Mid-Year Market Outlook: Rotation or More of the Same?

Chief among assets with paltry returns year to date through June is bonds, which are slightly negative (-0.7 percent). Another slightly negative performer year to date is small cap stocks, both U.S. and non-U.S. (-0.7 percent and -3.0 percent, respectively). And while the S&P 500® returned just over 15 percent, the average stock in that index returned just 5 percent.

As we look ahead to the back half of the year, the question we keep asking is: Will we see any rotation or more of the same?

Equity markets

Once again, the market year to date through June rewarded large-cap growth companies at the expense of all other parts of the market. Large growth returned over 20 percent while large value was up 6 percent.

Much of the current euphoria has been fed by the AI craze. AI is a revolutionary technology, much like the internet was three decades ago, but, as with most new technologies, hype will be followed by the reality of making money. Right now, very few players make money at, or with AI. There is, however, a boom in capital expenditures especially related to data centers to enable the computational needs of AI, but those that are making money as opposed to spending money on AI are not ubiquitous. And, just as many internet companies flamed out after the markets rewarded them for the number of eyeballs on a site, (yes, that really was a valuation metric in the dot.com bubble), we have to be careful not to get caught up in the eventual stories vs. today stories.

The good news for markets is we have seen execution rewarded in stock prices of late, and earnings have been generally good, which does support valuations that are healthy or, at best, fairly valued for large cap, less expensive for both small cap and non-U.S. Within each area, there is wide divergence between companies and sectors (see the graph on the previous page). Another positive data point is that so far in July, the equity markets are much broader, with small cap, for example, leading the way and large cap tech seeing some bumps. If this lasts, it provides a nice fundamental backdrop to the markets.

Outside the U.S., developed markets were also a mosaic of positive, improving momentum (e.g., the UK and Japan) and declining momentum (e.g., France). Emerging markets were no different in the quarter that ended in June, with India performing well, Korea and Taiwan (thanks to the positive technology markets) sprinting forward while other areas if the world, like Latin America, slid amidst election results and the resulting political uncertainties.

Speaking of political uncertainty, in our year-end outlook, we pointed out that 2024 would be characterized by the largest number of people electing new governments than ever seen in a one-year period. This backdrop has continued to feed volatility with the latest examples being France’s snap election, the UK going back to the Labour party for the first time in a decade and, of course, the U.S. political landscape.

Fixed income

The Bloomberg U.S. Aggregate Index continues to generate underwhelming performance as yields climbed and then fell over 50 basis points (bps) throughout the quarter that ended in June, amongst the backdrop of a continued yield curve inversion. But, as the higher-for-longer narrative took hold, the shape of the curve has flattened. By July the yield differential between the two-year Treasury and the 10-year Treasury, which started the year at 38 bps, narrowed, thus flattening of the curve. This was mostly due to the longer end as short rates didn’t really change. Spreads remain tight in the credit space, but investment-grade bonds continue to be attractive from a yield perspective.

Also, to put this year in a little more perspective, don’t forget about the huge rally in bonds going into year-end 2023, which provided a return of over 5 percent.

Emerging markets and non-U.S. debt

With heightened global macro risk, one should ask, are the spreads today generating enough cushion to invest outside the U.S., especially when calculating in the currency risk?

Thanks in part to the European Central Bank, among other central banks that have already cut interest rates, the U.S. has the highest yield at 5 percent versus any developed market, and versus the Emerging Market Debt index there is a 3-point spread.

Municipal bonds (munis) continue to provide positive tax equivalent yield spreads, with AAA 10-year munis at close to 5 percent and BBB at 6.4 percent. These yields are highest we have seen in over a decade.

In sum, real yields and downward-trending inflation support increasing bond exposure for investors with a positive real yield available in the markets today. We continue to favor lowering the volatility of portfolios with fixed income yields where they are.

Private markets

Is this the golden age of private credit or are we seeing the beginnings of huge differentiation in the market and managers given the higher interest rate environment and its impact on balance sheet and asset coverage? The answer remains to be seen. Currently, the environment of “amend and extend” is alive and well. We think restructuring and distressed management will be a key tenant for capital preservation, as will manager selection.

Real estate continues to be challenged. The current period is the third most significant period of value declines for real estate in the 45-year history of the NCREIF property index. Interestingly, unlike other periods, this time is not preceded by a recession, nor does it coincide with one. How challenged the environment is or will be depends on the type of real estate. Offices are the obvious poster child for problems; areas like industrial and data centers are on the winning side. Little transaction volume continues to make price discovery hard but, importantly, income is stable.

Infrastructure continues to be attractive amidst both positive fundamentals and a backdrop of positive supply and demand forces.

Private equity has a wide dispersion of performance depending on type, managers and sectors, similar to many private areas, such as real estate.

In venture capital, down rounds continue, with a focus on getting to profitability. Winners and losers are becoming more apparent. In the buyout area, a focus on strategic deals continues. Generally, in the private equity area, fundraising is down amidst longer fundraising cycles, as is a continuation of low distribution activity, and there is little in the way of IPO’s providing realizations.

While we don’t yet have a lot of hard data on recent valuations across privates, suffice it to say there has been, and probably will be, a dichotomy of performance characterized by haves and have nots.

Looking ahead

So, what about the rest of the year? We started this piece with the question, rotation or more of the same? A rotation for the equity markets would include a broadening A broadening of market performance among capitalizations and sectors (as we have started to see in July) and for bonds, the first rate cut.

However, there continues to be so many areas of uncertainty, such as:

• Will inflation continue to decline? With the June CPI results at -0.1 percent and the one-year CPI at 3 percent, results continue to favor a declining inflation scenario. The stubborn areas, such as shelter, are showing some slack, and important items, such as food and energy, are providing positive trajectories, as noted under the CPI graph below.
• Will the labor force continue at the slower yet strong pace we have been seeing (illustrated in the second graph below)?
• Will we get the first rate cut in September?
• Will the economy roll over or will it not roll over and continue its current strength?
• Will this be the first yield curve inversion without a recession associated with it? (Well actually not the first but a very rare occurrence)
• Will the upcoming U.S. election lead to increasing volatility? (Of late the markets have not seemed too concerned despite a backdrop of an attempted assassination and a change in the Democrats’ candidate — not insignificant events.)

In the first half of the year, stubborn inflation in many areas of the landscape, as well as a dichotomy of numbers related to economic growth, the consumer and manufacturing, led to a seesaw of emotions, reflected in up and down results for stocks and bonds. As we discussed earlier, the average stock in the S&P 500^® returned 5 percent for the six months that ended on June 30. For fixed income, we should focus on the strong yield currently available from bonds, since, over time, the majority of bonds returns come from yield.

Our advice continues to be the same: Rebalance your portfolio to target and focus on your longer-term goals, not short-term volatility.