Strategy and Outlook for 3rd Quarter 2024
Strong first half, mounting adversity
Broadly speaking, equities and risk-oriented investment asset classes more generally have performed well during the first six months of 2024. Although we entered 2024 with an optimistic outlook, we can’t help but be a bit surprised by how well equities have performed in the face of mounting adversity. Interest rate volatility, hawkish Fed talk, political uncertainty domestically and abroad as well as escalating conflict in the Middle East have all been brushed aside as many major equity indexes march to new highs.
The catalyst for these gains has been strong earnings growth, largely from a handful of megacap technology companies, that have exceeded lofty expectations. That said, it’s important to recognize that this is still a narrow market, meaning that index returns are being skewed by the outsized performance contribution of a small cohort of very large, technology-based businesses. Looking forward to the second half of 2024, all eyes will be on inflation. If those “sticky” inflation numbers experienced in the spring weaken sometime late summer or early fall, we would expect the Fed to follow-through on their projected rate cuts before year-end. Should this occur, then currently out-of-favor segments of the public markets should see momentum in attracting additional investor capital. If not, then it will be more difficult for equities to advance much beyond current levels.
While stagflation, a situation in which the inflation rate stays high and economic growth slows, is not our base case, it cannot be completely ruled out as we are already seeing signs of economic slowing. For example, the unemployment rate has risen three months in a row and payroll growth has slowed.
Equity Markets
The rally in equities has elevated investor optimism and bullish positioning. This is a contrarian condition, and one that suggests a short-term pause may be in order so markets can digest their recent gains. The Fed's delayed rate cuts and some softening in economic data adds to the near-term uncertainty. We’ve made a concerted move towards more active management in recent months to provide flexibility in navigating potential market fluctuations. In our public market portfolios, we continue to hold an overweight in equities, relative to fixed income, with healthy exposure in U.S. large capitalization and “growth” equities. However, as the economic outlook remains uncertain, we are prioritizing diversification. We don’t anticipate a recession in 2024, but rather a steady slowing as excess consumer savings continue to dwindle. We expect the impact of the artificial intelligence (AI) renaissance on corporate capital expenditure spending and economic productivity to be a secular investment theme, in other words, a long-term structural tailwind. It is our view that rate cuts are coming, but this could be tempered by tremendous debt issuance. Once the rate cutting cycle begins, we look for the performance of real estate, financials, and highly levered growth stocks to improve.
Fixed Income
Rising interest rates have translated to lower existing bond prices. In fact, the core public market bond index, the Bloomberg U.S. Aggregate Bond Index, has provided a slightly negative return over the past five years. Given uncertainty around the U.S. elections, inflation, monetary policy, deficits, and economic growth, we don’t see interest rate volatility abating anytime soon. Given such uncertainties, it is interesting that credit spreads (as a measure of getting paid for incremental risk) remain near historic lows. The long-term prospects for public fixed income are more attractive than they’ve been in the last several years, but we remain underweight due to opportunities we see in both equities and alternatives. Fixed income remains a vital portfolio diversifier and hedge against equity downturns, but being highly selective and flexible in this space is paramount.
Alternatives
In our opinion, select alternative and private strategies offer some of the most compelling risk-adjusted reward opportunities available across the investment continuum at this point in the cycle. Many of these strategies can capitalize on the financial stress and dislocations that cause volatility in public markets. In general, we have a high level of confidence in strategies such as direct lending, distressed debt, real estate debt and private equity secondaries. Manager selection here is key as not all strategies are created equal. We will continue to emphasize alternative and private strategies where appropriate.
Interest Rate Expectations
As mentioned earlier, anticipated rate cuts from the Fed were placed on hold due to a round of higher-than-expected inflation data. The Fed is now data-dependent, with the consensus expecting one to two rate cuts in the second half of 2024. Our view is consistent with consensus, as year-over-year inflation stabilizes. The yield curve is, and has been, highly inverted for an extended period, and this is not sustainable. Over time, the curve is most likely to normalize as rates on the front-end come down.
Conclusion
Following a strong first half, our current market outlook for the remainder of 2024 is now more balanced. Market headwinds that we’ve addressed remain intact, and significant moves higher while they remain unresolved would prove difficult. We hold a strategic focus on diversification and are consistently assessing tactical opportunities to help navigate potential near-term volatility. The high yields in select segments of fixed income are compelling and the valuation gap between market laggards and current market leadership is increasingly of interest to us. The current investment environment requires thoughtful implementation as potential outcomes should widen. As always, our primary focus is on risk mitigation where possible.
If you have any questions or want to set up a more in-depth conversation, please don’t hesitate to reach out to your client advisor.
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