Ripped from the Headlines

Investors are entering the new year with many concerns about macroeconomic conditions and market volatility. The heads of our fixed-income, equities and alternatives businesses lay out some of the key investment storylines to watch in 2024. 

Fixed Income: Time to Prepare for Falling Yields 

Key central bank rates and bond yields remain high globally and are likely to stay elevated well into 2024 before retreating. Further, the chance of higher policy rates from here is slim. The potential for rates to decline is much higher. 

In the euro area, for example, after years of negative yields, the highest-rated euro government bonds currently yield nearly 3%. Meanwhile, inflation in the region is heading back toward target. Given weak expected growth, the European Central Bank may need to ease midyear. 

In the US, where inflation—while declining—is still well above the Federal Reserve’s target, we expect rates to remain elevated into the second of half of 2024. Given current trends in economic data, we think the Fed has completed its rate-hiking cycle and will remain on pause until inflation is closer to 2%, when it can begin to ease in the face of cooling US growth. While the US Treasury market has experienced a bit of a relief rally in recent weeks, yields remain very compelling overall, in our view.

For bond investors, these conditions are nearly ideal. After all, most of a bond’s return over time comes from its yield. And falling yields—which we expect in the latter half of 2024—boost bond prices. Investors should consider extending duration in this environment to gain exposure to rates.

Both Government Bonds and Credit Have a Role to Play

Of course, developed-market government bonds represent just one part of the global bond market. Yields across credit-sensitive assets such as corporate bonds and securitized debt are also higher than they’ve been in years, giving income-oriented investors a long-awaited opportunity to fill their tanks. In fact, we believe that both government bonds and credit sectors have a role to play in portfolios today.

It’s true that sustained higher rates are likely to lead, eventually, to a turn in the credit cycle. Rate hikes are already weighing on activity in many sectors. Corporations have continued to beat earnings expectations, but not as impressively as earlier in the year. Some companies have noted that consumers are spending less. Indeed, households have nearly depleted savings accumulated during the pandemic. Leverage is creeping higher, and interest coverage—the ratio of a company’s EBITDA to its total interest payments—has begun to decline.

But because corporate fundamentals started from a position of historic strength (Display), we’re not expecting a tsunami of corporate defaults and downgrades. That said, investors should be selective and pay attention to liquidity. CCC-rated corporates and lower-rated securitized debt are most vulnerable in an economic downturn. Long-maturity investment-grade corporates can also be volatile and are currently overpriced, in our view. Conversely, short-duration high-yield debt offers higher yields and lower default risk than longer debt, thanks to an inverted yield curve. 

Equities: Positioning Allocations for a Range of Outcomes

Even in a world of higher bond yields, equities still have an important role to play in allocations. Higher bond yields have led to a decline in the equity risk premium (ERP), the excess return that investors expect to earn over a risk-free rate. However, between 1983 and 2008, when the ERP was at a similar level to today’s, the S&P 500 Index delivered solid annualized returns of 10.2%. 

Softening inflation data and still-healthy US employment figures have supported a recent recovery in equity markets. Still, market conditions are murky. Slower progress toward the Fed’s inflation target or a faster acceleration of unemployment—or both—could determine whether the global economy has a soft landing, hard landing or no landing at all.

As sentiment has shifted between these outcomes over the past year, so has equity market performance. After peaking in early August, the MSCI World Index declined through October before recovering in November, showing a lack of conviction in any one outcome.

Different equity strategies are sensitive to the potential outcomes in different ways. Our research of US equity factor returns in varying economic scenarios from 1991 to 2023 is instructive (Display). In scenarios with stronger economic growth and falling inflation, cyclical value stocks have generally performed well, while growth stocks lagged. When economic growth was weaker and inflation was rising, growth factors performed well. But in a hard landing—i.e., recession—past performance suggests that strategies featuring strong profitability or higher levels of dividend yield provide the best cushion. 

Quality factors performed well in all three environments. In a world of higher inflation and interest rates, we believe stocks with quality features will continue to deliver by virtue of their focus on balance sheet strength and profitability, which underpin financial resilience.

Are Conditions Improving for Active Equities?

But what about actively managed equity portfolios, which haven’t performed well this year? Growth managers have had a particularly tough year. The extreme market concentration seen in 2023, with the “Magnificent Seven” dominating market gains, has made it hard for active managers to outperform without positioning heavily in the entire group of mega-caps.  

We believe conditions are improving for active managers. Our research shows that performance of the S&P 500 and MSCI World Equal Weighted indices trailed their corresponding cap-weighted benchmarks by 14.9% and 8.9% in 2023 through November 24. History suggests that after extremely narrow returns, a broadening of the market can persist for several years. 

Meanwhile, our research shows that the dispersion of stock returns has increased in the US and global markets to levels that are typical of market stress, which we’ve seen during the US taper tantrum and Brexit and after the tariffs introduced by former President Donald Trump. After similar episodes, active managers have performed well. Today, the dispersion of returns has been particularly high outside the Magnificent Seven. That means that individual names are trading more independently, creating fertile ground for active managers to outperform, in our view. 

To identify stocks that can outperform, portfolio managers should look for quality businesses and rigorously assess how individual company earnings could be affected by a range of macroeconomic outcomes. 

Investors, too, should revisit their allocations. Those who have been underweight value stocks may want to consider adding exposure, as value may do well in a softer landing. Growth and quality-focused strategies should help if the economy muddles through. And we think lower-volatility equity strategies provide much-needed defenses if a deeper downturn develops. While the right mix will differ based on individual investor goals, striking a thoughtful balance between different active equity portfolios is the best way to position for a market that could veer in many directions during 2024.

Private Credit: Banks in Retreat

In a little more than a decade, private credit has gone from a niche strategy to a key component of a diversified investment portfolio. We expect that evolution to move forward in 2024 as stricter capital requirements force banks to continue their retreat from many types of lending, widening the opportunity set for non-bank lenders. At the same time, a potential turn in the credit cycle may increase borrower stress, making managers’ ability to underwrite credit risk more important than ever.

Rising interest rates have sparked deposit flight from banks in the US and Europe this year and forced many to take mark-to-market losses on assets and securities. Banks are also on the clock for complying with updated global Basel III regulations, which come into effect in 2025 and will include a rewrite of the risk-weighted asset framework. This is likely to prompt many to further reduce certain types of long-term lending and to shed some of the loans—residential, commercial, corporate, consumer—already on their balance sheets (Display).

Filling the Credit Vacuum

For alternative lenders, this represents an attractive opportunity to generate income by filling that credit vacuum. It may involve purchasing seasoned loans from banks or entering into forward flow agreements agreements to acquire new ones at high interest rates upon origination. Banks, meanwhile, benefit by maintaining customer relationships and generating fees without incurring the high regulatory capital charges that would come with keeping these loans on their books. We expect to see more partnerships between banks and asset managers in which the latter can provide a more diversified source of funding than deposits.

We also see a growing opportunity in specialty finance, a $4 trillion global market to which investors are largely underallocated. Specialty finance refers to directly originated, privately negotiated loans secured by specific cash-flowing assets or receivables. It spans loan portfolios and lender finance and ranges from underlying assets such as automobile and equipment leases to more esoteric assets, such as the revenue streams generated by royalty payments. These asset classes have the potential to generate attractive returns and also provide diversification to a broader private credit portfolio.

Overall, we expect a promising investment environment to persist into 2024. Yields may decline somewhat but are likely to remain well above their pandemic-era lows. Deal terms should remain favorable, with low loan-to-value ratios and asset values that reset as rates rise. At the same time, limited partners may face challenges, should persistently high rates increase borrower stress. This will underscore the importance of diversification and having a deep investment team with a track record of lending throughout the economic cycle.