As I reflect on markets through the start of Q4, a few things stick out.
First and foremost, the Federal Reserve cut interest rates by 50 bps at their September meeting. While a pivot to rate cuts was expected, the depth of that cut came as a surprise to many economists who had expected a smaller cut (25 bps) due to the strength of the U.S. economy.
Economic data has since surprised to the upside, with September’s nonfarm payrolls report beating consensus expectations by over 100,000 new jobs created and September retail sales rising 1.7% year-over-year.
This has been great news for stocks, but not-so-great news for bonds. Somewhat counterintuitively, longer-term bonds are down since the Fed’s September rate cut, as revised expectations around future rate cuts (a stronger-than-expected economy means less reason for the Fed to cut rates significantly) drove treasury yields up.
Cash rates have fallen, but longer-term bond yields have risen
Source: Bloomberg, 10/24/24.
Stock market outlook: what broadening equity performance could mean for your portfolio
In further good news for stocks, we’ve seen equity market performance broaden since June: many of the asset classes that were lagging in the first half of the year (and much of 2023) roared back to life through Q3, with utilities, large cap value and small caps pulling U.S. equities higher.
Source: Bloomberg as of 10/23/24. Small caps represented by the Russell 2000, Technology represented by the S&P 500 Information Technology sector index, and Utilities represented by the S&P 500 Utilities sector index.
This is generally good news – a broader equity rally may be at less risk of being thrown off by an idiosyncratic shock – but also a lesson for anyone whose portfolio had drifted too far away from benchmark. High dispersion creates opportunities for active managers, potentially increasing the possibility of alpha-generation, but high dispersion also creates risk for those who veer too far away.
The answer to this dilemma, of course, is a thoughtful approach to benchmarking and risk budgeting, ensuring that your portfolio’s tracking error remains at a reasonable level: high enough that correct market calls can have an impact, but not so high that an incorrect call can push the portfolio off-course.
One last portfolio allocation consideration is alternatives. With cash rates forecast to fall further, many may be wondering whether they still need an allocation to alternatives – after all, falling rates should mean better bond returns.
As we’ve already experienced in the weeks since the September Fed rate cut, not necessarily. Longer-term rates are less sensitive to Fed policy, and more sensitive to the economic outlook – which includes rising deficit levels that could put additional pressure on the long-end of the treasury curve.
And with longer-term bonds under-yielding cash… and credit spreads still really tight… alternatives with “cash plus” mandates may make more sense than ever.
After all, the opportunity to earn cash plus 4-6% sounds better than the opportunity to earn cash plus 3%, or worse, cash minus 0.40%.
Tight credit spreads and subdued longer-term bond yields make “cash plus” liquid alternative strategies relatively attractive
Source: Bloomberg as of 10/24/24. IG Credit represented by Bloomberg US Corporate Bond Index, HY Credit represented by Bloomberg US High Yield Index. Fixed Income index yields-to-worst represented by the Bloomberg US Corporate Bond Index and the Bloomberg US High Yield Index.
This is not an all-or-nothing proposition. Portfolio constructors should always have a hedge against the possibility of a recession, even if one isn’t expected. For instance, portfolio constructors running a 60/40 model will likely want to keep some longer-term treasury exposure on-hand . In a meaningful economic slowdown, I would expect the Fed to more aggressively cut interest rates, and for longer-term treasuries to act as ballast. And indeed, with bond prices having fallen in the past few weeks, today’s yields may suggest a more attractive entry point for those who have been underweight duration.
But for portfolio constructors, it also makes sense to complement that treasury exposure with strategies that can add “plus” returns on top of it, particularly given our current outlook. For instance, I like diversifying alternatives in particular, but also see value in adding diversified exposure to the credit sectors that can drive higher yields.
My colleague Kristy Akullian and I put together an Implementation Guide with our best ideas for Q4. Click the link below for more details on our thinking, as well as that of experts and PMs from around BlackRock.
You can also check out the Advisor Outlook for our monthly insights into what’s driving markets and what it might mean for portfolio builders.
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