The Resilient Bull: Dissecting the Market’s Strengths and Vulnerabilities

In my numerous conversations with clients to start off 2024, one common theme sticks out—people want to talk about the resilient U.S. economy and surprisingly strong equity market performance in 2023 (which has continued into 2024 thus far). Most of my clients are quick to point out the many factors that made this strong equity rally unlikely, including an inverted yield curve and a 20 year high in interest rates.

While everyone is hoping that the Federal Reserve can pull off a soft economic landing, I have been advocating for the need to prepare for a range of potential scenarios as 2024 unfolds. Here we’ll break down why market participants have been optimistic, but also highlight the risk factors that could knock stocks off track.

Why Have Markets Been Optimistic?

Amid ongoing economic challenges and global uncertainties, market participants have found reasons for optimism. Several key factors have contributed to this positive sentiment:

Financial Conditions Improved

Despite past volatility and uncertainties, financial conditions are currently more accommodating than they have been in the past two years:

• Strong S&P 500 earnings: The resilience of S&P 500 earnings has supported high equity multiples and contributed to tight credit spreads in both investment-grade and high-yield markets.
• Lower real yields: Real yields have notably declined over the past six months, dropping from 3.4% to 2.1%. This reduction signifies improved borrowing conditions and lower financing costs for businesses and consumers.

Resilient Economic Data

Economic data has shown remarkable resilience, boosting confidence in the economy's underlying strength. The key indicators I have discussed with clients include:

• Low unemployment: U.S. unemployment stands at 3.7%, lower than the anticipated 4.6% in Q4 2023. This strong labor market supports consumer spending and overall economic activity.
• Inflation approaching target: Inflationary pressures have been gradually aligning with target levels, indicating a balanced approach to price stability and economic growth.
• Strong consumer activity: The consumer sector (a key driver of U.S. GDP growth) has also shown resilience, reflecting underlying economic strength and consumer confidence.

Expectations of Rate Cuts

Anticipation of central bank easing in 2024 has further fueled market optimism, driven by expectations of reduced funding costs and a flatter yield curve. Regardless of the exact timing, most market participants broadly expect central bank easing in 2024, which is expected to stimulate economic growth and support equity market expansion.

Artificial Intelligence Fuels a Rally in Mega Cap Stocks

You couldn’t go anywhere in 2023 without hearing about AI and the related boom it caused in the stock market. In fact, I spent much of last year educating clients on the sources of return in the stock market. Many of the advisors I spoke with were surprised to see that the majority of 2023’s strong equity market performance came from the rally in the “Magnificent 7” stocks.

While the productivity enhancements from AI are expected to be a new structural growth driver of the U.S. economy, the market’s lofty expectations for growth are already reflected into current valuations. This, of course, leads us to the risks in the current market.

What Could Go Wrong?

Despite prevailing optimism in the current market landscape, several challenges stand on the horizon, jeopardizing the sustainability of the current upward trend. Understanding these challenges is vital for advisors aiming to navigate potential obstacles and effectively manage risks. Here’s how I have positioned risks in the current market environment in my conversations with advisors:

Don’t Become Complacent: Financial Conditions Are Unlikely to Remain Easy

While inflation is certainly heading in the right direction, there’s the possibility it starts to rear its ugly head again. Federal Reserve Chair Jerome Powell has hinted at the necessity to keep rates high (or even raise them more) in the face of persistent growth and inflation. This could create a self-reinforcing feedback loop towards tighter financial conditions via higher rates for longer than the market expects.

In general, the market may have been overly optimistic about rate cuts, as many investors are starting to rachet back their expectations for lower rates. In previous periods, this right sizing of the market’s expectations for future rate movements has caused significant equity volatility.

Are Markets Priced for Perfection?

Corporate earnings have been strong. However, as companies and analysts ratchet up their forecasts for future growth, it’s very difficult for companies to continue delivering upside surprises. In addition, it’s important to realize just how much of the equity market’s recent performance has come from the Magnificent 7. The S&P 500 returned 24% in 2023, but the equal-weighted S&P 500 Index returned just 11%. The last time that happened? That would be the dotcom bubble of 1998.

How Should You think About Portfolio Positioning?

While the overall trend in economic conditions has been positive, many corners of the equity and credit markets are priced for this reality. We have continued to steer investors toward quality and relative value, while looking for corners of the market with attractive risk-reward setups. Within fixed income I have been emphasizing the need to get paid an attractive coupon per unit of risk. Here are a few ideas to bolster your strategic asset allocation amid the current market risks:

Ideas for Equity Portfolios

The VanEck Morningstar Wide Moat ETF (MOAT) is currently underweight the Magnificent 7 stocks, the technology sector and growth as a style. We think MOAT offers strong diversification potential particularly for portfolios with significant exposure to these areas. Last mile inflation challenges and a higher for longer narrative should also benefit the current cyclical positioning. MOAT also checks the quality, relative value and attractive risk-reward boxes.

Small- and mid-cap companies also represent attractive relative value, trading at steep discounts to their large-cap peers. Small- and mid-cap (SMID-cap) exposure is particularly appealing for advisors in the soft landing camp and would be well positioned in a scenario where rates decline in 2024. The VanEck Morningstar SMID Moat ETF (SMOT) screens for companies with long term competitive advantages that can sustainably out earn their cost of capital over time. This focus on earnings durability could help investors both capture the opportunity in SMID-caps and also keep a keen eye on one of the primary risk factors that have driven underperformance in the space during this cycle.

Ideas for Fixed Income Portfolios

On the fixed income side, we have been advocating for a barbell approach. Historically it makes sense to extend duration into an easing cycle to benefit from a re-steepening of the yield curve. However, there remains ample opportunity to capture attractive front-end yields.

Collateralized loan obligations (CLOs) offer yield pickup over short-dated Treasuries and investment grade corporate bonds and have near zero interest rate duration. CLOs are also negatively correlated with intermediate and long-term Treasuries, which makes them a great diversifier, particularly if the path to lower interest rates is a bumpy one. With cuts getting priced out of the market already, the higher for longer camp will want to pay particular attention to CLOs.

The VanEck CLO ETF (CLOI), subadvised by PineBridge Investments, provides access to investment grade floating-rate CLOs. CLOI benefits from PineBridge’s decades of CLO market experience, both as a CLO manager and CLO tranche investor, and deep leveraged finance expertise.

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