Two global asset-allocation experts weigh in on the direction of interest rates, inflation, and the economy and their implications for stocks and bonds.
On today’s podcast, we’ll chat with two global asset-allocation specialists, Omar Aguilar from Charles Schwab and Sébastien Page from T. Rowe Price. Omar is CEO and chief investment officer for Schwab Asset Management. Before joining Schwab in 2011, he worked at a variety of firms including Financial Engines, ING Investment Management, Lehman Brothers, Merrill Lynch Investment Management, and Bankers Trust.
And Sébastien Page is head of Global Multi-Asset Investing at T. Rowe Price, where he oversees a team of investment professionals dedicated to the firm’s multi-asset portfolios. He’s a member of T. Rowe Price’s Asset Allocation Committee, and he’s also a member of the Management Committee of T. Rowe Price Group. Prior to joining the firm in 2015, Sébastien was an executive vice president at Pimco, where he led a team focused on research and development of multi-asset solutions. And he was a senior managing director at State Street Global Markets before that.
Background
Bios: Omar Aguilar
Beyond Diversification: What Every Investor Needs to Know About Asset Allocation, by Sébastien Page
Current Economic Environment
“Eight Ways RIAs, Investors View Markets Over the Next Year: Schwab,” by Dinah Wisenberg Brin, thinkadvisor.com, June 14, 2024.
“The Fed Will Now Focus on Unemployment and Labor Markets, Says Charles Schwab’s Omar Aguilar,” Video interview on Closing Bell: Overtime, cnbc.com, July 15, 2024.
“All Eyes on Central Banks,” 2024 Global Market Outlook Midyear Update, troweprice.com, June 2024.
“Inflation’s Ripple Effect on the Economy,” Market Overtime interview with Omar Aguilar, youtube.com.
“Why a Weaker Jobs Market Is Sparking Recession Fears,” by Scott Horsley, npr.org, Aug. 2, 2024.
“Inflation Coming Down Too Fast Could Hurt Earnings, Says T.Rowe Price’s Sebastien Page,” Video interview on Closing Bell: Overtime, cnbc.com, Jan. 30, 2024.
“The Four Horsemen of the Recession,” by Sébastien Page, linkedin.com, June 2, 2023.
“US Economy in ‘Solid Position’ Despite Slowing Job Growth, Says Schwab’s Aguilar,” Video interview on Squawk on the Street, cnbc.com, Aug. 4, 2023.
“Special Topic: Can the Fed Cut Rates With Financial Conditions This Loose?” by Sébastien Page, linkedin.com, June 27, 2024.
“2024 Global Market Outlook: Tectonic Shifts Create New Opportunities,” by Arif Husain, Sébastien Page, and Justin Thomson, linkedin.com, Dec. 21, 2023.
Asset Allocation
“Perspective: Asset Classes Versus Risk Factors or Asset Classes and Risk Factors?” by Sébastien Page, The Journal of Portfolio Management, Dec. 31, 2023.
“The Myth of Diversification Reconsidered,” by William Kinlaw, Mark Kritzman, Sébastien Page, and David Turkington, The Journal of Portfolio Management, August 2021.
“Personalized Target-Date Funds,” by Kobby Aboagye, Sébastien Page, Louisa Schafer, and James Tzitzouris, The Journal of Portfolio Management, March 2024.
“The Hottest Debate in Asset Allocation: Value vs. Growth Stocks,” by Sébastien Page, linkedin.com, April 25, 2024.
“The Sector X-Ray,” by Sébastien Page, linkedin.com, Aug. 31, 2023.
Valuation and Interest Rates
“When Valuation Fails,” by Sébastien Page, linkedin.com, May 29, 2024.
“Relative Valuation: A Crucial but Imperfect Guide,” by Sébastien Page, linkedin.com, Feb. 8, 2024.
“Is the Market Broadening?” by Sébastien Page, linkedin.com, Jan. 8, 2024.
“Let’s Get Real (About Interest Rates),” by Sébastien Page, linkedin.com, March 7, 2024.
Other
“The Sahm Rule Recession Indicator Definition and How It’s Calculated,” by Mallika Mitra, Investopedia.com, Aug. 5, 2024.
Christine Benz: Hi and welcome to The Long View. I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Amy Arnott: And I’m Amy Arnott, Portfolio Strategist for Morningstar.
On today’s podcast, we’ll chat with two global asset-allocation specialists, Omar Aguilar from Charles Schwab and Sébastien Page from T. Rowe Price. Omar is CEO and chief investment officer for Schwab Asset Management. Before joining Schwab in 2011, he worked at a variety of firms including Financial Engines, ING Investment Management, Lehman Brothers, Merrill Lynch Investment Management, and Bankers Trust.
Benz: And Sébastien Page is head of Global Multi-Asset Investing at T. Rowe Price, where he oversees a team of investment professionals dedicated to the firm’s multi-asset portfolios. He’s a member of T. Rowe Price’s Asset Allocation Committee, and he’s also a member of the Management Committee of T. Rowe Price Group. Prior to joining the firm in 2015, Sébastien was an executive vice president at Pimco, where he led a team focused on research and development of multi-asset solutions. And he was a senior managing director at State Street Global Markets before that.
Omar and Sébastien, welcome to The Long View.
Sébastien Page: Thank you. Thanks for having us.
Omar Aguilar: Thanks for having us.
Benz: Thank you both for being here. So, we want to talk about the current economic environment and the current interest-rate environment. The sentiment that the Fed would cut interest rates multiple times in 2024 was widespread coming into this year, but the Fed still probably won’t start cutting rates until September. What do you think economists underrated or missed about the economy and employment picture, which were both very strong until we had one slightly disappointing jobs report in August? Omar, let’s start with you.
Aguilar: Well, a big part of the discrepancies in the estimates related to central banks’ monetary policy started with the fact that this cycle is very unique coming out of the pandemic. And I think the biggest miss that most economists had going into this year was the assumption that things were going to play the same way that they used to play in previous business and economic cycles.
Coming out of the recession that we had back in 2020 through covid, we started to see that the strength of corporations’ balance sheets, the strength of the consumer, was something that clearly was going to be very different because of the stimulus that went into the economy back then. As a result, what we started to observe going in through the cycle of our monetary policy had to do that we instead of observing what the traditional cycles were, we observed these rolling recessions where different parts of the economy went into a recession, and then as we started to go in through the beginning of 2024, we’re starting to see the different parts of the economy started to recover. So, we’re starting to see weakness in manufacturing at the end of 2022, then we started to see strength of manufacturing at the beginning of this year, and then we’re starting to see this behavior that changes the dynamic drastically of what a traditional cycle might look like. And therefore, the assumption that we were going to see significant amount of rate cuts was wrong.
The second part of the reason why things were different in terms of the estimates and in terms of actuals of the Fed is that nobody expected that inflation was going to be as high and sticky as people actually observed. So, the fact that the Fed was looking at the levels of inflation that we observed and then was clear that was going to stay with a tight monetary policy until we saw those inflation numbers come down was another reason why the estimates in terms of number of cuts and the timing on cuts was actually going to be different.
Arnott: Sébastien, maybe we can direct this next question to you. Can you remember any other time when the conventional wisdom about the economy was as wrong about rate cuts as it was in 2024?
Page: I like that question. Those projections are usually wrong. You can go back in time, look at what the projections were at any point in time and see how wrong they were consistently. So no, it’s not that surprising.
To pick up where Omar ended, at the end of 2023, for the last three months, if you took the month-over-month CPI, we were running at 2% inflation. So, to your earlier question, at that time we had six, seven rate cuts priced in. So, my one answer to your earlier question is inflation. Economists got it wrong because then January, February, March, you take those three months, you take the headline print month over month, and we were running at 4.5%. So, I think commodity markets, the commodities, the housing, the services, they all surprised a bit on the upside. As Omar said, it’s the stickiness of inflation. That was a big part of that miss.
I’ll say another thing about getting economic forecasts wrong. It’s been difficult because of the pandemic. The stimulus has distorted all the models. And I think in general, as an industry, we often look at year-over-year changes. But if you’re coming down from unprecedented stimulus, $20 trillion by some estimates, the year-over-year changes aren’t going to look good. But I think a lot of economists just missed the fact that the economy, while it was decelerating fast, it was still pretty good. So, I’ve been telling my team to not just look at rates of changes in this environment but also look at levels.
And from a really big-picture perspective, I think we all underestimated the economy’s resistance to hikes. If I travel back in time before the Fed started hiking in early ’22, and I say, imagine that the Fed is about to hike by 550 basis points, and you’re going to have a war in Ukraine, and you’re going to have a banking crisis. What do you think is going to happen? I don’t think any economist or investor—this is not to pick on economists whatsoever—would have predicted that by now, it would still be pretty low at 4.3% unemployment. So, the response, those long and variable acts, the resistance of the economy to those hikes has surprised pretty much everybody.
Benz: Can each of you talk about where you were, if we were to be doing this discussion at, say, January 2024, what were you thinking in terms of when the Fed would hike rates and how much?
Page: Well, we thought inflation would be stickier. We looked at the last three prints going into January this year, which showed we defeated inflation, and we positioned our portfolios to be more resilient to sticky inflation. That was our big-picture view at the beginning of the year.
Aguilar: Yeah, we started at the end of 2023 at the beginning of ’24, the full discussion of our fixed-income team was precisely about what we call the analogy between the escalator and the elevator. And the assumption for us was the Federal Reserve raised rates by 500 basis points very quickly. In other words, they took the elevator up. And what that meant is that they were clearly in the process of making sure that they could actually fight inflation fast because they had a precedent that historically, if they waited too long, inflation could actually drive the economy really bad. And at that time, particularly coming out of the Covid recession, the Fed was not going to be in the place of letting inflation drive everything down to the bottom.
And so that elevator, they took the rates. It was very aggressive. It was the most aggressive, if not the most aggressive Federal Reserve tightening that we have seen in history. But our assumption was that because of the level of inflation, because, as Sébastien said, that we realized that the economy and the consumer were less sensitive to changes in rates, we realized that the way on the way down was going to be more like taking the escalator. In other words, our assumption was—we were less concerned about the number of rates but more about the pace on how they were going to actually reduce rates. So, we thought that the process of doing, instead of doing 75 basis points of pop or 50 basis points of pop where they were going to actually need and probably start slowing down as a function of inflation.
The interesting thing about this was really related to the fact that for the most part at the beginning of the year, none of us talk about the labor market. Everybody was talking about the level of inflation, the number of rates, but the unemployment was not in the radar. And that was the same case for the Federal Reserve. In their dual mandate, they assumed that the labor market and the consumers were going to take care of them by themselves, and they only had to do one thing, which is fight inflation with everything they could, and they did. The challenge now is that as we go through this, the unemployment rate started to rise faster when they had it. And as we have seen recently, the inflation and the slowdown in the economy is starting to just get a little faster than what they thought. And therefore, they’re at this point now where they need to make a decision on how fast and how strong they have. So, in other words, they may take the escalator, but they may have to take a couple of floors down by the elevator before they can slow down their pace for reducing rates.
Benz: So, this recent jobs report, which I guess was early August, got some people talking about recession. And I’m curious, Sébastien, maybe you can talk about where you are with respect to recession. Do you think that’s way premature, or do you think it should be part of the discussion at this point?
Page: Growth is slowing, but I don’t think a recession is imminent. And that print is an interesting illustration of looking at the rate of change and where the data comes out relative to expectations, as opposed to the level by prepandemic standards. So, we had two prints that were a little worrisome. We had the nonfarm payrolls, including some revisions, but the nonfarm payrolls come out at $114,000, and then the claims were a bit higher too. But if you go back prepandemic and you take the long-run average of job creation—first of all, the number is positive, so we’re creating jobs. And second, that number is, yes, slightly below average, but not a recession number at all. So, the reaction was, in part because the positioning was really optimistic going into this data, but also this focus on, yes, things are slowing down, rates of changes. Rates of changes, they do matter for sure, especially for unemployment, because when unemployment starts accelerating, it’s really hard to reverse it. It accelerates faster and faster, typically, into a recession. But in the current environment, I don’t think a recession is imminent or slowing.
The last GDP print surprised on the upside at 2.8%. But the market being the market, we tend to forget really quickly the data points. Part of this is created by the Fed being so data-dependent. Then as market participants, we become all data-dependent. And Jerome Powell had to say at the last press conference, look, just to be clear, we’re not data point-dependent. We’re just generally data-dependent looking at the data coming in, but that makes the Fed more reactive. It makes the market more jittery. And you combine that with the unwinding of the Japanese carry trade and the extreme optimistic positioning and sentiment going into it, and you get a pickup in volatility like we’ve seen.
Arnott: So, Omar, is that your take on the economic outlook as well that despite the economy slowing down slightly, a recession isn’t really in the cards right away?
Aguilar: Our view continues to be consistent to this idea of we’re in this rolling recession, rolling recovery structure that we have seen in this cycle where different parts of the economy go into recession and then recover while other parts of the economy get into the different parts of the cycle. And that sort of balances out. And I would probably say the common denominator across this has to do with how strong is the consumer, which represents 65% of GDP, and in general, still focusing on the top end of the consumer that drives a significant amount of that strength and resiliency. As we have said, and that Sébastien also mentioned, a big part of this is that the economy and the consumer seem to be less sensitive. It doesn’t necessarily mean that it’s completely neutral to interest-rate changes, but at the same time, they seem to be less sensitive to the changes like it used to be. In many cases, that has to do with the fact that if you think about the majority of consumers today and the housing market, the average mortgage that they are paying, it’s 4%. And if you want to get a new mortgage, it’s around 6.5%. So that tells you a lot about the mechanics that happen in the housing market, but at the same time, it also tells you that the majority of the consumers, they’ve been funding their levels at a much lower rate than what they have to pay.
That doesn’t necessarily apply to all types of the consumers. They actually apply for the majority to the top earners, which is a significant portion of that 60% of GDP, where the bottom part, which is 60% of the lower earners, they only represent 30% of consumption. So, the lower part of the consumer is starting to feel, and they’ve already seen that effect of higher rates, especially higher real rates, but they don’t necessarily take that big of a chunk in terms of the GDP growth and the slowdown. So, we see this slowdown, we see these changes in the economic GDP forecast, but we don’t necessarily think that because of this rolling recession component of different parts of the economy, we necessarily think that this will translate in the traditional recession that we normally have in a cycle.
Going back to something that I think Sébastien said about in terms of how data-dependent we have all become and what the Fed may have to discuss, it is that if you actually go theoretically of what means the Fed needs to do to avoid a recession, they should be cutting right now and they should be in panic. And I will mention two statistics. One is the inversion of the yield curve. We have been in an inverted yield curve for quite some time, and usually that translates into—the next two quarters or the next three quarters will actually end up in a recession. So, if the Fed was fully data-dependent and wanted to avoid the recession, they would have acted already on just that particular number.
And the second one that happened as a result of your question about the last job report we had is what is called the Sahm rule that basically suggested that the three-month moving average of unemployment rate is now more than 0.5% higher from the lowest level that they had in the last 12 months. And therefore, that is a sign of a recession. That’s a theoretical number and that’s a theoretical statistic that I think very few economists follow. But that being said, when you put those together, if you actually want to be completely data-dependent, if you just basically look at data, don’t look at anything that happens and you think that this is the same cycle as before, then the Fed will have jumped at this right away and start cutting rates. That’s not our position. Our position, and we seem to be having this slowdown more consistent with what Sébastien said, and we think that overall, these rolling recoveries will start sooner than what people anticipate.
Benz: Sébastien, I want to follow up with you on one of Omar’s points about housing and its role in all of this. It seems like that is one of the things that is troubling consumers, would-be-home purchasers are in this environment where interest rates are relatively high and mainly inventory is super low. So, can you discuss your perspective on that and how that is feeding into consumers’ perception of where the economy and inflation are currently?
Page: The surprise is that the mortgage rate went all the way up to 7% and even above and the housing market didn’t crash. And Omar described this really well. When rates were low, homeowners refinanced somewhere between 3% and 4%. I do this sometimes at conferences. I did this recently. I was in front of 300 advisors and said, raise your hand if your mortgage rate is below 4.5%. And I get the entire room raise their hand. And by the way, that’s also true for corporations that extended their debt when rates were really low when the Fed funds were at zero or near zero. So, you have less leverage, at least for the household and for corporations, and the effective rate—Omar mentioned it’s 4% for homeowners—it’s also very low for corporations. So, on housing specifically, this was unexpected if you think about it. And what happened was the housing market just froze.
If you have a 3.5% 30-year mortgage, why would you sell your house? You’re going to need to refinance to get your new house at 6.5%. So, the market froze. The supply is just not there. And that’s kept housing costs fairly high. And thus far, it’s made inflation a bit stickier than you would have expected. So, it’s part of the story about why is the economy not being that responsive to 550 basis points of hikes? Well, corporations, households, and notice I’m leaving out government debt, which is very high and worrisome, probably a topic for another question. But households and corporations have still low effective rates.
Arnott: So, we also wanted to talk about asset allocation and portfolio construction a bit. So maybe we can start on the fixed-income side. And we wanted to ask you about the implications of higher yields for investor portfolios. So, as we’re taping this around the middle of August, we still have about 5.5% on the one-month T-bill, almost 4% on the 10-year. Do those types of yields mean that the typical investor should hold more in bonds than a couple of years ago? Maybe you can tackle that one, Sébastien.
Page: The answer is yes in conservative portfolios. And that’s just math, if you think about it. So, imagine that you’re a fairly conservative income-oriented investor, and rates are still at zero. And based on the risk you’re willing to take, it’s reasonable for you to have, say, a 5% target return. So, you’re basically a very conservative investor. Well, when rates were at zero or near zero, very low for fixed income in general, even if you didn’t really have the risk tolerance for stocks, the only way to get to 5% was to actually buy stocks. But now that the T-bill is at 5%, you can get your 5% without buying any stock.
Does that make sense? It’s really major in conservative portfolios because you typically have a reasonable return target that you can now achieve fully with fixed income. But the thing I want to say though is that if you want long-term capital appreciation and you have a more aggressive return target, 7%, 8%, 9%, 10%, you still need a healthy amount of stocks. So, to me, the change is much bigger for conservative investors that have reasonable—but reasonable is a relative word; it depends on your time horizon—to have fairly low return targets and low risk tolerance. Then they can get a lot more of their returns from fixed income. But stocks are still really important to long-term portfolio construction, especially if you’re early in your life cycle saving for retirement.
Benz: Yeah, that is very helpful, Sébastien. I wanted to follow up with each of you on that and discuss the implications for your firm’s multi-asset portfolios. Let’s start with you, Sébastien, on that. It sounds like the implications would be mainly for people who are getting close to or in drawdown mode in terms of the equity versus fixed-income allocation for them?
Page: Especially for folks that have a focus on income. But if you allow me a slight tangent, the retirement income space is going through major transformations where you can get income in many different ways with guarantees, should you want guarantees, so annuities; or with a combination of stocks, bonds, and annuities, or with payout capabilities where you take a total return approach and you consistently basically write the monthly paycheck using a payout endowment kind of model. The retirement income space is evolving into a set of solutions. And if you have the right framework and understand the trade-offs between liquidity, longevity risk, and your risk tolerance and so on, you can find the right solution either in a 401(k) plan, increasingly in a 401(k) plan, or outside a 401(k) plan. So, it’s a long answer, a bit of attention, Christine.
The short answer is, for income near retirement, at retirement investors, higher bond yields are great news. They’re great news, all else equal. And yes, in conservative portfolios, they can play a greater role. We haven’t ultimately changed our life cycle models because you also have increased inflation volatility and a need for broader diversification. And we have also a much longer-term horizon that goes through different interest-rate cycles. Tactically, though, if you take a six- to 18-month horizon, right now we’re quite close to neutral between stocks and bonds.
Arnott: So, Omar, we hear from a lot of financial advisors who tell us that one of their biggest challenges today is coaxing investors out of cash with those 5% yields and into bonds, particularly given bonds’ really painful losses over the past few years. What kind of script do you think advisors should use if they’re talking to their clients about moving money from cash into bonds or rebalancing from stocks into bonds?
Aguilar: Well, let me start by just addressing these components. So yes, for the longest time, if you think about an attribution on what was the source of returns for most portfolios, and the typical discussion was the 60/40 portfolio—60% equities, 40% fixed income—was that the majority of attribution related to anything had to do with just equities when interest rates were at zero. As we started to just get into where we are now, and for the more natural part of what you expect out of bonds, we now have opportunities to invest in different parts of the fixed-income curve that we didn’t have before. We are now at the point where we do have the opportunity, and advisors have the opportunity, to have a true asset allocation beyond what it used to be just equities. For the majority of people that were looking to diversify, and what is interesting is when we started to see this volatility in the equity market and in the yields of bonds last week, it was actually finally the correlation between equities and bonds ended up working the way that it is supposed to work, and that’s exactly what you want to have when you build a portfolio.
When you saw that this unwinding of the carry trade, and you saw that the VIX ended up shooting over 60 in a very short period of time, then we started to see that we saw a significant drop in yields that made these bonds look like they were finally doing their job, and that’s exactly what you want when you’re building a portfolio. You want to create that diversification process that allows you to have growth and protection for inflation through equities and other asset classes, but also you want to have that safety in your fixed-income portfolio that allows you to do that.
To specifically answer your question, yes, what we saw as we had the monetary policy being tied too fast is that the majority of clients ended up putting a significant amount of money in cash or short-term instruments. And of course, as Sébastien said, it is very difficult not to convince people to have a 5.25% or 5.5% almost risk-free when you are in a money market fund or when you’re in a simple short-term instrument, an ultrashort bond or so. And that’s obviously very attractive, especially when the credit market is in very good shape. In other words, there is no need for you to increase your credit exposure and still have the benefit of having very attractive yields and having total returns in bonds that actually we haven’t had for a long time.
The challenge right now is because of the earlier discussion about the impending changes in monetary policy when the short part of the curve that, by the way, that’s the part that the Fed controls. The Fed doesn’t control the rest of the curve. They basically control the short part of the curve when we see that the reinvestment risk is getting higher and higher as we get closer to the first rate cut. So, a lot of the discussions that we have had with clients, is that this is the time—and probably two weeks ago was a much better time—to extend duration in their fixed-income portfolio so that they can avoid and reduce their reinvestment risk and still lock in very attractive yields that they can have without necessarily having to take significant credit exposure. Again, a big part of this is looking at the correlation, look at the structure, but still being able to have attractive yields that in combination with exposure in bonds will give them the level of diversification that each one of the risk profiles they need.
Benz: Omar, I would pose the same question to you about the implications of higher fixed-income yields for Schwab portfolios, the multi-asset portfolios that the firm runs.
Aguilar: And I go back to a lot of what Sébastien said, which is there’s two things. One is the two parts that we need to remember and we need to just realize—and this is a big part of the discussion that we have had with our clients—is that the majority of our clients have experienced for the last 15 years an area where there is very little volatility in the market, low risk, plenty of liquidity, interest rates that were, on average, fairly low and very low or limited inflation. That changed in the last 18 months, and what we expect to happen for the foreseeable future is we’re going to have higher interest rates. They’re never going to go back to zero—or hopefully never going to go back to zero because that actually will mean that we have other big issue or another big financial crisis—that we also are going to have levels of inflation that are also going to be more consistent to what history was and they’re not going to go down to the low levels that we had had in the past. And therefore, for any parts of our glide path or any type of our multi-asset strategies that depends on the time horizon that clients have, they have to put areas of focus on risk that they didn’t have to focus on before.
So, for one, they need to understand what is the level of inflation that they’re going to have and how that’s going to impact, especially for those that are close to retirement or in retirement. If anything else, when you actually think about multi-asset strategies for those clients that are very close to retire or they are in the first years of retirement, inflation and income and real income becomes the biggest risk that they have because they’re going to run out of money. I think especially because where we are in the society and the majority of these pension plans, we actually need to continue to help clients protect and be able to just have that because inflation could really make big changes into how their lifestyle goes in retirement if they don’t necessarily have the right portfolio in their strategy.
So, inflation is one area that we continue to work. We’ll need to continue to do more work around it because what that means, they cannot just be in fixed income or in cash. They need to have some equities. They need to have some real estate. They need to have other inflation-protected assets that allows them to just continue to grow part of their pot even when they’re in retirement. So, the glide path is slightly different than what it was five or 10 years ago precisely because inflation is not going to go down to zero.
The second part of this is because the yields are higher, as Sébastien said, where do you source your income is now a more interesting and a much better opportunity for most people. Whether it is you actually doing through equities, through fixed income, through REITs, through some other more absolute return type of strategies that allows you to keep that level of volatility low so that you don’t necessarily sacrifice your balance but allows you to have more consistency in your income is a big of the game. This is what sounds like a little bit of a nuisance, and sorry for the technical details, but when you started to just look at the allocation, especially for people in retirement, it’s less about how much volatility you see in your balances. In other words, how much they change on your balance than when you look at your accounts are like and more about how more certainty you have in your income. In other words, the payment check that you’re going to receive every month to pay your rent or buy your groceries, to go to the doctor, that is more important than having to change things on a more regular basis.
Benz: Such an important point there. Omar, I want to follow up with you on inflation protecting that income stream that a retiree might be drawing from his or her portfolio. You mentioned a few assets—equities, real estate. I’d like to ask specifically about inflation-protected bonds. And one thing I think a lot of retirees grapple with is of the fixed-income allocation, how much of that should go into TIPS and perhaps I bonds? Do you have a house view on that question? How should investors triangulate it?
Aguilar: Well, TIPS are a great way to have that combination of inflation protection and allocation. The challenge with this in terms of just breakevens and volatility is that obviously TIPS don’t necessarily get you the immediate inflation hedge. It basically tends to average over time, and they get you what you have when you get your coupons.
Our house view on TIPS is that you need to have TIPS as a component, especially as you get closer to retirement and still increasing your allocation as you go into retirement, but they don’t necessarily need to be all the allocation that you have. And the challenge it also becomes is that you need to just complement your allocation to TIPS to other parts of fixed income so that you can have a comprehensive, maybe higher nominal yields, with some components that have real yields in terms of the TIPS and what you have in breakevens.
Arnott: We wanted to shift to the equity side and Sébastien, T. Rowe Price’s Target Date series have had a persistent overweighting in stocks compared with some other target-date fund offerings. Can you talk about the thinking behind that positioning and at what life stage does your team start meaningfully ratcheting down that equity exposure within the target-date funds?
Page: That’s a great question. We have two series—one that’s higher equities, one that’s lower equities. So, we’re a solutions provider in target-date strategies and we have a wide range of capabilities blending active and passive, active only, and so on. But our flagship has a fairly healthy allocation to stocks, and I talk about this in my book. It has to do with the time horizon. And when you ask people how much stocks do you think you should own depending on how far you are from retirement? Well, the first answer is every situation is unique. But if you bear with me and think about broad averages or very simple guidance or modeling, the answer is often more than you think. I’m 47 years old and for me it’s 80%-plus in stocks because Omar hinted at this, once you retire, nowadays you can live another 30-plus years—hopefully, if all goes well, if you stay healthy.
So, when you have a long time horizon like this and you want the power of compounding to work for you, the definition of risk is very different. It’s not month-to-month volatility. It’s longevity risk. How many years will my savings last? It’s the level of payments you can generate once you’re in retirement to Omar’s point. The income component. It’s the liquidity component. It’s a combination of these different factors. And when you put them all together, the empirical research shows that a fairly healthy allocation to stocks is more likely to lead to better retirement outcomes if you’re willing to take the month-to-month volatility, which I would argue if you’re far enough from retirement or even in retirement, you should be willing to take some of that because it’s one of the trade-offs that you can get paid for.
It decreases once you’re close to retirement. We now have an innovation in our target-date strategies where we add some tail-risk hedging component to the equity part of the portfolio when you get close to retirement to protect the downside a bit more directly as you start converting your savings into income. And I’ll just leave it at that and say that you know this whole life cycle investing, it is, as Bill Sharpe said, the thorniest, hardest problem in finance. How do you generate income from your savings? And it’s fascinating how it’s evolving in many different directions into really—well, one thing I want to convey to you all and to your audience is there is no single solution for life cycle investing and especially for drawing income from your savings. It’s really about where you are. It’s about personalization ultimately.
Benz: Omar, I wanted to follow up on the current time period for equities. US stocks have had quite strong gains for the year to date in 2024. The question is, do you think that US stocks are expensive currently or do valuations look more attractive to you now that we’ve had a little bit of volatility in the equity market?
Aguilar: Well, a great question, and one that I think we have discussed extensively throughout this year. And I’ll mention a few things. One is, when you look at equities as an asset class and you look historically and you look at the traditional metrics that people look for evaluating whether equities are expensive or not, they look above average in terms of valuation. In other words, if you just close your eyes, look at what the indexes have and say, hey, based on history, where we are relative to the distribution of either multiples or valuation metrics, whatever is your best one that you want, definitely they look more expensive than what history may suggest for their own history.
When we tend to advise our clients and discuss with our clients, and we would like to discuss this with advisors as well, is to say, well, but equities are just one asset class that you need to put into context with the rest. And that’s when we start discussing the concept of equity risk premium. And what that means is, are the valuations or equities relative to bonds something that is still attractive for you for the risk you’re going to take? And when you look at historically, the equity risk premium is not at the level of being above average of what you would expect. What that suggests is that given—especially over the course of the last couple of months—that fixed-income assets actually tend to be a little more expensive than equities at the moment when you compare one versus the other. In other words, what that suggests is that there is still a good opportunity for you to have that diversification by providing and have a healthy allocation to equities. That doesn’t necessarily mean that you need to just be completely overweight or doesn’t necessarily mean that you need to be underweight because your concept is that valuations are above average.
The other component that I want to mention—which is critical for this—is that is if you look at the indexes and the challenge with the indexes, especially as we know this year is that the heavy concentration in the top 20% of stocks has actually created the illusion that equities are expensive. Not too long ago, and actually after the events of the unwinding of the current rate is actually more extreme, there were 70% of the stocks in the S&P 500 that had negative returns for the year. Even though the indexes overall were very positive and close to 15%-20%, not all individual securities and individual sectors ended up having the same level of performance for the year. So, what that means is that overall, because of the heavy concentration in a few stocks, that actually creates the illusion that equities have become expensive.
What we tend to emphasize for our advisors and our clients is to say, well, what that means is that you need to look beyond just the mega-caps and the large cap and the traditional definition of equities, which tends to be linked to one or two indexes, and basically look at what do you do with your value exposure? What do you do with your growth exposure? What do you do with your small cap? What do you do with your international? What do you do with emerging markets so that you can actually have an allocation that is robust at all times so that you don’t necessarily look expensive in your equity allocation related to bonds?
So, to answer your question specifically, we don’t necessarily think that equities are expensive at the moment. We actually think that equity risk premium allows you to be more thorough about allocating, but we also don’t think that it’s a good time now to take excessive risk because we expect more volatility in the second half of the year.
Arnott: You mentioned a variety of equity sectors beyond the large mega-cap tech names that are still dominating broad equity indexes. So small-cap stocks, value stocks, international stocks, emerging markets—are any of those areas particularly attractive to you now in terms of valuations?
Aguilar: Our work continues to suggest that having an allocation to small caps, mid-caps, and international, it is a good amount of strategic allocation that needs to happen. And yes, in many cases, theoretical research suggests that when you have lower levels of interest rates that tend to be a positive catalyst for small caps to outperform. We saw that a little bit at the beginning of the summer when we started to see that rotation away from those mega-caps into small caps and mid-caps. And we do expect that overall, that should be a healthy way to suggest that we’re starting to just get into the next phase of the cycle. The same thing goes with the growth and value.
It is interesting because when you take out those Mag Seven securities, the performance of growth and value becomes almost identical. And in other words, there is a significant amount still of impact of those Mag Seven and those mega-caps in that definition of growth and value, which suggests that there is still a good opportunity for that cyclical diversification that allows you to prepare for the next part of the cycle, which suggests to invest in financials and industrials, in materials that usually tend to do better in the early part of the recovery.
Benz: Sébastien, I wanted to ask about international equities, which look attractive relative to US on many measures—valuation, dividend yield. Do you think that many US investors are overly concentrated in US stocks and should think about diversifying internationally? And if you’re making the case to investors about that, what are your talking points there?
Page: The US has an advantage in terms of the dynamism of its economy and innovation and AI and technology that’s not to be underestimated. It also now, because it’s performed so well relative to the rest of the world, represents about 70% of the total size of world stock markets. So, you would expect investors, especially if they’re in the US, but just generally, to have a large allocation to US stocks.
The valuation case has been made before and it’s been a little bit of a value trap. So, you need to ask what would be the catalysts for this rotation? Omar talked about the rotation into small caps. Currently, tactically, we’re neutral between large and small caps. He hinted at the rotation between growth and value. Currently, we’re long value relative to growth. And that also dovetails with we’re actually neutral in international. But if you force me to make the case or push me to make the case, I would say that the valuations just generally for value and Europe is more value-oriented. You have to think about it in terms of sector differences as well. Has some upside as the world economies slow down and we get eventually to the other side. Non-US central banks have been even more aggressive in lowering rates. That could be the catalyst to unlock the valuation advantage. Some emerging markets have been beaten down substantially. And so, the sentiment is so negative that it becomes attractive to take the other side.
Again, that’s if you force me to make the case. I think it’s good to have a strategic allocation that’s closer to say the relative size of the markets, which is where we’re at. But I think it could be part of the whole rotation picture as the massive spend on AI, which by the way, we think is real and is going to lead to productivity gains, but still, it leads to margin compressions. And the market, now investors starting to ask, well, where are the AI application revenues? And as we go through that transition, just generally, whether it’s international, small or value, you’re looking at a situation where the comparables are so high for growth stocks that by the end of 2024, the consensus forecast is that you’ll see for value stocks, including abroad, a year-over-year earnings-growth rate that should outpace the growth stocks. And I don’t think a lot of market participants are really positioned for an improvement in fundamentals, a passing of the baton in the fundamentals.
I’ll say one more thing on valuation. And this applies to international stocks, but also value versus growth stocks. Omar mentioned the market concentration makes the market look expensive. 2021 price/earnings ratio is very expensive by historical standards. I like to tell that story of the statistician who had their head in the freezer and their feet in the oven, but was very comfortable saying, “Oh, I’m feeling great. On average, I’m feeling great.” And this kind of, the 21 is an average of 15 price/earnings ratio for value stocks, which is basically historical average and 30 for growth stocks. So, when you look at market valuation, you’re looking at head in the freezer, feet in the oven kind of bifurcation, which is very, very, very stretched by historical standards. When we were that stretched, in no way do I think we’re in a tech bubble, by the way, because the price/cash flows are much better now for tech companies than they were in the tech bubble. But nonetheless, when you were that stretched between value and growth, in the early 2000, value outperformed by 45% in less than a year. Even in 2022, you had a big snapback of the relative valuation and value outperformed by over 20%. And so, these things can happen pretty quickly when the valuation band is stretched like that.
Arnott: If we look beyond traditional stocks and bonds, Omar, what’s your take on alternative assets? Are there any types of alternatives that you think can add the most value to globally diversified stock and bond portfolio?
Aguilar: Yeah, absolutely. And before I go there, just to confirm and support Sébastien’s view on international, just a couple of data points. There is, normally, because of the composition of the indexes, if you want to diversify away from technology, which most people will have a US exposure, which is heavily tech, the history shows that whenever you see financials, energy, and materials work, you will actually have countries like Canada, the UK, and Australia doing much better than the rest of the world. On top of that, Europe went to an earnings recession in 2023, and the expectations for EPS year-over-year forecast for their growth in 2024 has surpassed the one for the US. Not only that, but in terms of valuations, the average, and I think this is again, go back to what I said before, I think the example that the statistician that Sébastien said, the overall average for international in terms of their P/E ratios is at a discount, whereas the US P/E ratios is at a sizable premium because of those Mag Seven. So, when you think about valuation, when you think about diversification, when you think about just the cycles for earnings growth, clearly you have an opportunity to do more internationally.
In terms of alternatives, we have done a lot of work in terms of thinking of the dynamics of dynamics, especially as a consequence of what we observe in the banking crisis. If you think about it, the way that particularly private credit has worked is the fact that you see as an opportunity for many companies that used to go to these regional banks for financing, that used to go to other areas of the financial sector for being able to get liquidity, that all of a sudden, those things are starting to collapse. That created that big opportunity and that big flow of assets going into private credit. That’s not necessarily going to be the ultimate solution for any liquidity and any credit availability going forward, it does provide an opportunity for diversification for traditional asset classes.
Of course, the challenge in there becomes how do you evaluate the risk and the liquidity associated with that, where we continue to advise and give clients guidance in terms of making sure that they do the due diligence in areas of the private credit, because it’s very hard to just necessarily find that liquidity in that area and all the risk gets transferred. In other words, if you go to alternative investments, the one thing that you need to consider is that liquidity premium that you’re going to have to pay, which is not necessarily something you have to worry when you look in public assets. But that being said, it does provide you with that alternative diversification that we didn’t have before. Private equity and the rest of the alternatives also becomes a good opportunity with the only challenge is that there is too much money there. Therefore, what I think the estimated potential returns going forward needs to be discounted, because, especially with the slowdown of the economy, especially when we are in the cycle, it is going to be very difficult to be able to put to work that much money into the different deals when it comes down to private equity and to other parts of that part of alternative investments. So, it is more about evaluating liquidity risk, evaluating opportunities, but certainly we are in the process of providing clients with advice on how much of their portfolio they can put into alternatives as another source of diversification.
Benz: Well, Omar and Sébastien, I think we have another hour or two worth of conversation left, but we so appreciate the time that you’ve spent with us today. It’s been a really fun and informative conversation. Thank you so much for being here.
Page: You’re welcome and thank you.
Aguilar: It was our pleasure.
Arnott: Thanks to both of you.
Benz: Thank you for joining us on The Long View. If you could, please take a moment to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
You can follow me on social media @Christine_Benz on X or at Christine Benz on LinkedIn.
Arnott: And at Amy Arnott on LinkedIn.
Benz: 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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