The risk of too much consensus

Heading into the second half of 2023, Seema Shah, Chief Global Strategist at Principal Asset Management, discusses some of the top questions facing investors and the key themes that will forge the economic outlook for the rest of the year.

Despite numerous short-term challenges, there seems to be a great deal of consensus about the macroeconomic outlook and global themes. Do you agree?

Completely. There is currently very little dispersion in the macro view amongst investors. It’s widely agreed upon that we’re expecting a recession; we’re expecting the Federal Reserve (Fed) to be close to or already done raising rates; and we’re expecting disinflation, albeit slowly. Those three almost universally shared beliefs are the thread connecting most conversations amongst strategist, economists, and investors at the moment.

What do you think about this level of consensus? Do you think it is a good or bad thing?

I wouldn’t say I think the consensus is either good or bad. I certainly don’t disagree with the consensus, but I find myself asking, “What are we not talking about?” Because that’s what is going to move markets.

There’s no safety in this numbers game. When everyone is bunched together, one small surprise could produce significant moves, so we must try to think about what everyone isn’t talking about.

What should investors focus on for the rest of the year? Do you think the Fed will cut rates this year?

The Fed has implied that they are pivoting to a more data-dependent perspective, moving away from using prior months’ CPI prints to influence future decisions. As such, the general view is that there will be a pause and maybe even a rate cut or two later in the year, all dependent on inflation coming down.

But what if inflation doesn’t come down? What if it plateaus around 4.5% or so?

I haven’t seen much discussion in the market about the potential for the Fed to un-pause their rate hiking campaign should inflation not abate as much as they’d like. Especially given historical instances where we’ve seen the amount of time it takes for inflation to come down in developed markets once it crosses the 5% threshold—as much as ten years​​​​​​​—so I find it strange that the consensus is entirely centered on this idea that rate hikes stop now and that we can potentially look forward to having a rate cut this year.

Let’s say rates start to renormalize; It is doubtful that they will get back to zero in the near term, but what is the impact if rates are somewhat lower?

In an ideal investment world, rates would go back to zero, central banks would flood the market with liquidity once more, and the economy would quickly start to take off again. But ultimately, we’d likely find ourselves back in the same position, sharing the same concerns about inflation.

In a more realistic scenario, rates come down to around 2.5%. This would present an almost unrecognizable investment landscape from the last ten years, where an extremely low cost of capital suppressed volatility and lifted asset prices, resulting in high returns for investors.

However, looking out over the next ten years, higher interest rates imply higher volatility and lower returns. In that environment, investors need to work harder to identify opportunities and must be much more selective. When rates are low, bad management, bad debts, and bad governance can all be hidden; those problems are unveiled when rates are higher—there is simply nowhere to hide.

Unusually, inflation is lower in emerging markets than many developed markets. What are your thoughts on this phenomenon?

Looking back at the inflation data since it started being collected, March was the first month that emerging market inflation was below developed market inflation. In fact, several emerging market central banks are now in a position to initiate rate-cutting cycles.

Ultimately, this is a remarkably different investment environment than investors have typically seen. As it stands, the U.S. is one of the least attractive markets in the world – we're seeing tightening financial conditions, low growth, and volatility in the banking sector. But looking at emerging markets, particularly in East Asia, we're seeing loosening financial conditions, lower inflation, and no banking sector issues thus far.

That said, emerging markets won't be immune to the ripple effects if significant financial strains appear, such as a U.S. national banking system failure. However, as long as we're looking at a fairly modest path for the U.S., then emerging markets are presenting a promising opportunity right now.

How should investors prepare their portfolios given the current economic conditions?

Given the current economic environment, investors need to stay acutely aware of the risks, and ensure that they can be able to capitalize on opportunities when they arise. Additionally, I think investors would be best served by having a broad toolkit that is well-diversified among strategies, products, and industries.

There will be plenty of opportunities for outperformance, and long-term investors who can rely on active managers to identify the companies or sectors that can maintain topline growth and withstand the volatile period ahead will likely benefit.

Looking around the world, in emerging markets, particularly East Asia, equities are currently trading at deep discounts, opening the door for outsized returns and performance. In the U.S., high-quality fixed-income products like Treasury's and municipal bonds should be staples in portfolios as we head toward a potential recession.

Finally, alternatives deserve a place in diversified portfolios. Inflation isn’t disappearing, so exposure to real assets such as listed infrastructure remains essential. And while private markets are likely due for a correction in the near term, they present opportunities for higher returns from a longer-term perspective.

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Risk considerations

Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. Asset allocation and diversification do not ensure a profit or protect against a loss. Inflation and other economic cycles and conditions are difficult to predict and there Is no guarantee that any inflation mitigation/protection strategy will be successful. Risk is magnified in emerging markets, which may lack established legal, political, business, or social structures to support securities markets. Fixed-income investments are subject to interest rate risk; as interest rates rise their value will decline.

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