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A taper tantrum is a ‘low probability event’: Strategist

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Michael Arone, Chief Investment Strategist, US SPDR Business at State Street Global Advisors, joins Yahoo Finance to discuss the market outlook amid earnings season, expectations for the Fed’s Jackson Hole meeting, and hedging against inflation.

Video Transcript

ALEXIS CHRISTOFOROUS: Let's stick with the markets now and bring in Michael Arone. He is Chief Investment Strategist at State Street Global Advisors. Michael, good to have you here on the show. Would just like your take on the market action we've been seeing-- I mean, earnings results continue to beat lowered expectations-- that lower bar. And we continue to see some of these indexes hit record highs. What's really driving this market right now?

MICHAEL ARONE: Well, I think it's interesting, Alexis, that there has been a lot of noise throughout the summer that could have derailed this market rally-- whether it was the Delta variant, DC dysfunction, the China crackdown, the Fed taper talk, and it didn't. So to me, the biggest driver of returns so far this year and this summer has been the outstanding earnings results.

Across the board, whether it's revenues, earnings per share growth, or even profit margins, surprisingly, the numbers have been outstanding. And one of the interesting things that's been happening is that stock prices have been struggling to catch up with future earnings growth prospects. And multiples have actually been contracting. So this gives investors a bit of confidence that valuations aren't as bad as they seem, and that these stock prices will grow into those earnings.

ALEXIS CHRISTOFOROUS: OK, so where are you seeing the most opportunity when it comes to valuation? Would you go as far as to say you're seeing bargains in certain sectors right now? And if so, which ones?

MICHAEL ARONE: Well I think given the economic picture and the potential for the economy to continue to recover from the pandemic, it looks like the Delta variant may be peaking in places like Texas and Florida, we think interest rates and inflation will continue to see some upside as the economy recovers. As a result, we still think the cyclical sectors of the market remain attractive.

And Jared has just shown the charts there-- so as the economy recovers, things like energy, financials, industrials, materials should perform reasonably well. And they're still at discounts relative to the broader market. And Alexis, the kicker here is their earnings growth is much higher than the broader market. So it's attractive from multiple standpoints.

ALEXIS CHRISTOFOROUS: Let's talk about another possible catalyst for this market, and that is the Federal Reserve's virtual Jackson Hole symposium which kicks off tomorrow. We're going to hear Fed Chair Powell speak on Friday. This is, of course, coming off of last week's FOMC minutes from that July meeting, which were a little bit more hawkish than I think some investors were expecting.

What are you going to be listening for in that speech from Powell?

MICHAEL ARONE: Well, I think the key here is about, is there any movement on their interest rate expectations? So the good news is that markets have seemed to take in stride the taper talk. They're expecting an announcement on tapering with a very well-telegraphed timeline that's very gradual in pace. So deviations from that will be a risk, so I'll be listening for that. And then certainly any kind of signals that interest rates may be coming sooner than the market's anticipating-- now, Alexis I don't anticipate that, but that's what I'm going to be listening for because that's what the market will react to from a negative standpoint or volatility standpoint.

ALEXIS CHRISTOFOROUS: Do you think that the possibility of a taper tantrum is pretty much 0 at this point because the Fed is trying to be as transparent as we've seen a Fed be in a very long time?

MICHAEL ARONE: I don't think the probability is 0, but I do think it's a low probability event because of the fact they've been so transparent, the market is expecting it. So the tantrum would take place if the timeline was far more aggressive, far shorter, and much shorter in duration, and reducing this unwinding much more quickly. That would be a surprise and then you might see a tantrum then. But again, I'm not expecting that. I give it a low probability, but it's probably not 0.

ALEXIS CHRISTOFOROUS: Would you say that we are at peak inflation and peak economic growth, at least, for the time being? Because we know that a big part of that formula for the Federal Reserve is inflation. And if it gets a little too wily, that could certainly move up the timeline for interest rate hikes and the bond tapering.

MICHAEL ARONE: Well, I think the Fed's in a very difficult position, because I do think we're at peak growth rates in things like economic data and earnings. So future quarters, I think the rate of growth will be slower. It'll still signal an expansion, earnings will still be growing, but at a much slower rate.

Now, on the inflation front, although I do believe it's largely transitory, the period in which it's transitory is probably a bit longer than some are expecting. So it's kind of an interesting one in that the Fed will be removing some monetary policy accommodation at a time when inflation is high, but economic and earnings data is starting to roll over some or slow some. That is a bit risky going forward. And it's something that I'll keep an eye on.

ALEXIS CHRISTOFOROUS: I think you're talking stagflation there, Michael. And if that's the case, as a chief investment strategist, how do you recommend investors hedge against inflation? We've seen investors get creative by doing that in the cryptocurrency space. Of course, there's good, old fashioned gold. But what are you telling clients?

MICHAEL ARONE: Well, certainly gold, I think, has proven as a decent inflation hedge over the longer term. So that's one option. The thing that's kind of interesting is if you expect inflation to push up interest rates, and the Fed will eventually tighten and rates will creep up, cyclical parts of the market that benefit from higher rates and inflation should do well.

And that goes back to that cyclical value trade we talked about up front. So your energy, your materials will benefit from higher prices, and your financial stocks will benefit from higher rates as their profitability gets flatter as interest rates begin to rise. So I like those cyclical trades given the inflation expectations.

ALEXIS CHRISTOFOROUS: All right, Michael Arone, Chief Investment Strategist at State Street Global Advisors, thanks for being with us today.