Why the Final Mile in the Battle Against Inflation May Lead to Recession

Much like last year, we again find ourselves firmly in the contrarian camp as 2023 draws to a close and we peer into 2024. Last year this time, investors were concerned about “sticky” inflation, which prompted pessimists to flee both equity and bond markets. We took a more nuanced approach guided by our “Space Between” fears outlook. Simply put, we believed that inflation had peaked and was set to move lower as the economy moved further past COVID-induced economic distortions. Our outlook was that falling inflation fears would serve to push angst-filled investors back to equity markets until they moved through the space between and started focusing on the next challenge: a recession.  

This is largely what has played out in 2023, albeit in an inconsistent manner as inflation has moved lower in fits and starts, while the economic narrative has oscillated between recession fears (early March) and soft-landing hopes (now). As 2023 draws to a close, the terms “soft landing” and even “Goldilocks” have become the rallying cries of now bullish investors. We think the easiest way to highlight the dichotomy in investor sentiment between then and now is the American Association of Individual Investors (AAII) Sentiment Survey. The survey measures whether investors are bullish, bearish or neutral on the economy in the coming six months. For the entirety of 2022, bullish readings were below the long-term average (back to 1988) of 37.5 percent. Last December, investors were extremely pessimistic, with every single weekly reading in the low to mid-20 percent range, with the December 22 reading notching a 20.3 percent bullish response reading. To put this into context, in the 1,874 weeks since the first week of 1988, this 20.3 level had been met or been exceeded to the downside only a meager 53 times (2.83 percent). This streak of below-average sentiment would last until June 1, 2023 (74 weeks), with the exception being a “tie” at 37.5 in the week ended February 9, 2023.  

We are heartened that inflation is faltering, but we don’t believe the last embers of price pressures have been extinguished.

As 2023 winds to a close, sentiment has swung to the upside since that June 2023 date, with survey readings now above 40 percent bullish for 16 of the past 26 weeks, with the last week of November coming in at 48.4 bullish. It appears that the conventional wisdom is that inflation is dead, the Fed is likely done hiking rates, and we will be able to avoid a recession. The story further goes that if economic weakness does seep in, the Fed will quickly cut rates to soothe any economic woes before they become deeper. Put simply, investors are once again optimistic and increasing their allocations to equities based on this much wished-upon soft landing coming to fruition. 

Allow us once again to disagree. We are heartened that inflation is faltering, but we don’t believe the last embers of price pressures have been extinguished. We believe the Fed will be hesitant to cut rates before it sees signs that inflation is SUSTAINABLY back to its stated 2 percent target. We believe the Fed wants to see the labor market soften before it feels comfortable that it has achieved its target. As such, we believe it will keep the liquidity tourniquet in place on the U.S. economy until the labor market slows to a point that labor demand meets supply. This raises the question of whether the Fed will be able to stick a landing wherein the labor market and economy soften enough to snuff out the remaining inflation embers without going so far that we see job losses. And if they go too far, will rate cuts be able to immediately stem the tide and pull the economy and labor markets back to the positive? Our answer to both questions is that such a perfect landing is highly unlikely. The reality is this is going to be an incredibly difficult needle to thread. We note that, historically, once the labor market begins contracting, job losses tend to continue.  

The Fed, through the blunt instrument of an incredibly aggressive rate hike campaign (which they admit has variable lags), is trying to land a $27 trillion U.S. economy and a 168-million-person labor market at a reduced but still positive pace of growth. History would suggest (and we believe) that it will be incredibly difficult to do so without some sort of economic and labor market contraction, especially given our belief that the Fed will err on the side of making sure inflation is sustainably back to its 2 percent target over avoiding an economic contraction.  

The good news is that inflation is coming down as the economy moves past COVID distortions and returns to a more normal equilibrium. The bad news is this reattachment to “normal” is occurring in a period when the economy is showing signs of being late in a traditional business cycle—the unemployment rate is low, workers are hard to find, and as a result wages are elevated. While predicting the exact timing of a recession is difficult, we do feel confident that we are later in the business cycle.  

Inflation is not yet sustainably at 2 percent 

Our disinflationary forecast has played out over the past year as the economy has returned to equilibrium post-COVID. Goods prices have faltered as spending has shifted to services and inventories/ supply chains have healed. Indeed, goods prices in the Consumer Price Index (CPI) have been in deflation for each of the past six months and are flat on a year-over-year basis. Commodity-driven inflation has eased as prices have faltered after the Russia invasion of Ukraine. The dramatic shift in spending from goods to services and the economy fully reopening drove services inflation dramatically higher through the end of 2022 and into early 2023. However, since then, services inflation has slowed to 5.5 percent year over year after peaking at 7.3 percent in February 2023. Additionally, as we have detailed in the past, when you subtract the impact of lagging shelter readings from the services calculation, the pace of inflation for the rest of services has slowed to 3.5 percent year over year.  

Finally, closing out our commentary on the path of inflation (a point familiar to regular readers): When shelter is removed from both headline CPI (+1.4 percent) and core CPI (+2.13 percent), inflation readings clock in at or below the Fed’s 2 percent target. And while housing prices have recently stabilized, they are now growing at a low single-digit pace on a year-over-year basis, well below the double-digit gains seen during the early stages of the post-COVID recovery. This brings us to the present day and a discussion of why our inflation outlook is pivoting and, more importantly, why we believe the Fed will be unwilling to declare victory over heightened price pressures in the near term.  

We believe the Fed’s focus and outlook on inflation has shifted much as ours has. At a recent event, Fed Chair Jerome Powell stated that much of the pullback in inflationary pressures over the past year has been because of pandemic supply chain issues healing and that he doesn’t believe that wages have been the principal cause of inflation in the recent past. However, he did state that maybe the labor market will become a more important driver of inflation in the future. We align.  

Over the past few weeks, as the data has begun to soften, we have begun to hear commentary about the Fed needing to slow down or even cut rates because the labor market and inflation readings are weakening. We believe the Fed is not going to risk easing rates too soon in an effort to keep the economy and labor markets strong. In a response to a question on this topic at a post-Fed-meeting press conference, Powell said that the Fed did not want to go too far, “but the biggest mistake they could make is not getting inflation under control.” And seemingly to tie the two mandates together (full employment and stable prices), he noted, “Without price stability we will not have a good labor market that benefits all”; he also said that the Fed is highly attentive to the risks high inflation poses to both sides of the mandate.  

The bottom line is that we believe the Fed is still haunted by the 1966–1982 period and is going to prioritize stamping out inflation over keeping the economy rolling. Allow us to pull one more quote from Chair Powell to support this view.  

The real point, though, is the worst thing we can do is to fail to restore price stability, because the record is clear on that. If you don’t restore price stability, inflation comes back, and you can have a long period where the economy is just very uncertain—and it will affect growth, it will affect all kinds of things. It can be a miserable period to have inflation constantly coming back and the Fed coming in and having to tighten again and again. So, the best thing we can do for everyone, we believe, is to restore price stability. 

We believe this is a direct reference to that time period when the Fed believes its failure to finish the job caused 16 years of elevated inflation and economic doldrums, which required it to aggressively overtighten the U.S. economy into recession in the early 1980s. We believe the bottom line is that the Fed isn’t going to take the liquidity tourniquet off until inflation is nearer to its target and the final embers of inflation burn out, which is where wage increases come into our equation. Wage growth is still too high, and unfortunately, we don’t think it will move sustainably lower until the labor market weakens, which we believe will ultimately be the cause of the recession.  

While the rise in participation and productivity is encouraging, we don’t believe either has staying power, particularly labor force growth given that the prime-age participation rate (25–54 years old) is above pre-COVID levels and has only been higher than today in the late 1990s.

Allow us to again acknowledge that there is a slim path to a potential soft landing. However, for it to occur would require an increase in labor force participation and a sustainable uptick in worker productivity. In either of those scenarios, wage pressures would likely decrease, which would short-circuit the risk of a wage–price spiral. Over the past few quarters, we have witnessed an increase in labor force participation and a solid uptick in productivity, but wage growth has remained elevated. While the rise in participation and productivity is encouraging, we don’t believe either has staying power, particularly labor force growth given that the prime-age participation rate (25–54 years old) is above pre-COVID levels and has only been higher than today in the late 1990s. Regardless, the reality remains that the U.S. economy appears late in an economic cycle, and as such, a recession likely lies somewhere on the near-term horizon. 

No recession yet does not mean there won’t be one 

Over the past 21 months the Fed has placed a liquidity tourniquet on the U.S. economy with 5.25 percent of rate hikes, while policymakers have pulled back fiscal stimulus (student loan/rent relief). Banks have tightened lending standards on consumer, commercial and residential loans to levels that historically have been consistent with recessionary conditions. This all has helped push the U.S. M2 money supply to negative (-3.3 percent as of 10/31) year-over-year levels for only the fourth time since 1900. It’s worth noting that in each of the prior three instances the contraction in M2 money supply led to, or was coincident with, recessions. Despite this, the U.S. economy has appeared to remain strong, with many seeing its resiliency as a reason to believe that the economy won’t fall into a recession. They suggest that the economy has too much momentum and that rate hikes have already likely worked their way through the system. As a result, the argument goes, if the Fed is done hiking, we are unlikely to have a recession.  

We believe this conclusion is likely to prove incomplete. First, we note that economic growth as measured by gross domestic product (GDP) is often strong before a recession; after all, the Fed is trying to slow down a too hot economy. Further, we note that while third-quarter 2023 GDP checked in at 5.2 percent quarter over quarter on a seasonally adjusted annualized rate and 3.0 percent year over year, its close relative, gross domestic income (GDI), which captures the income associated with production (GDP) (and as such the two measures should be equal over reasonable time periods), is painting a different picture. GDI is actually down 0.2 percent year over year since the end of Q3 2022.  

Second, we note that rate hikes have historically had long and variable lags. There has been much debate about whether those lags (previously thought to be between 12 and 18 months) have shortened. Perhaps, but we note that the U.S. economy has likely been less interest rate sensitive during this cycle. We note that around two-thirds of overall consumer debt is mortgage debt, and since the Great Recession a large majority of Americans have opted for fixed-rate mortgages. Contemplate that the effective interest rate on all current mortgage debt outstanding is 3.74 percent as of Sept. 30, 2023. Contrast that to rates on current 30-year fixed rate mortgages that are now at 7.5 percent and above. While many Americans haven’t felt the impact, they eventually will as the housing stock turns over.  

The consumer was also better insulated coming into this environment, as their balance sheets were padded with more than $2 trillion in excess savings from COVID; however, most estimates suggest the surplus has since been spent. Recall that student loans and even rent moratoriums are now winding down. This is occurring at a time when credit card debt now carries an average of 21.19 percent interest rate—a development that is likely to further drain savings and weaken balance sheets. Interest rates on auto loans are now near 8 percent compared to a loan average of 4 percent before COVID. As rates stay high, they will likely dent the strength of the consumer. But the same holds true for companies, which spent the prior years terming out their debt with lower rates. However, as that debt needs to be refinanced and wages remain elevated, which will likely cause margins to erode, and could be the precursor to job layoffs. 

We believe higher rates will erode consumer and corporate income statements and balance sheets. There is already evidence of a spike in interest outlays as a percentage of disposable personal income, and surveys are now showing consumers pointing to rising interest costs as a cause of their economic angst. We think this will eventually erode economic growth.   

“But the labor market is still strong”  

This is the common retort to any question regarding the economy’s strength, and it appears that companies have been trying to hang on to labor because it was hard for them to find workers post-COVID. However, this appears to be slowing, as many surveys, such as the Beige Book and Institute for Supply Management (ISM) surveys, now are pointing to companies beginning to let workers go. We have also seen the Conference Board’s Employment Trends index, an aggregate of eight labor market indicators that show trends in employment conditions, roll over. Turning points in the index indicate that a change in the trend of job gains or losses is about to occur in the coming months. The most recent data from October shows the index at 114.16, which is well off the peak of 119.55 in March 2022.  

While initial jobless claims have remained relatively low, continuing jobless claims have spiked. Continuing claims comprise people who file initial claims and remain on benefits, a condition that shows they are having a hard time rejoining the labor market. These continuing claims have recently spiked and ended November at 1.861 million, up from 1.658 million in September, which with the exception of April 2023 is the highest level since late 2021. Importantly, continuing claims are up 20 percent from last November—a rise of this size has either been coincident or led to eight of the last eight recessions since the mid-1960s.  

We also note that, as shown in the recent nonfarm payroll report, the number of industries hiring has shrunk to just 54.4 percent, which is nearing or at levels that historically have warned of job losses. Finally, the unemployment rate has risen from 3.4 percent in April to 3.7 percent today after a stop at 3.9 percent in October. This rate is calculated using the household report, a measure separate from the non-farm payrolls report. The household report shows that there are about 849,000 more unemployed Americans than there were in April.  

All of this leads to an important point: Once the three-month moving average of the unemployment rate increases by 0.5 percent or more from the prior 12-month low, further labor declines and an eventual recession are on the horizon. Known in economic circles as the SAHM rule, this indicator has been flawless in foretelling recessions. As we exit 2023, we are nearing this level.  

Over the past month, bad news has been embraced by investors as good news.

Most importantly, once unemployment climbs by 0.5 percent or more from the trough in that economic cycle, in every instance since WWII, the next stop during a recession is a rise in the unemployment rate of 1.9 percent or more. Put differently, job losses tend to trend. Given that we believe the Fed is unlikely to cut rates before inflation is sustainably defeated, we believe that even if it does eventually react to a faltering labor market, it will likely be too late, and a recession will ensue.  

Over the past month, bad news has been embraced by investors as good news. Economic growth has slowed sharply, and since October the labor market has increasingly shown cracks. However, these signs of slowing have bolstered the belief for some that the economy is headed for a soft landing. Bond yields have faltered as more investors become convinced the Fed is done raising rates, and the drop in yields has pushed equity markets sharply higher.  

The key question to ask when thinking about the bad-news-as-good narrative is this: Does this bad news of a slowing in the economy and now the labor market stop at still positive growth, or does the slowdown go too far and turn into a recession? Do you believe the Fed can micromanage a $27 trillion economy and a 168-million-person labor force into perfect equilibrium using the blunt instrument of rate hikes, which have unknown lags and uncertain impacts? Our answer is the same as what history would suggest: It’s not likely, and we continue to think the Fed will err on the side of leaving monetary policy too tight as it seeks to put an end to the threat of resurgent inflation. 

Since Q4 2022, we have been gradually repositioning our portfolio to reflect our “Space Between” outlook. The result has been increased exposure to fixed income given our belief that bonds represent real value. Based on our belief that inflation was peaking, in October 2022 we moved commodities to underweight and added to fixed income while lengthening duration. As a reminder, commodities are an asset class we held in anticipation of inflation rising in the aftermath of COVID. In January 2023 we pulled equities back to a slight overweight followed by a move to neutral in May and then finally to underweight in September. This move was based on our forecast that a recession was becoming more likely in the next 12 months. In that same September trade, we further reduced our commodity exposure by eliminating gold, a position we had bought in the immediate aftermath of COVID, given our belief that fixed income was an incomplete hedge against potential equity market downside driven by the potential of rising inflation and interest rates. At the time, the 10-year Treasury yield was around 0.6 percent, and a broader basket of investment-grade bonds represented by the Bloomberg Aggregate Index yielded about 1.4 percent. With those yields rising to the mid-4 percent range on 10-year Treasurys and above 5 percent on the Bloomberg Aggregate Index along with our forecast of declining inflation, we determined that a full return to the income generation and real yields of bonds was appropriate.  

Overall, we remain underweight commodities and equities with an overweight to fixed income given our economic and market outlook over the coming quarters. We acknowledge that recessions are difficult to time and that we could continue to be surprised by the economy’s resilience, and for this reason we have taken a gradual approach. However, we don’t believe that the anomalies from COVID have eradicated the traditional business cycle. We also believe that we are later in an economic cycle, a condition that merits paying greater heed to managing risk.  

These are not dire comments, and we believe opportunities exist for intermediate- to long-term equity investors. Over the past year as recession fears have come and gone, many have allocated their equity investments toward the perceived safety and “economic insensitivity” of the S&P 500 and Large Cap tech. We believe 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. This is not to say they might not decline further if a recession unfolds, but importantly, we believe these parts would recover quickly and don’t believe we have the ability (nor should we try) to precisely time market rotations. What if the space between is extended and our recession forecast does not play out in the coming quarters? We believe it is likely that these economically sensitive cyclical asset classes could surprise to the upside and provide investors with excess returns. 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 and pay greater heed to that time horizon rather than the nearer term.  

U.S. Large Cap  

Digging a level deeper reveals that the surge in the S&P 500 index in 2023 has been driven by an abnormally small number of Large Cap stocks, coined the “Magnificent 7.”

The overall resiliency of the U.S. economy has translated into the surprisingly strong performance of U.S. Large Caps in 2023. The S&P 500 index is up more than 21 percent after a strong surge in November. Ironically, the move came on the back of weaker but still positive economic data, which gave investors confidence that the Federal Reserve’s tightening cycle is ending. A look at the underlying fundamentals of the S&P 500 reveals how much sentiment has driven equity returns this year. Consider that this 21 percent return has occurred despite expectations that full-year 2023 earnings will be flat to slightly negative compared to 2022 levels (consensus estimates call for earnings of $221/share for 2023 vs. $223/share in 2022). This has increased the market’s price-to-earnings multiple from 17.6x to start the year to 20.97x, which is a more than 19 percent increase in this important valuation measure. 

Digging a level deeper reveals that the surge in the S&P 500 index in 2023 has been driven by an abnormally small number of Large Cap stocks, coined the “Magnificent 7.” These seven companies comprise an all-time high of 29 percent of the overall market capitalization weighted index and have produced stellar returns in 2023 (+108 percent on average). This weight and performance concentration has led to a striking performance disparity between the market cap-weighted S&P 500 index versus the equal-weighted S&P. The equal-weighted index is up around 7 percent year to date, 14 percent below the cap-weighted return. Should this level of outperformance persist through year-end, it would mark the second highest level of outperformance of the cap-weighted vs equal-weighted indexes over the last 34 years. The only time the disparity was greater was in 1998, with an 18.2 percent outperformance. This isn’t a bearish comment on the fundamentals of the “Magnificent 7” companies, as the quality profile and growth prospects are much better than the average S&P 500 company, but it does raise the risk profile of the index, as a large degree of optimism is priced into a concentrated subset that makes up around 30 percent of the total index. Should these companies fail to meet the lofty expectations priced into their respective valuations, we may see some form of a repeat of 2000 to 2005, when the equal-weighted index outperformed SPX by more than 51 percent cumulatively. We remain underweight to the S&P 500.  

 U.S. Mid-Cap  

We continue to have a positive intermediate view on U.S. Mid-Caps as we believe the combination of sensible earning expectations and discounted valuations creates an attractive return skew over our forecast horizon of 12 to 18 months. U.S. Mid-Caps trade at just more than 13x 2024 consensus earnings, which have been marked down by more than 7 percent from earlier this year as economic concerns have grown. Despite the macroeconomic headwinds, U.S. Mid-Caps are up almost 9 percent this year, landing in the top third of our nine asset class portfolios, and would be near the top if we compared the result against the equal-weighted Large Cap index (up 7 percent). While we expect performance to be volatile over the intermediate term if our recession forecast proves correct, the compressed valuations and earnings expectations do offer a degree of downside protection in our view. We also expect this asset class to perform well coming out of what we believe will be a mild recession.  

U.S. Small Cap  

Despite investor sentiment that has bounced between recession and soft landing, we continue to be drawn to the favorable optionality that we believe exists in U.S. Small Caps over the next 12 to 18 months. If the economy does fall into a mild recession, we believe Small Caps have already discounted some probability of a recession, as their earnings expectations have been reduced by more than 15 percent and the index is already trading near trough valuation levels seen over the last 15 years. On the other hand, if the economy moves sideways and eventually reaccelerates in the soft-landing scenario, the sensitivity Small Caps have to the economy combined with substantial multiple expansion opportunities could, in our view, easily catapult this asset class to the top performance position within our nine asset class portfolios. While downside risk always exists in any asset class, we like the probability-weighted forward return skew in small caps. Patience is warranted; remain overweight. 

International Developed 

The eurozone economy is broadly stagnating as the European Central Bank (ECB) aggressively raised rates by 4.5 percent since last June. This has resulted in steadily declining economic growth with third-quarter GDP checking in with a 0.1 percent decline, pushing the year-over-year number to the brink of contraction at a 0.0 percent gain. Indicators of future growth point to further weakness, with the S&P Global Eurozone manufacturing purchasing managers index (PMI) remaining in contraction (below 50) for 17 consecutive months and with readings for the last five months falling to historically depressed levels of between 42 and 44. After keeping the economy afloat for much of this time, the eurozone services sector has slowed, with the PMI registering below 50 for the past four months.  

The good news is that overall inflation has been slowing alongside economic growth, and currently headline readings are at 2.4 percent overall, and core inflation is down to 3.6 percent. Unemployment remains historically low, which is serving to keep wages elevated. Given this backdrop, the ECB decided at its September meeting to pause its rate hike campaign, saying it is now in a position to take a wait-and-see approach. However, worries about inflation and the potential for a wage–price spiral are prompting the ECB to refrain from declaring the inflation fight finished. Instead, it is keeping monetary policy tight and interest rates elevated despite the faltering economic backdrop.  

While other advanced economies have been tightening monetary policy, the Bank of Japan (BOJ) has been hoping to take advantage of price pressures to reflate the country’s long-time deflationary economy. The Bank of Japan’s move at its July policy meeting to widen yield curve control on the 10-year Japanese Government Bond yield to 1 percent is evidence that the central bank is on the path of policy normalization. Inflationary pressures have not abated, and the expectation is for further policy adjustments toward the end of the year or in early 2024. At the same time, inflation has been rising and currently sits at 3.3 percent overall; the core reading, which excludes food and energy categories, is at 4 percent. Accumulated price increases inflated by the weak yen, rising living costs, and increased tourism have been significant contributors. Simply put, the BOJ likely looks at this as its chance to finally end the deflationary spiral that has affected Japan for decades. We note that the core inflation level is the highest since the early 1980s. While other economies are trying to make sure that inflation doesn’t become embedded, the bank of Japan is taking the opposite stance. The key test remains wage declines, which have persisted for decades but are now giving way to increases.   

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  

As we approach the end of 2023, emerging-market equities have lagged developed markets internationally and U.S. markets largely due to the underperformance of equity markets in China, as the world’s second largest economy continues to muddle through a “recovery.” There have been some recent positives in China, with retail sales and industrial output in October surging more than expected; however, this coincides with continuing weakness in housing and the real estate sector. 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.  

A likely scenario, in which rates remain higher for longer in the U.S. while the People’s Bank of China cuts rates, is one that favors dollar strength and increases the potential for capital flows out of the developing world to opportunities with a better risk/reward trade-off.

A recent positive for performance in international developed and emerging markets has been weakness in the dollar, which has dropped to its lowest level in two months as markets believe interest rates in the U.S. have peaked. Our view is that Fed tightening cycles tend to be a headwind for emerging-market stocks, bonds and currencies. A likely scenario, in which rates remain higher for longer in the U.S. while the People’s Bank of China cuts rates, is one that favors dollar strength and increases the potential for capital flows out of the developing world to opportunities with a better risk/reward trade-off. In short, recent dollar weakness may not last in the short run. All eyes are on Chinese policymakers, and many are hoping for additional accommodative policy to support consumption. The Chinese government has the capacity to support additional stimulus, but the question is whether they will, as they have recently taken a more conservative fiscal approach. Lastly, U.S.–China relations saw some improvement as talks between Joe Biden and Xi Jinping led to an agreement to resume military-to-military communications and cooperate on anti-drug policies.  

China’s impact on emerging markets as a general asset class is significant, making up approximately one-third of emerging-market indices. 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. India is a good example; the country’s markets have risen and outperformed most other equity markets over the last three years. This highlights the diverse nature of the emerging markets asset class, and we note that today’s emerging-market equities, as a group, 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 historically cheap. 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, we continue to underweight the asset class.  

To say the move in fixed income markets over the past couple of years has been dramatic would be an understatement. Consider that as of December of 2020, Bloomberg calculated that there was more than $18 trillion of negative-yielding debt globally. Today that amount sits at a mere $206 billion as rates around the globe have risen. This move has come with volatility that has created fear in bond market investors. We think of it in this manner: 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 onslaught of supply to be mopped up by real buyers. We are going through a period of price discovery after years of the market being driven by policymakers. The resulting volatility and losses have led to many investors hiding in shorter-term bonds or cash. We continue to believe that investors need to invest along the yield curve to match their liabilities and acknowledge that intermediate-term rates remain attractive at current levels.  

The future is uncertain, and with interest rates currently attractive relative to future inflation, we believe that investors should consider tilting their portfolios toward bonds—across the yield curve and investment-grade credit spectrum, especially given our forecast of a coming recession.

The reality remains that bond yields today still reside near the highest levels since the 2005–2008 time period. In other words, it has been 15 years since yields have offered this level of potential income. That, in our view, is an attractive backdrop, especially given our forecast that a likely recession will extinguish inflation. We remind those tempted to hide out in shorter-duration bonds that no one knows with precision where rates will be in the future, and investors need to recall that investing only in shorter-term securities brings reinvestment risk into the conversation.  

The future is uncertain, and with interest rates currently attractive relative to future inflation, we believe that investors should consider tilting their portfolios toward bonds—across the yield curve and investment-grade credit spectrum, especially given our forecast of a coming recession. While we acknowledge the level of debt in the U.S. remains a risk (as witnessed by recent ratings downgrades), we believe that at the current 2 percent-plus real rate across the U.S. yield curve, investors are being compensated for that risk.  

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  

We continue to believe that investors who focus on duration win more often than they lose. Simply put, high-quality fixed income pays you for time. While there are times when a sharp shock higher in interest rates can overpower the power of time, those times are very rare. The past 18–24 months certainly qualify as rare and will go down in the history books as one of if not the worst in the history of the bond market. Despite this, we continue to watch as many investors seek shelter in only the very short-dated maturities vs. extending to include intermediate to longer-dated (seven to12 years) securities. Our answer is the same, regardless of the shape of the yield curve: Investors who concentrate exposure in the short end of the yield curve lose the benefit of time. The curve is inverted, and it currently is an aggressive inversion, but having high-quality duration in your portfolio buys you the time to have these higher rates for longer. At current levels, we believe longer-term bonds have returned to providing a hedge against riskier assets. We continue to favor modest, high-quality duration relative to your index. 

Government Securities/TIPS  

Given our economic outlook, we continue to favor high-quality bonds, which include Treasurys, and other U.S. government-sponsored securities. The heavy supply of Treasurys will likely serve to keep rates somewhat elevated for the foreseeable future. However, once the market digested the heavy supply at the end of October, rates rallied. For the first time in years, investors are paying heed to Treasury auction days, and the result has been elevated market volatility with financing rates driving the story. We favor taking advantage of these higher rates by increasing the credit quality of your fixed income portfolios. You are now buying U.S. government obligations that offer interest rates that, as of two years ago, investors could find only from junk bonds.  

As we exited the pandemic, we overweighted TIPS given our belief that inflation was an eventuality the bond market was underpricing. Last year, we pulled back this overweight given our belief that inflation was set to pull back, a belief we still hold today. The entire breakeven curve has settled back into its more than 20-year state of inertia, right around 2 percent. There will certainly be gyrations in inflation, but our call that inflation was a blip is playing out. Nominal rates offer nice real yields, and we continue to favor collecting coupons over inflation protection.   

Credit 

The biggest anomaly of the past six months has been the continued tightness of credit spreads. In the past 40–50 years, each Fed tightening cycle has led to significant widening of credit spreads at some point. We have yet to see that occur, and considering the massive scope of spread tightening over the past two months, we anticipate credit will eventually widen aggressively. When credit spreads do widen, it will likely be the precursor to the Fed rate cuts the market is starting to price in. Be cautious with credit here. We continue to favor 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. 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 munis. 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. 

We continue to believe that real assets deserve a place in fully diversified portfolios due to their ability to help serve as a hedge against unexpected inflation and their typically low correlation to stocks and bonds. This reality has been amplified over the past few years, especially in 2022, when both bonds and stocks produced negative returns, marking only the fifth time such an event occurred for a full calendar year going back to 1926. The anomaly in 2022 was driven by policymakers' actions in the prior years that were designed to push down bond yields and drive investors toward equities. We believed that rising inflation and the unwinding of the liquidity infusion by policymakers was likely to lead to a period when bonds and stocks declined together. Our answer was to include this “third asset class” because of our belief that it could serve as a hedge when inflation reared its ugly head. That was 2022; this is now.  

 We continue to believe that inflation is headed lower in the intermediate term on the back of weaker economic growth and a recession. That along with the dramatic repricing of interest rates and bond market yields has led us to now underweight commodities relative to fixed income. In September 2023, we reduced our commodity exposure by eliminating our position in gold, which yields nothing. We reinvested the proceeds from the sale of our gold position into fixed income, which offers yields for investment-grade credits of approximately 5 percent. Given our belief that a recession and faltering inflationary pressures lie ahead, we continue to maintain our underweight toward commodities.  

While the societal shifts that occurred as a result of COVID have begun to wane, REITs have remained under pressure given tighter lending conditions and now heightened interest rates. Worries about commercial real estate remain, and while we share many of those concerns, we note that publicly traded REITS remain 27 percent below their recent post-COVID high set in December 2021. Risks for the group continue, and much will be sorted out in the coming months (particularly in the office market) and as the impact of rate hikes is reflected in high re-financing costs. For now, given our forecast of a looming recession and the continued tightening of credit conditions, we remain underweight in this asset class.  

Real Estate 

Real estate prices depend on many factors, but a large component of valuation for this asset class is a function of long-term interest rates and their expected path. It is no surprise, then, that the aggressive hiking cycle had a negative impact on longer-duration assets, such a REITs, and remains a stark contrast to the comparatively easy period for real estate prices during the ultra-low interest rate environment we witnessed before and even during the pandemic. The Fed has undertaken a swift and determined effort to contain rising inflation by implementing 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. Not only has demand for new projects slowed and affordability ratios for existing projects continued to deteriorate, but lending standards on the part of banks and other financing companies have also been becoming 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 have to 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 exhibit 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 begun to see some severely distressed sale prices as supply and demand factors try to find a proper balance.  

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, this asset class is treading water at best given the current transitionary environment, which we expect to last well into 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  

Through early December, commodity prices have fallen approximately 6.5 percent over the last three months, and they remain down about 9.0 percent year to date.  

For some time, we have expressed our concerns that global growth would likely slow and that inflation in the U.S. had moderated after peaking last summer/fall. We believe that recent commodity asset class performance reflects these concerns. The relatively weak commodity performance this year follows a strong 16 percent gain in 2022 and a 27 percent gain in 2021. Given the negative returns posted by stocks and bonds last year, the past several years have underscored the diversification benefits the commodity asset class provides.  

Looking deeper into the rather flat to negative short-term performance of broad commodities, individual commodity performance has been varied and volatile. Losses in energy and industrial metals were offset by gains in gold and agricultural goods.  

A barrel of U.S. benchmark crude oil began the year at $77 and peaked at $93 in late September. Gains in crude were largely attributable to OPEC+ production cuts. Approximately 5 million barrels per day were taken off the market since 2022. Currently, the price of oil has fallen below $72 per barrel after OPEC+ delayed a key meeting to discuss additional cuts. In addition, concerns that the Israeli-Hamas conflict could escalate and impact Middle East oil production has eased, at least for now. On the demand side, global consumption for oil looks set to stay stable or grow. As travel abroad normalizes, we expect the consumption of gasoline and jet fuel to increase substantially. The largest detractor to energy continues to be collapsing natural gas prices (down 65 percent year to date). U.S. natural gas prices rose modestly over the last few months on higher exports and forecasts for cooler than expected weather.  

Industrial metals such as copper, aluminum, nickel, and zinc have fallen sharply throughout 2023. China’s growth has historically been a demand driver for industrial metals, so the current weakness in China’s economy largely explains why prices for these metals have slumped. Should China’s economy show signs of a rebound, industrial metals prices likely will move higher. 

Precious metals have continued to post decent gains (gold up almost 10 percent year to date), in part due to investors pricing in the prospect of continued economic and geopolitical risks. Gold prices rose in the last few months on strong demand for safe-haven assets and significant central bank buying. 

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. The return of El Nino weather patterns could also impact agricultural prices. In energy, persistent underinvestment, additional OPEC production cuts, and disruptions related to the Russia-Ukraine war have resulted in significant tightness in the oil and grain markets, which we expect to persist. Overall, we continue to believe the commodity asset class offers positive return potential and significant diversification benefits. However, given our nearer-term economic outlook, we remain meaningfully underweight the commodity asset class.  

The secular backdrop that has been firmly in place for more than a decade is shifting. After years of policymakers running to the rescue during economic or market hiccups, they will be proceeding far more cautiously in the future, we believe. We think about this “pivot” in the following manner: For much of the past decade until early 2022, the Fed was trying desperately to push inflation higher and had failed in this effort for years. We viewed COVID as policymakers’ best chance to push inflation and inflation expectations higher, and they responded much as we thought they would, with a monetary firehose. While we knew there could be stressors, we also believed those would be quickly alleviated by a tsunami of liquidity. Now, after living through the type of inflation economists were seemingly romancing, the public has seen enough.  

Similarly, fiscal policymakers cranked up the fiscal largesse post-COVID. Borrowing costs were low, and as such, conversations about the level of debt were dismissed, but that has since changed. Last summer, Fitch became the second of the three major ratings agencies to downgrade the U.S. credit rating from AAA to AA+. While Moody’s, the last the of three major rating agencies, affirmed its AAA rating for the U.S. in early November, it lowered its outlook on the U.S. government from stable to negative. Rising interest rates are bringing to light the reality that the U.S. has the highest amount of debt relative to GDP since the period immediately following World War II. The spike in interest rates has already pushed gross U.S. interest expenses toward $1 trillion and is making debt-service costs a regular part of every annual budget conversation.   

However, we have not become permabears, and we remind investors that recessions are a reality of every economic cycle.

Long-term readers will recall that during many of the past several years we were optimistic about equities and the economy given our belief that both fiscal and monetary policymakers would arrive quickly on the scene given any signs of any economic or market distress. Indeed, this belief paved our bullish outlook in the immediate aftermath of COVID’s arrival. We are now on the opposite side of this. We have an upcoming election season that promises to bring much debate on how to deal with the fiscal situation, not to mention the 2025 expiration of the 2017 tax cuts. Similarly, the Federal Reserve is determined to push inflation lower and has been acting intentionally to slow the economy, and we believe it is willing to trade a period of economic weakness for a return to price stability. We believe these factors change the macro backdrop in the nearer to intermediate term and will result in policymakers being more careful and measured in their monetary/fiscal response.  

This backdrop coupled with the reality that we are returning to a more normal business cycle has driven our outlook this year to be less optimistic than in the past and is behind our decision to tweak our portfolios toward fixed income, an asset class we believe will benefit from the new macro backdrop. However, we have not become permabears, and we remind investors that recessions are a reality of every economic cycle. Since the year 1900, we have had 24 recessions, and stock markets have fallen from time to time. We remind investors that stocks have excess returns because they are risky, and unfortunately, those who figure that out after the fact and sell during downturns are the ones who help create those excess returns for people who can hold or even increase their allocation.   

As such, this is not a call for a dramatic shift in your asset allocation. We believe that making significant changes to an overall strategic long-term asset allocation in hopes of capitalizing on short-term timing calls is a fool’s errand. Understand that embedded in any asset allocation recommendation and financial plan is the aforementioned reality that recessions occur and markets are volatile. It’s accounted for in the plan that is developed to help you reach your goals; as such, why risk derailing that plan? Instead, our sober assessment is a call to action to make sure you are ready for the possibility of a recession and further market volatility and won’t be tempted to sell at exactly the wrong time. If you’re concerned about a pullback, we advise you to have a conversation with your advisor now.   

Likewise, this isn’t a call that portfolio allocations can’t or shouldn’t be tweaked on occasion; indeed, we have detailed our tilts throughout this piece. Think about our changes as tweaks around the edges that never take you far afield from that target allocation but, hopefully, address what is incrementally attractive or where risks are and nudge you in that direction with an overall goal of getting you to your end destination a bit quicker and more comfortably.  

The reality is that equity markets still possess ample opportunity for those who are patient and remain diversified among many different types and styles of equities. Finally, after years of offering low to no yields, bonds once again offer income for those who don’t want or need only equity exposure. Last year we closed with a commentary and data that reiterated the value of a diversified portfolio against the chorus that was once again wrongly suggesting the death of a 60/40 portfolio. This year has proven anything but that. And we think in 2024 and beyond that statement will continue to hold true. After years of watching equity markets do the heavy lifting, bonds at current yields should play a more active role in doing some of the heavy performance lifting. Contemplate that as of the end of November, the Bloomberg Aggregate index of U.S. investment-grade fixed income had provided a 1.8 percent year-to-date return. On an annualized basis, the index returned -4.45 percent over the past three years, 0.71 percent over five years, 1.37 percent during the past 10 years, and 2.67 percent during the past 15 years. The reality is that starting yields across each of those time frames were low, and as such, performance followed suit. Now with investment-grade fixed income yielding 5 percent, we believe bonds are likely set to provide positive mid-single-digit returns in the coming years.  

The reality is that the ends of economic cycles (recessions) have been temporary disruptions that have led to the beginnings of the next economic cycles. The same commentary applies to financial markets. Staying invested and true to your strategic asset allocation in a diversified manner during these disruptions has proven time and again to be the best path to attaining and keeping financial security.   

Happy holidays and best wishes for a healthy and prosperous 2024. 

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.