2023 Midyear Perspectives: In the Hot Seat

John Moninger: Hi, my name is John Moninger, head of U.S. Distribution for Allspring Global Investments. And today, we're going to have a conversation about what's going on in the global economy and what's going on in the global markets. Joining me, I have two great colleagues who are going to spend some time with us talking about what's happening. And what we're going to really try to do is break down the hard questions. We're really going to get after what matters, how they're thinking about things, and use it as a way to help you think about what's going on in your business. So, let's think about what's happening today. We have issues around inflation. We have issues around rising rates. We have the impact of those rates and what it's doing to capital markets. And through that, we have decision-making going all over the place. We have asset flows moving all over. We have lots of indecision, frankly, happening today. And through that we want to cut through the noise. So, joining me I have, again, two great colleagues: Ann Miletti. Ann today is the head of Active Equity Investments as well as our chief diversity officer for the firm. And then also we have Henrietta Pacquement. Henrietta is a senior portfolio manager, head of Global Fixed Income, and head of Sustainability for Allspring. So, first of all, thank you for joining us.

Henrietta Pacquement: Lovely to be here.

John Moninger: So, let's get right into it, right? I think about what's going on in markets today. I think about the second half of the year. But before we do that, we should do a review. Let's talk a little bit about what happened in Q1. And, Ann, maybe I’ll start with you. What went right? What did you get right in the year? As you thought about coming into the year, you made some predictions. You had some thinking, what was going to happen? What worked? What didn't work?

Ann Miletti: I think what worked, which maybe surprised a lot of people, is that growth had a pretty big rally at the beginning part of the year. And we wrote about this at the end of the year that growth had really been pretty beaten out. Multiples were compressed—not too surprising given the rise in rates—but the multiple compression was pretty severe and yet fundamentals were pretty good within many of the growth stocks. Earnings were going up, not down, and so that left some of those growth stocks looking pretty attractive. And, so, you had a mad rush at the beginning of the year into growth stocks. That didn't surprise us that much. I think maybe what did surprise us is the overall equity returns that we saw.

John Moninger: What do you think you got wrong? I know it's hard for us to always think about these things. But if you were to assess back, like what were the predictions you thought what happened that didn't materialize or things you just got flat wrong?

Ann Miletti: I think China reopening has been a little bit disappointing, probably not only for us, but for many people. And that continues to be an area that we're looking at pretty closely. And it's been disappointing.

John Moninger: Yeah, yeah. Henrietta, what about you? When you think about your year and how it's transformed, what went right for you?

Henrietta Pacquement: Well, we thought that 2023, after a nasty year in 2022 that we can leave in the history books in the fixed income markets, was going to see a comeback of fixed income assets. And that really is what we saw. And it's been quite broad, be it on the government side, be it on the credit side, and across some of the sectors that we invest in. So, that really played out as we hoped and it gives a lot of opportunity to investors with a different set of risk profiles. And, so, that's something that we've really seen come to fruition over the first half of this year.

John Moninger: Yeah. What did you miss? Did you see anything that you wish you got right or you thought you were getting right but it just went the other way?

Henrietta Pacquement: There was one big surprise, and in a way, I'm surprised that you didn't mention that one. But after all the pain that we had over the Great Financial Crisis and all the banking regulation, how did we see what happened in the regional banks in the U.S.?

John Moninger: Yeah. That was a big one.

Henrietta Pacquement: That, I must admit, was a big surprise, for us and for the markets. And we really felt that that was probably one of the sectors that was going to do well, given the higher-rate environment. But that was not the case. And I think the rolling back of regulation, particularly in that specific area of the banking market, was a surprise.

John Moninger: Yeah. And what a ripple effect as well, right? What that's created is amazing. When you think of that, does that change how you think? Like going forward, what does that inform for you looking ahead? Does that change any of your perspectives on any sector for that matter, never mind the banking sector?

Henrietta Pacquement: So, two things. In a way, a bit of a silver lining. They're going to help the Fed (Federal Reserve) tame some of the more stickier inflation that we have. So, I think that's a positive benefit. But it is likely to put a bit more pressure on growth given that credit availability is going to be less prevalent.

John Moninger: Yeah. Ann, on your side, I mean, same thing. The equity market obviously has struggled a little bit in the news around what happened in the banking sector. How do you think of that now and how do you think of that going forward? Are there opportunities there or are you still sitting cautiously watching what's going on?

Ann Miletti: Yeah, well, it certainly has been a surprise and was a surprise in the equity space as well. I think for us, we didn't have as much exposure there. And, so, you're right, Henrietta. It was a surprise to everyone. Equity markets, fixed income markets as well. And I do think the most concerning part of it is what it will do to the economy going forward and certainly the impact that it will have on the equity markets. But to Henrietta's point, it's going to help the Fed. It's going to help the Fed slow things down pretty dramatically. Again, small and mid-size banks do a lot of funding for small- and mid-cap companies. And, so, while that is seemingly negative in the near term, what I think investors really need to start thinking about is how much small- and mid-cap stocks have underperformed. And, so, if I just give you a couple of statistics around that, 5 years in a row, the Russell 2000 has underperformed the Russell 1000. And in 9 out of the last 11 years. So, 5 consecutive years in a row and 9 of the last 11 years.

John Moninger: Wow.

Ann Miletti: And those statistics are pretty hard to find when you go back in history. Small-cap stocks also typically grow faster when the economy slows. But there's this pause—one because of the regional banking crisis. Also, if we go into a little bit of a recession, small-cap stocks usually hold back a bit until you start to see that recovery phase. For an investor, though, you want to be there before everyone else is. And, so, if your allocations are low, that's an area where I think it's just ripe for opportunity.

John Moninger: Let's maybe step back a little bit as we look ahead, and let’s start, maybe, Ann, with you is on inflation, right? What's your thoughts on how inflation plays out from here? Is it going to be overdone? Is it going to be contained? And then what are the impacts of that?

Ann Miletti: I think we have seen the worst of it, but I don't think it's necessarily going to be a straight ride down from here. We are seeing, if you segment out the pieces of inflation, you're seeing areas that certainly probably are directionally headed down. There will be other areas, though, that will be a little bit more challenging to stay in the downward flow. And, so, it’ll be probably a bumpy ride. We might have a couple of months where the direction will be right before we hit summer. And then just when you look at comps and some of the trends, it might get a little bit more challenging to stay in that downward slope. Either way, I think we’ve seen the highs and that’s a positive.

John Moninger: Yeah. Henrietta, how about you? Any differing thoughts there on inflation, and what's your perspective?

Henrietta Pacquement: I think you've covered a lot of ground there, Ann, in your comments about inflation. A couple of things that I like to add there. Yes, we have had progress—be it food, be it energy, and a bit more stickiness on the service side. I think one thing to look out for into the second half of this year is what happens to the energy piece. We did get a bit lucky over the winter. We had a mild winter. That helped Europe considerably. And, also, company and individual behavior meant that consumption, particularly on the gas side, was lower than it has been historically. And, so, it was starting from a much better position in Europe in terms of some metrics. If you look at gas fill levels in Europe—I know it's an arcane thing to look, but it's actually important—we're at 60% at the moment and that compares to 30% roughly this time last year. So, we're in a much better position there. And you have had a bit of a reallocation in terms of supply chains on the energy side. But I think it is still something to look at into this winter as the year progresses. And that could be another push on the inflation side. That being said, I do think that we are on a better track on the inflation side. Now your comment about stickiness is an interesting one because we also like to look at the longer term and are we going to return to that low inflation that we've enjoyed over the last couple of decades? We think that might be a bit more of a question going forward. Two reasons, really. Demographics is one. We're looking at the labor markets and some of the tightness there. There's the potential for that to continue. And so that could be a bit of pressure there. And, also, the risk of net zero. That is going to need funding and could cause some longer-term inflation pressures. So, interesting to look at in that regard as well.

John Moninger: Henrietta, I'll stay with you on moving out the curve. I think there's a whole bunch of money moving to cash, right? We've seen a massive influx. We've been a beneficiary of that, as well. But at the same time, when do you go out? When is the catalyst to go? Do you go now? What are your thoughts on the curve, the interest rate curve or the yield curve, for those we're talking to, and what's the recipe for success as we look ahead?

Henrietta Pacquement: Yeah, we've seen a variety of behaviors, actually. You talked about cash. We've also seen investors go into areas that they've been historically underinvested in. I'm thinking European credit, for instance. Roll back, call it 18 months ago, you had yields of around 10 to 20 basis points for investment-grade credit. Now that's 4%. So, it's been an area of the market where people have been historically underinvested. So, we're seeing interest there and some movement in terms of flows. As you said, a lot of cash, which is actually effectively sitting on one's hands and not taking a view. So, I think we've got a lot of cash on the sidelines looking to move. Now, if you look at the various dynamics along the curve, on the short end, yes, it's more about inflation—fighting inflation and the central banks. As you move out along the curve, it's more about growth and what we're expecting there at this point. And given that we've got a bit more of a mixed picture potentially in the second half from a growth perspective, that starts opening up opportunities. So, we still like up-in-quality trades, but we do think that given the yields on offer, if you do your homework, there are some nice opportunities depending on your risk profile, depending on who you are and your investment horizon.

John Moninger: Yeah, great. Ann, let's go back to you on recovery. Let's start with recession. As fears of a recession, one could argue we are probably already in it and we don't even know yet, what does that look like? When do you think we will be in one? And then, two, what does recovery look like in the equity markets specifically?

Ann Miletti: There's a lot of signs pointed toward a recession risk. And I think one of the things that I love about Allspring is that we do have this Allview approach that we're not projecting down to our investment teams that recession is imminent and here's how we have to invest our clients' portfolios. We allow the investment teams to think very much from a bottom-up perspective and look for opportunities that they see. And through that approach, I still think we see risk, right? Risk from the regional banks, risk from other areas of the market. However, with those risks, there are still plenty of opportunities and I think it's because of this narrowness in certain areas of the market that have worked and those that have not worked. And, so, I think to something you said, Henrietta, a little bit earlier that there's so much cash on the sidelines. And to your point, John, too, where investors have been a little bit fearful about what to do, in some ways, that's presenting a lot of risk that we'll have this surge up in equities a little bit sooner than we normally would. And we're not going to have the opportunity to be thoughtful about how to put money to work when you see a recovery. So, I think the tactical decisions are what's really important here. Like for me, it's always been really difficult on the allocation. That's clearly the clients and their needs and what's important to them. But for us, it's the tactical. And so, it's looking at these areas of the market that have showed significant underperformance. So, stock selection is critically important right now.

John Moninger: More than ever.

Ann Miletti: Active management, I think, is really, really critical in this environment. And I think that's something that we can really help our investors with today.

John Moninger: Do you agree with that, as well?

Henrietta Pacquement: Absolutely.

John Moninger: Are you seeing more of an opportunity today? I think you mentioned it before—issue selection matters more than ever. Up in quality, I think, were the words you used. How do you think of that going forward and putting the investor in the best position to win?

Henrietta Pacquement: Yeah, I think absolutely. And it's true in the equity markets, certainly true in the credit markets. And depending on where you are in the credit spectrum, it's more and more important. And so, yes, you need to do your homework. You need to understand how these companies are going to react to a high-rate environment. So, it's a question of being nimble and really looking at the credits and seeing what maturities they've got and how they’re funding themselves over the next few years.

John Moninger: So, Henrietta, you do a lot of work, obviously, overseas. You're in foreign markets and you can't have this conversation without the geopolitical risks that are sitting out there today. And there just seems like every day they're becoming more. How are you factoring that into your assessment? I know you're doing a lot of bottom-up work, but you still have the overhang of that. How does it come into play?

Henrietta Pacquement: I think you have to take it into account. And you're talking about overseas. Actually, I get to start with the U.S.

John Moninger: That's right. Fair enough.

Henrietta Pacquement: I mean, you look at the U.S. and the hand-wringing that we're having about the debt ceiling discussions. Yes, it is something that we have to live with. And I think there has been a pickup recently in terms of geopolitical risks. If you look at a variety of geographies, it's not just Eastern Europe, but it's also the relationship between the U.S. and China. Some of the trends from a political perspective in South America. So, I think it's something that investors need to live with and adapt to. And it's been quite extraordinary to see the adaptation post the invasion in Ukraine last year and what investors and companies have started thinking about, making sure they have considered the riskiness of their supply chain.

John Moninger: Ann, you obviously invest in international markets, as well. How does one think about international allocations in the equity markets today?

Ann Miletti: It's been a difficult area for investors and the U.S. has been maybe the best house on the street for a while. But as Henrietta pointed out, we haven't been without our own challenges and problems. And emerging markets especially have a tight correlation—actually, the reverse correlation—to the dollar, right? And, so, the dollar has been very, very strong in 2021, 2022 especially. And that's been really tough on emerging markets. We started to see the dollar flatten out at the beginning of this year and show signs of weakness. And I think that weakness really is a good opportunity for the emerging markets. The other point is that many emerging markets started to increase rates aggressively, interest rates aggressively, ahead of the U.S. Brazil, I think, they got as high as 17%. They're on the other side of that, so that headwind is now becoming a tailwind. And they're taking rates down. And, so, while that might not work immediately, it slowly catches on. Their economies light up a lot faster than ours do. And, so, again, with a lot of money on the sidelines, reallocation efforts happen pretty quickly and emerging markets could end up looking like the best house pretty soon.

John Moninger: Interesting. As you think about popular thinking about looking ahead, where do you diverge from that? Are there positions you have in your mind about the way you're approaching the markets that likely differs, and Henrietta, maybe I'll start with you, differs from where the competition sits today, or where the consensus is today is probably the best question?

Henrietta Pacquement Well, I think probably the non-consensus or divergent view is that we get a soft landing. We avoid recession. I think that's a real potential. If you look at some of the results that are coming out from the various companies in the last few days, they're not that bad. The consumer is pretty resilient. I mean, it's had a lot thrown at it over the last year.

John Moninger: It's still holding up.

Henrietta Pacquement: And it's still holding up. And it's not just in the U.S. It's actually internationally, as well. So, yes, I suppose a divergent view is that the central banks have played a blinder and they got it right.

John Moninger: Yeah. Amazing.

Henrietta Pacquement: Not an easy exercise to do. Maybe optimistic, but I think that justifies having a mix in your portfolio, some diversification, some exposure to rates, some exposure to growth at this point in time, because they have been quite fast at dealing with the problem. A little late to start, but they caught up.

John Moninger: Yeah. Ann, what about you? Any divergent views for you as you think about consensus out there today?

Ann Miletti: Certainly, it is challenging to be really optimistic about all the global tensions that are out there. And, Henrietta, you talked about them and we see a lot of them. There's a lot that potentially could go right. If we had peace talks in Ukraine, if we had the U.S. and China start to come to the table, have more talks, all of those things could actually fuel the equity and the fixed income markets and create a catalyst that nobody expects today. Those are all things that are not being talked about. Again, as much as I tend to worry, even as an equity investor, I'm a professional worrier and our job is to focus on risk—it's also our job to focus on reward and the upside. And, so, I think too little time is being spent on what’s the upside potential. And when you look at individual names, not just S&P multiples or Russell multiples, if you look at individual company P/Es, there are some out there that are really, really cheap and really high-quality companies that will survive. And I think there’s real opportunity.

John Moninger: So, another question I had is around, we talked about riding the curve and where we should be in yield, and we talked about the potential equity recovery, Ann, and how that might play out. The other question is another scenario, which would be a sideways market where we were range-bound for a long period of time. We’ve seen cycles in the market where this could go on for 10, 15 years. Maybe, Henrietta, I’ll start with you. What are your thoughts on a range-bound market, and what does that mean to you?

Henrietta Pacquement: I like it. I like it. It's Goldilocks. What's not to like? You're back in an environment where you have yield, right? You're back in an environment where yield is not just in the U.S., it's actually global. So, you got an opportunity to explore the full spectrum of fixed income. And so, actually, a range-bound market with less intervention from the central banks would be a blessing. And you have a bit more to work with as an investor. And companies that are going to thrive, some that are going to fail and be let fail and that means more stock picking. So, I'd be definitely very happy with that.

John Moninger: So, issue selection matters.

Henrietta Pacquement: Absolutely.

John Moninger: Diversification matters, right? But a good environment for you. Ann, how about you? Sideways markets present a different challenge potentially in the equity markets, but I'd love to hear your thoughts and how it works for you.

Ann Miletti: Yeah, it doesn't sound super appealing, I think, to investors when you say sideways markets after seeing double-digit returns for so long for people. But I agree with Henrietta. I mean there's some real positives. I think the challenging part for equity, for active equity investors, actually over the last several years has been how do you differentiate yourself when index returns have been pretty high. Like just invest anywhere. It didn't matter. That story, that chapter, whatever has ended with higher inflation probably for longer, as you pointed out, Henrietta, for very good reasons and higher rates. I think we are in a new regime. I think what we see now is you have to have companies that are functioning a little bit differently, that have better balance sheets, higher cash flow, management teams that have experience that can be more flexible and manage through it. And it is hard to pick the right securities. But if you're focused on doing that, you can still generate really good returns in the equity market in a sideways market by owning the right stocks, right? You just don't want to own everything.

John Moninger: So, as we recap the discussion today, my final question to you is what are the two or three things, Ann, I'll start with you, that investors should be thinking about and preparing for in the next six months?

Ann Miletti: Not to let emotions get in the way of decision-making. I think that is really, look, it's been something that investors have had probably a hard time doing, just given the volatility, the news flow, all of the challenges. But I think stick with the allocation decisions you make. Again, make those tactical decisions. Think about the areas of the market that have underperformed, that no one else wants to be in. Those are probably the areas that are likely to give you the best longer-term returns. And, again, it is hard to invest in these cycles, but history would suggest that if you sell now, you have to be right twice. You got to time it right going out and you got to time it right coming back in.

John Moninger: Yeah. Great. Henrietta, how about you—two or three things that folks should be thinking about for the next six months?

Henrietta Pacquement: Well, you actually stole my things, but I am going to say diversification is one. Lots of opportunity and different regimes at the moment. So, I think that that's a really one to look at. And I'll give you an example, just even looking at hedging costs. Looking outside the U.S. and hedging that back from a currency perspective, you got a couple of percent of pickup. That's quite interesting to look at. So, that's one. And the other thing, just to reiterate and Ann's mentioned it in various guises, as well, it's do your homework. Do your security selection. Go and pick the companies that you think are going to thrive in this kind of environment. And I do think that that is going to make a difference to returns going forward.

John Moninger: Yeah, it's great. Well, thank you both for taking the time today and thanks for the great insights. And I do think we tackled a couple of tough topics, as well as some of the mainstream ones I think are out there. I heard some divergent thinking, which was great, and some things that are maybe against the grain, but also we heard some things that I think we just got to be smart about and how do we just be practical about managing in today's market. So, I'll end with saying thank you to all of those who have listened in. Thank you for those who are clients for entrusting us with the opportunity to invest on behalf of you and your clients. And for those who are not, we look forward to the opportunity to earn your trust over time, as well.