Investors Consider New Challenges in a Post-COVID Economy

What a difference a year makes. Last December, we believed the U.S. economy was lurching back toward what it looked like pre-COVID. At the time, we were in the heart of another disruption from the omicron variant, yet the virus was loosening its grip on the U.S. economy. Our thesis was that continued reopening in 2022 would shift spending from areas that had “benefited” from consumers staying at home to those companies and industries that would benefit from our re-entry back to “public life.” While this has largely played out over the past year, the main side effect that has accompanied the economic oddities of COVID, inflation, has frustratingly taken longer to recede than we had hoped. 

Simply put, the economy experienced a sharp and largely V-shaped recovery post-COVID, but it was uneven and rolling in nature. Fast-forward to today, when the Federal Reserve has enacted 4.25 percent of reactionary and outsized rate hikes, the economy is undoubtedly slowing, and inflationary pressures are at long last receding. Now, investors are now shifting their worries from inflation to recession. However, much as we had a rolling recovery, one could argue 2022 has already featured rolling recessions. For example, while leisure and hospitality have experienced a resurgence in 2022, housing has fallen flat from recent highs, as has a large segment of the “goods economy.” After all, how many more exercise machines, furniture and electronics can consumers purchase?  

Despite continued volatility, we believe investors focused on the intermediate term could be rewarded for their continued conviction

We believe these rolling recessions will eventually impact the still relatively strong services side of the economy. This should put the final nail in the coffin of the supposedly strong labor market — which will give the Fed the ability to pause its rate hikes. Importantly, we forecast that any resulting recession will be shallow, uneven and short given that 1) we have already taken a lot of the “air” out of many segments of the U.S. economy and 2) the overall state of the U.S. consumer, which remains strong even after the difficulties of the past year.  

As we push into early 2023, we expect markets to remain volatile as we shift from inflation fears to recession worries. The good news is that both major asset classes (stocks and bonds) have already spent 2022 repricing to lower valuations based upon overall economic conditions. Despite continued volatility, we believe investors focused on the intermediate term could be rewarded for their continued conviction as the economy returns to full post-pandemic equilibrium and the economic and market oddities caused by COVID recede into history.  

Too much money chasing too few goods  

Much as we expected, the arrival of COVID in early 2020 set off a series of monetary and fiscal responses that could best be described as economic shock and awe. As we had forecasted, policymakers reacted to the economic downturn with ferocity. The response was predictable given that they believed their lack of a more aggressive response during the Great Financial Crisis (GFC) of 2007 to 2009, contributed to a slow, lackluster recovery from 2009 to 2020. From February 2020 to February 2021, the money supply in the U.S. economy grew by a record 26.9 percent.

Contrast this with the GFC response, which saw a peak of money growth at 10.2 percent year over year in January 2009.  

Nobel prize-winning economist Milton Friedman famously stated his belief back in the 1960s that inflation was always and everywhere a monetary phenomenon, when too much money chases too few goods. This statement accurately describes the post-COVID shutdown economy, when spending was enhanced by fiscal and monetary policy and laser-focused on goods purchases at a time when supply chains were snarled and inventories were non-existent. Real (inflation-adjusted) goods spending between February 2020 and its peak in March 2021 grew a staggering 21 percent. The result was a massive spike in the consumer price index (CPI) for goods, going from 0 percent year over year in February 2020 all the way to a peak of 12.3 percent year over year in February 2022.  

Enter the concept of rolling recessions.  

Goods 

The economy has reopened as we have pushed through 2022, and consumers who have likely pulled forward years of goods demand are now shifting their focus to service-sector spending. With supply chains now largely healed and inventories rebuilt against this waning goods demand, much as one would expect, goods prices are now dramatically moderating. As we exit 2022, the goods side of the economy as a whole appears to be entering a recession. During the month of November, the Institute for Supply Management (ISM) manufacturing index slipped below 50 (readings below 50 indicate contraction) for the first time since the pandemic’s arrival. The result has been a dramatic decline in goods inflation, from the 12.3 percent peak in February 2022 to November’s 3.7 percent level. We believe that goods inflation will continue to moderate in 2023 and provide a gravitational pull lower to overall inflation in 2023.  

Services  

Consumers have shifted their buying power toward the service sector even while overall spending in the economy has dramatically slowed. The aforementioned fuel for that spending, M2 money supply (which includes cash, checking accounts, bank deposits and other highly liquid sources of money), is now up a measly 1.3 percent over the past 12 months, which is the lowest level since 1995. Excess savings remain, but those balances are being pulled lower, and importantly, the consumer appears unwilling to rush out and buy ahead no matter the price. Much like the goods story, the shift to service-sector spending has led to a subsequent increase in services inflation, which began rising in March 2021 as the economy re-opened and demand shifted. After bottoming at 1.3 percent in February 2021, CPI services excluding energy services has moved to 6.8 percent in November 2022. However, we believe this is plateauing and set to move lower as we move into 2023. Shelter comprises more than half of service sector inflation, and current market home prices and rents enter the CPI calculation with a 12-month lag, according to the Bureau of Labor Statistics.  

Once again, this brings us to the concept of rolling recessions — as seen in the housing market, which has dramatically fallen from its break-neck pace of late 2021, thanks to skyrocketing mortgage rates in the second half of 2022. Not surprisingly, consumers are now putting off purchases, as they have rated buying conditions as the worst ever in the University of Michigan Consumer Sentiment survey data going back to 1978. The result has been a sharp decline in the pace of existing home sales, with purchases off by 32 percent from the beginning of the year. New home sales have also sputtered, and builders expect conditions will remain dour. The National Association of Home Builders (NAHB) sentiment index has plunged from 84 (readings above 50 indicate expansion) to now just 33 in November. The result has been a move lower in home prices for the past three months, according to S&P Corelogic Index, and further cooling is likely in the coming months. However, these numbers are just beginning to enter the inflation calculation. Given this as well as developments with other sectors that factor into the services number, we believe overall services inflation will plateau and move lower in 2023.  

Food & Energy 

Lastly, after spiking due to the Russian invasion of Ukraine, commodity prices have eased during the second half of the year. Spot commodity prices rose 36 percent from Dec. 31, 2021, to a peak on June 7, 2022. Since then, they have fallen 22 percent. If prices end the year at current levels, commodities would be up around 6 percent year over year. Contrast that with a 64 percent year-over-year increase in the middle of 2022. Commodity prices are notoriously volatile, but the recent decline should help pull down overall inflation in the coming months. As we close the year, price pressures have begun to subside with the November report showing inflation at 7.1 percent down for its peak of 9.1 percent. Interestingly, this report revealed that current inflation is concentrated in shelter. Overall, CPI excluding shelter is actually negative (prices declining) during the past five months. With current easing market housing and rents set to enter the CPI calculation in the coming months, we believe it is possible that inflation subsides more rapidly than expected in 2023.

The wrong-footed and reactionary Federal Reserve  

Pulling the above points together, we believe the bulk of forward-looking inflation data points to price pressures easing in 2023. This raises the question: If we can see it, why doesn’t the Fed? We believe they do but can’t acknowledge seeing it until backward-looking CPI inflation readings show it. That’s because expectations are a critical part of the Fed’s battle with inflation. If consumers believe price increases are permanent, inflation can take root as people try to buy ahead of expected cost jumps. 

This is what the Fed views as its biggest mistake in the inflation-riddled era of the 1970s and early 1980s. The Fed let inflation stick around, and it became embedded in the psyche and behavior of Americans to the point where annual price increases were able to take root. Avoiding the mistakes of the 1970s and ’80s is where the Fed is most focused; members of the current Federal Open Markets Committee don’t want to be the ones who unwind what U.S. central banking hero Chairman Paul Volcker did 42 years ago when he slayed the inflation demon.  

The good news here is that we don’t believe current inflation readings are anywhere near embedded in consumers’ expectations. The University of Michigan consumer sentiment survey shows that inflation expectations five to 10 years in the future are currently at 3 percent versus the February 1980 level of 9.7 percent. While 3 percent is higher than the 2.6 percent average during the 2014 to early-2020 time period, it’s important to note that this was a period marked by fears of deflationary pressures and featured a Fed determined and actively working to get inflation expectations back to more normal levels of around 3 percent. This is why we believe that once this bout of inflation shows further evidence of easing, the Fed will be able to pause its rate hike campaign while inflation expectations remain in check.  

Much of the current market chatter revolves around what the Fed says it is going to do in 2023 — raise rates above 5 percent and hold them there. We take this view with a grain of salt. Keep in mind that this Fed can be reactionary and data dependent. And its previous forecasts have dramatically missed the mark. On December 15, 2021, the Fed’s dot plot showed that board members expected to raise rates a total of 75 basis points during the entirety of 2022. The few outliers to the forecast suggested rates may be raised by a whopping 100 basis points. Those forecasts “just missed” the actual 4.25 percent in hikes approved in 2022, including four consecutive 75 basis-point increases. We believe that the end of 2022 marks the last of steep, market-disrupting rate hikes. We believe the Fed will pause its rate hike cycle when the labor market cracks. Given that price pressures should fall in 2023 and the fact that inflation expectations remained anchored, the Fed will have the option to pivot to rate cuts should the economy dramatically weaken.  

About that “strong labor market” 

The economy is in process of returning to a supply/demand equilibrium. The one area that still seemingly shows a lack of balance is the job market, where labor demand appears to be strong with labor supply constrained. This has created a backdrop over the past year for strong wage growth that is in conflict with the Fed’s desire to ease inflation pressures. However, we believe that at a minimum, the jobs reports are set to weaken and could more likely be painting an inaccurate picture.  

The government releases two primary labor reports on the first Friday of each month. Most people are familiar with the Nonfarm Payroll report that garners the bulk of media headlines. While the past months have seen hiring slow to an average of 275,000 workers, this remains above the level of the monthly growth in labor supply. Current population growth and current labor force participation point to the number of new workers growing monthly by about 60,000 to 90,000. Hiring needs to fall to a pace that matches growth in the labor supply for employment to reach equilibrium. Until a balance is struck, a tight labor market will persist and could continue to support current heightened wages. 

We believe the Household Employment report is likely foreshadowing future overall labor market weakness.

However, the second jobs report released each month, the Household Employment report, uses a different methodology to count workers and arrive at the unemployment rate. This approach has produced numbers that are significantly different from those found in the Nonfarm Payroll report. While there are often short-term divergences that result from slightly different counting methodologies, in the intermediate to longer term these reports produce similar numbers. Since the April jobs report, these two have strongly diverged; the Nonfarm Payroll report shows 2.7 million jobs have been added to the U.S. economy, but the Household Employment report, which has dramatically weakened, shows a net 12,000 employees hired during this same period.    

While intermediate-term divergences are odd, they are more likely to occur at turning points in the market. We believe the Household Employment report is likely foreshadowing future overall labor market weakness. Corroborating this belief, we point to weakness in the Conference Board’s Consumer Confidence report, in which respondents are asked two questions: 1) Are jobs plentiful? 2) Are they hard to get? The difference between the two is called the labor differential and has historically shown a high correlation with the unemployment rate. This measure peaked in March 2022 and has been trending lower since then. Readings are now at levels that have in the past coincided with or preceded job losses and a rising unemployment rate. 

Other economic releases support this viewpoint, with the ISM Manufacturing and Services reports showing contraction in labor; manufacturing employment has been below 50 (contraction) in six of the eight months since March of this year, and services has been at contractionary levels four of the past eight months, with another two readings barely in expansion territory at 50.2. Throw in job layoff announcements increasing and continuing jobless claims beginning to move higher, and we believe the data paints a picture of a labor market ready to crack, with wage-based inflation moving lower in 2023. 

A shallow 2023 recession  

While we have experienced a series of rolling recessions in 2022, we expect the economy as a whole will slip into recession at some point in 2023. Leading economic indicators peaked in February at 7.2 percent year over year, have rapidly fallen every month since and now are at negative 2.7 percent year over year. Historically, this level has signaled the economy is either already in a recession or on the verge of one. The yield curve has sharply inverted over the past few months, with the inversion gaining steam as the 10-year Treasury has reversed course and fallen from 4.24 percent on October 22 down to its current level of 3.50 percent. We believe these indicators point to a pending recession, but importantly, we continue to believe that it will be shallow, mild and uneven and will mark the end of the “sticky” inflation narrative as we push through 2023 and into an economically brighter 2024.  

Just as we forecasted in our 2022 market outlook that the economy would normalize, we also pointed to an unwinding of market oddities enabled by the easy-money frenzy that followed the early days of COVID. We pointed to excessive valuations in what we labeled as “hopes, dreams, themes and memes” stocks and our belief that inflated valuations needed to come down significantly. We noted investors may have been wise to avoid frothy areas of the market and to instead focus on segments with real earnings and cash flows. We emphasized the importance of looking beyond U.S. Large Cap growth stocks, technology companies and other segments of the market that were relatively expensive and were often early beneficiaries of the COVID-induced economic oddities. Our focus was on cheaper portions of the equity markets, which we believed would be less impacted by rising Treasury yields that would create valuation headwinds we saw impacting the most expensive and interest-rate-sensitive stocks. This road map has proven largely accurate in 2022, albeit unfortunately with overall negative returns.  

We expected a tough 2022 but did not foresee negative market performance. The dramatic repricing of the bond market has led to a repricing of the stock market. Putting this in a different context, many are familiar with the term “TINA” (there is no alternative), which had helped to drive equity valuations higher in previous years as anemic yields in fixed income led investors to pile into equities in search of dividend yield and capital appreciation. With low bond yields, stocks became similarly expensive. Our remedy for that in 2022 was to tilt toward parts of the market that traded at cheaper valuations to give us a margin of safety against rising interest rates. We continue to believe this is the path forward in 2023, as earnings estimates are likely to further decline as the economy slows. For example, U.S. Small Caps trade at 13 times 2023 earnings, which have already been revised down by 14 percent. This is well below their normal historical valuation and should provide a cushion against the potential for falling earnings. The other reality is many of these cheaper asset classes are the first to move higher in anticipation of an economic recovery, something we expect to occur in 2023 given our forecast of a mild and short recession. And let’s not forget the market often bottoms out well before any recession ends. 

This brings us back to the threat of recession, which we believe is increasingly becoming a focus for investors. As such, fears of an economic contraction will likely fuel heightened volatility that may lie ahead for the markets. In our September Asset Allocation Focus, we introduced the concept of the “Space Between,” in which investors would contemplate the shape and depth of a potential recession. We think investors are now in the midst of this process. Heightened inflationary fears drove interest rates higher, bond prices lower and equity markets lower until the middle of October. Indeed, after appearing to bottom in June the market retested its lows and ultimately found a bottom on Oct. 12, down 25 percent from its Jan. 3 highs. This bottom occurred the day before the September CPI report was released, which likely marked the peak in Core CPI. Since this date, both stocks and bonds have rallied as inflation fears have continued to cool as punctuated by another weak inflation report out this month. Now, we believe investors are beginning to shift their worries toward a recession. The focus on an economic contraction likely puts investors in that volatile Space Between, and this will likely remain the narrative until the Fed finally pauses its rate hikes and the economy climbs out of a shallow recession.   

While we increased our exposure to fixed income in October, based on our belief that bonds would rally as recession fears grew, we remain slightly overweight equity relative to fixed income. Recession fears could lead to volatile markets, but we are unwilling to try to time any such event given that markets have already sold off and that we believe the pace of inflation will ease dramatically, which should allow the Fed to switch from trying to restrain growth to encouraging it through lower rates if necessary. Certainly, earnings declines are a growing risk for 2023, but we note that the market often bottoms before earnings estimates do. We continue to tilt our exposure toward the cheapest parts of the market. In our view, reasonable valuations and still heightened levels of pessimism provide a base for a recovery in equities during 2023 — especially if Fed rate hike pressures subside.  

Within the U.S. we retain our favorable outlook toward value stocks and continue to overweight quality small caps (the S&P 600) based upon their attractive valuations relative to other parts of market. In October, we added to our U.S. exposure by moving our allocation to relatively cheap U.S. Mid Cap stocks to overweight. The increased mid-cap exposure was funded by our actions to reduce our allocation to international emerging markets to neutral — a process we began in June 2021. While we believe the U.S. dollar will likely be a tailwind to international equities during the next few years, we have chosen to emphasize developed international market stocks over emerging ones. While there are risks in places like Europe, current valuations have reached extremely discounted levels. The continued Russian war against Ukraine has undoubtedly complicated the calculus, but heretofore international markets have held up incredibly well as measured by local currency returns. Pessimism remains heightened, valuations are near multi-decade lows, and future returns may be enhanced for U.S. investors by the dollar weakening. 

Consistent with our falling inflation forecast in February 2022, we sold a majority of our Treasury Inflation-Protected Securities that we bought in late 2019 and again in mid-2020 to hedge against what we believed was coming: rising inflation. We sold half of our gold position in October 2022, based on our belief that inflation will continue to subside in 2023, and moved the proceeds into intermediate- and longer-duration fixed income. However, we continue to maintain some exposure to both commodities and gold to hedge against geopolitical uncertainties and the potential risk of rising energy and agricultural prices. 

U.S. Large Cap 

As we near the close of a challenging year for both equity and fixed income markets, we continue to see crosscurrents for U.S. equities. Let’s start off with the well-publicized headwinds for the U.S. stock market. The U.S. and global economies will likely move into a recession (if we’re not already in one); the dollar remains strong despite recent softening; and headline inflation readings remain stubbornly high, forcing monetary policy makers to continue to raise interest rates and to pursue quantitative tightening programs. On the positive side, we believe that we are in the late stages of the current Fed tightening cycle, as upward inflationary pressures are abating. The market has started to recognize this dynamic and is beginning to price in interest rate cuts by the Fed in the back half of 2023. Additionally, China appears to be softening its restrictive zero-COVID policy, which should lead to an improvement in aggregate global demand at a time when the global economy is slowing. 

Looking toward 2023, we think earnings estimates are likely to continue moving lower as the U.S. enters a mild recession.

Year to date, the S&P 500 is down about 15 percent, putting it near the bottom of our nine asset class models (with only Emerging Markets and Real Estate trailing U.S. Large Caps). Breaking down the components of return, the entirety of the downside move has been due to a change in valuation. The market entered 2022 trading at more than 22 times the next twelve months’ expected earnings of $222 per share. Today, estimates for the next 12 months of earnings are at $230 per share, but the market is trading just under 17.5 times that estimate. Changes in sentiment and interest rates explain the move in the multiple, as the U.S. 10-year Treasury yield has increased more than 200 basis points in 2022. Stocks compete with bonds for investor capital, and as a result, if the bond markets reprice, so too will the stock market. That has been the major story of 2022. 

Looking toward 2023, we think earnings estimates are likely to continue moving lower as the U.S. enters a mild recession. It would be unusual for earnings to grow year over year in a time of macroeconomic weakness, but that’s what consensus estimates are pricing in, calling for a 7 percent growth in earnings from 2022 to 2023. Projected earnings growth rates have deteriorated throughout this year, and we expect this negative earnings revision cycle to persist into next year. While this dynamic is a headwind for U.S. Large Caps, historically, short-term earnings growth or contractions do not significantly change the direction of the market. In fact, historically, some of the strongest market returns have occurred in earnings contraction environments (recessions) as investors anticipate fiscal and monetary policymakers will add liquidity to the economy as well as the prospect of an earnings recovery. While policymakers do not currently have room to ease financial conditions, the inflationary environment will likely be significantly different in the back half of 2023, leaving room for greater flexibility relative to monetary policy. We remain neutral U.S. Large Caps (S&P 500) with a continued bias toward cheaper or value stocks, which have provided outperformance once again this year. However, we are incrementally becoming more positive on the S&P 500 given the improved valuations found in the overall asset class. 

U.S. Mid Cap 

The investment strategy committee updated U.S. Mid-Caps to overweight from neutral in October while simultaneously eliminating our small overweight to Emerging Markets. While we continue to view Emerging Markets as attractively valued, the same can be said about U.S. Mid-Caps, which don’t have the unique currency and geopolitical risks that are present in emerging-market equities. U.S. Mid-Caps are trading at a little more than 13 times expected 2023 earnings, and it’s important to note that those expected earnings have already been trimmed by 8.5 percent in anticipation of a weaker macroeconomic picture next year. The roughly 20 percent valuation discount to U.S. Large Caps is unusual, as Mid-Caps typically trade at a premium to large caps. The last time Mid-Caps traded at a discount was back in the dot-com era of the late 1990s and early 2000s, which, looking back, was a wonderful entry point for relative performance. 

U.S. Small Cap 

U.S. Small Caps have one of the longest-lasting overweight positions in our portfolios and have been solid contributors on an allocation basis during the respective overweight holding period. The strong showing is due to the fact that performance for the asset class is closely aligned with the U.S. economy, which is the largest, most diverse and resilient in the world. Additionally, domestic Small Caps have offered investors highly attractive relative valuations. Similar to U.S. Mid-Caps, we note that U.S. Small Caps trade at 13 times 2023 earnings that have already been marked down 14 percent. We continue to believe valuations for U.S. Small Caps remain as attractive today as they were when we first initiated our overweight. Furthermore, we are excited about the prospect of what relative returns could be once the economy stabilizes and current macroeconomic headwinds potentially turn into tailwinds in late 2023 or 2024.  

International Developed 

Our forecast of the U.S. dollar shifting from a headwind to a tailwind in the fourth quarter has taken root. The U.S. dollar peaked on Sept. 28 and has depreciated approximately 10 percent in a little more than two months. As a result, the MSCI EAFE Index (the benchmark for International Developed markets) has climbed 22 percent in U.S. dollar terms, while the S&P 500 has appreciated 8.5 percent during this short time period. Rather quietly, the MSCI EAFE Index has now outperformed the S&P 500 year to date, negative 11.5 percent to negative 14.5 percent, respectively. While international markets have trailed domestic U.S. markets for more than a decade, we believe the tide may be turning as we move to a new economic cycle. It’s worth noting that a review of economic cycles since the 1980s shows that the U.S. and international markets have taken turns providing leadership. Certainly, this may change, but we note as we head into 2023 and look toward a new economic cycle that valuations for international developed equities are extremely cheap, investors are pessimistic and under-invested, and importantly, the U.S. dollar is expensive relative to foreign currencies. 

Europe has been able to fill its natural gas storage, put a price cap on Russian oil and has given itself a strong chance to survive the winter relatively unscathed, contrary to dire initial expectations. Granted, Europe is struggling with many of the same issues as the U.S.: high inflation, rising interest rates and COVID monetary excesses that are now shifting to recessionary fears. However, it appears the markets are turning. Investor anticipation that rate hikes by the Fed and the European Central Bank (ECB) are set to slow has pushed the European indices toward bull market territory. Rate and inflation levels will be key to the direction of future returns of International Markets over the next 12–18 months. 

Downside risks for Europe are similar to those for the U.S., notably higher inflationary pressure for longer, thus diminishing household purchasing power and triggering further monetary policy tightening; weaker than expected global growth; and new COVID variants that could lead to new lockdowns. The upside for Europe: faster than expected resolution of uncertainty related to the Russia-Ukraine war and/or lower energy prices, which will lead to consumer confidence, economic growth and dis-inflation. New political initiatives from the European Union could also boost business and consumer confidence. We expect inflation across the major components (energy, food and core) to decline in 2023. Recently, energy prices have started to fall from the surge triggered by Russia's invasion of Ukraine, and oil and gas prices are now down 29 percent and 53 percent, respectively, from February levels. We also see a combination of easing in supply disruptions and production costs (stemming from lower commodity prices) as well as weaker demand, which should lead to a slowdown in goods price inflation. We have seen this trend for the past six months. Finally, we expect easing demand for travel and recreation-related items, which benefited from the strong 2022 tourism season, to contribute to a decline in services inflation. 

As we have repeatedly said, valuations have been on our side. The MSCI EAFE Index has an estimated price-to-earnings ratio (P/E) of 12.1. The S&P 500 Index has an estimated P/E of 17.5. This is one measure of valuation, but we view this 40+ percent discount to be compelling. The International Developed markets also have favorable sector exposure, with a concentration in value-oriented sectors. The MSCI EAFE Index’s top sector exposures are banks, pharmaceuticals and insurance. In contrast, the S&P 500 Index’s top sector exposures are software, computers and the internet. The growth versus value trade couldn’t be more evident than it is in Europe. 

As we have stated, there are concerns in these regions, and the group’s underperformance over the past decade has been notable. However, the sector exposure is attractive, valuations appear incredibly cheap, and we believe even the slightest catalyst could lead to further future outperformance as investors underweighted to the regions rush to rebalance their global allocations. 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 slightly overweight. 

Emerging Markets 

The MSCI Emerging Markets Index rose about 12 percent in the month of November, the strongest monthly performance in years. A key catalyst for this outperformance against most other asset classes was renewed optimism around China relaxing its zero-COVID policy, potentially easing quarantine protocols and reducing mass testing. The Chinese economy has been hit hard by COVID lockdowns over the last three years, and there is hope that relaxed policies can ignite growth in the world’s second largest economy. Additionally, the Public Company Accounting Oversight Board in the U.S. is in the process of auditing 200 Chinese companies listed in the U.S., and it was recently reported that the group completed its first round of audits earlier than anticipated. Markets took the early completion as a positive; however, there is still uncertainty on the findings of the audits, and the ultimate outcome could lead to near-term volatility. Another tailwind to recent performance is that after 10 months of extreme dollar strength, November saw the dollar retreat sharply against most major currencies, registering its largest drop since 2010. The emerging-market foreign exchange index sat near three-month highs as December began, and capital flows into emerging markets have started to stabilize.    

The monetary policy backdrop in China continues to be relatively favorable as China’s central bank cut its reserve ratio for most banks by 25 basis points, which will result in more liquidity in the economy. Additionally, state-owned banks have offered $200 billion in credit to the struggling housing sector. These monetary and fiscal developments in China are generally positive. However, geopolitical concerns persist as Chinese President Xi Jinping still appears to have intentions to reclaim and reunify with Taiwan. The corresponding impact on U.S.-China relations and potential for U.S. involvement is a significant risk. Investing in the developing world often comes with additional geopolitical risks, and we believe both the U.S. and China have more to lose than gain in any conflict. However, tensions have risen in recent months, and we are watching this closely.  

Overall, in developing economies, relative valuations continue to be attractive 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. 

In October 2022 we reduced our exposure to Emerging Markets to our current neutral weight given the delicate balance of risk and potential rewards. 

After beginning 2022 with a paltry yield of 1.75 percent, the Bloomberg Barclays Aggregate Investment Grade Bond Index surged to a yield of more than 5.0 percent in early October on the back of stickier than expected inflation that caused rapid and reactionary Federal Reserve interest rate hikes. The result was a sharp decline in fixed income total returns, to negative 16.8 percent year-to-date by late October, which marked an 18.4 percent decline from its all-time high set in August 2020. Unfortunately, this sharp repricing in the bond market led to a sharp drop in stock prices. If both equities and fixed income post negative returns for the year, it will mark just the fifth time in 26 down-equity markets (measured on an annual basis since 1926) that bonds have posted losses at the same time as equities.   

While this decline has been painful, bond investors need to recall two important realities: 1) Investment-grade bonds more often than not mature at par and, as such, will pull back toward that level as that maturity date draws nearer; and 2) future returns now offer positive real value, with the index currently yielding 4.5 percent, well above where we think intermediate- to longer-term inflation will settle. Put differently, bonds are once again a real return vehicle and likely to re-connect to their historically normal hedge against falling equity prices, especially if we slip into a recession, which we believe would sap inflation of its strength.  

We do not expect interest rates to slip back toward the incredibly low levels of the last economic cycle,

Given this reality, in mid-October we increased our allocation to investment-grade fixed income and lengthened the maturity/duration of our overall bond portfolio. On its face, this may seem odd given that nearer-term Treasurys yield more than intermediate and longer terms. However, the reality is in two years one would have to reinvest the entirety of the two-year Treasury at an undetermined rate, while the 10-year Treasury provides some certainty of the future interest rate earnings, which are in excess of the level of inflation we expect during this time horizon.  

Overall, we continue to position the fixed income portfolio’s duration near neutral and favor higher-quality fixed income given the current economic backdrop and our preference for a slight equity overweight. We do not expect interest rates to slip back toward the incredibly low levels of the last economic cycle, and we believe that fixed income has once again returned to its historic role as an income-generation vehicle coupled with an ability to provide risk mitigation against the potential for falling equity prices in the future. Much like this year, three of the prior four times when bond and equity returns were simultaneously negative occurred when inflation was above 5 percent. The lone 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.  

Duration  

The Treasury curve remains significantly inverted between maturities of six months and 30 years. This suggests that the tightening cycle is in the later stages. While 2022 has witnessed historically significant moves in the Fed Funds rate and bond market weakness, we believe that 2023 will be less dramatic. While fixed income has still had minor negative total returns since our September Asset Allocation Focus, the beginning of the fourth quarter has coincided with reduced volatility in fixed income markets compared to what we saw during the first nine months of the year. Perhaps counter-intuitively, during periods of inversions (long bonds yielding less than shorter-term bonds) owning longer-duration/maturities is vital to an overall allocation since longer-term bonds will tend to be one of the areas that perform well as overall interest rates decline.  

However, we’d caution fixed income investors to avoid getting ahead of themselves by anticipating additional quick drops in yields. With real interest rates now positive and no longer being suppressed by policymakers (think quantitative easing or bond buying now becoming quantitative tightening) and volatility easing, fixed income yields should be attractive for the foreseeable future. We anticipate most of the volatility going forward will be in bonds with durations of three years or less as the market considers the path of future actions by the Fed and the potential that it will need to lower rates. Given these realities, we continue to favor modest tilts toward higher quality and intermediate to longer-term duration given that we want to lock in higher interest rates for longer. 

Government Securities/TIPS 

We believe the story for the past three years has been 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. When discussing TIPS, we tend to look at the shape of the breakevens curve (which represent the difference between the yield on inflation-protected securities and nominal rates across bonds with different maturity lengths) and less so at the absolute level of TIPS or breakevens. Based on this perspective, it is fair to say this year has been quite a ride. After seemingly decades of +/- 2 percent breakevens, front-end breakevens rose to nearly 6.30 percent by late March and since have fallen back to just above 2 percent. Perhaps surprisingly for investors, roughly 90 percent of the drawdown in fixed income happened in the first half of this year as inflation drove the narrative surrounding bonds. In February 2022, we shifted our exposure away from TIPS and toward nominal coupon-bearing shorter-term bonds. Additionally, we moved toward intermediate- to longer-term bonds in October as yields on those securities had moved dramatically higher.  

Credit 

The move in rates in 2022 has been one for the history books. The speed and size of the rise in rates is unlike anything fixed income investors have experienced in more than three decades. During virtually every past Fed tightening cycle, credit has experienced challenges. With that in mind, we are somewhat cautious going forward; many markets are still digesting the moves to higher rates. The likelihood of credit problems remains, as high-yield credits that were issued in an era of covenant lite and lower-issuance yield will need to be refinanced with tighter covenants and higher yields. We continue to favor investment-grade credit over higher-yield or lower-rated corporate bonds.  

Municipal Bonds 

The 1-10 municipal bond index has rallied and is now down just 4.5 percent year to date. At one point this index was down nearly 10 percent year to date. Municipal bonds (munis) have been on the same rate ride this year as all other fixed income. Historically, munis have been about 25 percent less volatile than other fixed income securities, and 2022 has proven no different as they have experienced a smaller total return drawdown year to date than most other areas of fixed income.  

We have long noted the benefit of owning commodities and real assets as a source of diversification. These benefits are particularly helpful during periods of unexpected inflation. The past few years have provided a real-time example of this point and have hopefully convinced investors that these assets should be included in a well-diversified portfolio. As we’ve noted previously, in three of the previous four times in which bonds and equities both posted negative returns for the calendar year, inflation was above 5 percent. Similarly, in all but one of those instances — 1931 — commodities posted positive returns. Put differently, when fixed income didn’t provide diversification of returns for equities, commodities did. This year is no exception, with the Bloomberg Commodities index posting a positive 18 percent total return year to date versus a sea of red in stocks and bonds.  

However, with our expectation that inflation will shrink further in 2023, we reduced our commodities exposure to underweight in October by trimming our allocation to gold. Remember, gold was an asset class that we first allocated to in April 2020, a time when the 10-year Treasury yielded .51 percent and there was significant economic uncertainty. Given this reality and our belief that there was a likelihood that fixed income was an incomplete hedge against all economic outcomes, most notably rising inflation, we decided to further diversify our commodity exposure to gold, an asset class that has historically done well in periods of real negative interest rates that often coincide with heightened levels of inflation. 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.  

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 as it sorts through its post-COVID and interest rate-sensitive rebalancing.  

Overall, we are underweight real assets given our 2023 outlook. We continue to note that these asset classes both maintain favorable diversification characteristics against the unexpected and, as such, continue to maintain exposure to real assets.  

Real Estate  

In periods of flat or negative equity market performance, REITs can offer attractive yields relative to other kinds of equity securities. 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. The reality is the search for yield (in its absence in fixed income) that occurred during the low rates in years prior to 2022 caused investors to move into REITs and other higher-yielding parts of the market. The dramatic rise in rates this year has 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 biggest swings in performance. The rise in rates this year 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 into early to mid-2023. We will continue to monitor the REIT market for signs that it is time to adjust our exposure but at this point continue to underweight the asset class. 

Commodities 

Commodity prices have rebounded recently after giving up some of the strong gains from earlier in the year.  

While energy prices are off peak levels hit in early June, they remain at somewhat elevated levels. In October, the Organization of the Petroleum Exporting Countries plus Russia agreed to slash output by 2 million barrels of oil a day, a move likely to provide support for already high global energy prices.  

Another recent tailwind to commodity performance is the weakening U.S. dollar, which in November retreated sharply against most major currencies, posting its largest drop since 2010. 

Through November 30, commodity prices have risen 19 percent year to date, following a strong 27 percent gain in 2021 due to supply-chain bottlenecks, industry underinvestment and anticipation of an invasion of Ukraine by Russia.  

Note that the sharp gains in commodity prices are not broad-based and are largely concentrated in the energy sector. Energy

prices have risen an amazing 55 percent year to date, including oil (up 43 percent), gasoline (up 45 percent) and natural gas (up 79 percent). Amazingly, natural gas prices surged 53 percent in July, while other energy-related commodities fell in price. In the U.S., natural gas inventories are currently trending below seasonal averages, creating the possibility of meaningful price spikes if this winter is colder than average. 

Beyond the energy sector, weaker commodity prices reflect expectations for reduced global economic growth. Global prices for agricultural commodities are up modestly, although wheat and sugar have fallen significantly. Industrial metal prices have declined 5 percent year to date, although copper, nickel, zinc and aluminum prices have rebounded over the last two months. A potential catalyst for this rebound is renewed optimism around China relaxing its zero-COVID policy, potentially easing quarantine protocols and leading to an uptick in consumer demand. 

Precious metals have also declined (gold down 4.7 percent year to date) despite the rise in geopolitical risk. Gold serves as a haven for investors, particularly in an environment with negative real (inflation-adjusted) interest rates. While we expected gold prices to rise in tandem with inflation expectations, the long-term relationship between gold and real rates remains intact, but there have been sustained short-term periods when the linkage has been inconsistent. That said, we find no reason to abandon the anchoring of gold to real yields and continue to expect gold to provide a hedge against unforeseen economic outcomes. 

While we have a positive outlook for commodity returns, our inflation outlook suggests the current rate of commodity appreciation isn’t sustainable.   

The last few years have provided a fertile backdrop for “supersized” predictions/media noise of where the economy and markets are headed as we continue to experience the dramatic impacts of the pandemic and all of its related economic and market oddities:  

• From negative 29.9 percent real quarter-over-quarter annualized GDP in the second quarter of 2020 to the following quarter’s 35.3 percent advance.  

• From more than 20 million jobs being lost in April 2020 to the past few years of significant hiring. From 0 percent interest rates and a Fed (and other central banks) buying massive amounts of government bonds in an effort to supercharge the economy and markets to the Fed slamming on the brakes with 4.25 percent of rate hikes in nine months as it seeks to halt an overheated economy.  

• From record money supply growth of 26.9 percent year over year registered in February 2021 to today’s 1.3 percent growth of money supply, which marks the lowest level since 1995.  

• From a narrative that inflation is forever dead to now inflation is here for the long haul.  

• From oil trading at negative $37 a barrel during the peak of COVID to a recent peak of $123 following the Russian invasion of Ukraine.  

• From the 10-year Treasury yielding a record low of .512 percent in April 2020 to this year’s 4.25 percent.  

• From the outrageous spike of hopes, dreams, themes and memes stock in 2021 to their plunge in 2022 and, more notably, both stocks and bonds posting negative returns for the first time since 1973.  

All of these abrupt shifts have caused considerable consternation and concern about the future. 

As we’ve noted, COVID had a dramatic impact on the economy and significantly disrupted its natural balance. However, with each passing day the impact has lessened. As a result, the U.S. economy continues to return toward equilibrium, and we believe the investment markets will follow and the hyperbole of market commentators will subside. Although we believe the largest impacts, notably inflation, are behind us, challenges remain as we look toward 2023 and the potential for a recession. However, we believe that as we push through 2023, the backdrop will become a bit less challenging than what we have seen during the past few years.   

This is not to suggest the world will soon be free from uncertainty. Instead, we simply believe that the seismic economic disruptions caused by COVID will continue to ease. Throughout the pandemic, we took every opportunity to remind investors that financial security is attained not by how investors act when times are good but primarily by their ability to maintain the course and stay invested when times are bad. While we expect to see fewer challenges in the year ahead, our belief in the importance of a diversified portfolio that is tied to a financial plan that focuses on staying the course remains unchanged. We’d like to offer two important comments as investors ponder a recession and continued volatile market. 

1. Much of the chatter today discounts the staying power of signs of strength in equity markets. The thinking goes that the surges are simply bear market rallies and investors should sell because they will give way to new equity market lows. We believe it is important for investors to realize that one of these market rallies will mark the start of the next bull run. Unfortunately for investors, market bottoms don’t announce themselves or provide an all-clear signal. The risk of missing out on meaningful gains while waiting for confirmation that the next bull market has arrived can be damaging to a long-term financial plan. Consider that the market bottom during the last recession occurred on March 9, 2009, a day that appeared to be nothing more than just another miserable day during an extended market decline. The reality is that low occurred nearly three months and 37 percent of upside before earnings estimates bottomed and four months and a similar percentage gain before the recession ended on June 30. It occurred nearly six months and 53 percent of positive performance before leading economic indicators turned positive on a six-month annualized basis. And finally, it occurred nine months and 65 percent before the first positive jobs report in November of 2009. 
    
   We are not suggesting that asset allocations can’t or shouldn’t be tweaked on occasion; indeed we have detailed our tilts throughout this piece. However, we believe that making significant changes to an overall strategic long-term asset allocation in hopes of capitalizing on short-term timing calls is a fool’s errand. 
    

2. Diversification, despite the difficulties of 2022, remains the best path forward to deal with life’s uncertainties. While we’ve heard talk that the challenges created by COVID spell doom for the time-tested 60/40 portfolio, we believe this view is misguided. Instead, we think the 60/40 portfolio concept needs to be expanded. It’s worth noting, as shown below, that since 1976 a simple 60/40 portfolio of U.S. large cap stocks and U.S. investment-grade bonds has posted positive five-year rolling returns in all but three months — during the first quarter of 2009 during the Great Recession. Importantly, we do not forecast that we are headed for another Great Recession and point out that even with the performance difficulties of the past year, over the past five years a 60/40 portfolio remains up more than 6 percent.  

Much as we mentioned in our closing last year, we believe this basic asset allocation can likely be improved upon looking forward. Over the past five years through the end of November, stocks have done the heavy lifting, with bonds up only 0.45 percent during the period (TINA). With yields now higher, we expect bonds to provide stronger returns going forward. Secondly, the above analysis simply includes two asset classes, the S&P 500 index of large cap stocks and investment-grade bonds. Consistent with our portfolio positioning, we believe that future return opportunities in the near to intermediate term can be enhanced by the inclusion of other equity segments that haven’t done as well over the prior five years. These classes include U.S. small caps and mid-caps and international developed stocks. Lastly, much as we argued in our closing last year, we continue to believe a third asset class — commodities — can be a valuable hedge in an overall portfolio allocation. 

 
Happy holidays and best wishes for a healthy and prosperous 2023. 

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.