Section 01 Good and bad on the road ahead
We often find it useful to look backward to help inform a forward-looking mosaic of where we believe the economy and markets are headed. This is especially true of this time period given the historical abnormality brought on by COVID during the past few years. On January 3, 2022, the S&P 500 index of Large-Cap U.S. stocks hit its all-time high as a strong economy and an incredibly accommodative U.S. Federal Reserve (Fed) created a powerful tailwind for equity markets. Consider that at its December 15, 2021, meeting, the Fed’s so-called “dot plot” of board members’ rate expectations showed a median forecast for a total of 75 basis points of rate hikes for the entirety of 2022.
As the year progressed, the Fed’s message rapidly evolved as inflation worries grew; aggressive interest rate hikes ensued, eventually encompassing four separate 75-basis-point hikes, with a total rate increase of 4.25 percent for all of 2022. These reactionary and outsized rate hikes caused fixed income yields to rise and equity markets to move lower as nearly all asset classes repriced to reflect the new economic environment. After a nearly 26 percent drop from its peak, the S&P 500 finally found its current bottom on October 12, 2022. This occurred, not coincidentally, the day before the September Consumer Price Index (CPI) report showed the first compelling evidence that much of the heightened inflation was tied to COVID-19 realities and, as such, was likely to cool as we approached 2023. Since that date, the S&P has rallied 12 percent as inflation has moved lower, while the economy has wobbled but not yet broken.
There are many crosscurrents in today’s economic environment, including good and bad news on the inflation front.
While recent economic data has caused a re-emergence of inflationary worries, we view the latest reports as a temporary blip and believe the trend forward is for continued easing of price pressures from October’s peak. Unfortunately, despite this constructive commentary, we don’t believe that market volatility has permanently subsided. Borrowing from a Dave Matthews Band song, we view the current time period as “The Space Between.” Simply put, we believe markets are currently in the space between fears. While inflation concerns are cooling, we believe that over the next few months markets will begin to move through the space between and toward the next fear — a recession. Only when investors realize that 1) a recession will mark the end of any residual fears of embedded inflation and 2) that any such recession is likely to be shallow and short do we believe that enduring gains can be made in equity markets.
The linchpin to our outlook remains the path of inflation. There are many crosscurrents in today’s economic environment, including good and bad news on the inflation front. While these aren’t mutually exclusive, allow us to pull apart the good vs. the bad to lay out the case supporting our forecast for a shallow and short recession.
The Good News: “Current Inflation” is tied to COVID and is diminishing
In the aftermath of COVID, monetary and fiscal policymakers arrived with buckets of liquidity. The Fed quickly slashed rates to 0 percent and undertook large-scale asset purchases (better known as Quantitative Easing, or QE), while fiscal policymakers flooded the economy with relief and stimulus packages. The result was a record 26.9 percent (year-over-year) spike in the U.S. M2 Money Supply from February 2020 to February 2021. To use an analogy, think of these policy actions as filling a bathtub full of water/liquidity.
Now we are on the opposite side of this, as the Fed has dramatically raised interest rates to 4.75 percent and is unwinding asset purchases through a process known as quantitative tightening. Meanwhile, U.S. commercial banks are tightening lending standards and making it harder for consumers and investors to borrow. Throw in fiscal policy that has tightened and the result has been a record – decline of 1.7 percent year over year in the money supply. We believe this turning off of the liquidity spigot will continue to slow inflation but will also cause a recession in the U.S. economy. Returning to our bathtub analogy, the liquidity faucets are shut off, but liquidity is still draining out of the tub. Simply put, it may take additional time to fall into a recession while the liquidity continues to drain from the “bathtub” that is the U.S. economy. However, we expect monetary tightening will eventually take hold given the Fed’s desire to ensure all potential sources of inflation are eradicated.
We emphasize the words all inflation because we believe the discussion above deals with only the portions of waning inflation directly tied to economic distortions related to COVID. Remember, consumers originally spent the surge of liquidity buying goods while stuck at home during widespread lockdowns. Between February 2020 and March 2021, the pace of goods spending in the U.S. economy increased by an astounding inflation-adjusted 20 percent. That occurred against a backdrop of low inventories and supply chain constraints. Much as an economic textbook would suggest, goods-based inflation skyrocketed from a meager 1.3 percent year-over-year pace in February 2021 to 12.3 percent by February 2022. Much as we forecasted, demand shifted to services over the past year just as inventories and supply chains healed. The result is that goods-based inflation returned to 1.4 percent year over year in January 2023. We continue to believe goods inflation will further subside and help keep the trend in overall inflation pushing lower.
As spending has shifted to services over the past year, so too has inflation. The January 2023 CPI report showed services-based inflation ticking in at its cycle high of 7.2 percent year over year. However, a growing percentage of this services inflation is driven by shelter costs and rent prices, which show up in the CPI calculation on a 12-month lag. Current measures of home prices and rents fell in the second half of 2022, and these numbers will begin exerting downward pressure on services inflation in the coming months. For example, the S&P CoreLogic Case-Shiller 20-city home price index has fallen every month since June 2022 with prices up 4.65 percent compared to a year ago; contrast that to a high double-digit appreciation pace during much of 2021 and early 2022, with a peak of 21.3 percent reached in April 2022.
Lastly, spot commodity prices, which saw a sharp 36 percent spike in the first half of 2022 sparked by the Russian invasion of Ukraine, have fallen by 25 percent from their recent peak and are off 22 percent year over year. Tying this all together, we note that all-in CPI excluding shelter is flat over the past three months and up just 0.5 percent over the past seven months (since June 2022). We forecast that COVID-related inflation will continue to wane in the coming quarters as the economy returns to pre-COVID norms. However, this is where we must distinguish between COVID-based inflation and all possible future inflation.
The Bad News: “Potential Future Inflation” is tied to the business cycle
The seemingly innocuous end to the prior section helps paint the picture of why we believe a recession is likely. Just prior to COVID, the U.S. economy was in the late stages of a business cycle. Over the past 40 years, prior to the end of each business cycle and the inevitable recession, the labor market has tightened as additional workers have become scarce, a condition that often causes companies to compete for employees by offering higher wages. The Fed fears that this kind of wage competition can lead to “sticky” inflation.
For much of the decade following the Great Financial Crisis, annual wage gains hovered at a pace of slightly above 2 percent. However, by the end of 2019, the U.S. unemployment rate had shrunk to 3.5 percent, and wages for non-supervisory and production workers finally began to move higher as labor markets started tightening. Wage gains rose from 2.2 percent in late 2017 up to 3 percent by late 2018 and then ultimately to 3.7 percent in late 2019. A review of every business cycle since the inflationary period of 1966–1982 reveals that wage gains peaked in the low 4 percent range before a recession ensued. For example, wage gains peaked at 4.4 percent before the 1990 recession, 4.2 percent before the 2000 recession and 4.2 percent before the 2007 recession. A common denominator in each of these periods was interest rate hikes undertaken by the Fed in an effort to slow employment growth and eliminate the prospects of a repeat of the wage–price spiral that led to the sticky inflation that persisted from 1966-1982.
While workers have returned to the U.S. economy over the past few years, we believe it is unlikely that the progress has been fast enough to appease the Fed.
The January 2023 jobs report showed the current unemployment rate at 3.4 percent, which is below the pre-COVID low of 3.5 percent and is flashing labor market tightness. However, there is a nuance here. To be counted as “unemployed,” individuals must be looking for a job or participating in the labor market. In late 2019, 63.3 percent of the population met the criteria to be counted among those employed or looking for work. Currently this measure is at 62.4 percent. A return to the pre-COVID level would translate to an additional 2.7 million workers coming off the sidelines to fill open jobs. We believe an influx of workers of this size would ease wage pressures in the coming quarters. We believe that given the importance the Fed assigns to labor markets, this is the only path for the much-desired soft landing to occur. Currently, the rate of wage increases for non-supervisory and production employees is falling, down to 5.1 percent after its recent high of 7 percent in March 2022. The decline is fueling hopes that perhaps wages will continue to move lower. We believe, unfortunately, that this is unlikely to occur.
While workers have returned to the U.S. economy over the past few years, we believe it is unlikely that the progress has been fast enough to appease the Fed. Simply put, the Fed wants to ensure that a wage–price spiral does not take hold and therefore is likely to err on the side of caution and continue raising rates until it sees the labor market crack, which would address all possible inflation probabilities. This approach has the unfortunate effect of creating employment slack by causing layoffs and rising unemployment. As such, we believe a recession is likely in the coming months or quarters.
The silver lining: A mild recession is likely
When most investors hear the word “recession,” they are immediately reminded of the last recession of 2007–09, which lasted 18 months, saw the economy and markets buckle and, as such, was only the second of the last 24 recessions since 1900 to be labeled “great” (the other being the Great Depression of the 1920s to 1930s). A review of other recessions shows that many are not deep and often are over in as little as eight months. We believe this is the type of recession that will occur in 2023 for three reasons.
Many parts of the U.S. economy have already experienced a downturn as the uneven recovery has given way to an uneven grind into a recession. In other words, much of the air has already been let out of the U.S. economy. For example, existing home sales are 36 percent off their pace from the beginning of 2022 after slowing through the year. Likewise, real spending on goods is now negative on a year-over-year basis.
The 2007–09 recession was long lasting and deep because U.S. consumers, banks and corporate balance sheets were weak. Today, the U.S. consumer’s balance sheet, as measured by debt-to-asset levels, is in as good a shape as it has been since 1970. While a slowing economy is likely to cause some deterioration in this measure, the reality is that consumers and businesses enjoy a much larger cushion against an economic downturn than during the Great Recession. Also, the labor market is already rebalancing; technology companies and those on the goods side of the economy that over-hired during the COVID recovery are beginning to cut jobs, while the services sides is still adding employees.
Most importantly, we believe that all inflation will be snuffed out by a recession, which will allow the Fed to ease policy if needed to keep the downturn from deepening. Much as the Fed’s rate hikes had a nearly immediate impact on the economy in 2022, we believe any such future easing will also quickly reverberate through the economy.
This threat of a recession has been widely acknowledged for much of the past year. Business owners have been preparing, and the goods side of the economy has arguably been in a recession. These realities should help to keep overall economic damage mild.
A majority of financial markets have also been normalizing
Much like the economy, the market has spent the past year repricing in response to a toxic combination of higher interest rates and the increasing threat of a recession. U.S. investment-grade bonds started 2022 with a yield of 1.75 percent against a backdrop of inflation that clocked in at 7.0 percent year over year. By October of 2022, the same bonds yielded more than 5 percent. We believe that valuations are a relative tool and that a repricing of the bond market and interest rates leads to the stock market repricing. This rings especially true for the most expensive and speculative stocks that we dubbed as “hopes, dreams, themes and memes” and paints a picture of why we have focused on cheaper parts of the market over the past few years — a view we continue to hold today. Despite the recent rally, many segments of U.S. markets remain more than 20 percent off previous highs.
After COVID’s arrival in early 2020, we overweighted equities relative to fixed income given our belief that the market would recover quickly due to the monetary and fiscal largesse. As we pushed through 2021, we expressed our view that commodities would likely provide value as a third asset class that could act as a hedge against both falling stocks and bonds if, as we expected, inflation was set to rise. This has become a reality over the recent past.
In early February 2022, as inflation pressures began to build, investors started frantically searching for hedges. Given their relatively elevated valuation, we exited the Treasury Inflation-Protected Securities (TIPs) position that we initiated in late 2019 (at a time when few were worried about the return of inflation) and added to in the aftermath of COVID’s arrival. Given the low prevailing intermediate- to long-term interest rates, we focused our coupon-bearing fixed income toward the shorter end of the yield curve. Then, in October, with inflation fears peaking and interest rates having moved higher, we extended the maturity profile/duration of our fixed income portfolio to lock in those longer-term yields and begin preparing for “The Space Between” and possible growing recession fears. We lowered our commodity exposure by downgrading gold and increased our exposure to the relatively cheap U.S. Mid-Cap asset class by downgrading Emerging Markets given economic and geopolitical uncertainty in China.
Section 02 Current positioning
In Mid-February 2023, given what we believe are growing recession risks coupled with the recent equity market rally, we reduced our equity allocation to slightly overweight by downgrading U.S. Large-Cap stocks to underweight in response to their recent increase in valuation. Given the still nearly 5 percent yield available in investment-grade bonds coupled with our belief that bonds will return to their historical role of hedging potential equity market downside, we returned our fixed income allocation to neutral. Lastly, we remain underweight to commodities with a bias toward gold.
Importantly, we believe equity markets have discounted some recession risks over the past year and remind investors that markets often bottom before recessions end.
This is not an outright negative call on equities but rather an acknowledgment that the path forward for the next 12 months remains highly uncertain. Importantly, we believe equity markets have discounted some recession risks over the past year and remind investors that markets often bottom before recessions end. Given our forecast that any recession is likely to be mild, short and uneven, we are retaining a slight equity overweight skewed toward the asset classes we believe are not only cheap but, importantly, are likely to rally the strongest coming out of any potential mild downturn — U.S. Small and Mid-Caps as well as International Developed Stocks.
Section 03 Equities
U.S. Large Cap
After a strong start to the year on rising optimism that the U.S. economy would avoid a recession, we recently downgraded our positioning in U.S. Large Caps to underweight in our nine asset class portfolios. We don’t share the market’s belief that the U.S. will avoid a recession over our forecast horizon and do not feel that this asset class has fully priced in a potential downturn. It is true that earnings estimates have been reduced, as we expected and described in our last AA Focus, but unfortunately the valuation on those reduced estimates remains relatively unappealing to other asset classes, especially in a real interest rate environment similar to last October. On a blended forward 12-month basis, the market valuations bottomed in October at around 15.5 times forward earnings estimates. Since then, forward earnings estimates have moved 3.5 percent lower (and we think additional negative revisions are likely), but the multiple has pushed 2.5 turns higher to 18 times as investor optimism has surged on the hopes of a soft landing for the U.S. economy. We think that optimism is misplaced, as the resiliency of the labor market is forcing policymakers to move interest rates further into restrictive territory and continue with quantitative tightening.
While our forecast of a mild recession as a base case might normally lead investors toward the quality of Large-Cap equities, we believe that current valuations remain elevated relative to other parts of the U.S. and global equity markets. Put differently, we favor positioning portfolios toward asset classes that we believe have priced in this forecast as much as possible while also considering what’s likely most sensitive to a recovery during the inevitable stabilization/reacceleration on the other side of this short and shallow economic slowdown. We don’t see U.S. Large Caps priced for a recession and prefer other equity asset classes, such as U.S. Small and Mid-Caps, for their relative cheapness and recovery positioning.
With our base case of some mild form of recession on the horizon, we favor asset classes that have priced in some degree of macroeconomic weakness. Trading at a sizable discount to U.S. Large Caps and their historical multiples on forward estimates that have been trimmed to a higher degree, we think that U.S. Mid-Caps continue to warrant an overweight position in our portfolios. We recognize that Mid-Caps are more cyclical and not ideally positioned from a quality perspective for macroeconomic weakness as compared to Large Caps, but we also value their current cheapness and sensitivity to the eventual recovery once economic stabilization becomes apparent to the investment community. As such, we remain overweight.
U.S. Small Cap
U.S. Small Caps continue to provide an attractive long-term investment opportunity and remain overweight in our portfolios. Despite material outperformance following the spring 2020 pandemic shock, we continue to see attractive relative valuations and the highest sensitivity to an economic recovery in our portfolio. While relative performance might be bumpy in the near term given the cyclicality of Small Caps, we are encouraged to see that forward earnings estimates for 2023 have already been reduced by more than 15 percent, and valuations are slightly more than 14 times those reduced estimates. We believe this gives us some form of downside protection via a discounted valuation, but we are more enthusiastic about the upside potential once the economy stabilizes. We see the opportunity for Small Caps to experience significant multiple expansions and rapid earnings growth in that environment. As such, we maintain a firmly overweight position.
The eurozone economy has recently witnessed a number of positive developments. Importantly, the economy is now expected to avoid the recession that was broadly expected at the beginning of 2023. For the first time in a year, the 2023 projections for economic growth have been revised higher, while the inflation outlook is grinding lower.
Many factors have improved the region’s outlook. Export demand has been more robust following China’s reopening. The European gas benchmark price has fallen below its pre-war level, helped by a sharp fall in gas consumption and continued diversification of supply sources, while the resilience of households and corporations has been impressive. Despite the energy shock and ensuing record high inflation during the fourth quarter, the eurozone economy managed GDP growth of 0.1 percent. Inflation has been stubborn but has recently fallen from peak rates. As in the U.S., labor markets have remained strong, with the unemployment rate in the European Union remaining near its all-time low.
The European Central Bank (ECB) is significantly raising interest rates at a steady pace in order to keep monetary policy restrictive. The goal of the move is to ensure a timely reduction of inflation to the bank’s 2 percent medium-term target. The ECB is also reducing the amount of securities held in its asset purchase program.
Japan’s economy is facing slow growth, mild inflation and geopolitical tensions. The country's real Gross Domestic Product expanded at an annualized rate of 0.6 percent in Q4 2022, marking a return to growth after a negative reading in the third quarter. There is hope that pent-up post-pandemic consumer spending can improve the economy. After years of stagnant or shrinking growth, wages are finally rising. However, inflation is also on the rise, which is moderating household purchasing power.
The Bank of Japan has long maintained an accommodative monetary policy. However, the Japanese Prime Minister nominated Kazuo Ueda to helm the Bank of Japan (BOJ). The move is likely to pave the way for a gradual paring back of the central bank’s aggressive approach to stimulus. There is a risk that Ueda could steer the BOJ away from its long-standing yield curve control policy.
Importantly, both regions appear to have broken from their previous negative interest rates and deflationary spirals. Time will tell what happens on the inflationary and interest rate front pushing forward; will deflation return, or can policymakers land inflation in 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 18. The sector exposure and relative valuations are attractive given the added economic and market tailwinds of their respective currencies being cheap relative to an expensive U.S. dollar. Institutional and individual investors appear to be underweighted to the regions, and a rebalance to target global allocations could provide an additional tailwind. While we continue to review our overall outlook and risk assessment, 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 a slight overweight with a tilt toward eurozone exposure.
This push and pull between what the markets expect and what the Fed plans to do will likely lead to more of this type of volatility as we progress into 2023 and the U.S. and economies around the world continue to normalize post-pandemic.
Renewed optimism around a reopening in China, a weaker dollar and more accommodative monetary and fiscal policy in China and across the developing world were recent catalysts for relative outperformance of Emerging Market stocks in the final months of 2022 and through January 2023. We believe these trends can continue, but markets tend to get ahead of themselves, and the relative under-performance of Emerging Markets in February 2023 suggests that investors may have been a bit too optimistic about the current backdrop. The China reopening is underway, and the government continues to apply accommodative monetary and fiscal policy, but geopolitical risks remain, and growth is slowing. In addition, the dollar has strengthened in recent weeks as a result of anticipated Fed action and, as of this writing, is approaching 2023 highs. This push and pull between what the markets expect and what the Fed plans to do will likely lead to more of this type of volatility as we progress into 2023 and the U.S. and economies around the world continue to normalize post-pandemic.
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 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 the world’s gross domestic product and 25 percent of world equity markets, which means it’s important to have some exposure in a well-diversified portfolio.
Given the delicate balance of risks and potential rewards, we continue to maintain a neutral weight to Emerging Markets.
Section 04 Fixed Income
After years of low interest rates and, frankly, low returns, bonds spent 2022 repricing to reflect the new realities of higher inflation rates and fewer central bank bond purchases, which had helped to keep yields low. The result was a sharp spike in yield in the Bloomberg Aggregate Bond index from 1.75 percent to 5.21 percent in October 2022, with an eventual year-end close of 4.68 percent. Unfortunately, the spike in yields led to a record 18.4 percent drawdown from June of 2020, when yields reached a historic low of 1 percent, and a -13.01 percent total return for 2022.
However, it’s important for bond investors to recall two realities: 1) Investment-grade bonds often mature at par and as a result will move back toward that level as the maturity date draws nearer; and 2) future returns now offer real positive value, with the index currently yielding 4.9 percent, the highest yield since 2008 and well above where we believe intermediate- to longer-term inflation settles. We believe that bonds can once again offer positive real returns and, most importantly, are likely to revert to their historical role as a hedge against falling equity prices. We believe this to be particularly likely should the economy slip into a recession that results in the end of inflation pressures.
The reality is that we believe investors should own bonds across the yield curve.
For much of the recent past, low starting bond yields have translated into low forward returns for investors. That is no longer a likely reality given current starting yields. The biggest question we currently get is whether investors should focus on shorter-term bonds or intermediate- to longer-term bonds given today’s yield curve inversion. Using the Treasury yield curve as an example, the two-year Treasury currently yields 4.95 percent, while the 10-year Treasury checks in at a lower 3.97 percent yield. The discrepancy leads many to want to gravitate toward the short-term Treasurys given their higher yields.
The answer first and foremost is that investors should make sure the duration of their bond portfolios match the duration of their liability streams. Put differently, individuals who are facing liabilities in the near term should, in our view, not use longer-maturing assets. The more nuanced answer is that investors should consider reinvestment risk along with current yields when choosing bonds. In two years, investors focused only on shorter-term maturities will be forced to reinvest the entirety of their bond principal at prevailing rates, whereas investors holding 10-year bonds will receive a nearly 4 percent interest payment for the next 10 years. Where will rates be in two years? While many think they have the answer (given current trends), we would invite them to think back a few years and how they might have answered the question then. The reality is that we believe investors should own bonds across the yield curve. This belief has resulted in us spending the past few months extending the maturity profile of our fixed income allocation, especially given our economic outlook.
In mid-October 2022 we increased our allocation to investment-grade fixed income and lengthened the maturity/duration of our overall bond portfolio. In mid-February of this year, we once again added to our investment-grade fixed income allocation and focused on intermediate-term bonds. Both trades reflect our view that current yields of nearly 5 percent are relatively attractive compared to more expensive parts of the market, especially in light of our recession call and inflation 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 traditional role as a vehicle that generates real income and that has the ability to provide risk mitigation against the potential for falling equity prices in the future. We note that equities have now experienced 26 negative calendar-year returns since 1926. Last year marked only the fifth time that bonds have not provided a positive offset when equity returns were negative. In four of the five periods when bond returns were negative, inflation was above 5 percent. The one exception was 1931 during the Great Depression. With inflation set to move below 5 percent in 2023 and our belief that any recession will be mild, we expect a better future for fixed income markets and investors.
The last time we saw a yield curve inversion reach current levels was in the early 1980s, which was also the last time the Fed was aggressively trying to slow the economy in an effort to tamp down heightened inflation. Falling rates and a steep yield curve followed for much of the next decade. The story repeated in the late 1990s through the early 2000s and then again from 2009 to 2021. Curve inversions may last a while, but historically they have not led to persistently higher yields going forward. The vast majority (if not all) of these inversions were driven by the Fed and its actions leading to rising short-term interest rates. We believe this makes perfect sense, as tighter financial conditions and rising interest rates should restrict money supply, which, in turn, should slow the pace of economic growth and lead to a final result: unwinding inflation. Although this process can unfold slowly, we favor intermediate to longer duration, as we expect that any indication that the Fed may pause its rate hiking program will likely cause intermediate- to longer-term rates to moderate.
The story for the past three years has been in Treasury Inflation-Protected Securities (TIPS). Normally they warrant a separate section of the Asset Allocation Focus, but in this edition, we are combining them with other government securities because they have been the driving force for all fixed income asset classes. During the past few weeks, shorter-maturity TIPS have increased in price in response to an uptick in inflation readings. Many investors have become highly sensitive to even the hint of a re-emergence of price pressures and so have sought out TIPS for protection. However, when viewed as a whole, the yield curve for these inflation-adjusted instruments does not suggest that inflation is here to stay. While front-end break-evens are very volatile and have risen, longer-dated TIPS (10 years and longer) have remained stable. We believe the lack of movement on the long end of the yield curve fits with our belief that the latest blip in inflation is temporary. There has already been significant monetary tightening, and while there will likely be additional rate hikes in the coming months, we believe we are nearing an end to the tightening cycle. We continue to view nominal Treasurys as more attractive than TIPS given our economic outlook.
Credit rallied to start the year as investors became optimistic about the prospects of a soft landing. However, since early February, spreads have started to widen as the market priced in additional Fed rate hikes and fears of a recession grew. Inverted curves, tighter monetary conditions and tight spreads are a challenging backdrop for corporate credit. As such, we favor high-quality corporate bonds and caution against chasing high yield given the uncertainty for credit over the next six to 12 months.
Municipal bond ratios continue to tighten. This move is common at the beginning of a calendar year as investors reinvest coupon payments and roll over maturing bonds. If rates rise, we expect municipal bond ratios to widen and municipal bonds to fall in price.
Section 05 Real Assets
While many investors were selling out of commodities during the past few years, we continued to embrace the asset class based on our view that it was another source of diversification and could be particularly valuable during periods of heightened inflation. We believed that investors were overweight equities due to the paltry yields offered by bonds. As such, we recognized that rising rates could result in both bonds and equities losing value. We viewed commodities as a hedge against this scenario. Since then, investors have watched as commodities posted a positive return last year while equities and bonds stumbled. Importantly, commodities have now posted positive returns in four of the five years in which bonds and stocks posted negative returns.
Given that we now expect a mild recession in the quarters ahead, as well as the sustained slowing of inflation, we pared our exposure to Commodities to underweight by trimming our allocation to gold. As you may recall, we first made an allocation to gold in April 2020, at a time when the 10-year Treasury yielded .51 percent and economic uncertainty was elevated. Against this backdrop, we viewed gold as attractive due to its history of performance during periods with negative real interest rates. With interest rates now moving higher and inflation lower, we decided to trim our allocation in October and as a result are now underweight commodities overall but maintain a slight allocation to gold given its historical outperformance relative to broad commodities during recessions.
Real estate investment trusts (REITs) were initially post-COVID laggards as investors contemplated and repriced the intermediate- to long-term impacts from the pandemic. As we progressed through 2021 and the U.S. economy adapted to COVID-19, REITs surged to the top of the performance heap. However, much as we forecasted, during the recent interest rate spike REITS have once again dramatically underperformed due to their interest rate sensitivity. We continue to underweight this asset class in light of risks cause by a potential recession as well as a general tightening of credit conditions.
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 additional yield premium in the public real estate market, rising interest rates continue to act as a headwind for this asset class. We have seen the search for yield (in its absence in fixed income) come to an end. 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. Tying this into our earlier theme, as the bond market reprices, so too do other markets. As a result, asset classes that are sensitive to interest rates, such as REITs, often see the largest swings. The rise in rates has 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. Additionally, lending standards have also been incrementally increasing, 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 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 underweight the asset class.
Commodity prices have pulled back recently after an extended multi-year surge. Through mid-February, commodity prices have fallen 4.5 percent for the year, following 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 this asset class provides.
Note that different commodities have recently performed independently, driven by their own unique variables. This has resulted in rotation away from earlier trends, which were dominated by surging oil and natural gas prices that peaked in June 2022. Specifically, industrial metals and precious metals prices have risen, while energy prices have underperformed.
During the recent Commodity price retreat, energy was the worst-performing sector. Natural gas prices collapsed in response to a buildup in inventories caused by 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. In October, the Organization of the Petroleum Exporting Countries plus Russia (OPEC+) agreed to slash output by 2 million barrels of oil per day, resulting in commodities like oil trading in a tighter range.
Renewed optimism surrounding China’s decision to relax COVID restrictions has boosted industrial metals during the last several months. In addition, the possibility of slowing rate hikes from the Federal Reserve may positively impact growth expectations and lead to higher industrial metals prices. Nickel surged in response to the announcement of U.S. sanctions on a large Russian nickel producer, which increased concerns about the future availability of Russian supply.
Overall, we continue to believe the Commodity asset class offers positive return opportunities and significant diversification benefits.
Precious metals have also risen significantly as gold prices have moved higher in response to rising geopolitical risk. Gold serves as a haven for investors, particularly in an environment with negative real (inflation-adjusted) interest rates. Gold prices rose as the U.S. dollar fell materially for the fourth quarter, increasing the value of gold and silver as alternate stores of wealth. Note that year to date, the dollar has regained some strength, which has contributed to the recent commodity pullback.
Gold purchases by global central banks also pushed prices higher. According to the World Gold Council, central banks added 1,136 tons of gold worth $70 billion to stockpiles in 2022, by far the most of any year on record going back to 1950.
The outlook for commodities, in our view, remains positive in the intermediate term. The re-emergence of demand from China, continued elevated inflation expectations and a weakening U.S. dollar are the primary catalysts for higher commodity prices in the future. In energy, persistent underinvestment, potential OPEC production cuts and disruptions related to the Russia/Ukraine conflict have resulted in significant supply constraints in the oil market, which we expect to persist. Overall, we continue to believe the Commodity asset class offers positive return opportunities and significant diversification benefits. In October 2022, we reduced our allocation to underweight for the asset class and used the proceeds to fund an increased allocation to fixed income due to the increasing attractiveness of this asset class and our belief that there will be a mild recession in 2023.
Section 06 The bottom line
The word “recession” can be scary to investors and lead them to consider making drastic changes to their portfolios. The reality is that well-constructed financial plans anticipate economic downturns and are designed to weather the occasional disruption. Recessions are notoriously hard to forecast. While a recession is our base case, there remains a path for a soft landing, especially if workers return and wages moderate or productivity spikes. While there is no guarantee we will have a recession in the coming quarters, we believe one will arrive in the not-too-distant future. Put differently, we don’t believe the economy has a long runway for growth as it did in 2012, when it was also just three years removed from a significant downturn.
While the last sentence may be taken as a negative, we would rather characterize it as a positive. One reason we believe the word “recession” is worrisome for investors is that their perceptions are influenced by the depth and length of the so-called Great Recession that began at the end of 2007 and lasted through June 2009. The reality that only two of the prior 24 recessions have earned the adjective “great” highlights that the downturn in 2007 was the exception, not the rule.
We note that nearly half (five) of the prior 11 recessions lasted eight months or less. Importantly, market performance also varied. Consider that if a recession started today, the nearly 17 percent decline from the market peak through today would mark the second largest decline in market value leading into a recession (2001’s decline was the largest). Put differently, we believe the market has already priced in at least the possibility of a recession in the coming quarters. It may be surprising to some that during five of the previous 11 recessions, the market moved higher during the economic contraction. Most importantly, in all but one — the 2001 recession — the market was up one year after the recession ended.
RECESSIONS AND STOCK MARKET PERFORMANCE
We note these statistics not to create a false sense of certainty but instead to provide context for how recessions have played out historically. Similarly, highlighting the variability of economic downturns shouldn’t undermine our forecasts and resulting allocation tilts but rather underscore our belief that that investors should focus on tying long-term strategic asset allocation decisions to a financial plan that acknowledges the unpredictable and variable nature of the economy.
Our tilts represent incremental changes to our base asset allocation plan and are implemented to take advantage of market mispricing. Making significant changes to a strategic allocation based on short-term disruptions can derail a financial plan from achieving its long-term financial objectives. Remember that over intermediate and longer periods, portfolio return dispersion shrinks. A good financial plan takes into account the choppiness of market returns in the near term through financial tools such as Monte Carlo analysis. A benefit of such analysis is the peace of mind it provides clients in knowing that they are likely to remain on track to meet their financial goals over the long term, and sudden, significant allocation changes aren’t necessary. This is why we strongly encourage investors to work with their advisors and create a plan that includes an asset allocation framework that positions them to go from where they are financially today to where they want to be in the future. Similarly, our tilts and our security selection are undertaken with the goal of getting clients to their end goals a bit quicker and
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.