2024 Mid-Year Outlook Blog: Chugging Along

Executive Summaryⁱ

• The US economy has shown remarkable strength in the past six months, surpassing expectations with strong GDP growth and easing inflation.
• The services sector has been the main driver of economic growth, compensating for the manufacturing recession and allowing the US to outgrow other developed economies.
• The S&P 500 returned 15% in the first half of the year, with significant contributions from AI-related companies. Market valuations raise some concerns, but the strong economy supports positive, albeit potentially below-trend, medium-term returns.
• Consumer discretionary, consumer staples, and healthcare sectors appear attractive, while energy, financials, industrials, and materials are less so. Internationally, the UK and Korea offer opportunities, India has a strong long-term outlook, and China’s market is cheap but politically risky.
• The upcoming US election introduces uncertainty, but the market is awaiting clearer policy outcomes before pricing it in.
• In the private asset world, private equity and real estate equity seem compelling, with private credit offering high-conviction opportunities despite increased crowding.

The US Economy Goes “Choo Choo”

The US economy has remained remarkably strong over the past six months, aligning more closely with the bull case we laid out as the year began versus either our base or bear cases. That has surprised us to some degree, but presumably not as much as it has surprised the Fed. They had already put rate hikes back on the shelf and shifted gears to discussing potential cuts at the start of the year.

Through the first several months, almost every major hard economic data point surprised to the upside. Still, inflation has continued to ease gradually, although not quite as much as the Fed or the market had hoped. It’s remarkable that it’s eased at all given the strong GDP growth we’ve seen. What explains such disinflation even in the face of robust expansion? Immigration. Previously unaccounted for, immigration has allowed GDP to grow beyond the economy’s productive potential without exerting as much pressure on prices as anticipated. Although immigration is a complex political and policy issue, from a purely economic perspective, the US has been able to surpass all other developed economies in growth—while simultaneously reducing inflation—thanks to the strength of its labor market.

As the labor market has been instrumental in checking inflation, the services sector has been the driving force behind keeping the economy growing. At the same time, the manufacturing side, along with global manufacturing, remains in a recession (Display). And while the British and eurozone economies appear to be just on the expansionary side of a recession at the moment, the US economy has been thriving.

What happens to that gap between manufacturing and services from here? Will services buoy the overall economy while manufacturing resets and embarks on a new expansion of its own? Or, instead of manufacturing catching up, could the services sector experience a downturn due to higher interest rates, extended credit, and corporate managers seeking to safeguard or increase margins? Both outcomes remain possible, but given the evidence currently at hand, we continue to expect manufacturing to ultimately reset and catch up.

The Bifurcated Market Continues

Strong economic expansion has also served as a backstop for the markets, with the S&P 500 returning 15% through the first half of the year. Yet under the surface, there has been a significant divergence in performance between companies associated with the AI theme and the rest of the market. Nvidia alone accounted for around one-third of the market’s gain so far this year. And when grouped with Microsoft, Apple, Amazon, Meta, Alphabet, Broadcom, and Lilly, those stocks accounted for 80% of that gain.

Overall, we have some concerns about the market’s valuation—but not enough to outweigh healthy economic fundamentals. Assuming the economy continues to grow, that should support the market. Keep in mind, we could still see occasional drawdowns that cause the market to drop by ~5%–10%. Historically, such pullbacks have been randomⁱⁱ and unpredictable, making them a constant possibility. But even factors such as the low equity risk premium (the expected excess return of stocks versus bonds) don’t suggest negative returns from here. Instead, we foresee merely lower but still positive returns over the medium term (Display).

Meanwhile, earnings growth remains strong, hovering in the 5%–7% range for each of the past three quarters. Digging deeper, we ran a cluster analysis, grouping sectors by earnings patterns through the pandemic. We are closely watching those groups for any signs of deterioration. The idea is that even if overall earnings hold up, there might be underlying issues that we can detect early in one or two categories if their cycles begin to decline before the rest of the economy. We were a little worried heading into Q1, but our concerns were alleviated as all of these clusters continued to expand earnings.

What’s more, there has been a large gap between the earnings growth of the “Magnificent Seven” and the rest of the market in recent quarters. However, that gap is expected to narrow sharply in the quarters ahead according to analysts’ estimates for each company.

Looking ahead, 2025 estimates appear too lofty, with 15% growth expected year-over-year. We think mid- to high-single-digits is more likely, though it’s normal for estimates to overshoot this far in advance and come down as the calendar rolls forward. We might have a little more indigestion than usual with numbers this high, so that will be something to watch in the next two to three quarters.

Both consumer discretionary and consumer staples look relatively attractive right now. So does healthcare, though it could become a political piñata during election season. In contrast, energy, financials, industrials, and materials appear less compelling.

Internationally, not a lot stands out. The UK could be a beneficial source of global staples and healthcare exposure and Korea appears to have some opportunities as well. India has one of the strongest long-term outlooks of any country due to its demographics, but valuations remain rather astonishing in many corners of its market. China is once again so cheap as to be interesting, but we still don’t see enough of a macroeconomic or political margin of safety to make that call just yet.

In the US, the election has reemerged as a source of uncertainty. Yet that does not seem to be diminishing the market’s risk appetite or stoking volatility. We think the market needs more clarity on the outcome and the policies that could be implemented before it begins to price in the results. The implications are too binary—and the odds too close—to allow for much pre-positioning. The only potential head start could be pricing in some degree of persistently large budget deficits, since that seems to be the lone area of bipartisan agreement. We’ll have much more to say on the topic of the US’s national debt and deficits in our team’s forthcoming in-depth research report.

As for bonds, the markets have been turbulent but rangebound so far this year, with the 10-year Treasury yield hovering around 4.0%–4.75% for most of the first half. With relatively high starting yields and a strong economic backdrop supporting credit, we continue to find core high-quality bonds appealing. And with rate cuts on the horizon, we feel comfortable extending duration on any up-moves in yields (i.e., owning longer-dated bonds which are more sensitive to interest rate movements). With rates at such high levels, they are also much better protected against any unexpected rate rises from here—it would take two to three times as large a move in 10-year yields to wipe out a year of interest income today as it did in 2020 or 2021 and six to fifteen times as large a move in 1-year yields to do the same (Display).

Better Options in Private Markets

For investors who can access private markets, we continue to see more opportunity.

Private equity remains a pillar of modern asset allocation. In addition to its evergreen appeal, two trends intrigue us at the moment. First, many large investors have reduced new commitments due to a lack of cash distributions from previous investments, which they had planned to reinvest. That gives investors who are making allocations today better access to higher-quality funds. Second, apart from AI, the risk appetite and capital flows into the venture capital and growth equity segments of the market remain well below their longer-term levels. That opens a window to invest in these areas at much more attractive valuations.

On a separate note, real estate equity is starting to look attractive again. As the market is expected to bottom in several areas within the next few years—coinciding with the investment periods of funds currently being raised—we are growing more optimistic about its potential over the next decade.

Private credit is still one of our favorite areas, especially if it can be done in a tax-efficient way through a tax-advantaged account or a private placement life insurance/variable annuity (PPLI/PPVA) structure (Display). We foresee compelling opportunities to deploy fresh capital shoring up real estate capital structures as the sector recapitalizes for a higher interest rate environment. Direct lending has garnered a lot of attention and capital in recent years due to its enticing risk-adjusted returns. That inflow of capital—combined with greater competition from banks and fewer M&A and buyouts—has increased crowding in the space. While it remains among our highest conviction ideas, with yields 3–4 percentage points above high-yield bonds and levered loans, we (and our competitors) are starting to see pressure on deal terms. We anticipate further crowding from here, which could lead some firms to take excessive risk with too little protection. If that bears out, we believe it could sow the seeds for us to acquire stressed debt through our opportunistic credit investments in a few years’ time. That’s partly why we favor a diversified approach to the private credit arena.

Markets Climb a Wall of Worry

With the economy and the markets still humming along, it’s easy to be either overly complacent or overly anxious. Some folks tend to overextrapolate the current upward trajectory. Others assume that the expansion must end soon. We’d say neither are givens—the expansion will come to an end at some point, but there are no large distortions in the real economy or major risks lurking in the financial sector that seem readily apparent. This implies that unless there is an external shock, or a slowdown caused by corporate managers attempting to boost their margins and growth—which could inadvertently lead to a surge in layoffs—the economy should remain healthy in the near to medium term. And even if such a downturn transpires, it would likely be mild and short-lived. Overall, the economic and market outlook remain positive.

We’ve highlighted several areas we’ve found more or less attractive across the global markets. But staying invested and maintaining a long-term perspective ultimately matters most. We’re keeping an eye on the changing risk landscape, but as we often are, remain rationally optimistic.