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Jurrien Timmer, director of global macro at Fidelity Investments, sees himself as a storyteller, connecting the dots between history and current economic trends to get a sense of where markets are headed. Although stocks are much cheaper today than they were a year ago, he worries that U.S. investors are still too sanguine about the outlook for the economy and corporate profits. In other words, they’ve bought into a just-right, or Goldilocks, scenario that seems unlikely to play out.

Timmer joined Fidelity in 1995 as a technical research analyst, and now is part of the firm’s global allocation team that oversees $586 billion. He expects non-U.S. stocks to outperform this year, and bonds to reward investors as inflation and interest rates return to more normalized levels.

Timmer recently spoke with Barron’s by phone about the challenges and opportunities that lie ahead for investors, and why the next 10 years won’t resemble the zero-interest-rate era just past. An edited version of the conversation follows.

Barron’s: Is the U.S. economy headed for a soft landing or a recession?

Jurrien Timmer: The recession call would seem obvious here, with the Treasury yield curve the most inverted in 40 years, and the Federal Reserve intending to take interest rates above 5%. Every time the Fed has gone that far into the restrictive zone—two to three percentage points above a neutral rate at which the economy is theoretically in balance—we’ve had a recession. The valuation of the S&P 500SPX –1.04% , as measured by the price/earnings multiple, declined by 31% last year. The question is, how much is priced in?

What is confusing the picture is that, as the U.S. is possibly going into a recession, China is finally coming out of its Covid lockdown. Three years of pent-up consumer-spending demand is being unleashed. China isn’t going to be able to prevent a U.S. recession, but it could prevent an earnings recession because a big chunk of S&P 500 revenue and earnings comes from abroad.

What does that mean for U.S. stocks?

The market is still pricing in too much of a Goldilocks outcome, given that the S&P 500 is trading for 18 times forward earnings. Also, consensus earnings estimates are flat for this year but show 10% growth for 2024. The market is anticipating a quick rebound in earnings. Investors are expecting the Fed to take rates up to 5%-ish but keep them there for only a New York minute, before pivoting to cut rates to less than 3%.

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We would need inflation to fall off a cliff for that to happen. The October 2022 low in stocks might well be a bottom, but it is hard for me to see the catalyst for a new bull market. To go from a 5% to 2.75% federal-funds rate in a year would also require a recession. The Fed has been explaining that it isn’t going to cut rates that fast because inflation, although moderating, isn’t likely to go back to 2%. For the inflation rate to average 2% over the next five years, it would need to fall below that and rise again.

Non-U.S. stocks are doing better than U.S. shares this year. Will that outperformance to continue?

Yes. Part of the outperformance so far has been because the dollar is falling in value, and partly, big earnings declines have already occurred in emerging and foreign markets. Relative valuation is compelling, but big performance moments are driven by relative earnings. The relative-earnings picture is improving [for foreign stocks], with China scraping off of a deep bottom while the U.S. is coming off a top. Corporate earnings growth in the U.S. was 50% in 2021. It was down to zero in 2022 and is probably contracting this year, while China and emerging markets are seeing the opposite.

What else does the rest of the world have going for it?

The past eight to 10 years have been about megacap stocks. Because the S&P 500 is laden with these big growth companies, that has led to outperformance for the U.S. versus the rest of the world.

When I look at a chart of the top 50 stocks relative to the bottom 450 stocks, I see a couple of waves: the original Nifty 50 stocks of the early 1970s, the market during the dot-com period, and a similar wave from 2014 to 2022. It looks like that wave has ended, partly because of the interest-rate reset by the Fed.

So, what comes next?

If the low-interest-rate era has ended, it may well mean that the secular trend has changed from the megacap growth stocks, which dominated from 2014 to 2021, to “everything else”—such as value stocks, small-caps, commodities, and international equities. This also happened during the original Nifty 50 era of the early 1970s, and again during the tech boom of the late 1990s.

There are market cycles of four to five years, but also secular trends or supercycles spanning decades. We have been due for growth stocks to pass the baton to the rest of the market [after a growth supercycle].

What does this mean for future returns?

The bull market was driven by low interest rates, lower taxes, companies earning a lot of free cash flow, and returning the excess to shareholders.

Since the financial crisis, initial public offerings and secondary offerings for S&P 500 companies have raised a combined $2.5 trillion, compared with $20 trillion spent on share buybacks and mergers and acquisitions.

People don’t appreciate how much buybacks and financial engineering contributed to the S&P 500’s outsize return. If companies are going to buy back fewer shares, that would lower the share of earnings returned to shareholders, which suggests a lower valuation.

That goes back to the narrative of outperformance for non-U.S. stocks. One reason the U.S. has collected such a premium [relative to foreign markets] is because more of its earnings were paid out to investors via buybacks and dividends. [As this trend wanes], we could see a leveling of the playing field for non-U.S. stocks.

What is the outlook for bonds after last year’s losses?

Over the past 150 years, periods of above-average inflation produced a positive correlation between stocks and bonds. That correlation was deeply negative during the past decade or more, but has now flipped to zero. Historically, when the 10-year inflation rate is above average, or 3%, this correlation has been positive. We are still at the average inflation rate, based on the 10-year annualized change in the consumer price index, so the jury is out as to whether the correlation will continue to be positive.

What parts of the bond market are attractive?

If you don’t think inflation is going to go all the way back to 2%, then the TIPS [Treasury inflation-protected securities] market offers value at these levels. Corporate bonds do, as well. High-yield corporate spreads have remained stable at around 450 basis points [4.5 percentage points above Treasury yields]. This appears to confirm the soft-landing narrative, but could also be the result of corporate issuers having “termed out,” or swapped short-term for long-term debt when interest rates were low.

What role does deglobalization play in your inflation outlook?

Deglobalization would suggest the run rate for inflation is going to be higher. The U.S. is about 10 to 15 years behind Japan in terms of demographic trends, such as the shrinking of the labor force. For Japan, that shrinkage has been deflationary, but that was during an era when the supply of available labor was rapidly expanding, with Eastern Europe [joining the global economy] during the 1990s and China since the 2000s. That labor arbitrage seems to have mostly played out, which suggests any further slowing in the labor force may be more inflationary than what was experienced in Japan.

Population is peaking in China, Japan, the U.S., and Europe, but it is less likely to be deflationary than in the past. Plus, geopolitical tensions that cause deglobalization would suggest that inflation’s run rate will be higher as countries reshore or bring supply chains closer to home. That requires infrastructure and capital expenses, not to mention labor. It could lead to resource scarcity, which is inflationary. That’s the opposite dynamic of the offshoring era that started when China joined the World Trade Organization in the early 2000s.

Also, during Covid, two to three million baby boomers retired. That, coupled with a more stringent immigration policy, means we have a labor shortage. The resultant inflation is what the Fed is trying to fight. The Fed is willing to induce a recession in the near term to preserve price stability.

How will this fight play out?

The risk is that inflation will come down, but not enough for the Fed’s liking, or not enough to prevent inflation from accelerating from a higher base in the next economic expansion. That’s what happened in the late 1960s and early ’70s. Inflation never got below its five-year trend; there was a series of higher lows.

If inflation is higher, how should investors think about diversification?

A 60% equities/40% bond portfolio produced an average annual return of 9% between 1950 and 2022. In the past 10 years, the S&P 500 and [the Bloomberg US Aggregate Bond Index] were all you needed. If you bought international stocks, they added to volatility and took away return. There was no reason to be an active investor. There is every reason to be an active investor for the next five or 10 years. That’s where the game is going to be.

What will market cycles look like in coming years?

During the Great Moderation from the late 1990s until more recently, we had a period of low interest rates, low inflation, low volatility. The cycle was smoothed out because of globalization, and inflation was tamed.

The cycle will return toward more of a typical four-year business cycle. The Fed is going to play a bigger role more often than in the past. [The market] will be more volatile than what investors are used to, and that speaks to the need to be more diversified.

What stands out in your charts?

We have had a huge reset—with the S&P 500 P/E going from 30 to 18—that has brought value to all corners of the market. For the millennial or the Gen Z investor just starting a 401(k), it’s a tremendous opportunity. For retirees in the withdrawal stage, 2022 was a perfect storm for the 60/40 portfolio, with a bear market and bond-market losses. The good news is that it came after many years of outsize returns.

True enough. Thanks, Jurrien.