For decades, investors have been advised to hold a portfolio of 60% equities and 40% bonds to generate the best risk-adjusted returns. While that turned out to be a disaster in 2022 as stocks and bonds plunged in tandem, Fidelity’s top macro strategist says this year will be different, and fixed income should once again serve as protection if the bear market in equities continues amid an economic slowdown.

One big risk? That inflation fails to fully normalize as many hope.

Jurrien Timmer, director of global macro at Fidelity Investments, joins the “What Goes Up” podcast to discuss this as well as his outlook for the year.

Q: There’s a lot of bullishness on bonds now. Some even say you flip the 60/40 stock-bond relationship and go 60% bonds or even 70% bonds, 30% equities. But embedded in that is the notion that inflation has peaked. How big of a risk is the idea that inflation isn’t as under control as everyone hopes it is? Is there a risk that that’s not really being appreciated?

A: I think that that is correct. It seems like a no-brainer that if we’re going to have economic weakness and now that inflation is coming down — the CPI peaked at 9% year-over-year in June, and it’s well off of those levels — and most economists that I follow, and even our in-house economics team, say it seems fairly likely that inflation will continue to come down at least till about 4%.

But the risk is that it stops there or that it doesn’t go all the way back down to 2%. And one thing that the Fed has been very clear about recently is that it’s not enough just to see inflation come down — it has to come down to the Fed’s target, which is 2% PCE, and generally the CPI runs a little higher than that because of the different composition. So basically 2.5% on the CPI is the Fed’s target. And the risk is that the Fed will go to around 5% in the next three months or so. But there’s a disconnect between what the forward curve — the SOFR curve or the Fed fund’s curve — is saying the Fed will do, and what the Fed is saying the Fed will do.

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The risk is the Fed wants to contain inflation all the way back to its target — because if it doesn’t do it now, even at the risk of a recession, then it may never be able to do it unless much more severe measures are taken. And imagine we do go into a recession the second half of this year, and inflation goes all the way to 4%, which is, of course, a hell of a lot better than 9% — but that’s then the trough. And let’s say inflation then accelerates in the following expansion off of a base of 3% or 4% instead of what normally would be zero or 1%.

That would create the risk that bonds are indeed no longer a port in the storm because if you think about where the term premium is, which is around zero or so, and let’s say that inflation does become more embedded at a higher rate, even if it’s only 3% or 4%, then you could see a period of structurally higher real rates and nominal rates. But for 2023, the focus will be more on recession risk and the 40 starting to negatively correlate again against the 60, which is what has happened in the last few months, although it’s only a few months.

Q: Do you feel that we’ve definitively made the switch from worrying about inflation to worrying about growth?

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A: Yes. I think for 2023, that is correct. Maybe in 2024 we’ll be worrying again about inflation. But for now, clearly inflation is on a decelerating track. Of course, the Fed is focused on the labor market, which remains very tight.

Last year, the first shoe dropped, which was the valuation reset driven by the Fed driving the cost of capital higher for everything. And remember, all assets are really just the present value of future cash flows. And so when the discount rate in that discounted cash-flow model goes up, the present value of those cash flows goes down, even if the cash flows themselves are still growing. And that really is what explains what happened last year. So, that is largely in the rear-view mirror. And it’s a stretch to me to argue that the PE ratio is going to go down even more than it already has. It went from the mid-20s to 15. But the PE is only as good as the E. The E is what the question is for 2023.

But when you think about disconnects, another disconnect is that it seems like a lot of people are worried about a recession, but if you look at the aggregated earnings estimates, it still points to positive expected growth in 2023. And I would be a lot happier — wearing my contrarian hat — if the earnings estimates were really bad right now because then you have a sense of, OK, investors are underpaying for what could be a positive surprise if we end up getting either no recession or a mild recession. And that’s one of the disconnects that worries me a little bit.

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