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By Erik L. Knutzen, CFA, CAIA
We may want to be optimistic about inflation and rates, but that only delays the hard questions we are likely to face as we enter the new economic era.
Our latest Asset Allocation Committee Outlook will appear in the next few days. The headlines are that we remain cautious on equities while seeing bonds as an increasingly attractive source of yield potential and portfolio diversification.
Last week seemed designed to test our resolve on this, delivering a two-day equity market rally bigger than any since April 2020, with bond prices rising in lockstep. Are we hastily rewriting our Outlook?
Too Optimistic
As Raheel Siddiqui writes in our latest quarterly update on equity markets, we have been here before.
When U.S. headline inflation dropped between June and July, it fueled a strong midsummer rally based on hopes that central banks might soon begin to ease their policy tightening.
Similarly, last week’s exuberance appeared to be triggered by a surprisingly small rate hike from the Reserve Bank of Australia and boosted by potential signs of cooling from the U.S. Job Openings and Labor Turnover (JOLTS) survey. Markets quickly moved from pricing for a 4.5% Fed funds rate at the end of 2023 to just 4.1%. Stocks rallied strongly before retracing somewhat later in the week, and Friday’s U.S. payroll number gave the U.S. Federal Reserve no reason to change its path.
As in July, we think investors are too optimistic: Too optimistic on consumer prices, which we see spreading and becoming stickier, in line with our outlook for persistent, structurally higher inflation, and too optimistic on central banks’ willingness to ease off; neither the Fed nor the European Central Bank is softening their unusually explicit language about the urgency and primacy of getting inflation back to target.
Specifically, should we take the Fed’s projections for the economy and its own rate hikes at face value, we could go from a deeply negative real Fed funds rate to a positive one. Positive real rates were the norm until the Great Financial Crisis, and yet many investors believe we can settle back into the “norm” of the past decade.
Diversifier
We, therefore, anticipate more tightening to come, a further slowdown in the economy and downgrades to corporate earnings outlooks. That is why we are wary of short-term equity market rallies at this juncture.
However, while we are not convinced the economic outlook is yet reflected in earnings outlooks, we do think this tightening cycle is close to being fully priced into bond markets. We also think many investors have begun pricing a recession into credit spreads, especially for high-quality issuers.
Current yields are attractive, then, and we think they’ll be especially attractive should risky assets come under renewed selling pressure. This raises a tantalizing possibility. We believe bonds could help diversify stocks once again in periods of stress, particularly if inflation starts to decline from its extremes, with policy rates still rising and growth fears building.
Questions
For some time, we’ve talked about the challenges facing the traditional 60/40 stock bond allocation. Most of our attention has been on the “40” part of the strategy: being more active in fixed income exposures to try to preserve yield and diversification, and having more exposure in alternatives. We still believe in that broad approach, but higher yields are making bonds more attractive.
Now may be an opportune time to focus more attention on the “60” part of 60/40. Low and declining rates are no longer floating all the equity market boats.
We see a need for more detailed analyses of underlying equity exposures, not only for efforts to sustain return potential but to maintain portfolio diversification. Could there be regions or sectors that can better withstand an environment of structurally higher inflation and rates? Might money now (equity income) be more valuable than money later (growth)? Could high-yield credit sometimes be a more attractive risk exposure than equity? To minimize equity-bond correlation, do investors need to minimize the rate sensitivity, or duration, of their equity allocation?
These are difficult but important questions, not only during the current slowdown but as we enter what we believe will be a new era for the global economy. In our view, if we let bear market rallies persuade us, there is some way back to the environment of the past 10 years, we only delay the day we start asking them.
In Case You Missed It
- ISM Manufacturing Index: -1.9 to 50.9 in September
- Eurozone Producer Price Index: +43.3% year-over-year
- ISM Services Index: -0.2 to 56.7 in September
- U.S. Employment Report: Nonfarm payrolls increased 263,000 and the unemployment rate declined to 3.5% in September
What to Watch For
- Wednesday, October 12:
- September FOMC Minutes
- U.S. Producer Price Index
- Thursday, October 13:
- U.S. Consumer Price Index
- Friday, October 14:
Investment Strategy Group
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