How Bad will it Get?

So let me start with you, David. The most basic question: how bad

will

the situation get? How bad things are going to get. Well, thank goodness it's Friday. The weekend should be a respite. Difficult day. Hard week. Tough year. The S&P 500 is down 25.26 percent from its all-time high. This is a bear market. I find myself thinking about the 1970s lately. And I think something to keep in mind is that in the bear market of 1982, when the Federal Reserve was aggressively fighting inflation, the S&P fell 27.28 percent, but in 1974 the S&P fell 48 percent. So I think a key question is whether this is the beginning of a period of high inflation.

Where are we near the end of a period of high inflation? If you think we are near the end of a period of high inflation, the worst is behind us and the market should not fall much further. But that is the key question. I don't feel much better. What do you think. Alright. I'm going to try to make you feel a little good. So look, we think the market is ready to fight a big battle at the 30,500 level. And the reason is that if you look at the course of recessions through the 1930s, the average decline in the recession is about 27 percent.

And so we'll get there when we're around thirty-five hundred on the S&P. And when I talk to investors I still think that many are still in the soft, fast or shallow camp. But I don't think there is a context of slow growth. Then I think people don't really look for anything important like what we had in the financial crisis. So I think we at least have that under our belts. I'll tell you if you think about where investors' heads are at, something else that makes me feel a little better is that I don't feel much panic, definitely alarm.

But the big question of the day is what higher rates for longer mean for valuation multiples. And that is a very constructive conversation. And we've done some work that suggests we're probably getting pretty close. If it reaches that 30,500 level on the S&P, the same type of multiple contraction that was seen in the 70s

will

occur throughout the entire decade. I want to get back to profits. But before that, we had brief, superficial news from Lori. I think you said I think it refers to a recession. You are projecting a recession. And I guess my question is: Normally, if there's a recession, we turn our heads and look at the Federal Reserve and say, "OK, please cut rates." Do we have much room to really face the recession?

When it comes, we expect a short, shallow recession, but we are a little concerned that the lows could persist well into 2023. We don't expect a V-shaped recovery after the small recession. We believe that there may be slow real growth afterwards. The problem here is that the Federal Reserve cannot bail us out because of the inflation problem and cannot attempt to rescue the stock market or even the economy in general until it is sure that the battle against inflation has been won. So I think what you know is that at this stage it's pretty clear that the Federal Reserve is committed to fighting inflation and they've decided that they're willing to risk tolerating a small moderate recession to make sure that this rise in inflation goes away. slow down.

So if we talk about stocks for just a moment, at least two things happen. One is the ratings. And what we expect at the highest discount rate affects that. Also profits profits. What do you expect from earnings at this stage? We expect earnings for 2022 to be two hundred and twenty-five dollars. I think at this stage you shouldn't expect any growth. It should remain stable in 2023. But with each passing day with the shocks we are experiencing from higher interest rates, the super strong dollar collapses and other currencies around the world, even oil prices, have dropped a lot.

And we're starting to see a lot of companies come out and say things are slowing down. So profit risk is increasing. What about the profits? When we saw FedEx we saw Apple. We've seen a lot of profit warnings now. So we're actually quite a bit below consensus: 18 for this year versus 11 last year. And then we're at 212 for next year in S&P earnings. So we think this will be pretty similar to 2015-2016, where earnings basically go nowhere for a couple of years. And I think companies are much more resilient in terms of managing their business models than in the past.

There is much more flexibility, many more ways to absorb costs and many more ways to manage supply chains are improving. But one thing we have been telling investors is that inflation is moderating. That reduces profits because it reduces revenue. So that's a big headwind. We have next year. So Lori, can companies be resilient consumers? How resilient are they? And particularly link that with unemployment. Because if we go in this direction, what kind of unemployment will we face? So look, I think consumers are facing some headwinds and we're starting to see the impact of downward trading. You're seeing a lot of those references in their earnings calls.

We are also starting to see a lot of impacts among the lower end consumers and we have held them much better. But we do think the consumer will take some hits. One of the things that reassures me is that when I spoke to my banking analyst, for example, they told me that the baselines for several credit metrics look much better than in past recessions. Therefore, we believe that many consumer trends are going in the wrong direction, but will not necessarily be as affected as in past crises. Just because balance sheets have cleaned up considerably in recent years, then we similarly think that the consumer is having a tough time being affected by this high inflation.

They see the high. Rates affect the housing market, but this small recession should be marked by an inflationary environment, not deflation, and we believe that the labor market will be relatively well. They will take some hits, but we don't think unemployment will rise more than 1 percent. Typically, our rate rises 3, 4, or 5 percent during a recession. So, if there is still inflation and not deflation and the labor market remains there largely because supply is tight, then credit conditions credit costs. They should be benign. That should help banks get through this very well and should help investors invest credit. 2023 should be a better year for fixed income investing.

So relatively benign. What we saw in the UK this week was not benign. There was a real break in the market dislocation. Do we have to anticipate something similar to the United States? The short answer is no. However, what is happening in the UK is a blow that I hope our policymakers take very seriously. And that comes down to when you're fighting inflation and your economy is suffering from supply-side shocks and other pressures. It is difficult to support the economy with monetary policy. Rates are rising, the BSE, and it is difficult to support the economy with fiscal policy.

They also have a deficit. Therefore, the United States needs to be much more aware of its deficits, whether they are tax cuts or spending. These deficits need to be monitored in this era of rising interest rates. So Larry is one more attempt to bring this up. Our broader perspective on a major financial crisis is what we all fear. Good. We are in better shape for this, whatever it is, than we were at that time. I think we are. I mean we are back again to our bank analysts who spend time scrutinizing the balance sheets of the big banks.

And we think the pipes are in much better condition. I mean, as I say, the stress tests seem to have worked. That's one of the reasons why banks haven't been able to really grow in recent years. But it's also something that I think is going to be a really asset to the financial markets in the coming years. And we are overweight in the banks that we have been adding this week. But in banks specifically that's great. And the banks, which are up to the task of proper regulation. What happens to the part that is not subject to recovery?

What about shadow banks? What about private credit issues? We don't necessarily know what's going on there. Well, there is some debt in the system because debt was very cheap and readily available for the last 10 to 20 years. But the banks, as Laurie said, are confident that their balance sheets are strong. Higher interest rates should lead to higher net interest margins as long as your credit costs don't increase. But a resilient labor market. Home prices may go down a little, but as long as they don't collapse, people will continue to pay their mortgages, especially since they are stuck with the low interest rates of before.