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Q4 2024 Investment Outlook
October 1, 2024
At a glance
Investor gains continue in 2024 as the fourth quarter begins, with global stocks, bonds and several real asset categories delivering solid returns. Despite early August volatility, equities have delivered double-digit returns, and country plus sector participation beyond U.S. technology stocks is a welcomed development. Bonds have provided both income and price appreciation despite corporate bonds offering historically low compensation relative to government bond yields. In the third quarter alone, investors absorbed Japanese interest rate increases, several regional conflicts around the world and an ongoing political news cycle turning at hyper speed.
However, the U.S. Federal Reserve (Fed) cutting interest rates for the first time since beginning its rate increasing cycle in March 2022 represents the most significant event for investors. We have likened the Fed to a personal trainer, raising interest rates (akin to increasing the ramp height on a treadmill) to slow the economy. After maintaining its interest rate target at between 5.25%-5.50% for more than a year, the Fed lowered interest rates by half a percent, giving the somewhat fatigued economic runner some relief. The key for consumer and business activity will be their ability to taper in a measured fashion versus a more severe slowdown; our base case is business and consumer activity will modestly decline.
While we retain a positive outlook for diversified portfolios, we face several major events in the year’s final quarter. The election looms large in November, with policy implications for several sectors as well as major tax and trade policy considerations. The Fed meets two more times this calendar year, with investors parsing every word to forecast if the half percentage cut versus the central bank’s usual quarter percent cadence carries any significance or merely represents a jumpstart in a phase transition. Global earnings and economic data releases will carry extra meaning as investors weigh how achievable the 11.8% global earnings forecasts and 14.5% U.S. large company earnings forecasts may be. As our most senior capital market analysts share below, we are optimistic about both yield and price appreciation opportunities for investors, but we will remain guarded about consumer health, policy risks and valuation metrics as each day presents new considerations. Thank you for your trust; enjoy the content that follows.
― Eric Freedman, Chief Investment Officer, U.S. Bank
Global economy
Quick take: Growth in the United States and India remains exceptional while other major economies, including China, Europe, Japan and the United Kingdom (UK) demonstrate modest but positive economic expansion despite elevated interest rates. Slowing growth and inflation trends are likely to persist well into 2025 due to lagged effects of high borrowing costs. U.S. election uncertainties and the specific path of the Federal Reserve (Fed) are key questions for investors as we head into year-end.
Sources: U.S. Bank Asset Management Group analysis, Bloomberg, July 31, 2004-July 31, 2024. Gray bars indicate recessionary periods.
- U.S. economic exceptionalism is likely to moderate into 2025. The U.S. Bank Economics Team anticipates some deceleration in activity into the new year as still-elevated borrowing costs dampen consumer spending from strong levels. Inflation is also likely to ease along with the restraint in spending and recent declines in commodity prices. The transition of the Fed to a more normal interest rate policy — lower interest rates and borrowing costs — should help the economy in the coming year. Attention soon turns to the November 5 U.S. elections, though market returns typically see greater impacts from the economic environment than election outcomes. Instead, the election results likely impact narrow sectors or regions based on the winning party’s scope of government control.
- Developed market economies deliver modest expansions as global central banks adjust policy rates. The recovery in developed market economies remains weak and uneven. Economic growth appears unlikely to accelerate, with consumers and businesses in Europe challenged by high interest rates the European Central Bank (ECB) and the Bank of England are only beginning to trim. In contrast, the Bank of Japan has initiated interest rate hikes with inflation holding above its target. Elevated rates and easing business activity should temper potential gross domestic product and inflation into year-end. Adjustments to global trade policies and tariffs arising from the U.S. election are risks into 2025.
- Emerging market activity likely slows as India passes peak acceleration, China struggles with housing market excess supply and low commodity prices hurt natural resource exporters. India’s economy likely decelerates from its recent peak, but the level of activity remains elevated as the economy benefits from the constituting effects of government investment and manufacturing expansion. China’s economic output likely disappoints, with languishing home prices and inadequate central government stimulus programs dampening consumer sentiment. Commodity exporting economies, such as Brazil and Mexico, are hurt by lower commodity prices and a dearth of global demand.
U.S. equity market
Quick take: U.S. equities begin the fourth quarter facing increased market volatility and political uncertainty. The artificial intelligence (AI) buildout bolsters growth-oriented Information Technology and related sub-industries, a trend we see continuing for the foreseeable future. Meanwhile, moderating interest rates and uncertainty regarding near-term economic prospects increase the appeal of defensive-oriented sectors such as Consumer Staples, Healthcare, Real Estate and Utilities.
Sources: Bloomberg, FactSet, U.S. Bank Asset Management Group Research, September 23, 2024.
- Inflation, interest rates and earnings are directionally consistent with higher equity prices. Waning inflation, moderating interest rates and stable earnings projections support higher-trending U.S. equity prices into year-end, albeit at a moderate pace. Expense control remains a common theme among companies, bolstering profit margins and earnings growth.
- We expect volatility to be the norm into year-end. Valuations are elevated, companies are likely to temper guidance following the release of third quarter results due to slowing economic growth, and government policy is subject to change depending on the election outcomes.
- Consumer and business spending remain resilient. Consumers continue to travel, spending on discretionary goods is growing and loan and credit card defaults are near normalized levels, setting the stage for a positive holiday buying season. Meanwhile, business technology spending remains robust, particularly around AI and related products. Accelerated computing and generative AI demand is surging across nations, industries and companies. Companies and countries are looking to employ AI capabilities to improve and modernize their workflow, reach production faster and improve accuracy and efficiency.
- We favor balanced exposure to both technology-oriented growth sectors and defensive, income-oriented sectors. This balanced approach provides exposure to evolving technologies while capitalizing on favorable risk profiles of sectors and companies that have lagged during the rising interest rate environment. We see compelling investment opportunities over both the short- and long-term in areas such as data capture, storage, processing, software and analytics, security, distribution and power generation. At the same time, defensive, income-oriented sectors such as Real Estate, Consumer Staples, Industrials and select Healthcare companies should respond favorably to a less-restrictive Fed policy stance.
International equity markets
Quick take: Modest earnings growth expectations and lower individual company and sector concentration coupled with ongoing monetary policy support back our neutral foreign developed equity view. Evolving emerging market growth drivers evenly balance near-term risks and opportunities.
- Central bank policies spurred broad-based gains in 2024 and remain an equity price tailwind into the year ahead. European central banks appear positioned to provide further monetary policy support, with interest rate markets anticipating one to two additional rate cuts by the ECB and Bank of England prior to year-end. Declining interest rates should promote increased economic activity, benefiting cyclical sectors such as Energy, Financials, Industrials, Materials and Real Estate, representing more than 50% of total foreign equity exposure (versus less than 30% in U.S. large company stocks).
- Diverse growth factors and concentrated risks inform our neutral foreign developed equity outlook. Analysts’ 2025 earnings forecasts have remained relatively stable throughout the year, less dependent on individual sector, industry or company prospects than represented in domestic markets. For example, the largest 20 companies constitute nearly 45% of the S&P 500 Index by market weight, more than double the weight of the top 20 companies in the MSCI EAFE Index. Meanwhile, risks to our cautiously optimistic outlook are concentrated in the European region. European wage inflation remains sticky, challenging companies’ ability to pass on cost increases amid subdued consumer demand, while the Russia/Ukraine conflict represents an ongoing regional event risk.
- The emerging market opportunity landscape continues to change. Since its inception in 1988, MSCI Emerging Market Index country representation has evolved from primarily raw materials fueling the global economy to China’s rapid economic ascendency and today’s emerging India. India has surpassed China in economic growth rate (6.7% versus 4.7% in the second quarter) and briefly eclipsed China in index market share during the third quarter, with strong year-to-date performance gains propelling India to a 20.8% market weight as of September 29, according to Bloomberg.
- Emerging market risks and opportunities appear evenly balanced as we look to 2024’s conclusion and the year ahead. Higher global interest rates drove an earnings contraction in 2023, but analysts forecast a robust profit recovery in 2024 (13.9%) and 2025 (15.8%) as central banks begin unwinding restrictive policies, lowering borrowing costs. Through September 2024, while emerging market equities have gained 17.5%, valuation remains within a normal historical range and a 2.7% dividend yield provides some total return support. Tempering our forward outlook, global growth concerns weigh on South Korea and Taiwan’s near-term export prospects, while China’s ongoing housing woes continue to impair consumers’ sentiment and spending.
Bond markets
Quick take: Blends of diversified high-quality bonds, including corporates, Treasuries and government-backed agency mortgage securities, offer opportunities to lock in yields above 4% before the Federal Reserve cuts interest rates further. Modest supplemental exposures to riskier high yield bonds and unique bond types such as non-agency mortgages and reinsurance can further improve return potential in fixed income portfolios.
Source: U.S. Bank Asset Management Group Research, Federal Reserve, Bloomberg; 6/12/2024-9/18/2024.
- Bond yields incorporate expectations that the Fed will continue with steady interest rate cuts through 2025. The Fed initiated rate cuts in September and Treasury yields reflect an additional 2.00% in cuts by the end of 2025. This sets a high, though not insurmountable, bar for further high-quality bond price gains while potential income returns remain compelling.
- Bond portfolios should align with the time horizon of investors’ goals. Slower rate cuts or the election drawing greater attention on federal government spending could cause swings in bond prices. Ensuring short- and long-term bond holdings match investment goals can help investors navigate interest rate uncertainty.
- Corporate and municipal bonds are slightly expensive but fairly compensate for credit risks. The extra yield on corporate bonds over Treasuries is slightly below long-term averages. The same is true for high yield municipal bonds after adjusting for their tax-exempt income status, whereas investment-grade municipals are near longer-term norms. Somewhat high valuations on corporate and municipal bonds reflect solid issuer fundamentals and strong investor demand. While sentiment shifts can cause temporary swings in riskier bond prices, their extra income improves long-run return opportunities.
- Mortgage bonds not backed by the government and reinsurance offer compelling income with unique return characteristics. Mortgage bond fundamentals remain solid. Home price gains in recent years create strong collateral support, and mortgage delinquencies remain low. Slow housing market activity also constrains new mortgage bond supply, providing a favorable technical tailwind. For qualifying investors, reinsurance (insurance-linked securities) offers above-average yields, currently in the low teens. This income compensates for insurance payout risks stemming from global catastrophes such as hurricanes. These events can be sporadic, and reinsurance can provide a meaningful and differentiated source of return that is uncorrelated with the normal business cycle.
Real assets
Quick take: Declining interest rates as global central banks begin a new easing cycle improve the outlook for real assets. However, decelerating growth and inflation may create headwinds for commodities.
- Publicly traded real estate is currently undervalued based on the Federal Reserve’s expected path for interest rate cuts. Aside from property types with idiosyncratic risk factors, such as office and retail, most Real Estate sectors are performing well despite slowing income growth. Real Estate stocks are well positioned for this environment.
- Utilities and midstream energy stocks should continue to generate above-average income growth. Increasing demands for electricity will benefit both sectors, enabling them to continue providing strong and stable dividends for income-oriented investors. Midstream energy stocks could face headwinds if crude oil trades lower.
- The energy needs to power artificial intelligence and the “green” transition will require a material increase in demand for fossil fuels and metals for an extended period. However, declining growth and inflation are not positive for commodity prices.
Alternative investments
Quick take: Hedge fund managers embraced recent volatility but may favor defensive positioning ahead of the November 5 elections. Managers who stay agile and appropriately size the risks in their portfolios for conditions that may quickly change appear well-positioned in this environment.
- Hedge fund managers reacted to volatility this summer by further reducing leverage and net market exposure (total securities invested long less securities sold short). Compared to positioning in the first half of the year, managers have lowered overall net exposure to reduce potential market downside and allow a portfolio starting point from which to tactically lean net long or short and pursue high conviction opportunities.
- Equity market neutral is one of the best-performing hedge fund strategies this year. Hedge fund managers have been shorting individual stocks more actively than hedging for broad market declines. This does not mean hedge funds will avoid risk, but we expect them to focus more on individual stocks and bonds than overall market directionality.
- Tactically oriented hedge fund managers who stay nimble and can trade quickly are well suited for this environment. In addition to the currently conducive environment for investing long and short, attractive longer-term opportunities may be emerging for managers focused on idiosyncratic endeavors. We are intrigued by managers seeking to exploit market inefficiencies and innovate, such as incorporating artificial intelligence, machine learning and shareholder activism.
Private markets
Quick take: Private market valuations lag public market pricing and are typically less volatile, resulting in short-term distortions that resolve over the longer holding period of the private investments. Despite these distortions, we continue to execute on our thesis-driven opportunities in the current market.
Sources: U.S. Bank Asset Management Group analysis, Pitchbook, Q1 2021-Q1 2024.
- Private market investments are normally valued on a quarterly basis, with valuations tested by third-party auditors annually, causing a lag in pricing. In 2022, during the selloff across publicly traded markets, private market investments were not marked down to reflect the steep drawdown in public markets. Similarly, private market valuations have not kept pace with rising public market valuations.
- Private market valuation is typically determined on a quarterly basis using a combination of inputs, including comparable private transactions, discounted cash flows and public market comparisons. Comparable transactions include recent sales, purchases or fundraising for a comparable private company. Discounted cash flows are projected earnings of the private company discounted by expected return. Public market comparisons include the prices at which similar public companies are trading. When public market companies are trading at elevated valuations, the median valuation determined using the methodology tends to be lower; when public market companies are trading at cheaper valuations, the median valuation tends to be higher.
- We continue to find opportunities in the current markets. Our thesis-driven research guides our private market investing approach, considering broader secular trends, dislocations and market exuberance. In private equity, we continue to focus on investment managers that find opportunity in founder-owned businesses in lower middle market where consolidation and professionalization can unlock growth potential. We are cautiously exploring opportunities to be involved with applications that leverage AI to provide real world solutions. In private debt, we see opportunity for alternative sources of debt financing taking market share from traditional corporate lenders such as banks, insurance companies and other institutional providers. Traditional commercial real estate lenders are managing their existing loan books down, thereby creating opportunity for alternative lenders to step in and provide debt solutions at attractive returns. Finally, we are excited about the growing opportunity of private equity investing in sports and media, including teams and related media and technology.
This commentary was prepared September 2024 and represents the opinion of U.S. Bank. The views are subject to change at any time based on market or other conditions and are not intended to be a forecast of future events or guarantee of future results and are not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable but is not guaranteed as to accuracy or completeness. Any organizations mentioned in this commentary are not affiliated or associated with U.S. Bank in any way.
U.S. Bank and its representatives do not provide tax or legal advice. Your tax and financial situation is unique. You should consult your tax and/or legal advisor for advice and information concerning your particular situation.
Diversification and asset allocation do not guarantee returns or protect against losses. Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio.
Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for investment. The S&P 500 Index is an unmanaged, capitalization-weighted index of 500 widely traded stocks that are considered to represent the performance of the stock market in general. The MSCI EAFE Index includes approximately 1,000 companies representing the stock markets of 21 countries in Europe, Australasia and the Far East (EAFE). The MSCI Emerging Markets Index is designed to measure equity market performance in global emerging markets.
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investing in fixed income securities is subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investments in debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer-term debt securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in high yield bonds offer the potential for high current income and attractive total return but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer’s ability to make principal and interest payments. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes but may be subject to the federal alternative minimum tax (AMT), state and local taxes. There are special risks associated with investments in real assets such as commodities and real estate securities. For commodities, risks may include market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults). Hedge funds are speculative and involve a high degree of risk. An investment in a hedge fund involves a substantially more complicated set of risk factors than traditional investments in stocks or bonds, including the risks of using derivatives, leverage and short sales, which can magnify potential losses or gains. Restrictions exist on the ability to redeem or transfer interests in a fund. Private capital investment funds are speculative and involve a higher degree of risk. These investments usually involve a substantially more complicated set of investment strategies than traditional investments in stocks or bonds, including the risks of using derivatives, leverage, and short sales, which can magnify potential losses or gains. Always refer to a Fund’s most current offering documents for a more thorough discussion of risks and other specific characteristics associated with investing in private capital and impact investment funds. Reinsurance allocations made to insurance-linked securities (ILS) are financial instruments whose performance is determined by insurance loss events primarily driven by weather-related and other natural catastrophes (such as hurricanes and earthquakes). These events are typically low-frequency but high-severity occurrences. Private equity investments provide investors and funds the potential to invest directly into private companies or participate in buyouts of public companies that result in a delisting of the public equity. Investors considering an investment in private equity must be fully aware that these investments are illiquid by nature, typically represent a long-term binding commitment and are not readily marketable. The valuation procedures for these holdings are often subjective in nature. Private debt investments may be either direct or indirect and are subject to significant risks, including the possibility of default, limited liquidity and the infrequent availability of independent credit ratings for private companies.
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