The Fed Signals We’ve Reached a Turning Point; Now What?

The post-COVID economic and market backdrop has included plenty of plot twists and turns that have rapidly shifted narratives and created heightened uncertainty about “what happens next.” Over the past few months, many investors appear to be increasingly certain that they know exactly how the story ends: an economic soft landing thanks to proactive and aggressive Federal Reserve (Fed) rate cuts. The thinking is that these cuts stop the spread of the labor market weakness that threatens to disrupt future economic growth. This increased confidence has led to a strong market rally that has pushed stocks to trade at historically elevated valuations. Unfortunately, we remain unconvinced that another narrative shift isn’t lurking in the near term and continue to urge prudence and caution in the coming months. 

Those who believe a soft landing is possible are ignoring a slew of economic and market warning signs—arguing they have been reduced to irrelevance today given the post-COVID oddities.  

The signs are seemingly everywhere and include: 

• An inverted yield curve, 

• Faltering leading economic indicators, 

• Tighter lending standards from banks, 

• A sense of pessimism among consumers, 

• Rising credit card and auto loan delinquencies (thanks to higher interest rates), and 

• The services sector showing fatigue after being a driver of growth for the past two years. 

We have spent much of the past year identifying and monitoring these historically relevant warning signs. While the economy has not officially fallen into a recession, the reality is that the longer rates remain elevated, the more they will work their way into the economy and impact economic growth. Indeed, we are now 10 quarters past the start of the Fed’s rate hike cycle, which is the average point in the prior eight recessions at which the Fed’s prior rate cuts finally toppled the U.S. economy into a recession.  

As the soft-landing narrative has taken hold, ironically, more signs the labor market is weakening have appeared. While this has sparked optimism that the Fed will cut interest rates and keep the economy from stumbling into a recession, we note that the labor market is where the rubber meets the road on a recession, because it is often the last economic indicator to falter. The reasons are twofold:  

1. Companies often hold onto until the last minute before letting workers go because those workers are hard to find and costly to re-employ. 

2. Historically, once the unemployment rate rises by a little, it tends to trend and ends up rising by a lot. Put in “Fed speak,” this is the point at which the rise moves from gradual to non-linear.  

The question now is whether we have already crossed that fine line or whether this time will somehow be different than what has typically happened throughout history.  

Based on valuations and the rise in equities, we worry that investors aren’t fully considering the risks that this economic story ends with a recession and greater market volatility. The silver lining is that despite our nearer-term cautious outlook, we believe that ample opportunities exist for patient investors focused on an intermediate- to long-term investment horizon who are willing to stick with the “plan” no matter what the next few quarters hold. Importantly, sticking with the plan means not only being prepared for market volatility and staying invested but also (importantly) staying diversified and ignoring the urge to concentrate in a few stocks and asset classes (e.g., the Magnificent Seven).  

 

Yes, but …  

The most common response to the economic concerns we have expressed over the past year has been twofold: 

1. This time is different due to the distortions caused by COVID and more importantly and emphatically stated. 
2. Yes, but the labor market remains strong.  

We recognize that the post-COVID period has left investors with many oddities to sort through, but we believe that the economy has largely moved past the COVID distortions and reconnected to a more historically normal economic and business cycle. Unfortunately, the data continues to show that we are later in the economic cycle. Traditionally, that has led to a recession in the nearer term.  

The labor market strength that many have pointed to over the past quarters to justify their continued optimism for a soft landing has recently taken a hit as signs of labor market weakness continue to grow. The most noteworthy sign that weakness may be accelerating was July’s jobs report, which showed the unemployment rate rose to 4.3 percent—a full 0.9 percent above the low the post-COVID cycle set in January of 2023. Not only does this exceed the level of rise from the cycle trough at which past recessions have begun, but, at least according to the much-discussed Sahm Rule, it suggests that the softening may be gaining momentum. The rule, which was created by former Fed economist Claudia Sahm, has a perfect track record of identifying recessions back to the 1940s. While rules are certainly not immovable laws of economics, and many note that immigration/additions to the labor market and even a hurricane that hit Texas in July have caused the recent rise in unemployment, we continue to note that a holistic review of the labor market beyond this rule points to weakness.  

Following the breach of this rule, the optimists’ rally cry quickly shifted to the other jobs report. The Nonfarm payroll report has diverged from the Household report (used to calculate the unemployment rate) and has remained strong. We note that these two reports use different ways to count employment and, as such, can diverge over shorter periods of time. But they have historically told a similar story over intermediate to longer time periods. Much like all economic data, these reports are subject to revisions, one of which happened in mid-August and was the first estimate of the revisions for the 12-month period that ended March 2024. The revisions are made because, over time, the Bureau of Labor Statistics (BLS) gets better data that allows it to more accurately track employment.  

This release showed that Nonfarm payroll growth overestimated the number of jobs gained during this period by 818,000 positions, which lowers the initial job growth from 2.9 million during this time period to 2 million. While many did the math and quickly responded that the downward revision simply meant that instead of averaging 242,000 jobs each month during the period, the number was now a still-healthy average of 174,000 added per month. However, it’s worth noting that the margin of error for the employment picture is getting smaller as job growth (according to the Nonfarm data) is slowing toward under 100,000 monthly job gains, and signs of labor market weakness have become more pronounced over the past few months. For example: 

1. Temporary employment services positions have declined—this is typically a group that is among the first to be laid off in a slowing job market. 
2. The diffusion index of industries hiring has slipped near/below 50 percent, with most hiring occurring in areas that aren’t influenced by the strength of the economy. 
3. Surveys such as the Conference Board’s labor differential have fallen sharply since March. 
4. The Institute for Supply Management (ISM) services Purchasing Managers Index (PMI) for employment fell into contraction in February through June, joining its manufacturing counterpart. 

Simply put, these various measures show signs that have historically appeared during periods of job losses, not gains. The trend continues with the recently released August jobs report. According to the latest data, as measured by the Household report, 66,000 jobs were lost during the past 12 months. Importantly, the pace of losses appears to be accelerating with the Household data showing 432,000 jobs lost in the past nine months. While Nonfarm payrolls still show gains, we note that focusing on private payrolls (which exclude government positions) two of the past three months now indicate gains of less 100,000. In light of the trend in prior revisions, this likely puts us at or near zero jobs added per month. Clearly the labor market is weaking and the Household reports is historically at levels which the U.S. economy has been in or entering a recession. Once again, this raises the question of which of these indicators are correct or whether this time is truly different. 

The Fed’s pivot  

Despite the continued positive economic narrative, signs of weakness in the labor market appear to have caught the eye of the Federal Reserve, which has been waiting anxiously for the appropriate time to cut rates. Their task is difficult given the trade-offs they are trying to balance on both sides of their dual mandate of stable prices and full employment. Cutting too early risks easing financial conditions, which could heighten upside risk to economic growth and inflation. Cutting too late risks that labor market weakness could transition to an even more serious deterioration.  

We do not seek or welcome further cooling in labor market conditions.

Federal Reserve Chairman Jerome Powell, in his much-anticipated comments at the Fed’s annual August gathering in Jackson Hole, made clear the job market has become the Fed’s primary worry. “The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook and the balance of risks. We will do everything we can to support a strong labor market as we make further progress toward price stability.”  

The reason, as he noted, was this: “The unemployment rate began to rise over a year ago and is now at 4.3 percent—still low by historical standards but almost a full percentage point above its level in early 2023. Most of that increase has come over the past six months.” And to make it perfectly clear as to the reason for rate cuts: “The cooling in labor market conditions is unmistakable. Job gains remain solid but have slowed this year. We do not seek or welcome further cooling in labor market conditions.” 

To be clear, we have always believed we would get to exactly this point. And we continue to believe that, as the story unfolds, a recession will be the result. We pushed back on those who foresaw Fed rate cuts early this year based on our belief that the labor market was the Fed’s final frontier in its battle against stubborn inflation. We believed that given that inflation pressure perked up in the beginning of the year, a time when the pace of wage growth was still strong, the Fed would have to wait for more compelling evidence of labor market cooling before it began cutting rates. As we’ve noted in the past, the Fed wanted to avoid a repeat of 1966, when it cut rates too early and inflation became embedded in the economy for the next 16 years. Most notably, earlier this year we pointed to the pace of wage growth, which is stickier later in a cycle and at least historically has only slowed toward the Fed’s target of 3 to 3.5 percent growth sustainably through a recession. We are nearing (but still above) the upper band of that range based on the latest jobs report, which is why the Fed is more comfortable cutting rates. The question is whether they have waited too long.  

A gradual rate cut cycle  

We continue to believe that absent clear and significant deterioration in the labor market, which unfortunately would likely signal rate cuts have arrived too late, the Fed is likely to cut rates gradually. As many Fed speakers noted, they don’t want to cut rates and then hike again if inflation reignites. The reality is that we are later in a business cycle, and inflation is highly sensitive to rising economic demand, so a rate cut that is too stimulative to the economy could lead to rising inflation. Put simply, late in the cycle supply becomes more constrained since there aren’t a lot of new workers to create an additional supply of goods and services. More economic demand against a constrained ability to create supply due to lack of new workers would likely reignite inflation. The risk then becomes that the Fed will lose its inflation-fighting credibility. If it does, consumers may change their buying behavior, which could lead to a feedback loop that drives prices ever higher. This is what happened in the late 1960s. It’s why Powell has discussed the importance of keeping inflation expectations anchored—to prevent it from becoming embedded in the economy. We also note that Fed minutes often include discussions about heightened asset valuations and the risk presented by the wealth effect on supporting demand even as prices climb.  

An overly aggressive Fed could reignite inflation.

While inflation expectations remain anchored, and the pace of inflation has slowed back toward 2 percent over the past three months, the reality is that the inflation rate is at levels seen toward the end of 2023, when Powell and other Fed members stoked optimism about the inflation problem being solved and hinted that rate cuts were on the way. Investors and corporations became optimistic about rate cuts, and equity markets surged. Given the rise of inflation during the first four months of 2024, the Fed must wonder whether the heightened optimism it helped create in late 2023 contributed to renewed price pressures earlier this year. With that in mind, absent any clear signs of labor weakness, we still believe that the Fed is likely to take a gradual approach. If they don’t, we will likely revisit our fixed income allocation given the reality that nearer-term inflation expectations currently are below 2 percent. An overly aggressive Fed could reignite inflation.  

The final economic word 

Economics and the market are humbling. Exactly timing developments is incredibly difficult. But trends, risks and even probabilities can be identified. We think the trend still points to a recession. The Fed cut rates prior to the start of the past four recessions. Cutting rates prior to the start of a recession isn’t a magic elixir that prevents one from occurring. We’ve also been noting that the Fed would have to wait longer this time to cut rates given the risk of inflation and it becoming embedded. 

The reality is that parts of the economy are struggling. Yes, price growth has slowed, but prices are still rising. Consumer sentiment surveys have shown this is causing an increased burden, especially for those on the low and middle parts of the income spectrum. These folks are struggling to make ends meet as rising interest rates have led to increased credit card and auto loan delinquencies. Home prices are up, and housing prices relative to the median household income are above 2006 levels. While the rent price increases have slowed, prices are still elevated. This is all happening as consumers have burned through excess savings accumulated during COVID. And wage growth while elevated, has slowed.  

Contrast this with higher-income consumers who likely already own a house that has skyrocketed in value. Most have fixed-rate mortgages that haven’t increased. They typically have little debt and have seen their savings now produce an income flow as equity markets moved sharply higher. How this ends is the biggest riddle yet and one that causes us angst in developing our outlook. Do higher-end consumers stay strong, or do they end up losing jobs as corporate margins get squeezed?  

We are humble and acknowledge a soft landing is possible. However, a continued review based on our investment process shows that risks are elevated. Today’s ample economic uncertainty continues to inform our desire to be cautious in our overall asset allocation.  

The market 

Against this economic backdrop, stocks have risen to new highs and appear expensive on a historical basis. Investors are optimistic and already heavily allocated to equities. The American Association of Individual Investors (AAII) sentiment survey shows bullish perceptions of the market for the coming six months recently rose above 50 percent for two of the past three weeks. Historically, this level of bullishness has seen the S&P 500 produce returns in the low single digits in the subsequent 12 months. It also has led to a nearly double (33 percent versus 17 percent) probability of the S&P posting negative returns in the next one year. Consumer sentiment surveys show that a near record number of respondents believe equity prices will move higher in the next year. All of this is happening when the economy is late in the cycle. Throughout history late-cycle economies have produced subpar returns going forward.  

Contrary to the current narrative in the market, we believe valuation does matter, especially over the long term. We note that the Shiller Cyclically Adjusted P/E (CAPE) ratio, which was created to allow apple-to-apple comparisons of valuations across a typical economic cycle, is at historically high levels. The measure was created by Yale professor and economist Robert Shiller and divides the price of the market by the average of the prior 10 years’ earnings adjusted for inflation. The current CAPE ratio of the market is 35. In data going back to 1888 there have been only two occasions when the market has had a higher ratio—one in late 2021 and in 2000. In 1929, the ratio was just under the current level. Historically, this measure has provided a good guide for future returns and, at current levels, suggests subpar returns in the coming years.  

It’s possible that valuations have moved secularly higher because of longer business cycles, better corporate management and higher-quality companies. Maybe they don’t matter, as many now argue (much as they did in 2000 during the dotcom bubble). Maybe, as many argue, with current economic data this measure has also been distorted by COVID. Maybe we have a soft landing that propels earnings higher while the AI revolution vaults the economy forward and we grow into the valuation. Maybe … but what if not?  

We continue to take a cautious approach given our concerns about the economy and markets. However, much as we detail in the coming sections, we also believe that there are ample opportunities for intermediate- to long-term investors in asset classes where optimism and exposure has not been elevated.  

Since the end of COVID, we have been repositioning our portfolios to reflect the ever-changing fiscal and monetary backdrop and our belief that these evolving conditions will lead to new opportunities in the years ahead. In many cases these opportunities seemed less than obvious to many at the time but, with the help of hindsight, now appear obvious in retrospect. 

For example, we were quick to anticipate that policymakers would do all they could through monetary and fiscal policy to cushion the economic blow from COVID. This recognition led us to overweight equities and add inflation hedges in the immediate aftermath of COVID’s arrival. Recall that at the time conventional wisdom still considered inflation a relic of the past. Then, after inflation spiked and many investors believed price pressures had become a permanent fixture of the economy, we trimmed our inflation hedges in 2022 (TIPs and Commodities) and kept equites overweight based on our belief that inflation was peaking and set to fall as we moved further past the COVID-related oddities. We concluded this would cause pessimistic investors to return to equites as a much-feared recession failed to materialize. While these trades all seem rational in hindsight, the reality was they were highly contrarian at the time.  

Given our belief that the economy was moving past COVID and reconnecting to a more traditional (late) business cycle in mid- to late 2023, when inflation became stickier and led the Fed to keep rates high to weaken the labor market, we continued to trim our overall equity exposure to today’s current slightly underweight positioning while increasing our allocation toward investment-grade fixed income, which saw an aggressive repricing and higher yield in 2022.  

Valuation is not an instant gratification or perfect timing tool, but we believe it wins in the intermediate to long term, which guides our investment process.

Over the past few years, we have increased the duration of our fixed income portfolio, while many others have advised hiding in shorter maturities in the front end of the yield curve because short-term bonds offered higher yields over intermediate- to longer-term fixed income. Our move to extend the duration culminated with our move in June of this year to add long-term Treasurys to our portfolios. We made the move based on our growing concern that labor market weakness threatened to cause a recession and create equity market volatility. Simply put, we wanted to lock in longer-term yields in advance of a rate-cutting cycle while at the same time hedging our equity portfolio against the risk of potential selling pressure in equities. Certainly, during the increased volatility caused by the unwinding of the yen carry trade in August along with the sell-off sparked by heightened recession fears stemming from July’s weak jobs report, these intermediate- to longer-term Treasurys passed the test as an equity market hedge. The overall picture resulting from these actions is that we are now slightly underweight equities and commodities while overweight to fixed income.  

Within our broad stock/bond framework, we continue to focus on valuation and areas that are under-appreciated while paying heed to the ever-growing concentration of risk that exists in U.S. Large Cap equities. Valuation is not an instant gratification or perfect timing tool, but we believe it wins in the intermediate to long term, which guides our investment process. Given this backdrop we shifted some of our Large-Cap exposure toward the S&P equal-weight index from the market-cap-weighted index earlier this year. While we share excitement about the potential for what artificial intelligence (AI) may become as well as the earnings and free cashflow many of these companies generate, we worry about the current premiums these names are garnering from investors. At a minimum, hopefully we can agree that having significant exposure to correlated corners of the market has proven historically to be a risky approach that can lead to significant losses in the long term.  

We also remain overweight Small and Mid-Cap stocks, which may seem at odds with our recession calls given their economic sensitivity. However, these stocks trade at relative discounts to their Large-Cap peers last seen in the late 1990s. Back then, the discounted valuations led to years of outperformance in the early 2000s. Earnings expectations for Small and Mid-Caps remain low. We believe the valuation discount inherent in these stocks shows that investors have already accounted for at least some possibility of a recession. These asset classes also give us optionality. If our base case of a recession doesn’t materialize in the near term, we believe it would be because the Fed is able to cut rates aggressively enough to feed economic growth. This in turn would cause the economy and markets to broaden, potentially benefiting small and mid-cap companies.  

Overall, we remain diversified and balanced in our investment approach. We believe this provides investors with the best path to gain and keep financial security through uncertain and potentially turbulent times. 

U.S. Large Cap  

After a sharp but brief sell-off in early August, the S&P 500 moved further into all-time-high territory as the prospect of Fed rate cuts fueled a rise in investor sentiment. Optimism is growing that an aggressive rate cut cycle from the Federal Reserve is imminent and will keep the economy and specifically the labor market from contracting and, as a result, sending the S&P 500 higher.  

We take a more cautious view based on our review of the history of the Fed’s ability to successfully engineer economic soft landings as well as our concerns over the current health and trend of the labor market. Put simply, our concerns about the economy are not reflected in the earnings growth expectations for today’s market. Furthermore, against what we think are rosy earnings expectations, investors are paying top-decile prices as measured by a variety of valuation metrics. 

We maintain our modest underweight positioning with a bias toward equal weight and value factor exposure within U.S. Large Caps.  

 U.S. Mid-Cap  

In our search to find investment opportunities that reflect attractive optionality surrounding the two most likely macroeconomic outcomes (soft landing or mild recession), we continue to see U.S. Mid-Caps as well positioned over the intermediate term in either environment. The combination of realistic earnings expectations and an attractive relative valuation along with a catalyst for growth on the horizon in the form of lower real interest rates is reflected in our overweight position.

U.S. Small Cap  

As more areas of the market have taken part in the rise in equity prices, U.S. Small Caps have moved to the top of the equity table sharply, gaining 3.0 percent as of this writing. For context, the rise is more than 2 percent above the quarter-to-date returns of U.S. Large Caps. The rise in small caps is likely the result of growing expectations that the Fed will cut rates in September. Across our nine asset class portfolios, U.S. Small Caps are among the most sensitive to changes in real interest rates. As a result, some of the best performance historically on an absolute and relative basis for this asset class has come when the economy has been rising as real interest rates are drifting lower.  

This is where we continue to discuss the optionality of this asset class. If there is a soft landing, we expect that the Fed is likely to be lowering rates and that economic growth will broaden, which would benefit a larger swath of the market, including small companies. If, on the other hand, there is a mild recession, we believe that the Fed will more aggressively lower interest rates, and inflation will crumble, resulting in real rates moving lower. At that point, we expect investors will start to reposition in anticipation of future economic strength. The reality is that we believe real interest rates are set to move lower one way or the other; it’s just a matter of time. Given the current discounted valuations of Small Caps we are willing to be patient in order to harvest what we believe will be attractive relative returns in the coming years. While the path forward may continue to be volatile, we remain overweight to the asset class given the attractive optionality in U.S. Small Caps. 

International Developed Markets 

The post-COVID economy has led to different economic challenges and monetary policies across the globe. Perhaps the most obvious difference can be seen when looking at Europe and Japan—two markets that make up the greatest share of international developed markets.  

The economic and monetary policy themes in the Eurozone are similar to the United States. Slowing economic growth and disinflation has led to rate cutting to unwind what was an aggressive tightening cycle. Conversely, Japan has seen rising inflation and strong economic growth, which has led the Bank of Japan (BOJ) to raise interest rates.  

The eurozone composite Purchasing Managers Index (PMI) survey ticked up in August, but there are signs that underlying growth is weaker than the headline suggests. Employment broadly stalled, and the Paris Olympics resulted in a temporary rise in economic activity. The headline reading rose to 51.0 in August from 50.2 in July versus expectations of 50.1. The increase was driven by the services sector, with the index climbing to 52.9 in August. Manufacturing activity remained weak, with the reading holding steady at 45.8. The latest composite PMI figure is below the 51.6 average from April to June. This theme of weak manufacturing and strong services is much the same as is taking place in the U.S.  

The eurozone’s second-quarter gross domestic product (GDP) reading was up an anemic 0.6 percent year over year and is a full 3 percentage points below pre-COVID levels. This decreased demand has likely contributed to the disinflationary trend that is also emerging in the region. The final July Consumer Price Index (CPI) release came in at 2.8 percent year over year. Inflation has been coming down steadily since the peak levels in early 2023. Expectations are for CPI to fall toward the low 2 percent range. Services inflation, however, remains elevated at around 4 percent. Importantly, the second-quarter negotiated wage growth slowed sharply to 3.6 percent year over year, down from 4.7 percent in the first quarter. Much as in the U.S., policymakers in Europe fear inflation becoming embedded in the economy through a wage–price spiral. With slowing economic growth and disinflation, the European Central Bank will most likely proceed by reducing rates by 25 basis points again in September after a similar move in June and then maintain a gradual, quarterly path going forward on a path to 3 percent. 

Japan has been the opposite: After years of deflation, policymakers had been trying to stoke inflation by stimulating strong economic demand through low rates. The goal was to embed some level of inflation in the economy through rising wages. Indeed, since the late 1990s wage growth in Japan has been remarkably lackluster and has resulted in deflation. That has changed course over the past few years. Earlier this year, Japan’s biggest companies agreed during the annual spring negotiations to increase wages an average of 5.28 percent for 2024. This marked the largest pay increase in 33 years. The hope is that this will filter through the economy.  

As evidence of rising inflation and wages accumulated, the BOJ unexpectedly raised rates in July, resulting in the country’s key interest rate rising to 0.25 percent from 0.1 percent. The move was taken to curb the yen’s slide against the U.S. dollar. The decision on the overnight rate came just four months after the central bank raised its key rate above zero for the first time in 17 years. BOJ Governor Kauo Ueda has said that he will continue to raise rates if inflation stays on course to sustainably hit his 2 percent target. The prospect of higher rates is lifting the yen, destabilizing leveraged markets and posing headwinds to Japan’s exporters, multinationals and tourist industry. Indeed, this was the move that launched the August carry trade unwind, when borrowers of Japan’s yen were forced to liquidate the assets they bought with the borrowed Japanese yen to settle their debts. This is likely to continue being a source of volatility in the future as monetary policy divergences between Japan and the U.S. likely grow.  

The EAFE Index (the stock benchmark for the international developed markets) is currently trading at all-time highs and has produced 8 percent returns year to date. The EAFE Index valuations are significantly discounted compared to the S&P 500. The trailing price-to-earnings ratio for the benchmark is 16x versus the trailing price-to-earnings ratio for the S&P 500 at 24x. Cheap relative valuations are likely in our view to lead to positive future returns that we believe will be attractive for U.S.-based investors. This is especially true given our belief that the currencies of these countries are now cheap and have the potential to appreciate versus the U.S. dollar in the coming years. Our positioning remains neutral relative to our benchmark given our overall lower equity allocation, but we have a positive intermediate- to longer-term outlook for the asset class.  

Emerging Markets 

We often start our comments on the Emerging Market asset class with a discussion of China, as the country has been the largest component of the MSCI Emerging Markets Index for years. While China continues to hold the largest country allocation in the index, its current exposure, at slightly less than 25 percent of the index, is its lowest in years. This year, MSCI has consistently removed Chinese stocks from the index in favor of Indian equities as the index has rebalanced. India now makes up more than 20 percent of the MSCI Emerging Markets Index. The face of emerging markets evolves, and country exposure in the Emerging Market Index reflects this.  As liquidity (ease of capital) flows and market accessibility increases, countries that make up the index will change. This highlights the dynamic nature of developing economies around the world and why it is important to consider this asset class and its role in a portfolio through a forward-looking lens.  

India is one of the fastest-growing economies in the developing world and now the fifth largest economy in the world. While the recent Indian election caused volatility as Prime Minister Narenda Modi’s party lost ground, markets quickly recovered losses. Demographics are very favorable, with a young and tech-savvy labor force. Indian equity markets are among the best-performing developing markets year to date.  

Turning to China: As noted in the last Asset Allocation Focus, the Chinese government has instituted measures to boost the economy and property markets and support equity markets. These measures have helped performance at times this year; however, at the time of this writing it is unclear as to whether enough has been done. It’s unlikely China will meet its 5 percent growth target this year, and slowing consumer and business spending has rattled equity markets. We also note that geopolitical risks between the U.S. and China, increasing debt and poor demographics all remain as short- and longer-term challenges for the Chinese economy. 

Federal Reserve policy, which has turned dovish recently, has acted as a tailwind for emerging-market currencies during the last couple months, with the MSCI EM Currency Index setting a record high in late August. This currency strength has led to recent improvements in emerging-market earnings estimates, which, when coupled with equity market valuations sitting at multi-decade lows compared to the U.S., led to strong performance in recent weeks and highlights why it’s important to have some exposure to the developing world. However, questions remain as to whether the recent dollar weakness will persist. Regardless of the strength or weakness of currencies, the currency impact on returns and portfolio diversification in general is something that we feel is underappreciated as dollar strength has persisted. This may not always be the case, and we believe it is a reason to have exposure to international developed and emerging-markets asset classes. 

The diverse nature of the Emerging Markets asset class is important to note, and as a group, these countries are different than those of 20 years ago, with technology and financials the two largest sectors. GDP growth is expected to be higher, and relative valuations versus the developed world continue to sit at historically cheap levels. Given this, we believe it is important to have some long-term exposure to Emerging Markets in a well-diversified portfolio. However, given our lingering concerns of currency stability, economic risk and geopolitical risk tied to China, we continue to underweight the asset class modestly. 

What a difference a few short months make. Consider this paragraph from our late June Asset Allocation Focus.  

The lackluster returns compared to equity markets that have recently moved higher, coupled with increased volatility, have led to many investors becoming pessimistic and concerned about fixed income. While inflation risks remain, and we continue to express our concerns about the ever-expanding deficit and rising interest costs, we believe that bonds continue to play an incredibly important role in portfolio construction, especially given our recessionary outlook. While we may not know for a few years what is considered the new normal for interest rates, we believe investment-grade fixed income at current levels largely reflects existing risks and provides real opportunity for investors in the coming quarters. 

Since that document was released and in the immediate aftermath of our move extending the quality and duration of our overall bond portfolio through the addition of long-duration U.S. Treasurys, the investment-grade bond market has outperformed U.S. large cap stocks. Importantly, despite the inverted yield curve at the time, lower starting yield longer-maturity bonds have outperformed those of higher-yielding shorter-term bonds. This included a sharp rally during the carry-trade unwind and a quick spike in recession fears following the July jobs report that led to volatility and equity declines.  

Our concerns about the size of the U.S. debt and its increasing costs are growing. Coupled with that, neither party appears willing to address the fact that as a percentage of GDP, the U.S. debt now exceeds levels seen in the aftermath of World War II. Still, we believe that bonds offer attractive yields, especially against the backdrop of a potential recession. We continue to overweight fixed income in our portfolios, with a focus on quality and an overweight to duration relative to the benchmark. 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 roots as a real income-generation vehicle that can also provide risk mitigation against the potential for falling equity prices.  

Duration 

Jerome Powell strongly pivoted at his annual Jackson Hole speech on the economy. While many may view the comments as a sign that rates across the board will move lower, in reality, the only rate to really move lower has been the two-year Treasury by about 15 basis points as of this writing. The 10-year is mostly unchanged. Since the beginning of August, the entire rates complex has moved lower in a nearly parallel shift by about 40 to 50 basis points (bond yields and prices have an inverse relationship). The discussion of rate moves is only one dynamic in discussing fixed income, but duration is also important. While it was great to see these higher rates at the front end of the yield curve, the two-year would have to move nearly 4.3 times as many basis points as the 10-year (assuming they start at the same rate) to match the 10-year’s total return. If the two-year and 10-year are both at 4 percent, the two-year would have to fall to almost 2.92 percent for an investor to get about the same total return as a 25-basis-point move in the 10-year bond. We maintain modest excess duration relative to our benchmark. 

Government Securities/TIPS 

Given our economic outlook and current compressed credits spreads, we continue to favor higher-quality bonds, which include Treasurys, and other government-sponsored securities. Implied volatility in future interest rates is slowly increasing as the potential change in Fed policy becomes more imminent. Once implied volatility starts to pick up, it is likely credit spreads will widen, which would likely lead to high quality bonds out-performance. This is especially relevant given that credit spreads currently are at historically low levels relative to Treasurys. This event could happen quickly, especially if it occurs at the same time that recession fears rise. Given these risks, we continue to focus on high-quality bonds. 

Shorter-term Treasury Inflation-Protected Securities (TIPs) have pushed substantially lower as inflation has faltered and the labor market has shown signs of weakness. That likely is supportive of the Federal Reserve’s decision to pivot to a rate cutting cycle. Longer-dated TIPS have been much more stable, seemingly anchoring inflation expectations five to 30 years out at about 2 percent, but the path to that could be messy and may not occur in a straight line. We continue to favor nominal coupon yielding bonds over their inflation-protection counterparts, but the potential for an unexpected reemergence of inflation keeps us actively watching the level of break-evens for any potential for the group in the future.  

Credit 

Credit spreads are, by some measures, as tight as they’ve ever been. This is a reflection of the strength of the economy up until now. Implied volatility in the fixed income space has slowly started to tick up since the beginning of August, and that could mean some trouble for credit spreads if it continues. The Sherman Ratio (a measure of yield relative to a unit of duration) has hit a 40-year low when measured through the lens of credit spread duration, which reflects historically tight credit spreads. If a recession does in fact arrive, these spreads pose risk. We believe it is prudent to stick with high quality to very high quality and have your excess duration in Treasurys or Treasury-like securities.  

Municipal Bonds 

Consistent with previous rate cycles, appetite for municipal bonds evaporated when yields were low, and munis were cheapest relative to their taxable counterparts. This led to 8 to 10 percent outperformance in this asset class. Demand has spiked recently as rates have climbed, and munis are now expensive relative to their taxable counterparts.  

The muni curve has been inverted for the longest period in its history, but that is slowly working itself out as the Treasury curve loses some inversion as well (steepening). This is likely to persist into an easing cycle. While munis as a percentage of Treasurys are slightly expensive they have become quite a bit cheaper since our last Asset Allocation Focus. This is also fairly consistent with a fall in Treasury rates, while muni rates stay much more stable. We continue to like municipals for investors in higher tax brackets, especially given their high-quality profile.  

Real Assets 

Real assets are an integral part of diversified portfolios due to their low correlation to traditional equities and fixed income. Additionally, real assets can provide valuable hedges against unexpected inflation and a strong sensitivity to real interest rates, which we think are important considerations in constructing resilient portfolios over an intermediate- to long-term time frame; 2021–22 provided an example of the value of this diversification with the standout performance of commodities in response to rising inflationary pressures and the Russian invasion of Ukraine. The sharp decline in real interest rates from 2010–12 and eye-popping performance of real estate are another example of the value of this diversification philosophy. Put simply, sharp changes in inflation and real interest rates are very difficult to call correctly from a timing perspective. This challenge underlies the rationale for a structural allocation to real assets.  

While the stock market is expecting a soft landing, we continue to believe the end outcome of the most aggressive Fed tightening campaign in over 40 years will be a mild recession. With that as our base case forecast, we think there’s also a likelihood of continued downward pressure on inflation given weakening economic growth. As a result, we have an underweight position in commodities to fund an overweight position in fixed income. 

As we mentioned earlier, real assets can be very sensitive to changes in inflation-adjusted interest rates, with real estate being the clearest example. While REITs have seen outsized impacts from the pandemic, they have also been under pressure from a dramatic 300-basis-point surge in real rates during the last two years. Further pressuring fundamentals is a decreased willingness by banks to lend to the sector given rising vacancies and moderating rents across the asset class.  

We note that over the past quarter, REITs have actually shifted to the best-performing asset class as interest rates have moved lower. This is likely because changes in real rates affect real estate more than any asset class in our portfolios. While this has piqued our interest, we remain concerned that a recession is still likely in the months ahead; as such, given our desire to take less overall equity market risks, we continue to underweight REITs. We’re not there yet, but a recession might be the catalyst necessary for a turnaround in REITs.  

While the stock market is expecting a soft landing, we continue to believe the end outcome of the most aggressive Fed tightening campaign in over 40 years will be a mild recession.

Real assets are an integral part of diversified portfolios due to their low correlation to traditional equities and fixed income. Additionally, real assets can provide valuable hedges against unexpected inflation and a strong sensitivity to real interest rates, which we think are important considerations in constructing resilient portfolios over an intermediate- to long-term time frame; 2021–22 provided an example of the value of this diversification with the standout performance of commodities in response to rising inflationary pressures and the Russian invasion of Ukraine. The sharp decline in real interest rates from 2010–12 and eye-popping performance of real estate are another example of the value of this diversification philosophy. Put simply, sharp changes in inflation and real interest rates are very difficult to call correctly from a timing perspective. This challenge underlies the rationale for a structural allocation to real assets.  

While the stock market is expecting a soft landing, we continue to believe the end outcome of the most aggressive Fed tightening campaign in over 40 years will be a mild recession. With that as our base case forecast, we think there’s also a likelihood of continued downward pressure on inflation given weakening economic growth. As a result, we have an underweight position in commodities to fund an overweight position in fixed income. 

As we mentioned earlier, real assets can be very sensitive to changes in inflation-adjusted interest rates, with real estate being the clearest example. While REITs have seen outsized impacts from the pandemic, they have also been under pressure from a dramatic 300-basis-point surge in real rates during the last two years. Further pressuring fundamentals is a decreased willingness by banks to lend to the sector given rising vacancies and moderating rents across the asset class.  

We note that over the past quarter, REITs have actually shifted to the best-performing asset class as interest rates have moved lower. This is likely because changes in real rates affect real estate more than any asset class in our portfolios. While this has piqued our interest, we remain concerned that a recession is still likely in the months ahead; as such, given our desire to take less overall equity market risks, we continue to underweight REITs. We’re not there yet, but a recession might be the catalyst necessary for a turnaround in REITs.  

Real Estate 

We have maintained a tactical underweight positioning in REITs for an extended period, which has been based on our analysis of not only the fundamentals of the asset class but also the likely movements in interest rates and inflation. Real estate prices are influenced by many factors, not the least of which is the anticipated trajectory of long-term interest rates. As we know, real estate prices have a direct inverse relationship with the financing costs associated with buying an existing property or beginning a new project. Consequently, the aggressive cycle of rate hikes had adverse effects on longer-duration assets, including REITs. This scenario is in stark contrast with the relatively favorable period for real estate prices during the ultra-low interest rate environment shortly after the onset of the COVID pandemic. 

To curb inflation, the Federal Reserve enacted a record-setting rate hike cycle along with quantitative tightening, both of which have negatively impacted the real estate market as mortgage and other financing rates surged to unprecedented levels. The heightened costs have led to reduced demand for new projects and sent affordability ratios for existing ones to levels rarely seen in decades. Lending standards have simultaneously tightened at banks and financial institutions. These changes are a part of the broader economic tightening effects that occur beyond the Federal Reserve's direct control and make up the long and variable lags that we account for in our economic and market forecasts. The tight conditions in the real estate market are likely to influence supply, demand and pricing dynamics for several more quarters. 

However, the REITs asset class is broad, with considerable disparity in performance across various sectors within the marketplace. While single-family home prices have still been resilient despite rising interest rates, segments like commercial office space have experienced significant pressure, with distressed sale prices highlighting the ongoing struggle to stabilize supply and demand. These troubled sectors have posed challenges for certain financial institutions, compelling investors to decide whether the issues are isolated or indicative of systemic risk. Although we consider the probability of a systemic crisis in real estate to be low, the persistent volatility and stress within certain real estate lending and servicing institutions prompt caution in our evaluation of this market. 

We are closely watching valuation differentials between the earnings multiples of U.S. equities and U.S. REITs to identify potential buying opportunities should REITs become attractively priced, and we are encouraged by recent trends. These trends, however, remain nascent, and we have not been compelled to act quite yet. We will remain vigilant for any cause to prompt a shift in our position, but we are currently slightly underweight REITs. 

Commodities 

Commodity prices have generated modest gains this year amid several headwinds that support our decision to be meaningfully underweight the asset class. We believe that commodities are affected by three primary drivers: global growth, inflation expectations and the strength of the U.S. dollar.  

Energy commodities such as crude oil are essentially flat for the year given higher than expected supply and moderate OPEC+ production cuts. Sizable U.S. production has also put pressure on prices. Natural gas prices continued to decline over the summer due to an elevated inventory buildup and projections for a warm winter. For industrial metals, the continued sluggish growth in China’s economy is expected to remain a headwind for demand for commodities such as nickel and aluminum. Agricultural commodities prices also are still soft with the expectation of a U.S. bumper crop. On the positive side, gold hit another all-time high this summer, as investors are likely seeking an uncertainty hedge.  

Market expectations for inflation have fallen significantly based on weakening economic data, which is consistent with our forecast for a mild recession in the U.S. The likelihood that the Federal Reserve will begin cutting rates later this year may put pressure on the U.S. dollar, but over the longer term the dollar remains relatively strong. 

The outlook for commodities remains mixed. Going forward, primary catalysts for higher commodity prices are the reemergence of demand from China, a return of higher inflation expectations and a weakening U.S. dollar. In Energy, persistent underinvestment, additional OPEC+ production cuts, and potential disruptions related to the Russia/Ukraine conflict and the events impacting shipping in the Middle East could add more pressure in the oil and grain markets.  

We remain meaningfully underweight the Commodity asset class, preferring fixed income and economically sensitive asset classes like Small Cap and Mid-Cap U.S. stocks. For some time, we have expressed our view that global growth (excluding the U.S.) would remain sluggish and that inflation would moderate as interest rate hikes worked their way into the U.S. and global economy. We believe that recent Commodity asset class performance reflects these concerns. Commodity prices were up 2.2 percent through July, fell 7.9 percent in 2023 and gained 16 percent in 2022 and 27 percent in 2021. Overall, we continue to believe the commodity asset class retains positive return expectations and significant diversification benefits. 

For nearly the past decade, we have filled this document with content that summarizes our investment process. This includes a deep analysis of economic data, market valuations, monetary and fiscal policy goals and behavioral implications. It is a process we use to build a probability mosaic based on the data’s weight. No one knows for certain how events will play out, and no one can exactly time the market. But one can assess risk and opportunities within an intermediate- to long-term framework. And history, while an imperfect guide, is a good professor since behaviors are often repeated. 

And while we enjoy the more optimistic role we have often played to others’ pessimistic calls, we feel it is our duty to point out risks when we see them. 

For much of the past decade this process has led to us pushing away fears and leading to a desire to take prudent risks. That was then; this is now. That same framework that we have used, those same charts and data that we have looked at are now pointing to different probabilities with human behavior now looking overly exuberant and valuations elevated. We have enough humility to realize we could be wrong, and others could be right. But that is not what our process suggests. 

At a minimum, the one thing we are comfortable saying with near certainty is that if a recession does indeed occur, no one can look back and say we didn’t see the warning signs. And while we enjoy the more optimistic role we have often played to others’ pessimistic calls, we feel it is our duty to point out risks when we see them. We will continue to follow our process in an attempt to remove emotion and the flaws of human behavior from the task.  

The reality is that, based upon most data, we are closer to a recession now than at any point in the post-Great Financial Crisis period, especially based on the labor market. Valuations are elevated. If ever there was a time to pay heed to risks, this might be it. We note that if valuations were different, even with our cautious economic outlook, we might conclude differently. But that is not the case.  

We again note that this is not a call to dramatic action and that there are ample opportunities for investors. Unfortunately, often opportunity exists in places where no one is looking. This is what makes investing so difficult; the longer something goes on, the more convinced you are that it is likely to continue, even though history would suggest it doesn’t. 

The bottom line is the Fed has driven us closer to the edge of recession than at any other time in recent history. Your only task is to make sure that you are aware these risks exist and that, if they come to fruition, you can stick with the financial plan and asset allocation that has been created. No one wins by panicking and selling when others are doing the same. Remember that the plan and your asset allocation include the reality that stocks go up but also fall and that recessions are an unfortunate feature of the business cycle.  

At a minimum, hopefully we can agree this is a time of heightened uncertainty—which will likely only be exacerbated by an emotion-filled election season. The solution is diversification, which is admitting that no one knows exactly what is going to happen. Concentrating in any one asset class or a few stocks suggests you know for certain what will perform well and the exact date when that will change. And we remind you that something not working is a feature—not a flaw—of diversification. This means that diversification is unlikely to produce the highest returns in the near term. Diversification is a cost—that is, until it isn’t. That’s when it pays you back. 

For much of the past we have focused on staying true to a financial plan no matter what the times hold. But our focus has been on when times are bad. Indeed, during COVID, we often noted that financial security is not kept or gained by how you behave when times are good. It’s easy to invest when times are good. It’s harder to be an investor when times are bad, to resist the temptation to bail. Recently we have been reminded that this is a two-sided coin. Can you stick with the plan when times are good, or are you tempted to take a little more risk and concentrate in the cycle’s often spectacular winners that, as we have shown, have historically become the next cycle’s laggards?  

Long-term focused investing is grounded in diversification and guided through adherence to a financial plan in partnership with an expert advisor. This remains the best approach on the flight path to gain and keep financial security.   

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 nonproprietary 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, and 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.