Why Diversification Is the Answer to Uncertainty

Investors hate uncertainty. Yet it’s a part of all aspects of life. And recently, in markets it seems like it’s become an even larger part. The unknown has driven up volatility—a pattern that’s likely to continue. 

Today’s uncertainty stems from the economy and the uniqueness of the post-COVID economic cycle. It’s also being driven by the current political climate as well as the current administration, which has made clear their intentions to restructure how the U.S. government works while reshaping the United States’ overall role in trade and defense globally.  

While we maintain our steady approach to investing driven by an unwavering belief in diversification and a focus on long-term outcomes driven by consistent adherence to a financial plan, we consistently evaluate the current climate as it relates to the relative attractiveness of the asset classes we invest in.   

Most importantly, we continue to focus on the intermediate to long term and believe you should stay true to your overall asset allocation that has been carefully crafted by our skilled financial advisors to meet your goals and objectives. Nothing that has occurred in the markets recently should change that unless your risk tolerance or goals have shifted. Here’s what we’re watching and our view on its impact for investors. 

The Federal Reserve and the impact of rates 

The post-COVID spike in inflation has been a roller coaster. While the nausea-inducing section of the ride appears to be behind us, the train is still meandering its way back to the station. Inflation remains stubbornly above the Federal Reserve’s target of 2 percent. While the Fed has reduced rates by a full percentage point since it began cutting in September 2024, the path forward is murky. It appears the Federal Open Markets Committee is likely to leave rates unchanged in the nearer term unless there is a tariff-related slide in the economy or labor market accompanied by a decline in inflation expectations. 

Labor markets have wobbled but not broken as a general lack of hiring has been offset by companies that have seemed to be hoarding employees. This stockpiling of labor comes despite pockets of weaker economic growth caused by rising and still elevated interest rates. Indeed, as we frequently point out, while overall U.S. economic growth remained resilient in 2024, it became increasingly bifurcated between sectors and industries as well as companies and consumers—some that were harmed by interest rates and others that were not.  

We continue to believe that the economy is in a late-cycle economic overtime that has been driven by heightened spending on artificial intelligence and a wealth effect from rising crypto, stock and home prices.

So, one has to ask this question: Given the still unbalanced nature of the economy, has the Fed achieved the coveted “soft landing” and reset the economic cycle? Or have we simply stretched the cycle? We continue to believe that the economy is in a late-cycle economic overtime that has been driven by heightened spending on artificial intelligence and a wealth effect from rising crypto, stock and home prices. The economic cycle has not reset. It’s been stretched out—much as in the late 1990s, when internet and Y2K spending helped push equity markets higher and similarly prolonged the economic cycle past its natural expiration date. 

An unbalanced economy has led to an unbalanced market 

The lack of economic balance is clear. A narrow group of mostly AI and technology companies is largely responsible for the recent growth in revenue and earnings that has driven the overall market higher. Meanwhile, most other companies have treaded water or even lagged. Adding to the challenge, valuation levels on equities are near levels not seen since the late 1990s. For example, the Shiller Cyclically Adjusted P/E, or CAPE ratio, (which was created to allow apples-to-apples comparisons of valuations across a typical economic cycle) is at historically high levels. The measure was created by Yale professor and economist Robert Shiller and divides the price of the market by the average of the prior 10 years’ earnings adjusted for inflation. The current valuation of the market (CAPE ratio) is at 38; in data going back to 1888 the current level has been exceeded only in late 2021 and, before that, the year 2000, with 1929 peaking just below current levels. This measure historically has provided a good guide for future 10-year returns and would also point to the potential for less than historical average returns in the coming years. Another sign of elevated equity valuations is that the earnings yield on equities is below that of 10-year U.S Treasurys.  

Despite the current market narrative to the contrary, we believe valuation does matter, especially over a longer time horizon.

Equity ownership among U.S. households is at near-record levels going back to 1945. It’s an encouraging sign that Americans recognize stocks as an important tool to help drive their long-term wealth. At the same time, we’re concerned about the number of investors concentrating into the narrow group of stocks that have driven recent performance. It’s as if they know that these stocks will continue to perform as they have over the past several years. Do these valuation measures no longer matter? Are they flawed? Have the world and the markets changed? 

Despite the current market narrative to the contrary, we believe valuation does matter, especially over a longer time horizon. Optimistically, investors who are focused on valuation can find many opportunities given relatively cheap valuations in various equity markets. But these opportunities often require patience, and we worry about those who aren’t willing to wait for the attractively valued areas of the market to perform. Still, these are the asset classes we continue to point investors toward.  

Perhaps the past is not prologue, and maybe the world is different; but what if it isn’t? The bottom line is that history is littered with examples of similar periods when investors were certain of the future. They were proven wrong.  

We encourage investors to pay heed to risks given the complicated economic and market backdrop. There are plenty of opportunities despite the uncertainty, and we believe investors can capitalize on them by adhering to a diversified, long-term approach. As we often point out, the best way to deal with uncertainty is to acknowledge it and to invest for it. That means more diversification, not less. This statement rings even more true today given the current economic backdrop coupled with current valuations, investor sentiment and market concentrations. We believe this time-tested approach gives you the best chance to meet your goals and objectives.   

2025 begins with questions about economic growth 

2025 has started with signs that overall economic growth is weakening. The previously resilient U.S. service sector is showing some signs of strain, while the manufacturing sector has shown indications of steadying but at an incredibly slow pace. A key question investors must contemplate is whether the slowdown is the result of demand that was pulled forward into the fourth quarter 2024 in response to the potential tariffs or the start of a downshift in growth. 

Some of the data we watch includes retail sales, which tumbled in January. Consumer confidence has pulled back sharply. Meanwhile, service sector growth appears to have stalled. For only the fourth time since 2014, the Atlanta Fed GDP Now (which is a forecasting model that provides a “nowcast,” or running estimate, of real GDP) currently points to overall economic growth contracting by 2.4 percent for the first quarter. While this measure could improve before the quarter ends, we’ve rarely seen a reading this weak in the past 11 years. The other instances include: 

• The onset of COVID, which was consistent with an actual economic contraction. 
• A brief period in early 2022 that saw the tracker briefly go negative (it did end the quarter barely positive). This reading coincided with a 1.6 percent contraction in first-quarter GDP. 
• A brief period at the end of the second quarter of 2022, when the last estimate of the Atlanta tracker showed a 1.2 percent decline. This was not far off from the actual reported 0.6 percent contraction during the second quarter (eventually the initial estimate was revised to a 0.3 percent gain). 

While the methodology behind the Atlanta GDP Now estimate isn’t perfect, we believe it provides a concise frame for the weak data that has been reported early in 2025.  

These emerging questions about growth come while inflation remains sticky. There are growing concerns that rising consumer inflation expectations could lead people to start buying ahead of expected price increases. This increases the risk of inflation becoming embedded in the U.S. economy.  

Admittedly, the current inflationary fears appear to be driven by talk of tariffs that may or may not be enacted permanently. It’s also unclear how much impact such tariffs might have on inflation. However, the reality is that overall consumer inflation expectations have spiked. Market participants are similarly pushing up nearer-term inflation breakeven rates, and long-term Treasury yields have fallen.  

Simply put, the market and consumers believe there is a growing risk of nearer-term inflationary pressures along with an unwanted side effect of slowing or even faltering economic growth. This puts the Federal Reserve in a difficult place as it thinks about its dual mandate of price stability and full employment. Each side of the Fed’s mandate appears to face heightened risks.  

The Fed’s rate cuts in the third and fourth quarters seemed to help pull a weakening labor market into growth toward year-end.

If we are later in an economic cycle, historically this is a time when incremental economic growth has often been accompanied by increasing and sticky inflationary pressures. And while overall economic growth appears to still be solid, there have been pockets of weakness, which increases economic risks, especially as the uncertainty surrounding tariffs grows.  

While our call of a mild recession did not come to pass in 2024, the simple turn of the calendar does not eliminate the risks that remain. The Fed’s rate cuts in the third and fourth quarters seemed to help pull a weakening labor market into growth toward year-end. But going forward, further cuts are likely on hold, and interest rates are still elevated. The housing market is still challenged, and manufacturing remains weak. Lower- to middle-income consumers continue to feel the dual impact of higher interest rates and higher prices. 

A bifurcated economy that still isn’t firing on all cylinders poses ongoing risks to future economic growth.  

Political uncertainty  

We do not want to pass judgment on whether any political policies are right or wrong. But we do need to consider the effect they could have on the economy and markets.  

The first month and a half of the new administration has been a blur. From an overall economic policy perspective, many economists believe there appears to be a mix of potential pro-growth initiatives alongside others that may detract from growth in the nearer term. Within this bigger picture the administration’s overall goals are to broadly change the way the U.S. government runs while also changing how the U.S. engages in global trade and defense. The questions investors are asking now: How do we get from where we are today as a country to whatever the future state becomes, and how much volatility will result from this transition?  

The most immediate question is about tariffs and their implementation. Currently (as of this writing) 25 percent tariffs have been levied on goods and services from Mexico and Canada that are not in compliance with the United Staes-Mexico-Canada Trade Agreement trade agreement (although automakers got a one-month exemption) and 20 percent on trade from China. Additionally, the administration announced a 25 percent tariff on all steel and aluminum imports from around the globe.  The total amount of imports under these tariffs is roughly $1.5 trillion. That total does not include the levies on steel and aluminum. The economic blow to both Mexico and Canada could be severe, with more manageable impacts to the Chinese economy. The impact to the U.S. economy will be less even with the possibility of countermeasures. 

However, tariffs are still likely to have an impact on economic growth and inflation. As of now, the levies are estimated to shave 0.5 to 1 percent from economic growth and cause a similar sized increase in the Personal Consumption Expenditures index. It’s estimated that these tariffs would bring global trade levies back to levels seen in the 1940s. Importantly, this current estimate does not count the potential for reciprocal tariffs or those on copper, autos, semiconductors, pharmaceuticals, lumber or even food that have all been proposed or mentioned but not yet implemented.  

Tariffs are one piece of the overall puzzle. Interestingly, the administration’s focus so far during the term has centered around driving yields on intermediate- to longer-term Treasurys lower. This fits into the context of the Treasury Secretary Scott Bessent’s 3-3-3 plan, which is a goal of 3 percent real economic growth and bringing the current budget deficit down to 3 percent of GDP while pumping three million more barrels of oil per day. The reality is that it will be incredibly difficult to bring the budget deficit down to 3 percent of GDP given that current annual interest costs alone are already consuming 3 percent of GDP. With rates currently above 4 percent and the outstanding interest rates on Treasurys at 3.2 percent coupled with expanding debt, rates need to go lower.  

How we get lower rates is an open question given the inflationary pressures that remain and the potential for price pressures to be amplified by tariffs. Rising inflation and falling yields often don’t go together. Additionally, tariffs have the potential to increase the value of the U.S. dollar. The administration appears to prefer a weaker dollar to make U.S. exports more attractive. 

The 3-3-3 plan has given rise to talk of a so-called Mar-A-Lago accord that lays out a blueprint for the economy based on a November 2024 paper by Stephen Miran, who is President Trump’s nominee to lead the White House Council of Economic Advisers. The paper makes the case that a persistently strong dollar has hindered U.S. trade competitiveness. The antidote to this appears to be to force revaluation of foreign currencies higher, which would weaken the dollar and ultimately lessen the debt load while also making U.S. exports more competitive on a global stage. Under the blueprint, the U.S. would also force foreign creditors to exchange long-term interest-paying bonds for 100-year non-tradeable zero-coupon bonds that pay no interest. The bonds would be issued at a discount and require holders to hold them to maturity. Should the holders need cash, they could borrow temporarily against the bonds. Moving debt into the zero-coupon bonds would serve to drive down interest costs. The overall goals of all this are a weaker dollar, lower interest rates and a lowering of the debt burden of the United States.  

The administration may feel the need to show that it is serious by not reversing course in the face of market weakness.

We highlight these concepts to note the extensive changes that could become reality and the complicated maneuverings that would be needed to achieve the administration’s overall goals. Whether these become a reality is up for debate; however, the administration’s broader goals appear to be clear. We believe this is going to be a complicated effort with many moving parts, and we believe this increases economic and market risks. 

Many market watchers suggest that these are just ideas that are being floated to serve as negotiating tools. Additionally, many (including us) have noted that during his first term the President seemed to judge his administration’s success based on how the equity markets performed. However, we note that this is a second-term president with a short window of time before mid-term elections. The administration may feel the need to show that it is serious by not reversing course in the face of market weakness. Recently, the administration and President Trump himself have made it clear that near-term gains in the stock market are not the priority and acknowledged that his administration is focused on change it believes will make the U.S. stronger in the longer term.  

Stock markets are similarly bifurcated and concentrated   

U.S. markets posted a strong advance in 2024, with U.S. Large-Cap stocks leading the way with a second straight 20 percent plus advance. However, a look under the surface shows that it was once again driven by a few companies. For the second straight year, fewer than 30 percent of the companies/stocks in the S&P 500 actually provided a return higher than the index. A review of returns back to 1973 shows this is rare. Indeed, the only other times performance has been this narrow was in 1998-99, 1980 and 1973. While admittedly not a large sample, we believe these periods share similarities. These were all later-cycle economies, which are often characterized by bifurcation—much like today—that eventually leads to overall economic recessions that eventually serve to refresh and broaden economic growth, corporate earnings and market breadth. Could this occur without a recession given the post-COVID “economic oddness”? Absolutely. The most important reality is that we are positioned for a broadening that has been typical for the past 50 years.  

A similar way to look at the impact of a few narrow stocks is to compare the market-cap-weighted S&P 500 index relative to the equal-weight index. 2024 marked the second year in a row that showed an extreme divergence between the two.

Likewise, Small- and Mid-Cap companies are often harmed by rising interest rates and narrowing economic growth. Last year saw a continuation of a trend that has been in place for much of the past few years and particularly pronounced over the past two years. These measures show that the markets are in a similar place as they were in the late 1990s. 

Returning to our valuation discussion, these areas also represent cheaper areas of the markets, with both Small- and Mid-Cap stocks trading at multiples relative to their Large-Cap counterparts last seen in 1998-99. These comments taken as a whole bring together our U.S positioning given the current economic uncertainty and our desire to stretch our horizon and focus on 1) relative valuation disparities coupled with 2) a return to a broader market environment, which we believe needs to occur for the market to move sustainably higher in 2025. Similarly, we believe that the economy needs to broaden, which is not without risks. Given this reality along with the myriads of risks that remain and given our belief that the economy is late in its growth cycle, coupled with the fact that certain segments of equity markets are trading at seemingly high valuations relative to fixed income, we continue to tilt slightly toward higher-quality fixed income.  

We remain overweight fixed income, which has been funded with an underweight to commodities and a slight underweight to equity, in particular, real estate equities. Within traditional equities, we retain our overweight to the interest rate-sensitive and cheaper segments of equity markets, Small- and Mid-Cap stocks. We are slightly underweight U.S. Large-Cap stocks, and in April 2024 we repositioned some of our exposure from the market-cap-weighted S&P 500 to an equal-weight version to amplify our broadening out theme. Overall, we are underweight international stocks with a preference toward International Developed Markets over Emerging Markets.  

International markets have started 2025 on a tear, with eurozone equities up over 17 percent as of this writing. These markets have been cheap for some time; however, they have been lacking a catalyst. Perhaps that has arrived in the form of a European economy that is being pushed to spend on defense and to stimulate their economies to acknowledge the potential for a shift in geopolitics. Indeed, in the aftermath of the German election, there has been a focus in the country on spending more on defense and trying to stimulate the economy. Indeed, Germany just announced a 500-billion-euro defense fund with the broader European Union expressing their desire to strengthen European defenses.  

We remain overweight fixed income, which has been funded with an underweight to commodities and a slight underweight to equity, in particular, real estate equities. Within traditional equities, we retain our overweight to the interest rate-sensitive and cheaper segments of equity markets, Small- and Mid-Cap stocks. We are slightly underweight U.S. Large-Cap stocks, and in April 2024 we repositioned some of our exposure from the market-cap-weighted S&P 500 to an equal-weight version to amplify our broadening out theme. Overall, we are underweight international stocks with a preference toward International Developed Markets over Emerging Markets.  

International markets have started 2025 on a tear, with eurozone equities up over 17 percent as of this writing. These markets have been cheap for some time; however, they have been lacking a catalyst. Perhaps that has arrived in the form of a European economy that is being pushed to spend on defense and to stimulate their economies to acknowledge the potential for a shift in geopolitics. Indeed, in the aftermath of the German election, there has been a focus in the country on spending more on defense and trying to stimulate the economy. Indeed, Germany just announced a 500-billion-euro defense fund with the broader European Union expressing their desire to strengthen European defenses.  

U.S. Large Cap  

2025 is off to a choppy start with more volatility and less upward momentum relative to the straightforward advances that investors have largely enjoyed in U.S. Large Caps during the past two years. The 57.8 percent advance in the S&P 500 from 2023 to 2024 came despite just one hiccup of a 10.3 percent drawdown in late October 2023 as yield on the 10-year U.S. Treasury briefly rose above 5 percent.  

To gauge the chances for a repeat of the strong advance of the last couple of years, it’s useful to break into two parts what drove the returns: multiple expansion and earnings growth. Blended forward 12-month earnings expectations were roughly $228/share beginning in 2023 and ended 2024 around $272/share, translating to a 19 percent increase in the expected earnings base over the two-year period. Dividend payments account for another 3.1 percent (or 4.6 percent if reinvested) of the index performance. That leaves a little more than 34 percent explained by multiple expansion, or the higher valuation that investors are willing to pay for the S&P 500 as the forward earnings multiple expanded from 16.8 at the beginning of 2023 and ended at 21.6 at the end of 2024.  

As we consider our positioning for 2025 and beyond, we question whether this steady multiple expansion can continue. Investors have largely priced out the recessionary risks that rose in 2022 as evidenced by investment-grade credit spreads that are still near 30-year lows. In our opinion, this paves the way for fundamental drivers such as earnings growth and dividend payments to replace multiple expansion as a major source of returns in the intermediate term. On this front, earnings are expected to grow a little over 10 percent in 2025, which is similar to the growth rate seen in 2024. The current dividend yield on the S&P 500 is 1.26 percent. As a result, adding the dividend yield to the earnings growth rate suggests it’s reasonable to expect solid returns for the S&P 500 this year if valuation multiples remain the same and current earnings expectations are met. Changes in the earnings outlook or unexpected macroeconomic developments could quickly change this fundamental setup. Should that happen, we believe the elevated valuation profile of the S&P 500 raises the chances that performance for the Large-Cap index could lag other areas of the equity markets. We’re modestly underweight U.S. Large Caps, as today’s pricing suggests downside risk to the economy is not fully reflected in prices. 

U.S. Mid Cap  

U.S. Mid Caps remain attractive over the intermediate term due to the appealing combination of inflecting fundamentals and relative valuation. The asset class trades at a roughly 30 percent discount to U.S. Large-Cap stocks, which reflects investors’ continued preference for holding companies that are less economically sensitive. In our view, we believe this discount represents a margin of safety in the forward outlook for Mid –Caps, as the 30-year average valuation spread between the two asset classes is minimal.  

More than 60 percent of U.S. purchasing managers indices (PMIs) are now in expansion territory, well up from the 20 to 30 percent reading that we saw during the Fed’s tightening cycle.

While valuation is not a near-term catalyst in the equity landscape, it does explain a large degree of relative performance over intermediate- to longer-term time periods. This longer time frame is precisely the time horizon that we target in our tactical positioning, particularly in light of the economic uncertainty and positioning that exists today. While we patiently wait for a catalyst to unlock the relative performance potential, we are encouraged by the improved breadth of the economy in recent months. More than 60 percent of U.S. purchasing managers indices (PMIs) are now in expansion territory, well up from the 20 to 30 percent reading that we saw during the Fed’s tightening cycle. We think it makes sense to translate broader economic participation to broader earnings growth across the equity landscape, with U.S. Mid Caps a potential beneficiary of this dynamic. While the recent announcement of tariffs could unwind some of this improvement, we believe that today’s relative valuation discounts provide a margin of safety and position this asset class for longer-term outperformance. We remain patient and overweight to the group. 

U.S. Small Cap  

Three rate cuts totaling 100 basis points by the Federal Reserve along with rate cuts across the globe, an improvement in small business confidence, recovering U.S. PMIs and a solid consumer spending backdrop have helped earnings growth expectations broaden in recent months. Unlike the last couple of years, when the so-called Magnificent Seven companies were the only consistent source of earnings growth, U.S. Small-Cap earnings expectations are finally moving in a positive direction. Sustaining this trend will be key to improved relative performance for Small Caps in 2025. Add in the potential for multiple expansion should the Federal Reserve cut rates more than currently expected, and we think the result is an attractive risk/reward profile over the intermediate term. We remain overweight. 

International Developed Markets 

The eurozone’s core inflation has remained above the European Central Bank’s (ECB) 2 percent target, with core inflation rising to 2.7 percent in January 2025. The ECB has noted that inflation is on track to approach 2 percent by late 2025, suggesting a continued gradual cooling trend. The eurozone’s GDP has been sluggish amid monetary tightening and geopolitical uncertainties. Major economies like Germany and France have been weaker, while tourism has been the main driver of a stronger Spain and Portugal GDP. To encourage economic growth, the ECB has pursued a gradual easing of monetary policy. ECB President Christine Lagarde believes the current policy is restrictive and has eased rates to support credit activity amid headwinds in the manufacturing sector. Markets are expecting at least one more rate cut this month. This view reflects current weak growth as well as confidence that inflation will decline. The Euro STOXX 50, Europe’s leading blue-chip index for the eurozone, has risen in local and U.S. dollars as equity prices reflect expectations of monetary easing. Positive earnings reports from major companies in the health care and financial sectors have also boosted confidence. While uncertainty around U.S. tariffs has likely tempered gains, their increasing likelihood coupled with the reshaping of the U.S. geopolitical role has led investors to expect increased government defense and infrastructure spending.  

Inflation in Japan remains well above the 2 percent target of the Bank of Japan (BOJ). The country’s Core Consumer Price Index has trended toward 4 percent in recent months. Wage growth in 2024 has supported underlying higher inflation, something that is structurally needed to end Japan’s decades-long deflationary spiral. Japan’s real GDP has trended higher in recent quarters with the fourth quarter checking in at 2.8 percent annualized pace. Consumer spending, fiscal stimulus, tax cuts and inventory builds ahead of potential U.S. tariffs have been the contributors to a slight increase in GDP. The BOJ has maintained a cautious approach to tightening. After raising rates 25 basis points in July 2024, the central bank has held rates steady at 0.25 to 0.5 percent. The BOJ ended negative rates in March 2024 and has prioritized re-anchoring inflation expectations at 2 percent. The BOJ’s accommodative stance reflects a balance between curbing inflation and supporting growth. The Nikkei 225, the index of the top 225 Japanese companies, has stabilized at 37,000 – 39,000 in local currency. Potential U.S. tariffs remain a threat and have been a headwind to market sentiment. 

We remain cautious in our outlook for both regions amid inflation pressures and global uncertainties weighing on growth. Central banks in both regions will continue to navigate a tight balance between inflation and economic recovery. We believe these markets have attractive relative valuations, especially within the eurozone, that are in need of a catalyst. Perhaps that day has arrived in the form of increased defense spending in Europe coupled with easing monetary policy. Meantime, the Bank of Japan remains accommodative with an economy that continues to expand. However, both of these comments are subject to the uncertainty of potential tariffs that could damage economic growth in the nearer term. Given this mix, our positioning remains neutral relative to our benchmark given our overall lower equity allocation. However, we have a positive intermediate- to longer-term outlook for the asset class. 

Emerging Markets 

Emerging Markets stocks have fared well so far in 2025 with renewed interest in Chinese equities sparked by the launch of the AI DeepSeek model in January. It’s unclear what DeepSeek’s future will hold, but Chinese stocks have been in search of a catalyst for the last few years and found one in this new, less costly AI model. At the time of this writing, MSCI China index was up about 20 percent year to date, while the broad MSCI EM Index was up nearly 6 percent. Foreign investment inflows have recently returned as investors search for a new way to play the AI story and find more attractively valued equities. That said, geopolitical risks between the U.S. and China, increasing debt, poor demographics and an announced 20 percent tariff on all imports from China all remain as short- and longer-term challenges for the Chinese economy. China has stated its opposition to U.S. tariffs and responded with targeted reciprocal measures. We caution that the ultimate magnitude of tariffs on China and the possible policy reaction from the country is still uncertain and will likely lead to volatility in the coming months. 

The prospect of more protectionist policies in the U.S. coupled with expansionary fiscal policy has ramifications for U.S. interest rates. While the Federal Reserve has cut rates in recent months, bond yields are still elevated in the intermediate to long part of the yield curve, albeit recently trending slightly lower as concerns about economic growth rise. Higher interest rates in the U.S. along with tariffs will likely shape the relative strength of the U.S. dollar versus emerging-market currencies. This is something we continue to watch closely. Regardless of the strength or weakness of currencies, the impact on returns and portfolio diversification in general is something that we feel is underappreciated as dollar strength has persisted in recent years. This may not always be the case, and we believe it is a reason to have exposure to International Developed and Emerging Markets asset classes. 

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

Fixed Income 

There’s been plenty of talk about the future direction of interest rates given the current signs of potentially sticky and perhaps rising inflation. This has led many investors to invest in shorter-duration securities given the belief that rising interest rates are here to stay. Perhaps, but we note that interest rates on longer-duration bonds have actually fallen over the past few weeks given that growth prospects have also faltered as equity markets have declined. We emphasize the latter because the ability of bonds to hedge equity market downside has been called into question given their inability to hedge against the equity market’s decline in 2022. The difference between then and now comes down to yields relative to stock valuations. Yields are much higher now than they were in 2022, while equities trade at similar if not higher valuations based on P/E ratios. This is something that we believe can persist in the shorter term but should normalize in the intermediate to longer term.  

While inflation could take hold and push yields higher, we continue to believe that the potential for an economic slowdown persists. In this scenario we believe that yields would likely move lower and longer-duration fixed income would likely rally, much as we have seen in recent weeks and even during periods in 2024 when recession fears perked up as labor markets wobbled.  

We also return to our opening commentary about fiscal policy and the reality that, so far, the administration seems focused on intermediate- to longer-term rates versus commenting on Federal Reserve policy. Indeed, if Treasury Secretary Scott Bessent’s 3-3-3 plan is to come to fruition, then something will need to give on the interest expenses paid on the U.S. debt (which by itself is equal to 3 percent of GDP). Perhaps a much-discussed Mar-a-Lago accord could include attempting to force intermediate term yields lower? 

While inflation could take hold and push yields higher, we continue to believe that the potential for an economic slowdown persists.

We continue to overweight fixed income in our portfolios with a focus on quality and a slight overweight to duration relative to the Bloomberg Aggregate Index. 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 should economic growth slow. While inflation remains a worry, we believe our allocation to commodities within our portfolios is a better way to hedge that potential risk than concentrating in shorter-duration bonds in our fixed income portfolios.   

DURATION  

The steepening toward a more normal-shaped yield curve is a welcome sign for fixed income investors. Throughout the past quarter, the spread (the difference in yield) between two-year and 10-year Treasurys has steepened by up to 40 basis points at any given time. This is primarily due to a rise in yields on the 10-year Treasury. This curve steeping, following a somewhat dramatic rise in yields for two-year Treasurys in early October 2024, makes the concept of “higher for longer” start to become embedded in the yield curve. This is being driven mostly by near-term TIPS breakevens moving dramatically higher over the past quarter and a half. While volatile, the one-year breakeven (which implies a forward expected inflation rate) has risen from less than 1 percent in late September 2024 to more than 4 percent as of this writing. While longer breakevens have moved less (10-year breakevens have moved less than 30bps higher over the same time period), they continue to march higher. Lingering considerations of whether sustained 2 percent inflation is feasible over the long term, curve steepening and expected inflation staying somewhat elevated continues to make a modest duration overweight to fixed income indices worthwhile as the carry and roll on securities in the eight- to 12-year part of the curve adds 20 to 40 basis points of cushion to the stated yield over the next year. 

GOVERNMENT BONDS/TIPS 

It’s always hard to pinpoint exactly what the primary driver of nearer-term interest rate movements is; however, the current environment has made that a much taller task given the complicated fiscal policy backdrop. The major question remains whether inflation can be managed without a pullback in the economy or equity markets and, if it continues to rise, at what point inflation actually starts to harm equity asset markets (as was the case in 2022). Credit continues to perform well early in 2025 with only a slight backup in spreads recently, which can have some seasonality to them. As such, it boils down to inflation and the subsequent move in rates. It’s even possible that, with spreads as tight as they are, they could widen regardless of which direction rates move. With rates and real rates elevated, we still prefer very high-quality bonds in the seven- to 15-year part of the yield curve.  

CREDIT 

Spreads can have inverse relationships relative to the direction of interest rates. Typically, as rates rise, credit spreads can maintain or even tighten in the nearer term, but there is a point when higher financing costs, less available credit and potentially stronger currencies can deteriorate the creditworthiness of the underlying security, with the end result being that investors begin to demand higher compensation for owning the rising credit risk. The inverse is also true: As rates fall, it’s typically due to some small deterioration in underlying economic strength, which causes spreads to widen. With continued inflation pressure causing still elevated interest rates but credit spreads remaining relatively tight, we believe that a potential large move in rates in either direction could lead to credit deterioration. However, if rates remain stable for an extended period of time, we may be able to avoid that scenario. Given our outlook that there are risks on both the inflation front and the economic growth front, we continue to focus on higher-quality credits.  

MUNICIPAL BONDS 

Municipals survived the longest and steepest curve inversion in their recorded history. While still marginally inverted for durations of less than one year, the rest of the curve is very normal and actually quite steep given the level of rates. For investors who have any sort of barbell in municipals or any other fixed income product, we believe now is the time to let it roll off or reposition it to a more normal curve stance. The curve now from one to 30 years is 140 basis points and positive at every node. A year ago, it was inverted from overnight instruments out to nine years. We believe that curve positioning should be neutral to modestly overweight duration in the municipal market.  

Municipals also could have some reform coming their way in the near or even extended future. Tax reform is always in the conversation when there are leadership changes in this country, and while we don’t anticipate changes to the tax exemption of municipals, it most likely will be in the headlines for a while. The “pre-refunding” option is also on the table to be reintroduced into the market, and that will have some ramifications on supply and demand dynamics over time. However, with rates higher for the first time in many years, the ability of municipalities to refinance outstanding bonds could be very muted.  

We believe Real Assets play an integral role in diversified portfolios due to their lower correlation to traditional equities and fixed income. Real Assets can provide valuable hedges against unexpected inflation and a strong sensitivity to real interest rates, which we think are important considerations in constructing resilient portfolios over an intermediate- to long-term horizon. The period 2021-22 provided an example of 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 2010-12 and eye-popping performance of real estate are other examples of the value of this diversification philosophy. Put simply, sharp changes on the inflation and real interest rate front are very difficult to time, which underscores the rationale for a structural allocation to Real Assets.  

Given the heightened level of uncertainties that exist, we believe that Real Assets play an increasingly important role in hedging the myriad risks that remain in the economy and markets. We believe the biggest questions yet to be answered are what happens to inflation and whether the Fed allows it to become embedded more permanently in the U.S. economy as it was from 1966 to 1982. The reality is that this risk is as heightened as it has been in decades. As such, we continue to want exposure to Real Assets, especially commodities given their sensitivity to unexpected inflation. Our forecast remains that an economic slowdown is more likely than an inflationary spiral, and therefore we retain an underweight position in commodities to fund an overweight position to fixed income.  

REITs remain highly sensitive to overall change in real interest rates and have spent much of the past few quarters oscillating between being the best-performing or the worst-performing of our nine asset-class models. This is likely because changes in real rates impact real estate more than any asset class in our portfolios, especially when overall REIT fundamentals remain weak. Given our desire to take slightly fewer overall equity market-like risks coupled with their still weak fundamentals, we continue to underweight REITs.  

While REITs have seen outsized and lasting impacts from the pandemic, they have also been under pressure from a dramatic 300-basis-point surge in real rates during the last three years. Interestingly, over the past few quarters REITS have shifted from the best-performing asset class as real interest rates moved lower to the worst when real rates reversed and moved higher. Importantly, over the past few weeks, when growth concerns have elevated and pushed nearly all U.S. equity markets lower, REITs have actually pushed higher and remain positive for the year. This is largely due to nominal and importantly real interest rates moving lower, and it supports our belief that the asset class currently offers important diversification characteristics.  

REAL ESTATE 

We’ve maintained a tactical underweight positioning in REITs for an extended period based on our analysis of not only the fundamentals of the asset class but potential interest rate volatility and inflation expectations as well. Real estate prices are influenced by several factors, not the least of which hinges on the anticipated trajectory of real long-term interest rates. In addition, REITs have become more correlated with moves in interest rates. The past year was no exception; real estate prices typically have a direct inverse relationship with the financing costs tied to buying an existing property or beginning new projects. Consequently, the aggressive cycle of rate hikes had adverse effects on longer-duration assets, including REITs. This is in stark contrast with the relatively favorable period for real estate prices during the ultra-low interest rate environment seen shortly after the onset of COVID. 

There are some potential bright spots appearing in the world of real estate and a host of potential new headwinds as well. On a historic, relative basis, REITs are trading at a discount to general equites. In the past, such relative valuation levels were followed by periods of REIT outperformance. The real estate market is expecting resilient demand and fairly muted supply growth, which could potentially support price levels. Cash flow growth may also accelerate if interest rate volatility subsides and allows the market to find clearing levels in some of the most hard-hit REIT sectors.  

Indeed, the resiliency of the U.S. economy over the past year has supported stronger than expected net operating income growth as the general positive correlation between positive GDP growth and REIT performance has held up. We find it encouraging that, broadly speaking, REITs have reduced leverage in recent years and, despite sharply rising interest rates, certain REIT sectors—like data centers, health care facilities and cell towers—have been able to show steady signs of rental growth above inflation. 

However, we must consider that increasing macroeconomic uncertainty will drive expectations about interest rates, volatility, economic growth and other factors likely to drive REIT performance. Inflation has remained above the Fed’s target, and while broad measures of inflation have been trending downward, recent readings have started to reveal some worrisome signs that the coast isn’t clear just yet. The Fed may be somewhat constrained in cutting rates further if inflation remains above target, and more rate volatility could be on the way given recent trends in long-term inflation expectations, adjustments in U.S. trade policy, fiscal deficit challenges, unemployment levels and more. Political risks in the U.S. and abroad could play a role in increasing upside risks in both inflation and rate volatility and downside risks in unemployment.  

We find this to be an asset class worth watching, and we are evaluating our positioning on an ongoing basis. The income-generating power of real estate can also be a compelling reason to own REITs, but we must weigh the long-duration nature of this asset class against other positions currently held in our portfolio, like long-term Treasurys, that may provide negative correlation to equities if risks to economic growth materialize.  

COMMODITIES  

Commodity prices have posted sizable gains so far this year, notably in energy, agriculture and gold. Currently, commodity buyers face numerous uncertainties, including the impact of Trump administration policies related to tariffs and energy as well as the ramifications of a large U.S. fiscal deficit and persistant sticky inflation concerns. These risks have resulted in an elavated level of buying by commodity consumers as a hedge against future risks. 

Energy commodities such as crude oil rallied early in the year due to an extension of OPEC+ supply cuts and the impact of new sanctions on oil-producing countries such as Russia, Iran and Venezuela. However, it was recently announce that that OPEC is now beginning to increase supply, a move likely influenced by President Trump’s desire to lower oil prices. Natural gas prices remain volatile but rose in the new year with the expectation of colder than normal weather depleting modest inventories.  

Market expectations for inflation have fallen over the last year but remain embedded in market expectations, which is a plus for commodities.

Industrial metals are an exception this year, with soft price appreciation due to concerns around potential tariff plans and continued sluggish Chinese demand. Agriculture is up overall with tight supplies across multiple commodities, particularly wheat. Finally, gold continues to remain near all-time highs as investors seek an inflation hedge. Ongoing purchases by global central banks also has put pressure on prices. 

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, potential disruptions related to the Russia-Ukraine war and the events impacting shipping in the Middle East could add additional pressure in the oil and grain markets. Market expectations for inflation have fallen over the last year but remain embedded in market expectations, which is a plus for commodities. 

Our outlook for commodities has shifted from mixed to modestly positive, driven by the current economic and political uncertainty. While uncertainties regarding tariff policies have had an impact already this year, the sequence in which the initiatives are implemented and their duration will determine the eventual outcome. That is a challenge commodity investors face today.  

We remain meaningfully underweight the commodity asset class, preferring fixed income and economically sensitive asset classes like Small-Cap and Mid-Cap U.S. stocks. Overall, we continue to believe the commodity asset class retains positive return expectations and significant diversification benefits. 

Every year, we, like many others in the Wealth Management business, produce an asset-class quilt that is designed to show the variability and rolling nature of the returns of different asset classes. The graphic is designed to show that performance leadership among asset classes rotates over longer periods of time. As such, trying to predict which class will come out on top, with any degree of accuracy, is a tough exercise. Unfortunately, for those who focus on shorter periods, the quilt can tempt them to gravitate toward what has worked well during the past few years. Look no further than the 2024 quilt, which showed Large-Cap stocks once again leading the way. Some investors took that as a sign that they should put all their assets in the S&P 500. After all, for much of the past six years, U.S. Large-Cap stocks have pushed to the top of the heap, which has driven them to the top of the heap on a 15-year (long-term for many) horizon. This has led some to believe that Large Caps would continue to outperform, and that the economy was truly different.  

However, what seems like an enduring change when viewed across a few years can end up being a temporary trend when looked at over longer periods. Importantly, we believe that history, while admittedly an imperfect guide, is worth paying attention to over the long haul. That’s because throughout time, many investors fall into the same patterns of thinking that often cloud their decision-making. Consider our 2013 quilt. 

Certainly, a review of this quilt in 2013 may have produced a different answer about how the future would unfold by looking at recent history, especially given the low ranking of U.S. Large Cap in 15-year rankings. Unlike now, when people want to own U.S. large cap only due to its recent performance, investors might have clamored to own REITs or International Emerging Markets or maybe even International Developed at the expense of U.S. Large-Cap stocks, which after the doldrums of the early part of the 2000s were squarely at the bottom of the equity asset-class rankings. 

We remain convicted in our belief that you should focus on the long term; invest in a diversified manner; and during good times or bad, adhere to an asset allocation that is part of a financial plan crafted by our expert advisors to meet your goals and objectives. The reality remains that the future is always uncertain and that the antidote for such is the continued adherence to these tried-and-true investment philosophies.  

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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