Webinar: Is now the time to redeploy cash?

Terry Davis

Hello everyone, and thank you for joining us for today's portfolio construction webinar, “Is Now the Time to Redeploy Cash?” I'm Terry Davis, and I'll be your moderator for today's discussion. Over the course of 2023, market uncertainty and high short-term interest rates contributed to record assets and cash equivalents such as money market funds. As we enter 2024, some of the uncertainty surrounding the economy and markets is starting to clear. And now with all this cash on the sidelines, many investors are starting to think about when and how to redeploy cash into the market.

Now let's introduce our panel. Again, I'm Terry Davis, director of investment solutions in the Portfolio Construction group here at T. Rowe Price. Our team of portfolio construction specialists work directly with financial professionals every day to improve their investment models through in-depth analysis and one-on-one consultation.

Next, we have Jeff DeVack. Jeff is a portfolio specialist in the Fixed Income Division, where he's a member of the investment-grade bond team supporting a number of fixed income strategies. His investment career began in 2000, and he's been with T. Rowe Price since 2011. Thank you for being here, Jeff.

Jeff DeVack

Thanks, Terry. It’s a pleasure to be here.

Terry Davis

Caleb Fritz is a portfolio specialist in the U.S. Equity Division, supporting large-cap value strategies. He rejoined T. Rowe Price in 2010 and has more than 20 years of industry experience. Thanks for joining us, Caleb.

Caleb Fritz

It’s great to be here. Thanks, Terry.

Terry Davis

And finally, we have Som Priestley. Som is head of Multi-Asset Solutions–North America and a portfolio manager in the Multi-Asset Division. Welcome, Som, we’re glad to have you.

Som Priestley

Great, happy to be here.

Terry Davis

Today, we’re going to touch on what’s going on in today’s market; why now might be a good time to consider redeploying cash into equities and fixed income; and ideas for how to redeploy cash across portfolios, including some key opportunities and risk. We've got a lot to cover. Let's get started.

Som, how much cash is on the sideline? And put this into context of what we have seen in previous cycles.

Som Priestley

Sure. So, thanks everyone for joining our webinar today. You're exactly right. There's a historically high level of cash equivalents on the sidelines today. More specifically, if you were to look at the assets and money markets right now, that value is over $6 trillion. Which is up over 60% since just December 2019. In large part, this is a legacy of the pandemic where we had near 0% interest rates. We had large government bond-buying programs that flooded a lot of liquidity into the markets. Many residents, many institutions, investors have saved that cash. And so it's been sort of parked waiting to reenter the financial system. That said, pandemic’s behind us, there’ve been several other reasons that have sort of incentivized folks to stay liquid. So, for example, we had the surge in inflation, which caused a near-historic bond bear market. Equity markets had a twin sell-off. And then we saw interest rates move from near 0% to above 5%. So, history would tell us that eventually this desire for liquidity will ease and those assets will reenter the broader financial markets. But the when, the where, is to be determined. And I think through our discussion today we'll talk about some of those opportunities.

Terry Davis

Great. Thank you, Som. Jeff, let's talk about the fixed income markets and the economy. Is there a recession lurking? And where are rates headed?

Jeff DeVack

Yeah, sure. So, the short answer is we don't think there's a recession on the horizon in 2024. And as far as rates go, we expect them to be lower by the end of the year, which is a little bit counterintuitive, but let me unpack that a little for the audience here. If you rewind the tape back to 2022, the Fed started a very aggressive rate hiking cycle, obviously, and the yield curve inverted. And that's historically been a really good barometer or indicator of future recessions, albeit with a time lag.

If you go back as an example to the granddaddy of them all in terms of recessions, the global financial crisis in 2008, the Treasury yield curve as measured by the three-month 10-year Treasury rates inverted in February of 2006. We didn't see the recession take hold in the United States until December of 2007, so there was almost a two-year time lag. So, you roll the tape forward to 2022. With the curve as inverted as it was, how quickly it was, I think the market narrative was pretty strong that we would see a recession in 2023. That obviously was not the right call. We had growth of 2.5% in that year, which exceeded actually 2022's growth rate. And so, what did investors get wrong? Underestimating the power of the consumer. U.S. personal consumption is about 70% of GDP or growth. And there were some real strong tailwinds for the consumer during that period. There were a number of them. I'll talk about three, and I think Som kind of hit on a few of these. The first one was employment, and we certainly underestimated the strength of the job market during that period. Employers were remiss to execute layoffs and instead hoarded labor and instead closed vacancies in their companies, and so the consumer was buoyed by strong jobs. The other was the glut of savings that that you talked about, thanks in large part to the fiscal stimulus globally that was record-breaking during COVID. So, investors were sitting on a lot of cash that could be deployed. And the third leg of that stool really was less sensitivity to interest rates increasing. And what I mean by that is investors were able to refinance their fixed rate debt at historically low levels during the COVID crisis, thanks to 0% interest rate policy. And so this all helped to buoy the economy and consumers and power us through what could have been a pretty troubling period with as inverted as the curve was. Today, where does the economy stand? If you talk to our chief U.S. economist—and keep in mind, T. Rowe does not have a house view—but our chief U.S. economist Blerina Uruçi does not have a recession in her forecast and thinks that we’ll continue to see inflation slow down, albeit at a slower pace. this year. Growth will be buoyed by continued fiscal stimulus, albeit at lower levels than what we've seen certainly since the COVID crisis. Now usually when you have a setup like that, it means the Fed’s not going to be cutting rates, but they've definitely signaled that they are. We believe that they will have to execute on that. Right now, the market’s pricing in about three and a half cuts. We think that's too few. We expect them to start cutting in the May/June time frame, and they'll have to go more than the market is currently anticipating. And what we really point to for that analysis is the fact that real rates, so nominal rates less inflation, are still elevated. And as inflation comes down, real rates just keep going up and that's very restrictive for the economy. And we think we saw that with the Fed’s big pivot at the end of last year and that they're going to be forced to do more than the market currently expects.

Terry Davis

OK, Caleb, pivoting to the equity markets. What are the markets pricing in now?

Caleb Fritz

Yeah, Terry. So, I think it’s a really optimistic scenario that the equity markets pricing in and a lot of the reasons that Jeff talked about. But I think we look at GDP expectations just a few months ago back in August, we were expecting, using the survey that Bloomberg does, we're expecting basically .6% GDP growth in 2024. Now it's 2%. So, it's come a long way. So, I think there's an optimistic scenario for economic acceleration being priced in right now in the equity market. I also think we're pricing in a continuation of some of those big themes that drove things last year. You know AI, GLP-1s—I think we're pricing in that that continues unabated. And all of that is going to happen in an environment where disinflation continues, and the Fed can be supportive of what's happening there. I also think, Terry, there's a sense in the equity market that if we do get a recession, if that were to happen, that it would be short and shallow, right? Because you look at what's going on under the hood, you see a fairly tight labor market. You see a bank sector that—we'll talk about this in more detail—that has really reserved already for credit events that haven't happened, so they're well reserved, they’re well capitalized. And you have a Fed that has the ability to come to the rescue of the economy and the markets and cut rates with a lot of dry powder. So it's an interesting scenario. I think it's worth it to take a step back a little bit and we're in the midst of a really strong run in the equity market. The S&P 500 is up over 20% from October 27. So, it's a pretty big move, but it's important to remember that happened right after a pretty big correction and the last two years have been quite volatile. So, we're essentially where we were or two years ago. We go back to the level of the S&P 500, we're about at the end of where we were at the end of ’21. Valuations are pretty similar there, about 21 times earnings, roughly, which overall doesn't look that scary. It doesn't look that cheap, doesn't look that expensive, but when you think about the real yield scenario, the real interest rate scenario that Jeff talked about, that's a little bit high historically. So, it's important, I think, to be somewhat cautious given where the market’s been and when you're thinking about redeploying capital, look for areas of the market that maybe have been left behind.  when. We're going to talk about that in more detail.

Terry Davis

Som, what does T. Rowe Price’s Multi-Asset group…how do they view the markets right now?

Som Priestley

Yeah, so similar to my peers here, we definitely feel as though the recession concerns have faded and the bottom line has been that the economy has been much less rate sensitive than many expected. So, I think there's a lot of reasons to feel constructive right now about the economy going forward. The challenge, as Caleb just noted,  understanding what has been potentially priced in. And so to illustrate that point, I’m actually going to talk about our recent add to equities. So, we just added to equities to go slightly overweight equities for the first time since 2020, and a big driver behind that was us actually thinking, you know, one of the primary concerns now was less recession, but then potentially inflationary. So, and an inflationary, oh sorry, in a recessionary sell-off bonds will be a good protection of the portfolio, but in an inflationary environment equities tend to do better given some of the benefits to earnings. The nuance here is within equities, right? So, we're going to actually look for opportunities in the more cyclical sectors, cyclical areas of the market while still trying to maintain healthy or not underweight to growth where we still see some upside opportunity. And so, to do this, we've actually funded our overweight to value from fixed income. So there's a lot of concerns out there about what's been priced into the market, is the market too expensive? But we still believe there are opportunities in value equities, small-cap, potentially international markets like Japan as well.

Terry Davis

OK, great. So, we've talked about kind of what the market anticipated. Let's talk now, you know, what it’s not positioned for. I'll start with Jeff. What do you see as the top risk to the economy and the fixed income markets?

Jeff DeVack

Yeah, great question. So, to give it some framing about how we approach things at T. Rowe in fixed income, we convene a monthly series of meetings where we go market by market, region by region, across the globe, looking for risks and opportunities in the fixed income markets. We do that as a division, we call it our policy week process. And during last month's policy week process, the key risk that stood out was certainly on the side of inflation. We had just gotten some pretty big inflation prints that were above expectations and that was starting to get baked into the market. I would say that that wasn't a huge red flashing light on the dashboard, so to speak, but it's something we definitely need to be mindful of because if we continue to get those inflation prints of, say, .4, .5 month over month for a series of months and/or job numbers that were exceeding 300K or 300,000 a month, that would certainly put some pressure on the Fed to act and hike possibly one or two more times. Now, to be clear, we do not think that that's our….that's definitely not our base case there, but it certainly is a risk because the market is not set up that way. I mentioned that the market’s pricing in three and a half cuts. So that would definitely catch the market off guard. But from a rates perspective, I actually think if you look at this heat map in this chart that's on the screen here, the fixed income market is set up really well for investors right now and you have some protection built in with rates and durations where they are. So let me explain that a little bit. The yields have gone up in the last two years and based on this heat map we've laid out the different maturities of the Treasury spectrum and different rate increase and decrease scenarios. And right now, there's much more upside if rates fall than there is downside if rates rise. And that's thanks to our friend bond math or convexity, which everybody loves to talk about. Bond prices increase at a faster rate than they fall, and that's more true when rates are higher. And so, we now have what I would call a margin of safety built into markets to make it analogous to the stock market. And so, I'll use an example right now. If you look at our ultrashort strategy, for example, you're looking at a duration of about three-quarters of a year, so still pretty short duration, but a yield on order of 5.5%. And a quick way to figure out what your breakeven is on that instrument is by just dividing the yield by the duration, which gives you 8.5%. That means that holding everything else constant, yields would have to go up 8.5% before you start losing money on that product. Now, that's just the rate. That doesn't include what would happen in credit, but that's a huge buffer for you as a fixed income investor. And so, we think there's a lot of value in extending duration at this point in the cycle. The other side of that coin, real quick, is valuations on credit products measured by spread. And spread’s the yield you're going to earn over Treasuries for compensation against the fall in downgrade risk. Right now, that compensation is very low across fixed income sectors. We've definitely priced in a soft landing or no landing environment in fixed income. And so that's certainly something that's not priced into the market. And so while our economist does not believe that we're going to see a recession in 2024, if we had one come out of the blue—and recessions tend to be Black Swan events—or we had another exogenous market shock, that certainly would be a stress on the credit markets and you would see spreads widen and prices fall in that circumstance.

Terry Davis

Great. And so, I'm going to pivot now to artificial intelligence, or AI. Artificial intelligence. I've heard some investors say it's the most important thing since the internet, and some have said it's the most important thing since electricity. Caleb, I'll start with you. In terms of a value person’s guide to AI, can you give us your thoughts?

Caleb Fritz

Absolutely, Terry. I've worked with value investors my entire career, and our role is usually to pour cold water on where everyone gets excited about something. But I think we have to look at AI and recognize that it's real, right? It's something that's going to impact the way we all live, the way we interact with other people, the way we do our jobs. It’s going to impact the economy for many, many years to come. And so, it's a real thing. We've looked at some of the trends that have come out over the last few years, like the Metaverse or Web 3.0, and we've been pretty skeptical about those things. And those ended up being, at least in the near term, correct to be skeptical. But this one, we're not that skeptical on. So, it's something we have to think about as value investors, something we have to pay attention to. I would point out, though, that at this point it really is a theme, right? All we really know about AI is that it's going to be really good for hardware. It's going to be really good for GPUs and demand there and everything in that ecosystem. The business models that get built on top of it, it's not quite clear. We have some visibility in what that might look like. We don't really know who's going to be winners in the business models. We know who's a winner in kind of the hardware. So, it's basically an arms race and speculation almost everywhere else. And there's exuberance, right? Exuberance is justified in this case, in our view. But exuberance, if it keeps going at the pace it's going, at some point it turns into irrational exuberance. And that's really where you need to be cautious. So, for us as value investors, we would say two things that are probably worth considering. And the first thing is that the benefits to artificial intelligence very likely to accrue to a broader subset than compared to the platform era. You think about the platform era of, companies like Netflix or Amazon coming into new categories and really dominating, creating network effects that made it hard for anybody to compete with them, number one, and really hurt incumbents. That was very bad for value. AI is really about maximizing productivity and improving human productivity. And so when you think about that, that means a lot of companies are going to benefit from this, right? Companies that have complex business models, complexity in their supply chains, the way they price their business, if they have complex relationships with regulators, they're all going to benefit from artificial intelligence. So, it doesn't scare us as value investors as much as the platform era really should have,  cause it created a lot of stranded assets, that era did. This era is maybe going to be a little bit more distributed, which means there's more opportunities for companies that look different from tech companies to actually benefit from artificial intelligence. So that would be the first thing. The second thing I'd say is that right now, there's been some pretty clear winners priced in. It's hard to quibble with any of those at this point, but we think there's some winners that are underappreciated right now that are where you're getting that at a lower probability in the overall distribution. And so, I'll mention just a couple of those real quick here. I think the biggest one is Qualcomm. Qualcomm is a company that makes chips for handsets. Our view is that at some point, some of the computing for AI to really work is going to have to happen at the edge, so at the device level. And companies like Qualcomm are going to be able to enable that kind of compute to happen there. So, Qualcomm, we think is not really being thought of as an AI beneficiary, but over time probably will demonstrate that it is. Memory is really important. We need a lot more memory, not only in the data center but also on the handsets if we're going to really have AI incorporated into a lot of different use cases. So that means companies that have really gone through a pretty bad memory cycle right now—so companies like Samsung and Micron—are probably going to benefit from the proliferation of memory and the supercycle that might come as a result of AI. And then the final one I'd mention is in services and business services, and in order for companies to be able to use this technology, they really need to get their data in pristine order and organized well. So, companies like Accenture are going to be able to help them do that and be able to benefit from that. So, there's opportunities we think from a value lens, but it's a really impactful thing for the world and the economy. And we really need to respect it.

Terry Davis

So, to follow up to you, besides AI, what other risks are there in the equity markets, potential in the equity markets?

Caleb Fritz

I'm going to clear my throat first and echo what Jeff said is that the risks that matter are always the ones that are hard to see. So, putting that aside, I think the risks are pretty similar to what Jeff laid out for fixed income. We talked about how the market’s kind of pricing in an acceleration in economic activity, or at least continued good economic activity. If anything disrupts that, that's probably a problem for the equity market. We're also pricing in disinflation. So, anything surprising on that front, similar to what Jeff noted, is probably going to be bad. If the next Fed move is a tightening rather than an easing, that's probably not priced in. You said outside of AI, I think it's important to note I did mention a little bit of risk there, but there's a lot of market cap tied up in AI and I add GLP-1s into that as a ton of market cap. So, anything that disrupts that is probably a pretty big problem. Maybe there's an air pocket in GPU demand, or maybe something comes out for the health side effects of GLP-1s. I'm not saying that's going to happen, of course, but that's something to think about. But maybe a more salient risk, something that's more near term for equity investors to think about and maybe along the lines of what we're talking about for where to deploy is that there's probably intra-equity risk. And I know that's probably an inartful term, but what I'm getting at is right now the leadership within the equity market has been very narrow. So, it's been a really small subset of the market that's been driving things higher. And that's created an environment where momentum, returns from momentum, the stocks that have been working have been really strong over the last 12 months. And when you look back historically, whenever you see that level of return to momentum, there's usually a reversal of that. So, something to think about is a leadership change in the interim term that might damage the current leadership. So when you're thinking about deploying capital, one of the things that probably should be on your mind is, what is the antidote to that? What are the other sides of those things? And a couple things I'll mention right now, and I know we'll talk about value in a little bit, I think value’s really in that camp, but I put dividend-paying companies in that camp as well. If you look at what is in the low-momentum category of the equity market, a lot of them are dividend payers, high dividend yielders, dividend growers. I think that's probably partly an antidote to what's been going on if momentum does break. And then the other thing I'd say is GARPy companies, the core part of the equity market, a lot of that's been left behind. So, you really need to pick your spots here and that's really probably the more salient risk to think about when we're thinking about deploying cash.

Terry Davis

Som what else is not priced in to the market from a multi-asset point of view?

Som Priestley

So, I'll talk about some of our concerns. I would say our biggest concern right now is that inflation remains stickier than folks are expecting, which would mean that the Fed is less dovish than the market is expecting. So, a big debate this year has been how many Fed cuts will we get. And we've seen seven go down to three and I think it’s about 3.5 today.

But we think really one of the real questions is, once we get past 2024, will the Fed still be cutting in 2025, 2026 where there's another four or five cuts that the market’s currently pricing that in our opinion to become less certain. Other things that aren't being positioned or priced, a recession, which again, we don't think is likely. And similar to Caleb's point, the market really isn't positioned for a broadening out from that Magnificent 7, which could be a potential risk. So, if we continue to see economic resilience, we would expect to see a broadening of the stocks that are participating. So the way that we're allocating against that is we've been investing in our real assets strategy. So having more exposure to areas of the market that have a higher inflation beta. I've mentioned the overweight to value equities, they tend to benefit in a period where the real rates are going to be potentially higher for longer. Areas like small-cap emerging markets haven't really participated in this upside as well. So you’re looking a little bit under the hood, but there are areas of the market that still provide plenty of opportunity for that cash as it comes off the sideline.

Terry Davis

OK, so we talked about what's happening in the market. Let’s kind of move now to why you would want to move some money out of cash and invest it. So, Som, based on some research that both Portfolio Construction, Multi-Asset did, can you share some of the findings from that research about redeploying cash?

Som Priestley

Sure. And I'm going to point to a graphic here that shows asset class performance around Fed rate cuts. And just so to orient yourselves to this chart, this is looking at the 12-month excess return against cash of three different assets. So, in light blue, you have stocks; in green, you have bonds; and then there's a 60/40 portfolio. Around the center of the chart we look at asset class performance at the rate peak, and that seems to be where…sort of plateau. And most of the performance a little bit asymmetric, actually comes before the Fed rates peak, not after. So, there's been historically a benefit to reentering markets earlier versus later. What we've seen, though, if we look at another chart which shows cash flows around Federal Reserve rate cuts, is that investors are typically late to making that entry back into the market. So this could be that Fed is usually cutting rates into sort of economic weakness. Risk assets might be selling off. But what's interesting today, as we've spoken about, is we kind of have this ironic nuance that the Fed might cut into economic strength, right? So that might mean that some of this cash might come off the sideline earlier. That might mean that there's more upside in risk assets than we've seen in the past post the rate-cutting cycle.

Terry Davis

OK. So, Jeff, please tell us about T. Rowe Price’s Fixed Income views on inverted yield curves and how they typically return to normal.

Jeff DeVack

Sure. And I would say that this isn't necessarily just T. Rowe Price’s view, because history would tell you that the Treasury curve can't stay inverted indefinitely, it just cannot happen. The financial markets are not set up to work that way. The capital markets are not set up to work that way. If I lend you, Terry, $100, I'm going to want more compensation if I lend it to you for 10 years than if I lend it to you for one year, right? Because with that 10-year time frame there's more time for you to not pay me back, and so it's not natural for short-term rates to be above long-term rates. And I think the market desperately wants that renormalization. It's almost like looking at a spring that's just been compressed and compressed and compressed. It's trying to break out of that compression, and we've seen a couple instances of that happen over the last year. I'll go back to March of 2023, the banking crisis, we saw the two-year yield drop almost 100 basis points, not just in a day, but almost instantaneously when we got some news about some of the regional banks having significant distress during that period. Of course rates, as things normalized, moved back up and we also saw when the Fed made its surprise pivot in the fourth quarter of 2023 yields drift down about 100 basis points from their peak above 5% and 5.25%. Again, we've normalized again, so we just keep pressing the spring back down. But the market really wants it to unwind. I don't think you're going to see a true re-steepening that sticks until you get more clarity and more definitive signs that the Fed is actually going to be cutting. But similar to what Som was saying, once that's become clear in the market, it's probably already too late because the moves are going to be big. They're going to probably happen quickly, especially with the way markets trade today, and you're going to want to be in that trade ahead of it. So we think legging into extending duration certainly starts to make sense at this point in the cycle, especially with what I showed you in that heat map. If you invest longer duration, yes, you're going to give up some yield coming out of money markets right now. But I view that as almost the premium that you're paying on an insurance policy, right? And so you have much more upside if rates fall at this point in the cycle. And one thing we haven't talked about yet is stock/bond correlations. They've certainly been disappointing to asset allocators over the last two years because they've been positive. That tends to happen when the Fed is hiking rates, especially when they do it aggressively. We're seeing signs, though, that the market wants that negative correlation to come back into play. And these flights to quality that we've seen recently when the stock market is selling off, I think, are signs that that relationship too will normalize. And so, whether you're doing it, extending duration, to play for lower rates or you're trying to build some diversification back into your portfolio because the upside is that much greater, I think it makes a lot of sense to be legging into those positions now.

Terry Davis

OK, so in terms of moving money out of cash into fixed income, one thing you didn't touch on, I don't think, was credit. Just kind of our credit outlook, broadly?

Jeff DeVack

Sure. So, credit right now, again, is priced pretty snugly across sectors. If you look at yields across fixed income sectors, they're very attractive, getting paid more than you have in decades. But I look at the option-adjusted spread on investment-grade corporates, for example, were, the last I looked, in the low 90s. That's not far off the all-time tights. That means the compensation you're getting for downgrade and default risk is very low relative to history. And so bond investing can be a very asymmetric return profile if not done correctly, which is why we always advocate for active management in fixed income. You have to be careful going into credit. That said, we talked a lot about a pretty sanguine economic environment—inflation coming down, the Fed cutting rates. All of that should bode really well for both the high-quality sectors and the plus sectors. I think until the Fed cuts, there could be some tailwinds for floating rate securities like bank loans or CLOs. We own those in our core plus and total return-oriented portfolios. They're going to benefit until the Fed fully engages in that cutting cycle, and they've done very, very well over the last couple of years. If they signal that they're going to go, then we'll be tactically shifting our portfolios.

Terry Davis

OK. Thanks, Jeff. Caleb, we've heard earlier, not all stocks are expensive. Should this provide solace for reluctant cash redeployers into equities?

Caleb Fritz

Yeah, it really should. I think there's a tendency when the market has moved a lot and you've been in cash to worry that you've missed it, right? And to think about the fact that, does it make sense, you’re taking risks, what to go with. I think that's a common and understandable concern. The only good thing, maybe about a bifurcated and narrow market is that that's not always true, right? If you are thoughtful about how you deploy today, you can really go into areas that have been left behind and you're not taking as much risk to the things that we've been talking about today. To borrow the equity term, there's a margin of safety. And I think value is one area that I'd highlight as an area where, once again, it is really the antidote to what's been going on in the market and will provide diversification, we believe. We're pretty interested in value today for a lot of reasons. Som talked about how there's a tactical view, and we certainly believe that. But we also believe there's a better environment for value investors. It's been quite a tough time for anybody focused on valuation and particularly for value investors for many, many years—over a decade. But the world's changing. So we think there's actually a structural case to be made for value today in addition to the tactical one. And that structural case is really about those headwinds that value investors have been facing changing in ways that will kind of alleviate those headwinds and make value more competitive. And so that comes down to, I would say, at the end of the day, two things. First is that we expect that interest rates and inflation are likely to be higher over the next decade than they were over the past decade. It's really not a comment on what's going to happen in the near term here. This era of inflation, this period of inflation probably gets settled here. But there's just more inflationary pressures involved in the global economy that's going to make the Fed focus on that part of their mandate a little bit more. And those inflationary pressures, just to name a few, we think there is a structurally tight labor market. We think there's going to be upward pressure on service inflation because of that. We see the world as a more dangerous place. We're seeing more flare-ups globally. We've seen a lot of geopolitically motivated supply chain movements and more protectionism. So that's inflationary. And then more recently we've come around to the view that we think we're going to start seeing real commodity inflation. So, if you put all that together, there's just going to be upward pressure. The Fed's going to have to contend with inflation and that will mean we'll probably have a real yield curve. And if you think about why that's really important for value, I would say in two ways. First, it just helps a lot of the fundamentals, so companies in financials, in energy and materials, their fundamentals are really aided by the fact that inflation will be higher and that there's actually going to be a yield curve. So, fundamentals out of the value side, a lot of those areas are value-oriented areas. That's going to be a lot better, we think, than what they have been. And then the second has to do with valuation. This goes to bond math. If you just think about discount rates and cash flow, companies where the payoff is in the long term—so maybe you're waiting on years 10, 11—you're going to get your cash flow then, but there's not much cash flow in between. Those companies are worth a lot when the discount rate is really low. So, when rates are really low, speculative companies are much more richly valued. But the opposite is true when rates go up. When rates go up, those kinds of companies are going to be worth a lot less. And companies that are more short- to intermediate-term cash flow, shorter- or mid-term duration equities, which is really more in the value world, will probably be worth more in that kind of an environment. So valuation is probably going to be a more important consideration in that environment. If rates actually move up, there's a cost of capital. People have to care about valuation a lot more. So that's kind of the first leg to that structural view. The second one is about disruption. We've touched on this a little bit. One of the biggest issues for value investors has been that idea of stranded assets. You really can't count on mean reversion anymore. Companies that are undervalued may actually be properly valued because they've been impacted by a new technology, a company that's come in and really changed the way they operate, and it's been hard for them to compete. So our view on this is not that disruption is going to stop, right? It's going to continue. Innovation will continue to happen, but it's much better understood today. If you go back 10 years ago, I think some of these platform companies really caught the market by surprise. We didn't really understand how good they were going to be. They ended up being fantastic, and they really created a tough competitive environment for a lot of the incumbents. All of the incumbents in some of the key categories understand that they're kind of in an existential dilemma here. So they're going to respond, and they're going to have a chance to kind of compete there. We'll see if they're able to actually do that, but it just changes the calculus a little bit. It also is true that a lot of these big companies are more mature, and that means they're going to be more economically sensitive. So, all of that, we think, put it together, and the headwinds that value investors have faced for some time are changing and we should be able to be more competitive. That's kind of the structural case. The tactical one is something Som mentioned, it really comes down to a really favorable starting point for value in terms of valuation. And one of the things we can point to is that the growth premium to value is quite high. It's in the 91st percentile right now, and that's similar to some of the levels we saw the last time in this more recent period where we saw rotation back to value—September 20, November 21—we're at similar levels there. So it's a stretch valuation on one side, and this is important because if you go back 10 years ago, that growth premium to value was much more modest. So, there you could make the argument that 10 years ago, the market was really underestimating how good growth would be. You had real valuation support. It's harder to make that argument today. And so when we look at this situation, we really believe it's important to pay attention to these swings. We've had pretty violent rotations over the last few years between value and growth. We're in the middle of a really strong growth market. Given that some of this has gotten stretched, it probably makes sense to think about tactically where there might be opportunities to play capital. Value’s an area that I would point to.

Terry Davis

And just a quick follow up on that. So value’s outperformed growth. When was the last time?

Caleb Fritz

So this is something that I get some grief for internally, but I've been pointing out to everybody that the value/growth dynamic really bottomed, or the growth outperformance to value really peaked in September of 2020. So if you go back to that point and measure from that point to now, growth is underperforming value by 77 basis points, annualized, even with this nearly 40% move that growth has had over the last 14 months or so. So there is an argument to be made that this idea that value can be more competitive is already playing out. But it's been far more volatile than we would have expected. And so that's important for folks to consider. That it is going to be a pretty herky-jerky ride or maybe a roller coaster. And we're at the edge of one of these extremes. And it might be important to kind of lean the other way.

Terry Davis

OK. So we have talked about the market, what's going on there. We talked about why you might want to redeploy some cash. Let's get to the how to redeploy cash and where are the opportunities. So, start with Jeff. How would you reallocate money from cash to fixed income right now, and is there a timing element to it?

Jeff DeVack

I think timing investments is a tricky proposition anytime. Talk to the asset allocators about this, but I think if you look at this chart that we have on the screen here, I think it really emphasizes this point. And what we're looking at is the 12-month rolling returns of an index like the Bloomberg U.S. Aggregate Bond Index, which is representative of the broader high-quality bond market has about a six and a quarter year duration versus that of the Lipper Money Funds Index, which has basically no duration because it's adjusting very quickly to interest rates. And so we're looking at one-month rolling, 12-month look-backs over time, and we've looked at this against the fed funds rate as a proxy for the monetary policy cycle, which is the light blue line here. And what you can see is that, intuitively, the shorter-duration assets are going to outperform the longer-duration assets in periods where the Fed is hiking and rates are going up. Vice versa also true, and it's shown here in the chart. But I think what is lost on investors sometimes is the magnitude of the difference. And again, it goes back to convexity—everybody's favorite topic. But again, bond prices go up faster than they go down. And so if you look at the table at the bottom underneath this chart, you can see that the upside when you’re long duration and rates are falling exceeds that of being overweight short duration when rates are rising and it's a magnitude of about over one and a half times there. And so you want to be in that trade when it turns. But it's really hard to call the turn exactly. And I harken back to Som’s charts about being ahead of the turn in the monetary policy cycle and it pays to be a little bit early. It might be painful for a few months, but again that yield give up or that modest underperformance is the premium, the insurance premium you're paying to put duration into your portfolio and you're getting paid while you wait. Whereas two years ago it was not as much of an attractive proposition. So I think there's a lot going for the bond market right now and really arguing for stepping out of money market funds into longer-duration assets.

Terry Davis

Caleb, how do you balance the promise of AI with other opportunities?

Caleb Fritz

I think you have to look at both, Terry. I mean, we talked about trying to find underappreciated beneficiaries of AI. I think that's probably an appropriate place to look on that side of the ledger. But outside of that, I would highlight two areas that we think are pretty interesting right now, and it's financials and energy. And these are two sectors that really haven't participated much in the way the equity market’s been going over the last 12 to 14 months. And so there's a pretty interesting situation there. And I'll start with energy because it's probably where we have the most conviction. We have long believed at our firm that commodities go in secular cycles, they go in either secular bull cycles or secular bear cycles, and those cycles are really driven by productivity. And productivity is just simply what amount of whatever you're trying to get out of the ground you can get per unit of capital. When productivity is going up, there's usually downward pressure on the commodity price and you're in a secular bear market. If productivity is falling, that means you need to kind of incent new supply and everything is more expensive, and you probably have an upward-sloping cost curve for that commodity. And so we've been very concerned about shale for some time, both in natural gas and oil. I’ll go back to 2009, 2010 when we developed views that this was going to be a major supply response to the global market for oil. And that thesis really played out. We saw what happens when you have a lot of supply and highly productive supply, you can get a lot of oil out of the ground through shale. And so productivity was really good in that era and that kept the lid on prices and made it really hard to make money as an investor in the energy sector. We're starting to see the productivity gains of shale come to an end. We're believers that we're at the early stage of that, particularly in natural gas, and eventually it's going to happen in oil. And what that means is that everybody who services these molecules are going to be able to sell them for a much higher level. It's going to put inflationary, as I mentioned before, kind of inflationary pressures in the broader economy that maybe are underappreciated today, but it's really good for companies that sell these molecules, right? So what we're looking at right now is companies that have low-cost, long-dated inventory, so many years of inventory, are probably going to benefit from this because we'll be able to continue to supply these needed commodities at a higher price. So, in the natural gas space we like EQT, in oil we like ConocoPhillips. But the oil field services companies are probably going to really benefit from this as well, given that whenever there's inflation in the commodity, that means you have to pay more to your service providers. And so companies like Halliburton and Schlumberger, Baker Hughes, probably benefit over the next 10 years from that as well. So that's energy. Financials is similar. We've had a real scare in banks last year. It wasn't a lot of fun to go through that, but banks are an interesting thing to look at today, particularly because even though we've come a long way from October of last year, the valuations aren't quite as good as they were then. They're still pretty cheap historically, and the issues that have surfaced as a result of those bank failures have really been settled. Time has been a real friend to banks. And if we are in this environment where the economy is getting better, banks have been preparing for a recession for about a year, they've been reserving ahead of credit events that haven't happened yet.  So if we don't actually get those credit events, these banks will be able to probably release some of those reserves. And if rates fall at just a Goldilocks scenario, maybe 100, 150 basis points, that's really good for banks because it takes some of the pressure off deposit. There's been this kind of fight for deposits and trying to outpace your competitor on what you could pay in deposit rates. That takes some of the pressure off of banks to try and outpace their competitors, but it also helps their securities book. So it allows them to mark up their bonds that they own, be able to maybe roll some of those bonds into higher-yielding securities, and maybe improve net interest margins. So there's a lot of reason to like those areas that I mentioned, financials and banks, and when you think about the way the market has been valuing them, if you look at the contribution that they've been making to the S&P 500’s earnings, there's a really big mismatch between that contribution and the weight that they're getting. So if you look at the financials sector on this chart that we have here, right now it's giving about 19% of the earnings of the S&P 500. It's only about 13% of the actual weight. So it's a pretty big difference there. Energy is contributing just under 9% of earnings, but it's only about 3.7% of the weight. So if you're looking for areas where maybe there's a disconnect between what their actual fundamentals are and the way the markets are thinking about them, these are two areas that I'd highlight.

Terry Davis

And Som, the multi-asset person, is diversification still a good strategy?

Som Priestley

Yeah, absolutely. We believe diversification is still a good strategy, and we think of diversification in multiple layers within the portfolio. So we would say it would start with a well-diversified strategic asset allocation, so being diversified, all things equal, across the global opportunities set, taking advantage of that full opportunity set but also dispersing risk across the portfolio. And a good SAA discipline avoids that temptation to potentially chase returns or succumb to recency bias. And we have talked about tactical allocation. We'll tilt the portfolio, but we'll continue to have that North Star. Another area of diversification will happen at the implementation level. So we have a saying that every asset in our portfolio needs to earn its place. And to me that means it's not just assessing the investment individually, but also its interaction across the rest of the portfolio. So we talk about things like correlation, but it also means looking at conditional performance. So when one investment is underperforming, what are others doing in the portfolio? Thinking about risk more fundamentally, looking at factor analysis, exposures like that, to ensure that we aren't over-allocated or having unintended biases in the portfolio. So by being disciplined, by maintaining diversification, we feel as though an investor is able to more likely achieve durable excess returns across market cycles. So yes, the market narrative always shifts. The 60/40 has died, has come back to life. Large-cap growth will outperform forever. It's important to think forward and maintain, again, that kind of North Star.

Terry Davis

Thank you. And I'll give just briefly, every day we talked to advisors on our team. A lot of them have put cash not in the model. It's really outside the model and we've been encouraging them to either put it back into the model or take some steps. Jeff mentioned earlier, take some cash, move it into ultrashort or short-term bonds, core bonds would be kind of that next layer, core plus, high yield, floating rate, other areas. And then on the equity side, I think one of our CIOs had a great line, he’s like, “Invest where valuations are undemanding.” And I think value fits into that camp both in the U.S. and outside the U.S., we like both of those areas. In terms of…I'll just go to Caleb. Metals and mining, you were talking a little bit about commodities. You just want to talk a little bit about that area?

Caleb Fritz

Yeah, absolutely. So if we're right about the oil call, the energy call, if that ends up being correct, it has implications on a variety of different commodities. So a lot of the cost of getting commodities is tied up in how much it costs you to get diesel fuel, for example. And just take copper, for example, roughly 40% of the cost curve for copper is fuel, basically. So if we see inflation in oil, that's really going to pressure the commodities outside of oil. Metals and mining, I'd focus on copper specifically because, and this is really more our US Value Equity Strategy that is focused on this, and Ryan Hedrick who runs that portfolio, his view is that there's been a change in the way that copper miners think about things, and the price is not really enough to get them to increase production. We've seen price signal and we haven't actually seen a lot of increase in the actual capacity. So there's not a lot of new projects being greenlit right now. So we had a copper day last year where we talked to copper companies around the world and try to understand exactly why that is. This is not a commodity where we have to be worried about any secular pressures. Almost whatever scenario you think over the next 10 years, we're going to need more copper, right? If we are going to have an energy transition, we're going to need more copper. If we're going to have AI be a part of our lives, we need more copper. If we're going to electrify a lot of things, we need more copper. So copper, there's no secular concern, and yet we've seen not a lot of appetite to go out and find new supply. And based on those conversations, what we learned is that there's just a bigger hurdle. There's more concerns about environmental risk, which are justifiable, of course, there's more concerns about politics and permitting. And so it's just a much harder environment right now to get projects off the ground. That could be really a problem for copper as time goes on, if demand really ramps up and there's not a lot of supply there. So that's one area that we are interested in. Those stocks have moved a lot. So you have to be thoughtful about where you're deploying there. But if we're right about this call on commodities, it's going to bleed through to a lot of different parts of the market, something people should be thinking about. We haven't really had a lot of commodity inflation in some time.

Terry Davis

Again, similarly in financials, you've mentioned banks, insurance companies—do we like insurance companies?

Caleb Fritz

Yes, we do. And I think we like a lot of different kinds of insurance companies right now. I mean, life insurance companies have been down as much as regional banks and yet they don't have as much of a credit issue. I think the real problem there has been the fact that they hold a lot of commercial real estate, so that's a risk. We've we spent a lot of time looking at those companies, and we believe that risk is not that high. So we like life insurance, property and casualty we've been in for many years, and this is an area that's really benefited from price inflation already. And we've seen a lot of terrible, catastrophic events over the last several years in the P&C world, and that's chased a lot of capital out and that’s allowed companies to kind of push up pricing. And so they're benefiting from what we call a hard market cycle. More recently, though, we've been very interested in car insurance along the property casualty line, so looking at the personal lines. Unfortunately, after everybody kind of went back to work and went back to their lives in COVID, we saw a lot more car accidents. We saw the severity of those car accidents get worse. We saw more litigation. It was really hard to get used cars. Used car prices, parts I should say. So repair was much worse, so a lot more cars got junked, so the costs went up for insurers. They are responding on price. It takes a little bit longer for that to happen because there's more regulation around those price increases and some of that has played out already. But we think within financials, if you're not comfortable buying banks but you want to be able to take advantage of an improvement in that entire sector, I'd say parts of insurance are worth looking at.

Terry Davis

OK. And so, 2024. Presidential election year. We had our own primary caucus here, and Caleb, you were elected kind of the spokesperson for how the presidential election will impact markets.

Caleb Fritz

It's really early, Terry, and I'd say looks like we're going to get a rematch from the last time, and I think in some ways that's probably an outcome that's favorable to the markets. In other words, if Biden wins, it's a lot of status quo. So we kind of know what to expect from that. You know, Trump is a volatile person in general, just apolitically speaking, but we probably kind of know what to expect from that. And so it is a rare case where we have a former president running against an incumbent. I think there's a little bit more visibility as a result of that than maybe there is otherwise. When we look through the things we've talked about today—banks, banks are under pressure from potentially higher regulation, although we've seen some movement recently where the initial calls for higher capital from Basel III are likely to be watered down a little bit even in the Biden administration. So you get Biden you probably see the status quo and it's probably OK. Whereas if Trump comes in, you probably see a little bit of an easing in some of the regulatory pressures on banks. So that's probably a scenario where banks can maybe react to that. In energy we've seen some, again justified, reluctance to have continued proliferation of liquefied natural gas and so maybe some of the regulation that’s been hurting the energy industry might be eased under a Trump administration. But again, I think the overall sense right now is that there's probably not a lot of change that's going to happen from either outcome and we have maybe a little bit better visibility than we typically do.

Terry Davis

Well that about wraps up today’s portfolio construction webinar, “Is Now the Time to Redeploy Cash?” We also encourage you to fill out our short survey, as your feedback is important to us for future webinars. It’s been a great discussion, and I want to thank our panelists for joining us. Thank you, Jeff, Caleb, and Som. I would also like to thank you for joining us today. Please click the Upcoming Webinars link beneath your video player to register for other T. Rowe Price-hosted webinars coming soon. Thank you.

Definitions

GLP 1: Glucagon-like peptide 1, a class of drugs that may lead to weight loss and improved blood sugar control.

GARP: Growth at a reasonable price.

SAA: Strategic asset allocation.

Investment Risks

All investments involve risk, including possible loss of principal.

International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. These risks are generally greater for investments in emerging markets.

Value and growth investing styles may fall out of favor, which may result in periods of underperformance.

Investments concentrating in a specific sector can be more volatile than investments in a broader range of industries.

Small-cap stocks are generally more volatile than stocks of large, well established companies.

Fixed income investing includes interest rate risk and credit risk. When interest rates rise, bond values generally fall. Investments in high yield bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt.

Investments in bank loans may at times become difficult to value and highly illiquid; they are subject to credit risk, such as nonpayment of principal or interest, and risks of bankruptcy and insolvency.

Alternative investments are speculative investments that typically involve aggressive investment strategies. In addition, alternative investments may be illiquid, difficult to value, and not subject to the same regulatory requirements as traditional investments. These factors may increase an investment’s liquidity risks and risk of loss.

Diversification cannot assure a profit or protect against loss in a declining market.

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