Where Should Investors Look Next Among Economic Mixed Messages?

Kunal Kapoor: Good morning, everybody, and I hope you’re all having a lovely summer. I’m excited to welcome you to our latest episode here on this Investor First series. And I have to tell you, as an investor myself, as an ex-analyst, I love nothing more than to spend time talking about the markets. And we’ve got three great panelists today from Morningstar to help me unpack what’s happened in the first half of the year and, more importantly, what it might portend for the future. And so we’re going to get right into it as usual. I’ll have some questions and then we’ll have questions that you’re submitting as well over LinkedIn. And we can kind of make our way through that.

So, rather than me spend time here introducing each of our panelists, hopefully you’ve seen their bios already, what I’m going to do is I’m going to ask each of them to jump right in with a quick introduction, but to do that by also talking about their top conviction heading into the second half of 2025. And Preston, let’s start with you. And we’ll go from there.

Preston Caldwell: Thank you, Kunal. Everyone, thanks for joining today. I’m Preston Caldwell. I lead our US economics research. And I just want to give an overview of our economic forecasts for the US. So on GDP, we are expecting a mild slowdown in GDP growth over the next two years, about a percentage point and a half slower over the next two years, 2025 and 26, than the prior two years. And tariffs are partly to blame for this, but actually, we had been expecting somewhat of a slowdown before the tariff surge in April. And that’s principally because it looked like consumers were getting overstretched, with a household savings rate below the prepandemic level. And so we’ve been expecting consumers to start to pull back, which we’ve been seeing actually in recent months’ data.

Then, in the back half of our forecast, in over 2027-29, we expect GDP growth to reaccelerate as some of the tariff impact fades and we get a bit looser monetary policy. On inflation, we were very close to getting back to the Fed’s 2% target, but I do think tariffs will ultimately cause prices to shift upwards, with the inflation impact peaking in 2026. But with the deceleration in GDP growth that we expect, that will create a bit of slack in the economy. I think that will push inflation back down ultimately.

Kapoor: Philip, what about you?

Philip Straehl: Yes. Hello, everybody. My name is Philip Straehl. I’m the chief investment officer for the Americas for Morningstar Wealth. I lead our investment team here in the Americas. And so, from my standpoint, if we think about moving forward in terms of what we’re expecting, we do think that the best opportunities lie outside of the market consensus. We’ve seen a bit of a recovery, particularly in some of the technology stocks. US stocks are trading at an all-time high. And so, from my perspective, one of the key opportunities still lie outside of the United States.

And if we go to the slide briefly showing the US relativities and some of the outperformance that we’ve seen over the past decade in the United States, we can kind of see what has driven the US outperformance over the past 10 years. That was really driven by some transitory factors. So, namely, the change in valuation, as we can see in this slide, 3.8% of the outperformance of US stocks over the past decade came from a change in valuation, which is shown in the purple line. We think that some of those trends will reverse over the next 10 years.

Kapoor: Great. And Toby, what about you?

Toby Moerschen: Yeah. Hi, Kunal. Hi, everyone. I’m Toby Moerschen. I’m the managing director of the private corporate credit group within Morningstar DBRS, which is Morningstar’s credit rating agency. So my group analyzes default risk specifically for so-called middle market companies. Those are smaller, almost all private equity-owned companies that borrow in the private credit market. We’ve seen quite a lot of growth.

So my prediction, conviction, is that we will see a gradual further rise in defaults of those middle market companies all the way through 2024, actually coming out of covid. We’ve seen extremely low defaults, which was largely because of the stimulus, the monetary easing we’ve seen during covid, and very robust US economic growth we saw coming out of that. It was really hard, even for these middle market companies who have high debt burdens. It’s really hard for them actually to default in that environment. That has certainly changed. We have seen through ’24 and so far this year, a gradual increase in companies that cannot meet their obligations fully. I do expect that to continue. But I would also say it continues to be gradual. It continues to be company by company, rather than any sort of systemic, across the board kind of systemic shocks. I don’t really see that currently, and I don’t expect that going forward.

Kapoor: So I sense some caution in the comments that all three of you are making, which is somewhat at odds with what you sort of see in the markets today, where it feels a little bit like people are pushing on risk a little bit more. But Philip, here at Morningstar, we try to assign fair values to individual companies, and then we roll those up to look at markets. And so if we were to roll up our fair values here in the US and tie it back to your comments around maybe the US being less attractive than international markets, can you help investors think about how to look at the US market through the lens of our fair values today?

Straehl: Sure. So if we do that sort of bottom-up analysis, as of midyear, the US market traded about a 2% premium to its intrinsic value. And so we do think that the US market, on a bottom-up basis, looks a little bit expensive. And so, if we contrast that to where we were at the height of the selloff in April, the US market traded at about a 17% discount to the intrinsic value. And so we kind of came full circle. We were about fairly valued at the beginning of the year, then the market dropped, at some point the US market was in a bear market, it dropped 20%. And so we’ve now kind of recovered and are now looking a little bit expensive on a bottom-up basis.

Kapoor: Great, that makes a lot of sense. Earlier on, Preston, you had made some comments potentially about maybe the consumer appearing weaker than what appears to be the case today. You’re sort of talking potentially about growth slowing, how do you compare that relative to what you’re seeing in the markets today? Because those concerns are well known, yet the market seems to shrug them off. And so what’s going to be different in your mind?

Caldwell: Yeah, I mean, I would say a mild GDP slowdown doesn’t necessarily have to translate into a big market selloff. Historically, we’ve had very large selloffs in environments where the economy does not weaken very much, which was the 2001 recession, for example. But we’ve also had vice versa, where we’ve had a textbook recession and markets don’t sell off that much. So here, we’re just calling for a deceleration in GDP growth. And so I wouldn’t necessarily expect to see this surge in risk premia that you do in a typical recession. Which is the main component that actually drives markets to sell off to an extreme degree because, from a valuation perspective, you wouldn’t expect just a transient deceleration in cash flows to drive equities to sell off necessarily. So I don’t think there’s necessarily any discrepancy there, but I do think the story that I mentioned is a little underappreciated because consumers have been spending at a high rate for so long that many are taking this for granted. But I think they’re kind of reaching a breaking point finally.

Kapoor: So what I’m hearing from you is it’s an underappreciated story and so, potentially, future returns could be more impacted than people are perhaps pricing in today.

Caldwell: Possibly, but I think it’s more important for our expectations of monetary policy, rather than its impact on equity prices.

Kapoor: Understood. OK. That’s good. Toby, you talked potentially about some marginal changes that might happen gradually, I think, is the terminology that you use. So what’s one economic or market indicator that you’re paying particularly close attention to? And what’s one you think is being overhyped?

Moerschen: Yeah, I would just go down to basics and say leverage. So, leverage, as we measure it, is the debt of a company relative to its EBITDA or its earnings before interest, taxes, depreciation, amortization. So, essentially their ability to generate cash to pay debt. Obviously, the more debt you have, the harder it is for you to pay that debt when things go wrong. But people seem to, there’s always a story. The counterpoint that what I consider sometimes a bit overhyped is growth. So we see a lot of growth in the companies that were asked to analyze, but usually that growth comes with growth in debt as well. So when you just buy your growth through debt-funded acquisitions, then it doesn’t actually improve your ability to pay your debt. So I think those are the two. The one that I think matters more is actually leverage. The one that is sometimes overvalued is growth.

Kapoor: OK. Not a surprising answer from a credit analyst, but a good one, for sure. Philip, So you’re building portfolios and thinking about it at a granular level, taking all that input. And so, if you’re building portfolios today and imagining what might work best for the future, what would you tell our audience they should be thinking about most if they’re thinking about repositioning their portfolios from this point on?

Straehl: The two I kind of talked a little bit about the biggest opportunities being outside of the market consensus, and the two ones I would mention on the equity side, I’d mentioned international stocks. And I might just show quickly a slide here, that just kind of shows our expectations for the next 10 years in terms of U.S. dollar returns for both emerging market, international development, U.S. stocks. And you can see that we expect continued outperformance of non-US stocks, particularly in emerging markets, over the next 10 years. And so that’s one of the areas we’re leaning into. We think US stocks had a phenomenal run. I mentioned the 13.6 performance over the decade to the end of 2024 earlier, which is really much better actually, even than the 100-year average that we see in the US, which was stellar to begin with. So we see opportunities in non-US stocks.

And the second opportunity I would call out is the opportunity that happens further down the market-cap spectrum. We can see that both when we roll up the same analysis we did earlier that we commented on, and where we saw that large-cap stocks traded at about a 2% premium to intrinsic value. If you go further down the market-cap spectrum and look at the style box components, we can see that small-cap stocks are actually trading at a discount and in this analysis here are poised to outperform the large-cap stocks.

Kapoor: OK. So one of our listeners, Theresa, is asking a question that I think you’ve partially answered, in terms of international outshining domestic and maybe being a good bet looking forward.

But the second half of her question, I think, is pertinent, too, which is, how do you really get comfortable with the idea that this is not a short-term trend? Because it does feel like we’ve been hearing the international versus US, as well as the small-cap versus large-cap argument for a few years now, right? And so some investors are skeptical that that trend will reverse. And maybe that’s what it takes. But I’m curious, and I think Theresa’s curious, how do you ensure that this is not a short-term thing when you’re building a portfolio?

Straehl: Yeah, I think on the international front, we have started seeing some positive momentum on, let’s say, the fiscal stimulus side internationally. So in Germany, in particular, more of a stance toward spending more to help promote growth in Germany, for example, or in Europe, in particular. And then the second part of that is the dollar weakness that we’ve seen over the first six months of this year. We think that looking at our long-term currency models, we think that there’s opportunity for the dollar to continue to weaken over the next, for years to come. And some of that is just because we have seen now catalysts where non-US investors are starting to think about how much US dollar exposure they might have in the portfolio.

Kapoor: Right. That’s good. Toby, so we’re spending time here talking about equities, but if we were to shift over to the credit markets in particular, I’m curious, when you look at credit markets, what role can credit ratings today play in helping investors navigate the current market and the volatility, and particularly as they think about potential credit tightening in the future, which you sort of alluded to earlier?

Moerschen: Yeah, Kunal. First maybe answering this for my group, and then maybe we can think a little more broadly. My group primarily provides private credit ratings to those that request it. So those are unfortunately not publicly available. But why do people ask us to analyze and rate the credit risk of middle-market companies and middle-market loans? Mostly, really, two reasons.

Kapoor: And Toby, “middle market,” just maybe for everybody, when you talk about the “middle market,” you’re referencing...

Moerschen: Yeah, so that would be smaller companies. Almost all private equity owned, so almost all reasonably high debt burdens. And when I say small, in terms of EBITDA or operating earnings, up to 100 million, usually below that. Sometimes there’s exceptions to that, but that’s kind of the size, that’s kind of the market segment. These companies are generally too small and too highly levered, and therefore risky to borrow in the public market. They’re also generally not necessarily going to find funding in the broadly syndicated loan market. So they go to large direct lenders and access financing from that private credit market.

So that’s the group we’re talking about. In terms of default risk, in our language, we would say almost all of them fall in the single B category or the triple C category. So that’s deep non-investment-grade. You would expect a significant portion of these to default. And again, historically, what we’ve seen is actually that defaults have been lower, although we currently see that changing.

Why do people request those ratings from us? It’s because it’s essentially an outside, independent view on the loans that somebody is investing in. And you could, for example, if you are a large institutional investor, you might say, OK, I’m happy to place funds in this private credit market with this asset manager, but I don’t want just to rely on the asset manager. I want an outside, independent opinion on each of those loans. You could put that into your investment guidelines or your risk-management guidelines. That’s one reason why we add value.

The other one is there’s also a regulatory value. So, we are a licensed rating organization in the United States, in Canada, in Europe, and various other jurisdictions. And when insurance regulators in the US, for example, look at US insurance companies’ capital, they will take our ratings into account. And so a US insurance company can use our ratings to manage their regulatory capital requirements.

Kapoor: Great. One of the questions, Philip, that’s come in is you’re talking about US equities. And given some of the comments that have been made by Toby and others on bonds, how do you think about the attractiveness of US bonds compared to US stocks? And when you’re building a portfolio, what’s the trade-off today between asset classes?

Straehl: Yeah. So from our perspective, we’re roughly kind of neutral on the stock/bonds split. And one of the reasons why we still think that there’s value to fixed income, despite some of the headlines we’ve seen around higher default risk with the Moody’s ratings, for example, being downgraded, is because yield levels are higher today than they were a few years ago. So real yields today on the US 10-year are around 2%. If you think about where real yields were going into the 2022 bond market selloff, real yields at the time were negative 1%. So we think that there’s just more diversification potential still within fixed income.

We’re cautious on credit. Toby mentioned some of the increased defaults in the areas that he’s covering. And so we do think that both investment-grade and high-yield credit are not particularly attractively valued. So we’re underweight those areas, and we emphasize Treasury bonds in our portfolio today.

Kapoor: Got it. Great. And Preston, a couple of questions here for you as well that are coming in. Where do you think the 10-year Treasury ends 2025? And also, can you talk a little bit about the US municipal-bond market and why it’s maybe underperforming the broader aggregate index this year? It seems that the muni yield curve is steepening, much more so than the Treasury yield curve. And so what’s driving that?

Caldwell: I’m going to speak on a bit longer-term perspective with regard to interest rates, because that’s really our focus. That is to say that in terms of our interest rate forecast, we’re still expecting quite a bit of reduction in rates owing to monetary policy, even toward the longer end of the curve. The 10-year is mentioned in the question. And so, of course, the market is baking in some degree of rate cuts, but we’re expecting even more, a full 200 basis points in Fed-funds rate cuts, the short-term interest rate over the next two and a half years. That will take us to a year-end 2027 federal-funds rate of 2.25% to 2.50% target range. And then I think that will drive the 10-year Treasury yield down from an average of 4.3% this year to 3.25% on average by 2028.

So that’s a long-term expectation. And in the shorter run, there’s a lot of uncertainty as far as the path. I think rates could move higher before they move lower. But one reason why I think they have to move lower is what we’re seeing in housing. I think homebuyers are finally losing patience in this story. That they can just continue to buy homes at extremely high mortgage rates and refinance a few years down the line. Because it’s been several years of high rates, and that refinance story is starting to lose credibility. So I think at some point, rates actually do have to fall.

Kapoor: OK. What about the muni market? Any comments or thoughts on muni market?

Caldwell: Yeah, I’m going to pass on that one. I don’t have a great story there.

Kapoor: OK. Sounds good. So as we approach the end here, I want to make sure I also ask you: What’s a contrarian view that each of you holds today that you think will play out over time?

Moerschen: Can I go?

Kapoor: Yeah, please.

Moerschen: OK. So I don’t know if it’s a contrarian view, actually, but there is certainly the question that you haven’t asked so far, but I get from many people is like, is this whole private credit thing a bubble, right? Is this going to burst? And then is it going to have all kinds of effects on other markets? And my usual disclaimer, like, I’m focusing on fundamentals of the companies that we look at, but obviously you get a feeling. For that, I don’t think, or from what I can see, I have no reason to believe that we’re sort of going to go over some kind of cliff. I’ll say that you have seen massive growth, both in terms of the size of this market and the number of companies that borrow from the lower end or the riskier end of the private credit market that my group covers.

However, it still feels healthy in that, you see transactions, you see underwriting. The new deals that we rate are relatively stable in that single B range. They’re carefully underwritten to the current level of interest rates. And I would also say there’s an alignment of incentives. So the private equity owners, they will lose control if a company defaults, right? Because the legal documentation is pretty tight. The private credit lenders, they have the ability to take these companies over essentially overnight if something goes wrong, and they do do that. So there’s a really strong incentive on the private equity owner to not allow that to happen.

The private credit lender doesn’t want to see defaults because they don’t want to have to report to their end investors that the loan went bad. And in all of these situations where we see things go wrong, the company management is usually changed. So the company management has a really strong incentive to somehow come up with the cash to pay those loans. Again, we do see deterioration, but it’s company-specific. And as long as we have this sort of strong alignment of interest between the players here, I think that leaves me, again, cautiously, well, expecting some deterioration, but I don’t see the bubble argument.

Kapoor: Yeah. That’s a good one. What about you, Preston?

Caldwell: I would just reiterate my views on interest rates falling. You don’t hear that as much these days. And even though, just going to back to what Toby has talked about, even though he’s not expecting a bubble popping, the fact that he’s expecting default, or he’s describing default rates, which are just now about to crest after over two years after we hit peak interest rates, a peak monetary tightening, to me, is emblematic of how many of the effects of high interest rates are delayed. And so, just because it’s been several years now of high interest rates does not mean that the effects have fully filtered into the economy. And so I think there would be further ill effects if rates were to remain high, that rates or interest rates are higher than their prepandemic levels substantially. And that’s further backing to my argument that rates will have to fall.

Kapoor: Great. And Philip, I’ll give you the final word.

Straehl: Yeah, I would say the AI trade, just some caution there. And I’ll kind of make two points. One of them is just the range of outcomes and the uncertainty. And so, for example, our analyst for Nvidia assigns a high uncertainty rating to Nvidia NVDA, despite the fact that the stock is rated at 3 stars. And so it’s a new technology. We still don’t know exactly how it will impact companies and supply chains, who’s going to be the winner.

And then the second thing I’ll say about the AI trade is that a lot of the companies that are big players, the Big Tech companies, the Googles GOOGL, the Metas META, the Amazons AMZN of the world, they have invested significantly in that segment. And as a result of that, the capital intensity of these businesses has significantly increased relative to the capital light model that they had just a few years ago. That’s an area to watch and perhaps a bit of a contrarian view.

Kapoor: That’s great. Thank you all for joining. This has been a terrific conversation and I think a good way to check in on how things are going. For all of you who have been watching, obviously markets are always changing. It’s a constant. But what we’d say, and I think hopefully what you took away from our panelists today, is to stay focused on things you control, like your goals, your time horizon. And how you respond to headlines. I thought Philip’s point that in April, our fair value market indicator was showing a 17% discount, and today it’s showing a 2% premium, kind of talks about how markets can swing and how you need to just stay focused on those long-term outcomes.

So thank you for joining us today, and if you’d like some of the slides that we put up, make sure you take a look at what we have in our tab here. So we’ve got the attachments linked in there. In case you’d like to have any of these tabs. But thanks to my panelists for joining, and thanks, everybody, for being here. And I will be back next month with a special guest. So look forward to seeing you soon. Bye. Thank you.