It’s been over a year since the Federal Reserve paused its rate hikes—a moment we believed would be a turning point for markets. The data backs it up: over the past twelve months, a US balanced 60/40 portfolio of equities and bonds surged, delivering returns of more than 26% through 30 September 2024, using the S&P 500 Index for equities and Bloomberg US Aggregate Index for fixed income as proxies.
In contrast, cash-like investments, such as a one-year CD barely hit 5%. The lesson learned is clear: investing should be about taking a long-term perspective in pursuit of long-term goals. For those who may have missed that upside, has the opportunity passed? We don’t think so.
The Fed is just getting started, and bonds should benefit.
The US central bank has made its path forward crystal clear: It is in rate-cutting mode. Monetary policymakers in the United States surprised many investors in September with a more aggressive 50-basis-point cut in its policy rate, rather than a more modest 25. It has projected another 50 basis points of cuts this year and an additional 100 in 2025. The market expectation is slightly lower, predicting roughly 125 basis points of cuts over the next five quarters, as of 28 October 2024. Many other major developed market central banks have also begun cutting as inflation pressures wane.
With bond yields lower than they were a year ago, investors might worry they’ve missed their chance. However, recent increases in rates provide another entry point, and history has shown that potential upside for bond investors persists following the start of Fed cuts. To be sure, past performance is not necessarily predictive of future performance. But historically, while bond yields declined in the period before the first cut, they continued to fall after that key pivot as well.
Bond yields have continued to fall after the first rate cut.
Declining yields are a key tailwind for fixed income returns, since bond prices rise when yields fall. That is a major reason why bond returns were so strong over the past year. The two- and ten-year US Treasury yields were down 140 and 79 basis points over the 12 months ending in September. Markets began to anticipate Fed cuts, yields moved lower across the Treasury curve, and bond returns benefited.
As the Fed continues cutting, history suggests that yields could continue to drift down. Of course, if the US economy hits an unexpected soft patch, the Fed could cut even more aggressively to combat rising unemployment. Importantly, rising bond prices are only one component of total returns in fixed income — and current market yields offer investors compelling income opportunity across a range of fixed income investments.
Here, investors could consider a high-quality bond fund with a moderate duration (a measure of interest rate exposure). Such a position would seek to take advantage of attractive current yields and the potential for capital appreciation as yields fall, while also providing diversification from equities if faced with unanticipated volatility. There are multiple paths to strong fixed income returns. If the Fed cuts more gradually from here, yields across corporate, securitised and other sectors could remain attractive relative to levels over the past decade. And if a soft landing is achieved, credit should thrive.
Some stocks have become expensive, but we still see opportunities.
We are seeing some mixed signals in equity markets, but at this point it looks like the Fed has managed to usher in lower inflation without jarring the economy into recession. Its cuts may help to reduce discount rates and provide some support for today’s high equity valuations. However, we are being selective and relying on our analysts’ fundamental research on sectors and companies.
For example, some of the largest 50 or so companies continue to dominate indices. Yet recent valuations and projected earnings indicate that growth may slow for some companies, specifically for the Magnificent Seven (Apple, Microsoft, Amazon, NVIDIA, Alphabet, Tesla, Meta).
Given this broadening of the markets, a few areas, such as aerospace equipment and biotechnology, may be of particular interest to investors. Travel has recovered to pre-pandemic levels, and a nearly decade-long backlog of passenger aircraft remains to meet the growing demand for air travel. For biotechnology, we are finding select companies developing gene therapies and other innovative treatments to address previously difficult to treat conditions.
Opportunities exist even in a narrow market.
The infrastructure required to build out data centres for artificial intelligence is an area of interest. The power needed for those data centres and growing penetration of electric vehicles is increasing electricity demand for the first time in 20 years. As power production rises while transitioning away from coal-powered generation, we see increased demand for nuclear power generation, natural gas generation, and batteries to increase the reliability of wind and solar.
Given this backdrop, we seek to target the right sectors and companies we believe will continue to produce strong relative returns. On a path of positive economic growth, we expect holdings to thrive.
Investors have better opportunities to reach their goals when invested.
After the turmoil of 2022, many investors understandably sought the safety of cash. However, with markets rebounding and rates falling, the case for re-entering equity and fixed income markets is compelling. Sitting on cash-like holdings has become less attractive as yields decline and opportunities for growth become clearer.
