Is the Economy at a Crossroads?

One of two economic scenarios is likely to play out in the coming months. The first possibility: Inflation falls to a sustainable level, giving the Fed room to cut rates rapidly enough to keep the bifurcated U.S. economy from tumbling into an overall recession. In the second scenario, the U.S. economy falls into a recession—dragging inflation back to acceptable levels. In this case, the Fed should be able to quickly cut rates to stem the length and severity of the downturn.  

We believe the second scenario is more likely but feel like we’re in a holding pattern as we wait to see what scenario will play out. 

Expectations for aggressive rate cutting, which had the markets pricing in six cuts total for the year, faded after a string of hotter than expected inflation readings to start 2024. More recently, a weaker than expected May Consumer Price Index (CPI) reading renewed optimism that the Fed would be able to cut rates two times in 2024. Despite this downshift in rate cut expectations, the market, especially a narrow handful of stocks, have continued to push higher.  

Simply put, policymakers have not yet figured out how to eliminate the ebb and flow of the economy through the perfect timing of interest rate adjustments.

We continue to view inflation as the “sticking” point that stands in the way of a soft landing. We believe the cause of inflation has shifted from the economic oddities caused by COVID to now being caused by a traditional economic cycle. Inflation’s decline in 2023 likely occurred as COVID-induced inflation was receding. Now, a tight labor market (typically a sign of being late in an economic cycle) is creating a stickier inflationary backdrop. We continue to expect that this will lead the Fed to keep interest rates higher for longer. The longer rates are high, the deeper they will seep into the economy and increase the risk of a recession.  

While it’s difficult to pinpoint exactly when we’ll hit the tipping point that ends in recession, we believe the weight of evidence points to a U.S. economy that is in the later innings of an economic cycle. Throughout history, the Fed has struggled to cool an overheated, late-stage economy without causing a recession. And the stakes are higher for the Fed this time as it struggles to rein in the highest inflation in 40 years. The concern is the potential of returning to something similar to the period between 1966 and 1982. During that time, the Fed was hesitant to raise rates to stamp out inflation and instead focused more on the labor market. As a result, inflation became embedded in the U.S. economy. Since then, the Fed has been more attuned to its dual mandate of price stability and maximum employment. While this has resulted in a more stable inflation backdrop over the decades, it hasn’t changed the limitations the Fed has in managing that natural course of the economic cycle. Simply put, policymakers have not yet figured out how to eliminate the ebb and flow of the economy through the perfect timing of interest rate adjustments. Unfortunately, we don’t believe this time is going to prove different. Instead, we believe this cycle will end like those of the past, with a recession. However, we believe this time it will be mild recession.  

It's possible that the current economic cycle could stretch into extra innings and continue to defy expectations for its near-term demise. If it does, we believe it would follow a formula similar to the 1990–2001 economic cycle: It stretched past its natural life cycle thanks to a large surge of workers returning to the labor market and a sharp rise of worker productivity fueled by robust business investment tied to Y2K and the widespread adoption of the internet. While we believe artificial intelligence will improve the productivity of existing U.S. workers, advancements in this area are in the early stages. And while the labor force has grown of late, we believe the easy lifting has been done, as the labor force participation rate for prime-aged workers (those 25 to 54 years old) is at levels last seen in 2002. 

While talk of a recession may sound dire, the good news is that we continue to believe any such recession would likely be mild. Additionally, we believe there are still plenty of attractive opportunities available for patient long-term investors who are willing to look into some of the less popular areas of the current market. More importantly, we emphasize that this is the time for investors to stay true to the principles of diversification and the portfolio allocation that has been designed as part of a comprehensive financial plan. While this may sound easy, the reality is that at the end of every economic cycle over the past 45 years there have been investors who fear missing out on the next move higher for the markets and end up chasing yesteryears’ winners. As we’ve noted, the most popular sectors at the end of a cycle often become the next economic cycle’s laggards. We continue to gradually reposition our portfolios from what worked in the last economic cycle to that which we believe will work in the next economic and market regime.  

Returning to our economic comparisons of the late 1990s, we note that the U.S. Large Cap market then was concentrated, much as it is today, and was being propelled higher by an ever-narrowing few companies. The impetus for a shift then was similar to what we believe it will be today: an eventual mild recession that allows investors to turn the page to the next economic cycle and the opportunities that it brings. Much like then, we believe that other asset classes and sectors of the U.S. economy will become the leaders in the next business cycle.  

The last mile of inflation remains the problem 

Much as we expected, after inflation peaked in late 2022, 2023 saw a sustained unwinding of inflationary pressures. This was because the economy worked past the oddities of stimulus-driven consumer spending and supply-chain bottlenecks that were sparked by the COVID pandemic. U.S. consumers who were flush with stimulus dollars were unable to gather in public, which caused a historic shift in spending toward goods amid supply chains snarls and worker shortages. The upshot of this anomaly was a sharp rise in inflation for goods, which peaked in February 2022. Then as public places reopened, spending began shifting to activities such as vacations and eating out at restaurants and caused services inflation to rise until its ultimate peak in February 2023. In between, Russia invaded Ukraine, causing energy costs to peak in June 2022, while food inflation peaked in September 2022. The forces that caused this inflation are now largely behind us and likely caused the decline in inflationary pressures throughout 2023.  

Indeed, a review of nearer-term trend measures shows that inflation pressures remain above the Fed’s 2 percent target.

Our inflationary outlook shifted in mid-2023 as it became apparent that we were entering the later innings of a business cycle. This is traditionally a time when workers are in short supply (measured by a low unemployment rate) while demand is elevated due to higher wages. This combination drives inflation higher. Much as we expected, this business cycle-based inflation began to bubble up as we moved through the end of 2023 and into 2024. While the May CPI report was remarkably weak, we note that it was preceded by several months of hotter than expected inflation readings to start the year. Indeed, a review of nearer-term trend measures shows that inflation pressures remain above the Fed’s 2 percent target. For example, the Atlanta Fed Sticky CPI shows the three-month annualized sticky CPI checking in at 4 percent, and the Cleveland Fed median CPI checks at 3.9 percent on a three-month annualized pace and 4.5 percent on a six-month annualized pace.  

We also note that setting May’s much cooler CPI reading aside, members of the Fed have ratcheted down their expectations for the number of cuts this year. At the Fed’s June meeting, the so-called “dot plot” of Fed member economic and rate forecasts showed that the median expectation was for just one rate cut in 2024, with four policymakers penciling in zero rate cuts. Federal Reserve Chairman Jerome Powell took time to speak directly of the challenge elevated wage growth brings to the disinflation process in his post-meeting comments. “As I mentioned, the labor market has come into better balance. Wages are still running ... above a sustainable path, which would be that of trend inflation and trend productivity. You’re still seeing wage increases moving above that. We haven’t thought of wages as being the principal cause of inflation. But at the same time, getting back to 2 percent inflation is likely to require a return to a more sustainable level, which is somewhat below the current level of increases in the aggregate.” 

Putting this into context  

We have consistently stated our view that the Fed wants to avoid a wage–price spiral similar to the one experienced during the 1966 to 1982 period of heightened and persistent U.S. inflation. While the pace of wage growth has slowed to 4.2 percent on a year-over-year basis, the level is still in excess of the 3 to 3.5 percent pace the Fed believes is consistent with 2 percent sustainable inflation. Put simply, the slowdown in wage growth has stalled at a level that is likely incompatible with the Fed’s stated inflation target of 2 percent. We note that in data released the week before the May CPI report and the Fed meeting, wages for nonsupervisory and production workers rose 0.47 percent month over month in May. Given that we believe wage growth is the last mile in the battle against inflation, we think it is unlikely the Fed will aggressively cut rates until wage growth slows to a level around 3.5 percent.  

The confusing labor market 

On the surface, the labor market appears strong, especially given the continued growth in jobs as estimated by the Nonfarm payrolls report from the Bureau of Labor Statistics (BLS). The Nonfarm report shows that employers have added an average of 230,000 jobs monthly during the past 12 months for a total of 2.76 million positions. During the past six months, the Nonfarm report pegs total job gains at 1.53 million. However, a broader look at employment data offers a more conflicted view. 

Over the past year, while the Nonfarm data has remained seemingly strong, the unemployment rate, which is based on a different report from the BLS (the Household report), has risen from a low of 3.4 percent to today’s level of 4.0 percent. That’s because the Household employment report shows that only 340,000 workers have been added to the labor market (28k per month) in the past year. In fact, the report shows the number of people employed in the last six months dropped by more than 780,000.   

Given still-elevated inflation and wage growth and a mixed picture on the employment front, the Fed faces a difficult choice on when to cut rates.

While we are not advocating that one of the reports is more accurate than the other, we do believe the strong Nonfarm number of new positions is overstated. Our view is based on the available evidence. For example, we note that the Institute for Supply Management Services Purchasing Managers Employment index has been in contraction for four straight months and five of the past six months, which has typically been tied to weak or negative payrolls. Meanwhile, hiring announcements from outplacement firm Challenger Gray and Christmas have plunged to the lowest levels since 2009, while layoff announcements have remained elevated.  

Given the size of the job losses showing up in the Household report, investor attention has turned to the so-called “Sahm Rule” for predicting where the economy is headed.  
According to this rule, developed by former Federal Reserve Economist Claudia Sahm, since at least 1948, every time the three-month moving average of the national unemployment rate rose by 0.5 percent or more from the previous 12-month low, a recession has followed. Nationally, the rise in unemployment remains just shy of triggering the Sahm Rule. However, as shown below, state-level data shows 21 states have already crossed the threshold, which has not occurred in the prior 50 years without a recession following.  

Given still-elevated inflation and wage growth and a mixed picture on the employment front, the Fed faces a difficult choice on when to cut rates. Certainly, the Fed wants to guide the economy to a soft landing—that’s always their hope. However, history shows that those hopes are rarely, if ever, realized. Given the impact a tight job market and higher wages can have on inflation, we believe it would be very difficult for members of Fed to justify cutting rates when nearer-term inflation measures are flashing yellow, and wages remain above the 3 to 3.5 percent level that the Fed believes is consistent with sustainable 2 percent inflation. Simply put, perfectly slowing the labor market enough but not too much has proven elusive in the past, and we don’t believe this time will be different. The labor market is a lagging indicator and, unfortunately, the indicator the Fed relies upon to begin cutting, which means the Fed is almost always too late in adjusting rates to stave off a recession.  

The lagged impact of rate hikes 

The longer rates stay elevated, the greater the impact they will have on the economy. While it seems like we have been discussing elevated interest rates for a long time, the reality is that in economic terms it hasn’t been that long. Historically, the average time between the first rate hike and the arrival of a recession is 2.5 years. The past eight recessions have begun between four and 16 quarters after the first rate hike in a tightening cycle. As of the end of June, the current rate hike cycle will be entering its 10thninth quarter, which is average for the starting time of the prior eight rate hike cycles.  

Signs of strain in the banking sector in the spring of 2023 caused many, including us, to fear that the rapid pace of the prior rate hikes was threatening to pull the economy into a recession. However, while the economy wobbled, it doesn’t appear to have broken. While the pace of rate hikes was aggressive, the impacts were delayed, as an economy awash in stimulus money was somewhat insulated from the effects of higher borrowing costs. Over the past few quarters, we have witnessed a growing divide between consumers/companies who are being impacted and those who are not.  

The New York Federal Reserve’s Quarterly Report on Household Debt and Credit for the first three months of this year showed that while overall delinquencies are ticking higher, they remain below historical levels. However, a closer look shows that delinquency rates among borrowers at lower income levels, where excess savings have been exhausted, are rising. Additionally, while delinquency rates are still relatively low, loan categories that typically are more interest rate sensitive and that reprice more quickly have seen a meaningful increase. Indeed, the flows into serious delinquencies (90 days plus) on credit card and auto loan debts are above levels that were seen during the recession of 2001 and that of 2007 to 2009.  

Further, we note that consumers are devoting more of their disposable income to servicing non-mortgage interest payments. Non-mortgage interest payments compared to income levels are now at levels consistent with the prior three recessions. Consumers have been able to afford these interest costs thanks to rising wages. However, companies are feeling the pinch from elevated payroll and input costs. Here, too, the impact is being felt unevenly, with small business noting that input costs are a growing concern, especially against slowing demand. Given that consumers have begun pushing back on higher prices, margins for businesses are likely being squeezed. Eventually, we expect some businesses may be forced to consider job cuts to protect profit margins. 

In contrast, consumers whose debt is mostly held in fixed-rate mortgages have felt less bite from higher rates. That may also be changing. Home equity lines of credit (HELOCs) grew by $30 billion in the first quarter and have grown 14 percent over the past two years, according to a recent report from the New York Federal Reserve bank. For context, the recent increase breaks a streak of 10 years of declining usage of HELOCs.  

The rise in wealth due to higher equity prices has likely offset some of the drag on the economy from higher rates.

We also note that large companies with lower debt levels have not been impacted as much by interest rate hikes. However, the longer rates remain high, the more the impact of rates will be felt as companies issue more debt at higher rates. Interestingly, over the past few months we have seen more stories of commercial real estate assets selling at depressed prices. This shows the limits to the strategy of extending loans in hopes of refinancing at lower rates when the Fed is forced to take a higher-for-longer approach.  

Early in the Federal Reserve’s fight against rising prices, it consistently pushed back against easing financial conditions—including in equity markets. However, the Fed has been largely silent on the recent rise in stock prices, which has likely helped ease financial conditions by creating a wealth effect. The rise in wealth due to higher equity prices has likely offset some of the drag on the economy from higher rates. Additionally, the rise in equity prices and corresponding increase in valuation multiples may add more risk for investors should the economy cool. But while the Fed has been less vocal about the risk, it has recently popped up on its radar once again. In the minutes from the May Fed meeting, members noted the following.  

On balance, the staff continued to characterize the system’s financial vulnerabilities as notable but raised the assessment of vulnerabilities in asset valuations to elevated, as valuations across a range of markets appeared high relative to risk adjusted cash flows.  

The final word 

Based on the data we track, we’re fairly certain we’re in the late innings of an economic cycle. But much as in actual baseball, it’s difficult to predict just how long that inning may last. Rather than attempting to time the arrival of a recession, we continue to focus our commentary and investing on the “more certain” reality of the economic cycle as represented by the output gap. While this measure is also subject to estimation risk, we continue to believe the weight of the data supports our theory. This reality—and the risk it brings—continues to help guide our asset allocation decisions.  

Since the end of COVID, we have been repositioning our portfolios to reflect the ever-changing fiscal and monetary backdrop and our belief that these evolving conditions will lead to new opportunities in the years ahead. In many cases these opportunities arise in less obvious places.  

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

Within this broad stock to bond framework, we are focused on valuation while also paying heed to the ever-growing concentration risk that exists in U.S. Large Cap equities.

With our shift to a focus on the business cycle in 2023, we concluded that inflation was becoming “stickier” because it was increasingly tied to a lack of slack in the job market and an economy running out of capacity. Against this backdrop, we continued to trim our overall equity exposure to today’s current slight underweight. At the same time, we’ve increased our allocation toward investment-grade fixed income, which saw an aggressive move higher in yield in 2022 and now possesses real value and acts as a hedge against a recession. As a result, our portfolios are now slightly underweight equities and commodities while overweight fixed income. We believe this positioning aligns with our economic outlook that a recession lies on the horizon in the not-too-distant future. Given market movements of the past few months, our positioning is once again contrarian, but we believe it should end up much like our previous moves when viewed in hindsight.  

Within this broad stock to bond framework, we are focused on valuation while also paying heed to the ever-growing concentration risk that exists in U.S. Large Cap equities. Valuation is neither an instant gratification approach nor a perfect timing tool, but we believe it wins in the intermediate to long term. Given this backdrop we recently shifted some of our Large Cap exposure toward the S&P equal weight index from the market cap weighted index. This move was made in response to the concentration of the top 10 names coupled with their ever-expanding valuation.  

Large Cap secular growth stocks have proven more resilient in the market, while smaller stocks and those tied to more rate-sensitive parts of the economy have struggled. This has led investors to push up these secular growth stocks, likely rationally given that is where the earnings growth has been. What may prove to be irrational, however, is the level of premium being paid for these handful of names. This is particularly true given the uncertainty around how long these businesses can produce extraordinary earnings growth. We recognize that the largest names are where the profit growth has been in this uneven economy, and this is where the sizzle of the AI stories lie. However, the question remains whether valuations are in line with the risks that may surface in the future.  

This month we further increased the quality and duration of our fixed income portfolios with the addition of high-quality, long-duration U.S. Treasurys. The addition pushes our duration/maturity profile to near a maximum level.

We also remain overweight Small and Mid-Cap stocks, which may seem counterintuitive given that small businesses tend to be more economically sensitive and we expect a recession. However, relative to their Large Cap peers, these stocks trade at discounted valuations not seen since the late 1990s. Back then, the discounted prices translated to years of outperformance in the 2000s. Earnings expectations for these smaller companies remain low. We believe the valuation discount inherent in these stocks shows that they have likely discounted some recessionary worries. We also note that these asset classes give us optionality. If our base case of a recession does not unfold in the near term, we believe it will most likely be because the Fed can cut rates, which would alleviate pressure and cause the economy and markets to broaden. As the market broadens, we expect that small and medium-sized companies will benefit. 

On the fixed income side, we continue to focus on quality and extending the duration of the portfolio. This month we further increased the quality and duration of our fixed income portfolios with the addition of high-quality, long-duration U.S. Treasurys. The addition pushes our duration/maturity profile to near a maximum level. We believe the result of this helps us lock in longer-term yields while adding to an asset class that historically has done well in recessions, especially when the Fed is forced to aggressively cut rates and inflation is moving lower.  

Before making adjustments to our portfolios, we always ask ourselves what could go wrong. Certainly, continued heightened inflation and rising debt levels are risks. However, we believe that the potential rewards justify the positioning. We note that the Fed knows how to kill inflation and can wield higher rates if necessary to control price pressures—just as it did in the early 1980s. And in the event of a soft landing, we believe it is likely that interest rates will have stabilized. And yes, we acknowledge that it’s an election year, and as of now it doesn’t appear that either party is willing to tackle the large and growing deficit we have. We note that certainly this could impact Treasury yields, but if that were to be the case, equities might perform worse; ultimately, the discussion is likely to evolve back to fiscal prudence.  

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

U.S. Large Cap 

The late 2022 to early 2023 consensus recession call has completely reversed to a near-unanimous view that the U.S. economy is comfortably on the path to a soft landing. This dramatic shift in investor optimism has propelled the S&P 500 to new all-time highs, pushing the forward 12-month price/earnings multiple (P/E) firmly into the top decile on a historical basis of this important valuation metric. Furthermore, expectations for 2024 and 2025 earnings growth are now in double-digit territory (11.0 percent for 2024 and 12.4 percent for 2025). To put it bluntly, we don’t share this renewed optimism given that interest rates are in restrictive territory, banks are tightening lending standards, consumer confidence is eroding, and the labor markets are showing signs of cracks. We also wonder what might happen to earnings if the tailwind of disinflation, which has helped margins the last few years, fades. We can get a sense of this risk by looking at the cyclically adjusted P/E that smooths out earnings over longer periods of time. Against this measure that adjusts down the outsized profit growth fueled by inflation and stimulus in 2021–2022, the S&P is trading in the top 5 percent of observations. While we understand that valuation is not a useful short-term timing tool, it does correlate well to expected returns over our intermediate- to longer-term investment time horizon. With that time frame in mind, we remain slightly underweight U.S. Large Caps while favoring asset classes in which expectations and valuations are at discounted levels.  

U.S. Mid-Cap  

We continue to have a positive view on U.S. Mid-Caps based on our intermediate- to long-term time horizon. We acknowledge that U.S. Mid-Caps are more economically sensitive and thus could be volatile in a mild recession, but that just may be what’s necessary for U.S. Mid-Caps to firmly move into a sustained trend of outperformance as we begin a new economic expansion. U.S. Mid-Caps trade at an attractive 15x 12-month forward earnings expectations, which is a discount to the forward earnings multiple of the S&P 500. We view this discount as attractive and likely unsustainable over our time horizon, as the historic trend of earnings growth for Mid-Caps is superior to that of U.S. Large Caps. With interest rates in restrictive territory along with banks tightening lending standards, this is impacting smaller and mid-sized firms that are more economically sensitive. As a result, these companies have seen earnings expectations revised downward to a greater degree than U.S. Large Caps. We see these headwinds turning to tailwinds at the start of the next economic expansion and want some excess portfolio exposure to a return skew that we believe will be favorable. 

U.S. Small Cap  

As investors collectively prioritize quality with the U.S. economy in late-cycle territory, U.S. Small Caps have struggled to keep up with less economically sensitive, higher-quality Large Caps. However, the higher-quality profile of U.S. Large Caps is coming at a premium, with valuations in the top decile of observations from our calculations and at levels not seen since the 1990s. Conversely, the S&P 600 currently trades at just 8x trailing 12-month cash flow, which historically is a level only seen during or just coming out of recessions. Valuation is not a near-term catalyst, but with a longer-term mindset, we view the potential relative return setup as one of the most favorable since this publication's inception. The best returns in any equity asset class generally occur when there is potential for strong earnings growth and valuation expansion. We see a mild recession as being the catalyst for this type of environment for U.S. Small Caps and patiently remain overweight. 

International Developed Markets 

After stagnating last year, the eurozone has recently experienced stronger performance. Gross domestic product (GDP) growth rebounded during the first quarter of 2024. A move higher in real wages coupled with declining inflation and the European Central Bank’s (ECB) June rate cut will likely provide a tailwind to the economy. Notably, the region has recently seen a rebound in its services sector, with the Purchasing Managers Index (PMI) climbing well above 50. Manufacturing has been a drag on GDP, with PMIs in contraction since mid-2022. Structural headwinds for Germany have lengthened the economic bloc’s manufacturing contraction. A prolonged energy transition coupled with China’s industrial sector weakness and the broader impact of competition from EV automakers has weighed on growth.  

Much as in the U.S., the question remains on the future path of inflation, especially against a historically low unemployment rate and heightened wages growth. ECB President Christine Lagarde cautioned at the June press conference announcing the cut that decisions on future rate cuts were “not following a pre-determined path” and that “there could be phases in which we leave interest rates unchanged.” And much like our commentary on the importance of wage pressures in the U.S., Lagarde noted, “We need to wait and see how labor costs develop.”  

Meanwhile, Japan’s economic performance has received significant attention from global investors of late. For the first time in a generation, Japanese core inflation looks poised to sustainably achieve the Bank of Japan’s 2 percent target. Growth has been at an above-trend pace as the economy continues its delayed bounce back from the pandemic and consumption is supported by historically rapid real-wage growth. 

At the same time, the marked weakness of the yen has become a heated political issue in Japan. The economy is heavily dependent on imported commodities, especially oil. When the currency weakens, the domestic cost of commodities rises. Bank of Japan Governor Kazuo Ueda downplayed yen weakness in April; however, after recently meeting with Prime Minister Fumio Kishida, the central bank’s communications have taken on a hawkish tone, leaning toward paying more attention to yen depreciation. In response, the Japanese Ministry of Finance has intervened in the foreign exchange market, but these efforts are getting only limited traction. The underlying driver of the weak yen is the gaping differential of interest rates versus the U.S. and other developed-market economies. With the Federal Reserve signaling increased patience, investors have increasingly looked to the Bank of Japan for a policy response. The Bank of Japan recently took rates back to zero, but sustained rate hikes to support the currency would risk compromising the economy’s recovery. 

The aforementioned commentary shows the nearer-term uncertainty in both the eurozone and Japan, where (much as in the U.S.) it appears as if each is at a possible tipping point, which warrants caution for the near term. The stock markets of Europe and Japan continue to post strong returns, with Japan’s Nikkei 225 still sitting near 35-year highs and the Euro Stoxx 50 nearing 25-year highs. While we retain a neutral allocation to the asset class, we believe international developed markets offer positive fundamentals over the intermediate to long term. Cheap relative valuations are likely to lead to positive future returns that we believe will be attractive for U.S.-based investors, as these countries' cheap currencies have the potential to appreciate relative to the U.S. dollar in the coming years.  

Emerging Markets 

Since bottoming in mid-April, emerging-market stocks have been one of the best-performing asset classes, led by outperformance in China. We noted in the last Asset Allocation Focus that signs that the Chinese government was more willing to intervene and provide stimulus to markets were increasing, and we cited examples (such as a recent rate cut on five-year prime loans, reducing reserve ratio requirements, and the application of some trading restrictions on institutional investors to reduce equity holdings at the open or close of markets). Since then, some additional measures have been instituted. They include the Chinese government and state-linked institutions buying stocks to support markets and the State Council issuing “9 Key Points” to improve China’s capital markets. Examples of these points include limiting IPOs and encouraging dividend payments and share buybacks. China’s property market has also improved as the Chinese government rolled out targeted stimulus measures, such as lowering mortgage rates and required down payment ratios as well as providing a re-lending facility for state-owned companies to buy unsold homes. These pro-growth, pro-market measures are notable and something we will continue to monitor. We also note that geopolitical risks between U.S. and China, increasing debt and poor demographics all remain as short- and longer-term challenges for the Chinese economy. 

Other developing-market countries have also performed well with outperformance in countries such as India; equity markets have recently hit all-time highs as investors continue to invest in the Indian growth story. India is one of the fastest-growing economies in the developing world and now the fifth largest economy in the world. While the recent Indian election caused volatility as Prime Minister Narenda Modi’s party lost ground, markets quickly recovered losses. Demographics are very favorable with a young and tech-savvy labor force. 

Turning to Federal Reserve policy, in our view, this is a nearer-term tailwind for the U.S. dollar as the Fed leaves rates higher for longer while governments in emerging markets, such as China, cut rates and/or provide additional types of economic stimulus. This has the potential to increase capital flows out of the developing world to opportunities with a better risk/reward trade-off. We’ve talked about our belief that dollar weakness at the end of 2023 would likely be short-lived. Indeed, we’ve seen strength in the greenback in recent weeks as expectations for a Fed rate cut have been dialed back. This has been a headwind for outperformance in international developed and emerging markets.  

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

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

While many investors continue to seek the perceived shelter of higher yields at the front end of the yield curve, we believe the current economic backdrop is increasingly favoring a shift toward intermediate- to longer-term fixed income. The reality remains that bond yields today are near the highest levels since the 2005 to 2008 time period. In other words, it has been 16 years since bonds have offered this level of potential income. That is an attractive backdrop, especially given our forecast that a likely recession will stomp out inflation. No one knows with precision where rates will be in the future, and investors need to recall that investing only in shorter-term securities brings reinvestment risk into the conversation should rates fall.  

We also note that currently Treasurys offer not only attractive yields but also a cushion against rising rates and the potential for nearer-term capital appreciation if rates fall during a recession. Consider the return skew on a 10-year constant maturity Treasury. If rates rise by 100 bps over the next year, an investor would lose approximately 2.5 percent, while a move lower in rates by 100bps would provide a 12 percent total rate of return. We believe this is a favorable skew given our economic and market concerns, all the while providing attractive yields.  

We continue to overweight fixed income in our portfolios and this month have shifted our duration from neutral to now overweight relative to the Bloomberg Aggregate Index. We also 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 vehicle for real income generation and can also provide risk mitigation against the potential for falling equity prices.  

Duration  

At the beginning of the year, there were upward of six 25-basis-point cuts priced into all markets. As of this writing expectations have diminished to just two cuts toward the end of the year. With this shift, spreads have compressed even more (from already very tight levels), and Treasury rates have risen modestly through the year. We believe this has created an opportunity to increase the duration of our portfolios. Simply put, we remain skeptical of the soft-landing narrative and continue to view high-quality duration as a hedge against an uncertain economic environment.  

Government Securities/TIPS 

We continue to favor high-quality bonds, including Treasurys and other government-sponsored securities. The flow of Treasury issuance will remain heavy in 2024, which we believe will likely create volatility. The second quarter of 2024 has seen a nearly 50 percent increase in net Treasury issuance, and we expect this to put upward pressure on interest rates. However, given the continued tightening of credit spreads and the significant decrease in implied volatility along the yield curve, we think adding to Treasurys is appealing. Generally, as rates (real and nominal) rise, increasing the credit quality of portfolios has been shown to be a wise move. We see the current backdrop as an opportunity worth taking in the Treasury market today. 

Uncertainty about the path of inflation has caused volatility this year for one-year Treasury Inflation-Protected Securities (TIPS). Longer-dated TIPS have been much more stable, seemingly anchoring inflation expectations five to 30 years out at about 2.3 percent. But the path to that rate could be bumpy. This inflation anchoring sits about 30 basis points higher than during the 2010–2020 time frame. Given our analysis that the Fed will ultimately succeed in snuffing out inflation, we continue to favor nominal coupon-yielding Treasurys over TIPS.  

Credit 

Credit spreads are, by some measures, as tight as they ever have been. This, to us, is a clear sign that the economy keeps chugging along and investors are expecting a soft landing. The Sherman Ratio (a measure of yield relative to a unit of duration, whether it be outright duration or spread duration) has hit a 40-year low in spread duration (more or less credit spread) space. If a recession does arrive, these spreads are risky. We continue to favor high quality to very high quality.  

Municipal Bonds 

Consistent with previous rate cycles, appetite for municipal bonds evaporated when yields were low (and munis were cheapest) and have since spiked as rates climbed and munis became expensive. When rates rise—and they have significantly outperformed their taxable counterparts (to the tune of 800–1,000 basis points total return)—investors seemingly flock to them. The muni curve is also inverted, a condition that is extremely rare for this asset class. There have been inversions for short periods of time, mostly on the front end, but this inversion is real; this means allocating capital focusing on one- to three-year maturities and eight- to 15-year maturities. 

Real assets are an integral part of diversified portfolios due to their ability to help serve as a hedge against unexpected inflation and their typically low correlation to stocks and bonds. We believe these attributes make real assets an important consideration in constructing resilient portfolios over economic cycles. The period from 2021 to 2022 provided a look at the value of this diversification with the standout performance of commodities in response to rising inflationary pressures and the Russian invasion of Ukraine. The sharp decline in real interest rates from 2010 to 2012 and exceptional performance of real estate are other examples of the value of this diversification approach. Put simply, sharp changes in inflation and real interest rates are very difficult to time precisely, which underscores the potential benefit of having a dedicated allocation to this asset class. 

While the stock market is expecting an economic soft landing, we continue to believe the Fed’s most aggressive tightening campaign in over 40 years will end in a mild recession. With that as our base forecast, we think it’s likely inflation pressures will ease in a weakening economy. As a result, we have an underweight position in commodities to fund an overweight position in fixed income. 

As we mentioned earlier, real assets can be very sensitive to changes in inflation-adjusted interest rates, with real estate being the clearest example. While REITs have seen outsized impacts from the pandemic, they have also been under pressure from a dramatic 300-basis-point surge in real rates during the last two years. A hesitancy among banks to lend to the sector at a time when vacancies are rising and rents are moderating is also weighing on fundamentals for the sector. We remain underweight to the group but want to point out that changes in real rates impact real estate more than any asset class in our portfolios. Current real rates are near 20-year highs, and when the Fed eventually cuts rates, real estate will likely respond positively given this sensitivity. We’re not there yet, but a recession might be exactly the catalyst necessary for a turnaround.  

Real Estate 

We have been tactically underweight to REITs for quite some time. Our analysis shows that real estate prices often depend on many factors but are largely a function of long-term interest rates and their expected future path. Indeed, when it comes to this asset class, the price of real estate is often directly but inversely proportional to the costs of financing. Indeed, the aggressive rate hiking cycle has had a negative impact on longer-duration assets, such as REITs. This is in stark contrast to the comparatively easy period for real estate prices during the ultra-low interest rate environment before and even during the early stages of the pandemic.  

To contain rising inflation, the Fed enacted 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 slowed, and affordability ratios for existing projects have continued to deteriorate. Lending standards at banks and other financing companies have also become more restrictive. These kinds of conditions are examples of the tightening that naturally occurs outside the direct control of the Federal Reserve and are a part of the long and variable lags that we carefully consider when we build our economic and market outlook. Tightening conditions in the real estate market may affect the supply, demand and pricing in this space for many quarters to come. 

We also recognize that the REITs asset class is very broad, and the various sectors that make up the marketplace are likely to have a fair amount of dispersion in their performance. While single-family home prices have held up well in the face of rising interest rates, other areas of the real estate market, such as commercial office space, have seen some severely distressed sale prices as supply and demand factors try to find a proper balance. Pockets of distress in some of these sectors persist and have caused problems for some financial institutions, forcing investors to consider whether these problems are idiosyncratic or systemic in nature. While we think that the risk of a systemic problem in real estate is low, the fact that economic data directly relating to real estate markets remains noisy, punctuated with ongoing stress for certain real estate lending and servicing institutions, gives us pause when evaluating this space. 

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, the fundamentals for this asset class remain uncertain given the current environment, which we expect to last throughout much of 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. 

Commodities 

Commodities rose significantly since the spring, joining the ongoing “risk-on” equity rally. The commodity asset class is diverse, and different commodities are influenced by different economic factors. This time, commodities have been driven by two very different commodities groups, specifically industrial metals and gold.  

For industrial metals, sluggish global economic growth—particularly in China—was a headwind earlier in the year. While global growth remains somewhat anemic, improving manufacturing data in March, April and May resulted in a swift rebound to aluminum, copper, zinc, nickel and lead prices. While prices have recently cooled from record highs in late May, they remain much higher than at the beginning of 2024, due in part to continued demand for green energy projects as well as meaningful supply constraints.  

Gold prices are not as sensitive to economic growth but do offer a hedge for investors concerned about ongoing inflation. Central banks continue to be buyers of gold, and demand outside the U.S. remains strong. Gold is currently priced near all-time highs.  

The energy sector—notably oil—has stabilized after surging earlier in the year. OPEC+ has extended its voluntary production cuts, which place a floor on oil prices. Energy markets continue to trade with a geopolitical premium due to potential disruptions related to the Russia-Ukraine War and the events affecting shipping in the Red Sea. Surprisingly, strong U.S. production of oil last year pressured prices, but domestic production is expected to moderate going forward. Gasoline demand is expected to be strong as we enter the summer driving season. Natural gas prices have temporarily bottomed after a staggering drop over the last nine months. A warm winter had a negative impact on natural gas demand, and markets were significantly oversupplied. A forecast for an abnormally hot summer could reverse this trend, but prices remain very low.  

Agricultural goods were the only group posting modest declines due to ample supply given strong harvests in wheat, corn and soybeans. Coffee and cocoa experienced a strong price surge due to adverse weather in key global regions. 

Going forward, primary catalysts for higher commodity prices are the reemergence of demand from China, a return of higher inflation expectations, and a weakening U.S. dollar. In energy, persistent underinvestment, additional OPEC+ production cuts, and potential disruptions related to the Russia-Ukraine War and the events impacting shipping could add additional pressure in the oil and grain markets.  

For some time, we have believed that global growth (excluding the U.S.) would remain sluggish and that inflation would moderate. Commodity asset class performance over the last year reflects these concerns. Commodity prices are up approximately 5 percent year to date; they fell 7.9 percent in 2023, gained 16 percent in 2022, and gained 27 percent in 2021. Overall, we continue to believe the commodity asset class offers positive return potential and significant diversification benefits. 

This summer promises to be busy and likely emotional as markets continue to debate the progress on inflation’s demise and a U.S. economy that is likely to continue slowing. Throw in a U.S. election season that will shift into overdrive, and the next few months have the makings for a potentially volatile market. Certainly, we acknowledge that presidents are important and encourage you to vote. However, we implore you not to vote with your portfolio. The U.S. economy is large, and it’s hard for any single person or even political party to dramatically shift it during the course of a four-year term in office. At Northwestern Mutual, we’ve been around for 167 years—through all sorts of different political climates. A big part of our staying power is based on our ability to think in terms of not just the next few years but the next few decades.  

The winner of the election is going to inherit what appears to be a late-cycle economy with a low unemployment rate and an equity market that’s trading at historically high valuations. Since 1960, seven presidents have taken office late in a similar economic climate. Five of these seven presidents had recessions occur during their time in office. The two that didn’t passed them to the next person to come into office. All seven of these presidents saw lower forward market returns during their terms—an average of 6 percent.  

Contrast that with presidents who enter office right after a recession or when the economy is still in the mid-stages of a business cycle. We have had nine presidents enter office in this condition, and only three were in office during a recession. President Trump experienced the impacts of COVID, while Presidents Carter and Reagan saw recessions in the late 1970s and early 1980s. The key is that during early and mid-stage economies, the unemployment rate was higher (7 percent), which means there were plenty of workers to bring back into the labor market and the inflation adjusted P/E was much lower (20x). As a result, each of the nine presidents in office during the early and mid-stage economies saw double-digit annualized returns (an average of 14%) while they were in office.  

While we acknowledge the sample size here is relatively small at 16, we believe it helps paint a picture of the importance of the economic cycle to the outlook for the U.S. economy. Whoever is elected in November will likely preside over a recession during their term, with the probability of lower future returns. However, the returns in the chart are the S&P 500. We believe that other segments of U.S. markets may provide attractive opportunities for investors in the coming years.  

We acknowledge that presidents often have specific agendas under the umbrella of the larger U.S. economy and that their impact on sectors/ industries and companies can be larger. However, even here we point out it is not the only factor. You can find a clear example of this during the recent two presidential terms. During the Trump presidency, the worst-performing sector was energy. During the Biden presidency, despite the recent surge in tech stocks, energy has been the best performer. The reason has nothing to do with either president or his policies. It was primarily driven by the impacts caused by COVID. Larger forces outside a president’s control can have a bigger impact than the president. 

As we approach summer, we think it’s time to get ready for more volatile markets.

We pay heed to the political backdrop but do not let it drive our outlook and encourage you to not let it drive your investment decisions. This does not mean elections are unimportant from a financial perspective; indeed, the outcome of the November election will help decide the fate of the Tax Cut and Jobs Act (TJCA), which expires in 2025. This is a potentially important event for tax policy, and if you have questions about how it may impact you, we encourage you to reach out to your advisors.  

As we approach summer, we think it’s time to get ready for more volatile markets. Periods of volatility are one of the most important times to stick with your plan and remember that a recession does not mean lack of market opportunity. We continue to believe patient long-term investors will win the financial security quest. Work with your advisor on a plan that includes a strategic long-term asset allocation that allows you to meet your goals and objectives. Stick to that plan overall. Tweaks to a strategic allocation like the ones described in this commentary are made with the goal of adding diversification to help you meet your long-term goals a bit more quickly and comfortably.  

The opinions expressed are those of Northwestern Mutual Wealth Management Company as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute individual investor advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and nonproprietary sources.  

Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company (NM), Milwaukee, WI, and its subsidiaries. Investment brokerage services are offered through Northwestern Mutual Investment Services, LLC (NMIS), a subsidiary of NM, broker-dealer, registered investment adviser, and member FINRA and SIPC. Investment advisory and trust services are offered through Northwestern Mutual Wealth Management Company® (NMWMC), Milwaukee, WI, a subsidiary of NM and a federal savings bank. Products and services referenced are offered and sold only by appropriately appointed and licensed entities and financial advisors and professionals. Not all products and services are available in all states. Not all Northwestern Mutual representatives are advisors. Only those representatives with “Advisor” in their title or who otherwise disclose their status as an advisor of NMWMC are credentialed as NMWMC representatives to provide investment advisory services. 

Please remember that all investments carry some level of risk, including the potential loss of principal invested. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss.  

Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market.  

With fixed income securities and bonds, when interest rates rise, bond prices usually fall because an investor may earn a higher yield with another bond. Moreover, the longer the maturity of a bond, the greater the risk. When interest rates are at low levels, there is a risk that a significant rise in interest rates can occur in a short period of time and cause losses to the market value of any bonds that you own. At maturity, the issuer of the bond is obligated to return the principal (original investment) to the investor. High-yield bonds present greater credit risk than bonds of higher quality. Bond investors should carefully consider risks such as interest rate risk, credit risk, liquidity risk, securities lending risk, and repurchase and reverse repurchase transaction risk. 

Investing in special sectors, such as real estate, can be subject to different and greater risks than more diversified investing and may present more financial and other risks than investing in companies of larger capitalizations and more seasoned companies. Declines in the value of real estate, economic conditions, property taxes, tax laws and interest rates all present potential risks to real estate investments. 

Investing in real estate companies entails some of the risks associated with investing in real estate directly, including sensitivity to general and local economic and market conditions, demographic patterns, changes in interest rates and governmental actions.  

Investors should be aware of the risks of investments in foreign securities, particularly investments in securities of companies in developing nations. These include the risks of currency fluctuation, of political and economic instability and of less well-developed government supervision and regulation of business and industry practices, as well as differences in accounting standards. 

Commodity prices fluctuate more than other asset prices, with the potential for large losses, and may be affected by market events, weather, regulatory or political developments, worldwide competition and economic conditions. Investment can be made directly in physical assets or commodity-linked derivative instruments, such as commodity swap agreements or futures contracts. 

Treasury Inflation-Protected Securities (TIPS) are securities indexed to inflation in order to protect investors from the negative effects of inflation. 

The U.S. Large Cap asset class is measured by the S&P 500 Index, which is a capitalization weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The gross domestic product (GDP) is the amount of goods and services produced in a year in a country.  

The U.S. Mid-Cap asset class is measured by the S&P MidCap 400 Index, which is the most widely used index for mid-sized companies and covers approximately 7 percent of the U.S. equities market.  

The U.S. Small Cap asset class is measured by the S&P Small Cap 600 Index, a market value weighted index that consists of 600 small cap U.S. stocks chosen for market size, liquidity and industry group representation.  

The International Developed Markets asset class is measured by the Morgan Stanley Capital International Europe, Australasia, and Far East (MSCI EAFE) Index, which is composed of all the publicly traded stocks in developed non-U.S. markets. The MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.  

The International Emerging Markets asset class is measured by the MSCI Emerging Markets Index, which is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging-market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.  

The Real Estate asset class is measured by the Dow Jones U.S. Select REIT Index, which intends to measure the performance of publicly traded REITs and REIT-like securities. The index is a subset of the Dow Jones U.S. Select Real Estate Securities Index (RESI), which represents equity real estate investment trusts (REITs) and real estate operating companies (REOCs) traded in the U.S. The indices are designed to serve as proxies for direct real estate investment, in part by excluding companies whose performance may be driven by factors other than the value of real estate.  

The Commodities asset class is measured by the Bloomberg Commodity Index (BCOM), formerly the Dow Jones-UBS Commodity Index, which is a highly liquid, diversified and transparent benchmark for the global commodities market. It is calculated on an excess return basis and reflects commodity futures price movements. 

The Consumer Price Index (CPI) examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.