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The most relevant market indicator 'is the shape of the yield curve': Strategist

Invesco Investment Solutions Senior Portfolio Manager Alessio de Longis joins Yahoo Finance Live to discuss unpredictable market growth amid the Omicron variant scare and inflation risks.

Video Transcript

BRIAN SOZZI: Alessio De Longis is the senior portfolio manager at Invesco Investment Solutions.

Alessio, it's fantastic to have you on the program to kick us off on this Monday morning. Obviously the theme last week, macro-wise, were a jitteriness over the omicron variant. We saw what that did to the equities market in a risk-off type of action there. What do you see as the big theme headed into this week? It's a Fed blackout week so no Fed speakers are going to be jawboning the market. But what do you think is the major theme that markets are paying attention to this week?

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ALESSIO DE LONGIS: Markets are assessing, really, the prospective slowdown in economic growth. I mean, there has been a lot of focus on the omicron variant as one of the catalysts for the prevailing view that we're overdue for a slowdown. But to be honest, I think that was already in the cards. So I think markets will-- as you correctly point out, I think markets will really focus on omicron as well as central banks, price action, and rhetoric. Maybe not so much this week, but as a preparation for the following week where we know the central bank action would be more prominent.

As you pointed out, the most relevant indicator in my mind at this stage is the shape of the yield curve, is the behavior of the long end. The long end of the yield curve has been rallying steadily. The yield curve has been flattening in the face of hawkish rhetoric, in the face of higher interest rate expectations in the near term. That is signaling that the market expects growth to return to the low growth, low inflation environment that characterized the GFC. That's what markets are focusing on.

BRIAN SOZZI: Alessio, let's just pull the Band-Aid off of this. We are likely at the point of peak liquidity from the Federal Reserve. Is that bear market worthy in the first half of next year?

ALESSIO DE LONGIS: So I think you're suggesting one of the key drivers of market, market structure over the next six months. Doesn't need to-- so the withdrawal on liquidity. And you're seeing it, by the way, in several relative price points. You see the underperformance of small and mid-caps relative to large caps. That's also a liquidity signal.

You have discussed Bitcoin and cryptocurrencies. That is also another indicator of less liquid markets beginning to suffer that liquidity withdrawal by investors. It doesn't need to translate, necessarily, into a bear market. The historical evidence is a little bit mixed on that.

When growth, even though growth is expected to decelerate, when growth remains solidly above trend, and monetary conditions are still generally easy, and liquidity is still abundant, though withdrawing, we can expect-- I would characterize the expectation for next year more as a low single digit volatile, below single digit positive market performance on average, rather than a clear bear market in sight.

BRIAN SOZZI: Alessio, on that point, we have already seen kind of some of that thesis play out in the tech stocks, where we saw the NASDAQ kind of get a little bit more of a vicious sell-off last week than even broader equities did. But what's interesting about the call that you had, at least from the note that I was reading, was that you're rotating even out of the cyclical factors like a value.

So where is the play-- if you want to stay in equities right now, you don't want to make it full fixed income play-- if you're staying in equities, where is the move to rotate into, as far as sectors?

ALESSIO DE LONGIS: Great question. Actually, the performance of tech stocks last week was a little bit surprising in the sense that if you subscribe to the view that the long end of the curve and interest rates will decline, and that growth is slowing, and the inflation will keep sometime in the middle of the year, one of the best ways to reshape portfolio risk in the equity portfolio is actually to go defensive within equities while remaining overweight equity risk. Which, from a valuation standpoint relative to bonds, still makes sense.

So rotating out of value, out of small and mid-caps, int, respectively, quality stocks with large profit margins, low volatility stocks which equate to moving from industrials, materials, and financials, into technology, communication services, consumer staples, the defensive sectors. In other words, as the cycle reaches its mid-cycle peak, reshaping of risk in the equity portfolio towards more expensive, less cyclical equity sectors has historically been a very good way to maintain overweight equity risk but in a more defensive structure.

BRIAN SOZZI: Alessio, I've had some folks tell me this morning we might be nearing a 7% headline reading on the CPI next week. And we haven't seen those readings in quite some time. What do you think the market reaction would be if we get that print?

ALESSIO DE LONGIS: We haven't seen those type of numbers since the 1980s. So it's an entire generation or two of investors. Now, the market-- in my opinion, the market has already passed that. Will we, on the day, get a little bit of a spooky reaction, maybe a marginal sell off in yields? Quite certainly, with those numbers we should be expecting a widening of Treasury bonds over tips.

But the market is already looking behind that. As you were pointing out, inflation has already gone from 2% to 6%. And 30-year bond yields are sub-2%. That tells us something. The market is looking past this shock. The market still believes, in my opinion, quite correctly, that this is still a transitory inflation shock. Although that word needs more connotation.

What we mean by that is these type of supply bottlenecks, one way or the other, have to be resolved. And by definition, that creates that transitory nature. Why I don't expect inflation to run away, I don't expect the economy consumers to build an inflation psychology towards higher inflation, is because credit growth is really anemic. We're not seeing credit growth. And when you see consumer demand, there is plenty of evidence that this rising inflation is actually causing demand to be postponed. There is demand disruption rather than front-loading of demand.

So I wouldn't be surprised if 12 months from now, we'll be worrying about the opposite problem of an economy that is slowing and that we will not be able to generate that excess consumer spending that we need.

BRIAN SOZZI: Alessio, lastly I want to ask you about currency markets, something we don't necessarily talk so much about. The dollar index interestingly has kind of gone sideways since the emergence of the omicron variant. And I imagine that a lot of that doesn't necessarily have to do with interest rate differentials across countries, but simply anticipation over where the US economic impact is going to be if the variant does come-- or when the variant becomes more substantial stateside. What do you see in terms of the currency markets plays here?

ALESSIO DE LONGIS: So over the medium term, we believe the dollar is still overvalued. And there is a very strong case over, say, a three to five-year investment horizon for investors, US-based investors, to deploy more capital into foreign equities and foreign assets to harvest that long-term depreciation potential in the US dollar, appreciation in other currencies.

With that said, in the near term, we see this negative growth momentum building more solidly in outside of the US. And our analysis shows that when you see these negative economic surprises relative to expectations outside of the US, that has always been a very strong catalyst for dollar strength in the near-term. This is what we're seeing today. This is what we expect to see today.

Among developed market currencies, we favor the Japanese yen and the euro. But if one wants to express $1 long view, we think a better place to do it at this stage is against the British pound, the Australian dollar, the Canadian dollar, and in emerging market currencies, a selective approach towards harvesting the high yielders such as the Indian rupee, the Indonesian rupiah. We think it's a sound strategy. But we are still in a dollar-strong environment at the moment.

BRIAN SOZZI: All right, Alessio De Longis, senior portfolio manager at Invesco Investment Solutions. Thanks so much. We'll talk with you again very soon.