Taking Stock of (and in) Markets

Key takeaways

• The world has evolved considerably in the past few years in terms of productivity growth and central bank policy, and current conditions suggest a return to economic normality. We favor asset allocations focused on stable income paired with growth upside of equities.
• The U.S. economy is in a good place: Growth and inflation are more stable than in the past due to a larger share of services, and developments in the labor market and corporate innovation support overall economic resilience.

• Asset allocation implications: In a whole portfolio or "60/40" context, pair stable income opportunities with equity upside to create powerful portfolios.

Rick Rieder and team argue that even as the economy appears to be returning to more normal conditions, there are profoundly important divergences by region and market segment that will be critically important to keep in mind for constructing effective portfolios in the future.

Back to Normality in an Economy Undergoing Extraordinary Change

We have recently argued that after witnessing four years of extraordinarily abnormal economic and market conditions, from a global pandemic, to heightened inflation and a dramatic interest-rate hiking cycle, a great range of economic and market measures are now looking much more “normal.” Indeed, whether looking at the unemployment rate, 3-month annualized U.S. core PCE inflation, the EUR/USD foreign exchange rate, or yield spreads on U.S. investment-grade and high-yield corporate bonds, we find ourselves very close to the levels of the end of 2019, before the world was plunged into crisis. Broadly speaking, this appears to be a good sign that many aspects of the economy have normalized after the roller-coaster ride of the past four years, but interestingly we do not believe it represents a simple return to the economy we had before. Without doubt, there are dramatic structural changes at play in the economy today, even as we appear to have normalized in many respects. This commentary will examine these changes, will explore what they mean for the economy and markets, and will conclude with important implications for asset allocation in the year ahead.

This picture of economic normalization is captured quite clearly in the forecasts put forward by the major developed market central banks, which take comfort in the stability of the economy, broadly declining rates of inflation, and the remarkable resilience of labor markets (see Figure 1), by displaying a remarkably narrow degree of dispersion over the forecast periods. In fact, in realized terms, we have never seen 0% labor market volatility over any 3-year rolling forecast horizon, so while this possibility seems unlikely, it does capture a sense of the resilience of the economy. Hiring overall, recovered fairly rapidly after the initial pandemic shock (albeit aided by extraordinary policy support) and the unemployment rate measure had remained within the 3.7% to 3.8% range for the last six months, but ticked just above that range in early March. Interestingly, hiring remains primarily supported by certain sectors, such as healthcare services, education and government, while much of the rest of the labor market resides at a trend of 90,000 private payroll jobs gained per month, excluding education and healthcare.

Figure 1: Dispersion of Central Bank Forecasts Remarkably Narrow Today

What accounts for this remarkable resilience in the labor market, for its extraordinary flexibility? We think that part of that dynamism can be explained by dual positive supply shocks stemming from changed norms in work-from-home policies and from surging immigration in the post-pandemic period, both of which hold a virtuous influence on overall growth and labor market resilience. That is particularly the case since the years immediately after the pandemic shock were characterized by a dramatic lack of available workers in many industries. The fact is that much more flexible work-from-home policies in the wake of the pandemic have enabled a surge in labor market participation, particularly among prime age female workers.

Furthermore, it is well known that working age population growth historically tracks very closely with GDP growth, and the surge in population we are currently witnessing (from all sources) is likely to eventually lead to greater growth than otherwise would have been the case. In fact, as recently as 2022 the Congressional Budget Office estimated that U.S. annual population growth in 2024 might be less than 0.50%, but instead estimates place the actual population growth rate this year in excess of 1.0%. These may not appear to be great differences, but the impact of the economy and labor markets can be material.

Even more broadly, the economic stability implied by these forecasts is partly the result of the fact that the U.S. economy has developed over the past few decades from a more goods-production-oriented economy to one that primarily supplies services. That matters because service sector consumption displays a much steadier and less volatile pattern to it than does goods consumption, as can be seen in the real Personal Consumption Expenditure data (see Figure 2). This also helps explain why service sector inflation is “stickier” and less responsive to monetary policy tightening than the goods sector. A dramatic recent example we’ve seen of these dynamics is the extraordinary post-pandemic pricing frenzy for experiential services, such as concerts and sporting events. The high grossing “Eras Tour” undertaken in 2023 by pop-star Taylor Swift is perhaps the most extreme example of this, where we can actually see dramatic impacts on the CPI ‘lodging away from home’ line item by city, depending on when the concerts fell relative to price measurement weeks. We’ve also seen similar dynamics across a host of other services, so with a nearly unlimited supply of goods available for quick delivery, and with perfect transparency into pricing, less money is now being spent on goods and ever more has been diverted to services and particularly to experiences.

Figure 2: The Service Sectors Display Much Greater Consumption Stability, Relative to the More Cyclical Goods Sector

We can see some of these dynamics highlighted in recent inflation data, where the goods sector is still essentially in modest deflation, while service sector inflation is still quite sticky and considerably higher than where the Fed would like it to be. The takeaway from this data is important, since it suggests that the Fed can remain more patient in its prospective rate cutting than markets currently anticipate, and that longer-end interest rates can remain higher for a time, which holds critical asset value implications. Moreover, even oil production, a meaningful driver of goods inflation, has benefitted from technological advancements that are helping to keep volatility more contained, and may result in more moderate price fluctuations in the future. Indeed, the U.S. has continued to produce impressive amounts of oil and natural gas, becoming an exporter of the commodities and is expected to nearly double its energy production by 2030. This holds huge implications for the consumer, inflation and growth, since as energy prices become more stable and make up a lesser proportion of the consumption basket, goods inflation and growth metrics can display more moderate volatility too.

Regional Divergences in Dynamism

Not only is the U.S. economy displaying resilience at a broad level, but even more interestingly, certain segments of its corporate sector are looking remarkably strong. For instance, corporate profits as a percentage of GDP have been near historic highs for several years now, while greater productivity and efficiency have been core drivers of S&P 500 EBIT margin expansion in recent years. Additionally, even as workers’ wages have risen more rapidly of late, corporate wages as a percentage of business income have continued the long-term decline witnessed in recent decades. In our view, then, this impressive profitability, when combined with the nature of spending in today’s tech-infused world, is creating a “new class of consumer” in the form of very big companies with significant capital expenditure (capex) budgets, which actually are having the effect of buoying economic stability.

This influence can be seen dramatically in the fact that non-financial corporate profits are today nearly 40% the size of aggregate U.S. household income; a remarkable increase from prior decades (see Figure 3). This development is creating a “new consumption wallet” that holds a powerful impact on the broader economy. Importantly, it’s not only the ability of large U.S. corporations to spend and invest, but it’s the willingness to do so. Yet, whether it’s in research and development (R&D) or other forms of capex, we most certainly have seen large companies become the drivers of huge investment growth, particularly in productivity-enhancing technologies, which over time should have a disinflationary influence.

Figure 3: Corporate Profits Display Robust Strength and Become a Greater Consumption Engine

Another hallmark of the extraordinary dynamism displayed by the U.S. economy is the ability to attract immigration and the innovation and entrepreneurship that often can accompany it. Indeed, an open economy has led to impressive levels of innovation in the U.S. (and in parts of the rest of the world), and where and how this happens regionally, and by sector, could be critical in driving asset allocation decisions in the years ahead. In our view, immigration and innovation have a symbiotic relationship, since the business environment and high-quality institutions in the U.S. function as a magnet for the best and brightest from the rest of the world, who in turn have an outsized impact on invention and entrepreneurship, reinforcing U.S. dominance in these areas. In fact, almost 45% of Fortune 500 company founders are either first- or second-generation immigrants to the U.S., a much greater proportion of their share in the population, which underscores the importance of these groups in building successful businesses in the economy. Moreover, many immigrants to the U.S. arrive for university education, particularly in the STEM fields, and some of the innovations they create are illustrated by the group’s significant number of patent approvals and the high market values of those patents.

In many respects, the U.S. leads the world in innovation, and for example, over the last decade U.S. R&D spending has increased 9x faster for U.S. companies than it did for those based in Europe. So, R&D spending in the U.S. now resides at 2.5x the amount in Europe as a percentage of GDP, which will remain fuel for greater relative growth in the years to come. Added to this, Europe’s tendency toward more aggressive tech-sector regulation may continue to drag on growth/innovation in the region, helping to perpetuate this divergence. Overall, the growth outlook in Europe has been more fragile, coupled with inflation that has come down precipitously in the last few months. We think this suggests that monetary policy easing in the EU and U.K. is likely to move faster and further than in the U.S., which along with slower economic growth prospects in these areas, argues for investing higher in the capital stack in Europe (debt instruments and greater duration), while focusing on more equity exposure in the U.S.

Figure 4: USD Currency Hedged Exposure to Japan Equity Markets has Been Impressive

Fascinatingly, Japan now represents a case study in how improved policy decisions, when combined with shifting global capital flows (in this case benefitting from China dis-investment), can combine to create a unique return environment across all asset classes. Japan’s nominal economic growth, which didn’t do much for roughly 30 years, may finally be approaching escape velocity. Added to that for U.S. dollar investors, the returns to buying fully-currency hedged Japanese equity have been astonishing since the Covid-era lows (see Figure 4), with some of this juiced by the gap in rates. And now, with the Bank of Japan taking a larger than expected step out of negative interest rate policy, the strength of small-and-medium-size enterprise wage increases and the scrapping of yield-curve-controls, we think Japan’s economy, and its equity markets, could see a positive runway for some time.

Asset Allocation Must Evolve Too

As we’ve said before, the still sticky levels of services inflation could well keep back-end interest rates higher, and may delay, or moderate the degree of Fed cuts this year, but there is little ambiguity that rate cuts are likely to be appropriate at some point. As inflation has broadly moderated over the last year, this has implicitly created higher real policy rates and if the economy continues to slow, it seems inappropriate for policy to become increasingly restrictive. Historically speaking, elevated real policy rates eventually weigh on growth, so making some “maintenance cuts” is likely in the cards.

We’ve described above the regional capital allocations that we think make sense, and while growth should be embraced primarily in those areas that display the greatest degrees of innovation and economic stability, the proper way to marry this to income has changed in recent years. For decades, the negative stock/bond correlation made the traditional 60%/40%, equities/bonds, portfolio an efficient strategy for maximizing risk-adjusted returns, but this relationship has become much more uncertain today. And the idea of using long-duration debt to balance out equity risk has become highly problematic, given that long-end positions have of late been adding much more volatility to portfolios without a lot of the added protection. In fact, a 60/40 portfolio that utilized 1- to 3-year corporate bonds, instead of the traditional Bloomberg Aggregate Index, for the 40% bond allocation has never outperformed the traditional 60/40 portfolio for multiple consecutive years, as it has over the past four years (see Figure 5). In our view, this can still be the case, as front-end investment-grade debt is yielding more today than the long-end of that curve yielded for the majority of the pre-Covid decade, and shorter-dated, high-quality, can likely continue to mitigate portfolio downside while also minimizing the volatility attached to the positive stock/bond correlation.

Figure 5: Short-dated Corporate Debt Appear a Much More Attractive Portfolio Ballast Than Traditional Agg Exposure

Further, we think there are good reasons to evolve the traditional 40% bond allocation to a 30% figure, and for those who are able to access less liquid, private debt, alternatives, the remaining 10% could be fruitfully allocated there. The fact is that there are significant opportunities to be found in this growing part of the debt market. Also, we’ve argued recently that while spreads have tightened, there is ample room for the risk-free rate to offset any spread widening and spread valuations here are less relevant as fundamentals remain healthy, and all-in yields are being propped up by the risk-free rate.

Further, we think there are good reasons to evolve the traditional 40% bond allocation to a 30% figure, and for those who are able to access less liquid, private debt, alternatives, the remaining 10% could be fruitfully allocated there. The fact is that there are significant opportunities to be found in this growing part of the debt market. Also, we’ve argued recently that while spreads have tightened, there is ample room for the risk-free rate to offset any spread widening and spread valuations here are less relevant as fundamentals remain healthy, and all-in yields are being propped up by the risk-free rate.

So, we think it’s quite possible to build a portfolio of short-duration, and solid quality, fixed income assets that would yield around 6% to 7%. The duration of such a portfolio would be significantly shorter than that of the Bloomberg U.S. Aggregate Index and it would only contribute modest volatility to a portfolio overall. Such a portfolio could contain allocations to mortgage-backed securities and 10-year U.S. investment-grade credit (15% each), short-to-belly of the curve European investment-grade credit (15%), select mid-quality U.S. and European high-yield credit (30% total), higher-quality securitized asset sectors (20% total) and small allocations to favored emerging markets debt (5%) in places such as Mexico and Brazil. We think such an allocation holds meaningful advantages over a more conventional bond index, such as the U.S. Agg.

Finally, on the equity side of the portfolio, the income opportunities we have described can be paired with equity upside to create potentially powerful portfolio returns in the years to come. However, all equity-upside potential is not created equal, as greater selectivity is required here since a greater share of growth may continue to accrue to fewer and fewer firms. And market capitalization matters in this regard. Of the 50 largest companies in the S&P 500, the majority have returns-on-equity (ROEs) that far exceed the index average, and of the largest 22 companies, 12 of them have ROEs greater than 30%, 8 ROEs greater than 40% and 6 ROEs greater than 60%, so clearly there is a growth differential that is accruing to the most dominant firms. And it’s not just market capitalization that matters, of course, but also which sectors and companies are heavily investing in R&D to attempt to generate even higher ROEs in the future (see Figure 6).

Figure 6: Technology, Data, Innovation, are Some Keywords for Maintaining Moats in the Future

With central banks set to eventually cut policy rates (with the question of when, how fast and ultimately how much), some well placed duration in the front-to-belly of the yield curve makes sense. And while credit spreads remain tight amid this high-rate environment, credit appears to remain fundamentally sound and attractive on a yield basis, including in private markets. Finally, 2024 can be used as a time to transition into a more effective 60/40 portfolio, with shorter-end credit and more bespoke financing opportunities underpinning the 40% and equity exposure in those regions, sectors and securities that are innovating and investing for their own futures.

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