Regular readers of our market commentaries are well aware of our belief that the economy and markets are inextricably linked, though not necessarily always in sync. The same things that affect the economy—monetary policy, inflation and employment—also affect various industries and individual businesses. The impact on businesses, in turn, is reflected in the markets and the prices investors are willing to pay for individual stocks.
The idea that the economy and markets are linked is straightforward, but the reality is that the size and complexity of the economy can be challenging for investors to navigate. That’s because the economy doesn’t expand or contract in lockstep. As we’ve detailed over the past two years, there are often significant divergences between areas that are experiencing growth and those that are struggling. Variations in growth are to be expected, but if gaps persist and widen between the strong and weak parts of the economy, distortions can develop and throw the markets out of balance. We believe the last two years serve as a prime example of how distortions can play out.
As we’ve shown through various economic measures we follow, the economy has been lopsided for the past two years, with some areas (such as services) enjoying strong growth while others, (such as manufacturing and housing) have struggled. Digging deeper shows that what separates the leaders from the laggards is how they are affected by higher interest rates. Businesses and consumers that are insulated or perhaps even benefit from higher rates have generally fared better than those that struggle against higher borrowing costs. For consumers, look at the housing market—where sales of homes valued at $1 million or greater rose while sales of homes valued at $250,000 or less languished. Businesses see a similar divide, with many large companies enjoying favorable intermediate- to longer-term borrowing terms they were able to lock in before the Fed began hiking rates, while smaller companies that rely on shorter-term floating-rate debt have had to grapple with higher interest costs.
Because the economy and markets are linked, we’ve seen similar distortions in performance. While the S&P 500 posted back-to-back years of better than 20 percent gains, strong gains at the individual stock level were more the exception than the rule. As we detailed in our latest Quarterly Market Commentary, just 29 percent of companies in the S&P 500 outperformed the aggregate index. This percentage is well below the long-term average of 48 percent. To find similar numbers in the past (on an annual basis) you’d have to go back to 1998 and 1999 and before that 1980 and 1973. Combine this with a similar reading in 2023, and it’s clear that the markets reflect the distortions we see in the economy.
Unfortunately, periods when the economy and markets are distorted can lead to frustration for investors who are focused on the long term and believe in the time-tested value of diversification. For some, the frustration can tempt them to abandon their financial plan and instead chase performance even if it means concentrating their investments into a small cluster of companies that are outperforming due to an unsustainable economic backdrop. While we understand this temptation, we also know that even the most unbalanced economic and market cycles eventually regain equilibrium.
The current distortions in the market, in our view, are most likely to dissipate either via a resumption of disinflationary trends that allow the Fed to cut rates more than investors currently expect in 2025, a mild slowdown that snuffs out lingering price pressures, or simply the passage of time (during which businesses are able to adjust to higher interest rates). Regardless of the catalyst, we believe the transition to a more normally functioning business climate will include more bouts of volatility. Indeed, last week’s stronger than expected jobs report, concerning inflation data in the Institute for Supply Management’s (ISM) report on services, and the University of Michigan’s Consumer Sentiment Survey showing signs that consumer expectations about inflation are on the rise all resulted in selling pressure. That’s because the data highlighted the potentially difficult task ahead for the Federal Reserve as it attempts to navigate the delicate balance between supporting the labor market while also not rekindling inflation. Given the cautionary reminders in last week’s data, investors concluded it was less likely the Federal Reserve will be aggressively cutting rates in the coming months. And rate cuts have been viewed as a painless way for economic strength to broaden and bring with them a return of balance in the markets. Simply put, the longer rates remain elevated, the more debt reprices and the greater the chance that the weaker parts of the economy continue to weigh on the strong areas. And with investment-grade bonds now yielding above 5 percent, the greater competition they provide for higher valuation equity markets.
Despite the likelihood of occasional bumps along the way, we continue to build broadly diversified portfolios that represent a balanced, long-term approach to investing. But we have tilted our portfolio toward asset classes that should benefit when economic participation broadens over the intermediate term. While this approach may mean the portfolios don’t fully participate when market distortions emerge, as they have recently, the benefit of diversification is that it is an all-weather approach that allows investors to have exposure to asset classes that may perform well even as others lag, regardless of the economic backdrop.
About the Author:
Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.