First Trust’s Issakainen on the current environment

Caruso: What are you most concerned about right now? What are you watching in the markets and how do you view the current economic environment?

Issakainen: I think the main concern of many investors and many financial professionals that we talk to is, first of all, inflation, which I think everyone recognizes has become an issue to be s ‘tackle. This is an all the more important problem since it will probably lead the Fed to pursue a rather aggressive policy of rate hikes. And we’re looking at what’s being priced in the market now, and what’s being priced is maybe a peak in the fed funds rate at some point, maybe in the first quarter of 2023 – and then market pricing makes some rate cuts in this last half of the year.

Our view is that the Fed is going to have to keep raising rates because of inflation. The track record of the Fed and rate hikes is that they tend to keep raising rates until something breaks, until they are able to slow the economy down, and I think that’s probably what’s going to happen this time as well. Our view is that inflation is the result of an unprecedented surge in M2 money supply, which has reached levels we have never seen before. The good news is that it has come down, but it will still take time for the system to work, so we think inflation will last for a while.

I mentioned market pricing in that we’re probably going to see rate reductions next year. I think it’s because market participants are expecting a recession that will cause the Fed to start cutting rates – it’s hard to imagine the Fed would start cutting rates as quickly as the market is pricing in the prices, so we think we’ll probably see a recession towards the end of next year or early 2024. We don’t necessarily think it’s going to be a deep recession, but we’ll probably see a recession.

Caruso: For advisors who want to gain a deep understanding of the current landscape and have informed conversations with their clients, what metrics and metrics are most important to monitor?

Issakainen: I think one of the things we would encourage people to pay attention to is, “What is the main driver of inflation? because I think it’s a very important question. And that, in our view, is M2 money supply, and our economics team forecast high inflation long before most other groups, and that’s because we’re looking at the money supply and we’re looking at the impact that it has historically had on inflation.

There are other indicators that are also important. There is no single indicator that is perfect, but many people pay attention to the yield curve and its inversion. Right now, that two- to ten-year Treasury yield curve is inverted, so that’s another thing we would say is important to pay attention to. The only limit to that in the current environment is that we view this yield curve inversion as an indication that the Fed is being too tight, that they’ve raised rates too much, and I think, in the current environment , it’s hard to argue that monetary policy is too restrictive, especially with the level of inflation we have.

Caruso: The S&P 500 rose more than 9% last month, marking its best month since November 2021. What happened? Is this management sustainable with all the current economic headwinds?

Issakainen: I wouldn’t expect to continue at 9% per month run rate – doesn’t seem sustainable; However, I think when you look at the drop off the longer end of the yield curve, the 10-year Treasury yield has come down quite significantly from its early summer peak. And I think when you think about stock valuation, the discount rate in other words, a lot of it is based on the 10-year Treasury yield. A lower discount rate means you can justify higher valuations for stocks, and I think that was a big part of what drove stocks higher last month. Of course, the other part of that is that the earnings reports are stronger than expected or possibly better than feared, depending on your perspective.

The other aspect is that the valuations of certain segments of the market had just reached the point where they were relatively attractive, especially compared to the type of relatively low yields that you always fight in the bond market. Some of the concerns about taking on too much interest rate risk in a rising rate environment. So all of those things together, I think, helped fuel the growth in stocks last month.

I don’t expect the rate of recovery from the bottom that we saw last month to continue, but I do think some of these gains could be lasting. Especially if 10-year yields don’t climb higher than they were at the start of the summer, and we think we’ve probably reached at least the short-term peak of 10-year yields, so I think That’s good news for equity investors.

Caruso: How should investors position themselves in the short and long term?

Issakainen: We have a fairly robust range of ETFs that investors and financial professionals can use to position various asset classes and segments of their portfolio. One of the areas we’ve seen continued interest in, and I think it makes sense in the current environment and in what could be a tougher economic environment, would be on the equity side: ETFs that are more geared towards quality and dividends. Investors can turn to First Trust Capital Strength ETFs (FTCS B+) for the greatest exposure to the quality factor, and the First Trust Value Line Dividend Index Fund (FVD A-) and the First Trust Morningstar Dividend Leaders Index Fund (LDF A) for dividends.

I think the energy sector, especially now that it’s down about 20% from its early summer peak (Writer’s Note: This conversation took place on August 9), I think this creates a more attractive entry point for many investors who are still underweight or don’t have much exposure to energy stocks.

The sector has underperformed for such a long time over the past decade that I think many investors have kind of given up on it. But when we look at the fundamentals of just traditional energy stocks, their valuations, their earnings growth, I think it’s a very interesting proposition. While we may be heading into a period of weaker economic growth, I think the market is pricing that in with single-digit earnings multiples for the energy sector, and so I think even if we heading into this type of weaker economic environment, I think the energy sector should still do well for investors. First Trust offers the First Trust Natural Gas ETFs (FCG C+) and the First Trust Energy AlphaDEX Fund (FXN B).

We like biotech because it’s in the healthcare sector, which tends to be a bit more defensive and has pretty decent pricing power. But I also think there’s a huge amount of innovation happening in this space in the biotech space that will drive results for the next few years. I think the ability of biotech companies to harness and use advanced technology allows them to solve very complex problems that will help create new treatments and cures for diseases that were cutting edge, I think, in the longer term. This is an important reason to be optimistic about biotechnology. But I also think that in the short term, valuations are relatively cheap when I look at sales or earnings multiples. They are as cheap as they have been for a long time.

Over the past few weeks, we’ve seen an increase in M&A activity, and I think that’s something that’s been a bit lacking. We haven’t seen a lot of mergers and acquisitions over the last year or so, and I think there’s good reason to think we’ll see a slight increase over the next two years which will be a significant performance engine. First Trust’s biotech offering is the First confidence NYSE Arca Biotechnology Index Fund (FBT C+).

Commodities had a great run, an excellent rally. They took some out, and I think some investors are like, “Well, is that it?” I think there is a long-term secular demand for commodities that should lead investors to consider maintaining or adding exposure to commodities during the pullback. I think the fact that the supply chains are reoriented, especially if you plan to move to renewable energy in the next two decades, there will be a huge demand for raw materials that will come from that. So our ETFs is the First Trust Global Tactical Commodity Strategy Fund (FTGC )a wide commodity ETFs which is actively managed. It’s been around for about a decade.

I think investors are worried about how interest rates fluctuate, rates are still relatively low, and you’re not well compensated for taking on a lot of interest rate risk or duration risk, so the one of our most popular ETFs this year has been the First Trust Enhanced Short Maturity ETFs (FTSM B+)which is our improved short term ETFsand it’s an ultra-short ETFs. The good news with this fund is that a large percentage of its portfolio will mature in the short term; it is designed to have a scale where a large portion of the portfolio matures and we are able to reinvest at higher rates. Thus, as short-term rates rise, we have been able to reinvest in bonds at a higher prevailing rate, allowing FTSM to increase its interest payments six times since November.

The last area I will mention, as investors look to position themselves, is using buffered ETFs. This is one of our areas where we have experienced the strongest growth this year. We call them our target ETFs, but with buffered ETFs, investors hedge some of their downside and, in exchange, they accept a return that caps some of their upside. But if you might want to diversify how you manage risk… allocate to a buffer ETFs has been an area where we think investors have been very well suited because you hedge some of that downside and you don’t assume anything about the path of interest rates, you just use the structure of a buffered fund. Our ETFs which has become one of our biggest is actually a fund of funds that incorporates several of these target outcome ETFs into its portfolio, it’s sort of a ladder approach throughout the year. It’s the First Trust Cboe Vest Buffer ETF Fund (BUFR B).

For more news, insights, and strategy, visit VettaFi.

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