An Economy Feeling the Effects of Fed Policy

The Fed’s rate hiking cycle is having an impact on the economy. NM’s Chief Investment Officer Brent Schutte looks to what both the intended and unintended consequences of the Fed’s actions may mean in the quarters ahead.

Forklift loading inventory in a warehouse.

Northwestern Mutual Wealth Management Company’s (NMWMC) investment professionals provide views and commentary on the current marketplace. This information is designed as general commentary regarding our views on the relative attractiveness of different asset classes and asset allocation strategy over the next 12 to 18 months.  

Keep in mind that this viewpoint can and will change as valuations and economic variables evolve. These views are made in the context of a well-diversified portfolio, not in isolation, and are not a recommendation for individual investors. Decisions about investments should always be made on an individual basis or in consultation with a financial advisor, based on an individual’s preferred risk levels and long-term goals. 

Section 01 Inching toward a recession

In a world that seems to spin quickly, you can characterize the economy over the past year as inching toward a U.S. recession sparked by a Federal Reserve (Fed) that has rapidly pushed interest rates higher in an attempt to squeeze the inflation genie back into its lamp after the same Fed awoke it from a nearly 40-year slumber. 

Following COVID-induced shutdowns in early 2020, policymakers flooded the economy with liquidity, which had the intended effect of spurring economic growth (albeit unevenly), but also caused the mostly unintended consequence of a jump in inflation. With the world still in lock down, consumers spent heavily on goods while sheltering at home. As prices began to rise rapidly, the Fed reversed course by instituting rate hikes at a historic pace throughout 2022 and into early 2023.  

The rate hikes, along with quantitative tightening and the winding down of fiscal stimulus programs, created a liquidity tourniquet that drained excess money out of the U.S. economy. The good news is that, despite a few hot spots along the way, this tightening appears to be having its intended consequence of pulling back inflation, but also with the likely unintended consequence of a recession. While we think the Fed would prefer that the economy not slip into contraction, it appears to be more focused on the labor market, which is the one primary hot spot that could still result in inflation becoming embedded in the economy. Given this focus we believe it is likely that Fed will go too far in raising rates, which will result in a rise in unemployment and lead to recession.  

While many investors have become more optimistic as the Fed paused rate hikes at its June meeting and the economy is not as yet in recession, we continue to believe that a recession is still in the cards.

Since the wage-price spiral of 1966–1982, when wages grew fast enough to support continued price increases, the Fed has intently focused its sights on the labor market and rising wages in an effort to keep inflation expectations anchored. Consider that in every economic cycle since 1982—wage increases reached 9.4 percent year over year in early 1981—policymakers have aggressively raised rates when wage growth for production and nonsupervisory workers approaches 4 percent. The result has been a “capping” of wage growth at around 4.2–4.3 percent annualized during each of the last three economic cycles. With the unemployment rate currently at 3.7 percent and production and nonsupervisory wage growth at 5 percent, the Fed remains intently focused on the labor market for cues as to when it can declare it has finished the job of stamping out all remaining inflation embers. The good news as it pertains to inflation is that wage increases are down from their year-over-year peak of 7 percent recorded in March 2022. However, with labor demand still appearing to outstrip labor market supply, it is likely that the Fed will not declare the battle against price pressures over until the unemployment rate moves higher (think job losses), which usually constitutes a recession.  

While many investors have become more optimistic as the Fed paused rate hikes at its June meeting and the economy is not as yet in recession, we continue to believe that a recession is still in the cards. This will have implications for financial markets over the next few quarters. As a result, we have been shifting our positioning over the past few months to reflect this viewpoint. The good news is that with the likelihood of a short and shallow recession, better days should follow in the coming quarters, particularly for parts of the market that are cheap. In the intermediate to longer term, we believe we will see a secular shift in the economy that will impact our asset allocation decisions in the years ahead.  

The secular investing impact of the aftermath of the Great Financial Crisis of 2007–09 

In the aftermath of the Great Financial Crisis (GFC) of 2007–2009, policymakers concluded that they may not have infused the economy with liquidity as aggressively as they should have. The muted intervention not only contributed to the recession’s 18-month duration, but it also set the stage for the weak recovery that occurred in the years after.  

Given this backdrop, with inflation and inflation expectations already too low in the Fed’s view, and with interest rates that were well below levels preceding the GFC, we believed that policymakers (both fiscal and monetary) had learned from the GFC and would arrive quickly at the scene of any economic or market “incident” with liquidity at the ready. While we still believed there could be economic and market hiccups, we concluded that the turbulence would likely be short given the powerful impact that liquidity has on both markets and the economy. 

26.9 %

The year-over-year increase in the M2 money supply shortly after the arrival of COVID

This view helped shape our years-long optimistic outlook for the latter part of the 2010–2020 period and served as an impetus to add to our risk asset exposure shortly after COVID’s arrival in early 2020. Much as we expected, policymakers reacted quickly with a record 26.9 percent year-over-year increase in the U.S. M2 money supply following the arrival of COVID, which not only propped up economic growth but also drove equity markets quickly higher. 

Now we are on the opposite side of the equation. Many economists and Fed officials seemingly romanced the idea of a return to higher inflation rates during a period of flat or muted prices following the GFC. However, now with a return of inflation thanks to excess liquidity, the Fed and policymakers have seemingly reversed their views and have effectively slammed on the economic brakes with 500 basis points in interest rate hikes, the pursuit of quantitative tightening and the winding down of economic stimulus. As a result, the U.S. M2 money supply has contracted by 4.6 percent year over year, thanks to the above-mentioned policy changes as well as banks tightening lending standards. 

Given our recent brush with inflation and the general angst it caused, it’s reasonable to ask whether monetary policymakers will be as quick to rush to the rescue during future economic challenges.

While excess liquidity remains in the economy and has likely staved off a recession to date, we believe that the continued drawdown of this stockpile will result in economic contraction. Importantly, we note that there have been only three other periods since 1900 in which the money supply has fallen on a year-over-year basis in the U.S.: 1921, 1930–33 and 1958. Not surprisingly, during each of these three periods a recession occurred. We believe, unfortunately, this time will be no different.  

While this is our near-term forecast, certainly we must also adapt our next “secular” investing backdrop for the potential of new economic realities. Given our recent brush with inflation and the general angst it caused, it’s reasonable to ask whether monetary policymakers will be as quick to rush to the rescue during future economic challenges. While fiscal policymakers recently resolved the debt ceiling issue without too much drama, it’s important to remember that the country’s annual interest costs on servicing that debt are rising. With interest payments taking up more resources in the budget, it is likely borrowing costs will become an issue that restricts future government spending. The reality is that we are likely to see an erosion of the ultra-favorable backdrop for equities in the coming years. This does not mean we will not overweight risk, but our positioning may become a bit more dynamic given the threat of smaller and slower fiscal and monetary policy interventions going forward. 

The impact of recent rate hikes  

Since October 2022, U.S. equity markets have rallied by more than 20 percent resulting in a bull market following last year’s 26 percent plunge into bear market from record levels reached on January 3, 2022. The sell-off during much of last year was driven by inflation fears and rapidly rising interest rates that resulted in the yield on the 10-year Treasury rising from 1.512 percent to start 2022 all the way to 4.24 percent on Oct. 24, 2022. We believe the recent rally in equities has stemmed from easing inflation fears and long-term intertest rates that have been rangebound or slightly lower, along with an economy that has so far appeared resilient. Unfortunately, we believe we are nearing the end of what we have characterized as the Space Between, and that rising recession fears and an eventual economic contraction is likely to take the steam out of recent equity market gains.  

This is where the current market divide lies. Is the much hoped-for soft-landing still a possibility? While many point to individual data points to argue “yes,” we continue to believe the overall trend and weight of the data point lower. The good news is that much as we had a strong but desynchronized reopening, the same is happening on the downside, something we believe will help blunt the overall shape and length of the recession.  

The reality is housing inventories are low, and overall housing remains unaffordable.

Additionally, while many comment on the recent “strength” in housing as an indicator of enduring economic growth, it is important to note how far the sector has deteriorated. Yes, existing home sales have ticked up recently, but the seasonally adjusted annualized pace of existing home sales has declined substantially. It was at 6.56 million units annualized in January 2021 and 6.34 million by January 2022, but by January 2023, the pace had fallen to 4 million. After rising back to 4.55 million in February, we are now back at 4.28 million. Others point to new home sales as a sign of resilience, but, once again, let’s put this into context. Yes, new home sales recently hit a one-year high of 683,000 units on a seasonally adjusted annual rate, but this pace was 830,000 at the end of 2021 and 1.029 million in August 2020. Are we surprised at this recent so-called strength? Not at all—existing home sales are stuck; homeowners don’t want to give up their sub-3 percent mortgages only to take out new loans that are now charging almost 7 percent. And existing homeowners also don’t want to charge less for their homes, so a new buyer might have a similar payment (with more going to interest). This dynamic, along with a lack of inventory, has driven buyers to new construction, according to Robert Dietz, chief economist of the National Association of Home Builders, who recently noted, “In March, 33 percent of homes listed for sale were new homes in various stages of construction. That share from 2000–2019 was 12.7 percent.” The reality is housing inventories are low, and overall housing remains unaffordable. We continue to believe that housing gains will remain muted until interest rates or prices move lower, something we believe won’t happen until a recession.  

Similarly, the goods market has struggled over the past year as spending has shifted to services. Manufacturing industrial production is down 0.9 percent year over year, a rate of decline that has typically only occurred during a recession. And this slump looks set to continue, as the Institute for Supply Management (ISM) manufacturing index has been in contraction for seven consecutive months through May. Future growth indicators, such as new orders, have been in contraction for nine months and are pushing deeper into contraction, while order backlogs are non-existent and nearing historical lows set only during recessions. Throw in customer inventories that are too high, and the recipe for further lack of manufacturing production (economic growth) is firmly in place. 

The good news has been that as manufacturing has weakened over the past year, services have been bolstered by a surge in spending that started once COVID mandates began to expire. The rise in services spending has been holding up the U.S. economy for the past several months. However, recent data suggests that this spending is also starting to fade as consumers concerned about the potential for a recession start to tighten their finances. The latest ISM services index fell to 50.3, just north of the 50 line that denotes expansion. New orders pulled back toward 50, while order backlogs have collapsed to historical lows set only during recession. Additionally, inventory sentiment has spiked (meaning too much). Although we highlight only the latest month, the trend has been lower; and when the two surveys are viewed together, they point to a recession.   

Lastly, we again note that the Conference Board’s Leading Economic Indicator Index has been falling for 13 straight months and is down 8.7 percent on a six-month annualized pace with a diffusion index (how widespread the decline is) of 20. The Conference Board notes that when this indicator reaches -4.2 percent on a six-month annualized pace with a diffusion index below 50, a recession usually follows. Current readings are not only well below that but at levels that during the last 50 years have always been consistent with a recession. Perhaps this time is different, but we don’t believe so.  

What about the Fed?  

The good news is that inflation is following the same path as the economy and is now faltering. Just as a surge in spending first occurred in goods, so did inflation, with goods prices rising to a year-over-year peak of 12.3 percent before consumers began to shift dollars to services. As fewer dollars chased goods, price pressures for manufactured products began to recede and are currently up a more modest 2 percent since last year. Commodity prices spiked next and became the driving force of inflation after the Russian invasion of Ukraine. Broad commodity prices are represented by the Bloomberg Commodity Spot Index rose from 500 to 682, or up 36 percent, through mid-June 2022 and have now returned to 484. Since then, services inflation has been leading the inflation charge. We think a story similar to the goods and commodities one is about to play out here. First, a large majority of services inflation is tied to housing, which we consistently have reminded feeds into the CPI calculation with a lag of 12 months or more. The delay is notable, considering home price indices peaked in June of 2022 and have spent the past months moving lower. The other part of services is reflected in the ISM services price paid (Services ISM Report on Business), which is now back to normal territory. 

The latest (May) CPI report shows that all-in CPI excluding the lagging shelter category is now up a mere 2.1 percent year over year and .4 percent since last June (11 months). Put differently, heightened CPI (above 2 percent) during the past year in aggregate has been driven by shelter. We think this approach provides a look at current price pressures instead of a measure influenced by lagging indicators. The Fed sees the same data we do but wants to be sure that inflation is fully extinguished. The more important part of the inflation equation the Fed is focused on is the labor market. The Fed, in our view, wants to make sure that labor demand and labor supply reach equilibrium to prevent wages from providing fuel for inflation, as they did from 1966 to 1982.  

Additionally, an economic contraction, in our view, would eliminate the threat that inflation becomes embedded in the economy

While wage growth has come down during the past year, some of that the decline is simply the result of already elevated levels that were in place a year ago. It’s hard to imagine that the Fed believes wage pressures will remain controlled until there is some slack in the labor market.  There are two ways the labor market can loosen: 1) Job demand falls below new labor supply, or 2) the labor participation rate rises as more workers return to the labor market. Given that the Fed is forced to use blunt instruments to strike a delicate balance on the labor front, we believe it is unlikely it will be able to navigate a soft landing that would pull down job demand without tipping the economy into recession.  

Although the Fed held rates steady at its meeting in June, we don’t think it will take the possibility of further hikes off the table until there is labor market weakness. The last bastion of strength in the inflation equation is the labor market, which still appears strong; however, the question remains as to how strong and whether companies will be able to continue to hire in a slowing economy. Temporary employment is falling. The Bureau of Labor Statistics Household report has shown strength but much less than Nonfarm payrolls. Claims bottomed in September 2022, and have risen by amounts that are similar to what we typically see prior to a recession. Indeed, continuing claims are up 36 percent from their recent lows, which is a pattern historically consistent with an arrival of a recession. Certainly, none of this guarantees the economy falls into a recession, but this is another reason we believe it is likely. The good news is that the economy has already been experiencing a rolling weakness that should lessen the sting of a potential recession. Additionally, an economic contraction, in our view, would eliminate the threat that inflation becomes embedded in the economy. As such, the Fed should be able to cut rates to steady the economy as necessary in the future.  

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Section 02 Current positioning

In the immediate aftermath of COVID, we over-weighted equities by further reducing our exposure to fixed Income and maintained a tilt toward shorter-maturity bonds and Treasury Inflation-Protected Securities (TIPs). Our positioning reflected our outlook that rising inflation would eventually lead to rising interest rates. This positioning proved beneficial as the stimulus-fueled U.S. economy and markets adjusted and adapted to life during COVID.  

As we pushed into mid-2021, we stated our belief that both monetary and fiscal policy would become restrictive. Given this backdrop, in June 2021, we began gradually removing our equity overweight and adding to investment-grade fixed income. In February 2022, we pulled back our TIPs exposure and allocated exposure to shorter-term coupon-bearing bonds based on our outlook that inflation was in process of peaking and the Fed was on the verge of raising interest rates to aggressively stomp out price pressures.  

As the Fed began aggressively hiking rates in March 2022, investment-grade fixed-income yields moved substantially higher, with yield for the Bloomberg U.S. Aggregate Bond index moving from a meager 1.75 percent at the beginning of 2022 to more than 5 percent by October 2022. Reflecting our belief that this was an attractive yield as well as an opportunity to begin positioning our portfolios for what we continue to believe will be an eventual recession, we increased our fixed income exposure and moved our duration (maturity) profile from short- to intermediate- to longer-term as we sought to “lock in” higher long-term yields. The source of funds for this move came from a sliver of our gold allocation, which we had initially made during the early months of COVID as an additional portfolio hedge based on our belief that low-yielding fixed income at the time was an incomplete hedge. 

The reality is that smaller to mid-cap companies often do well coming out of recessions.

Since October, equity markets have rebounded; the economy has appeared to remain resilient, while inflation has pulled back. However, given our belief that a recession is still on the horizon and could cause market volatility, we decreased our equity allocation in February and again in early May, with the proceeds in each instance reallocated to broad investment-grade fixed income. Importantly, we believe that any economic recession will put the final nail in the coffin of already decelerating inflation, and therefore, given the current yield of 4.7 percent, we believe bonds offer not only real value but also likely a hedge against any future equity market declines. 

Overall, we are now neutral equities, underweight commodities with a tilt toward the defensiveness of gold, and overweight to investment-grade fixed income. However, we think it is important to note that within our equities allocation, we are overweight U.S. Small and Mid-Caps. While this may seem counterintuitive given their economic sensitivity, we view it as a nod to a mild recession that is already at least somewhat priced into markets. The reality is that smaller to mid-cap companies often do well coming out of recessions.  


Section 03 Equities

U.S. Large Cap 

The resiliency of U.S. Large Caps over the first five months of this year has been nothing short of remarkable, in our view. Year to date, Large Caps lead our nine asset class portfolios and, as of this writing, is the only asset class with double-digit returns. What makes this performance surprising is that it’s occurring at a time of growing monetary and macroeconomic headwinds for the U.S. and global economy. Tightening bank lending standards, higher interest rates, regional bank stress and continued deterioration of broad-based leading economic indicators suggest to us that the probability of a recession has increased since the end of 2022. The steep inversion of the bond market is also signaling a likely recession. Despite all these negative factors, the forward 12-month earnings outlook for the S&P 500 has been reduced by only 6 percent, and investors are paying 19.2 times those earnings estimates. While current valuations aren’t significantly off from long-term averages, historically, earnings drop about 20 percent during recessions, and stocks typically trade at lower multiples prior to entering a recession. We’re simply not seeing that trend this cycle as valuations for U.S. Large Caps remain in a class of their own relative to other equities. Earlier this year we moved to an underweight position in U.S. Large Caps given the growing macroeconomic headwinds, and we’ve maintained that positioning because we see limited evidence that our forecast for a recession is priced into this asset class. 

U.S. Mid-Cap  

We believe U.S. Mid-Caps are priced attractively for investors with intermediate- to longer-term time horizons. In our opinion, U.S. Mid-Caps are priced more consistently with our economic forecast, as forward earnings estimates are down more than 9 percent off their peak, and the valuation against those reduced estimates are more than three times less than the long-run average (current is 14.0 times earnings). This setup broadly aligns with how we want to position our portfolio over the next 12 to 18 months. Specifically, we want the largest valuation cushion available in our equity positions while simultaneously having exposure to a recovery in economic conditions once a mild and short recession arrives. We believe U.S. Mid-Caps meet these criteria, and we remain overweight. 

U.S. Small Cap 

U.S. Small Caps have struggled relative to Large Caps so far this year, and this economically sensitive asset class has responded to the darkening economic outlook. Year to date, Small Caps are up about 5 percent vs. 13 percent for their Large-Cap peers. Small Caps have essentially been flat since mid-March, while shares of larger companies have fully recouped their losses. The short-term dynamic has created an almost 8 percent performance gap in a little more than two months. Some of this gap makes sense, as Small Caps have a higher allocation to financials compared to Large Caps. But we also think there’s simply been a growing valuation cushion that explains a lot of the story. Earnings estimates are down 15 percent from the peak for Small Caps, and current valuations (13.9 times earnings) are significantly below the group’s long-term average as well as on a relative basis compared to Large Caps. While we don’t expect this overweight to drive material outperformance if the U.S. economy does indeed fall into a recession, we do expect this position to be a significant source of return in the recovery phase. We think it makes sense to be patient with this asset class given its valuation discount/cushion and reiterate our overweight position.  

International Developed 

The International Developed economy in the eurozone is performing much like the U.S. economy. Markit Euro Area Manufacturing PMIs have been in contraction since June 2022 and reached a recent low level of 44.8 in May (a reading below 50 indicates contraction). Meanwhile, Markit Euro Area Services PMIs have been above 50, climbing to 55.1 in the most recent May survey. The eurozone has also experienced CPI inflation similar to that of the U.S. Eurozone inflation peaked at 10.6 percent in 2022 before steadily declining to 6.1 percent year over year in May of 2022 with a core CPI inflation (which excludes food and energy readings) appearing to peak in March 2023 at 5.7 percent before easing to 5.3 percent in May. 

The disruptions caused by the war in Ukraine and the energy crisis, coupled with monetary policymakers around the world embarking on a forceful tightening of monetary conditions, led many to forecast a potentially deep winter recession in the EU, which drove equity markets lower. While a very mild technical recession appears to have taken root over the past two quarters the bloc appears to have avoided the worst outcomes with the European Commission’s Spring 2023 Forecast revising forward EU GDP growth expectations to 1.0 percent in 2023 (from 0.8 percent) and 1.7 percent in 2024 (up from 1.6 percent). Upward revisions for the eurozone are of a similar magnitude, with GDP growth now expected at 1.1 percent and 1.6 percent in 2023 and 2024, respectively. 

As a result of the strengthening economy surpassing lowered expectations, China reopening from COVID lockdowns, a warmer winter and the ability to source energy outside Russia, eurozone stock market returns have been very strong. Our tactical tilt to the eurozone has resulted in greater than 42 percent returns since the low in the fall of 2022. Despite this strength, eurozone valuations are still relatively inexpensive, with The MSCI EMU (European Economic and Monetary Union) trading at mere 12.5 times forward 12-month earnings.  

The International Developed asset class exposure is attractive, valuations appear remarkably cheap, and we believe there are further catalysts for future outperformance as investors underweight in the regions rush to rebalance their global allocations.

Another big contributor to International Developed market returns has been Japan. Japan represents slightly more than 20 percent of the MSCI EAFA Index and has returned approximately 21 percent year to date. Japan’s stock market is pushing through 30-year highs. Recent economic growth has moved back into positive territory, with Q1 GDP checking in at 2.7 percent on a quarter-over-quarter seasonally adjusted basis. This trend looks set to continue with May’s PMI manufacturing index checking in at 50.6, which is the first expansionary reading in seven months, while the Services PMI hit 55.9, the highest reading since the series began. All the while, the Bank of Japan has kept monetary policy accommodative and left its yield curve control policy that sets a short-term interest rate target unchanged at -0.1 percent. 

Importantly, both regions appear to have currently broken from their previous negative interest rate and deflationary spirals. Time will tell what happens on those two fronts—will deflation return, or can policymakers reduce inflation to a goldilocks range? Regardless, equity valuations in these regions remain attractive. Overall, the MSCI EAFE Developed International Index has a forward-price-to-earnings ratio (P/E) of 13.3, while the S&P 500 has a P/E of 19. The International Developed asset class exposure is attractive, valuations appear remarkably cheap, and we believe there are further catalysts for future outperformance as investors underweight in the regions rush to rebalance their global allocations. While we continue to review our overall outlook and risk assessment given our outlook for an economic recession, we believe the valuation discount these markets have compared to U.S. stocks provides a margin of safety and an opportunity for future outperformance. As such, we are maintaining our overall position at slightly overweight with a slight tilt to the eurozone. 

Emerging Markets 

Emerging Market equities have struggled in recent months as the markets repriced weaker than expected economic data out of China. Manufacturing PMIs fell to a five-month low at the end of May in conjunction with slowing factory activity, suggesting a weaker recovery than originally anticipated earlier in the year for the world’s second largest economy. U.S./China geopolitical risks continue to swirl related to Taiwan and tariffs. In addition, the dollar has strengthened against the yuan, with the yuan recently reaching its lowest level vs. the dollar since last November. This was largely because of Fed action and a slowing Chinese economy. Fed rate hike cycles tend to be a headwind for Emerging Market stocks, bonds and currencies, as capital may flow out of the developing world to opportunities with a better risk/reward tradeoff.  

Overall, in developing economies, relative valuations remain attractive, in our view, compared to the developed world. As we look at Emerging Markets as a broad basket, the group is expected to grow at a higher rate than 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 the world’s gross domestic product and 25 percent of world equity markets, which we believe means it is important to have some exposure in a well-diversified portfolio.  

Given our concerns about currency stability as well as geopolitical risk tied to China, we have moved to a slight underweight to the asset class.  

Section 04 Fixed Income

Fixed Income 

Similar to equity markets, Fixed Income markets found firmer footing in October 2022 as inflation fears began to peak. Investment-grade bonds (as represented by the Bloomberg Aggregate Bond index) began 2022 yielding a meager 1.75 percent. But by October 2022, the yield had spiked to 5.21 percent, causing the deepest return drawdown in that index’s history. This coupled with falling equity prices caused investors angst, as they had not seen bonds and equities post negative returns in the same year since 1973.  

While bonds have remained volatile since October, returns have shifted positive as yields have come down thanks to receding inflation fears. Indeed, the current U.S. breakeven Treasury curve from two to 30 years paints inflation expectations in a narrow bound between 2.10 percent and 2.35 percent. Consider the real return possibility this creates with the current yield on the overall investment-grade bond market at 4.7 percent and with the investment grade corporate portion yielding a healthy 5.5 percent. 

This brings us to three crucial points: 1) For those who still have losses in their bond portfolios, we once again remind that investment-grade bonds often mature at par and will experience a pull back toward that level as that maturity date draws nearer. 2) Future returns now offer real positive value above and beyond expected future inflation. 3) More importantly, bonds are likely to revert to their historical role as a hedge against falling equity prices, especially if we slip into an inflation-sapping recession. 

We reiterate our belief that investors should not hide in the front end of the yield curve but should consider locking in higher intermediate-term rates.

The ultimate level of intermediate to longer-term yields in the future will be determined by the Fed Funds rate that is neither stimulative nor restrictive—the so-called “r*” or natural rate—which is defined as the interest rate that is expected to prevail when an economy is at full strength and inflation is stable (estimated at 2 percent). Consider that back in 2012, Fed members believed the natural rate was 4.25 percent. However, over the years this level has continued to fall as evidence to the contrary grew. For example, at the end of 2016, the rate was 3.0 percent before falling to its current level of 2.5 percent. At a recent conference, Federal Reserve Bank of New York President John Williams said there is no evidence that the COVID pandemic has ended the era of very low interest rates experienced before the crisis, although growth may be slower in the long run. The New York Fed chief also said the natural rate has returned to levels seen in 2019.    

We note the above point because it shows not only why we believe that the Fed will have the ability to cut rates in the future from the current 5 percent level to something much lower but also why we believe there is room in bond markets for positive returns in the nearer term. While we don’t believe we are likely to return to the days of 0 percent interest rates of the recent past, likewise, we don’t believe that interest rates will move significantly higher for intermediate- to longer-term investors. 

We reiterate our belief that investors should not hide in the front end of the yield curve but should consider locking in higher intermediate-term rates. Consider that in two years an investor focused only on shorter-term maturities will be forced to re-invest the entirety of the bond principal, whereas the investor with a 10-year focus will be enjoying a nearly 4 percent yield for the next 10 years. Where will rates be in two years? While many think they have the answer given current trends, it is impossible to know for sure. The reality is that we believe investors should own bonds across the entirety of the yield curve and have spent the past few months extending our maturity profile, especially given our economic outlook. 

We continue to position our overall duration near neutral and favor higher-quality fixed income given the current economic backdrop. While we do not expect interest rates to slip back toward the incredibly low levels of the last economic cycle, we believe that Fixed Income has once again returned to its old roots as a real income generation vehicle coupled with an ability to provide risk mitigation against the potential for falling equity prices in the future.  


We have not seen a yield curve inversion this large since the early 1980s, which was also the last time the Fed was explicitly over-tightening the economy to actively tamp down heightened inflation. What soon followed was nearly a decade’s worth of curve steepness and falling rates. The same thing occurred during the late 1990s through the 2000s, and then from 2009 to the present. Yield curve inversions may last a while, but they have not historically led to persistently higher future yields. The vast majority (if not all) of Fed-driven inversions primarily result from rising short-term interest rates. This makes sense because tighter financial conditions and rising interest rates should restrict money supply, which should slow the pace of economic growth, which in turn should temper and stomp out any inflationary pressures. Fixed Income total returns contain a very heavy component based upon the reinvestment of cash flows and maturities. Investors solely focused on extremely short maturities in a quest to capture current yields are likely taking on reinvestment risk and potentially forgoing reinvestment return. We continue to focus on benchmark-like duration given our belief that a recession will likely cause yields to moderate.   

Government Securities/TIPS 

We have stated here numerous times that the shape of the Treasury Inflation-Protected Securities (TIPS) breakeven curve provides critical information for bond investors. Typically, it will have a natural shape in which shorter-dated breakevens are lower than longer –dated ones, but for at least the past 24 months that curve has been inverted—until recently. As of this writing, TIPS breakevens are 1.83 for one-year, 2.16 for the five-year, 2.21 for the 10-year, and 2.25 for 30-year instruments. One of our calls since the pandemic has been that inflation is temporary, and while it has lingered, going forward, the inflation story seems to be fading. Once again, this supports our view on duration, as inflation stabilizing (or possibly falling) will reduce the likelihood of Fed activity, barring a deterioration in credit performance. Given our outlook for falling inflation, we continue to focus on coupon bearing treasuries over the inflation protection counterparts.   


Considering the shape of the yield curve, credit spreads are extremely tight across credit ratings.. If growth picks up and inflation sticks around, spreads do not have much more room to tighten, and investors will be dependent on movements of the rates markets (in this scenario, higher rates). Should growth slow dramatically and inflation continue to fall, actual credit impairment concerns will likely come to the surface. Put simply, caution is in order given the current state of the economy. 

Municipal Bonds 

Municipals have been tightening throughout the year but recently started to widen. Generally, municipal bond ratios will fall (meaning munis will outperform) when rates are rising for a variety of technical factors and rise (munis underperform) as rates fall. This is primarily what we have seen since 2020, and based on decades of investor behavior, we expect a similar outcome going forward. That being said, munis continue to represent a higher quality fixed income asset class that represents value for those in higher tax brackets.  


Section 05 Real Assets

Real Assets 

While much of the rest of the investing world was busy removing commodities from their portfolios over the past few years, we kept our allocation to the asset class based on our belief that it provided an important element of diversification in overall portfolio construction, particularly during times when unexpected inflation arises. It’s important to note that this was concurrent with our belief that lower bond yields had also pushed investors toward equities over much of the recent past and that the unwinding of this trade and the monetary conditions that drove it would likely lead to an environment where both stocks and bonds declined simultaneously. Our answer was to include this “third asset class” based on our belief that it could serve as a hedge when inflation reared its ugly head. Investors have once again seen that play out in real time as commodities posted a positive return in 2022 and now have been positive in four of the five years when bonds and stocks had negative returns.       

However, since last October we have begun preparing our portfolios for what we continue to believe will be a mild recession that will spell the end to already declining inflation. This forecast led us to pull our overall commodities allocation to underweight by trimming our allocation to gold, an asset class that we gained exposure to in April 2020 as an “extra diversification” tool against the unknowns of COVID. We found it particularly compelling given that the 10-year Treasury was yielding just 0.51 percent at the time. This underweight has proven prescient in 2023, as Commodities have fallen as inflation has grinded lower and global economic growth has slowed. Given our belief that a recession and faltering inflationary pressures likely lie ahead, we continue to maintain our underweight toward the asset class.   

While REIT performance has picked up this year, the group remains the laggard among our U.S. equity-based asset classes. Worries about commercial real estate abound, and while we share those concerns, we note that publicly traded REITs remain 28 percent below their recent post-COVID recovery high set in Dec 2021, which was before the Fed began its aggressive rate hike campaign that is currently exposing cracks in this rate sensitive asset class. Risks remain, and much will be sorted out in the coming months, especially in the office market, as the impact of rate hikes becomes increasingly clear. For now, given our recession forecast and the continued tightening of credit conditions, we continue to underweight this asset class.  

Real Estate 

In periods of flat or negative equity market performance, REITs can offer attractive yields relative to other kinds of equity securities. However, even with the added yield premium in the public real estate market, rising interest rates have acted as a headwind for this asset class. We have seen the search for yield (in its absence in fixed income) come to an end, illustrated by significant fund flows out of REIT mutual funds and ETFs over the past year. As traditional bonds offered diminishing income returns, investors moved into REITs and other higher-yielding parts of the fixed income market. The dramatic rise in rates since the start of the current Federal Reserve hiking cycle caused a sell-off in interest-rate-sensitive REITs, and as the bond market repriced, so too did other markets. As a result, asset classes that are sensitive to interest rates, such as REITs, saw some of the largest price swings. The rise in rates also caused fundamental disruptions to real estate as mortgages and other financing rates have quickly spiked to levels not seen in years, causing demand for new projects to slow and affordability ratios for existing projects to deteriorate. Additionally, lending standards have also been incrementally tightening, which is adding to challenges for potential borrowers.  

We are watching valuation levels between the earnings multiples of U.S. equities and U.S. REITs for signs that REITs are becoming attractive and may provide a future buying opportunity. However, this asset class is treading water at best given the current transitionary environment that we expect to last well into 2023. We will continue to monitor the REIT market for signs that it is time to adjust our exposure, but at this point we continue to maintain a slight underweight to the asset class. 


Commodity prices continue to weaken after an extended multi-year surge. Through early June, commodity prices have fallen approximately 10 percent year to date, highlighted by sharply declining oil and natural gas prices. Unlike in 2022, commodity price declines have been broad-based, with energy, agricultural goods, livestock and industrial metals all falling. Although each commodity is responding to unique factors, one underlying theme is a lowered outlook for future global economic growth.  

The major exception to this commodity decline has been precious metals—specifically gold—which have posted meaningful gains. Precious metals (gold up over 7 percent year to date) rose materially in March in response to the U.S. banking crisis, which increased demand for risk hedges. Gold serves as a haven for investors, particularly in an environment with negative real (inflation-adjusted) interest rates.  

During the recent commodity price retreat, energy was the worst-performing sector, led by collapsing natural gas prices (down more than 50 percent), which was caused by a sizable inventory buildup due to an abnormally warm winter in North America and Europe. In addition, repeated delays in reopening a major liquified natural gas export facility had an impact.  

Oil markets were rattled when Saudi Arabia announced in early June that it would cut oil production by 1 million barrels of oil per day as part of a deal between OPEC-plus members. This was a contentious meeting, during which major media outlets were denied access. We expect more details to emerge over time, but we currently see this as an effort by Saudi Arabia to establish a floor on oil prices. The output cut is scheduled to take effect in July and be in addition to previously announced curbs, which have been extended until the end of 2024.  

Industrial metals, a sector very sensitive to global growth expectations, have fallen modestly year to date. Zinc prices fell when it was announced Peru will resume exports after successful mediation between mining companies and protesters. Agricultural goods were also down overall, but individual agricultural commodities were mixed. Sugar posted strong gains. Wheat prices fell as Russia’s bumper crop reduced export demand for U.S. grains. In addition, another renewal of the Black Sea Grain Initiative increased the likelihood of ongoing Ukrainian wheat exports. 

The relatively weak commodity performance so far in 2023 follows a strong 16 percent gain in 2022 and a 27 percent gain in 2021. Given the negative returns posted by stocks and bonds last year, the past two years have underscored the diversification benefits the commodity asset class provides. 

The outlook for commodities remains mixed. Going forward, primary catalysts for higher commodity prices are the reemergence of demand from China, continued elevated inflation expectations and a weakening U.S. dollar. In energy, persistent underinvestment, potential OPEC production cuts and disruptions related to the Russia/Ukraine war have resulted in significant tightness in the oil market, which we expect to persist. Overall, we remain underweight to the commodity asset class with a tilt toward gold. 

Section 06 The bottom line

We believe history has shown that every economic cycle brings with it unique challenges, but the ultimate path followed is generally the same: investors should avoid the urge to react.

We have spent the past three-plus years navigating a virus-impacted economy that has seen large and historically odd dislocations that created large and odd market movements.  From an economic perspective, there is little historical precedent to make comparisons with this period; we lived through a truly once-in-a-lifetime moment. But as we noted in our Q4 2020 market commentary, the recipe for investor success was the “Same as It Ever Was”. We believe history has shown that every economic cycle brings with it unique challenges, but the ultimate path followed is generally the same: investors should avoid the urge to react.   

The reality is that with each month that passes, the word “COVID” appears less and less in our commentary. That’s because we are moving back toward an economy that is normalizing and returning to a similar place that it was pre-COVID. This is not to say that there won’t be longer-lasting shifts in the U.S. economy; some questions to contemplate are what happens to work-from-home rules, do supply chains continue to be diversified, and even how much is artificial intelligence leveraged to help alleviate the pressures of our aging society and labor forever? Change is inevitable, and the economy is always evolving. Most importantly, what we don’t believe changes is how investors should behave in the face of each new economic challenge. Once again, diversification has proven its worth, and long-term investing principles have endured though the challenges and uncertainties of a global pandemic.  

It is likely in the coming quarters, especially if a recession does come to fruition, that market volatility will likely test the staying power of some investors. We encourage you to stay the course, stick true to your financial plan and not panic when others hit the “eject” button.  

Northwestern Mutual Wealth Management Company (NMWMC) Investment Strategy Committee:

Brent Schutte, CFA®, Chief Investment Officer 

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.