We started 2024 with strong U.S. economic growth, low equity market volatility and significant outperformance from mega-cap tech. At the same time, the market looked for signs of forthcoming interest rate cuts from the Federal Reserve. By April, the economic tide began to shift as growth data moderated, inflation data fluctuated and mixed economic indicators clouded the timing and size of rate cuts. Amid these shifting currents, consumer and corporate balance sheets remained stable, as noted in our PM Perspectives. As such, we leaned into asset classes that could weather a high interest rate environment. This led our portfolios to remain moderately pro-risk, leaning into equities and credit over core bonds.

Basking in the sunlight of opportunity within equities

We came into the year favoring equities over fixed income in our portfolios. Broadly, U.S. equity markets remained resilient in the face of higher interest rates, and soared to all-time highs over the first half of the year. This surge has been fueled by a solid earnings outlook and advancements in artificial intelligence (AI). Strong first quarter earnings, along with positive forward guidance for the rest of the year, confirmed strength in the market. While earnings were expected to be 3%, they achieved a healthy 6%, effectively doubling expectations and delivering the highest year-over-year growth since 1Q22.

In our portfolios, we leaned into U.S. large cap equities throughout 1H24 given the following:

• Quality: U.S. large cap equities give us access to quality companies with diversified revenue streams, which offer stable earnings.
• Ample cash: Large cap companies are more insulated from high interest rates as their strong free cash flow generation facilitates ongoing investments in future growth, while small and mid cap companies have lower levels of cash reserves and carry more debt.
• Strong balance sheets: Large caps have resilient balance sheets, as seen by their high interest coverage ratios. The following chart shows that large cap coverage ratios remain above long-term averages, while small and mid caps’ ratios are at or below their long-term averages. 

Despite our regional preference for the U.S., we also acknowledge pockets of strength internationally. In Europe, inflation continues to fall, growth is stabilizing and company debt remains at low levels. In Japan, companies have the potential to benefit from corporate governance reforms and reinflationary dynamics, which could help spur consumer spending and investment that were dragged down by a prolonged period of deflation. As a result, we introduced an active equity manager that is selective in identifying high-quality companies across the globe.

Going beyond Treasure-ies with extended credit

While equities were the talk of the town, there were meaningful opportunities within fixed income. Our portfolios were neutral to slightly underweight duration relative to their benchmarks due to the uncertain path of inflation and central bank policy. As growth remained resilient, we leaned into fixed income asset classes that offered attractive yields and added to extended credit throughout 1H24. With an all-in-yield of ~8%, extended credit (i.e. high yield corporate and securitized credit) became a highlight of our portfolios as it provided a similar return outlook as equities with less volatility. We increased our conviction to extended credit throughout 1H24 given the following: 

• Low default rates: U.S. corporate bond default rates are below the 25-year average for most of the high yield index as companies have maintained healthy balance sheets in preparation for a potential recession, which has not materialized.
• Yield pickup: The higher coupon pickup from extended credit, relative to core bonds, increases the return on extended credit investments.
• Better quality versus history: The high yield market evolved to have higher-quality companies since the Great Financial Crisis in 2007 – over 50% of the index is made up of BB-rated bonds, which is the highest quality of the high yield market.

Catching the next wave

As we look ahead, we expect the disinflation trend to remain intact and economic growth to continue, albeit at a moderate pace. This environment should continue to support our conviction in equities and extended credit. Trends around AI along with higher corporate earnings expectations are likely to push equity markets higher, with potential for further broadening out across geographies and market segments. We continue to lean into the breadth of our active platform as a key lever in our portfolios to identify opportunities within equities and fixed income. Amidst choppy waters from geopolitical unrest, impending elections and uncertainty around central bank actions, we believe that a diversified portfolio is essential for navigating volatility and market fluctuations.