Hello everyone, and welcome. In the second quarter, risk-asset returns, like the first quarter, were a) strong; and b) followed a similar pattern of late-quarter “known unknown” resolution. In the first [quarter], it was about the regional banking crisis and policy relief leading to strong March returns.
In the second [quarter], it was the debt-ceiling crisis and very strong June returns following [a] resolution that produced the strong year-to-date returns that you see here—and pushed the S&P into bull market territory in June. On the back of that strength, though, are questions about what comes next.
For us, it’s the second of three themes that I believe investors will encounter through the end of 2024, and that is “resistance.” Because here’s the basic truth: from a market perspective, the S&P 500 looks toppy. Valuations sit at the very high end of the range, and earnings are expected to face absolute and relative pressure as growth likely recedes in the quarters ahead.
And from an economic perspective, inflation has been coming down, and we expect it to continue to do so, but it is still well above the Fed’s ultimate target.
And then there’s the job market. The Fed’s primary emphasis has been to normalize the labor market, but there continues to be lots of strength there. Jobs numbers continue to come in well above the clearing rate, the unemployment rate is historically low and the all-important (at least for me) household paycheck proxy, which tries to quantify the aggregate consumptive power of the nation, is not just growing at a really robust clip, but if [we] consider the impact of declining inflation, the inflation-adjusted (aka real consumptive power) growth rate has pushed even higher.
So if you are the markets, you’ve done this—you’ve priced in the expectation that rates are going to stay higher for longer—and if anything, the Federal Reserve will likely increase rates one or two more times before they’re done. Phew.
So what’s an investor to do in this period of resistance? Well, the first is, yes, the S&P 500 is toppy, but it’s toppy largely on the back of 10 of those 500 names, so I’d like to talk about the other 490, and specifically those with the characteristics we’ve talked about so many times before, such as quality and low volatility. Those factors defend well historically, and importantly are not expensive as we’re trying to find opportunities.
And the second thing is to zoom out, beyond the next handful of months, into our third theme—normalization. Those of you that I have spoken with know I refer to this as the “second inflection point,” when normalizing growth and inflation inflect central bank chatter to rate-cutting protocol, and yields fall across the curve. I believe that this is a later 2024 story, but regardless of when it happens, the bond market is going to be the star of the show, and it will ripple across capital markets.
So first of all, bond yields are high, from the 10-year Treasury all the way to high-yield bonds, but that’s showing up well beyond just yield curves. It’s showing up in capital markets’ expectations over the next decade. Indeed, a 60/40 portfolio today, based on our estimates, would generate 120 basis points more per year for 10 years than it would’ve pre-COVID, but to belabor the point, it’s not because of the equities. That’s a fairly modest uptick. Instead, it’s about the high-grade bonds, which are expected to produce greater than double the pre-COVID numbers on the back of those yields. Same thing for high yield.
As we’ve said many times, high yield historically generates average annual returns in the forward five years that are strikingly close to the starting yield to worst, which entered the quarter at 8.5%.
However—and this is the critical thing—I think those returns are going to be front-loaded. If we do have a world, as we expect, where inflation does come down and growth normalizes over the coming 12–18 months, rates are coming down with it, and those 10-year expected returns are going to be front-loaded.
As an example, the 10-year Treasury recently hit 4%. Let’s assume that it falls to 2.75 over the next two years. Using admittedly very simple bond math here, that means that over half the returns you would enjoy in a 10-year Treasury over a decade would be paid to you in two years, and the next eight years would be far more modest; aka pre-COVID.
And it would be true across bonds. While we talk about the predictive power of high yield’s yield to worst over a five-year horizon, historically it’s lumpy, with the vast amount of capital gains occurring sooner rather than later. And those modestly higher expected equity returns? I’ll bet you a donut that part of that would come from a valuation bump on the back of falling yields.
Net net, as investors we have to be cautious about current conditions, but I don’t think we should wait for a better time in order to find our opportunities. And that’s really the biggest thing about normalization for me—thoughtful portfolio construction in the now. As we make our way to the end of 2024, we believe inflation and growth will move toward trend, and yields will fall with it, and by the way so does the Fed and the rest of the market. There are clearly risks in the now, and the timing is highly uncertain as to how and when this will play out. But I think that one of the big risks for investors is not addressing the opportunity now, with a thoughtful eye beyond resistance to normalization and the opportunity that we see.