Fed rate hikes should stabilize markets to a 'benign' growth environment: Strategist

Invesco Global Market Strategist Brian Levitt joins Yahoo Finance Live to discuss how the Fed's rate hikes could impact markets going forward, earnings season, and the odds of a recession.

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- Brian, good to see you. I mean, what is driving those big growth tech stocks up since mid-June?

BRIAN LEVITT: So it's clear that the economy's slowing. And when you're in a slowdown, investors tend to pivot back towards those businesses that can generate true earnings growth and generate cash flow in a slow environment.

So when you're in a recovery or an expansion phase of the cycle, you want to be exposed to those parts of the market that need that catalyst, that require an improvement in economic activity to take you higher. As the economy slows, investors tend to shift back towards the big tech companies or the big growth companies that can generate earnings. And quite frankly, they have been.

- Hey, Brian. So a two-part question here. I guess, well, first, do you think that there's still room to run in some of these larger cap names? The fact that they have been beaten down for so long, coming off a strong month, is that momentum going to continue?

BRIAN LEVITT: Well, it might not be every day in the near term. I mean, we still have challenges here. Ultimately, this is a market that's waiting for greater clarity on inflation and greater clarity from the Fed. So we can't extrapolate this forward.

But in a slowdown, yeah. The larger, growthier businesses should be the outperformers. So we may not see it. There could be some near-term days of challenges if investors extrapolate interest rates moving significantly higher.

But ultimately, we do think this is a Fed that'll put the tightening in. The economy will slow meaningfully. The Fed'll back off, leaving us back in a pretty benign growth environment again that favors the true growers.

- Is it a market that's yet priced in a mild recession? And how will we know when it does? What are those lows going to look like?

BRIAN LEVITT: Yeah. I mean, if you look at recessions like 1980 or 1991, the returns were somewhere around 15-- the negative returns were 15% to 20%. Now the average return for recessions, the last 10 recessions-- and of course, that would include '08 and '01-- the average is negative 31.9. The median's negative 23.

So we've done 23.4% peak to trough. I think that was from January 4 through June 16. So you've done-- you've done the median. And you've done 3/4 of the way to the average.

It's a process. You know, as this works, interest rates start to come down. And so we've seen that-- not necessarily in the last couple of days. But rates come down. You reassess earnings a bit.

But as rates come down, multiples start to move up. So, you know, I don't know that we're all clear here. But it's a process. And the good news is, I think a lot of that process is behind us.

- Brian, we've got some comments out from San Francisco-- Fed President Mary Daly this afternoon or earlier today saying that the markets are ahead of themselves on the Fed cutting rates, also saying that raising the Fed's policy rate to 3.4% by the end of this year is, quote, "a reasonable place to think about us getting to." What's your reaction to that?

BRIAN LEVITT: Yeah. I mean, the more that the Fed talks hawkish, and the more that if the market starts to believe that they really need to drive short rates as high as she's suggesting, then yeah. It's likely we're going to have a recession. That's still a mild one.

Corporations and households are in generally good shape, but nonetheless, a recession. Again, as we talked about earlier, the market's priced in a decent amount of that. But it would suggest more volatility ahead and a little bit more work to put in a bottom here for these markets.

I would also say, though, let's be careful. I'm not sure that any Fed official's going to take advice from me. But let's be careful. We know that inflation is cooling.

We know that the economy is slowing. And we've also known that we've had a lot of tightening in a very short period of time. It would be nice to try and assess what that tightening is doing to the economy, especially given that long-term inflation expectations in this country remain very benign. This is not an environment where the Fed is losing control of long-term inflation expectations.

- Well, perhaps Mary Daly is listening-- if not, James Bullard, who said today, we're going to need to see convincing evidence across the board that headline and other measures of core inflation all coming down convincingly before we'll be able to feel like we're doing our job. To you, does that suggest yet another 75-point hike? Can't imagine we're going to see convincing numbers across the board by September that give them pause.

BRIAN LEVITT: Yeah, no. Unfortunately, we won't get that as quickly. So yeah, a 50 or 75 basis point rate hike is certainly in the cards. And I do start to worry it is too much tightening in a very short period of time.

But while it might not be convincing, I would say, look at what's happened to freight costs. Look at what's happened to gasoline prices. Even look what's happened in the bond market. I mean, the one-year break even-- so that's just subtracting a one-year Treasury from a one-year Treasury inflation-protected security-- that was over 6% a few months ago.

It's now at around 3 and 1/2%. It has come down rapidly. And as my old mentors in this industry used to tell me, of all the indicators, the bond market gets it right most often. The bond market is telling us that inflation is coming down.

So you know, again, if the Fed were to listen, I would advise them to tread carefully. We know what happens when there's high and rising inflation. The Fed has to combat it. The odds of a recession are elevated.

Now that may sound scary to investors. But again, markets tend to go down ahead of the recession. They tend to put in the bottoming process as you enter it. And actually, in four of the last nine recessions, stocks were positive.

So you know, as an investor, you know, I'm not all that concerned about the official definition of a recession. Rather, it's an economy that's slowing. And I want to be favoring those businesses that can do well in that slowdown.

- Brian, investors are keeping a close eye on that strong dollar, with the dollar pairing some of its earlier gains of this morning and jumping to its highest level that we've seen in about a week, a number of executives on these earnings calls over the last couple of weeks talking about their strong dollar. How big of a challenge do you see this being to the markets here, at least in the short term?

BRIAN LEVITT: Yeah, it's clearly a challenge. And it's all about this idea of tighter policy and rising interest rate differentials between the US and the rest of the world. And this is how this goes.

You know, when you think about how cycles come to an end, high and rising inflation, inverted yield curve, high yield spreads out, dollar strong. And so we've seen some of that. Certainly high yield has held in. But the dollar is strong.

You know, you combine that with businesses no longer restocking inventory to the extent they were and consumers probably slowing down a bit here. A mild recession is a reasonable possibility. But again, you know, the markets are well aware of that. And as the Federal Reserve, as inflation starts to moderate, and perhaps the Federal Reserve can provide some clarity on when that pivot may come, you'd likely see an alleviation of that pressure on the US dollar.