Market Insights: Make Hay While the Market Shines
By: Wayne Yi, CFA
The economy has delivered seven quarters of sustained expansion since the second half of 2022, and it looks like the trend will extend through the remainder of the year, despite the continued headwinds of sticky inflation and high interest rates. GDP growth forecasts have actually increased, and commensurately, recession fears have fallen, with most economists now considering a recession unlikely to occur this year.
GDP expectations have continued to rise
Source: Wall Street Journal
WSJ Survey on Probability of Recession
Source: Wall Street Journal
Broad equity markets also performed well over this period. After a strong recovery in 2023, the S&P 500 continues to march higher, and is up over 10% for the year through May, with most other equity indices also up in the solid mid-single digit percentage range. Market fears, as measured by the VIX index, continue to come down and are at their lowest levels since the COVID crisis. Fixed income has remained under modest pressure after a strong year-end rally in 2023, but attractive absolute yields drove overall positive flows as investors sought income opportunities in a high rate environment and have been rotating out of short-term and money market funds more recently. Economic fundamentals and market technicals seem to be aligned for continued positive momentum as we head into a sunny summer season.
Volatility has declined to Pre-Pandemic Levels
Source: YCharts
There has been an uneven distribution of these positive factors, as larger and stronger businesses/consumers have disproportionately benefitted from an improving economy, while the smaller and less-resourced participants face greater financial stress from higher costs and interest rates. Thus, the gap between the winners and losers continues to widen underneath the surface of benign headline data.
In equities, while overall market performance has been admirable, it continues to be driven by only a few stocks, predominantly the Magnificent 7 (“Mag-7”). We welcome the tremendous growth of Nvidia in light of the rapidly accelerating demand for artificial intelligence. We believe A.I. will be pervasive and transformative in how we work and live, but would highlight that the drivers for index returns are limited to a handful of the country’s largest tech companies. The Mag-7 have more than doubled the index performance this year, while the remaining 493 have returned less than half the index. This market continues to favor larger businesses for their overall more resilient balance sheets and scalability of their operations, as higher-for-longer interest rates are deteriorating weaker, more levered businesses, which tend to skew towards smaller, more cyclical companies. Today, in a high-rate environment, we’re seeing small caps come under greater pressure in making interest payments on their debt, while large caps tend to use less leverage and continue to generate healthy levels of cash flow to easily service debt payments. There is concern around how much and for how long the few mega-caps can continue to carry equity markets while the rest of the constituents lag.
The Mag-7 Continue their Market Dominance…while Small Caps Carry Heavy Interest Burdens
Interest rate coverage ratios
EBIT/interest expense on dept, monthly, LTM, 1998 – present
Source: JPMorgan
Higher interest rates and diminished cash holdings have caused a modest softening in the credit environment, as delinquencies and defaults have risen, but are currently within historical levels on an aggregate basis. However, smaller, more levered businesses and consumers are feeling greater financial strain. Amongst high yield bond issuers, default rates have picked up modestly to 1.55% from recent lows, still comfortably below historical averages of 3%. However, when looking specifically at the riskiest borrowers (CCC-rated below), defaults have moved up significantly to almost 7% and are now surpassing historical averages, despite the backdrop of a growing economy. Similarly on the consumer front, delinquencies on credit cards and auto loans are increasing across all borrower types, but at a much faster rate with lower income consumers versus high earners. This trend will likely accelerate as excess savings continues to be used up.
Lower Rated Companies are Now Defaulting at Elevated Levels
Source: JPMorgan
30-60 Day Delinquencies Accelerating Amongst Lower Income Population
Source:Reuters
November 5
The country is preparing for a rematch of President Biden and former President Trump for the White House this fall. What should be equally ulcer-inducing are the Congressional elections that will determine which party gains control of the House and Senate. Currently, the Republicans have the House, while the Democrats control the Senate, both by small majorities, and we could see either chamber flip. Markets favor party separation between the Executive and Legislative branches as this tends to create deadlocks and inaction that result in a steadiness to markets.
We’re not smart enough to make a prediction on who will win at this point, but ARE experienced enough to know that while there can be some market volatility heading into an election cycle, investors should not fear having capital invested during elections, as shown by the table below. Being invested in equities in a Presidential election year has historically resulted in better returns than the average of all years combined.
U.S stock performance
Average annual return: 1/1/26 – 12/31/23
Source: BlackRock
There has been speculation on whether the Fed would not cut rates close to elections to avoid biasing voters, however, prior Fed action during election cycles tells us that they are not afraid to cut or hike if deemed appropriate. We expect at least one rate cut in 2024, but given the persistence of inflation, this may not occur until the final few months of the year. If inflation readings continue to remain elevated, there may be no cuts until next year.
Source: BlackRock
Regardless of the elections, Chairman Powell is secure in his seat until his Chairmanship ends in 2026. While Trump may want to replace him, if elected he wouldn’t be able to do so for a couple years.
Making Hay
We anticipate further economic and corporate earnings growth this year, in light of the benign credit environment as we wait for the Fed’s first rate cut. But our optimism around fundamentals is somewhat tempered by relatively full valuations for stocks and generally tight spreads for bonds. As we note above, market strength has been limited to outsized performance from only a few exceptional companies rather than broad participation that would increase our confidence. Cracks are forming in the weaker parts of the credit market, notably with real estate exposures at regional banks.
Thus, rather than trying to stretch for more return, we look to take advantage of the relative calm in the markets to upgrade exposures for quality, liquidity, and diversification:
- We reiterate our balanced approach across asset classes for the diversification benefit and resiliency to unexpected events and market shocks. Hedge funds have been additive here by generating steady returns in the current period while bonds have been under pressure from higher rate dynamics.
- Our equity allocations are domestically oriented with an emphasis on large cap exposures with a quality tilt.
- The inverted yield curve diminishes some of the value of owning traditional fixed income, however high interest rates provide attractive short-duration income ideas that are complementary to equity returns.
- Opportunistic investments through illiquid closed-end vehicles can provide strong risk-adjusted return opportunities in a low M&A/IPO/exit environment, such as secondary transactions, dislocated real estate, and special situations equity and credit, that have shorter lives than traditional private equity.
Asset Allocation Recommendations
Equities: Target-weight
The domestic economy remains resilient, as we see continued GDP growth and corporate earnings strength. However cracks are starting to show in lower-income consumer delinquencies. The index appears to be fully valued and performance is still dominated by the Magnificent 7. We are balanced Value vs. Growth with a domestic leaning.
Fixed Income: Target-weight
We remain constructive on the diversifying, income-producing nature of the asset class, and would barbell the asset with short-duration income producing credit and longer-duration investment grade bonds. The Fed is at its peak but rate cuts may be delayed until later this year, and this may benefit short-term but les so long-term bonds.
Liquid Alternatives: Target-weight
Hedge Funds: Hedge funds have shown their ability to be sources of portfolio diversification over the past couple of years. While stocks and bonds still exhibit positive correlation in the current environment, we appreciate the contribution of alternative strategies with low directionality, but actively traded, dynamic portfolios that can take advantage of moments of disconnect between trading relationships of securities and asset classes in periods of transition. These opportunities can help funds generate steady returns with less sensitivity to market direction or the actual path of interest rate cuts in 2024. We continue to expand our multi-strategy allocation and complemented it with differentiated lending and volatility strategies to balance out the more directional small cap exposures.
Real Estate: We have been adding core-plus real estate opportunities, notably in residential assets for its inflation aligned properties and as a complement to stock and bond portfolios. We continue to remain cautious on the fundamental outlook of office buildings. Lower interest rates should ease some pressure on financing situations.
Illiquid Alternatives: Target-weight
The dirth of M&A and IPO activity is weighing on realizations for invested funds and dragging down IRR. However, current vintage opportunities are highly attractive, particularly for secondaries and opportunistic strategies. AI opportunities in VC will also be a long-term trend.
Wayne Yi, CFA
Partner / Chief Investment Officer
Wayne Yi is the Chief Investment Officer and a member of the Simon Quick Investment Committee and Executive Committee. In addition, Mr. Yi is also a member of the firm’s DEI Committee which aims to foster an environment of inclusion and promote diversity in the workplace. In his role as CIO, he drives the firm’s market outlook, allocation strategy, and investment implementation processes for client portfolios. He works with the Investments team to prioritize opportunities and oversees market research and manager diligence across traditional equity and fixed income strategies as well as alternatives, including hedge funds and private equity allocations.
Prior to joining the firm, Wayne was a Co-Portfolio Manager and member of the Investment Committee for SAIL Advisors, a hedge fund investment firm headquartered in Hong Kong. He also served as the Senior Analyst for their Credit and Event-Driven strategies. Prior to SAIL, Wayne was the Sector Head for Credit and Event-Driven strategies at Robeco-Sage, a hedge fund investment firm based in New York. Wayne started his career in investing at Delaware Investments as a Research Analyst for high yield and investment grade bonds across various industries. He then joined Goldman Sachs’ Investment Research department where he was the Senior Analyst covering high yield bonds in the Technology sector.
Mr. Yi is a CFA charterholder and a graduate of the University of Pennsylvania where he received a B.A. in both Economics and International Relations.
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