As we think about investing around a historic election, establishing what we know, what we need to know, and what we can count on is a useful foundation for navigating the uncertainty. The nature of markets today is one in which many prognosticators change their narrative with the release of each survey and data point – causing excessive moves in both directions that aren’t justified by the fundamentals of an incredibly stable economy. In this commentary, we will recount what makes the U.S. economy so impervious to drawdowns, the policy outcomes that could potentially derail it, and how to allocate capital on that backdrop.
What We Know
Growth has been defiant in the face of the hard-landing bears, who will need to go back into hibernation for some time. The Bureau of Economic Analysis’ revisions released in September found $300 billion in extra real GDP over the last couple of years that was previously unaccounted for. To put that in perspective, that’s equivalent to adding the entire economies of Finland or Portugal to an economy that was already markedly outperforming the rest of the developed world. Disposable income and the savings rate were also revised significantly higher. Americans have been earning, spending, and – crucially – saving more than originally thought, which inspires confidence in the durability of this growth trajectory. On top of this, September’s jobs report quelled worries about the labor market in dramatic fashion, adding nearly double the consensus estimate for jobs. American economic exceptionalism is alive and well.
This exceptionalism is in large part due to the dominant role of services consumption as an engine for growth. Services-oriented consumption, trade, and investment overtook goods to be the majority contributor to GDP in the late 2000s and has been the lion’s share of consumption since the 1970s. The implications of this for the resilience of the economy can’t be understated. Spending on services is 3x less volatile than spending on goods, which is where consumers tend to pull back under stress. When services are reliably growing at 2-3%, it becomes very difficult for the economy to dip into recession absent some major shock.
This compositional evolution is also clear to see in the constituents of the S&P 500. The 10 largest companies today are dominated by service-providing tech firms - a stark contrast to the conglomerates, oil, and auto companies that reigned in the 20th century. This leads us into a point we have been espousing for the last year, the economy of today is far less sensitive to interest rates than the economy of old. Thirty years ago, the 10 largest companies had a net-debt-to-market-cap ratio of 0.29, today that number is -0.04. These companies have more cash than they do debt, they are net beneficiaries of a higher rate environment. Relatedly, they don’t use debt to finance their operations. These 10 companies lead capital expenditure (CapEx) and research and development (R&D) spending, which is why it hardly skipped a beat during the fastest hiking cycle in a generation. As we have covered in depth in previous insights, wealthier households - with a lot of cash and little floating-rate debt - drive headline consumption and are also indifferent to (or even benefitting from) higher rates. This isn’t to say certain parts of the economy aren’t feeling the burden of higher borrowing costs, they are, particularly lower income, small business, and local banks, which is why we still believe the Federal Reserve should be swift in normalizing rates.
Another textbook effect of raising rates should be depressed investment, especially in costly infrastructure projects, ceteris paribus. If one thing is certain, ceteris has not been paribus. Momentous breakthroughs in technology and the largest fiscal stimulus in history have caused structures investment to skyrocket. The impetus to develop artificial intelligence (AI) and clean energy capabilities has invigorated both the public and private sectors to put trillions of dollars to work, that too in projects with high fiscal multipliers. The Covid-era infusions of cash are still coursing through the system, and the wealth effect from the rapid rise in asset prices will be here to stay. Aggregate household balance sheets have never been healthier, although there is definitely bifurcation under the hood. The flipside of higher rates also means that there are trillions of dollars being thrown off in annual coupon by fixed income securities which need to be reinvested. The confluence of these secular trends is yet another extraordinary force buoying growth in the U.S. for some time to come.
A corollary to these points is we believe that all the ink spilled, and effort expended on 25 vs 50 bps of cuts and hard vs soft landings is severely misplaced. It misses the fact that the U.S. economy is highly insulated to interest rates as well as global affairs. We liken it to a satellite, and satellites don’t land.
What We Need to Know
The big question mark hanging over markets today is what comes of the election and what it means for policy. Much of this won’t be known in full until many months from now, with a wide range of potential outcomes depending on the president and the split in congress. U.S. foreign policy, particularly as it relates to China and its role in diplomacy in Europe and the Middle East could look dramatically different under each possible permutation of government. Perhaps the biggest issue for markets is that of the debt burden, which neither party seems likely to address in earnest. The compounding nature of this issue has the potential to irreversibly clip the wings of the soaring economy described in the previous section. By the end of the decade, nondiscretionary outlays will permanently exceed total government revenues. Mandatory spending around social security and Medicare is only set to increase from here alongside the aging population, further eating into the funds available for education, urban development, research initiatives, and defense. Perhaps most worrying about this situation is the interest burden the government is set to incur in this environment with larger deficits and higher rates. At a 4% average cost of debt, interest expense reaches $2.7 trillion, or 37% of estimated revenues, in 2034. Net interest spending is due to overtake nondefense discretionary spending for the first time since WWII. The circumstances which allowed the U.S. to recover from that burden, namely pegged interest rates (a nonstarter for the modern financial system) and a growth-inducing baby boom, are unlikely to repeat themselves. Attempting to raise revenues via taxes would crush the middle class, another nonstarter, and cutting spending could be a zero-sum game if growth takes a commensurate hit. It’s a pretty dire picture, but there is hope…
The only viable option to solve this issue is to try to outgrow the debt. A country’s debt burden is only as dangerous as its size relative to GDP, we believe a focus on growing the denominator in Debt/GDP is the government’s best bet to avoid the doom spiral shown in their own projections. To quantify this, consider that if nominal GDP and the cost of debt both run at 4% for the coming decade, publicly held government debt would still outpace GDP growth by $12.5 trillion. The Debt/GDP ratio would grow to 1.3x from 1.0x today, with nowhere to go but up from there. In a scenario where NGDP grows at 5% and cost of debt averages 3%, this ratio would only be a much more reasonable 1.1x. Optimizing for this should be the priority for the Fed and policymakers today. The last few years are an excellent example of this idea in play; since the end of 2020, the government has racked up more than $6 trillion in deficit spending, yet the stunning growth of the post-pandemic years meant that Debt/GDP actually declined over this period. Now, hoping for double-digit growth as seen in 2021 is grossly unrealistic, but 5% is not unattainable, especially if that deficit spending is directed to the right places. The appropriate question today is not how much is being spent, but what is it being spent on?
Not all deficit dollars are created equal. A major factor in the growth of the last few years that has kept the debt issue contained for now is the historic amounts of Federal money directed towards productivity enhancing infrastructure projects. The fiscal multiplier, in other words the net effect on GDP, of money spent on infrastructure is the highest of any of the tools the at the government’s disposal. In general, each dollar spent on infrastructure projects is worth $1.4 to the economy due to the ripple effects and synergies it creates. Compare this to cutting corporate taxes, each dollar of corporate taxes the government foregoes collecting is only worth 20 cents of stimulus to GDP – such a policy is not nearly as effective in addressing the debt issue. If the infrastructure project is in an especially high productivity area, like semiconductors, the multiplier jumps to $4.74 of GDP for each dollar spent! Herein lies the answer to the debt problem. Not only do these deficit dollars go further than others, they also signal confidence to the private sector, which can do even more of the heavy lifting. Each federal dollar invested as part of the Inflation Reduction Act of 2022 has seen 5-6x that in private investment ride its coattails. The bang for deficit buck here is unrivaled. Additional strategic advantages of securing supply chains for critical industries and furthering energy independence are the cherry on top.
A strategic decoupling from China, and potentially several other trading partners, looks likely to have bipartisan support regardless of who holds office. How this plays out will greatly impact where you choose to be an equity vs debt investor. That doesn’t mean one should avoid taking risk altogether, but the imperative to be tactical, pragmatic, and more respectful of tail risks will be higher in a more protectionist world. Relatedly, inflation has come a long way from the peak, and we don’t see it reaccelerating as the Fed cuts, but we see little further downside from here. As favorable base effects fall out of the calculation, we see core CPI stabilizing somewhere in the mid-to-low 2s, with some risk to the upside. As such, there is a high likelihood that the conditions for making real money via interest rate exposure will remain highly uncertain for some time. With these unknowns in mind, we arrive at the question of how do you position for this all?
What We Can Count On
We have already touched on some reasons why returns from duration will continue to be volatile into 2025, and though the front-end of the yield curve has retracted to a more realistic valuation, the downside risks further out the curve are still tangible as that part of the curve is less tethered to Fed policy orientation. We maintain that there isn’t much money to be made in the back-end of the curve given how flat the yield curve is today and the lack of term premium further out the curve. While the debt dynamic could very well translate into higher long-term yields - muted supply, rapid nominal growth, and debt monetization undertaken by the Fed heretofore has kept curve steepening contained. Hence, we don’t see much potential in chasing value in rates overall. As we have been saying for some time now, with real rates the highest they’ve been in a generation, fixed income can now be more about income than duration. Just being long duration in the 40-year bull-market that started in the 70s worked well enough. Now, with substantially more two-way risk in interest rates, most of the volatility in fixed income can be attributed to holding duration. Unless you have some long-term liability to offset, with the opportunity to potentially clip north of 6% in high-quality income with little interest rate or default risk, why add unnecessary volatility to your portfolio?
Both the technicals and fundamentals of credit markets, especially in high yield, have arguably never been better. There is a good deal of dispersion, however, with a long tail of index constituents trading wider than 500 basis points (bps). Being selective with where we own our credit risk is hugely important as the economy comes off the boil. For investors with the scope to look overseas, the yields on offer in parts of Asia and total return opportunities as global central banks embark on asynchronous cutting cycles are massive. International markets also present attractive alternatives with more precision for those with liabilities to offset. We have called this a golden age for fixed income, and it is still in full bloom.
We showed last month that equities will still be a driver of returns in the long-term, especially as the tailwinds from the immense technology spend come to fruition. However, much of this is in the price. Valuations are stretched across the board; though earnings continue to grow, there is only so much further this can run in the medium term. The cutting cycle should also help, but it’s prudent to remember that rates are not likely to go back to zero. Equity risk premiums are expected to be tighter than in the 2010s. Markets are also quick to forget that when selloffs happen, the drawdown is typically 5x faster than the recovery. There is a rare, convex opportunity in volatility markets to be smarter with how you get your upside equity exposure while protecting the downside. The elevated income from an optimized fixed income allocation can be used to fund an incredibly efficient equity allocation.
Finally, with growing debt-burden and geopolitical risk, scarce real assets now look like a very interesting complement to core assets in portfolios. Gold, real estate, art, and Bitcoin make a strong case for having a place in portfolios today. The sizing of these positions would be heavily dependent on the rest of the portfolio and the overall desire for tail-risk protection.
Uncertainty is rife in the world today, but so too is opportunity. The U.S. remains an economic powerhouse that will be difficult to derail, though there are risks accruing that will have to be addressed. The good news is that this is a point in history where we are especially well equipped and incentivized to address them. Investors have a variety of options to manage around this dynamic that can produce very attractive returns without any of the unnecessary risks. An income-focused fixed income portfolio can yield 6.5% today with only 3% of volatility. This can be used strategically to support an efficient equity allocation for additional return potential, and real assets markets have matured to the point of being an attractive diversifier. We believe the traditional 60-40 can move incrementally towards a 40-50-10 with 40% in equities (with an orientation towards technology-heavy growth drivers), 50% in optimized fixed income (more yield through attractive real rates in spread sectors), and 10% in uncorrelated private deals (credit and real estate-related generally) to form a portfolio that is protected against the unknowns and leverages the knowns to perform under a wide range of potential outcomes ahead.
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