Today’s cash yields won’t last forever. Stocks could push toward new highs, and higher yields can be locked in.
It’s not always easy to discern a market mood, but the investor vibe plainly shifted over the summer of 2023. The recession obsession faded while prospects for a soft landing improved.
On balance we share that optimism. Inflation has fallen significantly. The labor market has cooled just enough to reduce wage pressure on companies while also tempting idle workers back to the office. Two economic game changers—artificial intelligence (AI) and industrial policy—are supporting investment and growth.
Here, we tell the current macroeconomic and market story in a series of charts, explaining why we believe now is a great time to be invested, for both the short term and the long term.
The macro backdrop: Resilient growth, fading inflation
Not too long ago, many prominent economists believed inflation could not fall without a material rise in unemployment. However, this seems to be exactly what is happening. Headline inflation has dropped to 3% on a year-over-year basis even as the U.S. economy has added an average of over 150,000 jobs a month over the past three months and the unemployment rate has hovered near a 70-year low.1
How is this possible?
First, we are finally starting to emerge into a post-pandemic normal for the economy. Supply chains have cleared, and consumer spending no longer reflects the impact of stimulus checks and public health policy. Perhaps most importantly, the supply of workers is on the rise. In fact, the employment-to-population ratio (for prime age workers ages 25-54) has finally recovered to where it was in the late 1990s and early 2000s.
Growth has been resilient as supply and demand have come into better balance. In fact, most estimates for third-quarter GDP are predicting an annual growth rate of 3%, higher than what most economists think is the trend growth rate of the economy.2
Inflation is falling while the labor market is solid and growth is strong
This chart shows U.S. headline CPI and Core CPI together, from January 2020 to July 2023. For headline CPI, the series starts at 2.5% in January 2020 and decreases to 0.1% in May 2020. it then increases to 1.4% in September 2020 and stays relatively flat until January 2021, at which time there is a sharp increase to 5.4% in June 2021. The series further increases to 9.1% in June 2022, before dropping significantly to 3.0% in June 2023. It then increases to 3.2% In July 2023 as the most recent point in the line. For core CPI, the series starts at 2.3% in January 2020 and decreases to 1.2% in June 2020. It stays flat at 1.3% in February 2021, then increases to 4.5% in June 2021. It then decreases to 4.0% in September 2021, and increases to 6.5% in March 2022. It falls shortly to 5.9% in July 2022 before rebounding higher at 6.6% in September 2022. It then decreases to 4.7% in July 2023.
This chart shows initial claims for unemployment insurance, and continued claims for unemployment insurance from 2020 to 2023. The initial claims series starts at 213 in January 2020, and sharply peaks at 4190 in April 2020. It then falls drastically to 757 in November 2020, and slightly increases to 833 in January 2021. It then decreases to 217 in December 2021 and stays flat at 229 in July 2023. The continued claims series begins at 1859 in January 2020, and peaks at 20210 in May 2020. It then decreases significantly to 5932 in November 2020. It continues to decrease to 1407 in May 2022 and stays flat at 1701 in July 2023.
This chart shows the Atlanta FED's GDPNowcast, from 2019 to 2023. It highlights the most recent quarter projection of Q3 2023 at 5.6%, which is much higher than several previous quarters preceding it. The full data is as follows: 09/30/2023: 5.6 06/30/2023: 1.7 03/31/2023: 0.7 12/31/2022: 3.1 09/30/2022: 2.1 06/30/2022: 1.9 03/31/2022: 0.1 12/31/2021: 6.6 09/30/2021: 6.1 06/30/2021: 10.4 03/31/2021: 5.2 12/31/2020: 2.2 09/30/2020: 11.9 06/30/2020: -12.1 03/31/2020: 2.7 12/31/2019: 1.5 09/30/2019: 2 06/30/2019: 1.3 03/31/2019: 0.3
What’s more, the elements for sustainable growth look to be in place. We don’t see many signs of the imbalances that tend to exacerbate recessions. Inflation might have played that role, but the trajectory for consumer prices now looks much more benign. In addition, the Federal Reserve probably does not need to work as hard to ensure that inflation continues to decline. We think its rate hiking campaign, which presented a powerful headwind to markets, is likely over.
The investment landscape: The search for yield is over
Amid a global rise in interest rates, income-seeking investors don’t have to look very far: Across the fixed income landscape, we see increasing opportunities for 5%+ annual yields. This is important because one of the best indicators of future returns for fixed income is the starting yield.
Consider: The worst 5-year forward return from this starting point in yields for 1–17 year municipal bonds is 3.9% annualized. Higher starting yields also limit the downside. For 1–17 year municipals, you still break even over one year if yields rise by 80 basis points (bps).3
Why not just stay in cash? (We hear this question a lot.) For one, those short-term yields won’t last forever. Yields will likely be lower one year from now when you need to reinvest. Also, the value of cash and short-term fixed income investments would likely not benefit if rates declined, while they could for longer-term fixed income.
Of course, everyone needs to hold cash, and it feels good to earn some income. But we think it makes sense to consider locking in today’s higher yields for a little bit longer by taking some steps out of cash.
Higher yields are currently offered across different types of fixed income investments
For the 10Y UST, the YTD annual yield is 4.1%, YTD high of 4.3%, and 2021 annual yield of 1.5% For Euro IG, the YTD annual yield is 4.3%, YTD high of 4.5%, and 2021 annual yield of 0.5% For the 3M US T-Bill, the YTD annual yield is 5.4%, YTD high of 5.4%, and 2021 annual yield of 0.0% For US IG, the YTD annual yield is 5.7%, YTD high of 5.9%, and 2021 annual yield of 2.8% For the 6M CD, the YTD annual yield is 6.0%, YTD high of 6.0%, and 2021 annual yield of 0.0% For US Munis (TEY), the YTD annual yield is 6.4%, YTD high of 6.4%, and 2021 annual yield of 1.9% For Euro HY, the YTD annual yield is 8.0%, YTD high of 8.3%, and 2021 annual yield of 3.4% For US HY, the YTD annual yield is 8.6%, YTD high of 9.3%, and 2021 annual yield of 4.7% For US Preferreds, the YTD annual yield is 8.7%, YTD high of 9.3%, and 2021 annual yield of 3.9% For Direct Lending, the YTD annual yield is 11.6%, YTD high of 11.6%, and 2021 annual yield of 8.5%
Equities: On the way to new highs
Resilient growth and subsiding inflation powered the first leg of this year’s 15%+ global stock rally. From here, we expect earnings growth to drive equity markets to new highs over the next 6–12 months. A ~10% return in equities is almost double what you are getting from Treasury bills (with better tax treatment), and we see potential for even higher returns over the medium term.4
Two potent forces—the growing use of artificial intelligence and deployment of industrial policy—could propel stock markets higher. As more and more businesses use AI to improve efficiencies, companies that produce the chips powering AI technology stand to gain. (Year-to-date, one of those companies, Nvidia, is the top performer in the S&P 500.)5 Similarly, industrial companies will likely benefit from fiscal policies that incentivize investment in new manufacturing systems, clean technology and a wide range of infrastructure projects. These trends will endure over many years, we believe, delivering critical support to equity markets.
Industrial policy is a game changer for US manufacturers
The chart on the left shows the number of mentions of the word "AI" in S&P 500 earnings calls, alongside NVDA's 12-month forward EPS estimates from Q1 2013 to Q2 2023. NVDA's EPS estimates follow this path: In January 2013, the EPS estimate was at 0.3. It increased to a relative peak in October 2018 at 2.1, then fell to 1.3 in February 2019. It rose again to 6.0 in May 2022, before falling once again to 4.1 in September 2022. It finally rose sharply to 13.4 in August of 2023. The series on "AI" mentions follows a roughly similar path, with sharp increases in the last three quarters. The quarterly data is as follows: Q2 2013: 2 Q3 2013: 4 Q4 2013: 5 Q1 2014: 3 Q2 2014: 3 Q3 2014: 3 Q4 2014: 2 Q2 2013: 2, Q3 2013: 4, Q4 2013: 5, Q1 2014: 3, Q2 2014: 3, Q3 2014: 3, Q4 2014: 2, Q1 2015: 5, Q2 2015: 3, Q3 2015: 4, Q4 2015: 6, Q1 2016: 8, Q2 2016: 14, Q3 2016: 16, Q4 2016: 19, Q1 2017: 25, Q2 2017: 40, Q3 2017: 36, Q4 2017: 35, Q1 2018: 53, Q2 2018: 52, Q3 2018: 45, Q4 2018: 40, Q1 2019: 59, Q2 2019: 50, Q3 2019: 57, Q4 2019: 64, Q1 2020: 43, Q2 2020: 52, Q3 2020: 52, Q4 2020: 58, Q1 2021: 70, Q2 2021: 59, Q3 2021: 67, Q4 2021: 68, Q1 2022: 61, Q2 2022: 57, Q3 2022: 53, Q4 2022: 78, Q1 2023: 115, Q2 2023: 179 The chart on the right shows Manufacturing Construction as a percentage of GDP, as well as Eaton's forward EPS estimates, from 2013 to 2023. For the Manufacturing series, it starts at 0.3% in 2013 and stays flat at 0.32% in July 2014. It then increases to 0.49% in June 2015, before falling to 0.35% in September 2017. From there it stays relatively flat at 0.34% in August 2021, and then increases sharply to 0.72% in April 2023. For the Eaton EPS series, it starts at 4.50 in 2013. It then increases to 5.08 in May 2014, before falling to 4.37 in December 2016. It then increases to 5.93 in October 2019, and falls to 4.09 in May 2020. Then, the series increases to 7.27 in September 2021, and continues to increase to 9.35 in August 2023.
Multi-asset portfolios: The best of both worlds
We expect solid returns from both stocks and bonds over the next 6–12 months. Once again, a multi-asset investment portfolio can work in different economic scenarios. For example, if growth slows to recessionary levels, interest rates will likely fall and bond prices could rise. This would help to offset equity market declines that would occur because of the earnings slowdown.
On the other hand, if inflation remains tame and growth resilient, it could provide a “goldilocks” environment for both stocks and bonds. Falling interest rates would boost bond prices, while decent growth would help corporate earnings.
We don’t need to look too far back in history to see what a powerful combination that could be. In 2019, the Federal Reserve lowered interest rates by 75 bps. The S&P 500 returned ~30%, while the U.S. Aggregate Bond Index earned nearly 9%. It may not be the most likely outcome for the next 12 months, but it is certainly a reasonable bull case.6
In sum: Against a backdrop of resilient growth and fading inflation, we find reasons for continued optimism across a range of markets—and see no investor vibe shift on the horizon.
1Sources: Bloomberg Finance L.P., Haver Analytics. Data as of September 14, 2023.
2Sources: Bloomberg Finance L.P., Federal Reserve Bank of Atlanta. Data as of August 31, 2023.
3Past performance is not indicative of future results
4Source: Bloomberg Finance L.P. Data as of September 14, 2023. Past performance is not indicative of future results. It is not possible to invest directly in an index.
5Source: FactSet. Data as of: September 14, 2023.
6Source: Bloomberg Finance L.P. Data as of: September 14, 2023.
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