Section 01 Wages remain a sticking point for the Fed
About this time last year, we borrowed from a song by the Dave Matthews Band and laid out our investing road map in what we termed “The Space Between.” Contrary to the popular narrative at the time, we believed that inflation fears were peaking and would push lower as the economy moved further past COVID-era distortions and returned to equilibrium. We forecasted that the improving inflationary backdrop would provide a “space between fears” for equity markets to move higher as pessimistic investors were forced to shift their outlooks. This was during a period in which the American Association of Individual Investors (AAII) Sentiment Survey registered a streak of some of the most bearish readings since the late ’80s and early ’90s.
Our forecast has largely played out over the past 11 months and is now reflected in the markets. However, we have once again found our evolving outlook in stark contrast to the current prevailing narrative that a recession—the other side of fears in our “space between” forecast—is now increasingly unlikely. The consensus thinking is that Fed tightening has pushed inflation lower without yet causing the overall U.S. economy to fall into recession. With the Fed nearing if not at the end of the tightening cycle, many are suggesting that, with almost surgical precision, rate hikes have exerted their maximum influence on inflation without significantly affecting the broader U.S. economy, and, as such, a recession is unlikely. This view appears to have emboldened previously pessimistic investors to now chase equity markets higher. Indeed, after 74 straight weeks of the aforementioned AAII Survey’s bullish responses checking in at less than the long-term average of 37.6 percent, optimism spiked during the months of June, July and early August, and equity markets have moved higher.
A soft landing could occur if the Fed is able to coax wage growth lower without causing a spike in unemployment.
We believe this optimism is likely fleeting. As we forecast, our bout of inflation that was largely tied to COVID distortions is ending. As it does, the economy is returning to a more traditional business cycle. Unfortunately, it appears that we’re relinking to an economy in which conditions are consistent with the end of an economic cycle. We acknowledge that every economic/business cycle is unique; however, they are not different in how they end. Simply put, since 1982 business cycles have ended when three things occur: 1) The U.S. economy runs out of labor slack as reflected by low unemployment rates—which causes 2) wage growth and inflation to rise—which leads to 3) the Fed raising rates over the fear that rising wages will cause rising inflationary pressures to become embedded in the U.S. economy as it was during the period of 1966–1982. This means the Fed may still have another battle to wage in its inflation fight.
The good news is that current inflation has faltered, and the economy has remained resilient. The bad news is we continue to believe a recession is the most likely path forward in the coming months as the Fed’s inflation-fighting focus shifts to what we have termed inflation’s final frontier: wage growth. The Fed fears rising wages could reignite inflation and reverse the current disinflationary process. Having seen the challenge of eradicating elevated price pressures during the 1970s and early ’80s, it is determined to not allow a so-called wage–price spiral to take hold. A soft landing could occur if the Fed is able to coax wage growth lower without causing a spike in unemployment. However, a review of the prior economic cycles reveals the only way this has sustainably occurred in the past is through a recession and higher unemployment.
The good news: Current CPI has been about COVID
The good news is that inflationary pressures have receded from the peak reached in the second and third quarters of 2022. This has led many to believe that rate hikes have impacted the U.S. economy more quickly than the historical 12- to 18-month lag that policymakers typically expect. While there is likely some truth to this conclusion, we don’t believe it is completely accurate. Consider that much as we forecasted, inflation has risen and receded consistent with the path on which the economy reopened and recovered from COVID-19. A spike in goods prices was followed by a surge in services prices as demand shifted. You also have to throw in the commodity price shock coincident with the onset of the Russa-Ukraine war. Finally, the nagging/lagging impact from a surge in housing prices and rents beginning in late 2020 and lasting through early 2022 are still affecting inflation readings because shelter prices feed into the Consumer Price Index (CPI) calculation with a 12- to16-month lag.
After the large fiscal and monetary stimulus of early 2020 drove a record increase of 26.9 percent in the U.S. money supply, homebound consumers shifted their spending toward goods at a historic pace. Against a backdrop of snarled supply chains and ports, goods inflation spiked and was the overwhelming cause of early inflationary pressures. By February 2022, the CPI reading for goods was up 12.3 percent year over year. Then as COVID receded and consumers returned to public places, spending shifted to services. Not coincidentally, services inflation became the driving force of elevated CPI after February 2022, and by February 2023, CPI services peaked at 7.3 percent year over year. As could be expected given this dramatic shift in spending from goods to services, goods inflation has continued to pull back and is currently at a meager 0.8 percent year over year.
Consider that while services inflation is still up 6.1 percent year over year, the rate is just 3.3 percent when the lagging shelter measure is excluded.
During the shift from goods to services spending, commodity prices spiked at the outbreak of the Russia-Ukraine war, and housing prices surged thanks to ultra-low interest rates and a significant uptick in demand against constrained supply. While commodity prices have since faltered and have contributed to the disinflationary process, the housing and rent spike has had a large and lingering impact on CPI even as shelter price increases have subsided during the past year. The staying power is due to the way CPI is calculated, where current shelter prices enter with a 12- to 16-month lag. The quirk in the calculation has heavily distorted the inflation measure because it reflects shelter prices from 12 to 16 months ago, when price pressures were still high. Today prices are down on a year-over-year basis, and given current rates on mortgage loans, which have created affordability issues for home buyers, we believe it is unlikely that home prices are going to reignite in the near-term. For housing to become more affordable, some combination of three factors would need to come into play: 1) Incomes rise sharply, 2) interest rates fall, or 3) prices come down. Of the three, we believe the latter is most likely.
How much has this odd shelter calculation distorted CPI? Consider that while services inflation is still up 6.1 percent year over year, the rate is just 3.3 percent when the lagging shelter measure is excluded. In fact, when shelter is excluded from the services side of the equation, prices are up just 1.5 percent on an annualized pace over the past seven months. As such, services inflation looks set to continue slowing, which will join faltering goods prices in bringing down overall inflation.
The crowd of naysayers who believe that inflation remains elevated despite progress over the past year has declined but not disappeared. Those who remain skeptical that elevated price pressures were primarily an outgrowth of COVID offer two primary arguments for their case.
The first argument is that core inflation has been sticky and is still at 4.7 percent year over year. Once again, we note that the lagging shelter calculation plays a large role in this “stickiness.” Importantly, core inflation excluding shelter is up 2.5 percent year over year, with the last nine months annualized checking in at the Fed’s 2 percent target. And while all-in CPI at 3.2 percent is still above the Federal Reserve’s stated goal of 2 percent, consider that all-in CPI excluding shelter is up just 1.0 percent year over year.
The other argument is that the year-over-year numbers are misleading and that they are pushing lower only because they are receding from abnormally high readings during the summer of 2022. The argument goes that when those elevated readings roll off the year-over-year calculation, readings will once again show annual price increases are above historic norms. This is why we are intently focused on the monthly numbers and the central tendency of all of the different individual components. History shows that when outliers are removed from the equation, and instead, the median or trimmed mean is used as a measure, it provides a good indication of where inflation is headed. Over the past few months these measures have moved back into a normal range and indicate that inflation is indeed stabilizing at lower levels.
We go through this exercise once again because it is important to recognize that there is a disinflationary impulse in current CPI that we believe will cushion the overall blow and potential inflationary impact of rising wages. When you couple this with the fact that inflation and wage expectations are anchored and well below those that existed in the 1966–1982 time frame, we believe that the Fed should be able to cut rates to help cushion the overall economic blow to the economy should a recession arrive in the U.S. This is not a dire backdrop.
Wages: The fly in the soft-landing ointment
During the Fed’s August post-meeting press conference, Chairman Jerome Powell was asked about the impact of current wages on inflation. His response sums up our belief that wages are indeed the Fed’s last frontier in its inflation-fighting campaign. His response was simple but telling: “Current wages are not consistent with 2 percent inflation.” While Powell was not asked nor offered any insights as to what wage level the Fed believes is consistent with 2 percent, a review of the past economic cycles provides some powerful clues.
As a reminder, the Fed and other economic historians refer to the 1966–1982 U.S. inflationary bout as a wage–price spiral. Put simply, wages grew at an annual rate of 3.9 percent in early 1966. By 1981, increases had climbed to 9.4 percent. This escalation resulted in inflation steadily increasing even through three economic recessions.
Since that period, the Fed has typically tightened rates in a pattern that caused yearly wage increases to consistently top out in the low 4 percent area. Think of this as what the Fed believes is the speed limit of wages. This is likely because productivity (or worker output per hour) historically averages 2 percent, while a 2 percent inflation target would seemingly make anything above 4 percent result in an environment for permanent inflationary pressures to take root.
While wages have recently pulled back from their post-COVID high of 7 percent year over year in March 2022, they appear to be stuck in the upper 4 percent range. Recent high-profile wage negotiations with unions representing airline pilots, transportation employees and auto workers have garnered national news coverage and show that upward wage pressures remain. While private sector unionization membership has fallen to 6 percent today from around 17 percent in 1983, wage growth remains strong across the employment spectrum (union and non-union), and these increases could create a domino effect of inflationary impacts.
If the economy is to experience a soft landing, we believe it will be because labor force participation increases or there is a sustainable uptick in worker productivity.
Given this backdrop, we believe the Fed will continue to squeeze liquidity out of the economy through continued higher rates and quantitative tightening until it is satisfied that wage growth is consistently at about 3.5 percent or lower. We believe this is a level the Fed views as more compatible with 2 percent inflation. Unfortunately, a look at history shows that since 1982, the Fed has had a poor record of engineering a soft landing when wage growth is at the levels seen today.
If the economy is to experience a soft landing, we believe it will be because labor force participation increases or there is a sustainable uptick in worker productivity. In either of those scenarios, wage pressures would likely decrease, which would short-circuit the risk of a wage–price spiral. Certainly, either scenario is possible, but we still believe either is improbable. Regardless, the reality remains that the U.S. economy appears late in an economic cycle, and as such, a recession likely lies somewhere on the near-term horizon.
Rolling to overall recession as the services sector folds
The U.S. economy has proven to be resilient; however, we believe that as monetary policy remains tight, the impact of rate hikes will weigh heavily on growth and eventually lead to a recession. There are two primary reasons we believe a recession has not yet arrived: 1) consumers accumulated significant savings during COVID, and 2) consumers are likely less sensitive to interest rates than in the past.
We believe the following analogy helps frame the excess savings commentary. In response to the arrival of COVID, central banks opened the faucets and filled the U.S. economy (bathtub) full of liquidity. For the past 18 months they have shut the liquidity faucets off and opened the drain. While much liquidity has been removed from the economy, the reality is that there’s still water in the tub. Put differently, during COVID U.S. consumers stockpiled excess savings (more than $2 trillion by most estimates), and during the past 18 months they have been spending but have not yet exhausted their excess reserves.
While it is difficult to pinpoint how much of the excess savings remain and when it will be exhausted, we believe those funds are almost depleted. A recent analysis from the San Francisco Fed supports our view. The estimate suggests the additional cushion of funds will be exhausted this quarter. In addition, borrowers will need to restart payments on more than $1 trillion of student loans this month. The depletion of savings along with the resumption of student loan payment requirements is likely to put a crimp in spending habits for millions of consumers. According to a Transunion study, the impact of loan payments alone will amount to an average of about $500 per month out of most borrowers’ pockets. Even after acknowledging that there is a one-year cushion before those who continue to not pay are considered delinquent, we believe the reality is that the consumer is likely to continue reining in overall spending during the next few quarters as excess savings are exhausted.
The second reason in our view that a recession has not yet arrived is the U.S. economy appears to be less interest sensitive. Mortgage debt comprises 65 percent of total consumer debt. Consider that since the end of the Great Financial Crisis of 2007–09, the U.S. consumer has opted for fixed rate mortgages due to the availability of historically low rates. For context, adjustable-rate mortgages accounted for more than 48 percent of the dollar value of all outstanding mortgages in late 2005 and remained near or above 40 percent until the recession of 2007–09. Since that date, the percentage of mortgages that have adjustable rates has been in the low teens, falling into the single digits during COVID. While this has caused the existing home sales market to grind to a halt as few borrowers are willing to trade a sub-3 percent mortgage for a mortgage charging 7 percent, it has helped insulate a large amount of consumer debt from rate increases. According to the latest Federal Reserve data, the U.S. Household Financial Obligations ratio (which calculates mortgage and consumer debt, rent payments, auto lease payments, homeowners insurance and property tax payments as a percentage of total disposable personal income) remains at a relatively low 14.3 percent as of March 31, 2023. While this is well off the low of 12.5 percent in March 2021, it remains well below the 18 percent high of December 2007 and just off the 14.6 percent pre-COVID level. However, we expect upward movement in the coming quarters as overall consumer and mortgage debt continues to reprice with higher interest rates.
Despite this narrative, parts of the U.S. economy have experienced uneven contractions. The overall housing market has experienced a sharp pullback, while the manufacturing economy has experienced recessionary conditions for much of 2023, with the Institute for Supply Management Manufacturing PMI in contraction since November of 2022. Manufacturing industrial production has been similarly weak, with negative year-over-year readings five months in row. A review of history shows that there have been nine recessions since 1957 (not including the COVID recession). In each of these, manufacturing industrial production was negative for several months on a year-over-year basis. Only one other time was it negative for a sustained period without a recession ensuing: in 2015–16, when OPEC attempted to drive oil prices down to force U.S. shale producers out of the market. More recently, industrial production was negative during the trade war of 2019, which continued into the COVID-induced short recession. In each of these instances, much like today, the services sector was holding up the U.S. economy. A key difference between then and now is that interest rates are much higher, and the current Federal Reserve is working to slow the economy as opposed to supporting it (as it was during the previous recessionary instances).
We continue to believe a recession is likely as liquidity drains from the economy. The money supply remains in contraction on a year-over-year basis, and it's worth noting that during the other three instances in which the money supply had been shrinking, a recession followed. Additionally, bank lending standards are at recessionary levels, the consumer is exhausting excess savings, and leading economic indicators continue to point lower. Indeed, for 16 straight months leading economic indicators have pointed lower. The six-month annualized pace of “growth” remains at negative 7.8 percent with a diffusion index (a measure of categories experiencing expansion minus those that are contracting) of 30 percent. This measure first moved into recession warning territory in June 2022 and is still there. This measure has an impeccable record in foreshadowing recessions, and we believe that while it is taking longer than expected for an economic contraction to arrive, the predictive value of this measure remains intact.
Section 02 Current positioning
Despite the recent strength, we believe stocks will eventually stumble as earnings come under pressure when the economy begins to falter.
Against a backdrop that points to economic weakness ahead, equity markets continue to show resilience as the U.S. economy has managed to stay afloat. Despite the recent strength, we believe stocks will eventually stumble as earnings come under pressure when the economy begins to falter. However, given our belief that any such recession is likely to be mild and short, we do not expect the market pullback will be deep or long lasting, especially in the pockets that we believe remain secularly cheap. The other good news from a total portfolio perspective is that bond yields have once again moved higher, with the Bloomberg Aggregate Index of Investment Grade Bonds clocking in with a yield of 5 percent, the highest since late 2008. We believe bonds once again offer real value and, importantly, can once again act as a hedge against equity market downside.
We believe a potential recession should mark the end of the oddities caused by the arrival of and our response to COVID. We have spent the past three and a half years navigating these markets and the risks and opportunities they have produced. In the immediate aftermath of COVID, we over-weighted equities and under-weighted investment-grade fixed income with a tilt toward shorter-maturity bonds and Treasury Inflation-Protected Securities (TIPS). This move was based on our belief that policymakers’ dramatic fiscal and monetary response to the pandemic would not only cause rising economic growth but also spark a rise of inflation that would eventually force the Fed to raise interest rates. This positioning proved beneficial, as the stimulus lifted the U.S. economy, and the market adjusted and adapted to life during COVID.
As we moved into the middle of 2021, we noted our belief that both monetary and fiscal policy would become restrictive. Given this backdrop in June 2021, we began gradually removing our equity overweight and adding to investment-grade fixed income. In February 2022, we pulled back our TIPS exposure and returned it to shorter-term coupon-bearing bonds given our outlook that inflation was in the process of peaking and the Fed was on the cusp of raising interest rates in an effort to battle price pressures.
As the Fed began aggressively hiking rates in March 2022, investment-grade fixed income yields moved substantially higher, with the Bloomberg U.S. Aggregate Bond Index moving from a meager 1.75 percent to start 2022 to more than 5 percent by October 2022. Based on our view that bonds were not only offering an attractive yield but also could serve as a key diversifier in our portfolios during what we continue to believe will be an eventual recession, we increased our fixed income exposure and moved our duration (maturity) profile from short to intermediate to longer terms. The move allowed us to lock in higher long-term yields. We funded this change by selling a sliver of our gold allocation that we had initially purchased in April 2020 following the initial arrival of COVID. At the time of the initial allocation to gold, we believed low-yielding fixed income offered an incomplete hedge against inflation.
Since October 2022, equity markets have rebounded as the economy has remained seemingly resilient, while inflation has pulled back. However, given our view that a recession is still an eventual reality that could result in volatility in the equity markets, we decreased our equity allocation in February and again in early May and reallocated the proceeds in each instance into broad investment-grade fixed income. Importantly, we believe that any economic recession will put the final nail in the coffin of already decelerating inflation; therefore, given a current yield of 5 percent, we believe bonds offer not only real value but also a likely hedge against any future equity market declines.
Overall, we are now neutral equities, underweight commodities with a tilt toward the defensiveness of gold, and overweight investment-grade fixed income. However, we think it is important to note that within equities we are overweight U.S. Small Caps and U.S Mid-Caps. While this may seem odd given their economic sensitivity, these asset classes have already been marked down in anticipation of a mild recession, and they typically do well coming out of a downturn.
Section 03 Equities
U.S. Large Cap
As we have written consistently for the last few quarters, valuations for U.S. Large Cap stocks are consistent with an economic outcome in which the domestic and global economies continue to slow but avoid an outright recession. This forecast is reflected in earnings expectations for the S&P 500. Expectations are for earnings to move from year-over-year declines in the second quarter (with estimates coming in 7 percent lower than the previous quarter) to positive growth returning in the upcoming third quarter. By the second quarter of 2024, consensus estimates are pointing to more than 12 percent earnings growth, which implies a very strong acceleration from Q2 2023’s expected bottom. We view this expectation as being optimistic and clearly at odds with economic history. Simply put, it's unprecedented to see a reacceleration of earnings growth following a Fed tightening cycle until after policymakers have begun easing in earnest. The Fed is not expected to begin lowering rates until the second half of 2024. Put simply, it would be surprising to see a broad acceleration of earnings without a supportive economic backdrop. For this reason, we continue to see an unfavorable risk/reward dynamic over our forecast horizon given our base case of a recession and valuations for the asset class that don’t reflect expected economic headwinds. As such, we remain underweight.
Valuation is a not a timing tool, but it does correlate to performance over longer-term holding periods.
As some of the worst fears from the recent regional bank crisis have largely come and gone, U.S. Mid-Cap fundamentals remain largely untouched, as the fallout from the regional bank failures have remained primarily contained to the specific financial institutions involved. Mid-Caps’ steady fundamentals remain attractive in our view, as we see an appealing combination of favorable absolute and relative valuations alongside earnings estimates that reflect some softness corresponding to the slowing economic conditions that we expect over the next 12 months. We expect our overweight position to drive strong performance over the intermediate term but acknowledge that it’s unlikely to be in a straight line. Valuation is a not a timing tool, but it does correlate to performance over longer-term holding periods. We encourage investors to stay the course and remain overweight.
U.S. Small Cap
U.S. Small Caps have lagged their larger-cap counterparts in the U.S. on a year-to-date basis; however, the mid-single-digit returns are reasonable when viewed in the context of our belief that a recession will likely arrive in the coming quarters. U.S. Small Caps are economically sensitive equities, and when recession risk rises, there tends to be an outsized performance impact to this asset class; hence we see the year-to-date performance as encouraging and a sign of the healthy valuation cushion we believe is contained in our overweight position. That valuation cushion continues to grow as we see multiple expansions driving performance of U.S. Large Caps. The inflating valuations of Large Caps this year continues to widen the relative valuation gap between U.S. Small and U.S. Large Caps. We don’t believe the difference in valuations can continue in perpetuity and therefore will remain patient in our positioning. As with Mid-Caps, relative performance won’t occur in a straight line for Small Caps. Historically, this asset class has typically outperformed significantly near the trough of an economic cycle going forward. Intuitively that makes sense given the asset class’s economic sensitivity, but to put that into practice requires a level of market timing expertise that we believe very few investors possess. Instead, we prefer to use patience and time horizon to capitalize on the valuation dislocation opportunity we see. Given this, we remain overweight.
The eurozone’s economy has largely trended in line with the U.S. economy during the past several quarters, but recent flash PMIs point to an uptick in weakness in the eurozone. While HCOB Eurozone Manufacturing PMIs compiled by S&P Global have been in contraction like the U.S. and currently reside at 43.5 in August (a reading below 50 indicates contraction), the HCOB Eurozone Services PMIs surprisingly fell into contractionary territory at 7.9. While this potential pullback in economic growth is troubling, it is being accompanied by falling inflation. Eurozone inflation was 5.3 percent in August, and expectations are for inflation to come closer to 2 percent by the end of 2024. GDP in the eurozone grew 0.6 percent for the second quarter, and much like the U.S., the region has not yet fallen into a recession. The European Central Bank’s (ECB) current policy rates of 3.75 to 4.25 percent are clearly below nominal GDP growth, which is still buoyed by legacy liquidity and fiscal stimulus implemented to offset the COVID and energy crises. Given the recent weakness in the eurozone, the market is now pricing in a less than 25 percent chance of a rate hike at the next ECB meeting on September 14. Our tactical tilt to the eurozone continues to outperform our benchmark, the MSCI EAFE index.
In Japan, CPI came in at 3.3 percent year over year in July, off the recent peak of 4.3 percent in January, which was the highest level since 1981. Notably, services inflation came in at 2 percent. This is the first time in 30 years that services inflation in Japan has reached 2 percent. This has been a long-awaited development for the central bank, as it seeks evidence of sustainable inflation before laying out a path toward policy normalization. The Bank of Japan has been attempting to kindle inflation for a quarter of a century, adopting an especially aggressive stimulus campaign over the last decade, when it set a target of 2 percent inflation on a sustained basis. Weak price momentum in services has kept Japan behind its peers in overall inflation as households coping with stagnant wage growth cut back on discretionary outlays for years. The 2 percent services inflation showed that dynamic may finally be changing after companies agreed to historic pay increases in this year’s annual wage negotiations. A surge in inbound tourism and pent-up leisure demand are also helping to spur price growth in services. Japan’s second quarter GDP grew at an annualized pace of 6 percent as a surge in exports more than offset weaker than expected results for both business investment and private consumption. Japan is the world’s third largest economy, and it is continuing to recover from the pandemic. Japan’s economy grew to $3.85 trillion, surpassing its pre-pandemic peak and setting a record. This validated the views of the International Monetary Fund, which recently bumped up its 2023 growth outlook for Japan to 1.4 percent.
We believe the valuation discount international developed markets offer compared to U.S. stocks provides an opportunity for future outperformance. As such, we are currently maintaining our overall position at slightly overweight with a modest tilt to the eurozone.
Emerging-market equities continue to struggle as investors reprice weaker than expected economic data out of China. Economic momentum has slowed with China’s GDP growing at just 0.8 percent from May through June this year, down significantly from more robust growth in the first quarter. Thus far in the third quarter, the data hasn’t improved, as business confidence and consumer spending have slowed, according to recent reports. The economic slowdown has led to deflation, with prices falling year over year in response to slowing demand. The property market is also in flux as the economic slowdown amplifies the strain on highly leveraged developers. U.S./China geopolitical risks continue to swirl related to Taiwan and tariffs, and U.S. officials have questioned the transparency of economic data coming out of China in recent months. In addition, the dollar continues to strengthen against the yuan, with the yuan recently reaching a 16-year low against the dollar. Weakness in the yuan has sparked concerns that Bejing may further deflate its currency to help exporters and a slowing economy. However, the People’s Bank of China (PBOC) has tried to support the currency, and state-run banks have entered currency markets to bolster the yuan. As we’ve mentioned in previous pieces, our view is these currency issues may continue in the near term, as Fed tightening cycles tend to be a headwind for emerging-market stocks, bonds and currencies. Even a scenario in which rates remain higher for longer in the U.S. while the PBOC cuts rates is one that favors dollar strength and increases the potential for capital flows out of the developing world to opportunities with a better risk/reward trade-off.
China’s impact on emerging markets as a general asset class is significant, making up around one-third of emerging-market indices. However, there are other countries within the developing world that are experiencing rapid growth, have favorable demographics and, like China, will contribute much to world GDP growth in the coming years. Growth in these economies will be driven by an ascending middle class, the transition from manufacturing-based economies to services, and technology. Today’s emerging-market countries, as a group, are different than those of 20 years ago, with technology and financials the two largest sectors. Developing countries account for about 40 percent of the world’s gross domestic product and 25 percent of world equity markets, which we believe means it is important to have some long-term exposure in a well-diversified portfolio.
Given our continued concerns about currency stability as well as economic and geopolitical risk tied to China, we continue to underweight the asset class.
Section 04 Fixed Income
Over the past few months, against a backdrop of resilient economic growth, a downgrade of the U.S. credit rating and a continued increase in overall global bond yields, U.S. Treasurys have moved back toward their recent October 2022 highs, while a broad index of investment-grade bonds (the Bloomberg U.S. Aggregate Bond Index) are now yielding 5 percent. This resurgence in yields and corresponding decrease in bond prices has caused investors to become fearful of investing in fixed income. Many seem to now believe the answer is to hide in cash given that the Treasury yield curve is inverted. Cash yields are well over 5 percent, while the two-year Treasury yields 4.89 and the 10-year 4.25 percent. We believe this is the wrong answer and that investors should first focus on matching their assets with their liabilities and additionally consider what is known as reinvestment risk.
Bond yields today reside at the highest levels since the 2005–08 time period. In other words, it has been 15 years since yields have offered this level of potential income. That is an attractive backdrop, especially given our forecast that a likely recession will stomp out inflation. This backdrop allows us to provide an example of why hiding in cash may not be the best solution; instead, investors may want to consider extending their duration out to include intermediate- to longer-term bonds.
While we do not expect interest rates to slip back toward the incredibly low levels of the last economic cycle, we believe that fixed income has once again returned to its old roots as a real income-generation vehicle that can also provide risk mitigation against the potential for falling equity prices.
Consider that in June 2006, the two-year Treasury yielded shy of 5.3 percent, while the yield on the 10-year was around 5.2 percent. While this inversion is not nearly as dramatic as it is today, it does provide a useful example of reinvestment risk. Consider that the investor in a two-year Treasury had to reinvest proceeds from maturing bonds four times, while the investor holding 10-year Treasurys collected a 5.2 percent coupon rate throughout the period. At the time investors holding the two-year Treasury would have needed to reinvest for the first time, yields were in the mid-2 percent range. The subsequent three reinvestment periods saw yields at 0.65 percent or lower. The point of this example is to emphasize that the future is uncertain, and with interest rates currently attractive relative to future inflation, we believe that investors should consider tilting their portfolios toward bonds—across the yield curve and investment-grade credit spectrum, especially given our forecast of a coming recession.
We continue to position our overall fixed income duration near neutral relative to the Bloomberg Aggregate Index and favor higher-quality fixed income given the current economic backdrop. While we do not expect interest rates to slip back toward the incredibly low levels of the last economic cycle, we believe that fixed income has once again returned to its old roots as a real income-generation vehicle that can also provide risk mitigation against the potential for falling equity prices.
We continue to believe that investors would benefit from having exposure across the yield curve (duration) rather than concentrating exposure in the front end of the yield curve. By doing so, investors can benefit from the power of time. Duration risk, unlike credit risk, cannot cause a permanent loss of capital. As such, taking duration risk is warranted in most situations, as it can maximize an investor’s ability to reinvest through time.
Fixed income total returns are heavily influenced by the reinvestment of interest payments and maturities. Investors focused on extremely short maturities in a quest to capture higher current yields that we believe are unlikely to last are likely taking on reinvestment risk and potentially forgoing reinvestment return. We continue to focus on intermediate-term duration in line with the benchmark based on our belief that a recession will likely cause yields to moderate.
TIPS break-evens have normalized to more moderate levels, with real TIPS yield across the curve residing in the high 1 percent to low 2 percent range. Given our forecast of a recession that puts the nail in the coffin of inflation, we are currently focusing on nominal coupon bonds over inflation-protection securities.
Tightening cycles, recession fears and higher debt service rates don’t sound positive for credit spreads, yet they are within striking distance of their lows year to date. Credit spreads are not compensating investors for the economic and corporate earnings risks that exist. As such, we believe it’s better to stay high quality.
Municipals have been tightening throughout the year but recently reversed the trend. Generally, muni ratios will fall (munis outperform) when rates are rising for a variety of technical factors, and they rise (munis underperform) as rates fall. This is primarily what we have seen since 2020 and, based on decades of investor behavior, would be a likely outcome going forward. That being said, munis continue to represent a higher-quality fixed income asset class that represents value for those subject to higher tax brackets.
Section 05 Real Assets
We have long shared our belief that real assets deserve a place in portfolios due to their ability to help serve as a hedge against unexpected inflation. For much of the recent past, investors were busy removing these assets from their portfolios simply because they had not performed well. At the same time, we maintained our belief that inflation was not dead and that a return to an inflationary environment would likely harm both bonds and stocks. We believed that lower bond yields at the time had pushed investors toward equities over much of the recent past and that the unwinding of this trade and the monetary conditions that drove it would likely lead to an environment where both stocks and bonds declined together. Our answer was to include this “third asset class” because of our belief that it could serve as a hedge when inflation reared its ugly head. Investors have once again seen that the hedging benefits of commodities play out in real time as the asset class posted a positive return in 2022 and has now been positive in four of the five years since 1926 in which bonds and stocks posted negative returns in the same period.
As inflation arrived in late 2021 and early 2022, commodities once again proved their worth; however, given our forecast of faltering inflation, we have reduced our hedges against inflation and prepared our portfolios for a mild recession that puts the final nail in the inflationary coffin. This move led us to pull our overall commodities allocation to underweight in October 2022 by trimming our allocation to gold, an asset class that we purchased in April 2020 as an “extra diversification” tool against the unknowns of COVID. At the time, the move appealed to us in particular because the 10-year Treasury was yielding a paltry 0.51 percent. the decision to underweight has proven prescient in 2023 as commodities have fallen as inflation has grinded lower and global economic growth has slowed. Given our belief that a recession and faltering inflationary pressures lie ahead, we continue to maintain our underweight toward the asset class.
REITs remain the asset class that has experienced the most challenges due to the societal shifts that have occurred as a result of COVID. Now, high interest rates are having a significant impact on this rate-sensitive asset class. Worries about commercial real estate are widespread, and while we share many of those concerns, we note that publicly traded REITs remain 23 percent below their recent post-COVID high set in December 2021, which was before the Fed began its aggressive rate hike campaign. Risk for the group remains, and much will be sorted out in the coming months (particularly in the office market) and as the impact of rate hikes are felt further. For now, given our forecast of a looming recession and the continued tightening of credit conditions, we remain underweight in this asset class.
Economic and market conditions have been especially challenging for REITs and other interest rate-sensitive asset classes in recent quarters. While real estate prices benefited from a tailwind during the exceptionally low interest rate period immediately after the COVID pandemic, REIT performance has suffered during the most recent hiking cycle. The Fed has undertaken a swift and determined effort to contain inflation by implementing the sharpest rise in rates on record while also performing quantitative tightening—two factors that have negatively affected the real estate market, as mortgages and other financing rates have spiked to levels not seen in years. Demand for new projects has slowed, and affordability ratios for existing projects have deteriorated. In addition, lending standards on the part of banks and other financing companies have been incrementally but materially tightening. The tighter standards are adding to the challenges facing potential borrowers and could continue into the future as the long and variable lags of monetary policy take time to play out in the real economy.
We are watching valuation levels between the earnings multiples of U.S. equities and U.S. REITs for signs that REITs are becoming attractive and may provide a future buying opportunity. However, this asset class is treading water at best given the current transitionary environment, which we expect to last well into 2024. We will continue to monitor the REIT market for signs that it is time to adjust our exposure, but at this point we continue to maintain a slight underweight to the asset class.
The recent rebound in commodity prices reaffirms in our view the importance of owning commodities in a diversified portfolio.
Commodities posted notable gains this summer, reversing some of the losses from earlier in the year. Through mid-August, commodity prices have risen approximately 3.8 percent over the last three months, although they remain down about 4 percent year to date. Gains over the summer have been broad based, with energy, agricultural goods, industrial metals and precious metals prices all rebounding. Of the major commodities, only natural gas has declined over the past three months. The recent rebound in commodity prices reaffirms in our view the importance of owning commodities in a diversified portfolio.
As we highlighted earlier, headline inflation in the U.S. has quickly moderated after peaking last summer. Unfortunately, core inflation has remained elevated, and the prospect of sustained wage inflation places the Federal Reserve in a challenging position. Critically, commodities have tended to benefit from their historically tight link to rising inflation.
Year to date, energy prices continue to be the worst-performing sector. As travel abroad normalizes, we expect the consumption of gasoline and jet fuel to increase substantially, which should boost performance for the asset class. The largest detractor to energy continues to be collapsing natural gas prices (down more than 50 percent year to date). The drop in prices stems from a significant inventory buildup due to abnormally warm weather in North America and Europe.
Precious metals continued to post decent gains, with gold up more than 6 percent year to date. The rise in prices is due in part to investors pricing in the prospect of continued elevated inflation. Gold prices rose materially in March in response to the U.S. banking crisis, which increased demand for risk hedges.
The relatively weak commodity performance this year follows a strong 16 percent gain in 2022 and a 27 percent gain in 2021. Given the negative returns posted by stocks and bonds last year, the past two years have underscored the diversification benefits the commodities asset class provides.
The outlook for commodities remains mixed. The strong returns in 2021 and 2022 were spurred by strong economic growth and heightened inflation, while this year’s weak performance comes as inflation faltered and economic growth slowed. In the medium term, primary catalysts for higher commodity prices are the possible reemergence of demand from China, the potential for inflationary fears to reignite, and the possibility of a weakening U.S. dollar from its current strong levels. We also note that the persistent underinvestment in energy and potential OPEC production cuts coupled with the disruptions related to the Russia-Ukraine conflict could provide additional tailwinds to energy markets and have also resulted in significant tightness in the oil and grain markets.
We continue to believe the recent past emphasizes the benefits of owning a properly sized allocation to the commodity asset class given its value as a source of diversification. However, given our forecast for economic weakness coupled with faltering inflation, we remain tactically underweight the asset class with a tilt toward the defensiveness of gold.
Section 06 The bottom line
Much of our forecast relies on how economic cycles have historically ended, with rising wages that result in the Fed hiking rates to keep inflation under control. We acknowledge that the current economic cycle has been dramatically affected by COVID, and the past may not become perfect prologue. Perhaps wages will push lower for reasons other than an economic recession. As we highlighted in our opening comments, there could be a surge in productivity due to technological enhancements that cause a sharp increase in worker output. If artificial intelligence lives up to its hype, it could result in a period in which wages rise but inflation remains controlled, and we experience the much hoped for “goldilocks” economy.
The other path to avoiding a recession could come from a surge in labor force participation, which would reduce competition among employers seeking qualified candidates. Currently, 62.8 percent of the U.S. civilian non-institutionalized population is participating in the labor market (employed or looking to become employed). Pre-COVID the participation rate was 63.3 percent, and although at that point wages were beginning to rise sharply (a 3.7 percent year-over-year increase), it appeared as if this was likely the upper end of the participation rate. Now the question is “What if we get back to that level?” The reality is that this would mean an additional 1.4 million workers would be available for hire. This increase in supply theoretically would drive wage growth down.
While this could happen, it’s likely that the easy lifting has been done. The prime age (25–54-year-old) labor force participation rate is at 83.5 percent compared to a level of 83.1 percent before COVID struck. It’s worth noting that the current levels are the highest for the prime age demographic since 2002. This means that the economy would likely need people outside the prime age group to reenter the workforce—think older people—something that we view as unlikely. If this does occur, we don’t believe the move will have staying power but could serve to delay an inevitable recession. A look at recent history provides an example worth considering.
At the end of the 1991–2001 economic cycle, wages pulled back into the range of 3 percent without the downward pressure exerted by a recession. Following a period of strong economic growth in the mid-1990s, the unemployment rate fell sharply, and by May 1998 wages were growing at 4.3 percent on a year-over-year basis, with equity markets posting a record high in July of 1998. However, economic fears mounted as an Asian currency crisis bled into a sharp oil decline that led to a Russian ruble decline that caused a large hedge fund named Long Term Capital Management to go bust. The stock market fell more than 19 percent by August, which caused the Fed to react and pivot to cutting rates to cushion the fallout.
After raising rates to 5.5 percent, the Fed cut rates by 25 basis points on September 29, followed by an additional intra-meeting 25-basis-point cut on October 15 and another 25 basis points in November. During this same period, wage growth receded to 3.5 percent by May 1999. Perhaps economic fears led workers to value job safety over wage increases, or perhaps it was a surge of workers coming into the labor market that helped push wages lower. Consider that the participation rate for prime-aged workers hit an all-time record high of 84.6 percent in January 1999. We also note that productivity surged in the late 1990s due to strong corporate investment and the internet boom.
This has certainly qualified as a unique economic cycle, but we don’t believe its ending will be different than those of the past.
The productivity gains, heightened labor participation rate and controlled wage growth became a potent cocktail of events that likely extended the economic cycle of the late 1990s into overtime. Whatever the cause, the reality is that it was only a temporary reprieve, as wages resumed their push higher and the Fed resumed its hiking cycle in May 1999. Eventually the U.S. economy faltered under the weight of rate hikes, and a mild recession ensued from March to November of 2001.
This story paints a picture of what could happen and how our recession forecast could be stretched out into the future. However, this historical example appears to be a perfect confluence of events that are not likely to occur again—especially any Fed rate cuts. We believe it is still probable that the Fed will maintain higher rates long enough to cause job losses and an overall recession in the U.S.
This has certainly qualified as a unique economic cycle, but we don’t believe its ending will be different than those of the past. The reality is that we are later in an economic cycle. At the end of these cycles, investors need to pay greater heed to rising risks. Given this backdrop, we are incrementally tilting our portfolios toward fixed income over both equities and commodities.
However, this commentary does not mean investors should make large changes to their overall asset allocation. The ends of economic cycles have been temporary disruptions that have led to the beginnings of the next economic cycles. The same commentary applies to financial markets. The reality is that staying invested in a diversified manner during these disruptions has proven time and again to be the best path to attaining and keeping financial security.
Northwestern Mutual Wealth Management Company (NMWMC) Investment Strategy Committee:
Brent Schutte, CFA®, Chief Investment Officer
Michael Helmuth, Chief Portfolio Manager, Fixed Income
Richard Iwanski, CFA®, CAIA, Senior Research & Portfolio Analyst
Matthew Wilbur, Senior Director, Advisory Investments
Matthew Stucky, CFA®, Senior Portfolio Manager, Equities
Doug Peck, CFA®, Senior Portfolio Manager, Private Client Services
David Humphreys, CFA®, Senior Investment Consultant
Nicolas Brown, CFA®, CAIA, Senior Research Analyst, NMWMC Research
The opinions expressed are those of Northwestern Mutual Wealth Management Company as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute individual investor advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.
Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company (NM), Milwaukee, WI, and its subsidiaries. Investment brokerage services are offered through Northwestern Mutual Investment Services, LLC (NMIS), a subsidiary of NM, broker-dealer, registered investment adviser, and member FINRA and SIPC. Investment advisory and trust services are offered through Northwestern Mutual Wealth Management Company® (NMWMC), Milwaukee, WI, a subsidiary of NM and a federal savings bank. Products and services referenced are offered and sold only by appropriately appointed and licensed entities and financial advisors and professionals. Not all products and services are available in all states. Not all Northwestern Mutual representatives are advisors. Only those representatives with “Advisor” in their title or who otherwise disclose their status as an advisor of NMWMC are credentialed as NMWMC representatives to provide investment advisory services.
Please remember that all investments carry some level of risk, including the potential loss of principal invested. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss.
Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market.
With fixed income securities and bonds, when interest rates rise, bond prices usually fall because an investor may earn a higher yield with another bond. Moreover, the longer the maturity of a bond, the greater the risk. When interest rates are at low levels, there is a risk that a significant rise in interest rates can occur in a short period of time and cause losses to the market value of any bonds that you own. At maturity, the issuer of the bond is obligated to return the principal (original investment) to the investor. High-yield bonds present greater credit risk than bonds of higher quality. Bond investors should carefully consider risks such as interest rate risk, credit risk, liquidity risk, securities lending risk, repurchase and reverse repurchase transaction risk.
Investing in special sectors, such as real estate, can be subject to different and greater risks than more diversified investing and may present more financial and other risks than investing in companies of larger capitalizations and more seasoned companies. Declines in the value of real estate, economic conditions, property taxes, tax laws and interest rates all present potential risks to real estate investments.
Investing in real estate companies entails some of the risks associated with investing in real estate directly, including sensitivity to general and local economic and market conditions, demographic patterns, changes in interest rates and governmental actions.
Investors should be aware of the risks of investments in foreign securities, particularly investments in securities of companies in developing nations. These include the risks of currency fluctuation, of political and economic instability and of less well-developed government supervision and regulation of business and industry practices, as well as differences in accounting standards.
Commodity prices fluctuate more than other asset prices, with the potential for large losses, and may be affected by market events, weather, regulatory or political developments, worldwide competition and economic conditions. Investment can be made directly in physical assets or commodity-linked derivative instruments, such as commodity swap agreements or futures contracts.
Treasury Inflation-Protected Securities (TIPS) are securities indexed to inflation in order to protect investors from the negative effects of inflation.
The U.S. Large Cap asset class is measured by the S&P 500 Index, which is a capitalization weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The gross domestic product (GDP) is the amount of goods and services produced in a year in a country.
The U.S. Mid-Cap asset class is measured by the S&P MidCap 400 Index, which is the most widely used index for mid-sized companies and covers approximately 7 percent of the U.S. equities market.
The U.S. Small Cap asset class is measured by the S&P Small Cap 600 Index, a market value weighted index that consists of 600 small cap U.S. stocks chosen for market size, liquidity and industry group representation.
The International Developed Markets asset class is measured by the Morgan Stanley Capital International Europe, Australasia, and Far East (MSCI EAFE) Index, which is composed of all the publicly traded stocks in developed non-U.S. markets. The MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.
The International Emerging Markets asset class is measured by the MSCI Emerging Markets Index, which is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging-market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.
The Real Estate asset class is measured by the Dow Jones U.S. Select REIT Index, which intends to measure the performance of publicly traded REITs and REIT-like securities. The index is a subset of the Dow Jones U.S. Select Real Estate Securities Index (RESI), which represents equity real estate investment trusts (REITs) and real estate operating companies (REOCs) traded in the U.S. The indices are designed to serve as proxies for direct real estate investment, in part by excluding companies whose performance may be driven by factors other than the value of real estate.
The Commodities asset class is measured by the Bloomberg Commodity Index (BCOM), formerly the Dow Jones-UBS Commodity Index, which is a highly liquid, diversified and transparent benchmark for the global commodities market. It is calculated on an excess return basis and reflects commodity futures price movements.
The Consumer Price Index (CPI) examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.