Picture the U.S. economy right now as a balancing act –much like Goldilocks searching for that perfect bowl of porridge. Not too hot, not too cold, we’re watching an economy that’s striving to find its sweet spot. The Federal Reserve (Fed), our economic chef, is attempting to adjust the temperature through monetary policy, trying to create the perfect recipe for stable growth.
Right now, the heat seems to be cooling in all the right ways. Inflation is becoming more manageable, and interest rates are coming down. Yet, like any good chef, we’re keeping an eye on some longer-term challenges that could affect your financial future. We believe this balanced environment creates opportunities to strengthen your financial foundation with the goal of protecting against whatever future risks might be cooking up ahead.
Let’s take a close look at what’s making this economic meal just right, starting with cooling inflation.
Inflation: The Cooling We’ve Been Waiting for
As of August, the Consumer Price Index (CPI) dropped to 2.6%, down sharply from nearly 9% seen in 2022. Like relieving the pressure from a valve, we’re seeing prices stabilize. However, there is more to consider.
Some long-term challenges include:
- Both major presidential candidates have proposed economic plans that could significantly expand the fiscal deficit and increase national debt.
- The Congressional Budget Office suggests while these policies aim to stimulate economic growth, they could lead to more debt than economic gain.
- Higher debt, especially for less productive investments, is not a sustainable strategy and could contribute to elevated inflation levels.
- Additionally, the U.S. dollar, which has enjoyed a 14-year run of strength, could weaken if deficits and debt levels rise. A weaker dollar could affect everything from your grocery bill to your investment returns.
While inflation’s cooling trend may provide relief, the Federal Reserve’s response has been equally noteworthy in shaping our economic landscape.
The Fed’s Bold Move: Creating Opportunities
The Fed’s recent 0.50% rate cut is already making waves.
- 10-year Treasury yields dropped from 5% to 3.8%.
- Mortgage rates decreased from 7.3% to 6%, offering relief to homebuyers.
- Bond investments are offering attractive rates not seen in years.
While this move has offered some relief, the Fed must tread carefully. Reducing interest rates too quickly could reignite inflation, especially with the U.S. economy showing resilience.
Rising government debt may keep long-term interest rates elevated, in this “higher for longer” scenario, particularly if economic growth remains strong. For investors, this could present an opportunity to lock in attractive rates on bonds, adding stability to your portfolio. These monetary policy shifts come at a time when our economy is showing remarkable staying power, even as we navigate various challenges.
U.S. Economic Resilience: Strength that Matters
While our economy continues to show resilience, we’re monitoring several soft spots including the rise in part-time jobs, higher credit card and auto loan defaults, and contractions in manufacturing sectors. Most economies have some weak layers, and the key question is whether these weaknesses will lead to broader instability. But consider this: airline travel has soared past pre-COVID levels, job numbers keep surprising to the upside, and second quarter GDP growth nearly doubled from the first quarter.
Despite this positive economic resilience, lower interest rates remain the top priority for a levered economy. While growth persists, the Fed will likely still deliver rate cuts in November and December. However, the size of these cuts remains uncertain, with smaller steps seeming more likely unless meaningful economic cracks emerge. This domestic economic resilience isn’t occurring in isolation – global factors, particularly China’s economic transformation, are playing an increasingly important role in our financial outlook.
China’s Rebound: What Does It Mean for Global Markets?
China’s economic story affects us all. After facing challenges from the lingering effects of stringent COVID-19 policies and housing market issues, China is taking steps to stimulate its economy.
- The government cut interest rates, encouraging cheaper borrowing.
- Restrictions on property purchases were eased to encourage investment in a post-bust housing sector.
These measures seem to have had an immediate effect, with investor sentiment improving almost overnight in early September. Chinese stocks rebounded, becoming the top-performing market by the end of the quarter. However, questions remain about whether this positive momentum can be sustained or if deeper economic issues will continue to weigh on investor confidence.
China’s recovery could have a broad impact on global markets, particularly in terms of inflation and economic growth. Global diversification helps investors capture these unexpected moves in the market, reinforcing why “time in the market” beats “timing the market.”
As we consider China’s influence alongside our domestic economic indicators, a clearer picture emerges of the complex landscape investors must navigate.
Navigating the Global Economic Landscape
We believe the U.S. economy and global markets are at a critical juncture. The Fed faces the delicate task of maintaining stable growth without reigniting inflation, while long-term risks like rising fiscal deficits, a potentially weaker U.S. dollar, and China’s rebound add layers of complexity.
As the Fed navigates this complex economic landscape, we encourage investors to focus on long-term strategies rather than short-term predictions. The goal, much like in the story of Goldilocks, is for the Fed to find the “just right” temperature for economic growth. Success isn’t about perfect timing –it’s about consistent progress toward your goals.
And now, for some asset class updates….
Fixed Income Outlook: Navigating Bond Markets in a Changing Rate Environment by Olivia O’Toole
Reflecting on 2024, it’s clear that the Fed’s decisions on interest rates played a pivotal role in shaping the markets. Throughout the year, the Fed emphasized the necessity of guiding inflation toward a sustainable 2% prior to executing any interest rate changes. After much anticipation, the Fed finally made its move in September, lowering interest rates by 50 basis points (0.50%) – the largest single reduction since 2008. Consequently, the yield curve normalized as shorter-term rates fell below their longer-term counterparts.
Overall, the U.S. bond market ended up through the third quarter, largely due to the interest rate adjustment (bond prices and interest rates move inversely). Despite the shift in interest rates, we believe bond yields remain relatively attractive. Municipal balance sheets and budgets seem to be well-prepared to maintain their credit quality in the event of a potential recession. We continue in our belief that this is an opportune time, before any further Fed cuts, to secure higher-yielding, investment-quality bonds for the long term.
Looking ahead to the end of this year and into 2025, we see the potential for significant returns on fixed income assets, especially if the Fed continues its rate-cutting cycle. We remain diligent in seeking opportunities while prioritizing capital preservation through any market condition.
Diversified Growth Update: Managing Risk in Volatile Markets by Dmitry Popov
Investing in stocks involves risk that comes in many forms. A significant one is being forced out at the bottom and missing the subsequent recovery – a costly mistake for an investor straying from disciplined investing. Another common pitfall is chasing the latest trend. Don’t let market exuberance dictate your emotions that lead to poor investment decisions. Instead, we believe in having a robust system to examine risk symptoms. While positive market returns can create overconfidence and an illusion of safety, it’s in challenging periods that investors and their strategies are tested for the real risk they bear.
The risk of investing in a specific stock isn’t just about the stock itself; it’s also about how market participants perceive that risk. It’s often about what you pay, not just what you buy. When an asset’s price rises, people see it as a sign of a good investment going forward, but the rising price makes it riskier. No asset is immune to being overpriced. Even high-quality assets can become risky if priced too high. Conversely, when stock prices drop, people view it as risky, but a lower price could mean a bigger margin of safety on the downside, making it less risky. This might explain why popular trades like shorting the Japanese yen and the Chinese equity market had meaningful reversals, both in speed and magnitude. A gentle push and the sentiment is changed.
We have varying degrees of ignorance about what the future holds, and it is from this ignorance that risk ensues. Intelligent investors acknowledge that more things can happen than will happen and position their portfolios for the range of possible outcomes. A well-designed portfolio aims to capture returns regardless of the source, whether it’s a sector, style, or regional rotation. Be wary of overcrowded trades. In our opinion, the riskiest belief is that there’s no risk.
Real Asset Updates: Impact of High Interest Rates on Property by Elias Bachmann
The impact of recent high interest rates has rippled through private real asset valuations, leading to significant price declines across various sectors. Hardest hit were office and retail spaces, which faced compounding challenges beyond interest rates. In a high-rate environment, investors typically demand greater income from their assets, which can be achieved by increasing asset income or lowering asset prices. While some sectors saw enough income growth to offset price drops, almost all asset classes experienced some degree of depreciation. However, stabilization seems to be finally occurring.
This trend is visible in semi-liquid investments like interval funds and non-traded REITs, which reflect current market values. Since interest rate shocks have already been absorbed, recent price shifts primarily reflect fundamentals such as rent and occupancy rates. Although it’s premature to declare a market bottom, long-term investors now see more attractive valuations than any time since pre-COVID, with yields significantly improved.
Earlier this year, 10-year Treasury yields declined from a high of 4.7% to 3.6% by September’s end. This drop facilitated stalled transactions as lower rates allowed buyers to meet their cash flow goals with higher offer prices, boosting transaction volume in recent months.
Despite this positive momentum, unresolved issues persist—especially in the office sector, where maturing loans remain a challenge. Banks have been reluctant to foreclose, preferring to extend loan terms instead. Still, we believe sectors like multifamily housing and infrastructure are poised for growth, supported by housing demand, low construction starts, and infrastructure needs driven by AI and electrification.
Private Equity Update: M&A Activity and Valuation Insights by Aaron Deitz
As we progress through the latter half of 2024, optimism is returning to the private equity (PE) market. The Federal Reserve’s recent shift towards a more accommodative monetary policy is expected to bolster M&A activity and drive valuation improvement across the PE landscape. Lower interest rates are likely to ease debt burdens, enhance free cash flow, and provide greater operational flexibility for portfolio companies.
Although deal flow and fundraising have not increased meaningfully, anecdotal evidence from our managers suggests signs of a pickup in M&A activity. The clearer outlook on interest rates has notably increased confidence among market participants.
Within this evolving landscape, the secondary market, continuation vehicles and take-private deals continue their momentum as other paths to liquidity remain tight. Additionally, the re-emergence of the IPO market – critical for venture capital exits – signals a broader recovery as we approach 2025.
However, challenges persist. Exit activity remains sluggish and mid-2010s vintages have faced notable valuation markdowns. In our opinion, this reinforces the importance of diversification across vintage years. We believe firms with perpetual PE deployment programs, like BSW, are well-positioned to navigate these complexities and seize future opportunities.
While PE returns have recently trailed behind the public equity market, we expect the return premium to re-emerge as market conditions stabilize. Looking ahead, we are optimistic that the combination of potential lower interest rates and sustained economic growth could provide a strong tailwind for PE in the coming years. In our opinion, maintaining a disciplined approach to vintage diversification and capital deployment will be key to capturing the PE return premium while mitigating downside risk.
Thanks for reading!
Elias Bachmann
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