The risk of too much consensus
Recently, Chief Global Strategist Seema Shah and I had the opportunity to attend the 2023 Milken Global Conference. When we returned to the office, we sat down to discuss our experiences at the conference, Seema’s panel on macroeconomics, common conversation themes, and her views on the economic outlook for the rest of 2023.
Brian Skocypec (BS): Seema, the theme of this year’s conference, ‘Advancing in a Thriving World,’ felt slightly optimistic at the onset—particularly given our somewhat unenthusiastic views on global growth. However, what stood out to me after attending was that despite the potential short-term challenges, investors are finding numerous differentiated opportunities across the public and private markets. What did you think of the conference as a whole, and how was your experience?
Seema Shah (SS): The Milken Global Conference is always one of the favorite parts of my work year. Sophisticated investors from all over the world, focused on different markets and sectors, come together to share ideas and hear from renowned experts in medicine, geopolitics, and technology. I always leave the conference with fresh perspectives and new ideas—this year was no different.
BS: At the conference, you told me there seemed to be a great deal of consensus about the macroeconomic outlook and global themes. Is that still your view?
Yes, there’s currently very little dispersion in the macro view amongst investors. It’s widely agreed upon that we’re expecting a recession; we’re expecting the Federal Reserve (Fed) to be close to or already done raising rates; and we’re expecting disinflation, albeit slowly. Those three almost universally shared beliefs were the thread connecting most conversations I heard and had at the conference.
BS: What do you think about this level of consensus? Do you think it is a good or bad thing?
I wouldn’t say I think the consensus is either good or bad. I certainly don’t disagree with the consensus, but I found myself asking, “What are we not talking about?” Because that’s what is going to move markets. There’s no safety in this numbers game. When everyone is bunched together, one small surprise could produce significant moves, so we must think about what everyone isn’t talking about.
BS: I want to discuss what investors should focus on for the rest of the year, one of the biggest being the path of interest rates. As we all know, the Fed voted to raise rates for a tenth straight time on May 3. Do you think they’re done raising rates?
In line with this theme of consensus views, everyone generally expected the Fed to raise rates on May 3, which, as you mentioned, they ultimately did. Most would agree that this is likely the last rate hike we see for the foreseeable future. With the most recent hike, the Fed implied that they are pivoting to a more data-dependent perspective, moving away from using prior months’ CPI prints to influence future decisions. As such, the general view is that there will be a pause and maybe even a rate cut or two later in the year, all dependent on inflation coming down. But what if inflation doesn’t come down? What if it plateaus around 4.5% or so? I haven’t seen much discussion in the market about the potential for the Fed to un-pause their rate hiking campaign should inflation not abate as much as they’d like. Especially given historical instances where we’ve seen the amount of time it takes for inflation to come down in developed markets once it crosses the 5% threshold—as much as ten years—so I find it strange that the consensus is entirely centered on this idea that rate hikes stop now and that we can potentially look forward to having a rate cut this year.
BS: Let’s say rates start to renormalize; I don’t think anyone expects them to go back to zero, but what is the impact if rates are somewhat lower?
In an ideal investment world, rates would go back to zero, central banks would flood the market with liquidity once more, and the economy would quickly start to take off again. But ultimately, we’d likely find ourselves back at the next Milken Global Conference, sharing the same concerns about inflation and having the same conversations as today.
In a more realistic scenario, rates come down to around 2.5%. This would present an almost unrecognizable investment landscape from the last ten years, where an extremely low cost of capital suppressed volatility and lifted asset prices, resulting in high returns for investors. However, looking out over the next ten years, higher interest rates imply higher volatility and lower returns. In that environment, investors need to work harder to identify opportunities and must be much more selective. When rates are low, bad management, bad debts, and bad governance can all be hidden; those problems are unveiled when rates are higher—there is simply nowhere to hide.
BS: On a global scale, we’re seeing an unusual situation where inflation is lower in emerging markets. What are your thoughts on this phenomenon?
This is very interesting. Looking back at the inflation data since it started being collected, last month was the first month that emerging market inflation was below developed market inflation. In fact, several emerging market central banks are now in a position to initiate rate- cutting cycles. So this is a remarkably different investment environment than investors have typically seen. As it stands, the U.S. is one of the least attractive markets in the world – we're seeing tightening financial conditions, low growth, and volatility in the banking sector. But looking at emerging markets, particularly in East Asia, we're seeing loosening financial conditions, lower inflation, and no banking sector issues thus far.
That said, emerging markets won't be immune to the ripple effects if significant financial strains appear, such as a U.S. national banking system failure. Ultimately though, as long as we're looking at a fairly modest path for the U.S., then emerging markets are presenting a promising opportunity right now.
BS: The Treasury Department, supported by Congressional Budget Office data, recently announced that the U.S. will likely hit the debt ceiling as early as June. From a macro perspective, what does that look like?
We watch this debt ceiling debate play out every couple of years, and it always results in the same drama—the same volatility. However, one thing I think is different this time around is that the market is already incredibly vulnerable to any additional volatility, and I don’t know that it can afford this added pressure. I feel optimistic that the situation will get resolved, as a U.S. default on debt is simply not an option. That said, because a resolution is the consensus view, a default would trigger a very severe market reaction.
BS: Considering this, how should investors prepare their portfolios given the current economic conditions?
We’ve touched on a few ways investors should navigate their portfolios given the current economic environment—namely, staying aware of the potential risks and opportunities—but I think investors would be best served by having a broad toolkit that is well-diversified among strategies, products, and industries.
In emerging markets, particularly East Asia, equities are currently trading at deep discounts, opening the door for outsized returns and performance. In the U.S., high-quality fixed-income products like Treasurys and municipal bonds should be staples in portfolios as we head toward a potential recession. Finally, alternatives deserve a place in diversified portfolios, as well. Inflation isn’t disappearing, so exposure to real assets such as listed infrastructure remains essential. And while private markets are likely due for a correction in the near term, they present opportunities for higher returns from a longer-term perspective.
BS: Seema, thank you for the great conversation. I know we’re both already looking forward to the 2024 Milken Global Conference.
To continue this conversation on market risks and opportunities ahead of a potential recession, click here to read the latest piece from our colleague David Blake, CFA, or watch his panel, Asset Management: Constructing Portfolios for the Future, from the 2023 Milken Conference.
Alternatively, watch Seema’s panel, Macroeconomy: Finding Checks and Rebalances.
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