Don’t Lose Your Balance in the AI Frenzy
What happened last week?
Last week, both the S&P 500 and Dow slipped by -0.08% while the Nasdaq rose 0.24%. In the first half of 2024, the S&P 500 price is up 14.5% and the gross total return is 15.3%.
3 Things to Know
Even AI Isn’t Immune to Boom and Bust Risk
The inexorable shift in the economy to digital life — lived through bytes of data — has still coincided with great volatility in financial asset prices.
The late 1990s dot com bubble and bust was the only time tech spending excesses kicked off a recession. Yet tech investments also posted severe, if temporary, losses in the Great Recession of 2008/2009 and vacillated sharply in the upheaval of 2020 and 2022.
Temporary declines in asset prices — is not a portfolio concern for investors with high risk tolerance. In this case, strong sustained returns are earned with equities, the ownership of the economy’s capital.
Even so, individual equities can sometimes fall to worthless levels.
Growth Doesn’t Happen Overnight
Asset allocation — what some oversimplify to “60/40 portfolios” of stocks and bonds — failed to shield investors in 2022 because central banks drove interest rates to history’s lowest levels.
For some economies, policy interest rates were slashed to negative levels, such as -0.75% in Switzerland. For the US, the yields on Treasury inflation-protected bond were negative.
But this is no longer the case. Despite recent price gains, a portfolio of varied types of USD-denominated fixed income continues to offer potential opportunity to earn returns that are far in excess of the lows of the recent historical period.
For investors considering building out a new portfolio of diversified fixed income, there is the possibility to construct holdings that yield 5.5%-6.5% on average, depending on the investor’s suitability and risk tolerance.
We believe that certain investors with the appropriate investment objective and risk tolerance should consider maintaining a duration around 5-5.5 years for their overall fixed income portfolio.
While we think rates will decline, longer-maturity Treasuries may not move higher in price and lower in yield as much as the “belly” of the yield curve (intermediate maturities) once rate cuts begin.
In short, we see potential value from expected rate cuts in the 5-7 year maturity portion of the UST yield curve.
Fixed Income Portfolios Can Help Hedge Downside Risk
Today, a broad range of fixed income instrument types and maturities allows investors to pick and choose an average maturity length and be comfortable that if the Federal Reserve cuts interest rates perhaps by 1.5% or more over the next two years, their income earned will be based on current higher yields (provided all fixed income instruments held pay out at par).
Looking out a bit further, the Fed forecasts that its policy rate will be 3.1% by end 2026 and 2.8% on average over the “longer run.”
With an inverted yield curve, the US Treasury market essentially embeds that outcome as a base case in current bond values. What is somewhat unusual now is that the yield curve has been inverted for a record time while credit spreads have tightened.
The Fed typically eases monetary policy in reaction to a slowing US labor market. We expect that to again be the case. What is unusual is that corporate profits were weaker in 2022/2023 when rising labor markets caused the Fed to tighten. The recovery in US corporate profits to a high-single-digit pace in 2024 — with more industries in recovery — is a boon to credit quality.
This comes at a time when the Fed is nearing a turning point and can be expected to reduce its policy rates this year. Like the economy itself, this unusual combination of factors drives us to select fixed income over- and under-weight positions somewhat differently.
See our weekly CIO Strategy Bulletin for more details