Key Observations
- Forward looking 10-year return forecasts show increased opportunity across fixed income with modest step back for equities. This makes for one of the more attractive risk-adjusted returns for fixed income relative to equity we have seen in several years.
- Moderating inflation creates a path for lower interest rates creating opportunities for tailwinds in fixed income and more rate-sensitive assets.
- The most predicted recession in history continues to be pushed into the future, however, investor mindset and behavior has shifted fully towards the soft-landing narrative.
- Narrow market leadership in U.S. equities will eventually create an opportunity for long-term investors to benefit from allocations to U.S. small capitalization and non-U.S. stocks.
Moderating Inflation
There is a lot of back patting and handshaking that can be done regarding inflation at the Federal Reserve (The Fed). Inflation has fallen from its peak of 9.1% in 2022 to 3.4% in December 2023. Some market participants see the progress made as an indication that the Fed will succeed on its goal of bringing inflation down to its 2.0% target without sending the economy into recession. Admittedly, The Fed deserves credit for the progress that has been made as the decline in inflation has come with 2023 GDP growth expectations increasing from 0.3% in January 2023 to 2.4% by December. Another key mandate of the Fed is employment, which has only seen a modest increase in the unemployment rate from 3.4% to 3.7% during 2023.
Regardless of the economic outlook, the decline in inflation has created room for the Fed to lower interest rates over the next 12 months. Since 1954 the average real Federal Funds Rate (Fed Funds less annual inflation) is 1.01%. Today, the real Fed Funds rate is 1.80%. This signals that not only is the Fed at the end of its hiking campaign, but there is room to cut rates if inflation remains in the downward trajectory. In addition, should the economy falter and succumb to restrictive rates, the Fed could cut rates meaningfully, thus positively skewing the risk-return of fixed income investments.
Prepare Portfolios for Recession Risks
Economists may mark 2023 as one of the greatest head fakes of all time. Bloomberg’s Here is (Almost) Everything Wall Street Expects in 2023 compiled outlooks from 51 institutions, the vast majority of which called for a recession. Quotes like “A recession is all but inevitable” or “2023 will go down as one of the worst for the world economy in four decades”. Yet here we sit with U.S. GDP expected to be up 2.4% for the year. What went wrong? Or should we say what went right? In short, the tenacity of U.S. consumer spending and far better than expected results of putting the inflation genie back in the bottle led the U.S. economy and markets higher. Does that mean victory should be declared on recession and that fear shelved? In a word – no. We should also plainly acknowledge that a recession is always coming. It may be right around the corner or years away, but recessions are a regular part of economic growth and contraction. A resilient portfolio maintains focus on the long-term objective while shifts to prepare for market drawdowns.
Narrow Market Leadership
Then came the “Magnificent 7” – Apple, Alphabet (Google), Meta (Facebook), Microsoft, Nvidia, Amazon and Tesla. The S&P 500 was up 26.3% in 2023 with these seven stocks up on average 107% for 2023. If we remove these securities from the S&P 500, through the same period the index would be up ~11%. The seven securities now make up a record setting 28% of the S&P 500 and 48% of the growth-oriented Russell 1000 Growth index. A key question is what impact will this narrow group of securities have on future outcomes? It is possible these securities have a repeat performance over the coming years and indices will grow even more unbalanced with a very concentrated group of securities at the top. It is also possible that these securities revert to broader market-level returns and everything else will catch up as markets charge ahead, but concentration dissipates. However, we think a more likely third path over the long-term is that new leadership takes hold making room for sectors, regions or capitalizations that have been left behind over the past decade.
Final Thoughts
The long and variable impact of the momentous move up in interest rates is still being felt and to some degree understood. It has also seemingly taken some of the hubris, though perhaps only temporarily, away from the recession prognosticators. These changes have many important implications for asset prices and the economy. If we step back though, we quickly realize this is a good problem to have. Long-term investors seeking reasonable rates of return no longer must do so by continually extending risk. This was a hallmark of the last decade in which extreme interest rate policies at times produced extreme allocations. As market opportunities “normalize” (if we dare say there is such a thing as a normal market) investors may choose to normalize their allocations with perhaps a more modest risk posture. As we noted, it is important to draw the line between updating portfolios to reflect current opportunities and trying to time the market.
