An Economy Shifting Gears on the Road to Normal

For the last year, we have been talking about an economic and market environment that we believed would lurch back toward “normal” following the distortions brought on by COVID’s arrival in early 2020. Extreme monetary and fiscal policy coupled with a shifting economy due to COVID lockdowns led to consumers focusing on spending on goods instead of services. Similarly, markets shifted and rewarded companies that benefited from the surge in goods spending and other beneficiaries of stay-at-home mandates. Meanwhile, extremely easy monetary policy led many to buy speculative stocks based largely upon hope, dreams, themes and memes of what these companies may become many years into the future.

Now the economy is quickly transitioning back toward what it was pre-COVID. Spending is shifting back toward services, while monetary and fiscal policy is tightening. This reality has led to a market dislocation that has primarily impacted the most expensive stocks and those that benefited from earlier COVID distortions. Unfortunately, as investors have grown incredibly pessimistic, that pain has leaked into the broader market, albeit to a much lesser extent. We continue to believe that the market will find a bottom and push higher in 2022 as goods inflation that has accompanied this shift in spending abates and gives the Federal Reserve room to fine-tune monetary policy without having to tighten so much that the U.S. economy falls into recession.  

COVID’s Distortion

The natural long-term growth rate of the U.S. economy is determined by two factors: 1) how many people are employed and 2) how efficient they are. Think about this as how much supply the workforce can create. As has been on full display in the prior couple of years, demand oscillates around this supply line, with the “normal” result being a business cycle. COVID caused a massive decline in demand (and even supply) as parts of the economy were taken offline. The decline created a huge economic hole below the natural trend line.

However, much as we forecasted early in the COVID crisis, policymakers arrived on the scene with buckets of liquidity (both fiscal and monetary) to “fill the economic hole” in an attempt to cushion the COVID blow for many Americans. Ultimately the goal was to bridge the COVID-induced economic gap and allow the U.S. economy to recover as quickly as possible when the country emerged from shutdowns.

One could argue this hole was overfilled. While we forecasted a quick, V-shaped recovery, the argument could be made that the rebound was actually stronger and resembled a check mark. The snap back occurred against a backdrop of constrained supply. The combination resulted in the unwelcome side effect of high inflation.

Now we are descending this stimulus hill at a rapid pace. The Federal Reserve is aggressively attempting to slow demand growth to bring it down toward our long-term trend supply-driven growth rate. The market has become volatile in response to concerns that perhaps the Fed will have to slow demand well past that long-term growth rate and possibly cause a recession. While this growth slowdown may feel like a recession to some, especially in the segments of the economy that were COVID beneficiaries, we continue to believe that the Fed will not have to tighten the economy into a recession. The good news is that even if a recession occurs, U.S. consumers as a whole — despite the recent spike in inflation — remain in great shape, and we believe any such recession would be mild. While inflation and gas prices are nibbling away at the consumer, consumers entered this time period with more cash than debt on their balance sheets for the first time in 30 years. Additionally, wages have increased across the income spectrum.

The Shifting Spending

While it’s been a checkmark-shaped economic recovery overall, it has been uneven under the surface, with the strong segments more than offsetting the weak parts. Goods spending was the primary beneficiary, while service-sector spending was dramatically restrained by continued COVID restrictions. Currently we believe the economy and the consumer are shifting back toward spending on services as we migrate back toward public life. This decrease in goods spending is occurring at a time when goods inventories have been aggressively rebuilt. The result, we believe, will be falling goods prices.

We continue to believe that the market will find a bottom and push higher in 2022

These realities have shown up in the recent earnings reports of several large U.S. retailers. Overall, the message from retail companies has been that the consumer continues to spend. However, Target’s Chief Executive Officer Brian Cornell described a change in spending habits. Instead of spending heavily on televisions, kitchen appliance and bicycles, Cornell said, consumers are buying luggage, booking trips and purchasing gift cards for restaurants. Similar comments were made during the Walmart earnings conference call, when management noted that general merchandise (goods) sales fell against a backdrop of high inventories. As a result, the retail giant is rolling back prices to reduce the glut of goods. Perhaps tying these together, Amazon, the ultimate goods-delivery company, noted that delivery times were back to pre-pandemic levels. Importantly, much like Walmart and Target, the company noted it had hired too fast and now had excess staffing the company would need to grow into.

Inflation

While the examples are company specific, they help paint a picture of the shift that we believe is currently occurring and bolster our view that core inflation has peaked and will dramatically moderate in the coming quarters.  We acknowledge that food and energy could remain elevated if the Russia-Ukraine war continues. However, we believe there is going to be a substantial easing of the goods inflation that has been the primary driver of the now year-old inflation spike.

Goods inflation in the Personal Consumption Expenditures (PCE) Inflation index is up 9.5 percent year over year as of April. Contrast this with the previous economic cycle, when goods inflation was 0 percent cumulatively. The most intense and historically “odd” inflation has occurred with durable goods.  Durable goods inflation is up 8.4 percent year over year, but that is off the peak of 11.5 percent year over year in January. In comparison, in the period 1995 to 2020 (25 years), inflation in this part of the economy actually fell 40 percent cumulatively. This is where we believe substantial relief is on the way as inventories are being rebuilt and demand is moderating.

Here are a few data points from recent economic data releases to support this view. Not surprisingly, overall wholesale and retail inventory data show a picture similar to what the large retailers are saying. Indeed, wholesale goods and retail inventories (not including autos) have been rebuilt at a time when demand is set to fall.

Let’s take the example cited by Target’s CEO and tie that to overall U.S. inventory data and Personal Consumption Expenditures (PCE) inflation data. The U.S. Census Bureau tabulates inventory levels relative to the sales levels for furniture, home furnishings, electronics and appliance stores. In the recent report this ratio came in at 1.64 percent, meaning that for every dollar of sales there was $1.64 worth of inventory. This number was as low as 1.25 percent back in January 2021. To find a number pre-COVID similar to today’s level you have to go back to 2014. If you have low inventories relative to high sales, the release valve is higher prices — and that was what occurred. Let’s tie this to PCE inflation to see the impact. These goods reside in the inflation category of furnishings and durable household equipment. As of April 2022 this category was up in price 12.1 percent year over year. To show how odd this is historically, from 1995 to 2020 (25 years) this category cumulatively depreciated 28 percent in price.

Another well-publicized story is that of the auto industry, where prices have skyrocketed for both new and used cars due to inventory shortages. This has had a huge impact on inflation; however, things also appear to be improving here. The latest reading of industrial production showed that manufacturers assembled autos at a 10.3 million annualized pace in April, just off the 2019 average pace of 10.7 million and substantially higher than the 7.5 million pace in September 2021 and 8.3 million pace in February 2022. Let’s tie this to PCE inflation, where prices in the motor vehicle and parts category are up 15.8 percent year over year as of April 2022 but off highs of 23.6 percent growth in January. Contrast these readings with the historical 1995-2020 (25 years) period, when prices rose a cumulative 5 percent during the entire period.

Rising interest rates that have occurred because of rising inflation and the Federal Reserve’s rate hike rhetoric have had an impact on the stock market.

We have focused on the rise in the cost of goods because that has been the driver of heightened inflation over the past year. This is also where we believe price declines are going to occur in the future, which should bring down overall inflation. Services inflation is likely to remain high, and the rising cost of homes will contribute to it remaining elevated. However, the recent spike in mortgage rates will cool the growth rate of home prices and should be reflected in the data in the coming months. Overall, we continue to forecast that the worst of inflation is in the rear-view mirror, and this reality will provide the Federal Reserve more flexibility in the rate hiking cycle.

The Federal Open Mouth Committee

Much of the current refrain remains that the Federal Reserve is behind the curve; after all, it has tightened policy by only  0.75 percent year to date, and the balance sheet unwind is just getting underway. However, we note that the Federal Reserve has used its forward guidance (words) to coax the market into fully pricing in the 3.0 percent tightening that is expected in the coming months. Put differently, all this expected tightening is already impacting the economy and markets as though it already happened. What happens from here is most important.

Federal Reserve Chairman Jerome Powell has continually reminded investors that the Fed’s rates hikes are designed to tighten financial conditions overall. That is the measure we should use to judge how much accommodation has been removed. A review of any chart of financial conditions reveals an incredibly sharp tightening has already occurred over the past few months as the market has dramatically pulled forward rate hike expectations. Want a simple visual? Think of a 2-year Treasury that went from .22 percent in October 2021 to a recent high of nearly 2.8 percent in early May. Think about 30-year fixed mortgage rates that went from under 3 percent for much of 2021 to a recent high of 5.5 percent.

This is where we believe there is good news moving forward given our inflation outlook. We believe this will allow the Federal Reserve to avoid having to intentionally overtighten rates to drive the economy into a recession. We again remind that the Federal Reserve remains focused on returning the inflation rate to its 2 percent target while still sustaining a strong labor market. We believe the Federal Reserve strongly values the labor side of the equation and is willing to show patience in its attempt to return the U.S. economy to 2 percent inflation, as long as those readings are moving in the right direction.

Market

Given the crosscurrents, confusion and dire forecasts issued by many, investor sentiment has plummeted. Since the week of the Russian invasion of Ukraine, we have had five sub-20 percent bullish readings on the Investor’s Sentiment Survey from the American Association of Individual Investors. In late April we had the fifth highest level of bearish responses ever in weekly data going back to 1987. Indeed, during that week, we had the highest gap between the percentage of investors who were bullish versus bearish since March 5, 2009. As many readers will note, that was one day prior to when the market bottomed intraday on March 6, reaching its maximum drawdown of 57 percent during the Great Financial Crisis. The punchline here is that this a reliable contrarian indicator that points to the potential for positive returns moving forward.

Rising interest rates that have occurred because of rising inflation and the Federal Reserve’s rate hike rhetoric have had an impact on the stock market. Valuation is a relative tool, so a repricing of the bond market usually coincides with the stock market repricing. Much as we have forecasted, this repricing has had the biggest impact on the most expensive stocks. Indeed, value stocks have been resilient with the S&P 1500 Value index down only 3.6 percent year to date, while the growth parts of the market have fallen by more than 20 percent. In riskier growth parts of the market, a basket of unprofitable tech stocks has fallen more than 50 percent year to date and over 70 percent from all-time highs. We continue to advise investors to focus on what is cheap, has earnings and is producing cash flow in the here and now, not way out into the future.

We remain slightly overweight equity relative to fixed income given our forecast of falling inflation which allows the Fed to refrain from tightening the economy into recession. Throw in heightened levels of pessimism, and we believe the ingredients exist for a recovery in equity markets. Overall, we continue to tilt our exposure toward what we believe are the cheapest parts of the market.

Within the U.S., we retain our favorable outlook toward value stocks and continue to overweight quality small caps (the S&P 600) based upon their attractive valuations. Within international markets we continue to prefer international developed stocks over international emerging markets. While there are risks in each of these asset classes, current valuations reside at extremely discounted levels. The Russia-Ukraine war has complicated the calculus, but heretofore international markets have held up incredibly well thanks to their discounted valuations and higher dividend yields.

Consistent with our inflation forecast in February 2022, we eliminated the majority of our Treasury Inflation Protection Securities (TIPS) — a position we added in late 2019 and increased in mid-2020. However, we maintain our current exposure to both commodities and gold to hedge against continued rising energy and agricultural prices and the unknown geopolitical situation.

U.S. Large Cap

U.S. equities remain volatile and in correction territory as inflation concerns, Fed tightening and geopolitical uncertainties continued to be pain points during the second quarter. The path forward will likely continue to be quite choppy, but the magnitude of potential further drawdown is answered by this simple question: Are we likely to see a recession over the next 6-12 months? Since 1950, the S&P 500 has had 25 drawdowns of 10 percent or more, inclusive of this year’s disappointing start. Corrections that crossed over from the 10 percent level and into 20 percent+ (bear market) territory are almost always associated with a U.S. recession. In fact, 7 out of the last 10 bear markets occurred along with a recession. The three bear markets that took place without a recession, bottomed faster and recovered losses quicker than those occurring in bear markets. The one outlier has been the recent COVID-induced recession.

While the economy is slowing from the stimulus driven sugar highs, we don’t think the deceleration ultimately crosses over into a recession. Consumer balance sheets remain in good shape with plentiful job openings and strong wage increases enabling continuing consumption growth into the intermediate term. Industrial production has strong tailwinds from energy investment, utility demand, and automotive manufacturing. Consumer spending and industrial production make up an overwhelming majority of U.S. GDP, and with these categories in strong growth mode we see a recession as an unlikely outcome.

With that high level overview, it’s important to point out that financial conditions are tightening as the Federal Reserve increases short-term rates and begins quantitative tightening in June. This has important style ramifications for markets, as tightening liquidity conditions like the current environment act as a headwind for equity valuations, especially for more speculative parts of the market. Our positioning in U.S. Large Caps is neutral, but we have an overweight to value stocks to reflect this current policy situation. So far this year, large-cap value stocks have outperformed the S&P 500 by nearly 9 percent, and we think there is plenty of relative upside left as value spreads have barely compressed from the widest levels we’ve seen in the last 30 years.

U.S. Mid-Cap

U.S. Mid-Caps are also in correction territory, but the damage hasn’t been as severe as in U.S. Large Caps. Relative valuation is the likely explanation, as U.S. Mid-Caps are very cheap relative to U.S. Large Caps. This outperformance is also noteworthy because of the more economically sensitive characteristics of mid- and small caps. Despite investor and consumer sentiment moving sharply lower throughout the first half of 2022, both mid- and small caps have outperformed. That type of outperformance is unusual when sentiment moves into very bearish territory and credit spreads widen materially. This is an important lesson about valuation: Eventually it always matters, and today it remains in favor of both mid-caps and small caps. We’re neutral right now in mid-caps, as we favor small caps more, but we continue to observe attractive investment characteristics toward the asset class.

U.S. Small Cap

We remain overweight U.S. Small Caps despite their significant outperformance over the past couple of years. While the forward macroeconomic picture is becoming more challenging with persistent inflation and an aggressive tightening cycle from the Federal Reserve, we don’t think that a recession, which would lead to a contraction in earnings, is imminent. With that as our macro base case and given that financial conditions are tightening, relative valuation continues to be critically important as an input into our dynamic asset allocation positioning. Across the equity asset class spectrum, U.S. Small Caps continue to look very cheap on a relative basis, and we like their high-sensitivity U.S. macroeconomic fundamentals, which over time has been more resilient compared to various other developed economies.

International Developed

International developed markets contain the economies most affected by the Russia-Ukraine war. The Eurozone in particular is economically sensitive given its geographical proximity and closer linkages to Russian and Ukraine. Due to energy and agricultural price increases as well as tension on global supply chains, there has been record inflation in the region. On a positive note, the region has moved past waves of COVID-19 infections, and the economy has been able to grow faster than expected. Economic output rose .3 percent in the first quarter, and employment gained .5 percent over the same period. Recent purchasing manager indices have held up well, with the service sectors providing a strong boost. This data highlights Europe’s underlying strength as consumers emerge from the pandemic with pent-up demand and large amounts of savings.

Japan’s economy has also performed better than expected recently as consumers have shown more resilience in the face of virus curbs. However, steep increases in commodity prices are hitting Japan’s trade and squeezing corporate profits. More fiscal stimulus is likely and the Bank of Japan will continue easing.

Not surprisingly, interest rates have increased in both regions, especially in the Eurozone where negative-yielding debt may become a thing of the past. This might help the overall Eurozone economy and its banking system in particular. Additionally, the Eurozone looks set to issue additional joint Eurobonds that will be used to fund energy and defense spending. Additionally, currencies in both of these economies have dramatically declined and now look cheap relative to their U.S. dollar counterpart. Falling expectations of Fed rate hikes could lead to future currency strength and be a tailwind for U.S.-based international equity investors.  

There is much to worry about within these regions, and their underperformance over the past decade has been notable. However, current valuations appear attractive, and we believe even the slightest catalyst could unlock future outperformance. While we continue to review our overall outlook and risk factors, we believe the valuation discount these markets have relative to U.S. stocks provides a margin of safety and an opportunity for future outperformance. As such, we retain our overall position at slightly overweight.

Emerging Markets

Emerging Markets have been hit with a variety of headwinds this year as the Fed’s hawkish stance, the dollar reaching all-time highs, continued COVID-19 lockdowns in China and the Russia-Ukraine war have made for a challenging backdrop for much of the developing world. On a positive note, commodities-producing and -exporting countries have performed well; for example, equities in Brazil are up over 27 percent at the time of this writing.

A discussion of Emerging Markets as an asset class requires a close inspection of China as the country comprises about 32 percent of the MSCI Emerging Markets index. Here we note a few items that are potential positives for equity markets. First, China is in the process of revisiting the country’s COVID-zero policy. The new approach proposes to put “people and life first,” according to Wu Zunyou, chief epidemiologist at the Chinese Center for Disease Control and Prevention. The Peoples Bank of China has recently been shifting to accommodative policies (versus contractionary in much of the developed world). President Xi begins his third term in the fall, which is an event that some believe will lead to additional fiscal stimulus. Lastly, recent chatter has hinted at the potential for the U.S. administration to roll back tariffs in the coming months. We must also remember that these economies are sensitive to global growth and should benefit from a continued global economic recovery in 2022.

This optimism must be balanced against current weakening growth and demand as a result of COVID-induced shutdowns. We must also acknowledge that a more sustained, long-term increase in inflation, while not our base case, is a possibility moving into mid to late 2022. If this were to unfold, central banks in emerging markets would likely have to tighten monetary policy even further and yield a market headwind. Last, but not least, tensions between China and much of the rest of the world remain high, especially in the aftermath of the Russian invasion of Ukraine.

Overall, relative valuations are very attractive and currently sit at 20-year lows versus the developed world. As we look at Emerging Markets as a broad basket, it is expected to grow at double the rate of the developed world over the next decade. Growth in these economies will be driven by an ascending middle class, the transition from manufacturing-based economies to services, and technology. Today’s emerging-market countries, as a group, are different than those of 20 years ago, with technology and financials the two largest sectors. Developing countries account for about 40 percent of world GDP and 25 percent of world equity markets, which means it’s important to have some exposure in a well-diversified portfolio.

In June 2021 we reduced our exposure to Emerging Markets to our current slight overweight, a position we retain today given the delicate balance of risks and potential rewards.

Over the past several years, the Federal Reserve has actively engaged in Quantitative Easing (QE) or large-scale purchase of U.S. treasury bonds and mortgage-backed securities. This decision was first made in the aftermath of the Great Recession. The Fed had lowered the Federal Funds rates — or the front end of the yield curve — to zero, but the economy didn’t respond as sharply as desired. The Fed chose not to push short-term rates into negative territory but rather embarked upon bond buying in intermediate- to longer-term Treasurys. Put differently, the Fed historically has impacted only short-term interest rates, while the market has set the rest. By buying Treasurys, this Fed wanted to impact the entire yield curve.

The goal of QE was twofold: 1) to push down the term premium, or the extra compensation investors require to own longer-dated securities versus rolling shorter-dated securities and 2) to remove bonds from investors’ balance sheets, and replacing them with cash with the hope that they would use these proceeds to buy riskier assets and fund economic growth. During COVID this strategy was re-engaged, and it worked. Treasury yields fell and remained incredibly low even in the face of rising inflation, and investors took risk (sometimes excessive). We would be remiss if we failed to point out that other countries around the globe followed a similar tact.

Now we are on the opposite side of this, as the Fed has begun to wind down its balance sheet and will no longer be buying bonds in an attempt to keep yields low. This has caused investors to reassess how much extra compensation they demand for holding longer-dated securities. The result has been a dramatic repricing in yields across the interest rate spectrum as investors grapple with high inflation and expectations of rising Fed interest rates. This has led to the second worst bond market drawdown (-12.2 percent vs. -12.7 percent in 1980) in investment-grade bonds in data that go back to 1976.

A common refrain we hear: What should investors do given the ending of QE coupled with fears of future Fed rate hikes? Our response is that these actions have already been fully priced into the yield curve and only deviations from those aggressive rate hike expectations matter. When considering our expectations of a return to a more normal economic and market environment, it is interesting to note that the Treasury yield curve resides at levels similar to those in 2018-19. This is before the aftershocks of the trade war become relevant and then the onset of COVID. What this means is that we are likely closer to a rate level that reflects the intermediate economic outlook.

This is not to say that rates can’t go higher. Ultimately, the question of where long-term Treasury yields settle will be determined by prospects for future economic growth. If we are on the precipice of heightened intermediate- to long-term economic growth on the back of productivity advancements, then it is likely that the neutral interest rate has risen. This rise would translate to an economy that can handle additional rate hikes, with a potentially higher ceiling on long-term interest rates.

The good news is that, after recent repricing, Treasurys and other bonds, are offering a counterbalance to equity risk while providing better yields. Once again we remind that in February of this year we sold our TIPS position, as we forecast that inflationary expectations were set to wane; therefore, we have lowered our outlook on TIPS to neutral and returned our Fixed Income allocation toward coupon-paying investments.

Overall, we continue to position our duration near neutral and favor higher-quality fixed income given the current economic backdrop and our slight equity overweight. Simply put, every slice of the portfolio has a role to play, regardless of the market mood or economic environment. Fixed Income is not simply a vehicle for income generation but also a necessity for risk mitigation.

Duration

The drawdown in fixed income has been swift and broad with virtually no place to hide unless you chose cash. For example, the two-year Treasury is up 1.85 percent in yield, and all parts of the yield curve beyond three months are up 1.0 percent or more as of this writing. While bond yields are up and prices are down, investors in high-quality fixed income need to remember that bonds have a maturity date — and as that date draws nearer, the price is pulled back toward par (assuming no default). Additionally, forward income levels are much higher given the recent rise in yields. For all the prior investor angst of sub-1 percent nominal rates and negative real rates during the past couple years, the internal rate of the bond portfolios we manage is actually improving. We implore investors to stay the course. The U.S. Treasury curve is very flat, implying that a large majority of the move in rates has likely already happened; certainly, we expect the speed of the increase to subside. We continue to favor modest duration relative to relevant benchmarks.

Government Securities

The U.S. dollar has been on a run since Q2 2021. This dollar strength has likely been responsible for the recent flattening of the yield curve. Looking forward, we believe there is a good chance the dollar is approaching its peak for the year as it has been buoyed by the prospect of aggressive Fed tightening that we believe is already reflected in current yields. Even against this backdrop we continue to favor U.S. bonds relative to their international peers and would rather gain exposure to international currencies through equity markets.

Credit

Sub-investment grade credit often has a hiccup during Fed tightening cycles. Widening of credit-spreads — the difference in yields for bonds of varying credit quality — has been somewhat slow to play out (while rates have risen over the past six months), but it's showing some signs of accelerating. Much of this widening can be attributed to the volatile stock market, or vice versa. However, high-quality credit will be less volatile going forward as opposed to lower rated credit. Given our equity overweight we continue to focus on higher-quality investment-grade credit.

TIPS

While it is no secret inflation has risen over the past two years to levels not seen in decades, protecting against it with Treasury Inflation-Protected Securities may no longer be the answer. That’s because so many investors have flocked to these instruments that valuations have been driven to the point that fully reflects the current realities. TIPS breakeven curves are very inverted which means that short-term inflation expectations are much higher than long-term expectations. While that means hedging long-term inflation may appear cheap, we have maintained that inflation may be a temporary thing and the aggressive Fed actions and rhetoric are doing their intended duty of reducing future inflation expectations. This backdrop, coupled with the recent rise in nominal yield, leads us to favor coupon yielding bonds over inflation protected securities.

Municipal Bonds

Municipal bonds are attractive given current valuations but investors should stick with high credit quality. As is typical in periods of large interest rate increases like today’s environment, municipal bonds have cheapened dramatically. Ratios (the percentage of U.S. Treasury yield relative to municipal yield of the same maturity) are currently well over 100 percent for 3-year and longer municipal bonds. This means investors are getting the tax benefits of municipals for free. These opportunities occur for many reasons, but mostly because municipal bonds are primarily owned by individuals who tend to get very sensitive to rate movements.  

For the past few years, we’ve regularly used this section to offer reasons for our belief that commodities belong in a diversified portfolio. This message may have fallen flat in the past given that the asset class hadn’t performed well. The price action of the past couple years, coupled with the recent struggle of both stocks and bonds, highlight why we favored (and continue to favor) portfolios own these instruments. Remember that a well-designed portfolio is likely to have an asset class that underperforms. This is the definition of diversification.

Over the past couple of years commodities have significantly erased their past performance woes and are now up nearly 10 percent annually over the past five years. This performance places them near the top of the asset class heap. The reality is that all of this return has come very rapidly in the past couple of years. This is why we maintain exposure but size the position at a relatively low weight in our portfolios. A little often goes a long way. Despite the recent increases in commodities that have been driven by shortages, including some directly caused by the Russian invasion of Ukraine, we continue to favor this asset class. Years of lower prices have led to underinvestment, which will ultimately be cured by higher prices that result in more investment.

Meanwhile, REITs were initially the post-COVID-19 laggards when investors contemplated and repriced the intermediate- to long-term impacts of the pandemic. As we progressed through 2021 and the U.S. economy adapted to COVID-19, REITs surged to the top of the performance heap. However, much as we have forecasted, during the recent interest rate spike REITS have once again underperformed due to their interest rate sensitivity.

Real Estate

REITs commonly pay higher dividends than other kinds of equity securities, a convenient feature in periods of lackluster market performance. The current dividend spread between many REIT indexes and large-cap equities remains close to 100 basis points. While this may normally provide a ballast for REITs, the reality is this lackluster market environment has been caused by rising interest rates, which currently are proving a headwind for this asset class

Valuation levels between the earnings multiples of U.S. equities and U.S. REITs are becoming attractive and may provide us a future buying opportunity. However, this is an asset class that appears stuck in the middle given the current transitionary environment. We will continue to monitor the REIT market for opportunities to adjust our exposure.

Commodities

Commodity prices continued their surge this year in response to global economic demand, rising U.S. inflation data, supply-chain bottlenecks, industry underinvestment and the impacts of the Russia-Ukraine war. Through May 31, commodity prices have risen 33 percent year to date, following a strong 27 percent gain in 2021. Commodities are the only major asset class to generate a positive return year to date and since the onset of COVID in early 2020 have dramatically outperformed all equity markets we track.

Largely due to the Russian invasion of Ukraine, energy prices have risen an astounding 91 percent year to date, including gasoline (up 79 percent) and natural gas (up 135 percent). Given the inability of Ukraine to export wheat, agricultural goods are up 25 percent, including corn (up 28 percent), cotton (up 26 percent), and wheat (40 percent).

A relative economic slowdown in China and other emerging markets has had an impact on industrial metals prices, which are up only 7.7 percent year to date. Aluminum (-2.2 percent) and Copper (-2.7 percent) have declined notably.

Our near-term outlook is for commodities to maintain their strength for the near term into mid-2022.

While we have a positive outlook for commodity returns, our inflation outlook suggests the current rate of appreciation isn’t sustainable. Over the past seven months, inflation has surged to levels not seen since the 1980s, but that’s also the era when inflation was finally broken, began a consistent push lower and eventually fueled the last economic cycle’s deflationary worries. The return of inflation has sparked a fierce debate in markets. Are we in a new inflationary regime, or is this a pandemic-fueled distortion?

We don’t believe we are in a new inflationary era. When digging deeper into headlines about inflation, it becomes apparent that it has largely been fueled by unsustainable durable goods spending. We believe spending on durable goods will normalize and pull headline inflation lower with it. Data indicates that a shift in spending is already underway, as expenditures toward services markedly increased in Q3, while overall goods spending declined. As a result, our overall enthusiasm for the asset class has been tempered.

Precious metals have been essentially flat (gold up 0.11 percent year to date), as gold prices have traded on the back of rising geopolitical risk. Gold serves as a haven for investors, particularly in an environment with negative real (inflation-adjusted) interest rates. We would have expected gold prices to rise higher in 2021 as inflation expectations rose and interest rates declined. The long-term relationship between gold and real rates is valid, but there have been sustained short-term periods when the linkage has been inconsistent. That said, we find no reason to abandon the anchoring of gold to real yields and continue to expect gold to provide us a hedge against unforeseen economic outcomes.

Many would suggest that Bitcoin may be attracting flows from traditional gold due to it being dubbed Gold 2.0. Perhaps, but we note that it has acted very sporadically — less like a haven and more like a risk asset. Recent sanctions on Russia may have led Bitcoin modestly higher as a perceived pathway around sanctions. While some may suggest this validates the asset class as a haven, we believe it will only serve to place it more firmly in the regulatory crosshairs.

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 Commodities spectrum and ensures that no single commodity has an outsized impact on overall risk and return. The individual components of the Commodity benchmark 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.

This year has once again proven that the economic and market environments often throw investors curve-balls. We don’t believe that investing is an exercise of chance but humbly admit that it lacks certainty, and surprises are a permanent feature. We once again remind that there are two ways in which we deal with this: 1) Diversification – Think about the reality that we described in the commodities section. 2) Much as we mentioned after the initial arrival of COVID back in early 2020 — it's your actions and how you behave after surprises that drive your investing outcomes. These are the most important determinants of your investing success on your path to financial security. Acknowledge that perfect foresight is unattainable, and focus on what you can control.

Allow us to re-introduce a third variable to the equation. No one asset class or segment of the market continually provides outperformance, and often each new economic cycle ushers in  new leadership. What investors thought they knew and had experienced in the past has seemingly unraveled all at once.

Think about it; many professed that inflation was a relic of the past, U.S. large-cap growth and technology were all that were needed in a portfolio, bonds always had negative correlations to equities and provided positive returns even at low starting yields, commodities weren’t worth owning and the path to extreme riches was garnered by taking inordinate risk in thematic stocks with big dreams about what the future my hold. Has everything changed all at once? No. But certainly, past economic cycles have taught us that different winners emerge in each cycle and that while asset classes can sleep for a while, very rarely do they die.

We take you back to what we wrote in May 2020 on the heels of the COVID-induced economic destruction. Fast-forward to today; we believe this current environment is really the bookend to the economic journey that began more than two years ago. Does this mean we are declaring COVID over? No, we don’t know for certain, but it is clear the economic oddities and market abnormalities caused by COVID are quickly unwinding. Now we are moving toward what is next. What is the new economic reality, and what happens to market leadership as we turn the page to the future?

We invite you to consider this chart as you think about the future and what you believe you know about the markets’ future leadership. We rehash this because despite the recent price action, many investors continue to express their desire to run back to the asset classes that worked in the past economic cycle. As the chart reveals, the onset of recessions mark not only new economic realities but also new market realities. At a minimum we hope this paints a picture of why diversification and humility remain important variables in investment success.

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.