The topics we're discussing today align with the recent release of Morningstar Wealth's 2024 Market Outlook. A recession seemed to be the consensus view entering the year, but markets love to fool the masses, and a stock market rally followed. However, the rally was not evenly distributed. Bonds, for example, remain in a multi-year drawdown, and many investors are questioning their role in a portfolio. With this as the backdrop, what actions make sense to support clients? In today's episode, we're delighted to have Morningstar Wealth's CIO of the Americas, Marta Norton, and Chief U.S. Economist, Preston Caldwell with us to dig into the outlook, share their perspectives, and, as always, be sure to address the implications on client portfolios and any suggested actions to take
(Stay tuned for additional important disclosure information at the end of this episode.)
Nicholas VanDerSchie: A recession seemed to be the consensus view entering the year, but markets love to fool the masses, and a stock market rally followed. However, the rally was not evenly distributed. Bonds, for example, remain in a multi-year drawdown, and many investors are questioning their role in a portfolio. With this as the backdrop, what actions make sense to support clients? The topics we're discussing today align with the recent release of Morningstar Wealth's 2024 Market Outlook. If you'd like to read the full report, you can go to the Morningstar Wealth website at mp.morningstar.com.
In today's episode, I'm delighted to have Morningstar Wealth's CIO of the Americas, Marta Norton, and Chief U.S. Economist, Preston Caldwell with us to dig into the outlook, share their perspectives, and, as always, be sure to address the implications on client portfolios and any suggested actions to take. Welcome to Simple But Not Easy, a podcast from Morningstar's Wealth Group, where we turn complicated financial developments into actionable ideas. I'm Nick VanDerSchie, Head of Strategy and Execution for Morningstar Wealth, and I'm delighted to be joined by our two special guests today. Before we get into the conversation, if you'd like to know more about how we support advisors, we welcome you to email us at simple@morningstar.com or me directly at Nicholas.VanDerSchie@morningstar.com. Now, let's get started.
Marta, Preston, welcome to Simple But Not Easy.
Marta Norton: So, good to be here.
Preston Caldwell: Thanks for having me.
VanDerSchie: Super. So, Marta, I should really probably say welcome back to Simple But Not Easy. We're always glad to have you here. And I think it's been about a year since you last joined us. What have you been up to?
Norton: What have I been up to? I mean, Nick, it's Morningstar. I'm up to so many things, but I think the most significant change over the past year has been an effort across Morningstar to bring our investment teams and research teams into one cohesive unit just so that we can share ideas, have greater efficiency, have greater insight, because there's so much, I guess, Morningstar IP around the organization – folks who are oriented toward thinking in the long run, thinking about fundamentals across stocks, across third-party strategies. So, we've been making a real effort to bring all of us together so that we can share those ideas. And so, that's been one of the areas I've been focused on over the past year.
VanDerSchie: Great. And Preston, we're certainly delighted to have you join Simple But Not Easy for the first time. Can you tell us and our listeners about your role as Morningstar's chief U.S. economist?
Caldwell: So, as chief U.S. economist, my job is to provide a view on the macroeconomy, what's going on and what's coming forward when it comes to GDP, inflation, interest rates, all the key macroeconomic variables. Now, I came into this role from a somewhat unusual path. I was originally an equity analyst for Morningstar, which was a fascinating experience. I covered energy stocks in the midst of the shale boom and saw capitalism work at the micro level from the ground up. And so, now I'm looking at things from the macro level. I got started early during the pandemic in 2020 in order to help our firm cope with the whirlwind of macroeconomic volatility that was enveloping the economy. So, that's been trial by fire. And it's been a very interesting experience to say the least.
Norton: Preston, what do you like better, the micro or the macro? Do you miss the shale?
Caldwell: I'm a generalist, so I'm happy to switch back and forth and do both one day and the other the next.
VanDerSchie: Well, we're certainly glad to have you here, Preston. Really before diving into 2024, which is the focus of today's episode, I do want to take a quick look back at 2023. Preston, entering the year, I think there was a consensus view that the U.S. economy would enter a recession. In fact, when you look at some of the survey data from a year ago, respondents were predicting the possibility of a recession at some of the highest rates we've seen in a while. Yet the three of us are sitting here in early December and that really hasn't come to fruition. So, what happened?
Caldwell: Yeah, the consensus probability of a recession was over 60% a year ago in terms of next 12-month probability. So, we were a bit lower, but we were still saying 30% or 40% at one point. And certainly, the economy in terms of the GDP growth has performed stronger than we were forecasting as well. So, the rate hikes that were executed a year ago, the fastest pace of rate hikes in 40 years since the Fed tried to tame the great inflation of the 1970s by hiking rates in the early 1980s. Those aggressive rate hikes have failed to slow down the economy as much as the Fed might have wished would have happened and most economists had expected to happen. Now, inflation has gone down anyways. We'll talk a lot more about that later because of supply chain improvement. But nonetheless, the real economy in terms of economic activity has been incredibly resilient to higher rates. But that may not last, and we can go into why I think that's the case.
VanDerSchie: Yeah, we'll certainly get there, Preston. Marta, with that as the backdrop, what has it been like managing portfolios in this environment?
Norton: Yeah, it's been super fascinating. I've been working on a piece that looks at lessons learned of 2023. And I think one of the real standouts to me is that the consensus view around recession, so Preston says 60%, right – folks were thinking of the likelihood of a recession – really forced a lot of investors into fixed income. So, if you were to listen to Bloomberg or CNBC in January of last year, almost every strategist, every CIO who was coming on was saying that they were favoring bonds because of this likelihood of recession. And I think there was some rationale from an evaluation standpoint just given how much bonds had sold off.
But the reality is that that move would have been pretty costly given some of the pain that bonds continued to experience in 2023. And given the rally that equities, particularly growth equities, but equities broadly have experienced around the world. So, I think a real takeaway for an investor looking back on 2023 is that you can't invest with an economic view as your sole input to your portfolios. And that valuation matters especially at the extremes. And we saw equities as well as fixed income valuation really start to look attractive across equities. And so, I think that was one of the big takeaways from 2023 was that, yeah, take a look at the economy; yeah, have a view on it, have a range of outcomes, have a base view, but also be pairing that with a view of valuation.
Caldwell: I just wanted to follow in on Marta's comment. This idea that we can make tactical portfolio decisions based off of the business cycle and whether we think a recession will happen is very contingent on our timing ability because why is a recession bad for equities? I mean, it's a temporary cyclical fall in earnings. But the biggest factor is risk premia go up. That's the main explanation for the sell-off in equity prices whenever it's particularly severe around recessions. So, predicting especially changes in risk premia is very hard. There's no really established economic theory to do so even. So, I think that would argue for caution for any portfolio manager trying to gain the timing around a recession.
VanDerSchie: Definitely that certainly makes good sense. So, with 2023 almost in the rear view at this point, let's shift to 2024. Every new year begins with some level of uncertainty. So, let's explore some of those areas that everyone is trying to wrap their head around. Marta, what do you think the big questions that investors are trying to figure out right now?
Norton: Well, I think one of the big questions relates to this idea that Preston just raised, this question of timing and severity, I guess I would add to that. So, I think a lot of folks are seeing signals of a slowing economy. So, Preston detailed how the Fed rate hikes did not have the sudden slowdown impacts that everyone was expecting. But I think that there's good rationale, especially as inflation declines and rates remain high, which would mean that the real rate of interest rates is higher that that's going to begin to have an economic effect that we will start to see some slowdown start to emerge. So, I think a lot of investors are trying to figure out how severe that slowdown is, when is it going to hit? What does this mean for interest rates? And then of course, where should I be in my portfolio today? So, we're wrestling with those questions as well. But as I mentioned earlier, we're pairing that with a valuation view. I don't want to get too far ahead of myself, but we're looking for areas where the market has assumed a really dire economic outcome and has really punished areas of the market. And then we're also shying away from areas where the only view or the only outcome that people priced in is really a perfect outcome. So, I think that economic question and then that consideration for evaluation is what's on investors' minds today.
VanDerSchie: Preston, on your side, what are the big questions that you think investors are tackling right now?
Caldwell: Yeah. So, from the economic vantage point, I would say the question of this lagged impact of rate hikes on the economy, how much is really in the pipeline? I think there's still quite a bit. And for other reasons, I still think there is likely to be a slowdown in GDP growth in 2024 compared to 2023. And there's still some possibility of a recession. So, there is a range of credible scenarios here. There's one environment where perhaps the consumer remains very optimistic. And even as they start to spend down their excess savings that were accumulated during the pandemic, maybe they start dipping into accumulating debt, and that allows them to continue to spend at a high rate and also asset prices continue to rise. And that further encourages the consumer as well as business spending and all that propels the economy in 2024. But our base case is that this depletion of excess savings weighs on spending next year. And as credit from the banking sector and other areas continues to contract, which is a lagged response to rate hikes that will weigh on spending next year, not dipping the economy into a recession, although a significant recession is a possibility if it turns out that the Fed has over-tightened and that all of these effects are in the pipeline and it's kind of the metaphorical ketchup bottle where you're shaking and shaking and then it all comes out all at once. So, those are all possibilities.
So, there's the recession topic. That's a key question, but there's also interest rates. I would say long-term interest rates – of course interest rates are intertwined with the recession question in the near term, but there's a long-term topic of has, what we call, the neutral or natural rate of interest in the economy shifted upwards compared to pre-pandemic levels. Long-term rates are, right now, they're about – if you look at the 10-year Treasury yield, it's about 150 basis points, above my long-run expectation and similarly, about 150 basis points above the average in the three years before the pandemic. So, the market seemed to be saying that a new normal of higher rates is possible. Of course, a few weeks ago, the 10-year yield was up 60 basis points higher than it is right now, so even more so. And that would be credible, in my view, only if certain secular forces in the economy have shifted in a permanent way. Now, in the decades leading up to today in the last 40 years, there's been secular shifts that have produced a fall in the natural rate of interest. That includes aging demographics, slowing productivity growth, increasing income inequality, perhaps. In my view, those long-term forces haven't shifted. Other than a small contribution from the increase in government debt over the course of the pandemic, there's not a factor which explains why interest rates could be higher for longer in my view.
VanDerSchie: Preston, you touched on it and Marta did as well – inflation, and inflation certainly has been a major force driving markets and impacting customer psychology in recent years. I noticed in the 2024 market outlook, you're predicting inflation to fall in 2024. And for those who haven't read the piece yet, maybe can you share your thinking and talk about some of the drivers?
Caldwell: Yeah. Just to set the stage, we hit inflation over 6% in terms of the PCE price index in 2022. In 2023, on a full year basis, that's falling to an estimated 3.8%. That's our latest forecast falling greatly over the course of the year. And we're expecting that to fall to about 2% in 2024 at an average, which is right in line with the Fed's target, and we expected it to average actually just under 2% over the next three years after that. So, we are expecting a swift return to normal for inflation. And the biggest factor has been this improving supply side of the economy, which has allowed inflation to fall about 300 basis points over the last year, in spite of an acceleration in GDP growth compared to a year ago. That's not the normal relationship between GDP growth and inflation, because normally we think about the Fed engineering lower inflation by creating slack in the economy, slowing down the rate of GDP growth. But what's happened is that the supply side of the economy has expanded just as it contracted during the pandemic as all of these bottlenecks and constraints that happened during the pandemic are being resolved. And that's happened in energy markets, for example, where energy prices are down sharply from their peak in summer of 2022. It's happened in used car prices in other areas of durable goods. So, we expect that to continue. It's not over yet, particularly, I think, for durable goods, used car prices and others, they still have a bit of room to converge back to the pre-pandemic trend line. And we see emerging capacity, even perhaps a capacity glut in many areas, many parts of the supply chain, which will weigh on consumer prices over the next few years. And all the while supply side expansion in the labor market still looks fairly positive to us. So, all of that will help bring inflation down.
VanDerSchie: Marta, another key theme I read about in 2024 sticking on the topic of inflation is inflation being lower for longer, from a portfolio management standpoint, how do you take this into consideration?
Norton: Yeah. So, when we think about the economic environment from a portfolio perspective, we tend to think in four quadrants. We think of high and low growth and high and low inflation and then the four pairings that that can have – high growth, high inflation, low growth, low inflation, that kind of thing. So, when we think about the portfolio, we think about what is the market not pricing in? What scenarios is the market not pricing in and how do we protect in that environment? I think Preston lays out a really rational base case for inflation and for growth, so expecting growth to slow down, expecting inflation to return to normal. So, that's something that I think we take into account as we position the portfolio. And there's a lot of assets that I think could benefit in that scenario. So, the most obvious to us is banks where a return to a more normal environment, given what's happened in that market, and we'll talk about that later, would really be a boon to those stocks.
But we also want to take into account what could happen if a slowdown doesn't occur, if inflation doesn't return to normal. Because I think there's a range around timing and a range around views, but it seems as though that is kind of the dominant market view that we will see a return to pre-pandemic life on both inflation and on growth. So, we want to make sure we have some protection in the event that that doesn't happen. So, what we're looking at today in terms of protection include MLPs, which to us have a nice yield that's less impressive today, given that fixed income yields have gone up, but also have reasonable valuations relative to their own histories and could be protective in the event that you have some surprises, whether that's from domestic inflation or whether that's from the war that we're seeing in the Middle East and some sort of energy price shock. European energy, another place where the valuations are better, we think the capital discipline is better. So, what I'm really painting for you here is not necessarily trying to position the portfolio for a dominant economic narrative, but positioning the portfolio for surprises that the market isn't really considering and having some protection in those environments.
VanDerSchie: No, that makes good sense, Marta. Preston, besides lower inflation, are there any other economic surprises that could be possible next year? Anything that others may not be expecting?
Caldwell: Well, within the recession theme, what I would say is that – again, we're expecting a mild slowdown in growth, GDP growth slowing down by about 100 basis points in terms of year-over-year GDP growth, and that will produce, in our view, a modest slowdown in the labor market, unemployment rate – the unemployment rate ticking up by about 70 basis points by the fourth quarter of 2024. But if we look historically, we rarely see just a modest uptick in unemployment. And perhaps this is because of the nature of the kind of dramatic boom and bust business cycles we've seen over the last few decades. But the point being is that, there's some possibility that this process of layoffs and economic slowdown once it gets in motion, it might be too hard for the Fed to stop. And so, we could see a much greater run up in unemployment and slowdown in the economy. Because typically, once the unemployment rate starts ticking up, it goes up by at least 200 or 300 basis points. But I do think – there's a reason to think this time is different. The Fed can achieve a soft landing. I think they're ready to move adeptly next year and start bringing the federal funds rate down and setting market expectations in a way that restimulate the economy. But yeah, I would look at the labor market as an area to watch to see if some sort of recessionary momentum starts getting put in place.
VanDerSchie: Great. Well, I want to take us and shift over to some of the potential risks heading into 2024. We all know the resilience of the broader markets, maybe cold comfort as we look at the litany of known risks facing investors at the start of the year. Marta, you mentioned the war in the Middle East, there's also Ukraine, questions about commercial real estate, China's secular growth and geopolitical challenges, and of course, the U.S. presidential election, just to name a few.
Norton: Yeah.
VanDerSchie: These are all top of mind for investors. But Marta, what do you see as the potential biggest risk in 2024? And how should advisors think about that as they're thinking about portfolio impacts for clients?
Norton: Yeah, it's a good question. And it's one that I wish I had a better answer to because when I think about it – you just gave the rundown of what we know, what the stage is set for today. And of course, that's only what we know, right? There's could be all sorts of things bubbling under the surface. I think that the difficulty here is putting a probability on what the actual outcome is. So, for example, take the Russia-Ukraine war. When Russia invaded Ukraine, the dominant narrative at the time was that Ukraine was going to fold like a house of cards. This was going to be over really quickly and there was going to be this huge shift in power. And what experts and pundits and the rest of us just watching along with it didn't anticipate was how forceful Ukraine's defense was. And what was going to happen over this long run, that there would be this long-standing conflict that's emerged since then.
So, what I hesitate to do is putting a really fine point on the probability of any of these risks. What I think is a far more prudent way to manage a portfolio is to know what the market impact could be. So, for example, if we're looking at the war that we're seeing in the Middle East, the greatest impact that we could see, because there's not a ton of direct exposure to those markets, is the energy market. And we know that if there is an energy shock, if somehow this war grows and spreads to other areas and there is some energy price shock, we know that that can have an impact on recession outcomes. We know that energy price shocks can often precede recessions. So, understanding that connection can help us look for areas in our portfolio that are exposed to that. So, again, having some energy exposure in the portfolio for areas that we think are better priced, thinking about what kind of defense you could have if a recession does bubble up either because that energy price shock was that last straw that broke the camel's back or because of what Preston is describing, that a soft landing is difficult to achieve, and we could see unemployment tick up far faster. So, that's where we start looking at longer-term bonds that are selling at much better prices.
I wish it was as easy as us looking at these risks and saying, aha, I put a 70% chance on that, and therefore I'm going to buy X, Y and Z. It's just a much more complicated mosaic than that. I think the biggest risk as we look at that is actually an overreaction to any of these risks. The China-U.S. conflict is something that can really make a lot of the hairs on people's necks stand up because it could have so many gruesome implications for investors. But the real risk is trying to assume you know what's going to happen and making choices because of that and then wrongfooting your portfolio. I'll give just one more example circling back to the Russia-Ukraine invasion in the wake of that the big consensus that was coming out was that a lot of the areas that touched that region, so Germany for example, or some of these European financials, some of the European energy names that they were dead in the water, that they were really going to suffer in the wake of that war. In fact, Germany had one of its stronger years after that invasion because the sentiment had grown so poor, and the actual outcome wasn't as bad as people had thought. So, I think it's really important to understand what the geopolitical risks are, to understand what the implications are to build a robust portfolio and then not to overreact.
VanDerSchie: Preston, same topic and really from your point of view, when we look at these risks, are there any that you think have a higher likelihood than others to persist for a longer period of time? And as a result, how should advisors think about that as they're navigating their client situations?
Caldwell: Yeah, I mean, first off, I would say I concur with everything that Marta just said, and I would also bring up the topic of geopolitical risk as being the most significant downside risk factor for the global economy over the next 5 to 10 years, particularly conflict surrounding Taiwan and U.S.-China relations. But again, to echo Marta, these things are extremely hard to predict, and I would not recommend most portfolio managers engaging in any kind of active positioning or speculation around these risks. But it is remarkable to the extent to which markets often fail to incorporate these risks, so markets not understanding the degree to which the Western countries would respond with these aggressive energy sanctions against Russia and the impact that had on oil prices in 2022. I mean, that was kind of a knock-on impact that no one was fully contemplating, although we did see oil prices run up prior to the invasion, but that may have been also due to other supply and demand factors. But I would say overall, markets were really caught off guard. If you go all the way even back to the run-up to World War I, of course, it's well known that the European powers thought it was going to be a short war, and markets certainly did not incorporate the impact of the war fully. There was a bit of a sell-off, but markets closed in summer of 1914 in many European countries, and they didn't open again for four years. Before they closed…
Norton: It's super fascinating.
Caldwell: Yeah, they didn't incorporate what happened, and of course they gapped down if they existed at all after the war. In some countries, they totally collapsed. So, these kind of once-in-a-decade, once-in-a-century events are very difficult for investors to grapple with. There are no easy answers that any kind of extended U.S.-China confrontation would be disastrous for the global economy. It could be highly inflationary. It depends on how monetary policy seeks to cope with the shock to the productive capacity to the global economy that would come from ripping up global supply chains if there was some sort of real decoupling between the Western countries, or at least the U.S. and China. But regardless, it would certainly be a hit to real incomes of U.S. households because obviously the prosperity that we enjoy is dependent on free global trade to a great degree and the economies of scale that provides. And it's honestly – I mean, there's really going to be probably no great way to prepare against that, even if you thought you had a surefire forecast that was going to happen.
Norton: Right. You can be right on what happens and wrong on what to do about it. I think the one thing that comes to mind, and this isn't any sort of insurance policy, but the one thing I do worry about for investors broadly is just a sense of complacency. And it especially relates to U.S. stocks. I think it used to exist with U.S. Treasuries, but hopefully people have rethought and understood how U.S. Treasuries operate a little bit more. But I was speaking with an advisor at the start of the year, and he was telling me the complexity of his financial planning engine. And then I asked him what was in his portfolio, and he said, well, I really need U.S. Treasuries in the S&P 500. And I think it's just worth remembering, even as powerful as large growth is to the U.S. and to the S&P 500, that it's not a guarantee, that those returns aren't a guarantee. And so, it really helps to have the right expectations with what markets can provide and what risk you're taking when you invest in them.
VanDerSchie: All right. So, Marta, Preston, we've exhausted all of the potential risks for the year ahead. Let's maybe focus on something a little more uplifting and that would be areas of opportunity. There's that old saying, pessimism sounds smart, but optimism is what makes investors money. And there are certainly no shortage of…
Norton: That sounds very American.
VanDerSchie: There's certainly no shortage of challenging asset classes out there. Marta, what are some of the areas of opportunity that you see where price is appealing relative to value?
Norton: Okay. So, within the U.S., the area that I think is probably at its greatest attractiveness to us within our portfolios is probably banks. I'd like to say that we had no bank exposure prior to the banking crisis. Of course, we did have some exposure, but not excessively. And then, the banking crisis emerged, and bank stocks just get pummeled, especially regional banks. So, of course, the JPMorgan's of the world hold up very nicely. But some of these banks that seem to have any sort of similar characteristics to SVB look very concerning to investors and so, their stocks' price plummets. And there's a lot of contingency with how banks perform relative to where rates are, what the monetary policy is, both for the securities they hold and then also for deposits and what they need to pay out to investors, especially the pressure that's come as depositors have demanded more for giving up their money or putting it in the bank. So, those stocks have been particularly hard hit by the narrative of 2022 and 2023. And I think their share prices reflected.
Actually, as you look at the historical performance of banks over time, take very long periods of time, 10, 20 years, banks tend to not outperform the broad market. They're not a great long-term holding. But if you look at their performance in the wake of bank crises, and we all know that bank crises are difficult psychologically and tend to be longer and rolling. So, they're not these pleasant experiences. But in the wake of those crises, we actually see pretty strong outperformance by banks relative to the broader market. And so, to us, this is an area where you are getting some margin of safety for the worst-case scenarios that are priced in. You can make adjustments for quality. You can look for the quality banks where maybe there's less commercial real estate exposure and there's less concentration among depositors and these different quality screens that you can put in place, and you can put together a pretty decent portfolio of banks that could potentially do quite well should the market environment see a soft landing and rates come back down a bit and not continue this ascent higher.
So, to us, there's risk there. It's not something that's all you own in your portfolio, but it is one of the areas of opportunity that jumps out to us. I mentioned MLPs being an area that's also something that we like in the U.S. But I think broadly speaking, as we look at the U.S. market, it's generally attractive to us with the exception of stocks that are really levered to the AI play. So, that particular area of the market, whether you want to call it the Magnificent Seven or whatever, has had a very strong run. And so, it's more avoiding that area than it is these other pockets of opportunity. And then, of course, there's tons of opportunities outside the U.S., and we talk about that in our market outlook. But I think if we're solely looking at valuation opportunities, I don't think it's a bad time to be an investor. I'm also enthused about fixed income, and we'll talk about that as well.
VanDerSchie: So, let's go there. One of the key themes in the market outlook that you just referenced was say yes to bonds and taking advantage of the reset in rates. Bonds have not been an asset class that investors have particularly enjoyed over the past few years. So, why should they consider them now?
Norton: Yeah, it's been such a historic route in fixed income. So, it's really been, I think, close to three years of losses for bonds. Last year was historic. So, of course, equity markets sold off and it was pretty painful. Bond markets had an historic loss. And then, this year, those losses continued. So, for really the first half of the year, it wasn't too painful in fixed income. But then over the course of the summer and really in the fall, especially at the longer end of the curve, we saw – and by the longer end of the curve, I even mean 10-year bonds and further out – those bonds took particularly hard hits. And that was partly deciphering exactly why things sell off is never a perfect science, but it was likely partly the result of the higher for longer narrative that was being talked about at the time and also concerned around fiscal stability, the government having to issue more and more debt with rates being higher and what that could mean. And there was downgrade and the like for U.S. to contend with. At that point, we started to see fixed income look far more attractive than it had both at the short end of the curve and at the longer end of the curve. So, for the fixed income market, we create fair values for all these different maturities. We do it for treasuries and we do it for corporate bonds in every which way. And especially for treasuries, we started to see the market look more attractive than it ever has for us.
Now, fixed income isn't the gang buster returns that equities offer. So, there is an opportunity cost to moving into fixed income vis-à-vis equities. But it is much more attractive, and you can get a much higher yield than you could previously. So, I think if you're an income-oriented investor, which I think encapsulates a lot of the retiree space where there's a lot of folks out there who rely on fixed income, I think now is a much better time to be relying on fixed income. Now I do want to caveat this with the one comment that, the fixed income market is a huge market. There's the government bonds, but there's also a lot of corporate bonds. And should we start to see, Preston detailed, a worst-case recession outcome, where you start to see unemployment tick up, there are corporate bonds, high yield bonds, where spreads are a little tighter, that extra income you're getting for lending money to a company rather than to the government has a certain level of risk associated with that. And that extra compensation isn't as wide as we would like to see. So, there are some areas of fixed income where I think it pays to be a little cautious. But broadly speaking, I think this is an environment that is far better than it was even last year. And markets are already starting to rally. So, it might be shifting. But for right now, it looks pretty good.
VanDerSchie: And Marta, related to that, one of the trends we've seen this year is money market funds attracting some of the largest flows in their history. Do investors think that cash is a free lunch? And what should they know about the benefits of fixed income relative to simple cash?
Norton: Yeah, cash is king. I think it's in some ways a very rational decision. If you have already a cash allocation, and you can get higher yields for it, go ahead and get those higher yields. I think the danger is when people are selling stocks and selling bonds to store it in fixed income. So, they have assets where they don't need to tap those assets anytime soon. They have a 10-year, 15-year horizon, and they're taking those dollars and putting it in cash. I think there's a real danger to that. One of the dangers is just a reinvestment risk danger. So, if the Fed starts to lower interest rates, cash obviously has a very short duration, 30 days or something along those lines. So, as interest rates tick down, that money frees up and the rates reset and you're constantly reinvesting at a lower rate. So, there is some opportunity cost to sticking with cash. As you go further out the curve, you can lock up those dollars for longer and then of course equities have higher return prospects. So, I think for those investors who have cash sitting around and need it, you want to make sure it's liquid and ready, store those assets in a money market, no question. But the idea of shifting wholesale portfolios into money markets, I think that's really misguided.
VanDerSchie: No, it's good guidance for sure, Marta. Thank you for that. So, Preston, related to bonds, obviously the Fed has had a major influence on the market this year. And over the last decade, many have argued that the Fed was actually punishing savers. Yet now we sit here flush with yield. What do you see happening with the Fed relative to rates next year and its relation to fixed income?
Caldwell: Yeah, so I've touched on my interest rate forecast already, but just to recap, we are expecting the Fed to start cutting rates. Ultimately, we expect the federal funds rate to fall about 300 basis points from where it's at right now by late 2025. Likewise, we expect yields at the longer end of the curve to fall with the 10-year yield eventually falling back down to 2.75%. The reasons why are essentially falling inflation as well as economic growth weakening next year, the Fed will react to that by pivoting quite quickly.
I do want to address really our monetary policy framework since you bring up the influence of the Fed. One thing I would say is that I think the market narrative in the financial press focuses a little bit too much on the Fed often when it's thinking about where interest rates are going to go. It's not that the Fed is not important, but we have to keep in mind the Fed is essentially reacting to the economy. There can be idiosyncrasies in how one Fed chair and FOMC committee might react to a certain economic state versus another person sitting in that position. But nonetheless, they're basically responding to the economy in a fairly predictable way, especially over the longer run, which is to say they want to keep inflation in line with their 2% target and they want to maintain all employment or basically GDP growing in line with its potential.
So, based on that, we really focus on predicting the economic variables and then we assume that the Fed is going to react in a way to achieve its targets. In the very long run, this idea that the Fed is manipulating interest rates, that the Fed has manipulated interest rates lower, we heard that throughout much of the 2010s, it doesn't really hold any water. The Fed is responding to changes in the natural rate of interest, a concept which I brought up earlier, which is basically dependent on the balance of savings and investment in the economy. For example, aging demographics expands the pool of savings and also constricts the desire to invest among firms. That reduces the natural rate of interest and that's something the Fed just passively responds to in order to achieve their goals for the economy. Savers are not being punished by the Fed on any long-term basis and neither are they benefiting from the generosity of the Fed right now. The reason why interest rates are high are because of what's going on in the macroeconomy, the elevated inflation and also just because the economic spirits are high and that's allowing the economy to temporarily cope with a higher-than-normal real interest rate.
VanDerSchie: Great. One last topic I want to touch on, and Marta, you brought it up earlier, is artificial intelligence, which is actually the theme of our last podcast. You also mentioned the Magnificent Seven. Preston, maybe I'll start with you. How do you see AI working its way through the economy? I've heard the analogy of AI to the industrial revolution and tractors making farmers more efficient and driving more production. Is that a fair analogy?
Caldwell: Instead of just comparing it to a single technology, what I would say is AI is among the class of so-called general-purpose technologies. Historical examples would be electricity or the personal computer or the internet. What we see is that it takes a long time for these general-purpose technologies to disperse throughout the economy and have their full impact. Once that does happen, the impact can be massive in the long haul. And I do think that will be the case for AI. I think there will be some measurable impact on productivity growth for the economy over the next few decades, although there's other factors that could negatively impact that. But I do think that's reason to be optimistic about productivity growth compared to the fairly weak productivity growth that we've seen over the last roughly 20 years on average in the U.S. That's reflected in our forecast where we're a little bit optimistic on productivity growth.
But the timing is key. It will take a long time for firms and individual industries to apply AI and regear their business processes around it. The entire job roles are going to have to be redefined so that humans can work optimally with AI. People talk a lot about the potential job loss. That is a possibility, and certainly in a gross sense, there will be job loss. Most of us living in modern society are basically unemployed farmers, but we found other work to do, even as agriculture's productivity became vastly greater over the last two centuries. Perhaps we will find new jobs to do once AI replaces our current ones, or maybe this time is different because of the magnitude of the disruption.
Also, I would say even though the market economy will tend to create new job opportunities, that doesn't mean they will be as good as the old ones that we had. There could be distributional impacts from AI. So, if you think about automation in manufacturing, that does have distributional impact. It benefits the remaining manufacturing workers. It benefits owners of capital, but for workers who move from a higher-paying manufacturing job to maybe a lower-paying service job, they might be negatively impacted. So, even though the worries about mass unemployment might be overblown, there still could be distributional impacts in the long run from AI. In order to cope with that, we will have to, I think, have a flexible public policy response to make sure that the composition of income in the economy doesn't become too skewed.
VanDerSchie: No, I think that's fair. Back to AI investing for a minute, Marta, I think it's fair to say that artificial intelligence optimism has certainly made investors money this year. How much optimism is priced into the market on this topic?
Norton: It's hard to say. When we take a look at some of these, the Nvidia's of the world, for example, it's hard to find fault with the business model. Certainly, I think as we have more clarity, as we've been given this year around AI, there's room to reset what that fair value is for that company. So, fair values are important because they tell you what you think the company is worth on an enduring long-term basis. The stock price fluctuates around that. But as we take a look at a lot of those companies, semiconductors, and the like, even with very generous assumptions, it's hard to get to today's prices and think that it's attractively priced. So, I think there is a lot of enthusiasm. What we talk about a lot in our market outlook is second derivative plays or AI-related stocks that aren't so closely associated with AI. So, those could be areas of opportunity.
I still resonate with the idea that there's a lot of uncertainty here. I remember we were having an investment meeting. One of my colleagues was just pounding the table for ChatGPT and how transformative it was. He was saying, I could give it some information and it would spit something out so incredibly concisely and articulately. And yeah, some of it was wrong, but it was great. I just stopped and thought, if that was an analyst, if you were describing a human being and you were saying this analyst gives me everything timely and is really articulate, a lot of his information is wrong, but it's still really timely and articulate, that would not be a good outcome for that particular analyst. I still think there's a lot of room for development and growth. Maybe it will happen much more quickly than I anticipate. But I think assuming that today's prices are representative of the true value of some of these companies, I would put a band of uncertainty around that.
VanDerSchie: Good insight, Marta. Thank you. All right. We're at the conclusion of the episode. Before we sign off, we want to go to each of you with 10-second takeaway. So, if our listeners have fallen asleep, not that they would, but if they have over the course of the last 45 minutes, and you want to leave them with one thing they should take away from today's recording…
Norton: Go to Preston first.
VanDerSchie: Preston, Marta is throwing it to you first.
Norton: 10-second takeaway.
Caldwell: 10 seconds. My hope is that the economy will return to a state over the next year where I won't be invited to podcast anymore because it will be too stable and boring. That is my base case, but we'll see what happens.
Norton: Preston is anticipating he will not have a job next year. 10-second takeaway. I think there is a lot of noise, a lot of uncertainty. I still think today is a good time to be an investor.
VanDerSchie: And there you have it. Another episode of Simple But Not Easy. As always, we thank Marta and Preston for their time and engagement. Once again, if you'd like to know more about how Morningstar can support you, please drop us a note at simple@morningstar.com or me directly at Nicholas.VanDerSchie@Morningstar.com. That wraps up this week's episode. Before we depart, if you enjoy hearing the insights on our podcast, please consider leaving a review on Apple Podcasts. Until next time, thanks for listening.
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