With the holidays around the corner, we can be thankful for the remarkable returns that equity markets delivered in 2024. Our clients have benefited from an overweight to U.S. equities for most of this year, and we continued to hold that overweight through the election, expecting a continuation of the positive economic environment and a post-election relief rally. Our economic and investment theses have played out, and equity markets have surpassed our expectations; the S&P 500 and Russell 2000 are both up 18% since we moved to an overweight on equities in April 2024. The recent strength in U.S. large- and small-cap equities has extended valuations and shifted the balance of risks at a time when we see building evidence of economic slowing. We have therefore made the decision to take some chips off the table by reducing our U.S. small-cap position to neutral versus our long-term strategic allocation and adding those proceeds to hedge funds (or liquid alternatives).
Shifting balance of risks
We have held an overweight to equities with the view that inflation would decline to the Federal Reserve’s (Fed) target, monetary policy would ease, and the economy would stick the soft landing. That view has largely played out. The September release of the Consumer Price Index (CPI) showed a year-over-year gain of 2.6%. That is expected to inch closer to 2% in next week’s October release. Outside of housing, inflation pressures have disappeared (Figure 1). We expect core inflation to hit the Fed’s target by the first quarter of 2025, giving them ample room to ease policy.
Figure 1: Outside of housing, inflationary pressures have disappeared
Data as of October 10, 2024. Source: Bureau of Labor Statistics.
Our 2025 economic and inflation baseline outlooks remain unchanged since prior to the election, though we acknowledge wider bands of uncertainty presented by policy discontinuity. Higher tariffs and immigration restrictions pose upside risk to prices, but it is unclear whether the Fed would react to these with higher rates. In particular, tariffs would result in more of a stepwise, one-time increase in goods prices, while immigration restrictions that limit the size of the labor pool could result in higher wages. This, in turn could be pushed through to higher prices of goods and services. There are still more questions than answers as policy details and timing are unclear, and we will dig deeper into these issues in our 2025 Capital Markets Forecast.
The U.S. economy materially exceeded expectations in 2024. Our GDP estimate for the year has been revised up by almost a full percent to 2.7%. We expect a slightly below-trend growth rate of 1.8% in 2025 but are cognizant of asymmetric risk to the downside. In other words, we think it is more likely that economic growth in 2025 will undershoot our baseline, rather than surprise to the upside. For several months we have noted a deterioration in credit quality for lower-quality borrowers. We continue to be attuned to signs of a more selective and discerning consumer, especially the lower-income cohort. Recently, we have become more concerned by the decline in labor demand (Figure 2). The unemployment rate and unemployment claims indicate that companies are not letting workers go in large numbers, but this could start to accelerate if job demand continues to move lower.
Figure 2: Labor demand continues to weaken
Shifting portfolios
Our heightened caution on the state of the economy is against a backdrop of extended valuations across asset classes. The equity markets have had a remarkable run, including since the election. If the year ended today, November 21, 2024, this would be the fourth year in six that the S&P 500 has returned more than 20%.; something that did not occur even during the tech bubble. U.S. large-cap equity market returns have exceeded earnings growth by approximately 20% this year, leaving valuations in the 96th–99th percentile versus their 15-year history, depending on the metric. Investor sentiment and positioning are also extended. As we look to the next 9–12 months, we believe the upside in equities is more limited.
These considerations have led us to take some risk off the table in a time of strength in the equity markets. We closed out our overweight to U.S. small cap, bringing that allocation to neutral versus our strategic asset allocation benchmark, and shifted the proceeds to hedge funds (or liquid alternatives). Smaller companies should continue to benefit from an easing of monetary policy, but any negative economic surprises would likely weigh on small cap more than large cap, as smaller companies have a higher sensitivity to economic growth. We expect 2025 to be a year of higher volatility for equities and fixed income. The defensive qualities of hedge funds make them more attractive in this type of environment rather than fixed income or cash. Investment-grade and high-yield fixed income face risks from rising long-term interest rates and compressed credit spreads. Cash will become less attractive with each successive rate cut from the Fed.
We are also rebalancing accounts back to tactical targets across asset classes. The recent market strength has resulted in a significant drift from our tactical asset allocation targets, with equities 1%–2% above our target (for a moderate risk profile) and fixed income approximately 1% below target. Asset class drift of this magnitude, if not addressed, can introduce unwanted portfolio risk. This is also a prudent long-term portfolio management strategy, as it reinforces contrarian investment thinking by buying the recent losers and selling the recent winners.
We now hold a very modest overweight to equities (Figure 3), favoring U.S. large cap over international developed equities. We continue to evaluate asset class tradeoffs to determine the most attractive destination for capital, which at this time we feel is closer to our strategic asset allocation benchmark. As details of trade, tax, and fiscal policies become clearer and investment opportunities arise in 2025, we will lean into our economic-led investment process to adjust portfolios as necessary.
Figure 3: Reducing equity risk in portfolios
High-net-worth portfolios with private markets*
Data as of November 19, 2024. Positioning reflects our monthly tactical asset allocation (TAA) versus the long-term strategic asset allocation (SAA) benchmark. For an overview of our asset allocation strategies, please see the disclosures.
*Private markets are only available to investors that meet Securities and Exchange Commission standards and are qualified and accredited. We recommend a strategic allocation to private markets we do not tactically adjust this asset class.
Disclosures
Facts and views presented in this report have not been reviewed by, and may not reflect information known to, professionals in other business areas of Wilmington Trust or M&T Bank who may provide or seek to provide financial services to entities referred to in this report. M&T Bank and Wilmington Trust have established information barriers between their various business groups. As a result, M&T Bank and Wilmington Trust do not disclose certain client relationships with, or compensation received from, such entities in their reports.
The information on Wilmington Wire has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. The opinions, estimates, and projections constitute the judgment of Wilmington Trust and are subject to change without notice. This commentary is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or a recommendation or determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on the investor’s objectives, financial situation, and particular needs. Diversification does not ensure a profit or guarantee against a loss. There is no assurance that any investment strategy will succeed.
Past performance cannot guarantee future results. Investing involves risk and you may incur a profit or a loss.
Indexes are not available for direct investment. Investment in a security or strategy designed to replicate the performance of an index will incur expenses such as management fees and transaction costs which will reduce returns.
CFA® Institute marks are trademarks owned by the Chartered Financial Analyst® Institute.
Any investment products discussed in this commentary are not insured by the FDIC or any other governmental agency, are not deposits of or other obligations of or guaranteed by M&T Bank, Wilmington Trust, or any other bank or entity, and are subject to risks, including a possible loss of the principal amount invested.
Wilmington Trust periodically adjusts the policy weights’ target allocations and may shift from the target allocations within certain ranges.
The asset classes and their current proxies are: • Large–cap U.S. stocks: Russell 1000® Index • Small–cap U.S. stocks: Russell 2000® Index • Developed international stocks: MSCI EAFE® (Net) Index • Emerging market stocks: MSCI Emerging Markets Index • U.S. inflation-linked bonds: Bloomberg US Treasury Inflation Notes TR Index Value Unhedged* • International inflation-linked bonds: Bloomberg World ex US ILB (Hedged) Index • Commodity-related securities: Bloomberg Commodity Index • U.S. REITs: S&P US REIT Index • International REITs: Dow Jones Global ex US Select RESI Index • Private markets: S&P Listed Private Equity Index • Hedge funds: HFRX Global Hedge Fund Index • U.S. taxable, investment-grade bonds: Bloomberg U.S. Aggregate Index • U.S. high-yield corporate bonds: Bloomberg U.S. Corporate High Yield Index • U.S. municipal, investment-grade bonds: S&P Municipal Bond Index • U.S. municipal high-yield bonds: 60% Bloomberg High Yield Municipal Bond Index / 40% Municipal Bond Index • International taxable, investment-grade bonds: Bloomberg Global Aggregate ex US • Emerging bond markets: Bloomberg EM USD Aggregate • Cash equivalent: 30-day U.S. Treasury bill rate.
Index Descriptions
The Bloomberg U.S. Aggregate Index measures the performance of the entire U.S. market of taxable, fixed-rate, investment-grade bonds. Each issue in the index has at least one year left until maturity and an outstanding par value of at least $250 million.
The Bloomberg U.S. High Yield Corporate Index, formerly known as Lehman Brothers U.S. High Yield Corporate Index, measures the performance of taxable, fixed-rate bonds issued by industrial, utility, and financial companies and rated below investment grade. Each issue in the index has at least one year left until maturity and an outstanding par value of at least $150 million.
The Bloomberg World Government Inflation-Linked Bond (WGILB) Index measures the performance of investment grade, government inflation-linked debt from 12 different developed market countries.
Bloomberg Commodity Index measures the performance of 19 futures contracts on physical commodities. As of the annual reweighting of the components, no related group of commodities (for example, energy, precious metals, livestock, and grains) may constitute more than 33% of the index and no single commodity may constitute less than 2% or more than 15% of the index.
The Dow Jones Global ex-U.S. Index is an equal-weighted stock index composed of the stocks of 150 top companies from around the world (excluding the U.S.) as selected by Dow Jones editors and based on the companies' long history of success and popularity among investors. The Global Dow is designed to reflect the global stock market and gives preferences to companies with global reach.
The HFRX Global Hedge Fund Index is designed to be representative of the overall composition of the hedge fund universe. It is composed of all eligible hedge fund strategies; including but not limited to convertible arbitrage, distressed securities, equity hedge, equity market neutral, event driven, macro, merger arbitrage, and relative value arbitrage. The strategies are asset weighted based on the distribution of assets in the hedge fund industry.
The MSCI All-Country World Index ex USA measures the performance of large- and mid-capitalization stocks in approximately 50 developed and emerging equity markets, excluding the United States.
The MSCI EAFE® (net) Index measures the performance of approximately 20 developed equity markets, excluding those of the United States and Canada. The total returns of the index are net of the maximum tax withholding rates that apply in many countries to dividends paid to nonresident investors.
The MSCI Emerging Markets Index captures large- and mid-cap representation across 26 emerging markets countries. With 1,198 constituents, the index covers approximately 85% of the free-float-adjusted market capitalization in each country.
Russell 1000® Growth Index measures the performance of those Russell 1000 Index companies with higher price-to-book ratios and higher forecasted growth values.
Russell 1000® Value Index measures the performance of those Russell 1000 Index companies with lower price-to-book ratios and lower forecasted growth values.
The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index. As of its latest reconstitution, the index had a total market capitalization range of approximately $128 million to $1.3 billion.
The S&P 500 Index is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States.
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