Rebounds, rate reductions and infrastructure

Bottom line up top

The U.S. Federal Reserve’s entry in “This day in history: 18 September.” It might not rank alongside George Washington’s laying the cornerstone of the U.S. Capitol building in 1793, but after a long period of speculation, fluctuating forecasts and investor impatience, the Fed finally pivoted to easier monetary policy last Wednesday. The announcement of a 50 basis points (bps) cut in the target fed funds rate, to a range of 4.75%-5.00%, came roughly two and a half years after the first hike in the historic tightening cycle that began in March 2022.

Last week’s move was in line with market expectations heading into the meeting. It’s also an aggressive first step in what is expected to be a series of rate reductions. Based on the Fed’s dot plot of rate projections (Figure 1), markets can expect an additional 50 bps of cuts in 2024, lowering the fed funds rate to 4.25%-4.50% by year-end. The rate should then decrease by an additional 100 bps in 2025, with the potential for 50 bps of easing in 2026.

It’s the economy (and unemployment and inflation)! In addition to signaling future rate levels, the Fed’s Summary of Economic Projections now points to a tick down in real GDP growth this year (+2.0% versus +2.1% in the June 2024 forecast), moderately higher unemployment (4.4%, up from 4.0% previously) and further cooling of inflation (core PCE Index at 2.6%, down from the prior outlook’s 2.8%). Bottom line: The Fed thinks a near-term recession is unlikely, expects inflation to continue falling toward the 2% target and believes further easing is warranted over the next two years.

Front-loading the rate-cutting cycle, as the Fed has done with its initial 50 bps move (with more to come next quarter), may improve the odds of achieving a soft landing for the economy, but brings with it the risk of reigniting inflation. Unforeseen economic and market events could potentially alter the Fed’s current projections. In our view, this backdrop suggests positioning portfolios somewhat more defensively, while maintaining exposure to select risk assets.

Portfolio considerations

It’s no secret global equity markets have rebounded impressively since the end of the 2022 bear market — a downturn brought on by the beginning of the rate hiking cycle by the Fed and other central banks around the world. In the 18 months between 01 January 2023 and 30 June 2024, the MSCI All Country World Index returned nearly +23%. During the same timeframe, the S&P 500 Index gained +28.5%, driven by the world’s largest technology stocks (the Magnificent Seven), which at times accounted for more than 100% of the overall index’s total return.

While euphoria surrounding artificial intelligence (AI) enabled the S&P 500’s comeback, the economic and market backdrop looks considerably different today. The U.S. labor market began to cool significantly in the second half of 2024 after a long period of surprising strength. This led to heightened concern about the health of the broader economy and made last week’s Fed rate cut a foregone conclusion. Since midyear, top-performing tech stocks have also taken a back seat to more rate-sensitive and economically resilient areas of the market that had underperformed during most of the Fed’s tightening cycle. Among those laggards that have now taken the lead is publicly listed global infrastructure (Figure 2), one of our most favored equity categories.

A confluence of economic and market developments has bolstered the rally in infrastructure equities and, in our view, should underpin its continued outperformance:

? The pause in the megacap tech rally has come at a time when valuations for infrastructure look quite attractive, relative to both broader markets and its own history.

? A falling (and lower) rate environment is likely to make capital-intensive sectors such as infrastructure look even more enticing to equity investors.

? Structural growth themes, including burgeoning demand for energy to support generative AI expansion and the onshoring/nearshoring of manufacturing operations by U.S.-based multinational companies, continue to offer compelling opportunities to invest in infrastructure.

Additionally, amid decelerating economic growth and the possibility of a recession, we like global infrastructure’s historical resilience in down markets. This ability to weather challenging conditions is due largely to inelastic demand for the necessary functions and services provided by several global infrastructure industries, including electric utilities, waste companies and data centers. Since its inception in December 2001, the S&P Global Infrastructure Index has generated a downside capture ratio of 80.5% versus the MSCI ACWI through 30 June 2024.