The 2024 Asset Allocation Draft
David Lebovitz, Global Market Strategist, Multi-Asset Solutions and Jared Gross, Head of Institutional Portfolio Strategy, conduct their annual asset allocation draft across various asset classes, and make their picks for the most promising investment opportunities in 2024.
CIE PODCAST DECEMBER
TRANSCRIPT
00;08;04;52 - 00;08;28;31
Speaker 1 – DAVID LEBOVITZ
Welcome to the Center for Investment Excellence, a production of J.P. Morgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. Today's episode is the 2024 Asset Allocation Draft. I'm David Lebovitz, global strategist from our Multi-Asset Solutions business and host of the Center for Investment Excellence. With me today is Jared Gross, head of institutional portfolio Strategy.
00;08;28;49 - 00;08;48;44
Speaker 1
Thanks, David. Good to have you back. So in terms of the agenda for today, we are going to do what we've done the past couple of years towards the end of the year and try to look forward over the next 12 months and think about which assets could potentially perform well and which assets may have a bit of a bit more of a struggle.
00;08;48;46 - 00;09;13;50
Speaker 1
But before we dive in, I think it's important to take stock of what's happened over the course of 2023 because it's a very different year than everybody expected. You know, you go back to the beginning of this year, 40% of forecasters were calling for a recession. People thought it was going to get worse before it got better. They thought that the bear market that materialized in 2022 was likely to continue throughout 2023.
00;09;14;11 - 00;09;30;55
Speaker 1
But in the event what have we seen, we've seen better than expected growth. We've seen inflation continue to decelerate and we've seen the S&P 500 up effectively 20% so far year to date. I know that there are still a couple of weeks left and I remember a few Decembers where things got a little hairy towards the end of the year.
00;09;30;55 - 00;09;55;28
Speaker 1
But again, a much better year for the economy and for risk assets than we originally expected. As we look ahead to 2024, we do think a soft landing is is in the cards. You know, it does look like inflation is going to continue to decelerate. We think that growth will slow from the very robust rate that we saw, particularly in the third quarter, to something more in the lines of of trend or slightly below trend over the coming calendar year.
00;09;55;40 - 00;10;20;24
Speaker 1
And we think that, frankly, that macro backdrop probably gives the Fed and other central banks a little bit more wiggle room than people originally thought was going to be the case. I don't see the Fed cutting aggressively if we don't have a recession. But if we get our base case view of, you know, call it trend growth and inflation that really approaches that 2% inflation target, we do see room for some modest Fed easing over the course of the next 12 months.
00;10;20;24 - 00;10;25;04
Speaker 1
But, you know, that's just one man's view. So how are you thinking about the economy as we look ahead to next year?
00;10;25;35 - 00;10;55;37
Speaker 2 – JARED GROSS
Yeah, well, I think the way you framed it right up front is interesting. You know, we were really surprised to the downside in 2022. You know, we had a positively correlated stock and bond market, significant losses across really any diversified portfolio. And so to some extent, you know, 2023 has been just the inverse of that. And so, you know, while it's surprising to see the strength from a macro perspective, you know, maybe we we could have anticipated a little bit of that natural snapback, which is a positively correlated market just going in a more favorable direction.
00;10;56;54 - 00;11;22;14
Speaker 2
You know, I think to your point right now, it appears that the Fed has peaked. And what we're now really focused on is the length of the pause. And beyond that, what is going to be sort of the end point for Fed policy, although that's probably a year or more away. And so, you know, the question I think we're all kind of wrestling with is what is sort of the fact pattern of macro data that's going to get the Fed to move in the other direction.
00;11;22;20 - 00;11;39;30
Speaker 2
It's pretty hard to see data points right now that would cause the Fed to go back the other way and re resume hiking. It's not impossible. I mean, we can't completely rule that out. We did have a pretty healthy jobs report. And if we got more in that direction, I suppose it's always possible that the Fed could go back the other way.
00;11;39;30 - 00;11;54;39
Speaker 2
But that certainly doesn't feel like the the base case at this stage. So it's really a question of what's going to cause the Fed to, you know, start to turn the other way. And, you know, it's, you know, headline inflation obviously has come down a lot. And some of that is food and energy. And we know that's very volatile.
00;11;54;39 - 00;12;15;26
Speaker 2
So we have to sort of look past that. But a lot of the core measures have also come down pretty materially. Wages have come down, at least in the most recent print. Expectations have come down, which I think is significant because previously expectations had been running a little hot and that was maybe something that the Fed would hold on to as making the case for sort of, you know, waiting a while longer.
00;12;16;34 - 00;12;32;22
Speaker 2
You know, they like the the the payrolls number, the JOLTS numbers, things like that. So, you know, everything is kind of leaning in that direction. And so, you know, I think what I've always come back to for the last year or two is thinking about the Fed as like a lot of central banks needing to regain a certain measure of credibility.
00;12;32;22 - 00;13;04;25
Speaker 2
They've done a lot of that Powell strategy appears to have worked. Mm hmm. And, you know, he's you know, I think sometimes it feels like he's taking a victory lap, maybe a little too soon. But, you know, that certainly is the direction of travel here. So I think we're we're kind of on the same page. And so, yeah, you know, it's an interesting environment in which to allocate capital because, you know, the traditional relationships between assets where bonds diversify stocks against a growth shock starts to feel like we're back to normal.
00;13;04;44 - 00;13;11;42
Speaker 2
And so some of those rules that we had grown accustomed to and got sort of shocked in 2022 maybe are back in play again.
00;13;12;05 - 00;13;29;42
Speaker 1
Yeah. No, I think that that's a really good point. And one of the things that we've been talking about quite a bit in the Multi-Asset Solutions business is really that positive correlation, right? And how long you can you can kind of leave a financial conditions trade on where equities and bonds both do well. You know, that's really that that exists because inflation is still in focus.
00;13;29;42 - 00;13;47;57
Speaker 1
I think you make a very important point that as markets begin to focus more on the outlook for growth and view inflation as maybe being mission accomplished, we don't want to say that prematurely. But at some point down the road. Right. Knock on wood. Then you get that negative correlation, then portfolio construction and asset allocation becomes a little bit more straightforward.
00;13;47;57 - 00;14;06;34
Speaker 1
But in terms of the process for today, so we are going to have four rounds of the draft. We're going to go back and forth. Each round is going to focus on a particular market sector. We'll spend some time discussing the various considerations around these investment opportunities. And then one of us will make the selection before moving on again.
00;14;06;35 - 00;14;22;40
Speaker 1
We will start with fixed income. Move on to public equity, then we'll cover real assets and finally wrap up with financial alternatives. And so with that is the road map for today. Jared, I'm going to let you go first. So. Fixed income bond market, what's your view on 2024?
00;14;22;46 - 00;14;44;04
Speaker 2
Yeah, and I'll just I'll add one sort of subtlety, because you and I have done this a couple of years now, and I think we want to be clear to the audience that our goal here is not to provide the pieces that would construct a fully diversified portfolio. It's really about looking at the market today from, you know, from our current vantage point, where would we sort of put a thumb on the scale in favor of asset classes or segments of the market that we think look, particularly attractive?
00;14;44;29 - 00;15;01;33
Speaker 2
And maybe we'll talk about a few things we think are less attractive as a result of that. But, you know, we'll start with fixed income. So, you know, it's a very interesting time for the fixed income market. We still have an inverted curve. In fact, with the rally in rates that we've seen over the last month or two, the curve is quite steeply inverted.
00;15;01;33 - 00;15;23;38
Speaker 2
And that, you know, obviously leads one to think that cash could be the right place to to to remain. But obviously, you know, as we've said previously, the Fed has reached the peak of its hiking cycle, I think almost certainly. And so on a forward looking basis, what you're going to get with cash is an attractive current yield, but that's going to be diminished over time as the Fed eventually starts to cut rates.
00;15;24;05 - 00;15;42;06
Speaker 2
And the downside of holding cash, of course, is that as rates fall, whether it's because the Fed cuts at the front end or the market prices in lower rates in the future, further out the curve, you're not going to benefit from that duration component of returns and you're not going to get that tailwind. And so, you know, we certainly think that adding some duration to portfolios makes sense.
00;15;42;06 - 00;16;06;46
Speaker 2
You know, particularly if you're sitting in cash, you know, where you go and how far out you go is a matter of some interest. You know, I think for most investors, this is a good time to be thinking about a, you know, sort of gradual return to your natural habitat. If you're a total return investor and you regard fixed income primarily as a source of, you know, relatively low volatility and diversification, moving back towards, you know, the short core.
00;16;06;46 - 00;16;26;58
Speaker 2
And then the core really makes sense if you're a liability hedge or with long duration as your natural habitat, you know, getting back to some form of long duration investing makes sense. And then the second layer, of course, is is spread sectors where in the credit markets do we think levels are attractive right now? And that and this is the trickier part.
00;16;26;58 - 00;16;50;46
Speaker 2
And, you know, you and I both were active in our long term capital market assumptions process. And I think this was one of the more interesting debates that we had while conducting that exercise, which is are we likely to see much of a credit cycle? And if so, where will that credit cycle hit? Because, you know, while 2022 was a pretty bad year for the markets, the credit spreads, sectors emerged relatively unscathed.
00;16;50;46 - 00;17;12;50
Speaker 2
I mean, other than some initial volatility, spreads didn't widen that much. And I think there was an expectation that, you know, inevitably that would happen, but it just hasn't occurred. And, you know, there are some very good fundamental reasons, You know, corporations termed out their debt. You know, there's pretty good, you know, financial, you know, kind of leverage metrics in cash on the balance sheet.
00;17;12;50 - 00;17;32;15
Speaker 2
The underlying economic environment is pretty positive. Revenues have held up. So it's not a bad credit environment, but credit spreads are pretty rich by historical standards. And so, you know, creates this sort of challenge in figuring out where you want to take risk. So, you know, I think when we step back from all of that, you say, look, you want to start adding some duration to portfolios.
00;17;33;14 - 00;17;52;49
Speaker 2
You know, two places that I think are the most interesting. One is sort of just the broader core plus space where you're getting that duration and you're getting the flexibility to move around sectors as they become attractive in that kind of dynamic. Asset management also, you know, kind of always makes sense. I mean, for the purpose of today's exercise, that's a little bit of a lazy answer because you're sort of saying, look, you're.
00;17;52;49 - 00;17;53;26
Speaker 1
Picking everything.
00;17;53;26 - 00;18;12;09
Speaker 2
Pick everything and pick everything in the PPMO will get you to the right spot. I think if you want to be a little more narrowly focused, I think high yield is really interesting, right now, despite the fact that high yield spreads have not widened out all that much. In fact, at around 400 basis points, they're pretty tight. That is a higher quality sector than it's ever been before.
00;18;12;09 - 00;18;49;04
Speaker 2
A lot of the lower rated credits have been pulled away into the levered loan market, into the private credit market. And so what remains in high yield is definitely skewed to the higher end of the quality spectrum. So those those tighter spreads are in many respects deserved based on fundamentals. And because we see the investment grade universe kind of crowded up the other way towards the triple B space, there's going to be a lot more ratings migration that occurs between IG and high yield, and that's actually a very good place for high yield managers to actively manage because they can capture those fallen angels after they've repriced and own the rising stars before they go
00;18;49;04 - 00;19;01;58
Speaker 2
back up. And so if we see a higher level of ratings migration across time, that's going to be a very attractive kind of opportunity for the high yield space. So I think for for fixed income, that's what I'm going to go with, which is which is high yield.
00;19;02;23 - 00;19;19;35
Speaker 1
And I think that that makes sense. You know, one of the things that we've been talking a lot about, given a somewhat constructive macro view for 2024, is you want to continue to lean into risk and it really becomes a question of how do you express that view? You know, S&P at 4600 goes to 5000. That's an eight and a half percent return.
00;19;19;35 - 00;19;30;06
Speaker 1
That's the same thing as the coupon on high yield. So if you're not totally sold on equities, but you don't want to run to, you know, pure play, high quality duration, I think you're spot on. I think high yield looks particularly interesting.
00;19;30;15 - 00;19;41;39
Speaker 2
And I think you've proposed a great segway to your topic, which is equities and sort of where where we think, you know, in that sort of riskier end of the portfolio, particularly in the public markets where the best places to take risk.
00;19;41;40 - 00;20;05;37
Speaker 1
Exactly. So unfortunately, I don't have a terribly exotic answer this year. I have thought a lot about this and we've had a lot of debate and discussion about the various opportunities. You know, to me, I when I look at the world, you've got the US where things have remained relatively solid and then you have the rest of the world where it kind of feels like things maybe starting to bottom and beginning to improve.
00;20;05;37 - 00;20;28;29
Speaker 1
And, you know, frankly, we need to sharpen the pencil on on places like Europe, places like China, places like M effectively. We think it could go one way or the other. You know, Europe looks like manufacturing is kind of bottoming out. Inventories were a big drag on growth that arguably creates some headspace for inventories to get rebuilt. If you see that coincide with, you know, decent final demand.
00;20;28;51 - 00;20;44;51
Speaker 1
There's a story there in Europe. But, you know, people oftentimes talk about how Europe is cheap. If you actually look on an equally weighted basis, valuations are right around the 50th percentile. So when you when you adjust for, you know, the various overweight and underweight sectors, you basically end up with a market that kind of looks fairly valued.
00;20;44;51 - 00;21;04;59
Speaker 1
And so could there be an opportunity in Europe? Maybe. But let's not forget Euro Stoxx is also up 20% year to date. When we think about the other developed markets outside of the U.S., obviously Japan has come up in conversation quite a bit, particularly over the past couple of months. I think that there are again kind of mixed signals on Japan.
00;21;05;00 - 00;21;24;11
Speaker 1
On the one hand, you have this idea that, you know, if we get corporate governance reform, the way that everybody's discussing, valuations can rewrite to something in line with what was observed during Abenomics. And maybe there's a trade there. But on the other hand, you look at the yen where it is today, and you have to ask yourself, is yen going to 130 or is it going to go to 155?
00;21;24;32 - 00;21;49;07
Speaker 1
Right. If you get that yen weakness, we like the Japan trade. If you get that yen strength, it could effectively erode any sort of benefit that you get from that corporate governance reform coming to fruition. And I would just tangentially point out that a lot of people are really bullish on Japan. It's becoming more and more consensus. And, you know, you've known me for for a couple of years now, You know, I can be a little bit contrarian.
00;21;49;07 - 00;22;09;01
Speaker 1
And so that just rubs me a little bit the wrong way. China, too many warts, you know, I'll just leave it at that. Whether it's the inability to stimulate with enough size to get the economy back on track, whether it's the lingering debt issues, you know, particularly in real estate, whether it's the rising regulatory risk, just difficult to get excited about China.
00;22;09;01 - 00;22;33;01
Speaker 1
But I will say there are parts of em outside of China that are looking more interesting, you know, particularly places like, say, Mexico, other parts of Southeast Asia, which we think will benefit from a reorientation of supply chains. But obviously the dollar plays a big role in all of that. And if we begin to find ourselves in a in a broadly risk off environment, the dollar is going to strengthen and that's going to blow away any return that you were generating from em.
00;22;33;03 - 00;22;59;42
Speaker 1
And so, you know, kind of a plain vanilla pick here at the end of the day, I'm going to go with the US Large-cap. I think that at the end of the day we like the idea of owning those higher quality assets. We recognize that tech plays a big role and that margins do look relatively elevated. Importantly, though, Tech took their medicine in 2022 with the layoffs, and so we actually think there may not be as much downside risk for some of those big names as might otherwise be the case.
00;23;00;13 - 00;23;20;43
Speaker 1
And then finally, you know, the growth businesses in particular, they've got a ton of cash. They can self-fund. They don't need the capital markets if they want to do CapEx. And so when I put it all together, I know that, again, it's not necessarily the most interesting pick, but US large cap for for for 2024. So we've gone through the public markets, fixed income and equity.
00;23;21;03 - 00;23;42;39
Speaker 1
Let's transition to alternatives, real assets, you know, up until 2022 when fixed income actually paid you something again every day. Right. We would have conversations with clients about real assets, income, inflation protection, uncorrelated source of yield. Now people look at me and say, well, I can get paid five and a half percent in two year treasuries, so why would I bother owning real assets?
00;23;42;39 - 00;23;49;29
Speaker 1
So remind us of why we think real assets add value over time. And then what's your thinking in terms of the opportunity set for 2024?
00;23;50;36 - 00;24;24;26
Speaker 2
Yeah. So, you know, real assets have grown significantly as a sort of structural component of diversified portfolios. And I think you have to start from the premise of what is the public market for real assets offering and then think about what the alternative and sort of more private versions will get you. In addition or sort of beyond that, you know, there is a point in the cycle where things like tips and commodities do very well for you, and that's when you reach an inflation surprise that the market has not priced in and a lot of assets kind of reprice to that new inflation environment.
00;24;24;26 - 00;24;46;14
Speaker 2
And tips and commodities tend to be the best at capturing that sort of inflation beta and are sort of levered to that moment in time. And in fact, that's what we saw in the early stages of the inflation spike. They did very well and certainly relative to most other asset classes. So, you know, there is an argument on sort of a tactical basis for owning public real assets.
00;24;46;14 - 00;25;08;10
Speaker 2
The problem, of course, is over long horizons, most of those asset classes tend to deliver very low real returns. And so it's very hard to justify holding a large enough position in things like tips and commodities to either one make a difference as an inflation hedge without scuttling the returns that you need to earn, you know, over your for your overall portfolio.
00;25;08;10 - 00;25;38;25
Speaker 2
And so I think, you know, that that moment in the sun has sort of passed. I think public real assets are going to be less interesting going forward because inflation has peaked. And now we're thinking about private real assets as a return generating sector that has a built in resiliency to inflation. You know, I think, you know, if there is a lingering lesson from 2022 and the positive correlation, it's that, you know, bonds do a good job of hedging growth risks which are going to be negative for equities.
00;25;38;44 - 00;26;03;18
Speaker 2
They don't do a very good job of hedging inflation risks, which can also be negative for equities. And so in that framing, you know, yes, inflation is coming down. It has almost certainly peaked and it's unlikely to go much higher. You know, is it likely to be sticky for a while? That's certainly possible. You know, I think there are there's a compelling case to be made that inflation is heading pretty consistently back towards the Fed's target.
00;26;03;23 - 00;26;28;17
Speaker 2
But, you know, we don't know that yet. And it's quite likely that there's going to be a little bit of chop along the way. And so, you know, even as we've seen episodes of strongly positive correlation not only in 2022, but more recently, mostly in our favor, thank goodness, but not always those real assets have the ability to sort of capture nominal growth in nominal pricing in their revenue stream.
00;26;28;17 - 00;26;54;09
Speaker 2
So, you know, what does that mean? Well, you know, the classic core real asset trio would be, you know, core real estate where, you know, you're getting paid for sort of fully stabilized assets, where the leases reprice to prevailing market conditions across time. And, you know, typically with a either a large, you know, property that has multiple leases or more likely a diversified portfolio of multiple properties, you're going to capture that kind of staggered repricing and that's going to build in some inflation resilience over time.
00;26;54;38 - 00;27;28;03
Speaker 2
You can also look at things like infrastructure, particularly infrastructure that's built around power distribution, where you have regulated pricing that specifically incorporates the input costs to generating, you know, the energy itself. And that's going to have a very strong inflation sensitive component. And then, you know, things like transportation or other sort of long lived hard assets where it's not so much about the assets themselves going up in value, whether they're some kind of catalyst to, you know, accreting value through the the price of those assets.
00;27;28;03 - 00;27;50;39
Speaker 2
It's the revenue streams that they generate. And so those are going to tend to be the most resilient to inflation. And, you know, because they offer high single digit to low double digit returns, it's a it's totally justifiable to carve out, you know, a meaningful part of a portfolio to hold those assets. And I think, you know, you're going to talk about those sort of remainder of the alternative asset classes.
00;27;50;39 - 00;28;15;12
Speaker 2
But I think one of the lessons from the last few years is that investors who exclusively focused on only the highest returning alternatives, you know, think of venture and sort of traditional private equity missed out on some opportunities to capture these diversifying return streams. And what is really called for is just a larger and more diverse allocation to alternatives, not so much just substitution within it.
00;28;15;12 - 00;28;20;32
Speaker 2
And I think that's an important lesson that investors need to be thinking about as they head into 2024.
00;28;20;32 - 00;28;22;09
Speaker 1
So in terms of your pick.
00;28;22;31 - 00;28;23;25
Speaker 2
Oh, I should say yes.
00;28;23;38 - 00;28;24;54
Speaker 1
So I'm not going to let you get away there.
00;28;24;55 - 00;28;43;37
Speaker 2
No, no. I was trying to slide that past you. I'm going to be a little contrarian here. Maybe I think, you know, as I think about 2024 and sort of the principle of how to invest, it's really about sequencing. You want to think about the assets that have already repriced to this higher interest rate environment, and that's where you want the new capital to go.
00;28;43;37 - 00;29;02;41
Speaker 2
The marginal dollars should flow into those sectors and there are some asset classes that may over the long horizon do just fine, but they haven't really repriced yet to this environment. I know you're going to talk about some of those, but one area that is starting to look interesting, despite some of the, you know, scary stories is commercial real estate.
00;29;03;01 - 00;29;25;17
Speaker 2
You know, first of all, this is a highly diverse, you know, kind of ecosystem. So, you know, we hear the headlines about, you know, midtown office space and some of the horror stories there. But the truth is, even within office space, there's lots of bright spots. But if you think about commercial real estate broadly, you look at, you know, life science, you look at multifamily, you look at industrial, you look at, you know, logistics, infrastructure, industrial infill.
00;29;25;17 - 00;29;42;18
Speaker 2
There's a lot of really interesting places to put capital to work. And it is a sector where the prevailing level of interest rates has largely flowed through into the asset prices. And so I think it's actually becoming a very interesting place to allocate new capital today. So so that would be my pick would be commercial real estate.
00;29;42;22 - 00;29;53;16
Speaker 1
Yeah. And I don't disagree. I mean, and again, you need to think about where things are priced in and infrastructure has shown pretty tremendous resilience. Transportation still benefits from a limited supply of ships. Yeah.
00;29;53;56 - 00;30;11;19
Speaker 2
They're all good. I mean, they're not mutually exclusive. But, you know, certainly I think real estate has sort of taken it on the chin a little bit more than some of those other asset classes. I mean, I think just to expand on your point slightly, you know, we look at infrastructure, particularly core infrastructure, a lot of these assets are financed using long term debt.
00;30;11;19 - 00;30;31;20
Speaker 2
And so the degree to which they're going to reprice in the near term is very modest and so if you're waiting for sort of a cheap entry point with those asset classes, you're probably going to be waiting. Yeah, that doesn't diminish their ability to generate positive returns at the operating level. It just means that you're not going to see a lot of price decline to take advantage of.
00;30;31;20 - 00;30;36;01
Speaker 2
Whereas in, you know, more traditional commercial real estate, you see a very attractive entry point right now.
00;30;36;06 - 00;30;56;56
Speaker 1
Exactly. And then that that brings us to the kind of remaining alternatives. So think, you know, hedge funds, private credit and private equity. You and I spent a fair amount of time on Friday talking about this and trying to think through, you know, what's going to be the best performer for 2024. And what we came to some modestly firm conclusions.
00;30;56;56 - 00;31;07;11
Speaker 1
I'm not necessarily sure that that that private credit stood out relative to private equity. And so let's just kind of talk through this and maybe we'll both provide an answer to this one rather than than just, you know, this.
00;31;07;20 - 00;31;08;12
Speaker 2
Is try to spread the risk.
00;31;08;12 - 00;31;26;18
Speaker 1
Around. Yeah, exactly. I see how this feels. So the way that I think about it is, on the one hand, you look at private credit and you've seen tremendous growth in the number of managers, tremendous growth in the number of assets. Arguably, from a valuation perspective, given the move in base rates, you know, things are looking a bit tight.
00;31;27;18 - 00;31;48;34
Speaker 1
On the other hand, you have tremendous flexibility and it is not in the best interest of neither the borrower nor the lender for the borrower to default and so I think you'll see continued amend and extend activity much like we've seen over the past couple of quarters. I don't think that the bottom falls out of private credit, but I do think that there are arguably some bad apples amongst the bunch.
00;31;48;34 - 00;31;58;33
Speaker 1
And I really think it's it's this idea of stepping into a asset class that has experienced hypergrowth over the past 10 to 15 years.
00;31;58;33 - 00;32;00;51
Speaker 2
Is this supposed to be a positive towards credit.
00;32;01;10 - 00;32;18;38
Speaker 1
Towards the end of of what we say, good. As you get closer to the end of the business cycle. And so you know where where I shook out on private credit is that it makes sense as a structural allocation in portfolios over time. But I'm not necessarily sure that that's where my incremental dollar goes today.
00;32;18;38 - 00;32;34;17
Speaker 2
Yeah, I don't disagree. I think, look, there's it's a very crowded space, as someone put it to me recently, There's a lot of tourists in the private credit market right now. And so you do have to be a little careful that some of that capital is just being allocated because it's been it's been assigned by the asset owners to the managers.
00;32;34;17 - 00;32;57;27
Speaker 2
The managers are sitting on dry powder. They have to put it to work. And, you know, you have to be a little concerned that the underwriting standards are going to fall and they're going to fall in a period of time where the end borrowers are, you know, experiencing extremely elevated cost of capital. I mean, a lot of this money is being lent out at, you know, very high single digit to low double digit yields and a lot of operating business models simply don't survive that kind of rate environment.
00;32;57;27 - 00;33;18;35
Speaker 2
So we do have to be a little bit, you know, sort of humble about, you know, expecting those returns to flow through without some credit losses. I think another way to sort of take advantage of the broader private credit ecosystem, though, is to one, you know, frontload some distressed managers who are going to be waiting to take advantage of some of that, you know, sort of credit cycle activity when it occurs.
00;33;19;06 - 00;33;36;22
Speaker 2
And also consider the secondary markets where, you know, if you're able to provide liquidity, you know, because this huge surge of capital has flowed into the private credit markets and, you know, some non-zero portion of that is not going to stay fully invested with the the full cycle. They're going to want liquidity at some interim point in time.
00;33;36;47 - 00;33;56;53
Speaker 2
And the secondary markets are not as well capitalized and not as liquid. And so there's real opportunity to generate returns from that, you know, much sort of smaller subset. But but certainly if you think about the whole private credit ecosystem, it's the direct lending piece, which is the the bulk. But around the edges you can sort of shape that exposure to be, I think, a little more resilient.
00;33;56;53 - 00;34;12;38
Speaker 1
And I think that that's that's the key point, is that, you know, when we talk to clients about private credit, they almost automatically assume that we're talking about direct lending. To your point, there are lots of different types of strategies, far more on ramps and off ramps than has been the case in the past. And so, you know, don't throw the baby out with the bath water.
00;34;12;38 - 00;34;33;26
Speaker 1
But would I put an incremental dollar into direct lending today? Probably not. Private equity, on the other hand, is looking kind of interesting. And I'm sure you saw the data from LCD Pitchbook that came out recently. We actually included it in our Guide to Alternatives. But the third quarter saw a pretty notable decline in purchase price multiples for buyouts in the United States.
00;34;33;26 - 00;34;55;56
Speaker 1
And so it feels like that long awaited repricing may be finally starting to materialize. You know, we furthermore believe that in an environment of slower nominal activity, right, you're going to see some businesses really begin to get squeezed by this higher cost of capital. And you think about the way that that PE investors finance their portfolio companies. It's primarily through floating rate debt.
00;34;56;16 - 00;35;17;53
Speaker 1
And, you know, you can sell the airplane and you can strip down the business. You can do all sorts of things to keep your head above water. But eventually, if growth is slowing and you have to pay a certain level of rates, right, valuations are going to need to come in to reflect that more challenging environment. And so I think that while we do not anticipate recession in 2024, we can kind of lean on that old adage of, you know, more challenging.
00;35;17;53 - 00;35;43;39
Speaker 1
Macro environments tend to correspond to the better vintages for private equity. And I think that that could well be the case for for 2024. So I'm going to pick private equity for my final, final selection. So that leaves us with high yield on the fixed income side. US large cap equities in the public equity space, real estate, commercial real estate in real assets, and then private equity for the remaining alternatives.
00;35;43;39 - 00;35;47;03
Speaker 1
Do you have a final pick of those four? What do you think is going to be the best of the bunch?
00;35;48;31 - 00;36;07;38
Speaker 2
Risk adjusted returns, I would say high yields. I think for nominal returns. I mean, private equity is always the easy pick, just given that it operates with a lot of leverage. But I think real estate might, you know, might over the medium to longer term might provide some pretty substantial returns. So I would stick with that one.
00;36;07;47 - 00;36;25;25
Speaker 1
Yeah. I think that interest real estate definitely looks interesting to me and kind of the more bombed out the the area of commercial real estate, the greater the potential price appreciation over time. And I also would just second your point on high yield, particularly from a risk adjusted perspective. You know, 89% coupons are nothing to nothing to shake a stick at.
00;36;25;25 - 00;36;51;00
Speaker 1
And arguably that'll be a lower volatility asset for a lot of the reasons that you outlined than what we see in the public equity space. And so that's going to conclude this year's asset allocation draft. Thank you again for joining us today on J.P. Morgan Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcasts on our website and on our Jp morgan Asset Management YouTube Channel recorded on December 11th, 2023.
This content is intended for information only, based on assumptions and current market conditions, and are subject to change. No warranty of accuracy is given. This content does not contain sufficient information to support investment decisions. It is not to be construed as research, legal, regulatory, tax, accounting, or investment advice.
Investments involve risks. Investors should seek professional advice or make an independent evaluation before investing. The value of investments and the income from them may fluctuate, including loss of capital. Past performance and yield are not indicative of current or future results.
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JP Morgan Asset Management is the asset management business of JPMorgan Chase & Company and its affiliates worldwide
CIE PODCAST DECEMBER
TRANSCRIPT
00;08;04;52 - 00;08;28;31
Speaker 1 – DAVID LEBOVITZ
Welcome to the Center for Investment Excellence, a production of J.P. Morgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. Today's episode is the 2024 Asset Allocation Draft. I'm David Lebovitz, global strategist from our Multi-Asset Solutions business and host of the Center for Investment Excellence. With me today is Jared Gross, head of institutional portfolio Strategy.
00;08;28;49 - 00;08;48;44
Speaker 1
Thanks, David. Good to have you back. So in terms of the agenda for today, we are going to do what we've done the past couple of years towards the end of the year and try to look forward over the next 12 months and think about which assets could potentially perform well and which assets may have a bit of a bit more of a struggle.
00;08;48;46 - 00;09;13;50
Speaker 1
But before we dive in, I think it's important to take stock of what's happened over the course of 2023 because it's a very different year than everybody expected. You know, you go back to the beginning of this year, 40% of forecasters were calling for a recession. People thought it was going to get worse before it got better. They thought that the bear market that materialized in 2022 was likely to continue throughout 2023.
00;09;14;11 - 00;09;30;55
Speaker 1
But in the event what have we seen, we've seen better than expected growth. We've seen inflation continue to decelerate and we've seen the S&P 500 up effectively 20% so far year to date. I know that there are still a couple of weeks left and I remember a few Decembers where things got a little hairy towards the end of the year.
00;09;30;55 - 00;09;55;28
Speaker 1
But again, a much better year for the economy and for risk assets than we originally expected. As we look ahead to 2024, we do think a soft landing is is in the cards. You know, it does look like inflation is going to continue to decelerate. We think that growth will slow from the very robust rate that we saw, particularly in the third quarter, to something more in the lines of of trend or slightly below trend over the coming calendar year.
00;09;55;40 - 00;10;20;24
Speaker 1
And we think that, frankly, that macro backdrop probably gives the Fed and other central banks a little bit more wiggle room than people originally thought was going to be the case. I don't see the Fed cutting aggressively if we don't have a recession. But if we get our base case view of, you know, call it trend growth and inflation that really approaches that 2% inflation target, we do see room for some modest Fed easing over the course of the next 12 months.
00;10;20;24 - 00;10;25;04
Speaker 1
But, you know, that's just one man's view. So how are you thinking about the economy as we look ahead to next year?
00;10;25;35 - 00;10;55;37
Speaker 2 – JARED GROSS
Yeah, well, I think the way you framed it right up front is interesting. You know, we were really surprised to the downside in 2022. You know, we had a positively correlated stock and bond market, significant losses across really any diversified portfolio. And so to some extent, you know, 2023 has been just the inverse of that. And so, you know, while it's surprising to see the strength from a macro perspective, you know, maybe we we could have anticipated a little bit of that natural snapback, which is a positively correlated market just going in a more favorable direction.
00;10;56;54 - 00;11;22;14
Speaker 2
You know, I think to your point right now, it appears that the Fed has peaked. And what we're now really focused on is the length of the pause. And beyond that, what is going to be sort of the end point for Fed policy, although that's probably a year or more away. And so, you know, the question I think we're all kind of wrestling with is what is sort of the fact pattern of macro data that's going to get the Fed to move in the other direction.
00;11;22;20 - 00;11;39;30
Speaker 2
It's pretty hard to see data points right now that would cause the Fed to go back the other way and re resume hiking. It's not impossible. I mean, we can't completely rule that out. We did have a pretty healthy jobs report. And if we got more in that direction, I suppose it's always possible that the Fed could go back the other way.
00;11;39;30 - 00;11;54;39
Speaker 2
But that certainly doesn't feel like the the base case at this stage. So it's really a question of what's going to cause the Fed to, you know, start to turn the other way. And, you know, it's, you know, headline inflation obviously has come down a lot. And some of that is food and energy. And we know that's very volatile.
00;11;54;39 - 00;12;15;26
Speaker 2
So we have to sort of look past that. But a lot of the core measures have also come down pretty materially. Wages have come down, at least in the most recent print. Expectations have come down, which I think is significant because previously expectations had been running a little hot and that was maybe something that the Fed would hold on to as making the case for sort of, you know, waiting a while longer.
00;12;16;34 - 00;12;32;22
Speaker 2
You know, they like the the the payrolls number, the JOLTS numbers, things like that. So, you know, everything is kind of leaning in that direction. And so, you know, I think what I've always come back to for the last year or two is thinking about the Fed as like a lot of central banks needing to regain a certain measure of credibility.
00;12;32;22 - 00;13;04;25
Speaker 2
They've done a lot of that Powell strategy appears to have worked. Mm hmm. And, you know, he's you know, I think sometimes it feels like he's taking a victory lap, maybe a little too soon. But, you know, that certainly is the direction of travel here. So I think we're we're kind of on the same page. And so, yeah, you know, it's an interesting environment in which to allocate capital because, you know, the traditional relationships between assets where bonds diversify stocks against a growth shock starts to feel like we're back to normal.
00;13;04;44 - 00;13;11;42
Speaker 2
And so some of those rules that we had grown accustomed to and got sort of shocked in 2022 maybe are back in play again.
00;13;12;05 - 00;13;29;42
Speaker 1
Yeah. No, I think that that's a really good point. And one of the things that we've been talking about quite a bit in the Multi-Asset Solutions business is really that positive correlation, right? And how long you can you can kind of leave a financial conditions trade on where equities and bonds both do well. You know, that's really that that exists because inflation is still in focus.
00;13;29;42 - 00;13;47;57
Speaker 1
I think you make a very important point that as markets begin to focus more on the outlook for growth and view inflation as maybe being mission accomplished, we don't want to say that prematurely. But at some point down the road. Right. Knock on wood. Then you get that negative correlation, then portfolio construction and asset allocation becomes a little bit more straightforward.
00;13;47;57 - 00;14;06;34
Speaker 1
But in terms of the process for today, so we are going to have four rounds of the draft. We're going to go back and forth. Each round is going to focus on a particular market sector. We'll spend some time discussing the various considerations around these investment opportunities. And then one of us will make the selection before moving on again.
00;14;06;35 - 00;14;22;40
Speaker 1
We will start with fixed income. Move on to public equity, then we'll cover real assets and finally wrap up with financial alternatives. And so with that is the road map for today. Jared, I'm going to let you go first. So. Fixed income bond market, what's your view on 2024?
00;14;22;46 - 00;14;44;04
Speaker 2
Yeah, and I'll just I'll add one sort of subtlety, because you and I have done this a couple of years now, and I think we want to be clear to the audience that our goal here is not to provide the pieces that would construct a fully diversified portfolio. It's really about looking at the market today from, you know, from our current vantage point, where would we sort of put a thumb on the scale in favor of asset classes or segments of the market that we think look, particularly attractive?
00;14;44;29 - 00;15;01;33
Speaker 2
And maybe we'll talk about a few things we think are less attractive as a result of that. But, you know, we'll start with fixed income. So, you know, it's a very interesting time for the fixed income market. We still have an inverted curve. In fact, with the rally in rates that we've seen over the last month or two, the curve is quite steeply inverted.
00;15;01;33 - 00;15;23;38
Speaker 2
And that, you know, obviously leads one to think that cash could be the right place to to to remain. But obviously, you know, as we've said previously, the Fed has reached the peak of its hiking cycle, I think almost certainly. And so on a forward looking basis, what you're going to get with cash is an attractive current yield, but that's going to be diminished over time as the Fed eventually starts to cut rates.
00;15;24;05 - 00;15;42;06
Speaker 2
And the downside of holding cash, of course, is that as rates fall, whether it's because the Fed cuts at the front end or the market prices in lower rates in the future, further out the curve, you're not going to benefit from that duration component of returns and you're not going to get that tailwind. And so, you know, we certainly think that adding some duration to portfolios makes sense.
00;15;42;06 - 00;16;06;46
Speaker 2
You know, particularly if you're sitting in cash, you know, where you go and how far out you go is a matter of some interest. You know, I think for most investors, this is a good time to be thinking about a, you know, sort of gradual return to your natural habitat. If you're a total return investor and you regard fixed income primarily as a source of, you know, relatively low volatility and diversification, moving back towards, you know, the short core.
00;16;06;46 - 00;16;26;58
Speaker 2
And then the core really makes sense if you're a liability hedge or with long duration as your natural habitat, you know, getting back to some form of long duration investing makes sense. And then the second layer, of course, is is spread sectors where in the credit markets do we think levels are attractive right now? And that and this is the trickier part.
00;16;26;58 - 00;16;50;46
Speaker 2
And, you know, you and I both were active in our long term capital market assumptions process. And I think this was one of the more interesting debates that we had while conducting that exercise, which is are we likely to see much of a credit cycle? And if so, where will that credit cycle hit? Because, you know, while 2022 was a pretty bad year for the markets, the credit spreads, sectors emerged relatively unscathed.
00;16;50;46 - 00;17;12;50
Speaker 2
I mean, other than some initial volatility, spreads didn't widen that much. And I think there was an expectation that, you know, inevitably that would happen, but it just hasn't occurred. And, you know, there are some very good fundamental reasons, You know, corporations termed out their debt. You know, there's pretty good, you know, financial, you know, kind of leverage metrics in cash on the balance sheet.
00;17;12;50 - 00;17;32;15
Speaker 2
The underlying economic environment is pretty positive. Revenues have held up. So it's not a bad credit environment, but credit spreads are pretty rich by historical standards. And so, you know, creates this sort of challenge in figuring out where you want to take risk. So, you know, I think when we step back from all of that, you say, look, you want to start adding some duration to portfolios.
00;17;33;14 - 00;17;52;49
Speaker 2
You know, two places that I think are the most interesting. One is sort of just the broader core plus space where you're getting that duration and you're getting the flexibility to move around sectors as they become attractive in that kind of dynamic. Asset management also, you know, kind of always makes sense. I mean, for the purpose of today's exercise, that's a little bit of a lazy answer because you're sort of saying, look, you're.
00;17;52;49 - 00;17;53;26
Speaker 1
Picking everything.
00;17;53;26 - 00;18;12;09
Speaker 2
Pick everything and pick everything in the PPMO will get you to the right spot. I think if you want to be a little more narrowly focused, I think high yield is really interesting, right now, despite the fact that high yield spreads have not widened out all that much. In fact, at around 400 basis points, they're pretty tight. That is a higher quality sector than it's ever been before.
00;18;12;09 - 00;18;49;04
Speaker 2
A lot of the lower rated credits have been pulled away into the levered loan market, into the private credit market. And so what remains in high yield is definitely skewed to the higher end of the quality spectrum. So those those tighter spreads are in many respects deserved based on fundamentals. And because we see the investment grade universe kind of crowded up the other way towards the triple B space, there's going to be a lot more ratings migration that occurs between IG and high yield, and that's actually a very good place for high yield managers to actively manage because they can capture those fallen angels after they've repriced and own the rising stars before they go
00;18;49;04 - 00;19;01;58
Speaker 2
back up. And so if we see a higher level of ratings migration across time, that's going to be a very attractive kind of opportunity for the high yield space. So I think for for fixed income, that's what I'm going to go with, which is which is high yield.
00;19;02;23 - 00;19;19;35
Speaker 1
And I think that that makes sense. You know, one of the things that we've been talking a lot about, given a somewhat constructive macro view for 2024, is you want to continue to lean into risk and it really becomes a question of how do you express that view? You know, S&P at 4600 goes to 5000. That's an eight and a half percent return.
00;19;19;35 - 00;19;30;06
Speaker 1
That's the same thing as the coupon on high yield. So if you're not totally sold on equities, but you don't want to run to, you know, pure play, high quality duration, I think you're spot on. I think high yield looks particularly interesting.
00;19;30;15 - 00;19;41;39
Speaker 2
And I think you've proposed a great segway to your topic, which is equities and sort of where where we think, you know, in that sort of riskier end of the portfolio, particularly in the public markets where the best places to take risk.
00;19;41;40 - 00;20;05;37
Speaker 1
Exactly. So unfortunately, I don't have a terribly exotic answer this year. I have thought a lot about this and we've had a lot of debate and discussion about the various opportunities. You know, to me, I when I look at the world, you've got the US where things have remained relatively solid and then you have the rest of the world where it kind of feels like things maybe starting to bottom and beginning to improve.
00;20;05;37 - 00;20;28;29
Speaker 1
And, you know, frankly, we need to sharpen the pencil on on places like Europe, places like China, places like M effectively. We think it could go one way or the other. You know, Europe looks like manufacturing is kind of bottoming out. Inventories were a big drag on growth that arguably creates some headspace for inventories to get rebuilt. If you see that coincide with, you know, decent final demand.
00;20;28;51 - 00;20;44;51
Speaker 1
There's a story there in Europe. But, you know, people oftentimes talk about how Europe is cheap. If you actually look on an equally weighted basis, valuations are right around the 50th percentile. So when you when you adjust for, you know, the various overweight and underweight sectors, you basically end up with a market that kind of looks fairly valued.
00;20;44;51 - 00;21;04;59
Speaker 1
And so could there be an opportunity in Europe? Maybe. But let's not forget Euro Stoxx is also up 20% year to date. When we think about the other developed markets outside of the U.S., obviously Japan has come up in conversation quite a bit, particularly over the past couple of months. I think that there are again kind of mixed signals on Japan.
00;21;05;00 - 00;21;24;11
Speaker 1
On the one hand, you have this idea that, you know, if we get corporate governance reform, the way that everybody's discussing, valuations can rewrite to something in line with what was observed during Abenomics. And maybe there's a trade there. But on the other hand, you look at the yen where it is today, and you have to ask yourself, is yen going to 130 or is it going to go to 155?
00;21;24;32 - 00;21;49;07
Speaker 1
Right. If you get that yen weakness, we like the Japan trade. If you get that yen strength, it could effectively erode any sort of benefit that you get from that corporate governance reform coming to fruition. And I would just tangentially point out that a lot of people are really bullish on Japan. It's becoming more and more consensus. And, you know, you've known me for for a couple of years now, You know, I can be a little bit contrarian.
00;21;49;07 - 00;22;09;01
Speaker 1
And so that just rubs me a little bit the wrong way. China, too many warts, you know, I'll just leave it at that. Whether it's the inability to stimulate with enough size to get the economy back on track, whether it's the lingering debt issues, you know, particularly in real estate, whether it's the rising regulatory risk, just difficult to get excited about China.
00;22;09;01 - 00;22;33;01
Speaker 1
But I will say there are parts of em outside of China that are looking more interesting, you know, particularly places like, say, Mexico, other parts of Southeast Asia, which we think will benefit from a reorientation of supply chains. But obviously the dollar plays a big role in all of that. And if we begin to find ourselves in a in a broadly risk off environment, the dollar is going to strengthen and that's going to blow away any return that you were generating from em.
00;22;33;03 - 00;22;59;42
Speaker 1
And so, you know, kind of a plain vanilla pick here at the end of the day, I'm going to go with the US Large-cap. I think that at the end of the day we like the idea of owning those higher quality assets. We recognize that tech plays a big role and that margins do look relatively elevated. Importantly, though, Tech took their medicine in 2022 with the layoffs, and so we actually think there may not be as much downside risk for some of those big names as might otherwise be the case.
00;23;00;13 - 00;23;20;43
Speaker 1
And then finally, you know, the growth businesses in particular, they've got a ton of cash. They can self-fund. They don't need the capital markets if they want to do CapEx. And so when I put it all together, I know that, again, it's not necessarily the most interesting pick, but US large cap for for for 2024. So we've gone through the public markets, fixed income and equity.
00;23;21;03 - 00;23;42;39
Speaker 1
Let's transition to alternatives, real assets, you know, up until 2022 when fixed income actually paid you something again every day. Right. We would have conversations with clients about real assets, income, inflation protection, uncorrelated source of yield. Now people look at me and say, well, I can get paid five and a half percent in two year treasuries, so why would I bother owning real assets?
00;23;42;39 - 00;23;49;29
Speaker 1
So remind us of why we think real assets add value over time. And then what's your thinking in terms of the opportunity set for 2024?
00;23;50;36 - 00;24;24;26
Speaker 2
Yeah. So, you know, real assets have grown significantly as a sort of structural component of diversified portfolios. And I think you have to start from the premise of what is the public market for real assets offering and then think about what the alternative and sort of more private versions will get you. In addition or sort of beyond that, you know, there is a point in the cycle where things like tips and commodities do very well for you, and that's when you reach an inflation surprise that the market has not priced in and a lot of assets kind of reprice to that new inflation environment.
00;24;24;26 - 00;24;46;14
Speaker 2
And tips and commodities tend to be the best at capturing that sort of inflation beta and are sort of levered to that moment in time. And in fact, that's what we saw in the early stages of the inflation spike. They did very well and certainly relative to most other asset classes. So, you know, there is an argument on sort of a tactical basis for owning public real assets.
00;24;46;14 - 00;25;08;10
Speaker 2
The problem, of course, is over long horizons, most of those asset classes tend to deliver very low real returns. And so it's very hard to justify holding a large enough position in things like tips and commodities to either one make a difference as an inflation hedge without scuttling the returns that you need to earn, you know, over your for your overall portfolio.
00;25;08;10 - 00;25;38;25
Speaker 2
And so I think, you know, that that moment in the sun has sort of passed. I think public real assets are going to be less interesting going forward because inflation has peaked. And now we're thinking about private real assets as a return generating sector that has a built in resiliency to inflation. You know, I think, you know, if there is a lingering lesson from 2022 and the positive correlation, it's that, you know, bonds do a good job of hedging growth risks which are going to be negative for equities.
00;25;38;44 - 00;26;03;18
Speaker 2
They don't do a very good job of hedging inflation risks, which can also be negative for equities. And so in that framing, you know, yes, inflation is coming down. It has almost certainly peaked and it's unlikely to go much higher. You know, is it likely to be sticky for a while? That's certainly possible. You know, I think there are there's a compelling case to be made that inflation is heading pretty consistently back towards the Fed's target.
00;26;03;23 - 00;26;28;17
Speaker 2
But, you know, we don't know that yet. And it's quite likely that there's going to be a little bit of chop along the way. And so, you know, even as we've seen episodes of strongly positive correlation not only in 2022, but more recently, mostly in our favor, thank goodness, but not always those real assets have the ability to sort of capture nominal growth in nominal pricing in their revenue stream.
00;26;28;17 - 00;26;54;09
Speaker 2
So, you know, what does that mean? Well, you know, the classic core real asset trio would be, you know, core real estate where, you know, you're getting paid for sort of fully stabilized assets, where the leases reprice to prevailing market conditions across time. And, you know, typically with a either a large, you know, property that has multiple leases or more likely a diversified portfolio of multiple properties, you're going to capture that kind of staggered repricing and that's going to build in some inflation resilience over time.
00;26;54;38 - 00;27;28;03
Speaker 2
You can also look at things like infrastructure, particularly infrastructure that's built around power distribution, where you have regulated pricing that specifically incorporates the input costs to generating, you know, the energy itself. And that's going to have a very strong inflation sensitive component. And then, you know, things like transportation or other sort of long lived hard assets where it's not so much about the assets themselves going up in value, whether they're some kind of catalyst to, you know, accreting value through the the price of those assets.
00;27;28;03 - 00;27;50;39
Speaker 2
It's the revenue streams that they generate. And so those are going to tend to be the most resilient to inflation. And, you know, because they offer high single digit to low double digit returns, it's a it's totally justifiable to carve out, you know, a meaningful part of a portfolio to hold those assets. And I think, you know, you're going to talk about those sort of remainder of the alternative asset classes.
00;27;50;39 - 00;28;15;12
Speaker 2
But I think one of the lessons from the last few years is that investors who exclusively focused on only the highest returning alternatives, you know, think of venture and sort of traditional private equity missed out on some opportunities to capture these diversifying return streams. And what is really called for is just a larger and more diverse allocation to alternatives, not so much just substitution within it.
00;28;15;12 - 00;28;20;32
Speaker 2
And I think that's an important lesson that investors need to be thinking about as they head into 2024.
00;28;20;32 - 00;28;22;09
Speaker 1
So in terms of your pick.
00;28;22;31 - 00;28;23;25
Speaker 2
Oh, I should say yes.
00;28;23;38 - 00;28;24;54
Speaker 1
So I'm not going to let you get away there.
00;28;24;55 - 00;28;43;37
Speaker 2
No, no. I was trying to slide that past you. I'm going to be a little contrarian here. Maybe I think, you know, as I think about 2024 and sort of the principle of how to invest, it's really about sequencing. You want to think about the assets that have already repriced to this higher interest rate environment, and that's where you want the new capital to go.
00;28;43;37 - 00;29;02;41
Speaker 2
The marginal dollars should flow into those sectors and there are some asset classes that may over the long horizon do just fine, but they haven't really repriced yet to this environment. I know you're going to talk about some of those, but one area that is starting to look interesting, despite some of the, you know, scary stories is commercial real estate.
00;29;03;01 - 00;29;25;17
Speaker 2
You know, first of all, this is a highly diverse, you know, kind of ecosystem. So, you know, we hear the headlines about, you know, midtown office space and some of the horror stories there. But the truth is, even within office space, there's lots of bright spots. But if you think about commercial real estate broadly, you look at, you know, life science, you look at multifamily, you look at industrial, you look at, you know, logistics, infrastructure, industrial infill.
00;29;25;17 - 00;29;42;18
Speaker 2
There's a lot of really interesting places to put capital to work. And it is a sector where the prevailing level of interest rates has largely flowed through into the asset prices. And so I think it's actually becoming a very interesting place to allocate new capital today. So so that would be my pick would be commercial real estate.
00;29;42;22 - 00;29;53;16
Speaker 1
Yeah. And I don't disagree. I mean, and again, you need to think about where things are priced in and infrastructure has shown pretty tremendous resilience. Transportation still benefits from a limited supply of ships. Yeah.
00;29;53;56 - 00;30;11;19
Speaker 2
They're all good. I mean, they're not mutually exclusive. But, you know, certainly I think real estate has sort of taken it on the chin a little bit more than some of those other asset classes. I mean, I think just to expand on your point slightly, you know, we look at infrastructure, particularly core infrastructure, a lot of these assets are financed using long term debt.
00;30;11;19 - 00;30;31;20
Speaker 2
And so the degree to which they're going to reprice in the near term is very modest and so if you're waiting for sort of a cheap entry point with those asset classes, you're probably going to be waiting. Yeah, that doesn't diminish their ability to generate positive returns at the operating level. It just means that you're not going to see a lot of price decline to take advantage of.
00;30;31;20 - 00;30;36;01
Speaker 2
Whereas in, you know, more traditional commercial real estate, you see a very attractive entry point right now.
00;30;36;06 - 00;30;56;56
Speaker 1
Exactly. And then that that brings us to the kind of remaining alternatives. So think, you know, hedge funds, private credit and private equity. You and I spent a fair amount of time on Friday talking about this and trying to think through, you know, what's going to be the best performer for 2024. And what we came to some modestly firm conclusions.
00;30;56;56 - 00;31;07;11
Speaker 1
I'm not necessarily sure that that that private credit stood out relative to private equity. And so let's just kind of talk through this and maybe we'll both provide an answer to this one rather than than just, you know, this.
00;31;07;20 - 00;31;08;12
Speaker 2
Is try to spread the risk.
00;31;08;12 - 00;31;26;18
Speaker 1
Around. Yeah, exactly. I see how this feels. So the way that I think about it is, on the one hand, you look at private credit and you've seen tremendous growth in the number of managers, tremendous growth in the number of assets. Arguably, from a valuation perspective, given the move in base rates, you know, things are looking a bit tight.
00;31;27;18 - 00;31;48;34
Speaker 1
On the other hand, you have tremendous flexibility and it is not in the best interest of neither the borrower nor the lender for the borrower to default and so I think you'll see continued amend and extend activity much like we've seen over the past couple of quarters. I don't think that the bottom falls out of private credit, but I do think that there are arguably some bad apples amongst the bunch.
00;31;48;34 - 00;31;58;33
Speaker 1
And I really think it's it's this idea of stepping into a asset class that has experienced hypergrowth over the past 10 to 15 years.
00;31;58;33 - 00;32;00;51
Speaker 2
Is this supposed to be a positive towards credit.
00;32;01;10 - 00;32;18;38
Speaker 1
Towards the end of of what we say, good. As you get closer to the end of the business cycle. And so you know where where I shook out on private credit is that it makes sense as a structural allocation in portfolios over time. But I'm not necessarily sure that that's where my incremental dollar goes today.
00;32;18;38 - 00;32;34;17
Speaker 2
Yeah, I don't disagree. I think, look, there's it's a very crowded space, as someone put it to me recently, There's a lot of tourists in the private credit market right now. And so you do have to be a little careful that some of that capital is just being allocated because it's been it's been assigned by the asset owners to the managers.
00;32;34;17 - 00;32;57;27
Speaker 2
The managers are sitting on dry powder. They have to put it to work. And, you know, you have to be a little concerned that the underwriting standards are going to fall and they're going to fall in a period of time where the end borrowers are, you know, experiencing extremely elevated cost of capital. I mean, a lot of this money is being lent out at, you know, very high single digit to low double digit yields and a lot of operating business models simply don't survive that kind of rate environment.
00;32;57;27 - 00;33;18;35
Speaker 2
So we do have to be a little bit, you know, sort of humble about, you know, expecting those returns to flow through without some credit losses. I think another way to sort of take advantage of the broader private credit ecosystem, though, is to one, you know, frontload some distressed managers who are going to be waiting to take advantage of some of that, you know, sort of credit cycle activity when it occurs.
00;33;19;06 - 00;33;36;22
Speaker 2
And also consider the secondary markets where, you know, if you're able to provide liquidity, you know, because this huge surge of capital has flowed into the private credit markets and, you know, some non-zero portion of that is not going to stay fully invested with the the full cycle. They're going to want liquidity at some interim point in time.
00;33;36;47 - 00;33;56;53
Speaker 2
And the secondary markets are not as well capitalized and not as liquid. And so there's real opportunity to generate returns from that, you know, much sort of smaller subset. But but certainly if you think about the whole private credit ecosystem, it's the direct lending piece, which is the the bulk. But around the edges you can sort of shape that exposure to be, I think, a little more resilient.
00;33;56;53 - 00;34;12;38
Speaker 1
And I think that that's that's the key point, is that, you know, when we talk to clients about private credit, they almost automatically assume that we're talking about direct lending. To your point, there are lots of different types of strategies, far more on ramps and off ramps than has been the case in the past. And so, you know, don't throw the baby out with the bath water.
00;34;12;38 - 00;34;33;26
Speaker 1
But would I put an incremental dollar into direct lending today? Probably not. Private equity, on the other hand, is looking kind of interesting. And I'm sure you saw the data from LCD Pitchbook that came out recently. We actually included it in our Guide to Alternatives. But the third quarter saw a pretty notable decline in purchase price multiples for buyouts in the United States.
00;34;33;26 - 00;34;55;56
Speaker 1
And so it feels like that long awaited repricing may be finally starting to materialize. You know, we furthermore believe that in an environment of slower nominal activity, right, you're going to see some businesses really begin to get squeezed by this higher cost of capital. And you think about the way that that PE investors finance their portfolio companies. It's primarily through floating rate debt.
00;34;56;16 - 00;35;17;53
Speaker 1
And, you know, you can sell the airplane and you can strip down the business. You can do all sorts of things to keep your head above water. But eventually, if growth is slowing and you have to pay a certain level of rates, right, valuations are going to need to come in to reflect that more challenging environment. And so I think that while we do not anticipate recession in 2024, we can kind of lean on that old adage of, you know, more challenging.
00;35;17;53 - 00;35;43;39
Speaker 1
Macro environments tend to correspond to the better vintages for private equity. And I think that that could well be the case for for 2024. So I'm going to pick private equity for my final, final selection. So that leaves us with high yield on the fixed income side. US large cap equities in the public equity space, real estate, commercial real estate in real assets, and then private equity for the remaining alternatives.
00;35;43;39 - 00;35;47;03
Speaker 1
Do you have a final pick of those four? What do you think is going to be the best of the bunch?
00;35;48;31 - 00;36;07;38
Speaker 2
Risk adjusted returns, I would say high yields. I think for nominal returns. I mean, private equity is always the easy pick, just given that it operates with a lot of leverage. But I think real estate might, you know, might over the medium to longer term might provide some pretty substantial returns. So I would stick with that one.
00;36;07;47 - 00;36;25;25
Speaker 1
Yeah. I think that interest real estate definitely looks interesting to me and kind of the more bombed out the the area of commercial real estate, the greater the potential price appreciation over time. And I also would just second your point on high yield, particularly from a risk adjusted perspective. You know, 89% coupons are nothing to nothing to shake a stick at.
00;36;25;25 - 00;36;51;00
Speaker 1
And arguably that'll be a lower volatility asset for a lot of the reasons that you outlined than what we see in the public equity space. And so that's going to conclude this year's asset allocation draft. Thank you again for joining us today on J.P. Morgan Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcasts on our website and on our Jp morgan Asset Management YouTube Channel recorded on December 11th, 2023.
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