For many years until the last, investors had been living under the same mantra of “There Is No Alternative” (TINA) to owning equities, helping prop up stock prices as yields on fixed income were too paltry to bother with. Times have changed; TINA ushered out and TARA welcomed in. Positive real rates are achievable, meaning “There Are Reasonable Alternatives” (TARA) to just owning stocks. We are looking at the possibility of having a higher real neutral rate (theoretical equilibrium policy rate, adjusted for inflation, that neither stimulates nor restricts the economy) than we’ve had in the last 15+ years. This shift from ultra-low interest rates to sustained higher rates has far-reaching implications for the economy and markets. Here are a few of the themes we’ll be keeping a close eye on going forward:
- Will the U.S. economy remain resilient if monetary policy doesn’t loosen? In other words, if inflation remains sticky and above the Fed’s target of 2%, will the economy be able to withstand further restrictive policy? The expectation on Wall Street is for policy easing to the tune of 150 to 200 basis points of rate cuts this year. The potential snag in this forecast is that it might require hitting a two-bet parlay to get rate cuts. The first leg is getting inflation to continue to ease, particularly in services and housing, which have been rather sticky; and the second is a slowing economy which has been incredibly resilient up to this point. If both don’t hit, will the Fed be forced to remain restrictive, and if so, how does the economy hold up?
- After posting consecutive years of negative total returns, bonds appear back in favor. Not only are yields higher than they’ve been in 15 years but the historical negative correlation with stocks that disappeared over the last two years seems to have been restored, meaning the diversification benefit of bonds is functioning again. Higher-for-longer interest rates coupled with slowing inflation mean fixed income has a high probability of outperforming inflation over the next several years. Positive real rates which have been the norm historically, but not for the last decade and a half, are back, and hopefully for a sustained period.
- With a 63% chance (according to the New York Fed) of a recession within the next 12 months, and domestic equity markets near all-time highs, will this finally be the year that non-U.S. markets outperform? U.S. equities have dominated their international peers going all the way back to the end of the financial crisis in 2009. This is due to many factors including structural advantages (top universities and ability to attract superior talent) that contribute to high levels of innovation, and the world’s deepest capital markets; but mostly from the fact that U.S. companies have performed better. Corporate earnings have grown faster, profitability metrics have been stronger, and most balance sheets have been healthier. With higher interest rates and stretched valuations, particularly in the tech sector, the question is, will U.S. companies continue to be the forerunner of equity markets or will we finally see some reversion to the mean?
With inflation and central bank tightening having likely peaked, the investment landscape has shifted and must be navigated with a slightly different compass. Certain sectors of the equity markets appear overvalued, likely in anticipation of rate cuts that may not come to fruition for some time. Given this setup and potential let down, our focus is on high-quality, lower volatility investments, both in equities and fixed income that hopefully provide a smoother ride for our clients during potentially turbulent times ahead.
