2024 Multi-Asset Strategies Outlook
Fourth Quarter
Key Takeaways
R-star is important because it tries to identify when interest rates are perfectly balanced in the tradeoff between higher inflation and full employment.
Investors shouldn’t fixate on R-star because it’s inexact and can’t be known beforehand. Stick to a diversified approach rather than trying to anticipate Federal Reserve (Fed) rate changes.
The (R) Stars in Our Eyes
What drives Fed rate policy? Hint — it’s not electoral politics. The Fed’s home base is R-star.
A year ago, we published an article about interest rates in presidential election years and the interaction effects between monetary and fiscal policy. One key takeaway from that article is that electoral politics don’t appear to influence Fed monetary policy decisions. While this may counter many people’s perceptions, the independence of Fed action is well-documented in the academic literature.
That’s good news. The Fed is an independent body that makes decisions in the economy's best interests regarding jobs and inflation, regardless of where we are in the electoral cycle.
But it’s fair to ask what guides Fed policy. That question is particularly relevant now because the Fed is about to embark on a rate-cut cycle, and investors are eager to identify the pace of cuts and the ultimate landing point for interest rates.
R-star Defined
The Fed’s dual mandate is to keep inflation in check and maintain full employment. The Holy Grail of Fed rate policy is reaching a point where the risks from higher inflation and a weaker job market are balanced. This is captured by a concept known as the “natural” or “neutral” rate of interest after adjusting for inflation. Economists and academics denote this neutral rate as R*, pronounced R-star. A Fed paper defines R-star as “an important benchmark for monetary policy because it determines the real [after-inflation] interest rate that policymakers should aim for.”
Sounds easy, right? Unfortunately, the devil is in the details — no one knows in advance what R* is at any given time. You can only estimate it after the fact using economic variables. In addition, the Fed itself maintains three competing R* models. The Federal Reserve Bank of New York publishes two estimates, and the Richmond Fed issues its own model of R-star. There’s even an R** (R-star-star)!
Why R-star Matters Now
Although identifying the precise level of R* remains elusive, it’s obvious why it’s important to policymakers, corporate America, investors and workers everywhere. Any Fed funds rate below R* would stimulate the economy and inflation. The opposite is also true — a Fed funds rate above R* would be restrictive. So, it’s easy to see why the Fed and economists devote so much energy to trying to tease out the number.
We can say with certainty that all the R* models agree on a few things. The number was higher 50, 40 or even 30 years ago. Then, it declined meaningfully after the Great Financial Crisis (GFC) before rising again due to post-COVID inflation. Conceptually, think of a rough Nike “swoosh,” and you have the broad shape or R* for the last 50 years.
Today, some economists argue that R* is already in line with real (after-inflation) interest rates, which are between 2% and 3%, depending on which inflation measure you use. This would explain why the economy has held up so well despite the rapid rise in the Fed funds rate beginning in 2022.
Let’s do some quick back-of-the-napkin interest rate calculations. As of early September 2024, the Fed funds rate was 5.5%, while consumer inflation was at approximately a 2.5% annual rate (July’s 0.2% monthly rate annualized). This would put the real Fed funds rate at 3%. By comparison, the Fed’s three published measures of R* currently stand at 0.8%, 1.2% and 2.6%.
These stats suggest that monetary policy today is very restrictive by two of three of the Fed’s own R* estimates. On the one hand, this makes intuitive sense — the Fed’s ready to begin cutting rates at the end of a long campaign to rein in inflation. It’s natural that Fed funds should be well in excess of R*.
If that’s correct, however, the Fed will have to cut rates aggressively to avoid derailing the soft-landing scenario many stock investors appear to have been positioning for. On the other hand, if R* is closer to 2.6%, then the Fed isn’t far from neutral, and the economy may well avoid a full-blown recession.
R-star Is Likely to Be Higher in the Future
The reality is that Fed rate policy has never been an exact science. Regardless of how you calculate it, R* is an important concept, but the exact number can’t be known with any degree of certainty. As a result, we don’t think you should make investment decisions based on the latest R* readings or spend a lot of time trying to anticipate and trade on Fed rate policy.
For our part, we believe that interest rates and R* will be higher going forward than they were in the post-GFC period. That’s because of the huge U.S. federal debt and deficit, the growing movement toward deglobalization and an aging population. We think investors should expect interest rates to settle at a level above, not below, the pre-pandemic norm. We’ll talk about the implications of structurally higher rates for investors in our upcoming 2025 outlook.
Asset Class
U.S. Equity vs. U.S. Fixed Income & Cash Equivalents
The qualitative interpretation of our quantitative models is that we are taking risk-off positioning on the margin. Stocks have been very volatile since hitting record highs in early July. We’ve been skeptical of equities for some time, given signs that the economy is slowing and the labor market is weakening. Indeed, the Fed is cutting rates because inflation has fallen and softer employment demands action. Add in electoral uncertainty, wars around the globe and rising trade tensions, and we just don’t think volatility is dead. Meanwhile, we think cash yields remain attractive relative to earnings yields on stocks.
Equity Region
U.S. vs. Developed Markets
Our momentum, interest rate and corporate earnings components favor the U.S. However, the fact that many developed market economies have already cut rates ahead of the Fed signals easier monetary conditions and a relatively better backdrop for growth. Add it all up, and we’re neutral on U.S. versus other developed market equities.
U.S. vs. Emerging Markets
Emerging market (EM) equities represent a diverse range of companies and investment opportunities. As a result, we believe active security selection is very well suited to this space. But we're modestly underweight emerging markets at the broad asset class level. In our view, momentum and credit factors favor the U.S., though we acknowledge that relative valuations point to emerging markets.
U.S. Equity Size & Style
Large Cap vs. Small Cap
Last quarter, we wrote extensively about how the long-term historical return relationship favored small-cap stocks over large-cap stocks. But we explained that today, high interest rates and better relative earnings growth favor large. To that list, we can now add economic uncertainty. Fed rate cuts should help small-caps, but not if the Fed cuts in response to an economic downturn. Favoring large is consistent with a modest risk-off approach.
Growth vs. Value
By our metrics, momentum and pending interest rate cuts favor growth, given that lower rates may greatly benefit the net present value of future cash flows. On the other hand, our risk and valuation measures point to value. Given the tension between these two positions, we remain neutral at the asset class level.
Fixed Income
U.S. vs. Non-U.S.
Consistent with our modest bias toward risk-off positioning, we favor higher-quality, investment-grade bonds over high-yield bonds. Yield spreads are tight by historical standards, meaning that the compensation for taking on the additional credit risk of high-yield bonds is less appealing. In terms of positioning by country, we see less differentiation from market to market now that the Fed appears sure to join most other developed countries in cutting interest rates.
Alternatives
REITs vs. Core Assets
At the risk of sounding like a broken record, our view of real estate investment trusts (REITs) continues to improve, just not enough to warrant an overweight position. Long-term bond yields have rallied, and the Fed looks dead set on cutting rates through the end of the year. Lower interest rates favor REITs. However, rather than overweight the entire asset class, we prefer to rely on the managers of our underlying REIT allocation to identify the best opportunities.
Capital market assumptions are not meant to reflect any projection or promise of performance. No guarantee or representation is being made that any account will or is likely to achieve the assumptions shown.
References to specific securities are for illustrative purposes only and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.
International investing involves special risks, such as political instability and currency fluctuations. Investing in emerging markets may accentuate these risks.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Historically, small- and/or mid-cap stocks have been more volatile than the stock of larger, more-established companies. Smaller companies may have limited resources, product lines and markets, and their securities may trade less frequently and in more limited volumes than the securities of larger companies.
Diversification does not assure a profit nor does it protect against loss of principal.
Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.
Past performance is no guarantee of future results. Investment returns will fluctuate and it is possible to lose money.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.