By Barbara Reinhard, CFA®
Prepare for the “K Economy”
Fiscal support is a critical for economic recovery. Despite challenges, markets have remained relatively relaxed as most market participants share our view that additional stimulus will ultimately come to fruition. However, in the meantime, a risk is becoming more apparent: There will be lingering damage on consumers in lower income brackets.
Prior to the pandemic, consumers on the lower end of the income bracket were in good shape primarily because of low unemployment (which provided cash flow liquidity), not necessarily because of asset growth or declining leverage. Consumers on the higher end of the income bracket have largely kept their jobs and adapted by working from home.
On the other hand, consumers on the lower end of the income bracket have relied primarily on stimulus provided by the federal government as jobs like leisure, lodging and retail have been eliminated or furloughed and haven’t returned.
Against this backdrop, the pandemic is creating a “two-speed” recovery between consumers on opposite ends of the income bracket. Similar to consumers, the fundamental outlook across corporate sectors is also fragmented. We see the U.S. economy shifting into a “K-shaped” recovery defined by uneven pressures that will create winners and losers with broad strokes across asset classes, sectors, and investment styles.
The Fed Plays the News Cycle: A Historic Change Garners Little Attention
The Federal Reserve is doing all it can to foster a vigorous revival in growth. In fact, while much of the headlines have focused on the lack of additional fiscal stimulus, the more significant story, long-term, is the new strategic framework outlined by the Fed. Going forward, Fed policy will be informed by assessment of the “shortfalls of employment from its maximum level,” whereas the Fed’s original language referred to “deviations from its maximum level.”
Complementary to this change, the Federal Open Market Committee (FOMC) has adjusted the approach to its longer-run inflation goal of 2%, now seeking to achieve inflation that averages 2% over time. After periods of persistently low inflation, the FOMC would tolerate inflation moderately above 2% “for some time,” to allow the economy to solidify a recovery. The updated strategy also acknowledges the challenges of a persistently low interest rate environment, in which policy rates alone have limited potential to benefit the economy.
Is the United States Becoming Japan?
The Fed’s approach to inflation has invoked comparisons to Japan. Sceptics argue that the Bank of Japan’s (BOJ) failure to achieve its inflation target over several decades is evidence that a central bank’s ability to generate inflation is very limited. However, a closer look at Japan reveals a more nuanced story and provides valuable lessons for the United States on the path ahead (lessons that U.S. policymakers seem to be heeding—at least so far).
Japan’s experience of stagflation during the 1970s caused the BOJ to hesitate and stop short of implementing fully accommodative policy. Even though the BOJ eased, the Japanese yen kept strengthening from 1990 to 1995. The Fed, on the other hand, has adopted a Zero Interest Rate Policy and announced that it will keep rates near their historic lows until at least 2022. Unlike the BOJ in the 1990s the Fed has been decisively committed to keeping monetary policy as accommodative as possible.
The Japanese government also held back on stimulus. Not only did the government wait until 1993 to introduce stimulus, the initial stimulus was minimal (resulting in only a 2% deficit). While policymakers in the United States are grappling over additional stimulus, the response since the pandemic has still been enormous. U.S. government spending has already resulted in a deficit of more than 20% and the expectation is that deficit will remain in double digits in the years to come.
There is another key difference. In Japan, the level of debt was unprecedented going into their crisis. In the 1990s, the private sector in Japan kept deleveraging, which made monetary easing ineffective. In the U.S. the starting point is much better and deleveraging has largely come to an end.
How to Prepare Portfolios: Is Value Dead?
At a high level, U.S. equities, large and small, remain our favorite asset classes. The U.S. market’s sector composition – heavily weighted with technology and healthcare companies – has helped buffer some of the earnings hits experienced through the COVID recession. Because of business models that are relatively resilient to the steps being taken to combat the coronavirus spread, we think these firms, particularly the large caps, will continue to gain the upper hand throughout the pandemic and during the early post-COVID period. Small cap equities also provide more cyclical exposure and should perform well as the economy continues to heal.
While this dichotomy is true at the asset class and sector level, it is also true for investment style, as the Fed’s adjusted stance on inflation and unemployment could have longer-term implications for the “growth versus value” debate in equities. History has shown that we need both real rates to be off their lows and inflation to be expected to pick up for value to deliver outperformance. Equity investors can add some value exposure to their portfolio for diversification, in case the Fed is successful and the long-standing leadership of growth stocks comes to an end.
While the fixed income markets staged a dramatic recovery since April, there are still opportunities to prepare portfolios today for the low-yield world ahead. Longer term, we continue to favor securitized credit over corporate credit. Drilling into securitized credit, we find the most attractive long-term opportunities in the commercial mortgage-backed securities (CMBS) sub-sector, which has yet to see the “V” shaped recovery of other fixed income segments. Risk has clearly increased in CMBS, but 6+ months into the pandemic, fundamentals are much clearer while market efficiency is not—creating opportunities to prepare portfolios for the low-yield world ahead.
About the author: Barbara Reinhard, CFA®
Barbara M. Reinhard is head of asset allocation for Voya Financial’s Multi-Asset Strategies and Solutions (MASS) team and is responsible for the day-to-day management and the decision-making process for asset allocation across a range of diversified portfolios for the MASS platform. In addition, she is also a portfolio manager for the firm’s target date suites.
Prior to joining Voya, Reinhard was a managing director and chief investment officer in Credit Suisse's private banking division, where she was responsible for asset allocation and advice for high-net-worth clients, institutions, endowments and foundations and also served as head of investment communications for OppenheimerFunds, and as deputy chief investment strategist for Morgan Stanley's Global Wealth Management unit. A graduate of Trinity College in Washington, D.C., with a B.A. in economics, Reinhard holds the Chartered Financial Analyst® designation.