Bulls, Bears and Ballots
What's in store in '24?Download PDF
We recently sat down with Dominic Nolan, CEO of Aristotle Pacific Capital, to look at the bull and bear case for the markets this year, how the economy is shaping up, upcoming Fed moves, the 2024 elections, and opportunities in fixed income. We finished up with a speed round of questions and a personal reflection.
Market Performance: Total Return
Let’s start with the markets. What happened in December, and could you put 2023 in perspective?
December was a monster month for risk assets, and I think at the core of it is the markets believing the Fed’s rate hikes are over. I also think we’re seeing overzealousness in the markets about potential rate cuts in 2024.
As for performance last month and for 2023, the S&P 500 Index was up 4.5% in December and finished the year with a 26% total return. That’s an outstanding year led by the Russell 1000 Growth Index, specifically the Magnificent Seven. It finished up an amazing 40% for the year. I would also note in December, the S&P Equal Weight Index outperformed the S&P 500 Index for the first time in a while. That tells you that the average equity did better than the heavier-weighted stocks.
The standout performer for December was the Russell 2000 Index, up 12% on the month and up over 14% for the year. That index was up only 2% for the first 11 months of the year.
What about fixed income?
In December, the 10-Year Treasury yield went from 4.35% to 3.87%. As a result, the Bloomberg US Aggregate Bond Index (Agg) was up almost 4% for the month and finished up ~ 5.5% for the year. High yield was above coupon and bank loans were slightly above coupon for the month, both finishing up over 13% in 2023.
Overall, the S&P 500, the Agg and leveraged credit all did well. If you had a 60-40 (equities-fixed income) portfolio, you’d probably be up somewhere in the high teens.
S&P: Year-End Forecasts for 2024 by Major Banks
Looking at 2024, what are you most curious to see unfold?
One of my concerns is that the Fed is holding too tight to its 2% inflation target, despite all the COVID-19 money that has been released in the economy. I think there’s a case the Fed’s long-term inflation expectation needs to be adjusted. The risk to me is the Fed holds monetary conditions tighter for longer than needed because they’re targeting 2% inflation. It boils down to this: Will the Fed pivot preemptively or reactively? I think that will be at the core of how markets will perform over the next year.
10-Year Treasury Rates: Year-End Forecasts for 2024 by Major Banks
What's the bull case for 2024?
The bull case hinges on monetary conditions. If central banks ease domestically and globally, companies and consumers should be able to operate with less financial pressure. The S&P 500 Index could rally to over 5,000, and for fixed income, monetary conditions soften short rates, dropping them to 4%
to 4.5%, which is about 100 basis points from where we are today. Long rates hold steady, but the curve ends up being more normalized. The economy holds, bonds clip the coupon or slightly more, and equities rally. That’s the bull case today.
The bear case?
Outside of unforeseen tail risks, which are extremely difficult to underwrite. If monetary policy stays too tight, in theory investment contracts, unemployment goes up, and risk premiums elevate. You then have
the S&P 500 flat to down and the fixed-income curve is more inverted, further curtailing access to capital.
Do you fall in the bull or bear camp?
I’m going to waffle here. I’m in both camps, and here’s what I’m getting at. If you have a very bullish first half of the year and the Fed leaves rates higher for longer, then things start to level out or correct. If you have a very weak first half, the Fed can be more accommodative earlier, and then markets rebound from there. I do think 2024 will have different halves: one bull and one bear.
How would you sum up the U.S. economy in 2023?
First and foremost, the economy outperformed expectations. In October 2022, a very well-known publication said its models showed a 100% chance of a recession in 2023. They weren’t alone in that sentiment. There’s no doubt the economy outper-formed expectations. The results of the outperformance were higher equity markets and higher interest rates. Also, the labor market and consumer spending remained strong, though it’s now slowing.
As the year wrapped up, market expectations were that the Fed had reached the end of its rate-hiking cycle and would begin cuts within a year. This generated a substantial risk-assets rally to close the year.
GDP: Year-End Forecasts for 2024 by Major Banks
What do you think will be different in '24?
The narrative on the Fed has flipped from “When will rate hikes stop?” to “When will rate cuts begin?” Hopefully, liquidity starts to open up. Most GDP estimates, on average, show a much softer economic environment with growth ~1%.
Now do you think consumers will ease spending in 2024?
Yes is the short answer. COVID funds received beginning in 2020 are dwindling, you are seeing lower-income households start to struggle a bit and middle-income households with less discretionary money to spend.
Fed Funds: Year-End Forecasts for 2024 by Major Banks
What grade would you give the Fed in 2023?
I’d give them a B. When I think about their battle with market expectations a year ago, the market believed we were heading toward a recession and rates needed to be cut. But the Fed believed that inflation was going to be stickier and kept raising rates. We did not get a recession, and the Fed was on the right side of that trade. For that, they get high marks.
The reason I gave the Fed a B is I don’t think they needed to go as far as they did. I think the number of hikes in 2023 reduced their margin of error. We saw inflation numbers start to roll over halfway through the year. They knew the direction inflation was headed, but they still raised rates, and now you have a 5.5% fed funds rate. That’s too tight to me.
So has the inflation monster been slain?
I’ll say largely it has, but it’s subject to spikes with dislocations. Right now, we’re seeing shipping challenges in the Suez and Panama canals. Those things are inflationary because they disrupt supply chains. It may lead to certain spikes in energy or cost of goods.
There’s a caveat. I don’t think the prices that have appreciated over the past two or three years will be dropping anytime soon. From that standpoint, inflation is going to stick, but the rate of inflation will drop.
Let’s talk about the U.S. elections in November. How are they shaping up?
All right, let’s take a way-too-early look at the election. For the presidential election, 44 states are thought to be either solidly red or blue states, leaving six swing states to determine who will be the next commander in chief: Nevada, Arizona, Georgia, Michigan, Pennsylvania, and Wisconsin, which all voted for Biden in 2020. A New York Times/Siena College poll conducted a couple of months ago showed that Trump was ahead in five of the six swing states for the 2024 election.
I don’t think the poll reflects voters gravitating toward the contender. I believe it’s more disenchant-ment with the incumbent and the current administration. When faced at the ballot box with a binary outcome, voters may certainly change their preference, but right now, the poll indicates the challenger is ahead of the incumbent.
What about the House of Representatives and Senate?
Though all 435 seats are up for election, there are about 45 competitive seats. Right now, the GOP holds the slimmest of margins in the House, and the 2024 election for House seats is generally thought to be a tossup.
However, on the Senate side, where the Democrats currently hold the slimmest of majorities, 34 seats will be up for grabs. The math right now breaks down like this: The Democrats have 43 seats thought to be safe or likely to be safe; the Republicans have 50 of those seats. That leaves seven competitive seats with Republicans projected to be already holding 50, even without winning one of the contested seats. Given that, it’s going to be very difficult for the Dems to take the Senate.
What’s the most intriguing thing to you about this election?
The X factor might be the overturning of Roe v. Wade. Since that happened, when pro-choice forces have put abortion measures on the ballot, it has swung elections, even in red districts. Advocates of this strategy are calling it “Roe-vember.”
Where are you seeing opportunities in bonds today?
Over the past 12 months, you got above-coupon returns on bank loans and high yield. For the Bloomberg US Aggregate Bond Index, you had coupon-like returns.
With rates longer-term rates dropping substantially in the last part of the year, the floating-rate trade is more attractive today. I continue to like the “barbell” strategy, which is a combination of longer duration investment-grade corporate bonds with floating-rate loans. When longer-term rates go up, you move a little bit of exposure from loans over to investment- grade corporate bonds and vice versa. The
floating-rate trade has been the contrarian trade for a while and it has worked well.
Even heading into this year, the coupon for bank loans is still 10%. The Fed is expected to make three to four cuts, which means you lose ~1% off of that, but you don't lose 1% for the year, you lose a quarter to a half a percent giving timing. But you hedge recession risk with duration.
High-yield bonds have gained a lot of ground in the last couple of months and the yield’s now about 7.5%. When yields on bank loans are higher than high yield by this amount, I tend to like the floating-rate story a bit more.
Let's shift gears and move to lightning round. Bitcoin versus gold in 2024. What do you think?
I'll take Bitcoin.
Magnificent Seven versus the rest of the S&P 500 Index?
I'm taking the S&P.
Oil was at $70 per barrel at the end of the year. Does it finish 2024 above or below $70?
I’ll take the under.
What television shows are you watching?
"Reacher" and rewatching some "Game of Thrones."
BYD versus Tesla electric vehicles?
BYD stands for Build Your Dreams. It’s a Chinese electric car manufacturer. When I started to look at BYD’s specs, the costs, the refueling or the recharging, I feel like they’ve disassembled a Tesla five years ago and then rebuilt it their own way. To me, Tesla to me will stay ahead on technology and reliability. Given that though, China has a ton of resources and a huge market base. It’ll be interesting to see if they can sell in Europe. I think it will be some time before Americans will trust a Chinese electric car manufacturer.
As a kid, what did you imagine 2024 to look like?
I was a kid in the ’80s. I thought we would’ve had faster, more impressive vehicles—meaning cars, trains, airplanes and passengers in space given we had the Space Shuttle. But those haven’t really changed much.
On a smaller scale, I never thought we’d be able to do what we can now do on a phone. The power of what you hold in your hand to me is unbelievable.
What are the chances of you keeping your New Year's resolutions?
There's a 100% chance I'll keep them, but about a 40% chance I'll complete them.
Super Bowl winner?
I think the San Francisco 49ers are such a talented team, and the Baltimore Ravens are a juggernaut right now. As for the winner, I’ll take the Niners.
Let’s close it with a personal reflection.
I’ve found that many times we hold promises to ourselves in lower regard than we hold promises to others. You hear, “I promised this person, so I have to keep it.” But when we make promises to ourselves, we don’t hold ourselves to that same accountability. My hope is that we hold promises to ourselves in the same regard as we hold promises to others. I think if you do that, you’ll end up being able to give more to others.
10-year Treasuries are bonds issued by the U.S. government and have a maturity of 10 years.
The Federal Reserve’s accommodative monetary policy is triggered to encourage more spending from consumers and businesses by making money less expensive to borrow through the lowering of short-term interest rates.
Bank loans (or floating-rate loans) are financial instruments that pay a variable or floating interest rate. A
floating rate fund invests in bonds and debt instruments whose interest payments fluctuate with an underlying interest-rate level.
The barbell strategy is an investment concept that suggests that the best way to strike a balance between reward and risk is to invest in the two extremes of high-risk and no-risk assets while avoiding middle-of-the-road choices.
One basis point equals 0.01%.
The Bloomberg US Aggregate Bond Index (Agg) is composed of investment-grade U.S. government bonds, investment-grade corporate bonds, mortgage pass-through securities, and asset-backed securities, and is commonly used to track the performance of U.S. investment-grade bonds.
Bonds are debt instruments and represent loans made to the issuer. Governments and corporations commonly use bonds in order to borrow money.
To receive the interest payments, bondholders clip off each coupon as its payment came due and redeem it for cash.
A coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity.
The federal funds rate is the interest rate that banks charge each other to borrow or lend excess reserves overnight.
The Gross Domestic Product (GDP) growth rate compares the year-over-year (or quarterly) change in a country’s economic output to measure how fast an economy is growing.
High-yield bonds (or junk bonds) are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds.
An inverted yield curve is an unusual state in which longer-term bonds have a lower yield than short-term debt instruments.
Investment grade refers to the quality of a company’s credit. To be considered an investment grade issue, the company must be rated at ‘BBB’ or higher by Standard and Poor’s or Moody’s.
A leveraged loan or leveraged credit is one that is extended to companies that already have considerable amounts of debt or a poor credit history.
The Magnificent Seven tech stocks are Apple, Alphabet, Microsoft, Amazon, Meta, Tesla, and Nvidia.
Maturity is the date on which the life of a transaction or financial instrument ends, after which it must either be renewed or it will cease to exist.
A risk asset is any asset that carries a degree of risk.
The risk premium is the excess return above the risk-free rate that investors require as compensation for the higher uncertainty associated with risky assets.
The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-value ratios and higher forecasted growth values.
The Russell 2000 Index measures the performance of the 2,000 smaller companies that are included in the Russell 3000 Index, which itself is made up of nearly all U.S. stocks.
The Russell 2000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell1000 companies with lower price-to-book ratios and lower expected growth values.
The S&P 500 Index is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States.
Tight or contractionary monetary policy is a course of action undertaken by a central bank such as the Federal Reserve to slow down overheated economic growth, to constrict spending in an economy that is seen to be accelerating too quickly, or to curb inflation when it is rising too fast.
The U.S. Treasury yield curve refers to a line chart that depicts the yields of short-term Treasury bills compared to the yields of long-term Treasury notes and bonds.
U.S. Treasury rates or yield is the effective annual interest rate that the U.S. government pays on one of its debt obligations, expressed as a percentage.
Yield is the income returned on an investment, such as the interest received from holding a security.
A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity.
Any performance data quoted represent past performance, which does not guarantee future results. Index performance is not indicative of any fund's performance. Indexes are unmanaged and it is not possible to invest directly in an index. For current standardized performance of the funds, please visit www.AristotleFunds.com.
The views expressed are as of the publication date and are presented for informational purposes only. These views should not be considered as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment or market. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant.
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