Why 3 Big Market Fears Aren’t as Worrisome as Advertised

At the start of summer, investors had grown increasingly optimistic about the economy, given growth was skyrocketing on the heels of vaccinations, declining COVID-19 cases and businesses reopening across the country. Recall, however, markets started pricing in an early summer “return to normal” when the first vaccine was approved for use in December 2020, and for the past few quarters we’ve said forward-looking investors would begin asking, “What’s next?” Figuring that out would likely yield volatility as uncertainty built.

Equity markets have logged a trendless summer, as several conflicting crosscurrents have made it difficult to forecast what’s next. In our view, investors are falling into one of three camps: those worried the economy is growing too fast (inflation), those worried growth is peaking, and those worried stock valuations are simply too high. Three camps, three conflicting outlooks.

However, as the summer months close and we push into the new year, investors in these three camps will likely abandon their worries, as we expect broad economic growth to bolster optimism across markets. While our base case is that these three worries are temporary, that doesn’t mean they aren’t rational or lacking in evidence. Recall that we did ratchet down our overall rating toward equities in early June given increasing risks. But let’s address these three camps of market worriers head-on and explain why they may be less worrisome than many investors fear.

CAMP 1: INVESTORS WORRIED ABOUT INFLATION

We have investors who are worried the economy is growing too fast, inflation is more persistent than forecasted, and the Federal Reserve will ultimately tighten monetary policy on a compressed timeline.

We originally predicted an early summer uptick in inflation, driven by a rapid recovery in demand. Indeed, inflation worries have intensified over the past few months as both the Consumer Price Index (CPI) and Personal Consumption Expenditures Index (PCE) have hit their highest levels since the early 1990s. Inflation will likely become a growing concern as this economic cycle progresses over several years, but we don’t think this current bout with rising prices is the decisive battle. Rather, we continue to view this as a short-term, transitory trend driven by unique circumstances.

The 2020 recession was unlike those of the recent past. Economies around the world intentionally shut down during the early months of the pandemic, and uncertainty reached a fevered pitch, as we knew very little about the virus. Many prepared for the worst. Policymakers here and abroad also prepared for the worst and opened a massive pipeline of economic aid to consumers and businesses. Indeed, consumer incomes, except for a brief blip in March, pushed higher, while savings also accumulated. As the country reopened in late spring, consumer demand accelerated sharply, particularly for goods and services hardest hit by lockdowns and other restrictions.

However, consumer demand can rise far faster than complex supply chains can gear up and meet that demand. Disruptions in shipping channels, storms and a host of other factors have made it difficult for producers to catch up. On the services side, labor shortages have made it challenging for business, such as restaurants, to accommodate the flood of customers.

As a result, we have witnessed spikes in prices for lumber, used and new cars, gasoline and airfares to name a few. But we’ve also seen prices moderate as supply and demand return to equilibrium. Indeed, a return to trend has been the theme for many “outliers” driving inflation higher, as lumber and auto prices have firmly fallen back from highs. Headline inflation may remain elevated, but price measures that attempt to capture the central tendency of inflation by diminishing the impact of outliers are showing moderate price pressures. For example, the Dallas Federal Reserve’s Trimmed Mean measure of PCE currently resides at 2.02 percent year over year, while the Cleveland Federal Reserve’s Median CPI is at 2.3 percent over the same time frame.

Inflation expectations, broadly speaking, remain anchored. Eventually we will need to worry about inflation, but not until labor market slack is eliminated and wage pressures become more persistent. According to our calculations, there are roughly 10 million individuals who still need to participate in the labor force before fully closing the COVID-19 gap.

As far as the Fed, we’ve believed for quite some time that it will do everything possible to support a full labor market recovery. Yes, the Fed will begin tapering asset purchases in the next few months, but this Fed is going to err on the side of doing too much to bolster growth rather than too little. This significant policy shift is what long-term investors should focus on, rather than day-to-day machinations of Fedspeak. We believe the Fed will continue to place priority on its employment mandate and not inflation (more on that later).

CAMP 2: INVESTORS WORRIED GROWTH HAS PEAKED

 

In a second camp, we have investors who are worried economic growth has peaked and is bound to fall back, perhaps aggressively, due to the emergent Delta variant.

This camp was originally a smaller group who feared that a “sugar high” from a wave of stimulus and accommodative monetary policy had worn off and growth would prove elusive. But over the past month this camp has grown as the Delta variant threatens growth.

The Delta variant is certainly impacting the economy, but its influence won’t rival what occurred in 2020. The Delta variant may push out the recovery timeline, but it won’t bring an end to global growth.

When COVID-19 first arrived, we plunged into maximum uncertainly as companies and consumers contemplated what the world would look like in the coming months. Through March and April, the entire U.S. economy was impacted, and the stock market reflected extremely high levels of uncertainty.

But then monetary and fiscal policy cushioned the blow from lockdowns while we pushed through the year. As time passed, the economy adapted to a new reality and reopened in limited fashion or with new accommodations. Then scientists delivered on a vaccine years ahead of what markets expected, pulling reasonable forecasts for a recovery from the pandemic into 2021.

Contrast 2020 with the Delta variant today. Monetary and fiscal policy remain undoubtedly easy. We are likely to see another $2 trillion of fiscal spending approved in the coming months. Companies have largely figured out how to operate amid the coronavirus, and science remains at the ready to continue its fight. Today, there’s an economic and market framework for operating during a pandemic. There wasn’t one in 2020. There’s uncertainty today, but it’s nowhere near 2020 levels.

That’s not to say pandemic uncertainties won’t trigger a market correction, but we believe that any such dip would be met with willing buyers. Think about it this way: The National Bureau of Economic Research recently announced that the recession of 2020, while deep, lasted only two months. Similarly, we experienced an incredibly sharp — but short — stock market drawdown that lasted roughly one month. Those who held steady regained all their lost dollars in less than six months.

CAMP 3: INVESTORS WORRIED STOCKS ARE TOO EXPENSIVE

Finally, we have investors who think markets are too expensive, believing stocks have rallied too much and are therefore due for a correction.

We remind readers that we believe valuation is best applied as a relative, not absolute, tool. Our research shows economic downturns trigger large, deep stock market drawdowns. Barring an economic slowdown, stocks will retain their value relative to other assets. Though stocks may appear expensive on a historical basis, they remain a preferred option for growth relative to other assets today.

Every day, investors decide where to allocate capital. Money funds offer near-0 percent returns, and the 10-year Treasury yields roughly 1.3 percent against a backdrop of 3 to 4 percent current inflation. Against this backdrop, stocks remain attractive relative to safer investments. Further, earnings have grown considerably over the past few months (even above 2019 levels), pulling valuations, or price-to-earnings ratios, lower.

Over the past few months, more defensive segments of the market, such as U.S. Large Cap stocks, have outperformed as the worries we described above expanded, causing markets to struggle for direction. As we push toward the end of the year, we think the three camps of investors will have fewer worries because economic growth should remain strong. We think cyclical sectors and asset classes will reclaim their market leadership mantle in the months ahead. We are still very much in a period of heightened cyclical growth, which isn’t the best environment for defensives or later-cycle investments.

In June, we scaled back our equity exposure from a near-maximum overweight position we had held since April 2020. We remain overweight equities versus fixed income, just less so than before. We believe the portfolio remains well positioned for a strong economic recovery. We continue to favor 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 you that in January of 2021 we moved REITs from max underweight to slightly underweight.

Similarly, in June we reallocated capital from inflation- and rate-sensitive Emerging Markets toward International Developed stocks. Over the past few months Emerging Markets have not only been hampered by central bank tightening but also fears of heavy government interventions in China — all in addition to reinvigorated COVID-19 fears. 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. We expect the eurozone to be the next economy to post explosive growth and a rapid market recovery.

Over the past few months U.S. Treasury yields have pushed lower, even as inflation and economic growth have remained strong. Why? Look no further than the three worries we outlined at the opening of this narrative. Quite simply, the meeting place for all these camps is in the U.S. Treasury market.

Low yields are a logical outcome for those concerned about peaking economic growth or overvalued stocks. However, this would seem odd for the camp concerned about inflation. This is where we believe investors need to think differently about the future. The old Fed reacted to inflation and attempted to quickly tame it by tightening economic conditions via higher short-term rates. This process caused economic growth to roll over (i.e., a recession). The natural reaction from savvy investors would be to buy, not sell, intermediate- to long-term Treasurys because Fed tightening would drive inflation out of the economy but also stifle growth. The old Fed viewed inflation as an enemy, and its track record defeating it over the past 30 to 40 years has been stellar.

But this is the new Fed, which is biased to let inflation run hot and place more policy attention on maximizing employment. This is why we continue to favor an allocation to Treasury Inflation Protection Securities (TIPs).

We must also be mindful of other risks and acknowledge the benefits safer assets provide in a portfolio. Central banks in nearly all developed economies continue to exert downward pressure on yields and will likely not take their foot off the yield suppression lever for years. With heightened levels of debt across the globe, policymakers will not have the stomach to let yields rise too much. While tapering could take some downward pressure off yields in the U.S. in the coming months, central banks are not going to entirely let go. Couple this with large amounts of liquidity seeking a home, and we continue to believe bond yields are set to rise but not by large amounts or in a disorderly manner.

We again implore investors to resist the urge to hunt for yield or higher returns by cutting exposure to safer fixed income assets. Every slice of the portfolio has a role to play, regardless of the market mood or economic environment. Don’t tear apart your portfolio based on short-term considerations

Even though we continue tilting our portfolios toward equity-risk exposure, we continue to hold high-quality, investment-grade bonds. Given the additional yield still offered in intermediate- to longer-term bonds, coupled with the Fed and other central banks’ desire to sit on the yield curve, we continue to favor duration near benchmark targets. And last but certainly not least, given that we believe the above statement rings true even if inflation rises, we continue to favor 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.

Over the past year, this document has been a commentary on the impacts of COVID-19 coupled with, and transitioning to, a strong dose of inflation expectations. For the first time in nearly a decade, investors are now actively discussing the potential for inflation worries to become more of a permanent feature in the future. We believe that real assets can perform well in such an environment.

We have long stated our belief that REITs were the asset class most impacted by COVID-19 and would likely sit at the end of the recovery line. This is exactly what has played out, as REITs were initially the post-COVID-19 laggards when investors contemplated and repriced the intermediate- to long-term impacts from the pandemic. In January 2021, we determined that this reality was largely being reflected in the prices of REITs, and we returned our max underweight to a slight underweight. Over the past few months REITs have surged to become the best-performing asset class as the world reopened and interest rates pulled back, both of which buoyed this asset class.

While we believe interest rates are likely to remain well behaved, we do believe there is an opportunity for yields to rise in the coming months as the three worries we have identified begin to wane. We note that we would likely contemplate any such REIT sell-off that would accompany this as an opportunity to increase our exposure. If inflation proves to be more persistent, REITs would likely provide some level of inflation protection given that they are a real asset with pricing power.

Similarly, we continue to hold a neutral allocation in Commodities due to their correlation to unexpected inflation. Building portfolios is about hedging risks, and we believe the inflationary risks will be a persistent worry, which favors commodity growth. We note that commodities have surged near the lead of the asset class performance rankings amid 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 bolstered by negative real interest rates. While we remain relatively optimistic about the future, certainly there are risks, and we believe additional exposure to gold provides diversification benefits.

Investors continue to focus on the daily machinations of Fed policy, fixated on every single meeting for more information. Currently, the chatter is about tapering and the recent Federal Reserve Jackson Hole Symposium. But we believe investors with a time horizon longer than a few days should think a bit differently and focus on the Fed’s primary reaction function. Last year’s big Jackson Hole meeting was the end of a nearly 40-year era of an inflation-fighting Fed. Today, the Fed has a different focus.

After the Great Inflation of the ’70s and ’80s, the Fed listed inflation as public enemy number one, and it was determined to quell it regardless of how markets reacted. Fed Chairman Paul Volcker arrived on the scene in 1979 and convinced markets he was dead serious about fighting inflation by raising rates and tightening the economy into a recession. Over the next four decades, the Fed followed Volcker’s inflation-fighting formula. Today, the Fed is more focused on maximizing employment even if inflation runs hot. It’s a complete policy shift.

That means this Fed is strongly biased to step in and do more to achieve its policy goals. This is a Fed that looks past inflation so long as employment is growing. The old Fed used to say that monetary policy was a blunt instrument and that fiscal policy could be more targeted and help society in this aspect. This Fed is different.

The old Fed worried about moral hazard and market bubbles and was willing to dish out tough love. The new Fed would rather bolster markets rather than risk a recession and damage to labor markets. This new Fed doesn’t ignore the market; they “listen” to it. We remind that the Fed even eased policy in 2019 — not because it wanted to but because the market told it to change. Stocks were falling, and the bond market was inverting, so the Fed acted.

Will this new Fed approach end badly? We don’t know. We also can’t say when or how badly it may backfire — if at all. We haven’t seen a Fed drive policy in this direction for very long, so there’s not much history to build from. However, we do believe this backdrop isn’t changing any time soon. In fact, the Fed won’t change until there is a cost. In the 1970s, society had grown tired of runaway inflation and demanded something be done. What will society demand from this Fed? We’ll eventually find out, but we aren’t there yet.

We have been investing with this as a backdrop in mind for the past few years, even erring toward a bit more risk. That doesn’t mean there won’t be sharp market drawdowns in the months and years ahead. However, given an aggressive Fed, we think downturns will be shorter in duration. Now, that doesn’t mean bulking up on risk and running into a burning house. But it is important to tailor portfolios to achieve your financial goals while also taking into consideration the broader economic backdrop. As always, we highly recommend working with a financial advisor to help you use markets to your advantage as part of a broader financial plan that seeks growth but also accounts for downside risks.

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.