Risks and Opportunity in a Post-Pandemic Economy

In 2020, a once-in-a-century global pandemic upended the world. It forced us to rapidly reassess our outlook and reposition our portfolios. Our goal was to reflect a broadly disrupted economy that we expected to fully recover once key milestones were achieved. Today, as we look ahead to summer 2021, the pandemic is in full retreat. Those milestones we outlined back in 2020, during the darkest days of the pandemic, have all been reached. Now a rapidly recovering economy is beginning to look like a booming economy.

Our recovery thesis last year outlined four critical steps to a post-pandemic economy: aggressively deploy monetary and fiscal policy to bridge a decline in economic activity, bend the virus curve, allow businesses to adapt and operate safely while the virus circulated and, finally, discover and widely distribute an effective vaccine.

Alongside our fourfold economic framework, we also revised our allocation strategy to capture tailwinds in parts of the economy that benefit during the early stages of a recovery. For us, that meant increasing our equity allocations during the height of the crisis in April 2020, particularly in cyclical sectors and asset classes, and adding more exposure to value stocks in August. It was a view shaped by history, as cyclicals tend to outperform at the beginning of an economic recovery. And we believed cyclicals were poised for a particularly robust upswing, given their historically cheapened valuations and our forecasted pace of recovery.

Our thesis proved extremely accurate, and cyclicals staged a prolonged rally that took hold in the second half of 2020 and continues today. Economic growth in the U.S. looks set to remain strong — the U.S. consumer is sitting on $2.2 trillion in savings, the pace of vaccinations is ahead of schedule, COVID-19 is in retreat, stadiums are filling to capacity, and the country is fully reopening. The momentum is also building internationally, particularly in the eurozone, where the pace of vaccinations is underpinning a reopening recovery.

Throughout 2020, we reminded investors to be patient; all signs showed there was light at the end of the tunnel. We’re now exiting the tunnel, which begs an important question: “What are we looking at through the windshield?”

A shifting economic and market narrative

Every move by policymakers over the past year had one outcome in mind: Return the U.S. and global economies to growth as quickly as possible. Indeed, the Fed and Capitol Hill worked quickly and in tandem to provide waves of relief, to the tune of trillions of dollars, in an all-hands-on-deck effort to backstop and kickstart the economy. If more stimulus was needed, more was made available.

Policymakers are seeing the economic growth they wished for, and now the conversation is shifting to the potential side effects (think inflation) of the economic medicine and how to pay for it (think taxes). In our Q1 market commentary, “Descending from the ‘Easy Policy Summit,’” we stated our belief that stimulus side effects would be the market’s chief concern and would likely lead to increased volatility.

The arrival of President Biden’s fiscal policy proposal has further stoked concerns about inflation and taxes. But thus far, markets have rightly shrugged off these fears. For one, while tax policy is likely to tighten, a divided Congress should limit the severity of any increase. Fiscal policy, overall, will also remain a tailwind for markets and the economy in the near and intermediate terms.

Inflation concerns are rising, but the market is pricing in transitory inflation rather than persistent inflation. The Fed also sees the current uptick in inflation as transitory and is unlikely to change its easy money policies. Keep in mind, the Fed’s dual mandate is to keep inflation on target and maximize employment. We think the Fed’s focus will shift to its employment mandate, and therefore it won’t pull its support for the economy and risk cutting off a recovering jobs market. The Fed is going to sit on its hands as long as possible.

The recovery has been rapid, and some are worried we’ve reached a peak. But we see too many economic tailwinds, coupled with growth abroad, to call a peak. As a result, we believe we may be reaching an extended plateau of strong economic growth. In our base case, the current macroenvironment remains conducive for investors.

In our view, we’re likely exiting the earliest recovery stage of an economic cycle, when market returns are typically the largest. And it’s a cycle that’s advancing quickly — contemplate that the U.S. unemployment rate could return to its pre-pandemic lows as early as late 2022. We’re quickly moving toward the middle stages of the cycle. We believe the question investors must begin asking now is, “How much time do we have left in the economic and market cycle?”

The answer will be revealed in much the same way it has been in cycles past. In other words, we’re no longer in a highly unusual pandemic economy; we’re back to more traditional economics. And traditionally, economic cycles end when the U.S. economy runs out of slack, triggering inflation, which ultimately compels the Federal Reserve to raise rates and cool off the economy. In many cases, a recession follows when the Fed is forced to play its cards aggressively.

Nearer-term inflation pressures are temporary

Over the past few months inflationary pressures have risen and are already beginning to cause market consternation. Indeed, the Fed’s preferred measure of inflation, the U.S. Personal Consumption Expenditures (PCE) Core price index was reported at 3.1 percent year over year — the highest reading since 1992. Every single economic data point hints at continued inflationary pressures over the coming months, which has many questioning what’s next.

In the nearer term, we believe that the spike in prices is due to base effects (low inflation last year) and supply chain disruptions meeting a tidal wave of post-pandemic consumer demand. This is not uncommon or unexpected at this point in the economic cycle. After most recessions, there’s a spike in inflation that subsides as supply ramps back up to meet demand.

We expect the supply side will begin to catch up in the coming months. There’s also good news on the demand front, as consumers appear to be slowing purchases as prices increase. Indeed, both the University of Michigan Consumer Sentiment Survey and Conference Board Consumer Confidence survey witnessed declines in the expectations component, largely because of rising prices affecting purchasing plans. It sounds like bad news, but it’s a good sign that demand will be pushed out a bit and allow supply chains — and prices — time to recover.

A large component of inflation is how consumers react to price spikes. Do they pull back spending, or do they rush to buy in front of their peers and trigger a price spiral? As of now, all signs point to tempering inflationary pressures as we push toward year-end.

Intermediate-term inflationary questions are an open debate

The bigger inflationary question is about the intermediate term — think 2022 and beyond. Besides expectations, which remain tame right now, the biggest determinant of intermediate-term inflation is demand exceeding supply. We believe monetary and (especially) fiscal policy are going to persistently push on the consumer demand side of the equation during this economic cycle. The course of inflation will ultimately be determined by the supply side keeping pace with demand, which greatly depends on how many people work and how productive they are.

Over the past few years, a positive, underreported story has been unfolding. Productivity has quietly been rising on the back of corporate investment. Indeed, year-over-year productivity is up 4.1 percent and has been in an uptrend since the middle part of the past decade. A silver lining of COVID-19 is that companies have been forced to innovate in order to serve their customers. We likely had several years of technological improvements pulled forward to today. Indeed, recent research published by the McKinsey Global Institute estimates that productivity growth in the U.S. and Western Europe could increase by about 1 percent annually to 2024. This would increase our ability to meet demand with supply and keep inflation in check. If supply catches up, this economic cycle could continue ticking longer than many currently imagine.

The length of this economic and market cycle will be defined by the path of inflation and the Fed’s ultimate response to it.

While we believe the economic cycle still has room to run, we must acknowledge that risks are rising, especially regarding inflation and the unintended consequences of ultra-aggressive monetary and fiscal policy. While we believe there’s ample time left in the economic cycle, we must also be aware that we are progressing at a quick pace, especially in the U.S. While the Federal Reserve will have a high tolerance for rising inflation, their comfort could wear thin. Finally, the “easy money” in the U.S. has likely been made. We’re likely past the outsize gains typical of an early cycle recovery, and questions about where we are in the mid- to latter stages will become incredibly relevant going forward.

With this outlook, we continue to overweight equity vs. fixed income, but we determined it was prudent to pare it back. We are moving from a near max to a more moderate equity overweight. Because we think U.S. markets are more advanced in the cycle, we have returned our allocation to U.S. Mid-Caps to neutral.

We continue to believe the biggest risk is that this economy overheats rather than runs too cold. That’s why for the past year we’ve favored Commodities and Treasury Inflation Protection Securities (TIPs), which we overweighted in April 2020, to hedge against these risks. This is especially true given our belief that monetary and fiscal policymakers will not rush to extinguish an overheating economy. Keep in mind, not every country can turn a blind eye to inflation like the U.S.

The areas of the world that we believe are most exposed, or potentially harmed by a rapid rise in inflation, would be the Emerging Markets. In these economies, central banks are forced to raise interest rates to stem outflows from their currencies. This often leads to slower growth and the potential for sharp currency deterioration. While this is not our base case, we decided to trim our Emerging Markets overweight given rising risks. We are relocating these proceeds and tilting our International Developed exposure to the eurozone given our belief the region is on the precipice of strong growth and the European Central Bank (ECB) is prepared and equipped to ignore any nearer-term inflationary concerns. 

Overall, we remain overweight equities vs. fixed income (just less so than before) and are still positioned for a strong economic recovery. We remain tilted toward U.S. value and cyclical asset classes, with our only U.S. overweight being in U.S. Small Caps, which are attractively valued and leveraged to our base case of sharp cyclical growth. We are underweight REITs, but remind that in January of 2021 we moved REITs from max underweight to slightly underweight.

We remain overweight Emerging Markets (just less so than before) and are now slightly overweight International Developed Markets with our exposure tilted toward the eurozone, as we expect this to be the next economy to post explosive growth and a rapid market recovery.

After a strong rise in yields to begin the year, rates have recently leveled off and stabilized at current levels. Much like our commentary on the economy and equity markets, our belief is that a path forward remains for higher yields but with increasing uncertainty around that forecast. A potential nearer-term catalyst could be a continued rise in eurozone bond yields on the back of a strengthening economic recovery. Over the past few months, German bunds have pushed higher and in some cases are now trading at positive yields. If it continues, this trend could release an anchor that has held U.S. yields lower than what U.S. fundamentals alone would have dictated over the past few years.

While there may be upward pressure from the economic recovery and rising inflation, central banks in nearly all developed economies continue to exert downward pressure on yields. With heightened levels of debt across the globe, there will be no desire from policymakers to let yields rise too much. There is a lot of money sloshing around the globe that’s looking for a home, and that typically presents investors a choice of stocks or bonds. While we maintain an overweight to equities relative to fixed income, we believe it’s prudent to shift some of that overweight back to fixed income.

These are the choices that investors have to make: Where do you place money given your outlook, the available choices and your risk profile or capital needs? Please don’t consider this reallocation to fixed income as individually good or bad. Most importantly, don’t pull your portfolio and judge the merits of each individual slice without understanding how all the pieces interplay together. Given our desire to continue tilting our portfolios toward equity-risk exposure, we maintain our conservative stance toward our fixed-income holdings and favor high-quality, investment-grade bonds. With the U.S. yield curve now steepening and thus offering additional yield premium, coupled with the Fed’s desire to sit on the yield curve and not allow an aggressive rise in intermediate to longer yields, we continue to favor duration near benchmark targets.

Lastly, we have discussed the risk that inflation could surprise to the upside in 2021 and throw a wrench in policymakers’ best-laid plans. While we think the Fed will ignore any such rise in inflation and not tighten the economy into submission, we continue to hedge against this risk with an allocation to TIPS. We note that much of the “easy returns” have been harvested here, as inflation expectations have firmed from their COVID-19-influenced lows. Still, this is a worthwhile diversification instrument to an overall portfolio.

We have long stated our belief that Real Estate (REITs) was the asset class that was the “most COVID-19 impacted” and would likely be toward the end of the asset class recovery line. Put directly, REITs have the most structural issues to sort out in the intermediate to longer term from the pandemic, as companies and shops sort out their virtual vs. physical presence requirements. However, in January 2021, we determined that this reality was largely being reflected in REITs’ current prices, and we returned our max underweight to a slight underweight. As the world continues to open in 2021, we will be looking for opportunities to add to this asset class that has income-producing potential. If reopening is a tailwind, we believe a potential headwind could exist if government bond yields rise as the globe recovers and would likely contemplate any such sell-off to increase our exposure. 

We continue to hold a neutral allocation in Commodities due to their diversification benefits and correlation to unexpected inflation. Building portfolios is about hedging risks, and we believe these risks are continuing to evolve to more commodity-favorable growth and inflationary risks. Indeed, on a year-to-date basis commodities have surged near the lead of the asset class performance contest on the back of heightened demand and rising inflationary pressures. We realize that the aversion to this asset class is strong given its disappointing returns over the past economic cycle. However, we believe the future is likely to be much kinder given the economic backdrop shift coupled with undersupply and infrastructure spending. Within Commodities, we continue to favor broad exposure with a tilt toward gold given our desire to further diversify our portfolios to hedge against unintended consequences. Importantly, we remind that if inflation does rise but the Fed remains well behind the curve, gold will likely provide portfolios with a pressure relief valve given its propensity to be positively impacted by negative real interest rates.

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

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

At the end of our May 2020 Asset Allocation Focus, we stated our belief that the future economic expansion would likely be pulled by different leaders, and we showed how recessions tend to switch up market leadership during the ensuing economic expansion. While the composition, or leaderboard, changes with each recovery, the forces that ultimately upend a traditional economic cycle are pretty much the same. It will, once again, come down to slack in the economy and inflation. The key question going forward is how policymakers and society react — or don’t.

Long-term predictions tend to be dubious, but we do feel we are in a paradigm shift from cycles past. Fiscal policy is likely to remain highly engaged, as witnessed by the president’s new budget. The eurozone deployed its own relief and stimulus during COVID-19, and the aforementioned €750 billion Next Generation EU Programme is shared debt. Treasury Secretary Janet Yellen recently discussed the need for more unionization, and minimum wages are rising across the country. These are simply facts, not an assessment on whether the facts are good or bad. However, they certainly color our outlook.

On the monetary policy side of the equation, the Fed last year shifted from an inflation-fighting regime that Paul Volcker created in the 1980s to one that now is focused solely on employment, even if it means tolerating higher inflation. The Fed used to claim it ignored markets and focused on the economy. However, recall the Fed cut rates in 2019 not because of a change in its economic forecast, but, rather, Fed officials were “listening to markets,” which had fallen precipitously at the end of 2018 as the Treasury yield curve inverted.

What does this all mean? Investing success in this expansion is likely to be the result of ignoring recent history. Instead, as we showed in our May 2020 Asset Allocation Focus, you must look farther back to see that recessions have consequences. Decades of investing history show us that leaders change after recessions. To put it bluntly: What worked in the past may not work in the future. But recency bias seems to be running full tilt, with many investors in a hurry to run back to the safety of Large Cap U.S. growth stocks, largely because they performed well during the prior cycle. Investors dislike International stocks and Commodities because they underperformed during the prior cycle.

History doesn’t have to repeat, but it often does. We implore you to view this expansion with an open mind and forget about last expansions’ relative winners. At a minimum, diversification is here to help keep your financial goals on track. And your advisor is here to provide the roadmap, expertise, guidance and discipline to help you accomplish your financial goals.

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.

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% 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.