After a year of surprises, wise investors entered 2024 expecting the unexpected. Now, almost halfway through the year, this approach to investing is still relevant.

For many, the U.S. economy continues to surprise. Despite tighter lending standards, higher prices, elevated borrowing costs and a dwindling supply of eligible workers, employment and consumption data remain strong and inflation persistently sticky at higher-than-expected levels. Even with the slowdown in the first quarter, a recession is still unlikely through the rest of the year.

This economic optimism comes despite myriad challenges to the “peak rates” narrative at the start of the year, with a combination of central bank speak and hot economic data forcing markets to accept that “higher for longer” will be around a bit longer than initially thought. Still, the hurdle for the Fed to raise rates from here is significant, and the bias toward cutting in 2024 is still evident. A lower federal funds rate will have broad – and generally positive – implications across capital markets and economies, both in the U.S. and around the world. Nonetheless, a busy year for global politics has the potential to inject temporary volatility.

In other words, investing remains a challenge, and asset allocation must reflect the inherent uncertainty of a world very clearly in flux.

Given the changing outlook for interest rates this year, bond investors should embrace shorter duration instruments, gradually extending duration while having confidence that attractive coupons will act as a “cushion” in portfolios if the rate view unexpectedly changes further. They should also shore up quality, which should prove to be an effective portfolio ballast, to account for tighter-than-expected credit spreads and protect against unpredicted economic risk.

From an equity perspective, the first quarter U.S. earnings season was likely a window into the rest of the year: strong profit growth with broad participation in earnings surprises. Even so, the market is modestly rich and earnings expectations are likely too aggressive. As a result, a bias toward active management and quality, balanced between growth and value and skewed toward larger names, remains prudent. Outside the U.S., discounted markets should allow for multiple expansion to support performance, and the significant currency drag should abate, especially as the Fed looks to ease through the back half of the year.

This backdrop is also supportive of alternative assets. Infrastructure investments can dampen portfolio volatility, particularly with a renewed interest in expansive industrial policy; real estate can protect against structurally higher inflation and prospects haveimproved; and private equity and hedge funds can thrive if the beta trade weakens. Against this, however, investors should recognize that a repricing in private markets is still underway, underscoring the need for careful manager selection.

Looking at portfolio positioning, this outlook has only partially been implemented. Within fixed income, appetite for higher-quality, extended-duration bonds has increased since the start of the year. Within equities, growth investing is back in vogue, likely a reflection of investors chasing momentum given this year’s surprise rally; this has somewhat unwound the shift toward value that had occurred earlier in 2023 and has driven up duration in stock allocations. Meanwhile, interest in non-U.S. stocks has increased since the beginning of the year, albeit mostly through passive vehicles, with investor allocations trending higher than the historical average despite a hazy geopolitical horizon. Finally, investors are still broadly overweight cash, a continued weight on returns this year, as had been the case in 2023.

All told, the investing landscape remains volatile. Investors would therefore do well to diversify and lean on active management, stepping out of cash and into risk assets to take advantage of the anticipated changes ahead.

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