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Weekly Market Analysis - Don’t Lose Your Balance in the AI Frenzy
Posted on3 Things to Know
Even AI Isn’t Immune to Boom and Bust Risk
With national elections to drive up political uncertainty and ambiguous economic data, investors have focused on one believable growth story: AI.
We are immediately bullish on related industry prospects and the long-term potential for Artificial Intelligence to boost economic output. Decades of experience also tells us that boom and bust risk never fades amid technological abundance.
Growth Doesn’t Happen Overnight
Twice in the past 30 years US equities fell about 50% even as the US market went on to become the world’s largest, strongest-returning asset class. The NASDAQ 100 exceeded those declines in both cases (2000, 2008) even as it has outperformed the S&P 500 total return in time.
Fixed Income Portfolios Can Help Hedge Downside Risk
Fixed income portfolio holdings seek to mitigate volatility and hedge against extreme downside risk in the assets that provide growth.
The correlation of US Treasuries to equities during declines of 20% or more has been -40% in the past half century, providing income and capital appreciation in most of those periods.
Summary
As we describe in the latest Quadrant, investors remain enthralled by AI fever. It’s hard to blame them. What was once science fiction is becoming reality. A gold rush for AI-enabling chips has sent what is now the world’s most valuable semiconductor maker to a 9-fold rise in 18 months.
But it is not always that easy. The inexorable shift in the economy to digital life – lived through bytes of data – has still coincided with great volatility in financial asset prices.
For those that would sacrifice potential returns to reduce risk at some level, fixed income assets are a compliment. In fact, the combination of high risk and low risks assets which do not move closely together in price has historically provided a higher risk-adjusted return than equities or fixed income alone. High quality bonds deliver yield and, in many cases, price appreciation when equities fall.
Portfolio considerations
Some bond market segments still offer attractive yields across risk categories. Even with base rate cuts and some rise in defaults, loans may augment bond portfolio yields. With changes this week at our Global Investment Committee, we are now overweight Loans, Preferred securities, Securitized Debt, US Treasuries, Intermediate Corporates and municipal bonds (for US taxed investors).
Source: Bloomberg as of June 26, 2024. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees, or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
Even AI Isn’t Immune to Boom and Bust Risk
The inexorable shift in the economy to digital life – lived through bytes of data – has still coincided with great volatility in financial asset prices. The late 1990s dot com bubble and bust was the only time tech spending excesses kicked off a recession. Yet tech investments also posted severe, if temporary, losses in the Great Recession of 2008/2009 and vacillated sharply in the upheaval of 2020 and 2022.
Temporary declines in asset prices – is not a portfolio concern for investors with high risk tolerance. In this case, strong sustained returns are earned with equities, the ownership of the economy’s capital. Even so, individual equities can sometimes fall to worthless levels.
Growth Doesn’t Happen Overnight
Asset allocation – what some oversimplify to “60/40 portfolios” of stocks and bonds – failed to shield investors in 2022 because central banks drove interest rates to history’s lowest levels. For some economies, policy interest rates were slashed to negative levels, such as -0.75% in Switzerland. For the US, the yields on Treasury inflation-protected bond were negative.
But this is no longer the case. Despite recent price gains, a portfolio of varied types of USD-denominated fixed income continues to offer potential opportunity to earn returns that are far in excess of the lows of the recent historical period. For investors considering building out a new portfolio of diversified fixed income, there is the possibility to construct holdings that yield 5.5%-6.5% on average, depending on the investor’s suitability and risk tolerance.
We believe that certain investors with the appropriate investment objective and risk tolerance should consider maintaining a duration around 5-5.5 years for their overall fixed income portfolio. While we think rates will decline, longer-maturity Treasuries may not move higher in price and lower in yield as much as the “belly” of the yield curve (intermediate maturities) once rate cuts begin. In short, we see potential value from expected rate cuts in the 5-7ymaturity portion of the UST yield curve.
Fixed Income Yields Can Help Hedge Downside Risk
Today, a broad range of fixed income instrument types and maturities allows investors to pick and choose an average maturity length and be comfortable that if the Federal Reserve cuts interest rates perhaps by 1.5% or more over the next two years, their income earned will be based on current higher yields (provided all fixed income instruments held pay out at par). Looking out a bit further, the Fed forecasts that its policy rate will be 3.1% by end 2026 and 2.8% on average over the “longer run.”
With an inverted yield curve, the US Treasury market essentially embeds that outcome as a base case in current bond values. What is somewhat unusual now is that the yield curve has been inverted for a record time while credit spreads have tightened. The Fed typically eases monetary policy in reaction to a slowing US labor market. We expect that to again be the case. What is unusual is that corporate profits were weaker in 2022/2023 when rising labor markets caused the Fed to tighten.
The recovery in US corporate profits to a high-single-digit pace in 2024 – with more industries in recovery – is a boon to credit quality. This comes at a time when the Fed is nearing a turning point and can be expected to reduce its policy rates this year. Like the economy itself, this unusual combination of factors drives us to select fixed income over- and under-weight positions somewhat differently.
