iShares Spring 2024 Investment Directions

The U.S. economy has evolved largely as we anticipated in our 2024 Year Ahead Outlook, with inflation remaining stubbornly above the Fed’s target while economic growth is slowing but still solid. What has changed since our last report is that downside risks to growth have largely diminished, buttressing our long-held view that investors are best served by staying invested in a diversified portfolio vs. trying to time the market — or the Fed.

Our investment preferences can be found below, but when it comes to the central bank, we maintain our long-held view that the Fed will deliver three policy rate cuts in 2024. However, the risk of only two cuts now appears higher to us than the risk of four cuts. In their latest Summary of Economic Projections, the FOMC reaffirmed expectations for 75 basis points of rate cuts this year but upgraded their outlook for near-term growth while reaffirming their expectation that inflation won’t hit their 2% target until 2026.¹

While core inflation continues to trend lower over the longer term, the Fed has expressed caution given the near-term upswing in 3-month annualized core CPI (Figure 1). Similarly, longer-term growth has generally trended lower since the stimulus and reopening-fueled growth of 2021; nevertheless, growth has remained persistently above the longer-run ‘neutral’ pace expected by FOMC members.

Growth has remained strong despite higher rates because higher rates have not notably impacted the ability of consumers to service debt. Many U.S. consumers were able to lock in fixed-rate mortgages during the period of exceptionally low rates of 2020-2021. While rate hikes have lifted 30-year mortgage rates to their highest level in 20 years, mortgage debt servicing is near its least costly levels on record.² In parallel, companies termed out their debt during the period of low rates. Even high yield companies currently have interest coverage ratios — a measure of a company’s ability to meet its debt obligations — well above historic norms (see fixed income section).

Looking forward, our base case is that the Fed engineers a soft landing and starts to normalize policy rates in the second half of the year. Before beginning this normalization, the Fed needs to have greater confidence on the trajectory of inflation. One key component of this is wages, where we’re closely watching several measures, including average hourly earnings and the employment cost index.

Macro matters for investors just as it always has, but the explosive earnings growth of AI-associated companies has broken longstanding macro relationships. In recent quarters, large cap technology has outperformed in both higher and lower rate regimes (Figure 2). Growth equities have outperformed their value counterparts by 21% over the past year, even though 10-year Treasury yields have risen 0.85%.³ No matter which way the macro data have turned over the past year, it feels to many investors like the same names, sectors, styles, and sizes always come out on top.

The weight of higher rates can still be observed in small-cap equities and non-AI exposed sectors, where higher rates and expectations of slower real growth have dampened earnings expectations and therefore performance.⁴ This has led to narrow leadership, where a select few names can buck the overall trend. Because of the weight of these few names in major indices, we believe equities as an asset class can continue to rally as detailed in our equity analysis. We believe investors should remain nimble with the use of ETFs and focus on actively managing portions of their portfolio to take advantage of the opportunities that may arise over the next few months.

A cautious Fed, stronger growth, normalizing inflation, and a strong labor market may reward investors for owning bonds and keeping their duration contained around the five-year part of the curve.

We anticipate a normalization of term structure, eventually resulting in an upward sloping yield curve. While short rates should eventually decline with Fed cuts, we think rates on the long end of the yield curve will instead be driven by rising term premium and supply concerns.⁵ This can result in a steeper yield curve. Given this outlook, investors can consider optimizing the tradeoffs of current yield and price appreciation by positioning in the 3- to 7-year segment of the yield curve.

We believe the recent back up in rates is probably the last best opportunity to extend duration. This year, as the market has priced out near-term Fed cuts, short rates have firmed by a further 40 basis points through the 2-year maturity.⁶ Consistent with higher short rates, there has been $220 billion of inflows to money market funds, bringing total domestic money market fund AUM to a record $6.1 trillion.⁷ However, cash alternative returns appear set to decline as the Fed is likely to begin cutting in the second half of this year. Waiting until the Fed actually cuts rates means investors may miss out on price appreciation due to the anticipatory nature of market pricing.

Corporate credit fundamentals look satisfactory, but tight spreads make a broad index exposure less attractive. We believe the default rate should remain near its current low level of 2.3%, as many high yield companies have successfully extended maturities, locking in lower rates and mitigating the impact of higher interest rates (Figure 4).⁸

While the interest coverage ratio for the high yield universe has come down from its late-2022 highs, it remains well above its long-term average (Figure 5). However, with high yield spreads near 300 basis points, we believe investors are not being compensated much at all for taking credit risk.⁹ For this reason, we think investors interested in high yield will want to be selective. Rather than simply adding broad high yield exposure, they may want to consider seeking out strategies that screen out the riskiest borrowers and invest in issues with the highest risk-adjusted yields.

We expect changes in investment grade corporate credit bonds to be mainly driven by coupon income, expectations of lower Fed funds rates, and attractive yields. Income-seeking investors can position themselves in short-term investment grade corporate credit to benefit from high quality credit.

We believe investors may be well-served in turning to an active manager to choose the best bonds for their needs especially within the “plus sectors” of the hard-to-reach segments of the fixed income markets. This is particularly true in this environment of tight spreads driving some investors to question valuations even as attractive all-in yields drive inflows into bond ETFs more broadly.

Recent firm Personal Consumption Expenditures (PCE) and Consumer Price Index (CPI) data amidst a backdrop of stickier services inflation make us favor inflation-linked bonds in the front end of the curve.

Our continued conviction in quality is underpinned by both the macroeconomic and earnings backdrop. As rates remain in restrictive territory, we believe quality factor outperformance will persist on the back of balance sheet resilience and strong earnings fundamentals, while their unprofitable counterparts continue to feel pressure.

The equity rally has increasingly been driven by earnings, not multiple expansion. Q4 earnings surprised to the upside, led by familiar juggernauts driving both the earnings beat rate and year-over-year growth higher.¹⁰ The top names outperformed despite lofty (and upwardly revised) earnings targets, and this narrow leadership has been sufficient to fuel the continued rally at an index level. While there are worries of a bubble forming, investors should be comforted that the highest quality and most profitable names are driving long-run growth expectations — a far cry from the previous bubbles in which unprofitable and speculative names pushed indexes higher (Figure 6).

Investors can tap into this up-in-quality trade by either deploying a sector neutral approach or leaning into active strategies. More nimble active fund management can tactically time a leadership rotation by watching incoming data, both traditional and alternative.

On a sector basis, we see revenue and margin growth expectations as key in determining tactical opportunities. We expect revenue growth within consumer staples — which grew at an 11% annualized rate between 2021 and 2024 due to inflationary pressures — to continue to moderate.¹¹ Lack of top line revenue growth and stagnant margins normalizing to their long-term average paint a bleak picture for the consumer staples sector.

The communication services sector stands ready to benefit from increased advertising spending. One way in which consumer companies are aiming to combat a downturn in top-line revenue growth is through advertising spend (to increase sales volumes). Between 2021 and 2024, revenue per share for the sector increased at an annualized rate of 10%.¹² In the first quarter of 2024, we saw that revenue growth jump to 15%. We believe this spend will continue to show up in earnings for the sector over the next quarter.

Financials continue to face broader headwinds, but there are opportunities in components like broker-dealers and exchanges. Financials remain relatively under-owned by the broader market for good reason: idiosyncratic risk and an uncooperative yield curve that weighs on bank balance sheets paint an unfavorable picture.¹³ However, we are turning constructive on the broker-dealer industry. Trading revenue within this industry group remains robust, driving a sizable portion of earnings beats over the past few quarters. Furthermore, with markets flirting with all-time highs, and a robust quarter of investment grade issuance, we see the prospect of an acceleration in capital market activity.

We still say ‘not yet’ for small caps. Although valuations for small caps linger near their early 2021 lows, and the prospect of rate cuts are a near-term tailwind, we think a sustained rally in small caps requires clear signs that the macro framework is shifting. Specifically, a durable rally in small caps likely requires wage pressures to alleviate, looser credit conditions, strengthening business sentiment, and improved earnings revisions.

International election uncertainty, monetary policy disparity and gradual impact of structural trends such as near-shoring all point to a year of elevated global dispersion. We think this presents investors with opportunities to differentiate by picking the right spots in both international equities and fixed income.

In emerging markets equities, investors could continue to separate China from broad exposures. While increased policy urgency and extreme bearish sentiment could set up Chinese equities for near-term tactical rebounds, we think a sustained rally is unlikely without the presence of large-scale monetary support. Poor investor sentiment towards China creates opportunities for other Asian countries to fill the gap.

We maintain our preference for Japan and India over China. While Japan is slightly more expensive than last year, it is still trading at a valuation roughly in line with its 10-year average.¹⁴ We believe this fair valuation, alongside supportive policies for international investors and increased dividends and buybacks, make Japan a strong international opportunity, especially as the Bank of Japan exits negative interest rate territory on the heels of positive inflation (Figure 8).

India’s popularity has taken valuation to a forward P/E of 22.5x, yet we think this premium is justified by high earnings growth expectations coupled with a history of strong returns.¹⁵ 12-month forward earnings growth expectations for India are 14.6%, underpinning strong fundamental earnings growth estimates over the longer term as well.¹⁶

Elsewhere in EM, we like small cap equities and hard currency debt. Emerging market small caps, which boast higher allocations to sectors like industrials and manufacturing, could provide more direct exposure to secular growth themes such as reshoring and infrastructure, especially in India and Brazil. Our optimism for emerging markets is equally strong for fixed income. Facing continued deceleration in inflation and strong growth, EM central banks across Latin America have begun easing — rates in LatAm have stabilized given the regional cuts, while remaining slightly higher in Asia where central bank cuts have yet to play out.

We believe the USD will remain rangebound this year, with room for short-term strength as expectations for first-half rate cuts are priced out. This presents a supportive backdrop for EMs across the board, in our view, alleviating pressure from EM economies with large external debt loads. This currency and rate backdrop underpin our preference for USD-denominated EM debt, which historically performs well in a rangebound dollar environment.