Markets are experiencing ‘somewhat of a defensive rally,’ portfolio manager says

Invesco Investment Solutions Senior Portfolio Manager Alessio de Longis joins Yahoo Finance Live to talk about the market gains amid strong earnings, the bond market reacting to the Fed's interest rate hikes, and which sectors remain defensive during inflation and recession concerns.

Video Transcript

DAVE BRIGGS: For more on the markets, let's bring in Alessio De Longis Invesco Solutions Senior Portfolio Manager. It's good to see you, sir. We won't ask what your shoes are-- we know you're not wearing them. You're on Zoom. So consumer sentiment all-time low-- markets finish way up. What are they reacting to?

ALESSIO DE LONGIS: Well, they are reacting to the fear of a slowing economy. And when you look at the rally today, it's actually an interesting one with slightly different characteristics. Today is a rally where quality-oriented stocks, more defensive sector, sectors with less cyclicality embedded in them, are actually outperforming. So it's somewhat of a defensive rally.

It's a very welcome rally because we've come now from six months of struggles in the equity market. So any rally will really be welcome. But it's important to notice those shifts, right? We have seen so far, up until this week, very clear outperformance for cyclical oriented sectors that benefited from rising interest rates. But over the last couple of weeks, what we've seen is that rates are beginning to beat, and inflation expectations are rolling over, and you are seeing that change in leadership, where defensive sectors are starting to lead that rally. It will be very interesting to see the continuation, or not, of that next week.

RACHELLE AKUFFO: So, then, as we think about earnings season, then, what are some of the trends that you're watching there? And could we be, perhaps, concerned? We're seeing some more stocks move into being considered value stocks-- what are you keeping an eye on there?

ALESSIO DE LONGIS: Well, what I'm keeping an eye on, it's really earnings per share. Because so much of the rhetoric year-to-date has been about, oh, look, the S&P 500 or global stocks are down 25%. We've got to be pricing in the recession already. Well, I would offer a different perspective.

Stocks are down as much as long-term government bonds. If you take the 30-year government treasury, it's down 25%. What that tells us is that stocks have simply underperformed in line with government bonds. In other words, they have underperformed as a result of higher discount rates. But there is no clear pricing of a recession.

If a recession had been priced, we would have seen stocks underperform government bonds. We haven't seen that. So what is missing? It's earnings.

Earnings are still resilient. Earnings expectations are still very strong, very positive. So seeing a rollover in earnings revisions, in earnings expectations, it's really what we want to focus on is that correct metric to assess whether the economy, whether investors are beginning to price in that recession.

DAVE BRIGGS: And next week is a key week in earnings. Do you expect a surprise on the upside? And getting back to the bond market there, is it leading the Fed or is the Fed leading the bond market?

ALESSIO DE LONGIS: The bond market has been leading the Fed. The bond market has literally been holding the Fed's hands and taking it here. Let's not forget that back in Q4 for 2021, the expectation was for one rate hike at the end of this year. And we're now pricing in-- we lost count, right? We are expecting Fed funds rate at 3%.

So I think at this point, however, what is changing is that now, growth expectations are likely to take lead again over market dynamics. So far this year, it's been mostly about inflation expectations, but the bond market leading the equity market. I think now it's going to change-- that leadership is going to change. It's going to be equities and growth expectations driving bond yields and driving the Fed.

RACHELLE AKUFFO: So, then, how do you rotate your portfolio given this in mind?

ALESSIO DE LONGIS: It's a very interesting question, because it is still too soon, in our opinion, to position for a recession. Positioning a portfolio for a recession can be very expensive if you are too early. So we suggest that we are positioning our portfolio still with an overweight in equities. So it's still appropriate to run about neutral to slightly above average risk in your portfolio, but with a composition that is a little bit more skewed towards equities and less towards credit.

So we're underweight credit, particularly risky credit. We have increased duration in our portfolios to begin to harvest the increasing yields that is now providing an opportunity that we haven't seen in a long time, still maintaining an overweight equity position, and more balance between cyclical and defensive sectors, preparing for that potential rollover in the second half for a more clear rotation towards defensive sectors, such as communication services, technology, health care, staples, and so on.

DAVE BRIGGS: Really are just two camps at this point-- anyone who believes that we will hit a recession in the next 12 to 18 months and those that think we can hit a soft landing. Where are you?

ALESSIO DE LONGIS: So far, I think a soft landing is still our base case. We are very much in flux, to your point. I think it's a given at this point that the economy is likely to grow below its potential for a while. So, then, it comes down to the technicality of defining a recession.

Is a recession prolonged periods of below trend growth? Or do we need to see negative growth? Ultimately, I think it's a recession if the unemployment rate begins to rise. Standard metrics by the Fed suggest that it's nearly impossible to avoid a recession if the unemployment rate rises by about 0.5%.

So so far, still a soft landing. But I think 2023 looks a little bit more troublesome than the rest of this year.

RACHELLE AKUFFO: We'll definitely have to follow up on the unemployment rate, especially with the number of layoffs and hiring freezes that we're also seeing. A big thank you there Alessio De Longis, thank you so much.