't adhere to necessarily to those types of patterns. You know, I think that the market is likely under-- going to be in more volatility, so long as policy uncertainty persists. Now, with the mega caps, what we've seen is move higher in rates and an adjustment in valuations. Those that where investors are questioning models, whether it's a Netflix or whether it's a Facebook, have been hit harder.

You know, I would expect for businesses like Apple or businesses like Amazon or even Microsoft, you know, more of the cloud computing business, I don't-- I think we've seen pretty significant hits to those parts of the market, valuation adjustments with a move in rates. But when you think about slowing economic activity amid tighter policy, investors tend to move back towards favoring those higher quality cash flow generating businesses.

BRAD SMITH: Brian Levitt, who is the Invesco Global market strategist, we're going to continue to watch all of these themes, not just going into the close, but especially going into the Fed's next meeting as well. We appreciate the time and insights here today.