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Is our nation actually teetering
on default? And more importantly,

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what does that mean for your pocketbook?
This is Quartz Smart Investing.

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Our guest today is Anna Han,

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who is the Vice President of Equity
Strategy at Wells Fargo Securities. Anna,

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welcome. There's enormous attention this
week on what's going on in Washington

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in efforts to avoid a debt celing crisis.

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What's your take on what
that means for investors?

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It's certainly something
that could instigate a lot
of risk off a risk aversion

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and already has. You know,

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the US economy has never been through
an actual default of the government,

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on their debt, on their what they're
owed. And that's a serious issue.

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But the way I would phrase it is it's a
very large tail risk and tail risks are

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hard to quantify.

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It kind of puts you in a situation where
you're trying to think of what is zero

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times infinity. But in
this case, it's not zero.

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It is a very possible chance that the US
government needs to default and if that

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was happen, it would be
catastrophic for the economy.

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So there's real fear there,

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but the hope is that a resolution can
be found before the X Day cited by

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Treasury Secretary Yellen.

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And what is that scenario?
Should there be default?

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What does it mean for the markets?

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Well, for the markets,

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I think some extreme volatility and we
don't even actually have to get to the

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default. I think as we get
closer and closer to that date,

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that in itself is enough to
instigate more volatility,

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both in the credit markets, the
equity markets, the FX markets,

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all around contagion. And
not just domestically,

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but globally as well because of so much
exposure and reliance on US government

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debt. Again, for equity
investors, some serious risk off.

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What could that look like? That could
look like a draw down in equity markets.

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It could look like defensive
sectors outperforming a little bit,

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at least on a relative basis.

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And it could look like traditional
volatility measures like the VIX and other

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implied volatility along
further terms being elevated.

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Speaking of equities,

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you have said that you think the market
is due for a meaningful correction,

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default or not. What is that
correction likely to look like?

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Oh, we're looking. It's possible to
be down even 10%. And part of that,

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what is difficult to really look at
is it's not just predicated on tougher

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economic times or a potential recession,

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which is what we expect later this
year. Or even with a bank's fallout.

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It's really not hard to go down 10% when
you think about an appropriate multiple

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for the S&P 500. And look
at our earnings estimate.

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So right now we're looking at about
10% contraction on the EPS and the S&P

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500.

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That's earnings per share?

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Yes, earnings per share. And that
contraction is not something unreasonable.

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If you've looked at how top line
figures or revenues for S&P 500

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companies have been trending,

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they're coming in at below 4%
coming out of this earning season.

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Now you tack on to that margin
compression, which is that bottom line,

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the earnings per share figure.

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Once you take out all the
costs and everything in your
taxes and your interest,

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that bottom line figure has
been compressing as well.

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So to put that all together,

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going down 10% on the S&P 500
to realistically reflect what

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earnings looks like and how
corporates are progressing,

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that's really what
builds our picture here.

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And in terms of specific
stocks and categories,

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investors ought to be looking at,

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I know you are favoring small
cap stocks these days. Why?

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Oh, well, small caps
within the small cap world,

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what we were favoring
really was high quality.

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And the reason we are looking at that,
when you think about investing styles,

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rather than thinking about in each sector,

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you look across all sectors and you
think about what is a characteristic of

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some of the stocks I would
want across all sectors.

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And high quality is one of them.

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High quality we define as clean
balance sheets, low leverage,

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but also good stewards of capital
that really shows up in high return on

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equities or ROIC.

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And these are the kind of figures we
think about within the small cap space

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'cause we think that will weather
better during the recession but also

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still has unexplored opportunities. It
still has multiples that look reasonable.

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So that's a space within the
small cap universe we like.

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But generally we are still favoring and
looking at large caps because they can

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have more defensive properties,
particularly in equity pullback.

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And in what industrial category should
people be looking at to add to their

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portfolio?

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Within industrials in the large cap
space, we like the cap goods space.

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And something that stood out to us about
capital goods is that the volumes that

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more capital goods companies have been
able to maintain have been actually

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pretty decent while other sectors of
the market have been seeing volume

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pullbacks. And now you have this twofold,

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when a company's trying to earn
money or make more revenue,

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they can either sell more
widgets as we call them,

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or they could raise prices.

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And raising prices we've all seen with
inflation that a lot of companies have

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raised prices and been making
more revenues that way.

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But when you think
about the real earnings,

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you have to also sell more volume or
volume becomes a weak point as you raise

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prices. But for cap good space,

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we've seen that volumes have been a
little more resilient and it's made us a

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little more positive on that space.

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We can't conclude a conversation without
the r - word - that's recession - and

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still talk of it in 2023.
What's your assessment?

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So we expect GDP contraction to begin
towards the back half of this year and to

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really hit its most painful
point in early next year.

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And when think about a GDP contraction,
we can think about quarter over quarter.

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But another way to think
about it is peak to trough.

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And we're looking at a peak to trough
from around third quarter this year being

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the peak. And early next year,

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probably around first quarter
of next year peak to trough,

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thinking around 1.8% contraction.
Now to put that in context,

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in the great financial crisis,

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we saw a peak to trough
contraction of 3.8% and on

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average throughout
cycles over many decades,

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peak to trough is around 1.6, 1.8.

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So these figures are not too extreme.

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We're not expecting a horrible recession,

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but it still can be very painful depending
on how consumer spending holds up.

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Well, we'll see what happens and a lot
will between now and the third quarter.

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Anna, thank you for joining us.

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For more of today's top business
news and insightful analysis,

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stick with qz.com. Thank
you for joining us,

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and tune in next week for another
edition of Quartz Smart Investing.