High Expectations
Bradley Wallace, CFA, CIPM
SVP, Chief Investment Officer at Stride Bank, N.A.
“It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain.”? –? John Maynard Keynes
The Paradox of Expectations attempts to answer a simple question: are expectations good or bad? Expectations that are too high can lead to disappointment, while expectations set too low may leave potential unrealized. Stephen Hawking, the English physicist who lived more than 50 years after being diagnosed with a muscular degenerative disease, was once asked how he maintained such a cheerful attitude despite being confined to a wheelchair. Hawking quickly replied, “My expectations were reduced to zero when I was 21. Everything since then has been a bonus.”
Given his low expectations, Hawking rarely had reason to be disappointed. Conversely, economists and market participants seem to be taking the opposite approach to capital markets so far this year. Recession forecasts have all but disappeared for 2024 with an economic soft landing the consensus base case. Additionally, corporate earnings growth is broadly expected to re-accelerate with S&P 500 earnings estimated to grow 9% in 2024 and 13% in 2025. Lastly, expectations have also grown for artificial intelligence to impact the profitability of early adopters and other enterprises along the value chain, as reflected in certain equity valuations. These high expectations have driven equity markets higher throughout the first quarter of 2024, resulting in all-time highs for major indexes after a “lost” two years. And while we continue to enjoy the legs of a rally that begin last December, we remain focused on what’s ahead.
The key to navigating the Paradox of Expectations involves being realistic about potential outcomes. As investors, we cannot avoid the need to forecast certain economic data or asset class return expectations when constructing a portfolio or investment strategy. But we must be reasonable and adaptable when formulating those expectations, relying more on history than headlines. As we wrote in a recent newsletter, a humble approach to setting expectations is to expect the unexpected.
Who Cuts First?
Few global economists expected the first central bank policy rate movement in 2024 to be a hike, but after nearly eight years of negative interest rates Japan raised its policy range to 0%-0.1% in late March. Of course, this is the opposite of expectations set for other developed economies, where the question remains: who cuts rates first? The U.S. has historically led the economic cycle relative to other developed countries and has traditionally been the first to cut rates as a result. This time, that may not be the case. Coming into this year, investors and economists expected the Federal Reserve to begin cutting interest rates in March, but as economic data continued to prove resilient, those expectations converged to reality.
At their March meeting, U.S. central bankers held rates steady at 5.25-5.50, unchanged since July 2023, but maintained expectations of three rates cuts throughout the remainder of 2024, with the first cut expected in June.
Now, with economic growth slowing in other developed economies, markets may see the first rate cuts come from central banks other than the Federal Reserve, creating a potential tailwind for international capital markets relative to the U.S. This, along with attractive relative valuations., international equities may exhibit strong relative performance over the short-to-medium term.
High Yield Bonds and the Economic Cycle
High-yield fixed income, or bonds with lower than investment-grade credit ratings, can be a useful indicator of investors’ expectations as to where we are in an economic cycle. The classic economic cycle includes four stages: expansion, peak, contraction, trough. Understanding where the economy is within any given cycle is important for investors as each phase can impact certain asset classes differently. Unfortunately, estimating an economy’s current phase in real time with precision is a challenging task. As an example, the National Bureau of Economic Research (NBER), an organization generally relied upon to define U.S. business cycles, can take up to 21 months after an economic peak or trough before issuing a formal declaration.
Given the difficulty in projecting each phase of the cycle, many economic indicators have been developed in attempt to better approximate the current phase. One of the lesser-known sources is the direction and level of high-yield bond spreads, or the yield differential between high-yield bonds and less-risky Treasury bonds. Based on research by Voya Investment Management, the level and trend of high-yield spreads may be correlated to each phase of the economic cycle as follows:
Bubbles and Concentration
Wall Street loves creative naming conventions, from the Nifty 50 in the 70s, to the FAANG companies a decade ago. Now, the Magnificent 7 have the limelight. These mega-cap technology-related companies, including NVIDIA, Meta Platforms, Amazon, Microsoft, Alphabet (Google), Apple and Tesla, have been rallying for more than a year. Although more recently it seems the group may have lost a couple of members, as Tesla and Apple have retreated around 30% and 11%, respectively, year-to-date, leaving perhaps just a Fabulous 5? Either way, these seven companies have grown to market capitalizations that, together, equal the total stock market value of Japan, India, and Germany combined – roughly $13.1 trillion!
While this is great for investors who own the names, the question making headlines now is whether this rally has inflated into another bubble. More specifically, current comparisons are being made between the Magnificent 7 and the 1999-2000 tech bubble. And while valuations have clearly widened (become more expensive) for these seven stocks, there are stark differences between then and now. Most importantly, the fundamentals for these companies today - such as profitability, earnings growth and stability, and balance sheet health - are much more supportive than was the case in 1999.
At the index level, however,? concentration risk is mounting as these companies continue to grow in size. The Magnificent 7 now account for more than 25% of the S&P 500 index. According to research by Goldman Sachs Asset Management, history shows that on a forward-looking basis the largest companies tend to underperform the rest of the index. This doesn’t necessarily mean poor absolute performance, however, as history proves that these large companies often continue to perform well.
What does this mean for investors today? First, this level of index concentration by a small number of large companies could provide opportunities to add value from names in the bottom three-fourths of the index. Companies that have been unloved or benefitted less from the AI hype may be offering much more favorable valuations than some of these larger “in the news” companies. Additionally, international markets may provide overlooked opportunities, especially as developed economies outside of the U.S. progress in the economic cycle and begin to cut their own policy rates. To reiterate one of our Investment Team’s key tenets, we believe careful security selection has more potential to add value today than has been the case for quite some time.
Healthy, But Slowing
Although inflation has come down significantly since its peak in mid-2022, interest rates have remained high as a result of the U.S. economy’s resilient health. Put simply, the job is not complete. Indeed, Fed chairman Jay Powell highlighted the need for further data showing continuous progress on inflation before lowering interest rates at his March 20th press conference. An important segment of data, and one half of the Federal Reserve’s dual mandate, is the labor market. This area of the economy has been remarkably resilient throughout this rate-hiking cycle, hindering central bankers’ willingness to cut rates sooner than later. As history shows, lowering interest rates prematurely could reignite inflation and require a fresh hiking cycle.
As seen in the chart above, however, labor markets have started cooling. The number of quits, many of which were employees leaving for a better (higher paying) opportunity, has come down meaningfully over the past two years, a trend the Federal Reserve would like to see continue. Similarly, the number of hires and earnings growth have both softened as well, another sign that economic activity could be slowing. Higher wages can lead to higher spending levels, leading to higher inflation, so moderating this segment of the economy is a key factor in bringing inflation back towards the 2% long-term target.
Given the stated importance that the Federal Reserve places on the labor market when evaluating it’s monetary policy, when should investors expect this cooling to result in the first rate cut? As of the end of March, market participants are pricing in a June 2024 first cut, along with multiple more in succeeding meetings. These expectations can be seen driving equity markets to all time highs as well, as investors have been pricing in an optimistic soft landing scenario since late last year.
And while this may be the base case probabilistically, we think the risk of no, or less, rate cuts throughout 2024 could be an underappreciated risk in capital markets today. High expectations can lead to disappointing results if the less-likely outcomes are not carefully considered.
Recalibrating Expectations
As U.S. equities revisit all-time highs and markets brace for rate cuts while avoiding a recession, it’s important to recalibrate risk and return expectations moving forward. To do so, investors must consider several questions as we approach mid-year:
This type of scenario analysis, understanding how a portfolio or investment strategy might behave in these different environments, is key in monitoring an investment plan. Likewise, understanding potential risk and return outcomes from today’s starting points matters as well. Our team does this by analyzing several Capital Market Assumptions – a fancy phrase for forward risk and return expectations – from various research institutions around the world. By aggregating these CMAs, we can make informed decisions based on world-class research, delivering on our Investment Team’s core values of discipline, diligence and independence.
Bottom-line
Expectations drive capital markets, from investor sentiment to asset valuations. But the Paradox of Expectations creates a dilemma for investors: low expectations can cause investors to miss out on potential future returns, while high expectations can deliver disappointing outcomes over the long-term. Given today’s new economic and capital market backdrop, with interest rates elevated, economic growth strong but slowing, and equity markets at or near all-time highs, risk and return expectations should be recalibrated moving forward. For investors, the next 10 years is more important than the last. After all, today’s capital is being committed for future returns, seeking to achieve future objectives, with the expectation that tomorrow will be better than today.?
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We believe the information contained within this material to be reliable but do not warrant its accuracy or completeness. Opinions and views expressed herein reflect our judgement based on current market conditions and are subject to change without notice. Past performance is not indicative of future results. Additional risk considerations exist for all strategies, and the information provided is not intended as a recommendation, or an offer or solicitation to purchase or sell any investment product or service.