Section 01 Inflation and Economic Growth Still Correlate
Over the past few months, economic growth has slowed dramatically as the impact of the Federal Reserve’s six-month string of rate hikes has rapidly dampened consumer demand. Stalling economic growth may seem negative, but it’s the medicine needed to cure what’s ailing the economy: heightened inflationary pressures.
The biggest fear in the markets over the past six months has been that growth would slow but inflation would persist even as the economy pushed closer toward recession — as was the case during the 1970s. Those who believe this narrative worry that the Fed will be forced to keep pushing rates higher, leading to a deeper recession and deeper market disruptions, much like the tightening cycle in early 1980s under former Chairman Paul Volcker. That cycle, while extremely painful, finally provided the Fed with the inflation-fighting credibility it had been lacking for much of the prior 14 years.
The good news in the Fed’s current battle against inflation is that after six months of rate hikes, demand is moderating, and (most importantly) inflation is being pulled lower as a result. Additionally, the supply chain is healing, which is translating to improved inventories and a greater balance between demand and supply. As supply and demand normalize, inflation should as well. Despite the struggles of the past year, the Fed has not lost its inflation-fighting credibility, and we don’t believe a full repeat of the Volcker era is in the cards. Back then, inflation had been elevated for 14 years, but today we have been battling inflation for just one year after spending the previous 25 years in a disinflationary cycle and the last 12 of those 25 worried about deflation. Put simply, inflation expectations remain firmly anchored.
A slowing and “rebalancing” U.S. economy and inflationary environment
The Federal Reserve has focused its efforts on 1) moderating demand to allow supply to catch up and 2) keeping inflation expectations anchored. While current measures of inflation remain elevated, it is worth remembering that actual inflation readings are lagging indicators and, importantly, are now coming off the boil. We believe the weight of the evidence points to the Fed already making progress toward its goals and that further progress will be reflected in future inflationary readings. We believe the pace of the decline of inflation will accelerate in the coming quarters for three reasons:
It’s easy to appreciate the immediate economic shock created by COVID-induced shutdowns of early 2020. But what may be underappreciated is the larger shock caused by the reopening of the economy. We have been feeling those effects for much of the past couple years, particularly a large and immediate shift in consumer spending away from services and toward goods consumption. This shifting of economic demand occurred against a backdrop of low inventory and supply chain disruptions. The result was demand exceeding supply, which led to heightened and historically odd inflationary pressures for goods. This has been the primary cause of inflation, and we believe this is set to dramatically weaken over the coming quarters.
This backdrop has shifted over the past year. Since peaking in March 2021 at a pace 20 percent higher than pre-COVID levels, real goods spending has fallen by 4.7 percent. Contrast that with service sector spending, which as of March 2021 was 5.5 percent lower than its pre-COVID highs but has recently regained all lost ground and is up 6.6 percent since then as consumers have ventured back out into public life.
This declining demand for goods is coming as supply chain issues are being resolved and inventory levels have been rebuilt. Inventory-to-sales ratios (a measure of current levels of inventories relative to the current pace of sales) are generally back to pre-COVID levels at both the wholesale and retail storefront level, with some areas showing extreme inventory levels. For example, furniture (an early COVID consumer spending favorite) at the wholesale level has an inventory-to-sales ratio of 2.06, which, apart from a one-month spike during the height of COVID, is the highest level since 1992. Retail storefront inventories are also elevated. Given the improved balance of inventories to sales, prices for goods should soften. The one extreme outlier on the inventory side remains autos at the retail level, but help is on the way at the wholesale level. A look at the past few industrial production readings shows auto and light truck assemblies have returned to pre-COVID levels.
There’s further evidence of the supply chain healing in the Institute for Supply Management Purchasing Managers Index, which shows supplier delivery times plummeting back below historical averages. Meanwhile, the price of shipping goods in containers around the world has fallen 45 percent from recent highs. Pulling all this together, we believe goods inflation is set to decline, which will have a large dampening effect on overall inflation levels.
While demand has shifted, the Fed’s rate hikes have also dramatically slowed overall demand as witnessed by the slowing pace of consumption. The latest reading of Personal Consumption Expenditures (PCE) from the Bureau of Economic Analysis shows overall spending growth has slowed to a pace of 2.2 percent year over year. For context, spending was up 6.5 percent on a year-over-year basis as recently as February of this year (pre-Fed hikes) and up 6 to 7 percent or more for much of 2021.
The most immediate impact has been to the previously red-hot housing market, which has moved from absolute boom to bust over the past few months as mortgage rates have risen from 3.25 to nearly 6 percent. The pace of new home sales is off 40 percent from levels seen at the beginning of the year, while existing home sales have tumbled 26 percent over the past six months. The slowdown points to a moderation in home prices and potential price declines, which will eventually translate to lower inflation readings, notably on the services side of the economy.
The one part of the economy where demand continues to noticeably outpace current supply is the labor market, which has remained resilient, adding 315,000 jobs in the month of August. During his recent speech in Jackson Hole, Wyoming, Fed Chairman Jerome Powell mentioned the hot labor market as one area in which demand has not slowed. However, we believe that labor market demand is set to soften further in the coming months as companies react to a slowing U.S. economy. Indeed, forward-looking measures like the Conference Board’s Consumer Confidence labor differential have deteriorated over the past five months, a condition which historically has led to a slowdown in hiring and an increase in the unemployment rate.
We also believe labor market supply could increase as Americans are compelled to re-enter the labor market. The August jobs report showed that 786,000 Americans re-entered the labor market, hopefully restarting a trend that had paused in recent months after a strong showing post the expiration of extended unemployment benefits in September 2021. Even after this, the labor force participation rate remains a full 1 percent below its pre-covid peak of 63.4 percent. If it were to return to this level, nearly 3 million additional workers could be added to the labor force supply and help “cure” the current supply/demand imbalance.
In response to the slowing (albeit still strong) pace of hiring, wages have fallen from a 5.6 percent year-over-year pace in March to the current 5.2 percent level in August. The Fed is likely focused on this area of the economy and will need to see additional moderation in the coming months before it feels comfortable easing its pace of rate hikes. It is worth noting that consumer sentiment surveys show that workers do not expect the current level of wage increases to persist in the future.
While the first two points are focused on supply and demand issues that cause inflation, the third point deals with consumer expectations for inflation and the impact this has on people’s buying habits. Economists believe that inflation becomes entrenched in an economy through consumer and business expectations. The thinking is that if buyers of goods and services expect inflation will persist, they will accelerate purchases to get ahead of what they view as inevitable price hikes. As such, demand will remain elevated, and supply will struggle to keep pace. For this reason, the Fed is concerned that the longer inflation stays in the economy, the more likely expectations of future inflation will rise. The good news here is that inflation expectations appear to be anchored. The bond market’s expectation of inflation one year from now as measured by breakeven rates between nominal Treasurys and inflation protection Treasurys is currently 1.81 percent. A longer-term measure, the 5-year 5-year forward breakeven rate, checks in at 2.35 percent. And consumer expectations have moderated recently, with the University of Michigan Consumer Sentiment Index showing expectations for inflation 5 to 10 years from now at 2.9 percent, which is in line with historic averages. In fact, the highest level registered during the past year was a brief spike in a preliminary report to 3.3 percent. Contrast that with the early ’80s, when expectations were above 9 percent.
Overall, the above points provide our mosaic on our belief that inflationary pressures will continue to pull back as we push toward the end of the year. Unfortunately, economic growth is slowing toward a recession. While third-quarter estimates of economic growth are currently positive, we have had two straight quarters of negative Gross Domestic Product, the yield curve is inverted, and the Conference Board’s Leading Economic Index (LEI) has fallen for five straight months (again concurrent with rate hikes) and now resides at 0 percent year-over-year. A review of the prior nine recessions indicates that all except the 1960 recession and the short COVID recession coincided with this number falling into negative territory — although it’s worth noting that there have been periods when the LEI reading has been negative and a recession did not follow.
The good news here is that inflation expectations appear to be anchored.
The next few months will be critical to answering the question as to whether we will enter a recession. We believe that if the economy does fall into recession, it will be mild given the overall condition of U.S. consumers and corporations as well as the fact that banks have spent the prior 12-13 years rebuilding their balance sheets. Couple this with our belief that inflation will turn lower, allowing the Fed to ease up on rate hikes. We believe that a mild recession will not be significantly disruptive for financial markets. Indeed, the argument could be made that financial markets have already discounted much of the potential for a brief and mild recession.
Financial markets currently reside in “the space between”
In June, we saw equity markets tumble into bear territory (down 20 percent from prior peaks). An elevated Consumer Price Index (CPI) reading along with the aforementioned heightened preliminary University of Michigan consumer expectations for inflation stoked fears that the Fed would be forced to be overly aggressive in raising rates. However, following the low (set on June 16), the S&P 500 has regained its footing and trimmed its losses as evidence emerged that inflation had likely peaked. By August 12, the S&P had regained more than 50 percent of its prior losses.
Historically, a strong price rally after bear market lows has been a strong indicator that the bottom has been hit. According to our analysis, in the 10 bear markets that have occurred since 1950, once the market recovered 50 percent from its low, the following occurred: 1) The low from which the rally occurred marked the low of the bear market in all 10 instances (meaning the market didn’t go below that level), and 2) as this chart shows, forward-looking returns were strong, particularly over longer time horizons.
Others have done similar work; for example, Aaron Brown, a former managing director at AQR Capital Management, noted in a Bloomberg article that in all but one of the 79 corrections (defined as a 10 percent or more decline in equities) that have occurred since 1926, a retracement of 50 percent of prior lows indicated the bottom had been established for that correction. The only outlier in the data was in March 1930 — at the height of the Great Depression.
This technical analysis comes with no guarantees, as every economic and market environment is different. However, when we couple this with our belief that inflation has peaked and any such recession would be mild, we do believe the bottom set on June 16 is likely to hold. However, this does not mean we believe markets are set to have a strong, smooth recovery. We expect continued volatility but with an eventual upward grind as the market debates inflation vs. recession and everything in between.
Historically, a strong price rally after bear market lows has been a strong indicator that the bottom has been hit.
To borrow from a Dave Matthews song, we equate the current market environment to The Space Between. We believe the most dramatic fears about inflation and Fed rate hikes are subsiding, but the markets aren’t fully convinced and are going to require further evidence. During this time period we are likely to see a debate begin about the shape and length of any potential recession. When Wall Street concludes that inflation is falling and that any recession will be short and mild, that is when we believe we will see a more sustained upside. In our view, this is likely to happen in 2023.
It is important to bear in mind the Fed tightening has had a quick and nearly immediate impact on the economy, a point recently noted by St. Louis Federal Reserve Bank President James Bullard. This flies in the face of the old adage that monetary policy (Fed rate hikes) impacted the U.S. economy with long and variable lags . However, a review of today’s data suggests it happens much more quickly. This is likely because the Fed’s new operating procedures (after the Great Financial Crisis of 2007-09) focus heavily on forward guidance and telegraphing to markets where the Fed expects rates to be in the future.
This likely has important implications for any potential future Fed pivot toward easier policy if economic growth dramatically weakens. In the past, the economy and markets responded slowly to any such rate cuts, but today’s experiences suggest the Fed may be able to resuscitate the markets and the economy more quickly, especially given the underlying condition of the U.S. consumer.
Section 02 Current positioning
We remain slightly overweight equities relative to fixed income given our forecast of falling inflation. Let’s not forget that stocks and bonds are both down through the end of August. Throw in still heighted levels of pessimism, and we believe the stage is set for a gradual recovery in equity markets. Overall, we continue to tilt our exposure in favor of what we believe are the cheapest parts of the market.
We maintain a favorable outlook toward U.S. value stocks and continue to overweight quality small caps (the S&P 600) based upon attractive valuations relative to other parts of the market. Within international markets we continue to prefer international developed stocks over international emerging market stocks. While there certainly are risks in each of these asset classes, current valuations are at extremely discounted levels. Certainly, the war in Ukraine and Russia has complicated the calculus, but to date, international markets have held up incredibly well when measured using local currency returns. Pessimism remains heightened, valuations are near multi-decade lows, and future returns may be augmented by currencies moving from weakness to strength for U.S.-based investors.
Consistent with our February 2022 forecast for falling inflation, we decided to eliminate a majority of our Treasury Inflation-Protected Securities (TIPS) that were purchased in late 2019 and again in mid-2020 to hedge against what we believed was coming — rising inflation. However, we continue to maintain our current exposure to commodities, including gold, to hedge against continued rising energy and agricultural prices and the unknown geopolitical situation.
Section 03 Equities
U.S. Large Cap
After a painful start to 2022, U.S. equities have experienced a recovery from the beginning of July and into the third quarter. Volatility remains high, as recession fears dominate both investor and consumer mindsets. But the strength of second-quarter earnings along with continued signs of a path toward normalization in inflation has helped to reduce some of the fears of a hard landing. In our view, a mild recession isn’t the real risk. The big risk is that the economy enters a mild recession over the next few quarters, but inflation remains elevated. This scenario would require the Federal Reserve to get even more aggressive with interest rate hikes, which would result in even stronger headwinds for the economy at a time when it doesn’t need them.
While absolute valuations have improved for U.S. Large Cap equities, they remain expensive on a relative basis compared to almost all other traditional equity asset classes in our portfolios. We remain neutral toward U.S. Large Caps, with a value bias expressed in a sector-neutral value factor manner. This current positioning has been in place for two years and has been a strong tailwind to relative performance (outperforming the S&P 500 by 5 percent per year). It’s worth noting that the outperformance has come despite the value factor positioning becoming even cheaper on a relative basis compared to our entry point, something that’s rare for a position that’s delivered strong relative performance. When we initiated the position at the end of August 2020, we estimated that over the last 30 years, value had been that cheap only 5 percent of the time. Today, we believe value has been this inexpensive approximately 2 percent of the time, and the gap in valuations is rivaled by only the historic value spread environment of the Dotcom Era.
While U.S. Mid-Caps remain underwater this year, the relative performance versus U.S. Large Caps is solid and has increased throughout the summer months. Attractive relative valuations and modest relative earnings revisions are the reasons for the strong relative results. Similar to the value factor, U.S. Mid-Caps and Small Caps are historically cheap on a relative basis, which means there is a significant valuation cushion in today’s prices. From a fundamental perspective, earnings revisions for the next 12 months are holding up better for U.S. Mid-Caps than for U.S. Large Caps. Mid-Cap earnings expectations are flatting out at about $193 per share, but they are starting to decrease for U.S. Large Caps as the economic slowdown and high inflationary conditions are starting to affect corporate bottom lines. This divergence in revision trends is likely due to varying sector exposures between the two indices. U.S. Mid-Caps have significantly more exposure to energy and industrials, which tend to do better in higher inflationary environments, while tech-heavy Large Caps are more exposed to the margin pressures of inflation. Our portfolios remain neutral to Mid-Caps but are on watch for an overweight.
U.S. Small Cap
U.S. Small Caps continue to be attractive and are overweighted in our diversified portfolios. For the last few years, we have had a positive view on U.S. Small Caps due to the attractive relative valuations in the asset class and favorable association with the resilient U.S. economy. Those major pillars of the original investment thesis remain intact, and the result has been solid relative performance this year despite growing macro headwinds that uniquely impact U.S. Small Caps. Weakening Institute of Supply Management Index readings, wider credit spreads and rising real interest rates typically lead to Small Cap underperformance. However, U.S. Small Caps continue to deliver positive relative performance. Attractive absolute and relative valuations for the group are the primary sources of performance strength. As an example, Small Caps are trading at just 13 times forward expected earnings, while U.S. Large Caps trade at over 18 times earnings. U.S. Large Caps are currently trading near long-term averages on absolute valuations, but U.S. Small Caps are trading 7 percent below the historical mean. On a forward-looking basis, we think the macroeconomic headwinds will abate over the next few quarters as inflationary pressures subside. This should be a strong tailwind for U.S. Small Caps due to their greater sensitivity to both financial and economic conditions.
The Russian invasion of Ukraine and the subsequent sanctions have impacted global economies and markets, but Europe has borne the most fallout, as the continent has a high dependence on Russian natural gas. In the immediate aftermath of the February 24 Ukraine invasion, markets across the globe sold off, but European equities felt a more severe impact. By March 8, the MSCI EMU index had fallen 22 percent versus the 12 percent decline for the U.S. S&P 500 — reversing its earlier outperformance. However, since that date, even as natural gas prices have risen and worries increased, the indices have performed similarly on a U.S. dollar basis. However, on a local currency basis (in euros), the MSCI EMU index is up, while the S&P 500 is down.
Investors must ask themselves if they believe we have seen the worst for the International Developed asset class as well as determine what they believe has already been priced into equities from the region. Yes, the news is bleak, but we view it as already priced in and expect things to marginally improve. For those who believe the answer is that the worst has already occurred and is reflected in current trading values, the path forward may be to think like a contrarian — particularly for those with time horizons longer than a few months. Undoubtedly risks remain elevated, and it could be a very long winter, but Europe is filling up natural gas storage as evidenced by Germany’s reserves being 86 percent full and the entirety of the EU capacity being 82 percent full as of late August. There is a growing belief these levels are enough to get through winter, and policymakers are looking to blunt the blow to consumers. It is possible Europe will be able to muddle through the coming winter as leaders continue to find other energy sources and may eventually no longer be heavily dependent on Russian gas.
Importantly, we believe currency could move from a headwind to a tailwind in the coming quarters and years as an expensive dollar loses strength.
This spike in energy prices has translated to high inflation rates, which we believe will compel the European Central Bank to further ramp up rate hikes after July’s .50 percent increase — the first since 2011. While this could continue to slow the economy, it could also arrest and reverse the rapid price decline in the euro. The potential for a stronger euro brings us back to our opening paragraph about the impact of currencies on returns. Currency is one of the largest factors that determine dollar-denominated returns on money invested overseas. European market returns are similar to the S&P 500 year to date as measured in local returns. On a broader scale, international developed markets as a whole, as represented by the MSCI EAFE Index, have outperformed the S&P 500 in local currency returns (-9 percent versus -17 percent) but are lagging when measured in U.S. dollar-denominated terms. The reason for the difference is the 14 percent rise in the value of the U.S. dollar. The strengthening of the dollar is the result of a Federal Reserve that has led the global rate hike campaign, as well as worries about Europe’s ability to deal with rising energy costs from Russia’s campaign to hold back natural gas supplies.
Importantly, we believe currency could move from a headwind to a tailwind in the coming quarters and years as an expensive dollar loses strength. We believe the current situation is similar to the late 1990s and early 2000s. After a long period of economic dominance by the U.S., a strong dollar spent the next five to seven years weakening relative to international counterparts which resulted in stronger returns for U.S.-based investors with holdings in International markets. Indeed, according to the Organization for Co-operation and Economic Development, the dollar is 42 percent overvalued relative to the euro, surpassing the previous high of 37 percent back in 2001. Conversely, the yen, after spending much of the past 30 years overvalued, is now 40% undervalued relative to the dollar on the heels of its recent sharp decline.
Admittedly, there are concerns in these regions, and the group’s underperformance over the past decade has been notable. However, current valuations appear attractive, and we believe even the slightest catalyst could lead to future outperformance. Not surprisingly, interest rates have increased in both regions, especially in the eurozone, where negative yielding debt may become a thing of the past. Might this help the overall eurozone economy and especially its banking system? While we continue to review our overall outlook and risk assessment, we believe the valuation discount these markets have relative to U.S. stocks provides a margin of safety and an opportunity for future outperformance. As such, we maintain our overall position at slightly overweight.
Economic growth in China dominated the news recently as the Chinese economy softened further due to widespread COVID lockdowns, a growing housing crisis and extreme weather across the country. In July, retail sales and industrial production growth slowed more than expected, while home prices declined for the eleventh straight month. COVID lockdowns, which were being lifted in the beginning of June, were partially reinstated in July as the BA.5 subvariant spread. On top of this, China has been dealing with extreme weather for the last few months, with a heat wave and droughts in some agricultural areas and flooding in other areas.
The result has been crop failures and higher prices for consumers. The Peoples Bank of China (PBOC) responded in August to these economic headwinds by unexpectedly reducing its main rate and cutting the rate on its one-year lending facility to maintain adequate liquidity in the system. Chinese Premier Li Keqiang has called for the six major economic provinces in China to support local businesses and open to more foreign trade and investments. President Xi begins his third term in the fall, which is an event that some believe will lead to additional fiscal stimulus. This monetary and fiscal support in China is generally a positive, but we note it has the potential to stoke inflation, which currently sits at 2.7 percent, below China’s 3 percent inflation target.
We must also acknowledge that a long-term increase in inflation, while not our base case, is a possibility moving into mid- to late 2022. If this were to unfold, central banks in emerging markets would likely have to tighten monetary policy even further, which would create a market headwind. Finally, tensions between China and much of the rest of the world remain high, especially in the aftermath of the Russian invasion of Ukraine.
Overall, in developing economies, relative valuations are extremely attractive and currently sit near all-time lows versus the developed world. As we look at Emerging Markets as a broad basket, the group is expected to grow at about double the rate of the developed world over the next decade. Growth in these economies will be driven by an ascending middle class, the transition from manufacturing-based economies to services, and technology. Today’s emerging-market countries, as a group, are different than those of 20 years ago, with technology and financials the two largest sectors. Developing countries account for about 40 percent of world GDP and 25 percent of world equity markets, which means it’s important to have some exposure in a well-diversified portfolio.
In June 2021 we reduced our exposure to Emerging Markets to our current slight overweight, a position we continue today given the delicate balance of risks and potential rewards.
Section 04 Fixed Income
While equity markets garner much of the attention in the media and financial press, the reality is that fixed income markets have experienced an abnormally sharp decline, suffering the worst drawdown (-14.37 percent) in the history of the U.S. Bloomberg Barclays Aggregate Bond Index dating back to 1976. Through the end of August, the Barclays Aggregate Bond Index was down 10.75 percent year to date, not substantially different than the decline of 16 percent for the S&P 500 (U.S. Large Cap), 13 percent for the S&P 400 (Mid-Caps) and 14 percent for the S&P 600 (Small Caps). While bonds often provide an offset or hedge against downside risk in equity markets, these two asset classes have performed similarly due to past and recent actions of the Federal Reserve.
Simply put, the largest price-insensitive buyer — the Federal Reserve — is likely to continue scaling back its impact on the Treasury market, which means that price-sensitive buyers will be needed to fill the void.
As we noted in our last Asset Allocation Focus, during the Great Financial Crisis, the Federal Reserve engaged in Quantitative Easing (QE), or large-scale purchases of U.S. Treasury bonds and mortgage-backed securities to bring down intermediate to long-term rates of varying maturity lengths. The goal of QE was twofold: 1) to push down the term premium, or the extra compensation investors receive for owning longer-dated securities versus rolling shorter-dated securities, and 2) to inject liquidity into the market with the goal of encouraging investors to buy riskier assets and fund economic growth. During COVID, this strategy was re-engaged and was successful. Treasury yields fell and remained historically low even in the face of rising inflation. As a result, investors took risk (sometimes excessive).
During 2022, Treasury yields have risen dramatically as rate hike expectations have grown and the Fed has begun to unwind QE and is now engage in Quantitative Tightening (QT). This has resulted in a marked increase in yields across the maturity curve, with the 10-year Treasury rising from around 1.5 percent at year-end to a high of 3.47 percent on June 14 before settling at 3.20 percent at the end of August. This dramatic repricing of the bond market has been a reason behind the repricing of U.S. equity markets. Importantly, we believe this shock to fixed income and equities markets is increasingly behind us as current inflation worries have begun to subside. However, we believe that Treasury yields could continue to inch upward for longer-term bonds in the coming years.
Simply put, the largest price-insensitive buyer — the Federal Reserve — is likely to continue scaling back its impact on the Treasury market, which means that price-sensitive buyers will be needed to fill the void. Currently the term premium, or the extra compensation that investors receive for buying the 10-year Treasury versus rolling shorter-term securities, is negative. With inflation scars and bond losses firmly ingrained in the minds of investors, we believe investors will demand extra compensation in the form of higher yields for bonds with longer maturities.
The Fed’s QT program is likely to keep upward pressure on interest rates in the coming quarters. However, we don’t believe that bonds will continue to post negative returns. The positive news in our view is that the recent rapid repricing in the fixed income market has re-established bonds as a future hedge against downside risk in equities. This is something that has been missing over the past year as both markets have re-adjusted to higher interest rates.
We believe the potential for loss in high-quality, long-dated bonds is low, particularly when compared to lower-rated and “equity-like” bonds.
Our research reaffirms this belief. Since 1926, stocks have posted negative returns 25 times on an annual basis. In all but four of those instances (as well as year to date in 2022), the bond market recorded positive returns. The years in which fixed income had negative returns were 1931, 1946, 1969 and 1973. The key takeaway is that the performance of bonds this year in relation to negative returns in equities is very unusual and, based on history, unlikely to persist. The common thread between three of the four outliers (1931 being the exception) as well as what has occurred this year is that they coincided with periods of elevated inflation of 5 percent or more, a level we do not believe will be repeated in 2023 and beyond.
Overall, we continue to position the fixed income portfolios with durations that are near those of the benchmarks. We also favor higher-quality fixed income given the current economic backdrop and our slight equity overweight. Simply put, every slice of the portfolio has a role to play, regardless of the market mood or economic environment. As such, we don’t believe it is prudent to make disruptive changes to portfolios based on short-term challenges. Fixed Income is not simply a vehicle for income generation but is also needed to fund near-term spending needs as well as provide vital risk mitigation.
The U.S. Treasury curve is now inverted across the entire term spectrum. Even with elevated CPI levels and a Federal Reserve that has been extremely active in raising short-term rates, interest rates across the term spectrum have been notably calm. Consistent with the past, we recommend adding high-quality duration to all our portfolios. We believe the potential for loss in high-quality, long-dated bonds is low, particularly when compared to lower-rated and “equity-like” bonds. Additionally, holding long-term bonds provides investors with an opportunity to be rewarded for their patience. Barring significant disruptions, which are unusual in fixed income markets, investors can generate greater yields and potential returns over longer periods of time by holding long-dated bonds. Even with an inverted curve, which implies lower rates in the future, we believe it is prudent to hold high-quality, intermediate-duration bonds as a core in a fixed income portfolio. While the yield curve suggests the Fed may need to continue to be aggressive in its battle against inflation, the impact will be primarily on near-term Treasurys, and yields on intermediate-term bonds are likely to be muted.
The Federal Reserve has a mandate to steer the economy toward an inflation rate of 2 percent. As a result, rates across the yield curve are settling in at the 2-3 percent range. As noted above, while the Fed Funds rate could be quite volatile over the next one to three years, the yield curve is suggesting that government bonds are likely to be relatively steady near current levels. Central banks globally are raising rates. Should the rate hikes lead to a general economic slowdown, which we believe is highly probable, 7-10 year Treasurys, agencies or mortgages are likely to be the most attractive segments in fixed income.
While credit spreads continue to recover a bit from levels seen in mid-June, the risk in fixed income remains that credit quality could continue to deteriorate. The Federal Reserve is focused on reducing aggregate economic demand to cool inflation. If its efforts are too aggressive, it could cause credit market volatility, particularly in high-yield or “junk” bonds. As such, we continue to favor high-quality fixed income over more speculative bonds.
Treasury Inflation-Protected Securities (TIPS) reflect the market’s view that inflation is temporary. Despite the steady climb in inflation data over the past few months, the TIPS breakeven curve never steepened, and longer-dated inflation expectations remained stable. This provided a hint that the market believes that inflation is temporary. Recently, shorter-term expectations have also declined, which points to inflation falling in the coming year. For example, in March of this year the one-year breakeven inflation rate was 6.3 percent, meaning the market expected inflation to be 6.3 percent over the coming year. Now that rate has fallen by more than 4 percent, in just six months, to 1.81 percent. This is a dramatic decline in forward-looking short-term inflation, while intermediate to longer-term inflation expectations remain steady. This implies that the uptick in inflation this year represents a short-term spike — a view we have long held. We continue to favor nominal or coupon-yielding bonds over TIPs that provide a hedge against inflation, as we believe price pressures are receding.
Consistent with the majority of all other fixed income maturity curves, the municipal bond yield curve is flat. We continue to favor a barbell strategy, focusing on municipals bonds maturing in slightly more than seven years along with those that mature in less than two years. With volatility in fixed income markets subsiding, many of the municipal bond indices have recovered nearly 50 percent of the historic losses incurred during the beginning of the year.
Section 05 Real Assets
We ended the fixed income section with a discussion of the four prior times in which bonds did not counterbalance equities. As we noted, in each of those instances — with the exception of 1931 — inflation was above 5 percent. This is a good segue to real assets. During three of those four periods, 1931 again being the exception, commodities posted positive returns with an average gain of 54 percent. Put differently, when fixed income didn’t provide diversification, commodities did.
Our allocation to commodities over the past few years had been met with significant skepticism because the asset class hadn’t performed well. The returns during the past few years, along with the recent struggle for both stocks and bonds, underscore why we believe portfolios need to own real assets to help dampen volatility. It is important to note that asset classes performing in different ways under the same circumstance is not a “bug” of a portfolio; it’s exactly how a portfolio is designed. This is the definition of diversification.
In recent years, commodities have erased most prior underperformance and are now up nearly 10 percent per year during the past five years, which makes the asset class a top performer. The reality is that the strong returns have come in a very short period of time. In response to the sharp rebound, we maintain exposure to the asset class, but the position is relatively small. Despite the recent increases in commodity prices that have been driven by shortages, including some caused directly by the Russian invasion of Ukraine, we continue to recommend that investors maintain a position in this asset class. Years of lower commodity prices have led to underinvestment, which we believe will ultimately be cured as higher prices result in more investment.
REITs were laggards in the early days of COVID as investors contemplated and repriced the intermediate- to long-term impacts from the pandemic. Throughout 2021, as the U.S. economy adapted to COVID, REITs became a top-performing asset class. However, much as we have forecasted, during the recent interest rate spike, REITS have once again dramatically underperformed as a result of the class’s sensitivity to interest rates.
REITs commonly pay higher dividends than other kinds of equity securities, a convenient feature in periods of flat or negative equity market performance. The current dividend spread between many REIT indexes and large-cap equities has tightened in recent weeks to below 100 basis points. While this still may provide a ballast for REITs, the reality is rising interest rates are acting as a headwind for this asset class. Mortgages and other financing rates have spiked to levels not seen in years, causing demand for new projects to slow.
Valuation levels between the earnings multiples of U.S. equities and U.S. REITs are slowly becoming attractive and may provide a future buying opportunity. However, this asset class is treading water given the current transitionary environment. We will continue to monitor the REIT market for opportunities to adjust our exposure.
The sharp rise in commodity prices earlier this year has cooled a bit over the summer, but prices remain at elevated levels. Rapidly rising energy prices have added to inflationary pressures as drivers grapple with higher prices at the gas pump and (more recently) surging natural gas prices, which will result in higher utility bills.
Through August 31, commodity prices have risen 23 percent, following a strong 27 percent gain in 2021. The surge in prices during the past 18 months has been driven by supply-chain bottlenecks, industry underinvestment and the impacts of the Russia-Ukraine war.
Note that the sharp gains in commodity prices are not broad based and are largely concentrated in the energy sector. Energy prices have risen an amazing 79 percent year to date, including oil (up 32 percent), gasoline (up 51 percent) and natural gas (up 153 percent). Amazingly, natural gas prices have recently surged, while other energy-related commodities fell in price. Natural gas — a notoriously volatile commodity — surged thanks to an exceptionally hot summer in the U.S., limited production growth, significant exports of liquified natural gas and storage levels that are well below long-term averages.
Beyond the energy sector, weaker commodity prices reveal an expectation for reduced global economic growth. Industrial metal prices have declined more than 11 percent year to date. Copper and aluminum prices have posted double-digit declines. In the U.S., recessionary concerns have lowered growth expectations, while a meaningful slowdown in China and other emerging markets has also had an impact on industrial metals prices.
Looking past the headlines regarding inflation, it is clear that it has been fueled largely by unsustainable durable goods spending.
Precious metals have also declined (gold down 6 percent year to date), as gold prices have traded on the back of rising geopolitical risk. Gold serves as a safe haven for investors, particularly in environments with negative real (inflation-adjusted) interest rates. As such, we expected gold prices to move higher as inflation expectations rose. The long-term relationship between gold and real rates aside, there have been sustained short-term periods when the linkage has been inconsistent. That said, we currently find no reason to abandon the anchoring of gold to real yields and continue to expect gold to provide a hedge against unforeseen economic outcomes.
While we have a positive outlook for commodity returns, our inflation outlook suggests the current rate of appreciation isn’t sustainable. Inflation has surged to levels not seen since the 1980s; however, that is also the period that marked the beginning of a steady move lower for price pressures and eventually led to deflationary worries that engulfed the markets during the last economic cycle. The return of inflation has sparked a fierce debate in markets. Are we in a new inflationary regime, or is this a pandemic-fueled distortion?
Looking past the headlines regarding inflation, it is clear that it has been fueled largely by unsustainable durable goods spending. We believe spending on durables will normalize and pull headline inflation lower. Data indicate that a shift in spending is already underway, as services spending markedly increased in the third quarter while overall goods spending declined. As an investment, commodities are the only major asset class to generate a positive return year to date and have dramatically outperformed all equity markets (that we track) since the onset of COVID in early 2020.
The three primary components of the Bloomberg Commodity Index are energy, metals (both industrial and precious) and agriculture. The benchmark is composed of approximately a third of each sector. As a result, the benchmark is broadly diversified across the commodities spectrum and ensures that no single commodity has an outsized impact on overall risk and return. The individual components of the commodity benchmark have unique characteristics and prices that are determined by different supply and demand drivers within individual markets. However, inflation, economic growth and the direction of the U.S. dollar are the largest drivers for overall commodity prices.
Section 06 The bottom line: Different economic environments have different leadership
One of the most cherry-picked numbers on Wall Street is that of inflation, where investors seemingly create an outlook and then find the inflation number that supports it. Is the current level of inflation at 8.5 percent, as the headline Consumer Price Index (CPI) suggests it is, or is it 4.6 percent, as represented by the Personal Consumption Expenditures core price index (PCE)? We think it is worth pointing out that the Federal Reserve has historically viewed core PCE as its preferred measure and remind that, unfortunately, the Fed rate hikes have limited impact on food and energy prices. Either way, the reality is that we believe all inflation indicators are set to push lower in the coming months.
While we hold what seems like a contrarian viewpoint that this current bout with inflation is cyclical and therefore will subside, we don’t think inflation is going away entirely. In fact, we have been noting for years that inflation is not a relic of the past. We pointed to the residual scars left by the Great Recession keeping inflation low but noted that de-globalization, the green energy push and other societal desires coupled with changes in monetary and fiscal policy would eventually bring inflation back to the fore. During the past few years, we have further added that we don’t believe this economic cycle or any in the future would resemble the one that we experienced from 2009-20, when deflation concerns were rampant. Instead, we believe future economic cycles will likely entail worrying about inflation.
We (with emphasis) remind our readers that inflation is a year-over-year measure. If prices next year stay at the “elevated” levels they reside at today, inflation will be 0 percent year over year. For context, in the aftermath of the late 1960s/1970s and early 1980s bouts of inflation, prices did not DECLINE; rather, the pace of appreciation slowed.
We believe inflation is set to fall but again note that from a secular perspective there are forces today that will keep inflation worries present in the coming economic cycles. While core measures of inflation spent the post-Great-Financial-Crisis period consistently below 2 percent, we believe the future will see core readings in a more normal 2-3 percent range with upside near the end of economic cycles. And this likely means bond yields will be at levels above those of the past few years. Perhaps most importantly, negative interest rates are likely a thing of the past.
This is not to say we are returning to the 1970s, when inflation became entrenched and was a persistent problem, but rather that the floor for inflation is higher than it was in the past. We note this because of its implications for asset allocation decisions. Consider this in the context of our last asset allocation piece, in which we discussed how the different economic cycles over the past 32 years have all witnessed a shifting leadership landscape. We place this narrative in the context of investors continuing to focus on yesterday’s winners, a formula that we believe is inadequate. We continue to believe that this and future cycles will once again see investors relatively rewarded for focusing on asset classes that are cheap rather than blindly chasing growth and story stocks.
At a minimum, we believe it is prudent to stay diversified and avoid the urge to eliminate asset classes that haven’t performed well (think commodities) and to work with your advisor to craft a plan that addresses all economic and market seasons to deal with life’s uncertainties.
Northwestern Mutual Wealth Management Company (NMWMC) Investment Strategy Committee:
Brent Schutte, CFA®, Chief Investment Strategist
Michael Helmuth, Chief Portfolio Manager, Fixed Income
Richard Iwanski, CFA®, CAIA, Senior Research & Portfolio Analyst
Matthew Wilbur, Senior Director, Advisory Investments
Matthew Stucky, CFA®, Senior Portfolio Manager, Equities
Doug Peck, CFA®, Portfolio Manager, Private Client Services
David Humphreys, CFA®, Senior Investment Consultant
Nicolas Brown, CFA®, CAIA, Senior Research Analyst, NMWMC Research
The opinions expressed are those of Northwestern Mutual Wealth Management Company as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute individual investor advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.
Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company (NM), Milwaukee, WI, and its subsidiaries. Investment brokerage services are offered through Northwestern Mutual Investment Services, LLC (NMIS), a subsidiary of NM, broker-dealer, registered investment adviser, and member FINRA and SIPC. Investment advisory and trust services are offered through Northwestern Mutual Wealth Management Company® (NMWMC), Milwaukee, WI, a subsidiary of NM and a federal savings bank. Products and services referenced are offered and sold only by appropriately appointed and licensed entities and financial advisors and professionals. Not all products and services are available in all states. Not all Northwestern Mutual representatives are advisors. Only those representatives with “Advisor” in their title or who otherwise disclose their status as an advisor of NMWMC are credentialed as NMWMC representatives to provide investment advisory services.
Please remember that all investments carry some level of risk, including the potential loss of principal invested. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss.
Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market.
With fixed income securities and bonds, when interest rates rise, bond prices usually fall because an investor may earn a higher yield with another bond. Moreover, the longer the maturity of a bond, the greater the risk. When interest rates are at low levels, there is a risk that a significant rise in interest rates can occur in a short period of time and cause losses to the market value of any bonds that you own. At maturity, the issuer of the bond is obligated to return the principal (original investment) to the investor. High-yield bonds present greater credit risk than bonds of higher quality. Bond investors should carefully consider risks such as interest rate risk, credit risk, liquidity risk, securities lending risk, repurchase and reverse repurchase transaction risk.
Investing in special sectors, such as real estate, can be subject to different and greater risks than more diversified investing and may present more financial and other risks than investing in companies of larger capitalizations and more seasoned companies. Declines in the value of real estate, economic conditions, property taxes, tax laws and interest rates all present potential risks to real estate investments.
Investing in real estate companies entails some of the risks associated with investing in real estate directly, including sensitivity to general and local economic and market conditions, demographic patterns, changes in interest rates and governmental actions.
Investors should be aware of the risks of investments in foreign securities, particularly investments in securities of companies in developing nations. These include the risks of currency fluctuation, of political and economic instability and of less well-developed government supervision and regulation of business and industry practices, as well as differences in accounting standards.
Commodity prices fluctuate more than other asset prices, with the potential for large losses, and may be affected by market events, weather, regulatory or political developments, worldwide competition and economic conditions. Investment can be made directly in physical assets or commodity-linked derivative instruments, such as commodity swap agreements or futures contracts.
Treasury Inflation-Protected Securities (TIPS) are securities indexed to inflation in order to protect investors from the negative effects of inflation.
The U.S. Large Cap asset class is measured by the S&P 500 Index, which is a capitalization weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The gross domestic product (GDP) is the amount of goods and services produced in a year in a country.
The U.S. Mid-Cap asset class is measured by the S&P MidCap 400 Index, which is the most widely used index for mid-sized companies and covers approximately 7 percent of the U.S. equities market.
The U.S. Small Cap asset class is measured by the S&P Small Cap 600 Index, a market value weighted index that consists of 600 small-cap U.S. stocks chosen for market size, liquidity and industry group representation.
The International Developed Markets asset class is measured by the Morgan Stanley Capital International Europe, Australasia, and Far East (MSCI EAFE) Index, which is composed of all the publicly traded stocks in developed non-U.S. markets. The MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.
The International Emerging Markets asset class is measured by the MSCI Emerging Markets Index, which is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging-market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.
The Real Estate asset class is measured by the Dow Jones U.S. Select REIT Index, which intends to measure the performance of publicly traded REITs and REIT-like securities. The index is a subset of the Dow Jones U.S. Select Real Estate Securities Index (RESI), which represents equity real estate investment trusts (REITs) and real estate operating companies (REOCs) traded in the U.S. The indices are designed to serve as proxies for direct real estate investment, in part by excluding companies whose performance may be driven by factors other than the value of real estate.
The Commodities asset class is measured by the Bloomberg Commodity Index (BCOM), formerly the Dow Jones-UBS Commodity Index, which is a highly liquid, diversified and transparent benchmark for the global commodities market. It is calculated on an excess return basis and reflects commodity futures price movements.
The Consumer Price Index (CPI) examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.