The Northern Trust CIO on the case for bonds, the Fed’s fight against inflation (and whether it’s succeeding), housing affordability, and more.
Our guest this week is Katie Nixon. Katie is an executive vice president and chief investment officer for the wealth management business at Northern Trust. Katie’s responsibilities include investment policy development, and she directs the investment management activities of Northern Trust portfolio managers across the firm’s wealth management offices. She also sits on the firm’s Investment Policy Committee and Tactical Asset Allocation Committee and chairs the Wealth Management Investment Advisory Committee. Prior to joining Northern Trust, Katie worked at U.S. Trust Company as a senior leader in the firm’s wealth management division. Katie received her bachelor’s from Wellesley College and her MBA from New York University, Stern School of Business. Among other designations she’s been awarded, Katie is a CFA charter holder.
Background
Inflation and Interest Rates
“Katie Nixon: Exploring the ‘What Ifs,’” by Katie Nixon, Morningstar.com, July 1, 2022.
“Markets Brief: There’s Good News for Investors in Rates Staying Higher for Longer,” by Tom Lauricella and Caryl Anne Francia, Morningstar.com, July 7, 2023.
“Stock Market Correction? It’s a Buying Opportunity,” by Anne Kates Smith, Kiplinger.com, Feb. 24, 2022.
“Triumph of the Optimists?” by Katie Nixon, Northerntrust.com, Aug. 18, 2023.
Yield Curve
“The Yield Curve and What It Tells Us,” by Katie Nixon, Northerntrust.com, March 30, 2022.
Jeff Ptak: Hi, and welcome to The Long View. I’m Jeff Ptak, chief ratings officer for Morningstar Research Services.
Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Our guest this week is Katie Nixon. Katie is an executive vice president and chief investment officer for the wealth management business at Northern Trust. Katie’s responsibilities include investment policy development, and she directs the investment management activities of Northern Trust portfolio managers across the firm’s wealth management offices. She also sits on the firm’s Investment Policy Committee and Tactical Asset Allocation Committee and chairs the Wealth Management Investment Advisory Committee. Prior to joining Northern Trust, Katie worked at U.S. Trust Company as a senior leader in the firm’s wealth management division. Katie received her bachelor’s from Wellesley College and her MBA from New York University, Stern School of Business. Among other designations she’s been awarded, Katie is a CFA charter holder.
Ptak: Katie, welcome to The Long View.
Katie Nixon: Thank you so much.
Ptak: Thank you for joining us. We’re really thrilled to have you. I wanted to start at a high level. You work extensively with high-net-worth individuals and families. One of the things I imagine you do is paint a picture for them of what’s happening from a broader macro perspective. What has experience taught you about the importance of editing and in focus and how you tell that macroeconomic story?
Nixon: Everybody today is just inundated with information. There’s tons of news. Of course, there’s a lot of noise. And my job is to put it in a context that actually means something to the client. So, I always put myself in their shoes and I ask myself, why should they care about what I’m telling them? And it leads me to some general rules to success. And I love the fact that you use the word editing because editing really is key. We in this business love to talk. We are experts. We love to showcase that expertise. For advisors, though, it’s important to dial it back and really think about the client experience and what’s going to drive value in their eyes. So, my goal always is to provide context—context in terms of how the macro outlook is actually impacting their portfolios, their financial lives, their ability to fund their goals, how the environment should drive decisions that they make.
Benz: What have you found that these individuals and families really need to know that it’s helpful to the client relationship, but I guess more important, the success of the plan? And what’s counterproductive? Like, what don’t they need to know?
Nixon: Those are two great questions, Christine, because it’s almost more important to know what’s counterproductive. But first, let’s start with the positives. I think clients want to be reassured, but they don’t want to be misled. You can’t whitewash the truth. So, I always say, be honest and use data and really use visuals to make your point as an advisor. How has the market downturn impacted them, if it has? What are some of the decisions that they may want to make or need to make? Clients want collaboration. They want to be part of the process. And honestly, this should come as a relief to advisors because we don’t have to know the answer anymore. It’s all about just outlining possible outcomes as well as trade-offs and helping clients make the best decisions given everyone’s inability to really predict the future.
Now, as an aside, I will say also that advisors have to absolve themselves of feeling the pressure to have to predict with perfect precision the future. At Northern Trust, we say, “prepare, don’t predict.” And at the end of the day, honestly, clients just want to know that you understand them, that you’re helping them to make good decisions based on your framework, your data, and your expertise. So, that’s what they need to know.
What is counterproductive? I think—and this is from decades of experience and having done this many, many times counterproductively—I think data overload, information overload, extraneous or irrelevant information, these are all very counterproductive. And I think back to that predicting the future comment I made earlier, suggesting that you know what’s going to happen with rates or the market, with the Fed or China, whatever, that’s just a mistake and it’s very counterproductive. Of course, we always have a base case. We all have a forecast. We have perspective on what’s going on in the world and that can provide some foundation, some grounding. But it’s a pretty deep and dark rabbit hole to go down when you make swings in client portfolios based on a short-term outlook. So, I would really avoid the tactical perspective, the short-term tactical action-oriented perspective. That’s pretty counterproductive, particularly when you’re trying to fund clients’ goals over the long term. And also, I guess I’ll say something that’s probably really obvious to your audience, but I’m going to say it anyway, and that is, just avoid industry jargon, acronyms, and so on. Those are all very counterproductive and that will definitely get your clients’ eyes glazing over very quickly.
Ptak: When clients have questions about the latest market gyration or data point and what it means to their portfolios or the success of their plans, how do you answer in a way that acknowledges that a lot of that is noise, but in a way that doesn’t make the clients lose faith that you know what you’re doing, so to speak?
Nixon: We always want them to think that we know what we’re doing. But for me, I think the easiest thing to do is always go back to your value proposition. I think you have to start on the right foot and earn that trust with a client before you have a market correction or you’re managing through any kind of white water. But for me and for Northern, it really starts with setting that strong foundation with a framework. We have a goals-based framework that focuses on clients’ financial goals over their lifetime and allows advisors really to construct portfolios that are aligned with each goal. It integrates the high probability that every investor is going to face tough times during their financial lifecycle. So, we plan for that by integrating into the framework and constructing a really high-quality, short-duration cashlike buffer portfolio. And during times of stress, it’s really helpful to be able to tell a client, “We prepared for this.”
2022 was a great example when we had a really tough stock and bond market together and we leaned very heavily on that cash buffer portfolio to fund goals. So, having set the foundation, it really allows you to have a lot of really valuable conversations during tough market times. And if you have that logical and intuitive framework, you’ve used it to guide clients during their financial life, you’ll have it to go back to when times get tough. So, it really becomes your touchstone. And it’s helpful to clients, of course, to know that they’re in a framework that acknowledges what makes them unique, their unique goal profile. And it helps advisors as well. It’s commonly said that the individual investor tends to buy high and sell low. I’m only going to say—again, I’ll put myself in this category—some professional investors sometimes fall prey to that too. We are all human.
As I know in your question, though, it’s all about how events impact the plan. And with a solid framework supported by good analytics, you can actually show clients how the durations are or aren’t impacting them. And that leads to really good conversations about whether they need to or want to make any changes. So really back to the idea of making sure your clients have confidence that you know what you’re doing, I always keep in mind that I’m doing not prediction of the future, but I’m helping clients make good decisions. And that’s really the value proposition. It’s what clients tell us time and time again, in person, through the client surveys that we do—that’s what they value in their relationship. They tell us, “You help me, you understand what’s important to me, you help me make decisions.”
Benz: We want to delve into current conditions, starting with inflation and interest rates. A few years back, it seemed like market participants thought that there was little risk of inflation. So, they stretched into longer-dated bonds for yield. And then, when inflation arrived, they raced into TIPs bonds. And when cash yields rose, money markets got hot, and they’ve stayed hot. So, in each case, it seems like investors were fighting the last battle. Where do you see evidence that that’s happening now?
Nixon: Christine, this is maybe an unpopular take, honestly. But I think the hyperfocus now on alternatives maybe falls into that category a little bit where investors see public-market volatility. And they’re very attracted to what looks like very low volatility in private markets. We all know though that that’s all about lagged pricing and that public and private markets really do rhyme over time. And that’s not to say we don’t like private markets. Of course, we do. Private assets hold a very important place in risk asset portfolios. But I just am cautioning investors to be really aware of what they’re buying and how the liquidity issues might impact them. So, as you said, we’re always going, sometimes managing in the rear of the mirror. And I think there’s a bit of solace investors are finding in the lack of volatility in private markets.
Ptak: Maybe switching to cash. Cash yields had become more attractive. And of course, bond prices suffered in 2022. And again, more recently. How would you talk to clients, or urge Northern’s advisors to talk to clients, about the value of making room for bonds in their portfolio amid these conditions?
Nixon: Good question. A very important question. And if there’s one thing the Fed’s done, it has put the income back into fixed income. So, it’s great time to be having this conversation. We’ve been encouraging our advisors to sit down with their clients, especially their goals-based clients to get back on base with their goal-aligned asset allocations. These allocations have gotten out of whack during the pandemic. And as I mentioned before, we had a cash-buffer portfolio set aside to deal with market turmoil, which we certainly had last year. And those reserves have been spent down. So, it’s an opportune time, given the rising yields that we’ve seen, to replenish those cash-buffer portfolios, and in more general way, to take a look at your goal-aligned asset allocation. And in some cases, investors can derisk their goal funding because interest rates are so much higher right now. In all honesty, these are not difficult conversations. And going back to how we started, we have been preparing our clients for this kind of rebalancing and a refresh of risk preferences. And we’re not getting too much pushback from clients, given the fact that real interest rates now are positive.
Benz: I’m wondering if you can get a little more specific on that in terms of the de-risking process, what that would entail? Would that be buying individual bonds that address the investor’s specific goals for a specific time horizon?
Nixon: This is a really interesting time, because prior to COVID, risk for a lot of investors was a requirement. Because with zero interest rates pretty much across the curve, investors, many could not fund their goals unless they took risks. So, what did they do? They legged out of money markets into bonds, they legged out of high-quality into lower quality, they legged into equity risk and other kinds of risks because they had to. Well, now, when you get very nice yields on high-quality bonds, they don’t have to anymore. They can probably fund a lot of their high-priority goals using the higher-yielding, high-quality bonds. So, it’s really a math exercise. And for many of them, risk now is a preference. They may decide to still take risk, but it’s not because they have to, it’s because they want to.
Christine, flipping the switch on that, the way you think about the role of bonds in your portfolio, and you put it in the context of goal funding, it makes the conversation really, really valuable and really helpful right now. So, yes, it would be a question of de-risking by selling risk assets, equities, and rebalancing into risk control or high-quality bonds. And I’ll just say last, not only is it a good time to have this conversation because we’ve seen interest rates rise, but we’ve also seen equity prices recover. So, you’re selling high, or certainly higher, to rebalance and to derisk your portfolio.
Ptak: Assuming there’s not a need to hedge a distant liability, why would someone want to invest in the belly or long end of the yield curve now while it’s inverted?
Nixon: The short answer is they probably wouldn’t. I think unless you have a really strong point of view around long-term interest rates falling, either because you think inflation is going to plummet or you think we’re going to have a recession or both, unless you have a liability to defuse, that’s a longer-term liability, in which case we would say asset-liability matching is the right thing to do, there wouldn’t be a reasonable scenario under which you would want to buy a longer-term bond.
Ptak: Given that, why haven’t intermediate and longer-term yields risen more? I think that you lay out a very cogent case for why somebody wouldn’t want to extend duration. But if there are other reasonable minds like yours that are out there, you would think that that would put pressure on intermediate longer-term yields, and they would have to rise to compensate people to make them more attractive. So, why haven’t we seen that happen?
Nixon: I think we’ve started to see it happen. Just in the last few weeks, we’ve seen a pretty dramatic increase in longer-term interest rates for a couple of reasons. I think at the core of your question is that economics 101 supply/demand. If there’s less demand for longer-dated bonds because investors are concerned about them, then those prices would react. And I think we are seeing some aspects of the supply/demand dynamics, maybe not for the reasons that we were talking about, but certainly we’re seeing lower demand for longer-dated U.S. Treasuries coming from abroad. Outside the U.S., rates are very competitive, and then the biggest buyer of U.S. Treasuries, Japan, is going through a relaxation of their yield-curve control regime, and that’s making Japanese bonds more attractive to Japanese investors. So, we’ve seen a number of things, a confluence of things, start to finally push up longer-term interest rates at a faster pace than we’re seeing short-term rates come up. So, it’s starting to happen.
Benz: I wanted to follow up on that and ask specifically about implications for a recession, because as you mentioned, long-term yields have risen a bit in recent months. And one school of thought is that this is evidence that the bond market has gotten less worried about the risks of a deep recession. But if that’s true, why did the stock market seem to anticipate the falling risks of a deep recession so much sooner than the bond market? What’s going on there?
Nixon: What a good question. We’re oftentimes told that the bond investor is the adult in the room, and that the bond market is a better forecaster than the stock market. I think the volatility that we’ve seen in both suggests that neither has been particularly good during this cycle. The stock market, as you note, went on a tear earlier this year, initially under this incredible rocket fuel of Big Tech and AI. So, it really wasn’t because investors were necessarily thinking that the macro outlook was better for growth per se as that rally that we had really up through June left most stocks in most sectors that weren’t related to AI or tech behind. And that rally did start to broaden in July, which, to your point, might suggest that equity investors were starting to believe that the macro backdrop was stronger. But really, since the beginning of August, I think the equal-weighted S&P is underperforming the cap-weighted benchmark again. So, the rally really hasn’t broadened out, which means it’s not really suggesting that the growth outlook is much, much better.
With respect to what the bond market is telling us, as I mentioned before, we have those supply issues, not just the demand on the Bank of Japan’s part, but the incredible supply that the U.S. Treasury is issuing right now, not just filling up that TGA account that went bone-dry during the debt-ceiling debate but funding the government. And we have light summer trading, and a lot of that is impacting bond pricing out the curve. So, we’re seeing those much, much higher rates.
Ptak: Do you think inflation breakevens priced into Treasuries do a good job of forecasting inflation? It looks like the five-year breakeven, for instance, that rate never exceeded 3.6%. Yet inflation ran at a much faster clip, as we know, albeit over a shorter time period than five years. So, should people look to inflation breakevens as something that might forecast future inflation, or are they too unreliable for that?
Nixon: I think they’re probably too unreliable for that. But there is important signaling in the inflation breakevens. There’s a lot of noise and a lot of volatility around the way they’re traded. But I do think a couple of things. Number one, the Fed looks at inflation breakevens as one of the indicators for how well inflation expectations are anchored. And the Fed is obviously trying to control inflation today, but maybe even more importantly, wants to make sure that inflation expectations stay at or around their policy target. They don’t want inflation expectations to become unmoored. So, the Fed is definitely looking at market-based, survey-based, a lot of different kinds of inflation expectations. Breakevens are certainly one of them.
The other thing is, from a market perspective, it gives you a sense of whether the market is believing the Fed and whether the market has faith in the Fed. And inflation breakevens hovering at or around that 2% level, straying a little bit, but as you know, nothing close to where we saw actual inflation. That tells you that the market still has a lot of faith in the Fed, that the Fed is going to be successful in tamping down inflation toward its goal.
Benz: What do you use to try to predict the inflation rate? Or I guess, I should say, do you try to predict the inflation rate? And do you subscribe to the view that it’s not so much the level of inflation that matters, but rather, stability of prices?
Nixon: It’s both and honestly, it’s not one or the other, Christine. But what I would say is, we can’t predict what inflation is going to be, but we do know that there are ways to hedge inflation. It’s an uncompensated risk. There’s no way to eliminate it from an investor’s portfolio, particularly in a goal-funding dynamic. So, what we do is we try to hedge inflation by using TIPS, duration-matching TIPS to goals, so that we know on a real return basis, our clients are going to be able to fund their goals with confidence over time. So, they play a really important role in portfolio management, particularly when you’re talking about a goals-based framework. And they’re super important in terms of hedging what is probably the single biggest uncompensated risk that investors face, and they face it in the area of their lives that are the highest priority. We all know the area of your goal funding that has the highest sensitivity to inflation is lifestyle spending. It is our highest-priority goal, and it is the most sensitive to inflation. So, we have to be able to hedge that risk. And the one perfect way of doing that is by duration matching your TIPS.
Benz: Are there any other tools that would be in your toolkit with respect to addressing inflation?
Nixon: Yeah. The other way that you can think about controlling inflation, hedging inflation is through commodities. But interestingly enough, futures-based commodities do a very poor job of actually hedging inflation. We like equity-based natural resources. In some ways, it’s a double bottom line because you get that inflation protection, and you also get the equity beta. And we know stocks generally rise, so the equity beta is positive. And then, you do get that inflation protection as well. So, it’s an additional tool in the toolkit in addition to TIPS, we have natural resources.
Ptak: Inflation has eased a bit. Do you think the Fed has succeeded in taming it? And how have your views on the manageability of inflation evolved over, say, the past year?
Nixon: I will say, I will hopefully be in good company in admitting that this last couple of years has been a very humbling experience for anyone trying to predict what was going to happen. I’ll put the Fed in that category, too, of having just a tough time getting their arms around not just the sources of inflation, but the antidote to inflation. To answer your question directly, I don’t think the kind of disinflation we’ve seen thus far has been a function of Fed policy outside of the housing market. That’s where we have seen the most direct impact. But outside of that, it’s really been the supply chain healing, the post-COVID supply chain healing, the logistics that have gotten back on track, that have brought goods prices back down-to-earth that were incredibly elevated amid the COVID overconsumption of goods. So, that’s really healed over time and as companies have focused on disentangling those very complicated logistics. But there’s nothing that’s really happened on the demand side. The Fed policy really works through the demand channel. And if you look at demand—and we just recently got retail sales, for example—demand is robust. So, the Fed has been super aggressive for a very long time now, and we’ve yet to really see the impact on demand that would pull through to a more disinflationary impulse in the service sector. So, we haven’t really seen the Fed policy impact inflation yet broadly.
Benz: The market seems to be expecting the Fed to begin cutting rates in the second half of next year, 2024. Do you think that’s overly optimistic?
Nixon: It probably is. Our view is, it’s possible that we could get one more rate hike this year, maybe two. It’s all going to be very, very, very reliant on the data. And I think the data is going to be very difficult to predict. A lot of the very low-hanging fruit on disinflation has been picked and harvested. And we’ve had these really strong base effects that have left us in pretty good stead as we’ve come into the latter part of 2023. Those are going to start to dissipate as we get into 2024, and the comps are just going to get more difficult. So, I would say, absent some sort of a financial accident or a significant slowdown in the economy, it would be unlikely for the Fed to start to cut rates until late 2024 at the earliest. That is not the consensus view. We’re seeing more and more bets being put on the Fed cutting rates in 2024. And we would lean against that consensus.
Ptak: Maybe if I can jump in, given that view, does that imply that there are assets being mispriced because investors are expecting the Fed to cut sooner than you think they’ll actually cut? Does anything jump out to you as something that’s been maybe overvalued based on that expectation?
Nixon: Well, when you look across the asset spectrum, there are certain areas of … It’s very hard to say—short term, anything can happen. Valuation is a very poor predictor of short-term performance, as we all know. However, I will say that where you see signs of excessive optimism, I would suggest they’re probably in the risk-asset markets. So, you’ve got U.S. equities that are selling at 20 times earnings, which to be reasonable, you have to think rates are going to come down significantly to justify a 20 times forward P/E. And I would also say you have credit spreads that are very, very tight. High-yield credit spreads are very tight. So, I think credit is also saying, we’re going to get through this, no big deal, no problem; the Fed is going to start to lower rates next year, and by the time we have to refinance, conditions will be much more favorable. So, I would note those two as areas that are flashing a little bit yellow right now in terms of valuation, in terms of perhaps overly optimistic forecasts for the Fed to start cutting rates. You have to say to yourself, under what conditions would the Fed cut rates in 2024? And it would have to be much, much slower growth or significantly lower inflation at the Fed’s target. And I don’t think that’s reasonable from where we are today.
Benz: I wanted to ask about the role of wages in all of this. Wages have risen faster recently than the Fed would probably prefer. And that seems welcome in that it gives consumers more spending power in the face of inflationary pressures, but also potentially unwelcome in that it could reignite inflation. So, how are you thinking about the net-net effect of this trend of rising wages on the economy and also on monetary policy?
Nixon: Well, I would say that we were in the Fed chair Powell camp earlier this year when he noted that the labor market was unhealthy. It was too tight. And we were seeing that getting pulled through in wages and in average hourly earnings. Obviously, we were starting to get worried about that wage price spiral. The good news, though, right now is that real wages are positive. That’s good news. But productivity has also surged with a 3.7% annualized rate in the second quarter, a big improvement over the first quarter. And productivity, when combined with higher wages, you can still have modest unit labor costs. And that’s really good news for inflation. So, I’m sure Powell, and we, were very happy to see productivity come through because in the absence of productivity, you are going to start to see some more implications of this super-tight labor market.
I will say the other thing that we are watching out for, though, is—this is a little bit in the flashing yellow camp—is the labor market is still really tight. The balance of power is definitely in the hands of labor and they’re wielding that power in a lot of really interesting ways. We’re seeing so many collective bargaining actions all around the country, across sectors. And yes, the U.S. economy is less exposed to unions than certainly we were in the past, where I think only 13% of workers are in unions today. But I think the message is very powerful and that might keep a lid on some of the progress that we’ve seen to date with respect to inflation.
Ptak: I wanted to talk about some other dimensions of the macroeconomic picture, one of which is real estate. What do you think it will take to get the U.S. residential real estate market sorted out, especially with respect to housing affordability? I think that the average 30-year fixed-rate mortgage, I think that it breached the 7% level recently, highest it’s been since 2001. So, what’s going to bring that market back into equilibrium given mortgage rates that high?
Nixon: It’s just amazing because this is another example of why the U.S. consumer is continuing to consume and transact despite the fact that we have these much higher rates. And the reason is people have locked in their debt. So, I think the average mortgage rate in the U.S. is something like 3.6%, so significantly below what you rightly referenced as a multidecade high in the 30-year financing cost. So, what’s going to help? Well, right now, we have this interesting stare down. We have a lack of supply as no one wants to sell their house because they’re locked in their house by their mortgage. And people don’t want to buy because prices are too high, not just in financing, but the price of houses is too high. So, we have this real interesting stare down right now. There is, though, some good news. There’s a lot of multifamily supply coming on, and that’s really going to help with rent inflation. And then, if we see a decline in mortgage rates, when we finally do see interest rates come down, I think that’s going to start to unlock both supply and demand. And I don’t think rates have to go back to 3.6%. But I think if we can get somewhere below 7% into the 6% or even into the 5% for an extended period of time, you’re going to start to see people transact.
Benz: I wanted to ask about corporate profit margins. They sagged, but they seem to have improved again. What has been the key to this resilience?
Nixon: U.S. corporations, don’t count them out, Christine. It’s been absolutely astonishing to me to see how masterful U.S. corporations have been in not only navigating the pandemic period but thriving in the postpandemic period. They’ve really benefited, frankly, in the ability to pass on those price increases and then some to consumers. And that is certainly manifest in the really high margins that we’ve seen. I think it’s reasonable to expect that these margins are going to be vulnerable as consumers are starting to push back against those price increases. So, inflation has been the corporation’s friend. Revenues are in nominal terms. And so, having high inflation and high nominal GDP has been a huge tailwind to both revenue as well as margins for U.S. corporations.
Ptak: You’re not expecting the economy to tip into recession this year. What about next year? And what do you view as the biggest threats to continued expansion at this stage?
Nixon: We don’t have a recession in our forecast right now for this year or for next year. It was a bit of a coin-flip, honestly, earlier this year. But the resilience and the strength that we continue to see in the data is giving us optimism that we’ll be able to avoid a recession. That’s not to say that we’re going to have terribly robust growth. We’re in the very soft-landing camp. But it’s possible that the U.S. economy skirts a real recession next year. I will say, though, in my mind, one of the biggest threats is—and we haven’t used this phrase yet, so I’ll throw it in here—those long and variable lags. Now we have higher rates across the curve. We have very tight financial conditions in certain areas. We have companies that are running out of the ability to pass on price increases. And we’re bumping up against refinancings that are going to have to take place in 2025 and beyond. So, I think those Fed hikes catching up is probably the biggest risk to the outlook next year. We know it takes time, but now is the time.
Benz: You referenced high-yield bond spreads earlier. They have significantly narrowed since Silicon Valley Bank and Signature Bank fell. The ICE BofA High Yield spread was recently sitting around 380 basis points, which is on the low end of the range since 2007. Seems like we have one of these credit crises every three to four years, and the last one was in 2020. Are we due or overdue? And what do you think would be a spark for that?
Nixon: I wish things were as predictable as a calendar pattern. Unfortunately, they’re not. I do agree with you, Christine, that credit spreads are very tight now. High-yield credit spreads are very tight, but they’re tight for a reason. Number one, these companies, like overall U.S. corporations, these companies have been very, very good at managing their balance sheets, and they’ve been great at taking advantage of the low rates during the COVID period and refinancing their debt. So, the refinancing risk has been pushed out to 2025 and 2026. So, time is on their side.
The other thing I will say is that this is not your father’s high-yield bond market. The quality of the high-yield bond market is really high right now relative to how it has been in prior periods. And the usual suspects, I would say in terms of default risk being the energy companies—they have been among the best at managing their balance sheets, managing their cash flow, not repeating the mistakes of the past and overinvesting. So, you have a higher-quality, high-yield bond market, you have the usual suspects in much, much better shape, and then you have companies that have termed out their debt to the next couple of years. For that reason, you could justify high-yield spreads around where they are now. I think it’s hard to say that they will get tighter than this, because I do think that, especially where we are in the economic cycle, they’re pretty tight.
Ptak: To what extent do you view credit as vulnerable to the rise of private sources of lending?
Nixon: I actually think private credit is stepping into a gap here. What we’ve seen—and Christine, you mentioned SVB earlier—I think you mentioned SVB earlier in terms of ebbing and flowing of credit. One of the overhangs of the Silicon Valley Bank and First Republic and some of the other issues that small and regional banks went through in the first and early second quarter is a regulatory overhang. That’s going to keep them, I think, a bit on their back foot in terms of lending. The other thing is that these banks generally have seen a lot of deposit flight as depositors have preferred to take less risk with their deposits, number one. Number two, they’ve preferred to get more return from their deposits. So, they’ve taken them and put them in Treasury bills and put them in money market funds and put them at other institutions that also curbs lending. So, small- and medium-sized regional banks are the life blood of some lending that goes on in this country. So, I think private credit is going to step in and fill a really necessary gap, because without access to credit, it’d be very, very difficult to have a constructive view on the economy going forward.
Benz: Corporate borrowing costs have actually fallen as a percentage of income despite rising interest rates. What explains that trend and how important has it been to the improvement in corporate earnings?
Nixon: I’ll just go back to the comment about revenue and earnings are nominal and inflation has been your friend. You’re getting your cash flow in nominal terms and your liabilities are fixed at lower rates. So that spread really works to your advantage in an inflationary environment.
Ptak: I wanted to shift the conversation to equities. You’ve alluded to it a few times. We’re told that what matters in investing is what kind of expectations are impounded into a security’s price and how achievable those forecasts are. How do you deal with that when it comes to corporate profits given the sell-side is notorious for its overly rosy earnings forecast?
Nixon: That’s for sure. I would say this. The market sets the price. Market set prices all day, every day based on a lot of factors, one of which is probably sell-side research. But also with Reg FD, there’s really no inside edge anymore. So, most institutional investors have their own models and trade on those. Research and history show that it’s very, very hard to beat the market, that is to outguess the collective wisdom of experts and millions and millions of investors. So, we don’t try to. We look at history as a guide to forward long-dated forecasts, and we overlay our forecasts with our own perspective on what might move the needle one way or another. But I think this is a time to just acknowledge that the market is, in aggregate, including sell-side analysts as a part of that aggregate, but not maybe a driving force of that aggregate, but they’re in aggregate pretty good at pricing assets.
Benz: Wall Street is expecting earnings to grow more than 10% next year. How achievable are those expectations and what are the implications for valuations?
Nixon: Well, I mentioned earlier that the forward earnings multiple on the S&P 500 is 20. What I did not mention, what you’re getting at in your question, is how vulnerable is the E in that P/E. And I would say very vulnerable. It’s hard to bottoms-up create a 10%-plus kind of gain in earnings. I think it feels a little bit tempting to think that this year represents a trough in earnings, and we’ll have this V-shaped recovery in earnings. We would say though, this is more like the old normal. Last year was not normal. So, we’re recovering to a normal, not from a trough. So, it does make next year’s earnings expectation vulnerable, and it also probably means that the market is even more expensive than we think it is at 20 times earnings. It’s hard when you have a very slow … So, you have inflation falling, whether it falls to the 2% target is a question, but let’s say it falls to 3.5%, and you have an economy that’s growing, on a real basis, less than 1%, it’s very, very hard to get to 10% earnings growth with slow nominal, meaning slow revenue growth. The rest of the world is certainly slowing down also. And that’s another thing I think it’s worth mentioning is we talk about the U.S. economy. The S&P 500 is not a U.S. economy. It has lots and lots and lots of earnings and revenue that come from overseas, and we can certainly see the headwinds there coupled with the headwinds that we’ve talked about here in the U.S. It makes that kind of a forecast just overly optimistic. And I think you’re right. It creates a vulnerability around the near-term forecast for equities.
Ptak: Do you think traditional valuation measures work anymore—values lack growth for a long time now. So, in view of that, what do you look at to gauge the reasonableness of prices having seen that maybe even a forward P/E multiple hasn’t done the best job in the last, say, 20 years that maybe it had done in previous decades?
Nixon: It’s a good question. I think it’s something that a lot of folks are grappling with now. I would just go to the research that suggests that valuations are just not very informative when you’re thinking about a short-term forecast. I think high valuations can create volatility because it certainly expresses optimism, but high valuations can get higher. High valuations can stay high. So, there’s not a lot of valuable news in today’s price/earnings ratio. What we do know, though, over time through history is that valuations matter longer term. And when you pay a high price for something, you are, by definition, accepting a lower return. Similarly, when you talk about value stocks, when you’re buying something cheap, you have embedded in that decision a higher expected return. And that’s a risk premium that you expect to be compensated for over time. And I don’t think those metrics are broken at all. I think it takes time to let these things play out.
I think we’ve been through many, many periods in the past where you’ve had excessive optimism very quickly shift to excessive pessimism and vice versa. And that’s why I think for most investors, the best thing to do, the optimal thing to do is to have a diversified portfolio in terms of those kinds of style bets, because you’re not going to know when things are going to turn around and when value, like 2022, completely outperforms growth by a wide margin and then completely flips around in 2023 with growth handily outperforming value. When you see those kinds of swings, I think the best advice for any investor from any advisor is to stay diversified.
Benz: Can you talk though about what looks stretched to you and your team right now in terms of valuation in the U.S. stock market? And conversely, where do you see bargains today?
Nixon: I wish I could say that there are a lot of bargains. Again, I do believe the market is pretty good at pricing assets. So, I’m not one to second-guess efficient markets. However, I will say that there are some areas that just seem to remind me of prior periods of excessive speculation. And you can pick your AI, AI adjacent, tech-adjacent company selling at 20, 30 times revenue. And from a bottoms-up perspective, you have to align a lot of very optimistic assumptions to even justify that kind of valuation. I think many of us have been here in the past. We recognize speculation when we see it, and momentum is strong. It’s hard to resist some of the strong momentum that’s lifted those stocks. But when I look for areas of vulnerability, I would say that’s probably an area that’s on the top of that leaderboard.
When I look for things that are super cheap, it’s hard to find anything in the U.S. market that looks particularly cheap right now. It’s tempting to look overseas where valuations are much, much lower on an absolute basis, and then, they’re also lower relative to how they trade against the U.S. market. But they’re cheap for a reason. There’s a lot of macro and micro issues in developed ex-U.S. as well as in emerging markets right now that is probably appropriately being priced in as very cheap valuations. So, no fat pitch right now.
Ptak: I wanted to shift to tactical. I know that you had cautioned earlier about this notion of being tactical over shorter spans of time. And I think that we would heartily agree with you on that. But I would also imagine that there’s a tactical overlay that you apply with a longer-term view toward it. So, maybe you can walk through what the tilts would look like if somebody were to peer into your tactical overlay right now. What do you overweight, what do you underweight, and maybe you can talk a little bit about the rationale that underpins that? It does sound like maybe you’re not quite as enamored with equities as you are with high-grade fixed income. Maybe there’s some other examples you can walk through?
Nixon: I’ll give you one pair trade, and it’s relative to what I said just a second ago, and that is, we prefer natural resources to emerging markets. You get inflation protection from natural resources. Natural resources do tend to be correlated to emerging markets to some degree, but much less risk than you have in buying an EM index. So, that would be one area that we would be overweight is natural resources over emerging markets. I will say also, we’re overweight the U.S. relative to non-U.S. investments. Again, U.S. assets are expensive, but we believe they’re expensive for a reason, and we have much more transparency and visibility with U.S.-quality stocks than we have outside the U.S. Then the last thing I’ll say is, we’re overweighted in cash relative to a longer-duration investment-grade fixed income. That’s really because we think the cash yields right now, given our view that the Fed is going to be on hold for the foreseeable future, you’re going to enjoy those cash yields for a while. So, we’ll take a very high risk-free return in a Treasury money market fund while we wait to see how these interest-rate volatility shapes out.
Benz: For our last question, we wanted to ask, what’s the most overrated report or data point in markets that you think people way overemphasize? Then on the flip side, what do you think people tend to underrate?
Nixon: I think there’s so many things that are overrated, honestly, Christine. I could go down a laundry list. But I will say, it’s hard for me to say because we spent some time talking about it today. I spend a lot of my time talking about it. But I think the GDP is overrated when it comes to a market view. It’s very interesting and obviously it’s intuitive. But if you look at the data and the research, it has absolutely no correlation to forward-looking market returns. So, while it’s interesting and fun to talk about, if you’re using that as a data point to drive investment decisions, it doesn’t have a strong track record.
One of the things that’s underrated is, we often talk about price/earnings ratio, which is the conventional industry thing to focus on and to hold on to. What we see as being much more valuable is price/cash flow. Earnings, especially these days, can be very manipulated, very noisy, but cash flow is a much cleaner view of how a company is doing. And also, because of that, not surprisingly, it also has a much better track record in predicting forward-looking returns. It has a better track record than price/earnings ratio. So, overrated is GDP, underrated is price/cash flow. I’ll just quickly say one more overrated. Again, it’s interesting to look at, but I would say fed-funds futures are probably a bit overrated also only because they change for a lot of different reasons—they’re very thinly traded, and they don’t contain a lot of very useful information that you could trade around. So, that might be in the overrated category, too.
Benz: Well, Katie, you’ve shared so much great and useful information with us today. We so appreciate you taking the time out of your schedule to join us.
Nixon: Thank you so much for having me.
Benz: Thanks so much, Katie.
Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
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Benz: And @Christine_Benz.
Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
Finally, we’d love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
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