The Markets and the Economy Are Connected

Has the market become disconnected from the economy? We don’t think so. In our Northwestern Mutual Asset Allocation Focus, we discuss how the market can be up when the economy is still recovering.

Man at a table reading Northwestern Mutual Asset Allocation Focus

In this publication for advisors and their clients, Northwestern Mutual Wealth Management Company’s (NMWMC) investment professionals provide views and commentary on the current marketplace. This information is designed to complement the long-term strategic view on asset allocation that is reflected in the model allocations shown in most clients’ investment policy statements.

We believe that these standard model asset allocations continue to be prudent and suitable for most long-term investors. The strategic viewpoint represented in the chart below illustrates our views based on the relative attractiveness of different asset classes over the next 12 to 18 months. Keep in mind that this viewpoint can and will change as valuations and economic variables evolve. Because our advisory programs provide different levels of investment flexibility, our strategic viewpoint may not be implemented in our home office-managed programs or may be implemented only in certain programs.

Section 01 Introduction: The markets and the economy are connected

Almost anywhere you turn these days, you’ll find someone arguing that equity markets don’t reflect the U.S. economy. Allow us, once again, to disagree: We believe equity markets and the economy are absolutely connected but with nuances in time horizon. However, one may need to dig a bit deeper to find the connection. Certainly, markets pay heed to current economic events, but more importantly, they’re a discounting mechanism of how the current environment relates to the future one. Put differently, markets move based on expectations of how the future will look different from today.

There may be no better example than last year, when U.S. equity markets began their rapid descent in February before economic data plunged. The markets moved based on the expectation that the future would look different because of the severe economic disruption from COVID-19 closures. But then, well before economic data began recovering, markets began a rapid ascent. Overall in 2020, the U.S economy contracted by 2.3 percent on a nominal basis, which may seem at odds with the U.S. stock market advance in 2020. However, the equity markets’ push higher has been driven on the back of an economy that is rapidly digging out of the deep economic hole that occurred in the first and second quarters of 2020. And we're continuing to fill the economic hole in 2021, as economic growth is set to gain vigor amid a broader reopening and return to normal as more people get one of at least three (and likely more) highly effective vaccines.

We continue to forecast strong and broad economic growth in 2021 across nearly all segments of the U.S. economy. Given this backdrop, we believe that the economic recovery will lead to higher stock prices in the intermediate term but with much broader equity market participation and leadership than has occurred over the prior few years. In the December Asset Allocation Focus we stated our belief that this broadening of the equity market was already underway, and as we expected, it has continued in early 2021. We believe these trends will continue through the remainder of the year.

A continued broadening of a previously narrow economy and markets

For much of mid-2018 through mid-2020, a narrow portion of the U.S. and global economy was advancing, which created a narrow market environment. This started in mid-2018, with a trade war that was designed to harm manufacturing, exports and the more cyclical segments of the U.S. and global economy. Given this economic reality, it should not be surprising that the trade war also harmed cyclical sectors and asset classes around the globe. 

However, secular growth stories like U.S. technology and FAANG stocks were largely not impacted and powered ahead as their earnings growth stood above the crowd. We got a brief reprieve in late 2019 and early 2020 as the trade war came off the boil. But then COVID-19 and its subsequent economic closures had nearly the same impact.

This economic reality carried over to the equity markets. From the end of September 2018 until the end of September 2020, the S&P 500, with its top-heavy concentration in technology and communications services sectors, advanced nearly 10 percent per year. However, if you remove the impact of those heavy market-cap-weighted behemoths and equally weight the S&P 500, it advanced only 2.9 percent each year. When you break the S&P into growth (technology, etc.) stocks and value (cyclical) stocks, a more alarming divergence emerges: Growth stocks advanced nearly 16 percent per year, while value nudged higher by a whopping 1 percent per year. Moving down the capitalization spectrum, more cyclical U.S. Mid-Caps actually fell 2 percent per annum, while U.S. Small Caps dropped 9 percent per year. Lastly, it should not come as a surprise that more cyclical world economies languished, as did their stock markets, with Developed International stocks “rising” 0.16 percent per annum, while Emerging Markets rose 4 percent.

Contrast this to the past few months as economic activity has broadened and looks set to push forward on the back of massive fiscal and monetary stimulus, inventory rebuilding and pent-up demand as economies reopen. Not surprisingly, the relative winners have shifted as the economic environment is broadening. The S&P 500 is up 16 percent cumulatively from the end of September 2020 through the beginning of March 2021. But when you take a deeper look, the leaders have changed with every other aforementioned market beating the broad index. The equal-weighted S&P 500 is up 27 percent. Meanwhile, S&P 500 Value stocks have bested their growth counterparts 22 percent to 13 percent. U.S. Mid-Caps have catapulted ahead by 38 percent, and U.S. Small Caps are up a staggering 55 percent. Globally, International Developed markets are up 19 percent, and Emerging Markets have risen 27 percent. Simply put, as the economic backdrop has changed, so has the market backdrop. Markets are still strong but with different leadership. We expect this to continue for the remainder of 2021.

2020 stimulus leaks into 2021 

One of the biggest economic divergences in 2020 was that U.S. economic growth fell 2.3 percent from 2019 on a nominal basis. That happened while total U.S. personal income actually rose 6.3 percent in 2020 — count that as another way 2020 was like no other, given that these two measures of U.S. economic well-being have been historically tied at the hip. Think of it this way: Typically, someone’s economic output is someone’s income — but not in 2020 because of the huge stimulus packages that were provided by fiscal policymakers: $2.2 trillion in March 2020 followed by $900 billion in December, not to mention the likelihood of an additional $1.9 trillion in March 2021.

While we believe persistent inflation is not a 2021 risk, we believe investors need to hedge against it.

And it’s not just fiscal policymakers but also monetary policymakers that are a tailwind to the U.S. and global economy. The economy and markets are currently being enhanced by a Federal Reserve (Fed) that is determined to keep rates low and continues to buy $120 billion a month in Treasury securities and mortgages to keep liquidity ample and to nudge investors toward taking risk.  

The economy felt the impact of these actions in 2020, but 2021 is likely to be amplified because consumers have saved much of the stimulus money they received. As of the end of February, the U.S. consumer in aggregate is sitting on north of $1.7 trillion in excess savings — and that’s before any additional stimulus in March 2021. As the economy reopens and employment grows, this wall of money could have huge impacts on not just growth but also potentially on inflation.

Hedging 2021’s evolving economic and market risk  

We believe that for the first time in years, the prime risk is that the economy overheats, not underheats like much of the past years. We have long stated our belief that inflation is not a thing of the past. Tying into our earlier story of the impacts of the trade war, we point out that inflation in 2018, as measured by the Fed’s preferred measure Personal Consumption Expenditures (PCE), was running above 2 percent for nearly all of 2018.

However, while we note that inflation is a growing risk, our base-case forecast is that it is not a risk in 2021. Nearly 10 million fewer Americans are employed today than were at the start of the COVID-19-induced recession. How quickly we return to pre-COVID employment levels will likely determine the path of inflation, and we don’t believe that will be until 2022 or 2023.

Even then, the Fed is determined to sit on its hands and not tighten policy until inflation has been above 2 percent persistently. Given the Fed’s desire to focus heavily on the employment mandate, we believe it will wait until there is significant improvement in the labor market to tighten — even if inflation begins pushing higher in the near-term. While we believe persistent inflation is not a 2021 risk, we believe investors need to hedge against it. We think of it this way: The policymakers have essentially covered the equity downside risk with the threat of more policy if need be. The only thing that would disrupt their best-laid plans would be inflation. We continue to recommend that investors own commodities and Treasury Inflation Protection Securities (TIPs) as hedges against too much of a good thing.

Section 02 Current positioning

Overall, we remain overweight to Equities relative to Fixed Income. As a review, in April 2020, during the heat of the market decline, we upped our overall equity allocation overweight by increasing exposure to more economically sensitive, relatively cheap U.S. Mid-Cap stocks. In late August 2020, we recommended investors shift some of their U.S. Large-Cap allocation (which we noted was increasingly dependent on the performance of a few “large growth” stocks) toward more economically sensitive cyclical value stocks. Since these dates, both shifts have paid performance dividends as the economy has broadened, and we expect this to continue into 2021. We also note our continued overweight to U.S. Small Cap stocks.

In January 2021, we further reduced our U.S Large Cap recommendation to neutral and reallocated the proceeds to Real Estate Investment Trusts (REITs), an asset class that we previously held as max underweight and are now slightly underweight. As the economy reopens and inches back to normal, we suspect this asset class will continue healing.

Within International markets we retain a neutral position in Developed Markets and are overweight in Emerging Markets, which stand to benefit from rising global growth and persistent low U.S. interest rates as well as accommodative monetary policy.

  • U.S. Large Cap

    So far in 2021, we’ve seen a further acceleration in the leadership style shift of equity markets that began at the end of last August. As global economies have adapted to the pandemic alongside a rapid deployment of multiple vaccines, the expectation of a broadening economic recovery has supported broader positive market participation across equity sectors and asset classes. You can clearly see this shift when you look at the performance of one of the most popular technology stocks, Apple, compared to a classic value stock, Exxon Mobil. Since the end of August to the last week of February, Apple is down about 4 percent, while Exxon Mobil is up a staggering 47 percent.

    The investment strategy committee downgraded the weighting of U.S. Large Caps to neutral from overweight in January after shifting a portion of the U.S. Large Cap allocation into U.S. Value back in August. You can see the detailed rationale for these decisions by visiting August Asset Allocation Focus. But broadly speaking, we think that the main drivers of our view (macroeconomic trends, fiscal and monetary policy, and relative valuation) continue to support a neutral position for U.S. Large Caps, as other equity asset classes offer more leverage to the economic recovery with more appealing relative valuations. 

  • U.S. Mid Cap

    We maintain a positive view and overweight allocation to U.S. Mid-Caps, a view that we established almost a year ago on April 13. The relative outperformance of U.S. Mid-Caps on the back of a stronger macroeconomic recovery and vaccination timeline has surpassed even our optimistic expectations since this date (+70 percent vs. +27 percent blended benchmark). Despite their strong outperformance, U.S. Mid-Caps still trade at deep discounts to U.S. Large Caps, and we view the broadening economic recovery and firming inflationary backdrop as continued macroeconomic tailwinds for U.S. Mid-Cap relative performance.

  • U.S. Small Cap

    If you were to dream up the Goldilocks scenario for U.S. Small Caps, it would look pretty similar to today’s current economic and market environment. Broadly speaking, that scenario would contain the following macroeconomic trends:

    1. Steepening yield curve
    2. Rising inflation expectations  
    3. Tightening credit spreads  
    4. Sharply rising manufacturing strength and leading indicators  
    5. Negative real interest rates 

    Throw in some of the cheapest relative valuations versus U.S. Large Caps in the last 30 years, and we’re not surprised that U.S. Small Caps are leading in our nine asset class portfolios. We remain overweight. 

  • International Developed

    International Developed markets are in a double-dip economic slowdown due to closures resulting from a second wave of COVID-19. But the deceleration should be short-lived as cases decline and vaccinations rise, monetary and fiscal stimulus takes hold, exports begin to grow and tourism returns.

    Looking through the current lockdown and relatively slow vaccine rollouts, the eurozone is positioned for strong growth in the back half of 2021 and into 2022. Massive fiscal and monetary support will provide powerful tailwinds. For example, the European Central Bank has aggressively grown its balance sheet by 50 percent over the past few years. Much as in the U.S., these actions should help Europe exit its COVID-19-induced “economic valley” in a powerful manner. Much of the export-heavy eurozone economy will benefit greatly as a rebound in global trade continues, which will likely be accentuated by a stabilizing euro.  Indeed, much of the recent economic weakness in the eurozone has been confined to the COVID-19-impacted services sector, while eurozone manufacturers have adapted and are growing. The eurozone’s  manufacturing PMI recovered 24.5 points from its April 2020 low and is already 8.7 points above its pre-COVID (and trade war impacted) level — now the highest it has been since February 2018.

    The eurozone’s service sector, including its big tourism industry, stands to benefit from a successful vaccine rollout. For example, 11.8 percent of Spain’s GDP comes from tourism. Stamping out the virus will be a boon to the Spanish economy.

    Japan’s GDP was down 4.8 percent for the full year 2020, but the country’s fourth-quarter GDP expanded by 3 percent quarter over quarter. Looking ahead, the economy is projected to contract slightly in the first quarter of 2021 as capital and consumer spending is reined in following January’s state of emergency declaration. However, the significant and sustained fiscal and monetary stimulus packages announced starting in April last year should lay the foundations for a recovery. We expect a recovery in Japan will revert to its previous uninspiring underlying rates of growth.

    Relatively attractive valuations give International Developed equities potential for competitive returns in the intermediate term. The MSCI EAFE index is weighted to Europe, Japan and Australia. While we believe these markets have potential for attractive future returns, we need to see greater relative growth. Therefore, we have focused our attention on other asset classes that we believe possess better near-term economic acceleration and keep a neutral rating on the International Developed asset class. Put differently, we have focused our current attention and international overweight toward Emerging Markets.

  • Emerging Markets

    Year-to-date, emerging-market equities have bounced around a bit but continue to outperform International Developed stocks and U.S. Large Caps. This outperformance has occurred for a variety of reasons, which we discuss below. We remain positive on this asset class as we move further into 2021.

    While Emerging Markets have less exposure to commodities than they used to a decade or two ago, they still have a higher correlation to commodities than other asset classes. As a result, emerging-market economies tend to benefit when a broad basket of commodities outperforms most equity asset classes, as has happened so far this year.

    Emerging Markets are cyclical and more sensitive to global growth and are set to take advantage of what we believe will be a broad global economic recovery this year. The differential in GDP growth rates between the developing and developed world is widening, a positive for these markets. For example, China is expected to grow GDP at 8.4 percent in 2021 vs. 5.0 percent in the U.S.

    As we’ve discussed in the past, currency strength is very important to Emerging Markets as stronger EM currencies vs. the dollar make it easier to service dollar-denominated debt. The dollar has remained weak as the Fed has reiterated its dovish stance on policy. A weak or even sideways moving dollar going forward is a positive.

    Valuations in Emerging Markets historically, on average, trade at a discount to the developed world to compensate for the additional risks of investing in developing countries. However, as compared to historical averages, valuations remain at greater than average discounts. Couple this fact with earnings growth that is expected to accelerate in 2021, and you have a potential tailwind.

    When we look at this overall net positive backdrop and take into account future risks to our forecasts, we continue to recommend an overweight toward the asset class.

Section 03 Fixed income

The recent rise in yields has caused many to worry about the relative valuation of equities. Nearly every analysis of the equity market begins with the comment that, yes, stocks appear expensive, but relative to paltry bond yields, they are cheap. We first point out that the recent rise in yields has occurred on the back of prospects for better economic and, importantly, earnings growth, with a minor simmering of inflation worries. We also remind that even after this push higher in interest rates, much of the U.S. yield curve still trades below current and expected future inflation. Given this reality and our forecast for strong economic growth in 2021, we continue to believe that equity markets overall hold better intermediate-term prospects than fixed income markets.

While rates have risen on the longer end, the Fed will remain anchored at 0 percent on the front end of the interest rate curve. Plus, the Fed may move some of its firepower to buying longer-dated maturities in an attempt to keep rates low if it believes intermediate- and longer-term rates have risen so much that they jeopardize its ability to reach its employment mandate.

However, we implore that you resist the temptation to pull your portfolio apart and judge the merits of each individual slice without the context of how all the pieces interplay together. Given our desire to continue tilting our portfolios toward equity-risk exposure, we maintain our conservative stance toward our fixed-income holdings and recommend high-quality, investment-grade bonds. With the U.S. yield curve now steepening and thus offering additional yield premium, coupled with the Fed’s likely desire to sit on the yield curve and not allow an aggressive rise in intermediate to longer yields, we continue to recommend investors embrace a duration near their benchmark targets.

Lastly, we have discussed 2021’s risk that inflation could surprise to the upside and throw a wrench in policymakers’ best-laid plans. While we don’t think this is likely, we continue to recommend that investors hedge against this risk and continue to recommend an allocation to TIPS. We note that much of the “easy returns” have been harvested here as inflation expectations have firmed from their COVID-19-influenced lows. But we still view this as a worthwhile diversification instrument to an overall portfolio.

  • Duration

    The end of February 2021 has witnessed fixed-income market volatility sparked by two main events. First and foremost, inflation expectations have risen, with the one-year inflation breakeven spiking to 2.66 percent, while 5- and 10-year breakeven rates rose to 2. 46 percent and 2.20 percent respectively.  This rapid rise in expected short-term inflation pushed nominal interest rates to rise off the low rates caused by the global pandemic. Second, the world appears to be heading toward a return to normalcy with  economic growth expectations rising. But with the Fed still anchoring short-term rates at 0, the yield curve  has steepened as longer bonds have priced to higher yields. This has hurt duration in the shorter term. We continue to recommend an overweight to “modest duration” relative to your prescribed benchmark, as the steepness that now exists speeds up the compounding of returns for intermediate- to longer-term investors.

  • Government Securities

    One of the biggest casualties of the rate move has been U.S. Treasurys. As of this writing, other credit-based and global fixed-income asset classes haven’t felt the full extent of the move in rates yet. With that said, we believe the belly of the U.S. Treasury cure is relatively cheap. For example, the 7-Year U.S. Treasury at its recent yield of 1.23 percent implies a 2.4 percent total return over a steady-state one-year time horizon. If you look for this level of steady-state total returns, you won’t find it in any other developed countries. Therefore, we maintain our preference to U.S. Government securities.

  • Credit

    Credit spreads are tight and have continued to tighten throughout the first couple months of 2021. As of this writing, they are just starting to widen, most likely in response to the move higher in longer-dated interest rates. The velocity of the move will matter should it continue, and, as such, we recommend sticking with  higher-quality, investment-grade credit instead of moving down the credit spectrum to chase additional yield.

  • TIPS

    TIPS have been the place to be for the past year. We are starting to see that fade a bit as the TIPS breakeven curve got very inverted toward the end of February 2021, with one-year breakevens printing at 3.93 percent when CPI was around 1.40 percent, therefore pricing in quite a bit of inflation expectation.  While we maintain a weighting to TIPS, the dramatic outperformance, absolutely and relatively, may be behind us. That said, TIPS can most certainly still be a hedge against future, unexpected inflation, which is certainly a possibility given the global landscape.

  • Municipal Bonds

    Municipals got quite rich during the first couple months of 2021. A combination of a change in presidency, which brought about the fears of higher individual tax, and a 26-year low in issuance of new  securities led to lower interest rates as buyers outnumbered sellers amid a dearth of new debt. As February is coming to a close, like most of fixed income, municipals are slowly starting to cheapen in absolute and relative terms.

Section 04 Real assets

Since the onset of COVID-19 in early 2020, only one “equity-like” asset class has provided investors with negative returns: Real Estate Investment Trusts (REITs). Broadly speaking, we believe REITs are the asset class that remains the “most COVID-19 impacted.” Put directly, it has the most structural issues to sort out in the intermediate to longer term from the pandemic, as companies and shops sort out their virtual vs. physical presence requirements. However, in January 2021, we determined that this reality was largely being reflected in REITs’ current prices, and we returned our max underweight to a slight underweight. As the world continues to open in 2021, we will be looking for opportunities to add to this asset class that has income-producing potential.

We continue to hold a neutral allocation in Commodities, primarily due to their diversification benefits and correlation to unexpected inflation. Building portfolios is about hedging risks, and we believe these risks may be evolving to more commodity-favorable inflationary risks. While recent history has not been kind to Commodities, perhaps the future will be as the economic back-drop shifts. We are not throwing in the towel on an asset class that may provide future diversification benefits as policymakers around the globe pull out all the stimulus levers to help their respective economies climb out of their COVID-19 economic valleys. And given our belief that inflation is the risk that could upend all the policymakers’ best-laid plans, we continue to recommend this asset class.

Within Commodities, we continue to recommend that investors “tilt” some of their broad exposure toward gold. If broad commodities are a call on future economic growth and inflation, gold can hedge against too little or even too much growth. Given this straddle and our desire to further diversify our portfolio, we continue to recommend targeted gold exposure within our commodity allocation. We’d also point out that if inflation does rise but the Fed decides to try and suppress its impact on interest rates, gold will likely provide portfolios with a pressure relief valve given its propensity to be positively impacted with negative real interest rates.

For those still not inclined to own commodities or gold solely due to their recent performance, we offer the following commentary. We believe monetary and fiscal policymakers will aggressively pull levers to stem any economic or equity market downturn in the future. Long-term readers know this has been a substantial basis for our equity overweight of the past few years. As we have said repeatedly, this doesn’t mean there won’t be shocks and downturns, but rather that any such events will likely be shorter because policymakers — especially the Fed — need markets to move higher to guide the economy and inflation higher.

Overall, this aggressive and quick use of monetary and fiscal policy as an economic and market backstop remains our central forecast. And why not? Currently there is no apparent “cost” on the other side to contemplate. Indeed, this remains our central forecast until there is a cost in the form of 1) an inflation surprise, 2) a rising interest rate market that doesn’t cooperate or 3) a dollar collapse. We believe this means commodities and gold play an important role in guarding against these unexpected events that could derail both the stock and bond markets. Given this backdrop, we continue to recommend that investors “spend” a small portion of their portfolio guarding against what could be a future market disruption.

  • Real Estate

    The COVID-19 pandemic threw the world into economic upheaval, affecting all areas of the market. REITs were hit harder than most, as the manner in which we conduct our lives was materially altered, perhaps permanently. But now, with promising vaccines on the near horizon, we see value in many real estate areas that were sorely beaten down in 2020.

    The hardest-hit sub-industry of real estate — commercial office — makes up only 12 percent of our real estate index. Furthermore, industrial real estate that supports ecommerce spending is approaching 17 percent of the index’s weighting. Residential, health care, cell tower, data centers and travel-exposed real estate also have a meaningful weight in the index.

    We do not know the lingering impacts of COVID-19 and its longer-term impact to the global economy, but as the economy continues to recover and expand in the coming quarters, we believe REITs may benefit from continued central bank accommodation as well as consumers and employees increasingly venturing back out into the world. REITs typically pay higher dividends than other equity securities and should remain attractive relative to other income-producing assets. Additionally, valuation levels between the earnings multiples of U.S. equities and U.S. REITs reached compelling levels early in 2021. Even in the face of a rising interest rate environment, we believe REITs can offer an attractive return while offering diversification benefits in our portfolios. In January we moved from a max underweight to a slightly underweight position in this asset class and will remain vigilant for opportunities to increase our exposure.

  • Commodities

    Commodity prices have rebounded sharply following their COVID-19-related plunge in early 2020. The gains are attributable to a rapid rebound in global economic growth expectations, which began over the summer and continue into 2021. The response to the pandemic had meaningfully impaired the outlook on both the supply and demand side of commodity markets. Commodity supply was affected by shutdowns, supply chain disruption and increased Saudi and Russian oil production. Commodity demand was impaired given sharply reduced economic activity. As we approach a full year since the onset of the pandemic, commodity markets have stabilized, prices have recovered, and the outlook has vastly improved.

    The three primary components of the Bloomberg Commodity Index are energy, metals (both industrial and precious) and agriculture. The benchmark is composed of around a third of each sector, which means that the benchmark is broadly diversified across the commodity spectrum and ensures that no single commodity has an outsized impact on overall risk and return. The individual components of the Commodity benchmark all have unique characteristics and prices that are determined by different supply and demand drivers within individual markets. However, inflation, economic growth and the direction of the U.S. dollar are the largest drivers for overall commodity prices.

    The pandemic effects were dramatic, particularly for commodities related to energy. Oil prices reached a historic low in April 2020, with the benchmark West Texas Intermediate crude price briefly turning negative. Efforts by the Organization of the Petroleum Exporting Countries (OPEC) and other oil producers to cut production in response to the plunge in demand eased some of the pressure. The oil markets have improved year-to-date, with crude oil inventories in the U.S. finally returning to their five-year average. The price of oil has rebounded to the mid $60s, representing the highest level that oil prices have seen in over a year.

    Gold prices declined modestly over the last six months after surging during the pandemic. Currently, the gold spot price is trading around the $1,695/oz level. Gold serves as a safe haven for investors looking to avoid volatility in risk assets, particularly in an environment with low real (inflation-adjusted) interest rates. Gold is also less sensitive to a change in economic outlook, so a pause is not an unpleasant surprise.  Commodities sensitive to economic growth like nickel, aluminum and copper have rebounded significantly. An easing in global trade tensions has also been beneficial for agricultural goods.

    As we look forward, our forecast is for both global growth and inflation to strengthen in the intermediate term. This would be a plus for commodity prices.

    It’s also important to remember that Commodities are very sensitive to unexpected inflation. Over the past 30 years, Commodities have exhibited the highest positive correlation to inflation of all the major asset classes. In today’s environment, where the market expects continued low inflation, we think it is important to have some commodity exposure within a portfolio. In an era of seemingly unlimited central bank accommodation, Commodities are the one asset class that can respond well if inflation unexpectedly returns in 2021.

Section 05 The bottom line: Focus on the big picture

Amid the chatter about a disconnect between the market and the economy is a growing chorus worried about a market bubble. Indeed, we have waded into the chatter with our claims that parts of the market today remind us a bit of the late 1990s. Think about it this way: Once again, we have day traders engaging in their “craft” through self-directed trading platforms guided by internet message boards. Most of the narrative in the stocks they trade is how these companies are changing the world through emerging tech platforms. People who buy these stocks appear willing to pay any multiple for the potential earnings largesse that may come to them many, many  years from now. Indeed, most of this investing is “earnings-agnostic” and rather focused on thematic investing. Lastly, we’d be remiss to not throw in that the U.S Large Cap stock market (the S&P 500) is similarly concentrated in technology stocks much like 1999, with a few high flyers making up a large amount of the overall market.

The pertinent questions investors must ask themselves are these: 1) Is this whole market overvalued? And 2) If the answer to No. 1 is “no,” do these pockets of overvaluation and the pullback that likely ensues take the overall market down? Our answer is that this is not a whole-market story but rather a slice or pocket of the market. While it certainly could cause a near-term broader correction, it would likely be short-lived given the economic growth we see in 2021 and the commitment from the Fed to not end the party too early.

Our fear is that investors have been lulled into complacency and have positioned their portfolios in the asset classes and segments that have performed well in the prior economic cycle. 

The 1999 bubble that burst did cause an overall market correction. However, it was short-lived in many of the asset classes outside of the bubble. Those asset classes went on to post strong returns in the coming year. More importantly, the cause of that market correction was likely economic rather than market based. Think about it this way: In the late 1990s, the U.S. economy hadn’t experienced a recession since 1990-91, and the Fed was tightening monetary policy to slow the U.S. economy. Contrast that to today, when the U.S. economy is just exiting a recession and the Fed is still providing monetary accommodation to stoke the economy higher. We’d also remind that not all stock valuation is created equal and must be placed in context on the potential returns from other assets. Then the 2- and 10-year Treasurys each yielded roughly 6 percent respectively, while today they are at 0.14 percent and 155 percent.

Our fear is that investors have been lulled into complacency and have positioned their portfolios in the asset classes and segments that have performed well in the prior economic cycle. That cycle was heavily influenced by a few events that are unlikely to happen again in the future. We’ve said it before, but we will say it again: Recessions have consequences, and the policy and societal changes that occur as a result not only change the next expansion’s economic reality, but also shift market leadership. Back to our original thesis: The economy and market are linked.

Northwestern Mutual Wealth Management Company Investment Strategy Committee:

Brent Schutte, CFA®, Chief Investment Strategist
Michael Helmuth, Chief Portfolio Manager, Fixed Income
Garrett Aird, CFA®, Senior Director, Investment Research
Matthew Wilbur, Senior Director, Advisory Investments
Matthew Stucky, CFA®, Portfolio Manager, Private Client Services
Doug Peck, CFA®, Portfolio Manager, Private Client Services
David Humphreys, CFA®, Senior Investment Consultant
Nicolas Brown, CFA®, Senior Research Consultant

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, Milwaukee, WI (NM) 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.

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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. 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.

All index references and performance calculations are based on information provided through Bloomberg. Bloomberg is a provider of real-time and archived financial and market data, pricing, trading, analytics and news. 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.

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. Specific sector investing such as real estate can be subject to different and greater risks than more diversified investments. Declines in the value of real estate, economic conditions, property taxes, tax laws and interest rates all present potential risks to real estate investments.

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.

Standard & Poor’s 500 Index (S&P 500) is a capitalization-weighted index of 500 stocks. The 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.Treasury Inflation-Protected Securities (TIPS) are securities indexed to inflation in order to protect investors from the negative effects of inflation. 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.