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Markets: ‘It’s become increasingly clear’ the Fed can’t stop yet, strategist says

Comerica Wealth Management CIO John Lynch and UBS Managing Director and CIO of Emerging Markets Americas for Global Wealth Management Alejo Czerwonko join Yahoo Finance Live to discuss how markets are responding to Fed policy, interest rates, and why value is being favored over growth for investors.

Video Transcript

[AUDIO LOGO]

INES FERRE: Here's the closing bell.

[MUSIC PLAYING]

[BELL]

SEANA SMITH: And that wraps up today's trading day. Once again, we are looking at losses for the second day in the row for the Dow, at least. Dow off 350 points, S&P falling for the fourth day in a row, really a loss of just around 1 and 1/2%. The NASDAQ the biggest decline here of the three major averages, off just about 2%.

We want to bring in Alejo Czerwonko, UBS Global Wealth Management chief investment officer of Emerging Markets Americas, and John Lynch, Comerica Wealth Management chief investment officer. And John, let me start with you. In terms of the losses that we've seen over the last couple of days, investors trying to wrap their heads around how aggressive the Fed could potentially get over its next couple of meetings, what's your takeaway?

JOHN LYNCH: Thank you, Seana. Good afternoon. I think, really, it's going back the last six weeks, seven weeks after we hit the-- I guess, it was the October 12 low. We engaged-- entered into our second bear market rally on hopes that the October CPI report was sufficient to cause the Fed to stop raising. We didn't buy into that, but clearly, many investors did, many traders did.

And I think right now, we're having the comeuppance to that. We had Powell's speech last week, and now, all of a sudden, people are looking at the strength in services, the strength in employment. And I think it's becoming increasingly clear to investors that the Fed can't stop just yet. And I think that's why we're seeing the pullback.

DAVE BRIGGS: Alejo, do you agree with that assessment in terms of the drag on the market?

ALEJO CZERWONKO: Pretty much. I think we're up for a couple of pretty volatile months ahead as we go into 2023. This has to do with the fact that the Fed will likely hike by more than what's currently priced in. The economy is slowing. This will impact earnings growth. We're likely going into an earnings recession that is not fully reflected into market pricing today.

So all in, I think the market action of the last couple of days simply reflects the reality that we're learning about the Fed terminal rate, just by how much the economy is slowing. And the picture is not necessarily going to be pretty, at least in the first few months of 2023.

SEANA SMITH: John, I think you tend to agree just in terms of the fact that you said that the Fed can't stop just yet or any time soon. How aggressive, then, do you think the Fed needs to be in order to get inflation, really, under control?

JOHN LYNCH: Yeah, I think Alejo and I should take the show on the road because we do agree. The Fed needs to go north of 5% on the short end of the curve. And earnings right now, projection for the S&P 500, north of 230 from consensus, up $230 in operating earnings for the index next year. We're showing flat earnings growth. So I'm afraid we need to test the October lows again to establish that double bottom. I think the Fed needs to take rates at least to 5% and then hold it.

The Fed-- Powell has made reference to-- and the bond market certainly bought into this, right? There's no ambiguity with the yield curve. But equities have been a little more volatile. And Jerome Powell clearly has stated that rates are going to be higher and for longer. He does not want to repeat the mistakes of the Burns Fed in the late 1970s. So consequently, we think even though inflation has peaked, that is not commensurate with a Fed pivot. And I think that's most important for equity investors to appreciate.

DAVE BRIGGS: All right, got to find out if Alejo agrees with that retesting of the October lows. And also, all the big bank CEOs spoke out today, Alejo. And let's just consume it with one word-- recession coming in 2023. Jamie Dimon says mild to hard recession could hit next year. Your thoughts.

ALEJO CZERWONKO: Yeah, no, I do think that the Fed will need to hike north of 5%. When you look at historical episodes of inflation, not only in the US, but in the emerging markets, it took central banks to put interest rates above the rate of inflation for a prolonged period of time to bring inflation expectations down and bring inflation back to target. And we do not think that what's going on in the US today will be an exception.

As I said before, the economy is slowing. We are seeing the labor market normalizing, as we speak. It started with tech. We all know the layoffs and reductions in force that we've seen over the last few weeks. And now, as you've rightly highlighted today, a number of financials have indicated their intention to reduce headcount or slow the pace of hiring. I think these are just a few indicators of the fact that economic activity is going to continue to moderate as we go into 2023.

This is going to impact earnings. And none of this is currently fully priced in. Therefore, our position and recommendation has to do with tilting portfolios towards quality, towards defensive strategy sectors. Be ready for challenging few months, even if, as the year matures, we'll find an opportunity to re-risk portfolios, as we see turning points in growth, turning points in inflation and interest rates. But the path from here to there is not going to be smooth.

SEANA SMITH: So John, given this backdrop, let's just drill down into more specifically what you like when it comes to the value versus growth debate, when it comes to domestic versus international. Where are you seeing the most opportunity?

JOHN LYNCH: Well, Seana, we just published our 2023 market outlook yesterday. And we are favoring value over growth. We're favoring domestic over international. And as I mentioned, we test the October low. We get through what we expect to be base case, mild recession in the first half of the year. At that point, I think the market starts to price in not necessarily a policy shift, but a policy pause. And you get to June and July, we start to look at 5% or 6% earnings growth in 2024, implying a 17 or an 18 multiple on that.

We think the index, the S&P, would be fairly valued in that 4,100, 4,200 range year end. But that would be cyclical leadership within the value space, you know, the short duration-type equities with energy, industrials. Financials are looking more and more attractive each day, unfortunately, these days. But we do think they'll catch a bit by midyear of '23.

DAVE BRIGGS: And Alejo, we'll close on emerging markets. As you say, domestic policy choices will matter more than ever in this environment. Why so?

ALEJO CZERWONKO: What I argue is that there's no room for error, as we learn from the UK example just a few months ago. If your domestic policy choices are poor, the market is going to let you know quite promptly and aggressively. I do think that the majority of emerging markets are well aware of this reality, and that they will pursue orthodox monetary and fiscal policy paths as we go into 2023. Those who decide otherwise will feel, of course, the consequences.

That's why we do see a number of opportunities within emerging markets. And emerging market equities countries, such as Brazil, stand out in emerging market fixed income. We see value in the short to intermediate area of the curve and the higher end of the credit quality spectrum.

DAVE BRIGGS: All right, appreciate that. Alejo Czerwonko, John Lynch, thanks so much for being here, both of you.