by Richard Brink, Senior Vice President, Market Strategist, Client Group. AllianceBernstein
In the second quarter, risk-asset returns, like the first quarter, were a) strong; and b) followed a similar pattern of late-quarter âknown unknownâ resolution. In the first [quarter], it was about the regional banking crisis and policy relief leading to strong March returns.In the second [quarter], it was the debt-ceiling crisis and very strong June returns following [a] resolution that produced the strong year-to-date returns that you see hereâand pushed the S&P into bull market territory in June. On the back of that strength, though, are questions about what comes next.
For us, itâs the second of three themes that I believe investors will encounter through the end of 2024, and that is âresistance.â Because hereâs the basic truth: from a market perspective, the S&P 500 looks toppy. Valuations sit at the very high end of the range, and earnings are expected to face absolute and relative pressure as growth likely recedes in the quarters ahead.
And from an economic perspective, inflation has been coming down, and we expect it to continue to do so, but it is still well above the Fedâs ultimate target.
And then thereâs the job market. The Fedâs primary emphasis has been to normalize the labor market, but there continues to be lots of strength there. Jobs numbers continue to come in well above the clearing rate, the unemployment rate is historically low and the all-important (at least for me) household paycheck proxy, which tries to quantify the aggregate consumptive power of the nation, is not just growing at a really robust clip, but if [we] consider the impact of declining inflation, the inflation-adjusted (aka real consumptive power) growth rate has pushed even higher.
So if you are the markets, youâve done thisâyouâve priced in the expectation that rates are going to stay higher for longerâand if anything, the Federal Reserve will likely increase rates one or two more times before theyâre done. Phew.
So whatâs an investor to do in this period of resistance? Well, the first is, yes, the S&P 500 is toppy, but itâs toppy largely on the back of 10 of those 500 names, so Iâd like to talk about the other 490, and specifically those with the characteristics weâve talked about so many times before, such as quality and low volatility. Those factors defend well historically, and importantly are not expensive as weâre trying to find opportunities.
And the second thing is to zoom out, beyond the next handful of months, into our third themeânormalization. Those of you that I have spoken with know I refer to this as the âsecond inflection point,â when normalizing growth and inflation inflect central bank chatter to rate-cutting protocol, and yields fall across the curve. I believe that this is a later 2024 story, but regardless of when it happens, the bond market is going to be the star of the show, and it will ripple across capital markets.
So first of all, bond yields are high, from the 10-year Treasury all the way to high-yield bonds, but thatâs showing up well beyond just yield curves. Itâs showing up in capital marketsâ expectations over the next decade. Indeed, a 60/40 portfolio today, based on our estimates, would generate 120 basis points more per year for 10 years than it wouldâve pre-COVID, but to belabor the point, itâs not because of the equities. Thatâs a fairly modest uptick. Instead, itâs about the high-grade bonds, which are expected to produce greater than double the pre-COVID numbers on the back of those yields. Same thing for high yield.
As weâve said many times, high yield historically generates average annual returns in the forward five years that are strikingly close to the starting yield to worst, which entered the quarter at 8.5%.
Howeverâand this is the critical thingâI think those returns are going to be front-loaded. If we do have a world, as we expect, where inflation does come down and growth normalizes over the coming 12â18 months, rates are coming down with it, and those 10-year expected returns are going to be front-loaded.
As an example, the 10-year Treasury recently hit 4%. Letâs assume that it falls to 2.75 over the next two years. Using admittedly very simple bond math here, that means that over half the returns you would enjoy in a 10-year Treasury over a decade would be paid to you in two years, and the next eight years would be far more modest; aka pre-COVID.
And it would be true across bonds. While we talk about the predictive power of high yieldâs yield to worst over a five-year horizon, historically itâs lumpy, with the vast amount of capital gains occurring sooner rather than later. And those modestly higher expected equity returns? Iâll bet you a donut that part of that would come from a valuation bump on the back of falling yields.
Net net, as investors we have to be cautious about current conditions, but I donât think we should wait for a better time in order to find our opportunities. And thatâs really the biggest thing about normalization for meâthoughtful portfolio construction in the now. As we make our way to the end of 2024, we believe inflation and growth will move toward trend, and yields will fall with it, and by the way so does the Fed and the rest of the market. There are clearly risks in the now, and the timing is highly uncertain as to how and when this will play out. But I think that one of the big risks for investors is not addressing the opportunity now, with a thoughtful eye beyond resistance to normalization and the opportunity that we see.
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About the Authors
Richard A. Brink is a Senior Vice President and Market Strategist in the Client Group. Previously, he served as a managing director in the Alternatives and Multi-Asset Group. Prior to that role, Brink was a senior portfolio manager in Fixed Income, and before that an investment director for fixed-income investments within the Global Retail Investments Group. Before joining AB in 2004, he was senior product manager at the Dreyfus Corporation, covering both retail and institutional fixed-income offerings. Brink was previously a senior trainer, dealing primarily with the design and delivery of product training to financial advisors and mutual fund sales representatives. He holds a BS in applied mathematics and economics from Stony Brook University, and is a CFA charterholder. Location: New York
