Matt Bartolini: We're now three months into 2024 and the markets have behaved quite well. Both stocks and bonds are up and volatility has been actually quite significantly low and well below historical averages. But that doesn't mean that risks are not on the horizon and that we haven't had to deal with some trepidation.
So, Mike, as we look forward to the next nine months of the year, and what is going on so far, what's that macro backdrop? What are some things that investors need to think about as this rally perhaps progresses or maybe regresses a little bit in the back half of 2024?
Mike Arone: So, Matt, I think the soft landing outcome remains the most probable. So the economy continues to expand, albeit at a slower pace compared to the third quarter of last year. The labor market remains strong, inflation’s cooling, earnings are growing, profit margins are high, and the consumer who's gainfully employed is spending like crazy. So this is really resulted in a very attractive backdrop for risk assets, building off of last year into this year.
But now, given the fact that most global markets, including the U.S., are either at or near all-time highs and valuations are above historical norms, I think the risks are skewed to the downside.
So I'll highlight three risks that I think investors should consider over the next few quarters as they think about their investment portfolio. So the first is certainly this idea that earnings growth for this year for S&P 500 companies is expected to be 11%, and that’s expected to accelerate in 2025 to 13%.*
So should companies not meet those lofty expectations, particularly at these valuation levels, I think that poses a risk to the market. The second is, we know that the Fed has been reluctant to cut interest rates. And so the target Fed funds rate remains above inflation. It's cooling the economy. There is a risk that the Fed stays too restrictive for too long, ultimately causing a recession.
Now, I don't believe that this is the most likely case, but if the risk is out there, there is a probability that that could happen. And kind of going hand in glove, is finally inflation. So, as we know, inflation has remained stickier than anticipated. So inflation we've made considerable progress from peak levels. But there's still imbalances in the labor market. The housing market, well, something I know is a bit near and dear to your heart.
We're trying to make this transition from fossil fuels to something else over the next few decades. It's proven a little bit more inflationary, with geopolitical risks and certainly deglobalization. So I think those three items all pose risks to the soft landing outcome, even though I believe it's the most probable.
So with that, Matt, how should investors be thinking about their stock portfolio?
Matt Bartolini: Well, I mean, I think one of the big things this year has been just the market concentration and the equity market rally, the Magnificent Seven or the wonderful Six, or whatever sort of acronym you want to be using for the collection of stocks that are powering the market.
And it's probably a bit anomalous to look at the top ten stocks that were turn contribution is well above what we've ever seen in a given year.
Last year and so far this year, you start to see it propel as well. I think, you know, to your point around growth, there's going to be more abundant growth out on the horizon for more stocks beyond just what’s in the top ten. So the other 490, there's only a broadening out of that growth in valuations for those top ten are actually quite stretched. The rest of the 490 are a little bit more fair and even.
So what I expect to see in the back half of 2024 is the rally broadening out where investors can be a little bit more judicious about the valuations they're paying for that growth. So I think having this mix of quality and value I think would still continue to do well because there will still be some trepidation around earnings and the stability of that if the Fed does remain too restrictive.
So I do like this balance of quality and value, and I do think you will see, from a market perspective, the other 490 starting to do a little bit better and pull more of their weight than they had in 2023 and so far this year. I also think to your point around consumers, cyclical industries, more consumer-oriented industries like homebuilders, you know, if the Fed does cut rates, that's going to add some extra juice to the overall housing market. It’s going to unlock a lot of housing demand that's been sitting on the sidelines amid very tight supply.
And like you said, the labor market remains healthy. Consumer balance sheets are strong, and that is going to continue to push those retail oriented homeowners owners, homebuilders, areas of the marketplace to continue to sort of do well on a forward looking basis, their earnings per share estimates for 2024 are above that of the market. Their valuations are actually below that of the market.
So then that speaks to that broadening out of the rally, too. But, you know, like most things, rates are going to drive what happens for homebuilders to some extent as well as growth stocks. But, you know, obviously, rates will massively drive what takes place in fixed income. So like, Mike, what's the outlook for fixed income as we head into 2024 in the last couple of months?
Mike Arone: Great. So the other thing that we've really been focused on with investors is making sure they get paid for their cash. So you and I both know, working with investors all over the US, that for years cash didn't pay them very much, it was always an afterthought and they kept those balances pretty low. But today we can get some pretty good rates of return on those cash balances, so we continue to suggest to investors to get paid for that cash. 1-, 2-, 3-month Treasury bills, 3- to 12-month Treasury bills, and even in some instances, active ultra-short bond funds are kind of interesting at this point. So yields are kind of somewhere in north of 5%, volatility relative to stocks and credit is really low.
You typically don't have much in the way of interest rate risk or credit risk in some of these instruments. And ultimately, what we do continue to encourage clients to consider when they make these choices is think about the liquidity profile, think about the volatility profile, the interest rate risk, the credit risk. But boy, there are some really good options for the first time in a long time in cash-like instruments. So I know that's a second big thing we've been talking about, but that's the short-end of the yield curve or short maturities of fixed income. What are you seeing — are investors at all concerned on the long end or adding duration to their portfolio?
So most investors continue to employ a barbell. It's their favorite thing to do. So many continue to have a healthy portion of that barbell in money market like investments. And I use a broad umbrella for that description. And let's face it, they're comfortably holding on to 5%-ish yields and basically risk-free income, and they haven't had that in decades. So they're really have a high allocation to that.
Now they're pairing that with longer duration Treasurys and the anticipation that as the economy cools, inflation moderates, and the Fed begins to cut rates, yields will fall and that will lead to price appreciation on those longer duration Treasurys. But we like to highlight certain risks associated with both parts of that barbell.
So from my perspective, although having a healthy dose of short duration or money market like investments makes sense, particularly given where yields are, I think the threat of reinvestment risk becomes a reality of reinvestment risk in 2024. So as those yields fall and those short duration instruments mature, you're going to have to reinvest at lower rates. That's that reinvestment risk.
So we're encouraging investors to think about that one step out in terms of short duration, active fixed income investments to help manage that transition and that reinvestment risk.
Now, as it relates to the barbell and the longer duration Treasurys, one of the more fascinating things is, for the first time ever, first time ever, eight months on from the last rate hike, which was in July of 2023, the Barclays Capital 20 plus year Treasury Index has a negative return.*
Investors haven't seen this from fixed income. So we think there's some risk there. So we're a bit more comfortable hanging on to the shorter duration and intermediate duration, which is what you and I put in our outlook.
So intermediate Treasurys, intermediate investment grade corporate bonds, where yields are commensurate with shorter duration, product, you are extending duration some. So, should yields fall, you'll get that price improvement, but you're not kind of way out there on the duration profile where all the volatility has been. And then finally, as it relates to fixed income for those seeking outright yield, credit has been interesting.
So, if the soft landing outcome is the most probable in terms of the economy continuing to expand without recession, as inflation cools and corporate profits are in good shape, taking on some credit risk makes sense, especially given where yields are. So, whether you like investment-grade corporate bonds, whether you like fixed rate, high yield bonds or even loans, if you want to take on additional risk in high yield and loans, total returns or outright yields are really attractive in that space, not for the faint of heart.
You do need that soft landing outcome to materialize, but that is our base case.
So certainly have given you a lot of food for thought. A little bit on the macro perspective, highlighted a few risks to consider in the coming months. Matt talked about stock positioning. I talked about fixed income positioning, and we're looking forward to catching up with you again in coming quarters.
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