What to Watch for in a Potentially Slowing Economy

Global financial markets have proven volatile in recent months, alternating between bearish and – more recently – decidedly more sanguine outlooks. We believe this reflects a widening range of economic outcomes. While it may appear that a resilient economy and steady corporate performance belie our sense of caution, we see a common thread among key indicators that reveals an environment that is potentially more fragile than many market participants realize.

Woe be the consumer?

As evidenced by blow-out third-quarter U.S. gross domestic product (GDP) data, the U.S. consumer continues to power the domestic economy. Consumption accounted for 2.69 percentage points of the aggregate 5.2% annualized quarterly growth rate. We don’t know how much longer this pace can last. The bulge in personal savings owed to pandemic-era stimulus packages has largely run its course. Furthermore, consumption has more recently been powered by credit cards. With borrowing costs having reset to decade-plus highs, we question American households’ desire – or ability – to keep racking up such purchases.

U.S. personal savings and credit card debt

Higher, longer, inevitable

Our reason for doubting consumption’s durability is our long-held view that policy rates will remain elevated for longer. Compounding this risk is our belief that the U.S. economy – and others, for that matter – have yet to feel the full brunt of previous rate hikes. Relative to other tightening cycles, we are still in early innings, meaning hawkish policy’s efforts to curtail demand are still working their way through the system. Business investment has already slowed, with non-residential fixed investment contributing nothing to third-quarter GDP growth.

Market-based policy rate forecasts

Perhaps the most powerful signal that economic growth faces headwinds is 2023’s rise in real yields, with that of the 10-year Treasury now topping 2.00%. This represents the highest cost of capital in inflation-adjusted terms in 15 years. Importantly, nominal yields continued to climb even as inflation has subsided. We interpret this as the recognition of a potential regime change in rates. Consequently, corporate managers will likely become more selective when allocating capital, as returns on investments must meet a higher threshold.

Composition of nominal 10-year U.S. Treasury yields

Markets: Staying invested, staying defensive

With both equities and bonds rallying in recent weeDks, some investors may presume current prices accurately reflect a favorable economic outcome. But we believe it’s too early to sound the “all clear.” Within fixed income, mid- to longer-date Treasuries and mortgage-backed securities (MBS) have registered considerable price swings and they may not be done Recent appreciation, in our view, is premised on imminent rate cuts – a scenario we believe is far from certain.

Within high-yield corporates, the spread between their yields and those of their risk-free benchmarks remains below long-term averages. Our concerns for this segment are compounded by the risk of a harder-than-expected landing, which could stress some of these companies’ leveraged business models.

Spreads between corporate bond yields and those of their risk-free benchmarks

Similarly, we don’t see risks dispersed evenly across the equities landscape. Over the course of 2023, mega-cap technology and Internet names have held up better than the broader market, and their valuations remain above their long-term averages. Yet unlike still-frothy high-yield credit, many of these business models, in our view, are well positioned to weather an economic downturn given their consistent cash flow generation, strong balance sheets, and exposure to durable secular themes. Value and more cyclically exposed names, on the other hand, could come under additional pressure in a slowing economy.

Despite gathering headwinds, earnings estimates for U.S. stocks have held up well, while estimates for ex-U.S. equities have proven softer. The resilience of tech’s business models has likely played a role in U.S. estimates holding firm, but we are less confident in other sectors should the country’s consumption engine lose steam.

Composition of 2023 year-to-date total equity returns

The merits of diversification

Lastly, a widening range of economic outcomes lends itself to increased market volatility. Uncertainty about the duration of elevated rates and rising geopolitical risks further clouds the situation.

When this type of volatility and uncertainty cause asset classes to move in tandem – as they have occasionally done of late – investors can lose sight of the need for diversification. After years of it not being the case, bonds once again have the potential to act as ballast to riskier assets in a broad portfolio. Yields have risen to levels that offer both attractive income potential and possibly lower levels of volatility if rates stay within their current range. And should a rapidly weakening economy force central banks to pivot – not our base case – bonds’ potential for capital appreciation could offset losses in more cyclically exposed asset classes.

Relative attractiveness of U.S. equities and Treasuries

Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.

Quantitative Tightening (QT) is a government monetary policy occasionally used to decrease the money supply by either selling government securities or letting them mature and removing them from its cash balances.

10-Year Treasury Yield is the interest rate on U.S. Treasury bonds that will mature 10 years from the date of purchase.

Credit Spread is the difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing indicate improving.

Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.

Price-to-Earnings (P/E) Ratio measures share price compared to earnings per share for a stock or stocks in a portfolio.

Standard Deviation measures historical volatility. Higher standard deviation implies greater volatility.

The Russell 1000® Index is a subset of the Russell 3000 Index that includes

approximately 1,000 of the largest companies in the US equity universe.

The Russell 1000® Growth Index measures the performance of the large-cap growth segment of the US equity universe. It includes those Russell 1000 companies with relatively higher price-to-book ratios, and higher sales and earnings forecast over the medium term.

The Russell 1000® Value Index measures the performance of the large-cap value segment of the US equity universe. It includes those Russell 1000 companies with relatively lower price-to-book ratios and lower sales and earnings forecast over the medium term.

The Nasdaq Composite Index is a stock index that conveys the overall performance of all Nasdaq-listed stocks according to market capitalization.

The MSCI World Index captures large and mid-cap representation across 23 Developed Markets (DM) countries*. The index covers approximately 85% of the free float-adjusted market capitalization in each country.

The MSCI Emerging Markets Index captures large and mid cap representation across 24 Emerging Markets (EM) countries. The index covers approximately 85% of the free float-adjusted market capitalization in each country.

The STOXX 600 Europe Index captures the 600 largest publicly traded companies on a range of exchanges across the European region.

W-1023 – 420592 – 11-15-2024

A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out our podcasts.