Charles Tan
We believe economic pressures from tariffs, still-high interest rates and persistent above-target inflation will stall the US economy over the next several months. For these reasons, we put the odds of a slowdown sharply higher than other possible economic scenarios.
- Slowdown/Recession: Although we continue to believe below-trend growth (flat to slightly positive) is a likely near-term outcome, we also think recession is a growing possibility. We remain concerned about mounting consumer headwinds, including rising auto loan and credit card delinquencies, and sagging consumer sentiment.
- Stagflation: The potential for higher inflation and weak economic growth has slipped back into our forecast. However, we think stagflation is much less likely than a slowdown or a recession.
- Growth Surprise: We believe the chance of growth surprising to the upside has decreased significantly in recent weeks. We gauge this scenario, including above-trend economic growth, above-target inflation and tight financial conditions, as less likely than stagflation.
What would a slowdown/recession scenario mean for investors?
As the economy slows, U.S. Treasury yields will likely fall. We also expect credit spreads to widen.
While inflation should slowly moderate, we still expect tariffs to create temporary price bumps in the road. Overall, we believe the slowing economy will outweigh temporary price hikes, prompting the Federal Reserve (Fed) to resume its easing program by mid-year. We estimate the Fed will cut rates three or four times by year-end.
Slowdown/Recession: Potential Investment Implications
Fixed Income
In a slowdown/recession, investors should consider:
- Shifting to shorter duration. We believe short-duration assets may help manage near-term interest rate volatility. Furthermore, along with generally offering higher yields than cash equivalents, short-duration assets also tend to offer price appreciation potential in a declining rate environment.
- Balancing duration exposure. Core bond strategies with intermediate-duration exposure may offer diversification and potential performance advantages as rates broadly decline and equity market volatility rises.
- Staying high in credit quality. In addition to delivering diversification to investor portfolios, a modest allocation to high-quality investment-grade credit may now provide more attractive yields. However, we believe credit selection is critical to avoid weaker, economically sensitive issuers.
- Maintaining inflation protection. We believe inflation strategies still appear attractive, given that inflation expectations remain higher than average, largely due to tariff policy uncertainty.
Equities and real assets
In a slowdown/recession, investors should consider:
- Emphasising quality stocks. Quality companies with higher profitability and healthy balance sheets may offer attractive potential. Investors tend to favor quality companies in more defensive sectors, such as utilities, health care and consumer staples. Additionally, we think select dividend-paying stocks that tend to provide consistent income streams are attractive.
- Looking to sustainable growth. Companies with dependable, sustainable earnings growth have tended to outperform competitors with weaker earnings profiles during economic slowdowns. Economically sensitive value sectors, such as financials, industrials and energy, have tended to lag alongside lower growth expectations.
- Treading carefully in the commodities market. As consumer and industrial demand wanes, commodities typically lose their luster. However, we believe gold may continue to shine amid falling interest rates and heightened economic and market uncertainty.
- Maintaining selective exposure to real estate stocks. Lower interest rates may boost the attractiveness of real estate investment trusts (REITs) if growth doesn’t slow to recession levels. In such a scenario, we prefer to rely on our REIT managers to identify the best opportunities.
What would stagflation mean for investors?
In our view, stagflation would push the 10-year Treasury yield higher amid significant volatility as slow growth and high inflation collide. We also believe the two-year Treasury yield could increase as the Fed maintains tight financial conditions. Meanwhile, credit spreads may widen amid weak economic growth, particularly in the high-yield sector.
Stagflation: Potential Investment Implications
We believe stagflation is unlikely but slightly more possible than a growth surprise.
Fixed Income
If stagflation emerges, investors should consider:
- Maintaining inflation protection. We believe inflation-protection securities, particularly with short durations, are attractive as rates rise and inflation remains elevated.
- Focusing on quality credits. Higher-quality short-duration strategies may offer benefits if yield outweighs the effects of spread widening. Given the pressures on corporate fundamentals from inflation, rising rates and muted growth, a focus on credit quality will be important.
Equities and Real Assets
If stagflation emerges, investors should consider:
- Focusing on traditional value sectors. The energy and basic materials sectors have typically benefited from higher commodity prices. Utilities have generally provided dependable cash flows and dividends despite higher inflation and interest rates.
- Favouring quality stocks. In this challenging environment, we believe higher-quality companies with less debt, higher profit margins and reliable cash flows from operations should hold up better. We expect the market to reward firms with pricing power and unique competitive advantages.
- Gauging commodities. Commodities have historically provided high average returns during periods of elevated and rising inflation. However, we believe astute management is required because geopolitics and supply chain issues may heavily influence performance.
- Limiting exposure to real estate. As mortgage rates rise and the housing market slows, REITs may underperform their long-term averages.
What would a growth surprise mean for investors?
If economic growth surprises to the upside, inflation would likely remain above the Fed’s target. A growth surprise scenario could keep financial conditions tight and trigger renewed Fed rate hikes.
Growth surprise: potential investment implications
We believe there’s a slim chance economic growth will improve.
Fixed Income
If growth accelerates, investors should consider:
- Focusing on credit-sensitive assets. Riskier fixed-income securities, including high-yield corporate bonds and bank loans, may offer attractive return potential when the economy is growing.
- Maintaining inflation protection. We believe inflation-protection securities, particularly with short durations, are attractive as rates rise and inflation remains elevated.
- Avoiding longer-duration assets. With the Fed in tightening mode, we expect longer-duration securities to underperform as interest rates rise.
Equities and real assets
If growth accelerates, investors should consider:
- Focusing on traditional value sectors. The energy and basic materials sectors have typically benefited from higher commodity prices. Utilities have generally provided dependable cash flows and dividends despite higher inflation and interest rates.
- Favouring cyclical stocks. Economically sensitive sectors, such as financials, communication services and industrials, have tended to benefit from strong economic activity.
- Gauging commodities. Commodities have historically provided attractive returns during periods of economic growth and elevated inflation. However, we believe astute management is required because geopolitics and supply chain issues may heavily influence performance.
- Adding exposure to real estate. REITs may outperform their long-term averages as the economy remains robust.
Tariffs: long-term goals vs. short-term economic effects
The Trump administration’s trade policy overhaul seeks three key longer-term goals:
- Seeking economic security by reducing the nation’s dependence on foreign goods and promoting domestic production.
- Establishing fair trade through policies that protect American industry and employees from unjust practices, including currency manipulation and bans on U.S. goods.
- Reducing taxes and paying down the nation’s record-high debt by generating revenue through tariffs.
While these goals seem reasonable, some economists remain sceptical that the plan for achieving them will work. And many worry about the broader implications, including reduced imports and retaliation from trading partners.
In our view, even a relatively low level of tariffs could flatten U.S. economic growth and inflate prices. We also believe other aspects of Trump’s policy agenda, including tax cuts and deregulation, may not be enough to counteract the recessionary effects of tariffs.
Given the scenario that’s unfolded so far, Trump may back off some tariffs. He could also strike deals with key trading partners to lower tariffs, secure free trade and relocate more manufacturing to the U.S.
Meanwhile, speculation, economic uncertainty and market volatility will likely persist as tariff negotiations continue. But we believe it’s still possible to get through this upheaval without a major trade war.
What a stalling economy may mean for portfolio allocations
We believe maintaining a broadly diversified portfolio is a prudent policy as the economy slows or potentially contracts. In our experience, investors who maintain their long-term strategies may persevere as markets gyrate. However, we also believe specific investment characteristics deserve consideration in this environment.
For example, given mounting recession worries, we believe overweighting duration relative to market benchmarks may deliver advantages if interest rates fall and a flight to quality ensues. Additionally, select agency mortgage-backed securities (MBS) and collateralized mortgage obligations (CMOs) offer defensive characteristics and attractive yields.
Among stocks, rather than focusing on growth versus value, we generally favour quality, such as dividend-paying companies in defensive sectors (health care, utilities, consumer staples). Additionally, sustainable growth companies with stable earnings and strong competitive advantages will likely be more resilient to trade disruptions and tariffs.
By Charles Tan (CIO, global fixed income), Richard Weiss (CIO, multi-asset strategies) and Nancy Pilotte (senior client portfolio manager, multi-asset strategies)
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