What Impact Will Inflation and the Business Cycle Have on the Markets?

This year started much like 2023 ended, with markets advancing sharply. Previously pessimistic investors seemingly scrambled to buy into the market based on their budding optimism that a soft (or even no) landing is on the economic horizon. Interestingly, while markets have moved steadily higher since late October 2023, the macroeconomic backdrop driving the advance has shifted dramatically over the past two months.  

From October of last year to mid-January 2024, economic data showing a slowing economy and faltering inflation readings drove interest rates dramatically lower and equity markets higher. The 10-year Treasury yield rose sharply from 3.75 percent in early summer to a peak just shy of 5 percent in late October before returning to 3.79 percent at the end of December. Similarly, the two-year Treasury peaked at 5.22 percent in October before dropping to 4.14 percent in mid-January. This pullback in interest rates set off a strong equity market rally from its October bottom. The move higher got an additional boost from Federal Reserve Chairman Jerome Powell’s press conference following the December Federal Reserve Board meeting. In remarks after the meeting, Powell made positive comments about progress in the fight against inflation while seemingly embracing the idea of rate cuts in 2024. Following those comments, investors expected a total of 1.6 percentage points in rate cuts this year, up significantly from expectations last October of 0.6 percent in total cuts for 2024. Heightened optimism about rate cuts emboldened investors, who increasingly believed the economy was in the clear since previous rate hikes hadn’t yet caused a recession and the Fed was set to cut rates going forward. The view resulted in a broad-based rally that saw stocks of all sectors and sizes rising.   

While the U.S. economy has wobbled but seemingly withstood the past 5.25 percent of rate hikes, we believe the longer rates stay elevated, the more they will filter into the economy.

Since mid-January, this macroeconomic backdrop has shifted. Economic data, especially survey data, has risen, as increased hopes for continued declining inflation and Fed interest rates cuts have created optimism among CEOs, business owners and consumers alike. Interestingly, even with strong growth, interest rates have moved only modestly higher. We believe that’s because of the market’s continued optimism on the inflation front. The result has been a slight pullback in 2024 Fed rate cut expectations, which have declined to “just” 75 basis points. Despite this change in backdrop, stocks have continued to rally, although investors appear to be hedging a bit as the once broad advance has again narrowed and is being driven by a select few Large Cap stocks. These names are viewed as benefiting from secular growth trends, such as artificial intelligence, and as such are believed to be more economically insulated.  

Despite the evolving outlook on Wall Street, our view has not changed. We continue to believe the most critical variable for markets in 2024 is inflation’s path. Simply put, we don’t share the market’s optimism that inflation is moving “sustainably” back to 2 percent. Instead, evidence points to price pressures reawakening. Given this backdrop we don’t see aggressive Federal Reserve rate cuts on the horizon and believe interest rates will remain elevated until a recession arrives. We’ll need to hit the end of the economic growth cycle to put the final nail in inflation’s coffin. While the U.S. economy has wobbled but seemingly withstood the past 5.25 percent of rate hikes, we believe the longer rates stay elevated, the more they will filter into the economy. This is likely to weaken consumers and corporations as the year progresses. While we forecast the Fed will eventually cut rates aggressively in response to a weakening labor market, our base case forecast remains that a mild recession still lies on the economic horizon. That’s because there is a delay from when changes in monetary policy are made and when they start to be felt in the economy. Additionally, once the labor market changes direction, the trend tends to accelerate. 

Transitory inflation is shifting to “sticky” inflation driven by the economic cycle 

Much as we forecasted, inflation pressures peaked and began faltering in mid- to late 2022 and throughout 2023. Indeed, there is growing evidence that price pressures were transitory—just as we believed when prices began to climb following the arrival of COVID. Importantly, our belief that inflation was transitory was driven by the underlying cause of inflation and not defined by time. We believed that the rise in prices that began mid-year 2021 were driven by the oddities caused by COVID and by policymakers’ actions as they aggressively attempted to bridge the deep economic valley the pandemic threatened to create.  

As a reminder, after COVID’s arrival in early 2020, monetary and fiscal policymakers flooded the economy with liquidity, resulting in a 26.9 percent year-over-year increase in the money supply between February 2020 and February 2021. With consumers largely stuck at home, this infusion of extra money tilted spending dramatically toward the goods market relative to services. The unprecedented surge in real goods spending occurred at a time when inventories were low, supply chains were snarled, and companies lacked workers. This combination sent goods inflation—as measured in the Consumer Price Index (CPI)—dramatically higher. Goods Inflation peaked at 12.3 percent by February 2022. That’s when the economy began to more fully reopen from its COVID-19 shutdown, and consumers who had binged on buying goods shifted their spending toward services. The result has been a dramatic pullback in goods inflation to its current level of negative 0.3 percent year over year as seven of the past eight months have seen outright deflation in the cost of goods.  

Just as goods inflation peaked and began to decline, Russia invaded Ukraine, which pushed up prices for food and energy. Prices for those categories peaked in the summer and fall of 2022. Since then, commodities inflation has pulled back sharply, with CPI for food checking in at 2.4 percent year over year and CPI for energy at negative 4.6 percent year over year. Lastly, the move toward service-sector spending that began in early 2022 served to accelerate service-sector inflation, which reached a peak in February 2023 at 7.3 percent year over year. The good news here is that as of January 2024, service-sector inflation has pulled back to 5.4 percent year over year. If you remove the lagged and outsized impact of shelter, services inflation fell all the way to 3.6 percent year over year.  

All of this has combined to push overall inflation and core CPI from their respective peaks in June (9.1 percent) and September (6.6 percent) of 2022 to today’s current levels of 3.1 percent and 3.9 percent, respectively. The falling-inflation narrative became market consensus in late 2023 when a large decline in inflation readings helped stoke the market’s recent rally from 4100 in October to 5100 today. Our belief that inflation pressures were temporary is why we were one of the few firms to remain optimistic at the depths of the market’s bottom at 3500 in October of 2022 (when core CPI peaked) and into 2023. 

However, our inflation forecast shifted in the second half of 2023 based on our view that the underlying cause of inflation was shifting from the transitory impacts of COVID to something “stickier”—the economic/business cycle. Simply put, we fear the economic gap created by COVID has been fully bridged, and the U.S. economy is reconnecting to a more historically “normal” business cycle. This reconnection is occurring, however, as we enter the late innings of a traditional growth cycle. This happens when the economy appears to be out of slack (not enough workers to hire), which causes wages to rise. The higher wages lead to increased demand (since workers have more money), which businesses have a hard time meeting because they don’t have the capacity to increase supply. We believe the current backdrop will most likely result in inflation remaining stickier. This makes the path to the Fed’s 2 percent inflation target more difficult. As a result, we expect the Fed will leave rates higher for longer, which will weigh on consumers and corporations. 

The business cycle as measured by the output gap  

Over longer periods of time the U.S. economy has a natural long-term trend rate of growth that is driven primarily by how many people work and how efficient they are. However, as we all know, the economy does not grow steadily at this long-term trend pace but rather experiences expansions and contractions around that potential trend growth. The output gap attempts to measure where we are at in that business cycle. The measure is the difference between the actual output of the economy relative to its potential output at any given point.   

A negative output gap is defined as a period when economic slack is high—we have idled or underutilized capacity because growth is less than what the economy could produce at full capacity. For example, this may occur when the unemployment rate is elevated. Contrast that with a positive output gap, in which the economy is operating above its full capacity output. For example, the unemployment rate is very low.  

We acknowledge that the output gap is an imperfect measure that is subject to revisions and forecasts. However, it’s noteworthy that the International Monetary Fund, the Organization for Economic Development and, finally, the U.S. Congressional Budget Office each peg the current U.S. output gap as positive, meaning it is operating above capacity.   

Every recession since 1950 has occurred with the output gap in positive territory.

We also recognize that the output gap is a poor timing tool and that the economy can exceed its natural capacity for brief periods, but it cannot produce sustainably above that limit. That’s because when the economic growth/demand is running above capacity to produce supply, inflationary pressures tend to emerge. This typically raises concerns for policymakers and leads them to raise rates.  

Unfortunately, as the chart below shows, a recession is usually what reins in an economy that is exceeding its normal capacity. Every recession since 1950 has occurred with the output gap in positive territory. While the current output gap could move even further into positive territory before a recession arrives, we believe the Fed will be wary of the current data and view it as another reason to keep rates elevated. 

It's possible that the current positive output gap could resolve itself without a recession. As we’ve acknowledged, the measure is based on estimates and as such could be misleading based on estimates that prove inaccurate. The size of the labor force could also increase as more people decide to rejoin the working world and fill open jobs, which would lead to more production. Another avenue is that existing workers become more productive and can create more output. This is where artificial intelligence (AI) could dramatically impact the economy’s longer-term growth. 

 The final indicator of where we are in the business cycle is inflation—and we see evidence that suggests it’s becoming stickier.

The above factors were in play in the late 1990s, when the economy operated above its potential for a few years. Labor participation rose, and the internet and corporate investment in preparing computer systems for the so-called Y2K glitch drove heightened productivity that helped keep the business cycle going. While we acknowledge this could occur again, we believe it is unlikely given that the prime age labor force participation rate has already risen to levels only exceeded during the late 1990s. While we believe AI offers strong potential for future productivity gains, we don’t believe its impact on output will be dramatic enough to change the business cycle in the near term. The final indicator of where we are in the business cycle is inflation—and we see evidence that suggests it’s becoming stickier. Sticky inflation is consistent with the economy being late in a business cycle.  

Inflation appears to be reaccelerating  

Current measures of inflation appear to show that it is reinvigorating, not faltering. While service-sector inflation has moved lower from its peak on a year-over-year basis, the more recent pace of growth is actually increasing. Both CPI services inflation and CPI services ex-shelter readings are in the 5 percent plus range annualized over the past three and six months. The same can be said about core inflation; recent shorter-term readings translate to an annualized rate well above the Fed’s 2 percent target.  

Additionally, the underlying trend of inflation as measured by the Cleveland Federal Reserve Bank’s Median CPI measure has also reversed course and is once again rising. After falling sharply to a more historically normal and stable 2.4 percent monthly annualized pace in July 2023, this measure has reversed course sharply, with the latest reading touching 6.5 percent. According to research from the Cleveland Fed, the median CPI provides a better signal of the underlying inflation trend than either the all-items CPI or the CPI excluding food and energy. The median CPI is even better than the core PCE price index at forecasting PCE inflation in the near and longer terms. 

We also turn to the Atlanta Federal Reserve Bank and its calculation of sticky CPI, which measures how the slower-moving, or stickier, components of inflation are trending. The good news is that this measure has slowed on a year-over-year basis, but we note that the slowdown is also threatening to move higher as the nearer-term numbers are reaccelerating. As the chart below shows, inflation tends to become stickier near the end of business cycles (blue shading). 

Investors may have been overlooking the CPI readings given that the Personal Consumption Expenditures (PCE) index (which is the Federal Reserve’s preferred measure) continued to show inflation fading. That changed recently as the latest PCE data showed traces of what we have been seeing in other inflation measures. 

Inflation becomes stickier at the end of a business cycle because wages rise above sustainable levels.

One such measure comes to us from the Dallas Federal Reserve, which calculates the distribution of components weighted by the share of total spending. According to the latest data, more than half (57.67 percent) of the components that are included in calculating PCE showed price increases of 5 percent or more on a one-month annualized basis. Similarly, only 28 percent of components saw declines in prices or gains of less than 2 percent, which is a historically low level and similar to readings seen in the 1980s. 

Inflation becomes stickier at the end of a business cycle because wages rise above sustainable levels. Wages typically start to rise as companies compete for workers to try to satisfy demand because they have jobs to fill. As the chart below shows, the 1966 to 1982 period was marked by persistently rising wages that kept pulling current inflation higher. Eventually the Fed broke this wage–price spiral. Since then, wage gains have peaked in the low 4 percent range at the end of each economic cycle. That’s not by accident. The Fed views wages as potential fuel for elevated inflation and believes that 3.5 percent wage growth is consistent with 2 percent inflation.  

While wages have pulled back from their breakneck pace following the pandemic, that slowdown has also stalled. Currently, broad measures peg wage growth in a range of 4.3 percent to 4.8 percent. Given the current low unemployment rate of 3.7 percent, we believe that upward pressure remains on wages. This view is supported by results of various surveys that suggest that 2024 wage increases are still likely to be in the 4 percent range.  

One such survey is conducted by the National Federation of Independent Business owners (NFIB). According to recent results, 39 percent of business owners reported that they raised compensation in the past three months. Prior to the arrival of COVID, the two previous highest readings were 37 in late 2018 and 34 in 2000. And as the chart below shows, a high number of small business owners plan to raise compensation in the next three months. Given the relation between wage increase plans (blue line) and actual wage growth (gold line), we believe there is potential for upward wage pressures in the future.

Similarly, the following chart, also using data from the NFIB, shows the percentage of business owners who plan to raise prices in the coming months. This is where the risk of a wage–price spiral becomes evident. For business owners, especially those in the service sector, wages are a significant cost. For those owners who have to raise wages, the most obvious way to protect profits is to increase prices. As this chart shows, plans to raise prices bottomed in April and have since moved higher to levels seen only a few times since the wage–price spiral of the late 1970s. Not surprisingly, plans to raise prices (dark blue line) have a relationship with CPI (light blue line) and highlight the potential for rising inflation in the future. 

The final word 

The post-COVID period has been unique and difficult to measure because of the large shifts it caused as the world economy closed and reopened during a period when significant fiscal and monetary stimulus was unleashed. Indeed, various closely related economic datasets have varied materially in the shorter term. Some examples that come to mind are gross domestic product (GDP) vs. gross domestic income, nonfarm payrolls vs. household employment, and even more recently the upward push in consumer prices as represented by CPI vs. a continued downtrend as measured by the PCE index.  

Additionally, tried and true measures that used to be reliable indicators of the arrival of a recession—such as faltering leading economic indicators, various sentiment measures, decreases in the money supply, increases in continuing jobless claims and inversion in the yield curve—have seemingly failed (at least as of now) in this unique economic cycle. A few years from now we will be able to look back with more complete data and get a clearer picture of what happened and why. 

Until then, we continue to believe the economy is moving beyond the oddities caused by COVID and appears to be reconnecting as an economy that is late in a business cycle. While there may be a margin of error in our view on just how late we are in the business cycle, there is significant evidence that shows we are not in the early or even mid-cycle, and the risk of inflation is still elevated.  

The Federal Reserve has raised rates aggressively, seemingly without causing a broad recession. But we’d note that there’s a lag in monetary policy; therefore, we don’t believe all risks of a contraction are gone. We are now at a time when, historically (on average), rate tightening cycles have traditionally just started to show up in the labor market. Additionally, the impact of rate hikes has been muted so far in this economic cycle because most consumer debt and corporate debt was issued at fixed lower rates. Add in excess savings from the cash infusion by policymakers and you have the recipe for a resilient economy. However, the longer rates stay elevated, the more impact they will have as credit cards, auto loans, corporate debt and mortgages reprice at higher rates.  

We believe the Federal Reserve has a challenging road ahead with many potentially difficult decisions. Can the Fed wield its blunt instrument of rate hikes to perfectly fine-tune a $28 trillion U.S economy with its 168-million-person labor market to a slower pace of growth without causing some degree of contraction? If it cuts rates too fast, inflation could reaccelerate and disrupt the U.S. economy, as was the case during 1966 to 1982. If the Fed cuts too slowly, it could risk causing job losses and a recession. While maneuvering during an election year certainly ups the stakes for the Fed, we continue to believe it will err on the side of making sure the inflation genie is firmly put back in the bottle it called home for nearly 40 years.   

Importantly, this is not a call to avoid risk in your portfolio but rather to make sure you are comfortable with your exposures and ready to take a recession in stride if it arrives. 

Given that the current Fed has favored data over forecasts, we believe it is likely that members will wait to see signs of labor market weakness before cutting rates—at which point it will likely be too late. Certainly, the Fed always aims for a soft landing, but its track record highlights the difficulty of achieving that objective. The business cycle is a powerful force, and unless COVID somehow eliminated the cycle, it’s safe to say a recession will eventually arrive. As we’ve noted, historically a recession is the only way to get an over-capacity economy back below its limitations. Put differently, the business cycle has an undefeated record.   

We acknowledge that timing a recession exactly is incredibly hard; however, we feel more comfortable in saying that business cycle risks remain elevated. Importantly, this is not a call to avoid risk in your portfolio but rather to make sure you are comfortable with your exposures and ready to take a recession in stride if it arrives. 

In the immediate aftermath of COVID’s arrival and the equity market plunge that accompanied it, we upgraded equities to overweight and reduced our exposure to fixed income, as we believed yields at the time didn’t offer enough compensation relative to inflation risks. We added to our inflation hedges given our belief that policymakers would act swiftly and forcefully to bridge the economic valley that would develop between the pre-COVID and post-COVID economy. We anticipated that steps taken by policymakers would stimulate economic growth and push markets higher. We also believed the stimulus would help the Fed accomplish its post-Great Financial Crisis mission to shock the economy out of its low inflation regime.  

Given our forecast that inflation was tied to COVID, and as we pushed further past the economic oddities and distortions caused by it, in 2022 we began pulling back our inflationary hedges and returning them to traditional fixed income as investment-grade bond yields moved above 5 percent. As equity markets rallied, thanks to faltering inflation from late 2022 to mid 2023, we trimmed our equity overweight given our belief that the underlying cause of inflation was shifting to the more intractable business cycle. This culminated with our push to slightly underweight equities in September 2023. As we reduced our exposure to equities, we have continued to add to (and are now overweight) high-quality traditional fixed income. This move reflects our belief that it offers attractive yields at current valuations, especially in light of our recession forecast. 

If the economic cycle extends and our recession forecast does not play out in the coming quarters, these discounted parts of the market could surprise to the upside given that they are economically sensitive.

Overall, we remain underweight commodities and equities with an overweight to fixed income. We acknowledge that recessions are difficult to time and that a resilient economy could continue to surprise us, which is the reason we have taken a gradual approach. However, we believe that we are later in an economic cycle, and investors should be paying more attention to risk.   

These comments aren’t meant to be doom and gloom. We believe opportunities exist for intermediate- to long-term equity investors. Most of Wall Street has to invest money every day, and for much of the past year as the recession fears have come and gone, the S&P 500 and especially Large Cap tech have been considered the safe bet for many. We believe, however, that other parts of the market have discounted at least some probability of a recession. Specifically, Small and Mid-Cap stocks and even many parts of S&P 500 represent value. These asset classes trade at a relative discount to their Large Cap counterparts that we haven’t seen since the late 1990s—a period that we believe has echoes of today. While these parts of the market might fall further if a recession unfolds, we believe they would recover quickly. If the economic cycle extends and our recession forecast does not play out in the coming quarters, these discounted parts of the market could surprise to the upside given that they are economically sensitive. Simply put, we are positioned with overweights in asset classes that we believe are set to do well over the next 12 to 18 months—or longer—and we pay greater heed to that time horizon rather than trying to perfectly time nearer-term developments.  

U.S. Large Cap  

As we closed the books on 2023 and turned the page into the new year, factors that have benefited U.S. Large Caps have become even stronger during the first couple months of the new year. Broadly speaking, the momentum factor (measured by rising share prices and upward earnings revisions) has determined equity market winners this year, accelerating the relative performance of U.S. Large Caps, which were 2023’s market leaders. Momentum-driven markets tend to be relatively narrow in terms of leadership, and that’s precisely what we’ve seen so far in 2024 with the continued surge in Mega Cap tech performance. The top five companies in the S&P 500 now comprise 25 percent of the index, twice what is typical in normal times. What’s particularly concerning is the relationship between the portion of the index concentrated in this small group and its profit contribution to the index. When it comes to profits, these companies are batting below their weight. Despite representing 25 percent of the market cap of the index, they generate just 17 percent of profits. This marks a greater disparity than was previously set in the late 1990s, a condition which later reversed. Given the group’s relatively high valuation coupled with our concerns about concentration, we continue to remain slightly underweight this equity asset class. 

U.S. Mid-Cap  

U.S. Mid-Caps continue to hold up well in our nine asset class portfolios and are producing slight outperformance versus our blended benchmark to start 2024. Hopes of rate cuts by the Federal Reserve have investors overlooking the challenges of a slowing economy and sticky wage costs. We have our concerns that this hope for monetary accommodation from the Federal Reserve is exaggerated given the unlikely scenario of “immaculate disinflation” that causes inflation to fall to the Fed’s target absent a recession. We think the more likely outcome is a mild recession that snuffs out lingering inflationary pressures once and for all during this cycle. In our view, this will pave the way for the start of the next economic cycle that we believe will once again be accelerated by significant policy accommodation from the Federal Reserve. While the ride may be bumpy, we believe the end of the current business cycle and beginning of the next should serve as a catalyst for a change in market leadership in the favor of U.S. Mid- and Small Caps. Both asset classes tend to do well during inflections in the business cycle and when real interest rates decline. Our belief in the likelihood of this macroeconomic scenario playing out along with reasonable valuation in the asset class has led us to remain overweight Mid-Cap stocks in our portfolio. 

U.S. Small Cap  

As long-term investors, we look beyond short-term shifts in sentiment that can cause near-term volatility in absolute and relative performance. The two-month swing in relative performance we saw in late November and early December in Small Caps is a good example. In late November, the market started aggressively pricing in rate cuts by the Federal Reserve, with many investors penciling in six to seven cuts in the upcoming year. This marked a significant change from the two or three cuts that were forecasted in October. This shift in sentiment pushed Small Caps up 25 percent in just two months, which was 10 percent more than U.S. Large Caps. Since then, continued strength in the labor market and sticky inflation readings have pushed down the number of rate cuts expected to just three for 2024. This switch in expectations has led to market leadership reverting to higher-quality Large Caps due to their perceived safety. We would rather look through this short-term noise and focus on the long-term setup, which we view favorably. Based on relative valuations, we see an out-of-favor class that we believe will do well in an easing cycle from the Federal Reserve. We maintain an overweight position and expect relative performance gyrations (like the example described above) to continue as investors continue to debate the timing and magnitude of easing actions from the Fed. 

International Developed 

The two largest regions of the international developed markets are Japan and the eurozone. These regions have experienced an economic slowdown, while their stock markets are at historical highs. Japan’s GDP contracted at an annualized pace of 0.4 percent in the final three months of 2023, following a 3.3 percent contraction in the previous quarter. The eurozone contracted 0.1 percent in the third quarter of 2023 and had zero growth in the fourth quarter. The technical definition of a recession is two consecutive quarters of GDP contraction, which means that, technically, Japan slipped into a recession and the eurozone narrowly avoided one. The major stock market indexes for Japan and the eurozone (the Nikkei 225 and the Stoxx 50) hit 30-plus-year and 20-plus-year highs, respectively, in early 2024.  

Japan’s GDP report showed both households and businesses cutting spending. Exports of goods and services, however, have been strong due to the weak Japanese yen. The economy could recover going forward due to an increase in private consumption, thanks to a stabilization in inflation and expected growth in wages. Also, the Bank of Japan’s Tankan survey showed business conditions across all industries and firm sizes were the strongest they have been since the fourth quarter of 2018. 

Yoshitaka Shindo, the Bank of Japan economy minister, would like to end the country’s decade-long negative interest rate policy, but the recent weak economic data has delayed a series of interest rate hikes. We note that while other central banks, such as the Federal Reserve and European Central Bank (ECB), are trying to make sure that inflation doesn’t become embedded, the Bank of Japan wants inflation to become embedded in the economy to erase the decades-long deflationary spiral the country has experienced. The key test remains wages, which have stagnated or fallen for decades but are creeping higher. 

The eurozone’s lower GDP stems from Germany’s economy contracting by 0.3 percent and France posting no growth. There were better results from the other two members of the Eurozone’s “big four.” Italy, which had been expected to stagnate, saw growth of 0.2 percent, while Spain’s economy grew by 0.6 percent—triple the pace expected. Italy and Spain benefited from tourism, stimulus, and the lagged impacts of structural reforms implemented after the pandemic. 

After an unprecedented barrage of rate hikes between July 2022 and September 2023, the ECB has opened the door to loosening monetary policy this year. Officials, though, are wary of providing clear guidance on timing until they are certain price growth is firmly on its way back to 2 percent. President Christine Lagarde said the Governing Council wants to be “further along the disinflation process to be sufficiently confident.” She signaled that a move before June’s meeting is unlikely, noting that eagerly awaited wage data due out just before the meeting is “critically important.” 

In September we downgraded our slight overweight to international developed markets to a neutral allocation. We believe this asset class possesses positive fundamentals over the intermediate to long term and note that U.S.-based investor returns are likely to be bolstered as these cheap currencies appreciate relative to the U.S. dollar. However, in the nearer term, we believe the same dynamics that will eventually push the U.S. economy into a recession will also weigh on international economies. 

Emerging Markets  

The start of 2024 has been volatile for developing market stocks, with a sell-off in January followed by an advance in February leaving the asset class flat for the year. Underperformance of equities in China has been a headwind to the asset class as the world’s second largest economy attempts to ignite its tepid recovery. Continued weakness in housing and the real estate sector along with challenging demographics and limited policy support have led to market declines, as foreign investment in China is at a multi-decade low. The economic slowdown has led to deflation, with prices falling year over year in response to slowing demand and a supply glut in some areas such as pork, of which China is the world’s largest producer. There have been signs that the government is more willing to provide some stimulus, as the Peoples Bank of China recently cut its five-year prime loan rate 25 basis points and reduced bank reserve ratio requirements, and Chinese securities regulators are now prohibiting institutional investors from reducing equity holdings at the open or close of trading. A new leader of the China Securities Regulatory Commission has been appointed and recently formed a task force with stock exchanges to oversee short selling and those who benefit from bearish trades. These measures have provided some support to markets in recent weeks.  

Underperformance in China has been offset somewhat by outperformance in countries such as India as investors continue to invest in the Indian growth story. Additionally, demand for technology stocks has led some markets higher. For example, Taiwan Semiconductor Manufacturing Co. is a top performer in 2024.  

Federal Reserve policy, in our view, is a tailwind for the U.S. dollar. That’s because we expect the Fed will leave rates higher for longer while the People’s Bank of China cuts rates. We believe this dynamic increases the potential for further capital flows out of the developing world to opportunities with a better risk/reward trade-off. In our last Asset Allocation Focus, we 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, which has been a headwind for outperformance in international developed and emerging markets.    

China’s impact on emerging markets as a general asset class is significant; however, there are other countries within the developing world that are experiencing rapid growth, have favorable demographics, and, like China, will contribute much to world GDP growth in the coming years. As we previously discussed, India is a good example; the country’s markets have risen and outperformed most other equity markets over the last three years. 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 vs. the developed world are sitting at historically cheap levels. Developing countries account for about 40 percent of the world’s GDP but only 25 percent of world equity markets. 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 and seeing no clear catalyst to outperformance, we continue to underweight the asset class.  

After years of low volatility, interest rates continue to fluctuate as investors try to appropriately price ever-changing possible outcomes. For example, 2023 saw an increase in the 10-year Treasury from a low of 3.31 percent in April 2023 all the way up to 4.99 percent in mid-October only to fall back to 3.88 percent by year-end, which is almost exactly at the level at which it ended 2022. This year has seen a subtle rise to 4.25 percent as of this writing.  

We continue to believe that investors should invest along the yield curve to match their liabilities and recognize that intermediate term rates remain attractive at current levels. 

This volatility is due not only to the rapidly changing outlook for the economy; we also believe that the fixed income markets are going through a period of price discovery after years of the market being driven by policymakers. For many years monetary policymakers, including the Fed, were engaged in quantitative easing, which was designed to suppress volatility and keep interest rates low. Now we are on the opposite side of this, and the Fed is engaged in quantitative tightening against a backdrop of rising Treasury issuance. This lack of demand from price-insensitive policymakers has left the heavy supply to be absorbed by real buyers. The resulting volatility and losses have led to many investors hiding in shorter-term bonds or cash. We continue to believe that investors should invest along the yield curve to match their liabilities and recognize that intermediate term rates remain attractive at current levels.   

The reality remains that bond yields today are still near the highest levels since the 2005–08 time period. In other words, it has been 15 years since yields have offered this level of potential income. That is an attractive backdrop, especially given our forecast that a likely recession will stomp out inflation. No one knows with precision where rates will be in the future, and investors need to consider that investing only in shorter-term securities brings reinvestment risk into the conversation.  

The future is uncertain, and with interest rates currently attractive compared to future inflation, we believe that investors should consider tilting their portfolios toward bonds—across the yield curve and investment-grade credit spectrum. While we acknowledge the level of debt in the U.S. remains a risk as highlighted by recent ratings downgrades, we believe that investors are being compensated for that risk given that real yields are 1.75 to 2 percent across the curve.  

We continue to position our overall fixed income duration near neutral relative to the Bloomberg Aggregate Index and favor higher-quality fixed income given the current economic backdrop. While we do not expect interest rates to slip back toward the incredibly low levels of the last economic cycle, we believe that fixed income has once again returned to its old roots as a real income-generation vehicle that can also provide risk mitigation against the potential for falling equity prices.  

Duration 

The persistent bid in fixed income that existed at the end of 2023 has dissipated as investors have pushed out expectations for the potential of Fed easing. The year started with investors pricing in expectations of six cuts of 25 basis points each in 2024. In under two months, market expectations are now down to about three cuts starting in June 2024. The curve reflects this, as it has steepened (or gotten less inverted) by about 40 basis points in a parallel shift from two years ago. With this general uncertainty, why do we continue to favor modest duration additions relative to benchmarks? Simply put, credit spreads remain historically tight, real rates are very positive, and the time value of fixed investment should enhance performance over reasonable investment horizon outcomes. 

Government Securities/TIPS 

We are big fans of high-quality bonds, including Treasurys and other government-sponsored securities. The flow of Treasurys issuance will remain heavy in 2024, which we believe will likely create volatility. The second quarter of 2024 will see a 50 percent increase in net Treasury issuance; however, we continue to believe that despite this volatility, current real interest rates are attractive, especially given our outlook that a recession remains likely.  

We believe that the Treasury Inflation-Protected Securities (TIPS) market is quietly signaling a potential resurgence of inflation.

Our recession outlook is predicated on our belief that inflation pressures persist and that they will not subside until a recession arrives due to the Fed holding rates at current levels for longer than is currently expected by the markets. We believe that the Treasury Inflation-Protected Securities (TIPS) market is quietly signaling a potential resurgence of inflation. One-year inflation breakevens have risen from around 2 percent in mid-January to nearly 4 percent today, with the two-year breakeven rising from 2 percent to nearly 2.8 percent, while the rest of the breakeven curve has risen by less than 20 basis points from five years ago or longer. Similar to our forecast, the market believes that inflation in the nearer term may reignite but that eventually the Fed will tame it. Given our expectations of the eventual demise of inflation, we continue to focus on nominal coupon yield bonds rather than trying to time shorter-term inflation movements using TIPS.  

Credit 

By some measures, credit spreads are as tight as they have ever been. This, to us, is clearly a sign that the economy keeps chugging along, and investors are increasingly 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 approximately 800–1,000 basis points in total return), investors seemingly flock to them. Overall, municipal bonds offer compelling yields for those in the highest tax brackets, but for others they have become expensive relative to taxable bonds. The muni curve is also inverted, a condition that is extremely rare for this asset class. We continue to recommend municipal bonds for investors in the highest tax brackets and favor a barbell approach to managing municipal maturities; 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. 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 REITs have experienced outsized impacts from the pandemic, they have also been under pressure from a dramatic 300-basis-point surge in real rates the last two years. Additionally, as banks have started to shy away from lending to the sector, valuations have fallen further. We remain underweight but do 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 can move to an accommodative stance, 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. 

Based on our expectations of a coming recession and resulting end to elevated inflation, we have an underweight position in commodities and an overweight position in fixed income. As we noted, real assets can be very sensitive to changes in inflation adjusted interest rates, with real estate being the clearest example.   

Real Estate 

Real estate prices depend on many factors, but valuations for this asset class are largely a function of long-term interest rates and their expected path. It is no surprise, then, that the aggressive rate hiking cycle had a negative impact on longer-duration assets, such as REITs, and it remains a 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 REITs are not a monolith, 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 had a rough ride the past few months, as commodity prices fell modestly overall and were a notable outlier in the “risk-on” rally that occurred in the equity and fixed income asset classes. Notably, the energy sector—particularly natural gas—fell sharply. On the positive side, gold posted double-digit gains in the period. 

In our view, falling inflation expectations and the prospect that the U.S. Federal Reserve could begin to cut rates in 2024 boosted returns for stocks and bonds, while commodities were pressured by several developments specific to the asset class.  

Energy commodities such as crude oil were particularly weak due to higher-than-expected supply that came despite OPEC+ cuts last year. Sizable U.S. production also put pressure on prices. Natural gas prices continued their sharp decline when it became apparent the northern hemisphere was on track for an exceptionally warm winter. For industrial metals, continued sluggish economic growth in China was expected to remain a headwind for demand for commodities such as nickel and aluminum. Agricultural commodities were another area of weakness, as U.S. crop production came in well above estimates. On the positive side, gold hit an all-time high late last year as investors sought to hedge the possibility that the Fed’s shift to a more accommodative policy could lead to a resurgence in inflation. Expectations for lower rates also fueled a downturn in the U.S. dollar, which also boosted precious metals prices. 

We remain meaningfully underweight commodities, preferring fixed income and relatively cheap asset classes like Small Cap and Mid-Cap U.S. stocks.

The outlook for commodities remains mixed. 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 conflict and the events impacting shipping in the Red Sea could add additional pressure in the oil and grain markets.  

We remain meaningfully underweight commodities, preferring fixed income and relatively cheap asset classes like Small Cap and Mid-Cap U.S. stocks. For some time, we have believed that global growth (excluding the U.S.) would remain sluggish, and that inflation would moderate. Recent commodity asset class performance, in our view, reflects these concerns. Commodity prices fell 7.9 percent in 2023 following a strong 16 percent gain in 2022 and a 27 percent gain in 2021. Overall, we continue to believe the commodity asset class offers positive return potential and significant diversification benefits. 

We’ve spent a lot of time in this piece discussing the concept of the economic/business cycle. That’s because we believe that business cycles, in general, follow a similar path from trough to peak. However, while business cycles are broadly similar, we find they are unique in the underlying economic trends that drive them. Pulling these concepts together, we believe the end of a business cycle serves as a reset button for both the economy and the financial markets, and the growth process begins again with a new set of unique characteristics. Simply put, we believe the economy and markets are connected. Broadly speaking, contractions in the economy lead to contractions in equity markets, while expansions have the opposite effect. However, within a given expansion, whatever is driving that business cycle economically also drives the markets. The result is changing market leadership within each economic cycle.  

Perversely, at the end of economic cycles before the trend changes, investors are tempted to concentrate on the current cycle’s leaders, which, unfortunately, become the next cycle’s laggards. Recent history is littered with examples of this phenomenon. 

• For instance, the economic cycle that lasted from 1981 to 1990 saw the continued growth of Japan’s importance in the global economy, which led to a dramatic increase in the Japanese stock market and drove international developed market stocks to the top of the asset allocation performance list. The Nikkei 225 index of Japan stocks hits an all-time high in 1989, a level it finally surpassed in February 2024—34 years later. 

• The narrative shifted between 1990 and 2001, which was a cycle that saw strong U.S. economic growth that concluded with the U.S. technology sector being the envy of the world given its leading-edge role pushing the internet forward. The result was massive outperformance for U.S. equities driven by the technology sector. Unfortunately, those investors who fell prey to concentrating in that segment had a long road back to break-even. After peaking in early 2000, the S&P U.S. Large Cap technology sector took more than 17 years to reclaim new highs, while the tech-heavy Nasdaq composite took slightly less than 15 years. 
• The 2001–07 economic cycle saw the global emergence of the Chinese economy that drove international emerging markets to the top of the asset class performance list. After a period of dramatic underinvestment, commodities also benefited as increased Chinese demand pushed them higher. European economies benefited from not only an increase in Chinese exports but also the positive impacts of the newly adopted euro currency. The story ends similarly here for investors who chose to chase this cycle’s market winners at the wrong time. Emerging markets have languished recently, with the Chinese Shanghai composite index residing at half its late 2007 level. European stocks recently logged a new high above their 2007 level, and U.S. energy stocks have not yet reclaimed their previous highs.  
• While we break the post-2007 time period into pre-COVID and post-COVID (two-month recession), the equity asset class leaders have remained consistent. It’s been a time period once again marked by U.S. economic resilience relative to other economies and once again favoring U.S. equities. 

What has changed post-COVID is the dramatic increase in inflation that drove commodities higher and bonds lower after many investors had positioned their portfolios as if inflation was a thing of the past. And much like what happened in the late 1990s, we have witnessed market leadership concentrate in a shrinking subset of U.S. Large Cap stocks driven by the technology sector. This is where we fear there are similarities developing between now and the late 1990s. The S&P 500 trades at forward price to earnings ratios last seen during the late 1990s. Similar to then, this is being driven by a concentrated group of stocks that investors are piling into to capture perceived future opportunities driven by today’s trends. Indeed, over the past few years, the top 10 names in the S&P 500 have become 34 percent of the index, easily eclipsing the 26 percent concentration that developed in the late 1990s. This is largely being driven by a select group of stocks that have become known as the “magnificent seven.” These market darlings have experienced strong growth in the past and have been rewarded by the market. They now make up 20 percent of the S&P 500 earnings but represent 29 percent of market capitalization. Simply put, significant optimism about the future growth trajectory may already be priced into the stocks.  

Concentrating your future on a single asset class or a small group of companies is not a prudent path forward.

While the past never perfectly repeats, we believe it rhymes, especially as we have just laid out the often-rotating market leadership that for at least the past 43 years has shifted in each NEW economic cycle. As we have documented, new market leadership emerged post-1999—not just internationally but also in the U.S., where Small and Mid-Cap stocks had been left behind by their Large Cap tech counterparts. Interestingly, we noted that U.S. Small and Mid-Cap stocks trade a similar valuation as in the late 1990s, which led to them leading U.S. markets during the coming economic cycle.  

The future is always uncertain. The way we deal with uncertainty is through broad diversification driven by a financial plan. Concentrating your future on a single asset class or a small group of companies is not a prudent path forward. For investors, navigating between the certain general path of the business cycle and the unknowable unique drivers that will define the contours of each market cycle can be daunting. We believe the best way to navigate between both elements is through diversification. 

Owning multiple asset classes should put you in a stronger position in the long run—especially given that markets are likely to continue to vary from one year to the next. If you feel you may be taking on unnecessary or unintended risks in your financial plan, we encourage you to reach out to your financial advisor. Remember, a smart investment strategy leads with a steady outlook and looks through an objective lens that incorporates valuations. It also considers where we are in the economic cycle and the forward path of monetary and fiscal policy and market structure. 

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 gross domestic product (GDP) is the amount of goods and services produced in a year in a country.  

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 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.