U.S. economic momentum remains solid, and while risks remain, a recession seems unlikely
U.S. economic momentum has remained strong in recent months, supported by resilient consumer spending. With few excesses building across the cyclical sectors of the economy, the risk of some endogenous shock causing a recession is low and moderate consumer spending should support trend-like growth into 2025. That said, with the U.S. election just over a month away, monetary policy at a critical turning point and geopolitical tensions still elevated, external risks to the current expansion remain.
Note:
An endogenous shock refers to a disruption or sudden change within an economic system that originates from within the system itself rather than from external factors. These shocks can be caused by internal economic dynamics, such as fluctuations in consumer spending, business investment cycles, or changes in financial markets or policy decisions.
In the context of a recession, an endogenous shock might include:
- Rapid changes in interest rates: If central banks suddenly increase interest rates to control inflation, it could slow down borrowing and spending.
- Financial market volatility: Sharp declines in stock or bond markets due to overvaluation or high levels of speculation can impact consumer and business confidence.
- Credit crises: Issues within the banking or credit sector, such as a wave of loan defaults or tightening of credit conditions, can reduce the availability of funds for businesses and consumers.
Endogenous shocks contrast with exogenous shocks, which come from outside the economic system, like natural disasters, geopolitical conflicts, or significant policy changes in other countries.
While the labor market is normalizing, it remains on solid ground
A cooling labor market should contribute to lower inflation
The unemployment rate has trended higher in recent months, sparking fears the labor market and broader economy are cooling too quickly. While layoffs near historic lows suggest the rise in unemployment may just be conditions normalizing as opposed to something more sinister, loosening slack in the labor market has helped slow wage growth. As labor markets continue to cool, easing wage pressures should contribute to lower inflation.
Inflation is on a sustainable path back toward the Federal Reserve’s 2% target
After a bumpy start to the year, recent data have given the Federal Reserve greater confidence that inflation is on a steady path lower. While price gains in shelter and auto insurance remain elevated, real-time data continue to point to easing price pressures ahead, and broader disinflationary tailwinds, such as easing wage pressures and stable supply chains, suggest that inflation is on a sustainable path back to 2%.
With an eye on the labor market, the Federal Reserve is ready to normalize policy
Cooling inflation in recent months has allowed the Federal Reserve to focus on supporting the labor market, prompting it to deliver a 50-basis point rate cut at its September meeting. While the pace of future cuts will hinge on the incoming data, interest rates will likely settle at a structurally higher level compared to the last decade absent any economic shocks.
Even after the recent rally, current bond yields still look attractive
Despite a broadening rally, still-elevated concentration risk calls for an active approach
Resilient economic activity and earnings growth north of 10% have propelled U.S. stocks higher in recent months. Importantly, the rally has extended to a broader cohort of stocks, and earnings growth outside of the most dominant companies inflected positive in 2Q24. While valuations at over 21x earnings remain a risk, the richest parts of the market have some of the strongest fundamentals. Moreover, other parts of the market remain depressed relative to the broader index, providing active investors plenty of opportunities across sectors.
Note:
In business and finance, fundamentals refer to the core, underlying data that help measure the financial health, performance, and potential of a company or asset. This can include various types of information:
- Financial Statements: Such as balance sheets, income statements, and cash flow statements. These provide a snapshot of the company’s assets, liabilities, revenue, expenses, and overall profitability.
- Economic Indicators: Broader economic factors that affect performance, such as interest rates, inflation, employment rates, and overall market conditions.
- Company Metrics: Specific ratios and metrics like earnings per share (EPS),
return on equity (ROE), profit margins, debt-to-equity ratio, and price-to-earnings(P/E) ratio. These ratios help investors analyze profitability, efficiency, and leverage. - Qualitative Factors: Business fundamentals also encompass non-numerical aspects such as company leadership, competitive advantages, market positioning, and operational efficiency.
Together, fundamentals provide insight into the intrinsic value of a business or investment, as opposed to its current market price. This analysis is the foundation for fundamental analysis in investing, where investors evaluate these factors to determine if an asset is overvalued or undervalued.
The global economy is improving, but not evenly
Global economic activity has improved from last year's sluggish pace, although there has been divergence beneath the surface. Manufacturing activity remains subdued in Europe while domestic demand in China has been weak. However, other parts of Asia are benefitting from a turn in the electronics cycle, driven by investments in AI and other advanced technologies. With many global central banks focused on normalizing policy, renewed economic tailwinds should highlight plenty of attractive opportunities across global markets.
Positive fundamentals should extend the international rally
Despite a volatile third quarter, international equities have maintained their upward momentum, and many markets are up over 10% this year. Even so, in both absolute terms and relative to their own histories, international markets continue to look attractively priced compared to the U.S. This, combined with improving fundamentals, structurally higher interest rates and a more favorable economic backdrop, presents an attractive opportunity for U.S. investors to diversify abroad.
Alternatives can meaningfully enhance portfolio outcomes
As elevated valuations, low income and positive stock-bond correlations continue to challenge the 60/40 portfolio, investors should consider alternative assets in the portfolio construction process. There are a wide range of assets in the alternatives landscape, each catering to the different investment objectives of alpha, income and diversification. As such, adding a sleeve of alternatives can meaningfully improve portfolio outcomes and help investors reach their strategic goals.
Note:
Alternative investments refer to asset classes that differ from traditional investments like stocks, bonds, and cash. These alternatives often provide different risk-return profiles, and investors may use them to diversify their portfolios. Common types of alternative investments include:
- Private Equity: Investments in private companies, often through venture capital or buyouts, aimed at gaining ownership or a stake in businesses not publicly traded.
- Hedge Funds: Pooled funds managed by professionals using a variety of strategies (like long-short positions, leverage, derivatives) to achieve returns uncorrelated with broader market movements.
- Real Estate: Investments in property, which can include commercial, residential, or industrial real estate, aiming for both income (rents) and capital appreciation.
- Commodities: Physical assets like gold, oil, or agricultural products. They offer protection against inflation but can be more volatile due to supply and demand dynamics.
- Infrastructure: Investments in assets such as bridges, toll roads, airports, and utilities that provide stable cash flows and potential long-term returns.
- Private Debt: Loans or credit issued by private individuals or companies. This can include direct lending or structured debt instruments not traded on public markets.
- Collectibles: Tangible assets like art, wine, vintage cars, and other rare items, often seen as a store of value but can be highly illiquid and require specialized knowledge.
Characteristics of Alternative Investments:
- Lower Liquidity: These assets are often harder to buy and sell quickly.
- Higher Risk and Return Potential: They may provide returns that differ from traditional assets, which can mean both greater risks and the possibility of outsized gains.
- Diversification: Alternatives can add diversification, as they often have low correlations with traditional investments.
